Week 3

Risk management in banking

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Week 3 Chapter 9

Risk management in banking

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
9.3 Identify the key risks in banking
9.4 Explain how these risks can be managed by banks
9.5 Explain ways in which banks can manage their assets
and liabilities to maximize profit.
9.6 Examine the importance of capital and capital
management in banks.
Financial Intermediation “going-between”
Assets Liabilities

Assets Risks Liabilities

• High Credit Risk • Credit risk • Low Credit Risk
• Long-term • Interest rate risk • Short-term
• Less liquid • Liquidity risk • Liquid
So many risks in banking!

• Credit risk • Technology risk

• Interest rate risk • Inflation risk

• Liquidity risk • Settlement risk

• Foreign exchange risk • Regulatory risk

• Market risk • Competitive risk

• Sovereign risk • Operating risk

• Operational risk • Reputation risk

• Off-balance sheet risk • Portfolio risk

• Capital risk (solvency) • Management risk

Lets look at a real bank

https://www.santander.co.uk/assets/s3fs-public/documents/santander_uk_group_holdings_plc_2022_an
nual_report.pdf
 Credit risk

• Risk that a borrower fails to make the contractual payment

on a timely basis to the bank
 Types of loans
• Transaction loans
• Negotiated for specific transactions and tailored to the needs of the
borrower
• Working capital loans
• Used to finance routine day-to-day transactions
• Term loans
• Longer maturity (3-10 years) loans used to buy fixed assets
• Direct consumer loans
• Made for financing purchases of durable goods and secured with the
asset being purchased
• Credit cards
• Short-term, unsecured general purpose credit - very profitable for
banks
• Mortgage loans
• For acquisition or improvement of real estate secured by the real
estate they finance
 Managing Credit Risk

• Banks must make successful loans that are paid back in full
in order to earn high profits.
• Remember adverse selection and moral hazard!
• What can banks do to manage credit risk?
• Screening: Adverse selection in loan markets requires that
lenders screen out the bad credit risks from the good ones.
• Lenders must collect reliable information from prospective
borrowers
• Effective screening and information collection together form
an important principle of credit risk management.
• Examples: Credit scoring (Retail), Financial Analysis
(Corporate)
 Credit Analysis
• Objective: to determine the ability and willingness of the
borrower to repay the loan
• How to do credit analysis?
– Examine factors that may lead to default in the repayment
of a loan
– Look at the borrower’s past record (reputation) as well as
its economic prospects
– Look at the present economic condition and forecast
future cash flows
• Must remember:
– Getting unwilling borrower to repay the loan in today’s
legal environment is not easy
 11

https://www.investopedia.com/terms/f/five-c-credit.asp
 Managing Credit Risk

• Specialization in Lending: Specializing in lending to local

firms or to firms in particular industries.
• Advantage:
• It is easier for the bank to collect information about
local firms.
• The bank becomes more knowledgeable about specific
industries.
• Disadvantage: Lower diversification.
• Monitoring and Enforcement of Restrictive Covenants: Aims
to reduce moral hazard.
• Covenants restrict borrowers from engaging in risky
activities
• Banks monitor if borrowers comply with covenants.
Managing Credit Risk

• Long Term Customer Relationship

• Checking past activity
• Balances to see how liquid is the borrower
• Transactions: Reveals borrowers suppliers.
• The cost of monitoring old customers is lower
• Benefits borrower as well: cheaper funds.
• Bank also create relationship through Loan Commitments
• A bank’s commitment to provide a firm with loans up to
a given amount at an interest rate that is tied to some
market interest rate.
• Advantages for both borrowers and lenders.
Managing Credit Risk
• Collateral and Compensating Balances:
• Collateral reduces the lender’s losses in the case of a
loan default.
• Compensating Balance: A firm receiving a loan must keep
a required minimum amount of funds in its account.
• Credit rationing: Defined as refusing to make loans even
though borrowers are willing to pay the stated interest rate or
even higher.
• Not making a loan: This is used to tackle adverse
selection problem.
• Charging high interest rate may make adverse selection
worse for the lender.
• Because it increases the likelihood that the lender is
lending to a bad credit risk.
Managing Credit Risk
• Restriction on size of the loan: This is used to tackle
moral hazard problem.
• The larger the loan, the greater the borrower
incentives to engage in activities that make it less
likely to pay the loan.
• Therefore, financial institutions ration credit by
providing borrowers with smaller loans that they seek.
Managing Interest Rate Risk

• Interest rate risk: The riskiness of earnings and

returns that is associated with changes in interest
rates.
• Unexpected movements in interest rates
• Interest rate risk arises from mismatching of maturity
and volume of assets and liabilities
• Not all assets and liabilities subject to interest rate risk
• Fixed-rate assets and liabilities: carry constant
interest rates and their cash-flows do not change
• Rate-sensitive assets and liabilities: can be re-
priced as consequence of changed interest rate
and their cash-flows vary
 18

Refinancing risk Profit 1% if interest

raises to 8%
interest
9%
Asset fixed to 9% for Profit 2%
2 years while Liability 8% if interest rate
fixed to 7% for only unchanged
1 year 7%

1 2 years

Reinvesting risk Profit 1% if interest

interest decreases to 8%
Liability fixed to 7% 9%
for 2 years while Asset
fixed to 9% for only 8%
Profit 2%
1 year 7% if interest rate
unchanged

1 2 years
 Managing Interest Rate Risk
Assets Liabilities
Rate sensitive assets + $20 Rate sensitive liabilities + $50
Variable-rate and short term loans Variable-rate deposits
Short term securities Money Market deposit accounts
Fixed rate assets + $80 Fixed rate liabilities + $50
Reserves Demand deposits
Long term loans Time deposits
Long term securities Long term deposits

• Suppose interest rise 5%

• The income on assets rises $1 → = 5% * $20
• The payments on liabilities $2.5 → = 5% * $50
• If a bank has more rate-sensitive liabilities than assets:
• a rise in interest rates will reduce bank profits
• a decline interest rates will raise profits
Gap Analysis
• Gap Analysis: Measures the sensitivity of bank profits to
changes in interest rates.

• In basic gap analysis the amount of rate sensitive liabilities

is subtracted from the amount of rate sensitive assets.
• Gap = $20 - $50 = - $30 → 5% * - $30 = -$1.5

• Maturity bucket approach: To measure the gap for several

maturity subintervals, called maturity buckets. The effects
of interest-rate changes over a multiyear period can be
calculated.
Duration Analysis
• Duration Analysis: Examines the sensitivity of the market
value of the bank’s total assets and liabilities to changes in
interest rates.
• Macaulay’s duration: Measures the average lifetime of a
security’s stream of payments.
Duration Analysis

• Duration is a useful concept because it provides a good

approximation of the sensitivity of a security’s market value
to a change in its interest rate.

% change in
= - % change in x
market value of Duration in years
interest rate
security
 Duration Analysis
Assets Liabilities

Rate sensitive assets + $20 Rate sensitive liabilities + $50

Fixed rate assets + $80 Fixed rate liabilities + $40

Equity Capital + $10

• Suppose that the average duration of assets is 3 years while the

average duration for liabilities are 2 years.
• With a 5% increase in interest rates how will the market value of
banks assets be affected?
• Assets → -5% * 3 = -15%, assets fall by 15%, $ 15 million
• Liabilities → -5% * 2 = -10%, liabilities fall by 10%, $ 9 million
• Net worth has declined by $ 6 million. 6% of the original assets
value.
• Similarly a 5% drop will lead to a $6 million increase in asset value.
Liquidity Risk

• Insufficient liquid assets: unable to meet requirements

without impairment to its financial or reputational
capital
• Mismatch between size and maturity of asset and
liabilities
Liquidity Management & the Role of Reserves
• Suppose a bank has following balance sheet, reserve
requirement is 10%
Assets Liabilities

Reserves + $20 Deposits + $100

Loans + $80 Bank Capital + $10
Securities + $10

• Suppose a withdrawal of $10

Assets Liabilities
Reserves + $10 Deposits + $90
Loans + $80 Bank Capital + $10
Securities + $10

• Ample reserves does not necessitate changes in other

parts of banks balance sheet.
Liquidity Management & the Role of Reserves
• In case of insufficient excess reserves.
Assets Liabilities

Reserves + $10 Deposits + $100

Loans + $90 Bank Capital + $10
Securities + $10

• Suppose a withdrawal of $10

Assets Liabilities
Reserves +$ 0 Deposits + $90
Loans + $90 Bank Capital + $10
Securities + $10

• Now the bank can not meet its reserve requirement.

Liquidity Management & the Role of Reserves
1. Can borrow from Other banks
Assets Liabilities

Reserves +$ 9 Deposits + $ 90
Loans + $90 Borrowings from other banks of +$9
Securities + $10 corporations

Bank Capital + $10

2. Sell securities.

Assets Liabilities
Reserves +$ 9 Deposits + $90
Loans + $90 Bank Capital + $10
Securities +$1
Liquidity Management & the Role of Reserves
3. Can borrow from Central Bank.
Assets Liabilities

Reserves +$ 9 Deposits + $ 90
Loans + $90 Discount Loans from the Fed +$9
Securities + $10

Bank Capital + $10

4. Wait till loans mature and does not roll over, reduce the
loan portfolio. Alternatively sell loans to other banks.
Assets Liabilities
Reserves +$ 9 Deposits + $90
Loans + $81 Bank Capital + $10
Securities + $10

• Bank might not prefer reducing the loans. Why?

Liquidity Management & the Role of Reserves
• Why banks hold excess reserves?
• When a deposit outflow occurs, holding excess reserves
allows the bank to escape the costs of
• Borrowing from other banks or corporations
• Selling securities (i.e. fire sales)
• Borrowing from the central bank
• Calling in or selling off loans
• Signals that bank is prudent and well managed
• Excess reserves are insurance against the costs
associated with deposit outflows.
• The higher the costs associated with deposit outflows, the
more excess reserves banks will want to hold.
• However, excess reserves have opportunity cost
Liquidity Management: Some techniques
• In measuring and managing a bank’s liquidity exposure,
the following techniques may be used:
• Cash flow projections of daily liquidity positions;
• Cash flow projections of daily liquidity sources;
• Scenario analysis and simulation models;
• Liquidity gap analysis.
 General Principles of Bank Management
• How a bank manages its assets and liabilities in order to
profit?
• Primary concerns
• Asset management: Acquiring low risk level assets which
have low default probability.
• Liability management: Acquiring funds at low cost
• Capital adequacy management: Maintaining the amount
of capital needed to support the activities of the bank.
• Credit risk management
• Interest rate risk management
• Liquidity risk management
Asset Management
• To maximize its profits, a bank must simultaneously seek
the highest returns possible on loans and securities,
reduce risk, and make adequate provisions for liquidity by
holding liquid assets.
• 4 strategies.
• High interest - low credit risk
• Branches, loan officers.
• Banks try to purchase securities with high return and
low risk.
• Lower risk by diversifying. How?
• Both in loans and in securities
• Bank must manage the liquidity of its assets so that it
can satisfy its reserve requirements.
Liability Management

• ALM (or ALCO) – Asset Liability Committee

• Banks use liabilities for reserves and liquidity.
• Utilise markets for O/N loans between banks
• Minimise the cost of deposits
Capital Adequacy Management
• Why banks decisions on the amount of capital is
important?
• 3 reasons
• Prevent bank failure: A situation in which the bank
cannot satisfy its obligations to pay its depositors
and other creditors and so goes out of business.
• The amount of capital effects returns for the owners
of the bank.
• A minimum amount of bank capital is required by
regulatory authorities.
 How bank capital helps prevent banks failure
Ernie Bert

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $90 Bank Capital $10 Loans $90 Bank Capital $4

• Suppose now $5 million of bad loans are had to be written

off – in other words bank makes a loss of $5 million.
Ernie Bert

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $85 Bank Capital $5 Loans $85 Bank Capital $ -1
How bank capital helps prevent banks failure
• Bank Bert with $ -1 bank capital has become insolvent: It
does not have sufficient assets to pay off all holders of its
liabilities.
• Insolvent banks are closed by government, its assets are
sold off, and its managers are fired.
• A banks maintains bank capital to lessen the chance that it
will become insolvent.

Ernie Bert

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $85 Bank Capital $5 Loans $85 Bank Capital $ -1
How bank capital helps prevent banks failure
• Because owners of a bank must know whether their bank
is being managed well, they need good measures of bank
profitability.
• Return on Assets: How efficiently a bank is being run, as it
indicates how much profits are generated on average by
each dollar of assets.

Net profit after tax

Return on Assets (ROA) =
Assets

• Return on Equity: How much the bank is earning on

shareholders equity investment.

Net profit after tax

Return on Equity (ROE) =
Equity Capital
How bank capital affects returns to equity holders

• There is a direct relationship between ROA (which

measures how efficiently the bank is run) and ROE (which
measures how well the owners are doing on their
investment).
• Equity multiplier (EM): The amount of assets per dollar of
equity capital.
Assets
EM =
Equity capital

Net profit after tax Net profit after tax Assets

= x
Equity capital Assets Equity capital

ROE = ROA * EM
How bank capital affects returns to equity holders
Ernie Bert

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $90 Bank Capital $10 Loans $90 Bank Capital $4

EM = 100 / 10 = 10 EM = 100 / 4 = 25

• Suppose both banks have the same return on assets → 1%

ROE = 1% * 10 = 10% ROE = 1% * 25 = 25%

• Equity holders in Bank Bert are better off as they earn

more that twice the equity holders of Bank Ernie.
• Given the return on assets, the lower the bank capital, the
higher the return for the owners of the bank.
Trade off between Safety and Returns to Equity
Holders

• Bank capital has costs and benefits.

• Bank capital benefits the owners of a bank, in that it makes
their investment safer by reducing the likelihood of
bankruptcy.
• However, bank capital is costly because the higher it is, the
lower will be the return on equity for a given return on
assets.
• Managers must decide how much of the increased safety
that comes with higher capital (the benefit) they are willing
to trade off against the lower return that comes with higher
capital (the cost).
• Banks are also required to hold certain amount of capital.
A real life example Operational Risk

• https://www.youtube.com/watch?v=mQCYl2jB42w
Risk culture: What is it?
Corporate Governance
Chair-CEO generation gap and bank risk-taking - ScienceDirect
https://www.sciencedirect.com/science/article/pii/S0929119922000566
Week 3 Chapter 11

Banking Industry Structure

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
11.1 Recognize the key features of the banking system
around the world
11.2 Distinguish between traditional and modern banking
and various factors that changed banking
Types of banking
• Retail or personal banking
– Commercial banks
– Savings banks, Co-operative banks, Building societies,
Credit unions
• Corporate banking
– Commercial banking, Business banking
– Investment banks
• Private banking
• Islamic banking
• Universal banking (Universal banks)
Traditional versus modern banking
Financial Innovation
• Financial innovation is driven by the desire to earn profits
• A change in the financial environment will stimulate a
search by financial institutions for innovations that are
likely to be profitable
– Financial engineering

Cambridge Fintech Ecosystem Atlas (ccaf.io)

Securitization

• To transform otherwise illiquid financial assets (i.e. loans)

into marketable capital market securities.
• Securitization played an especially prominent role in the
development of the subprime mortgage market in the mid
2000s.
• Securitization is one of the culprits of the 2007 Global
Financial Crisis
Loan sales

• Loan sales removes financial assets (e.g. mortgage loans) from

balance sheet
• long-term mortgages on balance sheet replaced by cash received from
new buyer
• bank has thus increased its liquidity by £50M

Balance sheet before securitisation

Assets Liabilites
Buyer
Cash reserves £5.33 Deposits £53.33

Cash £50.00 Long-term mortgages £50.00 Capital £2.00

Total £55.33 Total £55.33

Creation of an Asset-Backed Security
Lends
Bank originating
Borrowers
loans
Regular
payments
Loans sold Cash

Special Purpose
Entity (SPV)

Issues
Pays fee
securities
Repayment of Revenue
Underwriter principal and from sale
(investment bank) interest on of securities
the securities

Distributes securities

Buyers of ABS
(public investors)
59
60
Number of Commercial Banks in the
United States, 1934–2019

Source: Federal Reserve Bank of St. Louis, F RED database:

https://fred.stlouisfed.org/series/USNUM .
European Banking Sector

FACTS AND FIGURES - EBF