Equity* bank is a community bank located in downtown. It has 30 employees working in different roles to serve customers and the community. Equity bank has cemented its status as the ideal community bank through its commitment to helping community members overcome financial issues. Equity bank has developed a “culture of caring” and good relationship with the community. However, just like most community banks, Equity bank is struggling with revenue growth due to lower interest rates.
There are other notable risks that the financial institution grapples with, the risks include: market risk, credit risk, liquidity risk, earnings at risk and value at risk as discussed below. Also, discussed are the risk treatment techniques for each risk.
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Market Risk
Risk Description
The Federal Reserve System (2016) describes market risk as the risk of financial loss due to the changes in the market prices. Market risk encompasses various risk factors, though they emanate from the changes in market prices. Equity bank is vulnerable to market risk because of the constant changes in interest rates, forex rates, commodity risk, or equity prices. Market risk affects the financial institution’s earnings as well as the economic value. For instance, low interest rates mean that Equity bank will not achieve its revenue target.
Risk Treatment
Market risk cannot be avoided; hence the right treatment technique is to modify the impact (severity) of the risk. Banks can manage market risk by measuring the risk using value at risk (VAR) and sensitivity analysis. Value at risk establishes the maximum loss over a period of time, while sensitivity analysis evaluates how different values of an independent variable will affect the dependent variable. Each of the factors that make up the market risk, interest rate, forex rate, commodity risk and equity prices will be analyzed independently to determine its effects on Equity bank’s profitability. The bank will conduct a comprehensive VAR analysis to generate market risk scenarios and predict the implications of the scenarios using the model.
Credit Risk
Credit risk is another notable risk for a community bank. Equity bank offers small, medium and large scale loans to community members and businesses, thus making itself vulnerable to credit risk. With a credit risk, the borrower fails to pay either the principal or the interest associated with it (Ayam & Ahinful, 2015). Equity bank offers various types of loans; there is mortgages, credit cards, personal loans, small business loans among others. Banks charge interest as a reward for assuming credit risk, but in some cases the risk occurs. Though loans are the biggest source of credit risk, other banking activities play a role. Interbank transactions, forex transactions and trade financing are sources of credit risk.
Risk Treatment
The bank will retain the risk with the intent of paying it through funds budgeted for the purpose because. Most banks retain enough capital and loss reserves to cushion the bank against credit risk (Ayam & Ahinful, 2015). Community banks rely heavily on the interest from loans; hence the bank cannot stop offering credit services, rather it must put in place proper credit risk management. The goal of credit risk management is to maintain exposure to credit risk within acceptable parameters. However, maintaining loss reserve is not enough; the community bank must identify, measure, and control its credit risk. It must put in place proper credit management strategies such as charging reasonable interest rates and adhering to underwriting authority limits.
Liquidity Risk
Liquidity risk is the probability of loss from a situation where the bank will not have enough cash or cash equivalents to meet the needs of customers (Basel Committee, 2008). Short term and sudden financial demands may force the bank to convert its security into liquid asset, and the bank can lose capital or profit in the process. Drop in the value of stock and other securities often motivates investors to sell their stock leading to large price deadlines which the bank cannot meet. 2008 financial crisis exposed most banks to liquidity crisis because banks lacked enough liquid assets to meet the customer needs.
Risk Treatment
The community bank can exploit the liquidity risk by raising the liquidity on the liability side or act on the asset side. The bank should hold high quality liquid assets to draw them in case of liquidity shortage while investing in areas that pay off immediately (Basel Committee, 2008). While holding liquid assets will not be in the best interest of the bank, the bank has to protect itself from insolvency. Effective exploitation of the liquidity risk is necessary to establish the right balance between liquidity risk and profitability.
Earnings at Risk
Earning at risk (EaR) measures the quantity in which net income might change in case of adverse change in interest rates (Glacy & Sarna, 2005). Banks face many risks, and the risk fluctuating interest rates is probably the biggest risk. The community bank has investors that rely on the organization to make profits so that they can continue investing in the business. There are various aspects of an EaR, the bank can analyze its earnings, interest margins, cash flow and market values to derive loss percentiles. However, the EaR measure is often deemed unstable and volatile, it requires assumptions and it might not generate the real loss and effects on the net income (Glacy & Sarna, 2005). EaR does not also define the sources of risk, making it impossible for the organization to manage the risk.
Risk Treatment
The bank can avoid EAR by not engaging in activities related to the measure. EaR should be seen as an additional risk management tool, rather than a core risk management tool.
Value at Risk (VaR)
VaR is a statistical tool used to measure the amount of financial loss over a specific period of time. It is used to determine the occurrence of potential losses on the bank’s portfolios, and it applies to specific situations affecting the bank. A community bank has various trading desks and business units, each dealing with different aspects that affect the profitability of the bank. VaR is a measure that enables the bank to get a picture of the all of the potential losses so that it can come up with robust measures to prevent or mitigate the losses.
Risk Treatment
Though VaR has become a crucial tool for financial institutions, VaR calculations are technical and tasking (Halbleib & Pohlmeier, 2012). VaR can produce low numbers, hence misrepresenting the potential losses. For instance, VaR was criticized for its role in the 2008 credit crisis; it underestimated the danger from toxic mortgage products (Halbleib & Pohlmeier, 2012). While VaR plays an important role, the community bank must be careful to supplement it with other measures. VaR should not just rely on historical data, but it must be a careful analysis of the current situation. Halbleib & Pohlmeier (2012) suggest a better VaR approach based on the principle of optimal combination, the approach is robust and more precise and it can provide a clear picture of the overall performance of a bank.
References
Ayam, J. R. A., & Ahinful, G. S. (2015). Risk Management in Rural and Community Banks: The Ghanaian Experience. Case Studies in Business and Management , 2 (1), 17.
Basel Committee. (2008). Liquidity risk: Management and supervisory challenges. Retrieved from: Bank for International Settlements. Retrieved from: http://www.bis.org/publ/bcbs136.pdf
Federal Reserve System. (2016). Market Risk Management. Retrieved from: https://www.federalreserve.gov/bankinforeg/topics/market_risk_mgmt.htm
Glacy, J., & Sarna, C. (2005). Earnings at Risk:Real-world Risk Management. Allstate. Retrieved from: http://www.ermsymposium.org/2005/erm2005/B5_Sarna.pdf
Halbleib, R., & Pohlmeier, W. (2012). Improving the value at risk forecasts: Theory and evidence from the financial crisis. Journal of Economic Dynamics and Control , 36 (8), 1212-1228.
