Chapter 5: Types of Risks faced by banks

Question 1

What is solvency risk

Answer 1

Bank does not have enough funds:
* to satisfy minimum solvency requirements in countries where active
* To support credit rating
* To achieve growth objectives

• Regulators assess regularly

Question 2

What is liquidity risk

Answer 2

Risk that bank can not fulfil obligations
* withdrawls from accounts
* repayments of deposits, bonds and credit
* payment of undrawn credit
* settlement of derivative transactions

Banks are obligated to keep a significant amount of liquid assets

Question 3

What is a bank run

Answer 3

• form of liquidity risk
• customers suddenly lose confidence in a bank and try to withdraw money at same time
• bank does not usually keep this much liquid assets, and often leads to bankruptcy

Question 4

What is Market risk

Answer 4

• Risk that income/capital, or capacity to carry out transactions is negatively influenced by market changes (IR, credit spreads, share prices, commodity prices, FX).
• Some assets are valued at market value on the balance sheet
• Traders buy financial products to sell at a higher price later on

Question 5

What is credit risk

Answer 5

risk that a consumer/client/counterparty does not fulfil its contractual obligation
e.g. loans and credit provided to businesses and retail customers

Question 6

What is settlement risk

Answer 6

• form of credit risk
• risk that bank makes a payment to a counterparty in a transaction but corresponding consideration never recieved

Question 7

What is counterparty risk

Answer 7

risk size based on the other parties in the financial sector
e.g. banks hedge risks with other parties but if other bank defaults on a transaction, the hedged risk will not be covered properly

Question 8

What is systemic risk

Answer 8

risk that customers can lose confidence in several banks.
Since they often work together, this can cause problems among multiple banks.

Question 9

What is Interest Rate risk

Answer 9

risk that net interest result of the bank will be affected negatively by changes in the IRs

Question 10

What are legal risks

Answer 10

bank will not be able to legally enforce a claim against a counterparty (e.g. errors in the contract)

Question 11

Operational risks

Answer 11

• Not specific to banks
• four categories:
  *inadequate organization
  human error
  faulty systems
  external events

Question 12

Reputation risks

Answer 12

risk of reputation damage by a certain event e.g. bank is victim of major fraud

Customers subsequently lose confidence

Question 13

What are Strategic risks

Answer 13

risk that the wrong strategic decisions will be taken e.g. makes a loss on strategic takeover or low demand for a new product

Question 14

Risk management process

Answer 14

Compulsory requirement by regulators:
1. Identify risks
2. form policies on risks
3. translation of policies into perational procedures
4. measurement of risks

Question 15

Identification of risks

Answer 15

Most important, know the bank’s risks

Question 16

Formulation of policy

Answer 16

1. Define risk apetite
2. estalblish risk management structure
3. select systems to measure risk
4. Select instruments to manage risk

Question 17

Translation of policy into operations

Answer 17

e.g.
* setting of operational limits
* risk limits for activities
* counterparty limits, max financial value for obligations
* Trading limits - max size/positions

Question 18

Measurement of risks

Answer 18

determining the exact size of the risks to make informed decisions

Question 19

Expected/Unexpected Losses

Answer 19

Expected losses: incurred on analysis or historical data

Unexpected losses use computer models to estimate sizes