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Risk and Rate of Return

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Financial Risk: Key Fundamentals and Case Studies

Leonard Chumo, CFA, FRM
Strathmore University GARP Chapter Meeting
29th July 2011

Agenda
1.

Background

2.

Credit Risk and the Case of Washington Mutual

3.

Operational Risk and the Case of Rogue Brokers in
Kenya and Barings

4.

Market Risk and the Case of LTCM

5.

Liquidity Risk and the Case of Northern Rock

6.

Q&A

BACKGROUND

Main Types of Financial Risk
Risk Type

Definition

Credit Risk

The potential that a bank's borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

Market Risk

The risk that movements in market prices will adversely affect the value of on- or off-balance sheet positions.
The risk is attributable to movements in interest rates, foreign exchange (FX) rates, equity prices or prices of commodities.

Operational
Risk

Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The definition includes legal risk, but excludes reputational and strategic risk.

Liquidity
Risk

Liquidity is the ability to fund increases in assets and meet obligations as they become due. It is crucial to the ongoing viability of any organization.

Source: Financial Stability Institute

CREDIT RISK AND THE CASE OF
WASHINGTON MUTUAL

Sources of Credit Risk
Apart from traditional types of loans, credit risk can also be found in a bank's:
Investment portfolio
Overdrafts
Letters of credit

Credit risk also exists in a variety of bank products, activities, and services, such as:
Derivatives
Foreign exchange
Cash management services
Trade financing

Source: Financial Stability Institute

Case Study: Washington Mutual (1)
Year

Events

2004

Embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans

2006

High risk loans began incurring high rates of delinquency and default,

2007

Mortgage backed securities began incurring ratings downgrades and losses Began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities
Its stock price dropped as shareholders lost confidence
Depositors began withdrawing funds, eventually causing a liquidity crisis at the bank

2008

Seized by its regulator, the Office of Thrift Supervision (OTS)
Placed in receivership with the Federal Deposit Insurance Corporation
(FDIC)
Sold to JPMorgan Chase for $1.9 billion.

Source: Wall Street and the Financial Crisis: Anatomy of a Financial Collapse

Case Study: Washington Mutual (2)
Some of the lending practices included:
Qualifying high risk borrowers for larger loans
Steering borrowers from conventional mortgages to higher risk loan products
Accepting loan applications without verifying the borrower’s income
Using loans with low, short term “teaser” rates
Promoting negatively amortizing loans
Authorizing loans with multiple layers of risk
Source: Wall Street and the Financial Crisis: Anatomy of a Financial Collapse

Case Study: Washington Mutual (3)
Other shortcomings included:
Failure to enforce compliance with lending standards
Excessive loan error and exception rates
Weak oversight over the 3rd party mortgage brokers
Tolerated loans with fraudulent or erroneous borrower information
Compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans Source: Wall Street and the Financial Crisis: Anatomy of a Financial Collapse

Best Practice in Management of Credit Risk
A.

An appropriate credit risk environment

B.

Operating under a sound credit granting process C.

Appropriate credit administration, measurement and monitoring process

D.

Adequate controls over credit risk

Source: Principles for the Management of Credit Risk

OPERATIONAL RISK AND THE CASE
OF ROGUE BROKERS IN KENYA AND
BARINGS

Operation Risk
Includes losses that arise from events such as:
Internal and external fraud
Employment practices and workplace safety
Clients, products and business practices
Damage to physical assets
Business disruption and system failures
Execution, delivery and process management
Source: Financial Stability Institute

Lines of Defence
1st Line

Business line management Responsible for identifying and managing the risks inherent in the products, activities, processes and systems for which it is accountable 2nd Line

Functionally
Independent
(CORF)

A key function of the corporate operational risk function (CORF) is to challenge the business lines’ inputs to, and outputs from, the bank’s risk management, risk measurement and reporting systems.

3rd Line

Independent review Independent review and challenge of the bank’s operational risk management controls, processes and systems.

Source: Principles for Sound Management of Operational Risk

Case Study: Kenyan Stock Brokers (1)
The recent failure of some stock brokers in
Kenya could be attributed to:
Poor corporate governance and management practices Fraudulent practices such as unauthorized selling of client’s shares
Weak internal control environment and poor financial management
Key person risk and lack of a proper succession planning Some of the recently failed stock brokers in Kenya includes: Discount Securities, Francis Thuo and Partners, Nyaga
Stock Brokers and Ngenye Kariuki & Co. Ltd

Case Study: Kenyan Stock Brokers (2)
The failures could have been averted if the following were in place:
Comprehensive framework for the management of all material risks
Code of Conduct to be observed by all the market participants
Proper procedures for safekeeping and transfer of securities
Risk-based capital requirement for stock brokers

Case Study: Barings
Management failed to institute proper control systems Lack of adequate segregation between various functions Systems of checks and balances failed at a number of levels
Dubious practices designed to conceal losses
Failure to implement the auditor’s recommendations Source: Barings – A Case Study in Risk Management and Internal Controls by Hubert Edwards

Tools for Assessment of OpRisk
Audit Findings
Loss Data Collection and Analysis (Internal and External)
Risk Self Assessment (RSA)
Business Process Mapping
Scenario Analysis
Comparative Analysis
Source: Principles for Sound Management of Operational Risk

Traditional Internal Controls
Segregation of duties and dual control
Established processes for approval
Monitoring of adherence to risk limits
Restricted access to assets and records
Appropriate staffing level and training
Verification and reconciliation of transactions
Appropriate vacation policy
Source: Principles for Sound Management of Operational Risk

MARKET RISK AND THE CASE OF
LONG-TERM CAPITAL MANAGEMENT

Market Risk
Market risk is the risk that movements in market prices will adversely affect the value of on- or offbalance sheet positions. These movements can occur in:
Interest rates
Foreign exchange (FX) rates
Equity prices
Commodity prices

Case Study: Kshs/USD FX Rate

Data Source: Central Bank of Kenya

Case Study: LTCM (1)
It traded on its good name
Meriwether was renowned as a relative-value trader
LTCM’s on balance sheet assets totalled around
$125 billion, on a capital base of $4 billion, a leverage of about 30 times
Off balance sheet notional principal ran to around $1 trillion The fund lost $2.5 billion or 52% of its value in 1998
Source: Lessons From Collapse of Hedge Fund, Long-Term Capital Management, David Shirreff

Case Study: LTCM (2)
Factors playing against LTCM
Nobody could predict the time-frame within which rates would converge again
Counterparties had lost confidence in themselves and LTCM
Many counterparties had put on the same convergence trades
Some counterparties saw an opportunity to trade against LTCM’s positions.
Source: Lessons From Collapse of Hedge Fund, Long-Term Capital Management, David Shirreff

Case Study: LTCM
The LTCM fiasco is full of lessons about:
1.

Model risk

2.

Breakdown in historical correlations

3.

The need for stress-testing

4.

The value of disclosure and transparency

5.

The danger of over-generous extension of trading credit

6.

The woes of investing in star quality

7.

Investing too little in game theory.

Source: Lessons From Collapse of Hedge Fund, Long-Term Capital Management, David Shirreff

LIQUIDITY RISK AND THE CASE OF
NORTHERN ROCK (NR)

Liquidity Risk
Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due
The fundamental role of banks in the maturity transformation makes banks inherently vulnerable to liquidity risk
Every financial transaction or commitment has implications for a bank’s liquidity
Liquidity shortfall at a single institution can have systemwide repercussions

Source: Principles for Sound Liquidity Risk Management and Supervision

Some of the Best Practice
Defined liquidity risk tolerance
Maintenance of an adequate level of liquidity
Identification and measurement of the full range of liquidity risks
Allocation of liquidity costs, benefits and risks
Use of severe stress test scenarios
A robust and operational contingency funding plan Source: Principles for Sound Liquidity Risk Management and Supervision

Structural Liquidity Risk
Liquid Assets
Volatile
Liabilities
Structural
Liquidity Deficit
Illiquid Assets
Core Liabilities
& Equity
Source: David Silk, State Street, Liquidity Risk Management and Stress Testing

Examples of Early Warning Indicators
Rapid asset growth funded with potentially volatile liabilities Increasing concentrations in assets or liabilities
Currency mismatches
Decline in weighted average maturity of liabilities
Negative publicity
Credit rating downgrade
Rising wholesale or retail funding costs
Increasing retail deposit outflows
Source: Principles for Sound Liquidity Risk Management and Supervision

Case Study: Northern Rock (1)
Run on bank - ₤ 3 bln of deposits were withdrawn Bank of England (BOE) had to step in as lender of last resort (LoLR)
Funding strategy mainly based on wholesale money and other capital market funding
The bank remained legally solvent
The quality of its assets were never in question For many years regarded as a star performer
Source: The Northern Rock Crisis: A Multi-dimensional Problem Waiting to Happen, David T. Llewellyn

Case Study: Northern Rock (2)
LPHI risk

Business model exposed it to low-probability high-impact
(LPHI) risk

Business model

Centrepiece of its business strategy was securitisation

Solvency and
Liquidity

Distinction is more difficult to make in practice than in theory

Moral Hazard:

Deposit protection and BOE money market operations

Corporate
Governance

Practical ability of the board to monitor risk taking activities

Role of
Government:

Raised credibility issues regarding deposit guarantee system in place

Source: The Northern Rock Crisis: A Multi-dimensional Problem Waiting to Happen, David T. Llewellyn

Case Study: Northern Rock (3)
Lessons Learned
1.
2.
3.

4.

5.
6.

7.

Need to focus on liquidity management
Business model should be subjected to stress tests
Greater transparency with regard to banks’ risk exposures Deposit protection arrangements to be made more credible A review of the role of credit rating agencies
Corporate governance with a focus on monitoring of risk models
Improve management of LPHI risks

Source: The Northern Rock Crisis: A Multi-dimensional Problem Waiting to Happen, David T. Llewellyn

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