AT

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)