A bank is a critical institution in society due to its role in ensuring that a country remains financially balanced. Like any other business, risks are inevitable in the banking sector. Therefore, proper financial management is critical in ensuring the continuity of the bank. The degree to which a bank manages these risks is essential to defining its competitiveness and how it spreads the risk ( Tarullo, 2019). Banks face many risks that can stem from either its liquidity position, the interest rate in the market, and the credit risk. Each of these risks has implications, and the bank must come up with the best approach tom uniquely manage each of them to succeed. The first step towards achieving these risks is to understand them, as discussed in this article.
Credit Risk
One of the essential roles of a bank is the ability to give people credit. People need loans to initiate their business projects, purchase cars, and houses. When the bank provides credit, the banks trust a person with a massive sum of money. The banks benefit from such credit when the borrower can make payment in full after some durations. The risk that comes with credit is that the bank has fewer options to determine whether the person can pay the money back and the interest ( Hassan, Khan & Paltrinieri, 2019). There are also high chances that some will default on the payment, which adds more risk to the bank while giving credit. The credit risk in a bank takes three different forms. The first is credit concentration ( Hassan, Khan &Paltrinieri, 2019). In this case, the bank provides more credit to a specific company or its branches. In case such company or person default or faces any risk, the bank risk losing a tremendous amount of money.
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The next is credit processing issues. For a bank to give credit, they have to check the history of the person taking the loan. These may include credit history, the ability to repay the credit, capacity, the loan condition, and the collateral. These are essential issues that sometimes, the bank may not get accurate data, and thus increase their credit risk. The last is the cyclic performance of the economy. A person taking credit when the economy is stable is likely to face many challenges in repaying the loan when the economy is in a depression. The bank must shoulder such risks.
The Interest Risk
The interest rate is never constant for banks in the market. The interest can either be high or low, depending on different economic factors that reshape the money flow in the market. When the bank issue a loan when the interest rate is high, there is a chance that the interest rate can drop, and this means that those who pay such interest may be affected. Therefore, the fluctuating interest rate is what brings about the interest risk to the banks ( Tarullo, 2019). Thus, the role of a bank is to talk to those taking a loan and inform them of the best rate or amount they should take to avoid falling victims of default when the interest rates change.
The banks also have a chance of avoiding being the victims of the interest loan risks by changing their loan terms. For instance, they can reduce the loan repayment when they anticipate a fluctuating interest in the future. The bank can also take out loans at the correct time, and this will be critical in reducing their chances of falling victim to fluctuating interest ( Dolgun& Ng, 2019). They can also use the risk management product to maintain interest rates in a reasonable position for the business.
Liquidity Risks
Liquidity is the risk that the bank faces when it is unable to meet its short-term financial demand. The bank may have an asset that it needs to sell to gain some financial support. However, when the bank fails to meet such demand or sell such assets, it runs into liquidity risk. The bank can also run into a liquidity risk when it has no cash or financial power to make payments for short-term obligations. Sometimes, the bank may have an inventory that it needs to sell to make some financial obligations ( Boateng, Liu & Brahma, 2019). However, the customers may not desire such a list or may insist on low payment. In such a case, the business risk running into liquidity risks.
How Credit and Interest Risk Affect Liquidity Risk
Both credit and interest rates have an impact on the bank's liquidity. For instance, credit risk reduces the bank's ability to have cash flow, which it can use to settle its obligations. Take, for example, a situation where the person takes a large amount of money but defaults on payment ( Gomez, Landier, Sraer & Thesmar, 2020). In such a case, the bank may have little to cater to its financial obligations. The same applies to the interest rate. When a bank gives out a loan when the interest is high, and then it drops, it may be affected by gaining low profit. Also, there can be case defaulting payment when the interest fluctuates ( Al-Wesabi, 2020). Therefore, the bank may not have the excellent financial stability to allow it to settle its short term financial obligation. Thus, both credit and interest rates have a significant impact on the liquidity of the bank.
Therefore, the bank must be vigilant in ways of managing finances to reduce the risks that come due to interest fluctuation and liquidity. They also need to manage credit in the best way possible to reduce their chance of falling victims of credit risks.
References
Al-Wesabi, H. A. (2020). Credit risk of Islamic banks in GCC countries. International Journal of banking and finance , 10 (2), 95-112.
Boateng, A., Liu, Y., & Brahma, S. (2019). Politically connected boards, ownership structure, and credit risk: Evidence from Chinese commercial banks. Research in International Business and Finance , 47 , 162-173.
Dolgun, M. H., & Ng, A. (2019). Liquidity Risk Management in Islamic Banks: Evidence from Malaysia. In Islamic Monetary Economics and Institutions (pp. 159-179). Springer, Cham.
Gomez, M., Landier, A., Sraer, D., &Thesmar, D. (2020). Banks' exposure to interest rate risk and the transmission of monetary policy. Journal of Monetary Economics .
Hassan, M. K., Khan, A., &Paltrinieri, A. (2019). Liquidity risk, credit risk, and stability in Islamic and conventional banks. Research in International Business and Finance , 48 , 17-31.
Tarullo, D. K. (2019). Financial regulation: Still unsettled a decade after the crisis. Journal of Economic Perspectives , 33 (1), 61-80.
