Question

In: Economics

the three main sources of bank risk are liquidity, credit, interest rate. explain each risk and...

the three main sources of bank risk are liquidity, credit, interest rate. explain each risk and how banks attempt to manage each type?

Solutions

Expert Solution

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:

  1. Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"
  2. Stress testing this market value by shifting the yield curve in a specific way.
  3. Calculating the value at risk of the portfolio
  4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
  5. Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
  6. 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.
  7. 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.

Related Solutions

Consider the following different types of risks: Credit risk, Liquidity risk, Interest Rate risk, Market risk,...
Consider the following different types of risks: Credit risk, Liquidity risk, Interest Rate risk, Market risk, Off-Balance-Sheet risk, Foreign Exchange risk, and Insolvency risk. What types of risks from the above do you think are particularly timely items for financial institutions to worry about today? What are some items you think might become a bigger issue in the future but are not a major concern today?
1.Explain the main differences between: credit risk liquidity risk solvency risk operational risk 2.total assets are...
1.Explain the main differences between: credit risk liquidity risk solvency risk operational risk 2.total assets are worth $3,500,000 while they have a working capital of $4,200,000. Their liabilities stand at $5,000,000 while retained earnings amount to $800,000. Earnings Before Interest and Tax come to $6,500,000. Sales total $8,300,000 while the market value of equity is $7,000,000. Find  Altman z-score
What are the two main types of interest rate risk faced by a bank and how...
What are the two main types of interest rate risk faced by a bank and how each is measured?
explain why liquidity risk and credit in the financialcrisisin 300 word
explain why liquidity risk and credit in the financial crisis
On international financial crises: 2. What are interest rate risk, credit risk and exchange rate risk?
On international financial crises: 2. What are interest rate risk, credit risk and exchange rate risk?
1. Describe how bankers manage credit risk and interest rate risk. 2. Explain why regulators mandate...
1. Describe how bankers manage credit risk and interest rate risk. 2. Explain why regulators mandate minimum reserve and capital ratios. 3. Discuss the opportunity cost to holding reserves, which pay no interest, and capital, which must share the profits of the business.
Explain the following bank management activities: liquidity management, asset management, liquidity management, capital adequacy management, credit...
Explain the following bank management activities: liquidity management, asset management, liquidity management, capital adequacy management, credit risk management, interest-rate risk management.
According to the liquidity premium theory of the term structure, a) the interest rate for each...
According to the liquidity premium theory of the term structure, a) the interest rate for each maturity bond is determined by supply and demand for that maturity bond. b) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. c) because of the positive term premium, the yield curve will not be observed to be downward sloping. d) the interest rate on long-term bonds will...
Explain and discuss the purpose and implementation of (i) gap analysis for liquidity risk and interest...
Explain and discuss the purpose and implementation of (i) gap analysis for liquidity risk and interest rate risk, and (ii) credit risk management.
Explain and discuss the purpose and implementation of (i) gap analysis for liquidity risk and interest...
Explain and discuss the purpose and implementation of (i) gap analysis for liquidity risk and interest rate risk, and (ii) credit risk management.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT