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What is Financial Risk?

• Risk is the probability that the realized return would be different from the anticipated/expected return on investment.

• Risk is a measure of likelihood of a bad financial outcome.

• All other things being equal risk will be avoided.

• All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return.

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Financial Risks

Financial Risks

CreditCredit

Interest RateInterest Rate

MarketMarket

LiquidityLiquidity

OperationalOperational

Foreign ExchangeForeign Exchange

Other Risks, Country Risk,Settlement risk, performance risk

Other Risks, Country Risk,Settlement risk, performance risk

Some major financial risks

Some major financial risks

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Commercial Commercial BankingBanking

Commercial Commercial BankingBanking

Investment Investment BankingBanking

Investment Investment BankingBanking

TradingTradingTradingTrading

OthersOthersOthersOthers

Business PolesBusiness PolesBusiness PolesBusiness Poles Business LinesBusiness LinesBusiness LinesBusiness Lines

Retail Financial ServicesRetail Financial Services

Corporate-Middle Corporate-Middle ManagementManagement

Large CorporatesLarge Corporates

Advisory ServicesAdvisory Services

Mergers & AcquisitionMergers & Acquisition

LBOLBO

Banks & Financial FirmsBanks & Financial Firms

Asset FinancingAsset Financing

CommoditiesCommodities

SecuritisationSecuritisation

DerivativesDerivatives

EquityEquity

Fixed IncomeFixed Income

CustodyCustody

Lending & Collecting Deposits and Lending & Collecting Deposits and from/to Individuals, small businessesfrom/to Individuals, small businesses

Identified borrowers & relationship Identified borrowers & relationship bankingbanking

‘‘Structured Finance’Structured Finance’

Traded InstrumentsTraded Instruments

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SR

FS

Co

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Off-b

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Sp

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Sp

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Market

Market

Tran

saction

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ConsumersConsumers

Corporate- Corporate- Middle Middle marketmarket

Large Large Corporate Corporate firmsfirms

Financial Financial InstitutionsInstitutions

Specialise Specialise financefinance

Main Product-Market SegmentsMain Product-Market Segments

MarketsMarkets

Product Groups

Product Groups

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Mapping Banking Business lines with various activities:Mapping Banking Business lines with various activities:

Business Lines Sub-groups Activity Groups

Corporate FinanceCorporate Finance Corporate Finance

Municipal/Government Finance

Merchant Banking

Advisory Services

Mergers & Acquisitions, Underwriting, Privatisations, Securitisations, research, debt (govt,high yield), equity, syndications, IPO, secondary private placements.

Trading & SalesTrading & Sales Sales

Market Making

Proprietary Positions

Treasury

Fixed income, equity, foreign exchange, commodities, credit, funding, own position securities, lending & repos, brokerage, debt, prime brokerage.

Retail BankingRetail Banking Retail Banking

Private Banking

Card Services

Retail lending & deposits, banking services, trust & estates.

Private lending and deposits, banking services, trust and estate, investment advice.

Merchant/commercial/corporate cards, private labels & retail.

Commercial BankingCommercial Banking Commercial Banking Project finance, real estate, export finance, trade finance, factoring, leasing, lending, guarantees, bills of exchange.

Payment & SettlementPayment & Settlement External clients Payments and collections, funds transfer, clearing and settlement.

Agency ServicesAgency Services Custody

Corporate Agency

Corporate Trust

Escrow, depository receipts, securities lending (customers), corporate actions

Issuer and Paying agent.

Asset ManagementAsset Management Discretionary fund

Non-discretionary fund

Pooled, segregated, retail, institutional, closed, open, private equity.

Pooled, segregated, retail, institutional, closed, open

Retail BrokerageRetail Brokerage Retail Brokerage Execution & full service.

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BankingBanking Book & TradingTrading Book Concepts.

Banking BookBanking Book Trading BookTrading Book

• Lending & Borrowing.

• Extends to local regions.

• Buy & Hold.

• Book Values.

• Accrual Accounting

• Less Turnover of transactions.

• Market tradable transactions.

• extends across geographical borders.

• Buy & Trade.

• Market Quotes.

• Mark to Market Accounting.

• More Turnover of transactions.

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Exposure to Risk: Banking Book v/s Trading Book

• Banking Book:Banking Book:– All assets & liabilities generate accrued revenues &

costs, which are interest rate driven.– Asset liability mismatches result into excess or deficit

funds.– Mismatches exist between interest references, like

fixed or variable.– Asset side of banking book generates credit risk.– Liabilities side of the banking book contributes to

interest rate risk, however does not generate credit risk.

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some forms of banking book risk

• Interest rate sensitive deposits/loans.

• Net interest margins shrink.

• Imbalances in funds positions.

• Interest rate reference mismatches.

• Non-repayment in loans.

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Assets SideAssets Side Liabilities SideLiabilities Side

Credit RiskInterest Rate RiskLiquidity Risk(No market Risk)

Interest Rate RiskLiquidity Risk(No credit Risk)

Bank Book Risks – A comparative viewBank Book Risks – A comparative view

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Exposure to Risk: Banking Book v/s Trading Book

• Trading Book:Trading Book:– Market portfolio generates market risk.– Trading book is also subject to market liquidity

risk.– Over the counter products like derivatives are

responsible for credit risk.– Exposure to country risk.

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some sources of trading book risk

• Price sensitivity of tradable instruments to macro-economic factors.

• Market depth or volume.

• Level of customisation.

• Level of sophistication of products

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Assets SideAssets Side Liabilities SideLiabilities Side

Credit RiskInterest Rate RiskLiquidity RiskCountry risk

Interest Rate RiskLiquidity Risk(No credit Risk)

Trading Book Risks – A comparative viewTrading Book Risks – A comparative view

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Schematic classification of some major Financial RisksSchematic classification of some major Financial Risks

Financial Risks

Credit Risk Liquidity Risk Interest Rate Risk Market Risk Forex Operational Risk

Mismatch Risk People oriented Optionality Processes

Default Risk Procedural Decline in credit standing Technology

External events

Funding Risk Market Liquidity Risk Asset Liquidity Risk

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Credit Risk:Credit Risk: Composition

• Default Risk.

• Risk of decline in credit standing of an obligor.

• Market value loss due to change in credit standing of issuer.

• Difficulty in measurement on ex ante basis.

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Credit risk in banking portfolio:Credit risk in banking portfolio:

• Prolonged Delinquency.

• Deterioration in the credit standing of borrower

• Restructuring of debt obligations.

• Bankruptcies.

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Credit risk in Trading portfolio:Credit risk in Trading portfolio:

• Deterioration in the rating of a debt.

• Credit risk valued in market prices.

• Pre & post default comparison.

• Upward movement in the required yield.

• Highly customised derivative.

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Illustration: Downgrading of rating & movement in required yield on a security.

Consider a one year commercial paper with a face value of Rs 100.Consider a one year commercial paper with a face value of Rs 100.

Case A:Case A: Annual Yield, when the paper has a AAA rating, Assume that the market price of the instrument is 93.50, and its term to maturity is 254 days.

yieldyield = 100-93.50 X365 = 9.98%9.98%

93.50 254

Case B: Case B: Annual Annual Yield, when rating of paper changes to BB-, market price of instrument is adjusted to move yield upwards. Assume there is no change in term to maturity.

yieldyield = 100-92.50 X365 = 11.65%11.65%

92.50 254

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Liquidity Risk:Liquidity Risk: Composition

• Funding Risk.

• Market Liquidity Risk.

• Asset Liquidity Risk.

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Funding Risk:

• Inability to raise funds at normal cost.

• Market perception about a borrowing entity

• Linkages of credit standing and cost of funds

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Market Liquidity Risk:

• Liquidity crunches due to lack of volume.

• Funding risk due to market weakness.

• Distress on asset prices.

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Asset Liquidity Risk:

• Asset specific rather than market created.

• More prevalent in long term assets.

• Exotic products.

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Consequence of liquidity risk:

• Sale of asset on distressed prices.

• Borrowing extremely high rates.

• Depositors runs.

• Refusal of Lenders to further funding.

• Massive withdrawal of funds by financial institutions.

• Brutal liquidity crisis leading to bankruptcy