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risk management in banking
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| Words: 519 | Submitted: 07-Feb-2012
97.1% | Number of pages: 11 | Filetype: Word .doc
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Descriptionthis paper talk about risk manangement in banks
Risk Management in Banking
Particularly important given the QAT function of banks which gives rise to credit risk, liquidity risk and interest rate risk. Main focus (day to day) is on credit risk but also exists:
? risk that regulation may change and impact on individual bank
? risk that lender of last resort asks for “something back”
Credit Risk Management
Important because loans generate bank income but excessive loans ?loan quality? Þ credit risk Þ loan losses
Four parts to credit risk management:
(i) Underwriting/ loan origination:
All activities required before a loan decision is made: credit analysis plus loan contract design (covenants, collateral, terms, prices)
Loan decisions guided by “Policy Statement” approved by board of directors:
Aggregate loan limits
Credit analysis standards
Lines of authority ? relationship between loan size and decision maker’s hierarchy
(ii) Funding and Servicing: Role of Documentation
Documentation required to protect bank’s:
Legal right to borrower repayments
Legal right to collateral
Ability to enforce covenants
Documentation lapses during rapid expansion: Continental Illinois (1984) (Penn Square Bank’s loan files empty!)
(iii) Risk Processing:
After loan consummation. Consists of monitoring and diversification:
Keeping in touch with borrower, checking firm performance, ensuring compliance with covenants
Good monitoring is costly (resource intensive)
Credit culture important: balancing opposing attitudes of calling officers (frontline, maintain customer relationships) and credit professionals (aggressive)
Dislocations of these functions can erode credit culture: credit risk analysis outsourcing
See correlation of returns (lecture 1)
Concentrated lending can cause insolvency
Diversification often pursued passively ? reduce concentrations after identification instead of aggressively ? specify source and quality of loan (loans that lower portfolio risk should be priced lower ? “portfolio approach” to credit risk management)
Note however: specialisation allows efficiency in credit analysis (cross-sectional and inter-temporal informational reusability, lecture 1).
Dynamic programming versus linear programming problem: banks obtain illiquid assets on a sequential basis and face uncertainty about the future whereas investors can repeatedly reconfigure portfolios and trade liquid assets. Some blurring due to securitisation.
(iv) Credit Culture:
Relates to bank’s general approach towards risk management which synthesises underwriting, funding and servicing and risk processing.
Credit committee often formed with powers granted by Board of Directors
Ensuring consistent application of credit standards (avoiding “herding” and “myopia”)
Liquidity Risk Management
Main insurance of liquidity occurs via liability management.
Liability management ensures the bank has access to funds (most commonly the interbank market).
Good liability management ensures diversification (akin to asset side). Sub-Prime crisis shows the risks of undiversified funding sources in conjunction with liquidity risk on the asset side.
Liquidity/ liability management considers two types of funding requirements:
Routine (predictable, day to day cash needs)
Cash requirements during crisis events (unpredictable)
Crisis liquidity ensured via:
Cash reserves (costly)
Pre-arranged funding agreements (also costly)
Hence trade-off between costly liability management which incurs actual costs against the uncertain benefits that liquidity may provide.
Interest Rate Risk Management
High term premiums mean long-duration assets offer better yields ...
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