Module 4, Section 1: Bank Risk

Overview of Module 4, Section 1: Bank Risk, covering the three primary sources of bank risk and the regulations designed to mitigate this risk. An understanding of these sources of bank risk is key for comprehending the potential vulnerabilities within the financial system, how these manifested in the Financial Crisis of 2007-2009, and how the post-Financial Crisis regulations were designed to enhance the resilience of banks and contribute to overall global financial stability.

Main Themes

This section identifies three primary sources of bank risk that can lead to insolvency:

1. Loss of Asset Value (Capital Inadequacy Risk) This occurs when the assets held by a bank decrease in value. This can be due to bad loans (borrowers defaulting), poor investments, or correlated market risks affecting a significant portion of the bank's asset portfolio.
2. Bank Runs (Liquidity Risk) This involves a rapid withdrawal of deposits by a large number of depositors, typically driven by a perceived risk of the bank's insolvency. This can lead to a situation where the bank does not have enough liquid assets (currency and reserves) to meet these demands.
3. Wholesale Lending Shortage (Stable Funding Risk) Banks often rely on short-term loans from institutional investors (the wholesale market) to finance asset purchases. This risk arises when these lenders become unwilling to roll over these short-term loans, again often due to a perceived risk of the bank's financial health, creating afunding crisis.

The section also highlights the role of Basel III regulations, an internationally agreed-upon set of measures developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2007-2009 financial crisis. These regulations aim to strengthen the regulation, supervision, and risk management of banks globally to enhance financial stability.