Risk Management in Banks and the Regulatory and Capital Requirements

Analytic Overview

The aim of this section is to introduce the inherent risks of a bank's balance sheet and the need for capital to cover these risks.

Analyzing banks

• Why risk is inherent to a bank's business model and therefore why effective risk management is critical
• The balance sheet of a typical bank
• The importance of capital

Key risk areas

• Identifying and defining major risk groups: credit, market, liquidity, operational, legal, regulatory, counterparty and reputation
• Overview of how much risk banks take in each group and the complexity of the risk

Models and methodologies

• Basics of modeling financial risk
• Inherent problems with risk models

Risk management failures

• Historical failures in financial institutions
• Lessons from the global financial crisis (GFC)
• Regulatory changes since the GFC

Regulatory capital in banks

• Regulatory capital
• Basel and the three pillars
• Overview of minimum capital ratios

Legal and reputational risks

• Examples of reputational problems
• Suitability issues and derivatives
• Exercise: Matching risk to description

Market Risk

This section introduces sources of market risk in the balance sheet and how this risk can be quantified and managed. Finally, the section covers the principles of regulatory capital allocation for market risk.

Definitions and sources of market risk

• Defining market risk
• Exercise: Defining the magnitude of various market risks

Value-at-risk (VaR)

• Purpose of VaR
• Methodologies for calculating VaR
  • Variance-covariance
  • Historical simulation

Regulatory capital for market risk

• Trading book and banking book
• Standardized approach
• Internal models - the use of VaR to define regulatory capital
• Back testing
• Exercise: Market risk disclosures at a global bank

Beyond VaR

• Problem with VaR
• Expected shortfall
• The Fundamental Review of the Trading Book (FRTB)
• Stress testing

Credit Risk

Credit risk is possibly the most important risk faced by most commercial banks. This section explains the nature of credit risk, including the relevant products, types of credit risk, quantification and regulatory capital methodologies.

Identifying credit risk

• Credit products
• Types of credit risk

Credit risk indicators

• Credit ratings
• Credit spreads

Mitigating credit risk

• Contractual mitigants
• Securitization and credit derivatives
• Exercise: Credit portfolio management in a global bank

Quantifying credit risk

• Default probability
• Loss given default (LGD) and recovery
• Default correlation

Regulatory capital for credit risk

• Standardized risk weights
• Exposure at default methodologies
• Internal rating based (IRB) approach
• Exercise: Cost of credit

Counterparty Risk

Counterparty risk has grown in significance in recent years. It represents a combination of market and credit risk and is related mainly to OTC derivatives transactions. This section explains the nature of counterparty risk, risk mitigation and how regulatory capital methodologies for credit risk incorporate counterparty risk.

Defining counterparty risk

• Settlement and pre-settlement (counterparty) risk
• The derivatives market
• Risk mitigants for counterparty risk

Quantifying counterparty credit exposure

• Potential future exposure
• Monte Carlo simulation and add-on approaches
• Wrong-way risk

Regulatory capital for counterparty risk

• Default risk and CVA capital charges
• Current exposures and internal model methods
• Changes in methodologies and impact of central clearing

Operational Risk

Operational risk was a new risk to be quantified under Basel II, and occurs throughout a bank’s business model. This section aims to explore some of the challenges that face banks in controlling, quantifying and allocating regulatory capital to operational risk.

Defining operational risk

• Sources, categorization and drivers of operational risk
• Exercise: Operational risk examples
• Causes of operational risk in a bank
• Sarbanes-Oxley Act
• Exercise: The London Whale

Regulatory capital for operational risk

• Basic indicator approach
• Standardized approach
• Advanced measurement approach (AMA)

Modeling operational risk

• Modeling loss frequency
• Modeling loss severity

Liquidity Risk

Liquidity risk can be the most acute form of risk facing a financial institution at times of crisis as this is often the means by which providers of bank funding express dissatisfaction with management of other risks (e.g. credit risk). The aim of this section is to explore types of liquidity risk, how these risks are managed and the regulatory requirements faced by banks.

Nature of liquidity risk

• Definition
• Cause of liquidity risk in banks
• Historical liquidity risk in problems

Liquidity Risk in Financial Institutions

• Sources of liquidity in banks
• Exercise: Bank funding sources
• Nature of liquidity risk
• Case study: Northern Rock Collapse

Liquidity risk regulation

• Basel principles for the management and supervision of liquidity risk
• Liquidity coverage ratio (LCR)
• Net stable funding ration (NSFR)

Liquidity-adjusted VaR

• Modeling liquidity risk
• Liquidity loss and market risk VaR
• Optimal liquidation period