key financial in risks modern banks - Modern Banking

Any profit-maximising business, including banks, must deal with macroeconomic risks, such as the effects of inflation or recession and microeconomic risks like new competitive threats. Breakdowns in technology, commercial failure of a supplier or customer, political interference or a natural disaster are additional potential risks all firms face. However, banks also confront a number of risks a typical of non-financial firms.

It was argued that banks perform intermediary and payment functions that distinguish them from other businesses. The core product is intermediation between those with surplus liquidity, who make deposits, and those in need of liquidity, who borrow from the bank. The payments system facilitates the intermediary role of banks. For banks where intermediation is the principal function, risk management consists largely of good asset–liability management (ALM) – in the post-war period, right up to the early 1980s, whole books were devoted to ALM techniques.

The role of banks in the financial system changed substantially from the late 1970s on wards. The bank environment was relatively stable and characterised by close regulation; rules which limited the scope of operations and risk; cartel-like behaviour which kept competition to a minimum, and given steady, if not spectacular returns, little incentive to innovate. In most developed countries during the 1980s, regulatory reforms and innovation broke down barriers in financial markets and eliminated the high degree of segmentation, which in turn, increased competition. Japan was the notable exception. The 1990s saw the continued demarcation of financial markets which had begun in the 1980s, and banks faced new risks to manage as a result of continued disintermediation, innovation and greater competition, especially in wholesale markets, where globalisation further eroded barriers.

The movement of banks into new areas of off-balance sheet banking, such as the switch from interest income generating sources to non-interest income activities, was discussed.

  1. As a consequence, risk management has expanded to include not just ALM, but the management of risks arising from off-balance sheet activity. Furthermore, some new techniques developed to manage market risk are increasingly applied to credit risk management. Risk management involves spotting the key risks, deciding where risk exposure should be increased or reduced, and identifying the methods for monitoring and managing the bank’s risk position in real time. Though Walter Wriston’s quote is more than a decade old, it summarises the key role of the 21st century bank. At the same time, Nassim Taleb, a PhD with many years of trading experience and author of a book on options, cautions against excessive reliance on value at risk (VaR), one of the new models used to manage not only market risk but, in some banks, credit risk.Though the risks faced by banks in the 1970s appear straightforward compared to what they are now, there are examples of spectacular collapses in every decade. In the 1970s it was Franklin National Bank and Bankhaus Herstatt, and in the UK, the secondary banking crisis.
  2. In the 1980s, over 2000 thrifts and banks in the United States either failed or were merged with a healthy bank. The Spanish and Scandinavian banks also experienced severe problems, which led to a notable amount of bank consolidation. In the 1990s, it was the turn of Bank of Credit and Commerce International, Barings and the Japanese banking system as a whole. For the first time, problems with a non-bank, a hedge fund, to which many key global banks were exposed, threatened global financial stability. In the early 2000s, it may be the turn of the German banking system, where a crisis appears to be looming at the time of writing. Though these failures are the exception rather than the rule in most cases, it demonstrates that no matter what the structure of the banking system, poor risk management can cause insolvency, which may be endemic in a particular country.

Credit risk, the risk that a borrower defaults on a bank loan, is the risk usually associated with banks, because of the lending side of the intermediary function. It continues to be central to good risk management because most bank failures are linked to a high ratio of non-performing loans to total loans. However, as banks become more complex organisations, offering more fee-based financial services and using relatively new financial instruments, other types of financial risk have been unbundled and made more transparent.

The purpose of this one is to outline the key financial risks modern banks are exposed to, and to consider how these risks should be managed.

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