Risk Management in Banking

1
Risk Management in Banking
2
An Introduction to Risk

• Risk Management is the process of measuring or
  assessing the actual or potential dangers of a
  particular situation.

3
Risk Has Two Components

• Uncertainty.
• Exposure.

4
Types of Risk

• Operational.
• Credit.
• Reputational.

5
Operational Risk

• The risk of loss resulting from inadequate or
  failed internal processes, people and systems, or
  from external events.

6
Operational Risks Include

• Internal Fraud.
• External Fraud.
• Employment Practices and Workplace Safety.
• Clients, Products and Business Practices.
• Damage to Physical Assets.
• Business Disruption and System Failures.
• Execution, Delivery and Process Management.

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Internal Fraud

• Unauthorized Activity.
• Transactions not reported.
• Transaction type unauthorized.
• Mismarking of position.
• Theft and Fraud.
• Fraud/credit fraud/worthless deposits.
• Theft/extortion/embezzlement/robbery.
• Misappropriation of assets.
• Forgery.
• Account take-over/impersonation.
• Bribes/kickbacks.
• Insider trading.
• Money laundering.
• Willful blindness.

8
External Fraud

• Theft and Fraud.
• Theft/robbery.
• Forgery.
• Check kiting.
• Identity theft.
• Elder financial abuse.
• Systems Security.
• Hacking damage.
• Theft of information (with monetary loss).

9
Employment Practices and Workplace Safety

• Employee Relations.
• Compensation, benefit, termination issues.
• Organized labor issues.
• Safe Environment.
• General liability (slips and falls).
• Employee health and safety rules.
• Workers compensation.
• Diversity and Discrimination.
• All discrimination types.
• Harassment.
• Equal Employment Opportunity (EEO).

10
Clients, Products and Business Practices

• Suitability, Disclosure and Fiduciary.
• Fiduciary breaches/guideline violations.
• Suitability/disclosure issues.
• Retail consumer disclosure violations.
• Breach of privacy.
• Aggressive sales.
• Inadequate product offerings.
• Account churning.
• Misuse of confidential information.
• Lender liability.

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Clients, Products and Business Practices
(CONTINUED)

• Improper Business or Market Practices .
• Antitrust.
• Improper trade/market practice.
• Market manipulation.
• Insider trading (on firms account).
• Unlicensed activity.
• Money laundering.

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Clients, Products and Business Practices
(CONTINUED)

• Selection, Sponsorship and Exposure.
• Failure to investigate client per guidelines.
• Exceeding client exposure limits.
• Advisory Activities.
• Disputes over performance or advisory activities.

13
Damage to Physical Assets

• Disasters and Other Events.
• Natural disaster losses.
• Human losses from external sources (terrorism,
  vandalism).

14
Business Disruption and System Failures

• Systems.
• Hardware.
• Software.
• Telecommunications.
• Utility outage/disruptions.

15
Execution, Delivery and Process Management

• Transaction Capture, Execution and Maintenance.
• Miscommunication.
• Data entry, maintenance or loading errors.
• Missed deadline or responsibility.
• Model/system misoperation.
• Accounting error/entity attribution error.
• Other task misperformance.
• Record retention.
• Documentation maintenance.
• Delivery failure.
• Collateral management failure.
• Reference data maintenance.

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Execution, Delivery and Process Management
(CONTINUED)

• Monitoring and Reporting.
• Failed mandatory reporting obligations.
• Inaccurate external loss (loss incurred).
• Customer Intake and Documentation.
• Unapproved access given to accounts.
• Incorrect client records (loss incurred).
• Negligent loss or damage of client assets.

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Execution, Delivery and Process Management
(CONTINUED)

• Customer/Client Account Management.
• Unapproved access given to accounts.
• Incorrect client records (loss incurred).
• Negligent loss or damage of client assets.
• Trade Counterparties.
• Non-client counterparty misperformance.
• Vendors and Suppliers.
• Outsourcing.
• Vendor disputes.

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Operational Risk Checklist

• Employee training.
• Close management oversight.
• Segregation of duties.
• Employee background checks.
• Procedures and process.
• Purchase of insurance.
• Exiting certain businesses.
• Capitalization of risks.

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Credit Risk

• Risk due to an uncertainty in a counterpartys
  ability to meet its obligations in accordance
  with agreed upon terms.

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Credit Risks Include

• Loans.
• Acceptances.
• Interbank transactions.
• Trade financing.
• FX transactions.
• Futures.
• Swaps.
• Equities.
• Letters of credit.
• Options.

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Sound Practices for Managing Credit Risk

• Establish an appropriate credit risk environment.
• Operate under a sound credit-granting process.
• Maintain an appropriate credit administration,
  measurement and monitoring process.
• Ensure adequate controls over credit risk.

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Establish an Appropriate Credit Risk Environment

• Board of Directors should review credit risk
  strategy periodically.
• Senior management should implement credit risk
  strategy approved by the Board.

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Operate Under a Sound Credit Granting Process

• Criteria should include thorough understanding of
  the borrower, purpose/structure of credit and its
  source of repayment.
• Establish overall credit limits at the level of
  individual borrowers/connected counterparties.
• Have a clearly established process for approving
  new credits/extension of existing credits.
• Extension of credit must be made on an arms
  length basis.

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Maintain a Credit Administration, Measurement and
Monitoring Process

• Have in place a system for ongoing administration
  of various risk-bearing portfolios.
• Develop an internal risk rating system for
  managing credit risk.
• Have an information system and analytical
  techniques that enable management to measure
  credit risk of on/off balance sheet activities.

25
Maintain a Credit Administration, Measurement and
Monitoring Process (CONTINUED)

• System for monitoring overall composition and
  quality of the credit portfolio.
• Consider future changes in economic conditions
  when assessing individual credits.

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Ensure Adequate Controls Over Credit Risk

• System of independent, ongoing credit review.
• Credit granting function is properly handled and
  credit exposures are within limits.
• System for managing problem credits.

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Credit Risk Checklist

• Stringent credit standards for borrowers and
  counterparties.
• Strict portfolio risk management.
• Constant focus on changes in economic or other
  circumstances that can lead to a deterioration in
  the credit standing of a banks counterparties.

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Reputational Risk

• Reputational risk is the potential that negative
  publicity, whether true or not, will result in
  loss of customers, severing of corporate
  affiliations, decrease in revenues and increase
  in costs.

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Benefits of Effective Reputation Management

• Improving relations with shareholders.
• Creating a more favorable environment for
  investment.
• Recruiting/retaining the best employees.
• Reducing barriers to development in new markets.
• Securing premium prices for products.
• Minimizing threats of litigation.

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• The key to managing reputational risk is sound
  risk management, coupled with straightforward
  communication about the problem the bank is
  facing.

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• Re-establishing a firms
• reputation takes a long time.

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Reputational Risk Cases

• Perrier Toluene traces.
• Exxon Valdez spill.
• Union Carbide Bhopal, India.
• Arthur Andersen Enron shredding.
• Firestone Tires.

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Reputational Risk Checklist

• Processes for crisis management are planned and
  documented.
• External perceptions of the bank are regularly
  measured.
• Reputational threats are systematically tracked.
• Employees are trained to identify and manage
  reputational risks.
• Standards on environmental, human rights and
  labor practices are set publically.
• Relationships and trust with pressure groups and
  other potential critics are established.

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True or False?

• Corporate reputation is one of the primary assets
  of my bank.
• The risks involving a banks reputation have
  increased significantly over the past five years.
• Reputational risk is harder to manage than other
  forms of risk.
• My bank is proactive in enhancing and protecting
  its reputation.

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True or False?

• It is impossible to quantify the impact of
  reputational risks.
• My bank usually thinks about its reputation only
  when things go wrong.
• A well run bank doesnt need to invest extra
  resources into guarding against reputational
  risk.

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Risk Management

• Risk management is the process of monitoring and
  addressing the potential for loss.

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Evolution of Risk Management

• Emerged as a discipline during the early 1990s.
• Used long before (1960s).
• Typically used to describe techniques for
  addressing insurable risks.

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Old Risk Management

• Risk reduction through safety, quality control
  and hazard education.
• Alternative risk financing, including
  self-insurance and captive insurance.
• The purchase of traditional insurance products.
• Use of derivatives to hedge or customize market
  risk exposures.

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New Risk Management

• Treats derivatives as a problem as much as a
  solution.
• Focuses on reporting, oversight and segregation
  of duties within the organization.

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By the Mid-1990s

• Regulatory initiatives.
• Concerns about derivatives.
• Release of RiskMetrics.
• Published losses.

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Enrons Experience with Risk Management

• Maintained a risk management function.
• Lines of reporting were reasonably independent.
• Mark-to-market valuations were subject to
  adjustments by management.
• Few career risk managers.
• Fluid workforce.
• Employees constantly looking for next transfer.

42
Regulatory Responses from the Financial Services
Community

• Basel II.
• Sarbanes-Oxley Act of 2002.
• Graam-Leach-Bliley Act.
• Bank Secrecy Act/Anti-Money Laundering.
• Insider Trading Rules.
• Bank Bribery Act.
• Fair and Accurate Credit Transactions Act (FACTA)
• Fair Lending
• Federal Conflicts of Interest Statutes.
• Various record retention and reporting
  requirements.

43
Success Depends Upon

• A positive corporate culture.
• Actively observed policies and procedures.
• Effective use of technology.
• Independence of risk management professionals.

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• When risk management is done
• correctly you CAN sleep at night!

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Dr. Linda EagleFounder PresidentThe Edcomm
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