Nature of Market Risk Faced by Banks and How Financial Institutions Manage

University: University of Chester

  • Unit No: 11
  • Level: Undergraduate/College
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Organization Selected : Ernst & Young


Financial risk management is a very important concept in each and every organization and especially in banking, it is considered as a most essential industry for the economy. Various financial instruments are used by institutions for managing risk exposure such as operational risk, credit risk, market risk, forex risk, and liquidity risk. The present report gives giving brief discussion about the nature of market risk faced by banks and how financial institutions manage it in the very best possible manner. Various mathematical tools are used for managing risk in different areas. Further it has discussed market risk in a detailed manner and in the same context how it has been impacted by various types of risk like liquidity, credit, forex, and interest rate risk. The concept of Value at services (VaR) is elaborated as it plays a very important role in this area. The Global Financial risk of 2007-2008 is explained in this report with recommendation and the role of VAR. There is a brief analysis of an annual survey of major financial institutions' risk management with Ernst Young and the International Institute of Finance in the context of risk appetite, metrics, and bank culture.

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Explaining The Nature Of Market Risk Faced By Banks With Appropriate Role Of Mathematical Models In Risk Management

The risk that has been incurred from assets and liabilities in any trading book of a financial institution with the context of alteration in exchange rates, inflation rate, and other costs (Titman, Keown, and Martin, 2017). The firm that trades assets and liabilities is affected by market risk. Risk can be overwhelmed due to many reasons such as exchange rates, inflation rates, and other costs of financial assets that are traded instead of balance sheet. Various hedging risks can be implemented for reducing risks like swaps, futures, and options by applying a control that will be held by exposure amount which has been undertaken by makers of the market. There are various components of market risk which consists of interest rate risk, credit risk, forex risk, and liquidity risk.

Market rate risk is affected by various risks, in the context of interest rate risk means valuation of security has fluctuated because of changes in interest rates. This will directly impact bonds if there is a rise in interest rates and bonds which has been issued previously whose price has decreased on the contrary side if the interest rate falls then the bond price will increase (Bessis,   2015). The main principle of bonds has ensured payments of future stream and all investors will be offered less for bonds which will be giving pay of lower rate as offered in the present market. The vice versa of this situation is also indicated as a true statement.

Credit risk is the risk that indicates the obligor or borrower will be not able to meet all the terms that they have agreed on contract of lending with the bank. There are various extensions of bank credit such as loans, derivatives, investments, and foreign exchange in the context of risk. The main reason for bank failures and losses is credit risk. There is no presence of full payment. The money that has been lent by foreign institutions, for a long duration in the form of loans or purchasing bonds is acceptable for this risk rather than financial institutions that have a horizon of investment i.e. very short (Ahmed and et. al., 2014).

The exposure of banks in the context of foreign exchange or risk associated with currency risk. The bank or financial institution that is associated with global operations will have to have the presence of various multiple currency exposures. This risk has originated from exchange rate fluctuations which are very adverse in nature and it will directly impact the foreign exchange position of the bank which is undertaken from the perspective of the customer.

The main fundamental operation of any bank is known as liquidity. The demand of depositors and borrowers has been fulfilled by the essence of banking which is accomplishing day-to-day objectives. It indicates that the bank is not able to attain obligations which is threatening its financial position and existence. The bank is using various strategies for managing liquidity risk and encompassing the processes. These strategies are applicable for assessing liability for attaining cash flow and requirement of collateral which is not giving any negative cause on daily operations or on financial position. By applying these strategies risk has been mitigated by working on particular decisions which has ensured basic funds that are necessary and even available in need of collateral.

Value-at-risk modeling is very important in this area. For quantifying and identifying the risk it is referred to as a standard measure by each and every financial analyst. It can be stated as the presence of a more potential alteration in the portfolio's value of financial instruments with a probability given on the horizon which is given (Lane and Milesi-Ferretti, 2018). Various applications are measured by VaR that as risk management for evaluating the performance of regulatory requirements and risk takers, for finding accurate estimates there is a requirement for developing special methodologies. The models of VaR are used for elaborating about portfolios that can be loosed with n% of liability in the horizon which is stated. It is also used for identifying the amount which can be lost to a portfolio of the bank which has been raised from the factors of risk. There are different assumptions for estimating VaR that is: time period, position of portfolio in context to risk, and risk factors such as interest rate risk, FX risk, prices of the commodity, and equity which will be directly affecting the position of the market. In the context of VaR models are classified into three categories that are Risk Metrics, Historic or back simulation, and Monte Carlo simulation (DeAngelo and Stulz, 2015).

Global Financial Crisis 2007 - 2009 For VaR Modeling

Overview of problems of the Global Financial Crisis: The financial prudence rules were not followed, and there was over-borrowing, over-lending, and tax supervision. The regulators and policymakers did not take action, deregulations were motivated politically, and even there was the fascination of watch watchdogs by different mathematical models. The banks were under capitalise and along with this there was the presence of excess leverage. Capital cushions were not enough to absorb the losses but on the contrary, it was very difficult for counter-cyclical. The concept of liquidity was ignored, there was the presence of asset sales which has been triggered downwards and even prices were falling. The conglomerate was more concentrated in the context of financial powers which is very difficult to regulate and even manage as well and moved towards overproduction of complex instruments, proprietary trading has been over-traded, assets gathered and the interest of clients has been submerged with conflicts in interest. There was an imbalance in the economy, and there was a presence of evidence in the balance of payments. The behavior of humans was of greed, herd mentality, and fear of crisis which is amplified. Last but not least in the overviewing of problems there was the difference in time of extent and crisis complexity (DanışoÄŸlu, Güner and Ayaydın HacıömeroÄŸlu, 2018).

In the context of recommendation to the financial crisis, there was picking of a proper asset bubble that is the cost of the asset must be implied for targets of central banks. There must be the presence of very strong and prudential supervision of banks which has been required for the central bank and even dedicated bodies and international coordination is essential in this concept. The rules and regulation of capital must be tightened with an element of counter-cyclical and the limit of leverage must be set. The rules of liquidity must be tightened and even wholesale funding must be reliant. All the economic balances must be addressed such as Americans having huge savings and Asians spending more.

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In the context of human nature, it should not be changed. Economic slump can be mitigated by keeping the financial system with proper functioning. The business models of banks must be rethought such as risk assessment should be according to basics and there should be less reliability on models. They must use the concept of unbundling and internal firewalls for separating the deposit taking, banking should be on the basis of commercial and investment, and all the conflicts regarding interest must be tackled easily (Waemustafa and Sukri, 2015). The debt originators must attain some responsibility according to it. There should be a proper understanding of business and products in a better manner.

VaR Modeling in Global Financial Crisis

The various models such as VaR and mathematical finance models are blamed for the global financial crisis of 2007 - 2008 and its badness. From observing the crisis it has been clearly identified that senior bank management was not able to understand its use and its applicability in various scenarios. It was considered very heavy and these models were delegated in too much quantity, according to the risk of model-based management to specialists in banks who are very technical. There was a lack of knowledge of the detailed market and the ability of practicality to combine feel with the context of difficult models with output and input.

This model consists of various limitations and even technical problems. These models are not framed in the wrong manner but their application and interpretation were very problematic. As per the Basel Committee in July 2009, there was the announcement of two new recommendations on the perspective of VaR modeling and market risk (Liquidity risk, 2018). There was an introduction of the requirement of VaR which is a stressed requirement. All the losses pertaining to the trading books of banks are recognized during the financial crisis which is very large as compared to the minimum capital requirements of Pillar 1.

After this Basel, there was the introduction of Basel 2.5 which is represented as a move in the context of Basel 3 and it was applicable from 31 December 2011 in most of Europe and majorly in financial jurisdictions. Basel 2.5 was implemented for the first time and it charged extra capital in the context of credit risks which are held in a portfolio of trading. It has major involvement of the counterparty which goes bust charges in the context of risk and heavy charges are applied on assets that are secutarised. Basel 2.5 is referred to as very complex, the main criticism of VaR is that it gives details about risk to the risk manager with a confidence level of 99% with the assumption of normal distribution. On the contrary, the average losses with the context of the tail of the distribution of 99%. The expected shortfall is also considered as VaR which is conditional and tail loss is also expected.

Bank Risk Appetite, Bank Culture, Risk Metrics, And Risk Management Practices of Ernst Young On International Institute of Finance

The various banks which have considered huge pressure on investors with respect to return on equity, were pressing for reducing costs and for alteration in business model (Cohen and et. al., 2014). There is a presence of three priority risk areas in the context of the board of directors who implement the new regulatory rules, risk appetite, and risk of cyber security. The industry has been challenged that more than 60 percent of banks are altering lines of defense. The risk management approach has been strengthened with the level of the board across compliance, control, and risk from the financial crisis. In this context, industry is still finding a particular blueprint for attaining accountability of risk which is effective among lines of defense.

The progress of the industry has been observed by the Institute of International Finance for improving the management of risk by providing surveys to all senior risk executives. In the present year, 67 banks from 29 countries have been involved in this survey and it also includes 23 of 30 institutions that are pertained as global systematically important banks. With respect of risk management banks have performed various strides for proper enhancement during a crisis. The industry regulations were changing, and all the emerging and evolving areas were approached like nonfinancial risk and threats of IT security were yet maturing. It is leading toward a long road in the context of banks. To extract risk management that is sustainable for the operating model and there is the presence of flexibility through an environment of the current market it contributes a huge proportion to success (Investments Risks, 2018).

Significant progress has been observed from this survey, while practicing risk management banks might have halfway which can be a journey of 15 years but it is very substantial. For attaining higher returns or stable returns in the context of investor, as it has resulted in converging the banks towards the norm of the industry of three-year return on equity which has given a target of 10 to 15% across banks of G-SIB banks and Non-G-SIB banks which are forced for adapting their business models for accomplishing targets. The risk appetite of the bank includes the board and top management as it is directly linked to elaborating the overall strategy of the bank. The composition of the board must include all the members who are closely linked with risk management and different concepts of risk appetite.

To cope with changes in the environment of economic and regulatory, banks are under pressure on various fronts and the risk management function is evolving in a very rapid manner. The concept of risk is understandable via all processes of business and organization during stability can be regular and is termed as a very essential concept. There is a presence of nonfinancial risks which have continued and provides different financial strains in the context of business. A huge focus has been given to conducting areas which has increased sanctions, and money laundering and it has majorly moved up according to the agenda. Half of the respondents according to the survey has surged with cybersecurity and lighted it as an important risk for the board over the next consecutive years (Olson and Wu, 2017).

There is halfway through the 15-year journey of transformation and there is a huge requirement for implementing changes to attain the growth target and has specific aims with the expectations of investors. There are three specific themes in the context of survey of this year: the framework has been established by most of the banks for fully functioning of three lines of defense of model work and implementing for certain management of risk of each and every business. The most important aspect of the issue of management of nonfinancial risk management, new techniques have been experimented with by banks to provide a more sophisticated and disciplined approach to different risk types. They have faced various regulatory alterations which are ongoing and different uncertainty in the context of the agenda of capital and liquidity, the stable business models are navigated by banks which will create the ability to deliver different commitments to several shareholders (Jin, Kanagaretnam, and Lobo, 2018).

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From the above report, it has been concluded that financial risk should be managed as soon as possible because in history it played a huge role in the Global Financial crisis of 2007-2008. It has also given importance to a model of Value at risk for the crisis and it has been blamed for happening of this crisis. Further, it can be summed up as VAR models that can be replaced on the basis of extreme value theory.

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  • Ahmed, S., and et. al., 2014. Financial risk management for new technology integration in energy planning under uncertainty. Applied Energy. 128. pp.75-81.
  • Bessis, J., 2015. Risk management in banking. John Wiley & Sons.
  • Cohen, L. J., and et. al., 2014. Bank earnings management and tail risk during the financial crisis. Journal of Money, Credit and Banking. 46(1). pp.171-197.
  • DanışoÄŸlu, S., Güner, Z. N. and Ayaydın HacıömeroÄŸlu, H., 2018. International Evidence on Risk Taking by Banks around the Global Financial Crisis. Emerging Markets Finance and Trade. 54(9). pp.1946-1962.
  • DeAngelo, H. and Stulz, R .M., 2015. Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics. 116(2). pp.219-236.
  • Jin, J., Kanagaretnam, K. and Lobo, G. J., 2018. Discretion in bank loan loss allowance, risk-taking, and earnings management. Accounting & Finance. 58(1). pp.171-193.
  • Lane, P.R. and Milesi-Ferretti, G. M., 2018. The external wealth of nations revisited: international financial integration in the aftermath of the global financial crisis. IMF Economic Review. 66(1). pp.189-222.
  • Olson, D. L. and Wu, D. D., 2017. Data Mining Models and Enterprise Risk Management. In Enterprise Risk Management Models (pp. 119-132). Springer, Berlin, Heidelberg.
  • Titman, S., Keown, A. J. and Martin, J. D., 2017. Financial management: Principles and applications. Pearson.
  • Waemustafa, W. and Sukri, S., 2015. Bank specific and macroeconomics dynamic determinants of credit risk in Islamic banks and conventional banks. International Journal of Economics and Financial Issues. 5(2).
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