Pa2-1- Introduction
Arising from the experiences during the 1997/1998 Asian and 2008 sub-prime financial crises, greater emphasis has been placed on enhancing the credit skills and creating a more robust credit culture. In fact, banks in many emerging market countries are also increasing their focus on risk management in an effort to build more robust and sound financial systems, to remedy weaknesses that were exposed by recent regional problems and to position themselves to participate more fully in the global economy. Strategies are, therefore, focused on introducing reform measures to strengthen the banking sector as well as to develop and enhance alternative sources of financing.
The recent trends of financial liberation and deregulation (Marshall, 2001) have indeed created new challenges for conventional banks. And as the commercial banks diversify into private banking, they must manage new types of risk.
Since private banking is basically an asset management service, financial risk management becomes more important (Penza & Bansal, 2001).
2-2– The concept of Risk management
Management in the simplest understood definition can be defined as the act of planning, directing, controlling, monitoring and testing for desired results to be obtained. Or it is simply the act, manner, or practice of managing; handling, supervision, or control (answers.com, 2010). Risk can be defined as the possibility that something unpleasant or dangerous might happen (Macmillan Dictionary, 2002). When companies indulge in business, it is obvious that they will be exposed to one type of risk or another which in most cases is an uncertainty although at times it can be certain that it will occur. Banks are one of such businesses whose risk is very sure because they don‟t function in isolation given the dynamic environment in which they operate, the volatility of the FMs in which they participate, diversification and the competitive environment in which they find themselves. (Williams et al., 2006, p. 69). Even though it is certain that the risk will occur, it is not always possible in most cases to eliminate, reduce or ameliorate it (Keith, 1992, p. 16). So, the best possibility for companies is to try to manage the risk so as to reduce the possibility of occurrence or to reduce the consequences. These possibilities can range from “do nothing at all” to attempting to nullify the effect of every identified risk (William et al., 2006, p. 67). But, because of the nature of the banking activity, a bank can‟t find itself in a position to do nothing at all or to nullify the risk. So, all she does is to live with it but look for means to manage it. Given the riskiness of her activities, a bank does not wait to introduce risk management at a certain stage of its activities but does so right from the start. This is so because her activities are so correlated in such a way that if not well handled, the effect / consequences can be connected and can even lead to bankruptcy. For this goal to be attained, decision makers need to first of all identify the risk involved, measure its intensity, assess it, monitor it and then look for measures on how to control it. This act of managing the risk is called RM. RM is “a course of action planned to reduce the risk of an event occurring and/or to minimize or contain the consequential effects should that event occur” (Keith, 1992, p. 14).
This course of action linked, gives rise to a RM process which involved a number of stages. RM is very important and forms a main part of any organization‟s activities because it‟s main aim is to help all other management activities to reach the organization‟s aims directly and efficiently since it is a 11 continuous process that depends directly on the changes of the internal and external environment of the organization.(Tchankova, 2002, p. 290).
And The definition of risk varies from one branch to another. Even within the scope of one domain, there are contradictory definitions sometimes even in financial management where risk is central to the study. All definitions share two elements: uncertainty and loss. We will mention some of these definitions.
2-2-1- "Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. ".(Jump up^ McNeil, Alexander J.; Frey, Rüdiger; Embrechts, Paul (2005). Quantitative risk management)
2-2-2- "Financial Risk as the term suggests is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more". (EshnaPublished on February 24, 2012 via @simplilearn).
2-2-3- "Risk can be defined as the volatility of unexpected outcomes" (Jorion and Khoury, 1996,pp70) as a basis and extend it to make it more precise: Risk is the measurable probability of the negative deviation of a target value from a reference value. Note that risk is different from uncertainty, which is not measurable.
2-2-4- Financial risk is the possibility that shareholders will lose money when they invest in a company that has debt, if the company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before its shareholders if the company becomes insolvent. Financial risk also refers to the possibility of a corporation or the government defaulting on its bonds, which would cause those bondholders to lose money.(www.investopeda.com).
2-2-5- Reto Gallati (2003) defined it as: "a particular circumstance in the event that it occurs, there is the possibility of a deviation from the expected and desired outcome."
2-2-6- "Risks are a situation where the possibility of a deviation from the desired result. (Hammad, p. 50).
2-2-7- "The Basel Committee also know identified the risks as: "the probability of the Bank being exposed to unexpected and unplanned losses or the fluctuation of the expected return on a particular investment, resulting in a negative effect, which has the potential to affect the achievement of the desired objectives of the Bank and to implement its strategy successfully".(keegan, 2004).
2-2-8- "Risk financial are fluctuations in the market value of the enterprise" (Union of Arab Banks, March 2005, p. 42).
In the opinion of the researcher, The risk is the uncertainty of the future results, or the degree of dispersion of the future returns from the average expected value, Risk has many different meanings depending on the area of application and measurement of risk by standard deviation and variance And the difference coefficient of returns in the future.
2-3- Risk sources
2-3-1- Systemic risk
2-3-1-1- Definition of systemic risk
The systemic risk arises when the failure of a single entity or cluster of entities can cause a cascading failure, due to the size and the interconnectedness of institutions, which could potentially bankrupt or bring down the entire financial system. (Indian,2003,pp250).
• Systemic risk is a relatively new term that has its origin in policy discussions, not the professional economics and finance literature. A search of EconLit turned up the following: The first appearance of the term systemic risk in the title of a paper in professional economics and finance literature was in 1994. In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system (Banking and currency crises and systemic risk, George G. Kaufman (World Bank), Internet Archive).
• Systemic risk generally refers to the risk of a disruption to the flow of financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences on the real economy. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". (https://en.wikipedia.org/wiki/Systemic_risk#References).
It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market (Systemic Risk, Steven L.Schwarcz). It is also sometimes erroneously referred to as "systematic risk".
Risk that can be avoided by diversifying systemic risk The systemic risk generally affects all stocks in the market. As the state of financial markets can deteriorate and gradually affect your portfolio. By avoiding this risk by conscious choice of stocks in different industries, the amount of risk will be greatly reduced. ( Banking and currency crises and systemic risk, George G. Kaufman (World Bank), Internet Archive).
The risk inherent to the entire market or an entire market segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy. (Matar, Tamim, 2005, p. 47,49).
• Systemic risk, as the name implies, is the inevitable consequence of operating within any system. In this case, the system is the stock market. Traders may be able to hedge against certain risks, but they cannot hedge against systemic risk. Consequently, participation in the markets involves tacit acceptance of, its systemic risk.
Systemic risk can, in extremes, involve stock market crises with far-reaching consequences. A few of the most sobering examples are the Wall Street Crash in 1929, Black Monday in 1987, the Asian Financial Crisis in 1997 and the Credit Crisis of 2008. During such crises, all prices are likely to suffer. (Hindi, 2004, p13).
Traders often refer to the benefits of the system with the oft-repeated adage “A rising tide floats all boats.” Incoming tides certainly lift the entire stock market. Yet the self-same tide can also retreat and can leave the entire stock market marooned. It is when the latter happens that the ability to hedge is a useful tool to try and counteract the risk.
2-3-1-2- BREAKING DOWN 'Systematic Risk
For example, putting some assets in bonds and other assets in stocks can mitigate systematic risk because an interest rate shift that makes bonds less valuable will tend to make stocks more valuable, and vice versa, thus limiting the overall change in the portfolio’s value from systematic changes. Interest rate changes, inflation, recessions and wars all represent sources of systematic risk because they affect the entire market. Systematic risk underlies all other investment risks.
The Great Recession provides a prime example of systematic risk. Anyone who was invested in the market in 2008 saw the values of their investments change because of this market-wide economic event, regardless of what types of securities they held. The Great Recession affected different asset classes in different ways, however, so investors with broader asset allocations were impacted less than those who held nothing but stocks.
This type of risk is divided into the following
2-3-1-3- INTEREST RATE RISK
Interest rate risk (IRR) is defined as the potential for changing market interest rates to adversely affect a bank's earnings or capital protection .(Doug Gray, 2012).
• Interest rate risk arises from the possibility that there will be a difference between the yield realized and the actual rates of return due to a change in market interest rates during the investment. (Ahmed، 1996 ، p 99).
• An interest rate risk is the risk that an investment’s value will change due to a change, either in the total level of interest rates, or in the bid/ask spread.
To combat against interest rate risk, many companies aim to diversify their risk through hedging exposure to any one type of risk.(www.kantox.com).
Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment (www.investinganswers.com).
2-3-1-4- Market risk
• Market risk refers to the risk of losses in the bank’s trading book due to changes in equity prices, interest rates, credit spreads, foreign-exchange rates, commodity prices, and other indicators whose values are set in a public market. (William Poundstone, Fortune’s Formula New York, Hill and Wang, 2005, p. 296 ) .
• Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets in which he is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against.
There are ways to reduce market risk Diversify: As in the case of business risks, market risks can be mitigated to a certain extent by diversification—not just on the product or sector level, but also in terms of the region (domestic and foreign) and length of holdings (short- and long-term). And can spread your international risk by diversifying investments over several different countries or regions. (https://feelingfinancial.com/market-risk).
Also keep in mind that diversification is just a basic tool – it’s not a magical tool. It is still very possible to lose money when you diversify. It may happen that the losses in one portion of your portfolio are so great that they drag your account balance down to a level you’re uncomfortable with. It could also be the case that different types of investments will move in the same direction at the same time (even if that’s what you were trying to avoid). In 2008, for example, stocks weren’t the only thing to lose money. People were surprised to see meaningful losses in investments that were considered “safe” or “alternatives”. Bear in mind that diversification is just a basic tool – it’s not a magical tool. It is still very possible to lose money when you diversify. It may happen that the losses in one portion of your portfolio are so great that they drag your account balance down to a level you’re uncomfortable with. It could also be the case that different types of investments will move in the same direction at the same time (even if that’s what you were trying to avoid). In 2008, for example, stocks weren’t the only thing to lose money. People were surprised to see meaningful losses in investments that were considered “safe” or “alternatives”.
Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets in which he is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks.
2-3-1-5- Risks of business cycles
Potential fluctuations in the general economic situation of the country from recession to boom, and then from boom to the recession.
2-3-1-6- Purchasing Power Risk (Inflation Risk)
Economists generally believe that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply However, money supply growth does not necessarily cause inflation. Some economists maintain that under the conditions of a liquidity trap, large monetary injections are like "pushing on a string". Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities.
However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.
Today, most economists favor a low and steady rate of inflation . Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy . The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
Increases in the cost of living (that is, inflation) can erode the value of your retirement resources and what you can buy with that money — also known as its purchasing power.(Eric Tyson ASSESSING YOUR PURCHASING-POWER RISK (AKA INFLATION RISK).
Some say that the ordinary shares are protected from inflation, but that is not true in General, the fact that stocks tend to suffer less than bonds, Treasury bills fixed income and the purchasing power For money was buying securities today different from the purchasing power for the Same amount of money after a while if inflation rates soar. (Hammad, 1998, p. 271,73).
2-3-1-7- General climate change risks
Is the possibility of some significant events domestically and internationally, for example fundamental changes in the economic system of the country itself or other countries with which it has a close relationship, or the death of one of the local or global figures of political weight. (Aldabia, p. 28).
2-3-2- Specific Risk
The risk that affects a very small number of assets. Specific risk, as its name would imply, relates to risks that are very specific to a company or small group of companies. This type of risk would be the opposite of an overall market risk, or systematic risk.
Sometimes referred to as "unsystematic or diversifiable risk."
BREAKING DOWN 'Specific Risk:
An example of specific risk would be news that is specific to either one stock or a small number of stocks, such as a sudden strike by the employees of a company, or a new governmental regulation affecting a particular group of companies. Unlike systematic risk or market risk, specific risk can be diversified away.
2-3-3- Unsystematic Risk
Unsystematic risk is the part of an investment’s risk that is attributable to the investment itself or to the sub-group it belongs to—but not to the entire economic system. This is in contrast to the systematic—or more commonly, systemic—risk, which is the risk that affects all the investments in that system. Every investment has some of both types of risk. (www.investopedia.com/video/play/unsystematic-risk/).
Company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," can be reduced through diversification. By owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type. Examples of unsystematic risk include a new competitor, a regulatory change, a management change and a product recall.
This type of risk enables the investor to reduce or eliminate Unsystematic risk through diversification.
And divided into the following.
2-3-3-1- Management Risk
The risks associated with ineffective, destructive or underperforming management, which hurts shareholders and the company or fund being managed. This term refers to the risk of the situation in which the company and shareholders would have been better off without the choices made by management.
2-3-3-2- Industry risks
Is the result of factors that affect a particular industrial sector clearly and without significant impact outside the sector, such as the difficulty of providing the necessary raw materials, and the ongoing differences between workers and management (Mattar, Tim, 2005, pp. 47-49 ) . Finally, systemic risks and irregular risks are part of overall risk. It can be written in the form of the following equation
Overall risk = systemic risk + irregular risk
Figure 1: Classification risk and cases of diversification and lack of diversification
Source: The reality of many financngl works
-The largest share of total risk, due to systemic risk because the latter affects the market as a whole and unpredictable. Irregular risk can be reduced through diversification, but could not avoid the so called systemic risk.
-In the case of investor diversification for risk his forecast focuses on market movement and especially the general economic risks and financial market risks (such as the change in interest rate and changing prices Exchange rate risk and purchasing power of the monetary unit).
– In the case of non-diversification, if the investor wants to obtain a return for exposure to private risk or non-market through the analysis of the accurate share should focus on sources of irregular risk, which are themselves not linked to each other, and also subject to factors affecting the Systemic risk.( Ghoneim, 1999, p. 255. ).
2-4- Financial Risk
"Financial risk is the loss of key resources like funding. In this case the company will not have adequate cash flow to meet financial obligations".
"Financial Risk is one of the major concerns of every business across fields and geographies".
Financial risk "is an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans at risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss". (http://www.investopeda.c0m).
"Financial Risk as the term suggests, "is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more. And will discuss different types of financial risk" (Credit risk, liquidity risk, market risk, operational risk).
Types of Financial Risks
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to market movements and market movements can include a host of factors. Based on this, financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk. (Eshna via @simplilearn)
Figure 2: Types of Financial Risks
Eshna ، Financial Risk ، 2016
2-4-1- Credit Risk
This type of risk arises when one fails to fulfill their obligations towards their counter parties. Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk on the other hand arises when one party makes the payment while the other party fails to fulfill the obligations.
That credit risk occurs when the debtor cannot repay part or whole of the debt to the creditor as agreed in the mutual contract. More formally, “credit risk arises whenever a lender is exposed to loss from a borrower, counterparty, or an obligor who fails to honor their debt obligation as they have agreed or contracted”. This loss may derive from deterioration in the counterparty‟s credit quality, which consequently leads to a loss to the value of the debt. (Colquitt 2007, 1) Or in the worst case, the borrower defaults when he/she is unwilling or unable to fulfill the obligations.(Crouhy et al. 2006, 29).
And When the borrower becomes the default and was unable to make payments as promised it is said to be Credited risk, also called default risk. Investment risk was associated with this where the investor losses his principal and interest too.
According to the Bank for International Settlements (BIS), credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk is most likely caused by loans,acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. In simple words, if person A borrows loan from a bank and is not able to repay the loan because of inadequate income, loss in business, death, unwillingness or any other reasons, the bank faces credit risk.
• Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly or indirectly use or rely , forward commitment, or derivative instruments.
• Credit risk is the risk that a firm’s borrowers will not repay their debt obligations in full when they are due. The traditional method for managing credit risk is to establish credit limits at the level of the individual borrower, industry sector, and geographic area. Such limits are generally based on internal credit ratings. Quantitative models are increasingly used to measure and manage credit risks (Lopez, 2001).
• Credit risk is the risk businesses incur by extending credit to customers. It can also refer to the company's own credit risk with suppliers. A business takes a financial risk when it provides financing of purchases to its customers, due to the possibility that a customer may default on payment.
• A company must handle its own credit obligations by ensuring that it always has sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise, suppliers may either stop extending credit to the company, or even stop doing business with the company altogether.
Hence, to minimize the credit risk on the bank’s end, the rate of interest will be higher for borrowers if they are associated with high credit risk. Factors like unsteady income, low credit score, employment type, collateral assets and others determine the credit risk associated with a borrower. and credit risk can be associated with interbank transactions, foreign transactions and other types of transactions happening outside the bank. If the transaction at one end is successful but unsuccessful at the other end, loss occurs. If the transaction at one end is settled but there are delays in settlement at the other end, there might be lost investment opportunities..
• Types of Risk Credit risk
Credit Risk is the potential that a bank borrower/ counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reasons resulting in the crystallization of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters. Credit risk management includes a) measurement through credit rating/ scoring, b) quantification through estimation of expected loan losses, c) pricing on a scientific basis and d) controlling through effective review mechanism and portfolio management.
2-4-2- Market Risk
This type of risk arises due to movement in prices of financial instruments. And Due to the change in value of the market risk factor value of an investment portfolio or the value of a trading portfolio will decrease. Foreign exchange rates, stock prices, interest rates, and commodity prices are the standard Market risk factors.
Financial market risk is defined as the dispersion of unexpected outcomes of the financial assets’ market value, resulting from the firm’s financial market activities.
Market Risk defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices.
Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy Market risk involves the risk of changing conditions in the specific marketplace in which a company competes for business. One example of market risk is the increasing tendency of consumers to shop online.
This aspect of market risk has presented significant challenges to traditional retail businesses. Companies that have been able to make the necessary adaptations to serve an online shopping public have thrived and seen substantial revenue growth, while companies that have been slow to adapt or made bad choices in their reaction to the changing marketplace have fallen by the wayside.
This example also relates to another element of market risk – the risk of being outmaneuvered by competitors. In an increasingly competitive global marketplace, often with narrowing profit margins, the most financially successful companies are most successful in offering a unique value proposition that makes them stand out from the crowd and gives them a solid marketplace identity.
Market risk can be classified as Directional Risk and Non – Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non- Directional risk on the other hand can be volatility risks.
The most common types of market risks include interest rate risk, equity risk, currency risk and commodity risk.
Interest rate risk covers the volatility that happens with changing interest rates due to fundamental factors, such as Libor and other central bank announcements related to changes in monetary policies. Equity risk is the risk involved in the changing stock prices. An investor is exposed to currency risk if he is holding particular currencies facing volatile movements, because of fundamental factors such as interest rate changes or unemployment claims.
Commodity risk covers the changing prices of commodities such as crude oil and corn. (www.investopedia.com/terms/u/unsystematicrisk.asp).
2-4-3- Liquidity Risk
Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. With liquidity risk, typically reflected in unusually wide bid-ask spreads or large price movements, the rule of thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk. Drops in the value of stocks and other securities in the aftermath of the 9/11 attacks and the 2007-2008 global credit crisis motivated many investors to sell their holdings at any price, causing widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
Liquidity risk occurs when an individual investor, business or financial institution cannot meet short-term debt obligations. The investor or entity may be unable to convert an asset into cash without giving up capital and/or income due to a lack of buyers or an inefficient market. (http://www.investopedia.com/terms/l/liquidityrisk.asp).
This type of risk arises out of inability to execute transactions. And And Sometimes due to lack of liquidity in the market an asset cannot be sold to make the profit or to prevent a loss this is what called as Liquidity risk. Also arises Asset Liquidity risks either due to insufficient buyers or insufficient sellers against sell orders and buy orders respectively. Also arises Asset Liquidity risks either due to insufficient buyers or insufficient sellers against sell orders and buy orders respectively. and And Sometimes due to lack of liquidity in the market an asset cannot be sold to make the profit or to prevent a loss this is what called as Liquidity risk.
And Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk.
Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk. Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit Time risk: It is the need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into nonperforming assets Funding (or liquidity) risk is the risk that a firm cannot obtain the funds necessary to meet its financial obligations, for example short-term loan commitments. Three common techniques for mitigating funding risk are diversifying over funding sources, holding liquid assets, and establishing contingency plans, such as backup lines of credit. Generally, firms set funding goals as benchmarks to measure their current funding levels, and take mitigating actions when they are below certain thresholds.
Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals.
Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items.
Liquidity risk consists of Funding Risk, Time Risk & Call Risk.
Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit time risk: It is the need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into nonperforming assets Call risk: It happens on account of crystalisation of contingent liabilities and inability to undertake profitable business opportunities when desired.
Sources of liquidity risk
Liquidity risk can arise from a number of areas within the business, including
2-4-3-1- Seasonal fluctuations.
2-4-3-2- Unplanned reduction in revenue.
2-4-3-3 Business disruption.
2-4-3-4- Sustained reduction in profitability.
2-4-3-5- Unplanned capital expenditure.
2-4-3-6- Increase in operational costs.
2-4-3-7- Inadequate management of working capital.
2-4-3-8- Future debt repayments .
2-4-3-9- Breach of loan covenants.
2-4-3-10- Not matching the maturity profile of debts to the assets which they are funding.
2-4-3-11- Inadequate or non-existent financing facilities.
2-4-3-12- Inadequate cash flow management. (cpaaustralia.com.au).
2-4-4- Operational Risk
This type of risk arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to lack of controls and Model risk arises due to incorrect model application. .(Eshna via @simplilearn).
2-4-4-1- Operational risk is intrinsic to financial institutions and thus should be an important component of their firm-wide risk management systems. However, operational risk is harder to quantify and model than market and credit risks. Over the past few years, improvements in management information systems and computing technology have opened the way for improved operational risk measurement and management. Over the coming few years, financial institutions and their regulators will continue to develop their approaches for operational risk management and capital budgeting.
2-4-4-2- Although the definitions of market risk and credit risk are relatively clear, the definition of operational risk has evolved rapidly over the past few years. At first, it was commonly defined as every type of unquantifiable risk faced by a bank. However, further analysis has refined the definition considerably. As reported by BCBS (September 2001), operational risk can be defined as the risk of monetary losses resulting from inadequate or failed internal processes, people, and systems or from external events. (Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards – A Revised Framework – Comprehensive Version”, Bank for International Settlements, June 2006: s. 644. https://www.bis.org/publ/bcbs128.pdf ).
Losses from external events, such as a natural disaster that damages a firm’s physical assets or electrical or telecommunications failures that disrupt business, are relatively easier to define than losses from internal problems, such as employee fraud and product flaws. Because the risks from internal problems will be closely tied to a bank’s specific products and business lines, they should be more firm-specific than the risks due to external events.
2-4-4-3- Operational risk is the risk of monetary loss resulting from inadequate or failed internal processes, people, and systems or from external events (see Lopez, 2002, for a more complete discussion). Although operational risk management is a rapidly developing field, standard risk mitigation techniques have not yet been developed.
2-4-4-4- Operational risks refer to the various risks that can arise from a company's ordinary business activities. The operational risk category includes lawsuits, fraud risk, personnel problems and business model risk, which is the risk that a company's models of marketing and growth plans may prove to be inaccurate or inadequate
2-4-4-5- Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss. Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit systems are used as the primary means. Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. Insurance cover is one of the important mitigators of operational risk.
Operational risk events are associated with weak links in internal control procedures.
The key tothe management of operational risk lies in the bank’s ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios.
• Mitigating operational risk
In broad terms, risk management is the process of mitigating the risks faced by a bank, either by hedging financial transactions, purchasing insurance, or even avoiding specific transactions. With respect to operational risk, several steps can be taken to mitigate such losses. For example, damages due to natural disaster can be insured against. Losses arising from business disruptions due to electrical or telecommunications failures can be mitigated by establishing redundant backup facilities. Losses due to internal reasons, such as employee fraud or product flaws, are harder to identify and insure against, but they can be mitigated with strong internal auditing procedures.
Since operational risk management will depend on many firm-specific factors, many managerial methods also are possible and will probably
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