To monitor, manage, and measure these risks, banks are actively engaged in risk management. In a bank, the risk management function contributes to the management of the risks a bank faces by continuously measuring the risk of its current portfolio of assets and other exposures; by communicating the risk profile of the bank to others within the bank, to the bank's regulators, and to other relevant parties; and by taking steps either directly or in collaboration with other bank functions to reduce the possibility of loss or to mitigate the size of the potential loss.
From a regulatory perspective, the size and risk of a bank's assets are the most important determinants of how much regulatory reserve capital the bank is required to hold. A bank with high-risk assets faces the possibility that those assets could quickly lose value. If the market – depositors – perceives that the bank is unstable and deposits are in peril, then nervous depositors may withdraw their funds from the bank. If too many depositors want to withdraw their funds at the same time, then fear that the bank will run out of money could break out (Section 3.1 discusses how bank runs occur). And when there is a widespread withdrawal of money from a bank, the bank may be forced to sell its assets under pressure. To avoid this, regulators want a bank with high-risk assets to have more reserves available. Therefore, understanding banking regulation requires understanding financial risk management.
This section introduces the various types of risk a bank may face and provides examples that demonstrate each risk. Later chapters explore these risks and their regulatory implications in more detail. The key risks discussed below are those identified by the Basel Accords, the cornerstone of international risk-based banking regulation. The Basel Accords, described in greater detail in Section 3.3 and throughout the book, are the result of a collaborative attempt by banking regulators from major developed countries to create a globally valid and widely applicable framework for banks and bank risk management.
The Basel III Accord, the most recent of these accords, focuses primarily on four types of risk (see Figure 1.4):
1. Credit risk
2. Market risk
3. Operational risk
4. Liquidity risk
Figure 1.4 Bank Risks
The Basel Accords also recognize that there are other types of risk that may include these different core risk types.
1.3.1 Credit Risk
Credit risk is the risk that a bank borrower, also known as a counterparty, may fail to meet its obligations – pay interest on the loan and repay the amount borrowed – in accordance with agreed terms. Credit risk is the largest risk most banks face and arises from the possibility that loans or bonds held by a bank will not be repaid either partially or fully. Credit risk is often synonymous with default risk.
EXAMPLE
In December 2007, the large Swiss bank UBS announced a loss of USD 10 billion due to the significant loss in value of loans made to high-risk borrowers (subprime mortgage borrowers). Many high-risk borrowers could not repay their loans, and the complex models used by UBS to predict the likelihood of credit losses turned out to be incorrect. Other major banks all over the world suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. The inability to assess or respond correctly to this risk resulted in many billions of U.S. dollars in losses to companies and individuals around the world.
Credit risk affects depositors as well. From the depositors' perspective, credit risk is the risk that the bank will not be able to repay funds when they ask for them.
The underwriting process aims to assess the credit risk associated with lending to a particular potential borrower. Chapter 4 contains a detailed description of the underwriting process. Once a loan is underwritten and the loan is received by the customer, the loan becomes a part of the bank's banking book. The banking book is the portfolio of assets (primarily loans) the bank holds, does not actively trade, and expects to hold until maturity when the loan is repaid fully. Section 2.2 discusses the banking book further. Nearly all of a bank's credit risk is contained in the credit risk of the assets in its banking book, although some elements of credit risk can also exist in the trading book.
1.3.2 Market Risk
Market risk is the risk of losses to the bank arising from movements in market prices as a result of changes in interest rates, foreign exchange rates, and equity and commodity prices. The various components of market risk, and the forces that give rise to them, are covered more extensively in Chapter 6. The components of market risk are as follows:
• Interest rate risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the bank's equity. Section 2.2 discusses bank assets, liabilities, and equity further. Second, if interest rates rise, the bank will be forced to pay higher interest rates on its deposits well before its longer-term loans mature and it is able to replace those loans with loans that earn higher interest rates.
• Equity risk is the potential loss due to an adverse change in the price of stock. Stock, also referred to as shares or equity, represents an ownership interest in a company. Banks can purchase ownership stakes in other companies, exposing them to the risk of the changing value of these shares.
• Foreign exchange risk is the risk that the value of the bank's assets or liabilities changes due to currency exchange rate fluctuations. Banks buy and sell foreign exchange on behalf of their customers (who need foreign currency to pay for their international transactions or receive foreign currency and want to exchange it to their own currency), and they also hold assets and liabilities in different currencies on their own balance sheets.
• Commodity risk is the potential loss due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities (e.g., wheat, corn, soybeans), industrial commodities (e.g., metals), and energy commodities (e.g., natural gas, crude oil). The value of commodities fluctuates a great deal due to changes in demand and supply.
EXAMPLE
American savings and loans (S&Ls), also called thrifts, are essentially mortgage lenders. They collect deposits and underwrite mortgages. During the 1980s and early 1990s, the U.S. S&L system underwent a major crisis in which several thousand thrifts failed as a result of interest rate risk exposure.
Many failed thrifts had underwritten longer-term (up to 30-year) fixed-rate mortgages that were funded by variable-rate deposits. These deposits paid interest rates that would reset, higher or lower, based on the market level of interest rates. As market interest rates increased, the deposit rates reset higher, and the interest payments the thrifts had to make began to exceed the interest payments they were receiving on their portfolios of fixed-rate mortgages. This led to increasingly large losses and eventually wiped out the equity of thousands of S&Ls and led to their failures. As shown in Figure 1.5, as interest rates rose, the payments the S&Ls had to make on variable rate deposits became larger than the payments received from the fixed-rate mortgage loans, leading to larger and larger losses.
Figure 1.5 Gains vs. Losses for American S&Ls as Interest Rates Rise
EXAMPLE
In the early part of this century, the functionality and use of technology for social media grew rapidly. The Facebook networking site transformed the way in