What are the main risks faced by banks and how does a bank attempt to manage these risks?

What are the main fortunes faced by banks and how does a bank attempt to manage these bumps? What are the main risks faced by banks and how does a bank attempt to manage these risks? All companies which have a profit maximising objective hold a certain degree of risk whether by microeconomic or macroeconomic factors. Banks overly face a number of risks atypical of non fiscal companies due to the payment and intermediary function which they perform. Recent changes in the banking environment has proceed to an addd pressure to maximise shareholder value, this means that banks take on a higher risk in order to improver a higher flow. It is due to this increased pressure and market volatility that banking risk needs such effective management to ensure the banks continued solvency. endangerment stop be delimit as an exposure to uncertainty of outcome measured by the volatility (standard deviation) of net cash f unkept within the firm. Banks require to add equity to the bank by maximising the risk adjusted return to shareholders highlighting the importance of fully considering the risk and return business equation. vulnerability to risk does not always lead to a loss, pure risk only has a downside from the expected outcome but unfit risk dissolve produce either a better or worse result that expected. credit rating risk is the risk that the counterparty will fail to repay the loan in part or full. This includes delayed payments or whatever default on the loan agreement. It is widely know that credit risk is one of the most modify risks to banks, for this reason thither is usually a sepa footstep credit part run around a credit culture of the managements views. The objective of the credit department will be to maximise shareholder value added by dint of credit risk management. To manage credit risk banks do sometimes take a security over the loan such as property or shares which the bank can take possession of in the event of default on the loan ag reement. If the market legal injurys of the security become volatile the bank may ask for more security to offset the probability of marginal default increasing. Credit constraints are implemented to make sure there is a restriction on certain loan agreements to a specific category of borrower, well defined credit limits will reduce the risk of untoward selection. Pricing the loan is a technique which uses a risk adjusted premium to determine the range of reside on a loan, with the riskier the loan the higher the premium, although a higher interest rate may increase probability of default so essential be monitored regularly. The final credit risk management method is to reduce credit losses by building a portfolio with diversification between low and high risk lending. This essentially offsets high risk and return lending with low risk and return lending to minimise any losses incurred. A similar but more specific concept to credit risk is sovereign risk involving risk that a g overnment will default on a loan agreement from a private sector bank. This case is unusual because if a government sates that the default is due to movement of resources to resolve national issues it can declare the loan agreement void due to immunity in the legal process, this will barrier debt recovery through the taking the possession of pluss and often leave the bank with partial or full loss of the loan. Debt repudiation is an extreme case where the government no longer recognises their debt or obligations to creditors. due to problems and the high risk associated with government lending a foreign currency sovereign credit rating was defined in an attempt to enable aware investor lending decisions. An interest rate is a premium paid in order to consume resources in the register rather than at a subsequent date. Interest rate risk is loss or reach in the value of a position due to changes in the interest rate, it is a speculative risk because the changes in interest rate s can lead to both a positive and negative result. There are two types of interest rate which are fixed rate and rate sensitive, the simpler form of risk lies with fixed rate assets and liabilities because a change in the interest rate above or below the fixed rate with lead to a loss or gain in capital. Simulation adventes are highly complex and involve an sagaciousness of the potential changes of interest rates on earnings, future economic value and impact on cash merge. Static simulations assess only the cash flow of on and off respite sheet activity, whereas dynamic simulations build a model predicting the future changes of interest rates and expected changes in the banks activity. The best cognize interest rate risk management method is gap analysis. This is a detailed analysis of the gap between interest rate sensitive assets and interest rate sensitive liabilities over a specific duration. A rate sensitive asset or liability is defined by an asset or liability in which t he cash flow changes in the same direction as interest rates. The changes in interest rates have a damaging effect if there is a mismatch between rate sensitive assets and liabilities, this is because if the direct of rate sensitive liabilities is higher than rate sensitive assets, an increase in interest rates will lead to less profits. High quality interest rate risk management can effectively increase or decrease the gap in order to maximise revenue. Operational risk is defined at the risk of loss from a breakdown in indwelling processes and/or management failure. This can occur through different events such as a law suit, systems failure, or ill-use to assets and its effects can lead to an increase in unsystematic market risk and blandity risk. Although there has been significant importance placed upon operational risk there is at present still no clear method of measuring its risk and effects on a general basis. The Basle II provided three suggested methods of calculating the operating risk of a firm. The basic approach allocates capital using gross income as an indicator for the banks exposure to operational risk. The Standardised approach divides the bank into business units and lines and uses individualist indicators to calculate a department specific level of exposure to operational risk. The final method of calculating operational risk is the internal measurement approach which allows each bank to use individual internal loss data to determine the capital allocation. Market risk is the risk of movement in the price function of fiscal instruments, resulting in the loss/gain in value. It is a speculative risk, measured by the probability in potential loss/gain in value of a portfolio. The risk occurs in two separate forms Systematic market risk is caused by the price movement of all monetary instruments due to changes in the macroeconomic climate. Unsystematic risk occurs when an instrument moves out of line with the rest of the market due to i nternal factors with the issuer. Systematic market risk can be prepared for in event of downturn in the economic climate by capital allocation to the specific risk calculate by the risk adjusted rate on capital. Value at risk is a measure of potential losses incurred to a portfolio due to adverse market price movements often used in risk management. Unsystematic risk can be offset by diversifications of investments into several different countries and/or industries affectively spreading the risk in attempt to avoid huge losses in specific sector investment. The diversification of investment into foreign countries may increase the potential probability of currency risk. Exchange rate flexibility exposes all firms with a short or long term position in any given currency to currency risk. Globalised markets have lead to increases in multinational firms and foreign investment, increasing the level of foreign supersede and governmental risks. Any qualify of money in a currency other than the firms home currency would be expressed as a purchase of foreign currency. Foreign exchange transactions can involve many forms of on and off balance sheet financial instruments. Duration analysis can be used to study the value of foreign bond to the foreign or domestic currency interest rates. Measures of net risk exposure for each currency can be assessed using gap analysis and will be equal to the difference between assets and liabilities in each currency. Political risk arises through the risk of political interference in the operations of a private sector bank, the exposure of which can range between interest rate and exchange regulations to the nationalisation of the financial service industry. The main factors which have been stated as to affect political risk is internal or external armed conflict, democratic government, and government stability. The level of Liquidity risk can affected by many of the other risks and is defined as the risk that the bank will have i nsufficient smooth assets on its balance sheet and is therefore unable to fulfil financial commitments without the sale of assets this is generated from a mismatch in size and maturity of assets and liabilities on the balance sheet or due to loan defaults with a surge of depositor demands. Day to day liquidity risk (funding risk) relates to the daily withdrawals and is predictable due to low depositor withdrawals, if there was a surge of withdrawals then many banks would rely in loans from the interbank market to cover the short term illiquidity. A more unpredictable risk also arising from increased depositor withdrawals is a liquidity crisis. The increase in withdrawals often stems from lack of confidence in the bank, this view will force the bank to borrow at an elevated interest rate or rely on central bank intervention and deposit insurance to avoid a run. In this situation the central bank can provide provisions in the form of high interest loans or advances, however this is costly and can further damage the banks reputation. Ideally the bank could use a method of maturity twinned to guarantee liquidity and eliminate the funding risks. This is the coordination of cash flow by matching the maturity of an asset with the maturity of a liability. This is unlikely to be a widely used approach as asset transformation is a key fruit source of banking profit. Usually the bank will hold a certain level of liquid assets to reassure creditors and signal to the market that the bank is doing well, an increase retention of liquid assets will avoid the liquidity problem but due to a trade off between liquidity and profitability lower return on investments. The most widely used technique of managing banks liquidity is Gap analysis, the liquidity gap is defined by the difference between net liquid assets and unpredictable liabilities. This gives the ability to monitor available capital over time. Financial services differ from other firms because of the high level o f financial risks that they assume through the payment and intermediary functions. It is therefore critical to manage the risks faced to ensure solvency and to maximise the firms value added. In some cases the management of an individual risk can have a positive or negative effect on another risk which shows that they are not mutually exclusive. Many of the main financial crises have risen from a combination of risks surrounding losses due to poor credit risk management, it is main(prenominal) to highlight diversification of a portfolio and asset liability management as influencing factors in effective risk management as they can reduce the probability of several risks. In the future it is important to continue developing new formal and quantitative risk management processes to ensure continues solvency within the financial services industry.