This document summarizes a presentation by Leonard Hugenholtz on financial risk management and its impact on decision making. Hugenholtz argues that financial risk, such as credit risk from a mortgage portfolio, has a greater impact on decision making than operational risk. He provides examples showing how losses from unexpected default rates and loss amounts can wipe out profits in a "bad year" for credit risk. However, operational risks from process failures are also important to manage. The key is that financial risks are willingly taken and can be transparently priced into products, while operational risks are minimized. Hugenholtz recommends that organizations improve risk management by defining risk appetite, implementing risk budgeting, and explicitly pricing risks.
9. Banks are funded with:
• Funding (liabilities)
• Capital (equity)
Bank use deposits to make loans:
• Short dated funding versus long dated assets
• Positive interest rate margin
Banking
10. Banks group loans in portfolios.
Example
• € 1 billion mortgage portfolio
• 5000 loans
• Average loan: € 200.000,-
Mortgages: Credit Risk
14. Pricing example; bad year
Mortgages (receive): 2.50%
Funding (pay): 1.00%
Default Rate: 5%
Loss Given Default: 50%
Mortgages: Credit Risk
1.50% Gross Margin
2.50% Realised Loss
-1.00% Net Margin
15. -1.00% on € 1 billion is a € 10 million loss.
This loss will be deducted from capital (equity)
Gross return on this capital is € 12.5 mln / year
Mortgages: Credit Risk
18. Like credit risk, operational risk is mandatory
Cover large events with capital (equity)
Events have a value threshold
Mortgages: Operational Risk
20. Risks are downside only
Probability of Default ≈ Risk Likelihood
Loss Given Default ≈ Risk Impact
Smaller events are fine, larger events are crippling
Comparison: Similarities
21. Comparison: Differences
Financial Risk
Taken willingly
Internal to the product
Transparently priced
Events are worse BAU
Operational Risk
Minimized
External to the process
Pricing unclear
Events differ from BAU