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3. Risk in banking

3.1. Learning outcomes

After studying this text the learner should / should be able to:

• Elucidate the concept of risk.

• Evaluate the various risks with which banks contend.

• Comprehend the import of risk mitigation techniques.

3.2. Introduction

By virtue of borrowing and lending for various periods, at various rates of interest, engaging in many other interest rate-related activities, dealing in foreign exchange, undertaking different investments, dealing in the derivatives markets, etc, banks are exposed to an array of risks like no other institution. The risks faced by banks are usually identified in the statute/s relating to banks in many countries, and are as follows.

• Interest rate risk.

• Market risk.

• Liquidity risk.

• Credit risk.

• Currency risk.

• Counterparty risk.

• Operational risk.

Exposure to these risks makes for the banks being the most regulated and supervised of any financial institution. It will be evident that bank regulators are required to be experienced and astute in the business of banking. It is important that they be aware of innovations and worldwide trends.

In most countries the statute/s relating to banks makes it compulsory that banks have a robust risk management function, and that the board of directors has a risk management committee.

Each of the risks mentioned above is discussed below, but after we introduce a brief discussion on the concept of risk.

3.3. The concept of risk

Most19 financial intermediaries owe their existence to risk. They offer liabilities that are "convenient" to the holder; one of these conveniences is the taking on risk on behalf of the liability holder. The biggest risk takers are the banks, which someone once described as risk machines. This is an apt description, because they are exposed to all the risk-types. But, to go back to basics, what is risk?

The celebrated Prof Harry Markowitz teaches us that risk cannot be divorced from return: the risk of an asset has no meaning except with reference to the portfolio in which the asset is held.20 Financial intermediaries, like any business, endeavour to maximise profits and shareholder value, and risk is central to this endeavour. Banks make extensive use of leverage (borrowing in the form of deposits and loans) in order to achieve profits. The minimum a bank can earn without risk is the risk-free rate (rfr), i.e. the treasury bill or government bond rate, and higher returns beyond this rate of return are associated with higher risk (called the risk premium), as shown in the Figure 1.

relationship between risk & return

Figure 1: relationship between risk & return

Thus, financial intermediaries demand a higher return as the risk profile increases, and they attempt to maximise return for a given level of risk or minimise risk for a given level of return (the line is called the capital market line - CML).

Risk is usually defined as the uncertainty of future outcomes or the probability of an adverse outcome.21 It is usually measured as the volatility or standard deviation of returns around the mean return. Profitability is therefore dependent on the management of risk, and it will be obvious that inadequate risk management could threaten the solvency of the financial intermediary. It is important to keep in mind that risk management is core to financial intermediaries, particularly banks, because they "work" with financial liabilities and assets, as opposed to corporate entities, for example, because their core business is usually related to real, not financial, assets. Inadequate risk management by corporate entities can bring about losses, but it is unlikely to endanger their solvency.

It is important to mention at the outset that in modern day financial markets banks are able to hedge virtually every aspect of interest costs and returns. For example, a bank can hedge its margin (with interest rate swaps); it can ensure a return of a bond (with options); it can introduce caps and floors on rates paid and earned, etc. However, what does this mean? The answer is straightforward: the financial intermediary is mitigating risk, and in doing so it is pushing itself down the CML to lower earnings.

What is the conclusion? It is that banks must take on risk in order to be attractive as an investment. The trick is the risk-reward trade-off. It is for this reason that the management rules of banks in respect of risk should be such that the risk-taking process is not constrained to the extent that risk is eliminated. Financial intermediaries cannot be too prudent.

Is there a way to reduce risk without compromising return? The answer is a resounding "yes", and it is embodied in the portfolio theory principle: diversification and correlation. The very essence of the Harry Markowitz thesis in respect of portfolio management is that risk is reduced by diversifying the portfolio provided that the assets in the portfolio are not perfectly positively correlated, and that risk is further reduced as correlations move from +1 to -1. Banks are usually well-diversified.

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