Commercial Banking Risk Interrelationships and Model Evaluation

This report provides an in-depth analysis of commercial banking risks, exploring various sources of risk exposure faced by financial institutions. It identifies interrelationships between risks like credit, liquidity, interest rate, and price risks, emphasizing their dynamic nature. The report critically evaluat...Read More

Running head: COMMERCIAL BANKING
Commercial banking
Name of the Student
Name of the University
Author Note

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Executive summary:
The paper demonstrates the identification of several types of risk exposure faced by the
financial institution such as banks and discusses about the identification of the relationships
between such risks exposures. In addition to this, paper also presents a critical evaluation of
the bank risk management model and outlines the critical discussion on why the model would
be considered incomplete if it measures and manages one type of risks. For the detailed
analysis, several case analysis has been done by reviewing various published papers. Some
examples of models has been also presented for identifying the incompleteness of the model.

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Table of Contents
Introduction:...............................................................................................................................1
Discussion:.................................................................................................................................2
Evaluating the interrelationship among different sources of bank risk exposure:.....................2
Evaluating the bank risk management model to manage and measure one type of risk:...........4
Conclusion:................................................................................................................................7
References list:...........................................................................................................................8

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Introduction:
The paper is developed to identify the interrelationships amongst various sources of
exposure concerning bank risks. The model of bank risk management is also evaluated for its
construction for measuring and managing one type of risk. In the process of maturity
transformation and financial intermediation, there are various types of risks that banks are
exposed. The risks which the banks are exposed to include systematic and unsystematic risks
and the exposure to such risks are measured by several models. Some model measuring the
risk demonstrates that such risk is related to fluctuation in the debt market and stock market
(Paligorova & Santos, 2017). Another source of risk exposure is volatility in the exchange
rate. The exposure to the risks forms the basis of their economic value. Exposure risks are
chosen by the banks that are distinctive and due to change in the conditions, such risk
exposure have different experiences.
Discussion:
Evaluating the interrelationship among different sources of bank risk exposure:
The dynamic risk exposure of banks reflects the changes in the crisis period and
banking business. There are various sources of risks which the banking institution are
exposed to and such risks comprised of credit risk, liquidity risk, foreign exchange risk,
interest rate risk, investment risk, concentration risk which is the bank risk exposure to one or
group of any related person, legal risk in the form of operational risk, strategic risk, money
laundering risk, terrorist financing and risk of bank operation compliance (Clark et al., 2018).
The leading source of problems in any bank is the credit risk exposure of banks and
this calls for the need of having keen awareness for measuring. Identifying and controlling

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the credit risk for determining that the bank has adequate capital and are also adequately
compensated for the risks that is being incurred. The process of settling the financial
transactions is related to the credit risk and there exist loss, when one of the either side of
transaction fails. Gaining an insight into the interrelationship between different sources of
risk exposures poses a main challenge in managing the risk. All the identified risks are either
negatively or positively correlated to each other and the correlated risks are affected by the
events or actions. Banks by lowering down the risks related to assets issues would not only
lower the credit risk but also reputation and liquidity risk. Reduction of one risk might
increases other risk when there is a negative correlation between the risks. The capital and
earnings of a bank is exposed to all types of risks due to the lending function of bank
(Doumpos et al., 2019).
Interest rate risk- The lending function of bank is associated with the interest rate
risk and influence it significantly. The exposure of the revenue stream of bank to the changes
in the interest rate due to the terms of loan and the composition of portfolio of loan forms the
basis of lending activities. It is the borrowers who have to bear the burden of interest rate risk
that is frequently shifted by the bank using variable interest rate in structuring loans. An
increase in the interest rate on such loan might cause financial difficulty for the borrowers
having the capacity of repaying marginally (Ekinci, 2016).
Credit risk- The practice of credit risk management of any bank can be increased or
lessened by the possibility of obligator to fail in paying off their obligations. Credit quality of
lending by the banks can be questioned strongly by easily overcoming the borrowers having
the questionable character and capacity. Inadequate monitoring and the structuring of loan
might undermine the sound credit decisions and after the process of approval of loan, it is
required by the bank to manage the credit risk. In addition to this country risk is faced by the
banks when they are engaged in the lending at international level (Wamalwa & Jagongo,

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2017). All the uncertainties arising from the political, social and economic conditions of a
nation is encompassed in the country risk.
Liquidity risk- The issue of liquidation is related with managing the liquidity risk
effectively which is dependent upon the size of portfolio of loan. Management of liquidity is
done by initiating the activities for managing the credit risk and this can be done by actively
managing the portfolio of loans. That is, it can be inferred that liquidity can be managed
when the banks would be able to deal with its lending activity. Strategy of liquidity
management should incorporate identifying segment of loan portfolio and loans
identification.
Price risk- Price risk of financial institution such as bank is impacted by the liquidity
of portfolio of loan. Any change in the price in the secondary market for loans is affected by
engaging of banks in international lending. Traditionally, the price risks faced by the bank did
not impact the activities of lending. However, portfolio of loans became increasingly
sensitive to price risk with the deepening and expansion of loan market and development of
practices of actively management of portfolio.
Transaction risk- Transaction risk of any banks is related to the process of credit
administration and loan disbursement. The lease portfolios and considerable loan losses is
due to the control, procedure and inadequate information system. Increased credit risk is
incurred by the banks due to failure of the information system in providing adequate
information such as expired facilities and concentration (Chen et al., 2018). Moreover, failure
of banks in obtaining proper loan documents and to renew collateral liens have resulted in
incurring the loss.
Strategic risk- The lending activities of bank is associated with controlling the
strategic risk is the primary objective of managing the portfolio of loans. In order to ensure

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that risks are appropriately designed and managed, it is required to have careful insight and
significant insight of any new product and business venture. Strategic risks should be
realistically assessed by the bank when evaluating the process of managing the loan portfolio
(Wamalwa & Jagongo, 2017). In such scenario, it can be inferred that the risk of lending is
associated with the strategic risks faced by the banks.
Evaluating the bank risk management model to manage and measure one type of risk:
There is a dramatic rise in the number of models as such models are utilized by the
banks for the widening decision making. The framework of risk management model includes
a large number of model for increasing the sustainability. For the measurement and
management of risks, financial institution such as banks relies heavily on the numerical,
statistical and mathematic models. For various types of risk exposure such as market, credit
and operational, economic capital charges are computed using the models. Financial risks
might not be properly capture financial risk due to the increase in the use of model.
Increasing dependence of banks on the models requires the managers of banks to
manage and understand the risk in a better way. Use of models have been expanded because
of algorithm, advancement in modelling and computing and increased availability of data.
However, banks risks increases and results in poor decision making due to the error arising
from suboptimal models.
Decision models are increasingly used by the banks and if the models manage to
measure only one type of risks, it would fail to provide an accurate picture of the scenario
that might impacts the effective decision making. In terms of the computation of the
parameters, there exist difference between the risk management models. It was in the second
half of 1990, credit risk model was developed by the banks with the objective of potentially
measuring the loss generated in accordance with the identified privacy level. Banks adopts

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the models for measuring the credit risk which is treated as the model of statistical factor with
the help of which the possible economic variables are explored (Torna, 2018).
Financial stability measures relating to the unconditional and conditional default
probability of certain percentage of bank is accounted by one of the model based banking
stability measures. It is not straightforward to construct the useful measures of banking
stability and systematic risk. This is so because usually, a high cross sectional dimension is
involved in determining the risk of a systemic event such as simultaneous financial firm’s
failure. One important risk of financial systemic risk feature is higher margin risk in addition
to the existence of higher correlation of risks. A model confining to one type of risk faced by
the bank cannot be considered complete as the determination and assessment of one type of
risks would not provide a cross sectional analysis between various variables or the factors
impacting the risks (Bikker & Vervliet, 2018).
The incompleteness of the risk management model can be explained by taking an
example before the financial crisis. Prior to the financial crisis outburst, the VaR metrics used
by the banks and financial institutions failed to adequately capture the events of credit risk
and tall risk along with the market illiquidity. The events of credit risk drove the financial
crisis, daily trading loss was reported by considerable number of banks which was more than
the estimates of VaR. Model of market risk used prior to the financial crisis was based on the
assumptions which failed to reflect the real scenario of the world during the stressed financial
situation. Moreover, it was ascertained that there was not adequate modelling of events of tail
credit risk and the possible losses generated in the stressed conditions was underestimated. It
can be therefore observed that focus on model on determining a particular risk would fail to
give a complete idea of the financial position and the total exposure of risks (Aven, 2016).
The risk management model would not be regarded ideal if it incorporates only fewer
variables measuring one type of risk. In addition to this, some risk exposure of banks are

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interrelated with one another such as credit risk is related to the transaction risk, strategic and
liquidity risk. Although, determination of one risk using the risk management model would
be able to create linkage between other risks and just gives a rough idea of such other risks.
Decision models are increasingly used by the banks that helps in strengthening the process of
decision making. Loan portfolio of banks is measured by the banks using sophisticated loan
pricing models that helps in differentiating risks using multiple factors and they generate
acceptable results. It can be said that it is important to have a model that incorporates various
factors for determining various types of risk exposures (Clark et al., 2018).
It is required by the banks to have a whole inventory of the existing risk management
models that helps in facilitating the management and governance of risk model. Banks should
classify the model based on the risks used for the entity. A level of risk for the model is
suggested in the normal tiering process and the model in the form of economic, mathematic
and statistical tool have become central to the operation of the bank as a whole. It is required
to establish clear goals in the development process of model and such goals include reducing
the expected losses, improving the efficiency and developing better pricing (Cole et al.,
2017).
Conclusion:
From the analysis of various types of risk exposure of banks, it has been ascertained
that there exist interrelationship relation between different sources of risk exposure. The
construction of risk management model would not be complete if it measures and manages
only one type of risks. It is quite evident from various cases that banks uses and relies on the
models measuring the different risk exposures. The model generating the risk level faced by
banks based on one particular risk is not consider apt as it fails to provide a complete
financial position and does not results in effective decision making.

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References list:
Aven, T. (2016). Risk assessment and risk management: Review of recent advances on their
foundation. European Journal of Operational Research, 253(1), 1-13.
Bikker, J. A., & Vervliet, T. M. (2018). Bank profitability and risk‐taking under low interest
rates. International Journal of Finance & Economics, 23(1), 3-18.
Chen, Y. K., Shen, C. H., Kao, L., & Yeh, C. Y. (2018). Bank liquidity risk and
performance. Review of Pacific Basin Financial Markets and Policies, 21(01),
1850007.
Clark, E., Mare, D. S., & Radić, N. (2018). Cooperative banks: What do we know about
competition and risk preferences?. Journal of International Financial Markets,
Institutions and Money, 52, 90-101.
Cole, S., Giné, X., & Vickery, J. (2017). How does risk management influence production
decisions? Evidence from a field experiment. The Review of Financial Studies, 30(6),
1935-1970.
Doumpos, M., Lemonakis, C., Niklis, D., & Zopounidis, C. (2019). Introduction to credit risk
modeling and assessment. In Analytical Techniques in the Assessment of Credit
Risk (pp. 1-21). Springer, Cham.
Ekinci, A. (2016). The effect of credit and market risk on bank performance: Evidence from
Turkey. International Journal of Economics and Financial Issues, 6(2), 427-434.

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Paligorova, T., & Santos, J. A. (2017). Banks’ exposure to rollover risk and the maturity of
corporate loans. Review of Finance, 21(4), 1739-1765.
Torna, G. (2018). The impact of expanded bank powers on loan portfolio decisions. Journal
of Financial Stability, 38, 1-17.
Wamalwa, N., & Jagongo, A. (2017). Loan Portfolio Management and Firm Performance:
Theoretical Paper Review. International Journal of Management and Commerce
Innovations, 5(2), 638-643.