Different Risk Types, Part 1
Introduction
The recent unfolding banking crisis in the USA and now Europe has brought to the fore how important ‘risk’ is to a financial institution and what happens if risk is not managed adequately.
I thought it would be useful to examine some of the different types of risk that have been discussed on the news recently, as these are very different to the narrower definition of ‘risk’ used in the consumer credit risk industry.
Terms:
Credit Risk
“Credit risk is defined as the potential loss arising from a bank borrower or counter-party failing to meet its obligations in accordance with the agreed terms.”
Credit risk is associated with the 5 Cs of Credit that all risk managers learn in day one of their training:
- Capacity
- Capital
- Collateral
- Conditions
- Character
Of the 5 Cs of Credit, the most important is capacity, which is a borrower’s ability to repay the loan. This is typically assessed by affordability calculations, which are often mandated by government regulations, I in order to avoid over-indebtedness.
Credit Portfolio Risk
“Earlier, bankers used to measure the risk of individual loans with the help of loan officers who specialised in assessing risks related to a particular industry. However, over time, banks have realised that even if the transactions appear to be risk-free when you consider them one by one, they could have considerable risk when bundled together.
As a result, the concept of credit portfolio risk was created which measures the risks of all assets bundled up together. This risk is measured using metrics such as the Sharpe ratio and risk-adjusted return on capital.
Credit portfolio risk management allows risk managers to correlate their returns with the amount of risk being taken. Hence, portfolio managers can fine-tune their risk based on their expected return. Reduction of concentration via diversification is the basic principle used in credit portfolio risk management.
Once the loan has been given out, there is a separate department that is created to decide what action needs to be taken on the loan. They decide to securitize some loans, sell some others and hold some to maturity.
This decision is based on their understanding of the bank’s internal risk policy, the risk concentration levels of the bank’s current portfolio, and the characteristics of the loan, the department makes a decision about how the loan should be handled.
Active credit portfolio management is an alternative to the buy-and-hold strategies that have been used by banks for decades. As a part of this strategy, banks are constantly comparing the expected returns from their assets with a hurdle rate. This hurdle rate is the cost of funds for the bank. Based on the comparison against this hurdle rate, banks decide whether they want to hold a loan to maturity or whether some form of credit enhancement or credit transfer is required.
Active credit portfolio management allows banks and other financial institutions to trade loan assets amongst each other. This allows all banks to have risk-adjusted portfolios amongst themselves regardless of who originated the loans in the first place.”
Concentration Risk
The previous definition mentioned concentration risk, which is reduced by diversification. Concentration risk is described by the Office of the Comptroller of the Currency as:
“The accurate identification of a borrower’s credit risk and the assignment of an appropriate risk rating that describes that risk are at the heart of an effective credit risk management process. But credit risk management does not conclude with the supervision of individual transactions. It also encompasses the management of concentrations, or common pools of exposures, whose collective performance has the potential to affect a bank negatively even if each individual transaction within a pool is soundly underwritten. When exposures in a pool have a common characteristic or sensitivity to the same economic, financial, or business development, that characteristic or sensitivity, if triggered, may cause the sum of the transactions to perform or react similarly.
A concentration is defined as the sum of direct, indirect, or contingent obligations exceeding 25 percent of the bank’s tier 1 capital plus the allowance for loan and lease losses (ALLL) or allowance for credit losses (ACL), as applicable.
Excessive concentrations of credit have been key factors in banking crises and failures. Accordingly, this booklet emphasises the importance for bank management to establish processes to identify, measure, monitor, and control concentrations of credit. Sound processes generally consider and incorporate credit exposures that can originate outside of the bank’s lending portfolio, including those arising from the bank’s investment and trading portfolios and off-balance-sheet transactions. A central lesson learned from past financial crises is that concentrations can accumulate across products, business lines, countries, and legal entities within a banking company.”
Counterparty Risk
“A counterparty credit risk is simply a subtype of a credit risk. The term “credit risk” covers all types of economic loss, including both counterparty and issuer credit risks. It’s a term often used when talking about banks loaning money or corporate bonds.
Counterparty credit risk comes in two forms: pre-settlement risk and settlement risk. The former applies during a transaction while the latter applies thereafter. Settlement risk can then be further divided into default risks – i.e., a complete non-fulfilment of an obligation – and settlement timing risks, such as late performance.”
Contagion Risk
“One bank fails, not a big deal. Unless you have a lot of money in that bank. For the rest of us, the big risk is “contagion.”
“Contagion is really, obviously, taken from a medical term,” said Galina Hale, an economist at the University of California Santa Cruz and former adviser with the Federal Reserve.
She explained that just as an infectious disease spreads, the same thing can happen in the banking world.
“So, contagion is essentially, when a problem in one financial institution is creating problems for others, otherwise healthy financial institutions.”
In the case of Silicon Valley Bank, which collapsed on March 10, it went too big on bond investments. Depositors got spooked, wanted their money out right away, and a bank run ensued. Then, fear started to spread.
“What we see internationally is mostly this wakeup call, contagion, right?” said Hale, who is also a contributor to Econofact. “So, people realise, ‘Oh, I thought the banks would never fail again, but now, they actually are. So, let me see what’s happening with my bank.’”
Banks are different from other businesses. When one bank goes bust, it can ripple through the industry.
The problems at Credit Suisse were different than at Silicon Valley Bank. And to be clear, Credit Suisse was not a healthy bank — its balance sheet also looked shaky, filled with bad investments.
Still, when a few US banks went down, investors in Credit Suisse got panicky. Then, that set off worries about a possible chain reaction.”
Exchange Rate Risk
“Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies.
The risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than where it is headquartered. For example, a company based in Canada that does business in China – i.e., receives financial transactions in Chinese yuan – reports its financial statements in Canadian dollars, is exposed to foreign exchange risk.
The financial transactions, which are received in Chinese yuan, must be converted to Canadian dollars to be reported on the company’s financial statements. Changes in the exchange rate between the Chinese yuan (foreign currency) and Canadian dollar (domestic currency) would be the risk, hence the term foreign exchange risk.
Foreign exchange risk can be caused by appreciation/depreciation of the base currency, appreciation/depreciation of the foreign currency, or a combination of the two. It is a major risk to consider for exporters/importers and businesses that trade in international markets.”
Summary
In this initial examination of 6 different risk types it is very apparent that we operate in a very complicated and interlinked environment, necessitating specialist skills and a thorough commitment to mitigating risks, wherever they may come from.
“In financial services, if you want to be the best in the industry, you first have to be the best in risk management and credit quality. It’s the foundation for every other measure of success. There’s almost no room for error.” John G. Stumpf
About the Author
Stephen John Leonard is the founder of ADEPT Decisions and has held a wide range of roles in the banking and risk industry since 1985.
About ADEPT Decisions
We disrupt the status quo in the lending industry by providing lenders with customer decisioning, credit risk consulting and advanced analytics to level the playing field, promote financial inclusion and support a new generation of financial products.
