8/10/2019 Qf 305 Lecture 1 New 2014

1/49

8/10/2019 Qf 305 Lecture 1 New 2014

2/49

2

The concept of Risk

Risk is related to the expected losses(gains) which can be caused by a

risky event.

Uncertainty ofa factor or event

Probability of theOccurrence of

the factor or event

8/10/2019 Qf 305 Lecture 1 New 2014

3/49

3

Risk management

Man plans, God smiles -Hebrew Proverb

Crossing the road without lookingwill most likely

result ininjury

!

If you cant manage risk, you cant control it. And ifyou cant control it you cant manage it. That meansyoure just gambling and hoping to get lucky.

-- J. Hooten, managing Partner, Arthur Andersen &Co., 2000

8/10/2019 Qf 305 Lecture 1 New 2014

4/49

Prevention and mitigation

4

Prevention and mitigationare the actions we can

take to make sure that adisaster doesn't happenor, if it does happen, thatit doesn't cause as muchharm as it could.

8/10/2019 Qf 305 Lecture 1 New 2014

5/49

5

Sources of risk

A source of risk is any factor that canaffect project or business performance.

There are many sources of risk!

- political, financial and legal risks

- economic, natural and market risks

8/10/2019 Qf 305 Lecture 1 New 2014

6/49

6

Types of risks

Common risks:

1. Environmental risks

2. Operational risks3. Financial risks

8/10/2019 Qf 305 Lecture 1 New 2014

7/49

7

Managing risk

Risk management is the process ofmeasuring (or assessing) risk and

developing strategies to manage it.

8/10/2019 Qf 305 Lecture 1 New 2014

8/49

8

The evolution of risk management

The birth of risk management

In the 1970s - early work

In the 1980s - quantitative analysis

In the 1990s - methodology

In the 2000s - enterprise wide

8/10/2019 Qf 305 Lecture 1 New 2014

9/49

9

The risk management process

The process of risk managementinvolves:

- identification of risks

- evaluation of the risks

- management of the risks

8/10/2019 Qf 305 Lecture 1 New 2014

10/49

10

Risk management

ManagementMeasurement

Identification

8/10/2019 Qf 305 Lecture 1 New 2014

11/49

11

Identify risk

Examine all sources of risk bothinternal and external.

Identify risks through1. history

2. incidents

3. scenario analysis4. survey

5. ..

8/10/2019 Qf 305 Lecture 1 New 2014

12/49

Case study

Risk profile of Malaysia airline

12

8/10/2019 Qf 305 Lecture 1 New 2014

13/49

Evaluate risk

Risk evaluation allows you todetermine the significance of risks and

decide to accept or take action foreach specific risk.

Quantitative techniques are the tools

to do the measurement!

13

8/10/2019 Qf 305 Lecture 1 New 2014

14/49

14

Manage risk

Find suitable responses to risk (4 Ts)

1. Tolerate (Retention)

2. Treat (Mitigation)

3. Transfer (Buying Insurance)

4. Terminate (Elimination)

8/10/2019 Qf 305 Lecture 1 New 2014

15/49

15

Financial risk

Financial risk can be defined as those whichrelate to possible losses in financial markets.

Financial markets: Capital markets

Commodities markets

Money markets

Derivatives markets Insurance markets

Currency markets

8/10/2019 Qf 305 Lecture 1 New 2014

16/49

Financial Institutions Roles

Corporations

(net borrowers)

Households

(net savers)Cash

Equity & Debt

Without FIs

16

8/10/2019 Qf 305 Lecture 1 New 2014

17/49

With FIs

Cash

Households Corporations

Equity & Debt

FI

(Brokers)

FI

(Asset

Transformers)

Deposits/Insurance

PoliciesCash

17

8/10/2019 Qf 305 Lecture 1 New 2014

18/49

Functions of FIs

Brokerage function: Acting as an agent for investors

Reduce costs through economies of scale

Encourages higher rate of savings

Asset transformer: Purchase primary securities by selling

financial claims to households Transformation of financial risk

18

8/10/2019 Qf 305 Lecture 1 New 2014

19/49

Functions of FIs

Information costs Role of FI as Delegated Monitor

FI likely to have informational advantage

Economies of scale in obtaining information.

FI as an information producer

Shorter term debt contracts easier to monitor than bonds

Greater monitoring power and control

Acting as delegated monitor, FIs reduce informationasymmetry between borrowers and lenders

19

8/10/2019 Qf 305 Lecture 1 New 2014

20/49

Other Special Services

Reduced transactions costs

Maturity intermediation

Transmission of monetary policy.

Credit allocation (areas of special needsuch as home mortgages)

Intergenerational wealth transfers or timeintermediation

Payment services

Denomination intermediation

20

8/10/2019 Qf 305 Lecture 1 New 2014

21/49

Risk measurement and management

From originate and holdto originate anddistribute

Increase the systemic risk of the financialsystem.

Financial crisis reshaped the financialservices industry.

The economy relies on financial institutionsto act as specialists in risk measurementand management

21

8/10/2019 Qf 305 Lecture 1 New 2014

22/49

Products of financial Institutions

Table on page 35,36

22

Products sold

in 1950

Products sold

in 2013

8/10/2019 Qf 305 Lecture 1 New 2014

23/49

23

Financial institutions

Depository Institutions

Finance companies

Securities firms and investment banks

Mutual funds and hedge funds

Insurance Institutions

8/10/2019 Qf 305 Lecture 1 New 2014

24/49

Depository Institutions

Products of depository Institution:

o Payment services, savings products,

o Underwriting of debt and equity, Insuranceand risk management products

Three major groups:

o Commercial bankso Saving institutions

o Credit unions24

8/10/2019 Qf 305 Lecture 1 New 2014

25/49

Balance sheets

In financial accounting, a balance sheet orstatement of financial position is a summary of thefinancial balances of a sole proprietorship, a

business partnership, a corporation or otherbusiness organization, such as an LLC or an LLP.Assets, liabilitiesand ownership equityare listedas of a specific date, such as the end of its financial

year. http://en.wikipedia.org/wiki/Balance_sheet

25

http://en.wikipedia.org/wiki/Balance_sheethttp://en.wikipedia.org/wiki/Balance_sheet

8/10/2019 Qf 305 Lecture 1 New 2014

26/49

Example of a balance sheet

26

8/10/2019 Qf 305 Lecture 1 New 2014

27/49

Example of a banks balance sheet

27

8/10/2019 Qf 305 Lecture 1 New 2014

28/49

Specialness of Depository FIs

Products on both sides of thebalance sheet

Loans Business and Commercial

Deposits

28

8/10/2019 Qf 305 Lecture 1 New 2014

29/49

Size of Depository FIs

Consolidation has created some verylarge FIs

Combined effects of disintermediation,global competition, regulatory changes,technological developments,competition across different types of FIs

29

8/10/2019 Qf 305 Lecture 1 New 2014

30/49

Largest US Depository Institutions

30

1. J.P.Morgan Chase 2,321.3

2. Bank of America 2,168.0

3. Citigroup 1,931.34. Wells Fargo 1,374.7

5. U.S. Bancorp 352.3

6. PNC Financial Services Corp. 301.1

7. Bank of NY Mellon 340.1

8. State Street Corp. 204.1

9. TD Bank 212.5

10. HSBC North America 320.8

Holding Co. Assets ($Billions) 2012

8/10/2019 Qf 305 Lecture 1 New 2014

31/49

Commercial Banks

Largest depository institutions arecommercial banks, which accept depositsand make consumer, commercial and real

estate loans. Differences in operating characteristics and

profitability across size classes

Mix of very large banks with very small banks

31

8/10/2019 Qf 305 Lecture 1 New 2014

32/49

Breakdown of Loan Portfolios (US)

32

8/10/2019 Qf 305 Lecture 1 New 2014

33/49

Structure and Composition

Shrinking number of banks (US):

14,416 commercial banks in 1985

12,744 in 1989

6,911 in 2009

6,168 in 2012

Mostly the result of Mergers and Acquisitions

M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small

banks

Asset Concentration33

8/10/2019 Qf 305 Lecture 1 New 2014

34/49

Commercial Banks: Asset Concentration

Size

2012

Assets

Percent

of Total

2009

Assets

Percent

of Total

1984

Assets

Percent

of Total$100M or

Less

118.0 0.9 142.9 1.2 404.2 16.1

$100M - $1B 1,059.2 8.1 1,104.2 9.3 513.9 20.5

$1B - $10B 1,133.6 8.7 1,158.9 9.8 725.9 28.9

$10B or more 10,759.1 82.3 9,460.4 79.7 864.8 34.5

34

8/10/2019 Qf 305 Lecture 1 New 2014

35/49

Global trend

Top banks in 2008

Top banks in 2013

Top 100 Banks in the World

http://www.relbanks.com/worlds-top-banks

35

http://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-bankshttp://www.relbanks.com/worlds-top-banks

8/10/2019 Qf 305 Lecture 1 New 2014

36/49

Global trend

Banks TotalAssets

Deutsche Bank (Germany) 2,809.9

Mitsubishi UFJ Financial Group (Japan) 2,803.4

Industrial & Commerce Bank of China (China) 2,763.6

HSBC Holdings (United Kingdom) 2,721.1

Barclays Bank (United Kingdom) 2,584.3

BNP Paribas (France) 2,563.0

Japan Post Bank (Japan) 2,513.2

J.P. Morgan Chase (United States) 2,321.3

Crdit Agricole Groupe (France) 2,317.1

Royal Bank of Scotland (United Kingdom) 2,295.8

36

February 2012 2013

8/10/2019 Qf 305 Lecture 1 New 2014

37/49

List of banks in Singapore

http://en.wikipedia.org/wiki/List_of_banks_in_Singapore

37

http://en.wikipedia.org/wiki/List_of_banks_in_Singaporehttp://en.wikipedia.org/wiki/List_of_banks_in_Singaporehttp://en.wikipedia.org/wiki/List_of_banks_in_Singaporehttp://en.wikipedia.org/wiki/List_of_banks_in_Singapore

8/10/2019 Qf 305 Lecture 1 New 2014

38/49

Some Terminology

Offsetting

Commercial paper market

ROA (return on assets) ROE (return on equity)

Securitization

38

8/10/2019 Qf 305 Lecture 1 New 2014

39/49

Balance Sheet and Trends

Business loans have declined in importance

Offsetting increase in securities and mortgages

Increased importance of funding via commercialpaper market

Securitization of mortgage loans

39

8/10/2019 Qf 305 Lecture 1 New 2014

40/49

Balance sheet in September 2012

40

8/10/2019 Qf 305 Lecture 1 New 2014

41/49

Commercial Banks, September 2012

Primary assets:

Real Estate Loans: $3,569.9 B

C&I loans: $1,401.2 B

Loans to individuals: $1,206.9 B

Investment security portfolio: $3,909.3 B

Of which, Treasury securities: $1,705.6 B Inference: credit Risk, liquidity risk, interest

rate risk41

8/10/2019 Qf 305 Lecture 1 New 2014

42/49

Commercial Banks

Primary liabilities:

Deposits: $9,622.4 B

Borrowings: $1,568.6 B

Other liabilities: $378.2 B

Inference:

Highly leveraged

42

8/10/2019 Qf 305 Lecture 1 New 2014

43/49

Equity

Commercial Banks equity capital (2012)

(11.48% percent of total liabilities and equity

Common and preferred stock Surplus or additional paidin Capital

Retained earnings

A minimum level of equity capital is requiredto act as a buffer against losses

43

8/10/2019 Qf 305 Lecture 1 New 2014

44/49

Off-Balance-Sheet Activities

Heightened importance of off-balance-sheet items

OBS assets, OBS liabilities Regulatory incentives

Risk control and risk producing

Role of mortgage backed securities Toxicassets

Expansion of oversight

44

8/10/2019 Qf 305 Lecture 1 New 2014

45/49

Major OBS Activities

Loan commitments

Standby letters of credit and letters of

credit

Futures, options, forwards, and swaps

When-issued securities

45

8/10/2019 Qf 305 Lecture 1 New 2014

46/49

Other Fee-Generating Activities

Trust services

Correspondent banking

Check clearing

Foreign exchange trading

Hedging

Participation in large loan and securityissuances

46

8/10/2019 Qf 305 Lecture 1 New 2014

47/49

Savings Institutions

Comprised of: Savings and Loans Associations

Savings Banks Industry is smaller overall

Intense competition from other FIs

47

8/10/2019 Qf 305 Lecture 1 New 2014

48/49

Credit Unions

Nonprofit DIs owned by member-depositorswith a common bond of occupation

Exempt from taxes and CommunityReinvestment Act (CRA)

Expansion of services offered in order tocompete with other FIs

Claim of unfair advantage of CUs over smallcommercial banks

48

8/10/2019 Qf 305 Lecture 1 New 2014

49/49

Discussion

What are the benefits to have FIs?

What are the major assets hold by

commercial banks? What inference dowe get?

What are the benefit of OBS activities?

What are the risks of OBS activities?

49