Define Risk. Briefly describe the risks in the Banking Book, Trading Book, and Off-Balance Sheet Exposures.

Definition of Risk

Risk is the possibility that a financial institution may suffer a financial loss or fail to achieve its expected objectives due to uncertain events or conditions.

Example: A bank provides a loan to a customer. If the customer fails to repay the loan on time, the bank may suffer a loss. This is credit risk for the bank.

From the risk management perspective, banking business lines are divided into three major heads: The banking book, the trading book, & off-balance sheet exposures. Each line carries its own unique set of risks. The risks involved in each line are discussed below-

A. The Banking Book

The banking book includes all advances, deposits, and borrowings that arise from everyday commercial and retail banking. These assets and liabilities are normally held until maturity.

Four major risks are involved in the banking book. These are discussed below:

Liquidity Risk:

Assets and liabilities rarely mature at the same time. Banks fund long-term loans with short-term deposits. If depositors withdraw funds faster than loans are repaid, the bank may face shortage of cash. This creates liquidity risks.

Interest Rate Risk:

Under the banking book, the assets and liabilities are held until maturity. Interest rates on assets or liabilities may change during the period. This may negatively impact the net interest margin. This is the interest rate risk in the banking book.

Credit Risk:

Part of the asset side of a banking book includes loans and advances. Borrowers may fail to repay the loan or interest. This creates credit risk.

Operational Risk:

Banking book suffers from operational risks. Such risks arise from human errors, system failures, process lapses, and external events.

B. The Trading Book

The trading book includes all the assets that can be traded in the market. These types of assets are sold before maturity. The difference between book value and market price is the profit or loss. The assets include fixed income securities, equities, foreign exchange, commodities, and derivatives.

The following risks are associated with the trading book-

Market Risk:

The trading book assets are subject to adverse price movements in the market. This creates market risks.

Liquidation Risk:

Some instruments may have lower market demand. When the bank needs to sell them, there may not be enough buyers. This forces the bank to accept a lower price. This is called liquidation risk.

Counterparty Risk:

Even in trading, the other party may fail to keep commitments. This creates counterparty risk.

Operational Risk:

Trading operations are technology-intensive and fast-moving. System failures, input errors, and unauthorized trades create operational risks in the trading book.

C. Off-Balance Sheet Exposures

Off-balance sheet exposures include guarantees, letters of credit, and derivatives like swaps, futures, forward contracts, and options. They do not appear as assets or liabilities on the balance sheet. But they can create risks for the bank.

When a bank issues a guarantee or letter of credit, it becomes an obligation for the bank. The bank may have to pay if the counterparty fails. This creates credit risk.
Derivative contracts may create market risk, interest rate risk, and exchange rate risk.