Sources of Risk
The main sources of risk which concern regulators are as follows:
a) Credit Risk
b) Settlement Risk
c) Market Risk
d) Other Risks
a) Credit Risk
The risk of a trading partner not fulfilling his obligations in full on due date or at any time thenceforth is a risk that impacts all aspects of business. Among risks that face financial institutions, credit risk is one with which investor are more familiar. It is also the risk to which supervisors of financial institutions compensate the closest attention since it has been the risk most likely to cause a bank to fail.
With traditional instruments such as loans, bonds or currency trading, the amount which counterpart is compelled to repay is the full or principal amount of the instrument. For those instruments, the amount at risk equals principal amount. Derivatives are various - since they derive their value from an fundamental asset or index, their credit risk is not equal to principal amount of trade, but instead of the cost of replacing the contract if the counterpart defaults. This substitute value wavers over time and is made up of potential replacement and current replacement costs.
It is relatively straightforward to assess current replacement cost. The Basle Committee for Banking Supervision recommends employing the current mark-to-market value of the contract. Potential replacement value is harder to estimate since it is a function of the remaining maturity (which is given), as well as the anticipated volatility and price of the fundamental asset, both of which could fluctuate considerably. The Basle Committee recommends multiplying the conceptional element of a transaction by appropriate percentage, which it refer as add-on, to reach at a potential replacement value.
"Principles for the Management of Credit Risk" (1999) sets out 17 principle to address five primary areas: establishing an appropriate credit risk environment, operating under a sound credit granting process, maintaining an appropriate credit administration, assessment and monitoring procedure, assuring enough controls over credit risk and the role of supervisors. The board of directors of a bank should for illustration, should be responsible for the bank's credit strategy - which should include a statement of the bank's willingness to grant credit established on type, economic sector, geographical location, currency, maturity and anticipated profitability. This would include the identification of target markets and the complete characteristics that bank would want in its credit portfolio, incorporating levels of variegation and concentration tolerances.
b) Settlement Risk
Settlement risk is the risk that a settlement in a transfer system does not accept place as anticipated. Generally, this happens since one party defaults on its clearing obligations to one or more counter parties. As such, settlement risk incorporates both liquidity and credit risks. The former arises when a counterpart cannot meet an obligation for full value on due date and thenceforth since it is insolvent. Liquidity risk refers to the risk that a counterpart will not settle for full value at due date but could do so at some unspecified time thenceforth, causing the party which did not receive its anticipated payment to finance the shortfall at short notice. Sometimes a counterpart might withhold payment even if it is not insolvent causing the original party to scramble around for funds, so liquidity risk could be present without being accompanied by credit risk.
One of the best ways of mitigating settlement risk is a safe and efficient payment system established on internationally accepted standards and practices. To encourage such standards, the Committee on Payment and Settlement Systems issued "Core principles for systemically significant payment systems" (1999). Besides the 10 basic principles, the paper also outlines 4 responsibilities of the central banks in employing these principles.
The risk that transactions cannot be settled impacts every type of asset and instrument which requires a transfer system to pass from one party to another. But as a risk it figures most conspicuously in currency trading since the daily settlement flows in foreign exchange clearing overshadow everything else.
The most well-known illustration of settlement risk is the failure of a small German bank, Bankhaus Herstatt in 1974. On 26th June 1974, the business firm's banking license was drawn back and it was ordered into liquidation throughout the banking day, but after the closing of German interbank payments system 3:30 pm.
c) Market Risk
From January 1st, 1998, internationally active banks in G-10 countries had to maintain regulatory capital to cover market risk. This is the risk to an institution's financial condition leading from adverse movements in level or volatility of the market prices of interest rate, equities, instruments, currencies and commodities. Market risk is more frequently than not assessed as the potential gain/loss in a position/portfolio that is linked with a price movement of a given probability over a specified time horizon. This is by and large known as value at risk (VAR). An institution with a 10-day VAR of $100 million at 99% confidence will suffer a loss in surplus of $100 million in the one biweekly period out of the 20, and then only if it is not able to accept any action to mitigate its loss.
Financial institutions have faced the risk of losses in the on and off balance sheet positions coming up from unsuitable market movements. all the same, the sharp raise of proprietary trading in various banks has heightened the require among regulators to ascertain that these institutions have management systems to assure and the capital to assimilate the risks posed by market related exposures.
For interest-rate related instruments and equities, this framework is established upon a "building-block approach" which distinguishes capital requirements for specific risk from those for general market risk. The 1988 Capital Accord for credit risks to incorporate market risks put forward a standardized assessment framework to compute market risk for interest rates, equities and currencies. For interest-rate related instruments and equities, this framework is established upon a "building-block approach" which distinguishes capital requirements for specific risk from those for general market risk.
It sets forth two approaches for computing the capital charge to cover market risks; the standardized approach and the internal models approach. For banks which choose to employ their own internal models, the capital charge will be the more eminent of:
- The value at risk of the previous day .
- The 3 times the average of daily value at the risk of antedating 60 business days.
d) Other Risks
Regulators recognize that there are other substantial risks besides market, credit and settlement. The substantial among them are:
1. Liquidity risk, which comes in two forms. Market liquidity risk arises when a firm is unable to conclude a large transaction in a specific instrument at anything near the current market price. Funding liquidity risk is outlined as the inability to obtain funds to meet cash flow obligations.
2. Legal risk, which is the risk that a transaction proves unenforceable in law or since it has been inadequately documented; and
3. Operational risk, i.e. the risk of unforeseen losses coming up from deficiencies in a business firm's management information, support and control systems and procedures.
Of the documents which are on-line on this service, the Basle Committee's "Risk Management Guidelines for Derivatives" (1994), is the best introduction to the three risks mentioned above. It describes each risk and suggests sound risk management practices for each risk type as component of a robust internal control system. Even though the report concentrates on, say the operational risks of derivatives, its rules of thumb are just as applicable to the operational risks of other products, as they are to derivatives. For illustration, it states with the complexity of derivatives products and the size and rapidity of transactions, it is essential that operational units be able to captivate all the relevant details of business deal, discover errors and process payments or move assets promptly and accurately. This requires a staff of sufficient size, knowledge and experience to abide volume and the type of transactions created by the business unit. Management has to formulate appropriate hiring practices and compensation plans to enroll and retain high caliber staff.
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