Appunti Financial risk management

Index

I. Financial risk management

• Risk analysis
• Major risks in banking classification
• What is the risk appetite framework (RAF)?

II. The repricing gap

• Exercise 1
• Repricing gap and NII variations
• Weaknesses of repricing gap
• Marginal and maturity adjusted gap
• Standardized gap

III. Duration gap

• Reminder about duration
• Duration gap
• Weaknesses of duration gap
• Internal transfer rate

IV. Value at risk

• From traditional approaches to modern approaches
• The logic of sensitivity measures
• Weaknesses of traditional approach
• Advantages of VAR
• Different methodologies
• Variance-covariance approach
• Time horizon
• Confidence level
• Risk mapping
• Historical simulations
• Monte Carlo simulations
• Back testing of VAR models
• Stress testing
• Reverse stress testing

V. Credit risk management

• Expected and unexpected loss
• Measuring expected losses
• Exposure at default
• Probability at default
• Loss given default
• Estimating recovery
• Going concern
• Steady state approach
• Two-step cash-flows approach
• Hybrid approach
• Gone concern
• Loan loss provision

Financial risk management

Risk classification

Financial risks
Uncertain future event: I’m exposed to a risk, when there is uncertainty, it produces risk for me. (It is a common trait between financial risk and pure risks). Positive or negative outcome: If I buy a stock, I’m exposed to uncertain future events: price of stocks fluctuates. This uncertainty can be positive or negative, price can go up or down, increasing or decreasing the value of my investment.

If I book a holiday and the accommodation is in $, I really don’t know if I fixed the booking price today, and I don’t know the final price of € for accommodation. If the $ appreciates, I will pay in € more than what I would pay today. Exchange rate between € and $.

I’m not always interested in minimizing exposure, but I’m interested in cancelling the potential downside and remaining free to upside.

Pure risks
Uncertain future events with a negative outcome.
For sure, with pure risk, I’m interested in understanding the potential amount of damages. If the latter is too high, I will be interested in avoiding that risk exposure. I need to minimize the exposure to the risk.

Lavazza example – Imagine you are the risk manager of Lavazza; the company has a huge need to buy coffee. Price fluctuations in the market. Once the price of the final product is fixed, I have the task to try to control the price of raw material (coffee), which can go up or down. If the price of coffee goes up, Lavazza will see decreased profit margins, because the raw material will cost more than expected and, once having fixed the price for the product, the profit margin will decrease if the price goes up. But if the price decreases, it will be nice because the profit margin will enlarge.

If I’m a risk manager, I have the problem of evaluating the potential impact of the total cost of supply of raw material and making decisions (if I block the price today and the price of coffee goes up, the company will be happy; if the price goes down we have a problem) – we need to justify why we decided to block the price in advance.

Risk management policy is a document that provides guidelines to the risk department, and it’s important to risk management to act and justify why certain decisions were taken. The risk manager department will produce risk measurement and, based on the policy approved by the BoD, put in place risk reduction.

Risk analysis

Likelihood (probability) – The probability of an uncertain event taking place (e.g., probability of exchange rate €/$ to go up). Once the probability is evaluated, we can assess the impact.

Impact – What potential damage could I have from these events? How much do I lose in case an event occurs? These two aspects must be evaluated together to take decisions, because it’s different if I have a very probable event with low impact, and an improbable event with high impact.

Risk perception: past, present and future – Top 5 risks by likelihood

This table is taken from a report published by Marsh insurance company. This report is based on hundreds of interviews. Colors: Blue are economic risks, Red are societal, Green are environmental, Violet are technological, Orange are geopolitical. In 2009, most interviewed thought that the majority of risks were of economic nature (2009 was after the subprime crisis of Lehman Brothers).

Risk perception: past, present and future – Top 5 risks by impact

Major risks in banking classification

Market risk - Potential impact of an exogenous change in market prices, such as:

• Interest rates - important issue for banks, because they raise money, pay and receive interest. Both costs and revenues of banks are related to interest rates.
• Equity prices – important issue for banks, because banks buy equity and have large portfolios of equities. So, fluctuations of these may have a big impact.
• Foreign exchange rates – big issue in industrial and commercial companies.
• Commodity price – big companies in industrial companies.

Potential impact = potential losses related to exogenous (outside my capacity of control) changes. Managing market risk means trying to get a quantitative measure of the potential impact of movements of these items above.

Credit risk - Potential impact generated by a change in the creditworthiness of a debtor. It may be distinguished into:

• Default risk – when I lend money to someone, I’m exposed to the risk of default, which is the risk that the person to whom I’m lending money is not able to reimburse. If I’m a bank and I lend money to a company, the first risk I’m exposed to is not receiving the reimbursement.
• Migration risk – a change of evaluation of creditworthiness during the contract, even if there is no default.

Example: Imagine a bank receives a request for a loan for a company. What the bank has to do is evaluate if the company is reliable or not, done through procedures “rating procedure.” At the end of this process, the company requesting the loan will be given a rating or a grade (A, B, C, D, E): E is a negative evaluation and the loan is refused, A, B, C, and D the loan is approved. A client with an A evaluation is the least risky client, with a D evaluation is acceptable but is risky.

If a company goes to a bank and is rated A, the loan will be dispersed, and the interest rate applied by the bank will or may be a little lower and the reason is that the client is very reliable. This is because the risk is lower. Migration risk means that during the life of the contract, the client which initially was evaluated A, may increase the level of risk and gradually be evaluated again with grades (even go to E). Return on equity for transaction is the amount of interest rate/equity absorbed by the transaction. Other terms sometimes used in relation to credit risk:

• Settlement risk - particular type of default that takes place before the transaction is finalized.
• Country risk – situation where the reason for an increase in the level of risk is not related to a single individual but to the country where the individual lives. Imagine that Covid-19 will remain just in China: if China is strongly affected, this creates country risk.

Liquidity risk - Potential losses generated by difficulties in fulfilling regular payments and the consequent need to force sale assets or negotiate emergency loans.

Liquidity risk concerns more banks than commercial companies. Banks have big exposure to liquidity because for any company it’s a problem to not be able to pay money on time, for banks it’s dramatic not to be able to pay on time.

Operational risk - Potential losses resulting from failed or inadequate internal processes, systems, human error, fraud, or external events. Sort of residual category. Reputation risk is normally excluded.

Example 1

Consider a simple transaction whereby a US trader purchases 1 million worth of British pounds (£) spot (transaction negotiated) from Bank A. The current foreign exchange rate is 1.5 $/1 £. So, the trader will have to deliver 1.5 million $ in two working days in exchange for receiving 1 million £. Which types of risks can you identify in the transaction?

I’m exposed to market risk because I'm fixing an exchange rate of 1.5$ to 1£, but today the exchange rate could change: the value of £ I’m buying could change. I’m fixing to pay 1.5$ to 1£ each within 2 working days. If 2 days after, the exchange rate goes to 1.48$, I will be angry for having set 1.5$ instead of 1.48$. When I’m a US trader and I buy £, when £ are delivered I’m the owner of foreign currency and the value of this currency will fluctuate, according to the value of exchange rate in my own currency. Market risk could be immediately after I have fixed the price, and we remain exposed to risks as long as I’m the owner of the amount of money in a currency different from mine.

In terms of credit risk, there is a settlement risk, which here it’s not really dramatic, because the transaction will be finalized within 2 working days. But from the moment I have fixed the price, until I will pay the amount and receive the money, I will be exposed to the risk that the counterparty is not able to fulfill the promised amount. So, I expect within 2 working days to receive 1M £, and to pay $1.5M. If within 48 hours needed to receive the £, the counterpart makes default, I won’t receive the £, so this is settlement risk. If the counterpart makes default, within 2 days, there are 2 potential consequences: light that is I discovered that counterpart is not able to give me £ if I don’t pay before $; worst is that I don’t find out that the counterparty is not able to give me £, even if I pay $. In the past, this risk was sizeable.

There could be even operational risk. When banks negotiated, they chat on Bloomberg: there is a back office whereby someone in the administration records this transaction to be performed. If there is any type of mistake, it can happen that movement of settlement, there is something mismatching. This can create problems in transactions or delays.

How much risk?

The task of the risk management department is composed of many steps that need to be undergone:

• Risk identification and mapping – Analyze in detail all the processes of the organization and company, all the assets and liabilities of the company, to identify all potential sources of risks and classify them. Being aware of all the risks to which the company is exposed is the first step to proceed with measurement, evaluation, and mitigation of risks.
• Risk measurement – In terms of likelihood and impact. Quantify the probability of various risks and events the organization is exposed to, and quantify the potential impact on the company when the risk materializes.
• Risk appetite framework – Once I have measured risk, I want to avoid risks, but sometimes I want to keep the risk. Who decides how much risk I want to accept and how much I want to eliminate? This is a subjective decision, depending on the nature of shareholders, on the type of companies. There are shareholders which are more inclined to risk or risk mitigating.

It means that the transaction is negotiated and then the two amounts of money (£ and $) have to be exchanged physically within 2 working days. If the period is longer than 2 working days, it is called forward.

• Risk mitigation

What is the risk appetite framework (RAF)?

The overall approach, including policies, processes, controls, and systems, through which risk appetite is established, communicated, and monitored. It includes a:

• Risk appetite statement
• Risk limits
• Roles and responsibilities of those overseeing the implementation and monitoring of the RAF

The RAF aligns with the institution's strategy. RAF is not only the table containing percentage, but also a policy that says: if the tolerance is exceeded what happens? Who takes the decision? Which action plan must be taken?

Risk appetite statement

The articulation in written form of the aggregate level and types of risk that a company is willing to accept or to avoid, in order to achieve its business objectives. It includes qualitative statements as well as quantitative measures expressed relative to earnings, capital, risk measures, liquidity, and other relevant measures as appropriate. It should also address more difficult to quantify risks such as reputation and conduct risks as well as money laundering and unethical practices.

Example: This example refers to a bank. There are identifications of credit risks. In terms of credit risk, the bank would like to monitor the NPL (non-performing loan) Ratio – percentage of loans granted to clients when they are not paying regularly. Once identified this indicator, as a board, I define 4 different levels: capacity, tolerance, trigger, and target. The target is the optimal level: my goal, as a bank, is to keep the NPL ratio to be around 1.30%. Then there is the level of trigger, which is 3.21% - it is the first alert level. If the NPL ratio rises and arrives beyond 1.31%, there is a first alert, and something has to be done. Operational actions must be taken: the head of risk management will be informed, and they will get into contact with the credit department to agree on some action to reduce the credit riskiness of the portfolio. Tolerance is another alert level; if the NPL ratio from 3.21% continues to rise and arrives beyond 5.10%, this is a second alert. Capacity identifies the maximum level bearable for the organization, the level above which the bank will be in risk and default.

The repricing gap

Interest rate risk exposure – 2 perspectives

Short-medium term perspective - measured in months or years.

• Potential impact on the income statement (repricing gap model – impact of next semester or next year at maximum).
• Potential impact on the market value of net capital (duration gap model – impact over the coming 2/3 years) – potential impact over the balance sheets, so assets and liabilities of the company (medium term).

Repricing and duration gap model focused on interest rate risk.

Very short-term perspective – potential impact on the market price of bonds (value at risk and expected shortfall models). Here the time horizon is 1 day, a couple of weeks, not more than a month.

Interest rate risk measurement – repricing and duration gap

Fluctuations of interest rates can impact not only liabilities, but also assets, and even impacts on income statements.

• Banks and other types of financial intermediaries are more exposed to interest rate risk than other types of companies.
• This is why they have developed comprehensive and sophisticated models to measure this type of risk.
• Interest rate risk exposure in banks mainly derives from the mismatch between assets and liabilities.
• Banks typically borrow short and lend long.
• On top, banks often borrow at variable rates and lend at fixed rates (or vice versa).

Example: Imagine we are analyzing B.S. of a bank ALFA at 31 Dec 2020. Since deposits are contracts where there are no deadlines, the bank is able to change the interest rate applied at any moment. What will be the impact on the income statement of the bank if there is an increase by 1% in the market level of interest rate? It will be negative because on deposits, the interest rates can be changed by the bank and the bank, even if it is free to change or not, will be at a certain point forced to increase the interest rate. The interest rate received is fixed: so, borrowers continue to pay installments with a fixed interest rate, not adjusted to the new level of the market interest rate, whereas the cost for interest paid by the bank to depositors will increase because the bank will be forced to adjust the interest paid.

Imagine another situation: What would be, in this case, a 1% increase in the interest rate level? Neutral, because on one side we have deposits, so the interest rate will be adjusted but we also have assets (floating rate loans) where the interest rate will be adjusted, according to the market level of the interest rate. So, the bank will have an increase in costs but also receive higher interest. Here there is a matching between the amount of assets and liabilities, where the interest will be adjusted following the market level. There will be an increase in interest rate paid by the bank, but also an increase in interest received by the bank. Since the adjustment is applied to the same amount of assets and liabilities, the consequences should be neutral.

The repricing gap concepts

The gap is a concise measure that quantifies the potential impact of an interest rate change on the net interest income (NII), which is the difference between interest income and interest expenses in the income statement. The gap is always computed over a given gapping period – time horizon for the analysis. The repricing gap is computed as the difference between rate-sensitive assets (RSA)...