Chapter 39: Sources of Risk Flashcards
4 Financial risks
- credit
- liquidity
- market
- business
2 Non-financial risks
- operational
- external
What is credit risk
The risk of failure of 3rd parties to repay debts.
E.g.:
- issuer of a corporate bond defaulting on the interest/capital payments
- settlement risk, with one side of the transaction failing to meet their side of the bargain.
- purchasers of goods and services failing to pay for them
If good lending principles are adopted (Canons of lending), then credit risk can be reduced.
What are the 5 Canons of lending?
- Character and ability of the borrower
- Purpose of the loan
- Amount of the loan
- Ability of the borrower to repay
- Risk vs. reward
What questions would you ask of the borrower under the Canons of lending:
Character and ability of the borrower
- Is the borrower known, competent and trustworthy?
- Who introduced him?
- Can references be obtained?
- Do the key staff have the required depth and breadth of experience?
What questions would you ask of the borrower under the Canons of lending:
Purpose of the loan
to what USE will the monies be put?
is the borrower in a SECTOR where there are CONCERNS, or where the total EXPOSURE is already sufficient?
would the lending be subject to risks such as
- country,
- currency,
- environmental,
- resource,
- technological,
- ethical or
- moral risks?
are there CONTROLS to ensure that the monies will be spent as the borrower says it will be?
What questions would you ask of the borrower under the Canons of lending:
Amount of the loan
- Is the amount to be borrower reasonable, taking into consideration the stated purpose?
- Is the borrower contributing any funds?
- Who stands to lose if the project fails?
What questions would you ask of the borrower under the Canons of lending:
Repayment
- Can the borrower service and repay the debt when due?
- How certain is the source of repayment?
- What margin of safety has been built into the assumptions?
What questions would you ask of the borrower under the Canons of lending:
Risk vs Reward
- Has a proper due diligence exercise been carried out?
- Has the borrower signed it?
- Can each statement be verified?
- Are there any remaining doubts?
- Does the return adequately compensate for the risks?
Another issue linked to credit risk is whether there is any security backing the loan.
The decision as to what security is taken, depends on what 4 factors?
- the nature of the transaction underlying the borrowing
- the covenant of the borrower
- market circumstances, and the relative negotiating strength of the buyer and seller
- what security is available?
What is liquidity risk?
Liquidity risk is the risk that an individual or company, although solvent, does not have the financial resources available to meet its obligations as they fall due.
Examples of liquidity risk
- A bank would face liquidity risk if there is a loss of market confidence, resulting in more customers than expected, withdrawing their deposits.
- A general insurance company would face liquidity risk if widespread flooding would result in many property claims.
- A pension fund would face liquidity risk if there is a bulk transfer out of the scheme.
Market liquidity risk
In the context of financial markets, market liquidity risk is where a market does not have the capacity to handle the volume of an asset to be bought or sold at the time when the deal is required (at least, without an adverse impact on the price).
Market risk
The risk of changes in investment market values or other features correlated with investment markets.
Examples of market risk
- the consequences of volatile asset values if asset and liabilities are mismatched
- the consequences of a change in investment values of liability values, e.g. unit-linked liabilities.
- A change in interest of inflation rates, which might affect the level of provisions a provider needs to establish for future liabilities.
