Module 6 Basics of Risk AFN411 2024 PDF

Module 6 Basics of Risk 2024_AFN411 1  Financial Analysis & Capital Markets (C) (A) (B) Banking Supervision (D). Financial Analysis &...

Module 6 Basics of Risk 2024_AFN411 1  Financial Analysis & Capital Markets (C) (A) (B) Banking Supervision (D). Financial Analysis & Risk Management & Investment Capital Markets Corp Governance Banking Financial Analysis & Capital Markets & Bus strategy Basics of Risk Banking Fin Instruments (6) Supervision (9 (1-4) (11) Corporate Investment Banking Portfolio Theory & Governance (5) Credit Risk (7) (10) EMH (12) Mergers & Credit Rating Acquisitions Agencies (8) (13) Financial Databases (14) 2024_AFN411 2  Basics of Risk Management Learning Objectives 1) (LO1) What is risk? Main types? 2) (LO2) Understand the role of risk management and for whom it is useful. 3) (LO3) Understand what may be done and by whom to mitigate risks. 4) Real-world cases: What happens when risks do materialize! 2024_AFN411 33  Module Road Map Basics of Risk 6.3 Materialization of 6.1 What is risk; Main 6.2 Is risk management Risks and economic types of risk useful? For whom? crises; Cases. 2024_AFN411 4 1929 + 2013= !! LO1. What is Risk? “Certainty? In this world Dictionary definition: nothing is certain except “Exposure to danger and death and taxes” threat” - Benjamin Franklin Traditionally considered to be negative! 2024_AFN411 6 What is Risk? q Chinese have a more interesting approach... q First sign = Danger q Second sign = Opportunity! 2024_AFN411 7 What is Risk? q Chinese have a more interesting approach... q First sign = Danger q Second sign = Opportunity! 2024_AFN411 8 CASE 6.1 – Understanding Risks q Starting in 2008, the global economy faced its worse economic crisis since the 1929 US “Great Depression”. The economies that suffered more beyond US were the Eurozone countries, namely Greece, Ireland, Portugal, Spain, Italy, Cyprus as well as Iceland, a non-EU country. The banking sector in most above countries suffered substantially with major banks failing. qThe reading that follows discusses briefly the Eurozone crisis; questions follow on next slide. 2024_AFN411 9 CASE 6.1 – Understanding Risks q Required: 1. Using the attached table, identify the major causes of the global and Eurozone crisis. What were the main signs that indicated that there is a crisis coming? 2. Using the attached table, name the main types of risks faced by governments, banks, organizations discussed in this article. [You may add any other risks faced by the above, not discussed in the article]. Explain each one briefly. 3. Who are the major stakeholders who can take action to control risk (use the attached table)? 4. Did all nations, industries, firms, individuals face the same crisis? If not, why? 2024_AFN411 10  CASE 6.1 The European sovereign debt crisis resulted from a combination of complex factors, including the globalisation of finance; easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices; the 2007–2012 global financial crisis; international trade imbalances; real-estate bubbles that burst; the 2008–2012 global recession; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses. One narrative describing the causes of the crisis begins with the significant increase in savings available for investment during the 2000–2007 period when the global pool of fixed-income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2007! This "Giant Pool of Money" increased as savings from high-growth developing nations entered global capital markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought alternatives globally. The temptation offered by such readily available savings overwhelmed the policy and regulatory control mechanisms in country after country, as lenders and borrowers put these savings to use, generating bubble after bubble across the globe. While these bubbles have burst, causing asset prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors remained at full price, generating questions regarding the solvency of governments and banking systems across countries. 11 2024_AFN411 q How each European country involved in this crisis borrowed and invested varies. For example, Ireland's banks lent the money to property developers, generating a massive property bubble. When the bubble burst, Ireland's government and taxpayers assumed private debts. In Greece, the government increased its commitments to public workers in the form of extremely generous wage and pension benefits, with the former doubling in real terms over 10 years. Iceland's banking system grew enormously, creating debts to global investors (external debts) several times GDP. qThe interconnection in the global financial system means that if one nation defaults on its sovereign debt, or enters into recession putting some of the external private debt at risk, the banking systems of creditor nations face losses. For example, in October 2011, Italian borrowers owed French banks $366 billion (net). Should Italy be unable to finance itself, the French banking system and economy could come under significant pressure, which in turn would affect France's creditors and so on. This is referred to as financial contagion. qGreece, Italy and other countries tried to artificially reduce their budget deficits deceiving EU officials with the help of derivatives designed by major global banks. Although some financial institutions clearly profited in the short run, there was a long lead-up to the crisis. qMoreover, several EU financial institutions during these turbulent times failed the EU wide stress tests as well as did not assess properly credit and market risk, some even ‘put all their eggs in one basket’ and other ones had to resort to emergency liquidity assistance (ELA). 2024_AFN411 12  Case 6.1 – Q1 Which were the causes of the global and Eurozone crisis? Signs? Cause of the crisis Sign 1 2 3 4 5 6 7 2024_AFN411 13  Case 6.1 – Q1 Which were the causes of the global and Eurozone crisis? Signs? Which were the major causes of crisis? q Excessive risk appetite; greed! q Bad governance and flawed incentives q Excessive liquidity in the global system q Very complicated financial products q Lack of coordination at the global level Which are the major signs that indicate that there is economic crisis? q Recession q Defaults q High spreads and CDS premiums q Drop in bond ratings q Drop in share prices etc. 2024_AFN411 14  Case 6.1 – Q2 Which are the major types of risks that organizations (banks & industrial firms) and governments face? Type of risk Govnt Bank Industrial firms 1 Credit 2 Operational 3 Market 4 Sovereign 5 Concentration 6 Liquidity 7 Systemic, etc … 2024_AFN411 15  Case 6.1 – Q3 Major stakeholders? What can they do to control risk? Stakeholders 1 2 3 4 2024_AFN411 16  Case 6.1 – Q3 Major stakeholders? What can they do to control risk? a.Nations/firms/management of firms/individuals b.Supervisory bodies (e.g., Central banks, European Central Bank, European Banking Authority etc.) c.Basel Accords d.Credit Rating Agencies (CRAs); regulate them? e.Intermediaries (e.g., Inv. banks, fin analysts etc.) f.Investors themselves! 2024_AFN411 17 Which are the Main Types of Risk? Credit Risk Operational Risk Interest rate risk Exchange rate Types of Risk Market risk risk Capital markets Sovereign risk risk Concentration risk Liquidity Strategic risk. Systemic Risk 2024_AFN411 18  Module Road Map Basics of Risk 6.3 Materialization of 6.1 What is risk; Main 6.2 Is risk management Risks and economic types of risk useful? For whom? crises; Cases. 2024_AFN411 19 LO2 What is Risk Management? q Risk management is the identification, quantification, and monitoring of uncertainty q Basic intuition behind finance (risk and return relationship) q For whom is risk management useful? 2024_AFN411 20 Is Risk Management Useful? For whom? Usefulness of Risk Mgnt / Credit Risk 3. Financial 1. Bankers 2. Managers Analysts 4. Investors 5. Regulators - To evaluate - What is the risk of - Is there client’s - To evaluate excessive risk firm’s riskiness the firms that we Should we creditworthiness plan to invest, or in the system? adjust our and price loans - Should we we have invested? portfolio? (e.g., - Can the - To evaluate borrow or issue sell stocks and banking system new shares? - How it affects market risk their value? buy bonds) sustain it? - Reallocation of - Need for our investments? measures? 2024_AFN411 21 The Three Lines of Defence (LO3) (Risk Management in a Financial Institution) Risk taking Risk control Independent (operational (risk management assurance management) & compliance) (BOD) 2024_AFN411 22  Module Road Map Basics of Risk 6.3 Materialization of 6.1 What is risk; Main 6.2 Is risk management Risks and economic types of risk useful? For whom? crises; Cases. 2024_AFN411 23  When Risks Materialise … 2024_AFN411 24 Risk Management - Little things we should care (and be diligent) about! 2024_AFN411 25 The Flaw of Averages Always remember the statistician who drowned while fording a river that was, on average, only three feet deep … 2024_AFN411 26  Never Forget “Outliers” … 10 days in 20 years is equal to: 10/5000 = 0.2%! Source: “How the Finance Gurus Get Risk all Wrong” Mandelbrot & Taleb (Fortune Magazine Jul 11,2005) 2024_AFN411 27 “Black Swans” … q An event which deviates beyond what is normally expected of a situation and that is usually very difficult to predict (Nassim Nicholas Taleb) q In markets, it may refer to an event that has not occurred in the past … q What does this imply for risk management models that are based on historic data? q Examples of Black Swans Asian financial crisis (1997); Dot.com crash (2000); 9/11/2001 NYC attack; Global financial crisis (2008); European sovereign debt crisis (2010); Fukushima nuclear disaster (2011), Pandemic Covid19. 2024_AFN411 28  Basics of Risk Management What have we learned? 1) (LO1) What is risk? Main types? 2) (LO2) Understand the role of risk management and for whom it is useful. 3) (LO3) Understand what may be done and by whom to mitigate risks. 4) Real-world cases: What happens when risks do materialize! 2024_AFN411 29 29  BASICS OF RISK Summary q What is Risk? Exposure to danger and threat (considered to be negative) q Which are the main types of risk? Credit, operational, market, sovereign, concentration, liquidity, strategic, and systemic risk. q What is risk management? Identification, quantification and monitoring of risk. q Why is it important? For whom? Ø Bankers Ø Managers Ø Financial analysts Ø Investors Ø Regulators 2024_AFN411 30  BASICS OF RISK Summary q What will follow on risk management? Ø Credit risk (how can we measure it, deal with it) Ø Credit Rating Agencies (what is their role in the risk management process?) Ø Banking supervision (what is the role of supervising bodies?) Ø Basel Accords (what does the Basel Committee do?) Ø RAROC (Risk Adjusted Rate of Return) 2024_AFN411 31 Quiz 6.2 – Review Questions 1. Failures in risk management was a prime reason for the global financial crisis of 2008. T or F? 2. Risk management in a financial institution usually takes place at 3 levels. T or F? 3. Shareholders who had invested their money in Greek and Cypriot banks 15 years ago practically lost everything if they held their shares until the end of 2020. T or F? 4. Reputation risk is of paramount importance in the case of a financial institution. T or F? 5. The first line of defence for risk management in a bank is risk control. T or F. 6. The effect of the pandemic caused by Covid-19 on the global economy can be considered to be an example of a Black Swan. T or F? 2024_AFN411 32 Case 6.3 - Covid-19: Impact of the pandemic on the Cyprus economy (compared to the 2013 crisis): Read this article https://www.pwc.com.cy/en/publications/assets/pwc-covid-19-impact-on-cyprus- economy-may-2020.pdf 2013 2020 Economic Weak => economy faced serious More robust (economy on a growth Fundamentals trouble in 2014 path) => recovery in 2021/2022 (?) Fiscal Position Budget deficit and high public Stronger fiscal position (Gvnt can help debt businesses) No access to international HW Access to international markets markets Banking Sector Weak and vulnerable banks NPLs still an issue (much smaller), but (capital and liquidity) banks in a better position Banks could not support the European authorities and Cyprus economy Central Bank granted certain relaxations (reduction in capital requirements, definition of NPLs) Banks can support the economy better Local/Global Rather isolated case Global case; more flexibility regarding issue fiscal and monetary supervision Speed of No effective reaction before the Effective reaction both in terms of response monetary/fiscal situation became dealing with health and fiscal/monetary unsustainable issues 2024_AFN411 33  Case 6.4 Nobel in Economics 2024 (maximum 500 words for all 3 parts below, single space) 1. Who won the Nobel prize in Economics in 2024 (state name(s); affiliation)? 2. What was his/her/their major contribution ? 3. You were asked to write a short article in the leading magazine in Economics, The Economist about the following issue: “How does the contribution of the 2024 Nobel Laureate(s) in Economics can assist Cyprus (or your country) to get out of the crisis (due to the pandemic and geopolitical tensions) and thus improve its a) macroeconomic numbers and/or b) banking system? 2024_AFN411 34 Link: The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2023 (nobelprize.org) 2024_AFN411 35 Module 6 End 2024_AFN411 36