Management of Financial Institutions

DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk

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Management of Financial Institutions - MGT 604
Lecture # 41
DFIs & Risk Management
Risks are usually defined by the adverse impact on profitability of several distinct sources
of uncertainty. While the types and degree of risks an organization may be exposed to
depend upon a number of factors such as its size, complexity business activities, volume etc,
it is believed that generally the banks face Credit, Market, Liquidity, Operational,
Compliance / legal / regulatory and reputation risks. Before overarching these risk
categories, given below are some basics about risk Management and some guiding
principles to manage risks in banking organization.
Risk Management
Risk management is the human activity which integrates recognition of risk, risk
assessment, developing strategies to manage it, and mitigation of risk using managerial
resources. The strategies include transferring the risk to another party, avoiding the risk,
reducing the negative effect of the risk, and accepting some or all of the consequences of a
particular risk. Some traditional risk managements are focused on risks stemming from
physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits).
Financial risk management, on the other hand, focuses on risks that can be managed using
traded financial instruments. Objective of risk management is to reduce different risks
related to a pre-selected domain to the level accepted by society. It may refer to numerous
types of threats caused by environment, technology, humans, organizations and politics. On
the other hand it involves all means available for humans, or in particular, for a risk
management entity (person, staff, and organization). In every financial institution of
Pakistan, risk management activities broadly take place simultaneously at following
different hierarchy levels.
Strategic level: It encompasses risk management functions performed by senior
management. For instance definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish adequate systems
and controls to ensure that overall risk remain within acceptable level and the reward
compensate for the risk taken.
Macro Level: It encompasses risk management within a business area or across
business lines. Generally the risk management activities performed by middle
management or units devoted to risk reviews fall into this category.
Micro Level: It involves `On-the-line' risk management where risks are actually
created. This is the risk management activities performed by individuals who take
risk on organization's behalf such as front office and loan origination functions. The
risk management in those areas is confined to following operational procedures and
guidelines set by management.
Managing Credit Risk
Credit Risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit
(either the principal or interest (coupon) or both). Credit risk arises from the potential that
an obligor is either unwilling to perform on an obligation or its ability to perform such
obligation is impaired resulting in economic loss to the bank. In a bank's portfolio, losses
stem from outright default due to inability or unwillingness of a customer or counter party
to meet commitments in relation to lending, trading, settlement and other financial
transactions. Alternatively losses may result from reduction in portfolio value due to actual
or perceived deterioration in credit quality. Credit risk emanates from a bank's dealing with
individuals, corporate, financial institutions or a sovereign. For most banks, loans are the
largest and most obvious source of credit risk; however, credit risk could stem from
activities both on and off balance sheet. In addition to direct accounting loss, credit risk
Management of Financial Institutions - MGT 604
should be viewed in the context of economic exposures. This encompasses opportunity
costs, transaction costs and expenses associated with a non-performing asset over and above
the accounting loss.
Managing Market Risk
It is the risk that the value of on and off-balance sheet positions of a financial institution will
be adversely affected by movements in market rates or prices such as interest rates, foreign
exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to
earnings and capital. Financial institutions may be exposed to Market Risk in variety of
ways. Market risk exposure may be explicit in portfolios of securities / equities and
instruments that are actively traded. Conversely it may be implicit such as interest rate risk
due to mismatch of loans and deposits. Besides, market risk may also arise from activities
categorized as off-balance sheet item. Therefore market risk is potential for loss resulting
from adverse movement in market risk factors such as interest rates, forex rates, equity and
commodity prices.
Managing Liquidity Risk
Liquidity risk is the potential for loss to an institution arising from either its inability to
meet its obligations or to fund increases in assets as they fall due without incurring
unacceptable cost or losses. Liquidity risk is considered a major risk for banks. It arises
when the cushion provided by the liquid assets are not sufficient enough to meet its
obligation. In such a situation banks often meet their liquidity requirements from market.
However conditions of funding through market depend upon liquidity in the market and
borrowing institution's liquidity. Accordingly an institution short of liquidity may have to
undertake transaction at heavy cost resulting in a loss of earning or in worst case scenario
the liquidity risk could result in bankruptcy of the institution if it is unable to undertake
transaction even at current market-prices. Banks with large off-balance sheet exposures or
the banks, which rely heavily on large corporate deposit, have relatively high level of
liquidity risk. Further the banks experiencing a rapid growth in assets should have major
concern for liquidity.
Managing Operational Risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people and system or from external events. Operational risk is associated with human error,
system failures and inadequate procedures and controls. It is the risk of loss arising from the
potential that inadequate information system; technology failures, breaches in internal
controls, fraud, unforeseen catastrophes, or other operational problems may result in
unexpected losses or reputation problems. Operational risk exists in all products and
business activities. Operational risk event types that have the potential to result in
substantial losses includes Internal fraud, External fraud, employment practices and
workplace safety, clients, products and business practices, business disruption and system
failures, damage to physical assets, and finally execution, delivery and process
management. The objective of operational risk management is the same as for credit, market
and liquidity risks that is to find out the extent of the financial institution's operational risk
exposure; to understand what drives it, to allocate capital against it and identify trends
internally and externally that would help predicting it. The management of specific
operational risks is not a new practice; it has always been important for banks to try to
prevent fraud, maintain the integrity of internal controls, and reduce errors in transactions
processing, and so on. However, what is relatively new is the view of operational risk
management as a comprehensive practice comparable to the management of credit and
market risks in principles. Failure to understand and manage operational risk, which is
present in virtually all banking transactions and activities, may greatly increase the
likelihood that some risks will go unrecognized and uncontrolled.
Management of Financial Institutions - MGT 604
Currency Risk
Currency Risk is a form of risk that arises from the change in price of one currency against
another. Whenever investors or companies have assets or business operations across
national borders, they face currency risk if their positions are not hedged.
Transaction Risk is the risk that exchange rates will change un-favourably over time. It can
be hedged against using forward currency contracts;
Translation Risk is an accounting risk, proportional to the amount of assets held in foreign
currencies. Changes in the exchange rate over time will render a report inaccurate, and so
assets are usually balanced by borrowings in that currency. The exchange risk associated
with a foreign denominated instrument is a key element in foreign investment. This risk
flows from differential monetary policy and growth in real productivity, which results in
differential inflation rates.
Interest Rate Risk
Interest Rate Risk is the risk that the relative value of an interest-bearing asset, such as a
loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the price
of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the
bond's duration, the oldest of the many techniques now used to manage interest rate risk.
Asset liability management is a common name for the complete set of techniques used to
manage risk within a general enterprise risk management framework.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday