Question

Discuss and give examples of the following types of bank specific risks (Answers should explain the risks in terms of the banking sector):

1. a) Credit risk

2. b) Interest rate risk

3. c) Liquidity risk

4. d) Foreign exchange risk

5. e) Country (sovereign) risk

Answer 1

a) Credit risk: Credit risk is the risk that arises from the possibility of non-payment of loans by the borrowers. Although credit risk is largely defined as the risk of not receiving payments, banks also include the risk of delayed payments within this category. The moment a loan is made, a certain amount of money is appropriated to the provision account. Also, banks have started utilizing tools like structured finance to mitigate such risks. Securitization helps remove the concentrated risk from the bank’s books and diffuse it amongst the various investors in the capital markets. Credit derivatives like credit default swap have also come into existence to help banks survive in the event of a credit default.

b) Interest rate risk: Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s net worth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates.

c) Liquidity risk: Liquidity risk is another kind of risk that is inherent in the banking business. Liquidity risk is the risk that the bank will not be able to meet its obligations if the depositors come in to withdraw their money. This risk is inherent in the fractional reserve banking system. Therefore, in this system, only a percentage of the deposits received are held back as reserves, the rest are used to create loans. Therefore, if all the depositors of the institution came in to withdraw their money all at once, the bank would not have enough money. This situation is called a bank run.

d) Foreign exchange risk: The main source of forex risk is the bank’s open positions in individual currencies. An open position is a completely un-hedged exposure in a cur­rency. For example, if the bank has bought USD and sold INR, it is long USD and short INR – in effect it has a USD asset and INR liability.Thus, if the USD appreciates against the rupee, the bank gains, but if it depreciates, the bank loses. On the other hand, if the bank has sold USD and bought INR, it is exposed to the risk of USD appreciation. But banks generally hedge their positions as soon as they enter into a contract with the customer. Thus, this risk is fully hedged by bank in general.

e) Country (sovereign) risk: Country risk refers to the risk that a country won’t be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country.