The 3 sources of bank risk
are :
(1). Liquidity
(2). Credit
(3). invest rate
The explanation is given
below for the 3 sources of bank risk:
Liquidity Risk:
Liquidity risk is a
financial risk that for a certain period of time a given financial
asset, security or commoditycannot be traded quickly enough in the
market without impacting the market price.
TYPES:
Market liquidity –
An asset cannot be sold due to lack of liquidity in the market –
essentially a sub-set of market risk.[1] This can be
accounted for by:
- Widening bid/offer spread
- Making explicit liquidity
reserves
- Lengthening holding period for VaR
calculations
Funding liquidity –
Risk that liabilities:
- Cannot be met when they fall
due
- Can only be met at an uneconomic
price
- Can be name-specific or
systemic
- Liquidity risk is
the risk that a company or bank may be unable to meet short term
financial demands. This usually occurs due to the inability to
convert a security or hard asset to cash without a loss of capital
and/or income in the process.
How it works
(Example):
- Liquidity risk generally
arises when a business or individual with immediate cash needs,
holds a valuable asset that it can not trade or sell at market
value due to a lack of buyers, or due to an inefficient market
where it is difficult to bring buyers and sellers together.
- For example, consider a $1,000,000
home with no buyers. The home obviously has value, but due to
market conditions at the time, there may be no interested buyers.
In better economic times when market conditions improve and demand
increases, the house may sell for well above that price. However,
due to the home owner’s need of cash to meet near termfinancial
demands, the owner may be unable to wait and have no other choice
but to sell the house in an illiquid market at a significant loss.
Hence, the liquidity risk of holding this asset.
Causes:
- Liquidity risk arises from
situations in which a party interested in trading an asset cannot
do it because nobody in the market wants to trade for that asset.
Liquidity risk becomes particularly important to parties who are
about to hold or currently hold an asset, since it affects their
ability to trade.
- Manifestation of liquidity risk is
very different from a drop of price to zero. In case of a drop of
an asset's price to zero, the market is saying that the asset is
worthless. However, if one party cannot find another party
interested in trading the asset, this can potentially be only a
problem of the market participants with finding each
other.[2] This is why liquidity risk is usually found to
be higher in emerging markets or low-volume markets.
- Liquidity risk is financial risk
due to uncertain liquidity. An institution might lose liquidity if
its credit rating falls, it experiences sudden unexpected cash
outflows, or some other event causes counterparties to avoid
trading with or lending to the institution. A firm is also exposed
to liquidity risk if markets on which it depends are subject to
loss of liquidity.
Liquidity at
risk:
Alan Greenspan (1999) discusses
management of foreign exchange reserves and suggested a measure
called Liquidity at risk. A country's liquidity position under a
range of possible outcomes for relevant financial variables
(exchange rates, commodity prices, credit spreads, etc.) is
considered. It might be possible to express a standard in terms of
the probabilities of different outcomes.
For example, an acceptable debt
structure could have an average maturity—averaged over estimated
distributions for relevant financial variables—in excess of a
certain limit. In addition, countries could be expected to hold
sufficient liquid reserves to ensure that they could avoid new
borrowing for one year with a certain ex ante probability, such as
95 percent of the time.
Measures of liquidity
risk:
Liquidity gap:
Culp defines the liquidity gap as
the net liquid assets of a firm. The excess value of the firm's
liquid assets over its volatile liabilities. A company with a
negative liquidity gap should focus on their cash balances and
possible unexpected changes in their values.
As a static measure of liquidity
risk it gives no indication of how the gap would change with an
increase in the firm's marginal funding cost.
Elasticity:
- Culp denotes the change of net of
assets over funded liabilities that occurs when the liquidity
premium on the bank's marginal funding cost rises by a small amount
as the liquidity risk elasticity. For banks this would be measured
as a spread over libor, for nonfinancials the LRE would be measured
as a spread over commercial paper rates.
- Problems with the use of liquidity
risk elasticity are that it assumes parallel changes in funding
spread across all maturities and that it is only accurate for small
changes in funding spreads.
(2). Credit
risk:
A credit risk is
the risk of default on a debt that may arise from a borrower
failing to make required payments.[1] In the first
resort, the risk is that of the lender and includes lost
principaland interest, disruption to cash flows, and increased
collection costs. The loss may be complete or partial. In an
efficient market, higher levels of credit risk will be associated
with higher borrowing costs. Because of this, measures of borrowing
costs such as yield spreads can be used to infer credit risk levels
based on assessments by market participants.
Losses can arise in a number of
circumstances,[2] for example:
- A consumer may fail to make a
payment due on a mortgage loan, credit card, line of credit, or
other loan.
- A company is unable to repay
asset-secured fixed or floating charge debt.
- A business or consumer does not pay
a trade invoicewhen due.
- A business does not pay an
employee's earned wages when due.
- A business or government bond
issuer does not make a payment on a coupon or principal payment
when due.
- An insolvent insurance company does
not pay a policy obligation.
- An insolvent bank won't return
funds to a depositor.
- A government grants bankruptcy
protection to an insolventconsumer or business.
To reduce the lender's credit risk,
the lender may perform a credit check on the prospective borrower,
may require the borrower to take out appropriate insurance, such as
mortgage insurance, or seek security over some assets of the
borrower or a guarantee from a third party. The lender can also
take out insurance against the risk or on-sell the debt to another
company. In general, the higher the risk, the higher will be the
interest rate that the debtor will be asked to pay on the debt.
Credit risk mainly arises when borrowers are unable to pay due
willingly or unwillingly
Types:
A credit risk can be of the
following types:
- Credit default risk – The risk of
loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on
any material credit obligation; default risk may impact all
credit-sensitive transactions, including loans, securities and
derivatives.
- Concentration risk – The risk
associated with any single exposure or group of exposures with the
potential to produce large enough losses to threaten a bank's core
operations. It may arise in the form of single name concentration
or industry concentration.
- Country risk – The risk of loss
arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations
(sovereign risk); this type of risk is prominently associated with
the country's macroeconomic performance and its political
stability.
Assessment:
Main articles: Credit analysis and
Consumer credit risk
Significant resources and
sophisticated programs are used to analyze and manage
risk.[4][5] Some companies run a credit risk
department whose job is to assess the financial health of their
customers, and extend credit (or not) accordingly. They may use
in-house programs to advise on avoiding, reducing and transferring
risk. They also use third party provided intelligence. Companies
like Standard & Poor's, Moody's, Fitch Ratings, DBRS, Dun and
Bradstreet, Bureau van Dijkand Rapid Ratings International provide
such information for a fee.
For large companies with liquidly
traded corporate bonds or Credit Default Swaps, bond yield spreads
and credit default swap spreads indicate market participants
assessments of credit risk and may be used as a reference point to
price loans or trigger collateral calls.
Most lenders employ their own models
(credit scorecards) to rank potential and existing customers
according to risk, and then apply appropriate strategies.With
products such as unsecured personal loans or mortgages, lenders
charge a higher price for higher risk customers and vice versa.
With revolving products such as credit cards and overdrafts, risk
is controlled through the setting of credit limits. Some products
also require collateral, usually an asset that is pledged to secure
the repayment of the loan.
Credit scoring models also form part
of the framework used by banks or lending institutions to grant
credit to clients. For corporate and commercial borrowers, these
models generally have qualitative and quantitative sections
outlining various aspects of the risk including, but not limited
to, operating experience, management expertise, asset quality, and
leverage and liquidity ratios, respectively. Once this information
has been fully reviewed by credit officers and credit committees,
the lender provides the funds subject to the terms and conditions
presented within the contract
(3).Interest rate
risk:
Interest rate risk
is the risk that arises for bondowners from fluctuating interest
rates. How much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes in the market. The
sensitivity depends on two things, the bond's time to maturity, and
the coupon rate of the bond.
Interest rate risk analysis is
almost always based on simulating movements in one or more yield
curves using the Heath-Jarrow-Morton framework to ensure that the
yield curve movements are both consistent with current market yield
curves and such that no riskless arbitrage is possible. The
Heath-Jarrow-Morton framework was developed in the early 1991 by
David Heath of Cornell University, Andrew Morton of Lehman
Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell
University.
There are a number of standard
calculations for measuring the impact of changing interest rates on
a portfolio consisting of various assets and liabilities. The most
common techniques include:
- Marking to market, calculating the
net market value of the assets and liabilities, sometimes called
the "market value of portfolio equity"
- Stress testing this market value by
shifting the yield curve in a specific way.
- Calculating the value at risk of
the portfolio
- Calculating the multiperiod cash
flow or financial accrual income and expense for N periods forward
in a deterministic set of future yield curves
- Doing step 4 with random yield
curve movements and measuring the probability distribution of cash
flows and financial accrual income over time.
- Measuring the mismatch of the
interest sensitivity gap of assets and liabilities, by classifying
each asset and liability by the timing of interest rate reset or
maturity, whichever comes first.
- Analyzing Duration, Convexity, DV01
and Key Rate Duration.
At banks:
- The assessment of interest rate
risk is a very large topic at banks, thrifts, saving and loans,
credit unions, and other finance companies, and among their
regulators. The widely deployed CAMELS rating system assesses a
financial institution's: (C)apital adequacy, (A)ssets, (M)anagement
Capability, (E)arnings, (L)iquidity, and (S)ensitivity to market
risk. A large portion of the (S)ensitivity in CAMELS is
interest rate risk. Much of what is known about assessing
interest rate risk has been developed by the interaction of
financial institutions with their regulators since the 1990s.
Interest rate risk is unquestionably the largest part of the
(S)ensitivity analysis in the CAMELS system for most banking
institutions. When a bank receives a bad CAMELS rating equity
holders, bond holders and creditors are at risk of loss, senior
managers can lose their jobs and the firms are put on the FDIC
problem bank list.
- See the (S)ensitivity section of
the CAMELS rating system for a substantial list of links to
documents and examiner manuals, issued by financial regulators,
that cover many issues in the analysis of interest rate risk.
- In addition to being subject to the
CAMELS system, the largest banks are often subject to prescribed
stress testing. The assessment of interest rate risk is typically
informed by some type of stress testing. See: Stress test
(financial), List of bank stress tests, List of systemically
important banks.