1. Mrs.Shefa El Sagga F&BMP110/2/2010

2. 3.5.5. Problems with the VaR Approach   Bankers The first problem with VaR is that it does not give the precise amount that will be lost. However, it gives no indication as to how much VaR will be exceeded..   Second, the simpler VaR models depend on the assumption that financial returns are normally distributed and uncorrelated. Mrs.Shefa El Sagga F&BMP210/2/2010

3. 3.5.6. Stress Testing and Scenario Analysis to Complement VaR   Given the limitations of VaR, most banks apply scenario analysis and stress testing to complement estimates of market risk produced by VaR. Banks begin by identifying unfavorable scenarios which cause changes to the value of one or more of the four risk factors, 1. interest, 2. equity, 3. currency or 4. commodity prices.   The stress test, based on a scenario, computes how much a bank’s portfolio could lose. Which estimates the maximum amount that a portfolio, security or business unit (of the bank) could lose over a specified time period. Mrs.Shefa El Sagga F&BMP310/2/2010

4. 3.6. Management of Credit Risk 3.6.1. Background 3.6.2. Credit Risk Decisions: Retail versus Corporate 3.6.3. Minimizing Credit Risk 3.6.4. Assessing the Default Risk of Individual Loans 3.6.5. Aggregate Credit Risk Exposure and Management 3.6.6. Default Mode Approach 3.6.7. Credit Value at Risk 3.6.8. Financial Innovation and Risk Management. 3.6.1. Background   Credit risk is the ‘‘bread and butter’’ of most commercial banks. Every commercial bank, by definition, has a loan portfolio. Increases in credit risk will raise the marginal cost of debt and equity, which in turn increases the cost of funds for the bank. Mrs.Shefa El Sagga F&BMP410/2/2010

5. 3.6.2. Credit Risk Decisions: Retail versus Corporate   If a bank is looking to minimize its aggregate credit risk, then good risk management of retail and corporate lending is essential. Because a corporation is able to produce a variety of financial ratios.   Most bankers concede that lack of information makes retail lending more difficult than corporate lending. On the other hand, loans to corporate which turn out to be bad can be very serious for the bank because of the large sums involved. Mrs.Shefa El Sagga F&BMP510/2/2010

6. 3.6.3. Minimizing Credit Risk   There are five key ways a bank can minimize credit risk, through: 1. 1.Accurate loan pricing, 2. 2.Credit rationing, 3. 3.Use of collateral, 4. 4.Loan diversification and 5. 5.More recently through asset securitization and/or the use of credit derivatives. Mrs.Shefa El Sagga F&BMP610/2/2010

7. 3.6.4. Assessing the Default Risk of Individual Loans   If a bank is unable to obtain information on a potential borrower (using, annual reports), it is likely to adopt a qualitative approach to evaluating credit risk, which involves using a checklist to take into account factors specific to each borrower: 1. 1.Past credit history. 2. 2.The borrower’s gearing (or leverage) ratio. 3. 3.The wealth of the borrower. 4. 4.Whether borrower earnings are volatile. 5. 5.Employment history. 6. 6.Length of time as a customer at a bank. 7. 7.Length of time at a certain address. 8. 8.Whether or not collateral or security is part of the loan agreement. 9. 9.Whether a future macroeconomic climate will affect the applicant’s ability to repay. Mrs.Shefa El Sagga F&BMP710/2/2010

8. Continue:   Along a similar vein, Sinkey (2002) singled out what he calls the ‘‘fives Cs’’ to be used in a qualitative assessment of credit risk. 1. 1.Character: Is the borrower willing to repay the loan?. 2. 2.Cash flow: Is the borrower reasonably liquid?. 3. 3.Capital: What assets or capital does the borrower have?. 4. 4.Collateral or security: Can the borrower put up security (a house, share certificates which will be owned by the bank in the event of default)?. 5. 5.Conditions: What is the state of the economy?. Mrs.Shefa El Sagga F&BMP810/2/2010

9. 3.6.5. Aggregate Credit Risk Exposure and Management   There All banks will want to manage their aggregate credit exposure. Assessing aggregate credit exposure, four factors should be taken into account in any model of credit risk are: 1. 1.Compute the expected loss levels over a given time, for each loan and portfolio as a whole. 2. 2.Compute the unexpected loss for each loan, and the volatility of loss. 3. 3.Determine the volatility of expected loss for the portfolio as a whole. 4. 4.Calculate the probability distribution of credit loss for the portfolio, and assess the capital required, for a given confidence level and time.. Mrs.Shefa El Sagga F&BMP910/2/2010

10. 3.6.6. Default Model Approach   Default model approach draws on modern portfolio theory to measure a bank’s aggregate credit exposure for non-traded assets, such as loans on the banking book.   There must be data on the expected return on the assets, the risk of the asset (measured by the standard deviation), and the correlation between the risks of the assets. Mrs.Shefa El Sagga F&BMP1010/2/2010

11. 3.6.7. Credit Value at Risk   Credit metrics, is a marked to market approach, focusing on a loan loss value and/or a risk–return trade-off for a portfolio of debt. 3.6.8. Financial Innovation and Risk Management   The financial products are examples of recent financial innovations. Like the manufacturing sector, financial innovation can take the form of process innovation, whereby an existing product or service can be offered more cheaply because of a technological innovation.   Product innovation involves the introduction of a new good or service. Mrs.Shefa El Sagga F&BMP1110/2/2010

12. 3.7. Risk Management by Major Global Bank   Barclays Bank plc very kindly agreed to provide information on how a major global bank actually manages its risk. Barclays is a long-established British bank, headquartered in London but with major global operations. Barclays classifies risk into four categories: credit, market, non-financial and other risk. 1. 1.Credit Risk is defined as the risk that customers will not repay their obligations, and is divided into retail and wholesale risk. 2. 2.Market Risk is the risk of loss due to changes in the level or volatility of market rates or prices such as interest rates, foreign exchange rates, equity prices and commodity prices. Mrs.Shefa El Sagga F&BMP1210/2/2010

13. Continue: 3. 3.Non-financial Risk consists of operational risk, and business risk, defined as the potential to incur a loss. 4. 4.Other risk includes risks arising from all other sources, such as property, equipment, and so on. Mrs.Shefa El Sagga F&BMP1310/2/2010

14. Assignment : Course management of financial and banking operations.  Choose a Bank In the Gaza Strip and conduct empirical study on it. Consider the following elements: 1.Identify the name, Origin, life cycle, its branches, and partners it has. 2.The traditional banking activities, and services bank offered. 3.The modern banking activities, and services bank offered. 4.Types of risks the bank suffered. 5.How to manage each risk separately. 6. Relationship with the Central Bank. 7.What future strategies they plan (expansion, close-down)?.and why?.  Be practical you need to visit the Bank in the field.  Two students can join efforts in one assignment. Mrs.Shefa El Sagga F&BMP1410/2/2010