Lecture 4: Credit risk The nature of banking is strongly related to the management and control of risks. This lecture gives an overview of the main risks to which banks are subject, namely interest rate risk/market risk, liquidity risk and credit risk, as well as broader systemic risks. We then examine economic issues relating to the core of banks’ traditional business, namely onbalance-sheet lending. We focus in particular on the various ways in which banks seek to control the risks arising from their loan books. This discussion includes a brief assessment of issue of credit rationing which is an issue of both microeconomic and macroeconomic significance.

Bank risks – an overview What is risk? – danger that a certain unpredictable contingency can occur, which generates randomness in cashflow Risk and uncertainty – risks may be described using probability analysis (business cycle, company failures), while events subject to uncertainty cannot (financial crises, wars etc.) Risk and variability – variability alone may not entail risk as long as known for sure ex ante The nature of qualitative asset transformation- gives rise to risks because of mismatched balance sheet.

Main forms of risk Credit risk – risk that party to contract fails to fully discharge terms of contract Interest rate risk – risk deriving from variation of market prices owing to interest rate change Market risk – more general term for risk of market price shifts Liquidity risk – risk asset owner unable to recover full value of asset when sold (or for borrower, credit not rolled over) Market liquidity risk – risk that a traded asset market may vary in liquidity of the claims traded Other risks o operational risk o risk of fraud o reputation risk Systemic risk – that the financial system may undergo contagious failure following other forms of shock/risk

Introducing credit risk and the debt