What Are the Main Risks Faced by Banks and How Does a Bank Attempt to Manage These Risks?
What are the main risks faced by banks and how does a bank attempt to manage these risks?
A Bank is a financial intermediary that acts as an economic firm producing goods and services. With this view in mind it’s easy to see that a bank exists to make a profit. In order for a bank to be successful and make a profit, it has to take risk. A bank that is averse to risk will be a stagnant institution unable to adequately serve its customers effectively and produce a profit. However, a banking institution that takes excessive or unnecessary risk is also likely to run into trouble. All risk is uncertain but with bounds the probability of an outcome can be predicted using expectation. A bank can also run into trouble if it decides to take a risk but incorrectly fails to calculate the expectation and probability of that risk, if it fails to correctly price this risk, or even both of these, as was the case in the current financial crisis.
Banks are faced with a number of different risks. The first of these is the Credit Risk. The Basel Committee on Banking Supervision defined credit risk as, ‘the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms’. This is the risk that a borrower, someone who has taken out a consumer credit product with the bank, will not be able to repay the debt under the terms of the original loan agreement (Bad debts). Obviously this is a problem for the bank, as it will result in a fall in the expected assets of that bank, therefore possibly meaning that the bank has a greater level of liability than assets. To manage credit risk banks can employ various strategies. To start with they try to predict the consumers’ behaviour before the loan agreement is made. By using stringent vetting processes to sort out and deny borrowing to those most likely to default on their loan they can protect themselves from the majority of credit risk. This process is done in the form of credit
A Bank is a financial intermediary that acts as an economic firm producing goods and services. With this view in mind it’s easy to see that a bank exists to make a profit. In order for a bank to be successful and make a profit, it has to take risk. A bank that is averse to risk will be a stagnant institution unable to adequately serve its customers effectively and produce a profit. However, a banking institution that takes excessive or unnecessary risk is also likely to run into trouble. All risk is uncertain but with bounds the probability of an outcome can be predicted using expectation. A bank can also run into trouble if it decides to take a risk but incorrectly fails to calculate the expectation and probability of that risk, if it fails to correctly price this risk, or even both of these, as was the case in the current financial crisis.
Banks are faced with a number of different risks. The first of these is the Credit Risk. The Basel Committee on Banking Supervision defined credit risk as, ‘the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms’. This is the risk that a borrower, someone who has taken out a consumer credit product with the bank, will not be able to repay the debt under the terms of the original loan agreement (Bad debts). Obviously this is a problem for the bank, as it will result in a fall in the expected assets of that bank, therefore possibly meaning that the bank has a greater level of liability than assets. To manage credit risk banks can employ various strategies. To start with they try to predict the consumers’ behaviour before the loan agreement is made. By using stringent vetting processes to sort out and deny borrowing to those most likely to default on their loan they can protect themselves from the majority of credit risk. This process is done in the form of credit
References: Basel Committee on Banking Supervision (2000) What is operational risk management (ORM)?, www.continuitycentral.com/whatisoprrisk.htm, Date Accessed 04/12/2009 Llewellyn,D.T(1999) The New Economics of Banking, Manchester Statistical Soc. Scott MacDonald,S and Koch,T, Management of Banking 6th ed., Thomson South Western Unkown (2005) FSA Aims, www.fsa.gov.uk/pages/library/communication, Date Accessed 03/12/2009 mgtclass.mgt.unm.edu/Hickey/CHAP_02_6ed.ppt