1. The Basics of Risk Management
CHAPTER1
The Basics of Risk Management

2. INTRODUCTION Banks make money in one of two ways
providing services to customers
taking risks
In this book we address the business of making money by taking risk
Bank takes more risk it can expect to make more money
Greater risk also increases the danger that the bank could lose badly and be forced out of business

3. The risk–return relationship in banks
While a positive risk-return relationship is presented for profitable banks, the risk-return relationship is negative for profitless banks
In theoretical, a bank taking a relatively high risk is supposed to earn high profits
However, bankruptcy costs may be relatively high for a bank maintaining higher risk exposure

5. INTRODUCTION Banks must run their operations with two goals in mind
generate profit
stay in business.
Two goals of risk management in this book
Decide bank’s economic capital
Ensure that the risk being taken is matched to the bank's capital
The bank’s capital is much enough to absorb the losses of bad situations
Allocate bank’s economic capital
Help the CEO direct the limited resource of capital to the opportunities that are expected to create the maximum return with the minimum risk

6. INTRODUCTION
Risk measurement attempts to answer the following four questions:
How much could we lose?
Calculate the risk measure
Can we absorb a significant loss without going bankrupt?
Decide the economic capital
Is the return high enough for us to take that risk?
Calculate the return after considering risk
How can we reduce the risk?
Risk hedge by some financial instruments in the market (SWAP, Option, Forward and Futures)
Diversification

7. THE ORGANIZATIONAL STRUCTURE OF A TYPICAL BANK
banks are typically organized into five divisions
corporate banking
retail banking
asset management
Insurance
support.

8. The corporate banking division deals with other financial institutions and corporate clients such as large, industrial corporations.
deals with the mass of personal customers :

9. THE ORGANIZATIONAL STRUCTURE OF A TYPICAL BANK
Sales and Trading Group:
Activities:
Sells securities to investors, trades securities with other banks
Risks
market risk and liquidity risk in trading
ALM desk
manages the bank's asset and liability mismatch
Interest rate and liquidity risk in funding

10. The 7% spread between the loans and deposits should cover
the administrative costs
the credit loss on the loan
the interest-rate and liquidity risks due to the mismatch

11. There is a key problem with this situation:
It is not possible to attribute profitability/risk separately

12. THE ORGANIZATIONAL STRUCTURE OF A TYPICAL BANK
The commercial finance group
Activities:
Provides loans to company
Advises companies on their financial structures
For example, if a company wanted to fund a new venture, the commercial finance group would advise it on whether to use debt or equity to raise money
Risks
Credit risk or Default risk
Company borrowers are unable to pay money back to bank

13. THE ORGANIZATIONAL STRUCTURE OF A TYPICAL BANK
Retail Banking
Activities
take deposits from customers in the form of checking accounts, savings, and fixed deposits, then lend funds to other customers in the form of mortgages, credit cards, and personal loans
The division makes a profit by giving low interest rates to depositors and charging high interest rates to borrowers
Risk
Credit Risk or default risk
Retail borrowers are unable to pay money back to bank

14. HOW BANKS CAN LOSE MONEY
Market Risk
Sales and Trading Group
Sells securities to investors, trades securities with other banks and in markets
Market risk arises from the possibility of losses resulting from unfavorable market movements
Losing money because the value of an instrument has changed
Market risk factors:
Stock price: for example, in a recession period, the S&P 500 index fall down, then the price of the security a bank holds will fall down as well
Exchange rate: for example, if a bank holds a foreign bond, and the foreign currency depreciate
Interest rate: for example, if a bank hold a bond, and the interest rate increase

15. HOW BANKS CAN LOSE MONEY
Credit Risk
arises from defaults, when an individual, company, or government fails to honor a promise to make a payment
There is a gray area between market risk and credit risk
The price of corporate bonds falling down is due to the markets predicting the probability of a corporate default will increase
The risk before the default happens: market risk
The actual default: credit risk
Forms of Credit risk
Default on a loan: failure to repay an amount that has been lent
Default on a bond: bond issuer fails to make the payments promised by the bond.

16. HOW BANKS CAN LOSE MONEY
Operating Risk
the risk of direct or indirect losses resulting from inadequate or failed internal processes, people and systems or from external events
Operating risk includes fraud and the possibility of a mistake being made

17. HOW BANKS CAN LOSE MONEY
Blends of Risks
Often banks will lose money from an incident that involves several forms of risk
The case of Barings bank
Nick Leeson was a trader in the Singapore branch of Barings bank. He had seemingly generated 20% of Barings' profits in 1994
In fact, he had been making losses and hiding them in a fictitious account. (Operating risk)

18. HOW BANKS CAN LOSE MONEY
To recover the losses he tried a large, risky gamble with derivatives on the Nikkei 225. (Market risk)
In 1995, he lost $1 billion and consumed out Barings' capital. He was able to hide the original losses because he was in charge of both trading and accounting in the Singapore office. (operation risk)
He was able to take the final gamble because senior management had no effective measurement of the risks being taken.

19. HOW BANKS CAN LOSE MONEY
Most of this book will concern risk management and measurement at the transaction and business-unit levels
Several Risks we will discuss in this book
trading risks or market risk
asset/liability management
credit risk
operating risk

20. MANAGING RISK AT THE MACRO LEVEL
three keys for risk-management:
deciding the target debt rating
determining the amount of available capital
allocating risk limits to each business unit within the bank

21. MANAGING RISK AT THE MACRO LEVEL
Determining the Target Debt Rating
The debt rating is a measure of the bank's creditworthiness and corresponds to the bank's probability of default
A high debt rating corresponds to a low probability of default
For example, AAA-rated Bank vs. A-rated Bank
The bank's creditworthiness is determined by
(1)the amount of risks a bank takes
(2)the amount of capital a bank hold
Capital is the difference in value between the bank's assets and liabilities. It can be viewed as the current net worth of the bank

22. MANAGING RISK AT THE MACRO LEVEL
If the bank has a small amount of capital and takes a large amount of risk, there is a high probability that the losses will be greater than the capital, and the bank will go bankrupt
If the bank wants a high rating, it must hold a large amount of capital in relation to its risks.
But a bank have to pay cost for holding extra capital in hand
For example, by given fixed total profit of a bank, the average profit for per capital will decreases when the amount of capital increases
A low target debt rating has the advantage that the bank can take on many risks and expect to earn a high rate of return for the shareholders.
However, a low debt rating means that debt holders will charge higher interest rates to lend their money to the more risky bank

23. MANAGING RISK AT THE MACRO LEVEL
To conclude, a bank have to decide a suitable debt rating for itself and then decided the economic capital it has to prepare

24. Determining the Amount of Available Capital
The available capital is the current value of the assets minus the current value of the liabilities
Capital = Nominal Asset Value-Liabilities
If the board wishes to increase the capital quickly, it can do so by issuing more bank shares
This gives the bank more cash without increasing the liabilities to avoid default.
Alternatively, the capital can be increased over several years by retaining earnings and not paying dividends to shareholders

25. Allocating Risk Limits
Once the target debt rating is set and the amount of available capital has been calculated, the bank's total risk capacity is fixed
The next question is how to allocate the total risk capacity to the different business units
trading, credit cards, and corporate lending

26. Allocating Risk Limits
In doing this it must consider
the expected return and risk from each unit
the diversification of the risk between units
In general, we will allocate most (not all) of the risk capacity to the units that are expected to make the highest returns