Chapter 3 - Risks Inherent in Financial Institutions

Abstract

The major risks faced by banks and related financial institutions include credit risks, interest rate risks, market risk, and operating and liquidity risks. The other risks include residual, dilution, settlement, compliance, concentration, country, foreign exchange, strategic, and reputational risks. The major tools of a risk management system used by banks are stress testing and asset and liability management. The different forms of interest rate risk are gap or mismatch risk, basis risk, embedded-option risk, yield curve risk, price risk reinvestment risk, and others. The instruments for credit risk management consist of estimating expected loan losses, multitiered credit-approving systems, prudential limits, risk ratings, risk pricing, portfolio models, loan review mechanisms, and the like. The instruments for measurement of interest rate risk are maturity gap analysis, duration gap analysis, and simulation analysis. The basic model for measurement of market risk is value at risk. Liquidity risks are measured through various ratios. The risks in major nonbanking financial institutions such as insurance includes underwriting and investment risks along with market, credit, and provisioning risks. Pension fund risks consist of firm specific risks, funding risks, investment risks, plan termination risks, and compliance risks. Mutual fund risks consist of market risks, liquidity risks, call risks, and currency risks.