CHAPTER 4

BANKING RISKS AND REGULATION

v

Banking Business Department

Banking Faculty – Banking Academy
 Expected learning outcomes
Upon completing this chapter, students will be able to:

- Describe the nature of risks and common risks in banking

- Analyze the rationale of banking regulation

- Classify different types of banking regulation

CONTENTS

4.1
BANKING RISKS
4.2

BANK REGUALTION
4.1.1 What is a “risk”?

• Risk is defined in financial terms as the chance that an outcome will

differ from an expected outcome.

Risk-return trade-off

• Risk in banking means risks that may reduce the probability of the
banks to reach its initial goals.

Risks potentially lead to losses to the bank

 Common risks in
banking

•Credit risk

• Interest rate risk

• Liquidity risk

• Foreign exchange risk

• Market risk

• Operational risk
4.1.2 Credit risk
• Credit risk is defined as ‘the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with agreed
terms (Casu, 2015)

• “If you don’t have some bad loan you are not in the business”

(P.Volker, Chủ tịch của US Federal Reserve System)

4.1.2 Credit risk

• Group discussion:

Causes of credit risks?

4.1.3 Interest rate risk

- Interest rate is a price that relates to present claims on resources

relative to future claims on resources.

- Interest rate risk is the risk associated with unexpected changes in

interest rates
 Example Interest rate

Asset
Refinancing risk
Liability
Liability average rate: 7%,
duration: 1year, asset average
income rate: 9%, duration: 2
years:

Articulate the in net income for

the bank for year 1, year 2.
Comment on the result.
 Example Interest rate

Asset
Reinvestment risk
Liability
Liability average rate: 7%,
duration: 2 year, asset average
income rate: 9%, duration: 1
years:

Articulate the in net income for

the bank for year 1, year 2.
Comment on the result.
4.1.4 Liquidity risk
• Liquidity risk is generated in the balance sheet by a mismatch
between the size and maturity of assets and liabilities. It is the risk that
the bank is holding insufficient liquid assets on its balance sheet and
thus is unable to meet requirements without impairment to its financial
or reputational capital (Casu, 2015)

• Liquidity assets can be quickly converted into cash with relatively low
costs
NORTHERN ROCK
Northern Rock’s bankruptcy in 2007 caused by
a liquidity crisis: the bank used short term
liabilities to invest in long term assets
4.1.6 Foreign exchange risk

• Foreign exchange risk is the risk that exchange rate fluctuations

affect the value of a bank’s assets, liabilities and off-balance-sheet
activities denominated in foreign currency (Casu, 2015)
4.1.6 Foreign exchange risk

• VCB assets denominated in USD

100bn, and liabilities denominated
in USD: 60bn

• Articulate the changes in income of

the bank if the exchange rate
between USD and NVND
increases/falls
4.1.7 Market risk

• Market risk is the risk of losses in on- and off-balance-sheet positions

arising from movements in market prices. It pertains in particular to
short-term trading in assets, liabilities and derivative products, and
relates to changes in market prices.
Market risk – an example

What will happen to the corporate bonds held in the bank’s trading book
if the market interest rate increases?
4.1.8 Operational risk

• Operational risk is the risk of loss resulting from inadequate or failed

internal processes, people and systems or from external events”.

(BCBS, 2001)
Operational risk

• Group discussion:

Give examples of
operational risks in banks,
discuss causes and
potential losses for the
bank.
4.1.7 Operational risk

Source: Casu et. al. (pp. 347, 2016)

4.2. Bank regulation
• 4.2.1. The rationale of regulation

• 4.2.2. Macro-prudential regulation

• 4.2.3. Micro-prudential regulation

• 4.2.4. Bank capital regulation

• 4.3. Limitation of regulation

Group discussion:

Why banks have to follow heavy regulation?

Financial systems are prone to periods of instability
4.2.1 The rationale for regulation
• Regulation relates to the setting of specific rules of behavior
that banks have to follow to ensure financial systemic
stability and protect consumer.

• To ensure systemic stability

• To provide smaller, retail clients with protection

• To protect consumers against monopolistic exploitation

4.2.2 Types of banking regulation

Macro- Micro-
prudential prudential
regulation regulation

Conduct of
business
regulation
 4.2.2 Types of banking regulation
Macro-prudential regulation
• Systemic (macro-prudential) regulation is the regulation that deals
with the safety and soundness of the financial system.

• This comprises public policy regulation designed to minimise the risk

of bank runs (the financial safety net).
 4.2.2 Types of banking regulation
Macro-prudential regulation

Deposit insurance
• A guarantee that all or part of the amount deposited by
savers in a bank will be paid in the event that a bank fails
The lender of last resort (LOLR)
• The central bank will provide funds to banks that are in
financial difficulty and are not able to access any other
credit channel.
 4.2.2 Types of banking regulation
Micro-prudential regulation
• Micro-prudential supervision checks that individual financial firms are
complying with financial regulation.

• Prudential regulation is mainly concerned with consumer protection.

It relates to the monitoring and supervision of financial institutions,
with particular attention paid to asset quality and capital adequacy.
 4.2.2 Types of banking regulation
Micro-prudential regulation
Conduct of business regulation focuses on how banks and other
financial institutions conduct their business to reduce the likelihood of:
• consumers receive bad advice (possible agency problem);

• contracts turn out to be different from what the customer was anticipating;

• fraud and misrepresentation take place;

• employees of financial intermediaries and financial advisors act incompetently;

• insider trading takes place;

• money laundering.
4.2.4. Bank capital regulation

• Banks are requested to hold capital against their risk portfolio

• A bank’s capital is vital for the protection of its depositors, and hence
for the maintenance of general confidence in its operations, and the
underpinning of its longer-term stability and growth

• Capital Adequacy Ratio - CAR

Q&A