Name the principal risks that banks face and show how each of them comes about.
The idea
A bank's principal risks are credit, market, operational and liquidity risk, with interest rate risk in the banking book as an important relative. Credit risk is the loss when a borrower or counterparty fails to pay what it owes. It arises from loans, bonds held and derivatives, where the exposure is the positive replacement value, not the notional. Market risk is loss from moves in interest rates, exchange rates, equity prices or commodity prices on positions. Operational risk is loss from inadequate or failed processes, people and systems, or from external events, and includes fraud and legal risk. Liquidity risk is the inability to meet payments as they fall due. It comes from funding long-term assets with short-term deposits or wholesale borrowing. Interest rate risk comes from assets and liabilities repricing at different times, which squeezes net interest income. Exam point: classify a loss by its source, so a default caused by a currency fall is still credit risk.
Formulas
Change in net interest income from a repricing gap
ΔNII = (RSA − RSL) × Δr
- RSA
- assets that reprice within the period
- RSL
- liabilities that reprice within the period
- Δr
- the change in interest rates, applied to both
Covers only items that reprice within the period. A negative gap means rising rates cut net interest income; the usual trap is applying the rate change to one side only or getting the sign backwards.
A practice question
Which loss most clearly illustrates credit risk for a bank?
- A fall in the market value of the bank's equity portfolio after a broad stock index declines sharply.Why not: Market risk: a price move on a held position, not a failure to pay.
- A payment system outage that stops the bank settling transactions for a day.Why not: Operational risk: a failed system, not a counterparty failing to pay.
- A corporate borrower misses the scheduled interest and principal payments on a term loan. - correct
- A fall in net interest income because deposits reprice faster than fixed-rate loans.Why not: Interest rate risk from repricing mismatch, not default by a counterparty.
Credit risk is loss from a borrower or counterparty failing to honour its obligations. The equity fall is market risk, the outage is operational risk, and the repricing squeeze is interest rate risk.
A harder one
A bank has USD 400 million of assets and USD 550 million of liabilities that reprice within one year. All other items are fixed-rate or non-interest-bearing. If all interest rates rise immediately by 1 percentage point, the change in annual net interest income is closest to:
- A decrease of USD 1.5 million. - correct
- An increase of USD 1.5 million.Why not: Sign error: it is liability-sensitive here, so rising rates hurt net interest income.
- A decrease of USD 5.5 million.Why not: Applies the rate rise to the liabilities only and ignores the interest earned on repricing assets.
- An increase of USD 4.0 million.Why not: Counts the extra interest on the repricing assets only and ignores the higher cost of liabilities.
The repricing gap is 400 - 550 = -150 million. Change in net interest income = gap x rate change = -150 x 1% = -1.5 million. A negative gap means rising rates reduce income.
The hardest tier
A bank has an interest rate swap with a corporate counterparty. The swap has notional USD 100 million and a positive market value to the bank of USD 4 million. The counterparty defaults and the bank recovers 40% of the exposure. Ignoring collateral, the bank's credit loss is closest to:
- USD 60 million.Why not: Applies the loss rate to the notional; derivative exposure is the replacement value.
- USD 2.4 million. - correct
- USD 4.0 million.Why not: Ignores the 40% recovery.
- USD 1.6 million.Why not: Uses the recovery rate as if it were the loss rate: 40% x 4 instead of 60% x 4.
Counterparty credit exposure is the positive replacement value, USD 4 million, not the notional. Loss = 4 x (1 - 0.40) = 2.4 million.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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