Financial markets/Financial institutions : Bank Risk Management

Overview
o Risk management is at the heart of the banking business, allowing banks to continue to conduct business in a stable manner. Most bank transactions are wide open to multiple categories of risk. Thus risk management must be a part of operations and of strategy in order to maintain an acceptable level of risk while achieving the central objective of generating the highest possible business returns and building confidence among stockholders.
o The most important categories of risk in the banking business include: credit risks; market risks, such as changing interest rates and exchange rates; liquidity risks; operational risks; and capital risks.
o Credit risk is the risk that borrowers may fail to fulfill the terms of their contracts, for example, because financial difficulties prevent them from making payments or because they choose not to, resulting in bank losses. Credit risk is highly significant since loans are a bank's principle source of revenue.
o Market risks are those that arise from changes in interest and exchange rates, the price of equities, and the price of commodities. Such changes, in turn, cause fluctuations in revenue and in the value of assets relative to indebtedness, both in the present and in the future.
o Liquidity risk is the possibility that available cash and convertible assets may be insufficient for the bank access sufficient to fulfill its commitments within required timeframes and while maintaining a prudent level of reserves. Such a situation can lead to bank losses.
o Operational risks arise from flaws or inadequacies in the process of conducting business, employees, money systems and information technology. Operational risks also include external events or conditions that may directly or indirectly impact revenue or the value of existing capital.
o Capital risks are those that arise from changes in a number of conditions, for example, the economy, state regulations and the impact of other risks affecting the maintenance of capital. Capital may fall below the level necessary for conducting business first, by falling below the levels required by state regulations. Second, capital may fall below levels necessary to service indebtedness, and/or the market value of assets may fall below the level of indebtedness and stockholders are unwilling to purchase additional shares. In the extreme, the bank may come under state supervision or even be closed.