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Extreme Events – Specimen Answer A.8.2(a) – Answer/Hints

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Q. Summarise the main risks to which the following types of entity might be most exposed (and which it would be prudent to provide stress tests for if you were a risk manager for such an entity): (a) A commercial bank

 

Commercial banks are exposed to a variety of risks, but the most important are usually:

 

         i.            Exposure to interest rate movements. Commercial banks carry out maturity transformation as they typically borrow short and lend long. Substantial changes to yield levels (and to the shape of the yield curve) can give them major headaches depending on their aggregate cash flow profile.

 

       ii.            Exposure to liquidity squeezes. This was a particular issue for commercial banks during the 2007-2009 credit crisis. Banks reliant on particular markets for sources of funding can run into trouble if these markets dry up. When designing suitable stresses it is also worth considering the precise nature of the funding and the extent to which off-balance sheet arrangements might cease to be off-balance sheet in a stressed scenario. For example, several banks that ran into trouble during the 2007-09 credit crisis were heavy users of ‘shadow banking’ structures, which ostensibly moved their funding exposures to third party entities. However the liquidity squeeze during the 2007-2009 credit crisis was so severe that these banks often found that they had to support their own special purpose vehicles despite the aim being that these vehicles would be ring fenced away from the bank’s own balance sheet in adverse circumstances.

 

      iii.            Credit risk and bad debts. A particular issue here is that the credit exposures may turn out not be as diversified as the bank might have hoped. For example, residential and commercial mortgage business may ostensibly appear to involve a very diversified client base. However, it may actually turn out to be less diversified than expected if there is a major economic downturn that coincides with a major decline in general property values.

 

     iv.            Operational risk. Like other financial services, commercial banks are exposed to operational risks. These might include fraud (by the company’s own employees or directors), or inappropriate incentive elements for employees or within the products it is selling that lead to unhelpful aggregate customer behaviours.

 

P.S. Similar types of risk (but in other guises) usually arise with other types of financial services entities, which may be one contributory factor in the increasing popularity of the discipline of Enterprise Risk Management.

 


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