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Liquidity risk

admin — Sat, 12 Dec 2009 18:56:53 +0000

Banks are also exposed to liquidity risk. This is the risk arising from depositors unexpectedly seeking to withdraw their funds from the bank. A bank can fail if it is unable to liquidate assets to meet these withdrawal demands.
We will look at the management of interest rate and foreign exchange risk in the next series of posts.
Commercial banks operate in the money markets, the bond and equity markets, the foreign currency markets and buy and sell derivatives for the underlying instruments in all of these markets. Treasurers also need to take into account expected and unanticipated new deposits and withdrawals, and drawdown and repayments on loans.
They are also constrained by regulatory requirements on capital adequacy and reserve deposits. Banks unable to meet reserve requirements may buy Repos, borrow from other commercial banks or borrow from the central bank through its discount window.

Market risk

admin — Sat, 05 Dec 2009 18:55:55 +0000

Treasuries of major banks take positions in many different instruments in order to manage the preceding three risks and to try to profit from market movements. This leaves them exposed to market risk.

Foreign exchange risk

admin — Wed, 02 Dec 2009 18:54:36 +0000

International banks take deposits and make loans in many different currencies. They also actively trade currencies on their own behalf and for their customers. This can create risks that the bank’s position will be negatively affected by changes in foreign exchange (FX) rates between currencies.

Pension Funds

admin — Sun, 29 Nov 2009 18:53:47 +0000

A pension plan is a fund that is established for the payment of retirement benefits. The entities that establish pension plans—called plan sponsors—are private business entities acting for their employees, state and local entities on behalf of their employees, unions on behalf of their members, and individuals for themselves. In the United States, corporate pension plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA). Pension funds are exempt from taxation.
There are two basic and widely used types of pension plans: defined contribution plans and defined benefit plans. In a defined contribution plan, the plan sponsor is responsible only for making specified contributions into the plan on behalf of qualifying participants. The payments that will be made to qualifying participants upon retirement will depend on the growth of the plan assets; that is, payment is determined by the investment performance of the assets in which the pension fund is invested. Therefore, in a defined contribution plan, the employee bears all the investment risk. In a defined benefit plan, the plan sponsor agrees to make specified dollar payments to qualifying employees at retirement (and some payments to beneficiaries in case of death before retirement). The retirement payments are determined by a formula that usually takes into account both the length of service and the earnings of the employee. The pension obligations are effectively the liability of the plan sponsor, who assumes the risk of having insufficient funds in the plan to satisfy the contractual payments that must be made to retired employees. Thus, unlike a defined contribution plan, in a defined benefit plan, all the investment risks are borne by the plan sponsor.

Interest rate risk

admin — Thu, 26 Nov 2009 18:51:36 +0000

All banks are exposed to interest rate risk. Interest rates may rise or fall. The shift in rates may be parallel or non-parallel. These shifts will have a direct impact on the economic value of a bank’s assets and liabilities. Treasury is responsible for managing this risk. A wide range of financial derivatives has evolved that help banks manage these risks.

The Income Statement

admin — Mon, 23 Nov 2009 18:50:13 +0000

The income statement reflects the effect of management’s operating decisions on business performance and the resulting accounting profit or loss for the owners of the business over a specified period of time. The profit or loss calculated in the statement increases or decreases owners’ equity on the balance sheet. Thus, the income statement is a necessary adjunct to the balance sheet in explaining this major component of change in owners’ equity, and it provides a variety of performance assessment information. The income statement, also referred to as the operating statement, earnings statement, or profit and loss statement, displays the revenues recognized for a specific period, and the costs and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. Revenues and costs involve elements such as:
•   Sales for cash or credit.
•   Purchases of goods for resale or manufacture, or cost of services provided.
•   General and administrative expenses.
•   Sales and marketing expenses.
•   Research and development costs.
The income statement represents the best effort of the firm’s accountants to match the relevant items of revenue with the relevant items of cost and expense for the period, a process which involves accrual accounting and extensive use of allocation of prior and future revenues and costs.
Among the judgmental areas involving costs are:
•   Recognizing the incidence of revenues received in advance or delayed in time.
•   Depreciation of assets being used over more periods than the current reporting period.
•   Cost of goods purchased or manufactured in previous periods.
•   Proper allocation of general expenses to a specific period.
We’ll take up the more critical of these elements and choices as we apply the analysis techniques in later articles.

Review existing controls

admin — Fri, 20 Nov 2009 18:49:05 +0000

Risk management is an ongoing process with no real start or end. Existing systems and controls may be reviewed on an ad-hoc basis, on a scheduled regular basis (a full external audit is normally undertaken at least once a year and may be done on a semi-annual basis). Most financial institutions will also be subject to on-site examination by the relevant supervisory authorities.
One of the results of the review process is to identify control weaknesses in existing systems and these then feed through into control requirements.

Enforce compliance

admin — Mon, 16 Nov 2009 18:48:06 +0000

Day-to-day compliance is the responsibility of line management supported by their control systems. Some systems will identify transactions that break no controls but meet certain criteria for manual investigation.

Develop and implement controls

admin — Sat, 14 Nov 2009 18:47:15 +0000

Having identified and quantified business risks, banks need to amend or put into place systems to control those risks. These systems will usually be a combination of automated and manual systems. Most control systems use a method of checks and balances and define a clear division of responsibilities. A trivial, but familiar, example is that individuals at most companies are not usually allowed to sign off their own expense claims.
Credit risk, for example, can be managed by setting limits on exposures to companies, business sectors, geographical regions and countries. Positions and individuals within a bank will need to be identified and given the power to set limits up to a defined level. Those limits must be captured and incorporated into systems to ensure that lending officers and other individuals are prevented from taking action that results in these limits being breached. The way in which banks are organized is also important. In trading operations there has to be a clear distinction between the people making the trades and those accounting for and reporting the results of those trades. Designing and building integrated global systems that incorporate these controls requires great skill but this is only generally acknowledged in the event of failure.

Identify control requirements

admin — Thu, 12 Nov 2009 18:47:07 +0000

Specific control requirements may be the result of a need to correct weaknesses in existing controls or from the introduction of new products or transactions. Weaknesses in existing controls are usually identified through a review process. Well-managed banks establish procedures to break down and identify the specific risks associated with new transactions or products. Other requirements may arise from operational factors such as data center and network security and from changes in the legal or regulatory environment.
The next step is to attempt to quantify the potential for losses from possible control failures. This step is necessary to assess how urgent the requirements are and the downside risk of delaying or not taking action. Controls do not come cheap and action has to be prioritized.
It is possible to control losses to a bank arising from petty pilfering of the stationery cupboard but the direct costs of the controls necessary would likely be greater than the losses avoided. Horses for courses.
For most risks this quantification requires establishing an acceptable maximum level of potential losses, a confidence level that those losses will not be exceeded and a time frame during which those potential losses could be incurred.
This is easier to do with some risks than others. The likely credit losses arising from credit card operations can be determined relatively well given sufficient historic data. It is far harder to quantify the potential impact from operational risk that involves assessing the impact of possible, but unlikely, future events.
Once the requirements have been identified specific actions to meet these requirements are initiated. Some of these actions are likely to be relatively minor while others may require wholesale changes to systems and procedures.