We know that ALM is about properly matching assets and liabilities to manage risk, but what specific risks are faced by a typical bank?
The most significant risk is interest rate risk.
There are several different types of interest rate risk, as discussed below.
Interest rate gap risk occurs when:
(a) there is a mismatch between floating-rate and fixed-rate instruments
(b) the timing of rate-setting for floating-rate instruments is not aligned
Interest rate basis risk occurs when floating-rate assets and floating-rate liabilities are set to different indexes.
Option risk occurs when a counterparty exercises an option that changes the expected cash flows of a financial instrument (terminating a contract early, altering the contract, etc.).
• This is a type of interest rate risk because option risk is closely linked to the interest rate
Prepayment risk occurs when a borrower repays the principal sooner than required, and the bank gets stuck re-lending the money at a less favorable interest rate.
• Prepayment risk is a specific type of option risk and is closely linked to the interest rate
• Prepayment happens when interest rates decline and borrowers decided to refinance
Banks also face risk factors aside from interest rate risks. These include:
Exchange rate risk occurs when exchange rates change and the bank translates foreign currency back into its functional currency (the bank will recognize a gain or a loss).
Price risk occurs when there are changes to the price of investments in a bank’s trading portfolio.
Credit risk occurs when a counterparty defaults (e.g., a borrower fails to pay).
Liquidity risk occurs when the bank is unable to satisfy its obligations without suffering extreme losses when one or more sources of funding suddenly become unavailable.
• A liquidity crisis could be caused by a run on the repo market, an inability to roll over maturing debt, etc.
• Liquidity risk can be severe and cause the bank to become insolvent
—
Edspira is the creation of Michael McLaughlin, who went from teenage homelessness to a PhD.
Edspira’s mission is to make a high-quality business education accessible to all people.
—
SUBSCRIBE FOR A FREE 53-PAGE GUIDE TO THE FINANCIAL STATEMENTS
* http://eepurl.com/dIaa5z
—
LISTEN TO THE SCHEME PODCAST
* Apple Podcasts: https://podcasts.apple.com/us/podcast/scheme/id1522352725
* Spotify: https://open.spotify.com/show/4WaNTqVFxISHlgcSWNT1kc
* Website: https://www.edspira.com/podcast-2/
—
CONNECT WITH EDSPIRA
* Website: https://www.edspira.com
* Blog: https://www.edspira.com/blog/
* Facebook page: https://www.facebook.com/Edspira
* Facebook group: https://www.facebook.com/groups/561316587899818//
* Reddit: https://www.reddit.com/r/edspira
* LinkedIn: https://www.linkedin.com/company/edspira
—
CONNECT WITH MICHAEL
* Website: http://www.MichaelMcLaughlin.com
* LinkedIn: https://www.linkedin.com/in/prof-michael-mclaughlin
* Twitter: https://www.twitter.com/Prof_McLaughlin
* Facebook: https://www.facebook.com/prof.michael.mclaughlin
* Snapchat: https://www.snapchat.com/add/prof_mclaughlin
*Twitch: https://twitch.tv/prof_mclaughlin
* Instagram: https://www.instagram.com/prof_mclaughlin
*TikTok: https://www.tiktok.com/@prof_mclaughlin
![How to Start an Indian Restaurant Business [Video]](https://video.ednadigitalmarketing.com/wp-content/uploads/2024/03/mp_22065_0_0jpg.jpg)
![IFRS 16 Lessee Accounting Example 2 [Video]](https://video.ednadigitalmarketing.com/wp-content/uploads/2021/06/mp_197_0_0jpg.jpg)
![Top 50 Customer Service Tips | How To Give Great Customer Service [Video]](https://video.ednadigitalmarketing.com/wp-content/uploads/2024/01/mp_20116_0_0jpg.jpg)
![Inspiring Short Stories | Seeking Happiness | Motivational & Inspirational Video [Video]](https://video.ednadigitalmarketing.com/wp-content/uploads/2022/02/mp_8764_0_0jpg.jpg)