FoBR-Inside7-09:Layout 1 7/13/09 3:19 PM Page 4 Foundations of Banking Risk An Overview of Banking, Banking Risks, and Risk-Based Banking Regulation RICHARD APOSTOLIK CHRISTOPHER DONOHUE PETER WENT JohnWiley&Sons,Inc. Copyright©2009byJohnWiley&Sons,Inc.Allrightsreserved. Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. 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Summary:“GARP’sFoundationsofBankingRiskintroducesriskprofessionalstotheadvancedcomponentsandter- minologyinbankingriskandregulationglobally.Ithelpsthemdevelopanunderstandingofthemethodsforthemeasure- mentandmanagementofcreditriskandoperationalrisk,andtheregulationofminimumcapitalrequirements.Iteducates themaboutbankingregulationanddisclosureofmarketinformation.ThebookisGARP’srequiredtextusedbyrisk professionalslookingtoobtaintheirInternationalCertificationinBankingRiskandRegulation”—Providedbypublisher. ISBN978-0-470-44219-7 1. Banksandbanking,International—Management.2. Riskmanagement.3. Banksandbanking,International—Lawand legislation.I.GlobalAssociationofRiskProfessionals. HG3881.F6842009 332.1068’1—dc22 2009021635 PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 isbookisdedicatedtoGARP’sBoardofTrustees, withoutwhosesupportanddedicationtodevelopingtheprofessionof riskmanagementthisbookwouldnothavebeennecessaryorpossible, andtotheAssociation’svolunteers,representingthousandsof organizationsaroundtheglobe,whoworkoncommitteesandshare practicalexperiencesinnumerousglobalforumsandinotherways, whosegoalistocreateacultureofriskawareness. Contents Introduction xi Acknowledgments xiii CHAPTER1 FunctionsandFormsofBanking 1 1.1 BanksandBanking 3 1.1.1 CoreBankServices 3 1.1.2 BanksintheEconomy 4 1.1.3 MoneyCreation 6 1.1.4 PaymentServices 8 1.1.5 OtherBankingServices 8 1.2 DifferentBankTypes 10 1.2.1 RetailBanks 10 1.2.2 WholesaleBanks 10 1.2.3 CentralBanks 12 1.3 BankingRisks 12 1.3.1 CreditRisk 14 1.3.2 MarketRisk 15 1.3.3 OperationalRisk 18 1.3.4 OtherRiskTypes 18 1.4 ForcesShapingtheBankingIndustry 20 CHAPTER2 ManagingBanks 23 2.1 BankCorporateGovernance 25 2.1.1 BoardofDirectors 25 2.1.2 SeniorManagement 28 2.1.3 InternalandExternalAuditors 28 2.1.4 Transparency 28 2.2 BalanceSheetandIncomeStatement 29 2.2.1 BankAssets 29 2.2.2 BankLiabilities 30 2.2.3 Equity 31 2.2.4 IncomeStatement 32 2.2.5 TheRoleofBank’sEquity 34 v CONTENTS 2.3 AssetandLiabilityManagement 38 2.3.1 InterestRateRisk 38 2.3.2 LiquidityRisk 40 2.4 LoanLosses 44 2.4.1 ValuingAssetsintheTradingBook 44 2.4.2 ValueofAssetsintheBankingBook,PerformingLoans 45 2.4.3 ValueofAssetsintheBankingBook,NonperformingLoans 45 2.4.4 ProvisionForLoanLossesandLoanLossReserves 47 2.4.5 LoanLossReservesandLoanLosses 50 CHAPTER3 BankingRegulation 55 3.1 FromLiquidityCrisistoBankPanics 57 3.1.1 LiquidityCrisisandBankRuns 57 3.1.2 BankPanics 59 3.2 FoundationsofBankRegulation 62 3.2.1 RegulatoryObjectives 62 3.2.2 TheRegulatoryProcess 62 3.2.3 Stabilization:TheLenderofLastResort 63 3.3 InternationalRegulationofBankRisks 65 3.3.1 BankforInternationalSettlements 65 3.3.2 TheBaselCommittee 66 3.3.3 TheBaselIAccord 67 3.3.4 TheMarketRiskAmendment 70 3.3.5 WeaknessesofBankCapitalRequirementsinBaselIAccord 70 3.3.6 TheBaselIIAccord 71 3.3.7 AdoptingBaselII 73 3.4 DepositInsurance 74 3.4.1 DepositInsuranceCoverage 75 3.4.2 DepositInsuranceAroundtheWorld 77 3.5 TheRoadAhead 78 CHAPTER4 CreditRisk 79 4.1 IntroductiontoCreditRisk 81 4.2 Lenders 82 4.2.1 InvestmentBanks 83 4.2.2 CreditRatingAgencies 83 4.3 Borrowers 85 4.3.1 RetailBorrowers 85 4.3.2 CorporateBorrowers 86 vi CONTENTS 4.3.3 SovereignBorrowers 87 4.3.4 PublicBorrowers 89 4.4 CharacteristicsofCreditProducts 89 4.4.1 Maturity 90 4.4.2 CommitmentSpecification 92 4.4.3 LoanPurpose 94 4.4.4 RepaymentSource 94 4.4.5 CollateralRequirements 95 4.4.6 CovenantRequirements 99 4.4.7 LoanRepayment 102 4.5 TypesofCreditProducts 105 4.5.1 AgriculturalLoans 105 4.5.2 Asset-BasedorSecuredLending 105 4.5.3 AutomobileLoans 106 4.5.4 CommercialPaper 106 4.5.5 Factoring 107 4.5.6 HomeEquityCreditLinesandHomeEquityLoans 108 4.5.7 Leasing 109 4.5.8 Mortgages 111 4.5.9 OverdraftFacilities 112 4.5.10 Project,orInfrastructure,Finance 113 4.5.11 RevolvingLinesofCredit 113 4.5.12 SyndicatedLoans 114 CHAPTER5 TheCreditProcessandCreditRiskManagement 117 5.1 TheCreditProcess 119 5.1.1 IdentifyingtheCreditOpportunity 120 5.1.2 CreditEvaluation 120 5.1.3 CreditDecisionMaking 120 5.1.4 CreditDisbursement 122 5.1.5 CreditMonitoring 122 5.2 TheCreditAnalysisProcess 122 5.2.1 TheFiveCsofCredit 122 5.2.2 TheCreditAnalysisPath 128 5.2.3 Business,orMacro,Risks 130 5.2.4 Financial,orMicro,Risks 133 5.2.5 StructuralRisk 134 5.2.6 InformationSources 135 vii CONTENTS 5.3 PortfolioManagement 136 5.3.1 ConcentrationRisk 137 5.3.2 Securitizations 138 5.4 CreditRiskandBaselIIAccord 139 5.4.1 TheStandardizedApproach 140 5.4.2 InternalRatings–BasedApproaches 140 5.4.3 CommonFeaturestoIRBApproaches 141 5.4.4 MinimumRequirementsforIRBApproaches 141 CHAPTER6 MarketRisk 145 6.1 IntroductiontoMarketRisk 147 6.2 BasicsofFinancialInstruments 147 6.2.1 Currencies 148 6.2.2 FixedIncomeInstruments 149 6.2.3 InterbankLoans 153 6.2.4 Equities 153 6.2.5 Commodities 154 6.2.6 Derivatives 155 6.3 Trading 159 6.3.1 FundamentalTradingPositions 159 6.3.2 Bid-AskSpreads 162 6.3.3 ExchangeandOver-the-CounterMarkets 163 6.4 MarketRiskMeasurementandManagement 167 6.4.1 TypesofMarketRisk 167 6.4.2 Value-at-Risk 169 6.4.3 StressTestingandScenarioAnalysis 171 6.4.4 MarketRiskReporting 172 6.4.5 Hedging 172 6.5 MarketRiskRegulation—The1996MarketRiskAmendment 176 CHAPTER7 OperationalRisk 179 7.1 WhatIsOperationalRisk? 181 7.2 OperationalRiskEvents 182 7.2.1 InternalProcessRisk 183 7.2.2 PeopleRisk 184 7.2.3 SystemsRisk 185 7.2.4 ExternalRisk 186 7.2.5 LegalRisk 187 viii