The Risks In Finance And The Basel Guidelines Finance Essay - Free Essay Example

What is finance? Finance is all about the knowledge of funds management. Simply speaking, to finance something is the same as to fund something. The funds can be in form of loans, bonds, owned capital, shares, etc (anything that can generate funds legally). So in finance, we learn anything that directly or indirectly related to funds management. Whether it is interest rate, time value of money, the calculation of risk, how to measure movement of share price, etc. All of these are related to finance. Direct Finance. Direct finance comprises of every direct transaction on the financial market, transaction with no middleman or agent. For example: Shareholders buy share to fund a company or buy government bonds to finance the government. Another example of direct finance is the internal capital market of multinational organizations. Semi direct Finance: The bank acts like an agent or intermediate party. In return, they receive fee/commission for the transaction. Banks dont take position in the transaction; they strictly serve as a middleman and therefore are free from the risks that the transaction bears. Indirect Finance In indirect finance, which most people referred to as banking, banks take the direction/initiatives of all of activities. For example they receive money from households and lend it to organizations. Its not the household decision anymore how to use the money (for financing purpose); therefore we call it indirect. For example: Households save their deposit into bank in return of interest and the bank decide to loan the money to others (person, organization, company, etc) at higher interest rate (the difference becomes the banks profit). That way the bank will make a profit. In other case, the bank can choose to enter the stock market or buying bonds of its own choosing, etc in order to generate profit. This is the basic of banking. Many different kinds of risks exposed to the bank. Banks are exposed to many risks such as: Liquidity risk. Liquidity risk means that a given asset cant be sold quickly enough in the market to avoid a loss. This is the case when illiquid assets have to be sold in a short term. This is similar with cash flow insolvency. For example: Properties (hard to sell without incurring a loss at a short period of time). Liquidity risk can also mean that a bank isnt capable of paying her debts at a short term (similar to cash flow insolvency). This is different with balance sheet insolvency (negative net assets, therefore unable to pay). A bank maybe balance sheet solvent but still exposed to liquidity risk if it holds lots of illiquid assets. For example: Northern Rock (a perfect example of bank run). A bank run happens when large number of bank customers withdraw their deposits at the same period of time because of the fear the bank is unable to pay. In Northern Rock case, when the global demand for securitised mortgages droppe d in August 2007, Northern Rock became unable to pay back the loans from the money market with money which should have been raised from securitisation. On 14 September 2007, the bank obtained a liquidity support facility from the Bank of England, to return the funds it was unable to get from the money market. The banks assets were enough to cover its liabilities, but it suffered from liquidity problem. Because of this news, Northern Rock suffered a bank run and needed government intervention to guarantee its customers money. Later on, Northern Rock is nationalized. Credit risk/ counterparty risk/ default risk. It can be defined as any loss in the market value due to different reasons. It means as an investors risk of loss arising from a borrower who fails to make payments as promised. Or, it can also mean the loss because of the difference in firm value/ company value because the bank credit rating (one of the example) collapsed due to something happening within the bank (borr ower fails to pay up, bad management, etc)/ indirectly related to the bank. Market risk. Market risk is the risk that the value of a portfolio, going to decrease because of the change in value of the market risk factors. In case this happens, the bank will occur a loss. The four main factors are stock prices, interest rates, foreign exchange rates, and commodity prices. Therere 4 different kinds of market risk, such as: Equity risk, the risk that stock prices will change. Foreign exchange rate risk, the risk that foreign exchange rates will change. Interest rate risk, the risk that interest rates will change. Commodity prices, the risk that commodity prices will change. Operational risk. Operational risk is the failure of the people of the procedures of the systems. For example the mistyped case (fat finger) or simply known as typo. Example: Buying shares for $500, but instead mistypes it once so it becomes $5000. One of the biggest examples of operatio nal risk is Barings Bank, collapsed in 1995 after its employees, Nick Leeson, lost $1.3 billion speculating primarily on futures contracts and subsequently lost it all. Leeson was able to operate with no supervision from head office because of the banks poor internal auditing and risk management practices. Another type of operational risk is legal risk. In order to operate, the bank must operate based on the government rules and regulation. This is how the legal risk arises. It is a risk that arises when the bank is not in compliance with government regulation and therefore hinders it to enter a transaction or to operate. It includes the time and money wasted for the legal proceedings (or as a result of it, such as opportunity lost, etc) that the bank must endure in case it is accused of illegal conduct (or vice versa). It is one of the greatest challenges for managers to make their bank in compliance with government regulation. It is very difficult to predict the size of legal r isk. Its also very bad for the banks reputation. Settlement risk Settlement risk can be described as the risk that a counterparty fails to deliver a security or its value in cash per agreement when the security was traded after the other counterparty have already delivered security or cash value per the trade agreement. For example: Foreign exchange settlement risk or simply known as Herstatt risk. On 26th June 1974, some banks had undertaken foreign exchange transactions with Herstatt and had already paid Deutsche Mark to the bank during the day, believing they would receive US dollars later the same day in the US from Herstatts US nostro. But at the end of banking day, Herstatts topped all dollar payments to counterparties. As a result, the banks license was withdrawn because of a shortage of income and capital to make up for liabilities that were due. Reputational risk. Reputational risk is a type of risk related to the reliability of company. It may result in lost revenue or damage to shareholder value, ignoring to the fact whether the bank is actually guilty or not. Its about the image of the bank. Therefore, its related to many risks. If the bank is unable to settle its transaction (transaction risk) or have bad operation (operation risk) or making a big loss in financial market because of market risk, they all can damage the banks reputation, etc. Any kind of actions, wrongdoings, news that can have negative impact to the bank (whether its directly or indirectly (such as counterparties or investors bad reputation) related to the bank) can be considered as reputational risk. Therefore, reputational risk is closely related to the other risk. Other risks. There are many other risks that are exposed to the bank but havent been described in the lecture yet, such as systemic risk (risk of the collapse of entire financial system/entire market. Example: Lehman brothers (almost happening)), profit risk, and volatility risk (the risk that ari ses because the likelihood of fluctuations in the exchange rate of currencies). Saving mechanisms. Lender of last resort. Lender of last resort, as the name speaks for itself, is an organization which is willing to lend money to a bank when theres no alternative left. Usually banks want to avoid doing this, because it is damaging to the banks reputation and shows that the bank is in some sort of trouble (like what happen to Northern Rock, once they asked the Bank of England to bail them out, they suffered a bank rush). Most of the time, lender of last resort is the central bank of the country. Deposit insurance system. Every bank has to put a small percentage/portion of every deposit that its customers made in an insurance pool that is used to back up the customers deposit. This is useful when a bank has some liquidity problems, customers dont need to be a scared to lose all their money. But put in mind that the portion is relatively small. Maybe it can cover small banks, but not the big one. Capital adequacy. Banks are obliged to have minimum capital requirements to prevent them from failing. The more capital they have, the safer they are to meet their financial demands and obligations (because capital is their own money and they can use it for their own needs and demands). Bad banks. Bad bank is a term for financial institution that are created to keep the nonperforming assets owned by a state guaranteed bank. Bad banks are legal institutions that are used to isolate toxic products in order to save the healthy part of the bank. It is sometimes used to save the majority of the banks. Intentionally lose the bank in order to keep the others safe and afloat. Government bailout. Sometimes the government put themselves in, bailing the bank, financial institution, etc, in order to save the financial market (or in bigger case, the nations economy itself) from crisis and prevent it from systemic risk / collapsing. Capital Adequacy (Lecture 2). Basel I: Basel I is discussions by central bankers around the world in the year 1988 and resulted in a set of guideliness about minimal capital requirements for banks in case they want to lend their money . It was used by the G-10 countries before a more advanced guideliness made (notably Basel II). How Basel I works? Basel I implies that every time a bank makes a loan to other institution (then in balance sheet of the bank it is put on debit side by nature), the bank needs to have certain amount of equity on its credit side as a backup in case the loan gone bad. Example: If you give loan for $100 and put $100 on your asset side (left side of balance sheet), youll need to have 8 (as example) as equity on the liability side (right side of balance sheet. This 8 is different for different type of assets. Lending to government is much safer than lending money to corporation. How to differentiate it? We use risk weight. Example: If the lender is government, we use risk weight of 0% ( we assume the government is perfectly safe). For bank we use a risk weight of 20%. For mortgage loan we use a risk weight of 50%. For company, which is the riskiest of them all, we use full weight (100%) to calculate the equity needed to backup the loan. Bottom line is the bank differ the equity needed to cover up the loan based on whos borrowing it (government being the safest and therefore have 0% risk weight, company being the most risky and therefore have 100% risk weight. And therefore we have the risk weighted assets of banks. Calculated as the different types of assets that bank has, multiply by the risk rate, then multiply by the predetermined equity that needs to be keep (in this case $8 for every $100 of loan). Example: Loan of $100 to government (asset side), then, equity needed = $8 X 0% = $0 (liability side). Loan of $100 to company, then, equity needed = $8 X 100% = $8 and so on. Amendment 1996: Capital has to be set aside for Market Risk. In Basel I there was no rule for modeling. The only thing we did was classifying. Bank need to look this amendment and make a benchmark model for its own use. Translate it into percentage of returns. Create a histogram and cut off the tail (1% probability mass). The position of cut off tail is the value at risk (VAR). It determines which position is accepted and which one is below standard and therefore imposed to extra charge. It is a quantile of distribution. It is the base on which the capital set aside for market risk is calculated. Now bank has to model the changes in the value of the portfolio of the company/ borrower. If a company exceeds this VAR (loss is bigger than VAR) by 1%, then the company performs well. If it exceeds 1%, then company will receive an extra capital charge. Usually the multiplier is 3 (can be more). Bank has to present this model to the regulator. Basel II Basel II is an improved second version of Basel I. Basel II had undergone many proposal and updates as well as received much response. Quantitative impact studies ƒ   banks implement Basel II on a trial basis to check if it has an impact on their capital etc. There are 3 main point need to be stressed out on Basel II, such as: First pillar: Capital adequacy. Basel II still keeps the 1996 amendment with respect to market risk. Banks still have to keep capital aside for credit risk. Credit risk can be calculated in 3 ways component can be calculated in three different ways, such standardized approach, foundation IRB and advanced IRB. In standardized approach, risk weights are different for each individual borrower in each group. So now there is a credit rating (which is generated by external parties) which is different for each category. Lending to blue-chip company is absolutely safer than lending money to small unknown company. This is what Basel I lacks . The borrower is regrouped 2 times, therefore it is more accurate (we simply multiply the equity needed one more time based on the borrower rating which holds different rate of multiplier). Alternatively, bank can use Internal Rating-Based approach (banks are allowed to model the default probabilities of their own customers) was proposed. Second pillar: supervisory review. All banks have to model their economic capital and regulatory capital (the capital that the bank has to maintain in compliance with the law). Moreover, banks operate on the economic capital (their working condition), which (usually) is above the legal minimum. It gives the regulators much improved instruments compared to Basel I and framework to deal with the risk that a bank may face such as reputational risk, systemic risk, etc. It gives bank the ability to examine its own risk management system. Third pillar: market discipline, which means accounting disclosure. The idea is that we can safeguard banks if we let them disclose the riskiness of their positions. Bank needs to have a system in place to at least produce these numbers. By opening up their position, banks will be more thoughtful and careful in their actions. And regulator can keep track of them as well. 2.1. Financial market products. There are a lot of financial products; all has its own characteristic and classification. Examples of financial products are: Shares equity: : Certificates that represent that an investor has already invested in some form of investments (in the form of a company, etc) and therefore he/ she owns a portion of that investment and any underlying asset beneath it and entitled to claim any gains from that investment. Bonds: Certificates that represent money a government or corporation has borrowed from other entities. T-bills (Treasury Bills): Short term debt obligation guaranteed by the US Government with maturity of less than a year. Options: A contract that provides the buyer with the right to buy or to sell an underlying asset at a specific price during a specified time period. Futures: Contract between 2 parties to buy/ sell a standardized asset at specified future date with the price agreed today. Forwards: Same as futures with the exception that they are not exc hange-traded or standardized. Swaps: Agreement between parties to swap the benefits of their financial instrument. For example: In bonds, both parties agree to swap the coupon payments related with the bonds. Both coupon payments can have different payment timing and value. Commodities: Sold in commodity market where primary/ raw products are exchanged. Can be in form of derivatives trading or direct physical trading. Commercial paper: Corporations short term debt instrument (1 to 270 days), usually used for  the  funding of accounts receivable,  inventories or to  meet short-term liabilities. Strips (Separate Trading of Registered Interest and Principal Securities), as the name speaks for itself, strips is a seperate trading for the interest / principal portion for the securities. It is cut into different pieces which are sold separately. By this, strips can also give buyer a tax advantage (typical in Belgium). Medium term notes: A debt note that matures in 5 -10 years (usually). Foreign Exchange (Forex): Over the counter financial market for trading currencies. Forex have been known to use spot transaction regularly. In contrast with derivatives, the buyer buy right now, pay within 2-3 days time and you get instruments at that same period as well. Life insurance: Contract between the policy owner and insurer that the insurer will pay a sum of money to the owner in case of events (death, critical illness, etc). In relation to finance market, life insurance policy is so often combined with investment (get insured and have investment, managed by the insurer), with the exception of pure protection life insurance. Asset Backed Securities: A security whose value and payments determined by a specifically designed pool of underlying asset, usually illiquid assets. Doing so will allowed the asset to be sold into the financial market, therefore comes the term securitization (making securities from illiquid asset). Mortgage Backed Secu rities: The same as Asset Backed Securities, instead the cash flows now comes mortgage loans (underlying asset). Convertible bonds: A bond that can be converted to common stock shares at equal value by the issuing company. Repo (repurchase agreement): Agreement that lets the seller to buy back the securities from the buyer at a later date (usually a short one). 70% of repos mature in less than 7 days. Interbank loan: Direct loans between two banks to cover up their financial needs using predetermined interest rates (LIBOR Rates, etc). Credit Default Swap: Swap contract between buyer and seller with the buyer pays a series of payments to sell as an exchange of payoff in case a credit event happens to a credit instrument that currently being swapped. As the name speaks for itself, it swaps the default risk from one party to another in turns of payment. Mutual funds: Collective investment funds, gathered from numerous amount of people, institution and company and is mana ged by a professional fund manager, usually a bank, insurance company or investment company (and therefore the manager collects commission from it). The fund manager then can decide where to invest the fund in the financial market and therefore forming a portfolio. They also have different taxing implication than others. These financial products can be classified into many types (highlighted with different color), such as: Derivative (green color) is a financial tool, an agreement between 2 parties to transact something else (underlying asset). Therefore, derivatives value is determined by its underlying asset. Example: Option to buy AA shares for $20. If share AA goes up to $30, the option is worth $10. If share AA goes $20 or below, the option worth nothing. Thats option it is dependent to the value of its underlying asset. Its a type of linear products that gives you win-lose situation when bought and have a timeframe in it for it to do some effect (to gain or to lose). Money market (yellow color) and Capital Market (blue color). The main difference between money market and capital market is in the time to maturity / time frame. Money market being relatively short term (less than 1 year) and capital market being relatively long term (more than 1 year). The rest of the products such as commodities and Forex are slightly different and therefore have their own categories. Thats all about the summary of first and second lecture of CAF. We hope you find it useful.