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The Management of Risk

admin — Sat, 12 Dec 2009 18:29:16 +0000

Risk management overlays all financial institution functions. Banks cannot generate the returns required by shareholders without accepting risk. The two key challenges for the management of banks and other financial service companies are how to manage and price that risk.
Buying the equivalent of an insurance policy can reduce many of these risks, but insurance bears a cost. Management has to balance the costs of those implicit or explicit insurance premiums against the level of protection afforded. A bank analyst has to understand enough about the techniques and tools available to make a judgment on whether management at a particular bank has the skills and infrastructure to make these decisions effectively. The starting point is to establish the organizational infrastructure for risk management.

Replacement risk

admin — Sun, 06 Dec 2009 18:27:42 +0000

Replacement risk arises when a bank has an obligation to one party where the discharge of that obligation is conditional on a third party meeting its obligation to the bank. For example, the bank may have sold stock to the first party. It intends to deliver this stock using stock it has bought but not yet received from a third party. If the third party fails to deliver its stock the bank will have to buy it from the market at a potentially higher price.
The most common primary cause of bank failures is insolvency arising from credit losses. This is followed by failure to manage interest rate risk and foreign exchange risk. Failures arising from fraud, market risk and liquidity risk tend to hit the headlines but are far less common than those due to these first two factors.

Investment Companies

admin — Wed, 02 Dec 2009 18:26:11 +0000

Investment companies sell shares to the public and invest the proceeds in a diversified portfolio of securities. Each share they sell represents a proportionate interest in a portfolio of securities. The securities purchased could be restricted to specific types of assets such as common stock, government bonds, corporate bonds, or money market instruments. The investment strategies followed by investment companies range from high-risk active portfolio strategies to low-risk passive portfolio strategies.
There are two types of managed investment companies: open-end funds and closed-end funds. An open-end fund, more popularly referred to as a mutual fund, continually stands ready to sell new shares to the public and to redeem its outstanding shares on demand at a price equal to an appropriate share of the value of its portfolio, which is computed daily at the close of the market. A mutual fund’s share price is based on its net asset value (NAV) per share, which is found by subtracting from the market value of the portfolio the mutual fund’s liabilities and then dividing by the number of mutual fund shares outstanding.
In contrast to mutual funds, closed-end funds sell shares like any other corporation and usually do not redeem their shares. Shares of closed-end funds sell on either an organized exchange, such as the New York Stock Exchange, or in the over-the-counter market. The price of a share in a closed-end fund is determined by supply and demand, so the price can fall below or rise above the net asset value per share.

Pre-payment and reinvestment risk

admin — Sat, 28 Nov 2009 18:24:57 +0000

Reinvestment risk arises when a bank has fixed rate interest-earning assets, such as housing loans, where the borrower has the right to repay those loans early. If interest rates fall and borrowers repay their loans the bank will have to reinvest the proceeds received at the then prevailing lower rates.

Operational risk

admin — Wed, 25 Nov 2009 18:24:06 +0000

Operational risk is a catchall category for other things that could go wrong. It includes potentially catastrophic events such as earthquakes, flooding and fire and other more mundane factors such as power, computer or telecommunications failures.

The Balance Sheet

admin — Sun, 22 Nov 2009 18:23:05 +0000

The balance sheet, prepared as of a specific date, records the categories and amounts of assets employed by the business (i.e., the resources committed) and the offsetting liabilities incurred to lenders and owners (i.e., the funds obtained). Also called the statement of financial condition or statement of financial position, it must always balance. By definition, the recorded value of the total assets in- vested in the business at any point in time must be matched precisely by the recorded liabilities and owners’ equity supporting these assets. Liabilities are specific obligations that represent claims against the assets of the business, ranking ahead of the owners in repayment priority. In contrast, the recorded shareholders’ equity in effect represents a residual claim of the owners on the remaining assets after all liabilities have been subtracted.
The major categories of assets, or resources committed, are:
•   Current assets (items that turn over in the normal course of business within a relatively short period of time, such as cash, marketable securities, accounts receivable, and inventories).
•   Fixed assets (such as land, mineral resources, buildings, equipment, machinery, and vehicles), all of which are used over a longer time frame.
•   Other assets, such as deposits, patents, and various intangibles, including goodwill that arose from an acquisition.
Major sources of the funds obtained are:
•   Current liabilities, which are obligations to vendors, tax authorities, employees, and lenders due within one year or less.
•   Long-term liabilities, which are a variety of debt instruments repayable beyond one year, such as bonds, loans, and mortgages.
•   Owners’ (shareholders’) equity, which represents the recorded net amount of funds contributed by various classes of owners of the business as well as the accumulated earnings retained in the business after payment of dividends.
Balance sheets are static in that, like snapshots, they reflect conditions on the date of their preparation. They’re also cumulative because they represent the effects of all decisions and transactions that have taken place since the inception of the business and have been accounted for up to the date of preparation.
As we indicated earlier, financial accounting rules require that all transactions be recorded at costs and values as incurred at the time, and retroactive adjustments to recorded values are made only under very limited circumstances. As a consequence, balance sheets (being cumulative) display assets and liabilities acquired or incurred at different times. Because the current economic value of assets can change, particularly in the case of longer-lived items (such as buildings and machinery) or basic resources (such as land and minerals), the costs stated on the balance sheet are not likely to reflect true economic values. Moreover, changes in the value of the currency in which the transactions are recorded can, over time, distort the balance sheet.
Ultimately, the recorded book value of owners’ equity is affected by all of these value differentials. There generally is quite a divergence between this residual accounting value and the current economic value of the business as reflected in share prices or in valuations for acquisition. In fact, the shares of successful companies are usually traded at price levels far above their recorded book value.
Finally, a number of relatively recent accounting rules require the estimation and recording of contingent liabilities arising from a variety of future obligations, such as pension and health-care costs, further introducing a series of value judgments. These are frequently shown as “other liabilities,” listed just ahead of shareholders’ equity, and, in effect, amount to a reclassification from being part of the owners’ residual claims, to a special form of long-term liability.
The accounting profession’s FASB is expending a great deal of effort to re- solve these and other issues affecting the meaning of the balance sheet, but only with partial success. Accounting standards continue to evolve, and a manager or analyst must be aware of the underlying issues and processes when reviewing and analyzing this statement.

Actuarial risk

admin — Fri, 20 Nov 2009 18:21:53 +0000

Insurance companies sell policies that pay out in the event of death or disability. The premiums charged on these policies are based on actuarial assumptions about factors such as mortality rates. If those assumptions prove to be incorrect such policies may be loss making.

Judicial and legal risk

admin — Mon, 16 Nov 2009 18:20:59 +0000

Financial contracts are frequently complex and banks are exposed to the risk that their understanding of an agreement differs from that of a court. Legal disputes between American commercial banks and a number of insurance companies on credit derivative contracts written by the latter on failed energy trading companies around the turn of the century involved billions of dollars in disputed claims.

Fraud

admin — Sat, 14 Nov 2009 18:20:05 +0000

Banks are at risk from fraud and other criminal behavior by their staff, customers and counterparties. In some cases these actions may involve actual theft but in other cases it may simply involve the concealment of losses that do not become apparent until a later date.

Country risk

admin — Thu, 12 Nov 2009 18:19:48 +0000

A US bank with operations in a foreign country is, for example, at risk from the imposition of capital controls preventing it from remitting any profits or other funds it has in that country. In extreme cases foreign banks may even have their assets appropriated.