Question

1. Characterize the main risk exposure of the following

banking/FI transactions by choosing one of the following, and the rational behind your choice.

(Note: one or more of the 10 transactions listed below could have the same risk. Please do not answer in one or two words such as credit risk or systematic risk, etc. this is not enough, you need to explain why this risk is applicable).

1. Credit risk
2. Interest rate risk
3. Off balance sheet risk
4. Foreign exchange risk
5. Liquidity risk
6. Market risk
7. Sovereign risk
8. Operational risk
9. Compliance risk
10. Systematic Risk (Uncertainty)

1. A bank provides $1 million loan to a company with total annual debt service of 80%.

2. A bank’s balance sheet shows five large depositors accounting for more than 50% of total deposits.

3. An American bank buying a Lebanese bond denominated in US dollars.

4. An investment bank agrees to underwrite $50 million 10-year 8% bond issue, before selling it to investors in the following week.

5. A lawsuit against Arab bank in New York.

Systematic risk, since the probability

6. A Lebanese importer of oil from Saudi Arabia defaults on his

           dollar letter of Credit issued to him by BLOM Bank.

7. A trader in the Treasury of a bank taking a large euro/dollar

           foreign exchange position beyond the limits assigned to him

           by senior management.

8. BankMed buys a 10-year bond issued by the Lebanese

            government using one year certificate of deposit.

9. A sudden drop in LL exchange rate leading to losses in the bank’s trading portfolio in excess of VaR

10- A Lebanese bank not abiding by FATCA/Anti money

        Laundering requirements.

Answer 1

1. An annual debt service coverage ratio of 80% or 0.80 means that the firm can only repay 80% of its obligations. A debt service coverage ratio measures the ability of the firm to repay. So here the bank's exposure is credit risk i.e. the risk that the firm might default on its obligations.

2. A bank's balance sheet shows five large depositors accounting for nearly 50% of deposits. This means that the bank's 50% of liabilities are concentrated on certain depositors and if all of them want to withdraw their deposits at once, there will be a situation called Bank run. To retain its efficiency and to able to service it's depositors banks have to ensure that deposits are spread across depositors. This kind of risk is known as liquidity risk i.e. the risk of being unable to service a few concentrated deposits at once.

3. An American Bank buying Lebanese bonds issued in dollars is exposed to the sovereign risk of a country like Lebanon and credit risk that it will default on its payments. Lebanon has had a history of political instability and an American Bank investing in a euro bond like this would be exposed to the risk associated with investing in Lebanon and the risk that the borrower may default.

4. A lawsuit against Arab Bank in New York. The bank is a foreign bank in the US. It has to comply with certain rules and regulations associated with a foreign bank. If it does not comply with those and a lawsuit is filed, the bank has been non compliant, faces compliance risk.

5. A Lebanese importer defaults on dollar letter of credit issued by BLOM Bank. An LC ensures that the exporter is paid on time by the bank and the importer has to pay back the concerned bank. The risk involved here is the credit risk as well as foreign exchange risk. The importer has defaulted and the LC is denominated in dollars so it is also exposed to foreign exchange risk.

6. A trader taking a large position is a transaction and not complying with the limits set by senior management is a sign of operational risk. There can be an operational hazard if the trade goes wrong. Firms have quality and risk management rules in place to avoid operational hazards. If any employee is not complying with this, the firm is exposed to operational risk and compliance risk.

7. Buying a 10 year bond using a 1 year COD indicates a mismatch in the duration of assets and liability. This entails interest rate risk as there is a mismatch in the tenure.

8. A drop in the exchange rate means that exchange rate has fluctuated. This means the firm is exposed to exchange rate risk. VAR indicates value at risk and is a term commonly used in market risk. So losses in excess of VAR indicates market risk.

9. FACTA/ anti money laundering rules are compliance rules every bank should adhere to avoid financial fraud. So when a bank does not comply it is exposed to compliance risk.