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Corporate finance - mergers and acquisition underwriting and securitization Trading and sales Retail banking - private banking and card services Commercial banking
business lines may be grouped broadly under the following major heads
The banking book The trading book Off balance sheet exposure
Banking book
Banking book includes all advances deposits which usually arise from commercial and retail banking operations All assets and liabilities in the banking book are normally held until maturity and accrual system of accounting is applied on them
The banking book is mainly exposed to liquidity risk , interest rate risk, default or credit risk and operational risk
Trading book
The trading book includes all the assets that are
difference between market price and book value taken to profit and loss account.
Trading book mostly comprises of fixed income
securities, equities, foreign exchange holdings, commodities, derivatives etc. held by the bank on its own account.
nature, where banks issue guarantees, committed or back up credit lines or letters of credit etc.
Off Balance Sheet Exposures may become fund
interest rate risk, market risk, default or credit risk and operational risk.
Liquidity risk
Liquidity risk in banks arises from funding of long
term assets by short term liabilities thereby making the liabilities subject to rollover or refinancing risk.
Funding liquidity risk is the inability to obtain funds to
dimensions.
Funding risk - arises from the need to replace the net outflows due to unanticipated withdrawals / non renewal of deposits. Time risk - arises from the need to compensate for non receipt of expected inflow of funds i.e. performing assets turning into non performing assets. Call risk - arises due to crystallization of contingent liabilities.
or variations NIM (net interest margin), i.e. NII divided earning assets due to changes in interest rates.
assets and liabilities with a different principal amounts, maturity dates or repricing dates that is rollover rates.
Interest rate risk is broadly classified into mismatch or
gap risk, basis risk, net interest position risk embedded option risk, yield curve risk, price risk and reinvestment risk
Basis risk
The risk that the interest rate of different assets, liabilities and off balance sheet items may change in different magnitude is termed as basis risk. An example of basis risk would be say in rising interest rate scenario asset interest rate may rise in different magnitude than the interest rate on corresponding liability, creating variation in net interest income
Reinvestment risk
Uncertainty with the regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.
Market risk
Market risk is the risk of adverse deviation of a mark to market value of the trading portfolio due to market movements during the period required to liquidate the transaction. Market risk is the risk of adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities and currencies.
Market risk is also referred to as price risk. Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related.
The price risk is closely associated with trading book, which is created for making profits out of short term movements in interest rates.
Credit risk is defined as the potential of a bank borrower or counter party to fail to meet its obligation in accordance with the agreed term. For most banks, loans are the largest and most obvious source of credit risk.
This is a variant of credit risk and is related to non performance of the trading partners due to counter parties refusal and or inability to perform.
Country risk
This is also a type of credit risk where non performance by a borrower or a counter party arises due to constraints or restriction imposed by a country.
Here reason for non performance is an external factors on which the borrower or the counter party has no control.
Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. Operational risk includes transaction risk/fraud risk, communication risk, documentation risk, competence risk, model risk, cultural risk, external events risk, legal risks, regulatory risks, compliance risk, system risk etc.
Management of risk
Management of risks begins with identification. It is only after risks are identified and measured banks decide to
accept the risk or to accept the risk at reduced level by undertaking steps to mitigate the risk.
In addition pricing of the transaction should be in accordance
Risk identification Risk measurement Risk pricing Risk monitoring and control Risk mitigation
Risk Identification
Nearly all transactions undertaken would have one or
more of the major risk i.e. liquidity risk, interest rate risk, market risk, default or credit risk, and operational risk with their visibility in different dimensions.
Although all these risks are seen at the transaction
level, certain risks such as liquidity risk and interest rate risk are managed at the aggregate or portfolio level.
risk arising from individual transaction are taken note at transactional level as well as portfolio level.
Guidance for risk taking, therefore, at the transaction
associated with the risk taking at the transaction level and examining its impact on the portfolio and the capital requirement.
Risk content of a transaction is also instrumental in
pricing the exposure as risk adjusted return is the key driving force in management of banks.
Risk measurement
Risk management relies on quantitative
measures of risk.
The risk measures seek to capture variations
in earnings, market value, losses due to default etc (referred to as target variables), arising out of uncertainties associated with various risk elements.
Sensitivity captures deviation of a target variable due to unit movement of a single market parameter. E.g. change in market value due to 1% change in interest rate would be a sensitivity based measure.
Risk mitigation
Risk arise from uncertainties associated with the risk elements, risk reduction is achieved by adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is called risk mitigation. In banking a variety of financial instruments and number of techniques are used to mitigate risk. The techniques to mitigate different types of risk are different
Solutions
The banks senior management or board of
directors should, on a regular basis receive reports on banks risk profile and capital needs.
The banks conduct periodic reviews of its risk
concentrations, accuracy and completeness of data input into the banks assessment process and stress testing and analysis of assumption and inputs are all part of control and monitoring process.