What are the Risks faced by Commercial Banks?


1. Transaction Risk :
Banks continuously quote rates for different transactions and currencies to their
customers. After the rates are accepted by the customers, the bank dealers cover
these transactions to lock in the profit or loss. Covering means undertaking an
opposite transaction in the inter-bank market so as to square off the currency
exposure arising out of the transaction with the customer. Between the quotation to
the customer and covering of the transaction, an adverse exchange rate movement
may result in a loss. Such a risk is called transaction risk. Banks do not hedge
transaction risk but accept it as business risk. This is because the time gap between
the customer and cover transaction is too small for an economically viable use of
hedging mechanisms.
2. Position Risk :
Sometimes, dealers deliberately do not cover transactions in anticipation of
favourable rate movement thereby converting a normal business transaction into a
speculative transaction. This action is called creating an ‘Open Position’. Any adverse
developments resulting in a loss are treated as position risk.
If the open position is created by buying foreign currency, it is called over-bought or
long position, whereas if the position is created by selling foreign currency, it is called
oversold or short position. The maximum amount up-to which an open position can
be created is called ‘Day-light limit’. This limit signifies the total exposure which the
bank is willing to accept on behalf of the dealer. In case the view of the dealer is
wrong, the bank specifies a stop-loss limit at which point the dealer has to
compulsorily cover the open position. This limit therefore specifies the total loss
which the bank is willing to accept on behalf of the dealer. In case the view of the
dealer is correct, he books profits on a major component of his position by the end of
the day and may carry forward a small component to the next trading day. This
carried forward component is subject to ‘over-night’ limit which signifies the exposure
accepted by the bank during non-trade hours. The Over-night limit is normally much
smaller than the Day-light limit since the dealer is not in a position to take protective
steps during off-trading hours.

3. Pre – Settlement Risk :
Banks contract with each other and with customers for various forward maturities.
Such contracts being Over the Counter (OTC) contracts, they carry a credit risk for
both parties. If a counter party fails, i.e. becomes bankrupt or otherwise incapable of
fulfilling the contract, on any day from the contract date up-to one day before the
settlement date, then the other party is required to replace the counterparty with a
third party. The replacement contract rate may be adverse as compared to the
original contract rate. Such a loss which represents the cost of counterparty
replacement is called pre-settlement risk.

4. Settlement Risk :
On the day of settlement, if one of the parties to the contract fails after the other party
has delivered under the contract, then in addition to the loss of the principal, the other
party would also face the cost of counterparty replacement and minimum one day’s
overdue interest. This is because corrective action can be taken only after ‘cash’
transactions timing. Settlement day risk occurs due to time zone factors and may
exceed the principal value of the contract. (This risk attracted greater attention of risk
managers after the Bank Herstatt case of 1974)

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