Banking Risks & Risk Management Summary

Learning Outcomes

  • Outline types of risks faced by banks.

  • Explain key factors affecting credit and liquidity risk.

  • Discuss approaches to manage these risks.

Banking Risks

  • Potential threats to banks' daily operations include:

    • Credit risk

    • Operational risk

    • Market risk

  • Effective risk management is essential for financial performance and customer protection.

Main Types of Banking Risks

Principal Risks

  1. Credit Risk: Loss due to failure of borrowers to meet obligations.

  2. Market Risk: Loss from market variable fluctuations (interest rates, foreign exchange, etc.).

  3. Liquidity Risk: Inability to meet obligations as they come due.

  4. Capital Risk: Insufficient capital to support business and meet regulatory requirements.

  5. Operational Risk: Loss from inadequate or failed internal processes.

  6. Model Risk: Adverse impact from incorrect model outputs.

  7. Conduct Risk: Poor outcomes affecting customers.

  8. Reputation Risk: Loss of trust in the organization.

  9. Legal Risk: Loss from legal penalties or damages.

Risk Management Approaches

  • Credit Risk: Identification, evaluation, and monitoring by credit risk teams.

  • Market Risk: Managed using various assessment tools by market risk specialists.

  • Liquidity and Capital Risk: Managed by specialists; includes stress testing and monitoring.

  • Climate Risk: Assessed relative to business exposure to sustainability challenges.

Credit Risk

  • Definition: Possibility of borrower failing to meet obligations.

  • Common triggers include:

    • Poor credit assessment

    • Concentration risk in a single sector

    • Economic downturns affecting loan defaults.

  • Case Study: Lehman Brothers collapse exemplifies critical credit risk mismanagement.

Managing Credit Risk

  • Goals:

    • Maximize risk-adjusted returns within acceptable limits.

  • Strategies:

    • Risk identification (individual, portfolio-wide, macroeconomic risks).

    • Rigorous screening and continual monitoring of credit assessments.

    • Ratios to monitor credit risk exposures.

Capital Risk

  • Linked to credit risk; involves insolvency risks when assets fall below liabilities.

  • Management indicators include interest rate spreads and leverage ratios.

Liquidity Risk

  • Definition: Ability to meet financial obligations without incurring losses.

    • Day-to-day liquidity management and handling liquidity crises critical.

  • Sources of funding:

    • Deposits, asset sales, borrowings.

  • Case Study: Bank of Cyprus crisis illustrates severe liquidity failure.

Monitoring Liquidity Risk

  • Key ratios include:

    • Loans to deposits ratio

    • Liquid assets to total assets.

  • Strategies for managing liquidity:

    • Holding liquid assets, diversifying funding sources, and liquidity risk ratios.

Basel III Requirements

  • Liquidity Coverage Ratio (LCR): High-quality liquid assets against net cash outflows.

  • Net Stable Funding Ratio (NSFR): Measures stability of funding over a one-year horizon.

  • Both ratios should be 100% or above to ensure sufficient liquidity under stress conditions.

Recommended Readings

  • Chapter 12, Introduction to Banking by Barbara Casu et al.

  • Basel Committee Publications: Principles for Management of Credit Risk.