Faculty of Commerce, Administration and Law
Department of Economics
Assignment Cover Sheet
Student Name Student Number
Module Title Bank’s Equity Capital
Module Code CBBG332
Assignment Topic Discuss the different type of risks facing banks and evaluate the link between bank capital and each type of risk
Due Date 15 August 2018
Name of Lecturer Mr. S. Zhou
Table of Content
Content Page Number
1. Introduction 3
2. Bank Capital 3
3. Capital and risk 3
4. Different types of risks facing banks 3
5. The Link between bank capital and each type of risk 4
6. Defence strategies used by financial institutions 6
7. Conclusion 7
8. References 8
A bank is an institution that accepts money from the public and creates credit. Banks lend money through markets known as capital markets. They are highly regulated in most countries because of their importance.
Banks are regulated according to minimum capital requirements, in addition to other regulations intended to enable liquidity, based on an international set of capital standards known as the Basel Accords.
Bank capital is the difference between its assets and liabilities. Bank capital represents the net worth of the bank or its value to investors.
Bank capital is described as the margin that creditors are covered if it liquidates its assets.
Capital and risk
The amount of risk a bank faces determines profitability as well as how much capital it is required to hold.
Bank capital consists primarily of equity, retained earnings and subordinated debt.
Different types of risks faced by banks
There are mainly 8 risks facing the banking industry.
1. Credit risk
Credit risk is the risk that a bank borrower or counterparty will not meet its obligations according to stipulated terms of the credit agreement.
2. Market risk
Market risk is the risk that the value of a portfolio decreases because of a change in market risk factors.
3. Operational risk
Operational risk is the risk of losing money resulting from failed internal processes.
4. Liquidity risk
Liquidity risk is risk that an investment that is not marketable cannot be traded quickly to prevent or minimise a loss.
5. Reputational risk
Reputational risk is the risk relating to the credibility of a business.
6. Business risk
Business risk is the risk that a company will have lower than expected profits, or that it will experience a loss rather than a profit.
7. Systemic risk
Systemic risk are risks associated with cascading failures where the failure of one large bank causes the failure of other entities.
8. Moral hazard
Moral hazard happens when a big bank or large financial institution takes risks knowing that another financial institution will face the costs of those risks.
The Link between Bank Capital and each type of risk
Management decisions in the banking sector have become more vital and complex because of the volatility of financial markets.
Existing regulations attempted to control capital, liquidity, diversification, and risks while promoting sound management.
Banks are required to maintain adequate capital or are offered a choice of paying insurance penalties if their capital becomes inadequate.
The amount of capital a bank is likely to hold to maintain sound business practice is determined by the amount of risk that it assumes.
Modern theories of risk and capital aid decision-making. With a greater understanding of potential trade-offs, banks may choose a desired level of risks with a minimum waste of capital.
Measuring Adequate Capital
The use of a portfolio approach enables us to define capital adequacy. The measurement of capital adequacy must be useful to managers, insurers and regulators.
Risk assumed by a firm constitutes adequate capital.
Capital is adequate either when it reduces risk of future insolvency to some predetermined level or when the premium paid by the bank covers the expected losses of the insurer.
Portfolio theory gives the tools needed for measuring the risks of insolvency.
A bank selects a portfolio, consisting of a variety of particular activities. The expected changes in these activities, their rate of return, and the bank’s capital policy give an expected end-of-period net worth. However, expectations are unlikely to be realised exactly because of economic events.
Measuring the risk of a portfolio requires a calculation of its expected end-of-period net worth and the probable distribution of possible net worth’s around this level
The bank will become insolvent if it acquires a negative income.
There are two models used to measure adequate capital.
1. A Model of Insolvency
A bank is theoretically insolvent when its liquidity is so low that it cannot pay off its debts, or when the market value of its liabilities exceeds that of its assets.
2. A Model of Variances
To measure risk, liabilities and assets are pooled together into a limited number of activities.
The banks expected return and its variance depends on the weight of the individual activities, their expected returns, and their variances and co-variances.
Defence strategies used by financial institutions to reduce negative impact emanating from risks
The three lines of defence is an internal defence strategy that is used to reduce the negative impact emanating from risk.
The Three Lines of Defence in Effective Risk Management and Control
The three lines of defence model is an internal audit function that provides a simple and effective way to enhance communications on risk management and control by clarifying essential roles and duties.
It provides an outlook on operations, to ensure risk management success – irrespective of size or complexity.
A. Risk Management Oversight and Strategy – Setting
In the three lines of defence model, the first line of defence is management control, the second line of defence are risk functions established by management, and the third is independent assurance.
The Three Lines of Defence Model
B. Coordinating the Three Lines of Defence
Organisation should coordinate their own three lines of defence but must be aware of the role of each group in the risk management process.
Senior management must communicate information to each groups responsible for managing the organisations risk and controls.
It is often said that profit is a reward for risk bearing. Nowhere is this truer than in the case of the banking industry. Banks are literally exposed to many different types of risk. A successful bank is one that can mitigate these risks and create significant returns for the shareholders on a consistent basis.
1. en.wikipedia.org, (2018) Bank online Available at: https://en.wikipedia.org/wiki/Bank Accessed 8/13/2018.
2. www.investopedia.com, (2018) Bank Capital online Available at: https://www.investopedia.com/terms/b/bank-capital.asp Accessed 8/13/2018
3. Gangreddiwar, A. (2015). 8 Risks in the Banking Industry faced by Every Bank. Online Available at: https://gomedici.com/8-risks-in-the-banking-industry-faced-by-every-bank/ Accessed 8/13/2018
4. Sherman, S. Risk and Capital Adequacy in Banks. Pdf Available at: https://pdfs.semanticscholar.org/82ad/d4d05111029e65beca7cac1a382aaee44231.pd
5. The Institute of Internal Auditors, (2013). The Three Lines Of Defense In Effective Risk Management Controls. Pdf Available at: https://na.theiia.org/standards-guidance/Public%20Documents/PP%20The%20Three%20Lines%20of%20Defense%20in%20Effective%20Risk%20Management%20and%20Control.pdf
Accessed at 8/13/2018
6. Muziho Financial Group, Muziho’s Definition of the Three Lines of Defense. pdf Available at:https://www.mizuhofg.com/investors/financial/annual/data1603/pdf/data1603_25.pdf
7. www.managementstudyguide.com, (2018) Risks Faced By Banks online Available at: https://www.managementstudyguide.com/risks-faced-by-banks.htm