Risk Identification PDF

1 RISKS IDENTIFICATION A/ CONCEPT OF FINANCIAL RISKS B/ TYPOLOGIES OF FINANCIAL RISKS 1- SYSTEMATIC RISK 2- UNSYSTEMATIC RISK A/ Concept of Financial Risks Concept of risk can be traced back to the ancient Greek, a writer named Solon (2005) gave the very first approach of risk: “There is risk in eve...

1 RISKS IDENTIFICATION A/ CONCEPT OF FINANCIAL RISKS B/ TYPOLOGIES OF FINANCIAL RISKS 1- SYSTEMATIC RISK 2- UNSYSTEMATIC RISK A/ Concept of Financial Risks Concept of risk can be traced back to the ancient Greek, a writer named Solon (2005) gave the very first approach of risk: “There is risk in everything that one does, and no one knows where it will make his landfall when his enterprise is at its beginnings. One man trying to act effectively fails to forecast something and falls into great ruination, but another man, one who is acting ineffectively a God gives good fortune in everything and escapes from his folly.” Here are interesting etymologies about “Risk”: A/ Concept of Financial Risks Financial Risk definition can be given as: “It is the uncertainty for investors in collecting the return on their investment and capital they invested in a venture” Ø Uncertainty arises due to the difficulty to predict the future outcome relating to the investment. A/ Concept of Financial Risks Ø Managing risk comprises of the actions or steps taken to reduce or remove the risk exposures. Ø Risks when managed properly lead to desired rewards and innovative results. Ø From an organization perspective, risk management is the process of Identifying the threats, Assessing and Controlling them to protect the organization’s capital and earnings. Ø Manage risks refers to the process of identifying potential risks in advance, and take measures to reduce the financial impact of these risks. Ø These policies play a crucial role in curbing the losses resulting from these risks. B/ Typologies of Financial Risks Ø Risks can be of the two following types: 1/ Systematic Risks Ø These risks are due to factors which are uncontrollable from an organization purview and are macro in nature. What are these Risks? 1 Market Risk Ø Market risk is comprised of the “unknown unknowns” that occur as a result of everyday life. Ø It is unavoidable in all risky investments. Ø It can also be thought of as the opportunity cost of putting money at risk. Ø “Market risk can be defined as the risk of losses in on and off-balance sheet positions arising from adverse movements in market prices. From a regulatory perspective, market risk stems from all the positions included in banks' trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet” – European Banking Authority What are these Risks? Example of Market Risk What are these Risks? 2 Interest Rate Risk Ø It is the risk that arises due to the variability of interests from time to time. Ø Lending and borrowing is associated with interest rate. Changes in interest rate cause interest rate risk to the company. Ø Company being a net borrower would see increasing interest rate as a risk, whereas if it is a net lender reducing interest rate is the risk as the profitability drops. What are these Risks? Example of Interest Rate Risk What are these Risks? 3 Inflationary Risk Ø This risk originates from the fact that the purchasing power is exposed to a downfall Ø The possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency Ø Inflation causes money to decrease in value at some rate, and does so whether the money is invested or not Ø When this happens it is not desirable to invest in securities during this inflationary period What are these Risks? 4 Foreign rate exchange Risk Ø It corresponds for the bank to the risk of losses related to fluctuations in exchange rates. Ø Any unfavorable exchange rate fluctuations could negatively impact future cash flows expected by the bank as a result of its financial activity on currencies. Ø Foreign exchange risk may also impact the credit activities of the bank. Ø This is the case when a bank lends money to its client in foreign currency. Ø The bank takes the risk of seeing the capital that will be refunded decreased. 2/ Unsystematic Risks Ø Unsystematic risks are threats due to the internal factors prevailing within the organization and are controllable by nature. These affect only the particular organization and are micro in nature. What are these Risks? 1 Liquidity Risk Ø Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. Ø Conversely, liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss. Ø It is typically reflected in unusually wide bid-ask spreads or large price movements. Ø If an individual investor, business, or financial institution cannot meet its short-term debt obligations, it is experiencing liquidity risk. What are these Risks? 2 Credit Risk If you owe $ 100 the bank it is your problem If you owe $ 100 million the bank this is the problem of the bank What are these Risks? 2 Credit Risk It is usual for a trading business to do sales on credit basis or for a lending business to lend some money to other borrowers. In either case, it is possible that the counterparty is not paying back what is required to be paid back to the company or not paying them on time. Credit risk gives rise to additional expenditure on following up and recovering. Not paying on time could cause liquidity issues in the company as it would have planned its own investment or repayment using the money expected to inflow into the company. What are these Risks? 2 Credit Risk Banking Regulation Definition Default when – (i) the bank determines that the borrower is unlikely to pay its obligations to the bank in full, without recourse to actions by the bank such as the realization of collateral; – And / or (ii) the borrower is more than 90 days past due on principal or interest on any material obligation to the bank. Banque de France Failure: Opening of legal proceedings (recovery or liquidation). Default: Failure or Assignment of a 9 rating due to major payment incidents reported by one or more credit institutions. – This definition does not correspond to that of “Basel defect”. What are these Risks? 2 Credit Risk 3 main parameters : Probability of Default (PD) It defines the credit worthiness of a counterparty. – More formally, it is the likelihood that a counterparty will default over a particular time horizon (usually within a year). Exposure-At-Default (EAD) Exposure is the value of the underlying transaction(s).We can mathematically define exposure as max{V(t,T),0} – where V(t,T) is the value of the transaction and t is the time today with T being the time to maturity. Loss Given Default (LGD) The irrecoverable portion (loss) of an exposure at default once a default event occured LGD = (1-Recovery rate) What are these Risks? 2 Credit Risk What are these Risks? 3 Operational Risk Ø Possibilities of human errors or technical errors in operations expose the investments to operational risks. It may be model, people, legal or political risks Ø Potential loss resulting from deficiencies attributable to human and material resources, such as failing internal procedures, IT systems, external trigger events, and fraud What are these Risks? § Examples of Operational Risk Internal fraud: Orders, falsification of documents, insider trading, employees, inaccurate information communicated on their market positions Customers, products and business practices: Lack of advice, lack of information, breach of bank secrecy, forced sale, support, breach of abusive contract Execution, delivery and process management: Entry error, data recording, failures in collateral management, procedural deficiencies, lack of processing of the transaction; configuration error, non-compliance with legislative or regulatory requirements What are these Risks? § Concrete Examples Examples of Frequent operational risk IT incidents that temporarily prevent agents from doing business Error in the IT configuration of commissions A partner leaves us with their client portfolio; Some knowledgeable people leave the company without having transmitted their knowledge; Failure to meet delivery deadlines in product design Examples of Potential serious operational risk A computer server fire that paralyzes the whole company A hundred-year flood of the Seine that affects the company's offices A pandemic affects a large number of company employees and prevents business continuity Examples of Proven serious operational risk In banks and insurance companies around the world, the biggest operational losses observed are linked to risky or fraudulent financial investments These losses are linked to the deficiency in internal control: non-separation of powers, poor supervision of employees or non-compliance with processes What are these Risks? IT incidents do not lead financial supervisors indifferent. In a context when banks are forcibly digitizing their services, information systems , "cyber risks" are closely monitored by the branch of the European Central Bank in charge of supervising banks. Banks are supposed to notify ECB all the Cyber incidents. European banking supervisor has made these subjects one of his top priorities and has conducts onsite inspections. “Technically, banks need to simplify their information systems. It is not only that it reduces the area vulnerable to attack. It is also that the simpler the systems are to understand and the better they can be protected ”, ECB in a recent note What are these Risks? § Acceleration of regulatory constraints Continuation of a regulatory avalanche while the financial gendarmes of the planet are trying to finalize Basel III, resulting from the financial cataclysm of 2007. According to Boston Consulting Group, in 2016 banks had to face 51,600 regulatory changes, an average of 200 per day. Movement in acceleration, because the cabinet counted only 14,200 rule changes in 2011. Changes to be taken in the broad sense because integrating a local, national or global level of regulations, technical specifications of texts already known, or simple announcements. Global players: banks present all over the world are on the front line. In an increasingly protectionist climate, each zone risks developing ever more specific rules. What are these Risks? § Acceleration of punishment fees from Regulators Regulators are exploring new fields of action, such as that relating to Conduct -> all reprehensible behavior that can give rise to penalties. The digitalization of financial services calls for new rules of the game, as new players or new risks appear. But the regulations are also subject to a snowball effect, the main principles already known gradually declining in increasingly precise technical specifications. The cost of these regulations is by nature difficult to assess it is measured in particular by the costs of organization and recruitment for financial institutions required to remain in compliance at all times. Another cost factor, the penalties paid to regulators or compensation to their customers $ 321 billion over the period 2009-2016 - $ 42 billion in 2016 What are these Risks? § La Banque Postale Case The facts criticized by the ACPR: The functioning of national cash mandates The ACPR criticizes La Banque Postale for not having a mechanism enabling it to detect, before their execution, national cash mandate operations for the benefit of persons subject to a European measure to freeze assets. Reported already in September 2017. Between December 1, 2009 and March 13, 2017, LBP executed at least 75 NCM transactions on behalf of 10 clients whose identity elements correspond to those of persons who were, on the transaction date, a freezing measure, in 9 cases out of 10 due to terrorist activities “ Defense of LBP: The mandates suspected by the ACPR thus represent 0.00027% of the total amount of the national mandates over the period studied What are these Risks? § La Banque Postale Case 50 Millions € 4 Complaints with La Banque Postale - Absence of a device for detecting transactions carried out by or for a person subject to a European or national measure to freeze assets - The lack of implementation of a corrective device following a control carried out previously by the ACPR - Subject not raised during risk committees to the Supervisory Board - The information sent by Banque Postale to the ACPR on this subject was incorrect "La Banque Postale, a citizen bank, has the characteristic of being the only banking establishment in the territory whose services are accessible to all, de facture traitée par an customers or not" 13 Millions 3500 Entreprises clientes "Furthermore, none of the alleged acts is in itself constitutive of a money laundering or terrorist financing operation. All the checks carried out made it possible to highlight the absence of such operations " - La Banque Postale What are these Risks? BNP Paribas case 10 billion for hindering a currency embargo. Thursday, May 29, 2014 The Wall Street Journal alerts the public on the intentions of the US Department of Justice (DoJ).The New York financial newspaper reveals that the US judicial authorities ask the French bank a fine of more than 10 billion dollars (7.3 billion euros) for violating for four years the US embargo against Cuba, Sudan and Iran between 2002 and 2009 At the time, European regulation did not prohibit trade with these countries. Problem for his business, BNP was forced to go through the New York compensation room, to convert its cash into dollars. At the same time, it passed under American legislation