Sources of Risk
   Overview: Credit Risk
   Overview: Settlement Risk
   Overview: Market Risk
   Overview: Other Risks


Sources of Risk

Overview: Other Risks

Latest Update May 2000

Regulators recognise that there are other significant risks besides market, credit and settlement. The most important of these are:

  1. liquidity risk, which comes in two forms. Market liquidity risk arises when a firm is unable to conclude a large transaction in a particular instrument at anything near the current market price. Funding liquidity risk is defined as the inability to obtain funds to meet cashflow obligations.
  2. legal risk, which is the risk that a transaction proves unenforceable in law or because it has been inadequately documented; and
  3. operational risk, i.e. the risk of unexpected losses arising from deficiencies in a firm's management information, support and control systems and procedures.

Of the documents which are on-line on this service, the Basle Committee's "Risk Management Guidelines for Derivatives" (1994), is the best introduction to the three risks mentioned above. It describes each risk and suggests sound risk management practices for each risk type (as part of a robust internal control system.) Although the report concentrates on, say the operational risks of derivatives; its guidelines are just as relevant to the operational risks of other products, as they are to derivatives. For example, it states "With the complexity of derivatives products and the size and rapidity of transactions, it is essential that operational units be able to capture all relevant details of transactions, identify errors and process payments or move assets quickly and accurately. This requires a staff of sufficient size, knowledge and experience to support the volume and type of transactions generated by the business unit. Management should develop appropriate hiring practices and compensation plans to recruit and retain high calibre staff." The reader will appreciate the validity of this guideline for all products.

(1) Operational

One of the more comprehensive document to date on operational risk is Appendix 1, which accompanies the G-30 report entitled ,"Derivatives: Practices and Principles. (1993)" The on-line file just skims the surface of these risks; Appendix 1 delves into the details in clear, lucid prose. The sections of the Appendix most relevant to this key risk concept are: (a) Working Paper of the Systems, Operations, and Controls Subcommittee and (b) Working Paper of the Enforceability Subcommittee. The Appendix is available from the G-30.

Another is "Operational Risk Management" (1998) which summarises the findings of an operational risk working group of the Basle Committee. Several common themes emerged from their discussions with 30 banks. The most major were that virtually all banks assign primary responsibility for managing operational risk to the business line head, most banks were only in the early stages of developing an operational risk measurement and monitoring framework, and unlike market and credit risk, the risk factors that go into the measurement of operational risk are largely internal to a bank.

Six of the banks surveyed said that operational risk had a high potential impact in business lines with high volume, high turnover (transactions/time), high degree of structural change, and/or complex support systems. The most commonly identified risk factors in operational risk measurement are internal audit ratings, volume, turnover and complexity, and data on the quality of operations such as error rates, and income volatility. There is uncertainty about which of these factors are important because there is no evidence of a direct relationship between these risk factors and the size and frequency of losses. A few banks have established some form of operational risk limits, usually based on their measures of operational risk, or other exception reporting mechanisms to highlight potential problems. Several banks are also exploring the use of reinsurance, in some cases from captive subsidiaries, to cover operational losses.

No report illustrates better the dangers of operational risk than the Bank of England's report on the collapse of Barings. The "Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings" (1995) glaringly exposes the deficiencies in Barings' information and internal control systems, which allowed Nick Leeson to amass positions worth a notional US$27 billion (compared with the bank's capital of about $615 million.) The conclusion to the report states that this massive position was not noticed earlier because: (a) there was a complete lack of internal controls (b) there was a lack of segregation of Leeson's duties and (c) Leeson was not properly supervised. (See also "Not Just One Man", by Lillian Chew.)

Given that operational risk can and has caused many organisations to loose millions, it is not surprising that supervisors of financial institutions like the idea of capital to cover operational risks. The problem is designing an appropriate approach to calculate the capital charge necessary. The Technical Committee of IOSCO has put forward some ideas in "Methodologies for Determining Minimum Capital Standards for Internationally Active Securities Firms Which Permit the Use of Models Under Prescribed Conditions" (1998). The committee suggests an add-on based on key operational ratios, such as variability in earnings, turnover, staff turnover , error rates and technology costs. Another approach could be applying a base requirement reflecting the scale of the firm's activities (for example a percentage of fixed costs.)

(2) Liquidity

Liquidity (funding) risk played a major part in the collapse of Barings - indeed it was because Barings could not pay the margin calls of Leeson's futures positions on the Singapore International Monetary Exchange and the Osaka Stock Exchange that the 200-year old British bank collapsed. The liquidity demands made by Leeson were enormous - at the end of December 1994, the cumulative funding of Barings Futures (Singapore) by Barings London and Tokyo stood at US$354 million. In the first two months of 1995, this figure increased by $835 million to $1.2 billion. The fact that London dispatched $835 million to Singapore in a period of two months without asking any questions and without examining the implications on the firm's liquidity and capital base borders on the ridiculous, even impossible. But it did happen and the Barings case study shows that operational and liquidity risks can be the ruin of a venerated institution.

Market liquidity risk or the deterioration in liquidity in world bond markets is highlighted in "A Review of Financial Market Events in Autumn 1998" (1999) . The Committee on the Global Financial System, authors of the report, were asked to examine the market stresses of autumn 1998 into perspective, with special emphasis on understanding the suddeness of the deterioration in liquidity and elevation of risk-spreads. Market participants told the committee that drying up of liquidity took two forms - an unprecedented widening in bid-ask spreads and that markets became one-sided. Some respondents noted that even compulsory market-making was not sufficient to ensure the liquidity of a market: even in government bond markets, a number of market-makers withdrew from trading and did not ensure quotations and those who did, made prices only for on-the-run issues.

The report notes, "The deterioration of liquidity and widening of risk spreads were abetted by various market mechanisms that transmitted these developments to additional markets and amplified market dynamics. [One of these was] the failure to appreciate the role of market liquidity in risk management. The large positions that leverage allowed some firms to amass proved difficult to wind down in the general rush to safety. Essentially some firms' risk management planning neglected to envision the possibility that their own efforts to close out positions would worsen the terms they facedů.As liquidity dried up, hedging proved even more difficult, intensifying pressures in the few remaining liquid instruments."

One of the best papers on managing liquidity risks is "A Framework for Measuring and Managing Liquidity" (1992), wich describes the liquidity-management techniques used by large international banks, noting that a bank's liquidity policies and liquidity management approach are key elements of the institution's general business strategy. The framework for assessing and managing bank liquidity has three major dimensions: (a) measuring and managing net funding requirements (b) managing market access and (c) contingency planning for alternative scenarios.

Of these three dimensions, measuring and managing net funding requirements is the most important. The main elements of such a system are: (a) a maturity ladder of future cashflows over a series of specified time periods (b) an evaluation of the behaviour of cashflows under different conditions (c) familiarity with the assumptions underlying the cashflows regarding assets and liabilities as well as off-balance sheet activities.

The documents singled out so far look at the liquidity risk of a single institution (the micro-view). The macro-view of liquidity risk is linked to settlement risk - how an institution clears and settles its obligations within and across national boundaries affects its liquidity and that of its counterparties. A "Report on Netting Schemes (1989)" looks at the liquidity implications of netting arrangements. The authors of the report, the Payments Group of the G-10 countries, identified four specific issues pertaining to the global problems of liquidity risk. They are:

  1. the impact of netting, per se, on the liquidity risks of participants, in both bilateral and multilateral arrangements, and their correspondents;
  2. the role of the settlement agent in multilateral systems, and the allocation of liquidity risks between the settlement agent and the participants
  3. the cross-border implications of liquidity risk in offshore clearing arrangements, particularly the cross-border allocation of risks between the settlement agent and participants;
  4. the impact of centralised multi-currency clearing house arrangements on general market liquidity risk.

Another report on the macro-aspect of liquidity risks is the Committee on the Global Financial System's report titled, "Market Liquidity: Research Findings and Selected Policy Implications" (1999). The report looks at the determinants of market liquidity (in normal times and market shocks) and on how central banks and other public authorities influence them. It is important for central banks to study the determinants of market liquidity so they can use them more efficiently when conducting monetary policy.

The study divides the factors affecting market liquidity into three broad categories: product design, market microstructure, and the behaviour of market participants. It also suggests measures for enhancing market liquidity which include maintaining a competitive structure of trading, minimising the liquidity-impairing effects of taxation, increasing the transparency of trading information and the heterogeneity of market participants.

This same committee then issued its "Recommendations for the Design of Liquid Markets" (1999). To enhance market liquidity, its five recommendations are: (i) ensuring an appropriate distribution of maturities and issue frequency so as to establish large benchmarks at key maturities; (ii) minimising the liquidity-impairing cost of taxes; (iii) ensuring the transparency of foreign issuers, issue schedules and market price and trade information, with due attention being paid to the anonymity of market participants; (iv) ensuring safety and standardisation in trading and settlement practices; and (v) developing repo, futures and option markets.

(3) Legal

However netting may not be legally enforceable in all countries. The legal uncertainties surrounding netting arrangements (both bilateral and multilateral) in the event of bankruptcy is one of the major sources of legal risk facing financial institutions today. The legal risks of netting arrangements is covered in the "Report of the Committee on Interbank Netting Schemes of the Central Banks in the G-10 Countries" (1990), also known as the Lamfalussy report. The report recognises that the effectiveness of netting in reducing exposures depends on producing legally binding net exposures that will withstand any legal challenge. But this is not always achievable. For example, cross-border netting arrangements raise choice-of-law and conflict-of-law questions that cannot be easily resolved. Establishing a sound basis for the assertion of net exposures will, therefore, require thorough legal preparation by the participants in netting schemes and netting providers.

Other enforceability (legal) risks relate to documentation, the capacity of parties such as government entities and building societies to enter into transactions (ultra vires), collateral arrangements in bankruptcy and the legality of derivative transactions. The enforceability and netting risks of nine countries are analysed in Appendix 2, which accompanied the 1993 G-30 report. The nine countries are: Australia, Brazil, Canada, England, France, Germany, Japan, Singapore and United States. Appendix 2 is available from the G-30.

In its report on how to reduce systemic risk, the G-30 stresses the need for governments around the world to provide a reliable legal framework for international transactions. "Global Institutions, National Supervision and Systemic Risk" (1997) examines the potential for systemic risk arising from the gap between the global operations of financial institutions and markets and nationally-based systems of accounting, reporting, law and supervision. The enforceability of netting, collateral and derivatives contracts is cited as a cause of concern among many of the participants surveyed by the study. To reduce legal risks, the G-30 calls upon legislatures to strengthen laws regarding enforceability of netting, collateral contracts and speedy and sure insolvency procedures.

The G-30 realises that reducing the legal risks of netting, collateral and insolvency requires changes in national law which it admits is a protracted process. It therefore recommends that a careful evaluation of legal risk should be part of the overall risk control process and should provide an incentive, at the margin, to negotiate contracts in safer jurisdictions. It also suggests that legally risky transactions face a higher capital charge and more quickly exhaust credit limits. Carried to its logical conclusion, it argues "If this was perceived to restrict transactions on a particular exchange or in a particular country, this would create a constituency for change out of the exchanges, financial institutions, supervisors and finance ministries in the affected country."

"Financial Integrity Recommendations" (1995) looks at the legal issues facing participants and regulators of exchange-traded markets. It recommends that the bankruptcy (or other relevant) laws of each jurisdiction should provide for (or at least not prevent) the prompt close out of positions and/or transfer of customer positions and property from a defaulted broker/intermediary to another broker/intermediary. It also recommends that conflicting bankruptcy regimes be harmonised as much as possible so that customer/clearing house positions and property can be treated consistently.

Some of the legal issues customers must consider when entering into any relationship with a broker/intermediary are: (1) the broker/intermediary's right to close out the customer's account and liquidate positions, and the notice periods required for such actions; (2) the broker/intermediary's right to collect margin in excess of the clearinghouse requirements; (3) the customer's right to withdraw excess margin; (4) how the broker/intermediary manages the customer's property; (5) the customer's exposure to the failure of the clearinghouse and the clearing brokers selected by the broker/intermediary.

The operational, liquidity and legal risks facing a clearing house are clearly explained in "Clearing Arrangements for Exchange-Traded Derivatives" (1997). By substituting itself as a counterparty to its clearing members, the clearing house exposes itself to liquidity risks; it must fulfil its payment obligations to non-defaulting members on schedule, even if one or more members default. Indeed, it is particularly critical that a clearing house perform its obligations without delay so that questions about its solvency do not arise. The operational risk of clearing houses thus centres on its hardware, software and communications systems. Of particular concern is the breakdown of hardware that would impair the clearing house's ability to calculate money settlements, creating potential liquidity pressures for itself and clearing members. Clearing houses may face a variety of legal risks that have the potential to substantially increase losses from default, either by a clearing member or by a settlement bank. When a clearing member declares itself bankrupt, perhaps the most important legal risk is that the multilateral netting arrangement between clearing members and the clearing house would not be upheld under the national law. Clearing houses in many countries have been afforded special legislative protection to ensure that their netting is valid. Another significant potential source of risk is that bankruptcy administrators might challenge a clearing house's right to close out (or transfer) positions and liquidate (or transfer) a defaulting member's assets. Here again, national legislation often seeks to protect clearing houses from such challenges.

"Towards a Legal Framework for Clearing and Settlement in Emerging Markets" (1997) looks at the legal issues in developing automated clearing and settlement systems. A corner stone of such a system is establishing a central securities depository where securities are either 'dematerialised', i.e. there is no document which physically embodies the claim, or 'immobilised', i.e. they are immobilised in a depositor, which is the holder of record in the register. An investor can either appear as the named owner in the issuer's records (a direct holding system) or hold his securities through the accounts of financial intermediaries (indirect). The proper functioning of these systems depend on laws which define clearly the property interests and obligations and rights of the market participants. The laws in some emerging market countries have to be updated to define clearly property interests, to segregate assets properly and to protect the investors' assets and rights in the event of insolvency. Legal systems also need to be adapted to include provisions specifically designed for the pledging of interests in immobilised or dematerialised securities in a multi-tier holding environment to eliminate legal uncertainties and to ensure that a credit provider gets good collateral.

The growing use of collateral to reduce counterparty risk has been accompanied by an increase in legal risk. The primary legal risk associated with collateral is that the collateral agreement might not be enforceable. "OTC Derivatives: Settlement Procedures and Counterparty Risk Management" (1998) discusses the legal and liquidity risks of collateral and the steps financial institutions must take to reduce such risks. The recommended steps include the collateral taker conducting due diligence to ensure that the agreement constitutes a valid and binding agreement, determining which law governs the creation, perfection and priority of a security interest, whether the applicable law imposes any technical requirements that must be met to make the security interest enforceable, and determining whether it can enforce its security interest upon the provider's insolvency.

The report also warns that dealers might become more vulnerable to liquidity pressures with the growing use of collateral. Large changes in market prices could produce significant demands for collateral so that dealers must conduct stress tests to estimate potential demands for collateral and to ensure that they can meet these demands during periods of extreme market turbulence.

See also risk control and settlement risk

  • Report on Netting Schemes (1989)
  • Report of the Committee on Interbank Netting Schemes of the Central Banks in the G-10 Countries (1990)
  • A Framework for Measuring and Managing Liquidity (1992)
  • Derivatives: Practices and Principles. (1993)
  • Risk Management Guidelines for Derivatives (1994)
  • Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings (1995)
  • Financial Integrity Recommendations (1995)
  • The Year 2000: A Challenge for Financial Institutions and Bank Supervisors (1997)
  • Global Institutions, National Supervision and Systemic Risk (1997)
  • Towards a Legal Framework for Clearing and Settlement in Emerging Markets (1997)
  • OTC Derivatives: Settlement Procedures and Counterparty Risk Management (1998)
  • Market Liquidity: Research Findings and Selected Policy Implications (1999)
  • Operational Risk Management (1998)
  • Not Just One Man, by Lillian Chew

Updated May 2000


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