Largest Risks Facing The International Banking System

Running head: Define what you perceive as the largest risks facing the international banking
system? Support your work.
Define what you perceive as the largest risks facing the

international banking system? Support your work
FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA
Distance Learning Doctorate of Finance Program

This assignment is submitted in partial fulfilment of the requirements
for 5521S2091 DF Commercial & Investment Banking R2
School of Management
Professor Dr. Igor Gvozdanovic
June 2, 2016
Define what you perceive as the largest risks facing the international banking system? Support
your work.
Define what you perceive as the largest

risks facing the international banking
system? Support your work
Table of Contents
Table of Contents.............................................................................................................................3
2
your work.
List of Tables...................................................................................................................................3
Abstract............................................................................................................................................4
Introduction......................................................................................................................................5
International banking system...........................................................................................................7
Banking system............................................................................................................................7
International banking system.......................................................................................................7
Reasons for international banking................................................................................................9
Largest risks facing international banking system........................................................................10
Credit risk...................................................................................................................................11
Market risk.................................................................................................................................13
Interest rate risk or asset-liability management (ALM)........................................................13
Foreign exchange risk............................................................................................................14
Operational risk..........................................................................................................................14
Liquidity risk..............................................................................................................................16
Other risks..................................................................................................................................16
Country or Sovereign Risk....................................................................................................16
Systemic risk..........................................................................................................................17
Other perspective of risks of international banks.........................................................................18
Conclusions....................................................................................................................................18
References......................................................................................................................................20
List of Tables
Table 1 Top 10 largest international banks......................................................................................8
your work.
Abstract
The present paper defines the perceived largest risks facing the international
banking system based on the BCBS risk classification, namely credit risk,
market risk1, liquidity risk, operational risk, and other risks 2. It outlines the
underpinnings of each risk and associated standards and regulatory
organizations that support the
choice of the largest risks faced by the
international banking system.
1According to BCBS market risk includes interest rate risk, equity risk, foreign exchange risk, and
commodity risk
2 Business risk, reputational risk, systemic risk, moral hazard, settlement

risk, country risk, and so on.
4
your work.
Introduction
The deregulation and globalization started in the 1980s weakened the

banking systems and provoked banking crises, causing or aggravating
economic downturns and leading to significant fiscal costs (Caprio and
Klingebiel, 1999) as cited in (Demirg-Kunt, Detragiache, & Tressel, 2006).
The banking crises in the 1980s and early 1990s posed potential threats to
depositors, investors and the safety of the industry, with negative impact on
the economy as a whole (Pasiouras, Gaganis, & Zopounidis, 2006). To
improve crisis prevention and management, many countries have been
working to upgrade their bank regulation and supervision (Demirg-Kunt,
Detragiache, & Tressel, 2006) in a concerted manner under International
regulatory framework for banks3 known as the Basel Committee on Banking
Supervision (BCBS). (Dewatripont, Rochet, & Tirole, 2010) points out that
the main objective of BCBS since its creation in 1974 is to safeguard the
stability of the international banking system because banks face many types
of risks such as credit risk, market risk 4, liquidity risk, operational risk,
business risk, reputational risk, systemic risk, moral hazard, settlement risk,
and so on. Credit risk, market risk, liquidity risk, and operational risk 5 are the
3Responsible for Basel Accords of 1988 (Basel I), Basel Accords of 2007 (Basel II) and Basel
Accords of 2013 (Basel III)
4According to BCBS market risk includes interest rate risk, equity risk, foreign exchange risk, and commodity risk
5 http://www.bis.org/publ/bcbs239.pdf, Principle 8 No. 57.

5
your work.
most important risks judging from the content of Basel II prudential
regulation pillar 1 about Minimum Capital Requirements 6 that deals with
capital adequacy required to safeguard against the three major components
of risk that a bank faces - credit risk, operational risk, and market risk and
Basel
III
aiming
to
strengthen
the
regulation,
supervision
and
risk
management of the banking sector.
(Eun & Resnick, 2014) point out that the impetus for globalized financial
markets initially came from the governments of major countries that had
begun to deregulate their foreign exchange and capital markets and
liberalize trade. Globalized financial markets required banking services
beyond domestic transactions such as foreign exchange necessary to
conduct cross-border transactions and make foreign investments, and new
ways to deal with risk such as hedging exchange rate risk in foreign currency
receivables and payables through forward and options contracts, cross
currency interest rate risk management etc. Financial globalization brought
services demand and risk exposure that the banks were not prepared to offer
and manage, in particularly they lacked the
ability to aggregate risk
exposures and identify concentrations quickly and accurately at the
bank
group level, across business lines and between legal entities. This had severe
consequences to the banks themselves and to the stability of the financial
6 https://www.bis.org/publ/bcbs128b.pdf
your work.
system as a whole causing for example the global financial crisis that began
in 2007
The present paper defines the perceived largest risks facing the international
banking system based on the BCBS risk classification, namely credit risk,
market risk8, liquidity risk, operational risk, and other risks9.
International banking system

Banking system
A banking system is a structural network of institutions that offer financial
services within a county. The members of the banking system and the
functions they typically perform include: (1) commercial banks that take
deposits and make loans, (2) investment banks which specialize in capital
market issues and trading, and (3) national central banks that issue currency
and set monetary policy (Banking System, n.d., p. 1).
International banking system

An international banking system can be characterized by the types of
services they provide which distinguish it from domestic banking system.
First, international banks facilitate the imports and exports of their clients by
7 http://www.bis.org/publ/bcbs239.pdf
commodity risk

7
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arranging trade financing and foreign exchange necessary to conduct crossborder transactions and make foreign investments. Second, international
banks assist clients in hedging exchange rate risk in foreign currency
receivables and payables through forward and options contracts. Third, the
types of deposits that international banks accept and the loans and
investments they make are different from the domestic banks. Forth,
international banks both borrow and lend in the Eurocurrency market and
may participate in the underwriting of Eurobonds and foreign bonds. Finally,
international banks frequently provide consulting services and advice to their
clients in the areas of foreign exchange hedging strategies, interest rate and
currency swap financing, and international cash management services.
However, not all international banks provide all these services. Banks that do
provide a majority of these services are known as universal banks or full
service banks (Eun & Resnick, 2014).
An
international
banking
system
includes
international
banks
and
international money market made of (i) money market instruments such as

commercial paper, other instruments, and currency of issue 10, and (ii) foreign
exchange market, (iii) money market interest rate (Table 1) lists 10 largest
international banks based on market capitalization as of April 30, 2015.
Table 1 Top 10 largest international banks
Rank
1
2
Bank
12
ICBC
Wells Fargo
Market cap11
310.5B
284.5B
Employees
441,902
266,000
10 https://www.bis.org/statistics/r_qa1412_hanx13a.pdf
11 (US$b, April 30, 2015)
8
your work.
3
China Construction Bank
244.8B
4
JPMorgan Chase & Co
235.9B
5
Bank of China
225.5B
6
HSBC Holdings
191.5B
7
Bank of America Corp
167.3B
8
Citigroup
161.8B
9
Commonwealth Bank
114.3B
10
Banco Santander
105.7B
Source: http://www.relbanks.com/worlds-top-banks/top-international-banks
348,955
265,359
308,128
257,603
219,658
239,000
44,520
187,262
Reasons for international banking

(Eun & Resnick, 2014) list the following reasons for international banking:
Low Marginal Costs -
developed at home can be used abroad with low marginal costs.

Knowledge Advantage - The foreign bank subsidiary can draw on
Managerial and marketing knowledge
the parent banks knowledge of personal contacts and credit
investigations for use in that foreign market.

Home Nation Information Services - Local firms in a foreign
market may be able to obtain more complete information on trade
and financial markets in the multinational banks home nation than
is obtainable from foreign domestic banks.

Prestige - Very large multinational banks have high perceived
prestige, which can be attractive to new clients.
12 Industrial & Commercial Bank of China

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Retail Defensive Strategy - Multinational banks also compete for

retail services such as travelers checks, tourist and foreign business
market.
Regulatory Advantage - Multinational banks are often not subject
to the same regulations as domestic banks.

Wholesale Defensive Strategy - Banks follow their multinational
customers abroad to avoid losing their business at home and
abroad.
Transactions
circumvent government currency controls.

Growth - Foreign markets may offer opportunities to growth not
found domestically
Risk Reduction
Costs - Multinational banks may be able to
Greater
stability
of
earnings
due
to
diversification.
Largest risks facing international banking system

The banking sector has experienced a variety of risks such as credit risk,
market risk, interest rate risk, market risk, liquidity risk, operational risk,
foreign exchange and other risks: country risk, settlement risk, performance
risk (Bessis, 2002, p. 12).
(Angelopoulos & Mourdoukoutas, 2001), as cited in (Ewedemi, 2003),

distinguish between traditional and nontraditional banking risks, where
liquidity, credit, political, and legal, and operation risks are considered
10
your work.
traditional banking risks, while market13 and other14 risks are nontraditional
banking risks. (Angelopoulos & Mourdoukoutas, 2001)
affirm that the
classification of risk in traditional and nontraditional banking risks is not

universal and give the example of the U.S. Comptroller's Office that classifies
the risk in nine categories: foreign exchange, interest rate, price, liquidity,
credit, transaction, compliance, reputation, and strategic risks. In addition to
U.S. Comptroller's Office risk classification there are other risk classification
schemes such as the Federal Reserve Bank's that utilizes six categories to
define risk, and the European Union has its own risk classification.
(Dewatripont, Rochet, & Tirole, 2010) points out that the main objective of
BCBS since its creation in 1974 is to safeguard the stability of the
international banking system because banks face many types of risks such
as credit risk, market risk15, liquidity risk, operational risk, business risk,
reputational risk, systemic risk, moral hazard, settlement risk, and so on.
13 Market risks include interest rate and foreign exchange risks

14 Other risks include commodity price, investment portfolio, and financial
derivative risks
15According to BCBS market risk includes interest rate risk, equity risk, foreign exchange risk, and commodity risk
11
your work.
For the purpose of this paper, the BCBS risk classification is used to define
the largest risks faced by international banking system, namely credit risk,
market risk16, liquidity risk, operational risk, and other risks17
Credit risk
BCBS defines credit risk as the potential that a bank borrower, or counter
party, will fail to meet its payment obligations regarding the terms agreed
with the bank (Perez, 2014).
(Angelopoulos & Mourdoukoutas, 2001), as
cited in (Ewedemi, 2003), notices that credit risk is a major concern because
with globalization, deregulation and liberalization of foreign exchange and
domestic money markets came diversification of operations by banks and
the banking industry can no longer rely on simplistic credit analysis
techniques for assessing the risk exposure but on modern risk measurement
that include duration, convexity, and foreign exchange sensitivity analysis
and value at risk (VAR).
(Demirg-Kunt & Detragiache, 1998) points out that credit risk is so

important that it requires various ways to reduce it such as screening loan
applicants, diversifying the loan portfolio by lending to borrowers who are
subject to different risks factors, or asking collateral.
commodity risk

12
your work.
(Stefanowski & Wilk, 2001) observe that credit is the component of a banks
activities which is characterized by high risk because of its influence on the
banks financial liquidity and recommends a very detailed and careful
analysis of a credit application before its acceptance or rejection, an in the
case of the former, analysis of a borrowers behavior during the repayment
period is extremely important from the point of view of risk control.
(Wilmarth Jr., 2009)
notes that universal banks loans securitization and
reckless lending policies in the commercial real estate and corporate sectors
were the main causes for credit risk because the banks (i) originated risky
loans without screening borrowers and (ii) avoided post-loan monitoring of
the borrowers behavior.
(Phillips & Roselli, 2009) concluded that loans securitization have permitted
an enormous expansion of private debt and on the liabilities side,
where
deposits were the almost exclusive source of funds, have had a diminishing
role in bank funding leading to credit risk.
(Madura, 2015) affirms that regulations contributed to the development of

the credit market because they imposed restrictions on some local markets,
thereby encouraging local investors and borrowers to circumvent these
restrictions.
So, the lack of standardized regulations allowed banks to
circumvent these restrictions inducing banks to credit risks. (Madura, 2015)

13
your work.
points out that as a disciplining measure to enable competitive global
banking,
international banking regulations produced several regulations
such as Single European Act, the Basel Accord, the Basel II accord, and The
Basel III accord. Thus, these regulations show how important is credit risk.
Market risk
BCBS defines market risk as the risk of losses in on- or off-balance sheet
positions that arise from price changes that affects any firm that trades
assets and liabilities, in particular, changes in interest rates, foreign
exchange rates, and equity and commodity prices (Hassan, 2009). (Perez,
2014) states that market risk is the most prominent for banks present in
investment banking and (Saunders & Cornett, 2008) affirms that it can be
minimized by using hedging techniques such as futures, options, and swaps,
and by implementing controls that limit the amount of exposure taken by
market makers.
Interest rate risk or asset-liability management18 (ALM)
(Saunders & Cornett, 2008)19 define interest rate risk as the effect on prices
(value) and interim cash flows (interest coupon payment) caused by changes
in the level of interest rates during the life of the financial asset. Interest
rate risk occurs because the prices and income of long-term assets and the
18 In banking language
19 Answer Key Chapter Seven Risks of Financial Intermediation
14
your work.
prices and interest expense of short-term deposits react differently to
changes in market interest rates, that is, when financial institutions perform
their asset-transformation functions, often mismatch the maturities of their
assets and liabilities exposing themselves to interest rate risk (Saunders &
Cornett, 2008).
(Saunders & Cornett, 2008) note that in the 1980s a large number of thrifts
suffered economic insolvency because interest rate risk inherent in assettransformation functions and
(Ely, 2008) corroborates when saying that
borrowing short to lend long was the financial structure used by federal
policy that effectively forced 1980s Savings and Loan Crisis.
In order to
mitigate interest rate risks, the BCBS issued a consultative document

suggesting a standardized model, that is, a market value accounting and the
duration model instead of the repricing model20, to be used by regulators in
evaluating a banks interest rate risk exposure (Saunders & Cornett, 2008).
Foreign exchange risk
(Saunders & Cornett, 2008, p. 168) define foreign exchange risk as the risk
that exchange rate changes can affect the value of an financial institutions
assets and liabilities denominated in nondomestic currencies. In September
2000, BCBS21 published supervisory guidance for managing settlement risk in
foreign exchange transactions providing banking supervisors with information
20 The repricing or funding gap model concentrates on the impact of interest rate changes
on an Financial Institutions (FI) net interest income , which is the difference between an FIs
interest income and interest expense (Saunders & Cornett, 2008).
15
your work.
about foreign exchange settlement risk and its management that they should
take into account when assessing a bank's policies and procedures (p.5).
Operational risk
(Saunders & Cornett, 2008, p. 168) define operational risk as the risk that
existing technology, auditing, monitoring, and other support systems may
malfunction or break down. For example, computerized payment systems
such as Fedwire, CHIPS, and SWIFT allow modern financial intermediaries to
transfer funds, securities, and messages across the world in real time
allowing arbitrage opportunities in an extremely cost-efficient manner.
However, the interdependence of such transactions also creates settlement
risk because transactions can create cycles as funds and securities move
around the world. In case of a transmittal failure or high-tech fraud affecting
any one of the intermediate transactions, this could cause operational risk.
BCBS also defines operational risk as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external
events. This definition includes legal risk, but excludes strategic and
reputation risk. (Perez, 2014).
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your work.
BCBS22 considers that
the most important types of operational risk are
breakdowns in internal controls and corporate governance. Such breakdowns

can lead to financial losses through error, fraud, or failure to perform in a
timely manner or cause the interests of the bank to be compromised. Other
aspects of operational risk include major failure of information technology
systems or events such as major fires or other disasters. Since 1998, in
recognizing the importance of operational risks, BCBS 16 has been outlining a
set of principles that provide a framework for the effective management
and supervision of operational risk, for use by banks and supervisory
authorities when evaluating operational risk management policies and
practices
(Sound
Practices
for
the
Management
and
Supervision
of
Operational Risk - final document, 2003, p. 1) .
Liquidity risk
BCBS23 defines liquidity as the ability of a bank to fund increases in assets
and meet obligations as they come due, without incurring unacceptable
losses. Liquidity risk is the risk that a sudden surge in liability withdrawals
may require a financial institution to liquidate assets in a very short period of
time and at less than fair market prices (Saunders & Cornett, 2008, p. 168).
22 Operational Risk Management - http://www.bis.org/publ/bcbs42.htm
23 http://www.bis.org/publ/bcbs144.htm
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your work.
BCBS18 places high priority in liquidity risk management because a liquidity
shortfall at a single institution can have system-wide repercussions and cites
the impact of market 2007 crisis that highlighted the role of liquidity to the
functioning of financial markets and the banking sector. Thus, as response to
the liquidity risk problem, in February 2008 BCBS24 published Liquidity Risk
Management and Supervisory Challenges standards aimed to strengthen
individual banks liquidity buffers and lowering their maturity mismatches.
Other risks
Country or Sovereign Risk
Country or sovereign risk is the risk that repayments to foreign lenders or
investors may be interrupted because of restrictions, intervention, or
interference from foreign governments (Saunders & Cornett, 2008, p. 168).
As an example of a sovereign risk, (Saunders & Cornett, 2008) affirms that in
December 2001, Argentina ended up defaulting on $130 billion in
government-issued debt and, in 2002, passed legislation that led to defaults
on $30 billion of corporate debt owed to foreign creditors.
(Panagiotis Pantelidis, 2013) recognizes two aspects of country risk, a) the

risk that the new political situation will not recognize past actions and can
deny to undertake past engagements and b) the risk of not settlement of
loans due to unfavorable development in the balance of payments. The
authors recognize that sovereign risk can can be minimized, a) with the
18
your work.
financing plan of an economic unit, b) with plans of co-financing and with
other financier institutions, that are found outside by the country, and c) with
the distribution of danger, that is emanated from the danger of country, with
loans of multiple attendance, with a lot of foreigner currencies.
Systemic risk
(Caruana, 2010) affirms that following the work of the IMF 25, FSB26 and BIS27
for the G2028, systemic risk can be defined as "a risk of disruption to financial
services that is caused by an impairment of all or parts of the financial
system and has the potential to have serious negative consequences for the
real economy", such as institutional failure, market seizure, infrastructure
breakdown or even a sharp rise in the cost of financial services can have
serious adverse implications for many other market participants.
(Krahnen & Wilde, 2006) studied the effects of
securitizations on the
systematic risk of bank equity and found out that collateralized loan
obligations and
collateralized debt obligations may most likely increase
systemic exposure, rather than reduce it.
25 IMF - International Monetary Fund http://www.imf.org/external/index.htm

26 FSB - Financial Stability Board www.fsb.org
27 BIS - Bank for International Settlements https://www.bis.org/
28 G20 - is a forum of 19 countries plus the European Union, representing both developed and
emerging economies http://www.oecd.org/g20/about.htm
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your work.
(Cerutti, Claessens, & McGuire, 2012) studied systemic risks stemming from
common exposures, interbank linkages, funding concentrations, and other
factors that may have a bearing on income, liquidity and capital adequacy
conditions to highlight some of the unique challenges to global systemic risk
measurement with an eye toward identifying those high-priority areas where
enhancements to data are most needed (p. 1).
Other perspective of risks of international banks

Other perspective of
risks of international banks is given by (Baldwin, Bowles,
Campanile, DiSibio, & Jackson, 2012) that groups emerging risks for global
banking in four categories, namely, (1) Bank funding, liquidity, and collateral
management; (2) Regulatory changes around the globe are introducing new
strategic, operational, and potentially systemic risks; (3) Cybersecurity and
other geopolitical risks present unique oversight challenges; and (4)
Economic and market conditions continue to pose both short- and long-term
risks.
Conclusions
Risks of international banks are topics of major current interest and various
standards. They are being actively addressed by many government agencies
responsible for bank regulation and supervision working together under
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your work.
International
regulatory
framework
for
banks 29
known
as
the
Basel
Committee on Banking Supervision. (Dewatripont, Rochet, & Tirole, 2010)

observes that the existing regulations for commercial banks derive from the
Basel Accords of 1988 (Basel I), which require each bank to hold a minimum
of total capital equal to 8 percent of its total assets and Basel Accords of
2007 (Basel II) that is much more complex than Basel I, and it contains
three pillars, (i) the minimum capital ratio; (ii) the role of the supervisor;
and
(iii) transparency30. Basel Accords of 2013 (Basel III) proposes three
reform measures, namely, (i) capital reforms; (ii) short-term liquidity reforms;
and (iii) stability improvement in the financial system (BSBC, 2009; KPMG,
2011) as cited in (Mawutor, 2014).
The standards and guides from the Basel Accords provide an outline of
standards that are essential for managing bank risks, and they offer few
insights into how the risk management process works in practice. In addition
to Basel Accords, there is a vast literature that can be found in IMF31, FSB32
and BIS33 websites, journals and books34
that provides a practical
29Responsible for Basel Accords of 1988 (Basel I), Basel Accords of 2007 (Basel II) and Basel
Accords of 2013 (Basel III)
30 disclosure and market discipline

31 IMF - International Monetary Fund http://www.imf.org/external/index.htm
32 FSB - Financial Stability Board www.fsb.org
33 BIS - Bank for International Settlements https://www.bis.org/
34 (Saunders & Cornett, 2008)
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your work.
complement to these documents and publications, all addressing BCBS risk
classification namely credit risk, market risk 35, liquidity risk, operational risk,
and other risks36
From the previous review of risks of international banks, it is noticeable that

the largest risks facing international banking system are credit risk, market
risk37, liquidity risk, operational risk, and other risks38 that are objects of Basel
I, II and III prudential regulation and complementary publications.
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Running head: Define what you perceive as the largest risks facing the international banking

system? Support your work.

Define what you perceive as the largest risks facing the

Distance Learning Doctorate of Finance Program

Define what you perceive as the largest

choice of the largest risks faced by the

international banking system.

2 Business risk, reputational risk, systemic risk, moral hazard, settlement

The deregulation and globalization started in the 1980s weakened the

5 http://www.bis.org/publ/bcbs239.pdf, Principle 8 No. 57.

management of the banking sector.

ability to aggregate risk

exposures and identify concentrations quickly and accurately at the

International banking system

International banking system

9 Business risk, reputational risk, systemic risk, moral hazard, settlement

international money market made of (i) money market instruments such as

Reasons for international banking

Low Marginal Costs -

developed at home can be used abroad with low marginal costs.

Managerial and marketing knowledge

the parent banks knowledge of personal contacts and credit

investigations for use in that foreign market.

is obtainable from foreign domestic banks.

12 Industrial & Commercial Bank of China

Retail Defensive Strategy - Multinational banks also compete for

to the same regulations as domestic banks.

circumvent government currency controls.

Costs - Multinational banks may be able to

Largest risks facing international banking system

(Angelopoulos & Mourdoukoutas, 2001), as cited in (Ewedemi, 2003),

affirm that the

classification of risk in traditional and nontraditional banking risks is not

13 Market risks include interest rate and foreign exchange risks

(Angelopoulos & Mourdoukoutas, 2001), as

(Demirg-Kunt & Detragiache, 1998) points out that credit risk is so

17 Business risk, reputational risk, systemic risk, moral hazard, settlement

(Wilmarth Jr., 2009)

notes that universal banks loans securitization and

(Madura, 2015) affirms that regulations contributed to the development of

So, the lack of standardized regulations allowed banks to

circumvent these restrictions inducing banks to credit risks. (Madura, 2015)

international banking regulations produced several regulations

(Ely, 2008) corroborates when saying that

mitigate interest rate risks, the BCBS issued a consultative document

the most important types of operational risk are

breakdowns in internal controls and corporate governance. Such breakdowns

Operational Risk - final document, 2003, p. 1) .

22 Operational Risk Management - http://www.bis.org/publ/bcbs42.htm

(Panagiotis Pantelidis, 2013) recognizes two aspects of country risk, a) the

(Krahnen & Wilde, 2006) studied the effects of

collateralized debt obligations may most likely increase

systemic exposure, rather than reduce it.

25 IMF - International Monetary Fund http://www.imf.org/external/index.htm

Other perspective of risks of international banks

risks of international banks is given by (Baldwin, Bowles,

Committee on Banking Supervision. (Dewatripont, Rochet, & Tirole, 2010)

(iii) transparency30. Basel Accords of 2013 (Basel III) proposes three

that provides a practical

30 disclosure and market discipline

From the previous review of risks of international banks, it is noticeable that

36 Business risk, reputational risk, systemic risk, moral hazard, settlement

38 Business risk, reputational risk, systemic risk, moral hazard, settlement