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FIN3703 > Risk Management in Banks > Flashcards

Risk Management in Banks Flashcards

1
Q

How to conduct risk management?

3

A

1) IDENTIFY the risks
2) MEASURE the risks
3) MANAGE the risks

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2
Q

What is Interest rate risk?

A

The most pertinent risk in the bank given the bank’s business model.

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3
Q

What is liquidity risk?

A

Systematic risk where liquidity might dry up.

Liquidity dry up: Lack of liquidity, lesser buyers, lesser market participants, more volatile

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4
Q

What do financial intermediaries do?

2

A

They intermediate between suppliers and demanders of funds.
E.g.
1) If lenders and buyers have some differences, such that they do not want to talk to each other, financial intermediaries would step in to bridge the gap.
2) Helps to reduce the costs between lenders and borrowers

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5
Q

What type of intermediation are available?

3

A

1) Maturity Intermediation
2) Denomination Intermediation
3) Risk Intermediation

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6
Q

What is Maturity Intermediation?

A

*Note that maturity for deposits is 0.
- Borrow short-term loans from depositers and pay them interest
- Loan out long-term loans to lenders who pay higher interest
> Profits are made from the differences in interest rate
> Banks (Financial Intermediaries) step in facilitate such services so that funds continue to flow

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7
Q

What is an example of Maturity Intermediation?

A

A financial institution can BORROW money from certificates of deposits or demand deposits, then LOAN out the money as a 30-mortgage.

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8
Q

What is Denomination Intermediation?

A

A process whereby small investors are able to purchase pieces of assets that are sold only in large denominations.

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9
Q

What is an example of Denomination Intermediation?

A

Mutual funds pool small amounts to purchase a well-diversified portfolio of assets.

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10
Q

What is risk intermediation?

A

Banks incur and manage these risks.
Non-risky: Deposits
Risky: Loans

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11
Q

Why do interest rate risks occur?

2

A

1) Maturity mismatch between deposits and loans.
2) Affects interest income to fluctuate.

HOW?
Loans increase interest income, deposits decrease interest income.

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12
Q

When does a matched gap occur?

A
  • Maturities of the fixed-rate loan and fixed deposits are the same.
  • No interest rate risk if interest rates rise or fall
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13
Q

When does a mismatch gap occur?

A
  • When there is a difference in maturities.
  • When interest rates increase or decrease, the net interest income will change respectively

*refer to notes for examples

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14
Q

What is a gap report?

3

A

1) It helps banks measure the interest rate risks
2) It includes assets and liabilities that are due for re-pricing/interest rate sensitive –> Those that are reaching their MATURITY DATE and rates will have to be repriced/changed
3) Does not factor in discount rates

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15
Q

What is a gap position?

A

Total Assets repricing - Total liabilities repricing

Assets: Interest Income (Inflow) - from loans given like fixed rate loans (Corporate, housing, vehicle) and floating rate loans (Corporate, housing)

Liabilities: Interest Expense (Outflow) - from interbank borrowings; savings account; fixed deposits (pay consumers their interests)

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16
Q

Which is better: Positive or negative gap position?

A

DEPENDS.

When interest rates increase:
Positive Gap position benefits, Negative Gap position suffers.
WHY?
1) In a positive gap (A>L), when i/r increases, inflow increases more than outflows –> BENEFITS
2) Assets are repriced more than Liabilities

When interest rates decrease: Negative Gap position benefits, positive gap position benefits.
WHY?
1) In a negative gap (L>A), when i/r increases, outflow increases more than inflow –> SUFFERS
2) Liabilities are repriced more than Assets

QN TO THINK: So does this mean matched gap position means no interest rate risk?

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17
Q

Does matched gap position mean no interest rate risk?

A

Ans: Depends. Matched gap position –> Static

  • When i/r goes down, depositors will withdraw their funds.
  • When i/r goes up, depositors likely to change to another company that accepts higher deposits (assuming they are able to break their fixed-deposit); most people will lose extra interest that they earn over the period if they do not change
  • Need to account for basis risk (Definition is below)
  • > Intensity & magnitude on the change of value when interest rates change
  • Fixed deposits are not really that fixed
  • > Pre-withdrawal & redeposit
  • Loans are not that fixed
  • > Pre-payment & refinance
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18
Q

What are the 2 shortcomings of a gap report?

A

1) Time value of money is not taken into account (Gap report is a static statement; no discounting –> Does not tell us how much risk we are currently bearing)
2) Does not tell us how much the bank’s interest margin or value will be affected by external forces

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19
Q

How to overcome the 2 shortcomings of a gap report?

A

Ans: Duration

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20
Q

What is “Duration”?

A

It is a time-weighted average of the time value of all cash flows (of the banks’ portfolio), or a cash-flow-weighted average of the time-to-maturity. (PROVIDES MORE INFORMATION ABOUT MATURITY)

Weighted by:
1) Timing
2) Magnitude
of the cash flow

  • An estimation to tell the effective time taken to break even
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21
Q

How does the Duration equation look like?

A
  • Refer to notes
  • It reflects the (% change in price)/(% change in i/r)
  • To compute the duration of both assets and liabilities, you cannot combine the cash flow and find the duration
    • You have to compute separately the duration of assets and duration of liabilities respectively and subtract from each other
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22
Q

What does the length of the Duration tell you?

A 
*All else constant*
Longer: 
- More vulnerable the portfolio is to changes in i/r (MORE RISKY) 
- Penalizes later cash-flows more
- Has more cash-flows later

Shorter:
- Has more cash-flows earlier

When portfolios with all cash flow at termination –> Duration = maturity
(only get back money at maturity/termination)
(similar to a 0-coupon bond where the face value is repaid at the time of maturity)

  • Give us more information on the interim cash flows
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23
Q

What is Modified Duration?

A

1) It identifies how much the duration changes for each % change in the yield, while measuring how much a change in i/r impacts the price of a bond.
2) It can provide a risk measure to bond investors since it can measure/approximate how i/r affects the price of a bond

**IMPT: See how much price of bond change

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24
Q

What is the equation for modified duration?

A

Duration/(1 + i/r)
It assumes linear r/s of a bond –> Gives us the effective time taken for the bondholder to breakeven

Therefore, change in price = - ModD x change in i/r x Original price of bond/asset

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25
Q

What is a DURATION GAP?

A

It measures the sensitivity of a bank’s current year net worth when there is a change in i/r.

  • Tell us how much the value of the bank will be affected is i/r change.
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26
Q

What is the equation for Duration Gap?

A

*Refer to notes

Net duration = duration of ASSETS - duration of LIABILITIES

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27
Q

How does an INCREASE in interest rates affect a positive and negative duration gap respectively?

A

1) Positive duration gap: Suffers

2) Negative duration gap: Benefits

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28
Q

How does a DECREASE in interest rates affect a positive and negative duration gap respectively?

A

1) Positive duration gap: Benefits

2) Negative duration gap: Suffers

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29
Q

Is positive or negative duration gap better?

A

Ans: Positive net duration
WHY?
- It resembles a bond
- When interest rates increase, price and valuations come down (i.e the positive duration gap suffers)

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30
Q

Does a zero gap/zero duration gap means no interest rate risk?

A

No.

Theory:
Banks with zero duration gap should not suffer or benefit(profit) when interest rates change.

Reality:
Nothing remains constant.
- Human beings may misbehave –> May choose to withdraw the deposit before time/pay up loan before the 20-yr maturity.
- Assets and liabilities misbehave as well –> While interest rates have been going up and down, assets and liabilities may not be affected due to… BASIS RISK

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31
Q

What is Basis Risk?

A
  • Interest rates in different instruments (assets, liabilities) do not always move in tandem.
    i. e. they do not always move at the same time, same speed, same extent
32
Q

What are the 2 different types of embedded option risk?

A

1) Pre-withdrawal

2) Pre-payment

33
Q

What is a PRE-WITHDRAWAL embedded option risk?

A
  • Happens when i/r increase
  • Depositors would start to:
    1) Exercise the option
    2) Withdraw on fixed deposits before maturity (pre-withdrawal)
    3) Re-deposit at the higher rate (when bank’s interest rate does not increase, thus, do not want to let my money remain there)
34
Q

What is a PRE-PAYMENT embedded option risk?

A
  • Happens when i/r decrease
  • Borrowers would start to:
    1) Exercise the option
    2) Pre-pay loan
    3) Refinance at lower rates
  • Creates a reinvestment risk: The investor might be unable to reinvest cash flows at a rate comparable to their current rate of return (callable bonds)
  • Causes interest margin to decrease
35
Q

What is an example of PRE-PAYMENT embedded option risk?

A

Take a 30-year $1m mortgage loan at 6%.
BUT people usually, prepay before the maturity and get another loan at the lower interest rate that is set by the bank. (Take advantage of the lower i/r)

36
Q

How to counter PRE-WITHDRAWAL embedded option risk and PRE-PAYMENT embedded option risk?

A

*Penalise so that they will not exercise the option

How to compute the penalty?

  • Model the price of the option: Requires data
  • Price in the value of the option to correspond with the risk (Price the risk based on prepayment data)
  • Need to consider the strike price and its volatility (Price it the same way you will price an option)
  • Note that such penalties can:
    1) Destroy customer relationships
    2) Lead to loss of customer due to competition and other banks
37
Q

Using Balance Sheet strategies, how do you manage interest rate risks?

A

*Rebalancing to obtain a gap position of 0 so that change in i/r will not affect (benefit/harm) the position of the bank.

1) Positive Gap: Get rid of assets and increase liabilities
2) Negative Gap: Increase assets and get rid of liabilities

*Weigh between the probability, direction, and magnitude of the change of the interest rates with the cost involved

*Last resort of the bank to meddle with their own interest rates because: it will affect the services that the bank provides.
Example: Do not want to give up on giving mortgages since that is like the bank’s competitive advantage

38
Q

How to increase assets to target a negative gap?

A

Buy or issue more loan

39
Q

How to increase liabilities to target a positive gap?

A
  • Borrow more funds
  • Issue more bonds
  • Take in more deposits
40
Q

How to decrease assets to target a positive gap?

A

Sell or securitize them

41
Q

How to decrease liabilities to target a negative gap?

A

Reduce debt

42
Q

Using Off Balance Sheet strategies, how do you manage interest rate risks?

A

1) Buying futures contract (debt instruments, e.g. T-bills) to hedge against the fall in interest income

  • Futures pricing is marked to market for the trader, with their losses and gains being added up each day.
  • Forward pricing are settled at the settlement date in the future

– Both futures and forward terms are all signed today, but there are no cash transactions since only the change in price are calculated

2) Interest rate swap (Transaction hedge)

43
Q

What happens when you buy a 6 month future contracts of 3-mth T-bill?

A

6 months down the road, get 3 month T-bill

44
Q

How many percent is 1 basis point?

A

0.01%

45
Q

What are futures contract?

A

Any contracts that can fluctuate with i/r

  • It is traded on the exchange at a fair price
  • At different point in times, price will change
  • Price may be different from the launch
  • It allow 2 parties to deliver a product at a date in the future at a pre-determined future price
46
Q

Why buy a futures contract?

A
  • Afraid that i/r will go down, and cause interest income to fall
  • Want to hedge against this risk by ensuring that when i/r goes down, you can profit by selling the contract at a higher price
  • Going long (buy low, sell high)
47
Q

How to calculate the price of the futures for today?

A

*Refer to equation in notes

48
Q

What happens if you use an option to hedge?

A
  • When i/r increases, you can let the option expire without exercising it
  • A downside: Option premium can be very expensive, if you let it expire, the premium will be wasted
49
Q

What happens when T-bills futures are not available? What can you use?

A
  • Other interest rate futures can be used

> LIBOR - eurodollar futures
TIBOR
SIBOR
KLIBOR

  • The discount yield of T-bills are the respective interest rates (LIBOR, TIBOR, etc)
  • Sometimes, International Monetary Market (IMM) price is used instead of these yields (IMM = 100 - yields of __BOR)
    > When IMM increases, prices of futures increases (refer to equation to understand why prices of futures increase)
50
Q

How do these __BOR interest rates work?

A

Every major financial market will have an interest rate index

1) LIBOR - The london interest rate index
2) SIBOR - Singapore Inter bank offering:
- Banks will tell the Association of Bank Singapore (ABS) their estimation of how much they can borrow everyday
- ABS will take the average of the median area (without the lower and upper 25th quartile) to calculate the interest rate index

51
Q

What are some problems with all these __BOR?

A
  • Could lead to abuse: During the LIBOR crisis, many banks caught manipulating interest rates, if need i/r to be high, collaborate with everyone to throw in a high-ball figure and vice versa –> Paid millions of dollars of fine
  • Therefore, this way of calculating is changing soon. LIBOR supposed to be gone in the upcoming years.
52
Q

An example of interest rate swap (Case 1):

A

1) Client wants fixed rate loans but bank wants floating assets
2) Bank needs to persuade him to take a floating rate loan
3) If client insists on fixed rate loan, let him take that and then we swap it for a floating rate loan
4) Bank will receive 5-yr 5% from the client
5) They pay 5-yr 3% fixed (swap rate) to the swap counter party
6) And they receive 5-yr SIBOR (floating rate) from swap counter party
* Refer to notes for more details

  • No principal is exchanged between the bank and the swap counter party
  • Only the interests payments
53
Q

What are some formats of interest rate swaps?

A

1) Transaction hedge (swap contracts)

2) Balance sheet hedge (dependent on overall position of the bank and not just 1 transaction)

54
Q

What are some problems with interest rate swap (transaction hedge)?

A

1) Client can prepay but bank cannot as it will cause the bank to be stuck with the swap
2) Creditworthiness of swap counter party
- if swap counterparty fails, we can find another swap counter party (each swap counterparty has their own credit rate risk)

55
Q

When to use futures to hedge or interest rate swap to hedge?

A
  • Short-Term: No preference, but usually use Futures

- Long-Term (more than one year): Futures contract do not last one year, therefore USE SWAP

56
Q

How does interest rate swap (balance sheet hedge) works?

A
  • Depends on the overall position of the bank and not just 1 transaction
  • The forecasted impact to a firm in terms of operations are largely fixed
  • BUT hedging instruments seek to offset that (make it more flexible)
  • Focus on the swap asset one receives
57
Q

Example of balance sheet hedge?

A

1) Expected 100 basis points falls in i/r within 1 year
2) Bank Net Interest Income falls by $100,000
What will you do?
- Swap $10m: Pays SIBOR (3%) - [costs] and receive fixed (3%)
Interest rate decrease 100 basis points, causing SIBOR to decrease to reduce to 2% and fixed interest rate to remain the same
- Swap income = 10m(0.03-0.02) = 100,000

58
Q

What is Asset Liability Management (ALM)?

A
  • The ALM function of the financial institution manages the interest rate risk
  • The Asset and Liability Committee (ALCO) is a senior management committee that oversees the function
  • A good ALM system will go a long way in providing timely and useful information for decision making
59
Q

Main idea behind managing liquidity risks?

2

A

1) Focus on cash flow management

2) Moneyness of assets (how fast they can convert to money)

60
Q

Why do banks need to manage liquidity risks?

4

A

1) Banks must have sufficient liquidity to meet obligations (especially withdrawal)
- If do not meet sufficient liquidity, it can lead to bank runs (cash flow problems)

2) MAS Notice 758: Minimum Cash Balance (MCB) to be kept with MAS - 3% of liability base
- Banks cannot touch this amount of money that is kept with MAS (only can use on rainy days)

3) MAS Notice 649: Minimum liquid assets (MLA) and liquidity coverage ratio (LCR) requirements
- Combining Basel 3 liquidity requirements with requirements in Notice 613
* Basel 1 and Basel 2 did not look at liquidity of banks
- SGD MLA requirement: Liquid assets in SGD >/ 16% of all SGD qualifying liabilities
- All other currencies MLA requirement: Liquid assets in any currencies >/ 16% of qualifying liabilities in all currencies
- SGD and all other currency LCR requirement is short-term

4) MAS Notice 652: Net Stable Funding Ratio under Basel 3

**Note that the first line of defence is the MCB
(Use cash first due to its moneyness)
> Then we can start to liquidate MLA (as it is liquid but not as liquid as cash)
> worst case scenario

61
Q

What are the sources of liquidity?

3

A

1) Sell securities (e.g. from the REPO market)
2) borrow
3) Central bank’s discount window (Last resort, e.g. fed funds)

62
Q

What is a Central Bank’s discount window?

A

The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs.

63
Q

How is the seasonal requirement of cash affecting liquidity?

A

CNY –> Higher demand for cash for angbao

64
Q

How is the seasonal requirement of cash affecting liquidity?

A

CNY –> Higher demand for cash for angbao

65
Q

How does the structure changes in liquidity requirement affect liquidity?

Structure changes:

1) Fintech
2) Cashless Society
3) Online payments

A
  • Banks want us to leave our cash in the bank
  • Online data can be used for policy-making + devise policy strategies
  • Going digital have audit trail (prevent counterfeits)
  • Helps to increase the velocity of cash (we can spend more –> good for the economy)
  • Cash usually results in printing cost, shipping cost, hr costs to bring them to atms, atms servicing costs
66
Q

What are the disadvantages of cash such that there are structural changes?

A

1) A lot of forgone tax
2) Small businesses might under declare revenue
3) Cash is easy to launder
4) Counterfeit notes

67
Q

Then what are the disadvantages of digital payments?

A
  • Elderly cannot learn, leave them behind
  • Poor countries become poorer as they cannot keep up with the new technologies
  • Many different systems and apps, very confusing for consumers
  • Startup costs of such technologies are very hard for private enterprise
  • Concerns of digital securities
  • Selling data to third-party
68
Q

What is the price of liquidity for loans and investments?

A
  • Funds transfer pricing*
  • Funds are not free
  • The appropriate cost of funds is the rate the bank has to pay to source for outside funds
  • There is a loan pricing discipline
  • There is a need to evaluate the corporate loan division
69
Q

Why are funds not free?

A
  • Transfer pricing (Departments sell the work-in-progress to the next department)
  • Lending department revenue is the interest rate gained from borrowers
  • Cost of funds?
    ○ SIBOR
    ○ Central Bank Discount Rate
    ○ Interest rates from savings deposit
    ○ Wholesale funding rate
    ○ Opportunity cost of the above

If give out 8-yr loan need to give out 8-yr bond.
*refer to notes

70
Q

What is credit risk?

A

Possibility of default

71
Q

Who will have the possibility of credit risk?

4

A

1) Retail borrowers (e.g. residential, hire purchase, share financing, personal loans, credit cards)
2) Corporate borrowers (e.g. loans to SMEs)
3) Issuers of securities (e.g. bonds and commercial paper issuers)
4) Swap counterparties

72
Q

How to prevent bad loans?

A

Have a good in-house credit risk model so that we can detect when to call back the bad loans before the other banks do so

73
Q

What are forex risks?

A

Risk due to fluctuations of foreign currencies

- Caused due to global events

74
Q

What are trading risks or market risk?

A

Due to the trading activities of the treasury desk

75
Q

How can trading risks or market risk happen?

A
  • Treasury desks do not know what clients trade in
  • Loans are given out to clients to trade stocks with stocks, acting as a collateral

Note* Stocks are not given
- May be overexposed to a certain stock

76
Q

How to prevent trading risks or market risk?

A

Use various tools

1) VaR (value at risk)
2) EaR (earnings at risk)
3) EVE (Economic Value of Equity)
4) RiskMetrics (modelling market risks)
5) Mark-to-Market

FIN3703 (12 decks)

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