Lecture 1: Introduction

QF305
Shirley Huang
(Chapter 1 and 2)
1

The concept of Risk

Risk is related to the expected losses

(gains) which can be caused by a
risky event.

Uncertainty of
a factor or event

Probability of the
Occurrence of
the factor or event

Risk management

Man plans, God smiles -Hebrew Proverb

Crossing the road without looking will most likely

result in injury!

If you cant manage risk, you cant control it. And if

you cant control it you cant manage it. That means
youre just gambling and hoping to get lucky.
-- J. Hooten, managing Partner, Arthur Andersen &
Co., 2000
3

Prevention and mitigation

Prevention and mitigation
are the actions we can
take to make sure that a
disaster doesn't happen
or, if it does happen, that
it doesn't cause as much
harm as it could.

Sources of risk

A source of risk is any factor that can

affect project or business performance.
There are many sources of risk!
- political, financial and legal risks
- economic, natural and market risks

Types of risks

Common risks:
1.
2.

3.

Environmental risks
Operational risks
Financial risks

Managing risk

Risk management is the process of

measuring (or assessing) risk and
developing strategies to manage it.

The evolution of risk management

The birth of risk management

In the 1970s - early work
In the 1980s - quantitative analysis
In the 1990s - methodology
In the 2000s - enterprise wide

The risk management process

The process of risk management

involves:
- identification of risks
- evaluation of the risks
- management of the risks

Risk management

Identification

Measurement

Management

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Identify risk

Examine all sources of risk both

internal and external.

Identify risks through

1.
2.
3.

4.
5.

history
incidents
scenario analysis
survey
..
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Case study

Risk profile of Malaysia airline

12

Evaluate risk

Risk evaluation allows you to

determine the significance of risks and
decide to accept or take action for
each specific risk.
Quantitative techniques are the tools
to do the measurement!

13

Manage risk

Find suitable responses to risk (4 Ts)

1.
2.

3.
4.

Tolerate (Retention)
Treat (Mitigation)
Transfer (Buying Insurance)
Terminate (Elimination)

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Financial risk
Financial risk can be defined as those which
relate to possible losses in financial markets.
Financial markets:

Capital markets
Commodities markets
Money markets
Derivatives markets
Insurance markets
Currency markets
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Financial Institutions Roles

Without FIs
Equity & Debt

Households

Corporations

(net savers)

(net borrowers)

Cash

16

With FIs
FI

Households

(Brokers)

Corporations

FI
Cash

Deposits/Insurance
Policies

(Asset
Transformers)

Equity & Debt

Cash

17

Functions of FIs

Brokerage function:

Acting as an agent for investors

Reduce costs through economies of scale
Encourages higher rate of savings

Asset transformer:

Purchase primary securities by selling

financial claims to households
Transformation of financial risk

18

Functions of FIs

Information costs

Role of FI as Delegated Monitor

FI likely to have informational advantage

Economies of scale in obtaining information.

FI as an information producer

Shorter term debt contracts easier to monitor than bonds

Greater monitoring power and control
Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders

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Other Special Services

Reduced transactions costs

Maturity intermediation
Transmission of monetary policy.
Credit allocation (areas of special need
such as home mortgages)
Intergenerational wealth transfers or time
intermediation
Payment services
Denomination intermediation

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Risk measurement and management

From originate and hold to originate and

distribute
Increase the systemic risk of the financial
system.
Financial crisis reshaped the financial
services industry.
The economy relies on financial institutions
to act as specialists in risk measurement
and management
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Products of financial Institutions

Products sold
in 1950

Table on page 35,36

Products sold
in 2013

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Financial institutions

Depository Institutions
Finance companies
Securities firms and investment banks
Mutual funds and hedge funds
Insurance Institutions

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Depository Institutions

Products of depository Institution:

o
o

Payment services, savings products,

Underwriting of debt and equity, Insurance
and risk management products

Three major groups:

Commercial banks
Saving institutions
Credit unions

o
o

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Balance sheets

In financial accounting, a balance sheet or

statement of financial position is a summary of the
financial balances of a sole proprietorship, a
business partnership, a corporation or other
business organization, such as an LLC or an LLP.
Assets, liabilities and ownership equity are listed
as of a specific date, such as the end of its financial
year.
http://en.wikipedia.org/wiki/Balance_sheet

25

Example of a balance sheet

26

Example of a banks balance sheet

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Specialness of Depository FIs

Products on both sides of the

balance sheet

Loans

Business and Commercial

Deposits

28

Size of Depository FIs

Consolidation has created some very

large FIs
Combined effects of disintermediation,
global competition, regulatory changes,
technological developments,
competition across different types of FIs

29

Largest US Depository Institutions

Holding Co.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Assets ($Billions) 2012

J.P.Morgan Chase
Bank of America
Citigroup
Wells Fargo
U.S. Bancorp
PNC Financial Services Corp.
Bank of NY Mellon
State Street Corp.
TD Bank
HSBC North America

2,321.3
2,168.0
1,931.3
1,374.7
352.3
301.1
340.1
204.1
212.5
320.8
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Commercial Banks

Largest depository institutions are

commercial banks, which accept deposits
and make consumer, commercial and real
estate loans.
Differences in operating characteristics and
profitability across size classes
Mix of very large banks with very small banks

31

Breakdown of Loan Portfolios (US)

32

Structure and Composition

Shrinking number of banks (US):

14,416 commercial banks in 1985

12,744 in 1989
6,911 in 2009
6,168 in 2012

Mostly the result of Mergers and Acquisitions

M&A prevented prior to 1980s, 1990s

Consolidation has reduced asset share of small
banks
Asset Concentration
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Commercial Banks: Asset Concentration

Size
$100M or
Less
$100M - $1B
$1B - $10B
$10B or more

2012 Percent
Assets of Total
118.0
0.9
1,059.2
1,133.6
10,759.1

8.1
8.7
82.3

2009
Assets
142.9

Percent
of Total
1.2

1,104.2
1,158.9
9,460.4

9.3
9.8
79.7

1984 Percent
Assets of Total
404.2
16.1
513.9
725.9
864.8

20.5
28.9
34.5

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Global trend

Top banks in 2008

Top banks in 2013
Top 100 Banks in the World
http://www.relbanks.com/worlds-topbanks

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Global trend
Banks

Total
Assets

Deutsche Bank (Germany)

2,809.9

Mitsubishi UFJ Financial Group (Japan)

2,803.4

Industrial & Commerce Bank of China (China)

2,763.6

HSBC Holdings (United Kingdom)

2,721.1

Barclays Bank (United Kingdom)

2,584.3

BNP Paribas (France)

2,563.0

Japan Post Bank (Japan)

2,513.2

J.P. Morgan Chase (United States)

2,321.3

Crdit Agricole Groupe (France)

2,317.1

Royal Bank of Scotland (United Kingdom)

2,295.8

February 2012

2013
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List of banks in Singapore

http://en.wikipedia.org/wiki/List_of_ban
ks_in_Singapore

37

Some Terminology

Offsetting
Commercial paper market
ROA (return on assets)
ROE (return on equity)
Securitization

38

Balance Sheet and Trends

Business loans have declined in importance

Offsetting increase in securities and mortgages
Increased importance of funding via commercial
paper market
Securitization of mortgage loans

39

Balance sheet in September 2012

40

Commercial Banks, September 2012

Primary assets:

Real Estate Loans:

C&I loans:
Loans to individuals:
Investment security portfolio:
Of which, Treasury securities:

$3,569.9 B
$1,401.2 B
$1,206.9 B
$3,909.3 B
$1,705.6 B

Inference: credit Risk, liquidity risk, interest

rate risk
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Commercial Banks

Primary liabilities:
Deposits:
Borrowings:
Other liabilities:

$9,622.4 B
$1,568.6 B
$378.2 B

Inference:

Highly leveraged

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Equity

Commercial Banks equity capital (2012)

(11.48% percent of total liabilities and equity
Common and preferred stock
Surplus or additional paid in Capital
Retained earnings
A minimum level of equity capital is required
to act as a buffer against losses

43

Off-Balance-Sheet Activities

Heightened importance of off-balancesheet items

OBS assets, OBS liabilities

Regulatory incentives
Risk control and risk producing

Role of mortgage backed securities

Toxic assets
Expansion of oversight
44

Major OBS Activities

Loan commitments
Standby letters of credit and letters of
credit
Futures, options, forwards, and swaps
When-issued securities

45

Other Fee-Generating Activities

Trust services
Correspondent banking

Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security
issuances
46

Savings Institutions

Comprised of:

Savings and Loans Associations

Savings Banks

Industry is smaller overall

Intense competition from other FIs

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Credit Unions

Nonprofit DIs owned by member-depositors

with a common bond of occupation
Exempt from taxes and Community
Reinvestment Act (CRA)
Expansion of services offered in order to
compete with other FIs
Claim of unfair advantage of CUs over small
commercial banks
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Discussion

What are the benefits to have FIs?

What are the major assets hold by
commercial banks? What inference do
we get?
What are the benefit of OBS activities?
What are the risks of OBS activities?

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