Risk Management In

Financial Institutions

Sections
Section 1
Overview of Risk Management Process & Operational Risk
Section 2
Financial Risk Management:
Credit Risk Management
Asset and Liability Management
Interest Rate Risk
Liquidity Risk

Derivatives

Section 3
Bank Performance Measurement
Understanding Banks Financial Statements
Financial Risk Ratios

Section 4
Basel International Standard For Banking Regulation and Supervision
Basel I, II, 2.5 and III

Section 1
Session
1&2

Risk Management Process

Topic
Overview of the Risk Management Process:
Definition of Risk

Types of Risk managed by Banks

Risk Management Objectives

Enterprise Risk Management

Risk Management Process (7Rs and 4Ts)

Risk identification

Risk Evaluation (Measurement)

Risk appetite

Risk Responses (Methods of controlling

risks)
Risk Documentation Risk Management

Framework, Risk Events reports, Risk

Register
Risk-Aware Culture

Operational Risk

Business Continuity Plan

Reference / Chapter
Paul Hopkins: Chapter 1, 5, 19, 20,21

Handouts:
a) Risk Culture IRM
b) Structured Approach ERM (ISO31000) IRM
c) BOG Draft Risk Management Guidelines for
Banks and Other Fin Institution.

Section 2
Sessions
2&4

5&6

7&8

Financial Risk Measurement

Topics
Credit Risk Management
Bank Lending function

Credit appraisal factors 5c / CAMPARI

Credit Risk Measurement

Moodys EDF,

JP Morgan CreditMetrics

Asset and Liability Management

Interest rate risk

Interest Rate Gap Management

Interest Sensitivity Analysis

Duration Gap
Liquidity Risk

Value at Risk

Derivatives as tools for managing financial risk

Forwards

Futures

Options

Swaps

Credit derivatives

Reference / Chapter
Credit Risk Measurement New Approaches to Value At
Risk and Other Paradigms; Second edition, Anthony
Saunders and Linda Allen:
o Chapter2: Traditional approaches to credit
risk measurement
o Chapter4: Loans as Options the KMV and
Moodys Models
o Chapter6: The VAR approach CreditMetrics
and other models Credit Analysis & Lending Management; Sathye, Bartle,
Vincent and Boffey
o Chapter 5 Consumer Lending
o Chapter 8 Corporate lending

Bank Management 7 edition. Timothy W. Koch and S.

Scott MacDonald
Ch.7 Managing interest rate risk GAP and Sensitivity
Ch. 8 Duration Gap
Ch.11 Managing liquidity
Fundamentals of Risk Measurement Chris Marrison
Ch. 14 Funding-Liquidity Risk in ALM.
Financial Management and Analysis - FRANK J. FABOZZI
and PAMELA P. PETERSON (2nd Edition)
Chapter 4 - Introduction to Derivatives

Option, Future and Other Derivatives, 5th Edition, John

C. Hull

Chapter 1 Introduction to Derivatives

Chapter 2 Mechanics of Futures Markets

Chapter 6 SWAP

Chapter 27 Credit Derivatives

Section
3
Sessions
9 & 10

Bank Management & Performance Measurement

Topics
Bank Performance Measurement
Understanding a Banks Balance
Sheet and Income Statement
Measuring Returns and Risks in a
Bank Analysis of Key Return-Risk
Ratios.
Risk-Return trade off

Reference / Chapter

Bank Management: George H.

Hempel
o Chapter 2 & 3 (5th Edition)
o Understanding Banks
Financial statement
o Evaluating banks Returns,
Risks & Performance
The Bank Credit Analysis
Handbook: Jonathan Golin
Deconstructing a bank
F/S Chapter 3 & 4

Section
4
Sessions
11 & 12

Banking Regulations (Basel Accords I, II, III)

Topics
Capital Adequacy Requirements
Factors Determining Capital
Adequacy
Role of Capital In Banks
Capital Adequacy Requirement :
o Background
o Basel I, II, 2.5 & III
o Basel II Three pillars of
Basel II, Minimum capital
Requirements
o Basel III Revised regulatory
Capital and Liquidity
requirements

Reference / Chapter

Managing Bank Capital: Chris

Matten, 2nd Edition: Chapter 1 &
7
Credit Risk Measurement:
Saunders & Allen : Chapter 3
Risk Management & Financial
Institutions; John C Hull, 3rd
Edition. Chapter 12 and 13
http://www.bis.org/publ/bcbs118
.pdf

Section 1
Overview of Risk Management Process & Operational Risk

References
Fundamentals of Risk Management, Paul Hopkin (3rd
Edition), IRM; Chapter 1, 5, 19, 20,21
Handouts:
a) Risk Culture IRM
b) Structured Approach ERM (ISO31000) IRM
c) BOG Draft Risk Management Guidelines for Banks
and Other Fin Institution.

Topics
Definition of Risk
Types of Risk managed by Banks
Risk Management Objectives
Enterprise Risk Management
Risk Management Process (7Rs and 4Ts)
Risk identification
Risk Evaluation (Measurement)
Risk appetite
Risk Responses (Methods of controlling risks)
Risk Documentation Risk Management Framework, Risk Events reports, Risk Register
Risk-Aware Culture
Operational Risk

Definition - Risk
A chance or possibility of danger, loss, injury or other adverse
consequences Oxford English Dictionary
i.e. exposed to danger
Emphasizes on negative outlook of risk

Combination of the probability of an event and its consequences The

Institute of Risk Management
Emphasizes on likelihood of an event occurring and the severity of the impact
The consequences could however ranges from positive or negative

risk is the effect of uncertainty on objectives - ISO Guide 73 (ISO 31000 2009)
Provides a reference point i.e. the objective, from which a deviation could occur
Uncertainty denotes that the outcome (deviation from) the objective could be
positive (opportunity) or
negative (hazard, threat) or
results in uncertainty (deviation from the expected) - ISO Guide 73 (2002)

the uncertainty of an event occurring that could have an impact on the

achievement of the objectives institutes of Internal Auditors
Given that there are many available definition of risk, it is important the
organization chooses a definition that is most suitable for its own purposes.

D
Pe ang
en rils er
co y s /
u o
r nte u

Run short of cash /

Perilous Journey To the Cheese
liquidity

c
gi
te v e
r a cti
St bje
O

Activ
iti
achie es to
ve
Objec the
tive
invol
ve P s
erils

Customers /
counterparty do not
payback loan credit
risk
Lose customers
confidence reputation
risk
Indiscipline staff
operational risk
ICT infrastructure
Building
infrastructure
Profitability
Adequate
liquidity level
Customer service
Quality loan
portfolio
Build Best HR
team

Types of Risk
Generally, risk could be grouped into
Pure risk risks events which can only result in negative outcomes
Injury, death, fire, theft, legal liability
Referred to as insurable risks

Control (uncertainty) risk:

are associated with unknowns and unexpected outcomes
give rise to uncertainty about the outcome of a situation
Frequently associated with project management; uncertainties about:

the benefits the project will produce,

delivery of the project within time,
Delivery within budget and
Made to specification

Managing control risk is to ensure that the outcome stays within a tolerable range, that
the actual is not very much different from the expected.

Opportunity or speculative risks

Are risks that deliberately taken by an organization in order to exploit the positive
aspects of the risk event. E.g. commercial risk

Common Risk Managed by Banks identified in Draft BOG Risk Management

Guidelines (2013)

Credit Risk
Credit risk, also known as counterparty risk, refers to the possibility of a
debtor not able or not willing to pay the interest and/or principal according to
the terms specified in a credit agreement thus resulting in economic loss to
the creditor institution.

Country and Cross-border Risk

Country risk refers to the possible risk of loss arising when political or
economic conditions or events in a particular country reduce the ability of
counterparties in that country to meet their financial obligations to the
institution

Liquidity Risk
Liquidity risk arises from an institutions inability to purchase or otherwise
obtain the necessary funds, either by increasing liabilities or converting
assets, to meet on-and off-balance sheet obligations as they become due at
minimum cost or, without incurring unacceptable losses

Market Risk
Market risk is the risk of losses arising from adverse movements in market
prices such as equity, bond and commodity prices, currency exchange rates,
interest rates and credit spreads

Common Risk Managed by Banks identified in BOG Risk

Management Guidelines
Operational Risk
Operational risk is the risk of loss suffered as a result of inadequacy of, or a
failure in, internal processes, people and systems or from external events.

Business/Strategic Risk
Business or strategic risk arises from an institutions failure or inability to
implement appropriate business plans/strategies and to adapt to changes in
business environment.

Compliance (Legal and Regulatory) Risk

Compliance risk, also called legal and regulatory risk, arises from an
institutions non-compliance with laws, rules, regulations, prudential
requirements, prescribed practices, or ethical standards in any jurisdiction in
which the institution operates.

Reputation Risk
Reputation risk is the current and prospective impact on earnings and
capital arising from negative opinion of the public and/or market
participants.

Credit Risk
Credit Risk: refers to the risk associated with delays or failure in
payments on the part of a firms customers and/or parties to which it has
lent money.
Though credit risk is often associated with financial institutions such as
commercial banks that make routine loans, any organisation that sells on
credit or provides services before payments are made are exposed to
credit risk.
Telecom operates post paid, FMCG Nestle, UniLever, Cocacola etc. GNPC,
GRA

Credit Assessment: The objective of credit assessment process is to

assess the obligors:

Ability to pay,
Willingness to pay and
Commercial viability of the loan proposal/ purpose
The Five Cs Framework:
Character, Capacity, Capital, Collateral and Conditions

Monitoring: To reduce failure to pay, obligor is monitored after the credit is

given.

Market Risk
Market risk is the risk of losses arising from adverse movements in
market prices such as equity, bond and commodity prices, currency
exchange rates, interest rates and credit spreads.
Commodity price risk
This results from fluctuations in the prices of commodities, such
as copper, oil, gas and electricity that constitute inputs for one
firm and outputs for others.
(note: recent discussion on crude oil prices for electricity
generation in Ghana Also Atuabo gas is supposed to make
power generation cheaper)
Exchange and
globalization of economic activities even brings in fluctuation in
input and output prices due to fluctuations in foreign exchange
rates.
(The Cedi in constant decline making imports expensive
and generating inflation in general consumer goods)
Interest Rate risks

Operational Risk
Business Operations - refer to various activities or
processes that produce an output, product or services.
The effectiveness of an operation depends on factors like:
Information Technology, Human Resources, Infrastructure, Internal
Controls & processes and outside factors
Deficiencies in the above factors could mean that:
The business process will not achieve its intended objective
and could result in financial loss to the organization.

The deficiencies and the resulting financial loss is generally termed as

operational risks and losses.

Operational Risk could therefore be defined as:

the risk of financial losses or damaged reputation due to
failure attributable to technology, employees, internal
processes or procedures or physical arrangements including
external events and legal risks.

Liquidity risk
Liquidity represents the organizations ability to efficiently meet its:
Banks Due Obligations
Regulatory: Primary Reserve (9% of Deposits)
Depositors demand

Loan requirements
Other organizations:
pay suppliers, tax Obligations, employees wages

Liquidity risk arises when the organization is not able to raise the
cash needed to meet its maturing obligations
so that it is forced to sell assets at deep discounts or borrow at a highly
excessive cost.

Measuring Liquidity Needs

Maturity Gap Report: matching the maturities of assets (inflows) and
liabilities (outflows)
Liquidity Ratios:
Liquidity Stress Testing Reports: Depositors withdrawals

Managing Liquidity
Asset Quality: Reviewing the quality of the banks asset i.e.
monitoring
Liquidity Buffer Stock
Funding Concentration: diversify funding base across region,
industry, consumer customer base
Stress testing & Contingency Funding
Stable funding: Core Deposit Funding - sourcing from stable
source
For Non-Financial Institutions:
Investments in treasury bills, bank deposits
diversified customer base sales deterioration in regions and customer
type would not be by same degree.
Contingency plans where to source funds in time of troubles have
standby facility arranged with your bank.
21

Reputation Risk

Reputation Risk: losses arising from damage to the

organisations image and brand.
Brand takes ages to develop, and repairing damage
reputation is an arduous task.
Tobinco and Food and Drug Board Saga
Toyota Camry
The Camry is the best selling car in the US, which is a key market for
Toyota.

Toyota to recall 885,000 vehicles http://www.bbc.co.uk/news/business-24576729

Toyota is recalling 885,000 vehicles to fix a problem that could

cause a water leak from the air conditioning unit.
It said water could leak into the airbag control module, causing a
short circuit and triggering a warning light.
In some cases airbags "could become disabled or could
inadvertently deploy" and in limited cases the power steering
function could be disabled, it added.
The models affected by the recall are the Camry, Camry Hybrid,
Avalon, Avalon Hybrid, and Venza made in 2012-13.
Some 847,000 cars will be recalled in North America, while the rest
will be in Europe, Asia and the Middle East.
A spokeswoman for Toyota told the BBC that it had received reports
of two minor injuries due to the issue, but there had been no reports
of any vehicles crashing.
Reputational damage?
This is the third major recall that Toyota has issued in recent weeks.
Last month, the company called back more than 780,000 vehicles in the US
to address a suspension defect in its RAV4 and Lexus HS 250h models, after
fears that an initial recall last year did not fix the problem.

Toyota to recall 885,000 vehicles

In September, it recalled 615,000 Sienna minivans in the US to fix a lever problem that could
cause vehicles to shift out of park mode "without the driver depressing the brake pedal".
Toyota said at the time that it was aware of 24 "minor accidents" due to the issue.
In recent weeks more than 2.2 million vehicles have been recalled.
Analysts said the recalls could have an impact on its reputation with the customers.
"Repeated recalls definitely dent the image of any carmaker," Vivek Vaidya, an auto analyst with
consulting firm Frost & Sullivan told the BBC.
"If you have one big recall, it is still manageable. But if (a company) calls back different vehicle
models at different times for unrelated issues, customers tend to have a re-think about your
quality assurance.
"And if the problem involves airbag deployment - it becomes a serious issue," he added.
The latest move takes the total number of cars recalled by Toyota this year to six million vehicles.
Analysis - Puneet Pal Singh Business reporter, BBC News
Toyota's latest announcement puts the number of recalls over the past two years at nearly 20
million. That is far more than the number it called back in 2009 and 2010 - widely seen as the
worst years for its reputation.
Toyota's sales had suffered in the aftermath of those recalls, which were prompted by problems
with accelerator pedals becoming trapped under floor mats.
The current recalls haven't been linked to any major incidents or crashes. But 20 million is a
huge number and the recalls have been spread across various models and unrelated issues.
It is a big blow for Toyota, which has been trying to rebuild its reputation as a maker of high
quality cars.

Definition - Risk Management

Risk management is:
the set of structured processes through which management
identifies,
analyzes and
responds appropriately to risks.

The response to risks depends on the perceived magnitude,

and involves controlling, accepting, avoiding or transferring
them to a third party.

The Objective of Risk Management

The occurrence of a risk event could result in losses
which affects both profitability and business value.
Effective risk management aims:
to reduce the frequency of risk events and
also reduce the severity of impact on the organisation.

The objective of risk management in organizations is

made clear;
It seeks to mitigate reduction in value or wealth of the
organization
It has the objective of increasing the wealth of the
business.
26

Illustration Risk Management Creates Value

The risk of product liability claims against a
pharmaceutical company developing a new prescription
drug for the treatment of arthritis which is a crippling
disease of the joints.
Drug-related product liability claims come in three basic
varieties:
claims based on defectively manufactured pharmaceutical
drugs;
pharmaceutical drugs with dangerous side effects (even
though properly manufactured);
and improperly marketed pharmaceutical drugs
27

Illustration Risk Management Creates Value

These risk events could cause the drug company:
huge sums of money in defending lawsuits and
payment of damages could increase the expected costs to the business.

To prevent these risk events from occurring the pharmaceutical

company :
invest in product developments to ensure that product is not defective,
safety testing to ensure that there are no side effects
ensuring proper labelling and accurate claims in its marketing.

These are loss control methods to reduce risk thereby controlling

expected legal defense costs and
expected damage payments,

8/18/16

(c) Jan.2014,Prof. I.K. Dontwi & Seth K. Nkrumah

28

Illustration Risk Management Creates Value

These payments:

increase business cost and reduction of profitability to the

pharmaceutical company.
increase the price that the firm would need to charge for the drug
which can also discourage doctors from prescribing to patients
can also cost the business regarding sales

Though there are cost involved in managing risk,

risk managements protects value by preventing,
controlling or minimizing a far greater cost which
could have had a devastating consequence for the
firm, one that could even wipe off the value of the
organization (bankruptcy).
The following cases illustrates the importance of an
effective risk management.
29

Illustration Risk Management Creates Value

Fen-Phen Product liability against American Home Products
The drug fen-phen, was an anti-obesity treatment marketed by American
Home Products (later known as Wyeth) as Pondimin, but was shown to
cause potentially fatal pulmonary hypertension and heart valve problems.
In 1996, a paper in the New England Journal of Medicine (NEJM) from the
Mayo Clinic discussed clinical findings in 24 patients who had taken fenphen. The authors noted that their findings suggested a possible correlation
between mitral valve dysfunction and the use of these anorectic agents.
Later in 1996, a 30-year-old woman developed heart problems after a
month of using it; when she died in February 1997, the Boston Herald
devoted a front page article to her.
The FDA alerted medical doctors that it had received nine additional reports
of the same type, and requested all health care professionals to report any
such cases to the agencys MedWatch program, or to their respective
pharmaceutical manufacturers.

Illustration Risk Management Creates Value

The FDA requested that the manufacturers of
fenfluramine and dexfenfluramine stress the potential
risk to the heart in the drugs' labeling and in patient
package inserts.
After reports of valvular heart disease and pulmonary
hypertension, the FDA requested its withdrawal from
the market in September 1997.

Illustration Risk Management Creates Value

In April 2005, American Lawyer magazine ran a cover story on the
wave of fen-phen litigation, reporting that more than 50,000
product liability lawsuits had been filed by alleged fen-phen victims.
Estimates of total liability ran as high as $14 billion.
As of February 2005, Wyeth was still in negotiations with injured
parties, offering settlements of $5,000 to $200,000 to some of
those who had sued, and stating they might offer more to those
who were most seriously injured.
One plaintiff's attorney claimed that "the payments [were] not
going to be large enough to cover medical expenses. Thousands of
injured persons rejected these offers. At the time, Wyeth announced
it has set aside $21.1 billion (U.S.) to cover the cost of the lawsuits.

Illustration Risk Management Creates Value

Defective Breast Implant Sales Draw Prison Term for French
Executive
PARIS A court in Marseille, France, sentenced the founder of a French
company on Tuesday to four years in prison for selling hundreds of
thousands of defective breast implants in more than 65 countries.
Jean-Claude Mas, 74, the founder of Poly Implant Prothse, and four of his
former employees were found guilty last spring of aggravated fraud after
their company used a less expensive, industrial-grade silicone to fill
implants for a decade. The implants ruptured at a much higher rate than
the industry norm, leaking silicone into body tissues.
During the trial, which involved 7,400 civil plaintiffs and 300 lawyers, Mr.
Mas acknowledged that his company had used a cheaper, unapproved
product in its implants, but he argued that it was not harmful.

Illustration Risk Management

Creates Value
More than 16,000 women have had their implants removed since the
scandal emerged in 2010. Poly Implant Prothse, which was founded in
1991, was closed by the French authorities in March 2010.
In addition to imposing the maximum prison sentence on Mr. Mas, the
court ordered him to pay a fine of 75,000 euros, or $103,000, and
sentenced his former employees to between 18 months and three
years in prison. Some of those sentences were suspended. Yves
Haddad, Mr. Mass lawyer, said that his client would appeal.
Last month a French court ordered a German quality-control company
to pay $4,000 each to 1,600 women who received defective breast
implants made by PIP. The German company, TUV Rheinland, was
accused of granting European Union safety certificates to the defective
implants.
About 300,000 women around the world received the implants, which
were not approved for sale in the United States.

Illustration Risk Management Creates

Value
RBS sets aside 3.1bn for new mortgage and PPI claims
Royal Bank of Scotland is to set aside more than 3 billion in additional funds
to cover litigation and customer compensation claims, the state-backed
lender disclosed today.
The sum includes 1.9 billion to cover mainly US action over mortgagebacked financial products. There will also be an extra 465 million to cover a
redress scheme for customers mis-sold payment protection insurance (PPI).
The group has set aside an extra 500 million in relation to allegations over
the mis-selling of complex financial products, known as interest rate swaps,
to small firms.
There will also be an additional 200 million of provisions "for various
conduct related and legal expenses" when fourth quarter results are
published next month, said the bank, which is 80% taxpayer owned.
Chief executive Ross McEwan said: "At the peak of the financial crisis, RBS
was the biggest bank in the world.
"When the crisis broke the bank was involved in a number of different
businesses in multiple countries that have subsequently faced heavy
scrutiny by customers and regulators.

Illustration Risk Management Creates Value

"The scale of the bad decisions during that period means that some problems are still
just emerging. The good news is we are now a much stronger bank and can manage
these costs while still supporting our customers."
The bank also confirmed that its executive committee would not receive bonuses for
their performances in 2013. The announcement applies to eight senior employees. Mr
McEwan has already said he would not take a bonus for 2013 or 2014.
The extra 1.9 billion for mortgage-backed securities was announced "following recent
third party litigation settlements and regulatory decisions".
In November, the US Government and JP Morgan Chase agreed a record 13 billion US
dollar (7.8 billion) settlement over its sales of poor quality mortgage-backed
securities that collapsed in value during the financial crisis.
Meanwhile in the same month, an RBS subsidiary agreed to pay 153.7 million US
dollars (95.5 million) to settle a US probe into allegations it misled investors over
what was described as a "shoddy" subprime mortgage product.
In relation to PPI, RBS said claims had continued at the same rate as before - 225
million per quarter - rather than an expected decline, and that they were now
anticipated to continue for a longer period.
The total provision for the PPI compensation scheme now stands at 3.1 billion, of
which 2.2 billion had been used up by the end of 2013.

Illustration Risk Management Creates Value

From the forgoing analysis it could be established that
risk management adds value to an organization.
It minimizes the cost of risk
Preserve value by preventing uncontrolled losses
creates value for an organization by exploiting opportunities.

Principles of Risk Management

The main principle of risk management is create value for
the organisation. Risk management activities are
therefore designed to achieve the best possible
Principles of Risk Management (PACED)
outcome.
Principles
Description
Proportionate

Risk management activities must be proportionate to

the level of risk faced by the organisation.

Aligned

Risk management must be aligned with other activities

of the organisation

Comprehensive

In order to be fully effective, RM approach must be

structured, systematic and comprehensive

Embedded

RM activities needed to be embedded within the

organisation, not an after thought. Be part of the
decision making process

Dynamic

RM activities must be dynamic and responsive to

emerging and changing risks. Hence need for regular
review and monitoring of the risk management process.

What Is Enterprise Risk Management?

Enterprise: The whole organization
Risk uncertainty of outcome of a process or
undertaking
Types of Risk:
Financial (market, credit, capital, liquidity),
Operational Risk (failure of technology, human resources, internal
control processes, external events)
Compliance/legal/regulatory, market, strategic/business/reputation/
governance, capital etc.

Management - the risk management process : identify,

measure and control
Definition of ERM:
ERM is a strategic business discipline which advocates an integrated
approach to risk management process in an organization.

What Is ERM?

The risk management process under ERM:

evaluate risk from the perspective of the whole enterprise,
linked to the strategic objective and goal of the organization, its
environment and stakeholders.
Competing goals of departments: corporate deposit vs. lending, attracting
new customers by corporate market v demand for credit facility.

Embedded in the systems & control and culture of the

organization.
Encompass all areas of risk:
Each risk type is not managed in isolation, but in a coordinated approach
recognizing that risk types are inter related.
Machinery maintenance affects production, which in turns affects sales
(market) department, affects Finance, and Human Resource Dept.
Credit risk impacts liquidity, Liquidity risk impacts profitability, image /
reputation affects credit risk. Op-risk permeates all risk types etc.

Prioritizing each risk type according to severity and frequency

ERM Framework: Risk Management Association: www.rmahq.org

Risk Management Process

The global financial crisis in 2008 demonstrated the need
for adequate risk management.
As a result an international standard ISO 31000- Risk
Management Principles and guidelines was published:
Risk is defined as effects of uncertainty on business objectives
Guide 73 of ISO 31000 also states that an effect may be positive
(opportunity risks), negative (hazard risks), or a deviation from the
expected, and that risk is often described by an event, a change in
circumstances or a consequence.
There is an upside of risk

Principles that business must follow in order to achieve an

effective risk management.
How risk management must be implemented and integrated into
organizations.

In effects it describes an effective risk management

process.

Risk Management Process

Irrespective of the type of risk under
consideration, the general risk management
process would involve the following steps:
1. Identification of all significant risks
2. Evaluation of the potential frequency and
severity of losses
3. Develop and select methods for managing risks
4. Implement the risk management methods
chosen
5. Monitor the performance and suitability of the
risk management methods and strategies on a
regular basis.

Alternative Description of the Risk Management Process - IRM

The IRM describes the risk management process as a series

of co-ordinated activities. The components includes the 7Rs
and 4Ts of managing hazard (risk) management.
1. recognition or identification of risks
2. ranking or evaluation of risks
3. responding to significant risks
a.
b.
c.
d.

Tolerate
Treat
Transfer
Terminate

4. resourcing controls
5. reaction planning: includes business continuity planning and
disaster recovery planning.
6. reporting and monitoring risk performance
7. reviewing the risk management framework

The Risk Management Process based on ISO 31000(IRM)

Risk Context:
the risk management process must exist within a a framework which is
referred to context by ISO 31000

Risk identification:
establishes the exposure of the organization to risk and uncertainty.

Risk Analysis:
by identifying those risks that require attention by management.

Risk evaluation:
The result of the risk analysis is used to produce a risk profile that gives a
rating of significance to each risk and provides a tool for prioritizing risk
treatment efforts.

Risk Treatment:
includes as its major element, risk control (or mitigation), risk avoidance, risk
transfer and risk financing.
The presence of an effective control will determine the extent to which control
measures would reduce or eliminate risk.

There are two feedback mechanisms:

Monitoring and Review: Monitoring and review ensures that the organization
monitors risk performance and learns from experience.
Communication and consultation: Reporting and disclosure

Risk Management Process - Identification of all significant risks

Risk identification involves establishing the risk

type the organization is exposed to.
This requires a strong knowledge of:
- The context in which the organization operates:
its market, the legal, social, political and
cultural environment.
- The organization's strategic and operational
objectives and
- The critical success factors i.e. the threats and
opportunities related to the achievement of the
organization's objectives.

Risk Identification: Methods

In practice, there are various methods deployed in identifying risk
exposures.
They include:
1) Check List of Common Business Exposures.
In banking common risk exposures include- market risk, credit risk and operational
risk.
The check list could be done internally internal risk experts risk managers, internal
auditors or operational managers.
However, many organizations may use risk management consultants to produce a
comprehensive checklist of common business exposures.

2) Using the companys financial statements in identifying loss exposures.

The financial statements of the organization could reveal a lot of the financial risks
inherent in the organizations.
financial risks includes capital risk (adequacy), asset quality (especially for banks
non performing loans, other organizations bad debts debtors age analysis,
working capital cycle, stock turnover vs. obsolesce etc.), Earnings quality, liquidity)
These risks are often captured in financial ratios.

Risk Identification: Methods

3) Risk & Control Self Assessment (RCSA):
Survey of risk owners ( those in charge of processes / operations where the
risk drivers originates)
It could be obtained through surveys of employees and discussion with
managers throughout the organization to ascertain the probable risk and its
impact on the organization.

4) Business Process Mapping: Process mappings identify the key steps

in core activities and their respective key risk points.

List core activities of business units

Listing of discrete activities involve in each core activity
Identifying risks associated with each discrete activity by the schedule officer
Associating Risk Owners for each identified risk factor
Existing control measures and new ones proposed by the staff involve in that
activity

5) Questionnaires and Interviews of risks owners, workshops etc.

Risk Identification: Methods

Note:
Irrespective of the methods used in identifying risk exposures,
any attempt to identify risks require:
a full understanding of the business as an entity(its registration, its
composition, its structures and authority lines and leadership styles),
as well as the specific political, legal, economic and other regulatory
factors that affects the business.

i.e. knowing the context of the organization.

Risk Management Process: Risk Evaluation, Analysis and Ranking

Risk evaluation involves establishing the:

- levels of likelihood (potential frequency) of a risk event

and
- consequences (severity of impact) of all significant risks.

Risk ranking can be quantitative, semi-quantitative or

qualitative in terms of the likelihood of occurrence and
the possible consequences or impact.

It could be 2x2,3x3,4x4 or 5x5 risk matrix:

By considering frequency and severity of
impact, it helps organization to prioritize its risk

Risk Evaluation- Likelihood of Occurence

Risk Evaluation: Evaluating Impact / Loss severity

Risk Evaluation: Determining The Risk Level Rating

Evaluating The Severity of Losses

Frequency and severity of loss evaluation is crucial for
all risk managers
In practice, risk managers deploy a summary measures
of probability distribution such as frequency and
severity measures together with expected losses and
standard deviation of losses for a time period

Frequency Measures
The frequency of loss measurement takes
into consideration, the number of losses in
a given time period
In any company where there is historical
data regarding large number of exposures,
we could conclude that the probability of a
loss per exposure(or the expected
frequency per exposure) could be
estimated by the number of losses divided
by the number of exposure.

Example
Assume if ABT Timber corporation in Ghana had 10,000
employees in each of the past five years, if over the five year
period there were 1500 workers injured, then an estimate of
the probability of a particular worker becoming injured would
be;
F I = injuries = 1500
employee years
= 15

10,000 X 5

= 0.03 per year i.e. 3%

500
Note
Every company must have a risk manager that keeps a
database or worker injuries and frequency of occurrences
since without that, it will be difficult to quantify.

Severity Measurement
In any organization, measuring the severity of loss in terms of cost
or asset lost to the business is about the measurement of the
magnitude of loss per occurrence during a historical period.
The Measurement
If for example the 1500 injuries estimated over the five year period
cost the company GHC 3 million in total, then the expected
severity of worker injury would be;
The total estimated cost
injuries
GHC 3, 000,000
1500
= GHC 2000

The interpretation to this is simple;

On the average, each worker injured imposes GHC 2000
loss on the firm.
Note:
Due to lack of historical data in most companies and
infrequency of losses, adequate data may not be
available to estimate precisely the expected severity
per occurrence for a given exposure.

Risk Management Methods to respond to identified

significant risks i.e. risk treatments- ISO 31000

The scope of risk responses available for hazard

risks includes the options of:
Tolerate, treat, transfer or terminate (i.e. the 4Ts) the
risk or the activity that gives rise to the risk.
For opportunity risks, the option available includes
exploiting the risk.
The choice of response will depend on:

the evaluation of loss frequency vs. severity of impact

And the firms risk appetite
See figure below

For many risks, these responses may be applied in

combination.

Major risk management methods

Major risk management methods could be classified under three broad
categories (Loss Control, Loss Financing and Internal Risk Reduction). These
are not mutually exclusive.
Loss Control

Loss Financing

Reduced Level
of Risk Activity
(Treat)

Retention and
Self Insurance
(Tolerate)

Increased
Precautions
(Treat)
Divestment of
Risk Activity /
Business
(Terminate)

Insurance
(Transfer)
Hedging
(Transfer)
Other
Contractual risk
Transfer

Internal Risk
Reduction

Diversification
(treat)
Investment in
Information

Loss control
These are actions that reduce the expected cost of losses:
by reducing the frequency of losses and the severity(size) of losses
that occur.

Example of loss control could be:

Routine inspection of aircraft for mechanical problems.
The inspection could help reduce the frequency of crashes, though
have little impact on the magnitude of losses or crashes that occur.

Other examples could be:

Installation of heat or smoke activated systems designed to
minimize fire damage in the event of fire.
Cutting back production of risky products
Divestment of a non-core business activity that generates losses
Testing of safety and installation of safety equipment (to increase
precautions)

Loss Financing
These are methods used:
to obtain funds to pay for or offset the losses that occur.
It is also termed risk financing.

There are four methods of financing losses. They

are:
1.
2.
3.
4.

Retention
Insurance
Hedging
Other contractual risk transfers

Loss Financing - Retention

Retention:
With this approach, the business retains the obligation to pay for either part or
all the losses. It is sometimes called self-insurance
Note:
Firms could pay retained losses using either:
internally generated funds or
through external means.

The internal funds could include:

cash flows from ongoing activities and
investments in liquid assets dedicated for financing losses

External sources of funds include:

borrowing and
issuing new stocks

Borrowing and Issuing of stocks are sometimes very costly in cases of large
losses.
For instance, the firm must always pay back any funds borrowed and in cases where new
stocks were issued, the firm must share future profits with new stockholders.

Insurance
This is seen as the second major method of
financing losses.
It involves the purchase of insurance contracts.
Note:
A typical insurance contract requires the insurer to
provide funds to pay for specified losses(thus financing
these losses) in exchange for receiving a premium from
the purchaser at the inception of the contract.
Insurance contract reduce risk for the buyer by
transferring some of the risk of loss to the insurer.

Hedging
This is financing loss by the use of financial derivatives
such as; forwards
The most notable form of risk where this method could be
applied is price risk
Note;
A hedging contract can be used to hedge risk , thus, they
may be used to offset losses that can occur from changes
in interest rates, commodity prices, foreign exchange rates
etc.
Example, firms that use oil in their production process are
subject to loss from unexpected increases in oil prices
Oil producers are also subject to loss from unexpected
decreases in oil prices.

Hedging
Both firms can hedge their risk by entering into a
forward contract that requires the oil producer to
provide the oil user with a specified amount of oil on
a specified future delivery date at a predetermined
price, known as forward price regardless of the
market price of oil on that date.
The forward price therefore is the price agreed
upon when the contract was written and signed by
the two parties.

Other Contractual Risk transfers

This allows businesses to transfer risks to another
party. This could be likened to insurance and other
derivatives.
Credit derivatives for the transfer of credit risk
For Bonds and basket of commercial loans / credit cards/ personal
loans

Example is when businesses that engage independent

contractors to perform a task enter into contracts
known as, hold harmless and indemnity agreements,
that require the contractor to protect the business
from lawsuits that might arise if persons are injured by
the contractor
Outsourcing of cashiering in banking. The outsource
provider responsible for pilferage by cashier.

Internal Risk Reduction

Businesses can also reduce risk internally
There are two major forms this can take.
By diversification
Investment in Information

a) Diversification

Firms can reduce risk by internally diversifying their activities(thus

not putting all their eggs in one basket)
In practice, individuals also routinely diversify risk by investing their
savings in many different stocks.

b) Investment in Information
This is the second major method of reducing risk internally.
Companies under this method invest in information to obtain superior
forecasts of expected losses.

Investment in information
Investing in information can produce more
accurate estimates or forecasts of future cash
flows, thus reducing variability of cash flows
around the predicted value
Companies do specialize in the analysis of data
through market research to obtain accurate
forecasts of losses.
Examples:
Credit Reference Bureau XDS data, Standard & Poor,
Experian, Equifax (credit risk)
Bloomberg, Reuters etc. that provides information to
manage a firms market risk

Risk Appetite
The risk response chosen by a bank depends on the Banks Risk Appetite.
In pursuance of reward the Bank engages with risk. There are those risk
that:
The bank will actively seek or pursue or retain
The bank could put up with, tolerate
The bank wish to avoid.

Risk appetite:
refers to the amount and type of risk that the Bank is prepared to pursue and
retain (to seek, accept and tolerate) in order to achieve its strategic objectives.

Risk tolerance:
levels refers to the range of acceptable risk levels or risk boundaries, outside
which the Bank will not feel comfortable and would therefore not tolerate any
exposure in that risk region.

Risk Universe:
The full range of risks which could impact, either positively or negatively, on the
ability of the firm to achieve its objectives.

Risk Appetite and Performance

Sample Statements of Risk Appetite / Tolerance

Capital Adequacy
RAS 1

The Bank will maintain a minimum threshold Risk Weighted Capital

Ratio of 10% or (regulatory minimum requirement plus 5%)

Risk related to RAS

Key Objective Measure

Assets impairments emanating from provision of Liquidity relief to

distressed RCBs.
Occurrence of stress events
RWCR minimum 15%
Asset Quality Migration NPL < X%

Liquidity Management
RAS 4

RAS 5

RAS 6

Risk related to RAS

Key Objective Measure

The Bank will maintain a liquidity buffer of at least 55% of total

deposit in the form of treasury and government securities to ensure
immediate funds availability.
The Bank will ensure that enough liquid assets exists to cover volatile
Funds by more than 100%.
The Bank will ensure that long term assets of the Bank are financed
with the most stable funds and will therefore a keep a Net Stable
Funding Ratio (NFSR) of >100%.
Funding liquidity risk that immediate cash and its equivalents may
not be available to liquidity needs.
Volatile funds dependency the bank relying on volatile funds to meet
loan demands, to finance purchase of fixed assets.
Secondary Reserve to Total Deposits >= 55%
Liquid Assets to Volatile Funds >= 100%
NSFR >=100%
Net Volatile Funding Dependence ratio =< 0, i.e. negative

Risk Management Framework

For the risk management process to be successful
the process must exist within a framework / structure
which is referred to as the risk management
context by ISO 31000.
An effective structure would include: (RASP)
risk architecture,
risk strategy and
risk protocols,

These elements are internal arrangements for

communicating risk issues.
It gives the context or environment within which the
risk management process and activities will flourish,
be supported and sustained.

Risk Management Framework

The risk architecture sets out :
the roles and responsibilities of the individuals and
committees that support the risk management process.

The risk strategy:

sets out the objectives that risk management activities in
the organization are seeking to achieve.

Finally, the risk protocols:

describe the procedures by which the strategy will be
implemented and risks managed.

Content of a Risk Management Framework

Risk Management Architecture

Committee structure and terms of reference

Roles and responsibilities
Internal reporting requirements
External reporting controls
Risk management assurance arrangements

Risk Management Strategy

Risk management philosophy

Arrangements for embedding risk management
Risk appettite and attitude to risk
Benchmark tests for significance
Specific risk statements / policies
Risk assessment techniques
Risk priorities for the year

Content of a Risk Management Framework

Risk Management Protocol

Tools and techniques

Risk classification system
Risk assessment procedures
Risk control rules and procedures
Responding to incidents, issues and events
Documentation and record keeping
Training and communication
Audit procedure and protocols
Reporting / disclosure/ certification

Risk Management Organization

The position of the risk management function in the organizational
structure is dependent of the
views of senior management regarding the need for
scope and importance of risk management and
possible administrative efficiency required.

Most large size banks have specific departments or units responsible for
managing:
Operational risk,
Market risk
Credit Risk
Asset and Liability management

The overall management of risk is usually headed by a risk manager or

the Chief Risk Officer.
It should be noted however that
given that losses can arise from numerous sources,
the overall risk management process ideally reflects a coordinated effort
between all of the corporations major departments and business units
including Credit, ICT, Banking operations, marketing, finance and human
resources etc..

RISK MANAGEMENT GOVERNANCE STRUCTURE

BOARD OF
DIRECTORS
BOARD SUB-CTTEE
ON AUDIT

BOARD SUB-CTTEE
ON RISK MGT
MANAGING DIRECTOR

INTERNAL AUDIT &

INSPECTION DEPT

RISK MANAGEMENT
DEPARTMENT
EXECUTIVE
COMMITTEE

CREDIT
CTTEE

CREDIT
RISK

ASSET/
LIABILITY
CTTEE

TENDER
CTTEE

MARKET &
LIQUIDITY
RISK

OPERATIONAL
RISK

PORTFOLIO
REVIEW
CTTEE

CREDIT
RISK

DISASTER
MGT
CTTEE

OPERATIONAL
RISK

ICT
CTTEE

OPERATIONAL
RISK

Risk Documentation
Risk Event Report: a risk owner or champion reports a risk incidence
recording the details of the event that occurred,
providing analysis of the incidence e.g. causes, control failures, impact on the bank
etc.
provides recommendations for improvement.

Risk Register: is a document that records all the significant risks of the bank.
Typical records kept includes:
The risk index, risk description, current level of risk (likelihood, Impact, Risk level),
related risk controls, risk owners.
In sum, it gives the risk profile of the Bank.

Loss Event Database:

A loss database is a data table which contains records on operational loss-events
(occurred and near misses) and the characteristics of the loss events.
The features of the loss to be recorded are listed below:
Date loss event Occurred; Date loss event was detected, date loss was reported
(recorded), Reporting Officer, Loss Type, Estimated Loss, Loss Recovered, Actual Loss
Amount, Department of Origin, Department Detection, Cause of Loss / Incident,
Description of Incident, Control failures, Action and Recommendation

Risk Culture

ERM Framework: Risk Management Association: www.rmahq.org

Risk Culture Is the Cornerstone to Risk and Control

Effectiveness
Control
is the Mesh
How Effective
is Your
Mesh
?
that protects
the
mouse from perils.
The effectiveness of
your mesh depends
on your adopted
attitude towards
risk and control
measures.
Your attitude
reflects in your
practices, beliefs,
knowledge,
responses,
perception etc. i.e.
your
organisations
risk culture.
How well the mesh
is built depends on
your risk culture.

How do we
prevent the cat
from catching
the mouse?
Introduce Control
measures:
Guidelines and
procedures
Separation of functions
and four-eyes
principle
Need-to-know principle
(access control)
Physical access control
Co-ordination and
plausibility checks
Limit management
(Corporate Governance)
Inventories
Disaster recovery and
business continuity
planning

Culture Is Key To A Successful ERM System

Culture: Culture refers to shared underlying values, beliefs, attitudes, knowledge and understanding of a group of people

Why is culture so
essential ?

Culture
-

Culture is pervasive and

permeates throughout the
organization, reinforces
itself
Culture reflects in your

Organizat
ion

Prevailing
culture will
influence
existing VBAP

Prevailing
Culture:
in the
organizati
on
Your repeated behaviour will
help shape the prevailing
culture.
* People gravitate towards
Like minded people.
*culture reinforces itself and
propagates itself

Values,
Beliefs,
Attitudes,
knowledge,
understandi
ng
Perception
Culture is a cycle: either virtuous
or vicious cycle Which one is
your organization's culture?
Every organization / society has
a culture the question is
whether that culture sustains
the society to achieve its goal or
undermines the goal.

Repeated
Behaviour
s=> Your
Risk
Attitude

Your Risk
Attitude /
perception
=> chosen
position
adopted by
individual

actions or responses
towards:
Customers,
Work,
Control measures,
Liquidity,
Delinquent customers,
Staff fraud,
Staff indiscipline,
Staff errors,
Ethics etc.

Risk Culture
Risk Culture in a bank refers to the shared underlying values, beliefs, knowledge,
understanding and attitude towards Risks in the bank.
Your Risks Attitude i.e. the chosen position adopted by you the individual or group towards risk,
influenced by risk perception and pre-disposition.
Positive attitude: culture sustains the bank to achieve its goal

Culture of acceptance of responsibility, diligence, integrity, credibility and

problem-solving attitude.
Culture of adherence to the set operational procedures
Whistleblowing: on yourself errors made, fraudulent activities not same as
gossiping

Negative Attitude: undermines the banks goal, at odds with

organizational objectives
Engage in unethical behaviors and practices in the course of our duties.
Culture of apathy - turning blind eye on such practices,
Those who dont engage in such practices: either condones it, ignores or
pretend not to see what is going on.
blame culture and general dissatisfaction in the system.
Indiscipline: not adhering to rules and processes - generates op-risk
self seeking actions.
Culture of fear fear of making errors; and hiding errors made

Coursework
Having the right risk culture is key to effective
enterprise risk management. Risk Management
Association
Discuss this statement , explaining what makes an
effective risk management system and the relevance of
a right risk culture in risk management.
Submission date:???

Section 2 Financial Risk Management

Financial Risk
Credit Risk Management
Asset and Liability Management
Interest Rate Risk
Liquidity Risk

Derivatives

Credit Risk Management

References
Credit Risk Measurement New Approaches to
Value At Risk and Other Paradigms; Second
edition, Anthony Saunders and Linda Allen:
Chapter2: Traditional approaches to credit risk measurement
Chapter4: Loans as Options the KMV and Moodys Models
Chapter6: The VAR approach CreditMetrics and other models
-

Credit Analysis & Lending Management; Sathye,

Bartle, Vincent and Boffey
Chapter 5 Consumer Lending
Chapter 8 Corporate lending

Topics
Credit Risk Management
Bank Lending function
Credit appraisal factors 5c / CAMPARI
Credit Risk Measurement
Moodys EDF,
JP Morgan CreditMetrics

Overview

1.

Bank Lending As A Source of finance,

2.

The lending Function,

3.

Credit appraisal factors 5c / CAMPARI

4.

Consumer Lending,

5.

Credit Risk Measurement: New Approaches specifically

discussing

KMV-EDF

JP Morgan Credit Metrics (VaR)

6.

Credit Risk Management:

Securitisation

Credit Derivatives

94

Definitions:
Lending:
A contractual agreement in which a borrower
receives something of value now, with the agreement
to repay the lender at some date in the Future.
the expectation of a sum of money within some
limited time

Credit Risk:
The chance that this expectation will not be met.
the risk of loss through the default on financial
obligation Golin
Is the potential for the obligation of a contract not
to be fulfilled - Sathye

95

Credit Risk- BoG (Draft Risk Management

Guideline-2013)
54 - Credit risk, also known as counterparty risk, refers
to the possibility of a debtor not able or not willing to
pay the interest and/or principal according to the
terms specified in a credit agreement thus resulting in
economic loss to the creditor institution.
55- Credit risk arises mostly from lending and related
banking product activities such as trading and
placements:
a) In lending transactions, credit risk arises through
non-performance by a customer or market
counterparty for facilities granted. These facilities
are typically loans and advances, including the
provision of securities and contracts to support
customer obligations such as letters of credit and
96
guarantees.

Bank Lending As A Source of

finance:
Credit plays an indispensable role in modern
economy:
Public Expenditure:
Government Treasury borrows to invest in
public services
Corporate borrowing: Company borrows for
Expanding capacity, Working capital, Making
acquisition
E.g.
Uncommitted
facilities,
Committed
facilities, Syndicated Loans, Commercial Paper
Individual borrowing (Consumer Lending /
Retail Markets)
To buy houses, cars, holidays, repay
existing loans.
97
E.g. Overdraft, Personal loan, Mortgage
&

Principles of Lending
Lending Principles: Provides a framework

for the lender to make sound lending

judgements/ decisions. The Three Principles
are

Safety of Loan:
Loan lent to safe borrower (ability to pay and
willingness to pay
Collateral, as a backup to recover money
when things go wrong (safety valve)

Suitability Of Loan Purpose:

Legal purpose( illegal activities: narcotics
and terrorism)
Legal entity (ability to enter into financial
contract) lending to a minor
98
Purpose should be in line with the lending

Principles of Lending
Profitability:
Lending is only completed when principal
and interest are collected. Attempt is made
to minimise loss of income through a & b
above.
Pricing of loan: appropriate interest should
be charged based on risk perceived.

99

Credit Analysis
Credit Analysis:
Is the process / function by which a lender
assess the credit worthiness of the potential
borrower.
It seeks to answer the question:
Would the borrower pay the principal and
interest?
It does so by assessing the borrower:
Ability to pay
Willingness to pay.

100

The Lending Function

The lending process / function is not
completed until all principal and interest have
been collected.
Anyone can lend, but ensuring repayments of
principal and interest is what distinguishes a good
banker from a bad one

There are 4 components of the traditional

bank lending function:
This follows a loan from origination to (full)
repayment.
Originating:
Funding
Servicing

101

The Lending Function Contd:

Originating:
Assessing the customer to obtain the customer
credit risk profile
Contracting to reduce the agency problem

Funding:
Traditionally, loans are funded by customer
deposits.
Loans kept on Balance Sheet (Banking Books, i.e.
held to maturity) must be funded.

102

The Lending Function Contd

Servicing:
Collecting interest and principal repayments

Monitoring:
Estimating default probabilities
Provision for losses
Continuous loan quality review

Note:
Securitization eliminates the need for funding.
Where there is no recourse to the lender for the
securitize loans monitoring is eliminated.
Services could become optional- but banks would
continue servicing to provide seamless services for
customers.
103

Originating:

Credit Analysis

Assessing Customers Credit Worthiness:

Basically two Objectives:
Assess customers willingness to pay
Assess customers ability to pay
All financial and economic conditions that could affect
borrowers ability to pay.

In sum, the bank attempt to measure the credit risk

of the customer.
Credit Risk could simply be defined as the
uncertainty about loan repayment.
This is the major risk that banks measure, monitor
and manage.
Since about 60% of the banks assets are Credits
(loans)
104

Originating:
Generally, when the:
Borrowers Assets > loan, the loan is repaid
Borrowers Assets < loan, the loan is
defaulted.

It is therefore essential for banks to be

able to estimate borrowers:

Assets value
Liabilities
Cash flows
Probability of defaults &
Recovery rates in event of defaults

These could be done:

Scientifically: Modern approach
or rely on proxies: Traditional approach105

Traditional Approach: Expert System

The lending decision is left with the lending
officer, based on his/her expert knowledge.
The expert analyses 5 factors, subjectively
weights them and reach a decision.
The Five Cs of Credit lending:

Character
Capital
Capacity
Collateral
Cycle (economic) conditions

Note a 6th C: Compliance i.e. abiding by the necessary regulations

The 5Cs could be applied to both business

and consumer lending
106

Expert System: The 5Cs:Contd

Character: attempt to measure the
borrowers willingness to pay.
Most important but most subjective to measure;
done by proxy
Reputation & Willingness (honesty, integrity,
prudent, thrifty)
Affects the quality of information provided by
borrower
Payment history, current and previous application
forms, financial news (paper, internet etc), credit
agencies, employers

Capital: measure the

Leverage i.e. Equity vs. Debt
Capital contribution to project & mortgage. Why?

High leverage indicates high tendency to default

107

Expert System: The 5Cs:Contd

Capacity: measures
Volatility of earning or Cash flow
Cash flow or earnings is the primary source of
payments
High volatility suggest some restrain on firm capacity
to repay
Individuals: details of income and expenditure (Bank
statement and payslips)
Business: audited financial statement and cash flow
statement

Note:
Lending is done against the strength of your cash
flow rather the strength of the security.
Would you lend on basis of profitability?
Would you lend to a firm that makes losses but
108
has good stream of cash flow?

Expert System: The 5Cs:Contd

Collateral:
This is a secondary source of loan
repayment
Requirement depends on the purpose/ size
of the loan
Quality of the collateral:

Priority of claim
Market value (ascertainable and stable)
Durability (not perishable)
Marketability / how liquid

Problems with collateral

Legal issues
Damage customer relationship
Time consuming and costly

109

Expert System: The

5Cs:Contd
Cycle (Economic Conditions)

General economic conditions

Particularly industry specific
Competition; both locally + international
External Conditions: prevailing conditions in the general economy, the
particular industry. Is it favourable to the borrower?
Prevailing conditions of the international economy
Internal Conditions: Lending policies, loan budget

110

Expert System: The 5c Contd

Problem with Expert System:
Consistency: How to apply these factors consistently across
different sizes
types of loans
Types of borrowers

Subjectivity:
Mainly a question of weighting
What weight to attach to each of the 5 factors.

111

CAPMARI on ICE CN Rouse

Character: honesty and integrity of the business and
its management.
Ability: in managing financial affairs, capable to enter into a
contract, managerial capabilities, management commitment)

Means: borrowers technical, managerial and financial

means
Purpose: for granting the loan. Must be legal and in
line with bank area of business, acceptable to bank i.e. risk
appetite)

Amount: should be consistent with the purpose and

sufficient in amount.

Repayment: ability to repay, probability of repayment,

sources of cash flows

Insurance: collateral / security for the loan.

on

112

Interest rate vs. Return on loan

Relationship between interest rate and
expected return on loan is highly nonlinear.
At lower interest rates, a rise could increase
returns
At higher interest rate, a further rise may
decrease the returns due to:
Adverse Selection: good borrowers will drop out of
the loan market to self finance
Risk shifting: Those left are those with limited
equity at stake have the incentive to borrow to
finance high risk projects.
113

Lending Function: Monitoring Loan

Quality Review

Objective of Lending function is to create value for

the bank.
Weakness in the Originating process: E.g.
Lax lending policies
Inadequate information

Leads to poor lending, destroying value through:

Non performing loans
Loan loss provisions

Asset quality problems leads to:

Reduced net interest income

higher provisions,
writes off
depletion of capital,
potential liquidity problem.
If market gets know of excessive poor asset quality then
could lead to a bank run
114

Lending Function: Monitoring Loan

Quality Review
Prudent and proper banking requires Monitoring
the loan portfolio: i.e.

Conduct quality loan review:

To classify the loans portfolio
To establish probable losses (i.e. create a loss
reserve)
To take remedial actions to reduce losses

115

Generally Accepted Loan Classification:

Performing Loans (Current Loans):
Loan is being paid back on schedule and perceived to
be acceptable banking risk.

Other Loan especially mentioned (OLEM)

Loan has some minor problems (poor or inadequate
documentation)
borrowers financial conditioning is worsening, but
does not deserve substandard classification

Substandard
Over 90 days over due, borrowers weakness is visible
with chance of default, with inadequate collateral

Doubtful
Well over 90 days considerable weakness & serious
problems, full repayment is highly improbable

Loss (Bad loans)

Expected total loss, uncollectible debts; usually
written off
116
Note: possibility of some partial recovery in the

Bank of Ghanas classification of

advances and loan loss reserves
Loan Class
CURRENT
OLEM
SUBSTANDARD
DOUBTFUL
LOSS

Due Days
Passed

Loss Provision

1-30days

1%

31 - 90 days

10%

91 180 days

25%

181 360 days

50%

>360 days

100%

117

Problem Loans: Prevention, Identification &

Resolution:
Causes Of Problem Loans:
Internal
Aggressive policies ( excessive growth beyond
the banks ability to manage: managers,
organisation structure (IT, people, system etc)
Lax procedures ( non compliance with loan
policies)
Indiscipline (bad) people ( inadequate controls
over loan officers)
Lending outside banks risk profile ( outside
familiar market)
Insufficient knowledge about customers
Over concentration of bank lending
Inadequate systems to identify loan problems

External ( good customers could turn bad)

Recession, Competition
Natural disasters, regulatory changes
Demographic changes

118

Prevention occurs:

At the origination process,

preventing type 1 errors (lending to bad borrowers)
reducing non-performing loans,loss revenue, loss
reserve.

If banks credit standard is too tight, then type 2

error occurs-(rejecting good borrowers).
Tight credit standard leads to reduction in:

loan volume
Customer base
Cross selling opportunities
Could lead to loss in revenue

Prevention therefore involves a risk-return trade off.

Bank has to find the optimal credit standard:
That maximize the banks equity value

Prevention should focus on:

Information gathering and processing,
analysing the quality information
i.e. accuracy and timeliness.

119

Problem Loans: Identification

Loan monitoring
Problem loan identification starts with loan monitoring
Help to classify loans ( Current, NPL, Needing more
information)

Early Warning Signals- Companies:

Financial
Focus on financial performances
Balance sheet, income statement, cash flow statements,
debt analysis

Operational
Production & inventory management
Relationship with suppliers & distributors
Customer and employees relationship

Banking
Falling deposit balances
Frequent Loan request for working capital

Managerial
Changes in behaviour of management
Attitude towards risk

120

Problem Loans: Resolution

Decide if problem is solvable: YES OR NO
If No, then Payout / Liquidation
If YES, then there is a Workout situation
An attempt to recover the banks money from a
borrower having financial difficulties.
Objective is to minimise losses
Is workout : +NPV or NPV
-NPV, then Payout / liquidation

+NPV, then

Cost reductions
Asset Sales
Revenue generation
New Mgt/ Bank on Board
Reschedule
Then finally PAYOUT
121

Consumer lending
122

Consumer Lending
"Neither a borrower nor a lender be
(Hamlet, Act I Scene 3).

If you lend money, you make a secret enemy; if you

refuse, an open one
Voltaire

The holy passion of friendship will last through a whole

lifetime if not asked to lend money.
Mark Twain

123

Consumer Lending
Conditions / Factors affecting the personal
lending market:
Increase in demand for credit (esp. credit
card)
Evolution of technology
Highly competitive environment (that
creates pressure for )
Timely (quick) credit decisions (and need for
)
Lower cost structure resulting in use of
technology and
larger customer base
Types of Loans:
Personal loans and Overdrafts
Residential Mortgages / home equity loans
Instalments Loans: cars, furniture ( durable
124
goods)

Credit Analysis:

Individual Appraisal or

Credit Scoring
Principles / Canons of Lending relevant to
consumer lending.
Safety, suitability & profitability.
These should be our guiding principles, whatever
method use in the decision making

Rouse identifies 5 stages in the analysis of new

request for loans:
Initial contact / introduction to customer
Credit Application by customer
Review of the application/ credit analysis
Gathering information
Use of models like CAMPARI or 5cs (the canons of good
lending)

Evaluation:
Assess repayment plan is it feasible?
What could realistically go wrong and it impact on the bank.

Monitoring and control

125

Individual Appraisal:

Decision framework:
5Cs or Reduced form of 3Cs :
character, capacity (incl. Capital) & Collateral (incl.
conditions)

Character:
Track record of customer the longer the better
Own customer ( data already available at bank)
Other Bank customer ( reports from customers bank)
Use credit reference agencies (customer consent is needed)

Integrity of Borrower:
willingness to pay? - timely repayments.

Spending habits
spending in excess of income, overdrafts,
used credit cards (multiple debts),
life styles inconsistent with earnings

Purpose of loan: genuine?

126

Individual Appraisal
Capacity to repay:
Net Income: net earnings of borrower ( income &
expenditure)

Deposit balances (savings)

Average balances on current account or savings

Stability / continuity of Job

Permanent or contractual (continuity
Length of stay

Stability of residences
Indication of stable personal situation
Home ownership, telephone ( land or mobile?)

Borrowers Margin ( Capital)

Borrowers contribution ( mortgages, cars)

Collateral (inc. Conditions)

As a secondary source of repayment
Conditions to be attached to loan
General conditions of the economy

127

System Approach: Credit Scoring

Credit Scoring is a system used
pre-identify certain key factors of probability of default
Weight these factors to produce a quantitative score
Assign customers into a class of either Good or Bad
Based on a cut off point
Mostly used for:
Credit card application
Small business loan
Personal loans
Information about content and methods are scarce since credit
score models are proprietary in nature.
Rouse:
for consumer lending a system approach, as opposed to
dealing with each customer individually, is cost effective for
most personal lending
Hall & Cloonen:
Judgemental processing of consumer credit applications is
rapidly being assisted and in some cases replaced entirely
128
by computerised scoring systems.

Credit Score: Variables or Determinants

Model by FICO: Fair, Isaac & Co. Credit Scoring system

Payment History

refers to payments being made on time or late, judgments,

bankruptcies, collection accounts, and so on.

Outstanding Debt
examines the number of outstanding balances, average balance, and
ratio of total balances to total credit limits on revolving debt (i.e.
credit cards)

Credit History
refers to how long you have had your oldest account.

Pursuit of new credit

examines when and how many inquiries and new accounts there
are.

Types of Credit in Use:

refers to the number of reported accounts in the various credit
card categories (bank cards, travel & entertainment, and so on).

FICO ratings ranges from 375 to 900

>=660 is good credit

b/n 620 to 660 marginal, but not bad credit
< 620 small chance of getting credit
Lenders set their own guidelines, according to risk appetite
129

Some more Variables of Credit Score

Large retailers Models may include the
following variables:
Good credit record (supplied by credit
bureau or internal)
Married/Single/divorce or separated
Number of dependents, Age
Primary monthly income & Presence of
extra income
Home owner/ renter
Home telephone
Credit investigation made.

130

Pro & Cons: Credit Scoring

Advantages:
Cost Advantages:
Fewer and lower level experience staff required
Cost saved shared b/n lender and borrower

Time advantages:
Large volume of applications processed
Increase availability of credit
Time used on sales,cross sales & relationship
rather than on number crunching

Objective, not judgemental:

non-emotional decision in distinguishing b/n good
and bad loans.
Identifying and eliminating (Reducing) crosssubsidisation
Therefore appropriate loan pricing is done
131

 Disadvantages:
Lost of relationship
Treat customers as commodity
i.e. Commodity Loan as against relationship Loan

Relationship allows for discretion

132

Pro & Cons: Credit Scoring

Palmieri (1991):
the only time a human evaluator can beat
automated scoring systems is when the person
is highly experienced lender and has a personal
knowledge of the borrower. There are not
enough of those people to go around

Domis:
Blind use of computerized credit scoring is bad
banking

Sinkey:
Lenders should recognise that credit bureau

reports and credit scoring models need to be

tempered with judgement and common
sense.

All quotations are from Joseph F Sinkey- 133

Commercial Bank Management, Chap.12

Monitoring and control

Reasons for monitoring
Be aware of the most current situation of the borrowers
capacity to pay, confirm information supplied by borrower
during application.
Observe any adverse trends so that early action could be
taken.
To discover irregular practices money laundering
Update with customer character new habits, e.g.
gambling, excessive spending
Ensure loan is used for purpose.

Methods of monitoring:
inconceivable to monitor every customer / borrower and so
attention is focused on those accounts that are likely to
cause problems:
The use of computer generated management reports on
the historical trends of the accounts are essential tool in
monitoring.
Worst balance trend; overdraft, account in excess of
134
undisclosed limit?

Problem loans when things go wrong

1. Identifying problem accounts: warning signals.
Monitoring will reveal most problem accounts. Some
indication of problem loans:

Overdrawn above agreed /unadvised limits

Sudden overdraft on unused account
Cheques returned unpaid-evidence of cross firing
Credits not received on the accounts loss of job?
Defaults on loan repayments

2. Deal with problem accounts:

Initial contacts by letter to correct the position or to ascertain
if customer has a problem, and discuss if possible.
If not responded to with in reasonable time (2 weeks), follow
up by telephone.
Consider the following actions:
Return cheques drawn by customer
Cancel standing order and direct debits
135
Request for cheque book / cheque guaranteed card
to be

Problem loans when things go wrong

3. Reschedule Loan:
Loan may have to be rescheduled when it clear that
the customer would not be able to abide by the
original agreed schedule.
Obtain a list of customers present commitment
If over committed:
then it is possible to agree with other lenders to
reduce repayment amount,
or even the amount owed,
or sale of assets to reduce amount owed,
extend period of repayment

reschedule is last resort for customer

No further overdraft allowed.

4. Recovery:
Endeavour to make full recovery of amount, if not possible,
a maximum possible recovery; however action must be
proportionate, a sense of the banks social responsibility
136
must be shown.

Problem Loans: Identification (FT Fri, Feb

28th 2009)
Early Warning Signals: Individuals
Customers that were likely to run into difficulties
over the next year had their credit card withdrawn,
even if they have not defaulted.
Credit reference agencies trying to predict whether
a borrower will be able to afford the debt in future.
Early warning signal used:
Potential debt: Too many other credit cards: therefore
with large combined credit limit
Outstanding balance building each month and
approaching the maximum limit.
Missed payments on another card or in the past.
Pay only the minimum amount each month.
Income versus outgoings ( spending pattern monitored,
overdrafts)
137

Seminar Questions
What factors are influencing the use of credit scoring
system in bank lending?
Outline the features / elements when constructing a
credit scoring system.
How appropriate is a credit scoring system for evaluating
the credit worthiness of
a) Individual / consumer lending ?
b) Small business lending ?
c) Large business lending ?

Your bank is introducing a new product credit card. As

the banks risk manager, explain to the board of directors
and management the risk departments role in the
introduction of a new consumer product
Credit scoring: what is the business implication for the
growing use of the credit scoring approach for the
banking industry?
Lending Is an Art not a Science. Discuss this
statement with reference to the article What is the point
in credit scoring?
138

Corporate lending
139

Credit Risk Management & Credit Risk

Measurement
Credit Risk Management:
The process of identification, analysis and
either acceptance or mitigation of
uncertainty in granting loans.
Purpose:
Achieve balance between risk and return
Avoid concentration risk
Manage loans on portfolio basis (as against
relationship basis)
Remove loans off financial statement when
required.
New tools available for Credit Risk Management:
Securitisation
Credit derivatives
140

Credit Risk Measurement

To manage credit risk effectively attempt must
be made to measure it.
Credit Risk Measurement:
Attempts to quantify the credit risk the bank is
exposed to.

External ratings
Altman Z Score
KMV EDF & Portfolio mgt
JP Morgan Credit Metrics

Credit Risk Measurement:

reduces subjectivity in credit assessment, more
scientific, makes monitoring effective

Remember: - If you can Measure it, You can

Manage it
141

External Ratings:
Evaluates credit worthiness of corporate, municipal and
sovereign issuers of debt
Disintermediation has made their services more
valuable.
Investors rely on these ratings for lending decisions
Borrowers also pay attention to their own external
ratings as it affects the credit spread paid by them

142

External Ratings
E.g. Moodys, S&P and Fitch.
Each Agency uses a system of letter
grades from triple A to D ( Quality to
Default)
Types of ratings issued include:
Issuer rating: Foreign & Domestic currency
Debt Specific: long term debt & Short debt

Ratings are revised as necessary in light

of new information
143

S&P External Ratings

144

Moodys External Ratings

145

External ratings
Agencies are not forthcoming with their
rating process.
S&P however offer the following
emphasis:
Business Risk:
industry characteristic
Competitive position e.g. marketing, technology

Management: calibre
Financial Risk:
Policy, profitability, capital structure, cash flow
146

Credit Scoring Systems

Is a system used
pre-identify certain key factors of
probability of default
Weight these factors to produce a
quantitative score
Assign customers into a class of either Good
or Bad
Based on a cut off point

Mostly used for:

Credit card application (97% of Banks use)
Small business loan (70% of banks use)
Personal loans
147

Credit Scoring Systems: The Z

Score
Z score is a credit scoring system used
to predict bankruptcy of a company.
It is multivariate system, attempts to
describe overall performance of the
company.
Financial ratios are uni-variate: each
financial ratio cannot give a complete
picture of the firm.
The formula:

Z = 1.2x1 + 1.4x2 +3.3x3 +0.6x4

+1.0x5
148

Z Score
Co-efficient are predetermined weightings
Xs are predetermined factors of probability of
default
X1= working capital/Total assets:
Indication of liquidity

X2= Retained Earnings/Total assets:

Cumulative profitability

X3= EBIT/ Total assets :

return on assets ( current profitability)

X4= Mkt Value of Equity/Bk Value of Total liabilities:

Leverage of the company

X5= Sales/Total Assets:

Asset Utilization: how effectively is assets used to
generate sales (how effectively has managers invested
assets)
149

Z Score
Cut off point:
If Z< 2.675, assign firm to bankrupt group
If Z >=2.675, assign to non-bankrupt group
Z score range of 1.81 to 2.99: area of ignorance
due to misclassification.

Criticism:
Relies on accounting data:
Past and historical data,
account data provided at discrete intervals
As such cant pick companies that are rapidly
deteriorating

The Z score function is independent of the loan

amount.
The model is a linear relationship, while path to
bankruptcy is non-linear.
150

Z Score

151

Some Implications of Z
Score

Quantitative complement to qualitative

and intuitive approach.
Altman recommends his quantitative
approach to complement the more
qualitative and intuitive approach of loan
officers.

Symptoms:
Indicate symptoms not the causes.
Z score indicates overall performance
Individual ratios pinpoint the problem areas

Early warning system, not a a

bankruptcy sentence.
152

Moodys KMV Credit Monitor

Remember the criticism of Z score:
financial ratios: accounting data are backward
looking,
however defaults are forward looking.

Defaults is a function of :
market price of assets and market value of debts.
And both are forward looking.

KMV exploits this knowledge to calculate:

the distance to default &
default probability (EDF), using the option theory.

The premise is that:

When money is lent to a firm and the money is
used well, then the value of the assets will rise,
the firm will payback the loan. If fund are used
badly value of the assets will fall, the firm153will

Moodys KMV Credit Monitor

The KMV EDF model is a

is a default prediction model

which applies the option theory
to value risky loans.
It produces the probability of default
termed as Expected Default Frequency
(EDF)
See diagram below

154

Diagram: Put Option On The firms

Assets
Pay off
Pay off To A lender

Fixed (P+I)

A1

A2

Value of Assets

155

Pay Off To Lender

B is the $ amount borrowed
A1& A2 are Market value of the firms
asset
If at maturity the firms asset is valued
at A2 then the borrower will pay the
Loan $B.
If asset is valued at A1, then the firm will
default and turn over the asset to the
bank.
Note:
the borrowing firm is limited liability
The bank receives only fixed payment if the
156
Asset is valued over B ( i.e. principal and

Option Theory vs. Loan : Merton

The bank is the writer of a put option on the
borrowers asset
The buyer (borrower) of the put option has the
right to sell the stock (asset) to the bank at price
B, the strike price (Loan amt)
The writer receive a fixed margin (P+I)
If the price of the stock is above B, then the
borrower will not exercise the option,
Rather choose to sell the stock on the market for a
higher price. (i.e. keep asset and trade with it)
If price of the stock is below B, then will exercise
the right to sell the asset at B.
In other words, turn over the firms asset to the
bank.

The writer faces an unlimited loss.

157

Diagram
Pay off of Put option

B
Strike Price
Loan Amout

Stock Price

158

Option Theory v Loan

According to BSM (Black, Scholes & Merton)
Px of Put Opt. on a stock is=f(s, x, r, v, t)

S= Stock price
X= exercise price
R= short term interest rate
V= std dev (volatility of the firms equity)
T= maturity of the option

159

Option Theory v Loan

Merton noted that value of default
option on a risky loan is similar: = f (a, b,
r, v, t)

A = Market Value of the firm assets

B = The Value Of the Loan
R = short term interest rate
V = std dev (volatility of the MV of the firms
asset)
T = maturity or time horizon

All the variable in the BSM model are

directly observable (on the Market)
However in the case of the loan A and V
are not.
The loan equation with 2 unknown variable
160

Option Theory, Loan & KMV

KMV solved the problem
From the borrowers perspective (Equity
holder of the borrowing firm)
i.e. equity holder has a call option on a firm
Option to buy the firms assets
Equity holder has invested a fixed amount in
shares
If value of assets is less than B, the option will
lapse.
What the equity holder actually looses is Shares *
market value
Share price is observable, so variable A is
solved.
Same inference is made for the Standard
deviation (volatility) of the MV of the assets.
161

Diagram
Pay off Call Option

B
Asset Value

162

Calculating the EDF

A = Market value of the Firms Asset
$100m
B = Amount Borrowed
$80m
This is the default exercise point:
Value of Short term debt (< 1yr)
(Long term debt)

V= Std Deviation, $10m

Distance to Default (DD):
(A-B)/v
(100-80)/10= 2stdvn
The firm will default if the Market Value decreases
by more than 2StdDev.
163

EDF Calc
2StdDev implies that 95% of the time,
the asset will vary between $80m and
$120m.
But for 5% of the time Asset value could
exceed $120m or be below $80m.
Since we are only interested in default,
we have 2% probability that the asset
will fall below $80m. i.e. an EDF of 2%.
Observation:
EDF increases if:
Asset Volatility Increase
Market value decreases

164

Empirical EDF:
The above calculated EDF is theoretical
EDF.
KMV calculates the empirical EDF from a
large database of firms defaults, loan
repayments & theoretical EDFs.
Logic:
What percentage of Firms in the database
with EDF of 2% actually defaulted in the
last year? = 50
How does it compare to the total population
of firms with 2% EDF (2 std dev from .) ? =
1000
165
Empirical EDF = 50/1000 = 5%

EDF of M&S

166

EDF- Capital Structure

167

EDF-Drivers

168

Enron Corp: EDF & Agency Rating

169

Loan pricing
170

Elements of loan pricing

When loans are not priced correctly, better rated
obligors tend to subsidise the less credit worthy
customers.
3 elements to be considered:
Balance sheet cost (cost relating to the financial
position)
Capital cost
Liquidity cost
The cost of funds

Credit cost:
Expected losses
Unexpected losses

Non-Credit Cost
interest rate risk
Pre-payments risk
Origination cost
171

Balance sheet cost:

Cost associated with the financial position:

Capital cost:

Capital is needed to fund loans

Use Basle CAR guidelines for capital contribution
Equity holders demand returns on this contribution
Returns is set by the board

Liquidity cost:
Loans are the most illiquid assets
Prudence require providing for liquidity against
loans
Is set by the market

Cost of funds: mainly made up of:

Deposits: these funds the lending asset and the
liquid assets.
Required capital as in capital cost
172

Credit risk costs

To cover for the possibility of default:
Expected losses
Unexpected losses

Expected losses:
Lender expect some loans to default and this is
included in the loan pricing.
Expected losses = Default probability x (1 Recovery Rate)
Default probability, recovery could be
determined
internal models or
credit agencies.

Unexpected losses:
this reflects the volatility of the expected losses.
173

Non Credit risk Cost

Interest rate risk
Mismatch in maturity between funding
(shorter) and loans assets (longer)
Variable loans funded by at call deposits
Obligor may switch to fixed, while cost of funding
increases ( as interest rate rising environments)

Pre-payment risk
Fixed rate loans: borrowers seek to refinance
when interest rate falls
Lenders may not be able to re-invest the loan
pre-paid at previous higher rates
Often there is a penalty for pre-payments.

Origination cost:
Originating and operating costs (overheads)
174

Loan Pricing: E.g.

a)Briefly explain the elements of loan pricing. (10 marks)
b) A five-year mortgage application has been made to purchase a
house that costs 200,000 (two hundred thousand pounds). The
bank requires its customers to contribute 5% of the cost of the
house as deposit.
The bank provides for 5% liquidity against lending assets. The
liquidity investment earns 4.9%. The loan will be funded by a time
deposit, which attracts 3.5%.To protect its exposure against
interest rate risk, the bank engages in a five-year swap rate to
cover the loan duration at 5%. The overheads relating to this loan
is $1500.
The banks internal model estimates that house loans have a 2.5%
defaults probability and a recovery rate of 95%. To cover for the
possibility of customers paying earlier than maturity, the bank
includes 30bp in its pricing
Note: Basle II, Capital Adequacy Requirements: Loans secured by
mortgages on residential property will be risk weighted at 35%.
Required:
Calculate the price of the loan, if shareholders require an after tax
return on equity of 20%. The company tax rate is 33%. (15 Marks)
175

Steps: Loan Pricing

Step 1: Consider how much capital the bank should contribute
Then determine the equity returns, which should be the
minimum profit to shareholders.
Calculate the amount of liquid assets to be set aside
Construct a financial position (balance sheet) for the loan
this helps to know the funds elements in funding the loan.
Construct a mini profit and loss statement for the loan- derive
the cost of the loan. Note all the charges and ancillary income
to include in the PnL.
NOTE:

liquid assets (income)

Pre-payments charges (income)
Hedging - Interest rate swap- (cost)
Overhead cost
Expected loss (cost)
Unexpected loss Should add to capital requirement
Corporation tax.
176

Loan Pricing
Suggested Answer: Loan Pricing
Loan Pricing: For Purchase Of House which cost 200,000

Cost Of The House:

200,000
Deposit Required:
5%
Liquidity Asset against lending;
5%
Returns on the liquid investment
4.90%
Loan is funded by Deposits- attracts
3.50%
Five year swap rate (interest rate Risk)
5%
Overheads related loan:
1,500
Default probability on house loans:
2.50%
Recovery Rates on house loans:
95%
Pre-payment Risk
30bp
0.30%
Shareholders required return:
20%
Tax rate
33%
CAR RWA on House loan by Basle II guidelines:
35%
CAR=
8%
Loan Amount To be given: (200k less Deposit. [200kx95%))

190,000
177

Loan Pricing
a

Calculate the bottom line profit: return on equity:

Capital contributed:
CAR: 35% * 190,000*8% =
After tax return is 20%*5,320 =
Amount of Liquid Assets Required:
Eqn 1:
Liquid Assets = Assets * 5%
Where
Eqn 2:
Assets = (Loans + Liquid assets)
Substitute eqn 2 into eqn 1
Eqn 3:
Liquid Assets = (Loans + Liquid assets) x 5%
i.e.
Liquid Assets=(190,000+liquidAssets)x 5%
Liquid Assets=(190,000x 5%) + (Liquid Assets x 5%)
LqA'=9500 + 0.05LqA
Rewritten as:
= LqA - 0.05LqA =9500
=0.95LqA = 9,500
There4 LqA =
Proportion of Liquid Assets

5,320
1,064

9500
0.95
95%

10,000

10,000

Deduce the Amount of Deposit Required to fund the Loan and the liquidity investment:
Construct a simple Balance Sheet:
Assets
Loan
Liquid Assets
Total Assets
Liabilities:
Deposit
(balancing Item)
Equity

190,000
10,000
200,000

194,680
5,320
200,000

178

179

Value At Risk :VAR

VaR stands for Value at Risk:

VaR is a statistical technique which gives:
Maximum expected loss
Over a given holding period
With a given probability

VaR gives the maximum amount of loss the

company could accept.
It seeks to answer the basic question:
How much could a portfolio / exposure lose over a time
horizon (1day, 10days, 1month, 1 yr) with a certain
degree of confidence or probability.
We are X percent certain that we will not lose more
than V dollars in time T.
X = probability or confidence level
T = is the time horizon
180
V = var amount (maximum amount of loss)

Parametric VaR
This requires the statistical distribution of
the data observations:
Usually assume a normal distribution
The standard deviation of the data
The correlation, if more than one asset.

Key inputs to a VaR for tradable security:

Current Market Value of the Exposure.e
Volatility or standard deviation of the market
value
Assume risk horizon, i.e confidence level

VaR

= Exposure value x Std Devn (%) x Confidence level

(Probability)
= Standard Deviation ($ amt) x Confidence level (Probability)
181

Parametric VaR
E.g. for a stock (share)- traded daily so holding
period is 1 day.
MV is currently $80
The std is $10 i.e. the stock value could daily
change by +$10
If the next 1 day is a bad day how much could I
loose at 95% confidence interval?
The higher the confidence interval, the more
conservative

182

VaR: Explanation of Confidence

Interval
Area Under the curve:

68% of returns must lie b/n +1 and 1 std

95% of returns must lie b/n +1.96 and 1.96
std
98% of returns must lie b/n +2.33 and 2.33
std

So at 98% confidence interval: (1% in

each tail)

On a good day there is 1% chance that the

stock value will be $80+2.33 (10) = $103.3
or above
On a bad day there is 1% chance that the
stock value will be $80-2.33 (10) = $56.70
or below

We are only interested in the left tail

i.e.
183
the loss:

 A company with GHC10m has to buy

dollars. The daily standard deviation of
the Cedi-dollar is 0.6%.
Calculate VaR 95% and 99%

Company also has to buy GHS10m of

Euro with Cedi-Euro standard deviation
at 0.5%
Calculate the VaR of the currency
portfolio

184

VaR 2 Asset Portfolio

185

Attractions Of VaR
VaR refers to a particular amount
Provides a consistent measure across
different positions- a common yard stick,
i.e. expressed in amount.
Management could clearly see which
position is riskier, the higher the VaR the
riskier the activity.
Good for management decision making

186

VaR- Problem
The VaR procedure works excellent for
tradable since:
Price is directly observed hence
Volatility could easily be measured

For non-tradable such as loans and private

placed bonds Price and volatility are not
easily observed.
The normal distribution assumption posses
a problem.
Different VaR methodology give different
VaR estimates
VaR ignores the tail end, where serious
187
bankruptcy could occur.

CreditMetrics: J.P Morgan

This is a VaR framework developed:
for non tradable loans
private placed bonds.
loan portfolio management

It measures the credit VaR (credit risk)

if next year is a bad year, how much will the
bank lose on its loans portfolio

Input into the model:

Borrower credit ratings
Transition matrix (probability that borrowers
rating will change: rating
Recovery rates on defaulted loans
Credit spread or yields on the loans market.
188

Example: A $100m, 6% 5yr Fixed Rate Bond,

borrower rated BBB

1 YR Transition Matrix
AAA
0.02%
AA
0.33
A
5.95
BBB
86.93
BB
5.30
B
1.17
CCC
0.12
Default
0.18

These shows the probabilities

of the current BBB rated bond
migrating to other ratings.
This is based on historical data
of publicly traded bonds
Rating migration or defaults
are termed as Credit Events

189

CreditMetrics:
Valuation:
If bond is upgraded, credit spread required falls, that increase
PV of the bond, vice versa
NPV of the bond:
Future cash flows $6m for the coupon
Nominal value at maturity - $100m
Discount rate = Risk free rate + credit spread for each maturity class.
See below table Discount rate table

190

Risk free Rates +Credit spreads

Ratings
AAA
AA
A
BBB
BB
B
CCC

Year1
3.60
3.65
3.72
4.10
5.55
6.05
15.02

Year2
4.17
4.22
4.32
4.67
6.02
7.02
15.02

Year3
4.73
4.78
4.93
5.25
6.78
8.03
14.03

Year4
5.12
5.17
5.32
5.63
7.27
8.52
13.52
191

CreditMetrics
If borrower is upgraded from BBB to A then the PV of the
Bond will be:
6 + [6/1.0372]+[6/1.04322]+[6/1.04933]+[106/1.05324]
=$108.66
The bond could migrate to any of the other 7 ratings
So a PV for each ratings should be calculate.
the table below for the value for each ratings
192

PV of the bond for each rating

AAA
AA
A
BBB
BB
B
CCC
Default

$109.37m
109.19
108.66
107.55
102.02
98.10
83.64
51.13
193

Calculating the VaR

Determine the Expected Value (Mean) of
the loan [PV*Migration Probability (MP)]
AAA= .02% * $109.37 = $.02m
BBB= 86.93% * $107.55= $93.49

Calculate the std = $2.99m= equiv of

1std
Assume normal distribution & 1 tail

At 95% , there are 1.65 stds

The VaR is = 1.65 *2.99=$4.93m
At 99%, there are 2.33 stds
The VaR is = 2.33*2.99= $6.97m
194

Asset & Liability

Management (ALM)
Market Risk Managing Interest Rate Risk
Managing Liquidity Risk

References
Bank Management 7 edition. Timothy W. Koch
and S. Scott MacDonald
Ch.7 Managing interest rate risk GAP and Sensitivity
Ch. 8 Duration Gap
Ch.11 Managing liquidity

Fundamentals of Risk Measurement Chris

Marrison
Ch. 14 Funding-Liquidity Risk in ALM.

 Asset and Liability Management

Interest rate risk
Interest Rate Gap Management
Interest Sensitivity Analysis
Duration Gap

Liquidity Risk
Value at Risk

Introduction Asset & Liability Management

Asset and Liability Management (ALM) refers to the management of long-term and structural
positions of market risk and liquidity risk embedded in a Banks balance sheet. Hence, often
referred to as Balance Sheet Management
ALM manages the market and liquidity risks associated with the banks balance sheet; Assets
and liabilities
Assets: Loans and Advances, including commercial loans, mortgages, overdrafts, retail personal loans,
credit cards
Liabilities: customer deposits current accounts, savings and fixed deposits

The primary risks managed by ALM are:

Interest rate risk and
Liquidity risk

Banks with substantial position in foreign currency would also consider foreign exchange risk
via ALM.
Need to manage interest rate risk:
the structural position of the balance sheet arises as a result of the banks intermediation between
depositors and borrowers.
Customers wants long term loans while they want quick access to any deposits they have made. Banks
normally borrow short and lend long
Customer wants certainty in interest payment they would be required to pay, hence opt for fixed rate loans.
Banks may then end up with receiving long term interest payments from customers while they pay short
term floating rate to depositors.

Interest Rate Risk

Interest rate risk:

is the exposure of an institution's financial condition to unfavorable movements in

interest rates.
Note:

there are several interest rates in any given currency: policy or prime rates, treasury rates,
inter-bank borrowing and lending rates, deposit and lending rates, etc.
Though these rates tend to move together they are not perfectly correlated.
Interest rates also differ according to the related maturity. This is referred to as the term
structure of interest rate or the yield curve.
The most common described yield curve is that of the treasury rates, i.e. the risk-free interest
rate. This serves as a reference point from which all interest rate are quoted.

Changes in interest rates affect

earnings by changing its net interest income:

Affect interest income earned on investments and loans & advances

Interest expense paid on deposits ( funding)

the value of the institution: s assets, liabilities and off-balance sheet instruments:

the present value of the banks asset and liabilities change when interest rates change

The forms of interest rate risk include:

Re-pricing risk,
Yield curve risk,
Basis risk and
Options risk,
199

forms of interest rate risk

Maturity / Re-pricing Mismatch:
re-pricing mismatches are fundamental to the business of
banking as a result of banks intermediation function
There are timing differences in
the maturity (for fixed rate) and re-pricing (for floating rate) of assets,
liabilities and off-balance-sheet (OBS) positions.

Bank generally borrows short and lend long

E.g. a bank may fund a long-term fixed rate loan with a short-term
deposit.
It faces a decline in both the future income arising from the position
and its underlying value if interest rates increase.
the cash flows on the loan are fixed over its lifetime, while the interest
paid on the funding is variable, and increases after the short-term
deposit matures

Yield Curve Risk

Yield Curve plots interest rates of bonds (usually treasury bonds)
having equal credit quality but with differing maturity dates
Use as a benchmark for other debts or bank lending rates
Three main types: Normal (shown), inverted and flat (or
humped).
Normal- longer maturity bonds have higher yields than shorter
bonds due to time risk.
Inverted shorter term yields are higher than longer term yieldindication of coming recession
Flat or humped- shorter and long term yield are very close to
each other, indicating economic transition.
Yield curve risk arises when unexpected shifts of the yield curve
have unfavorable effects on an institutions income or underlying
economic value.
Parallel shift:
All points along the curve move by same basis points
Non-Parallel shift:
E.g. short-term rates changes by different basis points than
long term rates.

201

Basis risk:

Basis Risk:
arises from imperfect correlation in the adjustment of
the rates earned and paid on different instruments with
otherwise similar re-pricing characteristics.
Consider a strategy of
funding a one year loan that re-prices monthly based on prime rate
with a one-year deposit that re-prices monthly based on one month
Treasury bill rate.
This exposes the institution to the risk that the spread between the two
index rates may change unexpectedly.
The two rate index may change by different margin (basis points)

202

Options risk
arises from the options embedded in an institutions
assets, liabilities and OBS portfolios.
Examples:
various types of bonds and notes with call or put provisions,
loans which give borrowers the right to prepay balances, and
various types of non-maturity deposit instruments which give
depositors the right to withdraw funds at any time, often
without any penalties.

Measuring Interest rate Risk

Maturity Gap Report
Modified Duration
Interest Earning Sensitivity

Maturity Gap Report

The gap analysis technique:

measures the sensitivity of the bank's asset and liabilities to interest
rate changes over the maturity or re-pricing period of the banks balance
sheet.

The assets and liabilities are categorised into:

Interest Rate Sensitive Assets (IRSA)
Interest Rate Sensitive Liabilities (IRSL)
Non- Interest Rate Sensitive (NIRS)

These are then arranged into maturity ladder based on their repricing interval, repayments, maturity, and non-sensitive
the re-pricing date (for floating rated A&L) and
Contractual Maturity (fixed rated A&L).

Re-pricing date refers to the date when interest rate is due for reset.
Contractual maturity when cash flows are contracted to be paid.
e.g. 3 month deposit will be repaid or rolled over at the end of the three
month.

Gap Report
Maturity / RePricing
Buckets

IRSA
GHS m

IRSL
GHS m

Gap
GHS m

Cumulative
GHS m

<3 months

74

81.50

(7.50)

(7.50)

3-6 Months

10

9.50

0.50

(7.00)

6-12 Months

10

5.75

4.25

(2.75)

1-2 years

4.25

52.25

2.00

(0.75)

2-3 years

4.25

2.25

2.00

1.25

3-4 years

4.25

2.25

2.00

3.25

4-5 years

4.25

2.25

2.00

5.25

5-6 years

3.50

(2.50)

2.75

Gap Report
Interpretation of the Gap:
The difference between assets and liabilities per re-pricing time bucket represents the
interest rate exposure
i.e. the time bucket is either asset sensitive (RSA > RSL) - the bank gains with a rise in
interest rate or vice versa) or
liability sensitive (RSA < RSL) - the bank gains with a fall in interest rate or vice versa).

Usefulness of the gap report

The maturity gap analysis captures the interest rate characteristics of the balance
sheet.
Able to measure the sensitivity of the banks balance sheet to interest rate changes

Gap reports criticism:

Does not include customer behavior where:
Prepayment option is available - if interest rate is falling customers may chose to pay off existing
fixed loans
pre-maturity withdrawal - If interest rate is rising fixed depositors may chose to withdraw funds earlier
than agreed.

DURATION and Modified Duration

It measures the economic maturity of the set of cash
flows from a bond. The cash flows are weighted against
respective time buckets ( reflecting the time value of
money).
Duration is calculated as follows:
A = Compute the PV of all the cash flows of a bond
B = Add all PVs to arrive at the value of the portfolio
C= Multiply each cash flow PV by the time bucket it falls in (A
x Time bucket)
D = Sum of C
E=B/D

DURATION and Modified Duration

Duration as interest rate sensitivity

Modified Duration is used as a measure of sensitivity of
portfolio value as a result in changes in interest rate.
% change in value is approximately = ( - modified
duration x change in interest rate )
Modified duration = Duration divided by the factor (1 + r)
where r is the per-period interest rate.
7.55 / 1.0487 = 7.20 years
Interpretation:
1% change in interest rate will lead to 7.20% change in
the value of the Bond.

Interest Earning Sensitivity

The interest rate sensitivity or impact on the Net Interest
Income is calculated as:
[Cumulative Gap] x Change in Interest Rate x Proportion of the
year = IMPACT on Net Interest Income.
If interest rate changes by 10bp (0.1%), then the impact on the
0-3month bucket will be
GHS7.5m x 0.1% x (year) = GHS 1,875.00

2-3 year bucket

GHS 1.25m x 0.1% x 1 year = GHS 1,250.00

BOG draft guidelines on Supervisory Review Process (BS3 May 2009,

Paragraph 70 (vii) "Interest Rate Risk in the Banking Book" requires:
banks to conduct a stress test on its interest revenue by shocking interest
rate by 200bp;
which if resulted in a more than 20% fall in revenue (Net Interest Income) will
necessitate an additional capital requirement.

Interest Earning Sensitivity

Interest Rate Sensitivity- Modified Duration

(Basel )

Managing Liquidity
Risk

Liquidity Risk
Liquidity risk arises from an institutions inability to purchase
or otherwise obtain the necessary funds, either by:
increasing liabilities or converting assets, to meet on-and offbalance sheet obligations as they become due
at minimum cost or, without incurring unacceptable losses.

Liquidity risk arises from either:

the lack of funds due to maturity mismatch (i.e. funding liquidity
risk) or
market illiquidity (i.e. market liquidity risk).

Market Illiquidity:
This occurs when the readily liquid asset of the bank may not be
easily disposed- off either as a result of:
stressed market conditions or
that the market is not deep enough to absorb the asset being disposed.

 Funding Liquidity Risk:

A bank suffers funding liquidity risk when it is not able to meet its maturing obligations (such as
withdrawal by customers, draw down on approved credit facilities, payment of operational
expenses)
so that the Bank is forced to raise funds at a highly excessive cost i.e. either sell assets at deep
discounts or borrow funds at above the normal funding cost.

Funding-Liquidity risk arises from:

Mismatches between assets and liabilities
Banks normally funds themselves with short contractual liabilities ( demand deposits, savings and
fixed deposits)
Out of these liabilities:
Banks keep a small proportion for mandatory primary reserve (10% in Ghana cash, and balance with BOG) and
liquidity buffer (non-mandatory highly liquid assets treasury bills)
The remaining the bank would then lend as loans and advances (commercial and personal loans) which have longer
maturity periods.

Customers tend to leave their funds in their current accounts longer than the
contractual maturity ( core stable funding or deposit), so the small amount kept should
be able to cater for customers withdrawal.
However, if there is unusual or unexpected withdrawals then the bank may not have
enough cash to meet customer demand.

 If the bank is able to borrow on the inter-bank market at

normal operating cost or is able to dispose some of its
treasury bills at normal discount rates then there is no
liquidity issue.
Inability to meet customers demand may lead to loss of
confidence, triggering panic withdrawal or a run on the
bank.

Measurement of Liquidity Risk

It is essential to identify:
the banks uses and sources of funds and
the types or nature of the uses or sources.

The types / nature of funds

Scheduled payments those which have previously been agreed by the
counterparties:
Scheduled loans disbursements, maturing fixed deposits, scheduled loan repayments

Unscheduled payments arise from customer behaviours:

Customer withdrawal from current account or savings, customers use of overdraft facilities
or use of credit cards. Unscheduled deposits into current accounts, rollover of expired fixed
deposits

Semi-discretionary payments occur as part of the banks normal trading

operations but which can easily be changed if necessary:
Purchasing of treasury bills by the bank as liquidity buffer or as security for borrowing
Sale of foreign exchange currency

Discretionary transactions usually carried out by the banks treasury to

balance the cash-flow for the day:
Lending or borrowing on the inter-bank market, if the bank has cash surpluses or shortages,

Measurement of Liquidity Risk

With the above classification the bank could then prepare for
three types funding requirements:
Expected funding requirements:
Relatively easy to measure, includes all scheduled payments and
receipts
Expected pattern in accounts for current accounts are expected to
fall steadily in the month and then jump up at end month when wages
are paid.
Usually average balances on non-contractual facilities

Unusual funding requirements:

Unusual or unscheduled withdrawals or deposits by customers ( not
fueled by crisis), taking into considerations customers behaviours e.g.
as result interest rate changes, competitors action

Measurement of Liquidity Risk

Crisis funding requirements:
Crisis are rare, however contingency funding plans should be made.
First, estimate funding under above conditions ( I & II), then modify
model by estimating how much value would be lost in time of crisis.

Crisis / stress testing factors

Lost of confidence by customers large depositor withdraw

Other banks are not willing to lend to you.
Large exposures default
Contingent liability materialize - Judgment debt against bank

These assumptions should feed into the estimate for liquidity

requirements under crisis.

Liquidity Risk Models

Liquidity Mismatch Ladder (Liquidity Maturity Gap Report):
involves matching maturities of assets and liabilities per time buckets
to see what funding gaps exist,
so that plan for refinancing needs and build up for adequate liquidity
buffer could be done in order to adjust the maturity profile of the
Banks balance sheet.

The mismatch or funding gaps are generally subjected to the

following guidelines:
Any cumulative net position for buckets up to 1 month, must be a
positive figure,
Any negative cumulative net position up to 180 days must not exceed
5% of the total assets;
Any negative cumulative net position for buckets beyond 180 days
must not exceed 15% of the total assets.

Liquidity Ratios and Limits

A. Statutory Reserve Requirement
Primary Reserve: mandatory reserve of 10% of total deposits.
Secondary Reserve (Liquidity Buffer): not mandatory for universal bank, but a good
banking prudential practice to hold a minimum % of total deposit for liquidity buffer.

B. Operational Liquidity Ratios:

1. Liquid Assets to Volatile Funds:
the ratio measures the availability of liquid assets to meet volatile funds of deposits
and other creditors. The prudential ratio limits is greater or equal to 100% or 1.

Liquid assets is defined to include:

Cash and Balances with Banks,
Treasury Bills and Bonds,

Volatile funds includes:

Current accounts
Deposit by large institutions

Liquidity Ratios and Limits

2. Net Volatile Funding Dependence:
This measures the extent to which the Bank's most illiquid assets
(loans and advances) are financed by volatile (non-core) funding.

Any excess of volatile funds over liquid assets is deemed to

have been used to finance loans or fixed assets, therefore:
a positive ratio implies dependency on volatile funds.
A negative ratio is good as it implies that no volatile fund has
been used to finance illiquid assets.

Liquidity Ratios and Limits

Gross Loans & Advances to Deposits:
this ratio measures the proportion of deposits locked up in loans. If it is high then the
bank must have some short term investment to release liquidity when needed.

Gross Loans & Advances to Core Deposits:

Proportion of loans supported by the most stable deposits. Stable deposits are funds
which have high degree of probability of staying with the bank for a reasonable time.
Current account a minimum portion of current account stays with the bank within
the year.
Fixed deposits 6 months and above.
Short dated deposits which have a high tendency to be rollover.

Shareholders Funds to Total Fixed Assets (long-term assets) Ratio:

is designed to ensure that long term assets of the Bank are financed with net own
funds. The objective is to curb a banks over reliance on short-term volatile funding
for financing its long-term assets.
Shareholders funds / total fixed assets >= 1

Early Warning Indicators for Liquidity Risk:

indicators to identify the emergence of increased risk or vulnerabilities in its liquidity
risk position or potential funding needs.
Such early warning indicators should identify any negative trend and cause an
assessment and potential response by management in order to mitigate the banks
exposure to the emerging risk.
Early warning indicators can be qualitative or quantitative in nature and may include
but are not limited to:
1. Increasing weighted average cost of funds (WaCoF):
a) Weighted average cost is an indication of the average cost incurred by the Bank in respect of
the total borrowed funds (deposits and borrowings).
b) An increasing trend indicates that the Bank is incurring more expenses in respect of its
borrowings

2. Rapid asset (loans & advances, fixed assets) growth financed by volatile
funding:
a) ideally illiquid assets should be financed by stable funds. A worsening or positive Net Volatile
Funding Dependence ratio is an indication of increasing dependency on volatile funding.

3. Deterioration in loan asset quality:

a) an increasing Non-Performing Loans (NPL) ratio indicates non-receipts of expected cash flows.

Early Warning Indicators for Liquidity Risk:

4. Growing concentrations in assets or liabilities
5. increases in currency mismatches
6. a decrease of weighted average maturity of liabilities
7. repeated incidents of positions approaching or
breaching internal or regulatory limits
8. negative trends or heightened risk associated with a
particular product line, such as rising delinquencies
9. significant deterioration in the banks earnings, asset
quality, and overall financial condition
10.negative publicity

Early Warning Indicators for Liquidity Risk:

11. a credit rating downgrade
12.stock price declines or rising debt costs
13.widening debt or credit-default-swap spreads
14.rising wholesale or retail funding costs
15.counterparties that begin requesting or request additional collateral
for credit exposures or that resist entering into new transactions
16.correspondent banks that eliminate or decrease their credit lines
17.increasing retail deposit outflows
18.increasing redemptions of CDs before maturity
19.difficulty accessing longer-term funding
20.difficulty placing short-term liabilities (eg commercial paper).

Derivatives

Topics
Derivative Contracts:

Forward Contracts
Futures
Options
Swaps
Credit Derivatives

References
Financial Management and Analysis - FRANK J. FABOZZI and
PAMELA P. PETERSON (2nd Edition)
Chapter 4 - Introduction to Derivatives
Option, Future and Other Derivatives, 5 th Edition, John C. Hull
Chapter 1 Introduction to Derivatives
Chapter 2 Mechanics of Futures Markets
Chapter 6 SWAP
Chapter 27 Credit Derivatives

Introduction
Derivatives:
Financial instruments designed to efficiently transfer some form of risk between two
or more parties.
Classified by the type of risk being transferred

Types of risk:
Interest rate risk: (Interest rate derivatives: Interest Rate Futures, Interest Rate
Swaps)
Currency risk: (foreign exchange derivatives)
Commodity: (commodity derivatives)
Equity price risk: (Equity derivatives)
Credit Risk : (Credit Derivative)

A derivative can be defined as a financial instrument whose value depends

on ( or derives from) the values of other underlying instruments or
products or variables.
Very often the variables underlying the derivatives are traded assets.
E.g. Stock option is dependent on the price of the stock, Commodity futures ( gold,
cocoa etc.) is dependent on the prices of the commodities on the world market.

Introduction - derivative exchange

A derivative exchange is a market where individuals trade standardized

contracts that have been defined by the exchange.
The Chicago Board of Trades (CBOT), established in 1848 was to bring
farmers and merchants together.
It established the quantities and qualities (standardized) of grains to be
traded.
The first future-type contract developed was known as to-arrive
contract: meaning
buying and selling the standardised grains at a determined price now but to be
delivered in a set date in the future when the grains would have been harvested.
Speculators soon became interested in the contract rather than trading in the
grain itself.
Chicago Mercantile Exchange, a rival exchange market started in 1919. the
Chicago Board of Options Exchange started trading in call options in 16 stocks
in 1973, now trades in over 1200 stocks.
There are many exchanges all over the world- with underlying assets of foreign
currencies, futures contract, stock or indices.

Introduction - Over-the-Counter
(OTC)
Not all trade are done on exchanges. There are Overthe-Counter (OTC) market where trades are done
between two financial institutions via a telephone or
some computer network.
These contracts are not standardised and are done to
suit the special needs of the counterparties involved.
Contracts are often taped for dispute resolution.
The disadvantage is credit risk while the exchange
traded contracts, the exchange serves as intermediary
and reducing counterparty risk significantly.

Forward Contracts
A forward contract is an agreement to buy or sell an asset
at a future time for a certain price.
It can be contrasted to a spot contract, which is an agreement
to buy or sell an asset today.
A forward contract is an OTC contract between two financial
institutions or a financial institution and a client.

One parties assumes a long position:

i.e. agree to buy the underlying asset on a certain specified
future date for a certain specified price.

The other party assumes a short position:

and agrees to sell the asset on the same date for the same
price.

Forward Contract on Foreign

Exchange
Spot: the bank is prepared to buy GBP 1.4452 and sell 1.4456 today.
In 1-month it is willing buy GBP 1.4435 and sell 1.440

Hedging - Forward Contract on FX

A US Corporation knows that it has to pay 1m in 6 months
time and wants to hedge against movement in exchange rates.
The treasurer agrees to buy 1m six months forward at an
exchange rate 1.4359. the Corporation has a long forward
contract on GBP. The Bank has a short forward position on GBP
as it agrees to sell GBP.
Pay off:
Come six months, the day of delivery, the spot rate for GBP/USD is
1.5000.
The forward contract is worth (Spot-in-T6 K (fwd price) x Amount =
(1.5000 1.4359) x 1m = $64,100
The company gains because it buys the at 1.4359 instead of 1.5.

If the 6-month spot price turns out to be is 1.4 then the Bank
gains as it would sell at 1.4359 instead of 1.4000
(1.4000 1.4359) x 1m = $35,900

Profit-Loss diagram of forward contract

Futures Contract
Like a forward contract, Futures contract is an agreement between two parties to buy or
sell an asset at a certain time in future for a certain price.
The underlying assets are either commodities or financial assets.
Commodities live cattle, gold, wheat, sugar, copper etc.,
Financial assets stock / shares, currencies, treasury bonds

However futures contract are traded on an exchange, the exchange then becomes an
intermediary between the two parties
Hence Futures is defined as:
an agreement between a buyer (seller) and an established exchange or its clearinghouse in which
the buyer (seller) agrees to take (make) delivery of the underlying at a specified price at the end of
a designated period of time.

The price at which the parties agree to transact in the future is called the futures
price. The designated date at which the parties must transact is called the settlement
date or delivery date.
Unlike forwards, an exact delivery date is not specified a period in the delivery month is stated
when delivery should be made. For a commodity futures the delivery date is the entire month.

The exchange specifies certain standardized features of the contract.

Contract size ( 5000 bushels of wheat, standardised amount of a contract$100,000) quality of the
commodity (grades of grain), delivery dates: March, June, September and December)

The basic economic function of futures markets is to provide an opportunity for market
participants to hedge against the risk of adverse price movements

Example of Standard Asset

Futures Contract
To illustrate, suppose there is a futures contract traded on
an exchange where the underlying is Asset X, and the
settlement date is three months from now.
Assume further that Brent buys this futures contract, and
Susan sells this futures contract, and the price at which they
agree to transact in the future is $60. Then $60 is the
futures price.
At the settlement date, Susan will deliver Asset X to Brent;
Brent will give Susan $60, the futures price.
The seller of futures delivers the underlying assets
The buyer of futures takes delivery of the underlying asset

This transaction is illustrated below.

How Futures are Used to Manage Risk

a producer of crude oil:
The concern of the crude oil producer is that the price of crude
oil will decline, thereby forcing it to sell crude oil at a lower
price.
company that uses crude oil:
The concern of the user of crude oil is that the price of crude
oil will increase, resulting in a rise in its production costs.
The oil producer will therefore want to lock in a price to assure
himself of the stream of revenue.
He will sell futures enable him sell oil at a lock-in price, e.g. $50
dollars per barrel.
The oil producer (seller of futures) is said to be in a short
position or short futures
If oil prices falls within the trading period to $40, he is still able to
sell his oil at $ $50, thus making a gain of $10. if oil prices rises

How Futures are Used to Manage Risk

The oil user will also want to lock in a price to assure
himself of his production cost.
He buy futures to enable him buy oil at a lock-in price,
e.g. $50 dollars per barrel.
the oil user (buyer of futures) is said to be in a long
position or to be long futures.
If oil price increases to $55, he is happy as he is able to
buy oil at $50. however if oil price falls to $40, he still has
a commitment to buy oil at $50, thereby losing the
opportunity to buy oil at a lower price.
Buyer of futures gains when price of future goes up, and
loses when price of future falls.

In the same way that these two firms are able to use a

The Role of the Clearinghouse

1. Guarantees that the two parties to the transaction will perform:
Each counterparty must be concerned with the others ability to fulfil the
obligation at the settlement date.
The buyer of the futures lacks the funds to pay for the goods or refuses because the
cash price on the market is cheaper.
The seller of the futures is unable to produce or deliver the goods or refuses to
deliver the goods because the price is higher on the market.

The clearinghouse exists to meet this problem.

When a party takes a position in the futures market, the clearinghouse takes the
opposite position and agrees to satisfy the terms set forth in the contract.

2. Role in Unwinding the contract

the clearinghouse makes it simple for parties to a futures contract to
unwind their positions prior to the settlement date.
It takes the position of a counterparty to all trades, so when unwinding a
position one does not has to seek out the other party.

Liquidating a Position
Most futures contracts have settlement dates in the months of March,
June, September, or December.
This means that at a predetermined time in the contract settlement month
the contract stops trading, and a price is determined by the exchange for
settlement of the contract.
A party to a futures contract has two choices on liquidation of the position.
First, the position can be liquidated prior to the settlement date. For this purpose,
the party must take an offsetting position in the same contract.
For the buyer of a futures contract, this means selling the same number of identical futures
contracts;
for the seller of a futures contract, this means buying the same number of identical futures
contracts.

The alternative is to wait until the settlement date.

At that time the party purchasing a futures contract accepts delivery of the
underlying (financial instrument, currency, or commodity) at the agreed-upon price;
the party that sells a futures contract liquidates the position by delivering the
underlying at the agreed-upon price.

The Role of the Clearinghouse

Suppose that Brent wants to get out of his futures position.
He will not have to seek out Susan and work out an agreement with
her to terminate the original agreement.
Instead, Brent can unwind his position by selling an identical futures
contract.

As far as the clearinghouse is concerned, its records will show

that Brent has bought and sold an identical futures contract.
At the settlement date,
Susan will not deliver Asset X to Brent but
will be instructed by the clearinghouse to deliver to someone who
bought and still has an open futures position.

In the same way,

if Susan wants to unwind her position prior to the settlement date,
she can buy an identical futures contract.

Margin Requirements
When a position is first taken in a futures contract:
The investor must deposit a minimum dollar amount per
contract as specified by the exchange. This amount is called
the initial margin.
Initial Margin could be in the form of:
treasury bills at 90% of face value or
share at 50% of market value.
All subsequent variation margin are in cash.

Prices changes in futures contracts:

As the price of the futures contract fluctuates, the value of the
investors equity in the position changes.
At the end of each trading day, the exchange determines the
settlement price for the futures contract.
This price is used to determine the investors position, so that
any gain or loss from the position is reflected in the investors

Margin Requirements
Maintenance margin:
Is the minimum level (specified by the exchange) by which an
investors equity position may fall as a result of an
unfavourable price movement before the investor is required
to deposit additional margin.
The level of margin required is dependent on the degree of the
variability of the price of the underlying asset.
The higher the variability, the higher the margin levels
Variation Margin:
The additional margin deposited is called variation margin,
and it is an amount necessary to bring the equity in the
account back to its initial margin level.
Excess Margin:
Any excess margin in the account may be withdrawn by the
investor.

Futures versus Forward Contracts

Futures

Forward Contracts

agreement for the future delivery of the underlying at a

specified price at the end of a designated period of time.

contracts are standardized agreements as to the delivery

date (or month) and quality of the deliverable.

exchange-traded product

futures contracts are not intended to be settled by delivery

marked to market at the end of each trading day.

futures contracts are subject to interim cash flows due to

margin requirements

Counterparty risk is minimal in the case of futures contracts

as a result of clearing house guarantees

agreement for the future delivery of the underlying at a

specified price at the end of a designated period of time.

A forward contract usually non-standardized (that is, the

terms of each contract are negotiated individually between
buyer and seller),

there is no clearinghouse, and secondary markets are often

non-existent or extremely thin.

is an over-the-counter instrument.

are intended for delivery

may or may not be marked to market, depending on the

wishes of the two parties.
May not involve interim cash flows if no margin is required

are exposed to credit risk because either party may default

on the obligation.

Options
Options are traded both on exchanges and over-thecounter market. There are two basic types of options:
Call options gives the holder the right to buy the
underlying asset by a certain date for a certain price
Put options gives the holder the right to sell the
underlying assets by a certain date.
The price of a contract is known as exercise or strike price
and the date in the contract is known as expiration date
or maturity.
American option can be exercised at anytime up to the
date of expiry while an European option can only be
exercised at expiry date.

Call Option - Example

The purchaser of a call option hopes that the price of
the underlying asset will rise.
European call option to purchase 100 shares of
Microsoft with a strike price of $60. The option price per
share is $5. The current price of the share is $58 and
the expiry date is in 4 months time. At expiry date
A) the share price is below $60
B) share price is $75
C) share price is $62

Profit-Loss diagram of call option

Call Options
Scenario A: Share price is less than $60 ( strike price).
The investor will chose not to exercise his right as there is no point in
buying a stock at $60 when he can buy at a less price.
He loses $500 ($5 x 100 shares) of the initial investment.

Scenario B: Share price is $75

The investor would exercise his right to buy the 100 shares at $60 making
a profit of $15 per share. After taking care of the initial cost of $5 per
share a net gain of $10 per share.

Scenario C: share price is $62

The investor exercises his options and make a gains of $2 per share,
however the initial cost of an option of $5 per, he loses $3 per share. He is
better of exercising the right and reducing the initial cost.

Put Options
While the purchaser of a call option is hoping that the
stock price will increase, the purchaser of a put option
hopes that the stock price will decrease.
Investor buys a put option to sell 100 IBM shares at a
strike price of $90. suppose the current price is $85 and
the expiration date is in 3 months, and the price of the
option is $7 per share.
Scenario A: Price is $75
Scenario B: price is still $85
Scenario C: price is above $90

Profit-Loss Diagram of a put option

Put Options
Scenario A: Price is $75
The investor would buy the shares at $75 on the market and
sell the share to counterparty at $90, making a profit of $15
per share less the $7 per option price.

Scenario B: Price is retained at $85

The investor exercises the right and gains $5 per share but the
option price per share is $7, hence losses $2 per share. Better
to exercise and reduce loss.

Scenario C: the share price is above $90

The investor will let the option lapse and bear the loss of $700
( $7 x 100 shares).

Types of Traders On the Derivative

Market
Hedgers
Speculators
Arbitrageurs

Hedgers
Hedgers use futures, forwards and options to reduce the
risk they face from potential future movements in a
market variable.
A US based company ImportCO, has to pay 10 million
on 16 November 2001, for goods it has purchased from
its British suppliers. The company could hedge its risk
against FX movement by buying a 3-month forward at
1.4407. this has the effect of fixing the price to be paid
to the British exporter at $14, 407,000.
EXportCo also is expecting 30 million in three months.
It could fix its export income by selling the 30m in the
forward market at 1.4402, thus fixing its income at $43,

Speculators
Speculators bet on the future direction of movements in market
variables, and then take appropriate positions in order to profit
from it. Speculators, unlike hedgers, do not have any underlying
position to protect.
A speculator who has $4,000 to invest, believes that share price
of CISCO will increase in value over the next two months. The
stock price is currently $20, and a two-month call option with a
strike price of $25 dollars is selling for $1 per an option.
The speculator has two alternatives.
Buy 200 share with the $4000
Buy 4000 call options with the $4000

The speculator was correct, indeed the CISCO share price in two
months was $35.

Speculators
Option A: Profit made was ($35 $20) x 200 shares = $3,000
Option B: With a call option he has the right to buy 4,000 shares
for $25 and sell it at $35 ($35 - $25) x 4,000 = $40,000 less
$4,000 (option cost) = $36,000
The call option gives the speculator the opportunity to leverage his
funds, on the cash market he is able to buy only 200 shares and make
$3,000 but on the derivative market he has the right sell 4,000 shares
and is able to make $36,000 with the same $4,000 investment.

If the speculator got it wrong then his losses will also have been
large as well. Suppose that the actual price turns out to be $15.
The cash market speculator will lose ($15 - $20) x 200 shares =
$1,000
Call option: the speculator would let the option lapse as there is no
point in buying at $25 and selling at $15. He loses the entire
investment of $4,000

Arbitrageur
Arbitrageurs take offsetting positions in two or more
instruments to lock in a riskless profit.
Consider a stock which is traded in both NYSE and LSE.
Suppose that the stock price is $152 in New York and 100
in London at the time when exchange rate is $1.55/.
An arbitrageur will buy a share of the stock in the New York
and sell them in London at 100 translated to $155 making
a risk free profit of $3 per share in the absence of
transaction cost.
For a small investor, transaction cost will eliminate the
profit, but for a large investment house who faces a low
transaction take advantage and make a gain out of the
price mismatch

Swaps
A swap is an agreement between two companies to:
exchange cash flows in the future,
defining the dates when the cash flows are to be paid and
the way in which they are to be calculated.

The dollar amount of the payments exchanged is based

on some predetermined dollar principal, which is called the notional
principal amount or simply notional amount.

A swap is an over-the-counter contract. Hence, the counterparties to

a swap are exposed to counterparty risk.
There are three category on swap contracts
interest rate swaps
currency swaps
and commodity swaps.

The most common is the interest rate swap

Mechanics of Plain Vanilla -Interest Rate Swaps (IRS)

In this contract a company agrees to:
pay cash flows equal to interest at a predetermined fixed rate on a notional principal for
a number of years.
In return , it receives interest at a floating rate (e.g. 3 months $ Libor) on the same
notional principal for the same period of time.

A company may enter into an IRS agreement to transform a floating rate loan
into fixed rate loan. The other way is also true.
Example:
Microsoft borrowed $100m at Libor + 0.1% (10bp), and then enters into a 3year interest rate swap agreement with Intel. Microsoft agrees to pay Intel an
interest rate of 5% per annum on a notional amount of $100m, and in return
Intel agrees to pay Microsoft six-month Libor. The first cash flow payments is 6
months after the agreement. 6m Libor at time of agreement is 4.2%.
At the start of the Swap, there is no uncertainty about the first payments on
both sides. However subsequent interest payments on the floating side is
uncertain.

 IRS payments are done on net basis i.e. only the

difference in cash flow payments are made.
If the principals are exchanged at the end of the end of
the contract it would make no difference as exchanging
$100 million for $100 millions has no financial value.

Using Swap to Transform Liability

Microsoft:
has arranged to borrow $100m at Libor + 0.1% (10bp), after which it
entered into the above swap. Microsoft would have the following cash
flow
it pays Libor +0.1% under the terms of the loan
it receives Libor under terms of the swap
it pays 5% fixed under the terms of the swap

The three cash flows net out to a fixed payment of 5.1%

Intel:
has an outstanding fixed rate loan on which it pays 5.2%, after the swap
Intel interest payments:
It pays fixed 5.2% to its outside lenders under the terms of the loan
It pays Libor under terms of the swaps
It receives fixed 5% under terms of the swaps

The three cash flows net out to interest payment of Libor + 0.2%

Using Swap to Transform interest payments from Assets

Microsoft owns $100m in bonds that pays 4.7% per

annum for the next 3 years. After swap Microsoft has
these cash flows:
It receives 4.7% on the bonds
It receives Libor under the swap
It pays 5% under the terms of the swap

The cash flows net out to interest receipt of Libor 0.3%.

Intel- Earning assets of $100m with a floating rate of

Libor O.25%

It receives Libor minus 0.25% on its investment

It pays Libor under terms of the Swap
It receives 5% under terms of the contract
Net effect: Receives interest at 4.75% (5% - 0.25%)

Using Swap to Transform interest payments from Assets

Transfer of Credit
Exposure
Securitization
Credit Derivatives

Transfer Of Credit Exposure:

Some form of protection against or transfer of credit risk has always

existed:

Bonds back by collateral

Syndicated loans

buy and sell the loans - (transaction cost, tax issues, client confidentiality)

restrict lending policies and foreclosure: problem is client relationship

liquidating underlying collateral: but this is the worst scenario

sour customer relationships.

Possibility of litigation by obligor
Trigger a scramble for the debtors assets by other lenders.
The borrower could seek protection under bankruptcy act, which extends the liquidation
process.
Expensive: legal fees, storage, valuation etc.

Securitisation:

Asset Backed Securities ( Mortgage Backed Securities) and

Credit derivatives
274

Traditional Lending Function vs.

Securitisation
The lending function follows a loan life from its origination till it is fully repaid.
Anyone can lend, but ensuring repayments of principal and interest is what
distinguishes a good banker from a bad one

The lending function consists of loan origination, funding, servicing and

monitoring.
Funding:
Traditionally, loans are funded by customer deposits.
Loans kept on Balance Sheet (Banking Books, i.e. held to maturity) and must be funded.
i.e. originate and retain till maturity model

However, securitization eliminated the need to rely on deposit funds to finance

banks lending activities.
Loans, especially mortgages, credit cards etc. are turned into securities and sold
investors.
Needed funds are realised as soon as possible ( instead of waiting for the full maturity
of the loan).
i.e. originate and distribute model

Securitisation is also a means of transferring the credit risk embedded in the

banks portfolio to outside investors
275

Securitization
Securitization:
Process of packaging the cash flow from an asset into an
investment security and selling it to investors.
Assets characters:
High quality cash flows (with low defaults rates)
Homogenous assets (have similar risk profiles)
Seasoned and insured assets

Examples:

Home loans (mortgages)

Utility bills
Credit cards bills
Car loans and leases
276

Securitization
Purpose:
Credit Risk Management
Reduce concentration risk

Capital management
To satisfy the capital adequacy requirement

Liquidity management
To release cash tied up in long term (loan) assets

Interest rate risk management

Remove too much exposure to a particular term
(bucket) in the term structure (interest rate)

277

Securitization

Securitisation Structure:
Pass Through
Pay through structures

Pass Through Structures:

Lending assets are completely sold off (removed from balance sheet)
No recourse (legal or moral) in defaults
Fair value should be received (assets are deeply discounted)
Manage the customer relationship issue

Components: (see diagram)

The owner of the assets (lending institution)
Special purpose vehicle through which assets are sold
Trustee manager:
that manages the assets
Receives related cash flow from the lending institution and pass to
investors.

Investors who buy the securities

278

Diagram-Pass Through Structure

279

Securitization
Pay through structures:
The cash flows from the lending assets are
packaged into an SPV.
The assets remains on the balance sheet.
This is not for capital management, rather
liquidity.
Assets include: credit cards, car leases

280

Asset-Backed Security
ABS is a security created from the cash flows of financial assets such as loans,
bonds, credit card receivables, mortgages, auto loans and aircraft leases.
Securitisation Process:
A portfolio of assets is sold by the originators of the assets to a special purpose
vehicle and the cash flows from the underlying assets are allocated to tranches.
There could be several tranches usually:
senior tranche,
the mezzanine tranche and
equity tranche

Allocating cash flows or Losses

Cash flows are allocated to tranches by specifying what is known as the waterfall. Cash
flows are first allocated to the senior tranche, then to mezzanine and lastly to equity
tranche if there is any left.
Loses are first borne by the Equity tranche, then mezzanine tranche and lastly senior
tranche if any loss is still available.
Senior tranche is therefore more secured, followed by the mezzanine tranche, with equity
tranche being the riskiest.
However, the equity tranche attracts the highest return with the senior tranche taking
the least return.

ABS Example
The asset portfolio sold to SPV is $100m.
Senior tranche principal $75m, return of 6%
Mezzanine tranche Principal $20m with return of 10%
Equity tranche Principal of $5m with return of 30%
Allocating Losses:
First 5% of losses are borne by the principal of Equity tranche.
If losses exceed 5% the excess is born by the mezzanine until
its principal are wiped of.
In this case the loss percentage would have to be up to 25%.
Any loss in excess of 25% will be borne by the senior tranche.

Diagram of ABS Structure

Waterfall In Asset Backed Security

Credit Derivatives
Credit Default Swaps (CDS)
Basket Credit Default Swaps
Total Return Swaps

Credit Derivatives
Credit Derivatives are financial instruments that are
designed to transfer the credit exposure of an
underlying asset between 2 parties.
The Payoff depends on the creditworthiness of one or
more commercial or sovereign entities.
Credit risk is isolated from the bond or loan and managed
separately.
could sell the credit risk without selling the bond.
Credit derivative could be viewed as a natural extension of
shifting credit risk.

Types Of Credit Risk Transferred

Default Risk:
is the risk that issuer of a bond or the debtor on a loan will not
repay the outstanding debt in full.
Recovery Amount (Rate): that part the loan or bond recovered on
default.
Downgrade risk:
is the risk that credit rating of the obligor will deteriorate
affects the capability of repayment or the credit spread required.
Credit Spread risk:
is the risk that the credit spread over a reference rate for an
obligor will increase.
emanates from the markets perception of the credit standing of
the obligor
However downgrade risk is from an external agency formal review
288

Market Participants
End-buyers of protection:
Entities that seek to hedge credit risk taken in the course of their business.
E.g. a commercial banks faces credit risk for loans lent out.

End-sellers of protection:
are entities that seek to diversify their portfolio
by selling credit derivative on entities that they want to include in their
portfolio.

Intermediaries mostly the investment banks:

purely trade credit derivative on their own accounts for arbitrage opportunities.
provide liquidity for the credit derivative market
Reasons: Credit risk is not one sided:-Credit upgrades are possible: E.g.
A leveraged company could issue stocks to pay debt off, thereby improving the balance
sheets and credit ratings.
Expectation of a positive credit event, like M&A could positively improve the ratings of the
company.
The growing economy also makes high yield bonds attractive because, they continue to get
term loans that could be used to redeem/ replace their high yield bonds
289

Types of Credit Derivatives

Credit Default Swaps (CDS)
Basket Credit Default Swaps

Total Return Swaps (TRS)

Collateralised Debt Obligation (CDO)
Credit Linked Note (CLN)

290

Credit Default Swap- (CDS)

CDS is the simplest form and most popular Credit
Derivatives
Provides protections against the default of a particular
company i.e. a reference entity.
The buyer of the protection pays annual premium and
obtains the right to:
sell a particular bond (reference obligation)
Or basket of deliverable obligations (bonds) issued by the reference
entity.

issued by the reference entity for its par value (the swaps
notional principal)
Note: the amount insured need not be the par value.
when the credit event occurs ( i.e. when the reference entity
defaults)
291

CDS
The annual premium is paid until the CDS matured or credit event
occurs.
Premium paid depends:

On maturity of the trade

Default probability of the reference entity
Credit rating of the swap counterparty (seller)
Correlation between the reference entity and the swap counterparty
Expected recovery of the reference obligation.

Credit event:
list of credit event as defined by ISDA-1999 definitions (International
Swap & Derivatives Association)
bankruptcy, restructuring chapter11,
failure to meet an obligation
ratings downwards, change in spread above an agreed level.

The contract would spell what credit event is insured.

There is also a materiality clause: the level of value impairment and
price decreases.

292

CDS
The swap is completed either through:
Physical delivery of the bond:
The buyer delivers the bond to the protection seller for the
par value of the bond.

Cash settlement:
The Recovery value of the bond, Z, is determined.
The protection buyer keeps the bond.
Cash settlement equivalent to (100 Z) of notional
principal is paid to protection buyer
See Diagram below: Pay Off of CDS

293

CDS- Diagram

294

CDS Example I (Diversify Loan

portfolio)
Credit Defaults Swap quotes (basis points)

Company
Ratings
Toyota motor Corp Aa1/AAA
Merrill lynch
Aa3/AAFord motor company
A+/A
Enron
Baa1/BBB+
Nissan Motor Co Ltd
Ba1 / BB+

3 years
16/24
21/41
59/80
105/125
115/145

Maturity
5 years
20/30
40/55
85/100
115/135
125/155

7 years
26/37
41/83
95/136
117/158
200/230

10 years
32/53
56/96
118/159
182/233
244/274

The market maker will buy protection at lower price and sell protection at higher price.
The customer will buy protection at higher price and sell protection at lower price.
A company with exposure to Enron may buy $100 of 5yrCDS at 135bp, thus transfer
risk associated with the $100m (enron) to the Market maker. The customer percieve
Toyota as a good credit, and so will decide to sell protection on$100m for 5years at 20 bp

295

Example II: CDS

Exporter A & Bank B enter into a 5year CDS on the 1
March 2002.
A buys protection from B, against GM Bonds of a
notional principal of $100m, for an annual fee of 90
basis points.
A would pay $900,000 on anniversary of 1/03/2003,
2004, 2005, 2006 and 2007- until the CDS expires or a
credit event occurs.
If GM defaults in Sept 05, then the buyer will be
required to pay the 6 months accrued fees ($450,000).
If the recovery rate of the reference obligation is set to
$35 per $100,
then for cash settlement- the buyer of the protection
will be paid (100-35) * 100m= $65m, and would have
to sell the bonds for $35m on the market.
For physical delivery, the buyer will hand over the

296

Example III: CDS

Bank holds a syndicated, floating loan of

$10m to borrower XYZ ltd.
It is estimated that in the event of default,
the bank could only recover 70% of the loan.
XYZ ltd has also issued a bond which is
deemed to have a recovery rate of 50%.

How would the bank use CDS to hedge

this loan?
The bank could buy a protection against the
bond issued by XYZ ltd, it does not have to
own the bond to buy the protection.
LIED for the Loan
The bank must decide
the amount to hedge
LIED for the Bond
i.e. the hedge ratio:
LIED= Loss In Event of Default
297

Example 2: CDS
Amount to Hedge:
(1- 0.7)/(1 - 0.5)= 60%
i.e. only 60% of the Loan has to be insured,
which $6m.

If credit event occurs:

The bank will recover 70% from the loan,
which is $7m.
The bond protection, the bank will receive
(1- Recovery Rate) which (1-0.5)*$6m= $3m
Thus bank receive:
$7m (Loan) + $3m (from protection seller)

Note that bank pay annual premium

until default or CDS maturity.

298

Other Types of CDS

Basket Credit default swap:
here there are a number of reference
entities.
An add-up basket Credit Default Swaps:
provides a payoff when any of the
references entities default. It is an
equivalent of portfolio of CDS, one on each
reference entity.
First to default Basket CDS:
provides a payoff when one of the reference
entities defaults, after which the CDS ceases
to exist- there is no further payments.
E.g. 4 bonds of $20m face value- the provider is
providing a cover up to $20m for the $80m
basket)

299

300

TOTAL RETURN SWAP (TRS)

This is an agreement to exchange:
The total return on a bond or other reference asset
for LIBOR plus Spread.
The total return includes:
coupons, interest, and capital gain or losses on the asset over the
life of the swap.
Both the credit and economic exposure of the bond is transferred to
the total return receiver.

The TRS payer are:

lenders or investors who wants reduce their exposure to
an asset

TR receivers:
use by insurance companies, hedge funds, who want to
diversify risks or leverage their cash
301

Example: TRS
5yr agreement on a Bond $100m, 5% coupon for
LIBOR+25bp.

The total return payer pays the 5% coupon on the bond

to the total return receiver and receives LIBOR+25bp.
At the end of the swap life, there is a payment reflecting
the change in the value of the bonds Capital Gain or loss.
If the value has decreased by 15%, then the receiver is required to
pay $15m to the payer.
If the bond has increased by 10%, then the payer is required to
pay the receiver $10m.

TOTAL RETURN SWAP (TRS)

The TRS payer are:
lenders or investors who wants reduce their exposure to an
asset.
but wants to retain it on their balance sheet.
to maintain client relationship with borrowers and avoid breach
of client confidentiality

TR receivers:
use by insurance companies, hedge funds, who want to diversify
risks or leverage their cash
They get to hold a bank loan without all the necessary
administrations
The total receiver gets exposure to the underlying asset at rate a
much lower than it would if it does so through the market.
303

TRS
Note that in TRS there is no credit event for the
TR payer to receive payments.
There is automatic exchange of payments. If
there is default, the next payment is brought
forward to the date of default.
The recovery value of the bond is determined
by the market.

304

Collateralised Debt Obligation

CDO is made from a pool of assets which underlying

assets are fixed income securities out of which different
classes of securities (tranches) are created.

Collateralised Debt Obligation: CDO

The unit is divided into classes of securities,
called tranches.
The 1st tranche will absorb, say, the 1st 5% default
loss of the unit principal
The 2nd tranche will carry the next 10% of the
default loss,
The 3rd tranche absorbs the next 10%
The remaining 75% default loss to be absorbed by
the 4th tranche.

Tranche 4 has the least chance of default and

so attracts the least return and has the highest
ratings- usually `AAA`
Tranche 1 has the most chance of default and
attracts the highest return, refers to as the
toxic waste
The creator of the CDO normally holds the 1st
tranche (toxic waste) and sell the remaining
tranches in the market.

306

CDO
The CDO has the advantage of making a
high quality bond out of average quality
bonds.
This is because successive tranches
have better ratings than previous.
The risk of default depends on the
correlation between the bonds issuers in
the portfolio.

307

Risks Associated With Credit

Derivatives
Operational Risk:
It is essentially an off balance sheet item
Traders or managers may not manage it prudently.

Liquidity risk:
Low Secondary market
Since credit derivative are OTC, difficult to sell on.
Limited trade means difficulty in obtaining the fair value of the credit
derivatives.

Pricing Risk:
Pricing are based on complex mathematics models.
Like all mathematical models are based on assumptions.
The pricing of the credit derivative are therefore very sensitive to these models.

Compliance Risk:
New instruments and still evolving giving rise to legal uncertainties.
Reporting treatment and regulatory capital requirement are far from settled.
308

Risks Associated With Credit Derivatives

Documentation:
Definition of credit events, crucial to the protection cover.
There should be no ambiguity as what credit event is.

Liquidity and Transparency

Intermediate participants are still few
Mostly OTC, so transparency is an issue
There has been progression standardisation. Prices for major companies are quoted (traded),
and some trade platforms e.g. Creditex & CreditTrade

Hedging difficulty
Pricing complexity makes hedging by dealers difficult. Hence the few market
participants.

Information asymmetries
Banks buying credit derivatives on loan portfolio have more information about
the loan, not available to the public.

Lack of understanding by end users

New market, hence understanding it application is crucial to potential customers.
309

Risks Associated With Credit

Derivatives
Counterparty or Credit risk:
The risk that the protection seller will not pay up when
the reference entity defaults.
The credit ratings of the counterparty
The correlation between the counterparty and the reference
entity

It must be noted that for the credit protection buyer to

suffer this counterparty risk, 2 things must happen:
The issuer of the bond must default and then
the seller of the credit protection to default as well.

310

SECTION 3
BANK PERFORMANCE MEASUREMENT Using Accounting Data

References & Seminar

Questions

Bank Management: George H. Hempel

Chapter 2 & 3 (5th Edition)
Understanding Banks Financial statement
Evaluating banks Returns, Risks &
Performance
The Bank Credit Analysis Handbook: Jonathan
Golin
Deconstructing a bank F/S Chapter 3 & 4

312

Topics
Understanding financial statement
of banks
Measuring The Banks
performance
ROE: Du Pont Identity
Other Financial Ratio
Risk Measures
Return-Risk Trade off

313

Understanding Financial statement of Banks

1. The Financial Statement:
As part of the annual report published by the banks at the year end.
Mainly three parts:
The Balance sheet: a snap shot of the banks financial position at a
point in time, usually at the year end.
The Income Statement: statement of the banks financial activities
over a period of time, usually a year.
The Cash flow statement: a statement of the sources and application
of cash for the financial year

2. Balance Sheet : Asset = Liability + Capital

Equity/ Capital (Net Worth):
Contribution by the shareholders (paid capital) +
Residual assets after all other claims on the banks assets.

2.1 Liabilities: these represent the sources of funding for the bank.
2.1.1 Funding liabilities:
Customer deposits usually termed as core funding
Purchased funds commercial deposits from the money markets
(certificates of Deposits and Inter bank borrowings)
Providers of funds (non-owners), who have claims against the banks
asset.
Funding liabilities that normally bears interest: e.g. claims of
depositors, bondholders, central banks

2.1.2 Other liabilities:

Clearing cheques,suppliers of goods & services, taxes, leases
Usually non interest bearing.
314

Understanding Financial Statements of Banks

2.2. Assets:

Items of value owned by the bank,

including the banks claims against others.

The bulk of a bank assets are in the form of loans

specific tangibles, intangibles
Listed on B/S in order of decreasing liquidity

shows how the bank used the funds it has

attracted

3.0 The Income statement

measure bank performance over a period, 1year.

it explains how the banks operations has
increased or decreased equity.
315

Balance Sheet : Asset =

Capital+Liabilities
Balance Sheet: Assets
Cash and due from institutions:
i.
ii.
iii.

Currency and coin held in the banks vault

Deposits with Central Banks: legal requirement
Deposits with correspondent banks (Nostro or Vostro
Accounts)
i.
ii.

iv.

An account that a bank holds with a foreign bank(Nostro)

The account a correspondent bank, usually U.S. or UK, holds on behalf
of a foreign bank. (Vostro)

Cash items in process of collection: cheques clearing

These four categories do not generate income

and are referred to as non-earning assets.
Banks attempt to minimize these items.
316

Assets
Short-term instruments: Interest bearing
i.
ii.
iii.

Excess of Federal reserve (central bank reserves)

sold to other banks
Reverse repurchasing securities purchased under
agreement to resell.
Other banks certificates of deposits

Securities: Debt securities that the bank owns:

i.
ii.
iii.
iv.

Held to maturity (HTM): Cost + adjustment towards

maturity.
Available for sale: Any maturity and are valued at
market value
Most of these securities may be securities issued by
central bank.- treasury bills, notes & bonds.
Asset backed securities : Mortgages
317

B/S: Assets
Trading Accounts Assets:

i.

Securities or marketable assets primarily held for resale.

ii.

Reported at market values and pass through pnl account.

Loans: Primary earning assets of most banks

i.
ii.
iii.
iv.
v.

Fixed Assets includes: (non earning assets)

.
.

Commercial loans
Consumer loans
Real Estate loans
Leases: outstanding balance on leases of assets owned by
the bank
Reserve for loan losses:Banks bad debt reserve to absorb
future loan losses
Premises, facilities & equipments
Other real estates foreclosure, collateral, repossessed

Goodwill & Other intangibles

318

Categories Of assets:

319

Balance Sheet: Liabilities and Capital Accounts

Liabilities
i. Demand Deposits / Current accounts
ii. Savings- passbooks
iii. Time Certificates / Time deposit:
i.

Fixed or variable, with maturity of 7 days or

longer.< $100k

iv. Certificates of Deposits,

i.
> $100k of 14 day+, standard amount is $1m
ii. usual maturity of 3month to 12 months
iii. Negotiable- could be sold on
iv. Usually use by treasurers and wealthy
individuals

320

B/S - Liabilities:
Short term borrowing:
i.

Repurchase Agreements (Repos): Sale of

securities under agreement to repurchase.
ii. Reserve funds
iii. Inter-bank borrowings
iv. Other Liabilities: accrued taxes, expenses,
trade payables, dividends payables.

Subordinated Debts:
i.

Debentures exceeding one year

321

Balance Sheets: Capital Accounts

Capital Accounts

This is the difference between the book

value of a banks asset and its liabilities.

It includes :
i. Preferred Stock
ii. Common Stock (Shares)
iii. Reserves Retained Profit (Undivided
Profits)

322

Income Statement
Interest Income:
On the banks earning assets is the major source of revenue
for the banks.

Interest Expenses:
Is cost relating to funds employed by the bank. This is the
banks primary category of cost.

The above 2 are not significant on their own, it the net

which matters, note the importance of the interest rate.
The above (net) is the Net Interest Income:
It shows:
The rewards for intermediation,
Isolate impact of interest rate changes.
It is traditionally the biggest constituents of a banks
operating income. (about 60% / 70%)
Note the significant rise in non-interest income.
323

Income Statement
Non Interest Income:
Income that is not derived from interest-earning assets.
Service charges, fees & commission (providing guarantees,
letters of credit, clearings, ATM), sale of other financial
services, trading accounts income.
Note that expenses that directly linked to these income (fees
and commissions paid and trading losses) are deducted at
this stage.

Total Operating Income:

The sum of Net interest Income & Non-Interest Income
This is before accounting for Loan impairment (Credit risk)

Net Operating Income :

Total Operating Income less Loan impairments and credit
provisions.
Represents the entire pool of revenue from which the bank
must pay for its operations and make profit.
Note the proportion of net interest income to operating income
324

Income Statement
Non Interest expenses (Total Operating
Expense):
The cost of running the banks business
Salaries, administration, depreciations , rents,
office supplies
the analyst is particularly interest in this
section.
Take particular note of the size of the
compensation
cost.
Salaries
are
major
component of non interest expense.

Operating Profit - Before Taxes (EBT)

Deducting Non Interest Expenses from Net
Operating Income
An indicator of the banks core profit generating
capability, i.e. earning before profit325 before

Income Statement

Provision For Loan Losses:

To absorb future loan losses - a proxy measure of credit risk
Highly discretionary, often used to smooth profit
High provisions in good times, less provisions in bad times.
Check further if there is erratic movement in provisions

So EBPT is most preferred when showing the underling

profitability
Though non-cash expense, it is considered as financial out
flow.
Two types of Loan provision:
General provisions: using some statistical approach to
measure probability of default on all loans. These are reserves
against probable losses
Specific provisions: provided on individual loans deemed to be
bad or problematic.

326

Financial Statement

Interest Income
Interest Expense
Net Interest Income
Add Non-Interest Income:

Net Trading Income

Net Commission
Net fees
Others:
Disposal of Investments
Receipts from investments

xxxx
(xxx)
xxx
x
x
x
x
x

Total Operating Income

Loan Loss Provision
Net Operating Income

xx

xxx
(x)
xxx

Less Non-Interest Expense:

Salaries, Administration
Depreciation
Impairments

Operating Profit
Taxes
Net Operating Profit

x
x
x

(x)

xxx
(x)
xxx

327

Comparing:

F/S Non Financial Firm with

Financial Firm
Both have: Assets = Equity + Liability
Assets: banks have
Small proportion of assets in fixed assets: Premises
Main assets are short-term assets mostly Loans (60%)

Funding:
Banks relatively have small equity, barely above 8%.
Mainly short term debts from depositors

Income & Expense:

Major Income from Interest Receive (Earning assets)
Major expense from interest payments.

Other income was often less than other expenses

and so was often described as the banks
burden.
Note how important other income has become.
328

Measuring the Banks

Performance
ROE: Du Pont Identity
Other Financial Ratios
Risk Measures
Return-Risk Trade off

329

Performance Measurement
Every organisation exists to create value, and
should use the available resources to maximise the
value.
This is the value maximization concept.
The banks value maximization is often expressed
as:
Profit maximization
Shareholders value maximization.

Profit or shareholders value maximization, is often

captured as in the ratio:
Return On Equity (ROE)

This requires the bank

to maximise returns (i.e. those activities that
increase returns- specifically share prices) 330

Maximise Value To
Shareholders

Goal:

Balancing:

Measures:

Risks

Returns

Size of Returns
ROA
ROE
Timing of Returns
Future Prospects

Environmental Risks
Legislative Risk
Economic Risk
Competitive Risk
Regulatory Risk

Delivery Risk
Operational Risk
Technological Risk
New Product Risk

Management Risk
Defalcation Risk
Organisational Risk
Ability Risk
Compensation Risk

Financial Risk
Credit Risk
Liquidity Risk
Interest Rate Risk
Leverage Risk
International Risk

331

Returns: Return on Equity (ROE)

ROE: Indication of how well management is using
funds invested by shareholders to generate returns.
A measure of a corporation's profitability, calculated as:
ROE = Net Income (after tax) / Shareholders Equity
i.e. net income after all expenses & taxes divided by common
equity capital

Summary measure of:

Revenue generation
Operational efficiency
Financial leverage
Tax planning
332

Du Pont: Return On Equity

Leverage Multiplier
Assets
Equity

Gross Margin
Gross Operating Income
Revenue

Return On Equity

minus
X

Net Income
Equity

Net Margin

Required Expense Coverage

Net Income
Revenue

Expenses
Revenues

Return on Assets =
Net Income
Assets

Receivables
Asset Utilization
Inventory
Revenue
Assets

Fixed Asset Turn Over

333

Du Pont:

ROE- DECOMPOSED

Return On Assets:
Banks management ability to utilize the banks financial
resources to generate net income.
Measured by:
Net Income / Total Assets
Decomposed into: Net margin x Asset Utilization

Net Margin:
represents what is left out of one dollar revenue, after all
costs have been deducted. efficiency test
Measured by :
Net Income / Operating Revenues
Operating Revenue = Interest Income + Non-Interest
Income

Asset Utilization:
Reflects how effectively management has invested in
earning assets.
Measured by:
Operating Revenue / Total Assets.
334

ROE- DECOMPOSED
Equity Multiplier:
A measure of financial leverage
The equity multiplier is a way of examining how a
company uses debt to finance its assets.
this ratio showsa company'stotal assetsper dollar
of stockholders' equity

ROE = [Net Margin x Asset Utilization x Equity

Multiplier]
If ROE is unsatisfactory, the Du Pont identity helps
locate which part of the business is
underperforming

335

Measuring Risks:
Risk and returns go hand in hand:
High Risk, high returns. Low Risk, low returns.
The ideal situation is to attain a maximum return at the least
possible risk

The question to answer is:

How much risk have managers taken to earn the ROE?

336

Common Risks Measures

Liquidity Risk:
measures banks liquidity needs caused by
Maturing obligations such as - deposit outflows
(withdrawals)
Increase demand for loans
Banks operational expenses

As against the banks ability to raise liquidity

by:
Selling assets (CDs other short term investments)
Acquiring additional liabilities

Liquidity Risk is measured by

= [Short-term securities] / [Deposits]

Larger liquidity ratio indicates less risky bank

but also a less profitable bank.
337

Interest Rate Risk:

This refers to:
the changes in the value of liabilities and assets
caused by a change in interest rate.

It is measured by
= ( [Interest sensitive Assets ] / [ Interest
sensitive liabilities] )

Interpretation:
A ratio of 1 indicates stability.
The further this ratio is away from 1, the more
sensitive it is to interest rate.
A ratio of :
greater than 1 [i.e. net asset sensitivity- the bank
hopes for a rise in interest rate]
less than 1 [i.e. net liability sensitivity- the bank hopes
for a fall in interest rate]
338

Credit Risk
The risk that the interest or principal
may not be paid as scheduled
Credit risk is higher if a bank has a more
lower and medium quality loan.
The returns tends to be higher.
Use non-performing loans, loan losses,
pass-due loans, loan loss reserves as a
proportion of total assets (as a proxy)

339

Capital risk:
This indicates how much assets should
decline before the banks depositors are
affected.
It is measured by
= [Capital] / [Assets].

The higher the ratio, the better it is for

depositors.
E.g.10% indicates that in period of
declining assets (recession) the banks
asset will have to fall by 10%, before
depositors will be affected.
340
st

Interpreting the resulting return-risk measures:

1. Compare ratios with the banks own set

objectives: Is it the appropriate level of
objective?
2. Banks own trend analysis
3. Industry analysis:
1. Compare return and risk measurement
with similar banks to identify your strength
and weakness.
1. How similar are the 2 companies:
2. size, serving comparable market, each company
has unique characteristics, e.g. management
styles, market target.
3. Explain significant differences in ratios. 341

Return-Risk Trade Off:

Risk and Return are two conflicting
goals.
We want to maximise return and minimise
risk.

Could we:
increase returns without increasing risk or
reduce risk without decreasing returns?

Ideally we want:
more returns for a given risk
and less risk for a given returns.

Is this possible?
342

Decomposing The Banks Net Interest Margin

Net Interest Margin is a main factor of

ROE
Financial intermediation
involves two businesses:

traditionally

The business of Funding: raising funds from

available sources.
The business of lending: selecting earning
assets to invest in .

The bank makes money on both sides of

the equation.
343

Banks NIM
Banks normally:
Borrows short and lend long
Thus there is maturity mismatch of interest
sensitive assets and liabilities.
This exposes it to interest rate risk

The Asset & Liability mismatch creates a

3rd business for which the bank is
rewarded.
This 3rd business creates the 3rd
components of the banks net interest
margin.
The Banks NIM is made up of:
Credit Spread
Interest Rate Risk Spread

344

Net Interest Margin & The Yield

Curve
Yield Curve: depicts the relationship of
interest rates and maturities of
securities.
Investopedia .com provides this definition:

A line that plots the interest rates, at a set point in time

of bonds having equal credit quality
but differing maturity dates.
The most frequently reported yield curve compares
the three-month, two-year, five-year and 30-year U.S.
Treasury debt.
This yield curve is used as a benchmark for other debt
in the market
such as mortgages or bank lending rates.
The curve is also used to predict changes in economic
345
output and growth.

Net Interest Margin & The Yield

Curve
It is concave:
short-term maturities
earn less yield
Long-term maturities
earns more
Accounts for risk
associated with time

Is constructed from
government bonds thus
Risk free
Is a reference point for
lending and borrowing
The financial market serve
as an alternative market
for funding and investing
346

347

348

Decompose the banks Net Interest

Margin
Bank ABC: The lending division lends
5year $10m loan to company XYZ at
7.50%.
The retail banking division raised $10m
1-year deposit (CD) from Mr. MegaRich
at 3.5%.
5 year treasury bond is 6% and 1 yr
Treasury Bond is 4%
Use this and the yield curve to allocate 3
components of NIM
349

Decompose the banks Net Interest

Margin

350

SECTION 4
Basel International Standard For
Banking Regulation and Supervision

Topics

Factors Determining Capital

Adequacy
Role of Capital In Banks
Capital Adequacy Requirement :
Background
Basel I, II, 2.5 & III

352

References:
Managing Bank Capital: Chris Matten, 2nd Edition
Chapter 1 & 7

Credit Risk Measurement: Saunders & Allen

Chapter 3

Risk Management & Financial Institutions; John C Hull,

3rd Edition.
Chapter 12 and 13
http://www.bis.org/publ/bcbs118.pdf

Introduction
Capital is crucial in financial institutions:
Is a requirement for starting a bank
Is paramount for the bank to continue on
going operations.
Amount of capital available puts a limit on
how much losses the bank could absorb.

Managers, customers, regulators are

interested in a banks ability to raise and
maintain adequate capital
Capital adequacy is now a matter of
legal requirement.
354

Role Of Capital In Banks

In general capital has two functions:
Transfer of ownership
Funding the business - a business is funded
either by equity or debt

With regard to banks

Capital does not exist to fund the business.
Taking deposits (liability) is part and parcel of the
banks business.
The bank could therefore borrow as much as it
could at a much lower cost than raising capital.

355

Role Of Capital
The role of capital in banks is to absorb
future unidentified losses. Thus,
It serves as a buffer for unexpected losses
Protecting the interest of depositors
(creditors)
Indeed, the main objective of Basle I was
credit risk.

Other role:
Customer perception
Customers perceive a high capital bank as
safe
A healthy perfectly bank will go bankrupts
356
if there is a bank run.

Determining Capital Adequacy

The bank managers had to decide the
appropriate capital level based on these
3 factors:
Functions of a banks capital:
How much capital is available to absorb
unexpected losses?
The amount of capital must reflect the risk profile
of the bank.
Capital protects uninsured creditors of the bank.
(providers of long term bonds, short term credits
from the money markets)

Advantages of leverage to owners:

Banks also makes money on liability side of the
balance sheet

Regulatory requirements:
357
Requirements by the central banks or regulatory

Capital Adequacy
Requirement
Definition:

Capital Adequacy is the banks ability to

absorb unidentified losses associated with
the various risks of banking.
A bank, generally faces three types of risk:
Credit Risk
Market risk
Operational Risk

CAR is BIS regulatory requirement for banks

to have this buffer for losses.
This was 1st set up in Basel I (1988)
framework which has then been improved
through several amendments, cumulating in
Basle II and Basel III
358

Capital Adequacy Requirement:Background

Banks enjoyed heavy protection until 1970,
due to its role in the reconstruction of Europe.
The protection:

ensured that no competition existed

Strict control of banking licenses
Takeover was virtually impossible
Even the rates on deposits were regulated by the
banks.
This was a very stable banking environment (3-6-3)
Failing banks were bailed out by governments

In 1970 The Bretton Woods agreement

collapsed
Which led to volatile FX rates and Interest rates.
Suddenly banks had to operate in a volatile
environment.
359

CAR-Background

In the 1980s UK experienced its Big Bang in the

deregulation of the banking industry.
This led to:
Increase competition
Take over activities
Smaller margins
Also as a result of deregulation:
Banks were free to lend- (LDC loans, Latin
America)
M&A- which were often overpriced. E.g. Japanese
banks awashed with cash- to gain foot in Europe.
The consequences of these were:
Excessive Risk taken:
Erosion of banks capital
Bank failures

Unfair competitive advantage

360

CAR- Background

The Basel Committee was set up under

Bank for International Settlements (BIS)
in Basel-Switzerland.
The committee consisted of Central Banks
and Bank supervisory bodies.
It has no legal force but central banks are
morally bound to enforce its
recommendation within some allowances.
Its objective were two fold:
To strengthen (stability of) the banking system
To diminish sources of competitive inequality.

361

Basle I: Calculating CAR

The loan assets of banks are classified into
their risk weights categories.
Asset Types:
Banks, sovereign, mortgage
Non banks, private sector, commercial
Derivative- off balance sheet (OBS)

Risk Weighted Asset:

Each asset category is multiplied by the appropriate
weights to obtain the Risk Weighted Asset.
Only 5 weights: 0%, 10%, 20%, 50%, 100%

CAR: RWA x 8%.

This is the minimum requirement and is compared
with Tier 1+2 Capital
If Tier 1+2 > than RWA x 8%, then the bank satisfies
the CAR
362

Risk Weighted Amounts

Risk weights by category of on-balance-sheet asset
0%

(a) Cash
(b) Claims on central governments and central
banks denominated in national currency and
funded in that currency
(c) Other claims on OECD central governments
and central banks, guaranteed by OECD central
governments

0, 10, 20 or
50% (at
national
discretion)

Claims on domestic public-sector entities,

excluding central
government, and loans guaranteed4 by such
entities

20%

Claims on multilateral development banks (IBRD,

IADB, AsDB, AfDB, EIB)

50%

Loans fully secured by mortgage on residential property that

is or will be occupied by the borrower or that is rented

100%

Claims on the private sector, Claims on banks

incorporated outside the OECD, Claims on
central governments outside the OECD (unless
denominated in national currency - and363
funded
in that currency)

Add-On Factors as A Percent of Principal For

Derivatives Risk Weighted Amounts

Off-Balance sheet items are expressed as credit

equivalent amount of on-balance sheet item.
Credit equivalent amount = current value of
derivative + ( Add-on factor x principal of the
derivatives)
The credit equivalent is then multiplied by the
appropriate risk weighted factor.
364

Example

The asset of a bank consist of:

Gh100m of corporate bonds of uniliver, Ghana
Gh10m of government treasury bonds
Gh50m residential mortgages.

Risk weighted assets is:

100 x 100% + 10m x 0% + 50m x 50% = Gh125m

365

Example

A bank with IRS Gh100m with a remaining

life of 4 years. Current value of IRS is Gh2m.
Credit Equivalent is:
2 + (100 x 0.5%) = 2.5m

Risk Weights Amount,

Suppose, IRS is with a corporation then the RW
is 50%,
RWA = 2.5m x 50% = 1.25m

366

Eligible Capital elements

Tier 1
a. Paid-up share capital/common stock
b. Disclosed reserves

Tier 2
a.
b.
c.
d.
e.

Undisclosed reserves
Asset revaluation reserves
General provisions/general loan-loss reserves
Hybrid (debt/equity) capital instruments
Subordinated debt

The sum of tier 1 and tier 2 elements will be eligible

for inclusion in the capital base, subject to the
following limits.
. The total of tier 2 (supplementary) elements will be limited
to a maximum of 100% of the total of tier 1 elements;
. subordinated term debt will be limited to a maximum of
367
50% of tier 1 elements

BasleI: Limitations
Basle I disregarded the credit worthiness of
borrowers:
External ratings of borrowers
Collateral offered
Netting possibility

Risk weight was based on political and

Economic affiliation: loans to OECD countries
had a favourable risk weight.
Thus capital requirement for
High risk/low quality business loans was set too low
and
Low risk/high quality business loans was set too
high

This led to regulatory arbitrage- because bad

loans were under priced from regulatory 368
point
of view.

Basle I Capital Accord:1988

Despite its limitation it was a ground
breaking in developing
A single capital adequacy requirement
fair competitive playing field across
countries
Adequate and comprehensive supervision by
home regulatory authority.

It distinguished between credit risk of :

Banks, sovereign, & mortgage obligations.
All these were awarded lower risk weights

Non banks, private sector & commercial

loans were deemed to be of higher risk
369
weights.

1996 Amendment
Implemented in 1998, to keep capital for
market risks associated with the trading
activities of banks.
The trading book of bank are valued on daily
basis i.e. marked to market
Trading positions included were:
Debt and equity traded securities
Positions in commodities and foreign
exchange
Total capital requirement under this
amendment is
= 8% x (credit risk RWA + market Risk RWA)
370

Basle II- the 3 pillars:

a) Pillar I - Minimum capital requirements:
Additional capital charge was introduced to cover for Operational risk
This is made up of three fundamental elements:
i. Definition of regulatory capital: (RC)
ii. Risk Weighted Assets (RWA)
iii. The Capital Ratio = ( RC / RWA) >= 8%
. Minimum capital should be adequate to cover the following risk:
= 8% x (Credit Risk RWA + Market Risk RWA + Operational Risk
RWA)
b) Pillar II - Supervisory review of Capital Adequacy
Banking supervisors of member countries to
. Ensure that banks have adequate capital
. Encourage banks to develop better risk management
techniques.
. Evaluate the effectiveness of such internal techniques
. Consider other forms of risk not captured by Pillar I
Concentration risk
External factors- business cycle effects
371

Basle II- The 3 Pillars

c) Pillar III - Market Discipline:
Supervisors to have a set of disclosure
requirements which allow market
participants to access key information:

Capital
Risk exposures
Risk assessment process, hence
Capital adequacy of the bank.

This is essential because of the use of

internal models.

372

Pillar 1: Capital Requirements:

The Constituents of Regulatory Capital:
Measuring The Risk Weighted Asset:
Standardised Approach
Internal Foundation Approach
Internal Advance Approach

373

Pillar 1: The Constituents of

Capital

Basle II identifies 3 tiers of capital- in

order of quality:
Tier 1 capital: Equity & Disclosed
Reserves
Equity capital :
Fully paid ordinary share
Non-cumulative preference shares
Retained earnings

Disclosed Reserves:
Balance is separately disclosed in published
accounts.
The fund must be made available as soon as
losses occur
374
Allocation is made via pnl

Components of Tier 1
Issued + Fully paid Capital
Retained Earnings
Share Premium
Non Cum perpetual pref.Share
Disclosed general reserve
Minority Interest In Subsidiaries
Less: Unamortized Goodwill
Total eligible Tier capital

XXXX
XX
xx
xxx
xxx
x
(xx)
xxxx

375

Tier 2
Tier 2 :
=< 100 of Tier 1 i.e. 50% of Banks capital
could be made up of Tier 2.
This is referred to as supplemental capital
Made up of:

Undisclosed reserves
Revaluation reserves
General loan reserves
Hybrid debts
Subordinated debts

376

Tier 2
Undisclosed Reserves:
Reserves not publicly disclosed in pnl as an item, but should
be disclosed on confidential basis to regulators

Revaluations:
Formal revaluations of property or notional revaluation of
stock which have higher market value than on the balance
sheet.

General Loan Reserves:

If they are not related to some identified deteriorated loans.

Hybrid Debt Instruments:

Includes convertible bonds and cumulative preference share.
Criteria includes:

They are unsecured, subordinated, and fully paid

They are not redeemable
They participate in losses without the bank ceasing to operate
Service obligations (interest payment) can be deferred.

Subordinated debt:
Subject to size restriction (cannot exceed 50% of Tier 1)
Subject to a maturity discount of 20% per year once it is
=<5years
377

Tier 3
Introduced for market risk :
For short dated form of capital against
market risk.
Market risk is measured on the daily basis.
The instrument must have an original
maturity of at least two year.
Interest or principal repayment would not be
allowed if repayment would result in the
bank breaching it minimum capital
requirements.

378

Summary: Capital
Tier 1
Tier 2

xxxx

Undisclosed reserves
Revaluation reserves
General loan reserves
Eligible hybrid debt x
Surbodinated debt x

Tier 3
Less :

x
x
x
xxx

xx

Investment in unconso. banking subsidairies

x
Investment in other banks & FI
x
Eligible Total Capital

XXXX

379

Pillar 1: Capital Requirements:

Risk Weighted Assets- Methodology
Standardised approach
Internal approach
Foundation
Advance

380

Credit Risk: Standardise Approach

The banks loan assets are classified into
buckets of risk sensitivities
CAR= EAD x RW x 8%
EAD = Exposure At Defaults (book value of loan
asset)
RW = Risk Weights (given by Basel)
8% = is the agreed minimum capital
Requirements

CAR is compared with Eligible Capital

calculated earlier. Eligible Capital > = 8%

Eligible capital should

be greater
Risk weighted
Assets or equal to CAR

381

Claims On Corporate

382

Claims On sovereigns

383

Claims On Banks & Securities

2 options available, the banking
supervisor to decide and adopted
uniformly in the country.
Option 1:
Banks are assigned a risk weight of one
category less favourable to claims on
sovereign
Where sovereign is rated at BB+ to B- or
unrated countries risk weight is capped at
100%

Option 2:
Risk weights is based on the external 384
ratings

Claims On Banks & Securities

385

Example = RWA under Standardised

Approach
Suppose that the assets of a bank
consist of
Gh100m of loans to a company rated A,
Gh10m of government bonds rated AAA
and
Gh50m of residential mortgaged.

RWA under Basel II standardized

approach:
= 100m x 50% + 10m x 0% + 50m x 35% =
67.5m

386

Limitation: Standardised
Approach
Unrated risk bucket gets RW of 100%.
How come below Rated BB- gets 150% (more
expensive) than unrated loans
Thus lower quality borrowers may avoid external
ratings in order to reduce their cost of borrowing.

Concern about tying external ratings to CAR.

Ratings letters have multidimensional meaning.
There are a lot of factor involve in arriving at the
letter.
Ratings lags rather than leads (Remember EDF leads
Ratings)
Ratings are pro cyclical- ratings are more likely to be
downgraded in time recession, thus increasing capital
charge at a time when stimulation is needed.
Risk of Rate shopping- borrowers are free to chose
387
Rating Agency- possibility of moral hazard?

Internal Ratings Based Models

(IRB)
The CAR is based on internal ratings developed by the
bank.
It makes sense since the bank knows its own risk
drivers.
There are two internal models:
Foundation Approach
Advanced Approach

388

IRB Models

Elements of IRB:
The bank must use internal model to classify
credit risk exposure of each business activity:
i) Corporates ii) Banks iii) Sovereign iv) Retails
v) Project finance and vi) Equity

Risk components:
Probability of Default (PD)
Exposure at Default (EAD):
book value of the exposure outstanding.
possible adjusted for collateral, nettings, credit
derivatives etc

Loss Given Default (LGD)

The fraction of EAD that will not be recovered
following default

Maturity Exposure:
Weighted average life of the loan ( % of principal
389
repayments in each year multiplied by the year(s)

Risk Components
Risk weight function:
The bank calculate the risk weight for each

individual exposure (e.g. corporate loan)

using the risk components: PD, EAD, LGD, M.

Minimum requirements of eligibility:

The bank must at least have a good database
and administration.

Supervisory Review:
The bank must submit Internal Model for
regulatory review.

Difference between Foundation and

Advance:

Foundation: the banks provide PD & EAD and

the central banks provide the LGD, Maturity
of Exposure
Advanced: all the risk components are
390
provided by the bank.

Operational Risk Capital under Basel II

In addition to keeping capital for credit risk and
market risk, Basel II introduce a capital for
operational risk.
This is the risk of losses from situations where
the banks procedures fail to work.
Operational risk is defined as the risk of loss
resulting from inadequate or failed internal
processes, people and systems or from
external events.

Three approaches:
Basic Indicator Approach
The Standardised Approach
The Advance Measurement Approach
391

 Basic Indicator Approach

Op-Risk capital is Banks:

= 3 years Average Annual Gross Income x 15%.

Standardised Approach;
The banks is divided into 8 business lines which gross
income attracts different rates.

392

Op-Risk Standardised Approach

393

Advance Measurement
Approach

Basel required 4 elements to implement AMA.

Internal data
External data
Scenario analysis
Business environment and Internal Control factors

Internal Data:
historical data available within the bank to
estimate loss severity and loss frequency
distribution for particular types of losses.

394

Advance Measurement Approach

External Data:
The availability of external data helps a bank in estimating its
potential losses. It helps the bank to consider losses which has
never been incurred by the bank but are occurring elsewhere.
External data could be obtain:
Exchange of loss data among banks
Professional data vendors who collate available public data.

395

Advance Measurement Approach

Scenario Analysis:
The bank has to generate a range of scenarios to cover
the full range of:
High Frequency Low Severity Losses (HFLSLs)
Low Frequency High Severity Losses (LFHSLs)

396

Advance Measurement Approach

Business environment and Internal Control factors
Should be taken into account when estimating loss severity
and loss frequency
This depends on the complexity of business lines, the
technology used, the pace of change, staff turnover rates,

397

Basel 2.5
Basel 2.5 were series of technical changes that were
first made to calculation of capital requirements for
market risk of trading book during the ongoing crisis.
The calculation of stressed VaR
Incremental Risk Charge
Comprehensive Risk Measure

398

 The calculation of stressed VaR

The data used historical simulation VaR were from 2003 to
2006, a period when volatilies for most market variables were
low, thus yielded low VaR amount. Basel 2.5 recommended
the use of stressed data for past 250 days instead of the
normal day for 4 years.

399

 Incremental Risk Charge

Exposures that were kept on trading books are
charged market risk capital over 10-day time
horizon.
While similar exposures in banking book would
have been calculated over 1 year period. Thus
market risk was understated.

Basel then proposed:

incremental default risk charge to be
calculated at 99% confidence level over 1-year
time horizon
for instruments in trading book which are
exposed to default risk.
400

 Comprehensive Risk Measure

Calculates a capital charge on instruments
dependent on credit correlation.
That is portfolio of instruments that are
sensitive to the correlation between the
defaults risks of different assets,

Example - AAA rated tranches of ABS and

CDO suffer little losses, however in
stressed market environments, when
correlation increases losses in this tranche
rises.
401

Basel III
Capital Definition and Requirements
Capital Conservation Buffer
Countercyclical Buffer
Leverage Ratio
Liquidity Risk

402

Basel III- Introduction

Following the current crisis which started
in 2007, it was generally agreed that
major overhaul of Basel II was needed.
Basel III objective:
increasing the amount of capital that banks
have to keep for credit risk
tightening the definition of capital
Specification of liquidity requirements

Published in December 2010 to be

implemented gradually between 2013 to
2019.
403

 Basel III documents covered:

Capital Definition and Requirements

Capital Conservation Buffer
Countercyclical Buffer
Leverage Ratio
Liquidity Risk

404

Capital Definition and Requirements

Banks total capital will comprise:
Tier 1 Equity Capital >=4.5% of RWA
Referred to as Core capital includes:
Share capital and retained earnings
Changes in retained earning from securitized
transactions not recognised as capital

Additional Tier 1 Capital

Non-cumulative preferred stock
Tier 1 + Additional Tier 1 >= 6% of RWA

Tier 2 Capital
Debts that are subordinated to depositors with an
original maturity of 5 years.
Total Tier 1 + Tier 2 >= 8% of RWA

New capital being phased in over a longer

405
st
period till 1 January 2018.

Capital Definition and Requirements

Basel I & II
Tier 1 Equity Capital >=2% of RWA
Total Tier 1 >=4%
Tier 2 was limited to 100% of Tier 1, that is maximum of 4%

Basel III is more demanding:

The percentages for core capital has increased

Definition of what qualifies for capital has been tightened.
Systemically important banks have to keep additional capital.
This is left to countries to decide. USA defined a systemic
important bank as one with $50b in assets.
Common Equity is referred to:

as going concern capital that the bank has a positive equity

capital ( Tier 1 Equity Capital) to absorb losses.
Tier 2: is referred to as:

gone-concern capital, i.e. the bank has negative equity

capital and no longer a going concern.
Losses have to be absorbed by Tier 2 Capital.
Tier 2 capital ranks below depositors in liquidation, so as long as
Tier 2 capital is positive, depositors must not face any losses.
406

Capital Conservation Buffer

Capital Conservation Buffer
To ensure that banks build up capital during
normal times to meet losses that could occur
during bad times.
It is easier to build up capital in good times rather than
stressed environments.

Banks must keep additional capital in the form of

Core Tier 1 Capital to the tune of 2.5% of RWA.
There are restrictions on dividend payments if the
capital conservation buffer is not met.

This brings total Core Tier 1 capital to 7% from

4.5% in normal times.
This will be phased in between Jan 1st 2016 to
Jan 1st 2019
407

Countercyclical Buffer
This is at national discretion. This provides
protection for the cyclicality of bank earnings.
In good times:
banks do well in earnings and less credit provisions
are made.

In bad times:
when capital is needed that is when bank earnings
suffer
in that higher credit provisions have to be made.

The buffer could be set between 0% to 2.5% of

RWA to be met by Tier 1 Equity Capital.
This will be phased in between Jan 1 st 2016 to Jan 1st
2019
408

Leverage ratio
Basel III also specifies that Banksto keep
a minimum leverage ratio of 3%.
Leverage ratio refers to the ratio of
capital to total exposure.
Total exposure includes:
all items on and off the balance sheet
without any risk weighting
Capital for the purpose of calculating the
leverage ratio has not been defined.

Leverage ratio expected to be

introduced in Jan 1st , 2018
409

Liquidity risk
Prior to 2007 crisis, Basel regulations had concentrated
more on keeping adequate capital. It turned out that
many of the problems encountered during the crisis was
not as a result of inadequate capital but rather
inadequate liquidity.
Liquidity risk arose as a result of the tendency for banks
to finance long term needs with short term funding.
Example Northern Rock of UK financed its mortgaged
needs ( 25 year product) with 90 day commercial papers.
Lehman brothers also used similar funding strategy.
So long as the bank is able to refinances it with new
issues, then there is no problem.
However in the crisis there was a sudden dried up of
liquidity, collapsing banks which in all criteria were very
strong banks.
410

Basel III Liquidity Risk Ratios

Liquidity Coverage Ratio (LCR)
LCR focuses on banks ability to survive a
30-day period of liquidity disruptions in time
of stress.
High quality Liquid Assets divided Net Cash
Outflows in a 30-Day Period should be
greater than > 100%.

411

Basel III Liquidity Risk Ratios

Net Stable Funding Ratio (NSFR)
This is concern with long term liquidity
management over a 1 year period.
This ensures that bank relies on stable funds in
financing its assets rather than volatile funding
Calculated as:
Amount of Stable Funding divided by Required Amount
of Stable Funding. Ratio should be greater than 100%

Amount of Stable Funding: is calculated by

referring to a table which list all funding
types with respective weightings which
reflects the stability of that funding type.
412

Available Stable Funding

ASF Factor

Category

100%

Tier 1 and Tier 2 Capital.

Preferred stock and borrowing with a remaining
maturity of greater than 1 year

90%

Stable demand deposits and term deposits with

remaining maturity less than 1 year provided by
retail or small business customers

80%

Less Stable demand deposits and term deposits

with remaining maturity less than one year provided
by retail or small business customers

50%

Wholesale demand deposits and term deposits with

remaining maturity less than one year provided by
nonfinancial corporates, sovereigns, central banks,
multilateral development banks and public sector
entities.

0%

All other liabilities and equity categories

413

Required Stable Funding

The Required stable funding is calculated from the on
and off Balance sheet Assets, indicating how much
stable funding is required for each asset category.

414

Required stable funding

RSF

Asset Category

0%

Cash
Short term instruments, securities, loans to financial
entities if the have a residual maturity of less than 1
year.

5%

Marketable securities with a residual maturity greater

than 1 year, if they are claims on sovereign or similar
bodies with 0% risk weights

20%

Corporate bonds with a rating of AA- or higher and a

residual maturity of greater than 1 year

50%

Gold, Equity securities, bonds rate A+ to A -

65%

Residential mortgages

85%

Loans to retail and small business customers with a

remaining maturity less than 1 year

100%

All other assets

415

Net Stable Funding Ratio (NSFR)

Example
Assets

Funding

Cash

5 Retail Deposits( stable)

40

Treasury Bonds > 1

year

5 Wholesale deposits

48

Mortgages

20 Tier 2 Capital

Small business loans

60 Tier 1 Capital

Fixed Assets

10
100

100

416

 The Amount of Stable Funding is:

40 x 0.9 + 48 x 0.5 +4 x 1.0 + 8 x 1.0 = 72

The Required Amount of Stable Funding:

5 x 0 + 5 x 0.05 + 20 x 0.65 + 60 x 0.85 + 10
x 1.0 = 74.25

The NSFR is
72 / 74.25 = 0.970 , i.e. 97.0%. The Bank
does not satisfy the NSFR which should be
greater than 100%
417