of Reserve Primary also demonstrated the effect of interconnectivity and contagion in financial markets (see next section). Reserve Primary had bought large amounts of bonds issued by Lehman Brothers. When Lehman declared bankruptcy, signaling that it would not be able to repay its investors, Reserve Primary knew that it would not be able to fully repay its own investors.
As international financial markets have become larger and more complex in recent decades, they have become interconnected, and the risk of contagion has increased (see Section 3.2.1). For example, a banking crisis in one country, or even problems within a single large institution, can lead to problems in other countries and other institutions. Although problems can arise as a result of direct financial relationships – for example, when the failure of Lehman Brothers led the Reserve Primary money market fund to announce that it would be unable to pay investors in full – they can also arise as a result of perceptions and fear rather than actual financial exposure and risk.
For example, when Thailand devalued its currency in mid-1997, banks and investors began withdrawing money not only from Thailand but also from other Southeast Asian countries. In the aftermath of the crisis questions were raised about the strength of these other Southeast Asian economies, but in most cases the withdrawal of investment funds from these countries and the currency crises that they suffered were triggered directly by investors' fear that what was happening in Thailand might also happen in neighboring countries. In effect, investors did not want to run the risk that other regional economies might be harboring the same problems that had appeared in Thailand, but when they took the initiative to reduce their exposure, they precipitated the very crisis that they were seeking to avoid.
As financial systems become more international (for example as a result of companies and banks in one region raising bonds and deposits from investors in other regions) and electronic payment systems become more sophisticated, the ability of banks and investors to move money quickly from one place to another is increasing. In turn, this increases the risk that problems in one region will spread quickly to others.
The global financial crisis discredited the approach, prevalent before the crisis, that banks and banking systems work best if regulation and supervision are kept to a minimum. (In the United Kingdom this approach was known as “light touch” regulation and supervision.) As a result, the years since the crisis have seen a large number of initiatives to extend the scope of financial regulation worldwide and to intensify the scrutiny imposed on banks. This new regulatory landscape will continue to govern how banks are run well after memories of the crisis have faded and the people who were running banks at the time have retired.
Efforts to reform the global financial system were initially led by the G20 group of developed market economies. Finance ministers and central bankers from the G20 countries set the agenda, defined the priorities for financial market reforms, and delegated specific tasks to more specialized bodies, such as the Basel Committee on Banking Supervision (whose work has included new capital and liquidity standards for banks) and the International Organization of Securities Commissions (IOSCO) (whose work has included new rules on how to trade financial instruments). The Financial Stability Board has also undertaken work on issues such as corporate governance and best practices for bankers' pay. Standard setters, such as the Basel Committee, do not have the power to enforce their recommendations. Their recommendations carry a lot of weight, because they have been drawn up by representatives from many countries after a lot of consultation, but to take effect they need to be incorporated into the laws and regulations of individual countries.
In the United States, many of the new standards governing financial activity were defined in the Dodd-Frank Wall Street Reform and Consumer Protection Act (named after the two congressmen who sponsored the legislation), although the process of writing the detailed rules is delegated to specialized agencies such as the Federal Reserve Bank and the Securities and Exchange Commission. In Europe, new standards have been adopted by the European Union and then transmitted down to the Union's member states through directives and regulations.
Acknowledgments
GARP's Foundations of Financial Risk has been developed under the auspices of the Banking Risk Committee of the GARP Risk Academy, who guided and reviewed the work of the contributing authors.
The committee and the authors thank Alastair Graham, Amanda Neff, Graeme Skelly, Christian Thornas, Mark Dougherty, and Editor, Andrew Cunningham, for their contributions to the 2015 revision. Foundations of Financial Risk builds upon a previously published book titled, Foundations of Banking Risk, co-authored by Richard Apostolik, Christopher Donohue and Peter Went. We would like to specifically acknowledge that Peter Went's work along with the Foundations of Banking Risk other co-authors provides a material basis for the Foundations of Financial Risk, and would like to thank Peter on his much appreciated contributions.
Introduction
This textbook, previously published in 2009 as the Foundations of Banking Risk has been revised, updated and expanded. GARP has renamed the book to reflect the additional content which includes a new chapter on insurance risk.
The role of risk management is becoming more important as banks, insurance firms, and supervisors around the world recognize that good risk management practices are vital, not only for the success of individual firms, but also for the safety and soundness of the financial system as a whole. As a result, the world's leading supervisors have developed regulations based on a number of "good practice" methodologies used in risk management. The banking regulations, outlined in the International Convergence of Capital Measurement and Capital Standards, known as the Basel Accord, and the insurance regulations, known as Solvency 2, codify such risk management practices.
The importance of these risk management methodologies as a basis for regulation is hard to overstate. The fact that they were developed with the support of the international financial community means that they have gained worldwide acceptance as the standards for risk management.
The implementation of risk-based regulation means that staff, as well as supervisors, will need to be educated and trained to recognize risks and how to implement risk management approaches. Consequently, GARP offers this program, the Foundations of Financial Risk, to provide staff with a basic understanding of banking, banking risks, insurance risks, regulation and supervision. This study text has been designed to assist students in preparing for the Foundations of Financial Risk assessment exam. It is presented in a user-friendly format to enable candidates to understand the key terms and concepts of the industries, and their risks and risk-based regulation.
This study text concentrates on the technical terms used in banking and risk management, while providing an insight to the similar risk in the insurance industry. These terms are defined either in the text or in the glossary. As the material is at the introductory level, candidates are not expected to have a detailed understanding of risk management or significant experience in banking. In this text, they will gain an understanding of the commonly used terms in the finance industry.
Each chapter contains a number of examples of actual financial events, as well as case study scenarios, diagrams, and tables aimed at explaining banking, banking risks, and risk-based regulations. This study text has adopted the standard codes used by banks throughout the world to identify currencies for the purposes of trading, settlement, and displaying of market prices. The codes, set by the International Organization for Standardization (ISO), avoid the confusion that could result as many currencies have similar names. For example, the text uses USD for the U.S. dollar, GBP for the British pound, EUR for the euro, and JPY for the Japanese yen.
CHAPTER 1
Functions and Forms of Banking
Chapter 1 introduces banks and the banking system: their roles in facilitating economic activity, and their relevant risks banks face. The three core banking functions – collecting deposits, arranging payments, and making loans – and their attendant risks are described. As this chapter intends to provide a foundation for the