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Types of Risks Incurred by Financial Institutions

This chapter provided an overview of the major risks that modern FIs face. FIs face interest rate risk when the maturities of their assets and liabilities are mismatched. They incur market risk for their trading portfolios of assets and liabilities if adverse movements in the prices of these assets or liabilities occur. They face credit risk or default risk if their clients default on their loans and other obligations. They encounter liquidity risk as a result of excessive withdrawals of liabilities by customers. Modern-day FIs also engage in significant amount of off-balance-sheet activities, thereby exposing them to off-balance-sheet risks —changing values of their contingent assets and liabilities. If FIs conduct foreign business, they are subject to foreign exchange risk. Business dealings in foreign countries or with foreign companies also subject FIs to sovereign risk. The advent of sophisticated technology and automation increasingly exposes FIs to both technological and operational risks. FIs face insolvency risk when their overall equity capital is insufficient to withstand the losses that they incur as a result of such risk exposures. The effective management of these risks—including the interaction among them—determines the ability of a modern FI to survive and prosper over the long run. The chapters that follow analyze these risks in greater detail, beginning with those risks incurred on the balance sheet.

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