Traditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks.
Market Risk may be defined as the possibility of loss to a bank caused by the changes in the market variables. It is the risk that the value of on/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices.
Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those prices. Market Risk management provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the banks business strategy.
Scenario analysis and stress testing is yet another tool used to asses areas of potential problems in a given portfolio. Identification of future changes in economic conditions like-
- Economic/Induastry Overturns.
- Market Risk Events.
- Liquidity Conditions.
That could have unfavorable effect on banks portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keeps changing from time to time, out-put of the test should be reviewed periodically.
Market risk arises out of the dynamics of market forces, which, for the banking industry, may include interest rate fluctuations, maturity mismatches, exchange rate fluctuations, market competition in terms of services and products, changing customer preferences and requirements resulting in product obsolescene, coupled with changes national and international politico-economic scenario. These risks are like perils of the sea, which can be caused by any change-taking place anywhere in the national and international arena.
Market risks affect banks in two ways:
- The customer requirements are changing because of the changing economics scenario. Hence banks have to fine-tune/modify their products to make them customer friendly, otherwise the obsolescene of products will divert the customers to other banks thereby reducing the business and profits of the bank concerned.
- The macro-economic changes in the national and international polotico-economic scenario affect the risk element in different business activities differently. This aspect has assumed greater importance in the modern age, because of the increasing integration of global markets.
Since both these aspects are dynamic in nature, with change being the only constant factor, market risks need to be monitored on a continuous basis and appropriate strategies evolved to keep these risks within manageable limits. Again, given that one can manage only what one can measure, measurement of risks on a continuous basis deserves immediate attention.
Market risk can be defined as the risk of losses in on and off balance sheet positions arising from adverse movement of market variables.
Market Risk Management
Management of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. The Middle Office should comprise of experts in market risk management, economists, statisticians and general bankers and may be functionally placed directly under the ALCO. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregrate the total market risk exposures assumed by the bank at any point of time.
Read More: Asset Liability Management