Week 8 - Bank Management

Question 1

Risks must be…

Answer 1

1. Identified
2. Measured
3. Managed

Question 2

What are the major risks for banks?

Answer 2

1. Credit risk
2. Market risk
3. Interest rate risk
4. Liquidity/funding risk
5. FX risk
6. Country & sovereign risk
7. Operational risk

Question 3

What interests must be balanced in risk management?

Answer 3

• Regulators want less risk
• Shareholders want more risk

Question 4

How are losses covered?

Answer 4

• Expected loss covered by LLP
• Unexpected loss covered by capital

Question 5

What is the banking book?

Answer 5

Assets expected to be held to maturity

Question 6

What is the trading book?

Answer 6

Securities / loans held for sale

Question 7

What are a bank’s two books?

Answer 7

• Banking book
• Trading book

Question 8

What is PD?

Answer 8

Probability of default (for this year / 90 days – discretionary)

Question 9

What is included in credit risk?

Answer 9

• Failure to pay
• Credit rating downgrades
• Any failure to meet obligations

Question 10

What is LGD?

Answer 10

Loss given default (% of exposure lost in event of default – e.g. will we recoup some from selling the collateral?)

Question 11

What terms are important in measuring credit risk?

Answer 11

• PD
• LGD

Question 12

How is credit risk calculated?

Answer 12

• Historical data where possible
• Statistical models otherwise

Question 13

What are some traditional measures of credit risk?

Answer 13

• Total loans/total assets
• NPL/total loans
• Loan losses/total loans
• Loan loss reserves/total assets

Question 14

What are some additional measures of credit risk?

Answer 14

• Loan concentration
• Rapid loan growth
• High lending rates
• Loan loss reserves/NPLs
• Total loans/total deposits
• NPLs/deposits

Question 15

What is loan concentration?

Answer 15

Lending to one region/industry

Question 16

What is market risk?

Answer 16

Losses arising from movements in market price

Question 17

Where is market risk most relevant?

Answer 17

• Universal banks
• Arises from trading book

Question 18

What is interest rate risk?

Answer 18

Unexpected rate changes affect earnings or market value

Question 19

What causes interest rate risk?

Answer 19

Mismatch between fixed-rate vs rate-sensitive assets & liabilities

Question 20

What is the strategic variable for banks?

Answer 20

Interest rates – they compete by charging lower/paying higher

Question 21

What are the types of interest rate risk?

Answer 21

• Refinancing risk
• Reinvestment risk

Question 22

When is refinancing risk relevant?

Answer 22

When assets are more long-term than liabilities

Question 23

When is reinvestment risk relevant?

Answer 23

When liabilities are more long-term than assets

Question 24

What is the danger in refinancing risk?

Answer 24

Interest rates rise

Question 25

What is the danger in reinvestment risk?

Answer 25

Interest rates fall

Question 26

What is another name for liquidity risk?

Answer 26

Funding risk

Question 27

What are the types of liquidity risk?

Answer 27

- Day-to-day (managed by interbank lending) - Liquidity crisis

Question 28

What can FX risk affect?

Answer 28

- Assets - Liabilities - Off-balance sheet activities - Banking & trading books

Question 29

How can FX risk manifest?

Answer 29

- Make a loan in a foreign currency - That currency depreciates - You lose value

Question 30

What is country risk?

Answer 30

Economic / social / political conditions keep borrowers from paying

Question 31

What is sovereign risk?

Answer 31

Risk of government default

Question 32

What is an example of sovereign risk?

Answer 32

Greek sovereign debt crisis in 2011 / defaulting on €1.6b to the IMF in 2015

Question 33

What causes operational risk?

Answer 33

- External events - Internal process / people / systems

Question 34

What are examples of operational risks?

Answer 34

- Internal / external fraud - Workplace safety - Damage to physical assets - Natural disasters / business disruption - Technology / cyber risk

Question 35

What is the only type of risk that should be fully hedged, and why?

Answer 35

Operational risk cannot increase profit

Question 36

Why is operational risk difficult to measure?

Answer 36

Events are rare but severe

Question 37

What are examples of miscellaneous risks?

Answer 37

1. Off-balance sheet risk 2. Capital risk 3. Counterparty risk 4. Conduct risk 5. Reputational risk

Question 38

What happens when risks are aggregated?

Answer 38

The collective Value at Risk of all traders is greater than the sum of its parts

Question 39

What are examples of risk interrelation?

Answer 39

- Any crisis comes with reputational risk - Macro cycles affect both interest rates + default rates

Question 40

What are some risk mitigation techniques?

Answer 40

1. Guarantees to reduce LGD 2. Derivatives to hedge & reduce volatility 3. Insurance to reduce operational risk

Question 41

What is one ongoing trend in risk management?

Answer 41

It's getting more expensive to insure against climate risk

Question 42

How can market-based funding increase liquidity risk?

Answer 42

Market liquidity can rapidly disappear

Question 43

How can diversification be applied to loan portfolios?

Answer 43

e.g. 0.01% of funds per borrower