7.1 Credit Risk Management

Credit risk is the risk of loss from borrower default :

Credit Risk Components

  • Counterparty Risk: Risk of default by trading partner

  • Default Risk: Risk borrower fails to meet obligations

  • Spread Risk: Credit spreads widen, reducing value of existing loans/bonds

  • Settlement Risk: Risk of settlement failure

Credit Risk Mitigation

  • Collateral: Assets pledged as security

  • Guarantees: Third-party guarantees

  • Covenants: Loan agreement restrictions

  • Credit Default Swaps: Hedging credit exposure

  • Loan Syndication: Sharing risk among multiple lenders

7.2 Market Risk Management

Market risk is the risk of losses from changes in market prices :

Key Market Risks

  • Interest Rate Risk: Changes in interest rates affect loan/bond values

  • Foreign Exchange Risk: Currency fluctuations affect international positions

  • Equity Risk: Changes in stock prices affect trading and equity investments

  • Commodity Risk: Changes in commodity prices affect commodity-linked positions

Value at Risk (VaR)

A key metric measuring potential loss at a given confidence level over a specific horizon :

  • Historical Simulation: Using historical returns to simulate losses

  • Variance-Covariance: Parametric approach assuming normal distribution

  • Monte Carlo Simulation: Multiple random scenarios generated

Hedging Strategies

Banks and corporate clients use derivatives to manage market risk:

  • Interest Rate Swaps: Exchange fixed and floating rates

  • Cross-Currency Swaps: Exchange cash flows in different currencies

  • Options: Rights to buy/sell with limited downside 

7.3 Operational Risk Management

Operational risk is the risk of loss from failed internal processes, people, systems, or external events :

Sources of Operational Risk

  • Processes: Failed procedures, errors, omissions

  • People: Fraud, incompetence, errors, unauthorized activity

  • Systems: IT failures, cybersecurity breaches

  • External Events: Natural disasters, regulatory changes, fraud

Operational Risk Management Cycle

  1. Risk Identification: Through loss data collection and self-assessment

  2. Risk and Control Self-Assessment (RCSA) : Evaluating control effectiveness

  3. Key Risk Indicators (KRIs) : Monitoring early warning signals

  4. Business Continuity Planning: Disaster recovery and continuity arrangements

  5. Scenario Analysis: Stress testing of severe events 

7.4 Capital Management and Regulatory Compliance

Basel Capital Framework

Basel III/IV sets international capital standards for banks :

  • Minimum Capital Ratios:

    • CET1: 4.5% + capital conservation buffer

    • Tier 1: 6%

    • Total Capital: 8%

  • Leverage Ratio: Minimum 3%

  • Liquidity Coverage Ratio (LCR) : 100%

  • Net Stable Funding Ratio (NSFR) : 100%

ESG Considerations

Environmental, Social, and Governance factors increasingly influence risk assessment :

  • Climate risk assessment for corporate portfolios

  • Regulatory expectations on ESG disclosure

  • Growing demand for green and sustainable finance products

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