Banks and Bank Risks – Market Risk

Categories of Banking Risk

In banking and finance, the term 'risk' is generally associated with financial losses, but it
is more accurately described as uncertainty about the returns that will be earned on an
asset. It is an inherent part of a bank's business to bear certain risks in order to generate
returns for its shareholders.

Banks are exposed to a significant number of risks, which can be categorised into:

• credit risk
• operational risk
• liquidity risk
• market risk

How a bank defines these risks is important, as the definitions are the basis for both the
qualitative and quantitative assessment of the bank’s exposure to the risks. As a result,
the generally accepted definitions have been continually refined over the years, helped
in no small part by supervisory authorities imposing capital charges and related
requirements against these risks.

In this tutorial, we will focus on market risk.

Do You Know? - Asymmetry of Risks

Banks’ risk exposures are asymmetric. For example, in relation to credit risk, the upside
of an exposure is generally a small positive yield, whereas the downside can be a loss of
up to 100% of the exposure.

This perceived asymmetry in risks means that banks tend to focus on identifying and
managing the key risk drivers that are more likely to result in losses. For example, when
conducting stress tests of their portfolios, they focus on the negative aspects of an
exposure. In the case of:

• credit risk, stress tests focus more on economic recessions than recoveries
• equity prices, stress tests focus more on stock market crashes than booms
• interest rates, stress tests focus more on increases than decreases

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What Is Market Risk?
According to the Basel Committee on Banking Supervision (BCBS), market risk is the
risk of losses arising from movements in market prices. Changes in market prices can
adversely affect the value of both on- and off-balance sheet positions and in both
banking and trading book positions.

These movements can occur in:

• interest rates
• foreign exchange (FX) rates
• equity prices
• commodity prices

Do You Know? - Banking Versus Trading Books

All of a bank’s assets, liabilities and off-balance sheet positions can be classified either
as banking book or trading book positions. In a broad sense, positions in the banking
book, which include loans and deposits, are generally intended to be held to maturity.
From an accounting perspective, most banking book positions in most banks are not
marked to market but carried at historical cost.

Positions in the trading book, on the other hand, are generally held with the intent to
trade and generate profits from movements in market prices. They are typically held for
a short time, amounting to days rather than weeks or months. Banks must determine the
fair value of their trading book positions daily, with the difference in valuation flowing
through their profit and loss accounts.

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Interest Rate Risk
Interest rate risk (IRR), the exposure of a bank's financial condition to adverse
movements in interest rates, is a particularly important form of market risk. This is
because many on- and off-balance sheet items, such as loans, deposits and interest
rate derivatives, generate cash flows that are interest-rate sensitive. Like other types of
market risk, IRR arises from both market-related and idiosyncratic factors.

Market-related

The value of a particular instrument can rise and fall broadly in line with changes in the
value of other similar instruments because of developments in the market as a whole,
such as shifts in the yield curve.

Also known as the term structure of interest rates, a yield curve is a graph that shows
the relationship between the yield on fixed-income instruments of the same credit
quality, but with different maturities. Yield curves are generally upward sloping, indicating
that long-term rates are higher than short-term rates.

Idiosyncratic

The value of an instrument can move more or less than the general market, for example,
due to the relative creditworthiness of an issuer (this aspect of market risk is known as
credit spread risk).

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IRR Sub-types
Let’s take a closer look at the main sub-types of IRR.

Gap Risk

In most banks, the main sub-type of IRR arises from the term structure of interest rates
and describes the risk arising from timing differences in the maturity (for fixed rate) and
repricing (for floating rate) of a bank’s positions. Widely known as gap risk, it is also
referred to as repricing risk and yield curve risk.

The extent of gap risk depends on whether changes to the term structure of interest
rates occur consistently across the yield curve (referred to as parallel risk because the
yield curve retains its original shape but simply moves up or down) or differentially by
period (referred to as non-parallel risk because it involves changes in the slope or shape
of the yield curve). While such repricing mismatches are fundamental to the business of
banking, they can have an adverse effect on a bank’s income and economic value.

For example, consider a long-term, fixed-rate loan funded by short-term deposits whose
interest expense has risen due to an increase in interest rates since the loan was drawn
down. All other things being equal, the bank’s net interest income will be lower since
interest income from the loan remains the same, but interest expenses have risen as the
bank must pay higher interest on the deposits.

Basis Risk

Basis risk describes the impact of relative changes in interest rates for financial
instruments that have similar tenors but are priced using different interest rate indices
(for example, London Interbank Offered Rate (Libor), Euro Interbank Offered Rate
(Euribor) and prime).

For example, consider a one-year loan that reprices monthly based on the one-month
US Treasury Bill rate, funded by a one-year deposit that reprices monthly based on one-
month Libor. This funding strategy exposes the bank to the risk that the spread between
the two index rates may change unexpectedly.

Option Risk

Option risk arises from option derivative positions or from optional elements embedded
in a bank’s assets, liabilities or off-balance sheet instruments, where the bank or its
customer can alter the level and timing of its cash flows. The IRR from embedded
options can be particularly difficult for banks to assess because there can be factors
other than changes in interest rates (such as customer behaviour) that determine
whether the option is exercised.

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For example, interest rate options can be standalone instruments, such as exchange-
traded interest rate options contracts, or they can be features embedded within
otherwise standard instruments. The latter include:

• bonds and notes with call (the right of the issuer to redeem, or buy back, the
instrument before its maturity) or put provisions (the right of the holder to sell the
instrument back to the issuer prior to maturity)
• loans that give borrowers the right to prepay a larger amount or earlier than
contractually agreed
• term deposits that give depositors the right to withdraw funds prior to maturity

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IRR and Sensitivity
In practice, any asset, liability and off-balance sheet instrument whose price is wholly or
partly determined by interest rates is subject to IRR. Some instruments, however, are
more sensitive to interest rate movements than others.

Consider the following examples:

• Fixed-rate instruments, such as government bonds and certificates of deposit

(CDs), respond to changes in interest rates by an adjustment in price. For a given
change in market rates, the degree of price movement is determined by the
maturity, coupon and credit rating of the instrument. All else being equal,
instruments with a lower coupon, longer maturity and lower credit rating tend to
be more sensitive to interest rates.
• Floating rate instruments are less sensitive than fixed-rate instruments, as their
interest rates can be adjusted at interest repricing dates in response to changes
in the relevant interest rate index.
• Core deposits where the interest rate is not adjusted when interest rates change
are even less sensitive.

Core Deposits
Core deposits are deposits that tend to remain with a bank and are unlikely to reprice when market
interest rates change, even when the change in rates is significant.

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Managing IRR
Like other forms of market risk, IRR arises in both trading and banking books. As it can
be an important source of profitability and shareholder value for a bank, managing IRR
is an essential role for a bank's treasury function.

If not managed properly, excessive IRR can reduce a bank's future earnings, pose a
significant threat to its liquidity and capital position and, ultimately, jeopardise its
solvency. This is because changes in interest rates affect:

• a bank's earnings by changing its net interest income and the level of its other
interest-sensitive income and expenses
• the underlying value of a bank's assets, liabilities and off-balance sheet
instruments – and hence, the bank’s economic value – because both the present
value and timing of future cash flows can change when interest rates change

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Foreign Exchange Risk
Foreign exchange (FX) or currency risk is another form of market risk. It refers to the risk
that unanticipated exchange rate fluctuations will adversely impact the value of a bank's
on- or off-balance sheet positions. It can occur in both trading and lending activities.

FX risk arises from spot FX transactions, forward FX positions and future income or
expenses denominated in foreign currencies. For example, FX risk can arise when a
bank makes a loan denominated in foreign currency.

The global FX market is huge. Daily turnover averaged USD 5.1 trillion in April 2016,
with spot transactions accounting for USD 1.7 trillion of the total and forward
transactions accounting for the remaining two thirds.

Spot FX Transactions
A spot FX transaction is settled ‘on the spot’, as opposed to on a set date in the future. It involves the
exchange of one currency against another at an agreed rate, called the spot rate.

Spot FX transactions involving most currencies settle in two working days (an FX transaction ‘settles’
when the currencies are actually exchanged). For example, a spot transaction done on Monday will
settle on Wednesday, and a spot trade done on Friday will settle on Tuesday.

Forward FX Positions
A forward FX position is created when two counterparties enter into a contractual agreement to
exchange currencies at a specified rate for settlement on a future date that is generally more than two
days from the transaction date. For example, a forward trade dealt today could have a settlement (or
value) date of one month from today. Other common forward dealing periods, referred to as standard
or fixed periods, are two months, three months, six months, nine months and one year.

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What Is Equity Risk?
Equity risk is the potential for losses in on- and off-balance sheet positions arising from
adverse changes in equity prices. Like IRR, equity risk can also arise from both market-
related and idiosyncratic factors.

The risk of holding any stock is directly related to the possible changes in its price.
Idiosyncratic risk can be reduced by diversification. The effectiveness of diversification in
reducing portfolio risk very much depends on the degree of correlation between the
stocks in a portfolio.

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Equity Risk – Example
To illustrate how equity risk works, take a look at the following chart depicting share
price movements for two different stocks. In your view, which of the stocks has the
greatest equity risk, Stock A or Stock B?

Clearly, Stock B is the more volatile, so its risk is greater. Volatility, however, measures
the degree to which the price of a stock (or any other financial instrument) increases or
decreases over a given period of time. Market participants tend to be more concerned
with volatility during periods of falling prices, which is a function of the asymmetry of
risks. Therefore, although it may be a riskier investment, Stock B also offers the better
potential upside.

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Commodity Risk
Finally, we will look at commodity risk.

What Is a Commodity?

A commodity is a physical product that is traded on a secondary market. Commodities

are raw or partly refined materials that are typically classified under general headings,
such as:

• grains (for example, wheat, corn and soybean)

• softs (for example, coffee, sugar and cocoa)
• meats (for example, cattle and pork bellies)
• metals (for example, gold, silver and copper)
• power and energy (for example, natural gas and crude oil)

What Is Commodity Risk?

Commodity risk is the risk that on- or off-balance sheet positions will be adversely
affected by movements in commodity prices.

For spot or physical trading of commodities, the main consideration is directional risk –
the risk that a commodity's spot price will increase or decrease. Banks that trade
commodities forward, future or derivatives contracts are exposed to a number of
additional risks, including:

• basis risk – the possibility of losses as a result of adverse changes in the

relationship between prices of similar commodities
• IRR – in this context, increases in the cost of financing forward commodity
positions
• forward gap risk – the risk that the forward price of a commodity may change for
reasons other than a change in interest rates

In addition, banks may face counterparty credit risk on over-the-counter derivatives and
the funding of commodities’ positions may well open a bank to FX exposure.

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Review Question
A bank has extended a variable rate, five-year loan of USD 1 million to a customer,
priced off six-month Libor. The bank funds the loan with a six-month deposit.

What will happen to the bank’s profit margin on the loan if interest rates rise one
year after the loan is advanced?

• The profit margin will increase.

• The profit margin will decrease.
• The profit margin will not change. (correct answer)

Whatever happens to interest rates, any profit margin that the bank expects to make is
secure. Provided the bank continues to hedge its IRR every time the loan is repriced by
accepting a fresh six-month deposit, then changing levels of interest rates will have no
effect on the bank's profitability. However, if the bank instead raised a one-month
deposit, it would have a mismatch between one and six months as it could not be certain
that it would be able to raise deposits in one month's time at a rate resulting in the same
spread as that currently being earned on the loan.

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