Download model answers and marking scheme

MODEL ANSWERS AND MARKING SCHEME
RISK ANALYSIS AND MANAGEMENT
SECTION A – 5 QUESTIONS
(15 MARKS EACH)
QUESTION 1
Model Answer
a) Risk is a course of action or inaction, taken under condition of uncertainty,
which exposes one to possible loss, in order to reach a conclusion.
(1mark)
b) The basic principles in risk management are as follows:i.
ii.
iii.
iv.
v.
vi.
vii.
Board and senior management support – concern and tone must start
from the top and cascade sown to senior management and staff. Board
maintains oversight role
Risk management framework - to include scope of risks, process/
systems and procedures, risks and responsibilities MIS and review
Integration of risk management – management to have overall view of
risk and put in place structure to assess interrelationship of risks
Business-line accountability – business lines equally responsibility for
risk management, apart from dedicated individuals and departments
Risk Evaluation/Measurement – there must be system to assess and
measure risk for it to be managed.
Independent review – takers or acceptors of risk must not measure,
monitor and evaluate risk. It must be an independent function.
Contingency planning - mechanism for stress situations and ability to
deal with unusual occurrences timely and effectively.
(14marks)
1|Page
QUESTION 2
Model Answer
a) Interest rate risk is the potential for volatility in bank earnings and
declines in the market value of its equity as a result of changes in
interest rates in the macro economy.
(1mark)
Model Answer
b)
i. Repricing Gap
ii. Maturity Model
iii. Duration model
(3 marks)
Model Answer
c)
i. Gap or repricing risk
This is the risk that the bank may be forced to reprice its
assets or liabilities at higher or lower levels following
changes in market rates.
ii.
Basis risk
The risk that assets and liabilities do not reprice at uniform
rates
iii.
Reinvestment and funding risk
The risk of unknown future interest rates on net positive and
net negative cashflows when short-term cash flows are not
matched.
iv.
Yield curve risk
The risk that the interest rates on different maturities may
change by different amounts.
v.
Option risk
The risk of changing payment patterns for assets or liabilities
when interest rates change.
(10marks)
2|Page
QUESTION 3
Model Answer
a) Liquidity Reserve Requirement (LRR) is a specific non-interest earning
percentage of deposits that central banks or regulators impose on deposittaking institutions to hold with the central bank.
(2marks)
Central banks impose a LRR on banks for the following reasons:i. Liquidity management – LRR helps to manage daily liquidity as customers
withdraw money by acting as a “buffer” position in case there are
withdrawals in excess of the banks’ holdings in operating accounts.
ii. Insurance for Depositors – LRR acts as part-cover or fall-back position in
the event of bank failure.
iii. Instrument of Monetary Policy - the Reserve Bank of Malawi can use
LRR to control money supply and affect inflation as part of monetary
policy.
(9marks)
b) The current LRR in Malawi is 15.5% and the major implication is that it affects
the banks cost of funds i.e. for every MK100 that a bank receives as a
deposit, it can only lend MK85.50 whilst the MK15.50 with the central bank
lies idle and does not earn interest. Thus the higher the LRR, the higher the
cost of funds which may ultimately be passed on to customers through higher
interest rates.
(4marks)
QUESTION 4
Model Answer
a) Corporate governance is the system by which companies are directed and
controlled. The structure of corporate governance specifies the distribution of
rights and responsibilities among different participants in the company such
as the board, managers, shareholders and other stakeholders. It also spells
out the rules and procedures for making corporate decisions. In so doing, it
provides a mechanism through which the objectives of the company are set
and the means of attaining these objectives and monitoring performance.
(4 marks)
b) The three major objectives of Corporate Governance are:-
3|Page
Financial stability – Good corporate governance is designed to instill
confidence and prevent bank failure by a run on its deposits. This may have a
negative domino effect on the whole economy.
ii. To reduce criminal activity – Global banking is prone to “hot money” and use
by terrorists and money launderers. Good corporate governance is meant to
ensure that banks comply with appropriate legislation and directives to assist
the authorities to curb these practices. Recent KYC issues in Malawi are a
good testimony.
iii. To ensure proper accountability
- Banks need to be and to be seen to be
accountable to both their shareholders and to society in general and are
expected to behave in line with societal norms in tandem with the prevailing
socio-economic and political framework.
(9 marks)
c) The Corporate Principle that relates to compensation policy and practices
states that, “The Board should ensure that compensation policies and
practices are consistent with the bank’s corporate culture, long-term
objectives and strategy and control environment.”
(2marks)
i.
4|Page
SECTION B
marks)
(40
QUESTION 5
Model Answer
Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. Operational risk covers
legal risk but excludes strategic and reputational risk.
(2 marks)
1. Basic Indicator Approach (BIA)
This is where capital is calculated on gross income. In this case, banks are
required to hold capital for operational risk equal to the average over the previous
three years of a fixed percentage (denoted by alpha or α) of positive annual
gross income. Under the BIA, figures for any year in which annual gross income
is negative or zero should be excluded from both the numerator and denominator
when calculating the average. The charge is represented by the formula:
K =∑
BIA
[(𝐺𝐼..𝑛 𝑥 𝛼)]
𝑛
where
KBIA = the capital charge under the BIA
GI
= annual gross income, where positive, over the previous three years
N
= the number of the previous three years for which gross income is
positive
𝛼
= 15%, which is set by the Basel Committee, relating to industry-wide level
of required capital to the industry-wide level of the indicator.
Gross income is defined as net interest income plus net non-interest income. The
intention is that this measure should:
 Be gross of any provisions, e.g. for unpaid interest
 Be gross of operating expenses, including fees paid to outsourcing service
providers
 Exclude realized profits/ losses from the sale of securities in the banking
book and
 Exclude extraordinary or irregular items as well as income derived from
insurance.
(8 marks)
5|Page
2. Standardised Approach
The Standardised Approach divides banks’ activities into 8 business lines:
corporate finance, trading and sales, retail banking, commercial banking,
payment and settlement. Agency services, asset management and retail
brokerage.
Within each business line, gross income is a broad indicator that serves as a
proxy for the scale of business operations and thus the likely scale of operational
risk exposure within each of these business lines. The capital charge for each
business line is calculated by multiplying gross income by a factor (denoted beta)
assigned to that business line. Beta serves as a proxy for the industry-wide
relationship between the operational risk loss experience for a given business
line and the aggregate level of gross income for that business line.
Business Line
Beta Factor
Corporate finance
18%
Trading and sales
18%
Retail banking
12%
Commercial banking
15%
Payment and settlement
18%
Agency services
15%
Asset Management
12%
Retail Brokerage
12%
The total capital charge is calculated as the three-year average of the simple
summation of the regulatory capital charges across each of the business lines in
each year. In any given year, negative capital charges (resulting from negative
gross income) in any business line may offset positive capital charges in other
business lines without limit.
KTSA ={∑𝑦𝑒𝑎𝑟𝑠 1 − 3𝑚𝑎𝑥(𝐺𝐼1 − 8 𝑥 𝛽1 − 8), 0]}/3
Where:
KTSA = the capital charge under the standardised approach
6|Page
GI1-8 = annual gross income in a given year, as defined in the Basic Indicator
approach, for each of the eight business lines
Β1-8 = a fixed percentage, set by the Committee, relating the level of required
capital to the level of the gross income for each of the eight business lines.
(10 arks)
QUETSION 2
Model Answer
1. Systematic or Market risk - is associated with systematic factors. The risk can be
hedged but cannot be diversified away; it is undiversifiable. All investors assume
this risk whenever assets owned or claims issued can change following broad
economic factors e.g. interest rates and foreign exchange rates. Therefore,
banks put in place mechanisms to track, monitor and limit their exposure to
assets and liabilities that are affected by these variables.
Other forms of systematic risk include commodity price risk and industry
concentration risk.
2. Operational risk – is associate with the problems of accurately processing,
settling and taking or making delivery on trades in exchange for cash. It also
arises in record-keeping, processing system failures and compliance with various
legislation. Operational problems, thus, expose even well-run firms to potentially
costly events.
3. Counterparty risk – relates to non-performance of a trading partner arising from
refusal to perform due to an adverse movement in price caused by systematic
factors, or from unexpected political or legal restraint. Diversification provides a
means of managing this risk and it is usually dealt with as a transient financial
risk associated with trading vis a vis standard credit default risk. Note that
counterparty risk can arise from factors beyond credit issues.
4. Liquidity risk – is best described as the risk of a funding crisis, where the bank
does not have sufficient liquidity to settle its obligations due to some unexpected
event, like a currency crisis, other major national dislocational event, loss of
confidence leading to a “run” on a bank. This risk can be managed by having
appropriate liquidity facilities and a flexible portfolio structure that can meet
liquidity challenges.
5. Legal risk – Legal risks are pervasive in financial contracting and need to be
assessed and managed separately from credit, counterparty and operational risk.
7|Page
New laws, statutes, court opinions and judgments and regulations can put
formerly well-established transactions into contention, even where all parties
have previously held their part of the bargain and are prepared to do so in the
future e.g. environmental regulations and their effect on real estate values of
older properties.
6. Legal risks can also arise from the banks management and employees. Fraud,
violation of laws and regulations can lead to huge losses and impact on the
survival of the institution.
(20 marks)
QUESTION 3
Model Answer
a) Foreign exchange risk, also known as “currency risk” or “exchange-rate
risk” is the risk of an investment's value changing due to changes in
currency exchange rates or the risk that an investor will have to close out
a long or short position in a foreign currency at a loss due to an adverse
movement in exchange rates.
(2 marks)
b) Foreign exchange exposure can be classified under three headings:Transaction exposure – possibility of incurring gains or losses, upon
settlement at a future date, on transactions already entered into and
denominated in a foreign currency. The inherent cash flows of the
transaction are exposed to currency rate fluctuation.
Translation exposure – arises when, for reporting purposes and
consolidation purposes, the results of foreign operations, especially of
multi-national companies, are converted from local currencies to the home
or reporting currency of the parent company. Translation exposure results
from fluctuations in foreign exchange rates and the need to adhere to laiddown accounting conventions.
Economic exposure – relates to the impact of foreign exchange
movements on the net present value of a bank’s future after-tax cash
flows and, consequently, on the value of the bank. It is regarded as a cash
flow exposure together with transaction exposure.
8|Page
(9 marks)
c) Three types of hedging techniques are:Currency of invoicing – the invoicing currency has a great impact
on a company’s exposure profile. Generally, theoretically, a company
should invoice in the currencies trading at a premium to its home
currency and pay in a currency or currencies that are trading at a
discount to its base currency. However, in practice, government and
other restrictions may not make this feasible including market-related
factors and currency related issues.
Forward contracts – very popular, a forward contract is an
agreement between a bank and a firm to exchange one currency for
another at a future date. The rate, delivery date and amounts
involved are agreed at the outset. Forward contracts are used to
hedge transaction exposure and are flexible as they can be written in
most currencies.
Currency borrowing/ Money market hedge –This usually involves
an exporter borrowing the currency concerned in the foreign
exchange market in order to match this amount with expected
receivables. The currency borrowed is immediately converted to local
currency to meet domestic debt. It’s important to note that the hedge
for the borrowing incorporates both principal and interest.
Currency futures – this involves fixing in advance interest and
exchange rate in order to avoid variability which would have a
negative impact. The idea is to hedge against adverse movements in
interest rates or exchange rates. The products traded in organized
market specifically designed for this type of hedging are called
“financial futures.”
(9 marks)
QUESTION 4
Model Answer
Credit risk is the likelihood that a debtor or financial instrument issuer is unwilling or
unable to pay interest or repay the principal according to the terms specified in a
credit agreement, resulting in economic loss to the banking institution.
9|Page
(3 marks)
The 5 C’s of credit are:1. Character (the perceived integrity of the individual applicant)
2. Capacity (the customer’s resources)
3. Capital (customer’s long term financial resources
4. Collateral (assets or other form of security available)
5. Conditions (the prevailing economic condition of the customer and the seller)
(5 marks)
A bank needs to measure its cost of funds for the following reasons:1. Everything being equal, a bank will seek the lowest cost mix of funds in order to
maximize its EVA (Economic Value Added). When a bank’s risk is held constant,
then a lower-cost mix of funding will increase its value.
2. A bank also needs a reasonably accurate estimate of its cost of funds in order to
help it to define its minimum target return on earnings assets like loans and
investments
3. An accurate estimate of cost of funds is key for developing an internal transfer
pricing system and for internal performance evaluation purposes.
4. The sources and investment of a bank’s funds impact on the bank’s liquidity risk,
interest rate risk and capital adequacy risk.
(8 marks)
The four main sources of funds are:1.
2.
3.
4.
Cashflow from operations and deposits
Sale of assets
Capital
Debt
(4 marks)
10 | P a g e