Financial Risk Management – summary
Financial Risk
Different kinds
1 credit risk
2 market risk
3 liquidity risk
4 operational risk
Bank balance sheet
- Short-term debt has increased role
- Trading assets focus is also increasing
- Banks have low equity ratio (5%-8%)
Loans are main asset
= loans and trading assets are often long-term and with limited marketability
Credit risk = risk that counterparties in loan and derivative transactions will default
--> this can wipe out the “loans” and “trading and other assets” part of the assets of a bank
--> provision for loan losses can wipe out equity (if being used)
Market risk = risk that instruments in banks trading book will decline in value
Deposits are main liability
Liquidity risk = risk that bank is unable to meet short-term financial demand
Related to ability to convert assets into cash
Operational risk = risk of loss, resulting from inadequate or failing internal processes, people and systems or from external events
FE: pandemic or geopolitical risks
Financial risk and insolvency
Credit risk, market risk and operational risk can wipe out assets and equity leading to insolvency
Insolvent = not able to pay back debt
1 accounting based
Based on question if liabilities < assets
2 economic based
Based on question if an entity can raise new equity? (from private investor)
--> because banks usually have smaller share of equity equity (5%) so when they lose the 5% of assets, they can have big
value changes
Financial regulation
Why regulation is established
1 maturity mismatch (liquidity risk)
Banks are financed by short term debt (deposits) but they lend on long term
2 bank runs
If you’re last in bank run you will not receive money
3 deposit insurance
4 cheap debt
Because since the insurance the risk is lower and therefore lower interest rate
5 excessive risk (market ad credit risk)
6 systematic risk
7 capital regulation
Capital regulation
Minimum levels of capital that a bank is required to keep
Tier 1 capital = equity
Tier 2 capital = subordinated long-term debt
Financial innovations
= generates new approaches to financial circumstances
FE. new products, services or securities which improve efficiency or transfer risks
Risk can be transferred because it might have different meaning depending on regulation, diversification
Credit default swap = taking out risk of borrower and trading it with another party
Regulatory arbitrage
,Merton H. Miller = “The major impulses to succesful financial innovations have come from regulations and taxes”
Regulatory arbitrage = entering into a transaction or series of transactions, without affecting the risks being taken in order to
reduce regulatory requirements
Types of regulatory arbitrage
1 cross-national regulation race to the bottom
FE: institutions move to countries with low regulation
2 cross-sector fintech
FE: fintech offers a service to the bank and asks for less regulation
3 single-rule securitization, innovation
The stress (=considered risk management failure)
March 2023, Silicon Valley Bank (SVB)faced a depositor run
--> SVB was taken over bij US regulators
--> second largest bank failure in US history
- triggered a stress for multiple mid-sided banks in the uS as well als global banks
- SVB opted to report 43% of assets as HTM
-->depositors of DVB were not giving as much money --> they had to start selling asets --> losses arrived
Bank distress in pandemic
- banks fly to safety
- households were getting money from government, some of this ended up as deposits
- Quantitative Easing (QE)
Quantitative easing
Public sells long-term fixed income assets and stocks (to central bank via dealers)
--> deposits increase from financial institutions and more money becomes available (without being insured)
--> more money available leads to lower interest rate
Longer duration of assets because of forward guidance = constant low-for-longer interest rates at the zero lower bound (ZLB)
Riding the yield curve strategy = if you want to invest for 1 year, you invest in 2-year asset to get higher interest and sell it after 1
year
Interest rate risk
Maturity when all the payments are due (does not take into account when the principle is paid)
Duration = weighted average of the times when payments are received or sensitivity of fixed-interest asset to interest rate changes
--> considers when the money is paid on average, sensitivity on asset when interest rates change
Long-term fixed-rate assets loose value with increasing interest rates
Loss percentage (of total assets) = duration * ∆interest rate
How to account for unrealized losses?
1 at cost for held-to-maturity (HTM) assets
2 market-to-market for available-for-sale (AFS) assets
Deposits and interest rate risk
- deposits are short term
- high switching costs
- banks have market power and do not change deposit rate as much as FED rate (as long as they don’t lose clients)
Deposit franchise value = money a bank makes by paying lower interest rate than market value
-->Deposit franchise hedges interest rate risk in assets
Deposit beta
= the increase in deposit interest rate per increase in short-term interest rate
Deposit beta estimated around 0,3
-->Deposits beta work as hedge as long as there are no bank runs
Unlikely to run:
- Insured depositors
More susceptible to run:
- Uninsured depositors
- Homogenous, well connected depositors (undertake actions together)
- Online depositors (they have easy access and can take action quickly)
--> to prevent banking crisis, regulators invoked the systemic risk exception to protect all deposits
, Financial institutions managing market risk
Two approaches
1 risk decomposition.= tackles risks one by one
2 risk aggregating = aims to get rid of non-systematic risks at portfolio level
-->in practice both approaches are used
Value at Risk (VaR)
Q. what loss level is such that we are X% confident it will not be exceeded in N business days
Q. How bad can things go?
VaR = loss level that will not be exceeded with a specified probability
Gains
Losses
Advantages of VaR
+ captures important aspect of risk in single number
+ easy to understand
+ it asks simple question “How bad can things get?”
+ used extensively in internal risk management
Disadvantages of VaR
- one-dimensional
- creates illusion of control
- susceptible to manipulation
Expected shortfall (ES)
Q. If things do go bad, what is the expected loss?
+ ES is better measure, more dynamical and not only looking at the cut-off
- you need more data to expect ES, so you are more likely to have calculation errors/noise
ES = expected loss given that the loss is greater than the VaR level (c-VaR and Tail Loss)
Coherent risk measures
R (L) = risk of loss L
1 monotonicity = if one portfolio always produces a worse outcome than another, its risk should be greater
R(L1) < R(L2) if L1 < L2
2 transaction invariance = if we add amount cash K (=certain cash payoff) to a portfolio, its risk measure should go down by K
R(L – K) = R(L) – K
3 homogeneity = multiplying size of portfolio by l should result in risk measure being multiplied by l --> not always with VaR
R(lL) = lR(L) for every l > 0
4 subadditivity = risk measures of two portfolios after they merge should be no greater than the some before they merge
R(L1 + L2) ≤ R(L1) + R(L2)
VaR vs. ES
- Regulators want to go from using VaR to ES for determing the market risk capital
- Two portfolios with the same VaR can have very different expected shortfalls
- Var does not necessarily satisfy the 4th condition of subadditivity
- subadditivity criterion: risk can be reduced by diversification
If regulators use non-subadditive risk measure è institution has incentive to break into
subsidiaries
- ES always satisfies all four conditions
Normal distribution assumption
No difference if we have normal distribution, because than the shape of the tail is fixed
Financial Risk
Different kinds
1 credit risk
2 market risk
3 liquidity risk
4 operational risk
Bank balance sheet
- Short-term debt has increased role
- Trading assets focus is also increasing
- Banks have low equity ratio (5%-8%)
Loans are main asset
= loans and trading assets are often long-term and with limited marketability
Credit risk = risk that counterparties in loan and derivative transactions will default
--> this can wipe out the “loans” and “trading and other assets” part of the assets of a bank
--> provision for loan losses can wipe out equity (if being used)
Market risk = risk that instruments in banks trading book will decline in value
Deposits are main liability
Liquidity risk = risk that bank is unable to meet short-term financial demand
Related to ability to convert assets into cash
Operational risk = risk of loss, resulting from inadequate or failing internal processes, people and systems or from external events
FE: pandemic or geopolitical risks
Financial risk and insolvency
Credit risk, market risk and operational risk can wipe out assets and equity leading to insolvency
Insolvent = not able to pay back debt
1 accounting based
Based on question if liabilities < assets
2 economic based
Based on question if an entity can raise new equity? (from private investor)
--> because banks usually have smaller share of equity equity (5%) so when they lose the 5% of assets, they can have big
value changes
Financial regulation
Why regulation is established
1 maturity mismatch (liquidity risk)
Banks are financed by short term debt (deposits) but they lend on long term
2 bank runs
If you’re last in bank run you will not receive money
3 deposit insurance
4 cheap debt
Because since the insurance the risk is lower and therefore lower interest rate
5 excessive risk (market ad credit risk)
6 systematic risk
7 capital regulation
Capital regulation
Minimum levels of capital that a bank is required to keep
Tier 1 capital = equity
Tier 2 capital = subordinated long-term debt
Financial innovations
= generates new approaches to financial circumstances
FE. new products, services or securities which improve efficiency or transfer risks
Risk can be transferred because it might have different meaning depending on regulation, diversification
Credit default swap = taking out risk of borrower and trading it with another party
Regulatory arbitrage
,Merton H. Miller = “The major impulses to succesful financial innovations have come from regulations and taxes”
Regulatory arbitrage = entering into a transaction or series of transactions, without affecting the risks being taken in order to
reduce regulatory requirements
Types of regulatory arbitrage
1 cross-national regulation race to the bottom
FE: institutions move to countries with low regulation
2 cross-sector fintech
FE: fintech offers a service to the bank and asks for less regulation
3 single-rule securitization, innovation
The stress (=considered risk management failure)
March 2023, Silicon Valley Bank (SVB)faced a depositor run
--> SVB was taken over bij US regulators
--> second largest bank failure in US history
- triggered a stress for multiple mid-sided banks in the uS as well als global banks
- SVB opted to report 43% of assets as HTM
-->depositors of DVB were not giving as much money --> they had to start selling asets --> losses arrived
Bank distress in pandemic
- banks fly to safety
- households were getting money from government, some of this ended up as deposits
- Quantitative Easing (QE)
Quantitative easing
Public sells long-term fixed income assets and stocks (to central bank via dealers)
--> deposits increase from financial institutions and more money becomes available (without being insured)
--> more money available leads to lower interest rate
Longer duration of assets because of forward guidance = constant low-for-longer interest rates at the zero lower bound (ZLB)
Riding the yield curve strategy = if you want to invest for 1 year, you invest in 2-year asset to get higher interest and sell it after 1
year
Interest rate risk
Maturity when all the payments are due (does not take into account when the principle is paid)
Duration = weighted average of the times when payments are received or sensitivity of fixed-interest asset to interest rate changes
--> considers when the money is paid on average, sensitivity on asset when interest rates change
Long-term fixed-rate assets loose value with increasing interest rates
Loss percentage (of total assets) = duration * ∆interest rate
How to account for unrealized losses?
1 at cost for held-to-maturity (HTM) assets
2 market-to-market for available-for-sale (AFS) assets
Deposits and interest rate risk
- deposits are short term
- high switching costs
- banks have market power and do not change deposit rate as much as FED rate (as long as they don’t lose clients)
Deposit franchise value = money a bank makes by paying lower interest rate than market value
-->Deposit franchise hedges interest rate risk in assets
Deposit beta
= the increase in deposit interest rate per increase in short-term interest rate
Deposit beta estimated around 0,3
-->Deposits beta work as hedge as long as there are no bank runs
Unlikely to run:
- Insured depositors
More susceptible to run:
- Uninsured depositors
- Homogenous, well connected depositors (undertake actions together)
- Online depositors (they have easy access and can take action quickly)
--> to prevent banking crisis, regulators invoked the systemic risk exception to protect all deposits
, Financial institutions managing market risk
Two approaches
1 risk decomposition.= tackles risks one by one
2 risk aggregating = aims to get rid of non-systematic risks at portfolio level
-->in practice both approaches are used
Value at Risk (VaR)
Q. what loss level is such that we are X% confident it will not be exceeded in N business days
Q. How bad can things go?
VaR = loss level that will not be exceeded with a specified probability
Gains
Losses
Advantages of VaR
+ captures important aspect of risk in single number
+ easy to understand
+ it asks simple question “How bad can things get?”
+ used extensively in internal risk management
Disadvantages of VaR
- one-dimensional
- creates illusion of control
- susceptible to manipulation
Expected shortfall (ES)
Q. If things do go bad, what is the expected loss?
+ ES is better measure, more dynamical and not only looking at the cut-off
- you need more data to expect ES, so you are more likely to have calculation errors/noise
ES = expected loss given that the loss is greater than the VaR level (c-VaR and Tail Loss)
Coherent risk measures
R (L) = risk of loss L
1 monotonicity = if one portfolio always produces a worse outcome than another, its risk should be greater
R(L1) < R(L2) if L1 < L2
2 transaction invariance = if we add amount cash K (=certain cash payoff) to a portfolio, its risk measure should go down by K
R(L – K) = R(L) – K
3 homogeneity = multiplying size of portfolio by l should result in risk measure being multiplied by l --> not always with VaR
R(lL) = lR(L) for every l > 0
4 subadditivity = risk measures of two portfolios after they merge should be no greater than the some before they merge
R(L1 + L2) ≤ R(L1) + R(L2)
VaR vs. ES
- Regulators want to go from using VaR to ES for determing the market risk capital
- Two portfolios with the same VaR can have very different expected shortfalls
- Var does not necessarily satisfy the 4th condition of subadditivity
- subadditivity criterion: risk can be reduced by diversification
If regulators use non-subadditive risk measure è institution has incentive to break into
subsidiaries
- ES always satisfies all four conditions
Normal distribution assumption
No difference if we have normal distribution, because than the shape of the tail is fixed
