Banks have many risks which should be carefully monitored and effectively managed as they use huge amount of leverage. If these risks are not managed effectively, the banks would become easily insolvent.
If a bank shows any signs of financial weakness, the depositors would withdraw their funds, other financial institutions would stop lending and financial markets would refuse take its debt securities which would worsen it financial condition.
Since the 2nd half of 2007, international financial crisis has resulted insecurity and instability and specially shattered the investors' confidence resulting in liquidity shortages in international market. All the governments of the world injected huge amount of funds in financial institutions to resolve the liquidity problems and to boost the investor's confidence. UK government injected �37bn in financial institutions in late 2008. HBOS was one of them which was taken over by Lloyds Banking Group in later half of 2008.
Banks share many common risks as other businesses do, but the major risks that affect the banking industry include
Out of these many risks, main three risks have been explained relating to HBOS.
HBOS liquidity risk is governed by the group liquidity statement, which identifies, manages, measures and monitor liquidity risk across the group and is approved by the boards. Liquidity risk management is the responsibility of Group Capital Committee (GCC), which reviews the policy on annual basis for its current and continuous relevance.
Operational liquidity management is delegated to Treasury and Group Funding and Liquidity Committee (GFLC) is assigned to set limits and the specific guidelines for monitoring & controlling liquidity.
The Group's operations in the UK comply with FSA's Sterling Stock Liquidity approach which requires the bank to have sufficient liquid resources to meet its requirements in times of financial crisis.
The group has daily monitoring and control processes in place to meet both statutory and prudential requirements. In addition to these:
- HBOS stress tests its potential cash flows mismatch under various scenarios on ongoing basis; &
- It has a liquidity contingency plan to identify the emergency liquidity concerns at an early stage, so action can be taken to avoid serious crisis developing.
Since the start of recession in last quarter of 2007& during 2008, the group has been operating on full contingency arrangements including daily monitoring of funding and liquidity position & weekly meetings to monitor and manage the balance sheet. At December, 31 The Group's portfolio of market asset was �77.3 billion (2007, 67.0 billion) of which 39.5 billion (2007, 13.4 billion) is used for repo to save bank from liquidity crisis. The HBOS approach's for funding was focused on retail and other customers and wholesale sources.
During mid September 2008, the group suffered deposits outflow which increased its reliance on wholesale funding. Due to the economic conditions, when there was not enough long term funding, HBOS sourced itself with short term and overnight funding resulting in increased refinancing risk.
Market risk is controlled across the Group by setting limits using a range of measurement methodologies. The principal methodologies are
All are supplemented by scenario analysis which is performed in order to estimate the potential economic loss that could arise from extreme, but plausible stress events.
All market risk exposures are accumulated by Group Risk on monthly basis and submitted to the Group Market Risk Committee for review and portfolio assessment.
A key market risk faced by the Group in its non-trading book is interest rate risk. Interest rate risk arises where the Group's financial assets and liabilities have interest rates set under different bases or reset at different times.
The principal Board limit for structural interest rate risk is expressed in terms of potential volatility of net interest income in adverse market conditions. Risk exposure is monitored using the following measures:
Group Market Risk Committee allocates the limits and sets risk tolerance for each division. Divisions usually hedge all significant open interest rate mismatch positions with Treasury. They are not permitted to take positions of a speculative nature. A limit structure exists to ensure that risks stemming from residual and temporary positions or from changes in assumptions about customer behaviour remain within the Group's risk appetite.
Market risk in non-trading books consists almost entirely of exposure to changes in interest rates. This is the potential impact on earnings and value that could occur when, if rates fall, liabilities cannot be re-priced as quickly as assets; or when, if rates rise, assets cannot be re-priced as quickly as liabilities.
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