Q1: What is the risk management process in the banking industry? What steps are involved?
Answer:
The risk management process in banking involves three main steps:
1. Identification and Assessment:
o Identifying potential risks that could damage banking operations.
o Estimating the potential losses or impact of these risks.
2. Action Plan Development:
o Creating and implementing strategies to address and mitigate risks.
o Applying modern techniques and tools to reduce potential losses.
3. Monitoring and Reporting:
o Continuously reviewing the implemented risk management practices.
o Reporting outcomes to ensure that risks are effectively controlled.
The objective is to safeguard the bank’s assets and ensure its sound financial position while maintaining
profitability .
Q2: What is the historical development of risk management?
Answer:
Pre-1990s:
Risk management focused primarily on insurance to cover future hazards.
1990s:
Financial risk management emerged, emphasizing derivatives as tools for hedging and
speculation.
1997:
The Basel Committee introduced core principles for effective banking supervision. This
framework emphasized linking capital to risks and adopting measurement and management
procedures to maintain risk-adjusted returns.
Risk management has since evolved to address increasing market complexities and financial innovations.
Q3: What types of risks are considered in banking? Provide a preliminary examination of banking risks.
Answer:
The primary risks in banking include:
1. Credit Risk:
o Customers failing to repay loans, causing financial losses.
2. Liquidity Risk:
o Inability to meet cash needs or withdrawals, potentially leading to insolvency.
3. Market/Systematic Risk:
o Losses due to changes in market prices, such as interest rates or stock values.
4. Interest Rate Risk:
o Fluctuating interest rates affecting income and expenses.
5. Earning Risk:
o Reduction in net income due to regulatory changes or competition.
6. Solvency/Default Risk:
o Long-term financial instability arising from bad loans or poor asset performance.
Q4: What is the process of direct and indirect finance? Why should we invest our excess money?
Answer:
Direct Finance:
Funds are transferred directly between surplus (savers) and deficit (borrowers) units, bypassing
intermediaries.
Indirect Finance:
Financial intermediaries (e.g., banks) channel funds between savers and borrowers, addressing
issues of asymmetric information.
Why Invest Excess Money?
To avoid loss from idle money, which diminishes in value over time.
Investing generates returns, protects against inflation, and contributes to economic growth by
supporting profitable ventures.
Q5: What are the economic concepts of banking?
Answer:
1. Maturity Transformation:
o Banks convert short-term deposits into long-term loans, earning profits from the
difference in interest rates.
2. Money Creation:
o Through fractional reserve banking, banks lend a portion of deposits, effectively
increasing the money supply.
3. Intermediation Role:
o Banks act as middlemen, channeling funds between savers (surplus units) and borrowers
(deficit units), enabling efficient allocation of resources.
These concepts underpin the vital role of banks in liquidity provision and economic growth.
Q6: How do banks generate income? Explain the uses and sources of funds.
Answer:
Sources of Funds:
1. Deposits:
o Primary source; includes checking and savings accounts.
2. Equity:
o Capital raised through shares, serving as a buffer against risks.
3. Debt:
o Borrowing from other institutions or issuing bonds.
Uses of Funds:
1. Loans:
o Banks lend funds to borrowers, earning interest income.
2. Investments:
o Buying securities like bonds and treasury bills to generate returns.
Income Generation:
The primary income source is the “spread,” the difference between the interest charged on loans
and paid on deposits. Additional income comes from fees, trading activities, and off-balance-
sheet items such as derivatives.
