Risk Management Introduction

Agenda In this session, you will learn about: What is Risk? Types of Risk Managing Risk Key Elements of Risk Management Key Risks in Financial Services Sources of Risk Assessing Risk and their Potential Impact

Risk is a hot-button topic Introduction

Risk is all around– In life and in business

What is Risk? RISK: The possible harm associated with a situation

What is Risk? PROBABILITY (Likelihood of an event happening) IMPACT (Consequence of event happening) X Quantifies the Risk Building Blocks for Risk Management

Risk vs. Reward A positive correlation between risk and reward

Risk vs. Uncertainty Risk Uncertainty All risks are uncertain, but not all uncertainties are risks. RISK Known Unknown UNCERTAINTY Unknown Example: The probability that their flight will arrive several hours late Example: You were late because a meteorite demolishes your car an hour before you planned to leave for the airport

Risk Management

The practice of using processes, methods and tools for quantifying and managing these risks and uncertainties Risk Management Identifying what could go wrong Evaluating which risks to be addressed Implementing strategies to address those risks

Managing Financial Risk

Risk Management Process Risk Origination within Bank Credit Risk Market Risk Operational Risk Risk Identification Identify Risks Understand and Analyze Risks Risk Assessment and Measurement Assess the Risk Impact Measure the Risk Impact Risk Control Recommendations for Risk Control Risk Mitigation through Control Techniques Deputation of Competent Officers to Deal with Risks Risk Monitoring Supervise the Risks Reporting on Progress Compliance with Regulations Follow-up

Key Elements of a Risk Framework Risk Policies and Governance at Board Level IdentifyAssess MonitorControl Risk Oversight Day to Day Risk Management Business Unit #1 Business Unit #2 Business Unit #n Report

Financial Risk Increasingly complex, competitive and global markets Convergence, consolidation, globalization and shifting regulations Risks across geographies, products, asset classes, customer segments and functional departments

Financial Risk Management of financial risk on behalf of its customers and owners Driven by supervisory expectations as well as regulations

Types of Risk

Types of Risks Market Risk Operational Risk Credit Risk Fail to repay loans Uncertainty over asset’s future price Failure due to People, processes & systems

Types of Risks Liquidity Risk Inflation RiskInterest Rate Risk Systematic Risk Investment Risk Model Risk

Market Risk The risk of losses in positions arising from movements in market prices

Credit Risk The risk that a loan is not repaid as agreed Maximize a firm’s risk- adjusted rates of return Goal Credit Risk Counterparty Risk Issuer Risk

Operational Risk Due to breakdowns in people, internal processes and systems in use within a firm Diverse in scope – and therefore also its management

Liquidity Risk A BANK’S CHALLENGE: READY ACCESS TO CASH The risk that a firm has insufficient cash to meet its cash obligations What is Liquidity? Availability of, access to, or convertibility into cash Asset Easily be converted to cash FirmReady access to cash Market Participants can convert positions into cash Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations

Interest Rate Risk The risk that an investment's value will change due to a change in the absolute level of interest rates Interest Rates Bond Price Affects value of bonds more than stocks Reduce risk: Diversifying or Hedging BIGGEST INFLUENCER: Inflation

Systematic Risk Inherent to the entire market or an entire market segment. Affects the overall market, not just a particular stock or industry Unpredictable Impossible to completely avoid Example: Recession of

Investment Risk The probability or likelihood of occurrence of losses relative to the expected return on any particular investment. How much do I expect? Vs How much will I actually receive? Risk Return

Inflation Risk The uncertainty over the future real value (after inflation) of your investment. Reduction in purchasing power Inflation Yield

Model Risk The risk of loss resulting from using models to make decisions, initially and frequently referring to valuing financial securities Any model is a simplified version of reality. There is the risk that something will fail to be accounted for. Wrong Model used Model Implementation Issue Model Usage Issue Subset of Operational Risk

Sources of Risk

INTERNALEXTERNAL Arise from the events taking place within an organization Arise from endogenous variables Within an organization’s control Due to Human, Technological, Physical or Operational factors Arise from events taking place outside the organization Arise from exogenous variables Outside an organization’s control Due to Economic, natural or political factors Sources of Risk

Internal Sources of Risk There are three broad categories of internal risks:

Internal Sources of Risk Explained Strategic Financial STRATEGIC RISK The risk to earnings and capital arising from changes in the business environment and from adverse business decisions, improper implementation of decisions or lack of responsiveness to changes OPERATIONAL RISK The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events FINANCIAL RISK Financial misappropriation Liquidity Gearing

Assessing Internal Sources of Risk Structured Brainstorming Industry Best Practice Benchmarking

Assessing Internal Sources of Risk STRESS TESTING One input factor is varied at a time to determine impact To determine financial health SCENARIO ANALYSIS Constructing realistic scenarios, which can be used to ask questions of the current situation

External Sources of Risk Economic risk Political arena Competitive environment Social and market forces Technological innovation Unexpected shocks Actions of external stakeholders

Economic Risk THE INTERACTION BETWEEN INDIVIDUALS AND FIRMS, AND THE ALLOCATION OF THEIR LIMITED RESOURCES TO MAXIMIZE THEIR FINANCIAL POSITIONS. A failure to anticipate an imminent downturn will result in firms continuing to increase their stocks using current input prices of raw materials. They will then find they need to reduce the prices of their finished goods to sell them in a recession. EXAMPLE

Political Risk Financial services firms are affected in three main ways: 1.A rise or fall in the markets 2.An increase or decrease in demand for the products which the industry sells 3.Changes to the legislative and regulatory environment Political ideology impacts markets

Risks from the Competitive Environment Firms are affected by the performance of other companies, especially those operating in related industries and markets

Social and Market Forces Susceptible to certain changes in social and market forces

Technological and Cyber Risk Cyber risk Firms that do not anticipate or keep up with technological change run the risk of becoming obsolete. 1.Make protecting the firm’s information a board responsibly 2.Implement an information risk management regime 3.Gain assurance that the information risk management regime is effective

Shock and Natural Events Damage: $510 million 2004 Tsunami Reduced Thailand’s 2005 GDP by 0.5%. FTSE 100 Fell by 12%

Risks from Stakeholders The firm’s parent company Any major institutional investors Large or important customers External stakeholders that can present external risks typically include: Build Relationships Seek Understanding Manage Expectations STAKEHOLDER MANAGEMENT

Assessing Risk and their Potential Impact

PESTLE P P E E S S T T L L E E An analysis of the external macro environment in which a business operates Political Economic Social Technical Legal Environmental BIG PICTURE Useful for assessing market risk DRIVERS OF CHANGE

Business Process Analysis Examine each high-level business process Describe the internal low- level processes and external factors Business Process Analysis

Creation of a ranking hierarchy A method of ranking risks in order of their significance The assessments may be subjective The ranking decision depends on two criteria: The likelihood of the risk being realized The magnitude of the impact. Likelihood Probability Ratings VERY LOW LOW MEDIUM HIGH VERY HIGH Risk Rating Likelihood Rating Score < 1% 1-5% 5-10% 10-20% > 20%

Impact Loss Ratings VERY LOW LOW MEDIUM HIGH VERY HIGH Risk Rating Impact Rating Score £1 - £5 million £5 - £20 million £20- £ 50 million £50 - £ 100 million > £ 100 million The impact of the risk is the potential loss if the risk occurs. Risk score = likelihood score × impact score

Q A & Thank You For Your Attention