Banks lend money to different businesses and borrowers to earn interest on the same; this is most important part of banks’ business. As the money is given to others on the agreement that it will be repaid by the borrower, there can be different cases where the banks either not able to recover the money or suffer some losses on the same.
Risk is generally termed as any possibility of adverse and unexpected outcome which leads to losses or lower profit for the banks. This can happen due to any unexpected event or unexpected changes in the asset prices or earnings of the banks. Risks vary depending upon the type of business or investment since different factors affect businesses or investments in different ways.
Also here the relationship between risk and return comes into picture as the banks provide loan to different businesses or individuals across different risk categories to earn higher returns on their investments. Higher return comes with higher risk only, it means if the bank tries to earn higher return; it can come only at higher risk. Subprime loans carry much high risk as they are given to the people with very low credit rating; which has led to one of the worst financial crisis in recent times.
Risks arise from unexpected events which cannot be avoided at all, so how much risk a bank should take? Banks should take only those risks that it understands and should take them within manageable limits. These limits can be set by the regulatory authorities or the bank itself. For this, all the probable risks need to be understood and quantified properly. The mains risks that the banks are exposed to are mainly
Banks should be able to quantify all these risks and should have proper risk management methods to manage these risks. Failing to manage these risks can lead to huge loss to the banks…