Private & Confidential

333-664 Risk Management and Regulation

333-664
Risk Management and
Regulation
 Private & Confidential
333-664 Risk Management and Regulation

Organisation
 Lecturer: Harald Scheule
 Office hours: Wednesday, 4pm
 Email: hscheule@unimelb.edu.au
 Frequently check website: www.lms.unimelb.edu.au

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Organisation (cont.)
 Prescribed Text: Hull, J.C., 2010, Risk Management and Financial
Institutions. Second Edition, Pearson Prentice-Hall, Upper Saddle
River, New Jersey.
 Recommended Text: Saunders, Anthony, and Marcia Millon Cornett,
2007, Financial Institutions Management: A Risk Management
Approach, 6th edition, McGraw-Hill/Irwin, New York.
 Assignment 1: 15%
Assignment 2: 15%
Final Exam: 70%

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Resources
 Web page: http://www.finance.unimelb.edu.au/index.cfm
 Staff
 Giblin Library
 For information on the regulation of Australian depository institutions
and investment firms visit APRA website: www.apra.gov.au
 For information on the regulation of the Australian financial system
visit Reserve Bank of Australia website: www.rba.gov.au
 For US information visit Federal Reserve website:
www.federalreserve.gov

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Subject Objectives
 Explain the risks arising from financial intermediation.
 Evaluate risk management and pricing practices in financial institutions.
 Describe the regulatory environment in which banks and other deposit taking
institutions operate.
 Compare international regulatory environments for banks and central bank
roles.
 Analyse the effects of regulation.
 Analyse the key components of a bank's financial statements.
 Describe the sources of market and credit risks for both financial and non-
financial firms.
 Analyse the products and mechanisms for hedging market and credit risks.
 Apply techniques for hedging financial risks.

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Lecture 1:
Introduction
Financial institutions
Financial products
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Introduction
Chapter 1 in Hull

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Risk vs. Return

 There is a positive relationship between risk and expected return
 Suppose Treasuries yield 5% and the returns for an equity investment are:

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 -10%
0.05 -30%

 For the equity investment: expected return = 10%, standard deviation of

return = 18.97%

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Efficient Frontier of Risky Investments

Efficient
Expected Frontier
Return

Investments

S.D. of Return

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Efficient Frontier of All Investments

Expected
Return

E ( RM )

Previous Efficient
Frontier

Rf New Efficient
Frontier

M S.D. of Return

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Systematic vs Non-systematic Risk

 We can calculate the best fit linear relationship between return from investment
and return from market

R    RM  
Systematic Risk Non-systematic risk
(non-diversifiable) (diversifiable)

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The Capital Asset Pricing Model

Expected
Return

E ( RM )
E ( R )  R f   [( E ( RM )  R f ]

Rf

1.0 Beta

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Bankruptcy Cost
 Lost sales: reluctance to buy from a bankrupt company
 Key employees leave
 Legal and accounting costs

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Regulation
 Capital is designed to provide protection against extreme events that
have a very low (e.g 0.1%) chance of occurring
 Regulators set minimum levels for the capital a bank is required to
keep
 Equity is an example of Tier 1 capital
 Subordinated long term debt is an example of Tier II capital

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Regulation

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Role of Financial Institutions

 Brokerage function: FIs bring borrowers and lenders together, e.g.,
mortgage brokers, investment banks
 Asset transformation: FIs change the nature of “funds” (your assets) in
terms of return, risk, maturity, liquidity or denomination
 Other services:
- Transmission of monetary policy (open market transactions, setting the
discount rate, setting reserve requirements)
- Credit allocation
- Intergenerational transfers or time intermediation.
- Payment services

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Regulation
 Safety and soundness regulation:
- Regulations to increase diversification: no more than 10 percent of equity
to single borrower
- Minimum capital requirements
- Monitoring and surveillance
 Monetary policy regulation
 Credit allocation regulation
 Consumer protection regulation
 Investor protection regulation
 Entry regulation

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Regulation

ACCC Australian Competitor and Consumer Commission

ASIC Australian Securities and Investment Commission

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Financial Institutions

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Classification of FIs
 In Australia, institutions are classified into one of three categories
- Authorised Deposit-taking Institutions (ADIs): banks, building societies
and credit unions
- Non-ADI financial Institutions: merchant banks, finance companies and
securitisers
- Funds managers and insurers: superannuation funds, insurance companies
and trusts

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Classification of FIs (cont.)

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World’s Largest Deposit-taking Institutions

Total Assets 2004
(US$ billions) Country

UBS 1,533 Switzerland

Citigroup 1,484 US
Mizuho Financial Group 1,296 Japan
HSBC Holding 1,277 UK
Credit Agricole Group 1,243 France

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Deposit Taking Institutions

 Australian Authorized Deposit-Taking Institutions (ADIs) are
authorised under the Banking Act 1959
- Banks
- Building societies
- Credit unions
 ADIs are subject to the same prudential standards but the use of the
names 'bank', 'building society' and 'credit union' are subject to
corporations meeting certain criteria

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Deposit Taking Institutions (cont.)

 54 Banks
 14 Building societies
 163 Credit unions
 Size in total assets:

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Deposit Taking Institutions (cont.)

 Banks:
- Known as “universal banks” and may supply retail and investment
banking services
- All banks must be licensed by APRA under the Banking Act, 1959
 Credit Unions:
- Must have a mutual structure
- Must engage predominantly in retail financial business
 Building Societies: must engage predominantly in housing finance

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Deposit Taking Institutions (cont.)

 54 banks across 3 categories
- Majors (5):
• ANZ
• Commonwealth Bank of Australia
• National Bank of Australia
• Westpac Banking Corporation
• St George
- Other domestic (9): e.g., Bendigo, Sunway
- Foreign Banks (40): e.g., Citibank, Deutsche Bank

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Lending
 Key operation in banking (next to deposit taking and asset/liability
management)
 Composition of loan portfolio is governed by bank’s strategic plan which is
influenced by factors such as
- Economic factors
- Competitor actions
- Regulation

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Lending (cont.)
 Average loan portfolio of US banks

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Lending (cont.)
 Average loan portfolio of US banks over time

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Risks in Banking
 Credit risk: Uncertainty that the borrower is unable or unwilling to
fulfill the terms promised under the loan contract
 Market risk: Uncertainty of value of the trading portfolio caused by
changes in market conditions
 Operational risk: Uncertainty of losses due to failure of systems and
processes
 Interest rate risk: Uncertainty of value of loans (assets) and deposits
(liabilities) caused by interest rate changes

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ADI Balance Sheet (cont.)

 Resident assets on Australian books (source: APRA)

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ADI Balance Sheet (cont.)

 Resident liabilities on Australian books (source: APRA)

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Example Westpac
 Source: Annual Report 2005

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Example Westpac (cont.)

 Source: Annual Report 2005

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Profit and Loss Statement

Net interest income (interest income – interest expense)
+ Fees
+ Capital gains (losses)
= Net operating income
- Operating costs
- Depreciation
= Operating profit
- Provisions
- Tax
= Net Profit

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Insurance Companies
 Life insurance
 Property and Casualty insurance

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World’s Largest Life Insurers

Revenues 2004
(US$ millions) Country

ING Group 88,102 Netherlands

AXA Group 62,051 France
Nippon Life Insurance 61,175 Japan
Assicurazioni Generali 55,105 Italy
Aviva 53,723 UK

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Life Insurance in Australia

 34 life insurance companies

 Source: www.apra.gov.au
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Life Insurance Products

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Life Insurance Products

 Annuities: reverse of life insurance activities
 Private pension funds: compete with other financial service companies
 Accident and health insurance: morbidity insurance

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Balance Sheet
 Long-term liabilities
- Net policy reserves to meet policyholders’ claims
 Long-term assets
- Need to generate competitive returns on savings components of life
insurance policies
- Bonds, equities, government securities
- Policy loans

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World’s Largest P & C Insurers

Revenues 2004
(US$ millions) Country

Allianz 74,178 Germany

American Int’l Group 44,637 US
Munich Re Group 41,974 Germany
State Farm Insurance 40,656 US
Berkshire Hathaway 39,962 US

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General Insurance in Australia

 131 private sector insurers

 Source: www.apra.gov.au
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Balance Sheet
 Similar to life insurance companies (smaller asset base)
 Major liabilities: loss reserves, loss adjustment expense and unearned
premiums.

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The Three Risks in Insurance

 Underwriting risk may result from
- Unexpected increases in loss rates (loss risk)
- Unexpected increases in expenses (expense risk)
- Unexpected decreases in investment yields or returns (return risk).
 Property versus liability:
- Losses from liability insurance less predictable. Example: claims due to
asbestos damage to workers’ health.

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Loss Risk
 Severity versus frequency:
- Loss rates more predictable on low-severity, high-frequency lines (such as
fire, auto, homeowners peril) than on high-severity, low-frequency lines
(such as earthquake, hurricane, financial guaranty).
- Claims in high-severity, low-frequency lines may not be independent.
- Higher uncertainty forces PC firms to invest in more short-term assets and
hold larger capital and reserves than life insurance firms.
 Long-tail risk exposure: arises where peril occurs during coverage
period but claim is made many years later.

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Catastrophes

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Performance Ratios in Insurance

Loss ratio 79.8 %
+ Expense ratio 27.9 %
= Combined ratio 107.7 %
+ Dividend ratio 2%
= Combined ratio after dividends 109.7 %
- Investment Yield 12 %
= Operating ratio 97.7 %

Overall profitability: 100% - Operating ratio 100 % - 97.7 %

= 2.3%

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Performance Ratios in Insurance (cont.)

 Premiums earned: premiums received and earned on insurance contract
because time has passed with no claim being made.
 Loss ratio: ratio that measures pure losses incurred to premiums
earned.
 Expense Ratio: ratio that measures expenses (loss adjustments,
commissions and other) to premiums earned.
 Combined Ratio:
- Overall underwriting profitability.
- Includes both loss and expense experience.
- If greater than 100 then premiums are insufficient to cover losses and
expenses.

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