Financial Market and Risk: Credit Risk, Liquidity Risk, and Solvency Risk

Managing risks is one of the bank’s management functions. In this study we shall look at three types of risks; credit risk, liquidity risk and solvency risk.

Liquidity risk

Liquidity risk refers to a phenomenon where the bank is not in a position to honour its obligations whether regular, contingent or ad hoc on time, or in order to do so it has to make an emergency borrowing (Basel, 2008). The business of banks involves taking money from one party and providing it to other parties who repay the money at an interest, the deposited fund may be a customer deposit, a loan from central banks or even long-term deposits by institutions. It’s the function of the management to ensure that any form of investment that have been put within its custody, should be available whenever that customer requires it (Beattie et al, 1995). Liquidity risk management entails making efforts to ensure that when managing the funds, the bank can meet the customers’ needs without necessarily taking emergency measures such as sale of assets or an unplanned collection of an asset from where it was invested.

Solvency risk

Solvency risk refers to risk that the bank faces as a result of insufficient capital to enable it absorb the losses associated to all other risks. From this definition it is clear that due to the presence of the other kinds of risks, the bank will always be faced with this risk. It’s the responsibility of the management to ensure it has adequate capital to absorb all the risks arising from interest rates, currency, market shifts or even economic downturns as they make a bank prone to solvency risk (Beattie et al,1995).

Credit risk is used to refer to a situation when the counter party to a financial transaction will be unable to meet the specified obligations( servicing the debt), or the fact that his credit standing will worsen during the credit period specified in the agreement to an extent he will default paying his debt. How then does credit risk leads to solvency and liquidity risk.

A bank acts as an intermediary between investors and borrowers. The bank’s business entails obtaining money from people who need reward inform of capital gains, profit share (dividends), or interests and issuing it to others people who are willing to repay at higher amount or with interest(Berger et al, 2000). The bank ought to maintain a mix of the two that allows the investor’s access to his investment at all times and availability for capital to borrowers at the time they may need it. However, if the borrower defaults and the collateral for which he had placed against the debt do not repay the credit to full amount, then the bank will be forced to obtain the cash from somewhere else for the sake of the investor. If the bank cannot obtain an equivalent amount to replace the defaulted value then it’s said to be exposed to a liquidity risk. The bank at that time may liquidate a component of its capital so that it can raise some money/liquid asset to replace the defaulted amount. In case it does not have enough capital to do so the bank is said to be exposed to a solvency risk (Berger et al, 2000). In order to regain money to pay the investor the bank will have to be dissolved and sale of its assets used to cover the debt. A typical example is the banks in Dubai where as a result of economic down turn the borrowers would not be in a position to pay the loans they had taken. Efforts by the bank to obtain external funds from the government did not materialize until December 2009(The Economist, 2009). However even the money that came along was too little to settle a debt of over $16 billion owed to banks from all over the world. This led to their eventual collapse an issue that was echoed in the ratings by Standards & Poors where they were given a Junk Status (Economist, 2009).

Procyclicality

This refers to a condition when the value of a good or service or an economic indicator such as GDP acts as real reflection of the state of the overall economy (Berger et al, 2000). The life of a business is marked by cycles; these cycles are either upturns or downturns. During the upturns the business environment is favorable and the banks’ usually experience a credit boom. The expansion of credit will usually trickle to business and this contributes to economic growth, the asset value usual increase in response to expectations of the economy and this expected to sustain the availability of capital. This would only occur in a perfect environment where all information is available but in a day to day business all the required information may not be available (Berger et al, 2000).

Research has also shown that this period of credit boom is usually followed by a period of high rate of decrease in GDP, rising interest rates for funds, reduction of imports and a trade stock. These adverse effects usually affect the way businesses are run eventually lead to failure by clients to honour their deal in the long run. The effect of procyclicality is not one that can be eliminated in full especially when the economy is doing well as a reflection of the good performance is expected in the value of assets and the business of the bank. However in case of a down turn, if this effect is transferred to the economy excessively the result will affect the bank sector negatively. This negative effect arises from the following phenomena:

Collaterals

The banks usually try to reduce the risk of default by using collaterals which they hope to sell in future. The value of these collaterals usually increase during the period of upturns and this makes the credit analysts to allow for flexibility by offering terms that can be easily adjusted upwards. A latter sharp drop in the price of these assets reduces the security it offers meaning that the bank will be subjected to liquidity risk again. As an effort to reduce the effect of the decrease in value the banks will usually liquidate the collateral at values that are not equal to the value of assets this opens a window for liquidity risks for the debts that are not collateralized. This means that the financial systems cannot avail any more capital which in re turn (Berger et al, 2000).

Under pricing of credit

On the other hand during upturns the environment is usually very promising and research has shown that during upturn cycles the banks usually reduce the probability of default relating to the credit that they extend to client. This means they underestimate the cost they would incur in case of default.

So what does and bank do in times of downturn cycles to avoid transferring procyclicality to the economy? Basel II committee came up with these proposed measures to address procyclicality in down turns as well as boost resiliency in time of upturns (Basel, 2009). The measures include;

The committee proposed that the minimum capital requirement should have a large component of common stock, the banks should also avoid under pricing the credit risk by providing more forward looking provisions, the banks should increase the sensitivity analysis when assessing the risk associated with the credit that they offer and lastly the banks should ensure that they retain enough capital which will act as a cushion when the bank is exposed to risk in stressful periods.

These measures will go along way in ensuring that the banks are not adversely affected in times of economic down turns and at the same time they are in a position of recovery when exposed to liquidity risks. If these measures are included in the strategies that the banks operate then the banks will be in a position to avoid excessive negative procyclicality (Basel, 2009).

The liquidity turmoil

The liquidity turmoil experienced in 2008 brought into limelight the fact that banks are under an obligation to ensure that they are keen on their liquidity position at all times (Economist, 2009). The erosion of previously excess liquidity meant that the banks ought to maximize in period of abundant liquidity and at the same maintain a cushion to enable them to take them trough the stressful periods. The Basel committee proposed several measures that if used would enable the bank to be in liquid position at all times and avoid instances of liquidity turmoil like those experienced in 2008 (Alexander, 2010). The case of banks in Dubai is only one of the few lessons that indicate the need to have a good liquidity strategy as years of great efforts of bank can be eroded within a small period of time. One of the most important lessons that was leant in 2008 was the fact that liquidity is not a one time issue but it should be entrenched within the corporate strategy of the bank at all times (Alexander, 2010). The issue of liquidity should be expressed in every aspect of the bank right from internal pricing, interdepartmental transfer pricings, and evaluation of the performance of the departments as well as the basis of establishment of new products in the market. Liquidity should be the most important factor in any analysis and it should be ensured at all levels (Alexander, 2010). The Basel I committee released several principles to ensure that the banks are liquid.

The management ought to be keen on anything that will adversely affect the liquidity of a bank. The bank’s management can adopt the following principles as an aid to the liquidity management.

Establish a risk tolerance limit

The main reason why most of the banks end up in risk turmoil is due to the issue of more credit that the bank can adequately absorb incase of downturn of the clients. The Basel II committee has come up with a proposal that will be used to gauge the ability of a banks offering credit as a function of the risk and capital requirement. According to the report, the banks should avoid issuing a lot of credit without paying attention to their capital ability and their ability to fund those obligations accordingly (Basel, 2009).

The management should come up with strategies that indicate the accepted collaterals for particular kinds of debts, and those debts which cannot be collateralized. The bank shall also highlight the measures that should be used to liquidate the collateral and the value that they should be considered to be viable to be if it is liquidated (Basel, 2009). On the other hand these measures shall indicate the period of consideration for the analysis of issue of debts.

The management should also come up with means of measuring and managing of risks.

One of the issues that were realized by the just concluded global crises was the inability of banks to anticipate the economy collapse that left them and their clients in a crisis. One issue that has come to the lime light is that the banks are usually under a risk of under pricing of risks in upturns cycle. The Basel committee proposed the following in relation to measurement and managing of liquidity risk (Basel, 2009);

Have sound measures for identifying risks

Some of the risks that a bank is exposed to may not be seen at engagement. Base1 report came up with some form of formulas that were to be used is assessing the risk exposure of a bank. The formulas included the basic indicator approach and the standardized approach. In the latter approach the banks were expected to analyze the credit risk associated to a client on the basis of his industry, his credit rating and the amount of loan. The approach stated various weights for the risk associated to claims on the banks and security companies, corporate, retail products. Each of these clients was assigned a different weight and the decision to offer the loan was based on the value arrived from use of the weights associated. Those weights were used to come up with the kind of collateral that can be accepted in relation to that weight (Basel, 2009).

The committee also proposed that the management should consider investing in a diversified source of income. The bank shall ensure that when exposed to a risk of liquidity it should have a varied list of option. The strategy shall also indicate under what circumstances a particular option should be taken (Basel, 2008).

The management should also maintain a mix of assets and liabilities that allow for the bank to meet obligation as they fall due. The management should maintain a mix of assets and liabilities that ensure that the bank is in a position to meet regular liabilities and any contingent liabilities that may arise (Basel, 2008).

The management should also conduct regular stress tests to get an idea of the risk at every one particular time and have a cushion to make up for unexpected costs that arise.

On the other hand the financial regulations have set up benchmarks against which the management of banks should be managed under to ensure there is liquidity. For there to be liquidity there are some measures that ought to be taken by the industry as a whole. An example relates to an action by some banks in the period of recession. Since it was general knowledge of existence of credit crisis, the expected reaction was stringent measures directed towards the provision of credit. However, some banks went ahead to issue credit with discounted interest rates basing it on competition (Basel, 2009). This went against the efforts of most banks that had undertaken the required measures. The role of financial regulation is to come up with benchmarks that allow those banks that pursue certain strategies for the sake of the industry as a whole are given an opportunity to reap their benefits. These regulators will indicate measures to be taken when under crises or even some companies wish to go against other banks strategies. Examples of regulators include the Basel committee, the central banks of different countries and federal banks associated with different countries. During times of crises the big banks are usually adversely affected as compared to small banks. While small banks can adjust within a short time they are at times victims of the strategies of big banks (Alexander, 2010). The financial regulators allow either of the two to operate in a manner that they are in apposition to exploit the economies of the market without affecting the liquidity of the other party. The financial regulators also offer financial aid to the banks when they fall into credit turmoil.

However management of liquidity cannot be done so perfectly as to be in a position to eliminate any chances of risk. The business of banks is taking risks and capitalization on upturns. The best way to make best use of upturn is by issuing as much credit as possible. Several attempts have bee used to try reducing the risk such as use of collaterals and reduction period of credit into short terms where a client is offered additional credit on completion of the previous loans (Basel, 2008). However as discussed above all these measure do not cover the risk entirely and at times especially during downturns the companies find themselves entangled in the crisis. The best way to absorb risk associated with such liquidity is the transfer to insurance or other parties whose strategies complement the strategies of the banks according to the solvency II (Basel, 2009).

List of references

Alexander P (2010). Lean and liquid. The Banker, Web.

Basel Committee on Banking Supervision (2008). Principles for Sound Liquidity: Risk Management and Supervision. Web.

Basel Committee on Banking Supervision (2009) Consultative Document: Strengthening the resilience of the banking sector. Web.

Beattie et al (1995). Banks and Bad Debts: Accounting for Loan Losses in International Banking. London: John Wiley and Sons.

Berger A, Davies S and Flannery M (2000). Comparing Market and Supervisory assessments of Bank Performance: Who Knows What When? Journal of Money Credit and Banking, 32.

The Economist (2009). Dubai’s debt cliffhanger: A second life; Abu Dhabi rescues Dubai after all. The Economist, Web.

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NerdyRoo. (2022, March 15). Financial Market and Risk: Credit Risk, Liquidity Risk, and Solvency Risk. Retrieved from https://nerdyroo.com/financial-market-and-risk-credit-risk-liquidity-risk-and-solvency-risk/

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NerdyRoo. "Financial Market and Risk: Credit Risk, Liquidity Risk, and Solvency Risk." March 15, 2022. https://nerdyroo.com/financial-market-and-risk-credit-risk-liquidity-risk-and-solvency-risk/.

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NerdyRoo. 2022. "Financial Market and Risk: Credit Risk, Liquidity Risk, and Solvency Risk." March 15, 2022. https://nerdyroo.com/financial-market-and-risk-credit-risk-liquidity-risk-and-solvency-risk/.

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NerdyRoo. (2022) 'Financial Market and Risk: Credit Risk, Liquidity Risk, and Solvency Risk'. 15 March.

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