Summary of the book "Foundations of Financial Risk" by Richard Apostolik and Christopher Donohue. The book includes the basics of the risk management facing banks and insurance companies and how they mitigate it.
Summary foundations of financial risk with multiple choice questions
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Notes Risk Management in Banking
Notes from the book (Foundations of Financial Risk)
Preface
After the financial crisis, new regulations were needed to reform the traditional way of
working for banks. Efforts to reform the global financial system were initially led by the G20
group of developed market economies. Finance ministers and central bankers from the G20
countries set the agenda, defined the priorities for financial market reforms, and delegated
specific tasks to more specialized bodies such as the Basel Committee on Banking
Supervision (whose work has included new capital and liquidity standards for banks) and the
International Organization of Securities Commissions (IOSCO) (whose work has
included new rules on how to trade financial instruments).
Corporate governance = Corporate governance is the system of rules, practices and
processes by which a company is directed and controlled. Corporate governance
essentially involves balancing the interests of a company's many stakeholders, such as
shareholders, management, customers, suppliers, financiers, government and the
community. Since corporate governance also provides the framework for attaining a
company's objectives, it encompasses practically every sphere of management, from
action plans and internal controls to performance measurement and
corporate disclosure.
The Basel Committee are standard setters and have a big influence in all countries. However,
they cannot enforce their recommendations, because for that the laws and regulations for
every country have to be adjusted. For example, in Europe, the European Union have adopted
those new laws and transmitted them down to the Union’s member states through directives
and regulations.
Banking regulations are mainly outlined in the International Convergence of Capital
Measurement and Capital Standards (known as the Basel Accord). Insurance regulations,
known as Solvency 2 codify risk management practices.
Chapter 1: Functions and Forms of Banking
- There are three core banking functions. Those are: Collecting deposits, arranging
payments and making loans (loan underwriting). Banks may also offer financial
services such as cash, asset and risk management.
- Banks play a central role in facilitating economic activity through three
interrelated processes: Financial intermediation, asset transformation and
money creation.
- Retail banks mainly serve retail customers and wholesale banks primarily serve
corporate customers. A country’s central bank sets monetary policy on behalf of
the country’s government, liaises with other central banks and may act as the bank
regulator.
- The main risks banks face is: Credit, market, operational and liquidity risk.
, 1.1 Functions and Forms of Banking
Deposit collection: Accepting cash or money from individuals and businesses for safekeeping
and availability for future use. (Savings accounts or current accounts).
Payment services: The process of accepting and making payments on behalf of the customers
using their bank accounts. (Debit cards, electronic banking, foreign exchange).
Loan underwriting: The process of evaluating and deciding whether a customer is eligible to
receive credit and then extending a loan or credit to the customer. (Credit cards, mortgages
and consumer loans).
A bank ‘loans’ money from customer deposits and that money they lend to other customers or
corporates. The difference in the interest they pay to the depositors and they receive from the
people then lend that money to is their main source of revenue and profit to the bank. This is
called financial intermediation or asset transformation. In short, banks borrow money (low
risk) by getting deposits and savings. The interest rate on this is relatively low. With that
money, banks make large loans with higher risk and long maturity. The interest rate is higher
because of the increased risk. Customer deposits are turned into loans.
Banks also do money creation. An initial deposit of 100 in bank A causes the bank to reserve
10% and lend the 90%. This 90 is subsequently lend out to a customer who invests it in a
store. That store puts it in another bank B. Bank B reserves 10% as well and lends 90% of it
out What follows is that there is a multiplier of 10 (1/10%) of money creation. Therefore, an
initial deposit of 100 makes 1000 (900 created).
Banks also earn money by fee income. This is the greatest source of income after the interest
gap. Other banking services may include:
Cash management. (Treasury management from a large corporation)
Investment- and securities-related activities. (Investing on behalf for a customer
in for example stocks and bonds that carry a larger risk)
Derivatives trading. (Other financial instruments such as stocks or commodities
like oil/gold).
Loan commitment.
Letters of credit. (Guarantee of a payment so payment is guaranteed in case of
uncertainty).
Insurance services. (Done increasingly by banks because asset transformation
works similar).
Trust service. (Managing the assets of a wealthy individual for a fee).
Risk management service. (Banks have developed sophisticated skills and tools
to manage complex risks. For a fee banks offer this to customers).
1.2 Different Bank Types
Retail banks: Offer services mainly to individual customers or small- and medium
enterprises.
Wholesale banks: Offers services mainly to corporate and non corporate businesses. Those
kind of banks cannot accept deposits from individuals. They offer a lot of specialized
, knowledge services like risk management help and they act as intermediaries in raising funds.
It is beneficial for large corporations to use wholesale banks instead of a retail bank.
Bank holding companies: Companies that own one or more banks but do not conduct
banking business themselves.
Cooperative banks: In a cooperative bank, if a customer deposits money it will become
shareholder of that bank. Those banks therefore have strong ties with local community (like
the RABO Bank).
Credit unions: Those are also owned by their customer. However, in practice, they tend to be
small.
Micro-finance institutions: Usually seen in developing countries. Often used to replace other
lenders that exploit poor people in those countries. Money involved is limited.
Central banks: Central banks manage the amount of money and credit in an economy –
usually in an effort to contain inflation rates and/or to foster economic growth. They often buy
and sell government debt, determine and maintain core interest rates, set reserve requirement
levels and issue currencies. Besides this, central banks oversee the banking system as a whole
(macro prudential supervision) and the regulation and supervision of individual banks
(micro prudential supervision).
1.3 Banking Risks
The size and risk of a bank’s assets are the main determinants of how much regulatory reserve
capital a bank holds. The key risks are credit risk, market risk, operational risk and liquidity
risk according to the Basel Accords. The Basel Accords are the cornerstone of international
risk-based banking regulation.
Credit Risk: The risk that a bank borrower may fail to pay back the borrowed amount or the
interest on that amount. This often happens when money is loaned to high-risk borrowers
(subprime mortgage borrowers). From a depositor’s perspective, credit risk is the risk that the
bank cannot pay the interest back to the depositor.
Market Risk: The risk of losses to the bank arising from movements in market prices as a
result of changes in interest rates, foreign exchange rates and equity and commodity prices.
Interest Rate Risk: Potential loss due to movements in interest rates. If interest rates
rise, a bank has to pay higher interest to repay short term liabilities, but long-term
assets still have the same (lower) interest rate. The gap decreases partly or completely.
(see figure 1.5 on page 20)
Equity Risk: Potential loss due to an adverse change in the price of stock. If a bank
purchases ownership in a company and the company loses value, the bank loses value
as well.
Foreign Exchange Risk: The risk that the value of the bank’s assets or liabilities
change due to currency exchange rate fluctuations. Banks buy and sell in foreign
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