Financial Risk Management Overview

The following questions and answers should give an overview to the financial risk topic.

1. Securitization risk

While banks traditionally held any loans originated until maturity on their own balance sheets, the so-called „originate-to-distribute"-business model employs a different approach.

a. Securitization

Describe the basic structure of a mortgage loan securitization. Focus only on the relations between original borrowers, mortgage bank, special purpose vehicle (SPV) and investors. Support your description graphically (sketch).

One of the most important differences between the stock/bond and the mortgage market is, that the usual borrower is an individual. However the SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure, even if the parent company goes bankrupt. Concerning the question above, it can be stated, that homeowners receives a loan from their bank, which seeks to minimise the overall default risk of their customers by selling the respective receivables to a SPV. In a next step, a lot of loans are pooled together to form a bond and to get a rating. In case the rating is very good (e.g. AAA) one will find investors, who buy this instruments. This is the point where we can follow the funding cycle back to the homeowner.

Some other facts have to be mentioned too: Firstly the bank has to ensure, that the holders of the mortgage backed securities (MBS) are the first one to receive payments on the loan. For this the loans have to be separated from other obligations, in order to meet legal requirements. So a SPV is created and the loans a transferred to it. Secondly SPV's are a very powerful instrument to hide losses (like in the Enron scandal) and fabricate imaginary earnings.

b. Liquidity risk

What can cause liquidity risk in the SPV?

One: Companies may not be aware of the breadth of roles the may play in relation to SPV's und thus underestimate their exposure, which could result in severe liquidity risks.

Two: Some liquidity providers to SPVs are not regulated depository institutions and thus cannot generally access central bank "lender of last resort" facilities. During periods of market duress, SPVs associated with these liquidity providers are more susceptible to deleveraging and may face significant liquidity and solvency pressure if unable to refinance short-term liabilities.

Three: Securitization means that that the risk of poor-quality assets is dispersed throughout the capital markets. An instrument, which can be used for this are SPVs. Real life however has shown major disadvantages of this financial tool. As it became clear, that the quality of such assets was deteriorating rapidly, market participants sought to avoid exposure to others, because of an overall mistrusting environment. This finally let to difficulties in gaining additional liquidity.

2. Operational risk

a. Difference to market risk

Describe typical differences between operational and market risks regarding data availability, risk measurement, and the risk premium that can be earned by taking on these risks!

The Basel committee defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events." In other words this especially means, that if existing support systems malfunction or break down (Bank of America 2005 - loss of computer back-up tapes), this has a big impact on the company's people, assets and reputation. Another example is fraud, like it was in the "Kerviel" case, when a single trader lost 7,2 billion € .

Market risk, on the other hand, is defined as "the risk related to the uncertainty of a financial institution's earnings on its trading portfolio caused by changes and particularly extreme changes, in market conditions such as the price of an asset, interest rates, market volatility and market liquidity." One must add, that market risk emphasises the risk to financial institutions that actively trade assets, liabilities and derivatives rather than hold them for longer-term investment, funding or hedging purposes. A prime example for that are the heavy losses which Bearn and Sterns faced in 2007.

Characteristics and differences Operational risk Market risk

Data availability It is very difficult, to generate accurate data concerning operational risks like, fraud, misconduct and misuse of financial instruments, which would be very important for conducting a risk assessment. Furthermore predicting the impact of such events is also very vague (minor effects - compared to Madoff case) Either historical data, or random date can be processed in one of the three major approaches (risk metrics or the variance/covariance approach, historic or back simulation and the monte carlo simulation) An outcome of that is the so-called VaR.

Risk measurement A common approach for measuring operational risks is to use the formula: risk = probability times impact. The resulting earnings uncertainty of market risk, can be measured over periods as short as a day or as long as a year.

Risk premium One evaluates operational risks in order to implement preventive countermeasures. In an ideal world a risk manager would always select appropriate tools, so that a certain risk would never occur. This however deprives the basis for argumentation, why operational risk management is important, because one will hardly ever be able to measure a respective risk premium. The historical market risk premium will be the same for all investors since the value is based on what actually happened. The required and expected market premiums, however, will differ from investor to investor based on risk tolerance and investing styles. The market risk premium can be calculated as follows:

Market Risk Premium = Expected Return of the Market - Risk-Free Rate

b. Distinction from reputational risk

Discuss why reputational risk is excluded from the Basel II definition of operational risk.

Reputational risk is any risk to an organization's reputation that is likely to destroy shareholder value. It leads to negative publicity, loss of revenue, litigation, loss of clients and partners, exit of key employees, share price decline, difficulty in recruiting talent.

However the