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Thursday15 April 2021    

Key Financial Risks in the 21st Century

Icon Key Financial Risks in the 21st Century Key Financial Risks in the 21st Century Icon Key Financial Risks in the 21st Century

Risk management involves identification of the key financial risks, deciding where risk exposure should be increased or reduced, and finding methods for monitoring and managing the bank’s risk position in real time. For all banks, from the traditional bank where ALM is the key activity to the complex financial conglomerate offering a range of bank and non-bank financial services, the objective is to maximise profits and shareholder value-added, and risk management is central to the achievement of this goal.
Risk Definition
Risk is defined as the volatility or standard deviation (the square root of the variance) of net cash flows of the firm, or, if the company is very large, a unit within it.
The risks specific to the business of banking are:
  • Credit risk and Counterparty risk
  • Liquidity or funding risk
  • Settlements or payments risk
  • Market or price risk, which includes
    • currency risk
    • interest rate risk
  • Capital or gearing risk
  • Operational risk
  • Sovereign and political risk

1) Credit risk and Counterparty risk

Credit risk and counterparty risk
If two parties enter into a financial contract, counterparty risk is the risk that one of the parties will renege on the terms of a contract. credit risk is the risk that an asset or a loan becomes irrecoverable in the case of outright default, or the risk of an unexpected delay in the servicing of a loan. Since bank and borrower usually sign a loan contract, credit risk can be considered a form of counterparty risk. However, the term counterparty risk is traditionally used in the context of traded financial instruments (for example, the counterparty in a futures agreement or a swap), whereas credit risk refers to the probability of default on a loan agreement.
Banks are in business to take credit risk, it is the traditional way banks made money. If a borrower defaults on a loan or unexpectedly stops repayments, the present value of the asset declines. Losses from loan default should be kept to a minimum, since they are charged against capital. If losses are high, it could increase the bank’s cost of raising finance, and in the extreme, lead to bank insolvency. The bank would avoid credit risk by choosing assets with very low default risk but low return, but the bank profits from taking risk. Credit risk rises if a bank has many medium to low quality loans on its books, but the return will be higher. So banks will opt for a portfolio of assets with varying degrees of risk, always taking into account that a higher default risk is accompanied by higher expected return. Since much of the default risk arises from moral hazard and information problems, banks must monitor their borrowers to increase their return from the loan portfolio.
Good credit risk management has always been a key component to the success of the bank, even as banks move into other areas. The cause of the majority of bank failures can be traced back to weak loan books. Many of the ‘‘thrift’’ and commercial bank failures were partly caused by a mismatch in terms between assets and liabilities, and problem loans.

2) Liquidity or funding risk

Liquidity or funding risk
These terms are really synonyms – the risk of insufficient liquidity for normal operating requirements, that is, the ability of the bank to meet its liabilities when they fall due. A shortage of liquid assets is often the source of the problems, because the bank is unable to raise funds in the retail or wholesale markets. Funding risk usually refers to a bank’s inability to fund its day-to-day operations.
Liquidity is an important service offered by a bank, and one of the services that distinguishes banks from other financial firms. Customers place their deposits with a bank, confident they can withdraw the deposit when they wish, even if it is a term deposit and they want to withdraw their funds before the term is up. If there are rumours about the bank’s ability pay out on demand, and most depositors race to the bank to withdraw deposits, it will soon become illiquid. In the absence of a liquidity injection by the central bank or a lifeboat rescue, it could quickly become insolvent since it can do nothing to reduce overhead costs during such a short period.
The liquidity of an asset is the ease with which it can be converted to cash. A bank can reduce its liquidity risk by keeping its assets liquid (i.e. investing in short-term assets), but if it is excessively liquid, its returns will be lower. All banks make money by having a gap between their maturities, that is, more short-term deposits and more long-term loans: ‘‘funding short and lending long’’. They can do this because of fractional reserve lending – only a fraction of deposits are held in reserve, and the rest are loaned out. Liquidity can be costly in terms of higher interest that might have been earned on funds that have been locked away for a specified time.
Maturity matching (or getting rid of all maturity gaps) will guarantee sufficient liquidity and eliminate liquidity risk because all deposits are invested in assets of identical maturities: then every deposit is repaid from the cash inflow of maturing assets, assuming these assets are also risk-free. But such a policy will never be adopted because the bank, as an intermediary, engages in asset transformation to make profits. In macroeconomic terms, provided there is no change in the liquidity preferences of the economy as a whole, then the withdrawal of a deposit by one customer will eventually end up as a deposit in another account somewhere in the banking system. If banks kept to a strict maturity match, then competition would see to it that the bank which invested in assets rather than keeping idle deposits could offer a higher return (and therefore, greater profitability) compared to banks that simply hold idle deposits.
At the microeconomic level, the maturity profile of a bank’s liabilities understates actual liquidity because term deposits tend to be rolled over, and only a small percentage of a bank’s deposits will be withdrawn on a given day. This is another argument for incurring some liquidity risk. Given that the objective of a bank is to maximise profit/shareholder value-added, all banks will have some acceptable degree of maturity mismatch.

3) Settlements or payments risk

Settlement / payments risk
Settlement or payments risk is created if one party to a deal pays money or delivers assets before receiving its own cash or assets, thereby exposing it to potential loss. Settlement risk can include credit risk if one party fails to settle, i.e. reneges on the contract, and liquidity risk – a bank may not be able to settle a transaction if it becomes illiquid.
The reason settlement risk is closely linked to foreign exchange markets is because different time zones may create a gap in the timing of payments. Settlement of foreign exchange transactions requires a cash transfer from the account of one bank to that of another through the central banks of the currencies involved.
Settlement risk is a problem in other markets, especially the interbank markets because the volume of interbank payments is extremely high. At the end of each day, the central bank requires each bank to settle its net obligations, after cancelling credits and debits due on a given day. If the interbank transaction is intraday, the exposure will not appear on a bank’s balance sheet, which is an added risk.
However, settlement risk is still present because the netting is multilateral. The payments are interbank, and banks will not know the aggregate exposure of another bank. Any problem with one bank can have a domino effect. If one bank fails to meet its obligations, other banks along the line are affected, even though they have an indirect connection with the failing bank, the counterparty to the exchange. Given the large volume of transactions in relation to the capital set aside by each bank, the central bank will be concerned about systemic risk – the failure to meet obligations by one bank triggers system-wide failures.
Most increasingly, there has been a move from netting to real time gross settlement. Real time gross settlement (RTGS), allows transactions across settlement accounts at the central bank (or a clearing house) to be settled, gross, in real time, rather than at the end of the day.

4) Market or price risk

Market or price risk
Market (or price) risk is normally associated with instruments traded on well-defined markets, though increasingly, techniques are used to assess the risk arising from over the counter instruments, and/or traded items where the market is not very liquid. If a bank is holding instruments on account (for example, equities, bonds), then it is exposed to price or market risk, the risk that the price of the instrument will be volatile.
General or systematic market risk
is caused by a movement in the prices of all market instruments because of, for example, a change in economic policy.
Unsystematic or specific market risk
arises in situations where the price of one instrument moves out of line with other similar instruments, because of an event (or events) related to the issuer of the instrument. For example, the announcement of an unexpectedly large government fiscal deficit might cause a drop in the share price index (systematic risk), while an environmental law suit against a firm will reduce its share price, but is unlikely to cause a general decline in the index (specific or unsystematic market risk)
Interest rate risk
Interest rates are another form of price risk, because the interest rate is the ‘‘price’’ of money, or the opportunity cost of holding money in the narrow form. It arises due to interest rate mismatches. Banks engage in asset transformation, and their assets and liabilities differ in maturity and volume. The traditional focus of an asset–liability management group within a bank is the management of interest rate risk, but this has expanded to include off-balance sheet items, as will be seen below.

5) Capital or gearing risk

Capital or gearing risk
Banks are more highly geared (leveraged) than other businesses – individuals feel safe placing their deposits at a bank with a reputation for soundness. There are normally no sudden or random changes in the amount people wish to save or borrow, hence the banking system as a whole tends to be stable, unless depositors are given reason to believe the system is becoming unsound.
Thus, for banks, the gearing (or leverage) limit is more critical because their relatively high gearing means the threshold of tolerable risk is lower in relation to the balance sheet.
This is where capital comes in: its principal function is to act as a buffer by supporting or absorbing losses. Banks which take on more risk should set aside more capital, and this is the principle behind the Basel risk assets ratio. Banks need to increase their gearing to improve their return to shareholders. To see the link, consider the equation below:
                    ROE = ROA × (gearing multiplier)

ROE: return on equity or net income/equity
ROA: return on assets or net income/assets
Gearing/leverage multiplier: assets/equity

6) Operational risk

Operational risk
The Bank for International Settlements defines operational risk as ‘‘The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events.’’
The definition of operational risk varies considerably, and more important, measuring it can be even more difficult. The Basel Committee has conducted surveys of banks on operational risk. Based on Basel, the key types of operational risk are identified as follows.
(1) Physical Capital: the subsets of which are:
  • damage to physical assets,
  • business disruption,
  • system failure,
  • problems with execution and delivery, and/or
  • process management
Technological failure dominates this category and here, the principal concern is with a bank’s computer systems. A crash in the computing system can destroy a bank. Most banks have a duplicate system which is backed up in real time, in a secret location, should anything go wrong with the main computer system.
However, banks take out insurance against the risk of fire or other catastrophes, and to this extent, they have already hedged themselves against the risk. To the extent they are fully hedged, there should be no need to set aside capital. Problems with physical capital may interfere with process management and contribute to a break down in execution and/or delivery.
(2) Human Capital: this type of risk arises from human error, problems with employment practices or employees’ health and safety, and internal fraud. An employee can accidentally enter too many (or too few) zeroes on a sell or buy order. Or a bank might find itself being fined for breach of health and safety rules, or brought before an employment tribunal accused of unfair dismissal. In addition, employees can defraud their bank.
(3) Legal: the main legal risk is that of the bank being sued. It can arise as a result of the treatment of clients, the sale of products, or business practices. There are countless examples of banks being taken to court by disgruntled corporate customers, who claim they were misled by advice given to them or business products sold. Contracts with customers may be disputed.
(4) Fraud: the fraud may be internal or external to the bank. An operational failure may created settlement and liquidity risks. Or if a borrower is granted a loan based on a fraudulent loan application and subsequently defaults, it will be recorded as a loan loss, and therefore, a credit risk issue, even though the fraud was the original source of the problem.
Classification issues alone make quantification of operational risk difficult, so it should come as no surprise that the ‘‘Basel 2’’ proposals for the treatment of the operational risk proved highly controversial.

7) Sovereign and political risk

Sovereign and political risks
Sovereign Risk
normally refers to the risk that a government will default on debt owed to a bank or government agency. In this sense, it is a special form of credit risk, but the bank lacks the usual tools for recovering the debt at its disposal. If a private debtor defaults, the bank will normally take possession of assets pledged as collateral. However, if the default is by a sovereign government, the bank is unlikely to be able to recover some of the debt by taking over some of the country’s assets. This creates problems with enforcing the loan contract. Sovereign risk can refer to either debt repudiation or debt rescheduling. The banks agree to restructure debt repayments and make new loans. Normally the IMF acts as broker or intermediary.
The rescheduling agreement is made in exchange for the country agreeing to meet new macroeconomic targets, such as reductions in inflation and subsidies and/or an increase in taxation. The World Bank may also participate in rescheduling negotiations.
Political Risk
is broadly defined as state interference in the operations of a domestic and/or foreign firm. Banks can be subjected to sudden tax hikes, interest rate or exchange control regulations, or be nationalised. All businesses are exposed to political risk, but banks are particularly vulnerable because of their critical position in the financial system.
Interaction among risks
All of the various risks discussed above are interdependent, and as was noted earlier, there are other risks, common to all businesses including banks. These other risks are often more discrete or event-type, affecting a bank’s profitability and risk exposure. They include sudden, unexpected changes in taxation, regulatory policy or in financial market conditions due to war, revolution or market collapse, and macroeconomic risks such as increased inflation, inflation volatility and unemployment.
Regulators have identified three key risks related to banks:
  • Credit risk,
  • market risk (including risks arising from changes in interest rates, exchange rates, equity prices and commodity prices) and
  • operating risk.