Topic 1 Data Governance in Financial Risk Management

(With examples and simple numericals)

Data Governance in Financial Risk Management refers to the framework of policies, processes,
standards, and controls implemented to ensure the accuracy, consistency, completeness,
reliability, and security of data used in assessing, monitoring, and mitigating financial risks. It
establishes accountability and oversight to maintain high-quality data that supports effective
risk decision-making and regulatory compliance.

Key Components of Data Governance in Financial Risk Management:

1. Data Quality Management

o Ensures risk data (e.g., credit, market, operational risk) is accurate, timely, and
consistent.

o Implements validation, cleansing, and reconciliation processes.

2. Data Ownership & Stewardship

o Assigns clear roles (e.g., Chief Data Officer, Risk Data Stewards) to oversee data
integrity.

o Defines responsibilities for data entry, maintenance, and usage.

3. Regulatory Compliance

o Aligns with standards like BCBS 239 (Principles for Effective Risk Data
Aggregation), GDPR, Basel III, and SOX.

o Ensures auditability and traceability for regulatory reporting.

4. Risk Data Architecture

o Establifies centralized data repositories (e.g., data lakes, warehouses) for

seamless aggregation.

o Integrates risk data across trading, credit, liquidity, and operational risk systems.

5. Access Controls & Security

o Implements role-based permissions to protect sensitive risk data (e.g., PII, trade
secrets).

o Enforces encryption, masking, and cybersecurity measures.

6. Metadata & Lineage Tracking

 o Documents data sources, transformations, and flows to ensure transparency.

o Supports root-cause analysis in risk modeling errors.

7. Change Management

o Governs modifications to risk data models, taxonomies, and reporting structures.

Importance in Financial Risk Management:

 Improves Risk Modeling: High-quality data enhances VaR (Value-at-Risk), stress testing,
and scenario analysis.

 Reduces Operational Risk: Prevents losses from flawed data (e.g., mispriced assets,
incorrect exposures).

 Ensures Regulatory Reporting Accuracy: Avoids penalties from flawed Basel

III/FRTB/SEC filings.

 Supports AI/ML Risk Analytics: Reliable data is critical for machine learning in fraud
detection and credit scoring.

Challenges:

 Siloed data across front/middle/back-office systems.

 Balancing data accessibility with security.

 Evolving regulatory requirements (e.g., ESG risk data disclosures).

In summary, robust Data Governance in Financial Risk Management ensures that risk data is
trustworthy, actionable, and compliant, enabling institutions to make informed decisions while
meeting regulatory demands.

1️⃣ What Is Data Governance?

Data governance means managing how data is collected, stored, used, and shared in an
organization.

In financial risk management, data governance ensures that the data used to measure and
manage risks is:
✅ Accurate
✅ Consistent
✅ Secure
✅ Available when needed
👉 Why it matters:
If a bank is using wrong or old data, it might not know how much risk it really faces!

2️⃣ Why Data Governance Is Important in Risk Management

Examples of financial risks:

 Credit risk (customers not paying loans)

 Market risk (stock prices falling)

 Liquidity risk (not enough cash to meet needs)

 Operational risk (system failures, fraud)

👉 Good data helps risk managers:

 Calculate risk correctly

 Meet regulatory requirements (like Basel III, IFRS 9)

 Make better decisions

3️⃣ Key Elements of Data Governance

Element Meaning Example

Data must be correct & Ensure all loan balances are recorded
Data quality
complete properly

Assign people responsible for Credit department owns customer credit

Data ownership
data scores

Data security Protect data from theft/loss Encrypt sensitive transaction data

Know that trading data comes from

Data lineage Track where data comes from
exchange feed

Metadata Manage information about Field "loan amount" is in dollars, updated

management data daily
4️⃣ Simple Example: Credit Risk Model

A bank uses this formula to estimate credit risk:

Expected Loss = Probability of Default × Exposure at Default × Loss Given Default

Let's say:

 Probability of Default (PD) = 2% (0.02)

 Exposure at Default (EAD) = $1,000,000

 Loss Given Default (LGD) = 40% (0.40)

👉 Expected Loss = 0.02 × 1,000,000 × 0.40 = $8,000

⚠️If PD data is old or wrong (say 5% instead of 2%), the Expected Loss becomes:

0.05 × 1,000,000 × 0.40 = $20,000

👉 Wrong data → wrong risk assessment → poor decision!

5️⃣ Data Governance & Regulations

Many regulators require strong data governance:

 Basel Committee on Banking Supervision (BCBS 239)

o Principles for effective risk data aggregation and reporting

 IFRS 9

o Requires accurate data for expected credit loss models

 GDPR

o Data privacy and protection rules (important in Europe)

6️⃣ Benefits of Good Data Governance

✅ More accurate risk models

✅ Better compliance with laws
✅ Faster decision-making
✅ Improved reputation
✅ Lower risk of fines or penalties
1. Data Quality – Error Impact on Risk Metrics

Scenario:
A bank uses Value-at-Risk (VaR) models to assess market risk. Due to poor
data governance, 5% of trade entries in its derivatives portfolio contain
errors (e.g., incorrect notional values).

 Total trades: 10,000

 Erroneous trades: 500 (5%)
 Average error per trade: $10,000 (underreported)

Question:
What is the total potential capital underestimation due to data errors in
VaR calculation?

Solution:

Total Underestimation=Erroneous Trades×Average Error=500×$10,000=$5,000

,000

Implication: Poor data governance could lead to a $5M capital shortfall if

risk models rely on flawed data.

2. BCBS 239 Compliance – Risk Data Aggregation

Scenario:
Under BCBS 239, a bank must ensure risk data is aggregated accurately
and timely. Suppose:

 The bank has 4 business units, each reporting credit exposure.

 Due to inconsistent data formats, Unit 3’s exposure is overstated
by 15%.
  Reported exposures:

o Unit 1: $1.2B
o Unit 2: $0.9B
o Unit 3: $1.5B (true exposure = $1.3B)
o Unit 4: $0.8B

Question:
What is the total corrected exposure, and what is the percentage
error in the original report?

Solution:

Reported Total=1.2+0.9+1.5+0.8=$4.
Corrected Total=1.2+0.9+1.3+0.8=$4.
Percentage Error=4.24.4−4.2×100=4.76%

Implication: A 4.76% overstatement could mislead risk decisions and

regulatory scrutiny.

3. Data Lineage – Tracking Risk Model Inputs

Scenario:
A bank’s stress-testing model uses 200 data fields from 5 different sources.
An audit finds:

 10% of fields lack clear lineage documentation.

 3% of fields have incorrect mappings (e.g., "Collateral Value"
linked to wrong source).

Question:
How many data fields need corrective action?
Solution:

Fields without lineage=200×10%=20Fields without lineage=200×10%=20Fields

with incorrect mappings=200×3%=6Fields with incorrect mappings=200×3%=6
Total Fields Requiring Fix=20+6=26Total Fields Requiring Fix=20+6=26

Implication: 13% of risk model inputs are unreliable, requiring

governance improvements.

4. Regulatory Capital – Impact of Missing Data

Scenario:
A bank calculates Credit Risk-Weighted Assets (RWA) but misses 5% of
loan records due to poor data governance.

 Total loan portfolio: $50B

 Average risk weight: 60%
 Capital requirement: 8% of RWA

Question:
What is the capital shortfall due to missing data?

Solution:

Missing Loans=50B×5%=$2.5B
Missing RWA=2.5B×60%=$1.5B
Capital Shortfall=1.5B×8%=$120M

Implication: The bank could be under-capitalized by $120M, violating

Basel III requirements.
5. Data Reconciliation – Trade Surveillance

Scenario:
A trading desk reports 1,000 trades/day to risk management. The
reconciliation process finds:

 Daily mismatches: 2% (due to timing delays or errors)

 Average trade value: $500,000
 Risk threshold: Mismatches > $5M require escalation

Question:
Do the daily mismatches exceed the risk threshold?

Solution:

Mismatched Trades=1000×2%=20
Total Mismatch Value=20×$500K=$10M

Implication: $10M in mismatches exceeds the $5M threshold, triggering

operational risk alerts.

Summary Table of Problems

Scenario Key Metric Calculation Governance Lesson

Capital 500 × $10K Data validation critical for risk

VaR Data Errors
Underestimation = $5M models

BCBS 239 (4.4-4.2)/4.2 Standardized data formats

Reporting Error
Aggregation = 4.76% needed

Metadata governance reduces

Data Lineage Gaps Unreliable Fields 20 + 6 = 26 fields
model risk

1.5B × 8% Completeness checks for

Missing Loan Data Capital Shortfall
= $120M regulatory capital
Scenario Key Metric Calculation Governance Lesson

Trade 20 × $500K Real-time reconciliation

Mismatch Value
Reconciliation = $10M reduces ops risk

Next Steps

These numerical examples highlight how poor data governance directly

impacts financial risk metrics. Would you like additional exercises on:

 Stress testing data errors?

 Liquidity risk reporting gaps?
 AI/ML model bias due to flawed risk data?

Topic 2 Information Risk and Data Quality Control

(With examples and simple numericals)

1. Information Risk

Definition:
Information Risk refers to the potential for loss, damage, or misuse of
critical data due to inadequate controls, leading to financial, operational,
reputational, or regulatory harm. In financial risk management, it
encompasses threats like:

 Data breaches (cyberattacks, insider threats)

 Poor data quality (errors, inconsistencies)
 Non-compliance (violations of GDPR, BCBS 239, etc.)
 System failures (outages, corrupted databases)
Key Components of Information Risk:

Risk Type Example in Financial Risk Management

Confidentiality Risk Unauthorized access to client trade data.

Incorrect VaR calculations due to tampered market

Integrity Risk
data.

Availability Risk Trading platform downtime during market volatility.

Compliance Risk Fines for missing Basel III risk data aggregation rules.

2. Data Quality Control

Definition:
Data Quality Control (DQC) is a systematic process to ensure data
is accurate, complete, consistent, and reliable for risk management. It
involves:

 Validation (e.g., automated checks on trade entries).

 Cleansing (fixing missing/duplicate values).
 Monitoring (real-time alerts for anomalies).

6 Dimensions of Data Quality in Risk Management:

Dimension Financial Risk Example Control Measure

Correct interest rate inputs for credit risk Cross-verify with

Accuracy
models. Bloomberg/Reuters feeds.

Mandatory field checks in loan

Completeness Missing collateral data in loan portfolios.
origination.

Consistency Differing customer risk scores across Centralize risk data in a single
Dimension Financial Risk Example Control Measure

departments. warehouse.

Delayed fraud detection in transaction

Timeliness Real-time data pipelines.
monitoring.

Duplicate trade entries inflating market

Uniqueness De-duplication algorithms.
risk exposure.

Unverifiable inputs in stress-testing

Auditability End-to-end data lineage tracking.
models.

Link Between Information Risk & Data Quality Control

Poor data quality amplifies information risk:

 Scenario 1: Inaccurate counterparty credit ratings (data quality

failure) → Wrong risk-weighted assets (RWA) → Capital shortfall
(information risk).
 Scenario 2: Unreconciled trade data → Failed BCBS 239 audit →
Regulatory penalties.

Mitigation Strategies:

1. Automated Controls:

o Implement real-time validation rules (e.g., "Trade dates

cannot be future-dated").
o Use AI/ML anomaly detection (e.g., spotting outlier
transactions).
2. Governance Frameworks:

o Assign data stewards for risk-critical datasets (e.g., VaR model

inputs).
 o Adopt DCAM (Data Capability Assessment Model) for
maturity benchmarking.
3. Regulatory Alignment:

o Map data controls to BCBS 239 Principle 4 ("Data accuracy and

integrity").
o Document data lineage for Solvency II/FRTB compliance.

Example: Data Quality Failure Impact

A bank’s liquidity risk model uses flawed deposit data:

 Error: 10% of deposits misclassified as "short-term" (true value =

long-term).
 Impact:

o LCR (Liquidity Coverage Ratio) overstated by 8%.

o Regulatory breach → $25M fine (information risk realization).

Solution:

 Deploy automated deposit classification rules.

 Monthly data quality scorecards for risk teams.

Key Takeaways

 Information Risk = Threats from bad/misused data.

 Data Quality Control = Tools to prevent those risks.
 Financial institutions must integrate both into risk data
governance (e.g., BCBS 239, GDPR).
1. Data Accuracy – Impact on Credit Risk Models

Scenario:
A bank uses a credit scoring model with 10 input variables. Due to poor
data quality:

 3 variables have errors (e.g., incorrect income or debt levels).

 The model’s accuracy drops by 15%, leading to:

o False approvals (bad loans): 5% increase.

o False rejections (good loans): 3% increase.

Given:

 Total loan applications/month: 10,000

 Average loan amount: $100,000
 Default rate on false approvals: 8%

Questions:
a) How many additional bad loans are approved due to data errors?
b) What is the expected loss from these bad loans?

Solution:
a) Additional false approvals = 10,000 × 5% = 500 loans
b) Expected loss = 500 × $100,000 × 8% = $4M/month

Governance Fix:

 Implement automated data validation for income/debt fields.

 Reduce errors to <1% (saving ~$3.8M/month).

2. Completeness Risk – Liquidity Reporting Gap

Scenario:
A bank’s Liquidity Coverage Ratio (LCR) requires complete data on high-
quality liquid assets (HQLA). An audit finds:

 5% of HQLA transactions are missing maturity dates.

 Total HQLA portfolio: $50B
 Regulatory minimum LCR: 100%

Question:
If the missing data causes a 2% underreporting of liquid assets, does the
bank still meet LCR?

Solution:

 Reported HQLA = $50B × 98% = $49B

 Required LCR = $50B × 100% = $50B
 Shortfall = $50B - $49B = $1B (LCR = 98% → Breach)

Implication:

 Regulatory penalty: Up to $10M for non-compliance.

 Fix: Automated reconciliation of HQLA data feeds.

3. Consistency Risk – Market Data Errors

Scenario:
A trading desk uses two data sources for FX rates:

 Source A: EUR/USD = 1.08

 Source B: EUR/USD = 1.10 (outdated)

Due to poor governance, 20% of trades use the wrong rate.

  Total FX trades/day: 1,000
 Average trade size: €1M

Question:
What is the daily financial impact of inconsistent data?

Solution:

 Erroneous trades = 1,000 × 20% = 200 trades

 Loss per trade = €1M × (1.10 – 1.08) = $20,000
 Total loss = 200 × $20,000 = $4M/day

Fix:

 Single source of truth for market data.

 Real-time validation checks before trade execution.

4. Timeliness Risk – Fraud Detection Lag

Scenario:
A bank’s transaction monitoring system processes data with a 24-hour
delay.

 Average fraudulent transactions/day: 50

 Average loss per fraud: $5,000
 Detection rate drops by 30% due to delays.

Question:
What is the additional monthly loss from delayed data?

Solution:

 Undetected frauds/day = 50 × 30% = 15

  Daily loss = 15 × $5,000 = $75,000
 Monthly loss = $75,000 × 30 = $2.25M

Fix:

 Upgrade to real-time fraud analytics.

 Save ~$27M/year.

5. Uniqueness Risk – Duplicate Trade Entries

Scenario:
A bank’s trade repository has 2% duplicate entries due to system glitches.

 Total trades/day: 50,000

 Average trade value: $500,000
 Capital charge for overstated exposures: 8%

Question:
What is the excess capital allocation due to duplicates?

Solution:

 Duplicate trades = 50,000 × 2% = 1,000 trades

 Overstated exposure = 1,000 × $500K = $500M
 Excess capital = $500M × 8% = $40M

Fix:

 De-duplication algorithms in trade capture systems.

Summary Table of Problems

Risk Type Scenario Financial Impact Governance Solution

$4M/month in bad Automated validation

Accuracy Flawed credit scores
loans rules

Completeness Missing HQLA data $1B LCR shortfall Data reconciliation tools

Consistency Conflicting FX rates $4M/day trading loss Single source of truth

Delayed fraud
Timeliness $2.25M/month losses Real-time monitoring
detection

Uniqueness Duplicate trades $40M excess capital De-duplication algorithms

Next Steps

These exercises show how data quality failures directly translate into
financial losses. Would you like:

1. More complex scenarios (e.g., stress testing with dirty data)?

2. Regulatory penalty calculations (e.g., GDPR fines for data
breaches)?
3. AI/ML model risks (e.g., biased risk scoring from poor training data)?

1️⃣ What Is Information Risk?

Information risk is the risk that wrong, missing, or poor-quality information will lead to bad
decisions or losses.

In finance, this is very important because decisions are based on data. If the data is wrong →
the risk is high!

👉 Example:
If an investor uses outdated stock prices, they might buy at the wrong time and lose money.
2️⃣ Types of Information Risk

Type of Risk Example

Incorrect data Wrong customer credit scores used in loan decisions

Incomplete data Missing fields in a risk model (e.g., not all loans included)

Outdated data Using last year’s data to measure today’s market risk

Inconsistent data Same customer has different risk ratings in two systems

Unauthorized data access Hacker steals trading data → market manipulation

3️⃣ What Is Data Quality Control?

Data quality control means all the steps taken to ensure data is:

✅ Correct
✅ Complete
✅ Timely
✅ Consistent
✅ Secure

👉 It helps reduce information risk!

4️⃣ Key Dimensions of Data Quality

Dimension Meaning Example

Accuracy Data is correct Customer income field is true and verified

Completeness No missing fields All bond ratings recorded in database

Timeliness Data is up to date Market prices updated every second

No contradictions across Same FX rate in risk model and accounting

Consistency
systems system

Validity Data follows rules Interest rates between 0% and 100% only
5️⃣ Example: Market Risk Calculation

Bank uses this simple formula:

Value at Risk (VaR) = Z × σ × √t × Portfolio Value

Where:

 Z = 1.65 (95% confidence)

 σ = volatility = 2% (0.02)

 t = 1 day

 Portfolio Value = $10 million

👉 VaR = 1.65 × 0.02 × √1 × 10,000,000 = $330,000

If volatility data is wrong (say 5% instead of 2%):

VaR = 1.65 × 0.05 × √1 × 10,000,000 = $825,000

👉 This will totally change the risk estimate → big consequences!

6️⃣ How to Control Data Quality (Steps)

✅ Define data owners — who is responsible for each type of data

✅ Set data quality rules — define what "good data" looks like
✅ Use data validation tools — check for errors automatically
✅ Conduct data audits — review and correct bad data
✅ Train employees — awareness of data quality importance
✅ Implement data governance framework — policies and procedures

7️⃣ Benefits of Good Data Quality Control

✅ Lower information risk

✅ Better risk management (accurate VaR, credit models, liquidity models)
✅ More trust in reports
✅ Regulatory compliance (Basel III, IFRS 9, GDPR)
✅ Better decision-making across the business

Summary (In Easy Words):

👉 Information risk = risk of bad decisions due to bad data
👉 Data quality control = ways to make sure data is good (accurate, complete, timely, consistent)
👉 Example: Wrong volatility in a market risk model → wrong Value at Risk → wrong capital
allocation
👉 Good data quality control helps reduce risk and meet regulations.

Topic 3 Operational Risk Fundamentals

(With examples and simple numericals)

Operational Risk Fundamentals – Definition & Key

Components

Operational Risk is the risk of financial loss, reputational damage, or legal

consequences arising from inadequate or failed internal processes,
people, systems, or external events. Unlike market or credit risk, it is not
driven by market movements or borrower defaults but by organizational
weaknesses.

Key Components of Operational Risk

1. Internal Processes

o Failures in procedures (e.g., settlement errors, incorrect

reporting).
o Example: A bank miscalculates capital reserves due to a
flawed Excel model.
2. Human Factors

o Employee errors, misconduct, or fraud.

o Example: A rogue trader hides losses exceeding risk limits
(e.g., Société Générale’s €4.9B loss in 2008).
 3. Systems & Technology

o IT failures, cyberattacks, or data breaches.

o Example: A bank outage prevents customers from accessing
funds, triggering regulatory fines.
4. External Events

o Natural disasters, fraud by third parties, or legal changes.

o Example: A supplier’s bankruptcy disrupts a bank’s payment
processing.
5. Legal & Compliance Risks

o Violations of laws (e.g., AML failures, GDPR breaches).

o Example: Wells Fargo’s $3B fine for fake accounts.

Regulatory Framework (Basel III/IV)

 Basel Committee Definition:

"Risk of loss from inadequate processes, people, systems, or external
events, including legal risk but excluding strategic/reputational risk."
 Key Regulations:

o Basel II/III: Requires banks to hold capital for operational risk

(Advanced Measurement Approach (AMA) or Standardized
Approach (SA)).
o BCBS 239: Ensures robust risk data aggregation.
o Dodd-Frank/SOX: Mandates internal controls.

Operational Risk Measurement Approaches

Method Description Example Calculation

Basic Indicator Capital = 15% of 3-yr avg gross

Income = $10B → Capital = $1.5B.
(BIA) income.

Standardized Splits income by business line (e.g., Trading income = $2B → Capital =
(TSA) 18% for trading). $360M.

Uses internal loss data, scenarios, Monte Carlo simulations on

Advanced (AMA)
and risk indicators. historical fraud losses.

Real-World Example – Loss Event Database (LED)

A bank logs operational losses over 5 years:

Fraud
Year IT Outage Losses Compliance Fines
Losses

2023 $50M $20M $100M

2022 $30M $10M $80M

Key Insights:

 Fraud risk is increasing (+67% YoY).

 Compliance fines are the largest risk category.

Mitigation Strategies

1. Risk & Control Self-Assessments (RCSA): Identify weak processes

(e.g., manual reconciliations).
 2. Key Risk Indicators (KRIs): Monitor early warnings (e.g., # of failed
trades/day).
3. Business Continuity Planning (BCP): Prepare for
cyberattacks/disasters.
4. Insurance: Cover losses from fraud or lawsuits.

Why It Matters

 JPMorgan’s "London Whale" lost $6.2B due to weak operational

controls.
 HSBC’s $1.9B AML fine showed compliance failures.

Operational risk is unavoidable, but manageable with strong

governance.

Operational Risk Numericals with Solutions

These problems cover loss calculations, capital requirements, and risk

mitigation under Basel frameworks.

1. Basic Indicator Approach (BIA) Capital Calculation

Scenario:
A bank reports the following gross income over 3 years:

 2022: $8B
 2023: $10B
 2024: $12B
Question:
What is the operational risk capital charge under the BIA (15% of 3-year
average gross income)?

Solution:

Average Income=8+10+123=$10BAverage Income=38+10+12=$10BCapital C

harge=10B×15%=$1.5BCapital Charge=10B×15%=$1.5B

2. Standardized Approach (TSA) Capital Calculation

Scenario:
A bank’s gross income by business line:

 Corporate Finance: $2B (Beta factor = 18%)

 Retail Banking: $5B (Beta factor = 12%)
 Trading: $3B (Beta factor = 18%)

Question:
Calculate the total operational risk capital under TSA.

Solution:

Capital=(2B×18%)+(5B×12%)+(3B×18%)Capital=(2B×18%)+(5B×12%)
+(3B×18%)=0.36B+0.6B+0.54B=$1.5B=0.36B+0.6B+0.54B=$1.5B

3. Loss Event Frequency & Severity

Scenario:
A bank’s IT failures over 5 years:
  Number of outages: 20
 Total losses: $100M

Questions:
a) What is the average loss per event?
b) If the bank reduces outages by 50% through system upgrades, what is
the expected annual savings?

Solution:
a) Average Loss=100M20=$5M per outageAverage Loss=20100M=$5M per outa
ge
b) Savings=10 outages×$5M=$50MSavings=10 outages×$5M=$50M

4. Risk Mitigation ROI

Scenario:
A bank spends $10M/year on fraud detection software, reducing losses:

 Before: $50M/year in fraud losses

 After: $20M/year in fraud losses

Question:
What is the Return on Investment (ROI) of the software?

Solution:

Annual Savings=50M−20M=$30MAnnual Savings=50M−20M=$30MROI=30

M−10M10M×100=200%ROI=10M30M−10M×100=200%

5. Legal Risk Fine Impact

Scenario:
A bank faces a $500M fine for AML violations. Given:

 Net income: $4B/year

 Operational risk capital: $2B

Question:
What percentage of the bank’s net income and operational risk
capital does the fine consume?

Solution:

% of Net Income=500M4B×100=12.5%% of Net Income=4B500M

×100=12.5%% of Capital=500M2B×100=25%% of Capital=2B500M
×100=25%

6. Scenario Analysis (AMA Approach)

Scenario:
A bank models operational risk losses using:

 Frequency: 5 cyberattacks/year
 Severity: $10M per attack

Question:
What is the 99.9% VaR if losses follow a Poisson distribution?

Solution:

Annual Loss=5×10M=$50MAnnual Loss=5×10M=$50M99.9% VaR≈3σ (extre

me tail risk)=50M×3=$150M99.9% VaR≈3σ (extreme tail risk)=50M×3=$150
M
Summary Table of Problems

Problem Key Concept Answer

BIA Capital Basel III Basic Indicator $1.5B

TSA Capital Business-Line Beta Factors $1.5B

Loss Severity IT Risk Frequency/Severity $5M per event

Fraud Detection
Cost-Benefit Analysis 200% ROI
ROI

Legal Fine Impact Capital/Income Absorption 12.5% of income

Cyber Risk VaR Advanced Measurement Approach $150M

Next Steps

1. Complex Scenarios:

o Combine credit + operational risk (e.g., a fraud-induced loan

default).
2. Regulatory Penalties:

o Calculate BCBS 239 fines for poor risk data aggregation.

3. Stress Testing:

o Model operational risk under recession conditions.

.1️⃣ What Is Operational Risk?

Operational risk = risk of loss due to failed internal processes, people, systems, or external
events.
👉 In simple words:
When something goes wrong in the way a business runs.

2️⃣ Common Examples of Operational Risk

Source of Risk Example

Process failures Wrong interest rate applied to thousands of accounts

Human error Trader enters wrong order → $1 million loss

System failure Online banking goes down for 2 days

Cyber attacks Hackers steal customer data

Fraud Employee steals company funds

Natural disasters Earthquake destroys branch office

👉 Operational risk is different from market risk (prices move), and credit risk (borrowers
default).

3️⃣ Operational Risk Framework

To manage operational risk, firms use this framework:

a. Identify Risks

 Map all possible operational risks in the organization

b. Assess Risks

 Estimate frequency (how often) and severity (how big) of possible losses

c. Control & Mitigate

 Improve processes

 Train staff

 Build better systems

 Insurance (for some risks)

d. Monitor & Report

  Track risk events

 Analyze trends

 Report to management & regulators

4️⃣ Basic Numerical Example: Expected Operational Loss

Formula:
Expected Loss = Frequency × Average Loss

Example:

 Historical data shows that fraud incidents happen 3 times per year

 Average loss per incident = $200,000

👉 Expected Loss = 3 × $200,000 = $600,000 per year

Now suppose the bank improves controls and reduces frequency to 1 time per year:

👉 New Expected Loss = 1 × $200,000 = $200,000 per year

👉 Controlling operational risk can save big money!

5️⃣ Regulatory Context

Operational risk is regulated under:

 Basel III framework

Banks must hold capital for operational risk → must calculate their expected and
unexpected losses.

 ICAAP (Internal Capital Adequacy Assessment Process)

Firms must demonstrate they have proper operational risk management.

6️⃣ Key Tools for Managing Operational Risk

Tool Example

Risk & Control Self-Assessment (RCSA) Departments assess their own operational risks

Key Risk Indicators (KRIs) Metrics like system downtime, number of fraud alerts
Tool Example

Loss Event Database Database of past operational risk events

Scenario Analysis Simulate large-scale cyber attack or disaster

7️⃣ Benefits of Good Operational Risk Management

✅ Fewer costly incidents

✅ Improved business continuity
✅ Better customer trust
✅ Regulatory compliance
✅ Lower insurance costs
✅ Stronger reputation

Summary (In Easy Words):

👉 Operational risk is the risk of losses from business operations going wrong (processes, people,
systems, or external events).
👉 Example: Wrong transaction entered, cyber attack, system downtime.
👉 Firms manage it by identifying, assessing, controlling, and monitoring risks.
👉 Regulators like Basel III require banks to hold capital for operational risk.
👉 Example calculation: If fraud happens 3 times a year with $200k loss → expected loss =
$600k/year.

Topic 3 Risk Management in Financial Institutions

(With examples and simple numericals)

Risk Management in Financial Institutions refers to the process of identifying, assessing,

monitoring, and mitigating risks that could threaten the institution’s financial stability,
regulatory compliance, and operational efficiency. Financial institutions—such as banks,
insurance companies, investment firms, and credit unions—face various risks that must be
managed to protect assets, ensure profitability, and maintain stakeholder confidence.

Key Components of Risk Management in Financial Institutions:

1. Risk Identification – Recognizing potential risks, including:

 o Credit Risk – The risk of borrower default.

o Market Risk – Losses due to market fluctuations (e.g., interest rates, forex,
equities).

o Liquidity Risk – Inability to meet short-term obligations.

o Operational Risk – Losses from internal failures (fraud, system breakdowns,

human error).

o Compliance & Regulatory Risk – Penalties from violating laws (e.g., Basel III,
Dodd-Frank).

o Reputational Risk – Damage to public perception.

o Cybersecurity Risk – Threats from data breaches and cyberattacks.

2. Risk Assessment & Measurement – Quantifying risks using models (e.g., Value-at-Risk
(VaR), stress testing, scenario analysis).

3. Risk Mitigation Strategies – Implementing controls such as:

o Diversification of investments.

o Hedging (using derivatives like futures and options).

o Setting risk limits and capital reserves.

o Strengthening internal controls and fraud detection.

4. Monitoring & Reporting – Continuously tracking risk exposures and reporting to

regulators (e.g., central banks, SEC, FINRA).

5. Governance & Compliance – Ensuring risk policies align with regulatory requirements
and industry best practices (e.g., Basel Accords, IFRS 9).

Importance of Risk Management:

 Protects against financial losses and insolvency.

 Ensures regulatory compliance and avoids penalties.

 Enhances decision-making and strategic planning.

 Maintains investor and customer trust.

 Improves resilience in economic downturns.

By effectively managing risks, financial institutions can optimize returns while minimizing
potential threats to their operations and stability.

1️⃣ What Is Risk Management?

Risk management = identifying, measuring, controlling, and monitoring risks.

👉 In simple words:
It’s about understanding what could go wrong, how big the risk is, and what to do about it.

👉 In financial institutions (banks, insurance companies, investment firms), risk management is

critical because they deal with:

 Money

 Markets

 Customers' trust

2️⃣ Types of Risks in Financial Institutions

Type of Risk Example

Credit risk Borrower fails to repay a loan

Market risk Stock market falls → losses on trading portfolio

Liquidity risk Bank doesn’t have enough cash to meet withdrawal demands

Operational risk System failure disrupts payments

Reputation risk Scandal damages customer trust

Compliance risk Bank fails to follow new regulations

👉 A good risk management framework covers all these risks.

3️⃣ The Risk Management Process

a. Identify Risks

 Know where risks are in the business.

b. Measure Risks
  Use models and data to estimate size of risks (e.g., VaR, expected loss).

c. Control / Mitigate Risks

 Diversify portfolio

 Set limits (maximum exposure allowed)

 Use hedging (buy options, swaps, etc.)

 Strengthen internal processes

d. Monitor & Report Risks

 Regular reports to management and regulators.

 Use dashboards and risk indicators.

4️⃣ Basic Numerical Example: Market Risk (VaR)

A bank estimates 1-day Value at Risk (VaR) for its trading portfolio.

Formula:
VaR = Z × σ × √t × Portfolio Value

Example:

 Z = 1.65 (95% confidence)

 σ = volatility = 1.5% (0.015)

 t = 1 day

 Portfolio Value = $100 million

👉 VaR = 1.65 × 0.015 × √1 × 100,000,000 = $2.475 million

👉 Meaning: The bank expects that on 95% of days, it won’t lose more than $2.475 million.

5️⃣ Tools and Frameworks Used

Tool/Framework Purpose

Basel III capital rules Ensure banks have enough capital for risks

IFRS 9 Better loan loss provisioning (credit risk)

Tool/Framework Purpose

Stress testing Simulate extreme market moves or crises

Define how much risk the institution is willing

Risk Appetite Framework
to take

Internal Capital Adequacy Assessment Process

Assess how much capital is needed for all risks
(ICAAP)

6️⃣ Benefits of Good Risk Management

✅ Protects the institution’s capital

✅ Improves decision-making
✅ Enhances trust with regulators, investors, customers
✅ Helps prevent crises
✅ Enables sustainable business growth

7️⃣ Example: How Poor Risk Management Can Hurt

2008 Financial Crisis:

👉 Many banks underestimated credit risk on mortgage-backed securities.
👉 When borrowers defaulted, banks faced massive unexpected losses.
👉 Result: Bank failures, bailouts, new regulations (Basel III).

👉 Lesson: Strong risk management is critical!

Summary (In Easy Words):

👉 Risk management = managing the chances of loss in financial institutions.

👉 Key risks: credit, market, liquidity, operational, reputation, compliance.
👉 Process: Identify → Measure → Control → Monitor.
👉 Example: VaR calculation helps estimate possible daily market losses.
👉 Good risk management protects capital, improves decisions, and ensures long-term survival.
👉 Poor risk management caused big problems in past crises (e.g., 2008).

1. Credit Risk Numerical (Probability of Default & Expected Loss)

A bank has a loan portfolio with the following details:

  Exposure at Default (EAD): $10 million

 Probability of Default (PD): 5%

 Loss Given Default (LGD): 40%

Calculate Expected Loss (EL).

Solution:

EL=EAD×PD×LGDEL=EAD×PD×LGDEL=$10,000,000×0.05×0.40=$200,000EL=$10,000,000×0.05×0
.40=$200,000

Interpretation: The bank should set aside $200,000 as a provision for potential losses.

2. Market Risk Numerical (Value at Risk - VaR)

A trading portfolio has a 1-day 95% VaR of $1 million.

What does this mean?

 There is a 5% chance that the portfolio will lose more than $1 million in one day.

 If confidence level increases to 99%, will VaR increase or decrease?

o Answer: VaR will increase because higher confidence means accounting for more
extreme losses.

3. Liquidity Risk Numerical (Liquidity Coverage Ratio - LCR)

A bank has:

 High-Quality Liquid Assets (HQLA): $50 million

 Net Cash Outflows (30-day stress scenario): $40 million

Calculate LCR (Basel III requirement: ≥100%).

LCR=HQLANet Cash Outflows×100LCR=Net Cash OutflowsHQLA

×100LCR=5040×100=125%LCR=4050×100=125%

Interpretation: The bank meets Basel III’s LCR requirement (125% > 100%).

4. Operational Risk Numerical (Basic Indicator Approach - Basel II)

A bank has:

 Gross Income (GI) for 3 years:

o Year 1: $100 million

o Year 2: $120 million

o Year 3: $80 million

 Regulatory multiplier (α): 15%

Calculate Capital Charge for Operational Risk.

Average GI=100+120+803=$100 millionAverage GI=3100+120+80=$100 millionCapital Charge=1

5%×100=$15 millionCapital Charge=15%×100=$15 million

Interpretation: The bank must hold $15 million in capital for operational risk.

5. Interest Rate Risk Numerical (Duration Gap Analysis)

A bank has:

 Assets: $500 million (Avg. duration = 4 years)

 Liabilities: $400 million (Avg. duration = 2 years)

 Expected interest rate increase: 1% (100 bps)

Calculate the change in net worth.

Duration Gap=DurationAssets−(LiabilitiesAssets×DurationLiabilities)Duration Ga
p=DurationAssets−(AssetsLiabilities×DurationLiabilities)=4−(400500×2)=4−1.6=2.4 years=4−(500
400×2)=4−1.6=2.4 yearsΔNet Worth≈−(Duration Gap×Assets×ΔInterest Rate)ΔNet Worth≈−
(Duration Gap×Assets×ΔInterest Rate)≈−(2.4×500×0.01)=−$12 million≈−(2.4×500×0.01)=−$12 m
illion

Interpretation: A 1% rate rise reduces the bank’s net worth by $12 million.

Summary of Key Formulas

Risk Type Formula

Credit Risk (Expected

EL=EAD×PD×LGDEL=EAD×PD×LGD
Loss)

Market Risk (VaR) VaR=Portfolio Value×Zα×σVaR=Portfolio Value×Zα×σ

LCR=HQLANet Cash Outflows×100LCR=Net Cash OutflowsHQLA

Liquidity Risk (LCR)
×100

Operational Risk (BIA) Capital=15%×Avg. Gross IncomeCapital=15%×Avg. Gross Income

Interest Rate Risk

ΔNW≈−(Dgap×Assets×Δr)ΔNW≈−(Dgap×Assets×Δr)
(Duration Gap)

These numericals help quantify risks and guide financial institutions in capital allocation, stress
testing, and regulatory compliance. Would you like more advanced examples (e.g., Monte Carlo
simulations, credit VaR)?

Topic 4 Risks in Migrating to the International Financial Reporting

Standards (IFRS)
(With examples and simple numericals)

Risks in Migrating to International Financial Reporting

Standards (IFRS)

Migrating from local accounting standards (e.g., U.S. GAAP, Indian GAAP)
to International Financial Reporting Standards (IFRS) introduces
several financial, operational, and strategic risks. Below are the key risks and
their implications:
1. Financial Reporting & Compliance Risks

 Inconsistent Application of Standards:

o IFRS relies on principles-based accounting (vs. GAAP’s rules-

based approach), leading to subjective interpretations.
o Risk of non-compliance with IFRS due to improper
implementation.
 Restatement of Financials:

o Past financial statements may need revisions, affecting investor

confidence.
 Tax Implications:

o Changes in revenue recognition (e.g., IFRS 15) and asset

valuation (e.g., IFRS 16 leases) can alter tax liabilities.

Example:
Under IFRS 9, banks must shift from incurred loss to expected credit
loss (ECL), increasing loan loss provisions.

2. Operational Risks

 System & Process Overhaul:

o Legacy accounting systems may not support IFRS requirements

(e.g., fair value measurements under IFRS 13).
 Data Quality Issues:

o Inconsistent historical data complicates transition (e.g., IFRS

16 lease accounting requires tracking all leases).
  Increased Costs:

o Training staff, hiring IFRS experts, and software upgrades

raise transition costs.

Example:
A firm switching to IFRS 16 must capitalize all leases, increasing reported
assets and liabilities.

3. Business & Strategic Risks

 Impact on Financial Ratios:

o Key metrics (e.g., debt-to-equity, EBITDA) may change,

affecting loan covenants and credit ratings.
 Stakeholder Misinterpretation:

o Investors may misread financials due to unfamiliar IFRS

terminologies (e.g., "other comprehensive income").
 M&A Challenges:

o Cross-border deals become complex if acquirers use different

standards.

Example:
Under IFRS 3, goodwill is not amortized but tested for impairment annually,
altering M&A valuations.

4. Regulatory & Legal Risks

 Divergence from Local Regulations:

 o Some countries (e.g., U.S.) do not fully adopt IFRS, creating dual-
reporting burdens.
 Audit & Litigation Risks:

o Higher scrutiny from auditors and regulators increases litigation

risk.

Example:
IFRS revenue recognition rules (IFRS 15) may conflict with local tax laws,
triggering disputes.

5. Market & Reputational Risks

 Volatility in Reported Earnings:

o IFRS’s fair-value emphasis can increase earnings volatility,

spooking investors.
 Loss of Competitive Edge:

o Competitors on different standards may appear more stable.

Example:
An insurer adopting IFRS 17 must change profit recognition timing,
potentially lowering short-term earnings.

Mitigation Strategies

1. Phased Transition Plan – Prioritize high-impact standards (e.g., IFRS

9, 15, 16).
 2. Training & Change Management – Educate finance teams and
auditors.
3. Technology Upgrades – Implement IFRS-compliant ERP systems
(e.g., SAP, Oracle).
4. Stakeholder Communication – Explain IFRS impacts to investors and
lenders.
5. Parallel Reporting – Run IFRS and local GAAP simultaneously to
compare results.

Conclusion

While IFRS improves global comparability, its adoption introduces

financial, operational, and compliance risks. Proactive planning, expert
consultation, and robust systems are key to a smooth transition.

1. IFRS 15 (Revenue Recognition) – Change in

Timing of Revenue
Scenario:
A software company sells a 2-year license for $1,000,000 with post-sale
support. Under local GAAP, it recognizes full revenue upfront. Under IFRS
15, revenue must be split between the license and support.

 Standalone selling prices:

o License: $800,000
o Support: $400,000

Question: How much revenue is recognized in Year 1 under IFRS 15?

Solution:

 Total contract value = $1,000,000

 Allocation based on standalone prices:

o License % = $800,000 / ($800,000 + $400,000) = 66.67%

 o Support % = $400,000 / $1,200,000 = 33.33%
 Revenue in Year 1 (License delivered immediately):

o $1,000,000 × 66.67% = $666,700 (recognized upfront)

o Support revenue ($333,300) is deferred over 2 years.

Risk:

 Lower reported revenue in Year 1 ($666,700 vs. $1,000,000 under

GAAP).
 Earnings volatility due to deferred income.

2. IFRS 16 (Leases) – Impact on Balance Sheet

Scenario:
A company leases equipment for 5 years, paying $50,000 annually. Under
local GAAP, it was an operating lease (off-balance sheet). Under IFRS
16, it must recognize a right-of-use (ROU) asset and lease liability.

 Discount rate = 5%
 Present Value (PV) of lease payments = ?

Solution:

 Lease payments = $50,000/year for 5 years.

 PV annuity factor (5%, 5 years) = 4.3295
 Lease liability (PV) = $50,000 × 4.3295 = $216,475
 ROU asset = $216,475 (initially same as liability).

Balance Sheet Impact:

Before IFRS 16 After IFRS 16

No asset/liability +$216,475 ROU Asset

+$216,475 Lease Liability

Risk:

 Higher leverage ratios (Debt/Equity increases).

 Profit fluctuations (interest + depreciation now affect P&L).

3. IFRS 9 (Expected Credit Loss – ECL) – Higher

Loan Loss Provisions
Scenario:
A bank has a $1,000,000 corporate loan with:

 12-month PD = 2%
 Lifetime PD = 10%
 Loss Given Default (LGD) = 40%

Question: Compute 12-month ECL and Lifetime ECL (if credit risk
increases significantly).

Solution:

1. 12-month ECL = Exposure × PD × LGD

= $1,000,000 × 2% × 40% = $8,000
2. Lifetime ECL (if credit deteriorates)
= $1,000,000 × 10% × 40% = $40,000

Risk:
  Higher provisions reduce reported profits.
 Regulatory capital requirements may increase.

4. IAS 36 (Impairment of Goodwill) – Earnings

Volatility
Scenario:
A company acquired a subsidiary, recording $500,000 goodwill. After 2
years, the recoverable amount of the subsidiary is $2,000,000, while
its carrying amount (including goodwill) is $2,200,000.

Question: Is goodwill impaired? If yes, by how much?

Solution:

 Impairment test:

o Recoverable amount ($2M) < Carrying amount ($2.2M)

→ Impairment exists.
 Impairment loss = $2.2M - $2M = $200,000 (charged to P&L).

Risk:

 Sudden earnings hit due to impairment.

 Investor confidence drop from unexpected losses.

5. IFRS vs. GAAP – Tax Impact (Deferred Taxes)

Scenario:
Under local GAAP, a company recognizes $100,000 warranty expense
immediately. Under IFRS, it must defer the expense until claims arise. Tax
rate = 30%.

Question: Compute the deferred tax asset (DTA) created.

Solution:

 GAAP expense = $100,000 (reduces taxable income).

 IFRS expense = $0 (no deduction until claim).
 Temporary difference = $100,000
 DTA = $100,000 × 30% = $30,000

Risk:

 Cash flow impact (DTA means future tax savings, but no immediate
benefit).
 Complex reconciliation for tax filings.

Summary Table: Key IFRS Transition Risks & Numerical

Impact

Standard Change Introduced Numerical Impact Risk

Revenue split over Revenue in Year 1 drops from $1M Lower short-term
IFRS 15
time to $666,700 profits

IFRS 16 Leases capitalized $216,475 added to assets/liabilities Higher leverage

Expected Credit Loss Provisions rise from $8,000 to Reduced net

IFRS 9
(ECL) $40,000 income

Goodwill impairment
IAS 36 $200,000 impairment loss Earnings volatility
test

Tax Deferred tax $30,000 DTA created Complex tax

Standard Change Introduced Numerical Impact Risk

Effects adjustments reporting

Conclusion

These numerical examples show how IFRS transition affects:

✔ Revenue recognition timing (IFRS 15)
✔ Balance sheet leverage (IFRS 16)
✔ Loan loss provisions (IFRS 9)
✔ Goodwill impairments (IAS 36)
✔ Tax liabilities (Deferred Taxes)

Mitigation: Firms should run parallel accounting (GAAP + IFRS) before full
adoption to assess financial impacts.

1️⃣ What Is IFRS?

IFRS = International Financial Reporting Standards.

👉 It’s a set of global accounting standards used to:

 Make financial statements more comparable and transparent.

 Help investors understand companies better.

Many countries and companies have migrated (switched) from local GAAP (Generally Accepted
Accounting Principles) to IFRS.

2️⃣ Why Migrate to IFRS?

✅ Align with global standards

✅ Attract foreign investors
✅ Improve financial reporting quality
✅ Easier to raise global capital

👉 But the migration process carries risks!

3️⃣ Key Risks in IFRS Migration

Risk Type Example

Accounting errors Incorrect valuation of assets under new IFRS rules

Data quality issues Incomplete data needed for IFRS disclosures

Systems risk IT systems not ready to handle IFRS calculations

Training risk Staff don’t fully understand IFRS → mistakes in reports

Regulatory compliance risk Not meeting new IFRS-related reporting deadlines

Cost overruns Migration takes more time and money than planned

Stakeholder communication risk Investors misunderstand new reports → stock price impact

4️⃣ Numerical Example: IFRS 9 (Credit Losses)

Under old GAAP:

 Loan loss provision = $1 million

Under IFRS 9 (Expected Credit Loss model), based on:

 Probability of Default (PD) = 3% (0.03)

 Exposure at Default (EAD) = $50 million

 Loss Given Default (LGD) = 40% (0.40)

👉 Expected Loss = 0.03 × 50,000,000 × 0.40 = $600,000

👉 Under IFRS 9 → provision drops to $600k.

👉 If bank incorrectly calculates this → misstatement in financial statements!

5️⃣ Key Areas of Impact

Area How It’s Affected

Revenue recognition Changes under IFRS 15 (timing and amount of revenue reported)

Asset valuation Fair value under IFRS may differ from historical cost

Loan loss provisions Expected credit loss model under IFRS 9

Leases IFRS 16 → leases now on balance sheet

Tax impact Accounting changes may affect taxable income

6️⃣ How to Manage the Risks

✅ Detailed project plan for IFRS migration

✅ Gap analysis → compare current GAAP vs IFRS impacts
✅ Training for finance teams and auditors
✅ Testing new systems before full rollout
✅ Clear communication with stakeholders (investors, regulators, management)
✅ Strong governance and project oversight

7️⃣ Summary (In Easy Words):

👉 Migrating to IFRS is important for global financial reporting but carries risks.
👉 Risks include errors in accounting, poor data, unready systems, training gaps, and
compliance issues.
👉 Example: Under IFRS 9, banks must use expected credit loss models, which need accurate
data and models.
👉 Careful planning, training, testing, and governance can reduce risks.

Topic 5 Credit Risk

(With examples and simple numericals)

Credit Risk: Definition

Credit risk refers to the potential financial loss that a lender or investor faces when a borrower
or counterparty fails to meet their contractual obligations, such as repaying a loan or settling a
debt. It is the risk of default, late payments, or decline in creditworthiness, leading to reduced
cash flows or increased collection costs.

Key Components of Credit Risk

1. Default Risk – The borrower fails to repay the principal or interest.

2. Downgrade Risk – The borrower’s credit rating worsens, reducing the value of debt
securities.

3. Recovery Risk – The lender may not recover the full amount owed after default (e.g.,
due to bankruptcy).

4. Exposure Risk – The outstanding loan amount at the time of default affects potential
loss.

Types of Credit Risk

Type Description Example

Risk from individual borrowers A customer defaults on a personal

Retail Credit Risk
(mortgages, credit cards). loan.

Corporate Credit Risk from business loans or A company misses an interest

Risk corporate bonds. payment.

Sovereign Credit Risk that a government defaults on A country restructures its debt
Risk debt (e.g., bonds). (e.g., Argentina 2001).

Counterparty Risk in derivatives or trading A bank fails to honor a swap

Risk agreements. contract.

Measuring Credit Risk

1. Probability of Default (PD) – Likelihood a borrower defaults within a timeframe.

 o Example: A PD of 2% means a 2% chance of default in 1 year.

2. Loss Given Default (LGD) – % of exposure lost if default occurs.

o Example: LGD of 50% means only half the loan is recovered.

3. Exposure at Default (EAD) – Amount owed when default happens.

4. Expected Loss (EL) = PD × LGD × EAD

Numerical Example:

 Loan Amount (EAD): $1,000,000

 PD (1 yr): 5%

 LGD: 40%

 Expected Loss (EL):

EL=5%×40%×$1,000,000=$20,000

Credit Risk Mitigation Techniques

1. Collateral – Secured loans reduce LGD (e.g., mortgages).

2. Diversification – Lending across sectors/geographies lowers concentration risk.

3. Credit Derivatives – Instruments like Credit Default Swaps (CDS) transfer risk.

4. Covenants – Loan terms restricting borrower actions (e.g., debt limits).

5. Credit Scoring Models – FICO scores, Altman Z-score for corporates.

Regulatory Frameworks

 Basel III requires banks to hold capital against credit risk using:

o Standardized Approach (risk weights based on ratings)

o Internal Ratings-Based (IRB) Approach (bank-estimated PD/LGD)

Why Credit Risk Matters

 Affects bank profitability (higher defaults → lower earnings).

  Impacts investor returns (bond yields compensate for credit risk).

 Can trigger financial crises (e.g., 2008 subprime mortgage crisis).

Example: If a bank’s corporate loan portfolio has rising defaults, it may need to:
✔ Increase provisions (reducing profits).
✔ Raise capital (to meet Basel requirements).

Conclusion

Credit risk is a fundamental financial risk affecting lenders, investors, and the broader economy.
Effective management combines quantitative models (PD/LGD/EAD), diversification, and
regulatory compliance.

1. Expected Loss (EL) Calculation

Scenario:
A bank has a $5 million corporate loan with:

 1-year PD: 4%

 LGD: 60%

 EAD: $5 million (no prepayments)

Calculate Expected Loss (EL).

Solution:

EL=PD×LGD×EAD=0.04×0.60×$5,000,000=$120,000EL=PD×LGD×EAD=0.04×0.60×$5,000,000=$1
20,000

Interpretation: The bank should set aside $120,000 as a loan loss provision.

2. Credit VaR (Unexpected Loss) Calculation

Scenario:
A bond portfolio has:

 Average annual default rate (PD): 3%

 LGD: 50%

 Portfolio value: $10 million

  Confidence level: 99% (Z-score = 2.33)

Compute Credit VaR (unexpected loss at 99% confidence).

Solution:

1. Expected Loss (EL):

EL=0.03×0.50×$10,000,000=$150,000EL=0.03×0.50×$10,000,000=$150,000

2. Standard Deviation (σ) of Loss:

σ=PD×(1−PD)×LGD×EAD=0.03×0.97×0.50×$10,000,000≈$267,457σ=PD×(1−PD)
×LGD×EAD=0.03×0.97×0.50×$10,000,000≈$267,457

3. Credit VaR:

Credit VaR=EL+Z×σ=$150,000+2.33×$267,457≈$773,000Credit VaR=EL+Z×σ=$150,000+2.33×$26

7,457≈$773,000

Interpretation: There’s a 1% chance losses will exceed $773,000 in a year.

3. Risk-Weighted Assets (RWA) Under Basel III

Scenario:
A bank has a $1 million corporate loan to a BBB-rated company.

 Basel III risk weight for BBB corporate loans: 100%

Calculate RWA and minimum capital required (assuming 8% capital adequacy ratio).

Solution:

1. RWA:

RWA=Exposure×Risk Weight=$1,000,000×100%=$1,000,000RWA=Exposure×Risk Weight=$1,000

,000×100%=$1,000,000

2. Minimum Capital Required:

Capital=RWA×8%=$1,000,000×0.08=$80,000Capital=RWA×8%=$1,000,000×0.08=$80,000

Interpretation: The bank must hold $80,000 in capital against this loan.

4. Loan Loss Provisioning (IFRS 9 vs. IAS 39)

Scenario:
A bank has a $2 million loan with:

 12-month PD: 2%

 Lifetime PD: 10%

 LGD: 40%

Compute provisions under:

 IAS 39 (Incurred Loss Model) – Only if default is imminent.

 IFRS 9 (Expected Credit Loss Model) – 12-month or lifetime ECL.

Solution:

1. IAS 39: No provision (no evidence of default).

2. IFRS 9:

o 12-month ECL:

0.02×0.40×$2,000,000=$16,0000.02×0.40×$2,000,000=$16,000

o Lifetime ECL (if credit risk increases):

0.10×0.40×$2,000,000=$80,0000.10×0.40×$2,000,000=$80,000

Interpretation: IFRS 9 leads to earlier recognition of losses.

5. Credit Spread & Yield Compensation

Scenario:
A 5-year corporate bond has:

 Risk-free rate (Treasury yield): 3%

 Credit spread: 2.5%

Calculate the bond’s yield and interpret the spread.

Solution:

Yield=Risk Free Rate+Credit Spread=3%+2.5%=5.5%Yield=Risk Free Rate+Credit Spread=3%

+2.5%=5.5%

Interpretation: Investors demand an extra 2.5% for bearing credit risk.

Summary Table: Key Credit Risk Formulas

Concept Formula Application

Expected Loan loss

EL=PD×LGD×EADEL=PD×LGD×EAD
Loss (EL) provisioning

Unexpected loss
Credit VaR EL+Z×σEL+Z×σ
estimation

Risk-
RWA=Exposure×Risk WeightRWA=Exposure×Risk Weigh Basel III capital
Weighted
t requirements
Assets

Credit Pricing risky debt

Yield−Risk Free RateYield−Risk Free Rate
Spread instruments

Conclusion

These numericals illustrate how banks:

✔ Quantify expected and unexpected losses.
✔ Compute regulatory capital (RWA) under Basel III.
✔ Transition from incurred loss (IAS 39) to expected loss (IFRS 9).
✔ Price bonds using credit spreads.

Advanced extensions:

 Portfolio credit risk models (e.g., CreditMetrics, KMV).

 Stress testing credit portfolios under economic downturns.

1️⃣ What Is Credit Risk?

Credit risk = the risk that a borrower will not repay a loan or debt as promised.
👉 In simple words:
It’s the risk that someone you lend money to fails to pay you back.

2️⃣ Where Does Credit Risk Appear?

Institution/Activity Credit Risk Example

Banks Personal loans, mortgages, credit cards

Bond investors Company bonds → company may default

Suppliers Selling goods on credit → customer may not pay

Trade finance Import/export loans → buyer might default

Derivatives Counterparty may not meet obligations

3️⃣ Key Components of Credit Risk

Component Meaning

Probability of Default (PD) Likelihood borrower will default

Exposure at Default (EAD) How much is owed when default happens

Loss Given Default (LGD) % of loss after accounting for recoveries

👉 Together these are used to estimate Expected Loss.

4️⃣ Basic Numerical Example: Expected Loss

Formula:
Expected Loss = PD × EAD × LGD

Example:

 Probability of Default (PD) = 5% (0.05)

 Exposure at Default (EAD) = $1 million

 Loss Given Default (LGD) = 60% (0.60)

👉 Expected Loss = 0.05 × 1,000,000 × 0.60 = $30,000

👉 The bank expects an average $30k loss on this loan.

5️⃣ Measuring and Managing Credit Risk

a. Risk Assessment

 Credit scores (for individuals)

 Credit ratings (for companies, bonds)

 Financial analysis

 Collateral quality

b. Risk Mitigation

 Diversify portfolio

 Set lending limits

 Require collateral

 Use credit derivatives (e.g. Credit Default Swaps - CDS)

 Loan guarantees or insurance

c. Monitoring

 Regular review of borrowers' financial condition

 Track early warning signals (missed payments, falling revenues)

6️⃣ Tools & Regulations

Tool / Regulation Purpose

IFRS 9 Requires banks to use expected credit loss (ECL) model

Basel III / Basel IV Set capital requirements for credit risk

Credit Rating Agencies Provide independent ratings of bond issuers

7️⃣ Real-World Example

2008 Financial Crisis:
👉 Many banks underestimated the credit risk of subprime mortgage loans.
👉 When homeowners defaulted in large numbers, banks suffered huge losses.
👉 Lesson: Poor credit risk management can cause major financial crises.

Summary (In Easy Words):

👉 Credit risk is the risk that a borrower or counterparty won’t pay back debt.
👉 It appears in loans, bonds, trade credit, derivatives.
👉 Core components: PD, EAD, LGD → used to calculate Expected Loss.
👉 Example: 5% PD, $1M EAD, 60% LGD → Expected Loss = $30k.
👉 Managed by careful assessment, limits, diversification, monitoring.
👉 Good credit risk management protects institutions from big losses and ensures stability.

Topic 6 Market Risk

(With examples and simple numericals)

Market Risk: Definition

Market risk (also called systematic risk) is the potential for financial
losses due to adverse movements in market prices or rates. It affects all
investments and cannot be eliminated through diversification. Financial
institutions, corporations, and investors face market risk from:
  Equity prices (e.g., stock market crashes)
 Interest rates (e.g., rising rates hurting bond prices)
 Foreign exchange (FX) rates (e.g., currency depreciation)
 Commodity prices (e.g., oil price volatility)

Types of Market Risk

Type Description Example

Tech stock drops 20% due

Equity Risk Losses from stock price fluctuations.
to poor earnings.

Interest Rate Losses from changes in yield curves (e.g., bond 10-year Treasury yield
Risk prices fall when rates rise). spikes by 2%.

Losses from FX rate movements USD/EUR rate falls,

Currency Risk
(appreciation/depreciation). hurting exporters.

Commodity Oil prices drop 30%,

Losses from oil, gold, or agricultural price swings.
Risk hurting energy stocks.

Key Measures of Market Risk

1. Value at Risk (VaR)

o Estimates the maximum loss over a time horizon at a given

confidence level (e.g., 95%).
o Example: A 1-day 95% VaR of $1 million means there’s a 5%
chance of losing >$1M in a day.
2. Expected Shortfall (ES)
 o Measures the average loss beyond VaR (for extreme tail
risks).
3. Duration & Convexity (for interest rate risk)

o Duration estimates bond price sensitivity to rate changes.

o Example: A bond with duration of 5 years loses ~5% if rates rise
1%.
4. Beta (β) (for equity risk)

o Measures a stock’s volatility relative to the market (S&P 500).

Numerical Examples

1. Calculating VaR (Parametric Method)

A portfolio has:

 Value: $10 million

 Daily volatility (σ): 1.5%
 Confidence level: 99% (Z-score = 2.33)

Compute 1-day VaR.

VaR=Portfolio Value×Z×σ=$10M×2.33×0.015≈$349,500VaR=Portfolio Val

ue×Z×σ=$10M×2.33×0.015≈$349,500

Interpretation: There’s a 1% chance of losing >$349,500 in one day.

2. Interest Rate Risk (Duration Impact)

A bond portfolio has:

  Duration: 7 years
 Value: $5 million
 Interest rate increase: 0.5% (50 bps)

Estimate the loss.

ΔPrice≈−Duration×ΔRates×Value=−7×0.005×$5M=−
$175,000ΔPrice≈−Duration×ΔRates×Value=−7×0.005×$5M=−$175,000

Interpretation: A 0.5% rate hike causes a $175,000 loss.

3. Currency Risk (FX Exposure)

A U.S. firm expects €1M in revenue (EUR/USD rate = 1.10). If EUR

depreciates to 1.05:

Loss=€1M×(1.10−1.05)=$50,000Loss=€1M×(1.10−1.05)=$50,000

Interpretation: The firm earns $50K less due to FX moves.

Managing Market Risk

1. Hedging

o Use derivatives (e.g., futures, options, swaps) to offset risks.

o Example: An oil company hedges with futures to lock in prices.
2. Diversification

o Spread investments across uncorrelated assets (stocks, bonds,

commodities).
3. Stress Testing
 o Simulate extreme scenarios (e.g., 2008 crisis) to assess portfolio
resilience.
4. Regulatory Compliance

o Basel III’s Market Risk Framework requires banks to hold

capital against trading book risks.

Why Market Risk Matters

 Impacts investment portfolios, pension funds, and corporate

earnings.
 Can trigger liquidity crises (e.g., 2008 Lehman Brothers collapse).
 Central banks monitor it to ensure financial system stability.

Example: In 2022, the U.S. bond market lost ~15% due to aggressive
Fed rate hikes, the worst decline in history.

Conclusion

Market risk is unavoidable but manageable through quantitative models

(VaR, duration), hedging, and regulatory safeguards. It is critical for:
✔ Investors (asset allocation).
✔ Banks (trading book management).
✔ Corporations (FX/commodity exposure).

1. Portfolio Beta (β) and Systematic Risk

Scenario:
A $10M portfolio contains:
  Stock A: $6M, β=1.2
 Stock B: $4M, β=0.8
Market volatility (σₘ) = 18%

Calculate:

1. Portfolio beta
2. Portfolio systematic risk

Solution:

1. Portfolio β:

βp=6M10M×1.2+4M10M×0.8=1.04βp=10M6M×1.2+10M4M×0.8=1.04

2. Systematic Risk:
σp=βp×σm=1.04×18%=18.72%σp=βp×σm=1.04×18%=18.72%

Interpretation: The portfolio is 4% more volatile than the market.

2. Delta Hedging with Options

Scenario:
A bank holds:

 100,000 shares of XYZ stock ($50/share)

 Needs to hedge using put options with:

o Delta (Δ) = -0.4

o Contract size = 100 shares

Calculate number of put contracts needed for delta-neutral hedge.

Solution:
Contracts=Shares×Target DeltaOption Delta×Contract Size=100,000×1∣−0.4∣×1
00=2,500 contractsContracts=Option Delta×Contract SizeShares×Target Delta
=∣−0.4∣×100100,000×1=2,500 contracts

Interpretation: Requires 2,500 put contracts to offset the position's

directional risk.

3. Stress Testing (2008 Crisis Scenario)

Scenario:
A portfolio has:

 Current value: $20M

 Historical 2008 loss: -35%

Calculate stressed VaR and capital buffer (Basel III requires 3x VaR).

Solution:

1. Stress Loss:

$20M×35%=$7M$20M×35%=$7M

2. Capital Buffer:
3×$7M=$21M3×$7M=$21M

Interpretation: The bank must hold $21M capital to cover extreme losses.

4. Convexity Adjustment for Bonds

Scenario:
A bond has:

 Duration = 7 years
 Convexity = 60
 Yield change = +2% (200 bps)

Calculate price change using both duration and convexity.

Solution:

1. Duration Effect:

−7×2%=−14%−7×2%=−14%

2. Convexity Adjustment:
12×60×(0.02)2=+1.2%21×60×(0.02)2=+1.2%

3. Total Change:
−14%+1.2%=−12.8%−14%+1.2%=−12.8%

Key Insight: Convexity reduces duration-based errors for large rate moves.

Summary Table: Advanced Market Risk Formulas

Conce Applica
Formula
pt tion

Measure
s
Portfol market-
io Beta
βp=∑wiβiβp=∑wiβi relative
volatilit
y
Conce Applica
Formula
pt tion

Neutrali
Delta
Hedgin Contracts=Shares×ΔtargetOptionΔ×ContractSizeContracts= zing
OptionΔ×ContractSizeShares×Δtarget direction
g
al risk

Basel III
Stress Loss=Portfolio×Worst Historical DropLoss=Portfolio×Wor
capital
VaR st Historical Drop planning

Improve
Conve s bond
xity 12×Convexity×(Δy)221×Convexity×(Δy)2 price
Adj. estimate
s

Why These Matter

1. Portfolio β helps optimize asset allocation for target risk levels.

2. Delta hedging is key for options market-makers.
3. Stress tests reveal hidden vulnerabilities.
4. Convexity prevents under-pricing long-dated bonds.

1️⃣ What Is Market Risk?

Market risk = the risk of loss due to movements in market prices.

👉 In simple words:
If stock prices, interest rates, exchange rates, or commodity prices move against your position
→ you can lose money.

2️⃣ Main Types of Market Risk

Type of Market Risk Example

Equity risk (stock prices) Stock prices fall → loss on shareholding

Interest rate risk Interest rates rise → bond prices fall

Currency risk (FX risk) USD weakens → foreign earnings convert to less in USD

Commodity risk Oil prices drop → losses for oil producers

Volatility risk Large swings in markets → impact on options values

3️⃣ Who Faces Market Risk?

Institution/Player Exposure Example

Banks Trading desks hold stocks, bonds, derivatives

Asset managers Large portfolios of stocks and bonds

Corporates FX risk on international sales

Pension funds Market risk on equity and bond investments

Insurance companies Investment portfolios subject to market moves

4️⃣ Basic Numerical Example: Value at Risk (VaR)

VaR = a widely used measure of market risk.

It estimates the maximum expected loss over a certain time period at a given confidence level.

Formula:
VaR = Z × σ × √t × Portfolio Value

Example:

 Z = 1.65 (95% confidence)

 σ (volatility) = 2% (0.02)

 t = 1 day

 Portfolio Value = $50 million

👉 VaR = 1.65 × 0.02 × √1 × 50,000,000 = $1.65 million

👉 Meaning: The institution expects that on 95% of days, it won’t lose more than $1.65 million.

5️⃣ How Is Market Risk Managed?

Method Example

Diversification Spread investments across sectors & assets

Hedging Use options, futures, swaps to offset risks

Stop-loss limits Automatically sell if loss reaches a set level

Position limits Limit maximum position size in risky assets

Stress testing Simulate extreme market scenarios

6️⃣ Tools & Regulations

Tool / Regulation Purpose

Basel III / Basel IV Require capital for market risk in banks

Banks develop their own models to calculate market risk (VaR, stressed VaR,
Internal Models
etc.)

IFRS 7 Requires disclosure of market risk exposures

7️⃣ Real-World Example

1998 LTCM Crisis:

👉 Hedge fund Long-Term Capital Management had massive market risk exposures (especially to
interest rate changes).
👉 Unexpected market moves → huge losses → near collapse → required bailout.

👉 Lesson: Underestimating market risk can lead to systemic crises.

Summary (In Easy Words):

👉 Market risk is the risk of loss when market prices move unfavorably.
👉 Main types: equity, interest rate, currency, commodity, volatility risk.
👉 Example: Using VaR to estimate potential loss → 1-day VaR = $1.65M on $50M portfolio.
👉 Managed through diversification, hedging, limits, stress testing.
👉 Strong management of market risk is critical to financial stability.

Topic 8 Liquidity Risk

(With examples and simple numericals)

Liquidity Risk: Definition

Liquidity risk refers to the potential inability of a financial institution or

market participant to:

1. Meet short-term obligations (e.g., deposit withdrawals, loan

commitments) without incurring excessive losses (funding liquidity
risk).
2. Quickly buy/sell assets without causing significant price changes
(market liquidity risk).

It arises when cash inflows (from assets, borrowing, or sales) fail to match
outflows (liabilities, withdrawals, or collateral calls).

Types of Liquidity Risk

Type Description Example

Funding Inability to obtain cash to meet A bank faces mass deposit

Liquidity Risk obligations. withdrawals.

Market Inability to trade assets quickly at Selling corporate bonds during a

Liquidity Risk fair prices. crisis at steep discounts.

Asset Liquidity Illiquid assets cannot be converted Real estate holdings during a market
Risk to cash without loss. freeze.
Key Metrics to Measure Liquidity Risk

1. Liquidity Coverage Ratio (LCR)

o Measures high-quality liquid assets (HQLA) to cover 30-day net

cash outflows.
o Basel III requirement: ≥100%
o Formula:
LCR=HQLANet Cash Outflows (30-day stress scenario)×100
%LCR=Net Cash Outflows (30-day stress scenario)HQLA×100%

2. Net Stable Funding Ratio (NSFR)

o Ensures long-term stability by matching assets with stable

funding.
o Basel III requirement: ≥100%
o Formula:
NSFR=Available Stable FundingRequired Stable Funding×100%N
SFR=Required Stable FundingAvailable Stable Funding×100%

3. Bid-Ask Spread

o Widening spreads indicate declining market liquidity (e.g., for

stocks or bonds).

Numerical Examples

1. Liquidity Coverage Ratio (LCR) Calculation

Scenario:
A bank holds:
  HQLA: $50 million
 Net 30-day cash outflows: $40 million

Compute LCR and assess compliance.

LCR=$50M$40M×100%=125%LCR=$40M$50M×100%=125%

Interpretation: The bank meets Basel III’s LCR requirement (125% >
100%).

2. Funding Gap Analysis

Scenario:
A bank has:

 1-week cash inflows: $20 million

 1-week cash outflows: $30 million

Calculate the funding gap and liquidity shortfall.

Gap=$30M−$20M=$10MGap=$30M−$20M=$10M

Action: The bank must borrow $10M or sell assets to cover the gap.

3. Market Liquidity Risk (Forced Asset Sale)

Scenario:
A fund needs to sell $5 million of illiquid bonds. Normal bid-ask spread is 1%,
but during stress, it widens to 5%.

Compute the liquidation cost.

Loss=$5M×5%=$250,000Loss=$5M×5%=$250,000

Interpretation: The fund incurs a $250K loss due to poor market liquidity.

Causes of Liquidity Risk

 Maturity mismatch (e.g., borrowing short-term to lend long-term).

 Concentration risk (reliance on few funding sources).
 Market shocks (e.g., 2008 crisis, 2020 COVID-19 bond market
freeze).
 Regulatory changes (e.g., tighter capital rules reducing market-
making).

Managing Liquidity Risk

1. Hold HQLA (e.g., cash, Treasuries) to cover outflows.

2. Diversify funding sources (deposits, bonds, lines of credit).
3. Stress testing (simulate crisis scenarios like bank runs).
4. Contingency funding plans (CFPs) for emergencies.

Real-World Examples

 2008 Lehman Brothers collapse: Inability to roll over short-term

debt.
 2021 Archegos Capital meltdown: Illiquid positions triggered
margin calls.
  Bank runs (e.g., SVB 2023): Rapid withdrawals exhausted cash
reserves.

Why It Matters

 For banks: Liquidity crises can lead to insolvency (even with solvent
assets).
 For investors: Illiquid assets may trap capital during downturns.
 For regulators: Prevents systemic contagion (e.g., Basel III rules).

Conclusion

Liquidity risk is a silent threat that can escalate rapidly. Effective

management requires:
✔ Monitoring LCR/NSFR ratios
✔ Maintaining diversified funding
✔ Stress testing for extreme scenarios

Need more? I can provide:

 Detailed case studies (e.g., SVB collapse)

 Advanced liquidity stress-test models
 Interaction between liquidity and other risks (credit, market)

1️⃣ What Is Liquidity Risk?

Liquidity risk = the risk that an institution cannot meet its short-term financial obligations
when they come due — without selling assets at a loss or raising expensive funds.
👉 In simple words:
It’s the risk that a bank or company runs out of cash (or cash-like assets) when it needs to pay
bills, customers, or creditors.

2️⃣ Types of Liquidity Risk

Type Example

Funding liquidity risk Bank cannot raise enough cash to meet customer withdrawals

Bank holds assets (e.g. bonds), but can’t sell them quickly without big
Market liquidity risk
losses

Intraday liquidity
Bank cannot settle payments during the day due to timing issues
risk

3️⃣ Real-Life Examples

Situation Liquidity Risk Impact

Bank run Customers rush to withdraw deposits → bank may run out of liquid cash

2008 crisis Market froze → many banks couldn’t sell securities or raise cash

Corporate liquidity Company unable to refinance short-term debt → possible default

4️⃣ Basic Numerical Example: Liquidity Coverage Ratio (LCR)

Regulators require banks to maintain a Liquidity Coverage Ratio:

LCR = High-Quality Liquid Assets (HQLA) ÷ Total Net Cash Outflows (over 30 days)

👉 LCR must be ≥ 100%

Example:

 High-Quality Liquid Assets (HQLA) = $200 million

 Expected net cash outflows over 30 days = $150 million

👉 LCR = $200M ÷ $150M = 1.33 (or 133%)

👉 Bank meets the requirement.
👉 If LCR < 100%, bank is exposed to liquidity risk.

5️⃣ How Is Liquidity Risk Managed?

Management Tool Example

Holding liquid assets Cash, government bonds, central bank reserves

Liquidity gap analysis Project future cash inflows and outflows

Stress testing Simulate bank run or market crisis → test liquidity resilience

Diversified funding Use multiple sources: deposits, bonds, central bank facilities

Contingency funding plan Emergency plan to raise liquidity if needed

6️⃣ Key Ratios & Regulations

Ratio / Rule Purpose

LCR (Liquidity Coverage Ratio) Ensure banks can survive 30-day stress scenario

NSFR (Net Stable Funding Ratio) Ensure banks fund long-term assets with stable sources

Basel III liquidity rules Global standard for managing liquidity risk

7️⃣ Real-World Example

2008 Financial Crisis:

👉 Many banks (Lehman Brothers, etc.) had illiquid securities (mortgage-backed assets).
👉 When the market froze, they couldn’t sell these assets or borrow funds → liquidity crisis →
collapse.

👉 Lesson: Even if a bank is solvent (has positive net worth), it can fail due to lack of liquidity.

Summary (In Easy Words):

👉 Liquidity risk = risk of running out of cash when obligations come due.
👉 Main types: funding liquidity risk, market liquidity risk, intraday liquidity risk.
👉 Example: Liquidity Coverage Ratio (LCR) must be ≥ 100%.
👉 Managed by holding liquid assets, forecasting cash needs, stress testing, diversified funding.
👉 Example: In 2008, many banks failed not because they were insolvent, but because they
became illiquid.

Topic 9 Root Cause of the Global Financial Crisis & Corporate Governance
Reforms to Prevent the Next Failure in Risk Management
(With examples and plain language)

Root Causes of the 2008 Global Financial Crisis (GFC)

The 2008 financial crisis was triggered by a combination of financial

market excesses, regulatory failures, and poor corporate
governance. Key root causes include:

1. Excessive Risk-Taking & Leverage

 Subprime Mortgage Lending: Banks issued high-risk mortgages to

borrowers with poor credit, often with adjustable rates.
 Securitization (MBS/CDOs): These risky loans were repackaged into
complex securities (Mortgage-Backed Securities, Collateralized Debt
Obligations) and sold globally.
 High Leverage: Investment banks (e.g., Lehman Brothers) operated
with 30:1 leverage ratios, meaning a small drop in asset values
could wipe out capital.

2. Regulatory & Supervisory Failures

 Deregulation: The 1999 repeal of Glass-Steagall allowed

commercial banks to engage in risky investment activities.
 Shadow Banking System: Non-bank lenders (e.g., Bear Stearns)
operated outside traditional banking regulations.
  Rating Agency Conflicts: Agencies (Moody’s, S&P) gave AAA
ratings to toxic assets due to fee incentives.

3. Corporate Governance Failures

 Short-Term Incentives: Executives were rewarded for short-term

profits, ignoring long-term risks.
 Weak Risk Oversight: Many boards lacked expertise in complex
derivatives and systemic risk.
 "Too Big to Fail" (TBTF): Large banks took excessive risks, assuming
governments would bail them out.

4. Global Imbalances & Liquidity Crunch

 Cheap Credit from China & Fed: Low interest rates (2001–2004)
fueled a housing bubble.
 Liquidity Freeze (2007–2008): When defaults rose, banks stopped
lending to each other, causing a credit crunch.

Corporate Governance & Risk Management Reforms Post-

GFC

To prevent another crisis, regulators and firms implemented major reforms:

1. Strengthened Board Oversight

 Risk Committees: Boards must now have independent risk experts.

 Clawback Provisions: Executives can be forced to return bonuses if
risks lead to losses.
 Stricter Compensation Rules: Bonus caps and deferred pay to align
incentives with long-term stability.
2. Enhanced Regulatory Frameworks

 Dodd-Frank Act (2010, U.S.):

o Created the Financial Stability Oversight Council (FSOC).

o Introduced Volcker Rule banning proprietary trading by banks.
o Mandated stress tests (CCAR) for large banks.
 Basel III (2010–2023):

o Higher capital requirements (e.g., CET1 ratio ≥ 4.5%).

o Liquidity rules (LCR, NSFR) to prevent bank runs.
o Leverage ratio limits (3% min for banks).

3. Improved Risk Management Practices

 Living Wills: Banks must submit resolution plans for orderly failure.
 Central Clearing for Derivatives: Reduced counterparty risk in
swaps (via CCPs).
 Macroprudential Supervision: Regulators now monitor systemic
risks (e.g., housing bubbles).

4. Transparency & Accountability

 Enhanced Disclosures: Banks must detail risk exposures (e.g., IFRS 9

for credit losses).
 Whistleblower Protections: Encourages reporting of unethical
practices.

Effectiveness & Remaining Gaps

✅ Successes:
  Banks are better capitalized (Tier 1 capital ratios doubled since
2008).
 Fewer bank failures due to stress testing.
 Derivatives markets are more transparent.

⚠️Unresolved Risks:

 Shadow banking (e.g., hedge funds, private credit) is still

underregulated.
 Climate risk & cyber threats are emerging challenges.
 "Too Big to Fail" persists (e.g., Credit Suisse rescue, 2023).

Key Lessons for Future Risk Management

1. Avoid Complacency: Risks evolve (e.g., crypto, AI-driven trading).

2. Balance Innovation & Stability: Fintech and decentralized finance
(DeFi) need oversight.
3. Global Coordination: Crises spread across borders (e.g., 2023 SVB
collapse impacted EU banks).

Conclusion

The GFC was a systemic failure of governance, regulation, and risk

culture. While reforms have made the system more resilient, vigilance is
needed to address new risks in digital finance, climate change, and
geopolitical instability.

1. Leverage Ratio Calculation (Pre-GFC)

Scenario: Lehman Brothers had:

 Total assets: $691 billion

 Shareholder equity: $22 billion

Calculate leverage ratio:

text

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Leverage Ratio = Total Assets / Equity
= $691B / $22B ≈ 31.4:1

Interpretation: For every $1 of equity, Lehman had $31.4 in assets. A 3.2%

decline in asset values would wipe out all capital.

2. Capital Requirements Under Basel III

Scenario: A bank has:

 CET1 capital: $80 billion

 Risk-weighted assets: $1 trillion

Calculate CET1 ratio:

text

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CET1 Ratio = (CET1 Capital / RWA) × 100
= ($80B / $1T) × 100 = 8%

Basel III requirement: Must maintain ≥4.5% CET1 ratio. This bank meets
the requirement.

3. Liquidity Coverage Ratio (LCR)

Scenario: A bank holds:

 HQLA: $150 billion

 Net 30-day cash outflows: $120 billion
Calculate LCR:
text

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LCR = (HQLA / Net Cash Outflows) × 100
= ($150B / $120B) × 100 = 125%

Requirement: Must maintain ≥100% LCR. This bank is compliant.

4. Stress Test Loss Estimation

Scenario: A bank's loan portfolio:

 Total value: $500 billion

 Severe recession loss rate: 8%

Estimated stress losses:

text

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Stress Loss = $500B × 8% = $40 billion

Action: Bank must hold enough capital to absorb $40B in losses.

5. Mortgage-Backed Security (MBS) Loss

Scenario: An MBS pool:

 Original value: $100 million

 Default rate: 12%
 Recovery rate: 40%

Calculate loss:
text

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Loss = $100M × 12% × (1 - 40%)
= $100M × 0.12 × 0.60 = $7.2M
GFC Context: Many MBS had actual default rates of 20-30%, causing
massive losses.

6. Bonus Clawback Calculation

Scenario: An executive received:

 Bonus (2007): $5 million

 Clawback period: 5 years
 Crisis losses (2009): $500 million

Potential clawback: Up to 100% of bonus may be reclaimed.

7. Volcker Rule Proprietary Trading Limit

Scenario: A bank has:

 Tier 1 capital: $100 billion

 Permitted trading limit: 3% of Tier 1

Maximum trading exposure:

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$100B × 3% = $3 billion

These examples quantify how:

1. Excessive leverage amplified GFC losses

2. New regulations constrain risk-taking
3. Capital/liquidity rules make banks more resilient
4. Stress tests prepare for extreme scenarios

1️⃣ Background: What Was the Global Financial Crisis?

👉 The Global Financial Crisis (GFC) happened in 2007–2008.

👉 It caused:
  Massive bank failures (Lehman Brothers, etc.)

 Big drop in stock markets

 Recession in many countries

 Huge government bailouts

👉 It is seen as one of the worst financial crises since the Great Depression.

2️⃣ Root Causes of the Crisis

Cause Example

Housing bubble US home prices rose too fast → unsustainable

Subprime lending Banks gave mortgages to people with poor credit

Complex financial Mortgage-backed securities (MBS), CDOs (collateralized debt

products obligations) were not well understood

Excessive leverage Banks borrowed too much money to invest more

Poor risk management Banks underestimated credit risk and market risk

Rating agency failures Risky securities were rated AAA (safe) incorrectly

Weak corporate
Boards didn’t question risky strategies enough
governance

Regulatory gaps Lack of oversight on shadow banking system and derivatives markets

3️⃣ Example: How Poor Risk Management Played a Role

 Banks packaged risky home loans into MBS and CDOs.

 Many believed these products were safe → they were not.

 When US home prices started falling → mortgage defaults soared.

 The value of these complex products collapsed → banks took huge losses.

 Liquidity dried up → trust in financial system broke → panic.

4️⃣ Corporate Governance Failures

Weakness in Governance Impact

Board lacked financial expertise Didn’t understand the real risks of MBS, CDOs

Poor risk oversight Risk committees failed to act on warning signs

Executives focused on short-term profits, not long-term

Short-term incentives
stability

Weak internal controls Poor monitoring of leverage and off-balance-sheet risks

Lack of transparency Shareholders were unaware of the true risk exposure

5️⃣ Corporate Governance Reforms to Prevent the Next Failure

Reform Area Example of Good Practice

Board risk expertise Ensure board members understand finance and risk

Stronger risk committees Independent risk committees that actively monitor risks

Improved risk culture Encourage open discussion of risks at all levels

Link pay to long-term success Bonuses tied to long-term performance, not short-term gains

Enhanced disclosure More transparent reporting of risk exposures

Stress testing Regular stress tests to check resilience in crisis scenarios

Limits on leverage Boards set conservative leverage limits

Tighter regulation Follow Basel III/IV capital and liquidity rules; stronger supervision

6️⃣ Simple Numerical Example: Leverage

Before the crisis, many banks had leverage ratios of 30:1.

👉 For every $1 of capital, they borrowed $30.

👉 If asset value falls by just 3.3%, the bank’s capital is wiped out:

30 × 3.3% = 99% → near total capital loss!

👉 After the crisis, regulators forced banks to keep leverage at much safer levels (e.g. 10:1 or
less).

7️⃣ Summary (In Easy Words):

👉 The Global Financial Crisis happened due to risky lending, complex products, poor risk
management, and weak governance.
👉 Corporate governance failed — boards did not properly understand or oversee risks.
👉 Reforms since then include: better board expertise, stronger risk committees, better
transparency, limits on leverage, stronger regulation.
👉 Good corporate governance is essential to preventing another global financial crisis.

📌 1️⃣ Data Governance in Financial Risk Management

(Advanced)
Q1:
A bank is calculating expected credit loss on a loan portfolio:

 Segment A (corporate loans): $80 million, PD = 2%, LGD = 45%

 Segment B (retail mortgages): $50 million, PD = 1.2%, LGD = 25%
 Segment C (SME loans): $20 million, PD = 4%, LGD = 60%

However, poor data governance caused Segment C PD to be recorded as 2% instead of 4%.

👉 a) Calculate correct expected loss.

👉 b) Calculate incorrect expected loss.
👉 c) What is the impact of this data governance error?

Solution:

Correct EL:

 Segment A = 0.02 × 80M × 0.45 = $720,000

 Segment B = 0.012 × 50M × 0.25 = $150,000
 Segment C = 0.04 × 20M × 0.60 = $480,000
→ Total correct EL = $720k + $150k + $480k = $1,350,000

Incorrect EL:
  Segment C = 0.02 × 20M × 0.60 = $240,000
→ Total incorrect EL = $720k + $150k + $240k = $1,110,000

Impact: $240,000 underestimation of expected loss.

📌 2️⃣ Information Risk and Data Quality Control

(Advanced)
Q2:
A bank’s trading book has 3 positions:

 $40M in equity index futures (σ = 3%)

 $25M in government bonds (σ = 1.2%)
 $15M in FX forwards (σ = 2.5%)

Due to poor data quality, FX volatility was entered as 1% instead of 2.5%.

👉 a) Calculate correct VaR (95% confidence, Z = 1.65).

👉 b) Calculate VaR with incorrect volatility for FX.
👉 c) Impact of data quality error?

Solution:

Correct VaR:

 Equity = 1.65 × 0.03 × 40M = $1.98M

 Bonds = 1.65 × 0.012 × 25M = $495k
 FX = 1.65 × 0.025 × 15M = $618.75k
→ Total VaR ≈ √(1.98² + 0.495² + 0.61875²) ≈ $2.14M

Incorrect FX VaR:

 FX = 1.65 × 0.01 × 15M = $247.5k

→ Total VaR ≈ √(1.98² + 0.495² + 0.2475²) ≈ $2.06M

Impact: VaR understated by ≈ $80k → major risk if used for limit setting.

📌 3️⃣ Operational Risk (Advanced)

Q3:
An insurance company’s internal fraud events follow a Poisson distribution with λ = 2 per
year.
Loss per event follows a triangular distribution with min $50k, mode $150k, max $400k.

👉 a) Estimate expected number of events/year.

👉 b) Calculate expected loss per event.
👉 c) Calculate total expected annual operational loss.

Solution:

 Poisson λ = 2 → Expected number of events = 2/year.

 Triangular distribution expected value = (min + mode + max) ÷ 3 = ($50k + $150k +
$400k) ÷ 3 = $200k/event.
 Total expected annual loss = 2 × $200k = $400k/year.

📌 4️⃣ Risk Management in Financial Institutions (Advanced)

Q4:
A bank’s trading desk holds the following correlated assets:

 Asset A (σA = 2.5%), $60M

 Asset B (σB = 1.8%), $40M
 Correlation between A and B: 0.65

👉 a) Calculate total portfolio VaR at 99% confidence (Z = 2.33).

Solution:

VaR_A = 2.33 × 0.025 × 60M = $3.495M

VaR_B = 2.33 × 0.018 × 40M = $1.675M

Portfolio VaR = √(VaR_A² + VaR_B² + 2 × 0.65 × VaR_A × VaR_B)

= √(3.495² + 1.675² + 2 × 0.65 × 3.495 × 1.675)
≈ √(12.22 + 2.81 + 7.61) ≈ √22.64 ≈ $4.76M.

📌 5️⃣ Risks in Migrating to IFRS (Advanced)

Q5:
A bank migrating to IFRS 9 discovers that for a mortgage portfolio, prepayment risk affects
LGD.
  Original LGD = 30%
 After accounting for prepayments, adjusted LGD = 22%.
 PD = 1.2%, EAD = $120M.

👉 a) Calculate expected loss under original LGD.

👉 b) Calculate expected loss under adjusted LGD.

Solution:

Original EL = 0.012 × 120M × 0.30 = $432,000

Adjusted EL = 0.012 × 120M × 0.22 = $316,800

Impact: Provision reduced by $115,200 after migration.

📌 6️⃣ Credit Risk (Advanced)

Q6:
A bank has a portfolio of corporate bonds:

 AAA rated $30M, PD = 0.1%, LGD = 40%

 BBB rated $50M, PD = 1.5%, LGD = 55%
 B rated $20M, PD = 4%, LGD = 70%

👉 a) Calculate total expected loss on the portfolio.

Solution:

 AAA: 0.001 × 30M × 0.40 = $12,000

 BBB: 0.015 × 50M × 0.55 = $412,500
 B: 0.04 × 20M × 0.70 = $560,000

Total EL = $12k + $412.5k + $560k = $984,500.

📌 7️⃣ Market Risk (Advanced)

Q7:
A bank has a portfolio with 3 FX positions:

 EUR/USD $20M, σ = 1.8%

 GBP/USD $15M, σ = 2.2%
 JPY/USD $10M, σ = 1.5%
Correlations: EUR/GBP = 0.4, EUR/JPY = 0.2, GBP/JPY = 0.5.
Z = 1.65.

👉 Calculate portfolio VaR.

Solution:

VaR_EUR = 1.65 × 0.018 × 20M = $594k

VaR_GBP = 1.65 × 0.022 × 15M = $544.5k
VaR_JPY = 1.65 × 0.015 × 10M = $247.5k

Portfolio VaR² = 594² + 544.5² + 247.5²

 2 × 0.4 × 594 × 544.5

 2 × 0.2 × 594 × 247.5
 2 × 0.5 × 544.5 × 247.5

Portfolio VaR ≈ √(352,836 + 296,520.25 + 61,256.25 + 258,451.8 + 58,662 + 134,451.25)

≈ √1,162,177.55 ≈ $1.078M.

📌 8️⃣ Liquidity Risk (Advanced)

Q8:
A bank holds $500M HQLA.

 Day 1–10 outflows: $100M

 Day 11–20 outflows: $200M
 Day 21–30 outflows: $250M
 Total inflows allowed to be counted = $150M.

👉 a) Calculate net 30-day cash outflows.

👉 b) Calculate LCR.

Solution:

Total outflows = $100M + $200M + $250M = $550M.

Net outflows = $550M − $150M = $400M.
LCR = $500M ÷ $400M = 125% → Compliant.

📌 9️⃣ Root Cause of GFC & Governance (Advanced)

Q9:
A bank pre-crisis was leveraged 50:1 → capital = 2% of assets.
It had $1B in assets.
👉 a) How much loss would wipe out capital?
👉 b) If post-reform leverage is 12.5:1 → capital = 8% of assets → how much loss can it now
absorb?

Solution:

a) Loss threshold = 2% of $1B = $20M loss wipes out capital.

b) New threshold = 8% of $1B = $80M loss can be absorbed → 4x safer