1、Risk Management in Financial Institutions,Dr. Zhongyang Chen Associate Professor School of Finance Renmin University of China,What Today?,About me About the Course Why? What? How? Chapter One,About me,Born and brought up in Hunan Province, China, 1968-1987 Educated and Working in Renmin University,

2、Beijing, 1987-Present Associate Professor of School of Finance, Renmin University Visiting Scholar, Reading University, UK, 1998-1999 Fulbrighter, Suffolk University, U.S.A, 2002-2003 More Information: Resume in Webpage /zchen/,About the Course : What?,Risk Management course:

3、 an emerging course Just like the risk concept itself, risk management course is not yet unanimously defined, or designed. About derivatives and financial derivatives? About risk measuring models? About auditing and internal control? About financial institutions management? All of the above?,About t

4、he Course : What?,Our Planned Coverage Chapter 1 Introduction: What, Why and How? Chapter 2 Market risk management Chapter 3 Credit risk management Chapter 4 Operational risk management Chapter 5 Liquidity risk management Chapter 6 Risk-based regulation and the New Basel Capital Accord Special topic

5、: Risk of Chinas financial system,About the Course : How?,Lecturing, Case study and Presentation Middle-term test Final written examination About grading 20% Case Study and Presentation 30 % Problems assignments 40% Final written examination 10% Class Attendance and Participation,First of all,lets t

6、alk about risk! -How much do you know about risk?,List risk-related words Define risk in your own words. Make sentences using risk. Your preference/attitude to risk How do you manage or avoid risk in your everyday life? Your views on risk and finance/investment.,Your preference/attitude to risk,高、中、

7、低三種狀態(tài),Make sentences using risk.,風(fēng)險(xiǎn)是可控的 風(fēng)險(xiǎn)是由不可確定性造成的 風(fēng)險(xiǎn)是高投資，高收益的投資 人群是可以依據(jù)風(fēng)險(xiǎn)偏好分類(lèi)的 風(fēng)險(xiǎn)是可以預(yù)料的，但不可避免,List risk-related words,保險(xiǎn) 投資 損失 戰(zhàn)爭(zhēng) 婚姻 學(xué)習(xí) 就業(yè) 對(duì)沖基金 籬笆 旅行 期權(quán) 期貨,Define risk in your own words.,災(zāi)害 可能的損失 危機(jī) 不可預(yù)料的危險(xiǎn) 對(duì)某個(gè)客體在某種情況下造成危險(xiǎn)的事件 出乎自己的意料而造成的損失 不利的因素 可能承擔(dān)的代價(jià),Chapter 1 Introduction to Risk Management:

8、What, Why and How?,1 What is risk, especially in perspective of FIs? 2 Why FIs should manage risk? 3 How to manage financial risk? (Basic concepts and methodologies of managing risk) 4 Evolution, revolution and trends of risk management,1. What is risk?,Common word, hard to define clearly, precisely

9、 Intuitively, something which possible (not definitely)make you lose something else valuable to you, therefore (definitely) makes you worry or suffer Academically, and in perspective of FIs, (Some definition form popular text books) Risk is uncertainty of future outcome Risk is potential loss Risk i

10、s deviation from expectation Risk is any change resulting in loss Risk is volatility Risk is danger, or hazard,Comparing some involved or related concepts,Uncertainty Volatility Loss (severity) Hazard Probability Risk exposure,Uncertainty,Theoretical controversy about whether risk is equivalent to u

11、ncertainty Most of the finance books or investment books treat or define risk as uncertainty In some books, especially on decision making, risk is differentiated from uncertainty in the way how future situation is perceived. Risk: Decision maker has the knowledge of the possible outcomes and the res

12、pective possibilities of these outcomes. Thus, risk is measurable. Uncertainty: Decision makers have no such knowledge. Thus, uncertainty is not measurable.,Volatility,Volatility is measured by variance 2 or standard deviation , double-side measurement of risk, including upside potential and downsid

13、e potential First introduced by Harry Markowitz , as a basic measure of risk of investment on its own. Variance(2 ): The probability weighted sum of the squared deviations of all the outcomes from their mean (expected value). standard deviation(): the square root of variance,Loss (severity),Loss its

14、elf is not risk Realized loss (Probability not involved) Potential loss (Probability involved) Expected loss (Probability involved) Unexpected loss (at some specified confidence interval, Probability involved) Loss given default (LGD) or other event, (Probability not involved) (LGD=1recovery rate),H

15、azard,In insurance business and lending business, risk can be differentiated obviously from hazard. Risk is potential loss, or loss given a certain possibility, Hazard is the environment or event which can increase the scale (severity) or/and possibility of loss. Physical hazard and Moral hazard,Mor

16、al Hazard,Theoretically, moral hazard results from information asymmetry. Moral hazard occurs when the insured fails to take proper precautions to avoid losses because losses are covered by insurance. Hurricane Fran 1996 in North Carolina coast, yacht owners did not take down their old canvas covers

17、. Moral hazard plays important role in credit management. Borrow could intentionally violate the restrictive covenants and invest borrowings in high risk project. In managing credit risk, one important aspect is to reduce moral hazard, and hence to reduce information asymmetry. Financial structuring

18、, monitoring and enforcing covenants can help reduce moral risk in debt contract.,Probability,Risky investment is not a sure thing, probability calculation is inevitably involved and even become a core part of modern investment and risk management Expected return and Standard deviation (and hence co

19、variance and correlation coefficient ) are the most basic elements of analytic framework of modern investment and risk management Probability Distribution Function(PDF) is the core and hard part of risk modeling. Increasingly sophisticated statistic skills and advance probability theories are gainin

20、g more and more ground in risk management Large number law is a fundamental law in risk management. A jar filled with 3000 white pebbles and 2000 black pebbles, how do you know(estimate) the color structure without counting all the pebbles? Requirements of Independence of events and large sample,Ris

21、k exposure,Risk exposure is the total amount of investment or position which is exposed to a particular risk resource. Managing risk is actually managing the risk exposure, adjusting the risk exposure through hedging, insurance, or reducing investment scale. Risk exposureProbability of Default or ot

22、her event Loss given default (Severity) =expected loss, which is one measure of risk Suppose the size of your loan portfolio is $5m, it is exposed to credit risk, you can say”I have $5m risk exposure to credit risk”. If your research shows over a specified period, say one year, the loss probability

23、distribution is as follows: 10,000(0.3), 50,000(0.4), 100,000(0.3) The expected loss is $53,000. How much would you charge your customers for the lending business?,Categories of Risk in perspective of FIs,Risk typology in financial industry is far from unanimously defined due to diverse business and

24、 risk nature of different FIs. The increasingly popular Risk typology is that adopted by Basel Committee in “Risk Management Guidelines for Derivatives 1994”: Credit Risk (including settlement risk), Market Risk, Liquidity risk, Operation risk, Legal risk(, Regulatory risk, Compliance risk). It is a

25、lso changing and evolving.New Basel Capital Accord 2000: Credit Risk, Market Risk, Operational Risk,Credit Risk,Broadly defined, credit risk is the risk that a counterparty will fail to perform an obligation to the FI. Or, a change in the credit quality of a counterparty will affect the value of a F

26、Is position. Counterparty risk Default risk Credit event Settlement risk,(partly due to credit risk),Market Risk,Market risk is the risk to an FIs financial condition resulting from adverse movements in the level or volatility of market prices. Market risk is the risk that changes in financial marke

27、ts prices and rates will reduces the value of the FIs positions Market prices include interest rate, foreign exchange rate, equity price, commodity price,Operational Risk,Operation risk(BIS 1994)is the risk that deficiencies in information systems or internal controls will result in unexpected loss.

28、 It is associated with human error, system failures and inadequate procedures and controls. Operational risk(BIS 2000) is Risk of direct or indirect loss resulting from inadequate or failed internal processes, people and system or from external events. Operational risk under above definition is the

29、risk other than credit risk and market risk, including settlement risk (excluding those due to counterparty reason), legal and compliance risk.,Event types,Internal fraud, External fraud, Employment practices and workplace safety, Clients, products and business practices, Damage to physical assets,

30、Business disruption and system failures, Execution, delivery and process management,Derivative and operational risk,Derivatives trading is more prone to operational risk than cash transactions because derivatives are, by their nature, leveraged transaction, which means, a trader can make very large

31、commitments on behalf of bank, and generate huge exposures into the future (even up to 30years ahead), using only a small amount of cash(at the time the transaction is executed),Liquidity risk,Liquidity risk has two forms: Product (or trading-related) liquidity risk, is the risk that a FS may not be

32、 able to or cannot easily , unwind or offset a particular position at or near the previous (prevailing) market price because of inadequate market depth or because of disruptions in the marketplace. Funding liquidity risk is the risk that the FI will unable to raise the necessary cash to meet its pay

33、ment obligations on settlement dates, such as, to roll over its debt, to meet the cash, margin, and collateral requirements of counter parties and (in the case of funds) to satisfy capital withdrawals. The two forms are closely related and are both very hard to quantify.,Legal risk(Compliance risk),

34、Legal risk is the risk that contracts are not legally enforceable or documented correctly. Legal risk arises when a FI enters into a contract which is not appropriately or legally (lawfully) documented (worded), or where the counterparty might lack the legal or regulatory authority to engage in a tr

35、ansaction. Legal risk usually only become apparent when a counterparty, customer or an investor loses money on the transaction and decides to sue the FI to avoid meeting its obligation.,A case of Legal risk,In April 1994, Procter&Gamble, Gibson Greetings, and Mead Corporation announced hefty losses

36、from leveraged swap agreements with Bankers Trust. All three companies filed suits against Bankers Trust. Procter&Gamble lost $157million on two interest swaps, it then sued Bankers Trust for misrepresentation of the risks involved in the transactions. For details see Steinherr(1998),Another aspect

37、of legal risk is the potential impact of a change in laws. For example, when the British Government changed the tax code to remove a particular tax benefit during the summer of 1997, one major investment bank suffered huge losses.,Some basic conclusions and perceptions about risk,Risk is something p

38、eople (investors) normally are afraid of or dislike Some related concepts: risk aversion, risk taking and risk compensation, risk premium Risk(management) is something connecting future and present, i.e. your current perception of future situation(?), future situation affecting your current decision

39、 Is Managing Risk a “game against Gods”(by Peter L. Bernstein, 1998)?, or an attempt at beating your fate? Should risk manager be a fortune or disaster teller?) From a modern perspective, risk has a double-side nature: potential for loss and potential for profit Risk is about probability, One Price

40、Law is the fundamental law of risk management,Two dimension of describing (measuring) risk: loss size(Severity) and the probability of the loss. Loss size is related to risk exposure and recovery rate (like Loss Given Default in the case of credit risk management ) Risk is where profit comes from (n

41、o risk, no return), risk is a kind of resources, managing risk is not all about avoiding risk, more importantly, is about taking risk , which forms your core business competitiveness in marketplace. Risk is costly, and risk management can create value for firms In perspective of asset valuation, ris

42、k value (risk premium) is the other part of the whole value of an asset apart from its time value. Asset value= Time Value+ Risk Value,2. Why Manage Risk?,From viewpoint of the special nature of FIs and their business From viewpoint of the evolvement of risky environment over past half century From

43、viewpoint of the regulatory requirements From viewpoint of loss cases,From viewpoint of the special nature of FIs and their business,Basic business lines of FIs Functions of FIs High leverage nature of FIs High cost of bank failure,Basic business lines of FIs,deposit-taking and lending (commercial b

44、anking), asset management, trading, dealing and brokering, IPO, M&A (Investment banking) collecting and clearing (payment services), insurance, leasing, risk transferring (L/C, guarantee, derivatives, etc.) Banking Book activities vs. trading Book activities, On-balance activities vs. off-balance ac

45、tivities Commercial banking, investment banking, insurance,Functions of FIs,Funds transferring: Transfer funds from funds surplus units to funds deficit units, through: 1. asset transformation (indirect finance), 2. brokerage function(direct finance), Risk allocation: Transfer risk from units who ar

46、e not able or willing to take some risks to those who are able and willing to take them, through: 1. Cash transaction 2. Derivatives transaction Payment services and other economic functions,FIs in Financial System,Financial Intermediaries,FUNDS,Financial Markets,FUNDS,Lender-savers 1.Households 2.B

47、usiness firms 3.Government 4.Foreigners,FUNDS,FUNDS,FUNDS,DIRECT FINANCE,Indirect Finance,Borrower Spenders 1.Business firms 2. Government 3. Households 4. Foreigners,Risk transferring channels of financial system,Cash transactions (risk is transferred along with funds movements) A. debt finance, in

48、cluding bond and loan transactions Credit risk occurs in creditor side B. equity finance Market risk occurs in investor side Derivative transactions (Risk is transferred directly and independently from funds movement) A. future-type transactions B. option-type transactions,High leverage nature of FI

49、s,Leverage ratio: Capital(equity)/Asset Leverage is a common phenomenon in all business, but due to the special nature of financial business, leverage in financial industry is generally much higher than other industry, like manufacturing, Basel Required Capital Adequacy Ratio is 8%= Capital (tier 1+

50、2+3) Risk-adjusted asset Thus, financial business is much more risky than non-FB, and need more rigid risk management.,A Simplified Balance Sheet,Assets,Liabilities,Cash reserves Loans Bonds Others,Deposits Borrowings Others,$90 million,Capital,$100million,$10 million,$100million,L+C:,High cost of b

51、ank failure:,Bank failure: a bank is unable to meet its obligations to pay its depositors and other creditors and so must go out of business. bank runs: A sudden and unexpected increase in deposit withdrawals from a deposit institution. Bank panic: A systemic or contagious run on the deposits of the

52、 banking industry as a whole. contagion effect (domino effect): Uncertainty about the health of the banking system in general can lead to runs on banks both good and bad, and the failure of one bank can hasten the failure of others. Financial crises: major disruptions in financial markets that chara

53、cterized by sharp declines in asset prices and the failures of many financial firms and non-financial firms. Deposit insurance arrangement: FIDC (1934) of U.S. Need for (external) financial regulation and supervision,Conclusions:,Risk is indispensable and inherent nature or element of all business l

54、ines of FIs Doing financial business is almost all about dealing with risk Double side nature of risk is reflected in the success or failure of FIs risk management The basic mission of FIs is to take risk and get profit from managing risk (theoretically form risk premium),From viewpoint of the evolv

55、ement of risky environment over past half century,Interest rates risk: Interest rates became volatile from 1951 and the volatility intensified in the 70s and 80s Foreign exchange risk: Bretton Woods clasped in late 60s and early 70s and FX regime shifted from the fixed one to flexible one Risk manag

56、ement product, derivative innovation and expansion: both exchange-traded and OTC traded, impact on both market risk and credit risk (counterparty risk),Globalization (Development of large multinational corporations and mergers in both bank and non-bank corporations): impact on market, credit and ope

57、rational risk Deregulation (liberalization) and competition(See A556) 1.US financial system has been traditionally structured along separatist or segmented product lines.1933 Banking Act, or Glass-Steagall Act separated C-banking from I-banking 2. The passage of the Financial Services Modernization

58、Act of 1999 leads to universal banking, and more competition among FIs Securitization: The packaging and selling of loans and other assets backed by securities to increase liquidity, hedge interest exposure gap, and gain a new source of fee income, and also help reduce the effects of regulatory taxes such as capital requirements, reserve requirements, and deposit ins