Organisation of Risk Management in a company. Approaches, models and instruments to cope with risks in financial terms

Table of Contents

Abstract

Chapter 1: Introduction
1.1 Definition of Risk Management
1.2 Evolution of Risk Management

Chapter 2: Several Type of Risks a Company has to Cope with
2.1 Credit Risk
2.2 Market Risk
2.3 Operational Risk
2.4 Liquidity Risk

Chapter 3: Approaches to Cope with Risk
3.1 Risk Measurement
3.1.1 Value at Risk
3.1.2 Stress Testing
3.2 Risk Mitigation Instruments
3.2.1 Derivatives
3.2.1.1 Derivatives for Handling Market Exposure
3.2.1.2 Derivatives for Handling Credit Risk Exposure
3.2.2 Credit Scoring

Chapter 4: Organisation of a Risk Management within a Company
4.1 Enterprise-wide Risk Management

References

Appendix 1

Appendix 2

Abstract

This paper intends to give an overview about the different types of risks in the banking branch. A short explanation of the four most notable risks is given, which are: Credit risk, market risk, operational risk and liquidity risk.

The paper focuses on the two most important types of risk a bank has to cope with (credit risk and market risk). For this purpose some tools for risk measurement will be introduced before some approaches in respect of mitigation are shown, focusing on derivative procucts.

Last but not least a possible risk management organization is shown, using an Enterprise-wide Risk Management example.

Affidavit:

I hereby declare that the following advanced tutorial exercise "Risk Management in financial terms" has been written only by the undersigned and without any assistance from third parties.

Furthermore, I confirm that no sources have been used in the preparation of this thesis other than those indicated in the thesis itself.”

Baldham, 18. May 2005

Chapter 1: Introduction

1.1 Definition of Risk Management

The term “risk” as it is used in this paper, can be understood as the negative discrepancy between a forecast and the reality. Risk management, especially financial risk management, should be distinguished from other uses of the expression and can be defined as:

à Practices by which a company optimizes the manner in which it takes financial risks. Risk management does not mean that risk is in some way or another optimized. That is more the field of the board of directors. Also, according to the definition, risk management is not about mananging something, instead, it is really about facilitating. It is more a question of being aware which types of risk you have to take and make those risks transparent, than to avoid them. Often, if you want to achieve your earning goals this assumes taking some kind of risk. Especially in these times of high competition there is a big impact of taking risks and strengthening your revenues.

1.2 Evolution of Risk Management

Managing risks is an old attribute of the human race. In our day-to-day life, we seem always worried about future risks. As a result, we end up investing in insurance or other investment instruments to secure ourselves against those unseen risks. For example, accidents, environmental disasters, bankruptcy are risks that have plagued us since time immemorial. Generally, we cannot reach a complete protection against any upcoming risk, but we can adopt appropriate proactive measures to mitigate every risk¹. The risk management as it is understood nowadays has largely emerged during the early 1990´s. By looking back into the past, we can consider that the root cause for the major banking disasters was a poor management of credit risk. Taking and managing risk is a certain part of what companies must do to create profits and maximise shareholder value, which is recognised as an important objective of financial and corporate management these days. The market value states the overall value in a monetary unit of a specific company or a financial portfolio. The market value is threatened by forces like future cash flows, estimated dividends or returns on investment as well as through credit risk, market risk and operational risk. Referring to a study of McKinsey there seems to be a lack of awareness on the side of some companies.

The study suggests that many companies neither manage risk well nor fully understand the risks they are taking². To manage risk is more or less a question of understanding which risks you are taking and how much of them you can bear. Therefore, it is necessary to make all major risks transparent and define the types and amounts of risk you are willing to take.

Chapter 2: Several Type of Risks a Company has to Cope with

2.1 Credit Risk

Credit risk is the exposure to the possibility that a borrower or counterparty might fail to honor his contractual obligations. This situation turns up, because there is a high uncertainty in the ability of the counterparty to meet his obligations. Being the oldest risk in the market, it was not given much attention, but it has moved a long way. “While credit risk may constitute the oldest risk in banking, it remains the most important and is still one where we have much to learn”³. One of the biggest challenges facing the industry is credit risk, because large-scale borrower defaults may even force a bank into bankruptcy. As the market has turned increasingly competitive with the mushrooming of new players, it is quite evident that comp anies are taking on more credit risk if they want to save their further existent.

An institution must consider at least three issues, if it wants to assess the credit risk from a single borrower:

- default probability: How is the probability, that the counterparty will default on its obligation either over the life of the liability or over some specified horizon?
- credit exposure: In the case of a up-turning event of default, how large will the outstanding credit be at the time of default?
- recovery rate: In the event of a default, which share of the outstanding credit may be recovered through bankruptcy proceedings or some other forms of settlement?⁴

Basle II means new requirements for the banking sector. As a result of the dramatically change in the awareness of how important risk management is, resulting from the major banking disasters in the past years (for example Barings Bank), it is now understood as a detailed, sophisticated evaluation of an array on extended risks and adopting appropriate proactive measures to counter them, unlike the previous opinion of only a concept of setting aside an arbitrary percentage for credit value.

2.2 Market Risk

Beside credit risk, the second important risk a bank has to deal with is the market risk. Talking of market risk mainly involves the exposure to adverse market price movements, such as exchange rates, the value of securities, interest rates or spreads and commodity prices. Market risk can be splitted in to two components:

- trading risk
- structural-interest rate (or asset-liability) risk

Structural-interest rate means the risk of earnings and equity values from mismatches in the interest rate sensitivity of assets and liabilities. As an example for market risk, due to adverse commodity prices, Ford was hit by tumbling palladium prices and had to take a $ 952 million write down on its stockpile⁵. This is a type of risk, every single trader has to bear. By holding a portfolio you are automatically confronted with market risk due to the volatility of the assets you are invested in.

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¹ Enterprise-wide Risk Management: Myth or Reality?

² http://www.mckinseyquarterly.com

³ Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee on Banking Supervision, in his keynote address to the Credit Risk Summit USA 2003

⁴ http://www.riskglossary.com

⁵ http://www.mckinseyquarterly.com