When To Use Financial Risk Management

Published Date: 02 Nov 2017

Introduction 5-6

Risk management 7

When to use financial risk management 8

Risk modeling 9

Market risk 10

Methods of measuring risk 11-13

Measuring market risk 13-14

Market risk management alternatives 15-18

Credit risk 19-22

Credit strategy 22-23

Credit risk management 24

Measuring credit risk 25

Abu Dhabi Islamic bank background 26

ADIB risk management 27-32

Conclusion 33

References and appendix 34

Project Proposal

In this project I will talk about the risk management in financial institution, When to use financial risk management, way of Risk modeling,

and some of it’s main type of risks that the financial institution can face and two areas of it which is:

Market Risk.

Equity Risk

Interest rare risk

The methods of measuring interest rate changing:

Currency risk

MEASURING MARKET RISK

Market Risk Measurement Alternatives

Monte Carlo Simulation

Liquidity Risk

Credit Risk.

Faced by lenders to consumers

Faced by lenders to business

Faced by individuals

Consumer Credit Risk Management:

Credit Strategy

Underwriting:

Credit rating

Personal credit ratings

Corporate credit ratings

Short term rating

Credit risk management

MEASURING CREDIT RISK

Also I ll be talking about measuring these types of risk and risk modeling in details.

And for my project example I choose Abu Dhabi Islamic Bank.

Objectives:

Apply the theoretical study in real life functions and situations

Evaluate my knowledge and information I gained during my studying period in the university.

This project gives me the chance to research about my favorite topic which is how to measure risk in financial institution especially in Islamic banking sector.

Evaluate financial statement to reach specific information without wasting time.

This project makes me aware of analyzing money market movement and fluctuation.

The effect of the central bank on setting interest rate on the economy .

Introduction

A risk is any factor that may potentially interfere with successful completion of the project. A risk is not a problem -- a problem has already occurred; a risk is the possibility that a problem might occur. By recognizing potential problems, the project manager can attempt to avoid a problem through proper actions.

Project risks are identified and carefully managed throughout the life of the project. It is particularly important in the planning stage to document risks and identify reserves that have been applied to the risks.

Risk identification consists of determining risks that are likely to affect the project and documenting the characteristics of those risks. No attempt should be made to identify all possible risks that might affect the project, but anything likely to occur should be included in the analysis.

Risk identification is the responsibility of all members of the project team. The project manager is responsible for tracking risks and for developing mitigation strategies and contingency plans that address the risks identified by the team. Sometimes a risk identification "brainstorming" session can help in the initial identification process, mitigation strategies and contingency plans. Such meetings help team members understand various perspectives and can help the team better understand the "big picture."

In statistics, risk is often mapped to the probability of some event which is seen as undesirable. Usually the probability of that event and some assessment of its expected harm must be combined into a believable scenario (an outcome) which combines the set of risk, regret and reward probabilities into an expected value for that outcome.

Financial risk: "In essence of any risk associated with money". Is often defined as the unexpected variability or volatility "which is the measure of the state of instability" of returns, and thus includes both potential worse than expected as well as better than expected returns.

In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. So in finance "risk" has no one definition, but some theorists have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial market. Financial markets are considered to be a proving ground for general methods of risk assessment.

However, these methods are also hard to understand. The mathematical difficulties interfere with other social goods such as disclosure which means the giving out of information either volutarily or to be compliance with legal regulation or workplace rules, while valuation refer to the determination of the value of an asset or liability and transparency which explain the openness, communication, and accountability. The objective is one that can be seen through.. In particular, it is often difficult to tell if such financial instruments are "hedging" (purchasing/selling a financial instrument specifically to reduce or cancel out the risk in another investment) or "gambling" (increasing measurable risk and exposing the investor to catastrophic loss in pursuit of very high windfalls that increase expected value).

"A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk".

"For example, in UAE Sokok bond"national bonds" is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the UAE sokok bond issued by Dubai government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return".

Risk Management

Risk management is the human activity which integrates recognition of risk, risk assessment is the step in the risk management process which is measuring two quantities of risk R , the magnitude of the potential loss L, and the probability p that the loss will occur., developing strategies to manage it, and mitigation of risk using managerial resources. The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk.

Some traditional risk managements are focused on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments.

Financial risk management is the practice of creating economic value in an organization by using financial instruments which are a term used to denote any form of funding medium - mostly those used for borrowing in money markets, e. g. bills of exchange, bonds", to manage exposure to risk. Similar to general risk management, financial risk management requires identifying the sources of risk, measuring risk, and plans to address them. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.

In the banking sector worldwide, Basel Accord which refers to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlement in Basel and the committee normally meets there" are generally adopted by internationally active banks to tracking, reporting and exposing operational, credit and market risks.

When to use financial risk management

Finance theory (i.e. financial economics which is concerned with resource allocation over time.) prescribes that a firm should take on a project when it increases shareholder value. Finance theory also shows that organization managers cannot create value for shareholders, also called its investors, by taking on project that shareholders could do for themselves at the same cost. When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion is captured by the hedging irrelevance proposition :In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risk that result in unique risks for the firm are the best candidates for financial risk management.

Objective of risk management is to reduce different risks related to a pre-selected domain to the level accepted by society. It may refer to numerous types of threats caused by environment, technology, humans, organizations and politics. On the other hand it involves all means available for humans, or in particular, for a risk management entity (person, staff, organization).

Risk modeling

Risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio. Risk modeling is one of many subtasks within the broader area of financial modeling.

Risk modeling uses a variety of techniques including market risk, Value at Risk (VaR), Historical Simulation (HS) in order to analyze a portfolio and make forecasts of the likely losses that would be incurred for a variety of risks. Such risks are typically grouped into credit risk, liquidity risk, interest rate risk and operational risk categories.

Many large financial intermediary firms use risk modeling to help portfolio managers assess the amount of capital reserves to maintain and to help guide their purchases and sales of various classes of financial assets.

Formal risk modeling is required under the Basel II proposal for all the major international banking institutions by the various national depository institution regulators.

Quantitative risk analysis and modeling have become important in the light of corporate scandals in the past few years. In the past, risk analysis was done qualitatively but now with the advent of powerful computing software, quantitative risk analysis can be done quickly and effortlessly.

Market Risk.

Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:

1-Equity Risk: or the risk that stock prices will change. Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.

The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.

2- Interest rare risk , or the risk that interest rates will change. Interest rate risk is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond's duration which means the weighted average maturity of a bond's cash flows or of any series of linked cash flows. Then the duration of a zero coupon bond with a maturity period of n years is n years. In case there will be coupon payments, the duration will be less than n years. This measure is closely related to the derivative of the bond's price function with respect to the interest rate, and some authors consider the duration to be this derivative, with the weighted average maturity simply being an easy method of calculating the duration for a non-callable bond. It is sometimes explained in inaccurate terms as being a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. the oldest of the many techniques now used to manage interest rate risk. Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework. Interest rate risk analysis is almost always based on simulating movements in one or more yield curves to insure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible.

The methods of measuring interest rate changing:

There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include

1. Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"

2. Stress testing this market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel

3. Calculating the value at Risk of the portfolio

4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves

5. Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.

6. Measuring the mismatch of the interest rate sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

3- Currency risk, is the risk that foreign exchange rates will change. Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedge

• Transaction risk is the risk that exchange rates will change unfavorably over time. It can be hedged against using forward currency contracts;

• Translation risk is an accounting risk, proportional to the amount of assets held in

foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.

The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

For example if you are a UAE . investors have stocks in US, the return that you will realize is affected by both the change in the price of the stocks and the change of the US dollar against the UAE Dhs. Suppose that you realized a return in the stocks of 15% but if the US dollar depreciated 15% against the UAE Dhs, the investors would realize no gain.

When a financial institution conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a financial institution is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If it has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as foreign currency exposure

Equity index risk or the risk that stock or other index prices will change.

Liquidity Risk:

Liquidity risk includes both the risk of being unable to fund assets at appropriate maturities and rates and the risk of being unable to liquidate an asset at a reasonable price and in an appropriate time frame.

Liquidity risk is considered a major risk for banks. It arises when the cushion provided by the liquid assets are not sufficient enough to meet its obligation. It can also be caused by market disruptions or credit downgrades which may cause certain source of funding to dry up immediately. An effective measurement and monitoring system is important for adequate management of liquidity risk in order to be able to capture liquidity risk ahead of time, so that appropriate remedial measures could be prompted to avoid any significant losses. Banks have to guard themselves against this risk through diversifying financing and investing sources to avoid undue concentration of risks with individuals or groups of customers in specific locations or businesses. Banks also protect themselves by managing assets with liquidity in mind, maintaining a healthy balance of cash and cash equivalents.

MEASURING MARKET RISK

There are significant differences in the internal and external views of what is a satisfactory market risk measure. Internally, bank managers need a measure that allows active, efficient management of the bank's risk position. Bank regulators want to be sure a bank's potential for catastrophic net worth loss is accurately measured and that the bank's capital is sufficient to survive such a loss. Consider the differences in desired risk measure characteristics that these two views engender.

Timeliness and Scope

Both managers and regulators want up-to-date measures of risk. For banks active in trading, this may mean selective intraday risk measurement as well as a daily measurement of the total risk of the bank. Note, however, that the intraday measures that are relevant for asset allocation and hedging decisions are measures of the marginal effect of a trade on total bank risk and not the stand-alone riskiness of the trade. Regulators, on the other hand, are concerned with the overall riskiness of a bank and have less concern with the risk of individual portfolio components. Nonetheless, given the ability of a sophisticated manager to "window dress" a bank's position on short notice, regulators might also like to monitor the intraday total risk. As a practical matter, they probably must be satisfied with a daily measure of total bank risk.

The need for a total risk measure implies that risk measurement cannot be decentralized. For parametric measures of risk, such as standard deviation, this follows from the theory of portfolio selection (Markowitz (1952)) and the well-known fact that the risk of a portfolio is not, in general, the sum of the component risks. More generally, imperfect correlation among portfolio components implies that simulations of portfolio risk must be driven by the portfolio return distribution, which will not be invariant to changes in portfolio composition. Finally, given costly regulatory capital requirements, choices among alternative assets require managers to consider risk/return or risk/cost trade-offs where risk is measured as the change in portfolio risk resulting from a given change in portfolio composition. The appropriate risk scaling measure depends on the type of change being made. For example, the pertinent choice criterion for pure hedging transactions might be to maximize the marginal risk reduction to transaction cost ratio over the available instruments while the choice among proprietary transactions would involve minimizing marginal risk per unit of excess return.

Efficiency

Risk measurement is costly and time consuming. Consequently, bank managers compromise between measurement precision on the one hand and the cost and timeliness of reporting on the other. This trade-off will have a profound effect on the risk measurement method a bank will adopt. Bank regulators have their own problem with the cost of accurate risk measurement which is probably one reason they have chosen to monitor and stress test bank risk measurement systems rather than undertaking their own risk measurements.

Information Content

Bank regulators have a singular risk measurement goal. They want to know, to a high degree of precision, the maximum loss a bank is likely to experience over a given horizon. They then can set the bank's required capital (i.e. its economic net worth) to be greater than the estimated maximum loss and be almost sure that the bank will not fail over that horizon. In other words, regulators should focus on the extreme tail of the bank's return distribution and on the size of that tail in adverse circumstances. Bank managers have a more complex set of risk information needs. In addition to shared concerns over sustainable losses, they must consider risk/return trade-offs. That calls for a different risk measure than the "tail" statistic, a different horizon, and a focus on more usual market conditions. Furthermore, even when concerned with the level of sustainable losses, the bank manager may want to monitor on the basis of a probability of loss that can be

observed with some frequency (e.g. over a month rather than over a year).

Market Risk Measurement Alternatives:

There are two principle approaches to risk measurement, scenario analysis and value-at-risk analysis.

Scenario analysis: In scenario analysis, the analyst postulates changes in the underlying determinants of portfolio value (e.g. interest rates, exchange rates, equity prices, and commodity prices) and revalues the portfolio given those changes. The resulting change in value is the loss estimate. A typical procedure, often called stress testing, is to use a scenario based on an historically adverse market move. This approach has the advantage of not requiring a distributional assumption for the risk calculation. On the other hand, it is subjective and incorporates a strong assumption that future financial upsets will strongly resemble those of the past. Given the earlier discussion, it should be clear that stress testing can provide regulators with the desired lower tail estimates, but is of limited utility in day-to-day risk management. It should also be clear that meaningful scenario analysis is dependent on having valuation models that are accurate over a wide range of input parameters, a characteristic that is shared to a considerable extent by value-at-risk models. Pioneering research on capital asset pricing (Sharpe (1964)), option pricing (Black and Scholes (1973), Merton (1973)), and term structure modeling (Vasicek (1977)) has provided the basis for reliable valuation models, models that have become increasingly accurate and applicable with subsequent modification and extension by other researchers.

Value-at-Risk (VaR) analyses use asset return distributions and predicted return parameters to estimate potential portfolio losses. The specific measure used is the loss in value over X days that will not be exceeded more than Y% of the time. The Basle Committee on Banking Supervision's rule sets Y equal to 1% and X equal to 10 days. In contrast, the standard in RiskMetricsâ„¢ (the J.P. Morgan/Reuters VaR method) is 5% over a horizon sufficiently long for the position to be unwound which, in many cases, is 1 day. The difference in probability levels reflects the differences in informational objectives discussed above. The differences in horizon might appear to reflect differences in the uses to which the risk measure is put, in particular the desire of regulators to set capital rules that provide protection from failure over a longer period. This conclusion may be correct, but it is somewhat contradicted by the arbitrary multiplication of the resulting VaR figure by 3 to get regulatory required capital. The Basle Committee could have gotten about the same result using a 1-day horizon and multiplying by 9.5. Perhaps order of magnitude arbitrariness is less palatable than single digit arbitrariness.

There are two principle methods for estimating VaR … the analytical method and Monte Carlo simulation … each with advantages and disadvantages. There are implementation problems common to both methods, namely choosing appropriate return distributions for the instruments in the portfolio and obtaining good forecasts of their parameters. The literature on volatility estimation is large and seemingly subject to unending growth, especially in acronyms (Arch, Grach, Egarch, et.al.). Since I am not an expert on forecasting, it will be safest and perhaps sufficient to make two comments on forecasting for VaR analysis. Firstly, the risk manager with a large book to manage needs daily and, in some cases, intraday forecasts of the relevant parameters. This puts a premium on using a forecasting method that can be quickly and economically updated. Secondly, forecasting models that incorporate sound economic theory, including market microstructure factors, are likely to outperform purely mechanical models.

Modeling portfolio returns as a multivariate normal distribution has many advantages in terms of computational efficiency and tractability. Unfortunately, there is evidence going back to Mandelbrot (1963) and beyond that some asset returns display non-normal characteristic. The fact that they display "fat" tails…more extreme values than would be predicted for a normal variate…is particularly disturbing when one is trying to estimate potential value loss. To some degree, these fat tails in unconditional return distributions reflect the inconstancy of return volatility and the problem can be mitigated by modeling individual returns as a function of volatility as in the RiskMetrics model:

Another alternative is to assume that returns follow a non-normal distribution with fat tails (e.g. the Student's t distribution), but only if one is prepared to accept the concomitant portfolio return computation problems. Danielson and deVries (1997) have proposed a method for explicit modeling of the tails of financial returns. Since VaR analysis is intended to describe the behavior of portfolio returns in the lower tail, this is obviously an intriguing approach. Furthermore, the authors show that the tail behavior of data from almost any distribution follows a single limit law, which adds to the attractiveness of the method. However, estimating tail densities is not a trivial matter so, while promising, there are computational issues to be resolved if this is to become a mainstream VaR method.

Analytical VaR: The analytical method for VaR uses standard portfolio theory. The portfolio in question is described in terms of a position vector containing cash flow present values representing all components of the portfolio. The return distribution is described in terms of a matrix of variance and covariance forecasts (covariance matrix) representing the risk attributes of the portfolio over the chosen horizon. The standard deviation of portfolio value (v) is obtained by pre- and post-multiplying the covariance matrix (Q) by the position vector (p) and taking the square root of the resulting scalar:

This standard deviation is then scaled to find the desired centile of portfolio value that is the predicted maximum loss for the portfolio or VaR:

For example, for a multivariate normal return distribution, f(Y) = 1.65 for Y = 5% or 2.33 for Y = 1%. Analytical VaR is attractive in that it is fast and not terribly demanding of computational resources. As the following algebra demonstrates, analytical VaR also lends itself readily to the calculation of the marginal risk of candidate trades:

Given trade cashflow descriptions, the information needed to calculate the marginal risk of any candidate trade can be accumulated during a single calculation of v.

Analytical VaR has a number of weaknesses. In its simplest form, options and other non-linear instruments are delta-approximated which is to say the representative cash flow vector is a linear approximation of position that is inherently non-linear. In some cases, this approximation can be improved by including a second-order term in the cash flow representation. However, this does not always improve the risk estimate and can only be done with the sacrifice of some of the computational efficiency that recommends analytical VaR to bank managers.

Monte Carlo Simulation:

Monte Carlo simulation of VaR begins with a random draw on all the distributions describing price and rate movements taking into account the correlations among these variates. Mark-to-model and maturation values for all portfolio components at the VaR horizon are determined based on that price/rate path. This process is repeated enough times to achieve significance in the resulting end-of-horizon portfolio values. Then the differences between the initial portfolio value and these end-of-horizon values are ranked and the loss level at the Yth centile is reported as the VaR of the portfolio.

To avoid bias in this calculation, the analyst must use risk-neutral equivalent distributions and, if the horizon is sufficiently long, be concerned with bias introduced by the return on capital. If model error is not significant, the use of Monte Carlo simulation solves the problem of non-linearity though there are some technical difficulties such as how to deal with time-varying parameters and how to generate maturation values for instruments that mature before the VaR horizon. From the risk manager's viewpoint, the main problem is the cost of this method and the time it takes to get reliable estimates.

Credit risk:

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

Faced by lenders to consumers:

Most lenders employ their own models (Credit Scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of credit limits. Some products also require security, most commonly in the form of property.

Faced by lenders to business:

Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

• Limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.

• allow for monitoring the debt requiring audits, and monthly reports

• Allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.

A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

Faced by business:

Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services. By delivering the product or service first and billing the customer later - if it's a business customer the terms may be quoted as net 30 - the company is carrying a risk between the delivery and payment.

Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly.

For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by tightening payment terms to "net 15", or by actually selling fewer products on credit to the retailer, or even cutting off credit entirely, and demanding payment in advance. Such strategies impact sales volume but reduce exposure to credit risk and subsequent payment defaults.

Credit risk is not really manageable for very small companies (i.e., those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers.

The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

Faced by individuals

Consumers may face credit risk in a direct form as depositors at banks or as investors/lenders. They may also face credit risk when entering into standard commercial transactions by providing a deposit to their counterparty, e.g. for a large purchase or a real estate rental. Employees of any firm also depend on the firm's ability to pay wages, and are exposed to the credit risk of their employer.

In some cases, governments recognize that an individual's capacity to evaluate credit risk may be limited, and the risk may reduce economic efficiency; governments may enact various legal measures or mechanisms with the intention of protecting consumers against some of these risks. Bank deposits, notably, are insured in many countries (to some maximum amount) for individuals, effectively limiting their credit risk to banks and increasing their willingness to use the banking system.

Consumer Credit Risk (Retail Credit Risk) is the risk of loss due to a customer's non re-payment (default) on a consumer credit product, such as a mortgage, unsecured personal loan, credit card, overdraft et

Consumer Credit Risk Management:

Most companies involved in lending to consumers have departments dedicated to the measurement, prediction and control of losses due to credit risk. This field is loosely referred to consumer/retail credit risk management, however the word management is commonly dropped.

Scorecards

Credit Scorecards are mathematical models which attempt to provide a quantities measurement of the likelihood that a customer will display a defined behavior with respect to their current, or proposed, credit position with a lender.

A common method for predicting credit risk is through the credit scorecard. The scorecard is a statistically based model for attributing a number (score) to a customer (or an account) which indicates the predicted probability that the customer will exhibit a certain behavior. In calculating the score, a range of data sources may be used, including data from an application form, from credit reference agencies or from products the customer already holds with the lender.

The most widespread type of scorecard in use is the application scorecard, which lenders employ when a customer applies for a new credit product. The scorecard tries to predict the probability that the customer, if given the product, would become "bad" within a given timeframe, incurring losses for the lender. The exact definition of what constitutes "bad" varies across different lenders, product types and target markets, however examples may be "missing three payments within the next 18 months" or "default within the next 12 months". The score given to a customer is usually a three or four digit integer, and in most cases is proportional to the natural log of the odds of the customer becoming "bad". In general a low score indicates a low quality (a high chance of going "bad") and a high score indicates the opposite.

Other scorecard types may include behavioural scorecards - which try to predict the probability of an existing account turning "bad"; propensity scorecards - which try to predict the probability that a customer would accept another product if offered one; and collections scorecards - which try to predict a customer's response to different strategies for collecting owed money.

Historically, Credit scoring has typically been based on a data base built using the last observation on those former clients who defaulted on their loans plus the most recent observations on a large number of clients who defaulted. Statistically, estimation techniques called logit or probit are used to predict the probability of default of new clients based on this historical data base. The default probabilities are then scaled to a "credit score." This score ranks clients by riskiness without explicitly identifying their probability of default.

Credit scoring is being replaced gradually by a technique called by various names: hazard rate modeling, reduced form credit models, or logistic regression. The primary differences from credit scoring involve both the data base and the ability to calculate the financial value of a loan, given its riskiness from a credit perspective. The data base includes all of the available observations on both defaulted and non-defaulted clients. This makes it much easier to see the effects of macro-economic factors like stock prices, auto prices, interest rates, and home values on the default rates of retail loans secured by automobiles or homes.

Credit Strategy

Credit strategy is concerned with turning predictions of customer behaviors (as provided by scorecards) into decisions.

To turn an application score into a Yes/No decision "cut-offs" are generally used. A cut-off is a score at and above which customers have their application accepted and below which applications are declined. The placement of the cut-off is closely linked to the price Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan, taking into account one-time fees and standardizing the way the rate is expressed. (APR) that the lender is charging for the product. The higher the price charged, the greater the losses the lender can endure and still remain profitable. So, with a higher price the lender can accept customers with a higher probability of going "bad" and can move the cut-off down. The opposite is true of a lower price. Most lenders go further and charge low scoring customers a higher APR than high scoring customers. This compensates for the added risk of taking on poorer quality business without effecting the lender's place in the market with better quality borrowers.

Application score is also used as a factor in deciding such things as an overdraft or credit card limit. Lenders are generally more happy to extend a larger limit to higher scoring customers than to lower scoring customers, because they are more likely to pay borrowings back. Alongside scorecards lie policy rules which apply regulatory requirements (such as making sure there is no lending to under 18s). Credit Strategy is also concerned with the ongoing management of a customer's account, especially with revolving credit products such as credit cards, overdrafts and flexible loans, where the customer's balance can go up as well as down. Behavioural scorecards are used (usually monthly) to provide an updated picture of the credit-quality of the customer/account. As the customer's profile changes, the lender may choose to extend or contract the customer's limits.

Underwriting:

Not all decisions can be made automatically through the methods mentioned above. This may be for a number of reasons; insufficient data, regulatory requirements, or a borderline decision. In such cases highly trained professionals called underwriters manually review the case and make a decision. This is more common in highly regulated products such as mortgages, especially when large sums are involved

Credit rating

A credit rating assesses the credit worthiness of an individual, corporation, or even a country. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.

A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rate.

Personal credit ratings

A personnel's credit history is compiled and maintained by companies called credit bureaus. Credit worthiness is usually determined through a statistical analysis of the available credit data. A common form of this analysis is a 3-digit credit score provided by independent financial service companies.

An individual's credit score, along with his or her credit report, affects his or her ability to borrow money through financial institutions such as banks.

The factors which may influence the credit rating are:

• ability to pay a loan

• interest

• amount of credit used

• saving patterns

• spending patterns

Corporate credit ratings

The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. These are assigned by credit rating agencies such as Standard & Poor's or Fitch Rating and have letter designations such as AAA, B, CC.

Short term rating

A short term rating is a probability factor of an individual going into default within a year. This is in contrast to long-term rating which is evaluated over a long timeframe.

Credit risk management:

Credit risk management is the process of finding and managing risk in an investment When the risk has been identified, investment decisions can be made and the risk vs. return balance considered from a better position.

The main way to reducing credit risk is by monitoring the behaviors of clients who wish apply for credit in the business. These clients may be businesses or individuals. Credit Risk is further divided into many areas in a somewhat hierarchical fashion.

MEASURING CREDIT RISK

To be consistent with market risk measurement, credit risks are defined as changes in portfolio value due to the failure of counter-parties to meet their obligations or due to changes in the market's perception of their ability to continue to do so. Ideally, a bank risk management system would integrate this source of risk with the market risks discussed above to produce an overall measure of the bank's loss potential. Traditionally, banks have used a number of methods…credit scoring, ratings, credit committees…to assess the creditworthiness of counter-parties. At first glance, these approaches do not appear to be compatible with the market risk methods. However, some banks are aware of the need for parallel treatment of all measurable risks and are doing something about it . Unfortunately, current bank regulations treat these two sources of risk quite differently subjecting credit risk to arbitrary capital requirements that have no scientific validity. There is danger in this since it can lead to capital misallocation and imprudent risk-taking.

If banks can "score" loans, they can determine how loan values change as scores change. If codified, these changes would produce over time a probability distribution of value changes due to credit risk. With such a distribution, the time series of credit risk changes could be related to the market risk and we would be able to integrating market risk and credit risk into a single estimate of value change over a given horizon.

This is not a "pipe dream". Considerable research on the credit risk of derivatives, including a paper at this conference, is available. Obviously, banks themselves are in the best position to produce the data series necessary for broader application of this approach. If it is reasonable to require banks to produce and justify market risk measurement systems, why can't they be required to do the same for credit risk and to integrate the two? The House Banking Committee Chairman I mentioned at the start of this talk would have rejected this idea out of hand. I hope today's regulatory authorities won't.

Abu Dhabi Islamic Bank

Background:

Abu Dhabi Islamic Bank was established on 20th May 1997 as a Public Joint Stock Company through the Amiri Decree No. 9 of 1997. The Bank commenced commercial operations on 11th November 1998, and was formally inaugurated by His Highness Sheikh Abdullah Bin Zayed Al Nahyan, UAE Minister of Information and Culture on 18th April 1999.

All contracts, operations and transactions are carried out in accordance with Islamic Shari'a principles.

The Capital

ADIB commenced its operations with a paid-up capital of One Billion Dirhams divided into hundred million shares, the value of each share being ten dirhams. The shares are quoted on the Abu Dhabi Securities Market.

The Shareholders

The founders of Abu Dhabi Islamic Bank hold 39% of its equity while the remaining 61% is held by approximately 100,000 shareholders. The founding shareholders of ADIB are:

Members of the Ruling Family

The Abu Dhabi Investment Authority

Prominent UAE Nationals

Abu Dhabi Risk Management:

Risk: Detailed research is undertaken to ensure that the return from a particular product is commensurate with the associated risk. The overall style of ADIB’s investment products is "conservative" and ADIB currently does not offer "aggressive growth" or "high risk, high growth" products

ADIB as any financial institution face many risks on its assets and liabilities which are: Credit risk: is the risk when the customer couldn't pay the loan on time of payment, which causes financial loss, so the Group’s credit risk seeks to manage credit risk by monitoring credit exposures, credit limits, by entering into collateral agreements with counterparties in appropriate circumstances to limiting transactions with them and continually assessing the creditworthiness of counterparties. ADIB expect that when the number of creditors are involving in the same business activities in the same location the credit risk will increase or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic, political or other conditions is an indication of the relative sensitivity of the Group’s performance to developments affecting.

Foreign exchange risk: this type of risk managed by Board of Directors, group open positions who doesn’t engage in foreign exchange trading and where necessary matches currency exposures inherent in current assets with liabilities in the same or a correlated currency , current and expected exchange rate movements.

Pricing risks: managed by market valuation risk and assets allocations and estimating long and short term changes in fair value. So ADIB don't exposed to profit rate risk as its profit-sensitive assets and liabilities are reprised frequently.

Market risk: occurs when the market fluctuate as a result of changing in market price. So ADIB avoid this type of risk by diversified portfolio and monitoring the market developments especially in stock market.

Liquidity risk: it happen when the FI couldn't convert its current assets to meet its current liabilities because of market disruptions or credit downgrades. So management team must diversify funding sources and managed its assets with liquidity in mind, maintaining a

healthy and adequate balance of cash and cash equivalents.

Stock Performance

Market Information

Stock

UAE Index

Last Closing

AED 55.75

3826.66

YTD %

7.945%

11.66%

Weekly %

-0.976%

-0.59%

Year High

AED 61.16

3999.88

Year Low

AED 46.16

3125.56

52 Week High

AED 83.33

4239.36

52 Week Low

AED 46.16

3125.56

BETA

1.2884

Outstanding Shares

150,000,000

Market Cap

AED 8,362,500,000

Market Cap in $

USD $2,276,749,251

% of UAE Market

1.41%

% of Sector

3.22%

Rank by Cap

20

Key Figures in '000 AED

2005

2004

2003

Total Assets

22,189,405

12,687,169

9,220,713

Shareholder's Equity

2,022,593

1,435,643

1,330,419

NIAT

344,496

122,910

100,560

Dividends

N/A

70,000

70,000

Financial Ratios

2005

2004

2003

Assets Growth

74.90%

37.59%

16.17%

Earning Growth

180.28%

22.23%

32.97%

ROaA

1.98%

1.12%

1.17%

ROaE

19.92%

8.89%

7.79%

No. Of Shares

100,000,000

100,000,000

100,000,000

EPS

3.44

1.23

1.01

EPS Growth

180.28%

22.23%

32.97%

Payout Ratio

N/A

56.952

69.61

Valuation Ratios

Trailing

PE

24.28

PB

DVPS

N/A

Div Yield

N/A

EV

14,200,000.00

EV/Equity

7.02

Banks performance and profitability

From customer perspective, he needs to measure the performance and financial position of the bank to make adecision whether to invest in such bank or not. He has to evaluate it financial statement to help him to manage future risk in addition, if the assets and owner equities can cover their liabilities in short term and long term debt

Short term solvency ratio (debit ratio, current ratio)

Leverage ratio (debit equity).

Profitability ratio (ROA, ROE, E.P.S).

ADIB2005

Short term solvency ratio:

Debit ratio = total debit/total assets

Debit ratio =11181526/12687169= 88.13%

Current ratio = current assets / current liability

Current ratio = 55627054/47736714=116.5%

Leverage ratio:

Debit equity = total debit/total equity

Debit equity =11181526/1505.643=74.64%

Profitability ratio :

Net profit margin =net income/total operating revenue

Net profit margin =344496/1450611 =23.7%

Assets= 22189405

Net return on Assets =NI/T.Av.ASSET

Net return on asset=3444196/17438287 = 19.7%

ROE= NI/Av. stock holder equity

ROE =3444196/17603805 =19.5%

E.P.S= 3.45

1-Short term solvency ratio (debit ratio, current ratio).

Debit ratio:

The debit ratio indicates the percentage assets financed by creditor and it helps to determine how well creditor is protected in case of insolvency. If the creditors are not well protected, the bank is not in a position to issue additional long –term debt

Current ratio:

The current ratio shows the relationship between the size of the current assets and the size of the current liability, making it feasible to compare the current ratio, In short term solvency we find ADIB and ADCB they have strong assets to cover their liability.

2.Leverage ratio (debit, equity)

Debit equity:

The debt/equity ratio is another computation the entity’s long –term debt paying ability. This computation compare the total debt with the total shareholders equity .the debt equity ratio also helps determine ho well creditor are protected in case of insolvency. From the perspective of long-term debt-paying ability, the low this ratio is the better position.

3-Profitability ratio (ROA, ROE, E.P.S)

Profitability is the ability of the bank to generate earning. Analysis of profit is of vital concern to stockholders since they derive revenue in the form of dividends. Further, in creased profit can cause a rise in market price leading to capital gain.

Net profit margin: this ratio gives measure of net income dollar generated by each dollar of sale.

ROA: return on assets measure the bank ability to utilize its assets to create profits by comparing profits with the assets that generate the profit.

The total assets of ADIB is equal 22189405

ROE: the return on equity measure the return to both common and preferred stockholders.

Finally, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks. ADIB is currently focusing upon developing additional products for its clients across a range of asset classes and covering a wider range of risks.

Conclusion:

Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. It involves identification, measurement, monitoring and controlling risks to ensure that

a) The individuals who take or manage risks clearly understand it.

b) The organization’s risk exposure is within the limits established by Board of Directors.

c) Risk taking Decisions are in line with the business strategy and objectives.

d) The expected payoffs compensate for the risks taken.

e) Risk taking decisions are explicit and clear.

f) Sufficient capital as a buffer is available to take risk.

As we mentioned early, financial risk was fined as the possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings/capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Such constraints pose a risk as these could hinder a bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.

Until and unless risks are not assessed and measured, it will not be possible to control them. Further a true assessment of risk gives management a clear view of institution’s standing and helps in deciding future action plan.

While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity, business activities, volume etc, the most common risks that all banks face, whether Islamic or conventional, are Credit, Market, and Liquidity risks.

References:

Anthony Saunders & Marcia Millon(2006),(5th Edition).financial institution management" A risk management approach". McGraw-Hill Education. page 158-328.

http://home2.btconnect.com/managingstandard/risk_1.htm#INTRO

http://en.wikipedia.org/wiki/Risk#Definitions_of_risk

http://en.wikipedia.org/wiki/Market_risk

http://en.wikipedia.org/wiki/Credit_risk

http://www.adib.ae/

http://www.ameinfo.com/financial_markets/UAE/Company_AE0004

http://www.adib.ae/html/About%20ADIB/financial-info.html

http://www.ameinfo.com/financial_markets/UAE/Company_AE0004/

www.nationalbonds.ae