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18/07/2020 10:22:07 AM

BANK RISK MANAGEMENT (PART 1)

BANK RISK MANAGEMENT

Banking is risky both because depository institutions are highly leveraged and because of what they do. In the process of all banking activities, the bank is exposed to a host of risks. They include the chance that depositors will suddenly withdraw their balances, that borrowers will not repay their loans, that interest rates will change, and that the bank’s securities trading operation will do poorly. Each of these risks has a name: liquidity risk, credit risk, interest-rate risk, and trading risk. To understand how these risks arise and what can be done about them, we will look at each in detail.

Liquidity risk

All financial institutions face the risk that their liabilities holders (depositors) will seek to cash in their claims. The holder of a checking account can always walk into the bank and ask for the balance in cash. The risk of sudden demand for liquid funds is called liquidity risk. Banks face liquidity risk on both sides of their balance sheets. Deposit withdrawal is a liability-side risk but there is an asset-side risk such as lines of credit is taken down.

If the bank cannot meet customers’ requests for immediate funds, it runs the risk of failure. Even if a bank has a positive net worth, illiquidity can still drive it out of the business. For this reason, bankers must manage liquidity risk with great care. To assess liquidity risk, bank draws down its reserves. In the past, this was a common way to manage liquidity risk; banks would simply hold sufficient excess reserves to accommodate customers’ withdrawals. This is a passive way to manage liquidity risk. The problem is, holding excess reserves is expensive, because it means forgoing the higher rate of interest that typically can be earned on loans or securities. So, there are other ways to manage the risk of sudden withdrawals and drawdowns of loan commitments. The bank can adjust its assets or its liabilities.

On the asset side, the bank has several options. The quickest and easiest one is to sell a portion of securities portfolio. Because some of them are almost surely government securities, they can be sold quickly and easily at relatively low cost. Banks that are particularly concerned about liquidity risk can structure their securities holdings to facilitate such sales. A second possibility is for the bank to sell some of its loans to another bank. While not all loans can be sold, some can. Banks generally make sure that a portion of the loans they hold are marketable for selling. Yet another way to handle the bank’s need for liquidity is to refuse to renew a customer loan that has come due. Corporate customers have short-term loans that are periodically renewed, so the bank always has the option of refusing to extend the loan again for another week, month, or year. But this course of action is not very appealing. Falling to renew a loan is guaranteed to alienate the customer and could well drive the customer to another bank. The idea is to separate good customers from bad ones and develop long-term relationships with the good ones. The last thing a bank wants to do is to refuse a loan to a creditworthy customer it has gone to some trouble and expense to find.

Moreover, bankers do not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing so shrinks the size of the bank. Since banks make a profit by turning liabilities into assets, the smaller their balance sheets, the lower their profits. For this reason, today’s bankers prefer to use liability management to address liquidity risk. That is, instead of selling assets in response to a deposit withdrawal, they find other sources of funds.

There are two ways for banks to obtain additional funds. First, they can borrow to meet the shortfall, either from Central Bank or from another bank. A second way to adjust liabilities in response to a deposit outflow is to attract additional deposits. The most common way to do so is to issue large-denomination CDs. This explains why large CDs have become an increasingly important source of funds for banks. CDs allow banks to manage their liquidity risk without changing the asset side of their balance sheets


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