The risks of danking

Bankers manage portfolios of assets and liabilities and the accompanying information flows. The key portfolio risks of banking are credit risk, interest-rate risk, and liquidity risk. These specific risks generate variability in banks’ cash flows-a common general definition of risk in finance. Excessive risk taking and adverse economic conditions are the ingredients for bank failure. Chronologically, the typical failure scenario unfolds with excessive credit or interest-rate risk taking (bad policies), followed by unexpected inflation or deflation, which brings public recognition of the excessive risk taking (bad publicity) and precipitates a bank liquidity crisis. Although banks with good policies usually can withstand bad publicity, banks with bad policies cannot. The techniques for managing guarantees-monitoring, asset restrictions, and risk-based pricing-are the same tools lenders need for managing the portfolio risks of banking.

Credit risk

Credit or default risk refers to the uncertainty associated with loan repayment. Because most of a bank's earning assets are in the form of loans, problems with loan quality have been the major cause of bank failure. Symptoms of poor loan quality include high levels of nonperforming loans, loan losses, and examiner-classified loans'(i.e., substandard, doubtful, and loss: Sinkey [1978]). A high proportion of loans relative to total assets and rapid growth of the loan portfolio are potential early-warning signals of loan-quality problems, which may indicate potential failure.15 In contrast, high-performance banks tend to have high-quality loan portfolios as characterized by low levels of nonperforming loans and loan losses.

The fisher effect, monetary discipline, and economic growth and development

Inflation, foreign-exchange exposure, and capital scarcity represent three critical problems in the financial and strategic management of companies, especially in developing countries. Whereas capital shortages arc chronic in developing countries, inflation and currency devaluation tend to be episodic events driven by undisciplined monetary policy. In this kind of unstable financial environment, it is difficult to estimate expected int1ation and maintain a sound currency. Because lenders are hurt by unexpected inflation, the development of financial markets slows, retarding the pace of economic development with an unsound currency, both domestic and foreign trade suffer. If a country has monetary discipline, frequently associated with an independent central bank and a commitment to maintaining stable prices, it can create a financial environment more conducive to promoting economic growth and development.

Liquidity risk

Banks need liquidity for two reasons: (l) to meet deposit withdrawals, and (2) to fund customer loan demand. Bank liquidity can be stored in the balance sheet by holding liquid assets such as T-bills or short-term, high-quality loans, or it can be purchased in federal-funds and CD markets. The latter method requires a bank to maintain its creditworthiness and reputational capital and to have a market presence, whereas the former forfeits the higher yields associated with less liquid assets. The development of securitization has increased the ease with which banks can sell loans and generate liquidity.