1. Measuring Risks in Banks By: Dr. Ghassan F. Abu Alsoud 1

2. Measuring Risks Risk measures are related to the profitability measurements because a bank must take risks to earn adequate returns. We describe four categories of risk measurement in this section. Liquidity Risk deposit outflows loan increases selling an asset it holds acquiring additional liabilities Liquidity risk measures show the relationship of a bank's liquid­ity needs for meeting deposit outflows and loan increases versus its actual or potential sources of liquidity from either selling an asset it holds or acquiring additional liabilities. For the sample bank, we can approximate this risk by comparing a proxy of the bank's liquidity needs, deposits, with a proxy for the bank's liquidity sources in the form of short-term securities. 2

3. Although both variables are only rough approximations (funding loan demand may be a major liquidity need, and purchasing liabilities may be an important source of liquidity), this relationship is a beginning indicator of most banks' liquidity risk, Investment in short-term securities involves a sacrifice of the greater profitability of long-term securities for the liquidity of short-term ones. The reverse would be the case if long-term securities were increased. Thus, a larger liquidity ratio for the sample bank indicates less risky, but also less profitable, bank. 3

4. Interest Rate Risk The bank's interest rate risk is related to the changes in and liability returns and values caused by movements in interest rates. A beginning measurement of this risk is the ratio of interest-sensitive assets to interest- sensitive liabilities Particularly in periods of wide interest rate movements, this ratio reflects the risk the bank is willing to take that it can predict the future direction of interest rates. 4

5. If a bank has a ratio above 1.0, the bank's returns will be lower if interest rates decline and higher if they increase. Given the difficulty of predicting interest rates, some banks conclude that they can minimize interest rate risk with an interest sensitivity ratio close to 1.0. Such a ratio may be difficult for some banks to achieve and often can be reached only at the cost of lower returns on assets, such as short-term securities or variable-rate loans. 5

6. Credit Risk The credit risk of a bank is defined as the risk that the interest or principal, or both, on securities and loans will not be paid as promised. In the Smithville Bank example, credit risk is estimated by relating the proportion of assets that are medium-quality loans. The better measure would be the relative amount of past-due loans or loan losses, but such data are not available in this example. Credit risk is higher if the bank has more medium-quality loans, but returns are usually higher too. Returns tend to be lower if the bank chooses to lower its credit risk by having a smaller portion of its assets in medium-quality loans. Note that this measure is only available internally. If one is analyzing a bank from external data, such qualitative data are not available and one must use summary measures such as noncurrent loans, loan losses, and loss reserves as proxies for credit risk. 6

7. Capital Risk The capital risk of a bank indicates how much asset values may decline before the position of its depositors and other creditors is jeopardized. Thus, a bank with a 10 percent capital-to-assets ratio could withstand greater declines in asset values than a bank with a 5 percent capital-to-assets ratio. We measure the capital risk of Smithville Bank by examining the percentage of the bank's assets that are covered by its equity capital. The capital risk is inversely related to the leverage multiplier and, therefore, to the return on equity. When a bank chooses to take more capital risk (assuming this is allowed by its regulators), its leverage multiplier and return on equity, ceteris paribus, will increase. If the bank chooses (or is forced to choose) to lower its capital risk, its leverage multiplier and return on equity will decrease. 7