Textbooks say that banks transform risks: What are the risks involved? and how are they transformed?

Résumé du document

Financial crisis may be very damaging for the whole society, as bank failures can either lead to runs or to panic. Bank runs occurs when problems at a bank "undermine depositors' confidence." The depositors' reaction is to rush to withdraw their money since they know that the bank's reserves are limited and that there won't be enough cash for all the depositors, assuming they follow the same strategy. Nevertheless, banks run are limited to the bank involved and unlike panics they don't affect the whole economy. Indeed, banking panics paralyse the whole system in general and have severer consequences. Such a scenario happened in Argentina in 2001 following a confidence crisis in the Argentina's central bank.

Extraits

[...] This risk is different from the solvency risk. The former is a short-term concept and shows a firm's ability to meet debts when they become due. Then, the latter is a long-range concept which shows the firm's ability to meet all debts when assets are sold. The liquidity risk can off a domino reaction” when traders rely on the completion of one trade to enable them to complete others. The risk of this happening is called the systemic risk and can easily spill over from one market to another.[9] To understand this liquidity risk we have to think about the primary function of a commercial bank which is to “accept deposit and to issue promises to repay that circulate as substitutes for notes and coins.”[10] Hence banks have to borrow from depositors who want the facility to take their money back at any time, while lending to companies and others engaged in long term investments. [...]

[...] First, there are the ‘pure risks' which include credit risk and liquidity risk. Second, there are the ‘speculative risks' which include risks based on financial arbitrage such as interest-rate risk, currency risk and market-risk.[3] Finally, operational risks are related to bank's business environment, including measure of mismanagement, fraud and bank organisation. Yet operational risks are not transformed or reduced directly by the banks. Thus the aim of this essay will be to outline the implications of the pure and speculative risks and to see how they are transformed and managed by banks Definition and management of the pure risks: credits risk and liquidity risk In the financial system, banks are intermediaries. [...]

[...] Textbooks say that banks transform risks. What are the risks involved and how are they transformed Financial crisis may be very damageable for the whole society, as banks' failures can either lead to runs or to panics. Bank runs occurs when problems at a bank “undermine depositors' confidence.”[1] The depositors' reaction is to rush to withdraw their money since they know that bank's reserves are limited and that there won't be enough cash for all the depositors, assuming they follow the same strategy. [...]

[...] Banks hedging with futures is subject to some regulatory problems and is even forbidden in some countries because these instruments are considered as speculative.”[18] Thus, banks rather hedge their positions with options because they protect against loss without ruling out a gain. Currency options can be defined as a binding contract which gives the right to buy or sell a currency at a specific price. Similarly, interest rate options can be defined as a contract which gives the right to pay or receive an amount of money at a given interest rate. Banks also use swaps to hedge both currency risk and interest rate risk. Currency swaps involve exchange of loan liabilities in different currencies”[19]. [...]

[...] Those risks can involve systemic risks and therefore it is important to avoid them. Secondly, banks must also deal with speculative risks such are currency risk, interest rate risk or market risk. These are the consequence of the new trend of the financial system which is more internationalised and in which financial instruments such as derivative for instance play an important role. Nevertheless, these are not the only risk faced by bank. Some important risks are about banks' management and behaviour. [...]