AMERICAN COLLEGE

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• AMERICAN COLLEGE
• S K O P J E
•   PRINCIPLES OF BANKING
• Chapter 7
•  Instructor Tome Nenovski, Ph. D.

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7. RISKS IN BANKING

• - First bank interest Profitability and shares
  market value increase
• - Second (by importance) bank interest Locating
  (certifying their presence), measuring and
  managing risks
• - Risk definition Uncertainty in realizing
  expected money inflows in future
• - Reasons for intensifying bank risks market
  volatility, bank competition, bank innovations

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• 7. RISKS IN BANKING
• - Banking risks are certain. It is uncertain in
  which quantity and at what period of time they
  will appear in future
• - By projecting and controling future bank
  costs, present and future bank income would be
  protected
• -By treating risks the right way, possible
  future bank losses would be treated right, way as
  well
• - Serious tasks for banks Need for continous
  risk management as a manner for reaching basic
  bank goals

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• 7.1.Types of risks
• - Different bank risks categorizations depending
  on the reasons that cause them
• - Most important for all banks are interest
  rate risk, credit risk and operational risk.

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• 7.1.1. Interest rate risk
• - Definition Bank financial performance
  sensitivity to interest rate changes
• - Interest rate changes have direct influence to
  bank profitability and solvency
• - Interest rate risk appears when short time
  rates will be increased (bank costs as well) and
  long-term interest rates will stay relatively
  unchanged (assets and liabilities term of
  maturity dismatch)

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• 7.1.1. Interest rate risk
• 7.1.1.1. Interest rate risk appearance forms
• a) Refinancing risk
• b) Reinvesting risk
• c) Market risk (bank assets and liabilities
  market value is equal to present value of their
  current and future cash flow)
• d) Risk of paying credits before maturity term
  or drawing deposits

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• 7.1.1. Interest rate risk
• 7.1.1.2. Interest risk measurements
• a) The reprising model
• - Interest sensitivity Assets and Interest
  sensitivity gap
• - Example Assets 40 mil.
• Liabilities 30 mil.
• Gap 10 mil.
• Interest rate increase by 1 p.p.
• Negative interest margin effect of 100.000
• (10 mil. X 1 100.000)

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• 7.1.1. Interest rate risk
• 7.1.1.2. Interest risk measurements
• a) The reprising model/2
• Downside of the model
• - It ignores market value of the interest rate
  changes effect
• - It is too aggregate
• - It does not take into account paying credits
  before their term of maturity or drawing
  deposits
• - It neglects cash flows from off-balance bank
  activities.

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• 7.1.1. Interest rate risk
• 7.1.1.2. Interest rate risk measurements
• b) The maturity model
• - Reflects the economic reality or real assets
  and liabilities value
• - Marking the market
• - Interest rates increase cause decrease of
  assets and liabilities market value
• - If assets and liabilities term of maturity is
  longer, each interest rates increase will cause
  bigger decrease of their value
• - Dangerous for shareholder capital

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• 7.1.1.2. Interest rate risk measurements
• b) The maturity model/2
• Example
• A (three year bonds) 100 mil. L (one year
  bonds ) 90 mil.
• C 10 mil.
• Interest rate increases from 10 to 11.
• Results A decreases for 2,44 (100 2,44
  97,56 mil.)
• L decreases for 0,90 (90 0,82 89,19 mil.)
• C decrease from 10 to 8,37 mil. (97,56
  89,19).

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• 7.1.1.2. Interest rate risk measurements
• c) Simulation models
• - Static simulations
• - Dynamic simulations

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• 7.1.1.2. Interest rate risk measurements
• d) Duration model
• - Most complete and best interest rate
  sensitivity measure
• - Duration gap between assets and liabilities
  cash flow
• - Most important thing of this model is very
  precise time determination of inflows/outflows
  for securing better bank immunization of interest
  rate risk.
•  

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• 7.1.1.2. Interest rate risk measurements
• d) Duration model/2
• - Example A 100 mil. Average A
  duration 5 years
• L 100 mil. Average L duration 3 years
• Ad Ld 2 years
• Comment For each IR increase by 1 p.p., bank
  economic value will be decreased for 2 mil. (2 x
  0,01 x 100 mil.).
• - Interest rate risk decreasing is possible by
  assets duration decrease or by liabilities
  duration increase.
•  

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• 7.1.1. Interest rate risk
• - Basic bank strategy for interest rate
  management
• - everyday management with assets and
• liabilities gap
• - Credit portfolio diversification
• - Interest rates revision in determined time
• intervals
• - Usage of financial derivatives.
•  

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• 7.1.2. Credit risk
• - The importance of credits (80 od total bank
  assets)
• - Definition Possibile bank debtors not to
  fulfil their credit obligation in accordance to
  the agreed terms
• - Credit risk could be devided in three parts
• - Default risk
• - Exposure risk
• - Recovery risk.

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• 7.1.2. Credit risk/2
• - Need for credit request estimation at its
  early phase for determining possible credit risk
  elements
• - Different methods for client credit
  capabilities estimation (6Cs, CAMPARI, SWOT)
• - Method of 6Cs Character Capacity Cash
  Collateral Conditions Control
• - Method of CAMPARI Character Ability
  Means Purpose Amount Repayment Interest and
  Insurance
• - SWOT analysis Strengths Weaknesse
  Opportunities Threats
• - Long-term credits represent the most complex
  bank risk (they include all the other bank risks
  by themselves).
•  

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• 7.1.2.1. Credit risk measurement models
• 1) Qualitative models for measuring default
  credit risk
• a) Information on bank client (his credit
  reputation, leverage volatility of his
  profitability collateral etc.)
• b) Other information (market interest rates
  movements..)

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• 7.1.2.1. Qualitative models for measuring default
  credit risk
• 2) Quantitative models
• - Credit Scoring models
• a) Linear probability model
• b) Logit models
• c) Linear discrimination models
• - RAROC CreditMetrix Credit Risk .

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• 7.1.2.2. Models for measuring credit exposure
  risk
• a) Migration analysis
• b) Credit concentration limit
• c) Modern Portfolio Theory (MPT)
•  

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• 7.1.2.3. Credit risk mangament
• - Goal Maximizing risk-weighted bank revenue
• - Different stategies for credit risk
  management
• a) Selecting credit requests
• b) Credit limits
• c) Qualitative collateral
• d) Credit portfolio diversification
• e) Financial derivatives
• f) Adequate credit pricing.

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• 7.1.3. Operational risk
• - Technological risks
• - Staff risk
• - Operational risk is included in other bank
  risks.

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• 7.1.4. Other banking risks
• a) Liquidity risk
• - Definition Impossibility for the bank to face
  its liabilities at every moment
• - It is result of the gap between assets and
  liabilities
• - Classical cases of liquidity risk appearance
• - sudden deposit withdrawal from the bank
  (disintermediation)
• - Unexpected pay off of a certain off-balance
  obligation (guarantee, letter of credit etc.)
• - Ways for overcoming the risk
• - selling part of bank less liquid assets
• - borrowing fund at the money market.

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• 7.1.4. Other banking risks
• b) Foreign exchange rate risk
• - It is a result of disequilibrium between bank
  foreign assets and liabilities (open foreign
  exchange position)
• - Two ways of foreign exchange rate changes and
  influence appreciation and depreciation of
  foreign currency
• - Ways for foreign exchange rate risk
  protection
• - equalizing foreign exchange assets and
  liabilities
• - internal foreign exchange limits
• - financial derivatives
• - open foreign exchange position limits
  imposed by
• supervision body.

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• 7.1.4. Other banking risks
• c) Market risk
• - Changes in market interest rates, foreign
  exchange rates, public demand for bank services,
  monetary policy etc.
• - It is shown whenever banks trade with some
  assets (bond, for example) or liabilities
  (shares, for example)
• - There is a need for the bank to follow market
  movements and mark its instruments.

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• 7.1.4. Other banking risks
• d) Inflation risk
• - Definition Risk of possible real inflation
  rate increase over the expected one
• - Consequences
• - Deposit disintermediation
• - Decrease of net-debtors obligations
• - Risk for bank profitability and bank value
• decrease
• - The importance of Fisher equation.

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• 7.1.4. Other banking risks
• e) Country or Sovereign risk
• - Country moratorium on credit payment because
  of country macroeconomic problems
• - Protection
• - Bank investment dispersion on different
• countries
• - Limits for investing money in
• particular countries
• - List of countries not to
  invest money in
• - Deep analyses of information on particular
• country.

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• 7.1.4. Other banking risks
• f) Off-balance risk
• - Letters of credit
• - Guarantees
• - Financial derivatives.
• g) Insolvency risk.

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• 7.2. Banking risks management
• - Optimizing the relations (trade off) risk and
  return
• - Two way bank approach
• a) Risk taking
• b) Risk aversion approach

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• 7.2. Banking risks management
• - Tehnology of risk management consists of five
  phases
• 1) Risk identification
• 2) Risk measurement (the importance of Value at
  risk
• VAR and Capital at risk CAR
  coefficients)
• Nominal interest rate (1 r)
  (1 i) (1 ir) (1 kr) (1
• or) (1 dr)..
• 3) Risk control
• 4) Risk following
• 5) Risk eliminating (moving out).

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• 7.2. Banking risks management
• 7.2.1. Financial derivatives
• - Innovation in banking risks
• management
• - Together with securitization
• they are considered as most perfect
• financial innovation

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• 7.2.1. Financial derivatives
• 7.2.1.1. Financial term agreements
• - Definition Agreements between buyers and
  sellers of assets in change for money payment in
  future
• - Goal Transfer interest rate risk, foreign
  exchange rate risk and credit risk from investors
  (in this case banks) to others entities that are
  ready to accept risk
• - Two types Forwards and futures.

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• 7.2.1.1. Financial term agreements
• a) Forwards
• - Definition An agreement between buyer and
  seller of some assets in change for money in some
  future, precisely determined day on a previous
  precisely determined price
• - Example (selling some bond)
• - Usage Protection from interest rate and
  foreign rate risk
• - Advantage Bank asset is immunized from
  intrest rate risk (bank net-interest rate
  expossure is zero)
• - Weaknesses 1) There is no mediator b)
  Agreements are not tradable on secundary market
  c) Danger of not fulfilling the agreement
  obligation.

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• 7.2.1.1. Financial term agreements
• a) Futures
• - They are similar to forwards
• - Their selling price is not fixed
• - There is a mediator in signing that kind of
• agreemets
• - Futures are tradable on secondary market
• - Their fulfilment is controled by special
• regulatory body.

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• 7.2.1.1. Financial term agreements
• a) Futures/2
• - Basis, Spot price (Pst) and Future price
  (Pft)
• - Basis Pst Pft
• - Basic risk
• - Particular assets risk protection (Micro
• protection)
• - Total assets risk protection (Macro
• protection)

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• 7.2.1.1. Financial term agreements
• a) Futures/3
• - Future price for different financial
  instruments is expresserd in index points and is
  calculated on the basis of inverse relation
  between those instruments prices and relevant
  interest rates

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• 7.2.1.2 Options
• - Definition Agreement between two parties in
  which one party gives a right but not an
  obligation to the other party to buy or sell some
  assets on agreed price in a specified period of
  time
• - Call option
• - Put option
• - American and european options

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• 7.2.1.2.Options/2
• - The option price is determined by the relation
  between market price of some assets and option
  agreed price (exercise price or strike price)
• - Options in the money options out of the money
  and options at the money

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• 7.2.1.2. Options/3
• Options are used for bank protection of interest
  risk, foreign exchange risk and credit risk
• 1) Interest rate options
• 2) Credit options
• 3) Foreign exchange rate options.
• - There are much more options than futures
  because their market is deeper that the future
  ones.

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• 7.2.1.3. Swaps
• - Swap Change
• - Usage Bank protection of interest rate risk,
  foreign exchange rate risk, credit risk and for
  decreasing costs of the participants in the
  transaction
• - Interest rate swap
• - Foreign exchange rate swap
• - Credit swap

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• 7.2.1.3. Swaps/2
• Swap advantages They could be agreed upon for
  every period of time There is no need swap
  agreements to be adjusted to market conditions as
  is the case with futures
• Swap weaknesses
• 1) Swaps are more expensive than futures and
• options
• 2) There is still credit risk in swaps
• 3) Swaps are less flexible than futures and
• options and costs for their
  release are
• higher.

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• KEY WORDS/TERMS
• Risk
• Interest rate risk
• Credit risk
• Operational risk
• Market risk
• Liquidity risk
• Foreign exchange rate risk
• Inflation risk
• Country or Sovereign risk
• Off-balance risk
• Insolvency risk

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• KEY WORDS/TERMS
• Term of maturity
• The repricing model
• The maturity model
• Simulation model
• Duration model
• Default risk
• Exposure risk
• Recovery risk
• Risk taking
• Risk aversion approach

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• KEY WORDS/TERMS
• Bank risk management
• Financial derivatives
• Financial term agreements
• Forwards
• Futures
• Options
• Swaps

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• CHECKING QUESTIONS
• How can we define bank risk?
• What are the most important bank risks?
• When interest rate risk appears?
• Enumerate interest rate risk appearance forms.
• What are the most often used interest rate risk
  measurements?
• How can we define credit risk?
• What are the three parts of credit risks?
  Describe shortly each of them.
• Describe shortly Migration analysis and Credit
  concentration limit as models for measuring
  credit exposure risk.
• What are the strategies for credit risk
  management?
• Define operational risk.
• What are the ways for overcoming liquidity risk?

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CHECKING QUESTIONS 12. What are the ways foe
foreign exchange rate risk protection? 13. What
are the consequences of inflation rate risk? 14.
Define Country risk. 15. Define Off-balance
risk 16. Define Insolvency risk. 17. Enumerate
phases (5) of Risk management technology. 18.
Define forwards. 19. What are the differences
between forwards and furures? 20. Define
options. 21. What is the defference between
call and put options? 22. Give an example of
foreign exchange swap.