Meaning and Nature of Financial Risk

• Financial risk refers to the variability in the expected returns of the

bank.
• The maximum use of financial leverage (debt) can be attributed to the
variation in return. Higher the use of leverage, higher the probability
of variation in expected return. But, the profitability also increases if
the leverage is used in optimum level.
• There are various types of risk such as credit risk, interest rate risk,
operational risk, liquidity risk, price risk, compliance risk, FOREX
risk, strategic risk and reputation risk.
• Banking risk refers to the possibility that the outcome of an action or
event could bring adverse impact on the bank’s capital, earning or its
viability.
• Risk management is a discipline that involves identification,
measurement, monitoring and controlling of risk.
• Banks are different in terms of capital structure, objectives, technology
employees, and business activates. Risk management strategy
considered good for one bank may be unsatisfactory for another.
Therefore, sound risk management system should have a following
elements:
• Active board and senior management oversight
• Adequate policies, procedure and limits
• Adequate risk measurement, monitoring and management information system.
• Comprehensive internal control.
Types of major risk in treasury management
1) Counterparty default risk:
• Counterparty risk is the risk to each party of a contract that the
counterparty will not settle an obligations.
• Simply, it is risk to both parties that their counter party will not settle an
obligation in good condition within specified time frame.
• In most financial contract, the counterparty risk is also known as default
risk or credit risk.
• The financial contract may be in the form of deposit, borrowing,
lending, investment, financing, leasing etc.
• Therefore, counterparty risk is the risk to either of the parties engaged in
contract that the counter party will not meet an obligation in good
condition.
• BFIS can increasingly face the credit risk (counter party risk) not only
in loan but also in various financial instruments such as bankers
acceptance, interbank transaction, trade financing, foreign exchange
transaction, derivatives, swaps, bonds, LC transaction and alike.
• The BASEL committee has issued guidelines to manage the risk and
maintain the standard of such practice uniformly throughout the world.
• The BASEL committee has suggested two approach for credit risk
management. In the context of Nepal, Nepalese BFIS are adopting
Simplified Standardized Approach for credit risk management.
• Under Simplified Standardized Approach, banks are required to
assign a risk weight to their balance sheet and off balance sheet
exposure. The risk wight is based on the counterparty default.
• The counterparty default risk has basically two impact in business. If
failed to meet obligation (simply to repay the loan), the loss is incurred
equal to the principal amount of settlement and if the counterparty
fails to settle in time and settled latter, there is opportunity cost of
investment of that fund.
• Therefore, it is very important to establish a sound risk management
system in an organization to get prevented from such counter party
default risk. Proper monitoring of the credit lending process need to be
done and the guidelines of the provision made by BASEL committee
need to be implemented very well.
2) Sovereign Risk:
• Sovereign risk arises from the fact that some foreign borrowers may
not repay their loans, not because they are unwilling to pay, but their
government prohibits them from doing so.
• When a foreign country is expecting a financial crisis, the government
may decide to restrict dollar denominated payments, in which case U.S
bank would have difficulty collecting payments on its loans in the
country.
• Such circumstances have arisen on numerous occasion. For example
in 1997 in Asia, 1998 in Russia and 2002 in Argentina.
• In all these case, government and corporations alike had difficulty
raising enough dollar to repay their dollar denominated debts. In such
crises, a bank has very little recourse in the courts and little hope of
recovering the loans.
• Managing sovereign risk is very difficult. Banks have three options,
the first is diversification. Diversification means, distributing the
bank’s loan and securities holdings throughout the world, carefully
avoiding too much exposure in any country where the crisis might
arise.
• Second, the bank can simply refuse to do business in a particular
country or set of countries.
• And, third one is, the bank can use the derivatives to hedge sovereign
risk.
3) Foreign Currency Risk
• Foreign exchange risk is the risk of negative effects in the financial
result and capital of the bank caused by he change in exchange rates.
• It is the current or perspective risk to earning and capital of the bank
from adverse movement in currency exchange rates.
• It refers to the impact of adverse movement in currency exchange rates
in the value of open foreign currency position.
• The foreign currency position arise from following activities:
• Trading in foreign currencies through spot, forward and option transactions.
• Holding foreign currency position in the banking books (in the form of loan,
deposits, bonds or cross-boarder investment)
• Engaging in derivative transactions, that are denominated in foreign currency
for trading or hedging purpose.
• In the foreign exchange business, banks may also face default risk,
settlement risk or even sovereign risk
Arrangement for minimization of foreign exchange risk
• In order to minimize the risk arising from change in foreign exchange rates, the
BFIS shall maintain Exchange fluctuation fund as required under the directives of
NRB and bank itself.
• The licensed institutions shall group the currency wise foreign exchange into short
term and long term maturity period and determine the net position under both
categories. Short term for this purpose is defined to cover a period of one month
or less.
• The limit of licensed BFIS daily net position of foreign exchange has been fixed
up to maximum of 30 percent of the core capital. Where the net position exceeds
such limit, the respective BFIS shall put effort to bring down the same to the limit.
• And, BFIS must comply with the guidelines provided by BASEL committee to
manage the foreign exchange risk of banks.
Example:
U.S global corporation raises $160 million in the U.S. It is paying 8%
annually on the funds. It converts the dollar to British pounds (Current
exchange rate: $1.6 per pound), and invest the fund in England earning
a rate of 11%. The maturities of the investment and liabilities are the
same. Assume that interest is paid and received just in a year.
a) If the exchange rate remains unchanged, what is the U.S global’s
annual net interest income in US dollar from the transaction?
b) If the exchange rate changes to $1.70 per pound at the end of one
year, what is the U.S global’s annual net interest income in US dollar
from the transaction?
c) If the exchange rate changes to $1.50 per pound at the end of one
year, what is the U.S global’s annual net interest income in US dollar
from the transaction?
Solution:
Total fund raised = $160 million
Current exchange rate = $1.60 per pound
Total fund raised in British pound = $160 million/$1.60 = 100 million
a) Total interest received = 11% of 100 million pound (because the
investment is made in England) = 11 million pound
In terms of dollar, total interest earned = 11 million pound* 1.60
= $17.6 million
Total interest paid = 8% of $160 million = $12.8 million
Net interest income = Total interest income – Total interest expenses
= $17.60 - $12.8 = $ 4.8 million
b) Total interest received = 11% of 100 million pound = 11 million pound
In terms of dollar, total interest earned = 11 million pound* 1.70
= $18.7 million
Total interest paid = 8% of $160 million = $12.8 million
Net interest income = Total interest income – Total interest expenses
= $18.7 - $12.8 = $ 5.9 million

c) Total interest received = 11% of 100 million pound = 11 million pound

In terms of dollar, total interest earned = 11 million pound* 1.50
= $16.5 million
Total interest paid = 8% of $160 million = $12.8 million
Net interest income = Total interest income – Total interest expenses
= $16.5 - $12.8 = $ 3.7 million
4) Liquidity risk:
• Liquidity risk refers to the risk of incurring losses resulting from the
inability to meet payment obligations in the timely manner when they
become due.
• Liquidity risk occurs when BFIS , individual, investors, business
house cannot meet its short term debt obligations.
• In banking business, liquidity risk simply means the risk of sudden
demand for liquid fund by depositors.
• Bank face the liquidity risk in both side of the balance sheet. In the
liability side, customers withdrawal is a risk to manage liquidity and
on the assets side, the line of credit and loan commitment made by the
bank to its customers, and unable to pay on time with stated condition
is assets side risk.
• The liquidity risk faced by business can lead to the bank run and bank
panic, which ultimately leads to operational failure and reputational
risk.
• Therefore, the bank’s treasury handles the liquidity management
through money market and FOREX market operations; hence a careful
strategy need to be placed for market related activities.
• Additionally, an effective assts-liabilities matching strategy and
effective credit monitoring and operations of the banks can reduce the
impact of the liquidity risk.
• A good internal control review and monitoring system, identification
of weakness int eh internal system, setting internal limit for cash
management including foreign funds and an effective reconciliation of
nostro account are some of the measure to reduce the impact of
liquidity risk.
Mitigation of Liquidity risk
• To minimize the liquidity related risk, BFIS shall group the assets and
liabilities into their appropriate maturity period of various time
interval.
• The licensed BFIS on the basis of maturity periods, classify the time
intervals as:
1. Assets and liabilities having maturity up to 90 days.
2. Assets and liabilities having maturity of over 90 days to 180 days.
3. Assets and liabilities having maturity over 180 days to 270 days.
4. Assets and liabilities having maturity over 270 days to one year.
5. Assets and liabilities having maturity period of more than 1 year.
• In respect to the liabilities of licensed institutions without having fixed
maturity period like current deposit and saving deposits, the amount of
core deposit and minimum required balance has to be included under
the time interval of over one year period.
• The proportion of current deposit, which the licensed institutions
generally maintain on the permanent basis, shall have to be considered
as core deposit.
• With the objective of minimizing the liquidity risk of the BFIS, a limit
has been fixed so that the total loan and advance may not exceed 90%
of the resource mobilization (CD ratio of 90%).
• To manage liquidity, BFIS should comply with the provision made on
monetary policy in terms of CD ratio, SLR, CRR and other similar
stuffs.
Example:
Consider the following information of financial institutions before
withdrawal.
Assets Amount (Rs) Liabilities Amount (Rs)
Cash 10 million Deposit 90 million
Non- liquid assets 90 million Equity 10 million
Total 100 million Total 100 million

Suppose, depositors unexpectedly withdraw Rs. 15 million in deposit

and FI receives no new deposit to replace them. Prepare new balance
sheet by adjusting this effect.
Solution,
To meet this withdrawal, bank first use Rs. 10 million cash that it has
currently as liquid assets. Then, it sells some non-liquid assets to raise an
additional Rs. 5 million cash to meet an obligation. Assume that a bank
cannot borrow any more funds in money market and because it cannot
wait for longer period to get better price of its securities that it sold to
raise additional 5 million. This is because the bank ahs to settle the
obligation instantly. Thus, to cover the remaining 5 million obligation, the
bank may have to sell non-liquid assets equal to 10 million to realize the
net sale value of at least 5 million in hand. This result in a loss of Rs. 5
million in instant sale of non-liquid assets to meet an withdrawal need.
Then, a banks has to write off its loss of 5 million from its equity capital.
Since, its capital was only 10 million before withdrawal, the loss on fire
sale of assets reduce the capital to only Rs. 5 million.
Assets Amount (Rs) Liabilities Amount (Rs)
Cash (10-10) 0 Deposit (90-15) 75 million
Non- liquid assets (90-10) 80 million Equity (10-5) 5 million
Total 80 million Total 80 million
5) Market Risk:
• Market risk refers to the risk to BFIS resulting from movements in
market prices, in particular, change in interest rate, FOREX rate and
change in equity and commodity price.
• Market risk is defined as the risk of losses in On- Balance sheet and
Off- Balance sheet positions arising from movements in market prices.
• Market risk exposure may be explicit (clearly seen) in portfolios of
securities/equities and instruments that are actively traded.
• The market risk can be broadly recognized as :
1. Interest rate risk
2. Foreign exchange rate risk
3. Commodity price risk
4. Equity price risk
Interest rate risk:
• Interest rate risk is the risk of negative effects on the financial result
and capital of the bank caused by change in interest rate.
• Change in interest rate affects the bank’s earning by changing its net
interest income and the level of other interest sensitive income
operating expenses.
• Change in interest rate also affects the value of underlying assets,
liabilities, and off balance sheet instruments because the present value
of future cash flows changes when interest rate changes.
• The immediate impact of change in interest rate is on the net interest
income of bank, while a long term impact is on the net worth of the
bank, since the economic value of the banks assets , liabilities, and off
balance sheet exposures are affected.
Arrangement for minimization of interest rate risks:
• The interest sensitive assets and liabilities that may be affected due to
change in interest rate have to be treated separately and need to be
identified from other assets and liabilities.
• Gap analysis (technique of assets liability management that can be used
to asses the interest rate risk) need to be done very carefully.
• To minimize the interest rate risk, BFIS shall prepare the financial
statements quarterly and submit to bank’s concerned supervision
committee for review.
• The interest rate risk can be minimized by diversifying the investment in
different securities and different sector of investment.
• Interest rate risk can also be mitigated though various hedging strategies
such as purchase of different kinds of derivatives like interest rate swaps,
forward rate agreements etc.
Example:
Bank twenty has earning assets of $1.5 billion. It is earning a fixed rate
of 12 percent on them. The assets mature in 2 years. Bank twenty has
also an interest bearing liabilities of $1.5 billion. The interest rate on the
liabilities floats with the market; currently the rate is 6%.
a) suppose, market interest rate do not change over the coming two
years, compute bank twenty’s annual net interest income over the
next two year.
b) suppose, market interest rate do not change for one year, but then
rise by one percentage point, compute bank twenty’s annual net
interest income over the next two year.
c) suppose, market interest rate do not change for one year, but then
fall by one percentage point, compute bank twenty’s annual net
interest income over the next two year.
Solution:
a) Interest income = 12% of $1.5 billion = $0.18 billion
Interest expenses = 6% of $1.5 billion = $0.9 billion
Net interest income = Interest income – interest liabilities
= $0.18 billion - $0.9 billion = $0.9 billion
This would be the net interest income in each of the coming two year.

b) In the first year, the net interest income remains same as calculated in (a) i.e. $0.9
billion because the interest rate is constant for first year.
But, in second year, interest rate rise by one percentage point to 7% from 6%. Note,
the rate on assets remains same as it is fixed rate of interest. Therefore,
Net interest income for second year = (12% of $1.5 billion – 7% of $1.5 billion)
= $0.075 billion
therefore, the interest income for second year declined to $0.075 billion
c) Again the first year shows no change from part (a) in first year as the
exchange rate remains constant.
In the second year, the interest rate fall by one percentage point.
Therefore, net interest income = Interest income – Interest expenses
= (12% of $1.5) – (5% of $1.5)
= $ 0.105 billion
 Foreign Currency Risk
• Foreign exchange risk is the risk of negative effects in the financial
result and capital of the bank caused by the change in exchange rates.
• It is the current or perspective risk to earning and capital of the bank
from adverse movement in currency exchange rates.
• It refers to the impact of adverse movement in currency exchange rates
in the value of open foreign currency position.
• The foreign currency position arise from following activities:
• Trading in foreign currencies through spot, forward and option transactions.
• Holding foreign currency position in the banking books (in the form of loan,
deposits, bonds or cross-boarder investment)
• Engaging in derivative transactions, that are denominated in foreign currency
for trading or hedging purpose.
4) Commodity risk:
• A bank that is active in commodities trading should also account for
variations in the benefit for holding underlying assets in transaction
such as forward and swaps.
• Commodities differ from financial contract in several significant ways,
primarily due to the fact that most have the potential to involve
physical delivery.
• With notable exceptions, such as electricity, commodities involve
issues such as quality, delivery location, transportation, shortage, and
storability, and these issues affects price and trading activity.
• Commodity risk includes the price and quantity risk.
Commodity price risk:
• Commodity price risk is the financial risk on an entity’s financial
performance/profitability upon fluctuations in the price of
commodities that are out of the control of entity since they are driven
primarily by the external forces.
• Commodity price risk is the probability of change in the price of a
commodity that is a component of organization’s business.
• Typically, price risk arise from products that must be purchased or
sold, but it can also arise indirectly through price that are themselves
affected by commodity price.
• Commodity price risk affects consumers and end users such as
manufacturers, government, processors and wholesalers.
Equity price risk:
• Equity price risk is the risk that arises from security price volatility.
• The risk of decline in the value of security or a portfolio. Equity price
risk can be systematic or unsystematic risk.
• The systematic risk affects the multiple assets classes.
• It is risk to earning or capital that arise from adverse change in the
value of equity related portfolios of a bank.
• Price risk associated with equities could be systematic or
unsystematic. The former refers to the sensitivity of portfolio’s value
to change in overall level of equity prices, while the later is associated
with price volatility that is determined by firm specific characteristics.