STA 2322 Risk Management in Financial Institutions

What are the Major Risks for Banks?

Banking risks often stem from the inherent challenge of achieving perfect matching.

If banks could align their assets and liabilities perfectly, encompassing identical maturities,
interest rates, and currencies, the sole risk they would encounter would be credit risk.

However, achieving such precise matching is nearly impossible and, even, if possible, would
severely constrain the profit opportunities for banks.

Mismatching is a fundamental aspect of the banking business.

The moment the maturities of assets surpass those of liabilities, liquidity risk becomes a
concern. Likewise, when there are disparities in interest rate terms between items on either side
of the balance sheet, interest rate risk emerges.

Sovereign risk becomes a factor if the international components of each side of the balance
sheet are not matched by country.

It's important to note that many of these risks are interconnected.

Major risks for banks include credit, operational, market, and liquidity risk. Since banks are
exposed to a variety of risks, they have well-constructed risk management infrastructures and are
required to follow government regulations.

Why Do the Risks for Banks Matter?

Due to the large size of some banks, overexposure to risk can cause bank failure and impact
millions of people. By understanding the risks posed to banks, governments can set better
regulations to encourage prudent management and decision-making.

The ability of a bank to manage risk also affects investors’ decisions. Even if a bank can generate
large revenues, lack of risk management can lower profits due to losses on loans. Value investors
are more likely to invest in a bank that is able to provide profits and is not at an excessive risk of
losing money.

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Credit Risk
Credit risk is the biggest risk for banks. It occurs when borrowers or counterparties fail to meet
contractual obligations. An example is when borrowers default on a principal or interest payment
of a loan. Defaults can occur on mortgages, credit cards, and fixed income securities. Failure to
meet obligational contracts can also occur in areas such as derivatives and guarantees provided.

While banks cannot be fully protected from credit risk due to the nature of their business model,
they can lower their exposure in several ways. Since deterioration in an industry or issuer is often
unpredictable, banks lower their exposure through diversification.

By doing so, during a credit downturn, banks are less likely to be overexposed to a category with
large losses. To lower their risk exposure, they can loan money to people with good credit
histories, transact with high-quality counterparties, or own collateral to back up the loans.

In general, credit risk management for loans involves three main principles:

• selection

• limitation

• diversification.

First of all, selection means banks have to choose carefully those to whom they will lend money.
The processing of credit applications is conducted by credit officers or credit committees, and a
bank’s delegation rules specify responsibility for credit decisions.

Limitation refers to the way that banks set credit limits at various levels. Limit systems clearly
establish maximum amounts that can be lent to specific individuals or groups. Loans are also
classified by size and limitations are put on the proportion of large loans to total lending. Banks
also have to observe maximum risk assets to total assets and should hold a minimum proportion
of assets, such as cash and government securities, whose credit risk is negligible.

Credit management has to be diversified. Banks must spread their business over different types
of borrowers, different economic sectors and geographical regions, in order to avoid excessive
concentration of credit risk problems. Large banks therefore have an advantage in this respect.

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The long-standing existence of the above procedures within banks is insufficient to address all
credit risk problems. For example, the amount of a potential loss is uncertain since outstanding
balances at the time of default are not known in advance. The size of the commitment is not
sufficient to measure the risk, since there are both quantity and quality dimensions to consider.

Liquidity Risk
Liquidity risk refers to the ability of a bank to access cash to meet funding obligations.
Obligations include allowing customers to take out their deposits. The inability to provide cash
in a timely manner to customers can result in a snowball effect. If a bank delay providing cash
for a few of their customer for a day, other depositors may rush to take out their deposits as they
lose confidence in the bank. This further lowers the bank’s ability to provide funds and leads to a
bank run.

Reasons that bank face liquidity problems include over-reliance on short-term sources of funds,
having a balance sheet concentrated in illiquid assets, and loss of confidence in the bank on the
part of customers. Mismanagement of asset-liability duration can also cause funding difficulties.
This occurs when a bank has many short-term liabilities and not enough short-term assets.

Banks require liquidity for four major reasons:

• as a cushion to replace net outflows of funds

• in order to compensate for the non-receipt of expected inflows of funds
• as a source of funds when contingent liabilities fall due
• as a source of funds to undertake new transactions when desirable.
Liquidity risk relates to the eventuality that banks cannot fulfil one or more of these needs.
Banks must ensure that they have a satisfactory mix of various assets or liabilities to fulfil their
liquidity needs. The choice among the variety of sources of liquidity should depend on several
factors, including:

• Purpose of liquidity needed

• Access to liquidity markets
• Management strategy
• Costs and characteristics of the various liquidity sources
• Interest rate forecasts

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Seasonal liquidity requirements tend to be repetitive in extent, duration, and timing. Forecasts of
seasonal needs are usually based on past experience. On the other hand, liquidity requirements
relating to cyclical needs are much more unpredictable. Bought-in funds to provide liquidity
needs during booming economic cycles tend to be costly. Credit demands are high during such
periods, and liability sources tend to become expensive. Large banks with broad access to money
market sources have few problems during such periods, whereas smaller banks tend to rely on
their (less costly) non-bought-in liquid asset holdings.

The longer-term liquidity needs of banks are more complex than the aforementioned seasonal
and cyclical requirements. If loan growth exceeds deposit growth, banks must budget for longer-
term liquidity. Such net growth can be financed by selling liquid assets or purchasing funds. The
major problem with fulfilling such longer-term liquidity demands is that the supply of saleable
assets and the amount of borrowing permissible are limited. In addition, a bank should always
limit its use of bought-in liquidity, so as to have enough ‘borrowing capacity’ if future
unpredictable liquidity needs occur.

Liquidity risk is often an inevitable outcome of banking operations. Since a bank typically
collects deposits that are short term in nature and lends long term, the gap between maturities
leads to liquidity risk and a cost of liquidity. The bank’s liquidity situation can be captured by the
time profiles of the projected sources and uses of funds, and banks should manage liquidity gaps
within acceptable limits.

Regulations exist to lessen liquidity problems. They include a requirement for banks to hold
enough liquid assets to survive for a period of time even without the inflow of outside funds.

Interest Rate Risk

Interest rate risk pertains to the exposure of banks' profits to fluctuations in interest rates,
affecting assets and liabilities in different ways. Banks face this risk due to operating with
unmatched balance sheets. Strong beliefs among bankers regarding future interest rate
movements incentivize them to position the bank accordingly. When anticipating an interest rate
rise, assets become more interest-sensitive relative to liabilities, and vice versa for an expected
fall. Mixing assets and liabilities is a common practice to adjust exposures, and tools like
interest-margin variance analysis (IMVA) are employed to assess current and project future
exposures.

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The broader impact of interest rate changes on banks' risk exposure in the macro economy is a
significant concern for both bankers and regulators. Marked interest rate volatility in a monetary
environment may pose a threat to banking stability. As banks engage in maturity transformation,
unexpected and substantial market rate changes can lead to difficulties or even failures among
banks and financial institutions. Understanding these costs is crucial for evaluating policy
alternatives, and management must actively comprehend and manage the bank's exposure to
interest rate risk.

Given the increasing linkage of bank costs and revenues to market interest rates, determining the
net effects of interest rate changes on bank profits has become more complex. Bank interest rate
risk also involves changes in the balance sheet associated with the interest rate cycle. A bank
may alter its balance sheet volume and mix of earning assets to stabilize earnings in response to
significant profit variance linked to market interest rate changes. In a deregulated banking
environment, some effects may be initiated by the bank, while others may be external and
uncontrollable, adding to the complexity of interest rate risk.

To minimize interest rate exposure, banks employ the concept of matching, classifying assets and
liabilities based on their interest rates. The objective is to demonstrate how each side of the
bank's balance sheet relates to specific interest rates and how it is exposed to changes in market
rates. Perfect matching is unattainable due to unavoidable risks, acceptance of some risks to
accommodate clients, and uncertainty in banks' borrowing costs moving in step with market
rates. The interest rate gap serves as a standard measure, linking variations in interest margin to
fluctuations in interest rates and providing insight into a bank's exposure to interest rate risk.

Market Risk
Market risk pertains to the potential loss associated with adverse deviations in the value of the
trading portfolio, resulting from fluctuations in interest rates, equity prices, foreign exchange
rates, or commodity prices. This risk is particularly relevant when banks hold financial
instruments on the trading book or utilize equity as collateral, leading to increased exposure for
banks with larger and more active trading portfolios.

Market risk mostly occurs from a bank’s activities in capital markets. It is due to the
unpredictability of equity markets, commodity prices, interest rates, and credit spreads. Banks
are more exposed if they are heavily involved in investing in capital markets or sales and trading.

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A more specific definition of market risk is the risk of loss during the time required to affect a
transaction, known as the liquidation period. This risk is comprised of two components: volatility
and liquidity. Even within a relatively short liquidation period, deviations can be substantial in a
volatile market. Additionally, in markets with low transaction volumes, selling instruments may
be challenging without significant discounts. Beyond the liquidation period, the risk shifts to
potential deficiencies in monitoring the market portfolio, categorized as operational risk rather
than pure market risk.

Regulators emphasize the use of internally generated risk measurement models for assessing
market risk. The industry standard, the Value-at-Risk (VaR) model, calculates a VaR-based
capital charge, estimating the likely loss a bank might experience on its entire trading book. VaR
validity is evaluated through back testing, comparing actual daily trading gains or losses with the
estimated VaR over a specific period. Consistent underperformance compared to estimated VaR
raises concerns. Banks can measure specific risk using internal models or the standardized
approach, a risk-weighting process developed by the Basel Committee on Banking Supervision.
Some banks complement VaR estimates with stress tests, predicting losses under extreme
adverse market events.

The Value at Risk of a portfolio is defined as the maximum loss occurring within a given length
of time with a given small probability. VaR is widely adopted as the primary tool for risk
evaluation by large commercial banks, investment banks, insurance companies, and mutual
funds.

Three major approaches have been followed in the development of internal market risk models:

• Risk Metrics (or the variance/covariance approach)

• Historic or Back Simulation
• Monte Carlo Simulation
These approaches aid in assessing and managing market risk in various financial institutions,
providing valuable insights into potential losses and informing risk management strategies.

Operational Risk
Operational risk arises from deficiencies either at a technical level, such as in a bank's
information systems or risk measures, or at an organizational level, involving internal reporting,

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monitoring, and control systems. Technical operational risks manifest in various forms, including
errors in recording transactions, shortcomings in information systems, or the absence of adequate
tools for measuring risks. Basel Committee adopts a standard industry definition of operational
risk as 'the risk of direct or indirect loss resulting from inadequate or failed internal processes,
people, and systems or from external events.'

A crucial aspect of managing operational risk at the organizational level is ensuring the
separation of risk takers from risk controllers. This addresses a fundamental flaw exemplified by
the infamous case of Barings Bank, where a derivatives trader exploited the lack of separation,
leading to the bank's collapse. Risk takers, driven by the incentive to generate business and
profitability, should have their risk-taking activities controlled by a distinct unit within the bank.
Another vital principle involves formulating business rules that incentivize employees to disclose
risks rather than conceal them. This transparency is essential for effective risk management and
preventing potential catastrophic failures like the one witnessed at Barings Bank.