Types of Risk
BBA II
Understanding risk
• Risk is the possibility or probability that an event, such
as a change in interest rates, exchange rates, or
economic activity, may occur that is not forecast and is
therefore unexpected.
• Financial risk
• Exposures that result in unanticipated changes in projected
cash flows or the structure and value of balance-sheet assets
and liabilities
Risk Exposures
Financial
Balance Sheet risk
Solvency and capital
adequacy
Credit/Commercial
Liquidity
Interest rate
Market
Currency
Financial Risk
• Credit/Commercial Risk:
• Credit risk is the biggest risk for banks and Fintech
firms. It occurs when borrowers or counterparties fail to
meet contractual obligations. An example is when
borrowers default on a principal or interest payment of
a loan. Defaults can occur on mortgages, credit cards,
and fixed income securities. Failure to meet obligational
contracts can also occur in areas such
as derivatives and guarantees provided.
Financial Risk:
• Liquidity Risk:
• Liquidity risk refers to the ability of a bank and fintech
firms to access cash to meet funding obligations.
Obligations include allowing customers to take out their
deposits. The inability to provide cash in a timely
manner to customers can result in a snowball effect. If a
bank delays providing cash for a few of their customer
for a day, other depositors may rush to take out their
deposits as they lose confidence in the bank. This
further lowers the bank’s ability to provide funds and
leads to a bank run.
Interest Rate
• Interest rate risk is the potential for investment losses
that can be triggered by a move upward in the
prevailing rates for new debt instruments.
• Market risk:
• Market risk mostly occurs from a bank’s activities
in capital markets. It is due to the unpredictability of
equity markets, commodity prices, interest rates, and
credit spreads. Banks are more exposed if they are
heavily involved in investing in capital markets or sales
and trading.
Currency Risk
• Currency risk exposure is the risk that a company or investor
will experience losses or gains due to changes in the value of
one currency relative to another. It's also known as exchange
rate risk.
• Solvency Risk:
• The risk that a company cannot meet its financial obligations
• A company that is insolvent cannot pay its debts and will be
forced into bankruptcy
• Solvency ratios below 20% indicate an increased likelihood of
default
• Financial risk
• Exposures that result in unanticipated changes in projected
cash flows or the structure and value of balance-sheet assets
and liabilities,
• Operational risk
• Exposure that may impact on the normal commercial
functions of a business, affecting its operational and financial
performance
Risk Exposures
Operational
Financial
Capital adequacy Internal systems
Credit/Commercial risk(employee practices
Liquidity and safety)
Interest rate Technology risk
Market Fraud
Currency Suppliers
Property
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Operational Risk
• The following types of operational risk events as having
the potential to result in substantial losses:
• Internal fraud. For example, intentional misreporting of
positions, employee theft, and insider trading on an
employee’s own account.
• External fraud. For example, robbery, forgery, cheque
kiting, and damage from computer hacking.
• Employment practices and workplace safety. For example,
workers compensation claims, violation of employee health
and safety rules, organised labour activities, discrimination
claims, and general liability.
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• Clients, products and business practices. For example, fiduciary
breaches, misuse of confidential customer information, improper
trading activities on the bank’s account, money laundering, and sale
of unauthorised products.
• Damage to physical assets. For example, terrorism, vandalism,
earthquakes, fires and floods.
• Business disruption and system failures. For example, hardware and
software failures, telecommunication problems, and utility outages.
• Execution, delivery and process management. For example: data
entry errors, collateral management failures, incomplete legal
documentation, and unauthorized access given to client accounts,
non-client counterparty misperformance, and vendor disputes.
• Financial risk
• Exposures that result in unanticipated changes in projected
cash flows or the structure and value of balance-sheet assets
and liabilities,
• Operational risk
• Exposure that may impact on the normal commercial
functions of a business, affecting its operational and financial
performance
• Business risk
• Exposures associated with overall business environment
including macroeconomic and policy/regulatory concerns
Risk Exposures
Financial Operational
Balance Sheet risk Business strategy
Solvency and capital risk
adequacy Internal systems
Credit/Commercial risk
Liquidity Technology risk
Interest rate Management risk
Market Fraud
Currency Suppliers
Property
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Business Risk
Competitive risk
Legal risk
Policy risk
Strategic Risk
Business Risk:
• Competitive risk:
• Competitive risk is the possibility that a business's competitors
could prevent it from growing and succeeding. Some factors that
can make a company vulnerable to competitive risk include:
• Changing customer tastes and expectations
• Competition over resources for production or distribution
• Imbalance in use of new technologies
• Inexperienced management
• Poor customer service
• Inadequate or ineffective marketing and PR
• Ineffective distributors
Legal Risk
• Legal risk refers to the potential for financial or reputational
loss resulting from the failure to adhere with laws,
regulations, or contractual obligations that govern a
company's business activities.
• Policy Risk:
• Policy risks are the risks that arise from unexpected changes
to government policies and regulations .
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• Strategic Risk
• A strategic risk is when a company struggles to reach
their strategic goals as a result of internal or external
factors. Some examples of events which could be a
strategic risk include a new competitor entering the
market, changes to supply or cost of raw materials or
technological changes.
• Financial risk
• Exposures that result in unanticipated changes in projected
cash flows or the structure and value of balance-sheet assets
and liabilities,
• Operational risk
• Exposure that may impact on the normal commercial
functions of a business, affecting its operational and financial
performance
• Business risk
• Exposures associated with overall business environment
including macroeconomic and policy/regulatory concerns
• Event risk
• Exposure to all types of exogenous risk
Risk Exposures
Financial Operational
Balance Sheet risk Business strategy
Solvency and capital risk
adequacy Internal systems
Credit/Commercial risk
Liquidity Technology risk
Interest rate Management risk
Market Fraud
Currency Suppliers
Property
Event Risks
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Political risk
Business Risk
Contagion risk
Legal risk
Banking crisis risk
Policy risk
Systemic (country)
Financial infrastructure
risk
Other exogenous
risks
Risk Continuum
Stakeholder Attitudes to foreign
relations
Terms of Location Industrialinvestment
sector National originGovernment
contract stability
Micro project risk Macro country
risk
Commercial Currency risk Bank risk Political risk
risk
Event Risk Assessment
Country risk sources
• Political
• war, occupation, riots, territorial claims,
ideological differences, corruption,
• Social
• civil war, tribalism, income inequalities,
religious/ethnic divisions, rebellion,
nationalism,
• Economic
• long-term GDP decline, strikes, productivity
costs, export earnings decline, raw material
price increases
Political Risk
• Unquestionably this is the biggest risk when investing abroad.
• “Does the foreign government uphold the rule of law?” is a more
important question than normative judgements about the
appropriateness of the foreign government’s existing legislation.
• A big source of risk is the non-enforcement of contracts.
• Macro Risk
• All foreign operations put at risk due to adverse political developments.
• Micro Risk
• Selected foreign operations put at risk due to adverse political
developments.
Political Risk
• Transfer Risk
• Uncertainty regarding cross-border flows of capital.
• Operational Risk
• Uncertainty regarding host countries policies on firm’s
operations.
• Control Risk
• Uncertainty regarding expropriation.
Consequences
• Inconvertibility
• Expropriation
• Civil strife damage
• War damage
• Contract repudiation
• Negative government actions
• Process deterioration
• Event intervention
Measuring Political Risk
• The host country’s political and government system.
• A country with too many political parties and frequent changes
of government is risky.
• Track records of political parties their relative strength.
• If the socialist party is likely to win the next election, watch out.
• Integration into the world system.
• North Korea, Iran, Venezuela are examples of isolationist
countries unlikely to observe the rules of the game.
• Ethnic and religious stability.
• Look at the recent civil war in Syria.
• Regional security
• South Korea is a nice country, but it’s in a questionable
neighborhood.
Measuring Political Risk
• Key economic indicators
• Political risk is not entirely independent of economic risk.
• Relationships between risks: one risk affecting another
risk
• Direct risk—the initial risk event that impacts on the operational
or financial position of an organisation
• Consequential risks—exposures that eventuate as a result of an
initial direct risk event.
• Severe income inequality and deteriorating living standards can
cause major political disruptions.
• In 2002, Argentina’s protracted economic recession led to the
freezing of bank deposits, street riots, and three changes of the
country’s presidency in as many months.
Risk Continuum
Stakeholder Attitudes to foreign
relations
Terms of Location Industrialinvestment
sector National originGovernment
contract stability
Micro project risk Macro country
risk
Commercial Risk
Commercial Risk
Credit/Commercial Risk
• Possibility that counterparty will not be willing or able to
perform according to terms specified in contract or
otherwise expected.
Credit/Commercial Risk
• Asymmetric information
• Adverse Selection
• Actions before the commitment that produce negative outcome
• Moral Hazard
• Actions after the commitment that produce negative outcome
Credit/Commercial Risk
• Portfolio Management
• Limit total outstanding obligations/loans
• Geographic limits
• Concentration limits
• Category limits
• Type limits
• Maturities
• Loan pricing
• Appraisals
• Impairment/Provisioning
Credit/Commercial Risk
• Z-Score
• X 1: working capital/total assets
• X 2: retained earnings/total assets
• X 3: EBIT/total assets
• X 4: market value of equity/book value of total assets
• X 5: sales/total assets
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999X5
Z>3: unlikely to default
2.7<Z>3: on alert
1.8<Z>2.7: likely default
Z<1.8: very high
Credit Ratings
• Standard & Poor's, Moody's, Fitch evaluate creditworthiness
based on the same criteria as for domestic issues.
• No consideration is given to ex-rate risk, just default risk.
• Moody's 19 categories (9 general and 3 specific, e.g. A1, A2,
A3)
• S&P has 20 categories (using + and - for AA to CCC) from AAA
(almost no chance of default) to D (bond is in default - late,
partial or no coupon payments)
• The top four categories (AAA, AA, A, BBB) are Investment
Grade, the other categories are Speculative
Grade/High-Yield/Junk bonds.
• The International Bond market is mostly an investment grade
market - very large MNCs with excellent credit, brand name
recognition, etc.
• S&P and Moody‘s ratings for foreign countries, cities, utilities,
etc.
• Official borrowing (central banks, local and national
governments) is about 10% of international bond market
• Important because it usually establishes the benchmark for any
entity in that country.
Dun & Bradstreet
• Accounts receivable data
• D&B Credit gives data and tools to be smart, strategic growth
drivers.
• Segmentation capabilities and customized alerts
• Mine the world’s largest commercial database through an
intuitive interface, analytics, and scores.
• Monitor customer financial health and protect business with
customized daily alerts.
• Organize, monitor and report on customer base with flexible
tagging options that allow to segment companies by
characteristics
What Does a Credit Report Include?
• The information that appears on a credit report
includes:
• Personal information: Your name, including any aliases
or misspellings reported by creditors, birth date, Social
Security number, current and past home addresses, phone
numbers, and current and past employers.
• Accounts: A list of your credit accounts, including
revolving credit accounts, such as credit cards, and
installment loans, such as mortgages or auto loans. The list
includes creditor names, account numbers, balances,
payment history and account status (including whether or
not the account is past due).
• Public records: Court judgments, bankruptcies and tax
liens.
• Recent inquiries: Who has recently asked to view your
credit report and when.
