Credit Risk, Market Risks (interest, FX), LIquidity Risk, Operational RiskBack to chapter
The measuring and subsequent professional managing of risk is an important part of banking. The bank is required by legislation to measure and manage its risks, but it is also in the interest of the bank’s management to perform this duty as well as possible.
By taking risks the bank achieves income and profit, but risks can also cause costs and losses.
Though it is rarely emphasized and may not be clear at first glance, the main role of a responsible risk management is the same as and shared with business units - maximizing the profit of the bank. From the perspective of the risk management, this means maximizing the “de facto” profit and taking risks such that the bank’s function isn’t threatened, and that it does not experience undue losses. It is important to establish the limit of the bank’s actions, so that it achieves the maximum sustainable positive result. For this to be possible the bank must know its risks and correctly determine their height.
What is meant by risk measurement? Obviously, it would be ideal to know the answer to the question of how much a bank can lose within a given risk, where it is necessary to specify individual risks. The basic problem lies in the fact that historic data is usually used to measure risk, but for ideal measuring it would be good to know future development. However, this data isn't available. Therefore, the measurement of risk is dependent on the use of historic data, varying models, and estimates of future development.
In general, banks distinguish between these basic types of risk.
Each of these risks has its specifics and several methods are used for their measurement.
As is obvious from the nature of the bank’s function, the most significant risk is credit risk. It makes up the largest part of all of the risks that the bank takes, because the most prominent area of the bank is accepting deposits and providing loans.
Multiple definitions and names exist for credit risk (loan risk, counterparty risk, client risk, issuer risk ...), all of which are used in different situations, or more accurately express some aspects of this type of risk.
In general, it is about the risk of the debtor not fulfilling his liabilities, to which he tied himself in a certain amount and agreed upon term of maturity. These liabilities arise with various types of trades - providing/accepting loans, trading with debt instruments (mostly bonds), funds transfer, dealing with derivatives etc.
When measuring credit risk, its quantitative expression is most important. We distinguish between three main types of credit losses - expected losses, unexpected losses, and uncovered losses.
The expected loss is a statistical estimate of the average possible loss of the credit portfolio. The quantification of the expected loss is based on the assumption that the average historic losses of a given portfolio will occur again in the future. Banks take this type of risk into account right at the beginning of the credit relationship, so it cannot truly be considered as risk, but as a cost, known under the name of standard risk costs.