maturity when the loan is repaid fully. Section 2.2 discusses the banking book further. Nearly all of a bank's credit risk is contained in the credit risk of the assets in its banking book, although some elements of credit risk can also exist in the trading book.
1.3.2 Market Risk
Market risk is the risk of losses to the bank arising from movements in market prices as a result of changes in interest rates, foreign exchange rates, and equity and commodity prices. The various components of market risk, and the forces that give rise to them, are covered more extensively in Chapter 6. The components of market risk are as follows:
• Interest rate risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the bank's equity. Section 2.2 discusses bank assets, liabilities, and equity further. Second, if interest rates rise, the bank will be forced to pay higher interest rates on its deposits well before its longer-term loans mature and it is able to replace those loans with loans that earn higher interest rates.
• Equity risk is the potential loss due to an adverse change in the price of stock. Stock, also referred to as shares or equity, represents an ownership interest in a company. Banks can purchase ownership stakes in other companies, exposing them to the risk of the changing value of these shares.
• Foreign exchange risk is the risk that the value of the bank's assets or liabilities changes due to currency exchange rate fluctuations. Banks buy and sell foreign exchange on behalf of their customers (who need foreign currency to pay for their international transactions or receive foreign currency and want to exchange it to their own currency), and they also hold assets and liabilities in different currencies on their own balance sheets.
• Commodity risk is the potential loss due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities (e.g., wheat, corn, soybeans), industrial commodities (e.g., metals), and energy commodities (e.g., natural gas, crude oil). The value of commodities fluctuates a great deal due to changes in demand and supply.
EXAMPLE
American savings and loans (S&Ls), also called thrifts, are essentially mortgage lenders. They collect deposits and underwrite mortgages. During the 1980s and early 1990s, the U.S. S&L system underwent a major crisis in which several thousand thrifts failed as a result of interest rate risk exposure.
Many failed thrifts had underwritten longer-term (up to 30-year) fixed-rate mortgages that were funded by variable-rate deposits. These deposits paid interest rates that would reset, higher or lower, based on the market level of interest rates. As market interest rates increased, the deposit rates reset higher, and the interest payments the thrifts had to make began to exceed the interest payments they were receiving on their portfolios of fixed-rate mortgages. This led to increasingly large losses and eventually wiped out the equity of thousands of S&Ls and led to their failures. As shown in Figure 1.5, as interest rates rose, the payments the S&Ls had to make on variable rate deposits became larger than the payments received from the fixed-rate mortgage loans, leading to larger and larger losses.
Figure 1.5 Gains vs. Losses for American S&Ls as Interest Rates Rise
EXAMPLE
In the early part of this century, the functionality and use of technology for social media grew rapidly. The Facebook networking site transformed the way in which hundreds of millions of people communicated. It also transformed the way companies advertised to existing and potential customers. When Facebook went “public” on May 17, 2013, investor excitement pushed the launch price higher based on expectations and forecasts of advertising revenue. The opening share price was USD 38, but the price soon fell, dropping to USD 20 shortly afterward due to questions being asked about the effectiveness of Facebook advertising and the company's growth potential. The share price later rebounded, but its initial opening volatility was reminiscent of the dot-com bubble of 1997-2001; when it burst, the share prices of many technology companies fell, causing losses (due to equity risk) of 50 % or more.
EXAMPLE
The Crimean Crisis that started in February 2014 put Russia and the United States, along with the European Union on a collision course. While military conflict, although unfortunate, was largely contained, by late 2014 the crisis continued and its main theatre of operation moved to the international financial markets and banking and payment systems. A number of sanctions were imposed by countries around the globe on Russian individuals, businesses, and on the Russian State herself.
The sanctions ranged from travel bans, money transfer bans, bans on access to foreign bank accounts, reduced or denied access to raising capital in international financial markets, bans on correspondent bank activity in favor of identified individuals and companies, bans of imports from and exports to Russia of certain defined goods, including energy-related goods. The net effect of these sanctions was a slowdown of Russian business activity, reduction of personal freedoms, unavailability of international consumer products in Russia – and a collapse in the international value of the Russian ruble.
The ruble was valued at 32.6587 against the USD on January 1, 2014 – a value level it had held since the onset of the Financial Crisis in 2008 – and was still valued at 33.8434 on July 1, 2014 – a modest decline of 3.6 %. However, towards the end of October and early November, the ruble fell dramatically. On November 1, 2014 its value was 39.3519, and on November 7, 2014, it was valued at 45.1854, or a 38 % decline since the beginning of the year. These prices for USD/RUB were official Russian Central Bank prices, suggesting that the effective foreign exchange rate for Russian customers and companies were many times higher for real transactions. The effect on Russian businesses was an increase by at least 38 % in the price of foreign goods and/or a 38 % decline in earnings from exports to other countries.
Although designed to be a measure against Russia as a whole, and her leadership in particular, the measures were expected to impact small and medium-sized Russian companies much more than large corporations. So, although the currency movements were dramatic, at the end of 2014, it remained to be seen if any lasting impact on economic and commercial life in Russia would take place.
EXAMPLE
During the 1970s, two American businessmen, the Hunt brothers, accumulated 280 million ounces of silver, a substantial position in the commodity. As they were accumulating this large position – approximately one-third of the world's supply – the price of silver rose. For a short period of time at the end of 1979, the Hunt brothers had cornered the silver market and effectively controlled its price. Between September 1979 and January 1980, the price of silver increased from USD 11 to USD 50 per ounce, during which time the two brothers earned an estimated USD 2 to 4 billion as a result of their silver speculation. At its peak, the position held by the brothers was worth USD 14 billion. Two months later, however, the price of silver collapsed back to USD 11 per ounce, and the brothers were forced to sell their substantial silver holdings at a loss.
Market risk tends to focus on a bank's trading book. The trading book is the portfolio of financial assets such as bonds, equity, foreign exchange, and derivatives held by a bank either to facilitate trading for its customers or for its own account or to hedge against various types of risk. Assets in the trading book are generally made available for sale, as the bank does not intend to keep those assets until they mature. Assets in the
