Essay About Credit Risk And Main Sources Of Liquidity Risk

What Is the Purpose of Calculating Capital for Credit Risk?
Essay Preview: What Is the Purpose of Calculating Capital for Credit Risk?
Report this essay
Briefly Explain what credit risk is. What is the purpose of calculating capital for credit risk? Credit risk is a risk that an obligation to repay will not be honoured in full or will not be honoured on time. Capital is calculated to address the unexpected losses from making a loan. Expected losses are covered by setting money aside as provisions at the time the loan is made.What is the purpose of stress testing? How does it compliment the calculation of capital for credit risk?Capital is calculated for credit risk based on the characteristics of the loan. Capital is calculated to cover the average unexpected losses from the loan based on the level of credit risk it carries. Stress testing is an example of “what if” analysis, whereby a “severe, but plausible” scenario is developed (by either the bank or the regulator) and the bank applies the scenario to its operations. It converts the assumptions from the scenario to the quantitative implications on its balance sheet and calculates the impact. Overall, the bank assesses if it has sufficient capital buffers and other controls to withstand a crisis.Principle 2 of the Fundamental Principles of Operational Risk management states that “Banks should develop, implement and maintain a Framework that is fully integrated into the bank’s overall risk management processes”. Why is it important for operational risk management to be integrated into the overall risk management framework?Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events. In practice, operational risk events often coincide with other risk events. For example, in a credit downturn, operational mistakes in loan documentation or income verification come to attention. Similarly, more mistakes tend to be made when the markets are falling than when the markets are rising. Hence, it is important to ensure operational risk is considered as part of the overall risk management framework so that the connection between the different risks can be properly assessed and taken into account.What is a Risk Control Self Assessment (RCSA)RCSA is one of the tolls to identify operational risk. RCSA typically evaluates inherent risk (the risk before controls are considered), the effectiveness of the control environment, and residual risk (the risk exposure after controls are considered)What are the two main sources of liquidity risk?Liability-side liquidity risk:The FI may not have enough cash to meet the requests for withdrawals.Asset-side liquidity risk:The FI may not have enough cash to fund the exercise of loan commitment or other commitments for lending.The value of a FI’s investment portfolio may fall unexpectedly, although the loss can be absorbed by equity, the FI still need to fund the loss such that it has enough liquid assets to meet loan requests and unexpected deposit withdrawals. What are the two main ways to manage liquidity riskStored LiquidityRun down cash assetsSell liquid assetsBenefit is that less reliant on external market, but need to hold lower yielding assetsPurchased LiquidityBorrow funds from wholesale marketsAttract additional depositsUtilise central bank borrowingWhat is the Liquidity Coverage Ratio (LCR)LCR is a short term liquidity risk measure, whereby the bank is required to hold sufficient high-quality liquid assets (HQLA) to survive a significant liquidity stress scenario for a minimum period of 30 calendar daysIt is calculated by considering modelled outflows for the bank over a 30 day period, based on the prescribed assumptions. The bank can take into account the inflows as well, but they cannot exceed 75% of the outflows and are also based on the prescribed assumptions. The net outflows must be covered by the HQLA (need to have at least 100% plus buffer)What are the three main part of the Senior Manager Regime (SMR) in UKThe SMR regime in UK comprises of the following three key elementsSenior Management Functions (SMF), including prescribed responsibilities, with individual Statement of Responsibilities, and an overall Management Responsibilities MapCertification Regime – annual certification of fitness and propriety for staff that are regulated but are not part of SMFConduct rules – minimum standards of conduct, some of them apply to all staff and others are specifically designed for SMFs