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What risks does a bank incur? Essay


Introduction

Banks may be exposed to various external and internal risks. Some of them can be explained by lack of safety procedures and poor planning, while others can be attributed to the changes in economic and political environment1.

This paper is aimed discussing such issues as the fluctuations of the exchange rate, loan delinquency, default, mismatched funds, interest rate risk, and the changes in political and social culture of the country in which a bank operates.

Each of these events can have a profound impact on these organizations. Yet, the management of banks can either avert such problems or at least minimize their impact.

Delinquency Risk

One of issues that the management of banks should be aware of is the delinquency risk. Such a situation can occur when the loans issued by these institutions are not repaid on time; for instance, growing unemployment can increase the delinquency risk. Usually, banks attempt to insure themselves against such a risk by asking for a mortgage that can be taken from a borrower.

The management may assume that this asset that will not lose its value and the bank can claim the mortgage if the borrower defaults on payment. The economic crisis which broke out in 2008 indicates that delinquency risk can have catastrophic effects on banks. These institutions gave loans to many people who could not repay this money.

They believed that housing which they took as a mortgage will not decline in its value2. However, the price of housing did begin to decline because the number of foreclosures increased, and the value of houses dropped. Therefore, banks could no longer return their money3. This is the danger of the delinquency risk. Thus, it is necessary to evaluate the ability of a borrower to repay the loan.

Settlement Risk

Another type of danger that should be discussed is settlement risk. It can be mostly explained by the failure of one party to deliver either security or cash after trade agreement. Sometimes such a problem can arise because partners can operate in different zones.

Usually, the failure of one partner to fulfill its obligations can threaten short-term liquidity of the bank because this institution will have unsecured assets, and it may not be able to make payments to other parties. The banks safeguard themselves against such a risk by using the services of clearing houses4 which make sure that every partner follows the terms of the agreement.

Only when the assets and cash are exchanged, the transaction is considered to be valid. Moreover, banks can develop a transaction system that enables simultaneous exchange of asset and payments5. These are the main precautions that bankers can take.

Interest Rate Risk

Interest rate risk is another threat to which banks can be exposed. For instance, these organizations usually borrow money for a short-term period at a low interest rate, approximately 5 percent. Later they invest this money into long-term assets which have a higher interest rate. Thus, they expect to earn a certain amount of profit.

However, the problem is that the short-term and long-term interest rates can fluctuate in part because short-term interest are more sensitive to inflation. Thus, the value of assets that a bank holds can decline6. There could be a wide discrepancy between the expected and actual returns.

Secondly, one should take into account that banks normally use mathematical models in order to price their assets, for instance one can mention the GARCH model. These models are premised on the assumption that the growth or decline or interest rates can be predictable.

However, these models cannot account for every factor affecting the behavior of interest rates7. To some degree, this risk can be mitigated by using interest rate swaps. These tools can help banks to limit the amount of their possible losses.

Foreign Exchange Risk

Banking operations are also affected by foreign exchange (FX) risk. This risk can arise when the exchange rate between two currencies grows or drops very rapidly8. Such a situation can occur because the demand for a currency can either grow or decline dramatically. Banks can invest into a foreign currency. However, it is possible that the value of this currency can decline relative to others.

Normally, banks insure themselves against such losses. For instance, they can use foreign exchange derivatives or the contracts in which payoffs are determined by the exchange rate between two currencies. Besides, these institutions use various mathematical models that enable to forecast the fluctuations of the exchange rate.

However, one should take into consideration that the exchange rate cannot be accurately predicted and current measurement methods are far from perfect9. Therefore, FX risk cannot be properly assessed. Proper contractual agreements are the best ways of mitigating it.

Default Risks

Banks are also vulnerable to default risks. Overall, the term default risk can be used to describe every situation when they cannot fulfill its financial obligations, especially to investors and depositors10. In such cases, a bank fails to make payments to its investors or preserve the money of depositors.

This risk can have a catastrophic event on the bank. Such an event can be caused to market shocks, currency fluctuations, or the devaluation of its assets. The management has to take a set of measures in order to avert such a situation. In particular, they will have to focus on risk assessment, planning, and insurance against possible losses.

Country Risk

Additionally, bank managers should not disregard the so-called country risk. It means that that political and social environment in the country undergoes a dramatic change11. For instance the government of the country can adopt a different attitude toward financial institutions and insist on tight regulations of financial institutions.

For instance, governments can prohibit the merger of banks. Secondly, countries can be affected by military conflicts, strikes, or social strife. Under such circumstances, it will be difficult for a bank to conduct its operations. The country risk is particularly high in the developing regions of the world. They are characterized by political and economic instability12.

For instance, one can mention Libya and the war in this country. Banks operating in such countries cannot fulfill their obligations to foreign counterparts. Moreover, the investments that banks make into these countries do not always bring the expected returns.

Mismatched Funds

Finally, mismatched funds can also constitute a significant problem for many banks. As a rule, this risk arises when the liabilities of a bank exceed its assets. This risk can arise when the managers do not properly estimate the returns that a bank can achieve within a certain period.

This mismatch can prevent a bank from fulfilling its financial obligations. Overall, this situation can be easily averted provided that banks use realistic risk assessment models and apply proper methods for estimating the returns.

Conclusion

Overall, these examples shows banks should be aware of possible dangers to which they may be exposed. Some of them can be prevented and managed, for instance, foreign exchange risks or delinquency of borrowers, yet other depend on the factors that are beyond the control of the management.

Managers should view banks as complex entities that are influenced by economic, social, or political factors. This view of the organization will enable them to identify various threats.

Bibliography

Afzal, Ayesha, and Nawazish Mirza. “Market Discipline in Commercial Banking: Evidence from the Market for Bank Equity.” Lahore Journal Of Economics 16, (2011): 233-254.

Bech, Morten L., Antoine Martin, and James McAndrews. “Settlement Liquidity and Monetary Policy Implementation–Lessons from the Financial Crisis.” Federal Reserve Bank Of New York Economic Policy Review 18, no. 1 (2012): 1-25.

Brotman, Billie Ann. “Real estate loan delinquency, property prices and alternative income opportunities.” Briefings In Real Estate Finance 5, no. 3/4 (2005): 107-114.

Chernenko, Sergey, and Michael Faulkender. “The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps.” Journal Of Financial & Quantitative Analysis 46, no. 6 (December 2011): 1727-1754.

Elyasiani, Elyas, and Iqbal Mansur. “The Association Between Market and Exchange Rate Risks and Accounting Variables: A GARCH Model of the Japanese Banking Institutions.” Review Of Quantitative Finance & Accounting 25, no. 2 (September): 183-206.

Igan, Deniz, and Marcelo Pinheiro. “Exposure to Real Estate in Bank Portfolios.” Journal Of Real Estate Research 32, no. 1 (2010): 47-74.

Jian-Hsin, Chou, Chen Zhen-Yu, and Chang Chien-Yun. “The impact of yield curve movements on stock returns of Taiwanese financial institutions.” Journal Of International Finance & Economics 9, no. 3 (2009): 40-50.

McConnell, Patrick. “The governance of strategic risks in systemically important banks.” Journal Of Risk Management In Financial Institutions 5, no. 2 (2012): 128-142.

Popper, Helen. “Banks and foreign exchange exposure.” FRBSF Economic Letter 96, no. 27 (1996): 1-3.

Revoltella, Debora, Fabio Mucci, and Dubravko Mihaljek. “Properly Pricing Country Risk: A Model for Pricing Long-Term Fundamental Risk Applied to Central and Eastern European Countries.” Financial Theory And Practice 34, no. 3 (September 2010): 219-245.

Taketoshi, Mon. “Addressing risk through best practice in Japan: Shortening settlement cycles and imposing fail charges.” Journal Of Securities Operations & Custody 4, no. 2 (2011): 134-147.

Topak, Mehmet Sabri, and Erol Muzir. “Examination of Country Risk Determinants Using Artificial Neural Networks: The Case of Turkey.” International Research Journal Of Finance & Economics no. 75 (2011): 120-131.

Footnotes

1 McConnell, Patrick. “The governance of strategic risks in systemically important banks.” Journal Of Risk Management In Financial Institutions 5, no. 2 (2012): 128.

2 Igan, Deniz, and Marcelo Pinheiro. “Exposure to Real Estate in Bank Portfolios.” Journal Of Real Estate Research 32, no. 1 (January 2010): 48.

3 Brotman, Billie Ann. “Real estate loan delinquency, property prices and alternative income opportunities.” Briefings In Real Estate Finance 5, no. 3/4 (2005): 109.

4 Bech, Morten L., Antoine Martin, and James McAndrews. “Settlement Liquidity and Monetary Policy Implementation–Lessons from the Financial Crisis.” Federal Reserve Bank Of New York Economic Policy Review 18, no. 1 (2012): 5.

5 Taketoshi, Mon. “Addressing risk through best practice in Japan: Shortening settlement cycles and imposing fail charges.” Journal Of Securities Operations & Custody 4, no. 2 (2011): 145.

6 Jian-Hsin, Chou, Chen Zhen-Yu, and Chang Chien-Yun. “The impact of yield curve movements on stock returns of Taiwanese financial institutions.” Journal Of International Finance & Economics 9, no. 3 (2009): 41.

7 Chernenko, Sergey, and Michael Faulkender. “The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps.” Journal Of Financial & Quantitative Analysis 46, no. 6 (December 2011): 1730.

8 Elyasiani, Elyas, and Iqbal Mansur. “The Association Between Market and Exchange Rate Risks and Accounting Variables: A GARCH Model of the Japanese Banking Institutions.” Review Of Quantitative Finance & Accounting 25, no. 2: 183-206.

9 Popper, Helen. “Banks and foreign exchange exposure.” FRBSF Economic Letter 96, no. 27 (1996): 1.

10 Afzal, Ayesha, and Nawazish Mirza. “Market Discipline in Commercial Banking: Evidence from the Market for Bank Equity.” Lahore Journal Of Economics 16, (2011): 234

11 Revoltella, Debora, Fabio Mucci, and Dubravko Mihaljek. “Properly Pricing Country Risk: A Model for Pricing Long-Term Fundamental Risk Applied to Central and Eastern European Countries.” Financial Theory And Practice 34, no. 3 (September 2010): 219.

12 Topak, Mehmet Sabri, and Erol Muzir. “Examination of Country Risk Determinants Using Artificial Neural Networks: The Case of Turkey.” International Research Journal Of Finance & Economics no. 75 (2011): 120-131.

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IvyPanda. "What risks does a bank incur?" April 7, 2019. https://ivypanda.com/essays/what-risks-does-a-bank-incur/.

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IvyPanda. 2019. "What risks does a bank incur?" April 7, 2019. https://ivypanda.com/essays/what-risks-does-a-bank-incur/.

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IvyPanda. (2019) 'What risks does a bank incur'. 7 April.

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