a sound risk culture
A sound risk culture is characterized by the 4 indicators of the financial stability board
'- Tone from the top: committment to values, expectation that staff acts with integrity and escalates on-compliance
'- Accountability: employees understand, and are capable to perform their roles, and know they are held accountable'
- Effective communication and challange: open communication, effective challange
'- incentives should encourage and reinforce risk management behaviour and core values
A sound risk culture promotes sound risk-taking and ensures that emerging risks and excessive risk-taking activities are assessed, addressed and escalated in a timely manner.
Describe different ways to respond to
a) Credit Risk
b) Liquidity Risk
c) Market Risk
a.) Credit Risk
•Concentra-tion limits/ granularity
•Funded credit protection
•Unfunded credit protection
•Selling claims/assets to third parties
•Building loss absorbing capacities
b.) Liquidity Risk
•Liquidity Disposition/ Leading and Lagging
•Credit facilities / Money Market
•Cash Concentration/ Cash Pooling
•Netting / Clearing
•Portfolio of highly liquid assets
•Access to capital market
c.) Market Risk
•Hedging with Derivatives
Risk Appetite see 1.2
amount of risk, on a broad level, an entity is willing to accept in pursuit of value.
'- Qualitative (e.g. definition of categories high, medium incl. Requirement to manage risk on an assigned level)
'- quantitatively (e.g. risk metric), risk appetite may be allocated portion of capital or risk bearing capacity
'- through setting of policy
a) VaR Backtesting see 5.3
b) 4 Types of Stress Testing see 5.3
Basle traffic light approach, count outliers over 250 days, <=4 green, >4 < 10 yellow, >= 10 red (assumption problem exists with model)
–Regulatory implied: A regulatory body has defined scenarios that shall be „withstood“, e.g. 200bp Interest Rate Shock, EBA or EIOPA Stress tests or ESRB Stress Test scenarios for CCPs*:
'- Historic: The most extreme movements of risk factors in the available history is used, highest change of an equity index e.g. 1929 Black Friday, highest average probability of default for a rating class, most extreme currency movement, highest change of implied volatility.
'- Forward Looking: Artifical scenarios based on „expert judgement“ what could happen in the future.
–Reverse/Inverse: Based on above scenarios or simple sensitivities, the smallest scenarios are developed (e.g. by scaling) that the company just will not survive
5 Components of COSO Risk Management framework see 1.1
Governance & Culture // Strategy and Objective Setting // Performance (Assessment) // Review & Revision // Information, Communication & Reporting
Explain the 3 lines of defense model
1st LOD=operational management; 2nd LOD=control unit relevant for the specific risk, e.g. Risk Management or Compliance; 3rd LOD=independent Internal Audit
Differentiate between factoring and securitization
Factoring:A group (to avoid cherry picking) of short term receivables is sold to financial institution, continuous basis.
Asset Backed Securities: A pool of assets (often selected) is sold to investors, through SPV, rating agency is used to assess risk.
a.) Summarize the main risks resulting from pensions provisions on
the balance sheet!
b.) Explain the impact of the discount factor on pension provisions
Risks resulting from management plan assets (asset management) vs. Fixed rates on liabilities
interest rate risk
stock and fx-investment risk
real estate risk
Risks resulting from pension provisions
longevity of staff, retirees
interest rate risk due to risk of change of discount rate
Impact discount rate: The higher the discount rate the lower the present value of pension liabilites
And: the lower the discount rate the higher the present value of pension liabilities
Summarize the major impact of the company´s rating
on the funding risks!
Rating impact: determines investment grade, non-investment grade
The better the rating, the better is the access to external funds
The better is the access and range of funding instruments
The better the rating, the cheaper are the interest rate costs; the lower the credit spreads
High rating implies opportunity costs (low leverage; limited risks)
a) Process Market Risk Hedging see 4.7
b) Which conflicts can occur, see 4.7
1.) determine which exposure, 2.) how much to hedge and 3.) by which instrument to hedge
Hedging only vs. Optimizing market opportunities, solution: transfer risks to treasury, business can concentrate on its operation, treasury can be limited
Describe what characterizes a sound risk culture
A sound risk culture promotes sound risk-taking and ensures that emerging risks and excessive risk- taking activities are assessed, addressed and escalated in a timely manner.
1. ‘Tone at the Top’ starts with the board defining and showing commitment to the entity’s core values and desired behaviours, including the expectation that staff acts with integrity (doing the right thing) and promptly escalates observed non-compliance/excessive risk taking (no surprises approach). Leadership considers the impact of culture on safety and soundness and makes necessary changes.
2. Accountability: Employees understand the core values and the approach to risk, are capable of performing their prescribed roles, and are aware that they are held accountable for their actions.
3. Effective communication and challenge promotes an environment of open communication and effective challenge in which decision-making processes encourage a range of views allowing for testing of current practices;
4. Incentives encourage and reinforce the desired risk management behaviour and core values
Focus should be also on how sound risk taking is embedded in the daily behaviours and decision making processes throughout the organization.
Describe the 4 types of Stress Testing
Regulatory Stress Testing
Historic Stress Testing
Forward Looking Stress Tests
Reverse / Inverse Stress Testing
Differentiate between FX Spot-, Forward-, Option Transactions
Explain chances and risks for each instrument!
Spot transaction, Purchase /sale of foreign curencies
Prices fixed on trading date
Settlement: Same day or two days after concluding contract due to technical reasons
Implies no hedging effect; full chances and full risks
Forward transactions: Contract price fixed today; settlement date: Forward date
Implies full hedging, but no chances to benefit from future positive fx-rate development
Options contracts: Hedging effect and in addition chance to benefit from favourable market movements
However, implies option fees which can be significant
Explain in detail the 3 major types of foreign exchange exposures/risks!
Major types of FX-Risk Exposures
1. Transaction Exposure risk (trade related)
2. Translation Exposure risk (accounting related)
3. Operational Exposure risk (in the sense: real economic exposure due to long term fx-changes)
Explanation provided in the script
What are the implications of the leverage effect?
Idea: Reduction Equity ratio / increase debt ratio; positive only if return total capital exceeds debt interest, otherwise negative effect
Implications:reduction creditworthiness; increase financing rates
Potential rating reduction; reduction financing volume