Banking

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When a bank transforms your cash into another asset that earns them a profit they assume several different types of risk. The first type of risk that the bank will encounter is interest rate risk, which is associated with changes in market interest rates. In the broadest sense of the term, banking is the business of accepting temporary responsibility for safeguarding other peoples money and then lending out these funds in order to earn interest for the banks own account. This being said, a change in interest rates could have a large impact on a bank’s profit because the banks profits arise mainly from the (positive) spread between its costs of securing and servicing deposits and its revenues from fees and interest on the loans extended. The next type of risk that a bank assumes is credit risk. Credit risk is defined as the risk that the value of a loan will decrease due to a change in the borrowers ability to make payments, whether that change is an actual default or a change in the borrowers probability of default. Obviously the more defaults that a bank encounters the less profitable the bank is going to be, this is why they charge “high-liability” customers higher interest rates. The next type of risk that a bank must assume is liquidity risk. Liquidity risk is the risk that at some time an entity will not have enough cash or liquid assets to meet its cash obligations. The most striking example of loss due to this risk is a run-on-the-bank event that causes an institution to fail. This type of event hit banks during the Depression when too many customers demanded to have their money paid immediately in cash and that demand exceeded cash reserves. Less dramatically, smaller losses can occur when a company has to borrow unexpectedly or sell assets for an unanticipated low price. The last type of risk that a bank must assume is foreign exchange rate risk. Foreign exchange rate risk is the risk that the value in dollars of a promise of payment in a foreign currency will change as a result of a change in the exchange rate. This could effect you as a bank in two different ways, one is you are owed payment in foreign currency, and two is you owe payment in foreign currency. If there is a large fluctuation in an exchange rate between the U.S. and another county could either make money or lose money depending on whether the dollar has appreciated or depreciated. There are ways to minimize your risk as a bank by covering yourself with different investments in different areas, but we’ll save that for another discussion.

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