• 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

> 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

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.

• 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.