The fundamental objective of bank management is to maximize shareholder’s wealth. This goal is interpreted to mean maximizing the market value of firm’s common stock. Wealth maximization, in turn requires the managers evaluate the present value of cash flows under uncertainty with large, near term cash flows preferred when evaluated on a risk adjusted basis.
It is the process by which managers identify, assess, monitor, and control risks associated with a financial institution’s activities. The complexity and the range of financial products have made risk management more difficult to accomplish and to evaluate. In larger financial institutions, risk management is used to identify all risks associated with particular business activities and to aggregate information such that exposures can be evaluated on a common basis. A formal process enables these institutions to manage risks on both a transaction basis and by portfolio in light of the institution’s exposures in a global strategic environment.
The objective of risk management
– To reduce the cost of risk
Components of cost of risk include:
• Expected cost of losses
• Cost of loss control
• Cost of loss financing
• Cost of internal risk reduction
• Cost of any residual uncertainty
Types of Risk
The Federal Reserve Board has identified six types of risk
1. Credit Risk
2. Liquidity Risk
3. Market Risk
4. Operational Risk
5. Reputation Risk
6. Legal Risk
Credit risk is associated with the quality of individual assets and the likelihood of default. It is extremely difficult to assess individual asset quality because limited published information is available. In fact, many banks that buy banks are surprised at the acquired bank’s poor asset quality, even though they conducted a due diligence review of the acquir5ed bank prior to the purchase.
Loans typically exhibit the greatest credit risk changes in general. Economic conditions and a firm’s operating environment alter the cash flow available for debt service. These conditions are difficult to predict. Similarly, an individual’s ability to repay debts rivalries with changes in employment and personal net worth. For this reason, banks perform a credit analysis on each loan request to assess a borrower’s capacity to repay.
Banks evaluate their general credit risk by asking three basic questions: what is the historical loss rate on loans and investments? What are expected losses in the future? How is the bank prepared to weather the losses? Credit risk measures focus predominantly on these same general areas. Managers typically focus their attention initially on a bank’s historical loan loss experience because loans exhibit the highest default rate. Ratios (as a percentage of total loans and leases) that examine the historical loss experience are related to gross losses, recoveries, and net losses.
Liquidity risk is the current and potential risk to earnings and the market value of stock holders’ equity that results from a bank’s inability to meet payment or clearing obligations in a timely and cost effective manner. This risk can be the result of either funding problems or market liquidity risk. Funding liquidity risk is the inability to liquidate assets or obtain adequate funding form new borrowing. The inability of the bank to easily unwind or offset specific exposures without significant losses from inadequate market depth or market disturbances is called market liquidity risk. This risk is greatest when risky securities are trading at high premiums to low risk treasury securities because market participants are avoiding high risk borrowers. Liquidity risk is greatest when a bank cannot anticipate new loan demand or deposit withdrawals, and does not have access to new sources of cash.
Liquidity risk measures indicate both the bank’s ability to cheaply and easily borrow funds and the quantity of liquid assets near maturity of available-for-sale at reasonable prices.
Market risk is the current and potential risk to earnings and stockholders’ equity resulting from adverse movements in market rates prices. The three areas of market risk are interest rate risk equity or security price risk, and foreign exchanges risk.
Traditional interest rate risk analysis compares the sensitivity of interest income to changes in assets yields with the sensitivity of interest expense to changes in the interest cost of the liabilities. The purpose is to determine how much net interest income will vary with movements in market interest rates. A more comprehensive portfolio analysis approach compares the duration of assets with the duration of liabilities using duration gap and market value of equity sensitivity analysis to assess the impact of rate changes on net interest income and the market value (or price) of stockholders’ equity. Duration is an elasticity measure that indicates the relative price sensitivity of different securities.
Equity and security price risk examines how changes in market prices interest rates, and foreign exchange rates affect the market values of any equities, fixed-income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts large banks mush conduct value at risk analysis to assess the risk of loss with their portfolio or these trading assets and hold specific amounts of capital in support of this market risk. Small banks identify the exposure by conducting sensitivity analysis.
Foreign Exchange Risk arise from changes in foreign exchange rates that affect the values of assets, liabilities, and off-balance sheet activities denominated in currencies different from the bank’s domestic (home) currency. It exists because some b