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SC3-Chapter 19 -Types of Risks Incurred by Financial Institutions-SP2011

SC3-Chapter 19 -Types of Risks Incurred by Financial Institutions-SP2011

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1 Types of Risks Incurred by Financial Institutions SC3 Chapter 19
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2 Risk Risk is the likelihood or probability that outcomes will deviate significantly from expectations Unexpected variation Banks are primarily interested in the negative variations or LOSSES, both Expected Losses - EL Unexpected Losses - UL If a bank’s ultimate goal is to maximize the value of shareholder wealth or profitability, several types of risk (of loss) may prevent the bank from reaching its objectives.
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3 Relationship between risk of loss, pricing, loss provisioning and capital Price and Provision (Allowance for Loan and Lease Losses) to cover Expected Losses Charge expected losses off against revenue as a non-cash expense(PLLL) with the cash allocated to ALLL Mitigate identified losses that are not easily quantified collateral guarantees insurance (off-setting exposure through the use of derivative securities) Hold Capital to cover Unexpected Losses
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Price, Structure and Provision for EL Profit = Loan Revenue – Interest Expense on deposits or borrowed funds – Operating and Administrative Expenses – Expected Losses Loan Revenue = (base rate + mark-up ) x L + Fees Expected Loss = PD x LGD X EAD=Loss Provisioning LGD = (1- RCVR ) RCVR influenced by presence of collateral, guarantees, insurance etc. 4
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5 Relationship between loss, pricing, provisioning and capital Pricing & Loss Provisioning & mitigation Unexpected Losses (UL) Hold Capital Unexpected Losses against which it is too expensive to hold capital Economic Capital = VaR 99% 99% 1% 1% Losses ($) Probability Loss Distribution Expected Loss (EL) 1% Prob. that unexpected losses > EC resulting in insolvency EL UL
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Relationship between risk of loss, pricing, loss provisioning and capital If Unexpected Losses exceed loss reserves and capital (often called “risk funds”) …. This leads to insolvency NOTE: the probability of losses greater than the amount of capital ( TCE , tangible common equity) should be very low. (AA-rating = .03% or .0003 probability of default-losses exceeding capital cushion) TCE is book value of equity capital net of intangible assets, such as good will & net operating loss carry-forwards, that do not produce income and since they have no cash value, can’t be used to absorb losses 6
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7 Bank Risks- A recent estimate Risk Financial Risk Nonfinancial Risk Market Risk Credit Risk Structural A/L Risk Interest Rate Risk Liquidity Risk Operational Risk Other Business Risks Reputational Risk Counterparty Risk =earnings volatility (return volatility) 70% 30% 6% 46% 18% 12% 18% Technological Risk Strategic risk
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8 Bank Failures-Historical Causes Large Banks: Effects of Significant Credit Losses Loss of Liquidity Small Banks: Effects of Significant Credit Losses Fraud Loss of Liquidity
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9 Fundamental risks : Credit risk Liquidity risk Market risk
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SC3-Chapter 19 -Types of Risks Incurred by Financial Institutions-SP2011

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