# Key Financial Risks in the 21st Century - Modern Banking

Risk management involves identification of the key financial risks, deciding where risk exposure should be increased or reduced, and finding methods for monitoring and managing the bank’s risk position in real time. Throughout this, readers should bear in mind that for all banks, from the traditional bank where ALM is the key activity to the complex financial conglomerate offering a range of bank and non-bank financial services, the objective is to maximise profits and shareholder value-added, and risk management is central to the achievement of this goal. Shareholder value-added is defined as earnings in excess of an ‘‘expected minimum return’’3 on economic capital. The minimum return is the risk-free rate plus the risk premium for the profit-maximising firm, in this case a bank. The risk premium associated with a given bank will vary, depending on the perceived risk of the bank’s activities in the market place. The average risk premium ranges from 7% to 10% for banks in most OECD countries. The risk-free rate refers to the rate of return on a safe asset, that is, a rate of return which is guaranteed. The nominal rate of return on government bonds is normally treated as a risk-free rate, provided there is a low probability of the government defaulting on its obligation.4 Suppose an investor purchases equity in a bank and expects a minimum return of 15%. If, when the shares are sold, the return is 20%, then an extra 5% is added to the value of the investment, and shareholder value-added is positive. If the return is less than 15%, the outcome for the investor is a negative shareholder value-added.

There is a link between shareholder value-added and other performance measures, such as return on assets or return on equity. ROA, ROE and profitability are widely reported for publicly quoted firms, including banks, and are known to influence share prices. Thus, ifbank shareholders treat these measures as indicators of performance, and act upon them, they can affect shareholder value. For example, if a firm turns in an unexpectedly poor report for several quarters and shareholders act by dumping the shares, the price of the shares will fall. A prolonged decline will lower shareholder value-added and it could even turn negative.

Formal Definitions

Risk

The risks specific to the business of banking are:

• Credit
• Counterparty
• Liquidity or funding risk
• Settlements or payments risk
• Market or price risk, which includes
• currency risk
• interest rate risk
• Capital or gearing risk
• Operational risk
• Sovereign and political risk

Credit risk and counterparty risk

If two parties enter into a financial contract, counterparty riskis the risk that one of the parties will renege on the terms of a contract. Credit riskis the risk that an asset or a loan becomes irrecoverable in the case of outright default, or the risk of an unexpected delay in the servicing of a loan. Since bank and borrower usually sign a loan contract, credit risk can be considered a form of counterparty risk. However, the term counterparty risk is traditionally used in the context of traded financial instruments (for example, the counterparty in a futures agreement or a swap), whereas credit risk refers to the probability of default on a loan agreement.

Banks are in business to take credit risk, it is the traditional way banks made money. To quote a former chairman of the US Federal Reserve System:

‘‘If you don’t have some bad loans you are not in the business.’’

If a borrower defaults on a loan or unexpectedly stops repayments, the present value of the asset declines. Losses from loan default should be kept to a minimum, since they are charged against capital. If losses are high, it could increase the bank’s cost of raising finance, and inthe extreme, lead to bank insolvency. The bank would avoid credit risk by choosing assets with very low default risk but low return, but the bank profits from taking risk. Credit risk rises if a bank has many medium to low quality loans on its books, but the return will be higher. So banks will opt for a portfolio of assets with varying degrees of risk, always taking into account that a higher default risk is accompanied by higher expected return. Since much of the default risk arises from moral hazard and information problems, banks must monitor their borrowers to increase their return from the loan portfolio.

Good credit risk management has always been a key component to the success of the bank, even as banks move into other areas. However the cause of the majority of bank failures can be traced back to weak loan books. For example, Franklin National Bank announced large losses on foreign exchange dealings but it also had many unsound loans. Likewise many of the ‘‘thrift’’ and commercial bank failures in the USA during the 1980s were partly caused by a mismatch in terms between assets and liabilities, and problem loans. In Japan, it was the failure of mortgage banks in 1995 that signalled major problems with the balance sheets of virtually all banks.

Liquidity or funding risk

These terms are really synonyms – the risk of insufficient liquidity for normal operating requirements, that is, the ability of the bank to meet its liabilities when they fall due. A shortage of liquid assets is often the source of the problems, because the bank is unable to raise funds in the retail or wholesale markets. Funding risk usually refers to a bank’s inability to fund its day-to-day operations.

Liquidity is an important service offered by a bank, and one of the services that distinguishes banks from other financial firms. Customers place their deposits with a bank, confident they can withdraw the deposit when they wish, even if it is a term deposit and they want to withdraw their funds before the term is up. If there are rumours about the bank’s ability pay out on demand, and most depositors race to the bank to withdraw deposits, it will soon become illiquid. In the absence of a liquidity injection by the central bank or a lifeboat rescue, it could quickly become insolvent since it can do nothing to reduce overhead costs during such a short period.

The liquidity of an asset is the ease with which it can be converted to cash. A bank can reduce its liquidity risk by keeping its assets liquid (i.e. investing in short-term assets), but if it is excessively liquid, its returns will be lower. All banks make money by having a gap between their maturities, that is, more short-term deposits and more long-term loans:

‘‘funding short and lending long’’. They can do this because of fractional reserve lending – only a fraction of deposits are held in reserve, and the rest are loaned out. Liquidity can be costly in terms of higher interest that might have been earned on funds that have been locked away for a specified time.

Maturity matching (or getting rid of all maturity gaps) will guarantee sufficient liquidity and eliminate liquidity risk because all deposits are invested in assets of identical maturities: then every deposit is repaid from the cash inflow of maturing assets, assuming these assets are also risk-free. But such a policy will never be adopted because the bank, as an intermediary, engages in asset transformation to make profits. In macroeconomic terms, provided there isno change in the liquidity preferences of the economy as a whole, then the withdrawal of a deposit by one customer will eventually end up as a deposit in another account somewhere in the banking system. If banks kept to a strict maturity match, then competition would see to it that the bank which invested in assets rather than keeping idle deposits could offer a higher return (and therefore, greater profitability) compared to banks that simply hold idle deposits.

At the microeconomic level, the maturity profile of a bank’s liabilities understates actual liquidity because term deposits tend to be rolled over, and only a small percentage of a bank’s deposits will be withdrawn on a given day. This is another argument for incurring some liquidity risk. Given that the objective of a bank is to maximise profit/shareholder value-added, all banks will have some acceptable degree of maturity mismatch.

Settlement/payments risk

Settlement or payments risk is created if one party to a deal pays money or delivers assets before receiving its own cash or assets, thereby exposing it to potential loss. Settlement risk can include credit risk if one party fails to settle, i.e. reneges on the contract, and liquidity risk – a bank may not be able to settle a transaction if it becomes illiquid.

Amore specialised term for settlement risk is Herstatt risk, named after the German bank which collapsed in 1974 as a result of large foreign exchange losses. The reason settlement risk is closely linked to foreign exchange markets is because different time zones may create a gap in the timing of payments. Settlement of foreign exchange transactions requires a cash transfer from the account of one bank to that of another through the central banks of the currencies involved. Bankhaus Herstatt bought Deutschemarks from 12 US banks, with settlement due on 26th June. On the 26th, the American banks ordered their corresponding German banks to debit their German accounts and deposit the DMs in the Landesbank (the regional bank was acting as a clearing house). The American banks expected to be repaid in dollars, but Herstatt was declared bankrupt at 4 p.m. German time – after the German market was closed but before the American market had closed, because of the 6-hour6 time difference. The Landesbank had already paid DMs to Bankhaus Herstatt, but the US banks had not received their dollars. The exposed US banks were faced with a liquidity crisis, which came close to triggering a collapse of the American payments system.

Settlement risk is a problem in other markets, especially the interbank markets because the volume of interbank payments is extremely high. For example, it can take just 10 days to turn over the annual value of the GNP of a major OECD country – in the UK, it is roughly £1–£1.6 trillion. With such large volumes, banks settle amounts far in excess of their capital. Netting is one way of reducing payments risk, by allowing a bank to make a single net payment to a regulated counterparty, instead of a series of gross payments partly offset by payments in the other direction. It results in much lower volumes (because less money flows through the payments and settlement systems), thereby reducing the absolute level of risk in the banking system. Netting is common among domestic payments systems in industrialised countries. At the end of each day, the central bank requires each bankto settle its net obligations, after cancelling credits and debits due on a given day. If the interbank transaction is intraday, the exposure will not appear on a bank’s balance sheet, which is an added risk.

However, settlement risk is still present because the netting is multilateral. The payments are interbank, and banks will not know the aggregate exposure of another bank. Any problem with one bank can have a domino effect. If one bank fails to meet its obligations, other banks along the line are affected, even though they have an indirect connection with the failing bank, the counterparty to the exchange. Given the large volume of transactions in relation to the capital set aside by each bank, the central bank will be concerned about systemic risk – the failure to meet obligations by one bank triggers system-wide failures. Most central banks/regulators deal with this problem through a variety of measures, including a voluntary agreement to conform to bilateral limits on credit exposures, capping multilateral exposures, requiring collateral, passing the necessary legislation to make bilateral and multilateral netting legally enforceable, or imposing penalty rates on banks which approach the central bank late in the day.

Increasingly, there has been a move from netting to real time gross settlement. Real time gross settlement (RTGS), allows transactions across settlement accounts at the central bank (or a clearing house) to be settled, gross, in real time, rather than at the end of the day. By the late 1990s, most EU countries, Japan, the USA and Switzerland had real time gross settlement systems in place for domestic large value payments. In the EU, the plan is for the domestic payments systems to be harmonised, commencing with RTGS in all countries for large value payments, with cross-border participation in the payments systems. Under a single currency, it is likely there will be an EU-wide RTGS.

Some private netting systems have been established. ECHO is an exchange rate clearing house organisation set up by 14 European banks. Its business has diminished with the advent of the euro, because there is no foreign exchange risk in the eurozone. However, foreign transactions with countries outside Euroland continue. Multinet serves a similar purpose for a group of North American banks. Both commenced operations in 1994 to facilitate multilateral netting of spot and forward foreign exchange contracts. The clearing house is the counterparty to the transactions they handle, centralising and offsetting the payments of all members in a particular currency. Some central bank regulators are concerned the clearing houses lack the capital to cover a member’s default on an obligation, in other words, that there is some counterparty risk.

Market or price risk

Market (or price) risk is normally associated with instruments traded on well-defined markets, though increasingly, techniques are used to assess the risk arising from over the counter instruments, and/or traded items where the market is not very liquid. The value of any instrument will be a function of price, coupon, coupon frequency, time, interest rate and other factors. If a bank is holding instruments on account (for example, equities, bonds), then it is exposed to price or market risk, the risk that the price of the instrument will be volatile.

General orsystematic market risk is caused by a movement in the prices of all market instruments because of, for example, a change in economic policy. Unsystematic or specific market riskarises in situations where the price of one instrument moves out of line with other similar instruments, because of an event (or events) related to the issuer of the instrument. For example, the announcement of an unexpectedly large government fiscal deficit might cause a drop in the share price index (systematic risk), while an environmental law suit against a firm will reduce its share price, but is unlikely to cause a general decline in the index (specific or unsystematic market risk).

A bank can be exposed to market risk (general and specific) in relation to:

• Equity
• Commodities (e.g. cocoa, wheat, oil)
• Currencies (e.g. the price of sterling appreciates against the euro)
• Debt securities (fixed and floating rate debt instruments, such as bonds)
• Debt derivatives (forward rate agreements, futures and options on debt instruments, interest rate and cross-currency swaps, and forward foreign exchange positions)
• Equity derivatives (equity swaps, futures and options on equity indices, options on futures, warrants)

Thus, market risk includes a very large subset of other risks. Two major types of market risks are currency and interest rate risk. If exchange rates are flexible, any net short or long open position in a given currency will expose the bank to foreign exchange or currency risk, a form of market risk. In this case, it is the market for foreign exchange, and the ‘‘price’’, the relative price of currencies given by the exchange rate. A bank with global operations will have multiple currency exposures. The currency risk arises from adverse exchange rate fluctuations, which affect the bank’s foreign exchange positions taken on its own account, or on behalf of its customers. For example, if a bank is long on dollars and the dollar declines in value against other currencies, this bank is going to lose out. Banks engage in spot, forward and swap dealing, with large positions that can undergo big changes within minutes. Mismatch by currency and by maturity is an essential feature of the business – good mismatch judgements can be profitable and signal successful risk management.

If rates between two currencies are fixed, there is no currency risk, provided the arrangement lasts. Fixed exchange rate regimes were the norm from after World War II7 to the early 1970s. Some countries, such as Hong Kong and Argentina, chose to fix their currencies against the dollar. Unfortunately, Argentina’s peg8 unravelled after it declared it could not repay its international debt in 2001. As part of the transition towards a single currency in Europe, countries entered into a fixed exchange rate regime – the ERM or exchange rate mechanism.

Though there is no currency risk while exchange rates are fixed, investors or banks can be suddenly exposed to very large risks (and losses or gains) if the fixed rate arrangement comes under so much pressure that one of the currencies is devalued or it collapses. An example is when the UK came out of Europe’s exchange rate mechanism. In the days leading up to the collapse the UK government vowed sterling would stay in the ERM,9 and increased interest rates twice in one day – they peaked at 15%. By late afternoon of the same day (16/9/92), £10 billion had been used to support sterling. The UK left the ERM, quickly followed by Italy. Spain was forced into a parity change. For banks long in any of these currencies, the losses were substantial.

The only way of eliminating currency risk altogether is to adopt a common currency, the most recent example being the introduction of the euro by all but three member states of the European Union. Euro states share the same currency, getting rid of foreign exchange risk, though trade outside Euroland does expose these states to currency risk.

While an important risk consideration for banks, to do justice to the subject would require an extensive diversion. Whole books are devoted to the determinants of exchange rates and the management of currency risk, and it will not be considered in further detail here.

Interest rate risk

Interest rates are another form of price risk, because the interest rate is the ‘‘price’’ of money, or the opportunity cost of holding money in the narrow form. It arises due to interest rate mismatches. Banks engage in asset transformation, and their assets and liabilities differ in maturity and volume. The traditional focus of an asset–liability management group within a bank is the management of interest rate risk, but this has expanded to include off-balance sheet items, as will be seen below.

Capital or gearing risk

Banks are more highly geared (leveraged) than other businesses – individuals feel safe placing their deposits at a bank with a reputation for soundness. There are normally no sudden or random changes in the amount people wish to save or borrow, hence the banking system as a whole tends to be stable, unless depositors are given reason to believe the system is becoming unsound.

Thus, for banks, the gearing (or leverage) limit is more critical because their relatively high gearing means the threshold of tolerable risk is lower in relation to the balance sheet.

This is where capital comes in: its principal function is to act as a buffer by supporting or absorbing losses. Banks which take on more risk should set aside more capital, and this is the principle behind the Basel risk assets ratio. Banks need to increase their gearing to improve their return to shareholders. To see the link, consider the equation below:

ROE = ROA × (gearing multiplier)

where:

ROE: return on equity or net income/equity
ROA: return on assets or net income/assets
Gearing/leverage multiplier: assets/equity

Basel requires a bank’s risk assets ratio to be 8% (i.e. [capital/(weighted risk assets)] = 0.08). If a bank satisfies this requirement, it means its equity is about 8%, its debt must be 92%, giving a gearing/leverage ratio of 92/8, or 11.5.

Contrast this with a typical debt to equity ratio for non-financial firms, of, for example, 60/40 = 1.5.

Since the bank’s ROA is typically very small, the ROE can be increased by higher leverage or raising the ratio of assets to equity. But with higher leverage comes greater risk, because there are more assets on the bank’s balance sheet. Generally, a bank is said to be highly geared/leveraged when a large exposure is associated with a small capital outlay. This can occur in the more traditional activities such as fractional reserve lending (they only keep a small fraction of their deposits as reserves), or because of newer types of business, such as the use of derivatives.

Capital risk is the outcome of other risks incurred by the bank, such as credit, market or liquidity risk. Poor earnings, caused by high loan losses, or inappropriate risk taking in other areas puts the bank’s capital at risk. Banks perceived to have an insufficient amount of capital will find it difficult to raise funding. Two ratios will be monitored by agents funding or considering funding the bank:

• The bank’s capital ratio or its Basel risk assets ratio – capital/weighted risk assets;
• The bank’s leverage ratio – debt/equity.

Operational risk

The Bank for International Settlements defines operational risk as:

‘‘The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events.’’ (BIS, 2001, p. 27)

The definition of operational risk varies considerably, and more important, measuring it can be even more difficult. The Basel Committee has conducted surveys of banks on operational risk. Based on Basel (2003), the key types of operational risk are identified as follows.

1. Physical Capital: the subsets of which are: damage to physical assets, business disruption, system failure, problems with execution and delivery, and/or process management.
2. Technological failure dominates this category and here, the principal concern is with a bank’s computer systems. A crash in the computing system can destroy a bank. Most banks have a duplicate system which is backed up in real time, in a secret location, should anything go wrong with the main computer system. When banks and other financial institutions had their premises damaged or destroyed as a result of ‘‘9/11’’, they were able to return to business quite quickly (in alternative accommodation), relying on the back-up computer systems. More generally, the loss of physical assets, such as buildings owned, is a form of operational risk. However, banks take out insurance against the risk of fire or other catastrophes, and to this extent, they have already hedged themselves against the risk. To the extent they are fully hedged, there should be no need to set aside capital. Problems with physical capital may interfere with process management and contribute to a break down in execution and/or delivery.

3. Human Capital: this type of risk arises from human error, problems with employment practices or employees’ health and safety, and internal fraud. An employee can accidentally enter too many (or too few) zeroes on a sell or buy order. Or a bank might find itself being fined for breach of health and safety rules, or brought before an employment tribunal accused of unfair dismissal. In addition, employees can defraud their bank, but this is discussed in a separate category below.
4. Legal: the main legal risk is that of the bank being sued. It can arise as a result of the treatment of clients, the sale of products, or business practices. There are countless examples of banks being taken to court by disgruntled corporate customers, who claim they were misled by advice given to them or business products sold. Contracts with customers may be disputed. One of the most recent and costly examples of shoddy treatment of clients is the implicit11 admission, in 2003, by all the major investment banks that they failed to control the conflict of interest between research and investment banking divisions. In addition to fines summing up to hundreds of millions, these banks face civil law suits from angry clients who claim they acted on paid advice from research departments to invest in certain stocks, only to find there was no solid research to back the recommendations, but rather, pressure from corporate finance divisions to bid up the price of one or more shares.
5. Fraud: the fraud may be internal or external to the bank. For example, the looting of his company’s pension by Mr Maxwell affected the banks because they were holding some of the assets he had stolen from the funds as collateral. Another illustration of this form of risk is the Hammersmith and Fulham Council case. This London borough had taken out interest rate swaps in the period December 1983 to February 1989. The swaps fell into two categories, one for hedging and one for speculation. With local taxpayers facing a bill of tens of millions of pounds, the House of Lords (in 1991) declared all the contracts null and void, overturning an earlier decision by the appeal court. Barclays, Chemical, the Midland, Mitsubishi Finance International and Security Pacific were the key banks left facing £400 million in losses and £15 million in legal fees. Examples of internal fraud include rogue trading. Nick Leeson brought down Barings with losses of $1.5 billion, and John Rusnak was convicted of fraud at a US subsidiary of Allied Irish Bank, which cost it$750 million.

As can be seen from the classification above, factors contributing to operational risk are not necessarily independent of each other. Internal fraud could be classified as a human capital risk. If an employee sues because of breaches in health and safety, it falls in both the human capital and/or legal risk subclassifications. Certain payment risks may also fall into the operational risk category. For example, in 1985, a major US bank experienced computer problems which prevented it from making outgoing payments. It was forced to borrow \$20 billion from the Federal Reserve to meet these payments. Simultaneously, payments to this bank from other banks could not be made, so they flooded the interbank markets, forcing down the federal funds rate by 3%. Thus, an operational failure created settlement and liquidity risks. Or if a borrower is granted a loan based on a fraudulent loan application and subsequently defaults, it will be recorded as a loan loss, and therefore, a credit risk issue, even though the fraud was the original source of the problem.

Classification issues alone make quantification of operational risk difficult, so it should come as no surprise that the ‘‘Basel 2’’ proposals for the treatment of the operational risk proved highly controversial.

Sovereign and political risks

Sovereign Risk normally refers to the risk that a government will default on debt owed to a bank or government agency. In this sense, it is a special form of credit risk, but the bank lacks the usual tools for recovering the debt at its disposal. If a private debtor defaults, the bank will normally take possession of assets pledged as collateral. However, if the default is by a sovereign government, the bank is unlikely to be able to recover some of the debt by taking over some of the country’s assets. This creates problems with enforcing the loan contract. Sovereign risk can refer to either debt repudiation or debt rescheduling. Since the end of the Second World War, only China, Cuba and North Korea have actually repudiated their debt obligations. Some of the poorest countries had their debt forgiven after a 1996 agreement reached by western countries and their banks, the IMF and the World Bank.

Some countries (e.g. Argentina, Russia) have threatened to repudiate their debt, but in the end, were persuaded by the World Bank and the IMF to reschedule the debt. Other countries announce they cannot meet an agreed payment schedule and renegotiate new terms; usually with the IMF acting as an intermediary. The banks agree to restructure debt repayments and make new loans. Normally the IMF acts as broker or intermediary.

The rescheduling agreement is made in exchange for the country agreeing to meet new macroeconomic targets, such as reductions in inflation and subsidies and/or an increase in taxation. The World Bank may also participate in rescheduling negotiations.

Political Risk is broadly defined as state interference in the operations of a domestic and/or foreign firm. Banks can be subjected to sudden tax hikes, interest rate or exchange control regulations, or be nationalised. For example, since the Second World War, France has vacillated between nationalisation and privatisation of its banking sector. All businesses are exposed to political risk, but banks are particularly vulnerable because of their critical position in the financial system.

Interaction among risks

All of the various risks discussed above are interdependent, and as was noted earlier, there are other risks, common to all businesses including banks. These other risks are often more discrete or event-type, affecting a bank’s profitability and risk exposure. They include sudden, unexpected changes in taxation, regulatory policy or in financial market conditions due to war, revolution or market collapse, and macroeconomic risks such as increased inflation, inflation volatility and unemployment.

Regulators have identified three key risks related to banks: credit, market (including risks arising from changes in interest rates, exchange rates, equity prices and commodity prices) and operating risk. It will focus on the management of interest rate, credit and market risks. Much of the discussion on operating risk.