Types of risks
A major objective of financial institution management is to
increase the financial institution’s returns for its owners. This often comes,
however, at the cost of increased risk. This article overviews the various
risks facing financial institutions: interest rate risk, credit risk, liquidity
risk, foreign exchange risk, sovereign risk, market risk, off-balance sheet
risk, insolvency risk.
1.
Interest rate risk
Interest rate risk refers to the risk
incurred by an financial institution when the maturities of its assets and
liabilities are mismatched.
Asset transformation involves an financial
institution’s buying primary securities or assets and issuing secondary
securities or liabilities to fund asset purchases. The primary securities
purchased by financial institutions often have maturity and liquidity
characteristics different from those of the secondary securities financial
institutions sell. In mismatching the maturities of assets and liabilities as
part of their asset-transformation function, financial institutions potentially
expose themselves to interest rate risk.
2.
Credit risk
Credit risk refers to the risk that the
promised cash flows from loans and securities held by financial institutions
may not be paid in full. Credit risk arises because of the possibility that
promised cash flows on financial claims held by financial institutions, such as
loans or bonds, will not be paid in full. Virtually all types of financial
institutions face credit risk. However, in general, financial institutions that
make loans or buy bonds with long maturities are more exposed than are
financial institutions that make loans or buy bonds with short maturities. For
example, depository institutions and life insurers are more exposed to credit
risk than are money market mutual funds and property-casualty insurers.
3.
Liquidity risk
Liquidity risk refers to the risk that a
sudden surge in liability withdrawals may leave an financial institution in a
position of having to liquidate assets in a very short period of time and at
low prices. Liquidity risk arises when an financial institution’s liability
holders, such as depositors or insurance policyholders, demand immediate cash
for the financial claims they hold with an financial institution or when
holders of off-balance-sheet loan commitments (or credit lines) suddenly
exercise their right to borrow.
4.
Foreign exchange risk
Foreign exchange risk refers to the risk
that exchange rate changes can affect the value of an financial institution’s
assets and liabilities denominated in foreign currencies.
Financial institutions have recognized that
both direct foreign investment and foreign portfolio investments can extend the
operational and financial benefits available from purely domestic investments.
To the extent that the ruturns on domestic and foreign investments are imperfectly
correlated there are potential gains for an financial institutions that expands
its asset holdings and liability funding beyond the domestic borders.