1. *Credit Risk:*
- This risk occurs when people or companies who borrow money from the bank fail to repay their loans.
- It also includes the risk of the bank's trading partners, involved in contracts like derivatives, defaulting on their obligations when the contract has turned against them (negative value for them, positive value for the bank).
- To account for these risks, banks charge interest rates on loans that consider expected losses. For example, if they expect 0.6% of loans to result in losses, they might charge 2% more on average to cover those potential losses, leaving 1.4% for other costs and profits.
2. *Market Risk:*
- This risk arises from a bank's trading activities, where they may face losses due to changes in the value of assets (like securities) that the bank owns.
- Examples of market risk factors include fluctuations in interest rates, exchange rates, and stock prices.
- Banks allow their larger investors to trade in various financial contracts, and while the bank tries to control their exposure to market risks, it's not entirely possible to eliminate them.
3. *Operational Risk:*
- Operational risk relates to the possibility of losses caused by external events or internal control failures within the bank.
- External events may include things like cyber attacks or damage to physical assets.
- Internal control failures could result from employee misconduct (e.g., theft), business disruptions, IT failures, or human errors.
- Banks are particularly exposed to legal, compliance, and cyber risks in their day-to-day operations.
In summary, a bank faces risks from borrowers not repaying loans, trading activities, and internal and external operational factors. These risks include potential defaults, market fluctuations, and losses due to external events or internal control weaknesses. Managing these risks is crucial for a bank's stability and profitability.
1. Which risk refers to the possibility of borrowers not repaying their loans or counterparties defaulting on contracts such as derivatives?
a) Market risk
b) Credit risk
c) Operational risk
d) Liquidity risk
2. Market risk in a bank arises from:
a) Employees' fraudulent activities
b) Changes in interest rates, exchange rates, and stock prices
c) Cyber attacks
d) Business interruption
3. What is the primary concern of operational risk for banks?
a) Declines in the value of securities the bank owns
b) Employee defalcation and IT failures
c) Counterparty default on derivative contracts
d) Failure to comply with market regulations
4. When a bank acts as a market maker for its larger investors, it has controlled exposures to market risk factors, but the risk is not zero. This is an example of:
a) Credit risk
b) Systemic risk
c) Market risk
d) Operational risk
5. The interest rate charged by banks on loans takes into account expected losses, leaving the remaining amount for operating costs and profit. This is mainly related to:
a) Market risk
b) Credit risk
c) Liquidity risk
d) Operational risk
Answers:
1. b) Credit risk
2. b) Changes in interest rates, exchange rates, and stock prices
3. b) Employee defalcation and IT failures
4. c) Market risk
5. b) Credit risk
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