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Banking activity is generally considered to be risky. Banks earn money by borrowing money from people and then lending them to other people at a higher rate of interest. However, commercial banking activity is considered to be even riskier. This is generally because of the huge dollar value of the transactions in commercial banking.
Hence, commercial banks are required to create a system to manage the risk in a more appropriate manner.
In this article, we will have a closer look at some of the risk factors which are associated with commercial banking.
A commercial bank is considered to be riskier as compared to other lending institutions. This is because of the various risk factors which are associated with it. Some of the important ones have been listed below:
It is common for commercial banks to lend out millions of dollars to corporations. Since the ticket size is larger, there are fewer counterparties in a commercial bank’s portfolio. A default by any single counterparty has a larger impact on the workings of a commercial bank.
For instance, many auto ancillary companies might be selling to the same automobile company. Since the business of all these companies is related so closely, there is a possibility of a contagion effect. This means that the failure of one company has an impact on another company and can induce the failure of that company. This makes lending to corporates riskier.
Now, since we know that commercial banks face higher lending risks as compared to other lenders, let’s have a closer look at some of the risks which are faced by commercial banks.
There have been many cases in commercial banking history where bank officials have colluded with large corporations in order to defraud the shareholders of the bank. Commercial banks need to take such risks into account.
In some extreme cases, commercial banks may also face temporary suspension of their license. Hence, commercial banks need to be cognizant of these regulatory risks and have procedures in place to control them.
Commercial banks also interact with the markets if they securitize their long-term loans. An adverse movement in the markets exposes commercial banks to a lot of risks. It is important for commercial banks to plan for such risks and also use derivative instruments in order to manage them.
The fact of the matter is that commercial banking is an extremely risky operation. Banks are exposed to a wide variety of risks. However, over the years, banks have developed risk management systems that are quite effective.
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