Paper Example on Credit Valuation Adjustment

Introduction

A risk is the ability of an asset or wealth to reduce in its value, risk can be predicted or unpredicted, or taking action with the possibility of gaining or losing from the outcome. Banking risk is the possible reduction in profit and the value deviation that the banking industry is likely to go through (Saunders and Allen, 2010).

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For proper management in banking sector it is of value to factor out and identify the significant possible risk in the industry, then to do risk assessment activities in the banking sector and lastly set out a well-structured plan for the steps of reducing the risk (Bario, 2011). A good risk management approach will undoubtedly bring out the tools, processes and the available techniques used by a firm in the activities and also define roles and responsibilities of different personalities within the company who participate in the management process.

According to the world economic research it is found that, when considering the world economy and comparing different sectors of the economy, the financial industry is the largest industry in the global economy and in the big economy like the US, it is the banking and the insurance sectors that control the most significant percentage of their economy. However, the banking industry is going under different risk which needs to be identified and appropriately managed for continuous profit maximization.

These risks include credit risk which is the possibility that a bank counterparty is likely to fail to fully satisfy the requirements which are laid down as per the terms, this risk frequently caused by issues like the bank loans, the interbank transfer also by offering the foreign exchange transactions which mainly brought by the different exchange rates.

Moreover, the credit risk can also be as a result of financial features and the governments bond. For example when the bank lend money to its customer and due to any reason the customer fails to pay the money plus the interest then in such a situation the bank will be going through the credit risk, and if the clients fail to pay the credit card bill the bank will in such event faces a credit risk (Rosenberg and Schuermann, 2006). According to the bank of the internal settlement the best way to reduce the credit risk is to increase the charged interest rate to the borrowers with the high chances of failing to pay the loans. Many factors like the monthly income of the client and the collateral availability can help banks to easily and quickly identify the chances of the credit risk possibility.

Again addressing another cause of credit risk which is foreign transactions, where a sales have successfully gone through on one end but fails on another end due to insufficient funds in that account and in such situation it is highly advisable to process the payment for a longer time to confirm the transactions with the other end if the statement can successfully transact that amount.

The best example of credit risk situation which the bank incurred due to exchange rate include where a person sends money to another country on a day when the foreign exchange is low and the recipients receives money on another day when the exchange rates have changed on this occasion the bank will fully take the losses made due different in exchange rate. On managing the risk which is due to the exchange rate, banks are recommended to encourage the money sent to be calculated with the current exchange risk rate. Credit risk can also be managed by setting proper integrals components of bank risk management system and be up to the present and most updated exchange rates

The banks which give the credit cards to their clients are also likely to go through the credit risk, and in this specific issues the bank will experience the settlement risk, this may be due to deliberate fraud caused by the client and on such scenario the banks will have to make payments to the service providers (Jarrow and Turnbul, 1995).

Market risk is another critical risk that the banking sector undergoes, in this risk, it's usually considered under four different options which are formulated from their causes, this risk is caused by factors like interest rates, equity prices, different prices of commodities and also the foreign exchange rates. When there is a more significant fluctuation in the interest rates, the banks are likely to make losses, in an event where there is fluctuation in stock prices the banks will again cause a damage.

Commodity risk also is experienced in banks when there is random and unpredictable fluctuation in prices of industrial goods, agricultural products and even from natural commodities like minerals got in a country to manage the commodity risks the banks are advised to buy assets like minerals and put on reserve to maintain the market demands this will help to reduce the chances of the risk.

Banks for International Settlements (BIS) also identify the operational risk as one of the threats in the banking industry, this is explained as the risk which occurs as a result of poor working systems within the bank which further leads to failed internal processes.in most banks the operational risks is likely to occur due to manpower mistakes or due to boredoms. Some of the bank's employees may leak critical and most confidential information to outsiders as a result of system failure.

The banking operational risks can be either system risk which is as a result of programming errors or human risk which is due to personal negligence which is done knowingly or unknowingly and even, lastly process operational risk caused by system hacking or improper processing of banks information during transactions. An excellent example of a bank which went through the operational risk is Barings in 1995, this oldest Britain's banks.

Most modern and current banks are shifting from the indigenous ways of processing information and transactions to the contemporary ways, due to rise in technology and digital world where most banks automate most of their operations, thus it is essential to consider the operational risk. Some banks undergo a lot of losses from the operational risk like hacking, and a proper management system is being considered by the banks which also involve significant capital investment.

Another risk in the banking sector is the liquidity risk, this is where the banks have an insufficient fund to meet the daily transaction need of the customers, some banks invest a lot in the assets but this is likely to generate problem as the assets cannot be quickly sold when there is a need for cash. Customers always shy away from the banks with the liquidity issues as most of them fear the solvency, this is a situation where you withdraw, but the bank through the manager will promise you to come another day for your cash. Such risks were experienced by a small bank in Northern England and Ireland, so this forced the government to intervene, and the government took over the ownership of this bank because it was unable to pay the contractors in 2007 global financial crisis fully. The liquidity risk can be managed by the banks reducing the amount of assets goods and considering holding the capital on cash according to the need of the customers.

The Bank of global settlement has also considered the systemic risk as another a laming risk in the banking sector; this risk is mainly related to the pricing of banks assets as the prices of bank assets are being changed by the system factor (Jarrow and Turnbull, 2000). The system risk usually starts by affecting one bank, but due to the relationship on the transaction then other banks and branches will be changed due to one system being used. The system risk is always associated with the failure of the major or the main headquarter, but the problem will be distributed to other banks and further affect the whole system.

According to Bank of International Settlement can be managed effectively by setting a different but inter coordinating arrangements between banks and the branches, it can also be effectively achieved by setting up adequate internal controls, for example, the information and the communication systems should always be reviewed, and the procedure and findings of the banking audits should be discussed with the members. The general manager should address the weakness and every shortcoming from the systems.

The banking industry is a hazardous industry by nature, and it's therefore essential to discuss business risk as one of the banking risks. Business risk involves a lot of capital, and there should be both positive and negative outcomes, this risk is always related to the long-term management of the banks, thus the poor control of a bank, it can be managed by setting focus goals and proper coordination of all system in the industry.

A good structure of the internal controls system will always improve the operation of the banking systems, reliability to the customers and adaptability to the community. This will reduce the possibility of risk that would come up from the more considerable capital used on the initial or original establishment of banking farms (Brown and Mole, 2014). Another crucial banking risk which needs to be controlled is the Moral banking hazard as this is estuation where the big banks in the banking industry tend to get involved in a significant financial risk with the mind that

Bank of international settlements also experience a Reputational risk, like any other sector in the economy the banking sectors equally face reputational risk this would arise as a result of rumour about of banks which can be spread by the competitor, the negative information about the banks like poor customer care services and lack of confidentiality can also results to reputational risk which will in turn break the trust between the customers and the bank.

The bank movement team should be aware that every decision made is likely to affect their customer and a bad decision will automatically result to bank losing their trusted customers. To manage the reputational risks effectively, Banks of International Settlements suggest that there should always be a very active board of the bank and senior management taking the critical responsibility of oversight, as this will to make the rational decisions and take the opinion of the customers. All board of directors and branch managers are charged with the responsibilities to identify and deeply understand the nature of the risk which is likely to occur and take precautions and measures to address it adequately.

Credit Valuation Adjustment (CVA) is defined according to Bank of International Settlement as the difference between the risk-free portfolio and the likely hood that the customers having loans will default in payment (Hoffman, 2011). This is the actual market value of credit risk in the banking sector. The process of developing the model is very complex and needs a lot of statistical knowledge and understanding to relate how different components works and how they depend on each other in the system(Cherubini,2013).

The implementation of (CVA) has been facing a number of challenges on implem...