Risk managers in finance define risk as “the uncertainty that has adverse consequences on earnings or wealth, or the uncertainty associated with negative outcomes only” (Bessis 2). This view of risk is also shared by regulators who are interested in maximizing the resiliency of financial organizations under stressed conditions that are associated with great variability of negative outcomes (Bessis 2). Risk managers aim to identify, assess, and control the uncertainty of these outcomes, thereby reducing the consequences of adverse developments for an organization.
From this point of view, risk can be regarded as the potential of financial loss that might occur as a result of the exposure to the uncertainty of outcomes. Even though it is not possible to eliminate the presence of such randomness, it can be quantified. The case in point is exposure to foreign exchange rates, which can be measured by the size of foreign currency revenues (Bessis 2). It is extremely important for banks to be able to quantify and manage their exposure to unexpected events and outcomes because they are providers of risk capital without each the real economy would not exist (Docherty and Viort 48). If banks are not able to properly predict and react to events that trigger losses society as a whole might be damaged.
The aim of this paper is to provide Mr. Chen, a chief executive of Bank A, with a report on the major types of risks faced by banks. The paper will also give an explanation of two specific types of risks and how international banking institutions are dealing with them in their daily operations.
Types of Risks in Banking
In terms of broad classes of financial risks faced by banks in their daily operations, they can be classified according to the sources of uncertainty. The broad classes of such risks are reputational risk, credit risk, operational risk, liquidity risk, market risk, business risk, and interest rate risk (Docherty and Viort 48). A more brief taxonomy of the risks facing banks includes three risks that require capital: credit risk, market risk, and operational risk (Docherty and Viort 48).
Reputational risk is “the possible loss of the organization’s reputational capital” (Aboli). It should be noted that it does not matter whether the reputational risk is perceived or real, in terms of the severity of the consequences for a bank. An example of severe consequences of the loss of the public’s trust is the case of Salomon Brothers that manipulated records in order to acquire government securities in quantities excessing legal limits (Perez).
Credit risk can be defined as “the potential that a bank borrower, or counterparty, will fail to meet its payment obligations regarding the terms agreed with the bank” (Perez). This type of risk encompasses the exposure to unexpected outcomes in terms of meeting obligations by a borrower and meeting them on time. An example of an incorrect assessment of credit risk is the subprime crisis, which has led to many banks across the world suffering substantial losses in the value of their loans (Perez).
Operational risk is described as the risk of financial loss that results from faulty internal processes as well as exposure to external events (Weidong 54). Legal risk is also encompassed by this definition of operational risk. The major sources of operational risks can be divided into three categories: people-related risks, information-technology risks, and process-related risks (Weidong 54). Operational risks are often recognized as the main reason for a bank’s collapse. They occur in all bank departments and are caused by inadequate internal control processes.
Interest Rate Risk
Interest rate risk is one of the major components of market risks and can be described as an event that triggers loss that is caused by unexpected fluctuations in interest rates. The risk is due to the fact that the assets of a banking institution have a maturity that is longer than that of its liabilities (Chen 21). Risk professionals refer to the management of this type of banking risk as asset-liability management (Chen 22).
Liquidity risk can be defined as the risk of a banking organization not being able to meet its payment obligations due to the lack of cash (Weidong 67). A liquidity shortfall can result in severe repercussions for a bank because it might damage its reputation and prices of its bonds in the money market. Therefore, both full-service banks and investment banks have to be especially careful with their provisions for adequate liquidity in order not to cause a bank run—a situation in which “depositors rush to pull out their money from a bank” (Weidong 67), thereby aggravating a shortage of cash.
Market risk is defined by the Basel Committee on Banking Supervision as “the risk of losses in on-or off-balance sheet positions that arise from movement in market prices” (qtd. in Perez). Investment banks such as Goldman Sachs, Morgan Stanley, and Bank of America among others are the organizations that are the most exposed to this type of risk due to the fact that the majority of their activities are conducted in capital markets. The major sources of market risk can be divided into three categories: equity risk, commodity risk, and foreign exchange risk (GARP 137). Equity risk is the potential loss that can be caused by a negative change in the stock price (GARP 137). The risk is pretty substantial because any adverse fluctuation in the stock price can result in either “a loss or diminution in investments’ value” (Perez). Foreign exchange risk is another potential loss that can be caused by an adverse change in the value of a banking institution’s assets triggered by fluctuations of exchange rates of foreign currencies. Commodity risk is the possibility of a financial loss caused by a negative change in prices of agricultural, industrial, or energy commodities. The rate of fluctuation of commodity prices is exceptionally high because of significant variations in demand and supply. Therefore, banking institutions that hold them know that the chances of financial loss are also high. Business Risk
Business risk can be defined as the risk that comes as a result of a long-term strategy of a banking institution (GARP 114). This type of risk is associated with a bank’s inability to transform its policies in order to survive in the ever-changing competitive environment. Banks can also lose their market shares by choosing the wrong competitive strategy. A case in point is the crisis of 2007-2008 (Perez). Cheap credits issued by banks during the 1990s and 2000s allowed them to earn supernormal profits; however, when the housing bubble popped in 2007, many banks experienced severe losses and were forced to close down (Perez). Bank failures are so common that in the period from 2009 to 2014, almost 500 American banks were closed (Perez). The majority of these failures were due to their inability to manage risks discussed above.
Credit Risk Management
Credit risk is the risk of financial loss that arises from the possibility that obligators such as borrowers and bond issuers will not meet their obligations (Hull 383). A common way of managing this type of risk is by “posting collateral and guarantees of third parties” (Bessis 202). Borrowers pledging assets as collateral turn the credit risk into another, less toxic type of risk—asset risk. When it comes to transactions involving derivatives, collateral takes the form of cash or marketable securities. In the case of default, such assets can be sold in order to use the proceeds from the transaction to make a partial or full repayment. The quality of assets used as collateral is commensurate with their liquidity: the more liquid they are, the higher their quality. Unfortunately, it is impossible to estimate what the liquidation value of the collateral will be at the time when it is sold due to a multitude of market variables (Bessis 202). Due to this uncertainty, the value of the collateral is always lower than its value at the time when credit was issued. The difference between the two values is called a haircut, and it is being used as risk mitigation against “the fluctuations of values of securities posted as collateral and against potential adverse price variations arising from the liquidation” (Bessis 203).
In the case when collateral is placed by a trader, it is called margin, and the process of borrowing is called buying on margin (Hull 383). Such margins are continuously monitored in order to track market movements. If the market value of a margin is reduced, a trader may receive a call requesting that the variation margin be posted (Hull 383). If a trader fails to provide an additional margin within a short period, their position is closed out. In order to manage risks related to buying on margin international banking institutions also apply haircuts to securities.
A third-party guarantee is another instrument of credit risk mitigation. Bessis defines such guarantees as “binding commitments to honor the debt payment obligation in the event of a default of the direct lender, similar to insurance given by the guarantor to the lender” (204). Third-party guarantees help banks to manage the risk of default because in case of an adverse event it is transferred to a guarantor who is no different than a borrower in its obligation to an institution. However, a third-party guarantee can only be valuable if the guarantor’s credit standing is higher than that of a borrower (Bessis 204). Taking into consideration the fact that the likelihood of both a guarantor and a borrower simultaneously defaulting on a loan is much lower than in the case of one entity borrowing, third party guarantees are considered a fairly reliable credit risk mitigation mechanism. It should be mentioned that joint default probability is lower when the mutual dependency of the two parties is also low. International banks use credit risk modeling instruments in order to calculate the likelihood of default, thereby determining whether a certain loan is riskier or safer (Bessis 204).
Interest Rate Risk
Interest rate risk is the risk that “arises from the mismatches of maturities or of interest rate sensitivities of assets and liabilities” (Bessis 43). This type of risk is difficult to manage because of the sensitivity of earnings to the movements of interest rates. This complication arises from the fact that there is a host of various interest rates that are not perfectly correlated when they change. Another complication associated with interest rate risk is that the interest rate environment cannot be described by a single variable; therefore, in order to manage this type of risk, international banks use a function of variation of the interest rate with maturity, which is referred to as the yield curve (Hull 175).
Interest rate risks also depend on the credit standing of lenders. Therefore, sovereign borrowers that are associated with the highest credit ratings fall into the category of risk-free rates. In order to mitigate interest rate risks, banks apply “a spread above risk-free rate” (Hull 176), which is referred to as a credit spread. It is related to the compensation of lenders for the risk of default and is measured by credit ratings and other variables.
Daily interest rate risk management procedures and practices include, but are not limited to, adequate management and board oversight, installation of proper policies, risk measurement and monitoring, and exercise of control functions through both internal and independent audits (GARP 139). The application of these management elements and oversight mechanisms depends on “the complexity and nature of holding and activities” (GARP 140) of an international banking institution and on the level of risk exposure. In the case of banking corporations, risk managers have to control this type of risk on a combined basis while recognizing legal and structural distinctions between affiliates and adjusting their control functions accordingly. It is a duty of senior management of an international banking institution to regularly review policies and procedures for measuring and controlling the risk.
Mr. A has been informed that in their daily operations banking institutions have to deal with the following major types of risks: reputational risk, credit risk, operational risk, liquidity risk, market risk, business risk, and interest rate risk. The report has also explicated to the bank executive the daily practices of international banks in mitigating credit and interest rate risks.
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