RiskForeign exchange risk is the risk of incurring losses due to fluctuations of exchange rates. The variations of earnings result from the indexation of revenues and charges to exchange rates, or from the changes of the values of assets and liabilities denominated in foreign currencies (translation risk).
Solvency risk is the risk of being unable to absorb losses with the available capital. According to the principle of “capital adequacy” promoted by regulators, a minimum capital base is required to absorb unexpected losses potentially arising from the current risks of the firm. Solvency issues arise when the unexpected losses exceed the capital level, as it did during the 2008 financial crisis for several firms. This capital buffer sets the default probability of the bank, the probability that potential losses exceed the capital base.
Operational risks are those of malfunctions of the information system, of reporting systems, of internal risk monitoring rules and of procedures designed to take corrective actions on a timely basis. The regulators define operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.2 The focus on operational risk developed when regulators imposed that the operational risks should be assigned a capital charge.
1.3 Business Lines in Banking
There is a wide variety of business lines in the banking industry, with different management practices and different sources of risks. This section provides a brief overview of the diversity of activities conducted in banking.
Retail banking tends to be mass oriented and “industrial” because of the large number of transactions. Retail Financial Services (RFS) covers all lending activities to individuals, from credit card and consumer loans, to mortgages. RFS also extends to very small enterprises, such as those of physicians or home services. Lending decisions are based on a combination of automated systems and management monitoring. Statistical techniques are relevant for assessing credit risk.
Standard corporate lending transactions include overnight loans, short-term loans (less than one year), revolving facilities, term loans, committed lines of credit or large commercial and industrial loans. Such transactions are under the responsibility of credit officers and their reporting lines. For the large corporate businesses, relationship banking prevails when the relationship is stable, based on mutual knowledge. Credit analysts are industry specialists who monitor the credit standing of clients. They provide the individual credit assessments of obligors, based on expert judgment, for making lending decisions.
Investment banking is the domain of large transactions customized to the needs of large corporate and financial institutions. It also includes trading activities, under the generic name of “Corporate and Investment Banking” (CIB).
Large corporations demand a variety of services and products, for example from lending facilities and hedging instruments or issuance of securities. A number of very different activities are under the umbrella of the CIB pole. The financing of financial institutions, banks, insurance companies and brokers is organized as separate groups, distinct from those dedicated to commercial and industrial firms. Mergers and acquisitions form another business line.
All activities of specialized, or “structured”, finance are also conducted by dedicated units within CIB. The scope of specialized finance includes such activities as project finance, asset financing (ships or aircrafts), commodities finance, commercial real estate and exports. The risk analysis differs radically from the assessment of a corporate borrower. In general, the primary source of repayment is the cash flows generated by the asset(s), from its operations or from the sale of the asset(s). Structuring refers to the assembling of financial products and derivatives, plus contractual clauses (“covenants”) in order to make the risk manageable. Securitization is one of the fields of specialized finance: it consists of selling pools of loans, which are normally held in the balance sheet of banks, into the capital markets.
Trading involves traditional proprietary trading and trading for third parties. In proprietary trading, the bank is trading for itself, taking and unfolding positions to make gains. Trading is also client oriented. “Sales” designate trades conducted when the bank acts on behalf of their clients. The “sell side” is the bank, selling products to end-users. The “buy side” designates the clients, corporations and asset managers who buy the products, for example for hedging purposes. Traders and lending officers are not allowed to share information, as inside information on a corporate client could inspire trades based on undisclosed information. Banks are also exposed to market risk from their investment portfolio, which is not held for trading but with an objective of long-term performance.
Other activities do not generate directly traditional financial risks. For example, private banking, or asset management, is the activity of wealth management for third parties. Advisory services refer to consulting services offered by banks to corporations considering potential acquisitions, for example, which do not necessarily imply cash outlays. Risks are primarily legal and operational.
Figure 1.1 maps the banking activities grouped into main poles.
Figure 1.1 Business lines in banking
1.4 Banking Regulations and Accounting Standards
Banking activities are subject to a wide body of rules. Risks are subject to the regulations rules. Valuation of assets and liabilities and profit and loss are subject to accounting standards.
Risk regulations differ for the banking book and the trading book. The banking book refers to the transactions belonging to the core business of commercial banks, lending and deposit collection. It includes all assets and liabilities that are not actively traded by the institution, and generally held until they mature. The trading book groups capital market transactions, and is exposed to market risk. Positions held for trading are held over a short-term horizon, with the intention of benefiting from expected price movements. The trading book includes proprietary positions, and positions arising from client servicing and market making.
Risk regulations relate directly to the management of the balance sheet, to market risk and credit risk and are detailed in the corresponding sections of this text.
The accounting standards segregate instruments into four classes differing by valuation and treatment of profits and losses:
• Financial assets at fair value through profit and loss;
• Loans and receivables;
• Held-to-maturity investments;
• Available-for-sale financial assets.
The financial assets at fair value include all instruments acquired to take advantage of price fluctuations and are managed with the intention of making short-term profits, the performance of which is evaluated on a fair value basis. Derivatives are held for trading unless they are considered as hedges. The assets and liabilities of the trading book are under this category.
Fair value focuses on the price at which an asset can be sold: it is the amount at which an asset could be exchanged between parties, knowledgeable and willing to exchange. Valuation depends on whether markets are active or not. Active markets are those where the volume of transactions provide clear prices. For other instruments, prices can be derived from other traded instruments in active markets, or valuation is model based.
Accordingly, market instruments fall in either one of three categories: level 1 when quoted prices are available; level 2 when there are market prices for similar instruments;
The definition is from the Basel 2 document (2006), [21].
