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How are these techniques of risk management employed by the commercial banking sector? To explain this, one must begin by enumerating the risks which the banking industry has chosen to manage and illustrate how the four-step procedure outlined is applied in each area. The risks associated with the provision of banking services differ by the type of service rendered. For the sector as a whole, however the risks can be broken into six generic types: systematic or market risk, credit risk, counterparty risk, liquidity risk, operational risk, and legal risks. Here, we will discuss each of the risks facing the banking institution, and in Section IV we will indicate how they are managed.

Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk, whenever assets owned or claims issued can change in value as a result of broad economic factors. As such, systematic risk comes in many different forms. For the banking sector, however, two are of greatest concern, namely variations in the general level of interest rates and the relative value of currencies.

Because of the bank’s dependence on these systematic factors, most try to estimate the impact of these particular systematic risks on performance, attempt to hedge against them and thus limit the sensitivity to variations in undiversifiable factors. Accordingly, most will track interest rate risk closely. They measure and manage the firm’s vulnerability to interest rate variation, even though they can not do so perfectly. At the same time, international banks with large currency positions closely monitor their foreign exchange risk and try to manage, as well as limit, their exposure to it.

In a similar fashion, some institutions with significant investments in one commodity such as oil, through their lending activity or geographical franchise, concern themselves with commodity price risk. Others with high single-industry concentrations may monitor specific industry concentration risk as well as the forces that affect the fortunes of the industry involved.

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for banks that lend in local markets and ones that take on highly illiquid assets. In such cases, the credit risk is not easily transferred, and accurate estimates of loss are difficult to obtain.

Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from a counterparty’s refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk.

Counterparty risk is like credit risk, but it is generally viewed as a more transient financial risk associated with trading than standard creditor default risk. In addition, a counterparty’s failure to settle a trade can arise from other factors beyond a credit problem.

Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.

In any case, risk management here centers on liquidity facilities and portfolio structure. Recognizing liquidity risk leads the bank to recognize liquidity itself as an asset, and portfolio design in the face of illiquidity concerns as a challenge.

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly.

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, environmental regulations have radically affected real estate values for older properties and imposed serious risks to lending institutions in this area.

A second type of legal risk arises from the activities of an institution’s management or employees. Fraud, violations of regulations or laws, and other actions can lead to catastrophic loss, as recent examples in the thrift industry have demonstrated.

All financial institutions face all these risks to some extent. Non-principal, or agency activity involves operational risk primarily. Since institutions in this case do not own the underlying assets in which they trade, systematic, credit and counterparty risk accrues directly to the asset holder. If the latter experiences a financial loss, however, legal recourse against an agent is often attempted. Therefore, institutions engaged in only agency transactions bear some legal risk, if only indirectly.

Our main interest, however, centers around the businesses in which the bank participates as a principal, i.e., as an intermediary. In these activities, principals must decide how much business to originate, how much to finance, how much to sell, and how much to contract to agents. In so doing, they must weigh both the return and the risk embedded in the portfolio. Principals must measure the expected profit and evaluate the prudence of the various risks enumerated to be sure that the result achieves the stated goal of maximizing shareholder value.