International

banking notes w1-4

Week 1 lecture 1 28/07/2017
Essential Reading 1: Paul McCulley -- Learning from the Bank of Dad May 2010
The essence of banking
- Public’s ex-ante demand for liquidity at par is greater than the public’s ex-post
demand
- Banking systems exist because they can meet the ex-ante demand, but never
have to pony up ex-post.
Two principles for existence of banks
1. “The genius of banking is maturity, liquidity and quality transformation: holding
assets that are longer, less liquid and of lower quality than the funding liabilities.”
2. “A banking system is solvent only if it is believed by the public to be going concern”
- To implement Principle 1, you need Principle 2. Otherwise bank run!
- This applies to both conventional banks and ‘shadow’ banks.
- ‘If what you are doing is banking, you are in joint venture with the public sector’
- If you engage in banking with potential to cause systemic risk, you require
regulatory supervision and meet capital requirements.

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Shadow banking: Same as normal banks but without the regulatory burden of
conventional banks. They get their money from short-term funding or take a loan at

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other banks. Then they give out loans. Shadow banks exist because they can take greater
risk than conventional banks
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- Earn the net interest margin associated with maturity, liquidity and quality
transformation of conventional banks, but without the regulatory burden of
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conventional banks (e.g. regulatory capital requirements).

- To fund the assets, create information- insensitive liability through money
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market instruments such as repos and commercial paper.

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1) What is the difference between conventional banks and shadow banks?

2) What are the risks with shadow banking?
3) Discuss the pros and cons of regulating shadow banking with examples.
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Paul Krugman on shadow banking: "As the shadow banking system expanded to rival or
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even surpass conventional banking in importance, politicians and government officials

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should have realised that they were re-creating the kind of financial vulnerability that
made the Great Depression possible.
Influential figures should have proclaimed a simple rule: anything that does what a bank
does, anything that has to be rescued in crises the way banks are, should be regulated like
a bank.“ (Paul Krugman, Nobel Laureate, Economics)

Key points reading:
- We shouldn’t look at the conventional banking system and the Shadow Banking System as separate
beasts, but intertwined beasts.
2 principles:
1) The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore,
we can have banking systems because they can meet the ex-ante demand, but never have to pony up
ex-post. In turn, the essence or the genius of banking is maturity, liquidity and quality transformation:
holding assets that are longer, less liquid and of lower quality than the funding liabilities.
2) A banking system is solvent only if it’s believed by the public to be a going concern (keep on existing)
- There was a quid pro quo, which actually led to the old joke – which was actually said about the
savings and loan industry – that banking was a great job: Take in deposits at 3, lend them out at 6, and
be on the golf course at 3
- The birth of the Shadow Banking System required that capitalists be able to come up with an asset –
which actually for shadow bankers is a liability – that was perceived by the public as just as good as a
bank deposit. Therefore, shadow bankers had to be able to persuade the public that its asset – which is
actually the shadow banker’s liability – was just as good as the real thing.
- What went on the other side of the balance sheet? Money market instruments such as repo and
commercial paper (CP).
- So, explosive growth of the Shadow Banking System was logically the result of the invisible hand of the
marketplace wanting to get the profitability of the regulated banking system, but without the
regulation. Shadow banks created information-insensitive assets for the public that were perceived as
just as good as a demand deposit, and then levered the day- lights out of them into longer, less liquid,
lower-quality assets.
- Turn the deposit into asset-backed commercial paper. Turn the loan into a security. What you end up
with is the same vehicle as a bank from a functional standpoint, but you have it outside the
conventional bank regulatory structure
- Runs are self-feeding; you can’t stop them without the aid of somebody with the ability to print legal
tender.
- A run turns upside down the genius of banking. A run is when the public’s ex-post demand for liquidity
at par equals its ex-ante demand.
How should we reregulate the financial landscape?
1) If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be
considered functionally a bank, regardless of the name on your door.
2) If you engage banking, without making a big distinction here between conventional banking and
shadow banking, you will have higher mandated capital requirements and you will be supervised by
the Federal Reserve. Act like a bank, regulated like a bank.

Shadow Banking in Asia/China
Essential Reading 2: Global systemic risk: What’s driving the shadow banking system?

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1) Why is shadow banking growing in Asia/China?

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2) What are the key risks associated with shadow banking?
3) What should countries do to address these risks?

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Key points reading:
- Globally, growth of shadow banks has been driven by the tightening of regulation of the traditional
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banks.
- The same is true of China, where the recent growth of its shadow banks has been attributed to the
increased regulation and supervision of commercial banks following the global financial crisis.
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- Borst summarizes the main problem facing regulators as one of monitoring and transparency.
- He argues that the Chinese Government must reform the lending system to offer more investment
incentives to lenders in order to create regulated bonds and other financial products. Other policy
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options include the introduction of properly functioning private sector long-term savings, mutual
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fund or pensions markets as well as a standardized and unified bond market

- Key risks:
• Leverage risk: ‘the pro-cyclical nature of leverage means that firms will tend to increase their
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leverage during good times. When credit conditions change, highly leveraged firms may come
under stress. This condition could lead to the re-sale of assets’.
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• Maturity and liquidity mismatch: Disruptions in market condition may adversely impact the
shadow banking sector due to liquidity and funding risks faced by shadow banking institutions.
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• Indirect risks from interactions between shadow banking entities and regular banks: Risks can
take the form of direct credit exposures and interdependence in funding, which then allow for
greater propagation channels through which systemic risk can impact both sectors.
• Regulatory arbitrage: Incentives may exist for financial activities to move from the regulated
sector to the shadow-banking sector to avoid more stringent bank regulations and oversight.
- Recommendations: a stronger regulatory system is needed to monitor and supervise China’s SBS.
While China’s financial system is less connected to the global economy than Europe, a shadow
banking crisis in China would nevertheless dampen global growth. Stronger regulation of China’s
SBS is therefore crucial for the maintenance of financial stability for both China and the world.

How are global banks organised? Alternative organisational forms in foreign markets:
• Correspondent banking: arrange with other banks to serve as an agent
• Advantages: no investment in foreign countries, cost efficiency
• Disadvantages: agency problem, poor marketing presence
- Foreign representative office: find and service customers in foreign country
• Advantages: direct contact with customers, knowledge of foreign markets
and risks, low overhead
• Disadvantages: structural impediments in foreign markets, attracting and
retaining competent staff
- Foreign agency: wider scope than rep. office, but can’t take local deposits
• Advantages: can do more business (e.g. give loans), provide deeper client
base
 • Disadvantages: similar to rep office (better chance to retain staff)
- Foreign branch: Extension of parent bank, equity investment
• Advantages: Access to wholesale/retail markets (incl. deposits), stronger
presence and better service, diversification.
• Disadvantages: higher competition reduces profits, internet decreases need
for presence, globalisation reduces diversification benefits, double
regulation
- Foreign subsidiary: Separate foreign entity with own capital and charter
• Advantages: only subject to local regulation, parent only liable for
repatriated earnings, loss sharing, better branding
• Disadvantages: restrictions on ownership, differences in management
culture, government restrictions/inability of parent to take swift action

Essential reading 3: The Economist – Special Report International Banking
Read: Slings and arrows – pages 1 to 3; Crowd funding: Cool man – pages 6 and 7;
Blockchain: The next big thing– pages 11and 12
- Review how traditional banking will be challenged by Fintec companies.
- What are the barriers which Fintech companies may face to compete with banks?

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- What is crowd funding?

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- What are the factors that may drive growth in crowd funding?
- Are there any risks to the financial system due to crowd funding? Can the risks be mitigated?
- What is the concept of blockchain?
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How a typical blockchain transaction may be processed?
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What are the challenges in blockchain concept being widely accepted?
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- What do you think about the future of blockchain concept?
Key points reading:
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P 1-3: Financial technology makes banks vulnerable and less profitable, but it’s unlikely to kill them.
- Forget your local bank branch and head to Lending Club, a peer-to-peer platform which matches
people who need money with those who have some to spare.
- The financial crisis has left consumers more open to trying alternatives to banks they had to bail out.
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- Banks make money in three ways: 1) difference between rates they charge borrowers and interest
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they offer savers, 2) charging for making payments (e.g. credit card), 3) cornucopia fees. All of these
are under attack.
P 6-7: Where small businesses can borrow if the banks turn them down
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- Funding Circle, a British startup, advertises itself as “the bond market for small companies”. Funding
Circle’s method includes a flesh-and-blood credit agent from the company speaks to every new
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borrower before a loan is disbursed.

- Peer-to-peer lenders to businesses. Lending Club, the industry’s biggest firm in personal peer- to-peer
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credit, is edging into business loans.

- New models are emerging. Last Year Square, a company that enables small businesses and individuals
to process credit card payments, started offering cash advances to some customers.
- Small businesses would love to be able to monetize the money customers owe them. Most of them
have to wait for 30-90 days after they have dispatched the merchandise before getting paid. A slew of
smaller finance houses have offered to buy the outstanding invoices at a discount, paying perhaps 60
cents on the dollar. Leaving aside the risk of fraud, the paperwork was daunting.
P 11-12: Bitcoin
- It allows something of value to be transferred from one person to another without a middleman to
verify the transaction. Fans think this is a way of changing the centralized, institution-dominated
shape of modern finance. It is genuinely new. The question is whether it is useful.
- All that is needed, block chain boosters argue, is a “killer app” to find a use for the breakthrough, in
the same way that web browsers made the Internet useful.


Week 2 lecture 2 04/08/2017

Standard deviation (sigma): a measure of risk
Risk: the chance of something happening that will have an impact upon objectives. It is
measured in terms of likelihood and consequences. ! = ∈ !! (!! − !)!

Key issues in managing risk (Peter Bernstein): If you have less money you should take
more risk instead of only taking risk when you feel comfortable. If you feel comfortable
and you don’t necessarily need to take risk, then don’t.
What is prudent risk taking: prudence: know all the options that are on the table

Country risk: It is the potential for loss due to political or economic uncertainty in the
country of a foreign borrower or counterparty.
- For example, due to economic difficulties a country may stop payments by an
importer in that country to the exporter. Unlike credit risk, the borrower or
counterparty has no control on these risks.
- When the foreign government is the borrower or counterparty, the risk is termed
sovereign risk. We say country risk = sovereign risk
Country risk depends on 1) the chance (prob) of loss and 2) level of country exposure

Most banks undertake cross-border business:
- Trade credit
- Foreign exchange
- Derivatives trading

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- Securitisation

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- Borrowing
- Portfolio investments
- Foreign operations m
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Risk rating methodologies: Have two dimensions:
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- Economic: focuses on financial characteristics of the country

- Political: analyses the politico-legal aspects
Typically three different frameworks:
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1. In depth subjective analysis, done on a case-by-case basis

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2. Structured methods with a standardizes format, with reliance on subjectivity

3. Checklist of observable variables, however variables and their weights remain
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arbitrary

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- Economic factors: traditionally country risk analysis is based on the financial

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performance of many economic factors that affect country risk positively or

negatively.
- Liquidity: banks use various ratios to measure liquidity for debt servicing
(export receipts to debt service obligations, foreign exchange reserves to
imports, net capital flow to debt service obligation, etc)
- Debt structure: this is similar to the debt structure of a firm; it reflects the
financial risk of the entity (e.g. total external outstanding debt to export ratio,
debt to GNP)
- Profitability: this measure the potential for generating profits in the country. A
higher profitability leads to more liquidity and the ability the entice capital
inflows
- Willingness to pay: not easy to measure; if a country is omitted to economic
growth and imports are required for sustaining or improving economic growth,
then the ratio of imports to GDP will reflect the country’s willingness to repay
external debt.
- Political factors: are vital in the analysis of country risk; events such as civil war,
revolutions and invasions may affect the creditworthiness of countries involved

Economic resilience is decided by two factors:
- Economic strength: How strong is the economic structure?
 - Institutional strength: How robust are the institutions and how predictable are the
policies?
Financial robustness is decided upon two factors:
- Government financial strength: How does the debt burden compare with the
governments resource mobilization capacity?
- Susceptibility to event risk: What is the risk of a direct and sudden threat to debt
repayment?

Essential Reading 1: International Country Risk Guide methodology (Topic 2)
https://www.prsgroup.com/about-us/our-two-methodologies/icrg
key points reading:
The International Country Risk Guide (ICRG) rating comprises 22 variables in three subcategories of risk:
political, financial, and economic. A separate index is created for each of the subcategories. Political Risk
index is based on 100 points, Financial Risk on 50 points, and Economic Risk on 50 points (political risk
contributes 50%, financial and economic risk each 25%). Total points from the three indices are divided by
2 to produce the country risk score. Categories: very low risk (80-100), low risk (70-79.9), moderate risk
(60-69.9), high risk (50-59.9), very high risk (0-49.9).
Political risk rating:
- The aim of the political risk rating is to provide a means of assessing the political stability of the
countries covered by ICRG on a comparable basis. This is done by assigning risk points to political

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risk components

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- Components: government stability (12pt), socioeconomic conditions (12pt), investment profile
(12pt), internal conflict (12pt), external conflict (12pt), corruption (6pt), military in politics (6pt),

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religious tensions (6pt), law and order (6pt), ethnic tensions (6pt), democratic accountability
(6pt), bureaucracy quality (4pt). à total 100
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Economic risk rating:
- The overall aim of the Economic Risk Rating is to provide a means of assessing a country’s current
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economic strengths and weaknesses. Strengths > weaknesses à a low economic risk
- Components: GDP per head, real GDP growth, annual inflation rate, budget balance as a percentage
of GDP, current account as a percentage of GDP
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Financial risk rating:

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- The overall aim of the Financial Risk Rating is to provide a means of assessing a country’s ability to
pay its way. In essence, this requires a system of measuring a country’s ability to finance its
official, commercial, and trade debt obligations.
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- Components: foreign debt as a percentage of GDP, foreign debt service as a percentage of exports
of goods and services, current account as a percentage of exports of goods and services, net
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international liquidity as months of import cover, exchange rate stability,

In addition to the current forecasts of Political, Financial, Economic, and Composite Risk, the ICRG team also
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produces one- and five-year forecasts for each of the risk categories, produced using the same methodology
that is used for the current risk forecasts. Two forecasts are produced for each time period – a Worst Case
Forecast (WCF) and a Best Case Forecast (BCF).

Essential reading 2:
a) Greek debt crisis (Topic 2), 2 March 2012
http://www.bbc.co.uk/news/business-13798000
Key points reading:
- Why is Greece in trouble: high spending on public sector, debt for Olympics, public tax evasion
- They already got a lot of money from Europa. In return for this help, Greece had to take major
austerity measures. This again makes it hard to recover and grow.
- If investors stop buying bonds issued by other governments, then those governments in turn will not
be able to repay their creditors - a potentially disastrous vicious circle. To combat this risk,
European leaders have agreed a 700bn-euro firewall to protect the rest of the Eurozone from a full-
blown Greek default.
b) Greece debt crisis: Has Grexit been avoided?
http://www.bbc.com/news/world-europe-32332221
Key points reading:
- Temporary Grexit: believe Greek debt is unsustainable and that a debt write-off - a "haircut" - would
make more sense outside the euro, as it is not allowed inside it. But the terms of re entering terms
are too stringen

Managing country risk:
 - Avoidance
- Diversification
- Syndication: countries getting together to spread risk
- Securitisation: converting loan into a bond
- Offsets
- Hedging
- External guarantees
- Use of government export agencies
- Oversight by the board of directors
- Written risk management policies and procedures
- A system for reporting country exposures
- A process for analysing country risk
- A country risk rating system
- Country exposure limits
- Monitoring of country conditions
- Stress testing and integrated scenario planning
- Internal controls and audit function

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Managing debt crisis:

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- Government defaults have interesting ramification on syndicates
• Free rider problem makes consensus difficult to achieve
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• Lead bank has to inflict penalties on hols out banks (exclusionary provisions
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• An agreement by the majority may bind all members of the syndicate
(supermajority rule)
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- Default by a private borrower may result from sanctions imposed by the

government
- Government’s debt-for-cash plan was used to minimise defaulting of loans
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• This plan meant a loss for banks

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• Banks were assured debt would be serviced in original currency

• Loans did not have to be written off
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• Limiting overall losses on banks books

- Debt securitization: LDC loans held by banks were exchanged for new
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instruments issued by the debtor nation at a lower interest rate or face value
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- Non tradable loans could now be traded on the secondary market

- Debt-equity swap: involved the reimbursement of debt claims in local currency,
which is then used for direct private investment in the debtor country
- Debt for commodity swap: bank-held external debt claim is exchanged for claim
on physical commodities, which can be sold on the world market.
- Secondary market approach: a bank may “throw in the towel” when it sees
fruitless negotiations with debtor country and enters the secondary market.
(Buyer in secondary market has not reason to pay fair value for the loan)
- Tripartite negotiations: involves three parties or parts to the solution (e.g. the
lender, borrower and IMF).

Measuring company exposure to country risk: Two issues
1) Whether country risk should be considered explicitly in valuation, and is the
answer yes, how to do it
2) How to assess a company’s exposure to country risk

How to assess a company’s exposure to country risk:
Exposure to country risk can be measured by three metrics:
1) The default spread on a government bond issues by that country
 2) A premium obtained by scaling up the equity risk premium in the US by
volatility of the country equity market relative to the US equity market and
3) A melded premium where the default spread on the country bond is adjusted for
the higher volatility of the equity market
How to reflect country risk premium in the cost of equity of individual companies?
- Add country risk premium to be the cost of equity of individual companies in a
country, or
- Adjust the cost of equity by a factor (lamda):
• Either as a proportion of revenues or earnings from a country, or
• By regressing a company’s stock returns against country bond returns

Week 3 lecture 3 11/08/2017 risk and regulation (not attended)

Regulatory responses to banking crisis:
- Closer supervision
- Restrictions on asset growth and type of businesses
- Stricter asset quality and concentration risk assessment requirements
- Separation of commercial banking and other businesses of banks (e.g. insurance,

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investment banking)
- Stricter liquidity requirements
- More stringent disclosure requirements
- Redefining capital adequacy requirements. m
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Responses were country-based until liquidation of Herstatt Bank in Germany in 1974.

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Role of capital:
• Strong bank capital base reduces risk in two ways:
- Provides a cushion for absorbing losses from investments that have gone
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sour
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- It allows bank to meet liquidity needs arising from the unanticipated

deposit outflows either through sale of assets without duress or by
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maintaining uninterrupted access to financial markets

• Strong capital requirement intends to benefit the market
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- Reduces incentive for bank to take excessive risk

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- Mitigates the burden of partially subsidizing inefficient or weak banks

through deposit insurance premiums
- Reduces the likelihood of credit crunch
- Price-cutting competition is likely to loose momentum

Bank of International Settlements (BIS):
• World’s oldest international financial organisation (from 1930)
• The mission of BIS is to serve central banks in their pursuit of monetary and
financial stability, to foster international cooperation in those areas and to act as
a bank for central banks
• In broad outline, the BIS pursues its mission by:
- Promoting discussion and facilitating collaboration among central banks
- Supporting dialogue with other authorities that are responsible for
promoting financial stability
- Conducting research on policy issues confronting central banks and
financial supervisory authorities
- Acting as a prime counterparty for central banks in their financial
transactions
- Serving as an agent or trustee in connection with international financial
operations
Basel Committee on Banking Supervision (BSBS):
• A form of regular cooperation on banking supervisory matters
• Its objective is to enhance understanding of key supervisory issues and improve
the quality of banking supervision worldwide.
• The Committee is best known for its international standards on capital
adequacy; the core principles for effective banking supervision; and the
concordat on cross-border banking supervision.
• Committee’s members come from 26 countries.

Basel Capital Accord (‘Basel 1’):
• Basel 1 is now superseded by Basel 2 and Basel 3
Basel 1 Key elements:
• Banks minimum capital requirement based on credit risk of assets.
• Five risk weights are used to convert assets and off-balance sheet exposures into
risk-weighted assets – 0%, 10%, 20%, 50%, 100%.
• Capital is classified into core or ‘Tier 1’ capital (e.g. paid-up share capital,
common stock) and supplemental or ‘Tier 2’ capital (e.g. non- redeemable
preference shares).

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• Bank is required to maintain total Tier 1 and Tier 2 capital not less that 8% of
risk adjusted assets

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• Tier 2 capital is limited to maximum 100% of Tier 1 capital.
• Assets and off-balance sheet exposures are categorised based on their relative
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riskiness. e.g.
- 0% risk weight: cash or claims on central governments or central banks in
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national currency
- 0%, 10%, 20% or 50% risk weight (at national discretion): claims on
domestic public sector companies
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- 20% risk weight: claims on multilateral development banks, such as IBRD,

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ADB; documentary letters of credit

- 50% risk weight: loans secured by residential property, performance bonds
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- 100% risk weight: claims on private sector, financial guarantees.

• These requirements relate to potential losses from:
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- Changes in interest rates and equity prices in the bank’s trading book, and
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- Changes in prices of foreign currency and commodities in all business

activities.
• The major driving force is providing banks with a regulatory impetus to
introduce a strong value management culture into the organisation
• Makes capital requirement more sensitive to the level of risk of individual banks.
• Provides more responsibility to banks to calculate risk-based capital and n
active role to supervisors.

Basel 2: reading 1: International convergence of capital measurement and capital
standards (A Revised Framework Comprehensive Version – Read pages 1 to 11.
http://www.bis.org/publ/bcbs128.pdf
• The Basel 2 accord provides the basis for the regulators (e.g. APRA) in member
countries to formulate standards to be enforced.à implemented in each country
Three pillars of Basel 2:
Pillar 1: minimum Pillar 2: supervisory review process Pillar 3: market
capital requirements discipline
Minimum capital The bank’s own estimation of its capital needs Public disclosure
requirement for credit, can be estimated using economic capital models. of prudential
market and operational Supervisor assesses the amount of capital information
risks. necessary to mitigate Pillar 1 and other risks

The Basel 2 Pillar 1 capital requirement:

The Cook Ratio:

RWA= Risk-Weighted Assets, MRC= Market Risk Capital, ORC= Operational Risk Capital

What is regulatory capital: reading 2: Capital adequacy: Measurement of capital (Focus
on pages1 to 11, page 26 and pages 28 to 42).
http://www.apra.gov.au/adi/Documents/APS111- Capital-Adequacy-January2012.pdf
Key points:
- Tier 1 capital comprises the highest quality capital components. Tier 2 capital includes other
components that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless
contribute to the overall strength of an institution as a going concern.
- Tier 1 capital comprises the highest quality components of capital that fully satisfy all of the
following essential characteristics:
- (a) Provide a permanent and unrestricted commitment of funds;
- (b) Are freely available to absorb losses;
- (c) Do not impose any unavoidable servicing charge against earnings; and
- (d) Rank behind the claims of depositors and other creditors in the event of winding-up.

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APS111 defines capital and its components to meet regulatory requirements
Tier 1 capital
Fundamental Tier 1 (highest capital)
Requirement
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Must constitute at least 75% of net Tier 1 capital
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Residual tier
Non-innovative No more than 25% of Tier 1. Any excess amount is
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counted as Upper Tier 2 capital.

Innovative No more than 15% of Tier 1. Excess is counted as
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Upper Tier 2 capital.

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Tier 2
Upper Tier 2 No more than 100% of Tier 1
Lower Tier 2 No more than 50% of Tier 1
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• Tier 1 capital:
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- Permanent and unrestricted commitment of funds

- Freely available to absorb losses
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- No unavoidable service charges

- Rank behind all debt in the event of wind-up

• Fundamental Tier 1 is highest form of capital, it consists of:
- Paid-up ordinary shares
- General reserves (excluding credit loss reserves)
- Retained earnings
- Foreign currency translation reserves
- Capital profits reserves
- Minority interests in Tier 1 capital of consolidates subsidiaries
• Residual Tier 1 capital: which consists of all other components of capital
qualifying for Tier 1 status, is divided into non-innovative and innovative. In
general residual Tier 1 capital satisfies the following criteria: a) instrument is
unsecured and paid up, b) it’s perpetual, c) does not impose any fixed servicing
costs on the issuer, c) is able to absorb losses incurred by the issuer on a going
concern basis, etc.
- Non-innovative: comprising perpetual non-cumulative preference shares
that satisfy the relevant criteria
- Innovative Tier 1 capital: all other Tier 1 capital
 • Tier 2 capital: Lower quality than Tier 1, but contributes to overall strength of
the bank. It consists of:
- Upper Tier 2 capital: comprising components of capital that are essentially
permanent in nature, including some forms of hybrid capital instrument.
Examples: revaluation reserves, general reserves for credit losses, hybrid
capital instruments
- Lower Tier 2 capital: comprising components of capital that are not
permanent i.e. dated or limited life instruments


Week 4 lecture 4 18/08/2017 Capital Management
Difference between on and off balance sheet: It is contingent, cash flow commitment.

What are the key challenges with Basel 2 implementation?
- Estimation of key inputs – modelling issues, insufficient data history
- System integration challenges and costs
- Poor quality of data in bank’s systems
- What level of capital is required for plausible shocks – Stress testing?

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- Senior management and organisation involvement in integrated risk

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management (cultural change)
- Using rich and granular Basel 2 data to increase shareholder value (economic
capital implementation) m
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Basel 2 Pillar 2:
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- Pillar 1 addresses only capital requirements for credit risk and operational risk
(in Australia interest rate risk in banking book is also included in Pillar 1).
However, banks face many other risks
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- Pillar 2 does not consider all macroeconomic stresses (e.g. GFC)

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- The supervisory review process or Pillar 2 is intended to:

• To ensure that banks have adequate capital to support all the risks in
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their business and

• To encourage banks to develop and use better risk management
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techniques
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Four principles of Basel 2 Pillar 1 (in essential reading 1):
- Principle 1: Banks should have a prove for assessing their overall capital
adequacy in relation to their risk profile and a strategy for maintaining their
capital levels (ICAAP)
- Principle 2: Supervisors should review and evaluate banks’ internal capital
adequacy assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors should take
appropriate supervisory action if they are not satisfied with the result of this
process.
- Principle 3: Supervisors should expect banks to operate above the minimum
regulatory capital ratios and should have the ability to require banks to hold
capital in excess of the minimum.
- Principle 4: Supervisors should seek to intervene at an early stage to prevent
capital from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial action if
capital is not maintained or restored.
These Pillar 2 principles are directed at supervisory review and response, rather
than on quantifying minimum regulatory capital requirements in excess
of those arising from Pillar 1

Five features of ICAAP:
- Board of directors (Board) and senior management oversight
- Sound capital assessment
- Comprehensive assessment of risks
- Monitoring and reporting
- Internal control review

Basel 2 pillar 2
Essential reading 1 (Topic 4): Implementation of the Basel II Capital Framework
Supervisory Review Process
www.apra.gov.au/adi/Documents/APRA_IP_PillarII_ 122007_v3.pdf

Basel 2 Pillar 3:
- Strengthen the stability and soundness of the financial system through public
discourse of material risk and capital information
- These disclosures relate to: quality of capital, capital requirements for Pillar 1
risks, qualitative and quantitative information on risks in portfolio segments,

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risk mitigation strategies, risk management processes and so on..

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Basel 2 Pillar 3 – Capital Management at ANZ
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Essential Reading 2 (Topic 4): ANZ Bank‟s Basel II Pillar 3 disclosure for FYE Sept.2014
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(pages 1 to 18 and page 22)
https://www.shareholder.anz.com/sites/default/files/ANZ's%20September%202014
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%20Pillar%203%20disclosure.pdf

What are the Basel 3 changes?
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- Redefine minimum capital requirement: Effective 2013, increase the Common

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Equity Tier 1 ratio to 4.5% (2% under Basel II); increase the Tier 1 capital ratio
to 6% (4% under Basel II) and keep the total capital ratio at 8% (same under
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Basel II).
- Redefine the composition of eligible capital: Make the eligibility criteria more
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stringent for capital instruments to be accepted as Tier 1 and Tier 2.

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- Introduce a capital conservation buffer: Require banks to hold on an additional

2.5% of Common Equity Tier 1. As a result, the minimum Common Equity Tier 1
will be 7%.
- Build up a countercyclical capital buffer of up to 2.5%: The intention is to keep
aside some additional Common Equity in years of strong credit growth to
provide additional protection in a downturn. APRA is yet to decide on the
implementation of this buffer.
- Introduce a Tier 1 Leverage Ratio requirement: The intention is to supplement
the risk-based capital ratios with a simple measure based on exposures. This will
be set initially at 3%.
- Introduce the minimum liquidity ratio requirements: Banks are required to
maintain two liquidity ratios above 100%.

Current status of international banking:
Essential reading 3 (topic 4): The Economist Special Report International Banking (pp.
6-8 “How much is enough?”)
Key points reading:
- Too much capital could result in large unprofitability (resulting in higher borrowing costs and
slower economic growth), while too little capital could leave banks crisis prone and in need of
regular bailouts (Greece).
International banking notes w5-12


Week 5 lecture 5 25/08/2017 Credit Risk Management (not attended)

Credit risk: It is the potential for loss due to a counterparty failing to meet its financial
obligations in accordance with agreed terms
Sources of credit risk for a bank:
- Direct lending
• Large corporates
• Small and medium business
• Retail
- Traditional off-balance sheet business (e.g. direct credit substitutes, commitments)
- Investments
- Capital market operations (e.g. bonds, derivatives trading)

The collapse of Lehman Brothers: Essential reading 1 (Topic 5): Case study: Lehman
Brothers – Too big to fail? http://siteresources.worldbank.org/FINANCIALSECTOR/Reso
urces/J3-LehmanBrothersCaseStudy.pdf

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1. What were the reasons why Lehman changed from a conservative financial services organisation to a high-risk

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organisation?
2. What are the key reasons for its downfall?

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3. In hindsight, if you were the chief risk officer of the firm, list three changes you would have made in the firm’s
approach to credit risk management?
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4. What is the regulatory weaknesses which played a role in the downfall of Lehman?

How does corporate credit risk evolve?
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Approaches differ based on the nature of counterparty

1) Retail credit scoring models
- Retail business characterised by large number of transactions and relatively small
amounts of individual exposures.
- A credit score is calculated for each application for credit (e.g. home loans, credit cards)
based on a proprietary scoring formula.
Key features of a credit scoring model:
- Appropriate weights are assigned to attributes about the borrower such as credit
history, stability of employment, income and the security for the loan.
- To select the attributes and their weights, statistical analysis of large sample of historical
data on defaulted and good loans are undertaken. In this analysis, the scores are mapped
to the default probabilities associated with them.
- In addition to information provided by the credit applicant, the lender often sources
information about application through credit rating agencies (e.g. Veda Advantage in
Australia).
- Based on how an applicant rates on each attribute an aggregate credit score is calculated
using the scoring scheme. This process is automated. Higher the score the better is the
application.
- Typically aggregate scores are segmented into bands to represent the credit worthiness
of the application. For example, 1 = very strong, 2 = strong, 3 = satisfactory, 4 = weak and
5 = very weak. In this example, if an application scores 4 or 5, it is likely to be rejected.
Receiver operating characteristic (ROC) curve:

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- Hit rate: the number of defaulters correctly identified by the model/Total defaulters in
the sample
- False alarm rate: The number of non-defaulters incorrectly classified as defaulters/Total
non-defaulters in the sample
Credit models for SMEs:
- The risk of an SME may be assessed through an automated rating scheme involving
financial and qualitative factors or a combination of the two methods
- Credit decisions based only on automated credit scores are preferred only for small
amounts of credit.
- These scoring models are built using selected financial ratios to predict probability of
default or bankruptcy of the company.
- In the 1960s, Edward Altman published a model to predict bankruptcy of firms by
constructing a Z-score from financial information. The Z-score is derived from 5 financial
ratios calculated using 8 inputs from financial statements.
- A low Z-score means higher risk of bankruptcy. Firms with Z-scores above 3 are
considered are unlikely to enter bankruptcy. Scores in between 1.8 and 2.7 indicate a
high chance of the firm going bankrupt in two years.

2) Corporate credit rating
- Providing credit to large corporations involve detailed analysis in view of typically large
exposures involved in these transactions
- The credit analysis involves financial projections, ratio analysis, cash flow analysis,
assessment of industry and economic conditions and the management’s ability to
provide leadership to the company in stressed scenarios.

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Estimation of credit losses:
Expected credit loss = EAD x PD x LGD m
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EAD = Exposure at the time of default, and
LGD = Loss given a default has happened.
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What is the expected credit loss?

- A $50 million loan with a credit rating of Baa by Moody’s. The loan is collateralised with
real estate.
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- The probability of default can be derived from the credit rating, say 1.32%.
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- The loss in the event a default has happened for a similar loan is estimated at, say 60%.
- What is the expected credit loss?
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- The expected credit loss = $50 million x 0.0132 x (0.6) = $0.40 million
Credit default swaps: swap designed to transfer the credit exposure of fixed income products
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between parties. A credit default swap is also referred to as a credit derivative contract, where
the purchaser of the swap makes payments up until the maturity date of a contract. Payments are
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made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this
party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS
might be speculating on the possibility that the third party will indeed default.

Basel 2 – Regulatory capital for credit risk
- Risk Weighted Assets (RWA) are calculated based on four parameters
• Probability of default (PD),
• Loss given default (LGD)
• Exposure at default (EAD), and
• Maturity adjustment (M)
- Regulatory capital is set at 8% of total RWA
- There are certain differences in the formulas based on the segment of the credit portfolio
(e.g. corporate credit or retail credit).


Sound practices for the management of credit risk address four areas:
1) Establishing an appropriate credit risk environment (3 principles)
2) Operating under a sound credit granting process (4 principles)
3) Maintaining an appropriate credit administration measurement and monitoring process
(6 principles)
4) Ensuring adequate controls over credit risk (4 principles)
Common cause of major credit problems:

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- Credit concentrations

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- Credit process issues
- Market and Liquidity-Sensitive Credit Exposures

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Principles for the management of credit risk: essential reading 2 (Topic 5): Principles for the
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management of credit risk (including appendix) http://www.bis.org/publ/bcbs75.pdf

1. What are the key areas to focus on in managing credit risk?
2. What are the two categories of credit concentrations? Give examples.
3. What are market and liquidity sensitive credit exposures? Give examples.
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Estimating default probabilities

- Alternatives
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• Use historical data

• Use bond prices or asset swaps
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• Use CDS spreads

• Use Merton’s model
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Historical data: historical data provided by rating agencies can be used to estimate the
probability of default
Cumulative average default rates % (Moody’s):

- Table shows the probability of default for companies starting with a particular credit
rating
- A company with an initial credit rating of Baa has a probability of 0.181% of defaulting
by the end of the first year, 0.510% by the end of the second year and so on.
Do default probabilities increase with time?
- For a company that starts with a good credit rating default probabilities tend to increase
with time.
- For a company that starts with a poor credit rating default probability tend to decrease
with time.

Hazard rate vs. Unconditional default probability
- The hazard rate or default intensity is the probability of default over a short period of
time conditional on no earlier default
- The unconditional default probability is the probability of default as seen at time zero
Properties of Hazard rates
- Suppose that Suppose that !(!) is the hazard rate at time t
- The probability of default between times t and ! + ∆! conditional on no earlier default is
!(!)∆!
- The probability of default by time t is 1 − ! !! ! !
where !(!) is the average hazard rate between time zero and time t

Recovery rate: the recovery rate for a bond is usually defined as the price of the bond 30 days
after default as a percent of its face value.
Recovery rates depend on default rates:
- Moody’s best fit estimate for the 1982 to 2007 period is
!"# !"#$%"!& !"#$ = 59.33 − 3.06×!"#$ !"#$% !"#$%&' !"#$
- R^2 of regression is about 0.5

More exact calculation for bonds:

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- Suppose that a five-year corporate bond pays a coupon of 6% per annum (semi-
annually). The yield is 7% with continuous compounding and the yield on a similar risk-

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free bond is 5% (with continuous compounding)
- The expected loss from defaults is 8.75. This can be calculated as the difference between
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the market price of the bond and its risk-free price
- Suppose that the unconditional probability of default is Q per year and that defaults
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always happen half way through a year (immediately before a coupon payment).
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Calculations:
- We set 288.48Q = 8.75 to get Q = 3.03%
- This analysis can be extended to allow defaults to take place more frequently
- With several bonds we can use more parameters to describe the default probability
distribution

Components of a sound credit risk management program: Essential reading 3 (Topic 5):
Components of a Sound Credit Risk Management Program
https://www.frbatlanta.org/-/media/documents/banking/publications/components-of-a-
sound-credit-risk- management-program.pdf
1. Discuss key components of sound credit risk management framework in a bank
2. What are the key challenges in underwriting commercial loans and commercial real estate loans?
3. What are major lending mistakes banks make?



Week 6 lecture 6 01/09/2017 Managing Operational Risk

What are the seven sources of operational risk for a bank?
1. Internal Fraud: misappropriation of assets, tax evasion, bribery
2. External Fraud: theft of information, hacking damage, third-party theft and forgery
3. Employment Practices and Workplace Safety: discrimination, workers compensation,
employee health and safety
 4. Clients, Products, & Business Practice: market manipulation, antitrust, improper
trade, product defects, fiduciary breaches, account churning
5. Damage to Physical Assets: natural disasters, terrorism, vandalism
6. Business Disruption & Systems Failures: utility disruptions, software failures,
hardware failures
7. Execution, Delivery, & Process Management: data entry errors, accounting errors,
failed mandatory reporting, negligent loss of client assets

Key findings from operational risk capital estimates by region (2008 LDCE):
• The business line with the highest loss frequency and total loss amount was Retail. Retail
Banking continues to be a primary business line for most participants
• The Basel event types with the highest frequency of losses were Execution, Delivery, and
Process Management (EDPM), followed by External Fraud.
• The event type with the highest annual loss amount was Clients, Products, and Business
Practices (CPBP).
• The total loss amount for the typical bank for losses of €20,000 or more was €155,555
per year for each billion euros in consolidated assets.
• For the typical AMA bank, the loss amount was €196,655, which was higher than the loss
amount of €116,838 for the typical non-AMA bank.
• The ratio of operational risk capital to gross income for AMA bank was lower than non-

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AMA bank.

Does operational risk matter?
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From the 2008 LDCE data, we see that the average operational risk losses are not that high
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relative to the total income of banks? So why bother about measuring and managing this risk?
- UBS’s US $2 billion loss (2011): Unauthorised trading at its investment bank in London
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last year. The trader, Kweku Adoboli, took unauthorised open positions in synthetic
funds tracking European indexes by creating fictitious hedge positions.
- Société Générale €4.9 billion (2008): Trader, Jérôme Kerviel, had hidden the losses on
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the bank’s Delta One desk

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- National Australia Bank A$360 million (2004): A group of four currency-options

traders at the National Australia Bank (NAB) made the losses in unauthorised trades
- Allied Irish Banks US$691 million (2002): John Rusnak, a trader for Allied Irish Banks
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(AIB) in Baltimore, made the losses in bad currency bets that he hid with fictional trades.
- Barings Bank’s US$1.3 billion loss (1995): Nick Leeson brought down the bank by
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hiding an the loss in his supposedly lucky secret “five eights” account in Singapore
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- Daiwa Bank US$1.1 billion (1995): Toshihide Iguchi, who accumulated losses of
$1.1bn in bond trading at New York

Difficulties in measuring operational risk:
- Can we have exhaustive identification of all operational risk drivers?
- How much can internal or external loss data be relied up to predict future losses?
- Given the less frequent occurrences of major operational risk events, will we ever have
enough data to make reliable predictions?
- How to develop statistical approaches to make reliable predictions given the nature of
data and its limited availability (the sting is in the tail!)?
- How do we develop reliable operational risk scenarios?
 - How to incorporate the effectiveness of internal controls and mitigating actions on
estimation of losses?

How is operational risk capital calculated?
Basic Indicator Standardised Advanced Measurement
- Operational risk capital - Bank’s business divided into Operational risk capital
is 15% of average gross eight business lines estimated by the bank
income in the past 3 - Capital calculations for retail based on:
years and commercial banking is - Internal loss data
- Gross income is gross of based on gross outstanding - External loss data
provisions and operating loans and advances - Scenario analysis
expenses, but net of - For other businesses, - Business environment
interest expenses. calculations are based on gross and internal control
income systems
- Weightages differ from 12% to
18%

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Basel 2 – standardised approach for operational risk capital:

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Basel 2 – advanced measurement approach for operational risk capital:
- “An ADI must be able to demonstrate to APRA that its ORRC, as determined by the ADI’s
operational risk measurement model, meets a soundness standard comparable to a one-
year holding period and a 99.9 per cent confidence level”
 - “An ADI’s ORRC must cover expected losses (EL) and unexpected losses (UL) unless the
ADI can demonstrate to APRA that it has adequately measured and accounted for EL in
its business practices by way of EL offsets.”
- Appropriate insurance can mitigate up to 20% of operational risk.

Principles for sound management of operational risk:
- Principle 1: The board of directors should take the lead in establishing a strong risk
management culture and appropriate standards throughout the organisation
- Principle 2: Banks should develop, implement and maintain a Framework that is fully
integrated into the bank’s overall risk management processes
The board of directors:
- Principle 3: The board of directors should establish, approve and periodically review
the framework. Ensure that policies, processes and systems are implemented effectively
- Principle 4: The board of directors should establish, approve and review a risk appetite
and tolerance statement for operational risk that articulates the nature, types, and levels
of operational risk that the bank is willing to assume.
Senior management:
- Principle 5: Senior management should develop for approval by the board of directors a
clear, effective and robust governance structure with well defined, transparent and
consistent lines of responsibility

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Risk management environment: identification and assessment
- Principle 6: Senior management should ensure the identification and assessment of the
operational risk inherent in all material products, activities, processes and systems to
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make sure the inherent risks and incentives are well understood
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- Principle 7: Senior management should ensure that there is an approval process for all
new products, activities, processes and systems that fully assesses operational risk.
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Risk management environment: monitoring and reporting

- Principle 8: Senior management should implement a process to regularly monitor
operational risk profiles and material exposures to losses
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Control and mitigation:

- Principle 9: Banks should have a strong control environment that utilises policies,
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processes and systems; appropriate internal controls; and appropriate risk mitigation
and/or transfer strategies. Internal controls should be designed to provide reasonable
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assurance that a bank will have efficient and effective operations.

Business resiliency and continuity:
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- Principle 10: Banks should have business resiliency and continuity plans in place to
ensure an ability to operate on an on-going basis and limit losses in the event of severe
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business disruption. Plans should take into account different types of likely or plausible
scenarios to which the bank may be vulnerable.
Role of Disclosure:
- Principle 11: A bank’s public disclosures should allow stakeholders to assess its
approach to operational risk management. A bank’s public disclosure of relevant
operational risk management information can lead to transparency and the development
of better industry practice through market discipline.

Essential reading 1 (Topic 6): Principles for sound management of operational risk (pages 1 to
17) http://www.bis.org/publ/bcbs195.pdf
1. You are a member of the risk management committee of the board at a large bank. What are some actions you
may take to implement principle 1? - The board should establish a code of conduct or an ethics policy that sets
clear expectations for integrity and ethical values of the highest standard and identify acceptable business
practices and prohibited conflicts. Clear expectations and accountabilities ensure that bank staff understand
their roles and responsibilities for risk, as well as their authority to act.
2. Discuss the advantages and disadvantages of the tools for identification and assessment of operational risk
(principle 6)?
3. The bank is outsourcing all its IT services. Discuss the controls and monitoring it should institute to make
outsourcing a success (principle 9)?
The Committee intends that when implementing these principles, a bank will take account of the nature, size, complexity
and risk profile of its activities.

Contingency planning and business continuity: case study
Essential reading 2 (Topic 6): Another day, another trading scandal: The case of National
Australia Bank. In: Corporate Governance Case Studies Edited by Mak Yuen Teen Volume two.
http://governanceforstakeholders.com/wp-content/uploads/2013/05/CPA-CG-Case- Studies-
Vol2-0410.pdf
1. Evaluate the effectiveness of the board at NAB.
2. Were there other aspects of corporate governance at NAB that were problematic?
3. In 2003, the currency option control issues were not reported to Principal Board Audit Committee (PBAC)
despite it being a “3-star” problem. The Internal Audit function believed that the monetary value of this issue to
be less than A$5 million threshold. Was the reliance of the PBAC on Internal Audit to screen the firm’s control
issues reasonable? Should PBAC only have reviewed issues with a “3-star” and above rating? Discuss the
impact of using such a screening mechanism on NAB between 1999 and 2004.
4. In your opinion, what has to be done to improve the corporate governance at NAB?
5. Prior to the NAB trading scandal, rogue trader Nick Leeson’s unauthorised trading led to the collapse of
Barings Bank. More recently, Societe-Generale, UBS and JP Morgan also reported massive losses from
unauthorised trading. Why do such trading scandals continue to happen in banks? Are banks too complex to
govern and manage well?
There were cases of unauthorized foreign currency derivatives trading that resulted in losses of $360 million. The bank
had lax management as it had ignored the warning signs of irregular currency options trading practices.
Background: NAB provides personal and business financial services, including credit cards and loans. Traders discovered
that there was a one-hour window between the bank’s close-of-day and the review time, which allowed them to
manipulate the profits recorded. The culture of poor adherence to rules, responsibility shirking and suppression of bad
results was partly a consequence of the profit-oriented culture. At NAB the managers kept the directors in the dark. The
directors trusted the management deeply and relied on the information supplied. Collectively, the inaction of both parties
allowed the scandal to go unnoticed for a long time. According to the Chief Executive weak internal controls enabled the

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traders to carry out the fraud. In the end they were prosecuted and received jail terms.


Week 7 lecture 7 01/09/2017 Managing Market Risk and Liquidity Risk m
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Market risk: Risk that the value of an investment will decrease due to moves in market forces
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Types of market risk:

- Interest rate risk: the potential for loss due to changes in interest rates
- Foreign exchange risk: potential for loss due to currency fluctuations
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- Equity or commodity price risk: potential for loss due to changes in share prices or
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commodity prices

Standardised approach for market risk:
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- Regulator-specified capital weights for different types of market risk positions (e.g.
interest rate, foreign exchange risk, commodities, equities, derivatives risk).
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- For example, for investment grade bonds with greater than 2 years maturity, the specific
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risk capital charge is 1.6%.

Market risk measurement:
- The potential for loss of a portfolio of market sensitive exposures is commonly measured
using the Value at Risk (VaR) methodology
- Due to certain limitations of VaR, another method called Expected Shortfall is also used
by some
Value at Risk (VaR):
- Two parameters are involved in the definition of VaR, namely the confidence interval
(say 99%) and the time period (say 10 days) over which we want to estimate the losses

from the portfolio

Internal model approach:
- Market risk losses are estimated using VaR measure
- Holding period 10 days, one-tailed confidence interval 99% (i.e. it is focused on the
revaluation loss over a 10-day period that is expected to be exceeded only 1% of the
time).
- The historical observation period (sample period) chosen for calculating VaR must have
a minimum length of one year.
 - Basel III requires banks to calculate additionally stressed value-at-risk taking into
account a one-year observation period relating to significant losses.

Approaches to calculate VaR:
- The parametric approach assumes portfolio returns are normally distributed and
therefore uses the properties of normal distribution to estimate VaR.
- Historical simulation approach estimates VaR based on the assumption that data on
past changes in the market variables are a guide to the future.
- The Monte Carlo simulation approach generates a probability distribution of returns
using drivers of the returns and their probability distributions.

Weaknesses of Parametric approach:
- Requires assumption of symmetric distribution of asset returns (e.g. normal
distribution)
- Asset returns may not be symmetric (e.g. call or put options)
- Many asset returns have ‘fat’ tails
- For FIs with les diversified portfolios, it tends to significantly underestimate VaR
- Estimating correlations between returns of assets pose challenge and these correlations
may breakdown under stressed conditions

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Historic or Back simulation:
- Basic idea: revaluate portfolio based on actual prices (returns) on the assets that existed
yesterday, the day before that, etc (usually previous 500 days)
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- Then calculate 5% worst-case (25th lowest value of 500 days) outcomes
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- Only 5% of the outcomes were lower
Advantages:
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- Simplicity
- Doesn’t need correlations or standard deviations of individual asset returns
- Doesn’t require normal distribution of returns (which is a critical assumption for
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RiskMetrics)
- Directly provides a worst case value
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Weaknesses:
- 500 observations is not very many from a statistical standpoint
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- Increasing number of observations by going back further in time is not desirable

- Could weight recent observations more heavily and go further back
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Monte Carlo Simulation
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- To overcome problem of limited number of observations, synthesize additional

observation (perhaps 10000 real and synthetic observations)
- Employ historic covariance matrix and random number generator to synthesize
observations (objective is to replicate the distribution of observed outcomes with
synthetic data)

Use of VaR to manage risk
- When undertaking capital market trading position, what matters is not the size of the
position, but it’s the capital risk that matters
- VaR is used to set limits for the organisation, desks or individual traders
- Using Var instead of the traditional setting limits based on the dollar value of the
position has many advantages but also weaknesses
- All the banks which ran out capital during GFC were all complying with regulatory
capital requirements based on VaR calculations

Managing market risk:
Essential reading 1 (Topic 7): Managing market risk: Today and tomorrow
http://www.mckinsey.com/business-functions/risk/our-insights/managing-market-risk-today-
and-tomorrow
1. What are the factors banks take into account in choosing between Monte Carlo simulation and historical
simulation for calculating VaR? The Monte Carlo method is widely considered the better theoretical approach
to simulation of risk. But Monte Carlo places a burden of complexity on the bank. The result is often a
computational bottleneck that leads to much longer reaction times compared with the easier but less accurate
 historical simulation. In addition, many complain that it is a “black box,” which is not easily understood by
either the businesses or management. The majority uses historical simulation. Banks recognize the theoretical
limitations of this approach: its projections are directly derived from the distribution of past occurrences and
may be irrelevant or even unhelpful if the future is statistically different from the past. But because of its
greater simplicity most banks now favor the historical approach.
2. Explain key practices in the banking industry for modelling VaR.
3. What are some implications of choice of VaR modelling approaches to a bank’s IT, steering framewok and
governance? Any improvements in market risk modeling must be supported by corresponding changes in risk
IT. The complexity of today’s trading portfolios and pricing models presents obvious challenges to systems and
infrastructure.

Liquidity risk: The potential for loss because a bank may not be able to fund increases in assets
and meet obligations as they come due, without incurring unacceptable losses

Managing liquidity risk:
Essential reading 2 (Topic 7): Mayes, David G, and Wood, Geoffrey E, ‘The Northern Rock Crisis in
the UK’ in The failure of Northern Rock: A multidimensional case study, eds.
- What are the implications of the Northern Rock crisis? Firstly, depositors need to get the entire deposit back
otherwise they will withdraw at least the uninsured portion and possibly the whole sum, as this involves no
extra effort. At Northern Rock 90% of deposits were covered and therefore most depositors had something at
risk. Secondly, depositors require continuing access to their deposits. The UK (like whole EU) has an obligation
to pay out depositors within three months but this is extendable. The result in many countries is that they do
not know how long it would take to pay out depositors in the event of a substantial failure.

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kept operating. The size to be kept operating is smaller than many people thought.
- How may these implications be useful to other countries? The major lesson the US learnt is the importance of

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‘Structured Early Intervention and Resolution; (SEIR) and of ‘Prompt Corrective Action’ (PCA). The authorities
need to be compelled to act early as signs of distress emerge. What Northern Rock added to this realisation is
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that the capital triggers for action cut in too late in the US. There are thus two obvious sources of info to be
used, namely Pillars 2 and 3, the supervisory review of risks and the information that is publicly disclosed. The
major conclusion of the tripartite authorities following the Northern Rock is that the UK needs a special
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resolution regime for banks. Now, the UK uses normal insolvency provisions in company law for banks.
Conclusion: 5 main lessons
1. Deposit insurance needs to be designed so that: a) the large majority of all individuals’ balances are fully
covered, b) depositors can all have access to their deposits without a material break
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2. The activation of emergency liquidity assistance arrangements needs to give confidence that those being
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assisted will survive, and should be seen as the system working as it should, rather than signalling breakdown
3. There needs to be a regime of prompt corrective action for supervisors whereby prescribed actions of
increasing severity are required within short time periods according to a set of triggers based on capital
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adequacy and risks of failure.

4. There needs to be a legal framework such that the functions of systemic importance in banks that fail can be
kept operating without a material break.
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a) Such ‘failure’ should occur before the bank becomes insolvent so that there is little chance of losses to the
taxpayer
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b) This will normally involve a special insolvency regimes for banks

5. Some designated institution needs to be in charge of intervention in failing banks to ensure rapid action

Implications of Northern Rock:
1. Effectiveness of deposit insurance scheme
2. Redefining too big to fail
3. Standing facilities and emergency funding
4. Early intervention
5. A special resolution regime for the banks
6. Regulatory responsibility and coordination

Basel 3 liquidity standards:
!"#$% !" !!"!!!"#$%&' !"#$"% !""#$"
Liquidity coverage ratio: > !" = 100%
!"#$% !"# !"#! !"#$%!&' !"#$ !!! !"#$ !" !"#$%&$' !"#$
!"#$%#&!" !"#$%& !" !"#$%& !"#$%#&
Net stable funding ratio: > !" = 100%
!"#$%&"' !"#$%& !" !"#$%& !"#$%#&

Stress testing – it’s role in bank management:
- Providing forward-looking assessments of risk
- Supporting internal and external communication
- Feeding into capital and liquidity planning procedures
- Informing the setting of a banks’ risk tolerance
 - Facilitating the development of risk mitigation or contingency plans across a range of
stressed conditions
Stress testing – principles for banks:
Use of stress testing and integration in risk governance:
1. Stress testing should form an integral part of the overall governance and risk
management culture of the bank. Stress testing should be actionable, with the results
from stress testing analyses impacting decision-making at the appropriate management
level, including strategic business decisions of the board and senior management. Board
and senior management involvement in the stress testing programme is essential for its
effective operation.
2. A bank should operate a stress testing programme that promotes risk identification and
control; provides a complementary risk perspective to other risk management tools;
improves capital and liquidity management; and enhances internal and external
communication.
3. Stress testing programmes should take account of views from across the organisation
and should cover a range of perspectives and techniques.
Use of stress testing and integration in risk governance
4. A bank should have written policies and procedures governing the stress testing
programme. The operation of the programme should be appropriately documented.
5. A bank should have a suitably robust infrastructure in place, which is sufficiently flexible

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to accommodate different and possibly changing stress tests at an appropriate level of
granularity.
6. A bank should regularly maintain and update its stress testing framework. The
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effectiveness of the stress testing programme, as well as the robustness of major
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individual components, should be assessed regularly and independently.
Stress testing methodology and scenario selection
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7. Stress tests should cover a range of risks and business areas, including at the firm-wide
level. A bank should be able to integrate effectively, in a meaningful fashion, across the
range of its stress testing activities to deliver a complete picture of firm-wide risk
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organisation and should cover a range of perspectives and techniques.

8. Stress testing programmes should cover a range of scenarios, including forward-looking
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scenarios, and aim to take into account system-wide interactions and feedback effects.
9. Stress tests should feature a range of severities, including events capable of generating
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the most damage whether through size of loss or through loss of reputation. A stress
testing programme should also determine what scenarios could challenge the viability of
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the bank (reverse stress tests) and thereby uncover hidden risks and interactions among
risks.
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10. As part of an overall stress testing programme, a bank should aim to take account of
simultaneous pressures in funding and asset markets, and the impact of a reduction in
market liquidity on exposure valuation.
Specific areas of focus:
11. The effectiveness of risk mitigation techniques should be systematically challenged.
12. The stress testing programme should explicitly cover complex and bespoke products
such as securitised exposures. Stress tests for securitised assets should consider the
underlying assets, their exposure to systematic market factors, relevant contractual
arrangements and embedded triggers, and the impact of leverage, particularly as it
relates to the subordination level in the issue structure.
13. The stress testing programme should cover pipeline and warehousing risks. A bank
should include such exposures in its stress tests regardless of their probability of being
securitised.
14. A bank should enhance its stress testing methodologies to capture the effect of
reputational risk. The bank should integrate risks arising from off-balance sheet vehicles
and other related entities in its stress testing programme.
15. A bank should enhance its stress testing approaches for highly leveraged counterparties
in considering its vulnerability to specific asset categories or market movements and in
assessing potential wrong-way risk related to risk mitigating techniques.

Essential reading 3 (Topic 7): Principles for sound stress testing practices and supervision
http://www.bis.org/publ/bcbs147.pdf Read sections titled “Introduction” (page 1) and
“Principles for banks” (pages 8 to 17).
1. Discuss the role of stress testing in banks: Stress testing is an important risk management tool that is used by
banks as part of their internal risk management and, through the Basel II capital adequacy framework, is
promoted by supervisors. Stress testing alerts bank management to adverse unexpected outcomes related to a
variety of risks and provides an indication of how much capital might be needed to absorb losses should large
shocks occur.
2. Discuss the key principles for stressing testing in banks relating to integration of the testing into risk
governance, selection of methodology and scenarios and specific areas of focus.

A stress test is commonly described as the evaluation of a bank’s financial position under a severe but plausible scenario
to assist in decision making within the bank


Fund transfer pricing:
- In a bank, deposits are used to fund many types of assets. We can estimate the cost of
deposits, but returns on deposits are hard to estimate.
- We can estimate returns on loans. However, estimating the cost is difficult, because a
loan is funded by different sources of deposits and other funds
- Therefore, a function, such as Treasure, establish ‘fund transfer prices’. These prices are
used to estimate returns of deposits (bank branches) and of loans.
- The foundation approach is traditionally used for fund transfer pricing

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- The estimation of FTP depends on whether the products have fixed maturities or
undefined maturities.
- Post-GFC, there are arguments that the foundation approach has major weaknesses
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- There are views that the approach should be modified to incorporate rationing on the
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inter-bank market, Basel 2 liquidity buffer, credit risk of individual assets, liquidity
premium for long-term funding.
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Week 8 lecture 8 15/09/2017 Managing Market Risk and Liquidity Risk continued
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Global Systematically Important Banks (G-SIB):
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- A G-SIB is defined as a financial institution whose distress or disorderly failure, because

of its size, complexity and systemic interconnectedness, would cause significant
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disruption to the wider financial system and economic activity

- Failure of a G-SIB will have significant impact on financial institutions in many countries
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and on the global economy.

- It’s therefore important to reduce the probability of failure of G-SIBs by increasing their
going-concern loss absorbency
- It is important to: 1) assess systematic importance of G-SIBs, 2) specify additional
regulatory capital requirements for G-SIBs

G-SIB: Indicator-based measurement approach:
- Measures the systematic importance of G-SIBs along 5 dimensions:
• Size of the bank
• Interconnectedness: Financial distress at one institution can materially increase the
likelihood of distress at other institutions.
• Lack of readily available substitutes or financial institution infrastructure: For
example, the greater a bank’s role in a particular business line, or as a service
provider in underlying market infrastructure (eg payment systems), the larger the
disruption will likely be following its failure
• G-SIB’s global (cross-jurisdictional) activity: the importance of the bank’s activities
outside its home (headquarter) jurisdiction
• G-SIB’s complexity: the more complex a bank is, the greater are the costs and time
needed to resolve the bank
- An equal weight of 20% is assigned to each of these dimensions.
- Except for ‘size’, multiple indicators are used for the other dimensions.
 - For each bank, a score is calculated for each indicator by dividing the bank’s amount by
the aggregate amount for the particular indicator summed across all sample banks.
- Banks scoring above a specified cut-off score will be a G-SIB.

G-SIB: Bucketing approach of indicator scores:
Each year, the Committee will run the assessment again and, if necessary, reallocate G-SIBs into
different categories of systemic importance based on their scores. G-SIBs will be initially
allocated into four equally sized buckets based on their scores of systemic importance

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Although the bucket thresholds will be set initially such that bucket 5 is empty, if this bucket
should become populated, a new bucket will be added to maintain incentives for banks to avoid
becoming more systemically important.
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G-SIB: Loss absorbency requirement

Bucket Score range Higher loss absorbency requirement
(common equity as a percentage of
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risk-weighted assets)
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5 D-E 3.5%
4 C-D 2.5%
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3 B-C 2.0%
2 A-B 1.5%
1 Cutoff point - A 1.0%

G-SIB: Timetable for implementation:
2013 Mar: Collection of end-2012 data
Nov Publish updated draft list of G-SIBs
Publish cutoff scores, bucket sizes and denominators
2014 Jan: Implementation of national reporting and disclosure requirements
Mar: Collection of end-2013 data
Nov: Publish updated list of G-SIBs to be subject to HLA requirement from 1 jan 2016
and updated denominators
2015 Mar: Collection of end-2014 data
Nov: Publish updated list of G-SIBs to be subject to HLA requirement from 1 jan 2017
and updated denominators
2016 Jan: HLA requirement applied to banks: designated as G-SIBs published in Nov 2014
Mar: Collection of end-2015 data
Nov: Publish updated list of G-SIBs to be subject to HLA requirement from 1 jan 2018
and updated denominators
2017 Jan: HLA requirement applied to banks: designated as G-SIBs published in Nov 2015
Mar: Collection of 2016 data
Nov: Complete first methodology review and announce changes
 Publish updated list of G-SIBs to be subject to HLA requirement from 1 jan 2018
and updated denominators

Essential reading 1 (Topic 7 Part B): Global systemically important banks: updated assessment
methodology and the higher loss absorbency requirement
- What are the imperatives for establishing G- SIBs?
- Critique the approach adopted for identifying G- SIBs.
- What are some other possible approaches you suggest?

Essential reading 2 (Topic 7 Part B): Deutsche Bank Troubles Raise Fear of Global Shock reading
https://www.nytimes.com/2016/10/01/business/dealbook/deutsche-bank-stock-
bailout.html?action=click&contentCollection=DealBook&module=RelatedCoverage&region=EnOf
Article&pgtype=article&_r=0
- What are the key drivers of crisis at Deutsche Bank?
- What are the potential implications if the crisis is not contained?
- What do you think are the possible solutions to handle the crisis?


Week 8 continued: Structured Finance

Securitization:

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Traditionally banks collected savings from customers and used these savings to finance home

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mortgages. It’s very difficult to achieve real economies of scale in this situation. With
securitization, banks put together portfolios of mortgages called Mortgage Backed Securities.
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Like bond holders the MBS owners received regular payments from the mortgages.
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- In theory a portfolio of mortgages is less risky than individual mortgages as long as the
mortgages are truly diversified
- This lower risk made it easier to sell MBSs to a wider range of investors
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- As the MBS was no longer on the banks books it meant the banks could lend more
- Securitization let banks significantly reduce the cost of collecting savings & selling
mortgages
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- Banks went beyond home mortgages and developed Asset Backed Securities ABS that
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consisted of other loans e.g. car/credit card

- To increase demand they packaged these into tranches with different risks & rewards
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- Returns on 3 tranches:
• Senior ($80m) gets LIBOR + 60 bp (0.6%)
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• Mezzanine ($15m) LIBOR + 250 bp

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• Equity ($5m) LIBOR + 2000 bp

All available returns are used to pay the Senior (80%). What is left then pays the Mezzanine
(15%). The Equity (5%) receives what is still left.
When 5% of mortgages fail – Equity loses all
When 20% of mortgages fail – Equity & Mezzanine lose everything

ABS CDO: And ABS CDO (Collateralized Debt Obligation) is obtained by dividing the Mezzanine
tranche into 3 tranches.


The US Housing market: US average house prices started rising quickly around 2000. A key factor
was the change in the way that mortgages were provided to customers. Housing loans were now
made to many people who were more likely to default on them. These loans were packaged in
financial products and sold to investors. US real estate prices:

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What happened then:

- Mortgages were packaged in financial products and sold to investors
- Banks found it profitable to invest in AAA rated tranches because the promised return
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was significantly higher than the cost of funds and capital requirements were low
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- In 2007 the bubble burst. Some borrowers could not afford their payments when the
teaser rates ended. Others had negative equity and recognized that it was optimal for
them to exercise their put options
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- US real estate prices fell and products, created from the mortgages, that were previously
thought to be safe began to be viewed as risky
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- There was a “flight to quality” and credit spreads increased to very high levels
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- There were massive losses

Key mistakes made by the market:
- Lax standards & unethical behaviour
- Questionable ratings
- Default correlation goes up in stressed market conditions and we do not get the benefit
of diversification we’d expect with a portfolio of mortgages
- Assumption that a BBB tranche is like a BBB bond – tranche holders were less likely to
recover part of their investment

Avoiding future crisis – agency costs
Agency costs are the costs incurred when the interests of the parties in a business situation are
not aligned.
Originators and Investors: The interests of the originators of loans should be aligned with the
interests of those who ultimately bear the credit risk
- Originators were rewarded for signing contracts but were not penalised for signing
contracts that were not viable.
- Originator should be forced to keep a part such as 20% of every tranche
Financial Institutions & Employees: The compensation plans within financial institutions should
be changed so that there is much less emphasis on short-term performance
- Use of bonuses based on short term performance
- Size of the bonuses
- Bonuses should be based on long term performance with claw-back provisions
Avoiding future crises – transparency: Products that are traded should be made sufficiently
transparent that their risks are widely understood
- ABSs and ABS CDOs were complex inter-related products
- Once the AAA rated tranches were perceived as risky they became very difficult to trade
because investors realized they did not understand the risks
- Creators of the products must provide a way for potential purchasers to assess the risks
(e.g., by providing software)
Avoiding future crisis - Need for Models: Most financial institutions did not have models to value
the tranches they traded (it appears that they did not follow their own procedures on this). Risk
management should involve a heavy dose of managerial judgment, as well as the mechanistic
application of models.

More emphasis on stress testing: We need more emphasis on stress testing and managerial
judgement, less on mechanistic application of VaR models (particularly when times are good)

Securitization
Topic 8 Essential Reading 1: Securitisation and the credit crisis of 2007. John C. Hull,
Fundamentals of Futures and Options Markets 7th Ed, Chapter 8
1. Describe the securitisation process.
2. How are mortgage-backed securities and ABS CDOs created?

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3. Describe the causes for the crisis in the securitisation market during the GFC.

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4. How can future crises be avoided?

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Credit default swaps: or credit derivative contract. Payments are made to the seller of the swap.
In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is
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considered insurance against non-payment. A buyer of a CDS might be speculating on the
possibility that the third party will indeed default. Buyer of the instrument acquires protection
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from the seller against a default by a particular company or country (reference entity).
Example: Buyer pays premium of 90 bps per year for $100 million of 5-year protection against
company X. Premium is known as the credit default spread. It is paid for life of contract until
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default. It there’s a default, the buyer has the right to sell bonds with a face value of $100 million
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issued by company X for $100 million.

CDS structure:
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Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after
default to the face value of the bond
Attractions of the CDS Market:
- Allows credit risks to be traded in the same way as market risks
- Can be used to transfer credit risks to a third party
- Can be used to diversify credit risks
CDS valuation: CHECK SLIDES, calculations ..??
…


Credit indices:
- CDX NA IG is a portfolio of 125 investment grade companies in North America
- iTraxx Europe is a portfolio of 125 European investment grade names.
- Portfolios are updates march 20 and sept 20 each year
- Index can be thought of as the cost per name of buying protection against all 125 names

The use of fixed coupons:
- Increasingly CDSs and CDS indices trade like bonds
- A coupon is specified
- If spread is greater than coupon, the buyer of protection pays: Notional Principal x
Duration x (Spread - Coupon)
 - Otherwise seller of protection pays: Notional Principal x Duration x (Coupon – Spread)
- Duration is the amount the spread gets multiplied by to get the PV of spread payments

Total return swap
- Agreement to exchange total return on a portfolio of assets for LIBOR plus a spread
- At the end there is a payment reflecting the change in value of the assets
- Usually used as financing tools by companies that want exposure to assets

Asset Backed Securities:
- Securities created from a portfolio of loans, bonds, credit card receivables, mortgages,
auto loans, aircraft leases, music royalties, etc
- Usually the income from the assets is tranched
- A “waterfall” defines how income is first used to pay the promised return to the senior
tranche, then to the next most senior tranche, and so on.
Collateralised Debt Obligations (CDOs):
- CDOs are a type of structured asset-backed securities with multiple tranches that are

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issued by special purpose entities and collateralized by debt obligations including bonds
and loans

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- CDOs are unique in that they represent different types of debt and credit risk. In the case
of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. The
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higher the risk, the more the CDO pays.
- A cash CDO is an ABS where the underlying assets are debt obligations
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- A synthetic CDO involves forming a similar structure with short CDS contracts
- In a synthetic CDO most junior tranche bears losses first. After it has been wiped out, the
second most junior tranche bears losses, and so on. Example:
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• Equity tranche is responsible for losses on underlying CDSs until they reach 5% of
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total notional principal (earns 1000 bp spread)

• Mezzanine tranche is responsible for loss between 5% - 20% (earns 200 bp spread)
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• Senior tranche is responsible for losses over 20% (earns 10 bp spread)

• The income is paid on the remaining tranche principal. Example: when losses have
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reached 8% of the total principal underlying the CDSs, tranche 1 has been wiped out,
tranche 2 earns the promised spread (200 basis points) on 80% of its principal.
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- Single tranche trading: This involves trading tranches of portfolios of CDSs without
actually forming the portfolios. Cash flows are calculated in the same way as they would
be if the portfolios had been formed.

Credit derivatives:
Topic 8 Essential Reading 2: Credit Derivatives, John C. Hull, Futures, and Other Derivatives 9th
Edition, John C. Hull 2014
1. Explain the structure of a credit default swap 2. How is a CDS valued?
2. What is a Total Return Swap?
3. Explain the structure of a synthetic CDO



Week 9 lecture 9 22/09/2017 economic capital and risk-adjusted returns

Economic capital is mathematically determined to cover ‘unexpected losses’ at a stated level of
confidence.
- Expected losses: part of nosiness as usual, and are covered by reserves and income
- Unexpected losses: losses due to unexpected events (e.g. September 11)
Economic capital is the capital required to protect the bank from unexpected losses, except the
‘catastrophic events’
External rating ambitions of banks determine to what extent (that is, probability) unexpected
losses are to be covered by Economic Capital.


Economic capital is the ‘right’ amount of capital a firm needs to protect itself
- A financial institution generates earnings by taking various risks
- Risk taking causes earnings volatility which, if not managed prudently, can lead to huge
losses and even bankruptcy
- Capital is the bank’s protection against bankruptcy
- However, too much capital is expensive and affects the firm’s competitiveness

Business imperative for economic capital framework
A robust Economic Capital framework lays the foundation for maximizing a bank’s shareholder
value, and is the means to derive returns from the large investments made in their Basel 2
implementations
A robust economic capital framework will:
- Asses the level of equity required which is commensurate with the bank’s risk profile

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- Improve capital management processes by allocating Economic Capital to businesses

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- Assist in strategic capital planning and budgeting
- Form the basis of performance management framework (RAROC, EVA, SVM)
- Enhance portfolio management decisions (limit setting)
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- Introduce risk-based pricing based on Economic Capital

The regulatory imperative – Basel Pillar 2 & ICAP:
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Economic Capital Framework is at the centre of regulatory assessment of ICAP of Basel Pillar 2
- Basel Pillar 2 specifies that banks should have a process for assessing their overall
capital adequacy in relation to their risk profile and a strategy for maintaining their
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capital levels
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- The process to demonstrate this is by establishing a robust economic capital framework

and implementing processes to manage it effectively (ICAP).
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- If supervisors are not satisfied with the framework and the processes, they will take
‘appropriate supervisory action’
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Essential Reading 1 (Topics 9): ICAAP and economic capital: Where compliance and shareholder
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value meet (Peter John & Nick Gordon)

1. What are the opportunities for adding shareholder value by aligning regulatory capital initiatives with
economic capital development?
2. What are the challenges in developing an economic capital framework
Economic capital and regulatory capital should come together

Economic capital and performance measure: economic capital framework can be extended to
measure Risk Adjusted Return on Capital (RAROC) and can be used as performance measure

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Allocating Economic Capital to each Business Unit and measuring its RAROC performance drives
key management processes to maximise shareholder value.


Risk appetite
Risk appetite is represented by the losses the company is willing an able to stand in order to
reach the target results. The level of uncertainty a company is willing to assume given the
corresponding reward associated with the risk. A company with a high-risk appetite would be a
company accepting more uncertainty for a higher reward, and vice versa.

Risk appetite – the value proposition:
 - Articulates the tone from the Board to drive corporate strategy and risk management
framework.
- Defines accepted behaviour relating to risk and return - helps strengthening risk culture
- Increases transparency in decision-making
- Communication tool with internal stakeholders (e.g. business units) and external
stockholders (e.g. shareholders, regulators)
- Can increase capacity to take risks
- Enhance risk reporting

Linkage of risk appetite to risk management components:
Framework element Linkage to risk appetite
Risk governance Clear risk appetite statement approved by board and embodies in risk
policy and delegated authorities. This sets the ‘tone from the top’ and a
foundation for the risk culture.
Risk assessment Frequent risk assessment process to identify new and changing risk
landscape in context of risk appetite
Risk quantification and Regular quantification and aggregation of risk to prioritise focus of risk
aggregation management and control
Monitoring and reporting Monitoring and reporting of performance against risk based limits based
on risk appetite.

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Risk and control Framework of controls calibrated in line with risk appetite to optimise
optimisation cost/benefit

Rating risk appetite across key metrics – an example m
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Earnings at risk – and example of a risk appetite metric

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Essential reading 2 (Topics 9): Implementing an Effective Risk Appetite
http://www.imanet.org/insights-and-trends/risk--management/implementing-an-effective-
risk-appetite
1. What are the key elements of a risk appetite framework?
2. What are the key steps in developing a risk appetite framework
3. Identify some risk appetite (tolerance) measures?
4. What are the benefits of developing risk appetite to an organisation?

Key ideas of reading:
How to formulate risk appetite:
- Asses Regulatory Requirements and Expectations
- Communicate the Business and Risk Management Benefits of the RAS
 - Organize a Series of Workshops to Develop the RAS to address: 1) business strategy, 2)
performance metrics, 3) risk assessment, 4) define risk appetite
- Develop and Socialize a Prototype RAS and Dashboard Report; Produce a Final RAS
Based on Board and Business Feedback
- Obtain Executive Management Approval
- Obtain Board Approval
- Communicate the RAS, including Roles and Responsibilities
- Review and Update Current Business Plans and Risk Policies
- Provide On-going Monitoring and Reporting
- Provide Annual Review and Continuous Improvement

How do we assess economic capital framework?
All risks assessed separately and then added up
1) Profile and prioritize business line risks
2) Evaluate economic capital framework and policy
3) Benchmark economic capital process
4) Facilitate testing of key internal models that impact economic capital (are parameters
credible?)
5) Assess data quality and technology support (IT systems, data quality issues)
6) Summarize findings and report

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This gives the key things for change/improvement

Final exam: not multiple choice, topics after mid semester

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Week 10 lecture 10 06/10/2017 financing international trade and investment
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Something about calculating default probabilities of bonds: SEE SLIDES…

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Intro – Financing International Trade and Investment:

- The ever changing world of business has to lead to high demand changes to credit-
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related functions
- International trade financing was focused on risk management, today it is both used for
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risk management as well as a weapon for international marketing

- Banks play a major role in the changing credit functions. They charge fees to
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international clients for the provision of cross-border credit and other related credit
functions.
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Cross-border Transactions and its Financing
- A cross-border trade transaction involves the delivery of a good or service and the
transfer of funds. This is very similar yet different to domestic trade
- Cross-border trade: 1) involves a foreign currency, 2) business customs and practices
may differ, 3) legal structures differ and it my be hard to enforce an agreement in case of
violation
- Government legislation may form a barrier to trade or help to increase trade e.g. Tariffs,
quotas, laws and special documents
Mechanisms of cross-border trade:
- Tentative agreement- quality, quantity, price, shipping method and time, payment
method and time and guarantors are reached at this stage, and a proforma invoice is
issued.
- Exporter requires importer to negotiate with importer’s bank, to provide the exporter
with a letter of credit (L/C). This is a guarantee from the importer’s bank to provide the
exporter when the goods are shipped.
- After shipment of goods are made, the exporter sends the shipment documents and
payment order or draft through his domestic bank to the importer’s bank (or its agent),
which issued the L/C
- The importer bank checks the documents making sure they conform to the conditions of
the L/C and makes payment on the sight draft, or accepts a time draft from exporter for
future payment
 - A time draft becomes a bankers’ acceptance (B/A) when it’s endorsed and accepted by a
bank.
- A bankers’ acceptance is a negotiable obligation of the bank that accepted the draft (the
holder of the B/A can trade or sell the instrument on a discounted basis)
- Payment takes place: bank collects payment from importer and liquidates B/A at
maturity
- Most payment and settlements are done through interbank account transactions (These
interbank transactions are transmitted across an electronic network such as the SWIFT
or CHIPS
- Banks also assist in the procurement of foreign exchange
- Letter of credit:
- The issuing bank relies solely on the documents referred to in the L/C
- The onus is on the importer to specify the conditions and documents needed for
completion of the transaction
- However, if the bank finds discrepancies in the documents they must notify the
importer, who then decides if the discrepancies are a violation of the agreement (if the
bank fails to notify the importer, the importer may choose to not honour its obligations
and the bank will remain liable to the exporter).
- L/C represents a contingent liability for the issuing bank. This essentially means the
bank sells a Put option.

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- Payoff to the bank comes in form of fees charged to the importer
- The liability is that, if importer defaults the bank has to pay the exporter
Why would a bank take on this minimal gain for such a large liability?? à The expected benefits
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are greater than paying off the exporter: 1) Collateral (T-bills or CD) minimises loss and 2) the
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repeat business with importer

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Trade financing:
Essential reading 1: Financing international trade
http://academic.cengage.com/resource_uploads/downl oads/0324288417_68104.pdf
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1. Describe the alternative trade financing methods

2. Compare and contrast the alternative payment methods
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http://www.youtube.com/watch?v=KusNFAqlwRs

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Shipment related documents:

- Commercial invoice: Describes the product, unit amount and price of items being
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shipped. It contains the name and address of the exporter and importer, number of
packages, payment terms, name of shipping vessel and the port of departure and arrival
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- Packing list: Outlines what invoices are being filled for current shipment
- Certificate of insurance: All cargoes going abroad are insured
- Bill of Lading: A title document that shows ownership. It’s a contract between carrier
and exporter (shipper). It’s the shippers’ receipt of goods. A document that assigned
control over goods. Prefaced with the method of transportation (ocean bill of laden or
airway bill of laden for sea and air transported goods).
- Certificate of origin (required for good that are not allowed into a country, subject to
quotas or given preferential tariff treatment): Some times for goods that have to be of a
specific quality (alumni, iron ore etc.), both parties may agree to have third party as the
arbiter of quality. A certificate from this third party will be included with the other docs.

Other payment methods:

Method Usual Time of Goods available Risk to Exporter Risk to Importer
Payment to Buyers
Prepayment Before shipment After payment None Relies completely on
exporter to ship goods as
ordered
Letter of credit When shipment is After payment Very little/none, Assured shipment made,
made depending on credit but relies on exporter to
terms ship goods described in
documents
Sight draft; On presentation of After payment If draft unpaid, must Same as above unless
documents against draft to buyer dispose of goods importer can inspect
payment goods before payment
Time draft; On maturity of Before Relies on buyer to Same as above
documents against drafts payment pay drafts
acceptance
Consignment At time of sale by Before Allows importer to None: improves cash
buyer payment sell inventory before flow of buyer
paying exporter
Open account As agreed Before Relies completely on None
payment buyer to pay account
as agreed
- Cash advance: Used in cases of customised products, marginal credit, high credit &
political uncertainty. The exporter gains access to cash while the importer loses leverage
for bad goods being shipped
- Open account: Exporter establishes payment conditions and ships the goods before
payment is received. Used when there is an ongoing relationship between the two
parties and there is political stability in the importer’s country.
- Consignment: Goods are shipped and all relevant docs are sent to the importer.
However, The title of goods remains with the exporter. When the goods are sold the

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importers pay the exporter the cost of the goods and keeps the markup. Banks usually
not involved.

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Importer Financing:
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Importers may not have adequate liquidity to finance transactions, so it has to borrow funds
from a bank. The lending bank will require a trust receipt, which transfers the title of the goods
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to the bank. The importer is able to withdraw goods by arranging requisite funds or showing a
confirmed order for goods.
Lease Financing: Provided for importers of durable goods. Importers can enjoy the benefits of
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the use of the imported assets, but do not have the title of the goods. Lease term is multi-period,
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approximating the life of the goods, thus it is a financing lease.

Exporter Financing:
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Factoring: This is typically without recourse. It involves the sellers accounts receivables; thus
transactions don’t require acknowledgment of obligation by the buyer-importer. Short-term.
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Requires co-insurance but the seller-importer

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Forfeiting: Used for multi-period payments. Importer provides a set of promissory notes that
are fully guaranteed by the importer’s bank. The exporter is able to discount without recourse
these notes with the forfeiter, who will assume the risk of collecting the fund
à Both forfeiting and factoring are expensive way of trade financing as parties do not trade the
instruments (they take on liquidity risk) and the documents are not standardised (high
transaction cost)

Counter Trade
Refers to a wide range of business arrangements in the sale of a good where payment involves
forms other than cash.
- Counter purchase: Has two separate and independent contracts that specify the
commodity to be purchased and most times the value. E.g. party A buys X amount of rice
(in one country) for cash from party B (contract 1). Party B will buy another product, say
oil, for cash at the same value (contract 2) from party A
- Buy-Back: Involves (typically) building of a facility in another country, where the
building company is paid in products made by that the facility. At the end of a specified
period the facility will be purchased from the government.
- Switch: Is a counter-purchase agreement where the original exporter is allowed to
transfer credit to a third party (they must first find the third party)
- Offset: Typically involves the purchase of a big ticket item. It’s a counter-purchase
arrangement without any restrictions on the exporter for finding a third party
Bank’s role in countertrade:
 - Banks utilise global network to identify partners and clientele for countertrade
arrangement
- Bundling of different functions in countertrade transactions leads to a bundling of
different risks
- Asses the risk of the transaction
- Unbundling of the different risks to parties that can afford to bear them
- Cost effective shifting of risk
- Justify cost and risk so parties don’t use conventional trade transactions

Banking Services and MNC’s
- Banks play a constructive role in facilitating the access to information by MNCs
- Banks reduce investing time because they know and understand the local legal, political
and economic market
- Provide information on potential joint venture partners
- Analyse the benefits to each party in the venture
- Financing of ventures
- Banks play an advisory role mitigating risk
- Identify disparities in regulations across countries
- Full range of banking services to MNC’s local affiliates
- Banks may have a large branch & correspondent banking network

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Special Financing Needs of Customers
Large companies can sometimes access funds in offshore financial markets for financing needs.
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Why then do they need banks? à For project financing & International Merger and Acquisitions
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Project Financing: Advisory role- feasibility assessment, trade credit, international finance
expertise/experience, project development and management skills. Formation of a
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project company. Provide remittance to contractors & monitor the construction process
(money is spent wisely). Risk management
Merger and Acquisitions: Advisory role (analysis of potential target companies), M&A financing
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and leveraged buy-out financing

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Political Risk Insurance (PRI)

PRI captures most, but not all, non-commercial risks. It covers political events, including the
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direct and indirect actions of host governments that negatively impact investments and are not
properly compensated for. PRI can help investors access finance — often on better terms, thus
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increasing the tenors and size of available loans.

Three types of political risks insured by providers:
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- Expropriation: PRI protects against losses due to host government actions that may
reduce or eliminate ownership or control. It covers outright confiscations,
expropriations, and nationalisations, and losses resulting from a series of acts that have
an expropriatory effect.
- Currency Inconvertibility and Transfer Restrictions. PRI protects against losses
arising from an investor’s inability to convert local currency into foreign exchange and to
transfer it out of the host country. It also covers excessive delays in acquiring foreign
exchange. Typically, this coverage applies to the interruption of interest payments or
repatriation of capital or dividends resulting from currency restrictions. It does not
cover devaluation.
- Political Violence (War, Terrorism, and Civil disturbance). PRI protects against
losses resulting from the damage of tangible assets or business interruption caused by
war, insurrection, rebellion, revolution, civil war, vandalism, sabotage, civil disturbance,
strikes, riots, and terrorism. Coverage usually applies to politically motivated acts.

Financing and insuring foreign business (ECAs): Export Credit Agencies (ECA) are financial
institutions that provide trade financing to domestic companies for their international activities.
ECAs provide a variety of financing solutions to exporters and domestic investors who undertake
cross border investments. These solutions include credit insurance, export credit guarantees,
loans, political insurance. Export Finance and Insurance Corporation (EFIC) is Australian
government-owned ECA.

Essential reading 2 (Topic 10): Export Finance and Insurance Corporation (EFIC)
http://www.efic.gov.au/business-solutions/
Review EFIC web site. Explore how EFIC can assist exporters and banks to undertake international business by way of:
- Finance solutions
- Insurance solutions, and
- Structured trade and project finance solutions


Week 11 lecture 11 13/10/2017 Project Financing and Managing Cross Border Risks

Foreign Exchange Market: provides the physical and institutional structure through which the
money of one country is exchanged for that of another country.
Two categories of markets:
- Wholesale: dominated by commercial banks (also known as interbank market)
- Retail: Smaller than the wholesale market, and it facilitates international trade (import &
export), Foreign Direct Investments (FDI), foreign portfolio investment, tourism and
unilateral transfer (e.g. western union
Most widely traded currencies: 1) US dollar, 2) Euro, 3) Yen

Use of foreign exchange market by financial institutions:

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Type of Financial Use of Foreign Exchange Markets

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Institution
Commercial bank - Serve as financial intermediaries in the foreign exchange market by buying or

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selling currencies to accommodate customers
Speculate on foreign currency movements by taking long positions in some
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currencies and short positions in others
- Provide forward contracts to customers
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- Some commercial banks offer currency options to customers; unlike the

standardized currency options traded on an exchange, these options can be
tailored to a customer’s specific needs
International mutual - Use foreign exchange markets to exchange currencies when reconstructing
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funds their portfolios

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- Use foreign exchange derivatives to hedge a portion of their exposure

Brokerage firms and - Some brokerage firms and investment banking firms engage in foreign security
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investment banking transactions for their customers or for their own accounts
firms
Insurance companies - Use foreign exchange markets when exchanging currencies for their
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international operations
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- Use foreign exchange markets when purchasing foreign securities for their
investment portfolios or when selling foreign securities
- Use foreign exchange derivatives to hedge a portion of their exposure
Pension funds - Require foreign exchange of currencies when investing in foreign securities for
their stock or bond portfolios
- Use foreign exchange derivatives to hedge a portion of their exposure

There are two sets of transaction that take place in the foreign exchange markets:
- Spot- immediate exchange of currencies (t+2)
- Forward- contract to exchange funds at a future date at an agreed rate

Market makers: banks and brokers are ready and willing and able to purchase or sell any amount
of a specific currency for its own account or its customers. Market makers create liquidity and
provide continuous price quotes for other participants. They face substantial risk:
- Opportunity loss due to premature disposal of the currency
- Storage cost due to failure to dispose of currency
- Settlement risk due to one party’s inability to deliver their side of the contract

Mechanics of currency quotes and trading: Spot Market
In spot markets the bank gives a quote for the bid & ask (buying and selling in terms of the bank)
price for currency. (Bid=quote for how much bank will buy/pay for the currency. Ask=amount
the bank will take for selling you the currency)

 Foreign exchange forward contracts: The agreement to deliver one currency to another party
in exchange for another at a specific time in the future at a specific rate is known as a Forward
contract. For importers and exporters they function as a hedge against adverse exchange rate
movements

Motivations for participants:
- Participants in the foreign exchange markets undertake 3 activities: 1) Arbitrage, 2)
Hedging, 3) Speculation
- Hedgers use the market to diversify unsystematic risk
- Hedging allow companies to avoid currency exposure
- The provider of this hedging service are assuming the risk
- Speculators use their future expectations to determine the currency they wish to invest
in
- They provide additional liquidity to the market (by taking up positions others might not
wish to assume)

Risk-return Trade off:
- The risks stem from fluctuation in the market and credit risk (default by one party)
- Banks must be prudent when dealing with marginal customers and non-financial
customers

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- Interbank transactions also stand a risk of default even for spot trades
- Foreign exchange traders in a bank must be properly monitored as they have the
potential to cripple a bank with one bad trade

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What is project finance?
- Project finance is financing that, as a priority does not depend on the soundness or
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creditworthiness of the parties proposing the business idea to launch a project.

- Approval of the financing is basically a function of the project’s ability to repay the debt
contracted and also remunerates capital invested at a rate consistent with the degree of
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risk inherent to the venture concerned.

- In project finance the point of reference for any valuation is the ability of the project to
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generate cash flows.

- The distinctive features of a project finance deal are the following:
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• The debtor is a project company set up on an ad hoc basis that’s financially and
legally independent from the sponsors
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• Lenders have only limited recourse (or in some cases, none) toward the sponsors
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• Project risks are allocated equitably among all parties involved in the transaction
• Cash flow generated by the initiative must be sufficient to cover operating costs,
service the debt and pay relative interest
• Security is granted by the sponsors to lenders to secure debt service (interests +
principal payment) during the operating phase of the project

Why do sponsors use project finance?
Disadvantages Advantages
High transaction costs as compared to - The return on a project finance deal is
corporate-based financing because: higher, on average, thanks to the utilization
- The advisor, the arranger, and the legal and of financial leverage.
technical consultants need a great deal of - The commitments, security interests, and
time to value the project. contract terms do not always appear on the
- Negotiating the contract terms to include in balance sheet or in the notes of the
project documentation is labour-intensive. Directors.
- The cost of monitoring the project in - Creating an SPV makes it possible to almost
progress is very high. completely isolate the sponsors from events
- Lenders are expected to pay significant involving the project.
costs in exchange for taking on greater - Lenders can always count on security
risks. interests, and having an SPV makes
evaluation easier.

Who are the sponsors of a project finance deal?
There are 4 types of sponsors who would have the interest and motivation to launch a finance
initiative:
1. Industrial Sponsors who see links between the initiative and their core business.
Normally these players also act as suppliers or clients as well as lenders of the SPV (or project
company). Example: Many construction projects involving cogeneration power plants have
industrial sponsors who utilize the project finance deal to dispose of materials later used as
feedstock for power production.
2. Plant Contractor or Operator: sponsors who build or run plants. The plant contractor or
operator is motivated to participate in the project finance deal to supply plants, materials, and
services to the SPV. Usually this type of sponsor is involved in the initial phase of the initiative,
handling design and construction of the plant, and in later phases as well, as shareholder of the
SPV. It’s quite common for the contractor to offer to serve as plant operator once the facility is
finished and activated.
3. The Public Sponsor’s interest in participating in a project finance deal comes from the chance
to realize public works with private money, while tying up no (or only negligible) public
fundsàPPPs = Public Private Partnerships. In these cases the “industrial rationale” is:
- To supply a satisfactory and efficient service to the community.
- To realize public works which are economically self-sustaining and require limited
investment of capital by the public body
Moreover, project finance allows the public sponsor to limit outlay for works carried out with

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direct labour where there are structural constraints in the government budget and for the local
administration.
Most common contracts used in project finance and concession systems:
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- BOT (build, operate and transfer): Public Administration delegates planning and realization
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of the project to a private party, together with operating management of the facility for a
given period of time; the public body retains ownership.
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- BOOT (build, operate, own and transfer): Similar to the BOT framework, except the private
party owns the facility for the entire duration of the concession; when this expires
ownership is transferred to the public body.
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- BOO (build, operate and own): This contract has features in common with the first two. The
private party owns the works (as with BOOT), but does not transfer ownership at the end of
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the concession term.

4. Financial investors sponsor project finance initiatives with a single goal: to invest capital in
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high-profit deals.
Infrastructure funds: Greenfield funds vs brownfield funds
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Clearly, these investors have a high propensity for risk and seek substantial returns on their
investments; they’re similar in many ways to venture capitalists (pension funds, insurance firms,
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infrastructure funds). Expected net IRR: 15% (greenfield funds), 10- 12% (brownfield funds)
For these investors, there is no industrial project rationale like for industrial sponsors.

Overview of the features of project finance:
A project finance deal can always be viewed as a contractual network which revolves around the
SPV. Each counterparty sets up contracts with the SPV which refer to specific phases or parts of
the project. A deal is successful when all the interests of all the parties involved are satisfied at
the same time, even though these interests are not always perfectly compatible.
The same player can take on several different roles.
The same players are not found in every project finance deal.
The contractor:
- The contractor is the company (or consortium of companies) that wins the tender for the
design and construction of a given plant on the basis of a fixed price turnkey contract.
- Contract obligations are taken on by the main contractor (who commits directly to the
SPV) and are later passed on to consortium members.
- The main contractor is normally responsible for damages resulting from delays in
completing the facilities.
- The contractor is also required to pay penalty fees if the plant does not pass performance
tests.
- By the same token, the contractor may also receive bonuses if the plant performs at higher
than contracted levels or if the project is finished ahead of schedule.
The operator:
 - This is the counterparty who takes over the plant from the contractor after the
construction phase is complete and handles maintenance for a set number of years,
guaranteeing the SPV that the plant is run efficiently in keeping with the pre-established
output parameters
- This party plays a key role during the operational phase of the project finance initiative
- The operator may be an already-in-place company (perhaps even one of the sponsors) or a
joint venture created to serve as operator by the shareholders of the SPV
The buyers:
- These are the counterparties to whom the SPV sells its output
- Buyers of goods or services produced by the plant might be generic, which means not
defined ex ante (i.e. a retail market), or a single buyer who commits to buying all the
project company’s output. In the latter case, these buyers are called offtakers and output is
sold wholesale
The suppliers:
- These companies supply input to the SPV to run the plant on the basis of long-term
contracts which include arrangements for transporting and stocking raw materials
- In practice, there are rarely a large number of suppliers. More often, in fact, the project
counterparties prefer a single supplier who is frequently one of the project sponsors
Risk management:
- Project finance is a system for distributing risk among the parties involved in a venture

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- Identifying and allocating risks leads to minimizing the volatility of cash inflows and
outflows generated by the project
- This is advantageous to all participants in the venture, who earn returns on their
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investments from the flows of the project company
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The theory of project finance: