Table of Contents

Introduction2

Risk as a Central Ingredient to the Industry's Franchise3

What Type of Risk Is Being Considered?3

What Kinds Of Risks Are Being Absorbed?5

Why Do Banks Manage These Risks At All?6

How Are These Risks Managed?7

Risks In Providing Banking Services8

Systematic risk8

Credit risk9

Counterparty risk10

Liquidity risk10

Operational risk11

Legal risks11

Bank Risk Management Systems12

Conclusion13

Works Cited16

Microeconomics of Banking

Introduction

The past decade has seen dramatic losses in the banking industry. Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour, interest rate positions taken, or derivative exposures that may or may not have been assumed to hedge balance sheet risk. In response to this, commercial banks have almost universally embarked upon an upgrading of their risk management and control systems.

Coincidental to this activity, and in part because of our recognition of the industry's vulnerability to financial risk, the Wharton Financial Institutions Center, with the support of the Sloan Foundation, has been involved in an analysis of financial risk management processes in the financial sector. Through the past academic year, on-site visits were conducted to review and evaluate the risk management systems and the process of risk evaluation that is in place. In the banking sector, system evaluation was conducted covering many of North America's super-regionals and quasi-money center commercial banks, as well as a number of major investment banking firms. These results were then presented to a much wider array of banking firms for reaction and verification.

The purpose of the present paper is to outline the findings of this investigation. It reports the state of risk management techniques in the industry -- questions asked, questions answered and questions left unaddressed by respondents. This report can not recite a litany of the approaches used within the industry, nor can it offer an evaluation of each and every approach. Rather, it reports the standard of practice and evaluates how and why it is conducted in the particular way chosen.

But, even the best practice employed within the industry is not good enough in some areas. Accordingly, critiques also will be offered where appropriate. The paper concludes with a list of questions that are currently unanswered, or answered imprecisely in the current practice employed by this group of relatively sophisticated banks. Here, we discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk and the elements that are missing in the current procedures of risk management and risk control.

Risk as a Central Ingredient to the Industry's Franchise

What Type of Risk Is Being Considered?

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Over the last decade our understanding of the place of commercial banks within the financial sector has improved substantially. Over this time, much has been written on the role of commercial banks in the financial sector, both in the academic literature and in the financial press. These arguments will be neither reviewed nor enumerated here. Suffice it to say that market participants ...