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Summary of chapter 3: Managing Credit Risk

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Summary of chapter 3: Managing Credit Risk

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Concept of credit risk

The risk of an economic loss from the failure of a counterparty to fulfill its contractual obligation.

Credit risk comprises two different cases: the risk of loss from the borrower's actual insolvency and from a mere deterioration in its credit rating.

Pre settlement risk: due to counterparty failure to perform on obligation during the life of the transaction. Example, default on loan failure to make the required payment on derivative transaction.

Settlement risk: due to counterparty default, liquidity constraint or operational problem. It arises from the exchange of principal in different currencies during a short term.

Drivers of credit risk

Default: Discrete state for the counterparty either in default or not.

Credit exposure: Economic or market value of the claim on the counterparty.

Loss given default: Fractional loss due to default.

Constituents of credit risk

Default risk: Risk connected with a default by the counterparty that declares bankruptcy.

Exposure risk: Risk that exposure at default will be greater than the amount originally expected.

Recovery risk: Risk that the actual recovery rate recorded after liquidation of insolvent counterparty assets is less than the amount originally estimated.

Expected loss: The percentage of exposure that the bank forecasts it will be unable to recover. The average credit loss.

Unexpected loss: The risk that loss which seems to be greater than originally estimated. It's considered to be a true credit risk. The variation of credit losses beyond expected losses.

* Credit VaR is the unexpected credit loss at some confidence level.

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Summary of chapter 2: Nature of Financial Risk Management

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Summary of chapter 2: Nature of Financial Risk Management

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Importance of Capital

Financial institutions (FI) capital is a primary means of protection against the risk of insolvency and failure.

Function of Capital

The key function of capital is absorbing unexpected losses, protecting depositors, bondholders, and capital for long-term investment.

There are 5 functions in slide.

Definition of Capital

Capital is the net worth of Financial Institution (FI)

Net worth become device against credit risk

Net worth become key buffer to credit risk or default risk, where borrowers unable to pay the loan

Concept of Capital Requirement

- Financial Institutions should have regulatory capital and economic capital.

Regulatory Capital: Mandatory by regulators (central bank) to hold as safety against risk. The objective of FI is to make profit but the main risk is losses.

Economic Capital: Estimated by the bank management. internal measure bank sendiri yang suggestkan how much capital required to be maintained.

The Basel Capital Accord

Set by Basel Committee on Bank Supervision.

It is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

Classification of Capital in Basel Accords

Tier 1 (core capital)- Equity and disclose reserve

Tier 2 (supplementary capital)- Subordinate debt

Tier 3- Short-term subordinated debt with a maturity of at least 2 years

Three Pillars of Basel ll Accord

Pillar 1 (Minimum capital requirement)- Just tengok berapa jumlah risiko , berapa wang. based on numbers.

Pillar 2 (Supervisory review)- Judgement review by human layers.

Pillar 3 (Market discipline)- Bank need to disclose the risk.

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4/8- Monday

> Introduction to FIN 557

> Create Padlet portfolio

5/8- Tuesday

> Learn topic 1: Introduction to risk management

> Playing Kahoot: Topic 1 self test

> task given to make a video about agency theory

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Agency theory examines the relationship between the principal and the agent of a company that focuses on the potential conflicts that arise when their interests are not aligned.

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Yahooooo!!! I got first place in Kahoot. I thought there was no hope because I left 3 questions unanswered. But I made a comeback.

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Summary of Chapter 1: Introduction to Risk Management

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Summary of Chapter 1: Introduction to Risk Management

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Definition of risk management

Identifying, assessing, and controlling threats to an organization capital & earnings.

Helps reduce potential losses & improve decision making.

It can happen from financial uncertainty, legal liabilities, strategic error or natural disaster.

Its not about avoiding all risk, its about understanding the risk to minimize the impact to the company.

Key Theories

Risk-return Trade-off: High risk, High return

Modern Portfolio Theory: Diversification

Agency Theory: Deals with the conflict of interest between the owner (shareholders; BOD) and managers (Top Management Team; CEO, COO). If their goals are not aligned, high risk for the company. To reduce the risk, a company offers stock options to managers.

Types of Risk

Pure risk: Situation, the outcome is only loss or no change (natural disaster)

Speculative risk: Either loss or gain (investment)

Systematic risk: Cannot diversify. Out of control. Cannot eliminate the risk (Inflation)

Unsystematic risk: Company specific (CEO resigning or internal matters)

Risk Management Process

1. Risk Identification

2. Risk Assessment

3. Risk Mitigation

4. Risk Monitoring

Benefits of Risk Management

Solid Management...System

Can reduce financial damage

Enhance decision-making

Compliance with regulations

Increase business resilience

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Hi, my name is Harith Mukhriz Bin Mohd Zaini 💪🏻 can call me Harith 😊. I am 22 years old and I was born in Germany but raised in the northern part of Malaysia. Favourite things to do in free time are working out 🏋🏻, jogging, and karaoke 🎤. My ambition is to become a rich person 💰. My favourite colour is silver. Celebrity lookalike Zayn Malik 🙃. I don't have any favourite foods because I love all foods, and I love ‘air sejuk’ sooo much 🥶. What else?? Want to know more about me, leave in the comment section HAHAHAHA.