BFF5916 · International Banking
Bank Risk Management
A bank is a risk machine: it earns its margin by taking the risks the market pays it to bear, then managing the rest. This chapter names six risk families — credit, interest-rate, liquidity, market, FX and operational (plus country/sovereign) — and for each you must state the definition and the measure or tool that contains it. The signature method is the unit's way of sizing interest-rate risk: the repricing (funding) gap, GAP = rate-sensitive assets − rate-sensitive liabilities per maturity bucket, with the rule ΔNII ≈ GAP × Δr. Because deposits reprice faster than loans, banks usually run a negative short-term gap, so a rate rise squeezes net interest income. The chapter then separates two ideas examiners love to merge: solvency (a balance-sheet test, assets > liabilities) versus liquidity (a cash-flow test) — a run is a liquidity event that can sink a fully solvent bank through fire-sales. It closes with two more measures: Value at Risk (VaR) for the trading book (a threshold-at-a-confidence, not the worst case) and a brief note on the duration gap / ALM, the value lens on the same maturity mismatch.
What this chapter covers
- 01The six risk families and their measures/tools
- 02The yield curve as the rate backdrop (normal/flat/inverted)
- 03The repricing (funding) gap — GAP = RSA − RSL
- 04The repricing rule — ΔNII ≈ GAP × Δr, and the sign logic
- 05Liquidity risk and the bank run — solvency vs liquidity
- 06Value at Risk (VaR) — what it is and is not
- 07The duration gap / ALM — the value lens
Worked example: a rate shock on a negative-gap bank
- +1(a) The gap: GAP = RSA − RSL = 180 − 300 = −$120m — negative, the usual short-term picture (liabilities reprice faster than assets).
- +2(b) Apply the rule with Δr as a decimal: ΔNII ≈ GAP × Δr = (−120) × 0.01 = −$1.2m.
- +1Read it: NII falls by about $1.2m over the year, because $300m of liabilities reprice up at +1% but only $180m of assets do — the unmatched $120m of funding now costs more with no offsetting income.
- +1(c) Mirror case: if rates fell 100 bp, ΔNII = (−120) × (−0.01) = +$1.2m — a negative-gap bank actually benefits from falling rates.
Key terms
- Repricing (funding) gap
- Rate-sensitive assets minus rate-sensitive liabilities in a maturity bucket, in dollars. An item is rate-sensitive if its rate will reset within that horizon. The gap drives the income effect of a rate move: ΔNII ≈ GAP × Δr.
- Rate-sensitive asset / liability
- An asset or liability whose interest rate will reset within the bucket — a maturing bill, a floating-rate loan due to reset, a short deposit about to roll. Long fixed-rate loans and equity are not sensitive in the short bucket, which is why banks usually run a negative short-term gap.
- Solvency vs liquidity
- Solvency is a balance-sheet test (assets > liabilities → positive net worth); liquidity is a cash-flow test (enough reserves/sellable assets to meet withdrawals now). In a run, liquidity — not solvency — is what bites: a solvent bank can fail if it can't turn assets into cash fast enough.
- Value at Risk (VaR)
- The maximum loss not exceeded with a given confidence over a given horizon (e.g. a 99% 1-day VaR of $4m means the daily loss stays under $4m on 99 days in 100). It is not the worst possible loss and not a probability of failure — it is a threshold-at-a-confidence for the trading book.
- Duration gap
- The value-based version of the maturity mismatch: it nets the durations of assets and liabilities. A positive duration gap means rising rates erode the economic value of equity (long bonds lose more than short deposits gain). The repricing gap measures income; the duration gap measures value.
Bank Risk Management FAQ
What is the repricing gap and how do I use it?
In each maturity bucket you list the assets and liabilities whose rate will reprice within that window — rate-sensitive assets (RSA) and liabilities (RSL) — and take the difference: GAP = RSA − RSL, in dollars. The income effect of a rate move is then ΔNII ≈ GAP × Δr, with Δr expressed as a decimal. A bank typically runs a negative short-term gap because deposits reprice faster than loans, so a rate rise squeezes its net interest income.
Negative gap, rates rise — does NII go up or down?
Down. ΔNII has the same sign as GAP × Δr, so a negative gap with a rate rise gives a negative ΔNII (funding reprices up faster than assets). A negative gap with a rate fall gives a positive ΔNII. A positive gap flips both. The exam hands you a gap and a rate move and asks for the sign — anchor on the formula and remember Δr is a decimal.
What is the difference between solvency and liquidity?
Solvency is about the balance sheet — assets exceed liabilities, so net worth is positive. Liquidity is about cash flow — having enough reserves or sellable assets to meet withdrawals right now. A run is a liquidity event: rational depositors withdraw first, the bank fire-sells illiquid loans at a loss, and those losses can turn an illiquid-but-solvent bank into an insolvent one. 'It was solvent, so it was fine' is false.
What exactly does VaR tell me — and what doesn't it?
A 99% 1-day VaR of $4m says that on 99 days in 100 the daily loss stays under $4m. It does NOT tell you how bad the worst 1% can be, and it is NOT a probability of failure — it is a loss threshold at a chosen confidence over a chosen horizon. Don't confuse it with the repricing gap: VaR is the market-risk, trading-book measure, while the repricing gap is the interest-rate, banking-book measure.
Exam move
Make the six-row risk table automatic — for each family (credit, interest-rate, liquidity, market, FX, operational, plus country) be able to name the definition AND the measure/tool, because the exam matches them. The one you must be able to calculate, not just name, is the repricing gap: GAP = RSA − RSL, then ΔNII ≈ GAP × Δr with Δr as a decimal; lock the sign logic (same sign as GAP when rates rise). Keep two pairs crisp because they are the favourite traps: solvency vs liquidity (balance sheet vs cash flow; a run kills a solvent bank) and VaR vs the repricing gap (market/trading book vs interest-rate/banking book). Read the yield curve as the backdrop — inverted = recession signal — and treat the duration gap as the value-lens add-on to the income-lens repricing gap.
