INTRODUCTORY BANKING

v?
Lecture 3 – Introduction to of Risk Management

Magda Pečená
Institute of Economic Studies, Faculty of Social Sciences,
Charles University, Prague, Czech Republic

6 March 2025
Content
1. Risk categorization, definitions, and ALM
2. Overview of Credit risk
measurement/management
3. Overview of Market risk, IRRBB and
Liquidity measurement

3A – Liquidity risk
3B – Interest rate risk of the Banking
book (IRRBB)

6 March 2025
 Definition of risk and risk management
Risk is …
• the degree of uncertainty of future net returns.
The basic measurement tool is the volatility (standard deviation of price
outcomes associated with an underlying asset).

Risk management is … (different sources)

• Measurement/evaluation and monitoring of risks and, where appropriate,
the taking of action to limit the risks undertaken.
• A process involving the identification of the exposures to risk, the
establishment of appropriate ranges for exposures, the continuous
measurement of these exposures, and their execution.
• Structured asset and liability management as well as the management of
off-balance sheet items (ALM). But usually we concentrate on the
management of specific risks (specific stage of ALM).

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Why is Banking industry a sensitive industry –
why do we supervise?

 To safeguard an essential service - Banks provide financial services that we all

use. We deposit our money with them, borrow from them, take out mortgages
with them. We as individuals rely on them, as do households, businesses and
governments. Banks enable the financial markets to function, thereby
enabling economic activity.

 To instil confidence - The financial system is tightly knit. Its components are
held together by confidence. The failure of just one bank could shake confidence in
the system and jeopardise its integrity. For example, bank runs can quickly spread
from troubled institutions to healthy ones, harming them in turn. Like dominoes,
the fall of one bank can lead to the collapse of many more. Knowing that banks
are supervised reassures both markets and depositors, reducing the
likelihood of bank runs and other forms of financial contagion.
 Why do we supervise

 To protect savers - Ordinary savers are not able to evaluate a bank’s

safety and soundness. They do not have access to the necessary
information and perhaps lack the required background knowledge.
Therefore, supervisors act in the public interest by regularly
checking banks’ risk culture and corporate governance, and by granting
(or withdrawing) banking licenses. (ECB)

 Supervision shall act preventively to avoid excessive

cost of bail-out
 Why do we supervise

What is a typical bank (financial institution)?

What is a typical corporate?

Bank Corporate
Assets Liabilities and Equity Assets Liabilities and Equity

Liabilities
Liabilities
Assets Assets

Equity
Equity

how much
equity should a bank hold ?
assets
Depende i
 Why do we supervise

Typical bank has large number of Typical corporate has current

„uninformed“ retail and wholesale liabilities (due to suppliers),
depositors issued bond, bank loans –
„informed creditors“
Assets Liabilities and Equity Assets Liabilities and Equity

Assets Assets

Equity
Equity

Banks provide information transformation and so

the risk transformation
 gield a
n

Why do we supervise -

Assets Liabilities and Equity

Assets - O/N
Liabilities -O/N
Assets - 1W
Assets - 1M
Liabilities -1W
Assets - 3M
Assets - 1Y
Liabilities -3M
Assets - 2Y
Assets - 5Y Liabilities - 6M
Liabilities - 1Y
Assets - 7Y Liabilities -2Y
Liabilities -3Y
Liabilities -5Y
Assets - 10Y
Equity

Banks provide maturity transformation

Balancing Risk – Return - Liquidity

Banks/Financial institutions are balancing between

Risk, Return and Liquidity –
it is a risky business

RISK

RETURN LIQUIDITY
Categorization of risks (besides systemic risk)

Financial risks
when
providing loaus between banks
 not
credit risk, counterparty credit risk, credit valuation adjustment (CVA)
back
paying
 market risk (interest rate risk, FX risk, equity risk, commodity risk)
purchasing
 liquidity risk & funding risk equity

Non-financial risks
 operational, IT risk, cyber risk
 model
 ESG, climate related risks (physical risk, transition risk)
 settlement
Market risk
 legal Credit risk


taxes
regulation
↓ more difficult to
quantify
Liquidity risk
Operational risk
Political risk
Legal and regulation risk
↑ easier to
quantify

 political
 reputational……
The aim of bank´s management is to manage the bank with the goal of maximizing its
value for shareholders under risk conditions
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 Definitions of main risks + how are reflected in
financial reporting garanties
- mod BS

Credit risk only an assed side

Assets Liabilities and Equity
 risk to the bank of losses resulting Assets sensitive to credit risk (loans
from the failure of a counterparty to provided, securities purchased)
Liabilities (generally not exposed to
meet its obligations in accordance Assets non-sensitive to credit risk
credit risk)
(tangible and non-tangible
with the terms of a contract under investments, cash, deposits at the
which the bank has become a central bank, sovereign debt (?))
creditor of the counterparty, Equity
Off-balance sheet liabilities
Credit risk represents 50–80% of all Off-balance sheet assets sensitive to sensitive to credit risk (guantantees
banking risks. credit risk (accepted guantantees) provided)

Market risk
 risks to the bank of losses resulting Assets Liabilities and Equity

from changes in prices, exchange Assets sensitive to interest rates, FX movements, Liabilities sensitive to interest rate and FX
rates and interest rates on the stocks movements
financial markets. This is a summary
Assets non-sensitive to interest rate and FX Liabilities insensitive to interest rate and FX
term for interest rate risk, foreign movements movements
exchange risk, equity risk and other Equity
risk associated with movements in
Off-balance sheet assets sensitive to market risk Off-balance sheet liabilities sensitive to market risk
market prices,
 Very roughly, 5–20% of all banking
risks are accounted for as market 6 March 2025 FX risk -
dif erenturrencies for loans
and
deposits
 Definitions of main risks + how are reflected in
financial reporting
Operational risk
 risk to the bank of loss resulting from inadequate or failed internal processes,
people and systems, or the risk to the bank of loss resulting from external
events, including the legal risk. It excludes strategic and reputational risk.
Operational risk represents 5 – 30% of banking risks, depending also on the extent
to which it overlaps with the definition of other risks (especially credit risk),
examples (frauds, human failures - Barings, SoGe, UBS etc.)

Liquidity risk
 the risk that the bank will lose its ability to meet its financial obligations as they
are due, or the bank will not be able to fund its assets,
 „maturity mismatch“
 potential loss due to insufficient market depth.

!! The definitions may overlap; no single set of risks and definitions of

risks exists.
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 Loss distribution of credit, operational and
market risk
Market risk
Credit risk
More difficult to Easier to
quantify
Liquidity risk
quantify
Operational risk
Legal risk
Political risk
Reputational risk

~ Assymetry of losses (credit risk, ~ Symetry of gains and losses (market risk)
operational risk) ~ Limited gain in loans/bonds (interest, coupon)

Expected loss Unexpected loss Unexpected loss,

covered by covered by capital
uncovered
provisions

„Black swan“ risks

Potential loss in CZK

capital adquacy 8
%

I
expected ross-devintion from
mortgage state 6 March 2025 13
preuct
Capital regulation/adequacy framework,
Liquidity adequacy framework
Basel Capital Regulation Framework (Capital Adequacy), will be discussed in
more detail in April - Lecture on Bank Capital –
• Credit risk, Market and Operational risks (theoretically the „unexpected
losses“ arising from businesses exposed to these risks) are covered by
capital, expected losses are covered by provisions and reserves.

• Liquidity risk is managed by efficient maturity balance of assets and liabilities

and sufficient liquid assets or „liquidity buffer“ that covers the
outflow of liabilities.

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 Liquidity risk vs. Credit risk coverage
simplified illustration

Liquid
assets

Equity

In the liquidity adequacy you are searching for the amount of adequate
liquidity/liquid assets that covers the risks of your liabilities, while in capital
adequacy you are searching for the adequate level of capital that covers the risks of
your assets

- it is a general, illustrative and simplified view, capital covers the risks of broader set of items, not just
risks of assets, also maturity mismatch is important in liquidity assessment, not just the maturity of the
liability side (outflow of deposits)

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Market risk – interest rate, equity, FX and
commodity risk (more will follow)
Interest rate risk
• of the Trading positions x of the Banking book positions
• Absolute risk, Relative risk (Yield curve risk, Spread risk)

Equity risk
• Investment in equities of corporate or financial corporations
• (Insignificant positions in the Czech Republic)

FX risk (more on FX risk – Lecture Market risk)

• Long or short open positions in foreign currencies
• (Limited FX positions in the Czech Republic)

Commodity risk
• Gold, silver and other precious metal
• Energy, crude oil
• Derivatives on commodities
• (Insignificant positions in the Czech Republic)

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 Market risk - Interest rate risk arises from the
Banking book (IRRBB) and Trading Book
The trading book refers to assets held by a bank that are available for sale and hence
regularly traded.
The trading book is required (under Basel II and III) to be marked-to-market on a daily
basis.
The banking book refers to assets on a bank's balance sheet that are expected to be
held to maturity or a longer period.

Any instrument a bank holds for one or more of the following purposes must, when it is
first recognized on its books, be designated as a trading book instrument:
(1) short-term resale;
(2) profiting from short-term price movements;
(3) locking in arbitrage profits; or
(4) hedging risks that arise from instruments meeting 1, 2 or 3 above.

General Banking book features General Trading book features

-Medium and long term -Short term

-More simple instruments -More complex instruments

-Higher volumes -Lower volumes
-Lower cash flows -Higher cash flows
erh valer market vol
Valuation approach – at amortised costs Valuation approach – fair value/market
and (to limited extent) fair/market value value (marked-to-market on a daily basis) 17
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Trends in risks
Table II.1
Potential sources of risks to financial stability as perceived by selected national authorities
IT ES PL AT DK CZ DE HU NL UK FR FI BE SE NO SK
Excessive credit growth
Residential property prices
Household debt sustainability
Macroeconomic environment
NFC debt sustainability
Bank loan portfolio quality
Pension fund sector stability
Insurance company sector stability
Sovereign risk
Bank profitability

Level of risk: High Moderate Low

Risks in
2019
Source: The relevant countries’ latest financial stability reports, ESRB Risk Dashboard, CNB
Note: The assessment is based on a qualitative evaluation of the relevant countries' latest financial stability reports.
Where a risk is not mentioned in the report, the assessment is based on the CNB’s interpretation of the indicators used
in the ESRB Risk Dashboard. The ordering of countries and risks in the table is obtained using a visual contrast-
optimising algorithm.

NFC – non-financial corporations

Risks in
COVID-19 2020 -
War in Ukraine, agression of Russia 2022

Inflation
Risks in
Cyber risk – operational resilience
2022
ESG, climated related risks and on
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 Example 1 - Risk identification in bank´s
balance sheet
if bases are the some

due set at the

Interest rate risk and
somtim FX Risk
>
-
No interest rate risk
all items in the amount of 10 mio EUR CZK reporting entity
Asset Liability Asset Liability
Loan 6M LIBOR + 1 % Deposit 6M LIBOR + 0,5 % EUR Loan 20 mio CZK equivalent EUR Deposit A 10 mio CZK equivalent
↓
does not exist
PRIBOR/EURIBOR ,
SOFR CZK Deposit B 10 mio CZK

Asset Liability Asset Liability

Loan 3M LIBOR + 1 % Deposit 0,70% USD Loan 20 mio CZK equivalent USD Deposit 20 mio CZK equivalent
uncertain about the profit no FX rish

Asset Liability Asset Liability

Loan 3% Deposit 3,50% USD Loan 20 mio CZK equivalent EUR Deposit 20 mio CZK equivalent
Miss Certain less
big FX Misk
nur
,

Asset Liability Liquidity Risk

Loan 3M LIBOR + 1 % Deposit 6M LIBOR + 0,5 %
same inter. risk Asset Liability
5Y Loan 2Y Term deposit
there is
lig risk, still okay

Asset Liability
1Y Loan Sight deposit
model
depends the
on

Asset Liability
1Y Loan 3Y deposit

Now imagine, all combinations come together ALM management

assed liability
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 Example 2 - Risk identification in bank´s
balance sheet
Identify and discuss the risks to which the bank is exposed to:

As of Dec 31
Assets Liabilities and Equity
Cash 10Sight deposits 120
Overdrafts 201 Y Term deposits (retail customers), fixed rate 2 % 180
Interbank loans (based on PRIBOR) 303M Term deposits (large customers), PRIBOR + 1 % 160
mirks
Czech Government bills 30Short term Interbank deposits, denominated in EUR 215
German Government bills, denominated in EUR 155Y Bonds issued, USD denominated 20
20Y Government bonds, fixed and floating 25
6Y Commercial real estate loans (corporates) 280
20Y Receivables (retail) 320Equity 80
Equity Investments audit risl2 10
Fixed assets 35
Total 775Total 775
short in EUR
Credit risk ? -smaller assets seat ein

Liquidity risk ?
Market risk ? (Interest rate risk ?, FX risk ?, Equity risk ?)
Operational risk ?
?
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 Managing all risks together and at the same
time - Asset and liability management
ALM - coordinated management of the balance sheet using various
development scenarios of interest rates, liquidity and payments.
ALM is managed through special banking units and/or Assets and Liabilities
Committee (ALCO).
The objective of ALM is to assure a banks’ liquidity, solvency and
efficiency concerning:
• capital and liabilities structure in term of the management of capital
and external sources; most of the external sources come from small
depositors, but their influence on a bank is minimal, and on the other hand,
the influence of management and big creditors is substantial,
• assets structure, their liquidity, return and risks,
• assets and liabilities and off-balance sheet item relations.

At this point liquidity risk and insolvency risk shall be mentioned especially
because they might be in mutual contradiction when achieving an optimal
assets and liabilities structure.

6 March 2025
Content
1. Risk categorization, definitions, and ALM
2. Overview of Credit risk
measurement/management
3. Overview of Market risk, IRRBB and
Liquidity measurement

3A – Liquidity risk
3B – Interest rate risk of the Banking
book (IRRBB)

6 March 2025
 Credit risk – see also lecture on Credit risk
Instruments
• Loans - Non-standard contracts difficult to transfer to third parties
• Securities (Tradable securities) - Standard contract easy to transfer to third parties
• Guarantees

Counterparties
• Corporate financing (corporate loans, securities)
• Retail financing (retail loans, loans to households = individuals + small trades)
• Consumer credits
• Mortgages
• Etc.
• Government and public financing
• Loans to financial institutions
• Project financing and other structured financing (of corporate or public projects)
• Etc.

Counterparty credit risk (CCR) – counterparty risk arising from derivative deals (OTC derivatives, repo style
transactions)

Measurement tools:
• Credit rating and Credit scoring
• PD (probability of default)
• NPL (non-performing loans)
• LGD (loss given default), Recovery rate (RR)
• Models (combining all of these aspects)
• IFRS 9, provisioning
• Capital adequacy framework
• LTV (loan-to-value), in %
• DTI (debt-to-income), in number of years
• DSTI (debt-service-to-total-income), in %
6 March 2025
Content
1. Risk categorization and ALM
2. Overview of Credit risk
measurement/management
3. Overview of Market risk, IRRBB and
Liquidity measurement
3A – Liquidity risk
3B – Interest rate risk of the Banking
book (IRRBB)

6 March 2025
Basic Market risk and Liquidity risk measure –
GAP analysis
More on lectures on Market risk, IRRBB and Liquidity risk

GAP analysis - for measuring interest rate risk, liquidity risk, FX risk via GAPs - open
positions)
Volatility
Another instrument for measuring risk is the sensitivity to adverse movements in the value
of a key variable.
◦ First-order risk measures:
 Beta (β) - CAPM
 Duration (D)
 Delta (δ)
◦ Second-order risk measures (changes in sensitivities): Convexity, Gamma, Vega
and others
Models ([Link] at risk)

6 March 2025
Content
1. Risk categorization and ALM
2. Overview of Credit risk
measurement/management
3. Overview of Market risk, IRRBB and
Liquidity measurement
3A – Liquidity risk
3B – Interest rate risk of the Banking
book (IRRBB)

6 March 2025
 Liquidity risk in theory

Liquidity risk is (different sources)

▪ the probability of a situation when a bank cannot meet its proper (both cash
and payment) obligations as they become due
▪ the bank will not be able to fund its assets
▪ arises from the different timing of the cash flows of assets and liabilities.
▪ BCBS: “Liquidity is the ability to fund assets and meet obligations as they come
due, without incurring unacceptable losses”
Meeting liquidity objectives may get in contradiction with other objectives of the
banking activity, especially profitability goals

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Two archetypes of banks

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Liquidity versus Funding

Liquidity:
Funding:
Can a company generate
Attract own equity and funding
sufficient liquidity to service its
to fund LT credit portfolios
short term debt ?

General liquidity represents ability to meet Funding risk is a risk that bank’s activities are
proper obligations (short-term) in a funded with insufficiently stable funding.
corresponding volume and time structure
Can be mitigated via attracting more stable
Banking liquidity is its ability to react upon
funding, but this comes at a cost that needs to
demand on the requests of depositors
be earned by the business.
(generally creditors) to withdraw their deposits
(in cash or by an order)

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 Two sides of liquidity risk

A bank is facing two main liquidity risks of the balance sheet:

• Liability-side liquidity risk: the deposit drain or even runs

on banks, or a limited access to inter-bank market.

• Asset-side liquidity risk:

• Off-balance sheet activities appear on the balance sheet
(commitments)
• defaults (increasing NPLs)

6 March 2025
Liquidity risk
GAP Analysis – Basic view on macroliquidity in the
CZ (Balance sheet approach)
Time structure of all assets in the Czech banking sector (according to
their agreed maturity) ≈ average commercial bank

Today, the exposure toward CNB would imply higher 7D bucket

Source: [Link]

6 March 2025
Liquidity risk
GAP Analysis – Basic view on macroliquidity in the
CZ (Balance sheet approach)
Time structure of all liabilities in the Czech banking sector (according
to their agreed maturity)

Conclusions ?
Source: [Link]
Sight deposits, prepayment options etc.

6 March 2025
GAP analysis

Example 3 – Liquidity GAP

Below you see a simplified bank balance, which takes into account the
expected cash flows by contractual maturity of each item. Therefore, it
also contains expected future payments of interests and coupons, which
makes it different from a real bank balance sheet. In this case the
expected cash in-flows do not equal the expected cash out-flows.
However, this is a more realistic view of a bank’s liquidity situation than
a simple breakdown of assets and liabilities.

Task is:

a) calculate GAPs for each time period;

b) interpret the results calculated;
c) calculate the cumulative GAP for 6 months and for 1 year;
d) suggest how we could restructure this breakdown to better reflect
the actual maturity of each item.

6 March 2025
 GAP analysis

Example 3 – Liquidity GAP

Expected Cash Flows
1-2 2-5 6-15 N/A
O/N - 90 days 91-180 days 181-270 days 271-365 days
According to maturity Total years years years
Assets
Cash 10 10
Overdrafts 10 10
Interbank loans (PRIBOR) 55 40 15
Czech Government bills 90 25 0 2 63
Government bonds, CZ, fixed and floating 26 1 25
Receivables (retail) 96 3 4 2 25 2 60
Receivables (corporates) 280 60 80 20
Fixed assets 83 83
Total inflows 530 85 19 6 90 85 82 80 83
Liabilities and Equity
Sight deposits 100 100
Deposits (small customers), fixed rate 2 % 137 80 4 30 5 10 8
Deposits (large customers), PRIBOR + 1 % 96 6 40 20 30
Interbank deposits, denominated in EUR 100 20 50 30
Bonds issued, USD denominated 50 50
Capital 40 40
Total outflows 523 86 44 50 55 60 38 50 140

Actually, if the bank is profitable, the expected cash inflows should be Solution to
be provided
higher then cash outflows (here 530 > 523) in excel
6 March 2025
Content
1. Risk categorization and ALM
2. Overview of Credit risk
measurement/management
3. Overview of Market risk, IRRBB and
Liquidity measurement
3A – Liquidity risk
3B – Interest rate risk of the Banking
book (IRRBB)

6 March 2025
 Interest rate risk in the banking book (IRRBB)

IRRBB – where does the risk arise ?

Assets Liabilities and Equity

Financial assets held for trading (Trading portfolio)
Banking book instruments exposed to IRRBB (loans (all types), bond
investments)
Liabilities (generally exposed IRRBB - deposits, bonds issued,
* Non-trading financial assets mandatorily at fair value through profit or loss
money market obligations)
* Financial assets at fair value through other comprehensive income
* Financial assets at amortised cost (debt securities, loans and advances)
Fixed investment (e.g. property) and other IRRBB insensitive items (e.g.
equity investments) Equity
Off-balance sheet assets sensitive to IRRBB Off-balance sheet liabilities sensitive to IRRBB

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 Example 4 - interest rate risk - floating vs. fixed
rates – effect of interest rate change on NII
Here see a simplified balance sheet with pricing of assets and [Link] see interest income and
interest cost over a one-year horizon (-IBOR rate of 3%) and recalculation when short-term
interest rates are changing – sensitivity.
The overall impact is dependent upon the pricing structure of different types of assets and liabilities
Note, that the example is simplified (no differentiation among different short-term rates (e.g. -
IBORs (1W, 1M, 3M, 6M…..)), only annual frequency of interest rate, etc…..
-IBOR 3%
As of Dec 31
Assets Pricing Asset App. annual Liabilities and Equity Pricing Liab. and App.
Cash 0% 80 0 Sight deposits (-IBOR-0,2%) 2,80% 120 3,36
Overdrafts (-IBOR + 1%) 4,00% 20 0,8 1 Y Term deposits (retail customers), fixed rate 2 % 2,00% 180 3,60
Interbank loans (based on -IBOR) 3,00% 30 0,9 3M Term deposits (large customers), fixed rate 1,5% 1,50% 160 2,40
Government bills (fixed 0,1%) 0,1% 30 0,03 Short term EUR deposits 0,30% 215 0,65
20Y Government bonds, (fixed 3 %) 3% 25 0,75 5Y Bonds issued, USD denominated, fixed 3,3% 3,30% 20 0,66
6Y Commercial real estate loans (corporates), -IBOR + 2,5% 5,50% 200 11
20Y Receivables (retail), -IBOR +1,9% 4,90% 250 12,25
Equity Investments 10 0 Equity 80
Fixed assets 130 0
Total 775 Total 775

Annual income 25,73 Annual costs 10,67

Interest rate profit 15,07
Net Income vs -IBOR rate
-IBOR rate NII 30,00
-IBOR rate sensitivity 1,00% 7,47 20,00
NII

(with this structure of the balance sheet - short term rates are rising -> profit is rising) 2,00% 11,27 10,00
3,00% 15,07 NII
0,00
4,00% 18,87
1,00% 2,00% 3,00% 4,00% 5,00% 6,00%
5,00% 22,67
-IBOR rate
6,00% 26,47

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Reading for the this lecture

✓ChapterIV – Risk
measurement and risk
management

6 March 2025