Faculty of Commerce, Administration and LawDepartment of EconomicsAssignment Cover SheetStudent Name Student Number Module Title Bank’s Equity CapitalModule Code CBBG332Assignment Topic Discuss the different type of risks facing banks and evaluate the link between bank capital and each type of riskDue Date 15 August 2018Name of Lecturer Mr.
S. ZhouLecturer’s remarks Table of ContentContent Page Number1. Introduction 32.
Bank Capital 33. Capital and risk 34. Different types of risks facing banks 35. The Link between bank capital and each type of risk 46. Defence strategies used by financial institutions 67.
Conclusion 78. References 8IntroductionA 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 CapitalBank 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 riskThe 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 banksThere are mainly 8 risks facing the banking industry.
1. Credit riskCredit 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 riskMarket risk is the risk that the value of a portfolio decreases because of a change in market risk factors.3. Operational riskOperational risk is the risk of losing money resulting from failed internal processes. 4. Liquidity riskLiquidity risk is risk that an investment that is not marketable cannot be traded quickly to prevent or minimise a loss.
5. Reputational riskReputational risk is the risk relating to the credibility of a business.6.
Business riskBusiness 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 riskSystemic risk are risks associated with cascading failures where the failure of one large bank causes the failure of other entities.
8. Moral hazardMoral 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 riskManagement 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 CapitalThe 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 levelThe bank will become insolvent if it acquires a negative income.
There are two models used to measure adequate capital.1. A Model of InsolvencyA 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 VariancesTo 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 risksThe 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 ControlThe 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 – SettingIn 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 ModelB. Coordinating the Three Lines of DefenceOrganisation 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.ConclusionIt 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.
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The Institute of Internal Auditors, (2013). The Three Lines Of Defense In Effective Risk Management Controls. Pdf Available at: https://na.theiia.
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