What are the types of risks incurred by banks and why is the sound management of these risks central to the banks’ performance? Discuss with reference to three types of risks faced by banks in their day-to-day operation.
For any bank whether it be privately or publicly owned, the main aim, like any business is to generate a profit for itself and the shareholders. This is done through risk and the more risk one takes, the higher the return. “When we use the term ‘Risk’, we all mean financial risk or uncertainty of financial loss” (Raghavan 2003). With increasing pressure on banks from shareholders in addition to globalisation and conglomeration this risk is on the rise. This essay will analyse three main types of risk (credit risk, liquidity risk, interest rate risk) and how the sound management of them is crucial to the banks’ performance. Risk:
The first risk to be analysed is credit risk. According to the Basle committee on banking supervision, credit risk, is defined ‘the potential that a bank borrower or counterparty will fail to meet its obligations in accordance to agreed terms’ (Basle 2000). This means that it is a decline in credit-standing, therefore the risk of them defaulting increases. (Casu 2006) In addition, one can assume that due to the increasing risk of the borrower not able to pay, the lender is entitled to increase interest rates on the loan given, hence the higher the risk the greater the return. “The objective of credit risk management is to minimize the risk and maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters” (Raghavan 2003) similarly the ratio between loans and deposits must stay fairly stable. If this ratio were to increase this would be a cause for concern as more loans are being given out, than deposits entering the bank. There are several ways in order to minimise this type of risk, one of them being doing your due diligence. This means...
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