1. R I S K
1 1

2. What is Risk?
―hazard, a chance of bad consequences, loss or
exposure to mischance‖
―any event or action that may adversely affect
an organization‘s ability to achieve its objectives
and execute its strategies‖
―the quantifiable likelihood of loss or less-
than-expected returns‖
1 2

3. Risk is everywhere – future cannot be
predicted
The intuitive commonsense of Risk- Reward
coupling
– No risk; no reward
– Taking on more risk is sensible only if
it results in greater likelihood of greater
reward!
– Appetite for risk determines what
reward one seeks
And the good news is – Risk can be Managed
1 3

4. Risk is Costly
Greater risk imposes costs (reduces value)
Example:
Identical properties subject to damage. Greater
expected property loss lowers value of
property, all else equal
Greater uncertainty about property loss often
lowers value of property, all else equal
1 4

5. Importance of Indirect Losses
Direct Losses often cause indirect losses
Example: What are the direct and indirect losses
if a manufacturing plant experiences a major
fire?.
Cost of Risk Example
Firm value in ideal world of no risk = Rs.1,000,000.
Issues to be examined:
What is firm value with risk of worker injuries?
What is relation between firm value and cost of risk?
Business is faced with one source of risk:
Probability of worker injury = 1/10
Losses from a worker injury:
medical expenses Rs.100,000
lost pay Rs.500,000
total Rs.600,000
Expected loss = Rs1/10 * 600,000 = Rs60,000
1 5

6. Option 1: Do Nothing
Cost of risk:
Expected loss = Rs.60,000
Cost of residual uncertainty = Rs.40,000
(assumed)
Cost of loss control = Rs.0
Cost of loss financing = Rs.0
Cost of internal risk reduction = Rs.0
Total cost of risk = Rs.100,000
Firm value = Rs.1,000,000 – Rs.100,000
= Rs.900,000
1 6

7. Option 2: Loss control
Spend Rs.20,000 to reduce probability of loss to 1/20
Cost of risk:
Expected loss = Rs.30,000
Cost of residual uncertainty = Rs.30,000
(assumed)
Cost of loss control = Rs.20,000
Cost of loss financing = Rs.0
Cost of internal risk reduction = Rs.0
Total cost of risk = Rs.80,000
Firm value = Rs.1,000,000 – Rs.80,000
= Rs.920,000
1 7

8. Option 3: Additional Loss control
Spend an additional Rs.20,000 to reduce probability of
loss to 1/40
Cost of risk:
Expected loss = Rs.15,000
Cost of residual uncertainty = Rs.27,000
(assumed)
Cost of loss control = Rs.40,000
Cost of loss financing = Rs.0
Cost of internal risk reduction = Rs.0
Total cost of risk = Rs.82,000
Firm value = Rs.1,000,000 – Rs.82,000
= Rs918,000
1 8

9. Option 4: No loss control, but full insurance
Premium = Rs.75,000
Loading = premium - expected loss
= Rs.75,000 – Rs.60,000 = Rs15,000
Cost of risk:
Expected loss = Rs.60,000
Cost of residual uncertainty = Rs.0
Cost of loss control = Rs.0
Cost of loss financing = Rs.15,000
Cost of internal risk reduction =Rs.0
Total cost of risk = Rs.75,000
Firm value = Rs.1,000,000 –Rs.75,000
= Rs.925,000
1 9

10. Key points from example:
Do NOT minimize risk, minimize cost of risk
There are cost tradeoffs:
Increase insurance coverage ==>
Increase loading paid
Decrease residual uncertainty
Additional loss control ==>
Decrease expected losses
Increase loss control costs
1 10

11. Problem: If in an ideal world of no risk, the value of Building & Plant including Machinery
& Equipment = Rs.120,000,000/-. Calculate the value of Building & Plant with risk of
damage on all undermention options:
Losses from a Building & Plant:
•Repair expenses = Rs.1,000,000/-
•lost accrue due to change damage Machinery & Equipment = Rs.4,500,000/-
Total = Rs.5,500,000/-
What will be the Building & Plant value with risk of damage and the relation between
Building &Plant value and cost of risk?
Option 1:Firm face one source of risk with cost of residual uncertainty of Rs.500,000/- &
Probability of loss = 1/5.
Option 2:Spend Rs.90,000 to reduce probability of loss to 1/10 with cost of residual
uncertainty of Rs.250,000/- .
Option 3:Spend an additional Rs.80,000 to reduce probability of loss to 1/20 with cost of
residual uncertainty of Rs.125,000/- .
Option 4:Spend Rs.550,000 Insurance Premium against full coverage with no loss
control and no cost of residual uncertainty.
1 11

12. Problem: If in an ideal world of no risk, the value of a Bank is Rs.765,906,169,000/-
including all tangible & intangible assets. Calculate the value of Bank with risk of Cash
& Valuable in lockers Burglary on all undermention options:
Losses from Burglary :
•Damage expenses =Rs.056,000,000/-
•Loss accrue due to cash Burglary =Rs.474,500,000/-
•Loss accrue due to lockers Burglary =Rs.113,908,000/-
Total = Rs.644,408,000/-
Option 1:Firm face one source of risk with cost of residual uncertainty of
Rs.13,000,000/- , Probability of cash Burglary = 1/20 & Probability of lockers Burglary =
1/10.
Option 2:Spend Rs.22,500,000 to reduce Probability of cash Burglary = 1/10 &
Probability of lockers Burglary = 1/8 with cost of residual uncertainty of Rs.12,250,000/- .
Option 3:Spend an additional Rs.5,780,000 to reduce Probability of cash Burglary = 1/5
& Probability of lockers Burglary = 1/4 with cost of residual uncertainty of Rs.6,125,000/-
Option 4:Spend Rs.52,000,000 Insurance Premium against full coverage with no loss
control and no cost of residual uncertainty.
1 12

13. Enterprise-wide Risk
1-Internal Risk
People Risks
Fraud
Human Error
Health & Safety
Employment Law
Training & Development
Process Risks
Financial Process & Control
Customer Relationship Management
Project Management
Supply Chain Management
1 13

14. Technology Risks
Data Security
Data Integrity
System Performance
Capacity Planning
Change Management
2- External Risk
Financial Risks
Credit Risk
Market Risk
Liquidly Risk etc;
Non-financial Risks
Political Risk
Competitor Risk
1 14

15. Socio Economic Risk
 External Fraud
Identifying Business Risk Exposures
Property
Business income
Liability
Human resource
External economic forces
Earnings
Physical assets
Financial assets
Medical expenses
Longevity (durability)
1 15

16. Financial Risk
We are primarily concerned with the main
categories of financial risk:
• Market Risk- Pricing Risk
• Credit Risk- Default Risk
• Operational Risk- Failing Processes/Systems
•Liquidity Risk – Funds
•Other Relevant Risks
1 16

17. •Market Risk — the risk of a change in the
value of a financial position due to changes in
the value of the underlying components on
which that position depends, such as stock and
bond prices, exchange rates, commodity prices,
etc.
Value of Financial Position Changes due to:
1- Interest rate risk is the risk of negative
effects on the financial result and capital of the
bank caused by changes in interest rates.
1 17

18. 2-Foreign exchange risk is the risk of negative
effects on the financial result and capital of the
bank caused by changes in exchange rates.
Problem: To explore the new relation with the
customer, during bank representative visit to the
customer, who wish to have Forward cover against import of
goods for 180days $600,000 Usance LC. If the Spot Rate is
Rs.87.98, profit on Foreign Currency is 5.85% and
Borrowing Rate is 14.65%. Calculate the minimum rate with
2% margin a bank can offer to it's customer.
• Credit Risk — the risk of not receiving
promised repayments on outstanding
investments such as loans and bonds, because of
the ―default‖ of the borrower.
1 18

19. •Liquidity Risk - the risk that it will not be
possible to sell a holding of a particular
instrument at its theoretical price.
•Operational Risk — the risk of losses
resulting from inadequate or failed internal
processes, people and systems, or external
events.
•Law, Compliance, Government Affairs-
Legal Risk, Regulatory Risk, enforceability Risk
etc. 1 19

20. •Energy Risk- Increasing globalization and
interdependence of energy products, delivery
mechanisms, and risk management techniques.
•Exposure Risks include risks of bank‘s
exposure to a single entity or a group of related
entities, and risks of banks‘ exposure to a single
entity related with the bank.
•Investment Risks include risks of bank‘s
investments in entities that are not entities in the
financial sector and in fixed assets.
•Stand-alone Risk
•Portfolio Risk
1

21. Sovereign Risk
Probability that the government of a country (or
an agency backed by the government) will refuse to
comply with the terms of a loan agreement during
economically difficult or politically volatile times.
Although sovereign nations don't "go broke," they can
assert their independence in any manner they choose,
and cannot be sued without their assent. Sovereign risk
was a significant factor during 1970s after
the oil shock when Argentina and Mexico almost
defaulted on their loans which had to be rescheduled.
1 21

22. What do you Mean by Risk Management?
―An integrated framework for managing credit
risk, market risk, operational risk, economic
capital, and risk transfer in order to maximize
firm value.‖
1 22

23. Objective of Risk Management
Need for a RM Objective
•Risk imposes costs on businesses and individuals.
•Risk Management (e.g., loss control and insurance)
also is costly
• Tradeoffs must be made
•Need a criteria for making choices about how much
risk management should be undertaken
Appropriate Criteria
Minimize cost of risk - direct or overall
Cost distribution: one time, periodical, over a certain
time horizon. 1 23

24. The Risk Management Process
1. Identification of risks
2. Evaluation of frequency and severity of
losses, including maximum probable loss =
value at risk
3. Choosing risk management methods
4. Implementation of the chosen methods
5. Monitoring the performance and suitability of
the methods
1 24

25. Economic Capital - Capital is held to ensure
that a bank is likely to remain solvent, even if it
suffers unusually large losses.
Available Economic Capital - The amount by
which the value of all assets currently exceeds
the value of all liabilities.
Required Economic Capital- The amount by
which the value of all assets should exceed the
value of all liabilities to ensure that there is a
very high probability that the assets will still exceed
1 25

26. Function of Economic Capital
1. To Address the unexpected loss at certain
confidential level for certain time horizon
2. „ Ensure solvency and stability of Financial
Institutions in cases of market shocks
3. „ May be aligned (associated) with the
firm‘s risk appetite
1 26

27. State Bank of Pakistan
As per the revision of capital requirements for
new entrants, banks in different modes of
operations are required a minimum paid up
capital of Rs 10 billion, instead of Rs 2 billion
previously, depicting a surge of Rs 8 billion or
400 percent. Minimum Paid up Dead line by which
Capital to be
(Net of losses) increased
Rs 5 billion - -
Rs 6 billion - -
Rs 10 billion - -
Rs 15 billion - -
Rs 19 billion - -
1
Rs 23 billion - - 27

28. IMPORTANT RATIOS
1. Debt to Service Coverage Ratio=Net Operative
Income/ Debt Service
- It is used to measure the ability of prospect to
meet the financial obligation. For example, if the
net income available to shareholder=
Rs.55,234,098/- and it‘s financial obligation
against facility= Rs.24,777,980/-
2. Loan to Value Ratio= Amount of Facility/ Value
of Asset or Security
- It is used to measure the security is to facility
amount in order to recover the facility in case of
default.
1 28

29. Bank Regulation and Basel
Important State Objective Bank
-Stable Economic Environment for Private
Individuals and Businesses.
-Providing Reliable Banking System & Protect
Depositors even in the event of Bank Failure.
-Deposit insurance introduced to build the
depositors confidence.
-Bank Regulators prescribe minimum level of
capital to cover the worst case loss over some
time horizon (possibility).
1 29

30. The worst case loss is the loss that is not
expected to exceed with some high degree of
confidence. The high degree of confidence
might be 99% or 99.9%.
The expected losses are covered as product
price.
For example: the interest charged by the bank is
designed to recover expected loan losses.
Capital is a cushion to protect the bank from
extremely un-favourable outcome. 30

31. Reason For Regulating Bank Capital
― Bank regulation is unnecessary. Even if there
were no regulations, banks would manage their
risks prudently and would strive to keep a level
of capital that is commensurate (matching) with
the risks they are taking.‖
•Without state interventions, banks that took
risks by keeping low levels of capital equity.
•Deposit insurance may encourage banks for
low equity.
•Due to cost of insurance, regulations on the
capital banks must hold.
1 31

32. The capital a financial institution requires
should cover the difference between expected
losses over some time horizon and ‗worst-case
losses‘ over the same time horizon. The idea is
that expected losses are usually covered by the
way a financial institution prices its products.
For example, the interest charged by a bank is
designed to recover expected loan losses.
Capital is a cushion to protect the bank from an
extremely unfavorable outcome
1 32

33. Risk Based Assets = Total Asset - Cash and Equivalents -
Fixed Assets
OR
Risk Based Assets = Other Earning Assets excluding Loans +
Net Loans
Basel
Basel Accord: The Basel Committee on
Banking Supervison‘s regulatory framework of
capital standards for banks, established in 1988
to protect bank owners, depositors, creditors,
and deposit insurers (e.g., governments) against
financial distress. 33

34. The Road to Basel
―Risk management: one of the most important
innovations of the 20th century.‖
[Steinherr, 1998]
• The late 20th century saw a “revolution” on
financial markets. It was an era of innovation
— in academic theory, product development
(derivatives) and information technology — and
of spectacular market growth.
1 34

35. • Large derivatives losses and other financial
incidents raised banks‘ consciousness of risk.
• Banks became subject to regulatory capital
requirements, internationally coordinated by the
Basle Committee of the Bank of International
Settlements.
1 35

36. Some Dates
• 1950s. Foundations of modern risk analysis are
laid by work of Markowitz and others on
portfolio theory.
• 1970. Oil crises and abolition of Bretton-
Woods turn energy prices and exchange rates
into volatile risk factors.
• 1973. CBOE, Chicago Board Options
Exchange starts operating. Fisher Black and
Myron Scholes, publish an article on the rational
pricing of options. [Black and Scholes, 1973]
1 36

37. • 1980s. Deregulation; globalization - mergers
on unprecedented scale; advances in IT.
The Regulatory Process
• 1988. First Basel Accord takes first steps
toward international minimum capital standard.
Approach fairly crude and insufficiently
differentiated.
1 37

38. The BIS Accord defined two minimum capital
adequacy requirements:
1. The first standard was similar to that
existing prior to 1988 and required banks to
have assets-to-capital multiple of at most 20.
Assets-to-capital <+20
2. The second standard introduced what
became known as the Cooke ratio.
3. The Cooke Ratio
Used to calculate what is known as the bank‘s
total risk-weighted assets (also sometimes
referred to as the risk-weighted amount).
1 38

39. Cooke ratio calculated both on-balance sheet
and off-balance sheet.
Risk weight for on balance sheet items
Risk Asset Category
Weight %
0 Cash, gold bullion, claims on OECD governments such
as T. Bonds or insured residential mortgage
20 Claims on OECD Banks and OECD public sector
entities such as securities issued by government agencies
or claims on municipalities
50 Uninsured residential mortgage loans
100 All other claims, such as corporate bonds and less-
developed country debt, claims on non-OECD Banks,
real estate, premises, plant & equipment.
1 39

40. Calculate risk weighted assets (RWA), if the
assets of the banks consist of $100 million of
corporate loans, $10 million of OECD
government bonds, and $50 million of
residential mortgages.
RWA= 1.0*100 + 0.0*10 + 0.5*50 = $125 Million
Problem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 579.59 million of
retail loan with the risk weight of 35.67%, Rs. 299.98 million of mortgages with the risk weight
of 21.45%, Rs.987.09 million of corporate loans with risk weight of 16.79% and Rs.887.89
million of state loans with risk weight of 0%.
Problem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 799.09 million of
corporate loan with the risk weight of 19.75%, Rs. 199.98 million of T.B with the risk weight of
0%, Rs.337.95 million of SME loans with risk weight of 36.79% and Rs.233.56 million of agri-
loans with risk weight of 37.08%.
1 40

41. Off balance sheet items are expressed as Credit
Equvilent Amount
Credit Equvilent Amount is the loan principal
that is considered to have the same credit risk.
Credit perspective are considered to be similar
to loan, such as bankers acceptance, have a
conversion factor of 100%.
1 41

42. •1993. The birth of VaR. Seminal G-30 report
addressing for first time off-balance-sheet
products (derivatives) in systematic way. At
same time JPMorgan introduces the
*Weatherstone 4.15 daily market risk report,
leading to emergence of RiskMetrics.
•1996. Amendment to Basel I allowing internal
VaR models for market risk in larger banks.
Also referred as BIS 98.
The Amendment requires financial Institutions to hold
capital to cover their exposure to market risks as well as
credit risks. 1 42

43. *Weatherstone Capital Management is a money
management firm that utilizes active money
management strategies that are designed to generate
strong returns while reducing the level of risk that is
found in most stock and bond market investments.
Goal is to provide investment programs that generate
strong returns relative to the amount of risk that is
taken.
Allows conservative and risk conscious investors the
ability to comfortably allocate a higher portion of their
investment portfolios to the segments of the financial
markets that have historically generated the highest
returns.
1 43

44. •Credit Risk Capital charged in 1988
•Amendment also apply to all on-balance sheet
and off-balance sheet in the trading and banking
books, except positions in the trading books that
consist of:
•Debt and equity trade securities and
•Positions in commodities and foreign
exchange.
The market risk capital requirement for banks by
using internal model-based approach
k*VaR + SRC
1 44

45. Where k=multiplicative factor, VaR= value at risk &
SRC= specific risk charge
RWA for market risk capital is defined as
12.5 *k*VaR + SRC
The total capital required for Credit and Market
Risk is given by
Total Capital= 0.8 x (Credit risk RWA + Market risk RWA)
1 45

46. •2001 onwards. Second Basel Accord, focusing
on credit risk but also putting operational risk
on agenda. Banks may opt for a more advanced,
so-called internal-ratings-based approach to
credit.
•July 2009 onwards, Second Basel Accord,
focusing on Revised Securitisation and Trading
Book Rules & implemented by Dec 2011.
•Nov 2010 Third Basel (G 20 endorsement of
Basel III) will be implemented by Jan 2013-
Jan2019.
1 46

47. Basel II: What is New?
• Rationale for the New Accord: More flexibility
and risk sensitivity
• Structure of the New Accord: Three-pillar
framework:
Pillar 1: minimal capital requirements (risk
measurement)
Pillar 2: supervisory review of capital
adequacy
Pillar 3: public disclosure
1 47

48. •Two options for the measurement of credit risk:
•Standard approach
•Internal rating based approach (IRB)
For an on-balance-sheet item a risk weight is
applied to the principal to calculate risk-
weighted assets reflecting the creditworthiness
of the counterparty. For off-balance-sheet items
the risk weight is applied to a credit equivalent
amount. This is calculated using either credit
conversion factors or add-on amount.
1 48

49. -Standardized approach (for small banks. In
USA, Basel II will apply only to the largest
banks and these banks must use the foundation
internal ratings based (IRB) approach). risk
weights for exposures to country, banks, and
corporations as a function of their ratings.
•Pillar 1 sets out the minimum capital
requirements (Cooke Ratio):
total amount of capital ≥ 8% risk-weighted
assets
Total capital = 0.08*(credit risk RWA + Market
risk RWA + Operational risk RWA).
1 49

50. • MRC (minimum regulatory capital) def = 8%
of risk-weighted assets
• Explicit treatment of operational risk
The Market Risk Capital Requirement:
k * VaR + SRC,
where SRC is a specific risk charge. The VaR is
the greater of the pervious day‘s VaR and the
average VaR over the last 60 days.
The minimum value for k is 3.
1 50

51. Operational Risk: Banks have to keep capital
for operational risk.
Three approaches.
- Basic indicator approach: operational risk
capital = the bank‘s average annual gross
income (=net interest income + noninterest
income) over the last three years multiplied by
0.15.
- Standardized approach: similar to basic
approach, except that a different factor is applied
to the gross income from different business
lines. 1 51

52. -Advanced measurement approach: the bank
uses its own internal models to calculate the
operational risk loss that it is 99.9% certain will
not be exceeded in one year.
Tier 1 - Capital- Equity and similar sources of
capital
Tier 2 - Subordinated debt (life greater than five
years) and similar sources of capital.
Tier 3 - Short –term subordinated debt (life
between two and five years).
1 52

53. Calculation of total risk weighted assets under the
Basel II standardized approach, if the assets of the
bank consist of $100 million of loans of corporation
rated A (weighted risk=50%).$10 million of
government bonds rated AAA(weighted risk=0%), and
$50 million residential mortgages(weighted
risk=35%).
Total Risk Weighted Assets
= 0.5 *100 + 0.0*10 +0.35*50= $67.50 Million
Problem: Calculate the risk weighted assets under the Basel II standardized approach, if
the assets of bank consist of Rs. 579.59 million of retail loan average rating of A+ Rs.
299.98 million of mortgages , Rs.987.09 million of corporate loans average rating of
AA- and Rs.887.89 million of state loans average rating of AAA.
1 53

54. Problem: Calculate the risk weighted assets under the Basel II standardized approach, if the assets
of bank consist of Rs. 799.09 million of corporate loan with average rating of A-, Rs. 199.98
million of T.B with average rating of AAA, Rs.337.95 million of SME loans with average rating
of A+ and Rs.233.56 million of agri-loans with average rating of BBB+.
AAA A+ BBB+ BB+ B+ Below Unrated
To To To To To B
AA- A- BBB- BB- B-
Country 0 20 50 100 100 150 100
Banks 20 50 50 100 100 150 50
Corporations 20 50 100 100 100 150 100
1 54

55. Adjustment for Collateral
There are two ways banks can adjust risk weights for
collateral.
1- Simple Approach- the risk weight of the
counterparty is replaced by the risk weight of the
collateral for the part of the exposure covered by the
collateral.
2- Comprehensive Approach- banks adjust the size of
their exposure upward to allow for possible increases
and adjust the value of the collateral downward to
allow for possible decreases in the value of the
collateral. 1 55

56. Example: Suppose that an $80 million exposure to a particular
counterparty is secured by collateral worth $70 million. The collateral
consist of bonds issued by an A-rated company. The counterparty has a
rating of B+. The risk weight for the counterparty is 150% and the risk
rate for the collateral is 50%. The risk –weighted assets applicable to the
exposure using the simple approach is therefore
0.5 x 70 + 1.50 x (80 -70) = 50
Consider next the comprehensive approach. Assume that the adjustment
to exposure to allow for possible future increases in the exposure is
+10% and the adjustment to the collateral to allow for possible future
decreases in its value is -15%
(1.0 + 0.10) x 80 – (1.0 – 0.15) x 70
= 1.10 x 80 – 0.85 x70 =88 – 59.5= 28.50
If the risk weight of 150% is applied to the exposure, the risk adjusted
assets equal to 42.75 million
(1.50 + .10) x 80 – (1.50 -.15)x70
=128 – 94.5 1?????? 56

57. Expected losses are those that the bank knows with
reasonable certainty will occur (e.g., the expected
default rate of corporate loan portfolio or credit card
portfolio) and are typically reserved for in some
manner.
Unexpected losses are those associated with
unforeseen events (e.g. losses experienced by banks in
the aftermath of nuclear tests, Losses due to a sudden
down turn in economy or falling interest rates).
Banks rely on their capital as a buffer to absorb such
losses.
Risks are usually defined by the adverse impact on
profitability of several distinct sources of uncertainty.
1 57

58. SBP Guidelines on Internal Credit Risk Rating Systems
The banks are required to establish criteria to map their
internal obligor & facility ratings according to the broad
regulatory definitions of rating grades 1 to12.
Facility grades should be assigned according to the severity of
the expected losses in case of default, keeping in view the
factors from A to F.
OBLIGOR/ 1 2 3 4 5 6 7 8 9 10 11 12
FACILITY
A A1 A2 A3 A4 A5 A6 A7 A8 A9 A10 A11 A12
B B1 B2 B3 B4 B5 B6 B7 B8 B9 B10 B11 B12
C C1 C2 C3 C4 C5 C6 C7 C8 C9 C10 C11 C12
D D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 D11 D12
E E1 E2 E3 E4 E5 E6 E7 E8 E9 E10 E11 E12
F F1 F2 E3 F4 F5 F6 F7 F8 F9 F10 F11 F12
1 58

59. IRB (Internal rating based) approach – one-
factor Gaussian copula model of time to
default. WCDR: the worst-case default rate
during the next year that we are 99.9%
certain will not be exceeded
PD: the probability of default for each loan in
one year
EAD: The exposure at default on each loan (in
dollars)
LGD: the loss given default. This is the
proportion of the exposure that is lost in the
event of a default.
1 59

60. Expected Loss (EL) Calculation
Lending institutions need to understand the loss
that can be incurred as a result of lending to a
company that may default; this is known
as expected loss (EL).
EL can be expressed as a simple formula:
EL = PD * LGD * EAD
1 60

61. The total exposure to credit risk is the amount
that the borrower owes to the lending institution
at the time of default; the exposure at default
(EAD). Generally, EAD will not be larger than
the borrowing facility.
PD & LGD are risk metrics employed in the
measurement and management of credit risk.
The metrics are used to calculate EL.
1 61

62. The probability of default (PD) is the
likelihood that a loan will not be repaid and will
fall into default. It must be calculated for each
borrower. The credit history of the borrower and
the nature of the investment must be taken into
consideration when calculating PD. External
ratings agencies such as Standard and Poors or
Moody‘s may be used to get a PD; however,
banks can also use internal rating methods. PD
can range from 0% to 100%. If a borrower has
50% PD it is considered a less risky company
vs. a company with an 80% PD.
1 62

63. For Example:
A borrower (Company X) takes out a loan from Bank
ABC for $10 million (EAD). Company X pledges $3
million collateral against this loan (for simplicity, let’s
say the collateral is cash). The Company’s PD is
determined by analyzing their credit risk aspects
(evaluate the financial health of the borrower, taking
into account economic trends, borrower relationship
with the bank, etc.) For Company X, let’s say the PD is
0.99. This means that the Company is extremely risky;
the probability of them defaulting on the loan is 99%.
1 63

64. Loss given default (LGD) is the fractional loss due to
default. Continuing from the previous example:
If Company X defaults (is unable to pay back the $10
million to Bank ABC), the Bank will be able to recover
$3 million (this is the cash-secured collateral).
So, how do we calculate the actual loss given default
(LGD)?
LGD = 1 – Recovery Rate (RR)
The Recovery Rate (RR) is defined as the proportion
of a bad debt that can be recovered. It is calculated as:
RR = Value of Collateral/Value of the Loan
1 64

65. Back to our example, the recovery rate for Bank ABC
= $3 million/ $10 million = 30%
So % LGD= 1- 0.30 = 0.70 or 70%.
$ LGD= 70% of a $10 million (EAD) loan is equal to
$7 million.
$ LGD = $7 million
Expected Loss (EL) is what a bank can expect to lose
in the case that their borrower defaults. It is calculated
below:
EL = PD * LGD * EAD
EL= 0.99* 70% * $10 million
EL = $6.93 million
Bank ABC can expect to lose $6.93 million
1 65

66. Problems: Kamran & Sons is a company rated as A+ takes out a loan from Bank ABC for Rs.150
million against the mortgage of residential property having market value for Rs.160 Million &
forced sale value for Rs.110 million(for simplicity, let’s say the collateral is cash). Calculate the
PD, LGD, EAD and EL .
Problems: If the loan wise credit exposure of a bank alongwith other data PD is given below:
Type of Loan ExposureSecurity Cash Value Rating
Corporate Loans 241,673,000,000 229.885,000,000 AA+
Retail Loans 329,881,000,000 299,887,000,000 A-
Agri- Loans 098,875,000,000 034,888,000,000 BB+
State Loans 167,988,000,000 000 AAA
On the bases of above data calculate the EAD, LGD , EL & EL %.
Problem: If the credit exposure against the medium term loans of a financial institution as per
loan rating is given below:
ExposureRating
241,673,000,000 AAA
329,881,000,000 AA-
098,875,000,000 AA+
167,988,000,000 B
196,778,000,000 BB-
On the bases of above data 1calculate the EAD, LGD ,EL & EL %. 66

67. The VaR Measure
Value at Risk (VaR) is an attempt to provide a
single number that summarizes the total risk in a
portfolio of financial assets.
VaR measure is used by the Basel Committee in
setting capital requirements for banks
throughout the world.
1 67

68. Value at Risk: A loss that will not be exceeded
at some specified confidence level.
We are X% certain that we will not lose more than $V
in the next N days.
The Variable V is the VaR of the portfolio. It is a
function of two parameters the time horizon (N days)
and the confidence level (X%).
E.g; In 5 days (N=5), VaR is the loss corresponding to
the (100- 97)%=3 % (X=97%) of the distribution of
the change in the value of the portfolio over 5 days.
Portfolio gain is +ve & Loss is –ve.
1 68

69. Using the VaR measure with N=10 and X=99. This
means that it focuses on the revaluation loss over a 10
day period that is expected to be exceeded only 1% of
the time.
VaR vs Expected Shortfall
VaR is used in an attempt to limit the risks taken by a
trader. Suppose that a bank tells a trader that the one-
day 99% VaR of the trader‘s portfolio must be kept at
less than $10 million.
Trader can construct a portfolio with 99% chance that
the the daily loss is less than $10 million but 1%
chance of loss of $500 million.
1 69

70. Expected Shortfall, like VaR, is a function of two
parameters:
-N(the time horizon in days) and
-X (the percentage confidence level)
Expected loss during an N-day period conditional on
the loss being greater than the Xth % of the loss
distribution.
E.g; X=99 and N=10, the expected short-fall is the
average amount lost over ten day period assuming that
the loss is greater than 99th % of the loss distribution.
1 70

71. Properties of Risk Measures
A risk measure used for specifying capital
requirements can be thought of as the amount of cash
9or capital) that must be added to a position to make
its risk acceptable to regulators.
Proposed Properties that such a Risk Measure should
have:
Monotonicity: If a portfolio has lower returns than
another portfolio for every state of the world, its risk
measure should be greater.
Translation invariance: If we add an amount of cash
K to a portfolio, its risk measure should go down by
K. 1 71

72. Homogeneity: Changing the size of a portfolio by a
factor λ while keeping the relative amounts of
different items in the portfolio the same should result
in the risk measure being multiplied by λ.
Subadditivity: The risk measure for two portfolios
after they have been merged should be no greater than
the sum of their risk measure before they were
merged.
First three conditions are risk acceptable by adding
cash needed to the portfolio.
Forth condition states that diversification helps reduce
risks. 1 72

73. Example: Consider two $10 million one-year loans each of which has a 1.25% chance
of defaulting. If a default occurs on one of the loans, the recovery of the loan principal
is uncertain, with all recoveries between 0% and 100% being equally likely. If the loan
does not default , a profit of $0.2 million is made. To simplify matters, we suppose that
if one loan defaults then it is certain that the other loan will not default.
For a single loan, the one-year 99% VaR is $2 million. This is because there is a 1.25%
chance of a loss occurring, and conditional on a loss there is an 80% chance that the
loss is greater than $2 million. The unconditional probability that the loss is greater than
$2 million is therefore 80% of 1.25% or 1%.
Consider next the portfolio of two loans. Each loan defaults 1.25% of the time and they
never default together. There is therefore a 2.5% probability that a default will occur.
The VaR in this case turns out to be $5.8 million. This is because there is a 2.5% chance
of one of the loans defaulting, and conditional on this event there is an 40% chance that
the loss on the loan that defaults is greater than $6 million. The unconditional
probability that the loss on the defaulting loan is greater than $6 million is therefore
40% of 2.5%, or 1%. A profit of $0.2 million is made on the other loan showing that
the one-year 99% VaR is $5.8% million.
The total VaR of the loans considered separately is 2 + 2 = 4 million. The total VaR
after they have been combined in the portfolio is $1.8 million greater at $5.8 million.
This is in spite of the fact that there are very attractive diversification benefits from
combining the loans in a single portfolio.
1 73

74. Pure Risk Characteristics and Management
Generalizations:
•Pure risk usually involves large potential losses
relative to the expected loss and relative to available
resources.
•Pure risk involves events that are firm-specific
•Price risk affects many firms
•Pure risk is managed by insurance
•Price risk is managed by derivatives (forward &
option contracts, hedging)
•Pure risk involves wealth losses to society
•Price risk often involves wealth redistributions in
society
Nevertheless, we use the same framework for management of pure risk and price risk
1 74

75. What Is Credit
•Person‘s confidence in person.
Credit Risk:
•A Performance Risk: specifically, the risk of loss due
to a Borrower‘s/Debtor's non-payment of a loan or
other obligation (i.e., the possibility that borrowers
will not repay their loans on time or at all).
Borrowers:
•Lenders distinguish between retail and commercial
borrowers.
•Banks customize products to meet each group‘s
unique financial needs.
1 75

76. The Principles of Good Lending
The Credit Analysis Process:
•Information sources/data-gathering
•Complete a comprehensive analysis
•The Five Cs of Credit
•The structured framework of analysis
•Rating agencies and other analytical tools
1 76

77. The principles of lending ensure that the Borrower
is able to make payments as and when due:
•To identify a clear purpose with defined terms
•To understand the Borrower and Borrower needs
•To understand the collateral/security
• To understand repayment risk (liquidity or solvency)
•To understand the future deterioration factors that
may impact cash flow and thus, repayment of the
obligation(s)
1 77

78. Steps of the Credit Process (how banks lend money)
•Several sequential steps
Management Profile
Company Profile
Industrial Review
Credit History
Facility Structure etc
•Identify the credit opportunity
•Evaluate credits
•Monitor credits on an ongoing basis
1 78

79. Steps and considerations when evaluating credits
•Credit analysis process evaluates the borrower‘s
ability to repay
•Assess the borrower‘s financial position using several
different methods and sources of information
Banking Book Management
•Banks use various tools to reduce the overall risk of
their loan portfolios
1 79

80. The 5 Cs (or 7 Cs) of Credit:
1.Character
2.Conditions
3.Capital
4.Capacity
5.Collateral
6.Common sense
7.Control
1- Character:
Character is a lender‘s way to summarize a borrower‘s
determination to manage its cash position and more
importantly, honor its obligations (financial or
otherwise). 1 80

81. 2- Conditions:
Conditions focus on the economic and environments
influences that may impact a company‘s financial
position and its ability to honor its obligations.
3- Capital:
The financing structure and level of capitalization
(leverage) of a company.
4- Capacity:
The predictability and sustainability of the cash flows
of a company to service debt.
1 81

82. 5- Collateral:
Collateral protects the lender –when all else fails. In
lending, collateral represents a borrower‘s asset pledge
to secure a loan (collateral is a lender‘s protection in
the event of a borrower‘s default).
Structured Framework of Analysis*:
•Banks must have credit risk management systems
that:
•Produce accurate and timely risk ratings
•Accurate classification of the ratings
•Well-managed credit risk rating systems promote
bank safety and soundness by facilitating informed
decision making.1 82

83. The Principles of Credit Risk through a review of a
Structured Framework of Analysis
-Business Risk
-Financial Risk
-Structural Risk
Business Risk
Influenced by:
•Macro economic trends
•Industrial Status
•Micro economic trends
1 83

84. Include:
•Economic environment
•Business cycles
•Industry and regulatory trends
•Political risks
•Other social issues
Changes to these factors have wide ranging
implications to business and credit
1 84

85. Financial Risk
Affected by:
•Quality of management
•Company operation
•Financial position
Include:
•Management strategy and skills
•Management integrity
•Company systems
•The borrower‘s operating and financial performance
1 85

86. Structural Risk
Reflect how the loan is structured:
•Terms
•Payments
•Collateral
•Other credit features
The borrower’s support of repayment:
•Collateral
•The ability (willingness) to pay
1 86

87. Loss Distributions
To model risk we use language of probability
theory. Risks are represented by random
variables mapping unforeseen future states of
the world into values representing profits and
losses.
The risks which interest us are aggregate risks. In
general we consider a portfolio which might be
•a collection of stocks and bonds;
•a book of derivatives;
•a collection of risky loans;
•a financial institution‘s overall position in risky
assets. 1 87

88. Portfolio Values and Losses
Consider a portfolio and let Vt denote its value
at time t; we assume this random variable is
observable at time t.
Suppose we look at risk from perspective of
time t and we consider the time period [t, t + 1].
The value Vt+1 at the end of the time period is
unknown to us.
1 88

89. The distribution of (Vt+1 − Vt) is known as the
profit-and-loss or P&L distribution.
We denote the loss by Lt+1 = −(Vt+1 − Vt).
By this convention, losses will be positive
numbers and profits negative.
We refer to the distribution of Lt+1 as the loss
distribution.
1 89

90. Risk Factors
Generally the loss Lt+1 for the period [t, t + 1]
will depend on changes in a number of
fundamental risk factors in the time period, such
as stock prices and index values, yields and
exchange rates.
Writing Xt+1 for the vector of changes in
underlying risk factors, the loss will be given by
a formula of the form
1
Lt+1 = l[t](Xt+1). 90

91. where l[t] : Rd ! R is a known function which
we call the loss operator.
The book contains examples showing how the
loss operator is derived for different kinds of
portfolio. This is a process known as mapping.
Loss Distribution
The loss distribution is the distribution of
Lt+1 = l[t](Xt+1)?
But which distribution exactly?
1 91

92. The Conditional distribution of Lt+1 given given
Ft = σ ({Xs : s t}), the history up to and
including time t?
The unconditional distribution under assumption
that (Xt) form stationary time series?
Conditional problem forces us to model the
dynamics of the risk factors and is most suitable
for market risk.
Unconditional approach is used for longer time
intervals and is also typical in credit portfolio
management. 1 92

93. Value at Risk: A loss that will not be exceeded
at some specified confidence level.
Risk Measures
Risk measures attempt to quantify the riskiness
of a portfolio. The most popular risk measures
like VaR describe the right tail of the loss
distribution of Lt+1 (or the left tail of the P&L).
To address this question we put aside the
question of whether to look at conditional or
unconditional loss distribution and assume that
this has been decided.
1 93

94. Denote the distribution function of the loss
L := Lt+1 by FL so that
P(L ≤ x) = FL(x).
1 94

95. 1 95

96. KEY FINANCIAL RATIOS
1. TOTAL ASSETS
2. TOTAL EQUITY
3. PRETAX PROFIT
4. POST TAX PROFIT
5. PRETAX PROFIT/ TOTAL ASSETS (av)
6. PRETAX PROFIT/ TOTAL EQUIT(av)
7. TIER 1 CAPITAL RATIO
8. TOTAL CAPITAL RATIO
9. TOTAL EQUITY/ NET LOANS
10. NET LOANS/ TOTAL DEPOSITS
11. LOAN LOSS RESERVES/ GROSS LOAN (av)
12. LOAN LOSS RESERVES/ NET LOANS
13. LOAN LOSS RESERVES/ NET LOANS (av)
14. TOTAL DEPOSIT/ NET LOAN RATIO
1 96

97. 1. TOTAL ASSETS
Total assets represent resources with economic value
that a corporation owns or controls with the
expectation that it will provide future benefit.
Total assets are calculated from year end figures
gained from bank balance sheets.
Formula = Cash and Equivalents + Other Earning
Assets excluding Loans + Net Loans + Fixed Assets
2. TOTAL EQUITY
Stockholders' equity represents the equity stake
currently held on the books by a firm's equity investors
or shareholders.
Formula = Equity Reserves + Total Share Capital
1 97

98. 3. PRETAX PROFIT
A measurement of financial profitability, pre-tax profit
combines all profits before tax, including
operating, non-operating, continuing operations and
non-continuing operations.
Formula = Total income - Total expenses (before
taxes)
4. POST TAX PROFIT
Post-tax profit is a measure of profitability and
represents net income for the group as a whole. This is
calculated before deducting minority interests and
preference dividends.
Formula = Pre-Tax Profit (PBT) – Taxes
1 98

99. 5. PRETAX PROFIT/ TOTAL ASSETS (av)
The return on assets (ROA) percentage shows how
profitable a company's assets are in generating
revenue. The ratio is considered an indicator of how
effectively a company is using its assets to generate
earnings before payment of taxes and dividends.
Formula = Pre-tax profits / Total Assets average
The ratio is part of ‗Profitability‘ ratios of the bank, where:
Pre-tax profits = Total income - Total expenses (before taxes)
Total income includes interest income, commission, fees, other operating
income, non operating income, exceptional and extraordinary income.
Total Expenses includes interest expense, commission, fees, other
operating expenses, non operating expenses, exceptional and
1 99
extraordinary expenses.

100. 6. Pre-Tax Profit / Total Equity (Av)
Return on equity (ROE) measures a corporation's
profitability by revealing how much profit a company
generates with the money shareholders have invested.
Formula = Pre-tax profit / Total Equity average
The ratio is part of ‗Profitability‘ ratios of the bank, where:
Pre-tax profits = Total income - Total expenses (before taxes)
Total equity = Equity Reserves + Total Share Capital
Equity Reserves includes retained earnings, current year earnings, other
equity reserves, revaluation reserves and minority interests in reserves.
Total share capital is sum of common shares/stock, preferred
stock/shares, minority interest less treasury stock.
1 100

101. 7. Tier 1 Capital Ratio
Tier 1 capital is the core measure of a bank's financial
strength from a regulator's point of view. It absorbs
losses without a bank being required to cease trading.
Formula = (Total Equity - Revaluation Reserves) /
Risk Based Assets
Tier 1 Capital Ratio is part of 'Capital Adequacy' ratios
of the bank, where:
1-Total equity = Equity Reserves + Total Share Capital
Equity Reserves includes retained earnings, current year earnings, other
equity reserves, revaluation reserves and minority interests in reserves.
Total share capital is sum of common shares/stock, preferred
stock/shares, minority interest less treasury stock.
1 101

102. 2 Risk Based Assets = Total Asset - Cash and Equivalents - Fixed Assets
OR
Risk Based Assets = Other Earning Assets excluding Loans + Net Loans
3 Total Assets = Cash and Equivalents + Other Earning Assets excluding
Loans + Net Loans + Fixed Assets
Other earning assets includes treasury and other bills, government
securities, deposits with banks, trading, financial and other listed
securities including bonds, other equity investments such as equity
share, non-listed securities, other assets and intangible assets such as
software, patents etc.
Net loans include loans to banks or credit institutions; customer net
loans; HP, lease or other loans; mortgages; loans to group companies and
associates and trust account lending.
Fixed assets include land and buildings and other tangible assets such as
plant and machinery, 1furniture, fixtures and vehicles etc. 102

103. 8. Total Capital Ratio
Total capital Ratio or Capital Adequacy Ratio (CAR)
measures a bank's capital position and is expressed as
a ratio of its capital to its assets.
It determines the capacity of the bank in terms of
meeting the time liabilities and other risks such as
credit risk, operational risk, etc. CAR below the
minimum statutory level indicates that the bank is not
adequately capitalized to expand its operations. The
ratio ensures that the banks do not expand their
business without having adequate capital.
Formula = (Tier 1 Capital + Tier 2 Capital) / Risk
Based Assets 1 103

104. Total Capital Ratio is part of 'Capital Adequacy' ratios of the
Bank . Where,
1 Tier 1 Capital = Total Equity - Revaluation Reserves
2 Tier 2 Capital = Revaluation Reserves + Subordinated Debt
+ Hybrid Capital + Provisions including Deferred Tax+ Total
Loan Loss & Other Reserves
3 Total equity = Equity Reserves + Total Share Capital
9- Total Equity / Net Loans
This ratio forms part of the Capital and Funding ratios
of a bank, and measures a company's financial
leverage by calculating the proportion of equity and
debt the company is using to finance its assets.
Formula = Total Equity / Net Loans
1 104

105. Total equity covers total equity reserves, total share capital and treasury
stock.
Net loans include loans to Banks or Credit Institutions, Customer net
Loans and loans to group companies.
10- Net Loans / Total Deposits
Forming part of the Liquidity ratios of a bank, this
ratio is often used by policy makers to determine the
lending practices of financial institutions.
The higher the Loan-to-deposit ratio, the more the
bank is relying on borrowed funds.
Formula = Net Loans / Total Deposits
Net loans include: loans to banks or credit institutions; customer net loans; HP, lease or
other loans; mortgages; loans to group companies and associates and trust account
lending.
Total deposits cover customer deposits, central bank deposits, banks and other credit
1
institution deposits and other deposits. 105

106. 11- Loan Loss Reserves / Gross Loans (Av)
This ratio is part of 'Asset Quality' ratios of the bank
and determines the quality of loans of a bank. The
higher the ratio, the more problematic the loans are
and vice versa.
Formula = Loan Loss Reserves / Gross Loans
average
Gross loans average comes from the average of the gross loans of prior
year and the gross loans of the current year.
12- Loan Loss Reserves / Net Loans
This financial ratio is a part of 'Asset Quality' ratios of
the bank and is calculated by loan loss reserves by net
loans. 1 106

107. The ratio determines the quality of loans of a bank.
The higher the ratio, the more problematic the loans
are and vice versa.
Formula = Loan Loss Reserves / Net Loans
13- Loan Loss Reserves / Net Loans (Av)
This ratio forms part of the 'Asset Quality' ratios of the
bank and determines the quality of loans of a bank.
The higher the ratio, the more problematic the loans
are and vice versa.
Formula = Loan loss reserves / net loans average
Net loan average is defined as the average of net loans
of the prior year and the net loans of the current year.
1 107

108. 14- Total Deposits / Net Loans Ratio
Total deposits / net loans ratio is a measure of
'Funding Base Analysis' of the bank and calculates the
deposit drains. If the ratio is less than 1:1, it indicates
that the bank is in danger of becoming insolvent.
Formula = Total Deposits / Net Loans
Total deposits include customer deposits, central bank
deposits, bank and other credit institution deposits and
other deposits.
Net loans cover loans to banks or credit institutions;
customer net loans; NP, lease or other loans;
mortgages and loans to group companies.
1 108

109. 1 109