Bessis (2002) posit that liquidity risk refers to three (3) multiple dimensions: inability to raise funds at normal cost; market liquidity risk and asset liquidity risk.

  a) Funding risk depends on how risky the market

perceives the issuer and its funding policy to be. An institution coming to the market with unexpected and frequent needs for funds sends negative signals, which might restrict the willingness to lend to this institution.

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The cost of funds also depends on the bank’s credit standing. If the perception of the credit standing deteriorates, funding becomes more costly.

b) The second dimension which is the liquidity of the market relates to liquidity crunches because of lack of volume.

Prices become highly volatile, sometimes embedding high discounts from par, when counterparties are unwilling to trade.

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Funding risk materializes as a much higher cost of funds, although the cost lies more with the market than the specific financial institution. Market liquidity materializes as an impaired ability to raise money at a reasonable cost.

C) Asset liquidity risk results from lack of liquid related to the nature of assets (etc. mortgage) rather than to the market liquidity.

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Holding a pool of liquid assets acts as a cushion against fluctuating market liquidity, this is because liquid assets, allows the meeting of short-term obligations without recourse to external funding, thus, the rationale for banks to hold a sufficient fraction of their balance sheet as liquid assets (a regulatory rule).

The ‘liquidity ratio’ of banks makes it mandatory to hold more short-term assets than short-term liabilities, in order to meet short-run obligations.

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Liquidity risk might become a major risk for the banking portfolio.

Extreme lack of liquidity results in bankruptcy, making liquidity risks a fatal risk. However, extreme conditions are often the outcome of other risks. Important unexpected losses raise doubts with respect to the future of the organization and liquidity issues.

When a commercial bank gets into trouble, depositors “run” to get their money back. Lenders refrain from further lending to the troubled institution. Massive withdrawals of funds or the closing of credit lines by other institutions are direct outcomes of such situations. A brutal liquidity crisis follows, which might end up in bankruptcy (Bessis, 2002).

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The interest rate risk is the risk of a decline in earnings due to the movements of interest rates.

Most of the items of banks balance sheets generate revenues and costs that are interest rate driven. Since interest rates are unstable, so are earnings.

Anyone (especially banks) who lends or borrows is subject to interest rate risk. The lender earning a variable rate has the risk of seeing revenue reduced by a decline in interest rates. The borrower paying a variable rate bears higher costs when interest rates increase.

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Both positions are risky since they generate revenues or costs indexed to market rates. The other side of the coin is that interest rate exposure generates chances of gains as well (Bessis, 2002).

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Market risk is the change in net asset value (the value of an entity asset less the value of its liabilities) due to changes in underlying economic factors such as interest rates, exchange rates and equity and commodity prices (Pyle, 1997).

Market risk arises when FIs actively trade assets and liabilities (and derivatives) rather than hold them for longer-term investment, funding or hedging purposes.

The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

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Large banks invest heavily in off-balance sheet assets and liabilities, particularly derivatives securities and letters of credit

The risk incurred by a FI due to activities related to contingent (dependent/ conditional) assets and liabilities.

A letter of credit is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring.

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Currency risk is the risk of incurring losses due to changes in the exchange rates.

Variations in earnings result from the indexation of revenues and changes to exchange rates or of changes of the values of assets and liabilities denominated in foreign currencies.

Foreign exchange risk is a classical field of

international finance.

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Exposure of exchange rate fluctuations comes in three forms:

1. Transaction exposure

2. Economic exposure

3. Translation exposure

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Transaction exposure is the degree to which the value of future cash transactions can be affected by exchange rate fluctuations.

The value of a firm’s cash inflows received in various currencies will be affected by the respective exchange rates of these currencies when they are converted into the currency desired.

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The degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates.

All types of transactions that cause transaction exposure also cause economic exposure because these transactions represent cash flows that can be influenced by exchange rate fluctuations.

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The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure.

An MNC creates its financial statements by consolidating all of its individual subsidiaries financial statements. A subsidiary’s financial statement is normally measured in its local currency.

To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNC parent. Since exchange rates change over time, the translation of the subsidiary’s financial statement into different currency is affected by exchange rate movements.

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Solvency risk is the risk of being unable to absorb losses, generated by all types of risks, with the available capital. Solvency is a joint outcome of available capital and of all risks.

The basic principle of ‘capital adequacy promoted by regulators is to define what level of capital allows a bank to sustain the potential losses arising from all current risks and complying with an acceptable solvency level.

The capital adequacy principle follows the major orientations of risk management.

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The Basel Committee on Banking Supervision (2001) defines operational risk as, the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.

This class of risks has unlimited downside and can expose a financial institution to serious financial and reputational losses.

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Underwriting Risk/ Insurance Technical Risk

These are the risks undertaken by insurance companies through the contracts they underwrite.

The risks within this category are associated with the perils covered and with the specific processes associated with the conduct of insurance business.

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They include underwriting process risk (financial loss related to selection and approval of risk to be insured),

Pricing risk (financial loss due to insufficient premium charged for a risk undertaken),

Product design risk (exposure to events not anticipated in the design and pricing of the insurance contracts), and

Claims risk (more than expected number of claims arising) amongst many others.

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