Riassunto esame Risk management, Prof. Capizzi Vincenzo, libro consigliato Risk Management, Mario Valletta

Risk management

1 The title of the course is risk management.

In the first part of the course, we analyze techniques and methods that are currently used to measure the main types of risk to which financial intermediaries and banks in particular are exposed: credit risk, interest rate risk on the banking book, market risk, operational risk, etc...

And then we will make reference to the emerging risks: the model risk, which is related to the reliability [affidabilità] of the various models that are used by banks in order to comply [conformarsi] with certain supervisory regulations, but also in order to implement their respective decision-making processes.

The other emerging risk, which is becoming more and more important, is the climate-related risk or, more generally, the environmental, social and governance risks.

Indeed, we know that all public institutions and almost all public authorities and governments are attaching a growing importance to sustainability: the European Commission has launched a green plan, but also the European Central Bank and the IMF (International Monetary Fund) and, generally, many other institutions.

For instance, the so-called New Generation Europe Plan at EU level is strongly oriented towards the various aspects of sustainability. And, as a consequence, also our national Recovery and Resiliency Plan (PNRR) devotes great attention to sustainability issues.

So, techniques and criteria that are useful to analyze and evaluate these risks.

We’ll make reference to statistical and mathematical models, techniques and indicators, even if we will be concerned about the organizational and managerial aspects related to the use of certain techniques, procedures and indicators.

Capital allocation process

Then, in the second part of the course we will devote our attention to very relevant managerial problems, that are: how banks allocate their capital (in ideal terms) to different business units taking into account 2 main criteria:

• The profitability of each BU and;
• The risk attached to activities performed by a single BU.

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So, in other words, we will discuss aspects that are linked to the capital allocation process.

“Capital” is to say that own funds are a scarce [scarsa] resource for whatever firm (and for banks, in particular).

So, the use of capital as an amortizer [ammortizzatore] against losses that could stem from risks has to be carefully optimized: this means that capital should be allocated to different BUs taking into account the profitability of each BU, but the profitability has to be weighted with risk and, therefore, we will analyze some risk adjusted measures.

And this capability of the financial intermediaries is a key to achieve a fundamental objective (of any firm), that is to create value for all the stakeholders (not only the shareholders (!)) that are interested in the performance of a certain firm.

[Esame: 6 domande, 60 minuti]

Role of risk management in financial intermediaries

Now, we present what is the role of the risk management in financial intermediaries and, in particular, in banks…

First of all, we share some considerations about the meaning of risk in finance.

The term risk has a neutral meaning in finance because, if we go through some common definitions of risk in finance, we see that all these definitions share a common element: the risk in finance is closely connected to volatility, to the potential variability of the outcome of a certain financial operation/financial transaction.

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So, the actual outcome of a certain financial transaction could be either better or worse than the expected outcome of that transaction.

So… “investment”… let’s suppose that you invest 1.000€ in a given stock of company Alpha Ex: and that the market price of this stock is 10€: therefore, we can buy 100 stocks.

Let’s focus on the unit market price (10€).

You buy this share and the outcome of this investment depends on the market price of the share (linea blu): if the market price increases (15€), then you will get a profit of 5€ for each share; but, on the contrary, if the market price decreases (4€), then the outcome of your investment will be -6€…

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… So, we have entered in a speculative transaction and, if we decided to buy that share, it’s because that we think that, over a certain period of time, we will get a positive result, but we are not sure (!) and the final outcome could be a net profit or a net loss, and the net profit will be either greater or lower than our expected profit.

How could you hedge this risk?

For instance, rather than buying the share in the market, I could buy a call option on this share: so, we immediately pay a premium, which is the price of the option, and the premium paid enables us to decide in the future whether we purchase the share at a given price, which is the so-called strike price, or we give it up.

So, if we buy an option with the strike price of 10€ and a premium of 1€, this represents a 1€ cost that we can’t avoid and this (linea rossa) is the so-called payoff of the investment, that is to say [che è come dire] that:

• If the market price of the share on which you have bought the call option will be lower than 10€, then we won’t exercise the option and our final outcome will be a net loss of 1€ (= the premium to buy the call option); but,
• If the market price of the share goes up, initially you will reduce your loss below 1€ and, starting from a market price of 11€, you will start reporting a profit…

This is an example of this risk can be hedged.

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But let’s compare the payoff corresponding to the purchase of the call option on a share with the payoff corresponding to the outright [a titolo definitivo] purchase of the share.

What about the payoff of buying the share at the price of 10€? The payoff would be the blue line.

So, if we compare the 2 payoffs [linea rossa e linea blu], we see that:

• If the market price moves upwards, by buying the share, we will gain more because we don’t have the 1€ fixed cost (which is paid in order to buy the option); but, on the other side,
• If the market price of that share moves downwards, if we have just bought the share, we risk to lose the whole capital we invested; while,
• If we purchased the call option on that share, there is a floor (!) to our possible losses, which is the cost of the call option…

This is just to emphasize that the term “risk” in finance has a two-way (!) dimension.

1. Not necessarily, if you are exposed to a risk, you will lose something, but you could gain more than expected (!);
2. And, if you want to maximize your profit, you can’t avoid risk.

Unless you decide to reduce your expected result and you hedge the risk, even if, by hedging, you forego [rinunci] the part of your expected profit.

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So, risk is unavoidable if we want to maximize your result, even if the negative aspect of this behavior is that we could lose the capital invested.

Another definition of risk in finance is “often defined as”… slide… [secondo punto].

[Terzo punto]… “than the expected return”… and, in this case, the negative occurrence is more emphasized than the positive.

Risk surrounds the institutional activities of financial intermediaries.

Why do financial intermediaries exist? One of the reasons is that they are able to manage financial risks better than individual agents (!).

We may remember, indeed, that banks perform a very important function, which is maturity transformation: they borrow with relatively short maturities and they lend with longer maturities.

So, the “traditional types”…

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Credit risk

1. “Credit risk”… When we think about credit risk, we think about the danger or the possibility that a person to whom you lend a certain amount of money won’t reimburse [rimborsare] the principal and pay the interests.

But this isn’t the correct idea of credit risk because credit risks consists in the possibility that “unexpected change”… slide.

“Unexpected change… creditworthiness” and “unexpected change… exposure”… What has to be underlined?

Suppose that we have invested money in a Bond issued by a non-financial company and that the market price of this Bond follows the following path (linea blu).

And let’s suppose that this financial company in which we have invested your money is a rated company, which means that it has received a rating grade by a certain rating agency, where this rating grade represents an opinion of the rating agency as regards [in merito a…] the creditworthiness of this non-financial company.

So, let’s suppose the rating grade of this company is quite good: AA (rating assigned in T0).

What does it happen if the rating agency downgrades this company, so that at time T1 the rating grade is A?

There will be surely a negative impact on the market price of the Bond: it will fall [dopo l’ultimo punto, tendenza al ribasso] because, knowing that the Bonds issued by this company has become riskier, market investors will require a higher yield to maturity (!) in order to be compensated for the higher risk attached to this Bond…

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[Lo Yield to maturity (YTM) o, nella versione italiana, Tasso di rendimento effettivo a scadenza (TRES) è il tasso implicito di rendimento di un particolare titolo (obbligazione). Quando il titolo viene emesso il suo tasso riflette il rendimento che il mercato garantisce ad un prestito a lungo termine ed esso si determina dall'incontro di offerta e domanda di risparmio].

So, why does market price fall? Because, after the downgrade, market investors are no longer satisfied with the yield to maturity corresponding to the previous price, but they require a premium, an additional yield, in order to be compensated for the higher risk they are facing due to the negative perception of the issuer’s creditworthiness.

So, the downgrade, in this case, is an unexpected change (!) in the counterparty’s creditworthiness which entails [comporta] an unexpected change in the market value of the associated credit exposure.

In the example provided, we have not said (!) that the issuing company goes bankrupt.

We weren’t talking about this, but we represented the situation in which the perception (!) of that company’s creditworthiness has worsen: therefore, we don’t have to associate credit risk to bankruptcy.

The bankruptcy or the default is just the extreme event (!) that may occur, but the credit risk can be determined by various factors (that are related to the creditworthiness of the issuer) that don’t coincide than the actual default of the issuer.

So, the credit risk isn’t something “binary”: no risk, yes risk. No, it’s a multifacial risk.

Market risk

2. Market risk…

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“Connected with”… not with the creditworthiness of the issuer (!), but with… slide… “conditions”… that is to say, unexpected changes in the level of market interest rates, exchange rates, etc… slide.

Suppose that the Fed, in the next meeting of the board of governors, decides to increase the Federal funds rate, which is the short-term reference interest rate for monetary policies and which leads the movement of the other market rates.

So, the hypothesis is that the Federal Open Market Committee, which is the board entitled with monetary policies decisions in the US, decides to do that.

What would be the reaction of market price of US Treasury Bonds? Would the market price increase or decrease? Decreases.

So, that has nothing to do with the creditworthiness of the issuers, but this change in the market price has to do with market conditions (!), like interest rates, exchange rates and so on.

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Interest rate risk on the banking book

3. Interest rate risk on the banking book…

Let’s make reference to a situation: bank “A”, which borrows a certain amount of money by placing a term deposit [deposito a termine] with retail customers and let’s suppose that what the bank collects is worth 1.000€ and that the maturity of this deposit is 6 months (rosso).

What does the bank do with this money? Let’s suppose that the bank grants a loan [concede un prestito] with a maturity of 12 months (blu).

• The deposit is fixed-rate and the interest rate that the bank has to pay to the depositor is contractually set at the level of 2% per annum;
• Let’s suppose that the loan is fixed-rate and that the interest rate at which this loan is granted [concesso] is 6%...

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What about the 1st semester? What about the interests earned and the interests paid by the bank?

• The interests paid by the bank are 2% * 1.000 * 1/2 = 10€;
• The interests earned are 6% * 1.000 * 1/2 = 30€;
• The Net Interest Margin for the bank for the first 6 months is 30 – 10 = 20€.

Let’s consider the following 6 months.

The problem is that the deposit through which the bank had collected 1.000€ has expired: therefore, the bank has to place a new deposit: let’s suppose a new 6 months deposit.

Indeed, the bank has to renew the supply [rinnovare la provvista]: it has to collect 1.000€ by convincing someone to deposit 1.000€ with itself. So, we have a new 6 months deposit (verde).

But are we sure that the bank will be able to raise 1.000€ with the promise of paying an annual interest rate of 2%? No: if the central bank has increased the so-called official interest rate, the bank will have to pay a higher (!) interest rate.

Let’s suppose that the interest rate of this new deposit is 3%...

… Is this interest rate, charged on the loan granted by the bank, affected by the official rate increase?

Can the bank call the borrower and tell him, since the central bank increased the official rate, to pay more? No, because contractually the loan is a fixed-rate (!) loan.

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So, this means that, in the 2nd semester:

• The interests paid by the bank will be 3% * 1.000 * 1/2 = 15€;
• The interest earned will be always 6% * 1.000 * 1/2 = 30€;
• The Net Interest Margin will be 30 – 15 = 15€.

So, we notice that the Net Interest Margin of the bank decreases in the 2nd semester because of the movement in the market interest rates, induced, for instance, by the tightening of the monetary policy.

This is an example in which we see the effects of the interest rate risk on the banking book.

This is linked to maturity transformation or it could be linked to the fact that the liability is floating-rate and the asset is fixed-rate.

So, what is important to consider is that the interest rate risk on the banking book has to do with the maturity mismatching or with the mismatching of contractual interest rate conditions.

Liquidity risk

4. Liquidity risk…

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What does “liquidity” means? The liquidity of a financial instrument means the possibility of converting the financial instrument in money with very low transaction costs and without incurring in significant capital losses.

When is the bank liquid? There are 2 factors:

1. The 1st type of liquidity risk is the so-called market liquidity risk. It means that the bank is able to sell certain financial assets it holds, that is to say that the bank is able to convert these assets into cash/money, in a very short period of time, with low transaction costs and without suffering significant capital losses. This last term means that the bank is able to sell these assets in the market without bringing the market price down (!) because, if the market price goes down, the bank would suffer a capital loss;
2. The other way to understand the liquidity risk is linked to the so-called funding risk. Let’s go back to the example before: in the example, we considered a 1-year loan, which was funded by a 6 months deposit. When the deposit expires, the bank has to reimburse the amount of the money that it has borrowed: therefore, the liquidity risk, in this case, is the possibility that the bank doesn’t find another deposit at convenient terms or the bank is not allowed to borrow in the market because, for instance, the creditworthiness of that bank has worsened. So, the funding liquidity risk has to do with the risk that the bank is not able to meet its own payments (!) when it has to do.

Therefore, the problem of liquidity is that there isn’t a balance between inflows and outflows: a lack of cash (!).

Operational risk

5. Operational risk.

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Just think what would happen, from the point of view of a bank, if there is a blackout lasting for many hours during a working day: the bank exposed to that won’t be able to make real time transactions in the market of Bonds, etc…, because all banks rely strongly on ICT technologies: this means losing money and customers.

Or think about the negative impact of a bank linked to the not correct functioning of the software the bank has in order to manage all its business activities.

Or cyber risk is a kind of operational risk: so, think about to the potential damages for a bank stemming from the steal of the identity of the bank’s customers.

These are also problems on a reputational side (!).

But operational risk has also to do with “failed or inadequate processes”… so, internal controls (!).

We can imagine Lehman Brothers, but we can also think of Bearings Bank.

Barings Bank was a London-based investment bank, very strong in the asset management business. The Royal Family entrusted a lot of money to Barings Bank in order to get profits.

Barings Bank went bankruptcy in the 80s because it was the victim of one of its employees, a trader, Nick Leeson.

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Nick Leeson was a dealer working at Barings Bank, which was in duty of the derivatives desk, and started arranging very complex speculative strategies and, at the end, he completely lost the control of the situation: so, the result was a huge loss for the bank.

So, a bank can suffer a huge loss because the internal control system at a bank could not be enough effective (in the example, because n