Entification of risks to financial institution
AnÂ operational riskÂ is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such asÂ fraudÂ risks,legal risks, physical or environmental risks.
A widely used definition ofÂ operational riskÂ is the one contained in theÂ Basel IIÂ Â regulations, the means by which the European Capital Requirements DirectiveÂ Â has been implemented across the European banking sector. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The approach to managing operational risk differs from that applied to other types of risk, because it is not used to generate profit. In contrast,Â credit riskÂ is exploited by lending institutions to create profit,Â market riskÂ is exploited by traders and fund managers, and insurance risk is exploited by insurers. They all however manage operational risk to keep losses within their risk appetite - the amount of risk they are prepared to accept in pursuit of their objectives. What this means in practical terms is that organisations accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations. The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk.
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Determining appetite for operational risk is a discipline which is still in its infancy. Some of the issues and considerations around this process are outlined in this Sound Practice paper published by the Institute for Operational Risk in December 2009.
The Basel Committee defines operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."
However, the Basel Committee recognizes that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their own definitions of operational risk, provided the minimum elements in the Committee's definition are included.
The Basel II definition of operational risk excludes, for example, strategic risk - the risk of a loss arising from a poor strategic business decision.
Other risk terms are seen as potential consequences of operational risk events. For example,reputational riskÂ (damage to an organization through loss of its reputation or standing) can arise as a consequence (or impact) of operational failures - as well as from other events.
Base III event type categories
The following lists the official Basel II defined event types with some examples for each category:
Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions,Â bribery
External Fraud- theft of information, hacking damage, third-party theft and forgery
Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and safety
Clients, Products, & Business Practice- market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning
Damage to Physical Assets - natural disasters, terrorism, vandalism
Business Disruption & Systems Failures - utility disruptions, software failures, hardware failures
Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets
It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk because models exist which attempt to predict the potential impact of market movements, or changes in the cost of credit. It should be noted however that these models are only as good as the underlying assumptions, and a large part of the recent financial crisis arose because the valuations generated by these models for particular types of investments were based on incorrect assumptions.
By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. Many now though collect data on operational losses - for example through system failure or fraud - and are using this data to model operational risk and to calculate a capital reserve against future operational losses. In addition to the Basel II requirement for banks, this is now a requirement for European insurance firms who are in the process of implementing Solvency IIÂ , the equivalent of Basel II for the banking sector.
Categories of operational risk
Information technology risk
Information technology risk
Reputational risk, often calledÂ reputation risk, is a type of risk related to the trustworthiness of business. Damage to a firm's reputation can result in lost revenue or destruction of shareholder, even if the company is not found guilty of a crime. Reputational risk can be a matter of corporate trust, but serves also as a tool in crisis prevention.Â Extreme cases may even lead toÂ bankruptcyÂ (as in the case ofÂ Arthur Andersen). Recent examples of companies include:Â Toyota,Â Goldman SachsÂ andÂ BP. The reputational risk may not always be the company's fault as per the case of theÂ TylenolÂ cyanide panic in 1982.
Legal and regulatory risk: Sometimes governments change the law in a way that adversely affects a bank's position.
The Risk Principle is an area of law closely tied toÂ legal causationÂ inÂ negligence. It provides limits on negligence for harm caused unforeseeably.
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Political riskÂ is a type ofÂ riskÂ faced byÂ investors,Â corporations, andÂ governments. It is a risk that can be understood and managed with reasoned foresight and investment.
Broadly, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisions-or "any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives."Â . Political risk faced by firms can be defined as "the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection)."Â Portfolio investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk.
A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the mostauthoritarian. Long-term assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world.
Understanding risk as part probability and part impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns.
There are both macro- and micro-level political risks. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, it would be incorrect to equate macro-level political risk analysis with country risk as country risk only looks at national-level risks and also includes financial and economic risks. Micro-level risks focus on sector, firm, or project specific risk.
Macro-level political risk
Macro-level political risk looks at non-project specific risks. Macro political risks affect all participants in a given country. A common misconception is that macro-level political risk only looks at country-level political risk; however, the coupling of local, national, and regional political events often means that events at the local level may have follow-on effects for stakeholders on a macro-level. Other types of risk include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose both portfolio investment and foreign direct investment risks that can change the overall suitability of a destination for investment. Moreover, these events pose risks that can alter the way a foreign government must conduct its affairs as well.
Research has shown that macro-level indicators can be quantified and modeled like other types of risk. For example,Â Eurasia GroupÂ produces a political risk index which incorporates four distinct categories of sub-risk into a calculation of macro-level political stability. This Global Political Risk Index can be found in publications likeÂ The Economist.Â Other companies which offer publications on macro-level political risk includeÂ Business Monitor International,Â Exclusive Analysis,Â Economist Intelligence Unit, andÂ Political Risk Services.
Micro-level political risks
Micro-level political risks are project-specific risks. In addition to the macro political risks, companies have to pay attention to the industry and relative contribution of their firms to the local economy. An examination of these types of political risks might look at how the local political climate in a given region may impact a business endeavor. This type of risk includes project-specific government review (such as theÂ Committee on Foreign Investment in the USÂ (CFIUS) process in theÂ United States), the selection of dangerous local partners with political power, and expropriation/nationalization of projects and assets.
To extend the CFIUS example above, imagine a Chinese company wished to purchase a US weapons component producer. A micro-level political risk report might include a full analysis of the CFIUS regulatory climate as it directly relates to project components and structuring, as well as analysis of congressional climate and public opinion in the US toward such a deal. This type of analysis can prove crucial in the decision-making process of a company assessing whether to pursue such a deal. For instance,Â Dubai Ports WorldÂ suffered significant public relations damage from its attempt to purchase the US port operations of P&O, which might have been avoided with more clear understanding of the US climate at the time.
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Political risk is also relevant for government project decision-making, whereby government initiatives (be they diplomatic or military or other) may be complicated as a result of political risk. Whereas political risk for business may involve understanding the host government and how its actions and attitudes can impact a business initiative, government political risk analysis requires a keen understanding of politics and policy that includes both the client government as well as the host government of the activity.
Companies may have aÂ Chief Risk OfficerÂ who is charged with managing political risk or, in many cases, this job falls to theÂ Chief Financial Officer.
At the macro-level, largely involves understanding political uncertainties of the operating environment and the risks faced by all business operations in individual countries. Such information can come in the form of customized analysis or in-depth subject matter reporting; information that can enable an investor or firm to calibrate their risk appetite. Mitigation tactics involve both macro- and micro-level strategies. A recent article on the subject suggested that political risk mitigation should not simply revolve around the decision to enter or avoid a given country's marketplace, but should rather center on the pragmatic usage of contingency planning, intellectual property safeguards, risk diversification, and sound exit planning to guard against uncertainty.
At the micro-level, political risk insurance and hedges play a larger role.Â MIGAÂ andÂ OPIC, both public sector insurers, provide project-specific political risk insurance while private market insurers can provide cover for projects as well as a portfolio of investments. This type of insurance usually outlines specific triggers, such as expropriation or breach of contract by a local party, which entitle the insured entity to a pay-out after relinquishing control of the insured project to the insurer.Â Political risk insurance, however, often involves premiums which must factor in considerable uncertainty and the threat that arbitrary decisions will affect the value of insured property. Policies therefore can be expensive and are manuscripted after extensive negotiations. An experienced and specialist broker can assess the availability of appropriate cover from private and public insurers and then, based on their experience and expertise, negotiate appropriate policies. Businesses can also purchase hedges, which could be derivative instruments, which allow them to reduce risk by selecting a level of return based on a given set of outcomes.
Political risk mitigation takes place before, during, and after an investment. Prior to investment, businesses can perform due diligence related to local partners and carefully word and structure their contracts. While a project is on-going, the investor may benefit from building local political leverage through community activities. After a risk has been realized, its effects may be mitigated through post-hoc litigation and retaliation, as well as the implementation of a previously developed contingency plan, or exit from the market.
Volatility riskÂ inÂ financial marketsÂ is theÂ likelihoodÂ offluctuationsÂ in theÂ exchange rateÂ ofÂ currencies. Therefore, it is aprobability measureÂ of the threat that anÂ exchange ratemovement poses to anÂ investor'sÂ portfolioÂ in a foreign currency. TheÂ volatilityÂ of the exchange rate is measured asÂ standard deviationÂ over a dataset of exchange rate movements.
A far more sophisticated extension of this model is theÂ Value at RiskÂ method, which helps to determine the actual risk exposure to a portfolio of several currencies.
Consequences of Currency volatility
Reduces volume ofÂ international trade
ReducesÂ long termÂ capital flows
Increases resources absorbed inÂ risk management
Economic policyÂ making becomes difficult
Profit riskÂ is aÂ risk managementÂ tool that focuses on understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective.
Profit risk is a risk measurement methodology most appropriate for theÂ financial servicesÂ industry, in that it compliments other risk management methodologies commonly used in thefinancial servicesÂ industry -Â credit risk management, [[Asset liability management]](ALM).Â Profit risk is the concentration of the structure of a company'sÂ income statementÂ where the income statement lacks income diversification and income variability, so that the income statement's high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company's inability to grow earnings with high potential for future earnings losses .Â Profit risk can exist even when a company is growing in earnings, where earnings growth will decline when levels of concentration become excessive.
Basis of profit risk
The concept of Profit risk is loosely akin to the well known "80-20" rule or theÂ Pareto principlethat states that approximately 20% of a company's customers drive 80% of the business .Â This rule and principle may be appropriate for some industries, but not in the financial services industry .Â According toÂ ABA's Bank Marketing Magazine, the term was coined by Rich Weissman who says that the rule is more in line with 10-500 rule, where 10% of a bank's customer base can produce up to 500% of all bank net income.
Measuring of profit risk
To measure these concentrations and manage "Profit Risk", the most important tool for financial institutions may be their MCIF,Â CRM, or profitability systems that they use to keep a track of their customer/member relationship activities. The data in these systems can be analyzed and grouped to gain insights into profitability contribution of each customer/member, product, market, delivery channels, salespeople .Â Reports showing the concentrations of net income are used by senior management to show (1) where the concentrations are located in the income statement, (2) at what levels are the concentrations, and (3) at what point do the concentrations predict future earnings losses .Â Often, these reports examine earnings contributions bydecilesÂ (groupings of customers or other units of analysis by 10% increments), illustrating concentrations for each 10% group.
Settlement riskÂ is theÂ riskÂ that aÂ counterpartyÂ does not deliver aÂ securityÂ or itsÂ valueÂ in cash per agreement when the security was traded after the otherÂ counterpartyÂ or counterparties have already delivered security or cash value per theÂ tradeagreement.
One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes calledÂ Herstatt riskÂ after theÂ German bankÂ that made a famous example of the risk. On 26th June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due. But some banks had undertaken foreign exchange transactions with Herstatt and had already paidDeutsche MarkÂ to the bank during the day, believing they would receive US dollars later the same day in the US from Herstatt's US nostro. But after 4:30 pm in Germany and 10:30 am in New York, Herstatt stopped all dollar payments to counterparties, leaving the counterparties unable to collect their payment. The closing ofÂ Drexel Burnham LambertÂ in 1990 did not cause similar problems because the Bank of England had set up a special scheme which ensured that payments were completed.BaringsÂ in 1995 resulted in minor losses for counterparties in the foreign exchange market because of a specific complexity in the ECU clearing system.
Mitigation of settlement risk
Delivery versus payment
Settlement viaÂ clearing houses
Foreign exchange settlement usingÂ continuous linked settlement
Financial riskÂ is normally anyÂ riskÂ associated with any form offinancing. Risk is probability of unfavorable condition; in financial sector it is the probability of actual return being less than expected return. There will be uncertainty in every business; the level of uncertainty present is called risk.
Financial risk is one type of risk in which one may have the chance to lost the capital or entire money
Classification of financial risk
A common concern with any investment is that the initial amount invested may be lost (also known as "the capital"). This risk is therefore often referred to asÂ capital risk.
Liquidity risk defined as the
failure of a financial institution to meet expected and unexpected cash flow needs as they arise - is inherent in the financial intermediation function assumed by banking institutions and is a central component of the prudential regulation and supervisory framework.
Market risk is theÂ riskÂ that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices.
Classification of market risk
Interest rate risk
Foreign exchange risk
Interest rate risk
Interest risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or aÂ bond, due to variability ofÂ interest rates. In general, as rates rise, the price of aÂ fixed rate bondÂ will fall, and vice versa. Interest rate risk is commonly measured by the bond'sÂ duration.
Asset liability managementÂ is a common name for the complete set of techniques used to manage risk within a general enterpriseÂ risk managementÂ framework.
Calculating of interest rate risk
Interest rate risk analysis is almost always based on simulating movements in one or moreÂ yield curvesÂ using theÂ Heath-Jarrow-Morton frameworkÂ to ensure that theÂ yield curveÂ movements are both consistent with current marketÂ yield curvesÂ and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1990s by David Heath of Cornell University, Andrew Morton of Lehman Brothers, andÂ Robert A. JarrowÂ of Kamakura Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"
Stress testing this market value by shifting theÂ yield curveÂ in a specific way.Â DurationÂ is a stress test where theÂ yield curveÂ shift is parallel
Calculating theÂ Value at RiskÂ of the portfolio
Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of futureÂ yield curves
Doing step 4 with randomÂ yield curveÂ movements and measuring the probability distribution of cash flows and financial accrual income over time.
Measuring the mismatch of theÂ interest sensitivity gapÂ of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
Bank and interest rate risk
Banks face four types of interest rate risk:
The risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.
Yield curve risk
The risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.
The risk presented by assets and liabilities that reprise at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.
It is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due toÂ prepaymentÂ speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.
Hedging interest rate risk
Interest rate risks can be hedged using fixed income instruments orÂ interest rate swaps. Interest rate risk can be reduced by buying bonds with shorter duration and/or high coupon rates, or by entering into a fixed-for-floating interest rate swap
Foreign exchange risk
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.
For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would make a small loss.
Equity riskÂ is the risk that one'sÂ investmentsÂ will depreciate because ofÂ stock marketÂ dynamics causing one to loseÂ money.
The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.
Commodity riskÂ refers to the uncertainties of futureÂ market valuesÂ and of the size of the futureÂ income, caused by the fluctuation in the prices ofÂ commodities.Â These commodities may beÂ grains,Â metals,Â gas,Â electricityÂ etc. A commodity enterprise needs to deal with the following kinds of risks:
Price riskÂ (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices)
Cost riskÂ (Input price risk)
Group at risk
There are broadly four categories of agents who face the commodities risk:
ProducersÂ (farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk
BuyersÂ (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.
ExportersÂ face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion.
GovernmentsÂ face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.
If the invested assets are being held in another currency, there is a risk that currency movements alone may affect the value. This is referred to asÂ currency risk.
Currency riskÂ is a form ofÂ riskÂ that arises from the change in price of oneÂ currencyÂ against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
Currency risk exists regardless of whether you are investing domestically or abroad. If you invest in your home country, and your home currency devalues, you have lost money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system.
Measuring the potential loss due to market risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to useÂ Value at Risk. The conventions of using Value at risk is well established and accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.
TheÂ Variance CovarianceÂ andÂ Historical Simulationapproach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
Credit riskÂ is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called aÂ default. Another term for credit risk isÂ default risk.
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