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CHAPTER 5: INTERNATIONAL BANKING RISKS :warning: (TYPES OF INTERNATIONAL…
CHAPTER 5: INTERNATIONAL BANKING RISKS :warning:
INTERNAL RISK ASSESSMENT :pencil2:
CREDIT SCORING SYSTEM - THE TRADITIONAL APPROACH
it can be found in virtually all types of credit analysis, form consumer credit to commercial loans.
the idea is essentially to pre-identify certain key factors that determine and probability of default and combine or weigh them into a quantitative score.
VALUE AT RISK (VaR) - THE MODERN APPROACH
seek to measure the minimum loss (of value) on a given assets or portfolio over a given time period at a given confidence level either 95%, 97.5% or 99%.
VAR is powerful in assessing the risk exposure of a portfolio of assets because it takes into account the correlation among different assets.
CREDIT DERIVATIVES
designed to transfer the credit risk on portfolios of bank loans or debt securities from bank to non-banks, particularly insurance companies.
4 INDIVIDUAL INSTRUMENTS
:diamonds: CREDIT DEFAULT OPTION (CDO)
a credit spread / net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices.
CDO is an option to buy protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference credit with a specific maturity.
:large_orange_diamond: CREDIT DEFAULT SWAP (CDS)
a CDS is a financial swap agreement that the seller of the CDS insures the buyer against some reference loan defaulting.
in the event of default the buyer of the CDS receives compensation usually at the face value of the loan and the seller of the CDS takes possession of the defaulted loan.
:large_blue_diamond: CREDIT FORWARD AGREEMENT (CFA)
it is a CFA that hedges against an increase in default risk on a loan or decline in credit quality of a borrower after the loan rate is determined and the loan has been issued.
The CFA specifies a credit spread i.e a risk premium above the risk-free rate to compensate for default risk on a benchmark bond issued by the borrower.
:lock: CREDIT SECURITIZATION
refers to the complex process of transforming individual loans into assets that may be purchased by investors.
banks coordinate these transactions to reduce their exposure to individual financial risks.
TYPES OF INTERNATIONAL BANKING RISKS :check:
OPERATIONAL RISK
Internal factors include losses or breakdown caused by inefficient management, by physical causes, by personnel failure, misleading information, from liability for accidents, and due to mismanagement of business ventures.
external aspect such as the market environment, credit situation, and other risk condition.
MARKET RISK
risk of losses in on and off balance sheet positions arising from movements in market prices or rates including interest rates, exchange rates, securities prices, and commodity prices.
:star: Systematic market risk
caused by a movement in the prices of all market instruments due to macro factors such as a change in economic policy
:fire: Unsystematic market risk
where the price of one instruments moves out in line with other similar instruments because of events related to the issuer of instrments i.e. law suit against the issuer.
CREDIT RISK
it is a probability that a loan will not be repaid or there will be default in payment
another definition is the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms.
it is associated with the traditional lending activity of banks as it is simply described as the risk of a loan not being repaid in part or full.
Base I
primarily focused on credit risk, where banking and financial institutions were required to maintain their capital levels equal to 8% of risk-adjusted assets.
Base II
has revealed numerous loopholes in accurately managing credit risk during the financial crisis.
Base III
had to provide more effective regulations about addressing credit risk.
INTEREST RATE RISK
can be defined as the exposure of a banking financial condition to adverse movement in interest rate.
the bank makes profit by paying a lower interest rate on its liabilities that it earns on the assets, the difference is called as net interest margin.
FOREX RISK
it is a financial risk that exist when a financial transaction is denominated in a currency other than the currency of the origin country.
international banks trade large amount of currencies, which definitely will expose them to the FOREX risk i.e. the value of currency falls with respect to another.
SOVEREIGN RISK
sometimes it also refers to political risk
many foreign loans are paid in US dollars and repaid with dollars.
however, some of these foreign loans are given to countries with unstable political environment.
LIQUIDITY RISK
arises when bank has to meet its obligation as they come due, without incurring losses.
:moneybag: Funding liquidity risk
occurs when a firm is unable to obtain sufficient funds to meet cash flow obligations.
:part_alternation_mark: Market liquidity risk
refers to inability to conclude a large transaction near the current market price.
TRANSPORT RISK
due to long distance between countries, goods are dispatched by shipping or airways.
sea and transport are exposed to many types of additional risk.
CULTURAL RISK
culture differs from one country to another.
the language, value of time, customs and lifestyle.
as a result a business firm faces additional risk.
SUPERVISION & REGULATION :explode:
SINGLE BANK SUPERVISOR / MULTIPLE BANK SUPERVISORS
a key policy decision in designing the framework or structure of the bank supervisory system is whether there should be a single or multiple bank supervisors.
the strongest reason for some to advocate a single bank supervisory authority is the fear of a competition in laxity between multiple bank supervisors.
those who favour a system with two or more bank supervisors stress the benefits of a competition in ideas among multiple bank supervisors.
BANK SUPERVISORY ROLE OF THE CENTRAL BANK
countries must also decide whether to assign responsibility for bank supervision to the central bank.
as with the issue of single / multiple bank supervisors, the conceptual literature is split on the relatives advantages and disadvantages of the CB being a bank supervisors.
this in turn can help it identify and respond to the emergence of a systematic problem in a timely manner.
:check: ADVANTAGE
CB will have first-hand knowledge of the condition and performance of banks
:red_cross: DISADVANTAGES
CB may be drawn to pursue a too-loose monetary policy to avoid adverse effects on bank earnings and credit quality.
encourage banks to extend credit more liberally than warranted based on credit quality conditions to complement and expansionary monetary policy.
SCOPE OF SUPERVISORY AUTHORITY
financial conglomerates that operate in the banking, securities, and insurance sectors are among the most powerful MNCs in many countries.
the most significant argument against a supervisory authority with broad scope is that it would result in an undue concentration of power that would otherwise be dispersed among several agencies.
this could increase the likelihood of regulatory capture and retard financial innovation.
SUPERVISORY APPROACH OF COUNTRIES
the approach in which the supervisory authorities supervise banks is quite important.
more importantly, it is the supervisory who have direct contact with the banks and therefore represent the main line of defence against unsafe and unsound banking practices.
however, it is proportionately more common for the high-income countries to provide greater independence to bank supervisors than countries in the three other income groups.
:<3: MAIN DIMENSION
The independence of supervisory authorities
Enforcement powers
The degree of disclosure supervisory authorities must comply with.
ANTI-MONEY LAUNDERING (AMLA) REGULATIONS
defined as the act or a process of transforming profits earned from a criminal or illegal activity into legal profits.
there are 3 stages of money laundering which is placement, layering and integration.
the guidelines are established and formulated to address the requirements that must be complied with by the reporting financial institutions under AMLA to effectively combat money laundering and financing of teorism activities
:checkered_flag: STAGES OF MONEY LAUNDERING
LAYERING
2nd stage is the movement of funds from one institution to another in order to disguise the original source and ownership of the funds.
INTEGRATION
3rd stage is the time when the funds, having been laundered are reinvested into a legitimate business.
PLACEMENT
1st stage is placement of currency into a banking and financial institution e.g. commercial bank, brokerage house, investment bank, etc.
:forbidden: PREVENTION MEASURES OF AMLA
conduct customer due diligence (reasonable care) and obtain satisfactory evidence in its records, the identity and legal evidence thereon.
shall conduct on going customer due diligence to examine and clarify the economic background and purpose of any transaction.
develop a customer acceptance policy and procedures to address the establishment of business relationship with the customer.
appoint one or more officers at the senior management level to be the compliance officer responsible for the submission of suspicious transaction reports to the Financial Intelligence Unit in CB.
THE BASEL COMMITTEE ON BANKING SUPERVISION (BCBS)
the BCBS is a committee of banking supervisory authorities that was established by the CB governors of the group of 10 countries in1974.
it provides a forum for regular cooperation on banking supervisory matters.
its objective is to improve understanding of fundamental supervisory aspects and increase the quality of banking supervision worldwide.
OFFSHORE FINANCIAL CENTRES (OFCs)
OFCs have posed special regulatory and supervisory challenges since their emergence in the 1960s and 1970s.
OFCs exist in large part because they offer financial market participants tax, regulatory, and supervisory advantages not available in their home markets.
the nature of financial activities in OFCs highlights many of the challenges internationally cooperative supervisory groups face in encouraging transparency and disclosure.
BANKING & THE WORLD TRADE ORGANIZATION (WTO)
the WTO General Agreement on Trade in Service (GATS) and its Annex on Financial Services (ANNEX) took effect in 1999, specify the general principles that govern cross-border trade in financial services.
the GATS and the ANNEX also specify the restrictions that may be imposed on trade in services for prudential purposes by the current 161 WTO member countries.
ISLAMIC BANKING SUPERVISION & REGULATION
The fundamental
features
of Islamic banking include:
prohibition against the payment and receipt of a fixed or predetermined rate of interest i.e. riba.
replaced by profit and loss sharing (PLS) arrangements where the rate of return on financial assets held in banks is not known and not fixed prior to the undertaking of the transaction.
-requirement to operate through Islamic modes of financing.
investment deposits are not guaranteed in capital value and do not yield any fixed or guaranteed ROR.
if banks record losses because of bad investment decisions, depositors may lose part or all of their investment deposits.
2 SYSTEMS OF OPERATION
TWO-TIER MUDARABAH
:small_orange_diamond: the assets and liabilities sides of a bank's balance sheet are fully integrated.
:small_orange_diamond: on the liabilities sides, depositors enter into a
Mudarabah
, a profit sharing contract with the bank to share the overall profits accruing to the bank's business.
:small_orange_diamond: thus, depositors act as capital providers or financiers by providing funds, and the bank acts as an entrepreneur by accepting them.
:small_orange_diamond: on the assets side, the bank in turn enters into
Mudarabah
contracts with agent-entrepreneurs who search for investable funds and who agree to share profits with the bank according to a certain percentage stipulated in the contract.
:small_orange_diamond: in addition to investment deposits, banks are allowed to accept demand deposits that yield no returns and may be subject to a service charge. These deposits are repayable on demand at par value.
TWO WINDOWS
:pen: bank liabilities are divided into two windows which is one for demand deposits and the other for investment deposits.
:pen: the choice of the window is left to depositors.
:pen: demand deposits are assumed to be placed as
Amanat
(safekeeping), thus they are considered to belong to depositors at all times.
:pen: hence, they cannot be used by the bank as the basis to create money through fractional reserves.
:pen: consequently, banks operating according to this arrangement must apply a 100% reserve requirement ratio on demand deposits.
PAST YEAR QUESTION
:female-student::skin-tone-2:
DECEMBER 2018
:pencil2:
5a) Credit derivatives are designed to transfer the credit risk on portfolio of bank loans or debt securities from banks to non- banks. Explain the following
types of credit derivatives
.
i) Credit Default Options
ii) Credit Forward Agreement
b) Explain any
(5) risks involved in the international banking system.
JANUARY 2018
:pencil2:
5a) Explain any
(5) risks involved in the international banking system.
b) Credit derivatives are designed to transfer credit risk on portfolio of bank loans or debt securities from banks to non-banks. Explain the following
types of credit derivatives.
i) Credit Default Swap
ii) Credit Securitization
JUNE 2018
:pencil2:
5a) Global banking systems concern about risks. Discuss any
(4) types of risks related to international banking.
b) Basically, there are
(2) types of bank internal risk assessment
approaches for banking systems.
Elaborate on the traditional and modern approaches of internal risk assessment
for international banking.
MARCH 2017
:pencil2:
5) Write short notes on the following international banking risks:
a) Credit risk
b) Interest risk
c) Market risk
d) Liquidity risk
OCTOBER 2016
:pencil2:
There is a need for bank internal risk assessment models to manage risk. For the credit derivatives model, it is designed to transfer the credit risk on portfolios of bank loans or debt securities from bank to non-banks. Basically, there are
four individual instruments in credit derivatives
including the followings:
a) Credit Default Options
b) Credit Default Swap
c) Credit Forward Agreement
d) Credit securitization