Question

Describe financial institution risk exposures and how to manage these risks. Hint: risk exposures show themselves both within quoted interest rates and on financial institution’s balance sheets. The institutions try to manage those risks both on and off the balance sheet. Given the COVID-19 environment, your answer should definitely include a discussion of how default risk has become more apparent in the last couple of months.

Answer 1

Financial establishments, such as banks, routinely face different types of risks in the course of their operations. Risk stems from uncertainty of financial loss and can potentially cripple the business if not managed in time. This demands that mechanisms to manage risk be created via a risk management philosophy, with the objective of minimizing negative effects risks can have on the financial health of the institution. This involves identifying potential risks in advance, analyzing them and taking steps to diminish or eliminate them.

Market Risk

Financial institutions face the possibility of loss caused by changes in market variables, including interest rate and exchange rate fluctuations, as well as movements in market prices of commodities, securities and financial derivatives. These constitute risks that can negatively impact the financial capital of the institution. Market risk management involves developing a comprehensive and dynamic framework for monitoring, measuring and managing liquidity, interest rate, foreign exchange and commodity price risks. This should be integrated with the institution’s business strategy. In addition, stress testing can assess potential problem areas in a given portfolio.

Credit Risk

Credit risk is the potential that an entity that borrowed money will default on that obligation to the financial institution. It may be because of the inability or unwillingness of the client to honor their part of the bargain in relation to the financial transaction. To manage credit risk, the institution has to maintain credit exposure within the acceptable parameters. One effective way is via a risk rating model that gauges how much a bank stands to lose on credit portfolio. Further, lending decisions are routinely based on the credit score.

Financial establishments, such as banks, routinely face different types of risks in the course of their operations. Risk stems from uncertainty of financial loss and can potentially cripple the business if not managed in time. This demands that mechanisms to manage risk be created via a risk management philosophy, with the objective of minimizing negative effects risks can have on the financial health of the institution. This involves identifying potential risks in advance, analyzing them and taking steps to diminish or eliminate them.

Market Risk

Financial institutions face the possibility of loss caused by changes in market variables, including interest rate and exchange rate fluctuations, as well as movements in market prices of commodities, securities and financial derivatives. These constitute risks that can negatively impact the financial capital of the institution. Market risk management involves developing a comprehensive and dynamic framework for monitoring, measuring and managing liquidity, interest rate, foreign exchange and commodity price risks. This should be integrated with the institution’s business strategy. In addition, stress testing can assess potential problem areas in a given portfolio.

Credit Risk

Credit risk is the potential that an entity that borrowed money will default on that obligation to the financial institution. It may be because of the inability or unwillingness of the client to honor their part of the bargain in relation to the financial transaction. To manage credit risk, the institution has to maintain credit exposure within the acceptable parameters. One effective way is via a risk rating model that gauges how much a bank stands to lose on credit portfolio. Further, lending decisions are routinely based on the credit score and report of the prospective borrower.

Operational Risk

Operational risk is associated with the potential negative consequences of the operations of the financial institution, such as those caused by inadequate or failed internal processes, people and systems, or unforeseeable external events. Internal operational risks include omissions in the work of employees, inadequate information management and losses arising from fraud, trading errors or system failures. External events such as floods, fire and natural disasters also pose risks. Operational risk management involves establishing internal audit systems, assessing and eliminating weak control procedures, familiarizing all levels of staff with the complex operations and having appropriate insurance cover.

Regulatory Risk

All financial institutions face regulatory risk, since the U.S. has several financial regulations implemented at federal and state levels that have to be complied with. This is to enhance governance and safeguard the public against loss. Banks and other financial establishments that have gone for public issue face a multiplicity of regulatory controls in order to ensure greater responsibility and accountability. These regulations can inhibit free growth of business as institutions focus on compliance, leaving little energy and time for developing new business. To manage regulatory risk, institutions should conduct their business activities within the regulatory framework.

CREDIT RISK MANAGEMENT

Assistance to banks as they implement the following responses to the current market conditions:
• Accelerate the management of credit spread risk in the banking book if not sufficient yet;
• Cater for the impacts of interest rate and credit spread movements on accounting P&L and capital
management;
• Re-allocate risk-based limits to reflect new market conditions;
• Revise stress testing scenarios and back-testing methodologies;
• Adopt methodologies for fair value adjustments to account for liquidity discounts, close-out costs (bid-
offer) and higher volatilities;
• Incorporate thorough quality assurance of pricing feeds and alternative data for valuation; and

OPERATIONAL RISK MANAGEMENT

 Identify key risks inherent in changes to operational processes to enable home office arrangement as well as
business processes related to new products launched as relief measures for COVID-19
 Assess the adequacy of controls to mitigate risks arising from the new and revised processes
• We can facilitate the identification and assessment the impact of COVID-19 related stresses through a scenario analysis
process:
• Our in-house regulatory compliance tool can assist you with achieving operational optimisation. Key features of the tool are as
follows:
 Captures Hong Kong regulatory requirements applicable to your business
 Assesses the transformational considerations impacting the business and operating model
 Understands interdependencies between different regulatory requirements
 Clear assignment of roles and responsibilities
 Tracks the implementation of control processes to ensure regulatory compliance
 Designs and implements a monitoring and testing approach which links to specific Hong Kong regulatory obligations
• We can review and provide tailored recommendations on the appropriateness of your operational risk stress testing
methodology, taking into consideration regulatory expectations and peer practices. This includes review of scenario setting and
stress testing approach, such as data selection, frequency, severity, parameters or multipliers, assumptions, justifications,
model limitations, etc.
• We can support with enhancing enterprise-wide operational resilience:
 Operational resilience governance and strategy
 Operational resilience policy and framework
 Design target operating model for operational resilience for third party risk management, resource management,
cybersecurity management, as well as business continuity management

LIQUIDITY RISK MANAGEMENT

Banks need to ensure they have
operational efficiency to have
timely access to liquidity facilities
and efficient utilisation of their
liquidity buffers
Scenario Design and Models
Banks should incorporate the
COVID scenarios in their stress
testing and adjust models in
order to assess the potential
impacts and ensure appropriate
action under the crisis
Contingency Funding Plan
and Recovery Plan
Banks should revisit the
contingency funding plan and
recovery plan to adapt to the new
reality
Reporting and Escalation
Banks should improve content,
readability, and timeliness of their
crisis reporting