banking risks

Banking Risks Overview

• Types of banking risks:

  • Credit Risk

  • Market Risk

  • Interest Rate Risk

  • Liquidity or Funding Risk

  • Foreign Exchange Risk

  • Country and Sovereign Risk

  • Operational Risks

  • Other Risks

Bank Risk Management Process

1. Identification of Risks

• Risks arise from uncertainty due to factors like changes in interest rates, stock prices, or borrowers' ratings.

2. Measurement of Risks

• Assessing identified risks:

  • Expected Losses: Provision for loan losses.

  • Unexpected Losses: Deviation of realized outcomes from expected.

3. Management of Risks

• Bank management acts based on risk appetite and exposure to identified risks.

• Considerations include:

  • Regulatory Perspective

  • Shareholder Perspective

Credit Risk

• Defined as the potential for a borrower or counterparty to fail in meeting obligations as per agreed terms.

• Relates mainly to traditional lending, impacting all activities in the banking book (assets intended to be held to maturity, non-traded securities).

Key Sources

• Deterioration in borrower creditworthiness (migration to lower ratings, higher required spreads).

Relevant Factors for Credit Risk Models

• Probability of Default (PD): Likelihood of default within a year.

• Loss Given Default (LGD): Percentage of exposure lost in a default event.

• Expected losses are covered with Provisions for Loan Losses (PLL) and unexpected losses are covered by bank capital.

Traditional Measures of Credit Risk

• Total loans/total assets

• Non-Performing Loans (NPL)/total loans

• Loan losses/total loans

• Loan loss reserves/total assets

• Additional measures:

  • Loan concentration

  • Rapid loan growth

  • Market conditions

Market Risk

• Represents potential losses from movements in market prices affecting on- and off-balance sheet positions, mainly due to trading activities.

• Types:

  • General/Systematic Market Risk

  • Unsystematic Market Risk

• Measured using Value-at-Risk (VaR).

Interest Rate Risk

• Arises when changes in interest rates affect bank earnings or market value due to mismatches between:

  • Fixed-rate assets and liabilities

  • Rate-sensitive assets and liabilities

• Types include:

  • Refinancing Risk

  • Reinvestment Risk

Refinancing Risk

• Occurs when the bank’s assets and liabilities have different interest rate sensitivities, affecting profitability.

Reinvestment Risk

• Shifts in interest rates create risks linked to reinvesting earnings at lower rates.

Liquidity Risk

• Resulting from a mismatch between the size and maturity of assets and liabilities leading to an inability to meet financial obligations without impairments.

• Types:

  • Day-to-day liquidity risk

  • Liquidity crisis

Foreign Exchange Risk

• Fluctuations in exchange rates affect values of assets and liabilities in foreign currencies.

Country and Sovereign Risk

• Economic, social, and political conditions in foreign countries potentially affecting banks’ interests.

• Sovereign risk is related to governments' ability to meet debt obligations.

Operational Risk

• Defined as the risk of loss due to failures in internal processes, people, systems, or external events.

• Includes:

  • Internal and External fraud

  • Employment practices

  • Business disruption and system failures

  • Technology risks

Other Risk Categories

• Off-balance sheet risk

• Capital risk

• Counterparty risk

• Conduct risk

• Reputational risk

• Strategic risk

• Cyber Risk

Risk Management Strategies

• Risk Decomposition: Identifying and handling risks separately.

• Risk Aggregation: Reducing risks through diversification.

Managing Credit Risk

• Traditionally managed via risk aggregation.

• Importance of diversification to minimize exposure by spreading loans across various borrowers.

Effect of Diversification

• Reduces risk by lending to many borrowers across different sectors/regions.

• Systemic risks remain a concern as economic shifts affect default probabilities.

Mitigating Credit Risk

• Use of guarantees, derivatives for hedging, and insurance policies to reduce exposure and risk volatility.

Suggested Readings

• CGM: Chapter 11 (specific sections covering relevant topics from slides)