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) Liquidity is related to a problem when bank is facing difficulty in meeting it's short term obligations. Illiquidity arises when the banks assets are tied in long term loans and it is facing to meet it's obligations (deposits) on temporary basis. Therefore, banks borrow short-term money from the money market to meet it's short-term obligations.

Insolvency means that bank's assets are not enough to meet it's liabilities. Insolveny problem arises when the mortgages or long-term loan provided by banks gets default. Default can be due to inabilty of a borrower to repay it's loan to bank. Thus, bank doen't have enough assets to meet the liabilities i.e. deposits. Even if bank sell all it's assets and withdraw the loans, then also bank is unable to fulfill it's obligations. Thus, all this causes a problem of insolvency.

The relationship between liquidity and insolvency is that liquidity problem is temporary, but if it continues to arise on a permanent basis then bank might goes into insolvency. Liquidity problem arises when when doen't have enough resources to meet it's current obligations. On contrary, insolvency means bank owe more than what it owns. Thus, bank must solve it's liquidity problem by borrowing short-term loan from the money market or overnight borrowing from other banks. Whereas, in insolveny banks need to sale it's assets to fulfill it's liabilities.

(b) Operational risk is related to a risk of loss arises due to error or interruptions, either intentionally or accidently by humans or system.For example, if there is an error in credit underwriting, it may have an adverse effect on credit cost.

Market risk arises when there are fluctuations in the securities prices in the capital market. When banks make investment in securities and the prices of securities becomes highly volatile, it is said that banks might face the market risk. Mostly, banks that offers investment banking services faces the market risk. market risk can can effect the bank's income from capital gain.

(c) Credit risk is a risk of default that may arise when borrowers fail in making the repayment of loan. The techniques used by banks to manage the moral hazard created by a credit risk exposure is:

• Risk- based pricing: Banks may charge high interest rate from the borrowers who are more likely to get default in payment.
• Covenants: Banks may impose restrictions on customer having high risk of default to submit it's financial report from time to time. Bank may also refrain borrower from taking further loan.
• Credit insurance: Credit insurance helps banks in hedging the credit risk by purchasing the insurance policy. This will transfer the bank's credit risk to insurer in exchange of payment.
• Deposit insurance: It will help in maintaining a good faith in bank by depositors as their money will be secured with banks.