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

University: University of Chester

  • Unit No: 11
  • Level: Undergraduate/College
  • Pages: 12 / Words 2884
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Organization Selected : Ernst & Young


Financial risk management is very important concept in each and every organization and especially in banking, it is considered as most essential industry for economy. Various financial instruments are used by institution for managing the risk exposure such as operational risk, credit risk, market risk, forex risk and liquidity risk. The present report is giving brief discussion about the nature of market risk faced by banks and how financial institutions manage it in very best and possible manner. Various mathematical tools are used for managing risk in different areas. Further it has discussed about market risk in 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 is plays very important role in this area. Global Financial risk of 2007-2008 is explained in this report with recommendation and role of VAR. There is brief analysis of annual survey of major financial institutions risk management with Ernst young and International Institute of finance in context of risk appetite, metrics and bank culture.

Explaining the nature of market risk faced by banks with appropriate role of mathematical models in risk management

The risk which has been incurred from assets and liabilities in any trading book of financial institution with the context of alteration in exchange rates, inflation rate and other cost (Titman, Keown and Martin, 2017). The firm who trade assets and liabilities is affected by market risk. Risk can be overwhelmed due to many reasons such as exchange rates, inflation rate and other cost of financial assets which are traded instead of balance sheet. Various hedging risk can be implemented for reducing risk like swaps, futures and options by applying a control which will be held by exposure amount which has been undertaken by makers of 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 risk, in context of interest rate risk means valuation of security has been fluctuated because of changes in interest rates. This will directly impact bonds if there is rise in interest rates and bond which has been issued previously whose price has been decreased and on contrary side if interest rate falls then bond price will increase (Bessis,   2015). The main principle of bond has ensured payments of future stream and all investor will be offered less for bond which will be giving pay of lower rate as offered in present market. The vice versa of this situation is also indicated as a true statement.

Credit risk is the risk which has indicated obligor or borrower will be not able to meet all the terms which they have agreed on contract of lending with bank. There are various extensions of bank credit such as loans, derivatives, investments and foreign exchange in context of risk. The main reason for bank failures and losses is credit risk. There is not presence of full payment. The money which has been lent by foreign institution, for long duration in form of loans or purchasing bonds are acceptable for this risk rather than financial institutions who have horizon of investment i.e. very short (Ahmed and et. al., 2014).

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

The main fundamental operation of any bank is known as liquidity. The demand of depositors and borrowers has been fulfilled by essence of banking which is accomplishing day to day objectives. It is indicating that bank is not able to attain obligations which is threatening 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 decision which has ensured on basic funds which are necessary and even available in need of collateral.

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

Global Financial crisis 2007 - 2009 for VaR modeling

Overview of problems of Global financial Crisis : The financial prudence rules were not followed, there was over borrowing, over lending and tax supervision. The regulators and policy makers were not taken in action, deregulations were motivated politically and even there was fascination of watch dogs by different mathematical models. The banks were under capitalise and along with this there was presence of excess leverage. Capital cushions were not enough to absorb the losses but on its contrary it was very difficult for counter cyclical. The concept of liquidity was ignored, there was presence of asset sales which has been triggered downwards and even prices were falling. The conglomerate was more concentrated with context of financial powers which is very difficult to regulate and even for managing as well and move towards over production of complex instruments, proprietary trading has been over traded, assets are over gathered and interest of clients has been submerged with conflicts in interest. There was imbalance in economy, and there was presence of evident in balance of payments. The behaviour of human was of greed, herd mentality and fear of crisis which is amplified. And last but not leas in overviewing of problems there was difference in time of extent and crisis complexity (DanışoÄŸlu, Güner  and Ayaydın HacıömeroÄŸlu, 2018).

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

With 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 bank must be rethought such as risk assessment should be according to basics and there should be less reliability on models. They must use concept of unbundling and internal firewalls for separating the deposit taking, banking should be on basis of commercial and investment and all the conflicts regarding to interest must be tackled easily (Waemustafa and Sukri, 2015). The debt originators must attain some responsibility according to it. There should be proper understanding of business and products in 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 on various scenarios. It was considered as very heavy and these models were delegated in too much quantity, according to risk of model based management to specialists in banks who are very technical. There was lack in knowledge of detailed market and ability of practicality to combine feel with context of difficult models with output and input.

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

After this Basel, there was introduction of Basel 2.5 which is represented as move in the context of whole 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 first time and it charged extra capital in context of credit risks which are held in portfolio of trading. It has major involvement of : counterparty which goes bust charges in context of risk and heavy charges are applied on assets which are secutarised. Basel 2.5 is referred as very complex, the main criticism of VaR is that it gives details about risk to risk manager with the confidence level of 99% with assumption of normal distribution. On the contrary, the average losses with context of tail of 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 has considered huge pressure of investors with respect to return on equity, they were pressing for reducing costs and for alteration in business model (Cohen and et. al., 2014). There is presence of three priority risk areas on the context of 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 board across compliance, control and risk from the financial crisis. In this context industry is still finding particular blueprint for attaining accountability of risk which is effective among line of defense.

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

The significant progress has been observed from this survey, while practising risk management banks might have halfway which can be journey of 15 years but it is very substantial. For attaining higher returns or stable returns in context of investor, as it has resulted for converging the banks towards norm of industry of three year return on equity which has given 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. Risk appetite of bank includes board and top management as it is directly linked towards elaborating the overall strategy of bank. The composition of board must include all the members who are closely linked with risk management and different concepts of risk appetite.

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

There is halfway from 15 year journeys of transformation and there is huge requirement for implementing changes for attaining the growth target and has specific aim with expectations of investors. There are three specific themes with the context of survey of this year as : 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 issue of management of non financial risk management, new techniques have been experimented by banks for providing more sophisticated and disciplined approach of different risk type. They have faced various regulatory alterations which are ongoing and different uncertainty in context of agenda of capital and liquidity, the stable business models are navigated by banks which will be creating ability for delivering 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 plays huge role in Global Financial crisis of 2007-2008. It has also given importance in model of Value at risk for the crisis and it has blamed for happening of this crisis. Further it can be summed up as VAR models 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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