Banking: Financial Transaction Risks

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Table of Contents

Interest Rate Risk
Credit Risk
Foreign Exchange Rate Risk
Sovereign Risk
Technology Risk
Measuring Interest Risks
References

Central banks hold significant power over financial institutions and business enterprises. Their decisions, especially the interest rate movements, can influence the value of assets and affect already undertaken liabilities. Usually, the central banks operate from the macroeconomic perspective and take steps to solve problems on the national level. As a result, their decisions might be beneficial for the economy as a whole, but particular entities may suffer severe losses. In addition, financial transactions may be negatively affected by various factors not related to interest rate movements. Those risks should also be taken into account by financial analysts and business owners.

Interest Rate Risk

Interest rate risk comes into consideration when the entities acquire interest-sensitive assets or undertake interest-sensitive liabilities. For instance, the central banks movement of the interest rate can affect such assets as municipal or national bonds. A bond dealer who uses their equity to buy Mexican debt risks losing funds if the Bank of Mexico or the Federal Reserve moves the interest rate. Investing in a municipal bond portfolio might pose a risk as well since those bonds would be significantly affected by intervention from the central bank. The central banks decisions can also influence mortgage loans, making them a risky investment.

Credit Risk

Credit risk emerges in transactions that involve giving or taking out a loan. There will always be a risk of a commercial loan not being returned in time. For example, entrepreneurs might face difficulties in establishing new businesses and not repay the loan in time. A purchased entity might have financial liabilities which can be risky to undertake for the new owner. The risks related to credit are common, so the banks usually have security departments, which evaluate the clients financial metrics. The level of scrutinizing depends on the scope of the deal.

Foreign Exchange Rate Risk

Foreign exchange rate risk becomes a factor in international transactions when the procedure requires the currency exchange. This type of risk is common for companies working on the global markets. For instance, the transaction between a French bank and a British entrepreneur would require an exchange within the EUR/GBP currency pair. However, a deal like that would not create a significant risk since both the euro and the British pound are stable currencies. The risk would be much greater if a Russian-based company decided to purchase German equipment since the Russian ruble is more volatile than the euro. A possible risk mitigation solution would be buying more stable currency at a favorable exchange rate and holding it for the right moment. Another way of avoiding the risk would be adding the possibility of price adjustment in case of severe exchange rate fluctuation.

Sovereign Risk

Sovereign or country risk manifests in political decisions, affecting the transaction or even nullifying the deal. Force-majeure situations like war or sudden legal changes on the national level can liberate the parties from liabilities and associated risks. However, less drastic situations could be more harmful since they would cause losses without a way of mitigating them. For example, a Japanese bank might lose a chance to acquire an Austrian one if the Austrian government blocks the deal. In that case, even the losses-free termination of the transaction would be a failure since the goal of acquisition would remain unachieved. Dealings with less-developed countries also pose a significant risk of losses due to their governments unexpected political or economic decisions.

Technology Risk

Technology risk in transactions comes from the technical and IT aspects when the lack of cybersecurity or equipment malfunction leads to eventual losses. For example, contemporary digital financial services create the risks of corporate or personal data theft, account compromising, or file destruction. In addition to that, merging and acquisition might create an overly complicated IT environment, which would cause severe losses (Deloitte, 2018). Therefore, the Japanese banks attempt to acquire its Austrian partner for facilitating the clearing operations might fail due to the technological differences. A possible alleviation of technological risks could require a standardization of technological processes before the acquisition and cybersecurity enhancement.

Measuring Interest Risks

Financial transactions of significant scope demand careful planning since they are susceptible to various types of risks. While some of those risks are predictable or reliably manageable with common sense, the interest rate risks require conducting a special analysis to reveal them. One of the popular interest risk measurement methods duration gap analysis-serves to evaluate how long the entity holds the interest-sensitive assets and how quickly it pays the liabilities.

Duration gap is a quantitative technique used for interest risk measurement. Gup et al. (2007) define duration as the weighted average time (measured in years) to receive all cash flows from a financial instrument (as cited in Chattha et al., 2020). Therefore, the duration gap means the difference between the duration of the assets and liabilities. In simpler terms: the longer the assets or liabilities being held in proportion to the opposite metric the bigger the gap.

The duration gap evaluation might reveal the interest rate-related risks and prevent the losses to overly-risky transactions. Kagan (2020) provides three possible general conditions of the gap:

zero gap: an ideal situation, in which the company is reliably protected against the interest rate movements;
positive gap: a situation in which interest-sensitive assets exceed interest-sensitive liabilities;
negative gap: an opposite situation, in which interest-sensitive liabilities exceed interest-sensitive assets

The use of the duration gap analysis technique can improve risk management of business entities. A research of Chinese banks by Ausloos et al. (2020) showed that the joint-stock banks which performed the duration gap analysis showed a better risk control ability under the influence of interest rate liberalization. In that regard, those banks managed to outperform state-owned and local commercial banks (Ausloos et al., 2020). Therefore, the duration gap analysis proved its usefulness for measuring and managing the interest rate risks in the Chinese case.

The duration gap analysis is also helpful for discovering concerning trends in financial institutions. For instance, Chattha et al. (2020) claimed that a big duration gap of Islamic Commercial Banks (IBCs) makes them vulnerable to a significant loss of net worth and economic value equity. The use of the duration gap technique helped reveal that ICBs constantly allow the mismatch of their assets and liabilities (Chattha et al., 2020). Without a measurement, those problems would have likely remained hidden, leaving the ICBs susceptible to interest rate movements.

Overall, the big or negative duration gap is not necessarily harmful; however, it reflects the entitys susceptibility to transaction risks associated with the interest rate movements. Therefore, financial analysts should pay attention to the duration gap metric before giving or taking out loans or purchasing bonds. A negative duration gap of a significant amount can send a warning sign, vital for calling off a risky deal and saving the company from the potential losses.

References

Ausloos, M., Ma, Q., Kaur, P., Syed, B., & Dhesi, G. (2020). Duration gap analysis revisited method in order to improve risk management: The case of Chinese commercial bank interest rate risks after interest rate liberalization.Soft Computing, 24, 13609-13627. Web.

Chattha, J. A., Alhabshi, S. M., & Meera, A. K. M. (2020). Risk management with a duration gap approach: Empirical evidence from a cross-country study of dual banking systems.Journal of Islamic Accounting and Business Research, 11(6), 1257-1300. Web.

Deloitte. (2018). What board members need to knowand do: Information technology risks in financial services. Web.

Kagan, J. (2020). Negative gap. Investopedia. Web.

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