Financial markets and risks

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Explain the difference between solvency risk and liquidity risk, and also how credit risk contributes to both solvency risk and liquidity risk.

While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties
Solvency risk is the risk that an institution cannot meet maturing obligations as they come due for full value (even if it may be able to settle at some unspecified time in the future) even after disposal of its assets.

Liquidity risk refers to the risk that involves the disposal of assets or selling of assets. An asset may be sold quickly thus stating that the asset is highly liquid. Indeed, liquidity risk includes the management of funding sources and the overall monitoring of the market conditions. This is therefore bound to affect the ability to liquidate the assets of the firm with very little loss in the value of the assets.

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Liquidity problems can result in opportunity costs, defaults in other obligations, or costs associated with obtaining the funds from some other source for some period of time. In addition, operational failures may also negatively affect liquidity if payments do not settle within an expected time period. Until settlement is completed for the day, a financial institution may not be certain what funds it will receive and thus it may not know if its liquidity position is adequate. If an institution overestimates the funds it will receive, even in a system with real-time finality, then it may face a liquidity shortfall. If a shortfall occurs close to the end of the day, an institution could have significant difficulty in raising the liquidity it needs from an alternative source.

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The default events include a delay in repayments, restructuring of borrower repayments, and bankruptcy. Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services.By delivering the product or service first and billing the customer later.

By there being a credit risk, it means the firm is not liquid since debtors are not paying back their loans, on the other hand Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Solvency risks occur by the fact that defaults from repayment of loans and also interest often leads to bankruptcy.

The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculationincludes the borrowers'collateral assets, revenue-generating ability and taxing authority (such as for governmentand municipal bonds).

Describe the nature of dynamic provisioning (or procyclicality), and suggest how a policy of dynamic provisioning by a bank could reduce solvency risk.

Indeed, any quantity that tends to increase when the overall economy is growing is classified as procyclical. Quantities that tend to increase when the overall economy is slowing down are classified as countercyclical.

Dynamic provisioning is an approach used to measure a bank's loan losses and income .The fundamental principle underpinning dynamic provisioning is that provisions are set against loans outstanding in each accounting time period in line with an estimate of long-run, expected loss.

Dynamic loan loss provisions can help deal with procyclicality in banking. By allowing earlier detection and coverage of credit losses in loan portfolios, they enable banks to build up a buffer in good times that can be used in bad times. Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful during financial crisis for example in Spain.

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Banking supervisors know that lending mistakes are more prevalent during upturns: borrowers and lenders become overconfident about investment projects and tend to lower credit standards. During recessions banks suddenly turn conservative and tighten lending standards. Moreover, a monetary policy that remains lax for too long may increase the risk-taking incentives of banks as they search for yield. An anticyclical loan loss provision is a tool that can be used to cope with the excess procyclicality that the lending cycle injects into the real economy.

A provisioning system offers a way to both address the adverse impact of the lending cycle on banks' financial positions and deliver appropriate information to investors by correcting the bias in the measurement of profits and incurred losses over time.

Suggest ways in which liquidity risk should be controlled, by internal systems within banks and by financial regulators, and identify the main problems that a bank may have in controlling liquidity risk effectively.

Liquidity risk is at the heart of the banking industry. More generally, because it materializes at the level of the balance sheet, it provides a synthesis of the sum of risks a company faces.

Management of liquidity risk must be underpinned by the implementation of early warning indicators, by a dynamic process of stress testing, and the drawing up of contingence plans running from the most operational to the most strategic. The following principles detail the key elements for effectively managing liquidity. Banks should formally adopt and implement these principles for use in the overall liquidity management process.

Banks must develop a structure for liquidity management.

Each bank should have an agreed strategy for day-to-day liquidity management. This strategy should be communicated throughout the organization. The strategy shall ensure the bank understands the daily flows associated with their customers' activity to gain an understanding of peak funding needs and typical variations. To smooth a customer's peak credit demands, a bank might consider imposing overdraft limits on all or some of its customers. Moreover, banks must have a clear understanding of all of their proprietary payment and settlement activity in each of the payment and securities settlement systems in which they participate.

  1. A bank Governing Board should approve the strategy and significant policies related to liquidity management. The Governing Board should also ensure that senior management of the bank takes the steps necessary to monitor and control liquidity risk. The Governing Board should be informed regularly of the liquidity situation of the bank and immediately if there are any material changes in the bank current or prospective liquidity position.
  2. Each bank should have a management structure in place to effectively execute the liquidity strategy. This structure should include the ongoing involvement of members of senior management. Senior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are established to control and limit liquidity risk. Banks should set and regularly review limits on the size of their liquidity positions over particular time horizons.
  3. Banks must have adequate information systems for measuring, monitoring, controlling and reporting liquidity risk. Reports should be provided on a timely basis to the banks Governing Board, senior management and other appropriate personnel.

Banks must measure and monitor net funding requirements.

  1. Each bank should establish a process for the ongoing measurement and monitoring of net funding requirements.
  2. Banks should analyze liquidity utilizing a variety of what if scenarios.
  3. Banks should frequently review the assumptions utilized in managing liquidity to determine that they continue to be valid.

Banks should manage market access. Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets.

Banks should have contingency plans in place that address the strategy for handling liquidity crises and which include procedures for making up cash flow shortfalls in emergency situations.

Banks should manage their foreign currency liquidity.

  1. Each bank should have a measurement, monitoring and control system for its liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually.
  2. A bank should, where appropriate, set and regularly review limits on the size of its cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which the bank operates.
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Each bank must have an adequate system of internal controls over its liquidity risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made.

Each bank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information about the bank in order to manage public perception of the organization and its soundness.

Quality of Liquidity Risk Management

There are certain indicators that ought to be used to assess the quality of liquidity risk management. These include:

Strength: the board is responsible for approving policies which would effectively ensure that sound guidelines are passed for the regulation of liquidity risk management.

The liquidity risk management process aids in the identification and measurement of the liquidity risk as well as monitoring of the risk as appropriate to the assessment of the financial risk. It is imperative that the firm's management understands fully the impact of the liquidity risk. This will help avert the impact that the liquidity risk may have on the dynamic market conditions.

Satisfactory: the liquidity assessment methods employed must be sound and easily understood by the management. This therefore implies that these risk methods should meet the standards set. A contingency plan would therefore be effective in ensuring that there is adequate plans for the effective management of the liquidity risk.

Weak: it is imperative that management maintains adequate policies which would be pertinent to the management of the liquidity risks. Management should be aware of their weaknesses as pertains to the management of the liquidity risks.

While banks have been implementing measures to manage emerging liquidity risks, further work is inevitable to satisfy the higher regulatory standards underpinning the proposed rules. Specifically, this is likely to involve:

  1. Updating internal risk governance to include the establishment of liquidity risk tolerance, review of stress scenarios and the funding strategy, and approval of contingency funding plans by the governing body. The key challenge will be in implementing a comprehensive and easily understandable approach to setting liquidity risk tolerance, particularly for diverse institutions, and in designing appropriately severe stress scenarios to reflect the nature of the businesses;
  2. Implementing a robust and well documented Individual Liquidity Adequacy Assessment process. It will need to address adequately the main areas that are likely to be reviewed by the regulators in their assessment of adequacy of liquid resources;
  3. Enhancing internal stress scenario testing processes to accommodate the three types of stress scenarios; to derive stress parameters to implement these scenarios; and to consolidate the results to provide a group-wide position;
  4. Ensuring transparency and greater use of the stress results in the management of liquidity risk such as enhancing contingency funding plans and funding strategy to ensure that it reflects diversification of funding sources, and managing the resultant changes required to the business models;
  5. Ensuring that liquidity risk is managed at an entity level and that it satisfies local liquidity requirements while, at the same time, ensuring efficient use of liquid resources at group level;
  6. Improving internal systems to be able to produce the new data for liquidity reporting, which is likely to require consistent and integrated view of data across the organisation, and be able to cope with daily reporting, when required.