Question

Discuss the main sources of risk in commercial banking, and critically discuss the Value-at-Risk (VaR) approach to risk measurement.

Answer 1

Main sources of Risks in Commercial banking : -

1. Credit Risk 2. Market Risk 3. Operational Risk. are risks in general in commercial banking. The sources for these risks are as follows;

• CREDIT RISK:Credit Risk arises when the borrower defaults to honor the repayment commitments on their debts. Such a risk arises as a result of adverse selection (screening) of applicants at the stage of acquisitions or due to a change in the financial capabilities of the borrower over the process of repayment.
• MARKET RISK:Market Risk includes the risk that arises for banks from fluctuation of the market variables like: Asset Prices, Price levels, Unemployment rate etc. This risk arises from both on-balance sheet as well as off-balance sheet items. This risk includes risk arising from macroeconomic factors such as sharp decline in asset prices and adverse stock market movements. Recessions and sudden adverse demand and supply shock also affect the delinquency rates of the borrowers. Market Risk includes a whole family of risk which includes: stock market risks, counterparty default risk, interest rate risk, liquidity risk, price level movements etc.
• OPERATIONAL RISK:Operational Risk arises from the operational inefficiencies of the human resources and business processes of an organization. Operational risk includes Fraud risks, bankruptcy risks, risks arising from cyber hacks etc. These risks are uncorrelated across the industries and is very organization specific. However, Operational risk excludes strategy risk and reputation risk.

Value At Risk :-

Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.

Value At Risk Measurement Approach: -

To compute Value at Risk, though there are numerous variations within each approach. The measure can be computed analytically by making assumptions about return distributions for market risks, and by using the variances in and covariances across these risks. It can also be estimated by running hypothetical portfolios through historical data or from Monte Carlo simulations. In this section, we describe and compare the approaches.