RISKS IN BANKING

OPERATIONS

Chapter 4

William Chittenden edited and updated the PowerPoint slides for this edition.
 7-2

Key topics

1. Overview of risks in banking operation

2. Credit risk
3. Interest rate risk
4. Liquidity risk

2
1. Overview of risks in banking operation

 Definition of risk
 Types of risk in banking sector

3
Definition of risk

 In simple terms, risk is the possibility of

something bad happening.
 Risk involves uncertainty about the
effects/implications of an activity with respect to
something that humans value (such as health,
well-being, wealth, property or the
environment), often focusing on negative,
undesirable consequences

4
Types of risk in banking sector

 Out of these eight risks, credit risk, market risk, and operational risk are
the three major risks.
 The other important risks are liquidity risk, business risk, and
reputational risk.
 Systemic risk and moral hazard are unrelated to routine banking
operations, but they do have a big bearing on a bank’s profitability and 5
solvency.
Credit risk
 The risk that a borrower will not pay back
interest or principal on a loan.
 A key comparative advantage of banks is
analyzing and monitoring the behavior of
borrowers.
 Banks may enhance their advantage by
specialization in loans to certain regions,
industries or types of borrowers.
 Such a strategy exposes the banks to systemic
risk
6
How Banks manage credit risk?

Credit Risk Management Process include:

a. In a loan policy of banks, risk management
process should be articulated.
b. Through credit rating or scoring the degree of
risk can be measured.
c. It can be quantified through estimating
expected and unexpected financial losses and
even risk pricing can be done on scientific basic.

7
Market risk
 Earlier, majorly for all the banks managing
credit risk was the primary task or challenge.
 But due to the modernization and progress in
banking sector, Market risk started arising such
as fluctuation in interest rates, changes in
market variables, fluctuation in commodity
prices or equity prices and even fluctuation in
foreign exchange rates etc.
 Market risk comprises of interest rate risk,
foreign exchange rate risk and hedging risk

8
How banks manage market risk?
 Top management of banks should clearly
articulate the market risk policies, agreements,
review mechanisms, auditing & reporting
systems etc.
 Banks should form Asset-Liability Management
Committee whose main task is to maintain &
manage the balance sheet within the risk or
performance parameters

9
Operational Risk
 This risk arise due to the modernization of banking
sector and financial markets which gave rise to
structural changes, increase in volume of
transactions and complex support systems.
 Operational risk cannot be categorized as market
risk or credit risk as this risk can be described as
risk related to settlement of payments, interruption
in business activities, legal and administrative risk.
 As operational risk involves risk related to business
interruption or problem so this could trigger the
market or credit risks. Therefore, operational risk
has some sort of linkages with credit or market
risks 10
How banks manage operational risk?
 For measuring operational risk, it requires
estimation of the probability of operational loss
and also potential size of the loss.
 Banks can make use of analytical and
judgmental techniques to measure operational
risk level.
 Risk of operations can be: audit ratings, data on
quality, historical loss experience, data on
turnover or volume etc. Some international
banks has developed rating matrix which is
similar to bond credit rating
11
Liquidity risk
 Liquidity means that a bank is able to meet its
obligations. In other words, if a bank can pay its
obligations, it is liquid.
 Banks liabilities are available to depositors on
demand. Banks must wait long time for
repayment for their loans.
 Banks can experience liquidity risk from
unexpected deposit withdrawals, credit
disbursements, and a dependence on market
assets that suffer a loss of liquidity.

12
How banks manage liquidity risk?
 Banks must constantly calculate their liquidity to
know where liquidity stands on a daily basis. The
results inform bank managers if the bank can meet
its cash flow and collateral needs without negatively
impacting daily operations or its overall financial
position (i.e., as perceived by other entities).
 Banks maintain their liquidity profile through a
reserve of liquid assets, which include government
bonds and management of liabilities. A component
of liability management is the maturity ladder or
profile. This means liabilities are due further out than
the income arriving from a bank’s loan portfolio, a
scenario also known as the liquidity gap. 13
How Banks manage liquidity risk?
 One of the main sources of liquidity, in this case,
might be other banks, which may be unlikely to
lend to the bank given its liquidity risk to them.
 If outflows continue and the bank is unable to
cover them, it may have to start selling illiquid
assets. Because of the nature of illiquid assets,
the bank will be limited in its ability to liquidate
those assets. The end result of the liquidations
will likely be a large loss of assets.

14
2. Credit risk

 Credit risk, also known as counterparty risk is

the risk of loss due to a debtor's non-
payment of a loan or other line of credit
(either the principal or interest (coupon) or
both).
 Credit risk is most simply defined as the
potential that a loan borrower or counterparty
will fail to meet its obligations in accordance
with agreed terms.

15
2. Credit risk

 In most banks, loans are the largest and most

obvious source of credit risk.
 Other sources of credit risk exist throughout
the activities of a bank. They include activities
in the banking and trading books, and those
both on and off the balance sheet.
 Banks are increasingly facing credit risk or
counterparty risk in various financial
instruments other than loans (e.g., bankers’
acceptances, interbank transactions, trade
financing, etc.)
16
2. Credit risk

Causes of credit risk:

#1 Credit concentration
 Where a majority of the lending of the banks is
concentrated on specific borrower/borrowers or
specific sectors, it causes a credit concentration.
 The conventional form of credit concentration
includes lending to single borrowers, a group of
connected borrowers, a particular sector or
industry.

17
2. Credit risk

Causes of credit risk:

#1 Credit concentration
 Ex.: A bank lends only to borrowers in the real
estate sector. In the event that the whole sector
faces a slump, the bank would also
automatically be at a loss as it will be unable to
recover the monies lent.
 In this scenario, although the lending is not
restricted to one company or related group of
companies if all the borrowers are from a
specific sector, there still exists a high level of
18
credit risk.
2. Credit risk

Causes of credit risk:

#2 – Credit issuing process
 This includes flaws in the banks’ credit granting

and monitoring processes, such as incomplete

credit assessment, subjective decision making,
inadequate monitoring, etc.
 Although credit risk is inherent in lending, it can

be kept at a minimum with sound credit

practices.

19
2. Credit risk

Causes of credit risk:

#3 – Cyclical performances
Almost all industries go through a depression and a
boom period. During the boom period, the
evaluations may result in the good creditworthiness of
the borrower. However, the cyclical performance of
the industry must also be taken into account in order
to arrive at the results of credit evaluations more
accurately.

20
2. Credit risk

Stages of bad loans:

 Over due loans: Loans for which contracted payments
have not been made, but interests are still accrued.
- More than 90 days over due is Non-performing
loans
 Non-accrual loans: Loans that are habitually past due

and no longer accruing interest.

Total Noncurrent = Over due + Non-accrual
 Charge-offs: Loans written off as uncollectable
 Recoveries: Sums later collected on loans written off.
Net Charge-offs = Charge-offs - Recoveries
21
2. Credit risk

Non-performing loan (NPL) loans

 NPL is a loan in which the borrower is in default and
hasn't made any scheduled payments of principal or
interest for a certain period of time.
 In banking, commercial loans are considered
nonperforming if the borrower is 90 days past due.
 IMF considers loans that are less than 90 days past
due as nonperforming if there's high uncertainty
surrounding future payments.
 However, there is no standard or definition of NPLs.

22
2. Credit risk

Measures of bad loan

 We can also measure banks credit risk by their

past performance.
 Non-performing Loans to Outstanding Loans
 Net Charge offs to Loans, Net Charge Offs to
Assets
 Noncurrent Assets to Loans tend to lead to
Charge-offs

23
2. Credit risk

Composition of a bank loan portfolio

 Some loans are riskier than others, so a high
share of loans in risky categories involves
higher risk.
- Banks concentrate on real estate lending which
tends to have very high default rates.
 An undiversified portfolio also exposes a bank
to risk. Concentration in the property market
exposes the bank to systematic risk of property
collapse.

24
2. Credit risk
 Credit Risks in Banks are inherent to the lending
function. They cannot be avoided wholly; however,
their impact can be minimized with proper
evaluation and controls. Banks are more prone to
incur higher risks due to their high lending
functions.
 It is important that they identify the causes for
major credit problems and implement a sound risk
management system so that they maximize their
returns while minimizing the risks.

25
2. Credit risk

26
2. Interest rate risk

 Interest rate risk

 The potential loss from unexpected changes in

interest rates which can significantly alter a

bank’s profitability and market value of equity.

27
 7-28

Interest rate risk

 Reinvestment risk

 When interest rates fall, the coupon payments

on the bond are reinvested at lower rates

 Price risk

 When interest rates rise, the market value of the

bond or asset falls

28
 Interest rate risk:
Re-investment rate (spread) risk
 If interest rates change, the bank will have to
reinvest the cash flows from assets or refinance
rolled-over liabilities at a different interest rate
in the future.
 An increase in rates, ceteris paribus,

increases a bank’s interest income but also

increases the bank’s interest expense.
 Static GAP Analysis considers the impact of
changing rates on the bank’s net interest
income. 29
Interest rate risk:
Price risk
 If interest rates change, the market values of

assets and liabilities also change.

 The longer is duration, the larger is the
change in value for a given change in
interest rates.
 Duration GAP considers the impact of changing

rates on the market value of equity.

30
What determines rate sensitivity (ignoring
embedded options)?
 An asset or liability is considered rate sensitivity
if during the time interval:
 It matures
 It represents and interim, or partial, principal
payment
 It can be repriced
 The interest rate applied to the outstanding
principal changes contractually during the interval
 The outstanding principal can be repriced when
some base rate of index changes and
management expects the base rate / index to
change during the interval
31
 11-32

3. Liquidity risk

 Liquidity is the availability of cash in the

amount and at the time needed at a

reasonable cost
 The size and volatility of cash requirements

affect the liquidity position of the bank

 Examples:

 Deposits and withdrawals;

 Loan disbursements and loan payments 32
 11-33

Supplies of liquid funds

 Incoming customer deposits

 Revenues from the sale of non-deposit services

 Customer loan repayments

 Sales of bank assets

 Borrowings from the money market

33
 11-34

Demands for liquidity

 Customer deposit withdrawals

 Credit requests from quality loan customers

 Repayment of non-deposit borrowings

 Operating expenses and taxes

 Payment of stockholder dividends

34
 11-35

35
 11-36

A financial firm’s net liquidity position

L = Supplies of liquid funds
- Demands for liquidity
 Liquidity deficit (L < 0)
 Liquidity surplus (L > 0)
 Time dimension of liquidity
 immediate liquidity (CD due to mature, deposit
withdrawn tomorrow)
 longer-term liquidity (arising from seasonal,
cyclical & trend factor)
→ manager must plan how, when & where liquid
fund can be raised 36
 11-37

Quick quiz: Comprehensive problem

Suppose that a bank faces the following cash inflows and outflows during
the coming week:
1. Deposit withdrawals are expected to total $33 million;
2. Customer loan repayments are expected to amount to $108 million;
3. Operating expenses demanding cash payment will probably
approach $51 million;
4. Acceptable new loan requests should reach $294 million;
5. Sales of bank assets are projected to be $18 million;
6. New deposits should total $670 million;
7. Borrowings from the money market are expected to be about
$43mil;
8. Non-deposit service fees should amount to $27 million;
9. Previous bank borrowings totaling $23mil are scheduled to be
repaid; &
10. A dividend payment to bank stockholders of $140 million is
scheduled. 37
 RISKS IN BANKING
OPERATIONS

Chapter 4

William Chittenden edited and updated the PowerPoint slides for this edition.