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... Banks are no exception. Indeed, these risks are negligible when compared to the additional risks that banks also face, ranging from credit risks to currency risks, which are uncharacteristic of firms that do not specialise in finance. Moreover it is how banks manage this risk that will play a central part in determining the success and profitability of the bank, hence truth in the titles statement.
Risk management techniques in the past have traditionally focused on “asset-liability” management (ALM) which encompasses proactive management of interest rates and liquidity risks. However with the developing nature of a modern banks business, risk management techniques have since expanded to incorporate not only the bank’s banking book (on-balance sheet assets and liabilities) but also its trading book (off-balance sheet financial instruments). Credit risk, generally the most commonly perceived risk associated with banking, is in fact usually managed by a separate division or department, however as “loan quality problems are an important cause of bank failure” (Heffernan, 1996, 182), it is essential that all bankers are familiar with the fundamental factors affecting the quality of a loan portfolio.
Credit risk is the risk that borrowers are unable to repay their loan agreement or the risk that there is a delay in settlement of the loan, either way causing an ill effect on the bank’s solvency status. Methods of managing credit risk are generally well known due to the banking sectors long history of experience in this area and according to Heffernan there are four essential ways to control credit risk: “through accurate loan pricing, credit rationing, use of collateral, and loan diversification”.
· Loan pricing: when pricing the loan, the bank must take into account the market rate of interest, the risk premium, and the administrative costs of the loan. The risk premium should be based upon what the bank considers the likelihood that the borrower will default on their loan repayment. The more risky the borrower, the higher the risk premium. However, banks must be cautious when setting the risk premium as there must be a balance, i. ... they cannot set the risk premium excessively high otherwise the borrower may accept the loan contract only because they know that there is an extremely high probability that they will default on the agreement. Excessively high risk premiums might even in fact, proactively cause a higher rate of loan default.
Approximate Word count = 1959
Approximate Pages = 7.8
(250 words per page double spaced)
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