Day Two

1. Day Two Period 9:00 to 10:40 AM

2. Day 2 Managing Market and Credit Risk • Market Risk • Credit Risk - General • The Credit Risk Model in Modern Banking • Lending to Small Business 2

3. Market Risk • Market risk is the potential for loss arising from changes in interest rates, foreign exchange rates, equities, commodity prices, or credit spreads in market risk sensitive instruments. • In banks, market risk exists in trading form or in non-trading form (asset/liability risk arising from the balance sheet)

4. Market Risk – Balance Sheet • The bank’s balance sheet contains market risk • The bank will earn less revenue if a) interest rates decline, reducing the yield on assets, or b) interest rates rise, increasing the cost of liabilities, or c) some combination of the two • Management of balance sheet risk is called ALM, Asset/Liability Management • ALM is very sensitive to the different maturities of assets and liabilities; banks analyze the weighted average maturity of assets/liabilities

5. Market Risk - Trading • Trading is the buying and selling of financial instruments carrying market risk, such as equities, commodities, foreign exchange, bonds, and derivatives • Trading risk usually arises when the bank fills a customer’s buy or sell order for a financial instrument, but the bank can initiate trading risk for its own account as well • Trading risk is managed through Value at Risk

6. Market Risk - Trading Method 1 Grouping Method 2 Grouping

7. Market Risk – Value at Risk • Value at Risk (VAR) is a process to calculate the potential loss in a trading portfolio • VAR requires: • An accurate list of the bank’s trading assets and liabilities • Current market prices and valuations for these assets and liabilities • A computer model to match up the trading portfolio with current prices, and then generate a mathematical distribution of potential losses • VAR is calculated daily and a limit is set on the acceptable loss amount

8. Market Risk - Value at Risk INPUT MODEL OUTPUT VAR CONTROL Functions Trading Portfolio Algorithm Probability Distribution Potential Loss VAR Limit and Historical Market Data Mapping Process Range Of Values Risk Measure Risk Mitigation Support Asset Grouping And Portfolio Values Overage Procedures And Back Testing Time Horizon And Base Currency Confidence Level And Single Measure Financial Theory Value at Risk Process

9. Value at Risk Current Value = mean μ Normal Distribution describing potential market values for a portfolio with linear risk characteristics Loss at 1 standard deviation μ - 1σ + 1σ Potential losses Potential gains

10. Value at Risk New Current Value = mean μ Portfolio Distribution skewed by inclusion of call options purchased μ Potential losses Potential gains

11. Value at Risk Current Value = mean μ Studies have shown that for many tradable products the Normal Distribution does not exactly hold – extreme market events tend to make losses more severe than would otherwise be expected Loss at 1 standard deviation “Fat tail” exposure μ - 1σ + 1σ Potential losses Potential gains

12. Value at Risk If the bank selects the 95% confidence level (2σ) as its measure of risk tolerance, this will generate a single number representing the Value at Risk for the portfolio VAR is set here at the 95% confidence level 2.5% of all potential values are found in each of these areas under the curve - 2σ μ + 2σ Potential losses Potential gains

13. Credit Risk • Credit risk is defined as the potential for loss if a customer fails to perform on their obligations • Credit risk, and credit loss, occur both on the transaction and portfolio level • The credit risk management model that follows shows how credit risk is handled

14. Effective Risk Management Process 14

15. Effective Risk Management Process Risk Analysis Set Credit Strategy: • By industrial sector (hydrocarbons, mining, chemicals, agriculture, etc.) • By wholesale/retail (export/import firms, grocers, tourist shops, hotels, etc.) • By individual (business owners, high net worth, service industry) • Identify risk/return requirements 15

16. Effective Risk Management Process Risk Analysis Set Target Market: • Which companies will be selected for marketing? • How are industries to be defined? • Which SMEs qualify for credit? • How does the Target Market match with the bank’s traditional strengths? 16

17. Effective Risk Management Process Effective Risk Management Process Risk Analysis Assign roles, responsibilities, authorities: Assign Target Markets to the appropriate bank department Define who solicits clients, who assesses the credit risk, who books loans Who is accountable if something goes wrong with the credit? What actions may they take? 17

18. Effective Risk Management Process Effective Risk Management Process Risk Controls For the Portfolio: • Create portfolio limits and limits based on risk ratings or credit quality • Ensure limits provide proper diversification • Determine how exposure against the limit is measured • Define how exceptions to limits may be approved 18

19. Effective Risk Management Process Risk Controls DetermineCommittee Approval Process Policy Committee Highest Level Internal Committee Credit Committee Asset/Liability Committee Reserve Committee Risk Mgt. Committee Approves portfolio limits, large credits, credit policy Manages market risk and bank liquidity Approves loan loss reserves Coordinates risk/return across bank 19

20. Effective Risk Management Process Risk Controls For the Portfolio: The combination of credit risk strategy, target markets, portfolio/concentration limits, and committee approval process constitutes the bank’s….. ……Credit Risk Philosophy 20

21. Effective Risk Management Process Risk Controls Portfolio diversification is essential so that no one industry or individual credit becomes too large a part of the portfolio 21

22. Effective Risk Management Process Risk Controls Proper credit risk management is not gambling…. ….Proper credit risk management strikes a judicious balance between risk and return 22

23. Effective Risk Management Process Risk Controls For individual credits establish: • Risk Acceptance Criteria • Risk Ratings • Documentation and Covenant Standards • Due Diligence 23

24. Effective Risk Management Process Risk Controls Risk Acceptance Criteria … …define the types of credit products to be sold to a client, maximum amounts of acceptable exposure, collateral requirements, etc. 24

25. Effective Risk Management Process Risk Controls Risk Ratings… …are internal ratings (such as 1 to 10) used to assess the client’s credit-worthiness and loan loss potential …increasingly they mimic the rating system used by Standard & Poor’s or Moody’s …they determine the required loan loss reserves for the client’s exposure 25

26. Effective Risk Management Process Risk Controls Legal Documentation and Covenants… …are the minimum legal standards required from the client (such as parent guarantees for subsidiary exposure) …Covenants such as a maximum debt/equity ratio, pari passu clauses, etc. are important protections for the bank 26

27. Effective Risk Management Process Risk Controls Due Diligence… …defines what is expected of the loan officers who monitor the credit …this will include routine review of financial information, industry analysis, and checks on collateral 27

28. Effective Risk Management Process Portfolio Valuation • In a sophisticated credit risk management process, all credits are treated on a portfolio basis • In a portfolio, some credit risks increase total exposure, and some provide offsets • Proper portfolio review identifies unacceptable concentrations of risk (by industry, product, maturity, etc.) Ideally, credit reserves are set for the portfolio, not for the sum of all individual credit exposures 28

29. Effective Risk Management Process Portfolio Valuation Probability of Default x Loss Given Default = Expected Loss Expected Loss Loan Loss Reserves 29

30. Effective Risk Management Process Portfolio Valuation • Accurate credit portfolio valuation requires sophisticated computer modeling, and an excellent statistical history on credit losses by industry • This will not be possible for Libyan banks; portfolio valuation for the time being will continue to be the sum of individual credit risks 30

31. Effective Risk Management Process Portfolio Oversight and Monitoring • All loans require on-going review to detect any problems as soon as they occur • If the problems get worse, the loan turns into a Workout credit, and may eventually require increased credit reserves or a charge against earnings for credit loss 31

32. Effective Risk Management Process Portfolio Oversight and Monitoring • Workout loans are often defined as those credits whose Risk Rating has deteriorated beyond a certain point • Workout loans can require tough negotiations with the customer • The Workout loan is transferred from the loan officer who originated the credit, to a Workout loan unit specializing in problem credits 32

33. Effective Risk Management Process Portfolio Oversight and Monitoring An independent unit is required to review the loan portfolio This unit is Loan Review Loan Review has the power to check any aspect of a loan, change the risk rating, require additional reserves, and force a change in Risk Acceptance Criteria Loan Review confirms underwriting and analysis comply with the bank’s credit policies 33

34. Effective Risk Management Process Portfolio Oversight and Monitoring Many external players also provide oversight for the bank’s credit risk • Bank auditors ensure that the loss reserve process follows acceptable accounting standards • Central credit reporting bureaus such as Standard & Poor’s can downgrade the bank’s debt if problem loans increase 34

35. Effective Risk Management Process Portfolio Oversight and Monitoring Many external players also provide oversight for the bank’s credit risk • Regulators and supervisors frequently inspect the loan portfolio, and may require a change in Risk Ratings or in reserves • The legal and judicial system enforces contracts and covenants, and provides for an orderly insolvency process 35

36. Small and Medium Enterprise Lending 36

37. The Secret of Lending to SMEs… …Modernize Your Credit Process Small and Medium Enterprise Lending 37

38. Business Growth Patterns Small and Medium Enterprise Lending Seed Start-Up Growth Stable Large Enterprise Source: Bank Negara Malaysia SME Stage 38

39. SME Credit Providers Small and Medium Enterprise Lending Venture Capital Commercial Banks (Loans, Trade Finance) Leasing and Factoring Seed Start-Up Growth Stable Large Enterprise Bond and Equity Markets Development Finance, Government 39

40. Challenges in Lending to SMEs Multiple financial books, usually unaudited Collateral difficult to value and secure Limited access to other forms of capital Often family owned and operated, and they are usually not familiar with banking forms, application process Small and Medium Enterprise Lending 40

41. Advantagesof a Modern Credit Process The SME market can be carefully targeted, and credit guidelines properly arranged Many SME loans can be bundled together and treated as a portfolio Risk can be better matched against return Small and Medium Enterprise Lending 41

42. Using Risk Management skills when lending to an SME Set the target market carefully Where does the bank have expertise – tourism industry, agriculture, manufacturing? Hire loan officers and risk managers who know these industries well Set Risk Acceptance Criteria – minimum size of customer, basic financial condition, availability of collateral Small and Medium Enterprise Lending 42

43. Using Risk Management skills when lending to an SME Keep the loan product simple Use a basic loan credit structure or trade finance approach Legal documentation should be easy to understand for the borrower Maturities should be short term Small and Medium Enterprise Lending 43

44. Using Risk Management skills when lending to an SME Understand the risks Quantify the default probabilities for the industry involved, even if you must estimate Price the loans based on these probabilities Determine the value of collateral and your ability to sell collateral if necessary Keep the loan amounts small Small and Medium Enterprise Lending 44

45. Using Risk Management skills when lending to an SME Manage the risks How often does your banker need to meet with the customer to assess financial condition? How expensive will any extra effort be? Have a plan in place in case something goes wrong Small and Medium Enterprise Lending 45

46. Using Risk Management skills when lending to an SME Find a government partner Government has a strong policy interest in supporting SME lending Government can set up programs to educate entrepreneurs in applying for credit, making payments on time, preparing financial records, and keeping assets pledged as collateral in good condition Government may offer your bank insurance against SME losses Small and Medium Enterprise Lending 46

47. Using Risk Management skills when lending to an SME Manage the risks Risk managers should monitor the portfolio regularly Is the rate of default in the portfolio higher or lower than anticipated? How much can be recovered after default? Build up a data base of default history Small and Medium Enterprise Lending 47

48. Using Risk Management skills when lending to an SME Seek out opportunities A few SMEs will grow to become large corporations Learn to spot these opportunities and help them along with additional financing and new products Small and Medium Enterprise Lending 48

49. Measuring Your Success Did the portfolio behave as anticipated? Were defaults no greater over time than expected? Were your returns sufficient to cover all your costs plus generate the expected return? Small and Medium Enterprise Lending 49

50. Measuring Your Success Did the risk managers work well with the business managers? Were your risk controls appropriate and useful? Did you develop a competitive advantage using Risk Management in a new market sector? Small and Medium Enterprise Lending 50