Question

1. (a) Discuss the main causes of illiquidity and insolvency in banking and discuss the relationship between them.
(b) Explain operational risk and market risk as it affects banks. Give examples.
(c) Explain credit risk as it affects banks and discuss the techniques banks can use to manage the moral hazard created by a credit risk exposure.

Answer 1

a) Illiquidity is the situation where the bank is not able to pay its all current obligations(unable to repay depositors amounts). Insolvency is the situation where a bank owes more than what it's own in total. Banks generally accept deposits from depositors and lend it to borrowers. The main reasons for Illiquidity are heavy demand for cash withdrawals from depositors, unable to collect loan payments from borrowers on time and non-maintenance of sufficient cash reserves. the main reasons for insolvency are the increase of bad debts, sub-standard assets from borrowers, improper credit risk assessment. the relationship between insolvency and illiquidity is that when bank give loans to depositors who will not pay, It causes illiquidity risk of realising the loans lent because of which money is not available with the bank to pay to depositors causing insolvency.

b) Operational risk in banks means risks which are purely arising out of the operations carried out in the bank. It arises from internal failure in carrying out operations. An example is that when a loan sanction manager does not carry out credit assessment properly it will give operational risk.

Market risk is the risk caused due to market factors. Examples are Inflation rate, Interest rate changes in the economy

c) Credit risk is the risk of default from borrowers. It is the risk that the bank is subjected to when borrowers failed to repay the loans taken which may lead to insolvency of the bank. To manage the moral hazard created by credit risk, Banks can create provision for bad debts regularly at a standard percentage to manage credit risk and it can enter into settlement arrangements with borrowers having high credit risk. Banks can continuously monitor the transactions and credit payment by borrowers and credit score in order to manage credit risk.

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