Class 8 - risks

What is the fundamental relationship between uncertainty and risk in banking?

Uncertainty is inherent in banking as the industry operates under incomplete information and unpredictable environments.

Can risk be eliminated in banking?

No, risk cannot be eliminated

Why is risk-taking essential for banks?

Risk-taking is essential because without it, there would be no lending, no investment, and no financial intermediation.

List the main categories of Banking Risks mentioned in the slides.

Credit, Interest rate, Market, Liquidity, Foreign Exchange, Off-balance, Operational, Sovereign, and Insolvency risk.

What is the definition of Credit Risk?

Credit risk means that a claim may not be paid as expected (in full).

How can Credit Risk be split into different components?

Credit risk can be split into individual credit risk and portfolio credit risk.

What type of risk does a well-diversified loan portfolio primarily suffer from?

A well-diversified loan portfolio suffers from systematic risk.

What two types of risk does every single loan bear?

Every single loan bears both systematic and idiosyncratic risk.

What three Risk Inducing Behaviors challenge banking stability?

Herd behaviour, Adverse selection, and Moral hazard.

What risks are fueled by Herd Behaviour (depositors rush to withdraw because others are doing it)?

Herd behaviour fuels market & liquidity risks.

What type of risk is worsened by Adverse Selection?

Adverse selection worsens credit risk (banks end up lending to high-risk borrowers).

What risks are increased by Moral Hazard?

Moral hazard increases insolvency/systemic risk (creates incentives for excessive risk taking when losses can be shifted to taxpayers, etc.).

What can Risk Inducing Behaviors lead to in the market and banking system?

They can lead to asset bubbles (e.g., housing market pre-2008), bank runs, and incentives for excessive risk taking.

According to the BIS, what acts as an important safeguard to mitigate the moral hazard problem?

Effective supervision can act as an important safeguard to mitigate the moral hazard problem that accompanies government safety nets or deposit insurance system