Financial crisis may be very damaging for the whole society, as bank failures can either lead to runs or to panic. Bank runs occurs when problems at a bank undermine depositors' confidence. The depositors' reaction is to rush to withdraw their money since they know that the bank's reserves are limited and that there won't be enough cash for all the depositors, assuming they follow the same strategy. Nevertheless, banks run are limited to the bank involved and unlike panics they don't affect the whole economy. Indeed, banking panics paralyse the whole system in general and have severer consequences. Such a scenario happened in Argentina in 2001 following a confidence crisis in the Argentina's central bank.
[...] Secondly, banks must also deal with speculative risks such are currency risk, interest rate risk or market risk. These are the consequence of the new trend of the financial system which is more internationalised and in which financial instruments such as derivative for instance play an important role. Nevertheless, these are not the only risk faced by bank. Some important risks are about banks' management and behaviour. That's why, it is important to have good regulation authorities to supervise banks and to avoid bank's failures. [...]
[...] Then, banks must deal with moral hazard problems which are about the “risk that the borrower will engage in activities that are undesirable from the lender's point of view because they make it less likely that the loan is repaid.” To reduce this risk, banks can use restrictive covenants which aims are to discourage undesirable behaviour and monitor borrowers' actions. Diversification is also a key element of risks transformation. Banks pool the deposits of thousands of people and make many loans, each of which is small relative to the size of its total portfolio. [...]
[...] It results from “volatility of positions taken in the four fundamental economic markets: interest sensitive debt securities, equities, currencies and commodities.” The increasing exposure of banks to market risk is due to the “trend of business diversification form the traditional intermediation function toward trading and investment in financial product that provide better potential for capital gain, but which expose bank to significantly higher risks.” Thus market risk requires a constant management attention and specific analysis. Managers need to be prudent and must know exactly how a bank's market risk exposure relates to its capital. [...]
[...] Therefore banks need to engage in maturity transformation that the structure of their assets is longer than that of their liability.” By doing so, they are said to be “mismatching their balance sheets.” Thus, to transform maturity, banks need to estimate their expected cash-flow regularly. Secondly, a bank “commits a large proportion of its asset to investment which cannot be sold at a moment's notice or to a loan than cannot be readily recalled.” Hence, if depositors suddenly want to redeem a large quantity of deposits for cash, then the bank could find its reserve not sufficient enough. [...]
[...] Payment related to fixed interest rate on a notional capital sum with those representing a floating rate on the same sum in the same currency.” One should also mention the basis rate swap which is about the exchange of one type of floating rate for another. Lastly, currency risk can also be managed and reduced by appropriate reserves hold by banks and by an estimation of the appropriate mismatch between maturing foreign assets and liabilities. Market risk is another kind of speculative risk. [...]
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