Module1: Risk and Capital

 Risk Vs Uncertainty

Risk is part of uncertainty which can be measured so basically risk is a subset of uncertainty.

The biggest risk is not taking any risk. In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking any risks." -Mark Zuckerberg Facebook

Risk-Reward Ratio

But can we keep taking higher and higher risk to keep getting higher and higher returns. 

Banks need to take risks to get returns. But they should be able to identify, measure, monitor and control the type and amount of risks they are taking. Please note we are talking about managing risk not avoiding it. Banks fix the maximum amount of risk they are willing to take by defining the risk apatite. This is one of the most critical jobs in risk management. Banks struggle in defining their risk apatite. 

Relationship between risk and capital

Capital is extremely important for resiliency and stability of banks. We need to conserve capital, banks need to be recapitalized. 

People provide money to the bank, banks lend and makes investments hence no capital is needed if things go well. Capital is needed if loss happens like the investment goes bad or loan turns into non performing asset. Banks capital is the difference between banks assets and banks liabilities. 

If the bank doesnt have capital and the bank has to set off losses liabilities will exceed assets and the bank will become insolvent. Banks need capital to take care of the risk of loss on its assets. 

Expected and Unexpected losses

1.Banks giving out loans are expected to suffer losses because of defaults and banks are expected to forecast and make provisions for t. This is termed as Expected loss.  Expected loses are viewed as cost of doing business. 

2. However there can be losses which are sudden and severe these are unexpected losses. The peak losses that exceed the expected level. Unexpected or peak losses do not occur every year but when the occur they can be very large. Like the losses due to COVID-19 pandemic. Hence the function of Banks Capital is to provide a buffer that exceeds banks expected levels. 

Type of Bank Capital

How much capital to keep. The worst case scenario would the bank loses its entire credit and investment portfolio. If the bank keeps capital upto that level the bank cannot fail. However capital is costly holding capital upto that level would be inefficient. 

Banks have an incentive to minimize the capital they hold. because reducing capital frees up economic resources, that can be directed to profitable investments. 

On the other hand the less capital a bank the greater is the likelihood that it would not be able to meet its debt obligations as a result the bank would become insolvent. 

How much capital to keep is prescribed by the regulator. This capital is called regulatory capital. This is more of a one size fits all.

A bank can also do its own assesment of capital requirement. It may use its own data and model as Value At Risk or VAR to calculate its capital requirement. This capital is called economic capital.

Economic capital can be more or less that the regulatory capital. The banks have to maintain at least regulatory capital. 

Regulatory capital is prescribed by regulators based on guidelines issued by Basel.