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

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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.

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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.

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