Risk Management - Essay Example

Download file to see previous pages... This paper will describe a risk context that may be faced by the top level executive of a bank while marketing it financial services. Risk contexts A bank executive normally faces different types of risks once the bank deals with ranges of transactions and uses a large amount of leverage every day. When a bank’s financial position becomes weak, naturally its depositors may withdraw their savings. Under such a difficult situation, the bank cannot sell debt securities in financial markets; and this condition would worsen the bank’s financial state. For instance, the major cause of 2007-2009 credit crisis can be attributed to the fear of bank failure. According to Pyle (2007), although a bank executive may share many of the same risks of other organizations, the major risks that really trouble an executive are liquidity risk, credit default risks, interest rate risks, and trading risks. Risk Identification and Analysis 1. Liquidity risk In case of a bank, the term liquidity indicates its ability to pay bills and other payables, to repay money to a depositor, and to lend money to a borrower as part of bank’s credit policy. Hence, liquidity is the basic tool that is used to assess the financial viability of a bank. A bank executive faces great troubles while dealing with liquidity management because demands for funds are often unpredictable. Other off-balance sheet risks including loan commitments, letters of credit, and derivatives also constitute liquidity risks. A loan commitment indicates a line of credit that a bank issues on demand. Letters of credit are credit securities by which the bank guarantees that an importer will pay the exporter for imports or a commercial paper of bonds issuer will repay the principal. Finally, derivates are also an off balance sheet risk, which played a crucial role in the collapse of American International Group (AIG). 2. Credit Default Risks Credit default risk occurs when a borrower fails to repay the loan amount. In general practice, loans are written off after a period of 90 days of nonpayment. Law demands banks to maintain a loan loss reserves account to cover the losses arising from unpaid loans. A bank executive or manager has the responsibility to ensure that the borrower has submitted collateral securities that are adequate to cover his loan amount. In addition, the bank executive has the primary responsibility to recover the loan amount from the borrower. Therefore, bank executives would be liable to answer the board of directors when a loan goes unpaid. 3. Interest Rate Risks Banks usually pay lower interests on its liabilities such as deposits and borrowings and charge higher interests on their assets such as loans and securities. Hence, it is obvious that difference in these interest rates is the main source of profit for any bank. However, a bank’s terms of liabilities are usually different from its terms of assets. In other words, interest rate paid on liabilities is highly subjected to short term rate fluctuations while interest rate earned on assets is fixed. Sometimes, the interest rate variation may cause the bank to pay more for its liabilities and thus reducing the bank’s profit rates. Under such circumstances, a bank executive faces interest rate risk. Since the interest rate fluctuations are unpredictable, often a bank executive f ...Download file to see next pagesRead More