Risk Management in Banking. Bessis Joël

industry, with different management practices and different sources of risks. This section provides a brief overview of the diversity of activities conducted in banking.

      Retail banking tends to be mass oriented and “industrial” because of the large number of transactions. Retail Financial Services (RFS) covers all lending activities to individuals, from credit card and consumer loans, to mortgages. RFS also extends to very small enterprises, such as those of physicians or home services. Lending decisions are based on a combination of automated systems and management monitoring. Statistical techniques are relevant for assessing credit risk.

      Standard corporate lending transactions include overnight loans, short-term loans (less than one year), revolving facilities, term loans, committed lines of credit or large commercial and industrial loans. Such transactions are under the responsibility of credit officers and their reporting lines. For the large corporate businesses, relationship banking prevails when the relationship is stable, based on mutual knowledge. Credit analysts are industry specialists who monitor the credit standing of clients. They provide the individual credit assessments of obligors, based on expert judgment, for making lending decisions.

      Investment banking is the domain of large transactions customized to the needs of large corporate and financial institutions. It also includes trading activities, under the generic name of “Corporate and Investment Banking” (CIB).

      Large corporations demand a variety of services and products, for example from lending facilities and hedging instruments or issuance of securities. A number of very different activities are under the umbrella of the CIB pole. The financing of financial institutions, banks, insurance companies and brokers is organized as separate groups, distinct from those dedicated to commercial and industrial firms. Mergers and acquisitions form another business line.

      All activities of specialized, or “structured”, finance are also conducted by dedicated units within CIB. The scope of specialized finance includes such activities as project finance, asset financing (ships or aircrafts), commodities finance, commercial real estate and exports. The risk analysis differs radically from the assessment of a corporate borrower. In general, the primary source of repayment is the cash flows generated by the asset(s), from its operations or from the sale of the asset(s). Structuring refers to the assembling of financial products and derivatives, plus contractual clauses (“covenants”) in order to make the risk manageable. Securitization is one of the fields of specialized finance: it consists of selling pools of loans, which are normally held in the balance sheet of banks, into the capital markets.

      Trading involves traditional proprietary trading and trading for third parties. In proprietary trading, the bank is trading for itself, taking and unfolding positions to make gains. Trading is also client oriented. “Sales” designate trades conducted when the bank acts on behalf of their clients. The “sell side” is the bank, selling products to end-users. The “buy side” designates the clients, corporations and asset managers who buy the products, for example for hedging purposes. Traders and lending officers are not allowed to share information, as inside information on a corporate client could inspire trades based on undisclosed information. Banks are also exposed to market risk from their investment portfolio, which is not held for trading but with an objective of long-term performance.

      Other activities do not generate directly traditional financial risks. For example, private banking, or asset management, is the activity of wealth management for third parties. Advisory services refer to consulting services offered by banks to corporations considering potential acquisitions, for example, which do not necessarily imply cash outlays. Risks are primarily legal and operational.

Figure 1.1 maps the banking activities grouped into main poles.

Figure 1.1 Business lines in banking

      1.4 Banking Regulations and Accounting Standards

      Banking activities are subject to a wide body of rules. Risks are subject to the regulations rules. Valuation of assets and liabilities and profit and loss are subject to accounting standards.

      Risk regulations differ for the banking book and the trading book. The banking book refers to the transactions belonging to the core business of commercial banks, lending and deposit collection. It includes all assets and liabilities that are not actively traded by the institution, and generally held until they mature. The trading book groups capital market transactions, and is exposed to market risk. Positions held for trading are held over a short-term horizon, with the intention of benefiting from expected price movements. The trading book includes proprietary positions, and positions arising from client servicing and market making.

      Risk regulations relate directly to the management of the balance sheet, to market risk and credit risk and are detailed in the corresponding sections of this text.

      The accounting standards segregate instruments into four classes differing by valuation and treatment of profits and losses:

      • Financial assets at fair value through profit and loss;

      • Loans and receivables;

      • Held-to-maturity investments;

      • Available-for-sale financial assets.

      The financial assets at fair value include all instruments acquired to take advantage of price fluctuations and are managed with the intention of making short-term profits, the performance of which is evaluated on a fair value basis. Derivatives are held for trading unless they are considered as hedges. The assets and liabilities of the trading book are under this category.

      Fair value focuses on the price at which an asset can be sold: it is the amount at which an asset could be exchanged between parties, knowledgeable and willing to exchange. Valuation depends on whether markets are active or not. Active markets are those where the volume of transactions provide clear prices. For other instruments, prices can be derived from other traded instruments in active markets, or valuation is model based.

      Accordingly, market instruments fall in either one of three categories: level 1 when quoted prices are available; level 2 when there are market prices for similar instruments; and level 3 for model valuation for instruments that are not extensively traded but have a value derived from models, or mark-to-model, such as options traded over the counter. Model valuation is recognized as fair value in the absence of an active market.

      Loans and receivables are instruments with contractual payments and are not quoted in active markets. These assets are held in the banking book. In the banking book, income is determined according to accrual accounting rules of revenues and costs.

      Held-to-maturity instruments are financial assets with contractual payments for which the management intention is not trading. Investment portfolios of banks' group financial assets, such as bonds, in which banks invest for the long term with no trading intent, are in this category. All other assets are available for sale.

      Liabilities are either at fair value through profit and loss or other liabilities. The liabilities at fair value are held for trading, or designated as such, and the performance is based on fair value. The other liabilities include the normal financing of the bank, debt issued in markets or wholesale debt, which arises from lending and borrowing from other banks or financial institutions.

      For the trading book, valuation is based on mark-to-market, or mark-to-model for illiquid instruments. The performance is evaluated on the basis of fair value: profit and loss (P&L) is measured as the variations of value between two dates.

      1.5 Risk Management

      Risk management requires that the risks of a financial institution be identified, assessed and controlled. Enterprise risk management addresses a combination of credit risk, market risk, interest rate risk, liquidity risk and operational risk. Sound risk practices define who should be accountable for these risks and how the risk processes should be implemented.

1.5.1 Motivations

      There are strong reasons motivating the sound assessment and management of risks in decision-making processes, other than compliance with risk regulations.

      Risk and return