Risk management is the process of assessing risk and developing strategies to manage the risk. In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and greatest probability of occurring are handled first. In practice the process can be very difficult, and balancing between risks with high probability of occurrence but lower loss & risks with high loss but lower probability of occurrence can often be mishandled. Financial firms face four common risks:
Market risk refers to possibility of incurring large losses from adverse changes in financial asset prices, such as stock prices. Standard risk management involves use of statistical models to forecast probabilities & magnitudes of large adverse price changes.
Credit risk is the risk that a firm's borrowers will not repay their debt obligations in full. The traditional method for managing credit risk is to establish credit limits at the level of the individual borrower & industry sector. Quantitative models are increasingly used to measure and manage credit risks.
Funding risk is the risk that a firm cannot obtain the funds necessary to meet its financial obligations, for example short-term loan commitments. Three common techniques for mitigating are: diversifying over funding sources, holding liquid assets, and establishing contingency plans, such as backup lines of credit.
Operational risk is the risk of monetary loss resulting from inadequate or failed internal processes, people, and systems.
A defining characteristic of commercial banking is extending credit to borrowers of all types. Hence, commercial banks' main risks are the credit risk arising from lending activities and the funding risk related to structure of balance sheets. Banks are required to hold minimum levels of regulatory capital, and regulators in most countries adhere to Basel Capital Accord. Credit risk management is placing greater...