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Peter Larose
OPERATIONAL RISKS
MARKET RISKS
Credit Risk
Trading Risk
Concentration Risk
Earnings at Risk
Funding & Liquidity Risk
Value at Risk
Solvency Risk
Strategic Risk
Reputation Risk
OTHER RISKS
Weather Risk
Terrorist Risk
Money Laundering
Trading Risk
This type of risk originate when a bank sells or securitize
its loan portfolio or other assets with counterparty.
The agreement based on the trading risk will consider
amongst other issues, the right of course by the purchaser
in the event that the data and information were not correctly
calculated at the time of the transaction.
Trading risk may also arise in the case where a bank
engages into a swap of floating interest rate to a fixed
interest rate on a borrowing contract with another
counterparty.
Concentration Risk
This risk arises, when a bank or financial institution has
lent to a single borrower, a group of borrowers, or
borrowers engaged in or dependent on one industry (say
tourism sector).
Concentration risk of credit consists of direct, indirect,
or contingent obligations exceeding 25% of the banks
capital structure.
Concentrations within, or dependent on, an industry are
subject to the additional risk factors of external
economic conditions.
From a sound risk management perspective, a periodic
review of the industry trends be made in order to assess
its susceptibility to external factors.
Solvency Risk
Basel II introduces a far more sophisticated approach to
bank solvency than Basel I the prior international capital
accord dating from 1988.
Earlier regime represented little more that a flat tax on
banks, which were required to hold capital equal to 8% of
their assets.
New Accord differentiates among risks with far greater
precision.
Strategic Risk
In todays commercial languages, there are many
definitions, which can be associated with strategic risk.
Reputation Risk
Such risk is of significant negative public opinion that
results in a critical loss of funding or customers.
It may involve actions that create a lasting negative image
on the institutions operation.
Weather Risk
Over the years, the weather condition all over the world has
changed drastically with untold consequences. It is still
changing without much of early warning signs.
The risk of catastrophic losses originating from extreme
weather condition poses a much greater danger today than
in the last decade or so.
Credit risk specialists are now very much concern with the
potential implication of this phenomenon, when assessing
borrowers business plans.
Such a factor is quite prevalent in countries sitting on the
earthquake zone. Even the new Basel II takes into account
that banks should make provision for such eventualities.
Borrowers
Retail
Market
Individuals
Medium-Size
Businesses
Mid
Market
Large
Companies
Small
Low
Credit Exposure
Corporate
Market
High
Borrower
Submission
Approval/Rejection
Credit Application
or Origination
Capital
* Capacity
Character * Collateral
* Consideration
Credit Analysis
& Assessment
*Credit Structuring
*Credit Sanctioning
Credit Policy
Credit Limit
Credit Pricing
Credit Management
& Administration
Capital (Economic, and Regulatory)
Provision for Default
Provision for Risk Sharing (e.g. co-financing)
Borrower
*Origination
Credit Application
or Origination
Structuring
Pricing
Underwriting
Sanctioning
Monitoring
Credit
Management
Capital
Market
Credit Derivatives
Credit Securitization
Third Party Assets Sales
Credit
Portfolio
Credit
Capital
Portfolio Assessment
Portfolio Valuation
Value-at-Risk (VaR)
Portfolio Management
Credit Modeling
Portfolio Valuation
Credit Evaluation
Capital Management
*Economic Capital
*Regulatory Capital
Credit Modification
Credit Administration
& Monitoring
Credit Procedures
& I.T. Systems
Repayment Capacity
This test would give the banker a fair idea on how to assess
the repayment capacity of its borrowers.
Borrowers Contribution
A borrowers contribution towards the total borrowing
application is very vital for the banker to gauge the degree
of seriousness of the applicant.
A small or no contribution towards the total loan applied
represents to the bank that the borrower is very uncertain
or uncommitted towards the entire obligation.
It is one of the indicators that the banker would be mindful
when due consideration is given to the application.
Even, when a customer makes a significant contribution
towards the whole project, there is no assurance that the
project will succeed. Nevertheless, it gives an indication as
to the strength of the entire business concept.
Borrowers Character
A very vital piece of information that will allow the banker to
decide to lend, or not to lend.
A banker should not deal with a customer or potential
customer that he/she cannot trust.
The business of banking is all about trust, confidentiality
& risk involved.
Environmental Considerations
During the last decade or so, the conservation/protection of
the environment took centre stage in whatever business
decision is taken.
Banks have been accused of financing many projects at the
destruction of the environment. In fact, repeated threats
have been issued against the banks that engages into such
projects.
Systematic Risk
This type of risk is also referred as undiversifiable risk or
market risk, and sometimes also known as macro-economic
risk.
The macro-economic risk can embody:
(1) Interest rate,
(2) exchange rate, and
(3) inflation.
Unsystematic Risk
This type of risk is sometimes referred as unique risk.
It is particularly tied to the business specifics and some to
Its immediate competitors.
Such risk can be avoided and minimized, if the management
of a business is able to diversify the companys activities
having paid due regards to the specific problems relating to
the business.
Examples:
Company profit,
Products/services,
Geographical areas, the market where the company operates,
Management issues, and
Operating costs structure.
GDP
Interest Rate
Exchange Rate
Inflation
Cash Flow
Borrowings
Portfolio
Credit Risk
For most banks, loans are the largest and most obvious
source of credit risk.
There are also pockets of credit risk both on & off-balance
sheet of the banks (e.g. investment portfolio, overdrafts, & letters
of credit).
Liquidity Risk
Because of the size of the loan portfolio, effective
management of liquidity risk requires that there be close ties
to and good information flow from the lending function.
Banks can use their loan portfolios as a source of funds by
reducing the total dollar volume of loans through sales,
securitization, and portfolio run-off.
Many larger banks have been expanding their underwriting
of loans for the loans syndicated market.
As part of the liquidity planning, banks overall liquidity
strategy should include loan portfolio segments that may be
easily converted into cash.
Price Risk
Most of the developments that improve the loan portfolios
liquidity have implications for price risk.
Traditionally, the lending activities of most banks were not
affected by price risk. This is due that loans were held to
maturity, accounting doctrine required book value
accounting treatment.
As banks develop more active portfolio management practice
and the market for loans expands and deepens, loan
portfolios will become increasingly sensitive to price risk.
Transaction Risk
In the business of lending, transaction risk is present
primarily in the loan disbursement and credit administration
processes.
The level of transaction risk depends on the adequacy of
Information systems and controls, the quality of operating
procedures, the capability and integrity of employees.
Banks have and continue to experience credit risk when
information systems failed to provide adequate information
to identify concentrations, expired facilities, or stale
financial statements.
Compliance Risk
Lending activities encompass a broad range of compliance
responsibilities and risks.
By law, a bank must observe limits on its loans to a single
borrower, connected person, affiliates, limits on interest
rates and other regulatory limits imposed by the Central
bank or monetary authority.
A bank may also become the subject of borrower initiated
lender liability lawsuit for damages attributed to its
lending or collection practices.
Strategic Risk
A primary objective of the loan portfolio management is to
control the strategic risk associated with a banks lending
activities.
Inappropriate strategic or tactical decisions about underwriting standards, loan portfolio growth, new loan products,
geographic markets can compromise a banks future.
These strategies require significant planning and careful
oversight to ensure the risks are appropriately identified
and managed.
It is important for bankers to decide whether the benefits
outweigh the strategic risk.
Reputation Risk
When a bank experiences credit problems, its reputation with
investors, the community, and even individual customers
usually suffers.
Inefficient loan delivery systems, failure to adequately meet
the credit needs of the community, and lender-liability
lawsuits are also examples of how a banks reputation can
be tarnished because of problems with its lending division.
Reputation risk can damage a banks business in many ways.
(e.g. share price falls, customers & community support is lost, and
business opportunities evaporate).
To protect this reputation, they often have to do more than
is legally required.
Project Cost
Financial Return
Risk
Project X
SR50,000
SR50,000
SR25,000
Project Y
SR250,000
SR200,000
SR200,000
Project Z
SR100,000
SR100,000
SR10,000
The most likely informed decision, which a risk manager will take
depending, of course his attitude towards risk:
*For a budget-constrained manager, the cheaper the project the
better.
This will result him/her selecting Project X.
*The returns-driven manager will choose Project Y with the highest
returns, assuming that budget is not an issue.
Project Z will be chosen by the risk-averse manager as it provides
the least amount of risk while providing a positive net return.
What is interesting here is that with 3 different projects and 3
different managers, 3 different decisions will be made.
The typical question, which follows from this short overview drives
us to ask.
Which manager is correct, and Why?
The price (index rte, spread, and fees) charged for an individual
credit should cover funding costs, overhead costs,
administrative costs, required profit margin, and a premium
for risk.
Independence
Independence is the ability to provide an objective report
of facts and to form impartial opinions.
Without independence, the effectiveness of control units
may be in jeopardy. It requires generally a separation of
duties and reporting lines.
Independence of the credit risk department of a bank
depends on the corporate culture and the promotion of
objective criticism within the bank so as to improve or
modernize the operations.
Audit of Transactions
Audit activities in lending departments usually focus on
the accounting controls in the administrative support
functions.
While loan review has primary responsibility for evaluating
credit risk management controls, audit will generally be
responsible for validating the lending-related models.
Audits should be done at least annually and whenever
models are revised or replaced.