INTRODUCTION TO BANK MANAGEMENT
(FIN-403)
COURSE FACILITATOR: FAHEEM A. QURESHI
NBS = SPRING SEMESTER 2025
WEEK-6 TOPICS
RISKS IN BANKING & THEIR MITIGATION-PART 1
1. CREDIT RISK
2. INTEREST-RATE RISK
3. LIQUIDITY RISK
4. FOREIGN EXCHANGE RISK
5. MARKET /TRADING RISK
6. COUNTRY & SOVEREIGN RISK
7. OPERATIONAL RISK
8. OFF-BALANCE SHEET RISK
9. other risks
1. UNDERSTANDING CREDIT RISK
According to the Basel Committee on Banking Supervision (2000), credit risk is defined
as ‘the potential that a bank borrower or counterparty will fail to meet its obligations in
accordance with agreed terms’.
Generally, credit risk is associated with the traditional lending activity of banks, and it is
simply described as the risk of a loan not being repaid in part or in full.
Bankers minimize credit losses by building a portfolio of assets (loans and securities) that
diversifies the degree of risk. This is because very low default risk assets are associated
with low credit risk and low expected return, while higher expected return assets have a
higher probability of default (i.e., A higher credit risk).
The traditional lending function involves four different components:
1) Originating (the application process)
2) funding (approving the loan and availing funds)
3) servicing (collecting interest and principal payments)
4) monitoring (checking on borrowers’ behavior through the life of the loan).
All banks experience some loan losses, the degree of risk aversion varies significantly
across institutions. All banks have their own credit philosophy established in a formal
written loan policy that must be supported and communicated with an appropriate
credit culture.
The lending philosophy could reflect an emphasis on aggressive loan growth based
on flexible underwriting standards. Alternatively, it could reflect the goals of a more
conservative management aiming at achieving a consistent performance of a high-
quality loan portfolio.
Loan policies reflect the degree of risk bank management is ready to take and may
change over time. This is called the Risk Appetite of a Bank.
MEASURES OF CREDIT RISK
Credit risk can be monitored by looking at the changes in the following ratios.The bank can
choose to lower its credit risk by lowering these ratios:
❑ Total loans/total assets
❑ Non-performing loans/total loans
❑ Loan losses/total loans
❑ Loan loss reserves/total assets.
Banks also look at lead indicators such as:
❑ Loan concentration in geographic areas or sectors
❑ Rapid loan growth
❑ High lending rates
❑ Loan loss reserves/non-performing loans (NPLs)
Another important credit risk measure is the ratio of total loans to total deposits. The higher the
ratio, the greater the concerns of regulatory authorities, as loans are among the riskiest of bank assets.
A greater level of non-performing loans to deposits could also generate greater risk for depositors.
Since in the presence of credit risk, the mean return on the banks’ asset portfolio is clearly lower than if
the loan portfolio was entirely risk-free, the bank will find it necessary to minimize the probability of bad
outcomes in the portfolio by using a diversification strategy. Diversification will decrease unsystematic
or firm-specific credit risk. This is derived from ‘micro’ factors and thus is the credit risk specific to
the holding of loans or bonds of a particular firm.
While diversification decreases firm-specific credit risk, banks remain exposed to systematic credit
risk. This is the risk associated with the possibility that default of all firms may increase over a given
period because of economic changes or other events that have an impact on large sections of the
economy/market (e.g., in an economic recession, firms are less likely to be able to repay their debts).
2. INTEREST-RATE RISK & ITS MITIGATION
Interest Rate Risk (IRR) is the potential for changes in interest rates to negatively impact a bank's
profitability, cash flows, or the value of its assets and liabilities. Banks use a combination of strategies to
manage and mitigate this risk:
1. Asset-Liability Management (ALM)
Matching Maturities:Align the maturities of assets (e.g., loans) and liabilities (e.g., deposits) to reduce the
impact of interest rate fluctuations.
Gap Analysis: Measure the difference between rate-sensitive assets and liabilities over specific time periods
to identify exposure.
Duration Analysis:Assess the sensitivity of the bank's portfolio to interest rate changes by calculating the
weighted average duration of assets and liabilities.
2. Hedging Strategies
Interest Rate Swaps: Exchange fixed-rate payments for floating-rate payments (or vice versa) to stabilize cash
flows.
Futures and Options: Use financial derivatives to hedge against adverse interest rate movements.
Caps and Floors: Set upper (cap) and lower (floor) limits on interest rates to protect against extreme
fluctuations.
3. Diversification
Portfolio Diversification: Spread investments across different asset classes
with varying interest rate sensitivities.
Geographic Diversification: Operate in multiple regions with different
interest rate environments to reduce concentration risk.
4. Pricing Strategies
Variable-Rate Loans: Offer loans with interest rates that adjust periodically
based on market rates.
Fixed-Rate Loans with Short Terms: Limit the duration of fixed-rate loans to
reduce long-term exposure.
5. Stress Testing and Scenario Analysis
Simulate the impact of extreme interest rate changes on the bank's balance
sheet and income statement.
Identify vulnerabilities and adjust strategies accordingly.
6. Capital Buffers
• Maintain adequate capital reserves to absorb potential losses from
interest rate fluctuations.
7. Regulatory Compliance
• Adhere to regulatory guidelines, such as Basel III, as well as the SBP
Prudential Regulations, which require banks to measure and manage
interest rate risk.
By employing these strategies, banks can effectively manage and mitigate
interest rate risk, ensuring financial stability and profitability.
3. LIQUIDITY RISK
A liquid asset may be defined as an asset that can be turned into cash quickly
and without capital loss or interest penalty.
Most bank deposits are, therefore, very liquid, but investment in, for example,
property is highly illiquid.
Moreover, a bank needs liquidity to cover its operating activities as well as to
meet the regulatory requirement, i.e. the SLR requirement of SBP (15% of
demand and time liabilities).
Liquidity risk is generated in the balance sheet by a mismatch between the size
and maturity of assets and liabilities. It is the risk that the bank is holding
insufficient liquid assets on its balance sheet and thus is unable to meet
requirements without impairment to its financial or reputational capital.
Banks have to manage their liquidity to ensure that both predictable and
unpredictable liquidity demands are met.
THE LIQUIDITY TRADE-OFF: MITIGATION
Typically, banks can reduce their exposure to liquidity risk by increasing the
proportion of funds committed to cash and readily marketable assets, such
as Treasury bills (T-bills) and other government securities, or use longer-
term liabilities to fund the bank’s operations.
The difficulty for banks, however, is that liquid assets tend to yield low
returns, so if a bank holds sub-optimal levels of such assets, its profits will
decline.
This is the trade-off between liquidity and profitability: the opportunity cost
of stored liquidity is high, and holding low-yielding assets (and/or zero-
yielding assets such as cash) on the balance sheet reduces bank profitability.
4. FOREIGN EXCHANGE RISK
Foreign exchange risk is the risk that exchange rate fluctuations affect the value of a bank’s assets,
liabilities, and off-balance sheet activities denominated in foreign currency.
A bank may be willing to take advantage of differing interest rates or margins in another country or
simply invest abroad in a currency different from the domestic one.
Clearly a bank that lends in a currency that then depreciates more quickly that its home currency will
be subject to foreign exchange risk.
To measure foreign exchange risk, banks calculate measures of net exposure by each currency. It will be
equal to the difference between the assets and liabilities denominated in the same currency.
MITIGATION OF THE FOREIGN EXCHANGE RISK
These strategies help banks stabilize cash flows, protect profitability, and
manage risks in international transactions:
Hedging with Derivatives:
Use financial instruments like forward contracts, futures, options,
and currency swaps to lock in exchange rates and protect against
adverse currency movements.
Matching Currency Exposure:
Align foreign currency assets with liabilities (e.g., borrowing in the same
currency as overseas investments) to naturally offset gains and losses
from exchange rate fluctuations.
Diversification:
Spread investments and operations across multiple currencies and
geographic regions to reduce reliance on a single currency and minimize
exposure to exchange rate volatility.
5. MARKET /TRADING RISK
Market risk is the risk of losses in on- and off-balance sheet positions arising from movements in
market prices. It pertains in particular to short-term trading in assets, liabilities, and derivative
products, and relates to changes in interest rates, exchange rates, and other asset prices.
Modern conditions have led to an increase in market risk due to a decline in traditional sources of
income and a greater reliance by banks on income from trading securities.
This process has increased the variability in banks’ earnings due to the relatively frequent changes in
market conditions.
INDICATORS OF MARKET RISK
Typically, market risk relates to changes in interest rates, exchange rates, and
securities’ prices driven by the market overall. In the case of bank lending,
credit risk is the most important, but for banks lending to companies that are
investing in securities (such as bank loans to hedge funds), the bank’s
assessment of credit risk will be influenced by the hedge funds’ exposure to
market risk.
Important indicators of market risk in banking are (Rose and Hudgins, 2002):
❑ Book value assets/estimated market value of assets
❑ Book value of equity capital/market value of equity capital
❑ Market value of bonds and other fixed-income assets/book value of bonds
and other fixed-income assets
❑ Market value of common and preferred stock per share.
MITIGATING THE MARKET RISK
These strategies help banks limit losses, stabilize returns, and maintain
financial stability in volatile markets:
Diversification:
Spread investments across different asset classes, sectors, and
geographic regions to reduce exposure to adverse price movements in
any single market.
Hedging with Derivatives:
Use financial instruments like options, futures, and swaps to offset
potential losses from market volatility.
Value-at-Risk (VaR) Models:
Employ statistical models to estimate potential losses in a portfolio over
a specific time frame, enabling proactive risk management and capital
allocation. Value at Risk (VaR) quantifies the maximum expected loss under normal market
conditions, helping financial institutions and investors assess and manage risk.
6. COUNTRY & SOVEREIGN RISK
Country risk is the risk that economic, social, and political conditions of a foreign country will
adversely affect a bank’s commercial and financial interests. Banks manage country/sovereign risk
through diversification, risk assessment, credit limits, and hedging strategies.
Even governments may default on debt owed to a bank or government agency.This is the sovereign
risk and refers to the possibility that governments, as sovereign powers, may enforce their authority
to declare debt to external lenders void or modify the movements of profits, interest, and capital.
Such situations typically arise when foreign governments experience some sort of economic or
political pressure and decide to divert resources to the correction of their domestic problems.
7. OPERATIONAL RISK
The Risk Management Group of the Basle Committee on Banking Supervision (2001)
defines operational risk as ‘the risk of loss resulting from inadequate or failed internal
processes, people and systems or external events’.
In general terms, this is the risk associated with the possible failure of a bank’s systems,
controls, or other management failures (including human error).The definition of
operational risk given above includes technology risk, however, there are some differences
between the two that are outlined below (Saunders and Cornett, 2003):
❑ Technology risk occurs when technological investments do not produce the anticipated
cost savings in the form of either economies of scale or scope; this risk also refers to the
risk of current delivery systems becoming inefficient because of the developments of
new delivery systems.
❑ Operational risk occurs whenever existing technology malfunctions or back office
support systems break down.
OPERATIONAL RISK EVENT TYPES
Mitigated by Effevtive Internal Controls, Business Process Eng. and Internal Audit Function
Internal fraud: Intentional misreporting of positions, employee theft, and insider trading on an employee’s own
account.
External fraud: Robbery, forgery, cheque kiting,* and damage from computer hacking.
Employment practices & workplace safety: Workers’ compensation claims, violation of employee health and safety
rules, organised labour activities, discrimination claims, and general liability.
Clients, products & business practices: Fiduciary breaches, misuse of confidential customer information, improper
trading activities on the bank’s account, money laundering, and sale of unauthorized products.
Damage to physical assets: Terrorism, vandalism, earthquakes, fires and floods.
Business disruption & system failures: Hardware and software failures, telecommunication problems and utility
outages.
Execution, delivery & process management: Data entry errors, collateral management failures, incomplete legal
documentation, unapproved access given to client accounts, non-client counterparty mis-performance, and vendor
disputes.
8. OFF-BALANCE SHEET RISK
Off-balance sheet (OBS) risk relates to the risks incurred by a bank in dealing with non-
traditional banking activities such as financial derivative products (e.g., futures and options),
guarantees, and letters of credit. Mitigated by appropriate recognition and disclosure.
Such activities do not appear in the bank balance sheet, and they involve the creation of
contingent assets and liabilities. It is common to refer to the risks of these activities as OBS
risk, but they nevertheless include all the main types of risk faced by banks, including credit
risk, interest rate risk, exchange rate risk, and liquidity risk.
While OBS can provide some protection against important risks like interest rate or
currency risk, excessive OBS exposures due to mismanagement or speculative use of
derivative instruments can result in spectacular losses.The Barings Bank failure in 1995 is
an often-quoted example of insolvency of a British investment bank due to the misuse of
derivatives activities and other OBS items (foreign exchange trading and investment fund
business).
9. Other risks
Macro-risks are also known as environmental risks, and some of them are common to all
businesses.They can include the risk of an economic recession, a sudden change in taxation,
or an unexpected change in financial market conditions, due, for example to war, revolution,
stock market crashes, or other factors.
Inflation risk – the probability that an increase in the price level for goods and services will
unexpectedly erode the purchasing power of a bank’s earnings and returns to shareholders.
Managed through inflation-linked instruments, diversified portfolios, and interest rate
adjustments.
Settlement or payment risk– a risk typically faced in the interbank market; it refers to the
situation where one party to a contract fails to pay money or deliver assets to another party
at the time of settlement. It can include credit/default risk if one party fails to settle. It can
also be associated with any timing differences in settlement between the two parties.
Mitigated via real-time gross settlement (RTGS) systems and counterparty credit checks.
Regulatory risk – the risk associated with a change in regulatory policy. For
example, banks may be subject to certain new risks if deregulation takes place and
barriers to lending or to entry of new firms are lifted. Changing rules relating to
products and dealing with customers are other examples of potential regulatory risk.
Addressed by strict compliance programs, regular audits, and regulatory capital
buffers.
Competitive risk– the risk that arises as a consequence of changes in the
competitive environment, as bank products and services become available from an
increasing number of new entrants, including non-bank financial firms and retailers.
Reduced through product innovation, digital transformation, and customer-centric
strategies.
Microeconomic risks are generally due to factors inside the bank, rather than
external factors, such as:
Operating risk– the possibility that operating expenses might vary significantly from what is expected,
producing a decrease in income and the bank’s value. Controlled via cost optimization, automation, and
strategic outsourcing.
Legal risk– the risk that contracts that are not legally enforceable or documented correctly could
disrupt or negatively affect the operations, profitability, or solvency of the bank. Managed through strong
legal frameworks, compliance teams, and contractual safeguards.
Reputation risk– the risk that strategic management’s mistakes may have consequences for the
reputation of a bank. It is also the risk that negative publicity, either true or untrue, adversely affects a
bank’s customer base or brings forth costly litigation, thereby affecting profitability. Handled with
transparent communication, strong governance, and proactive crisis management.
Portfolio risk– the risk that the initial choice of lending opportunities will prove to
be poor, in that some of the alternative opportunities that were rejected will turn out
to yield higher returns than those selected.
Mitigated by asset diversification, stress testing, and risk-based capital allocation.
Finally, it is worth mentioning the MANAGEMENT RISK.
This is the risk that management lacks the ability to make commercially profitable and
other decisions consistently. It can also include the risk of dishonesty by employees
and the risk that the bank will not have an effective organization.
Mitigated by effective Corporate Governance.
