Foundations of Financial Risk. Apostolik Richard

are some large non-U.S. banking groups that operate through a holding company structure, such as HSBC Holdings and Royal Bank of Scotland.

      Bank holding companies often raise funding on behalf of their group and then “downstream” it to their operating companies. They are able to service interest on the debt from dividends that are “upstreamed” from the operating companies.

       1.2.4 Cooperative Banks

      Cooperative banks are owned by their customers and usually have a large branch network that covers small towns and villages as well as larger cities. Their core strength is often lending to and taking deposits from individuals and small businesses.

      For most banks, there is a distinction between shareholders, who invest in the bank and who therefore own it, and customers, who do business with the bank but have no ownership rights. In contrast, someone who deposits money with a cooperative bank automatically becomes a shareholder in that cooperative bank. In some cooperative banks, customers who receive loans also become shareholders. Such customers are, in principle, entitled to vote and to control how the local cooperative bank is run. Cooperative banks are structured like a pyramid, with individual customers controlling local cooperatives, these local cooperatives in turn controlling regional organizations, and these regional organizations controlling a national organization that oversees the network as a whole.

      Examples of such cooperative banks include Rabobank in the Netherlands, the Nationwide Building Society in the United Kingdom, and the Shinkin cooperative bank network in Japan.

      Although cooperative banks usually have strong ties to local communities, many have become very large and in some ways behave just like other banks. Rabobank, in the Netherlands, is one of the biggest banks in the world. The BPCE Group in France works with large companies and offers sophisticated financial products.

      Many of the larger cooperative banks have a central entity – still ultimately owned by the members – that manages liquidity and risk for the group as a whole.

       1.2.5 Credit Unions

      Credit unions are similar to cooperative banks in that they are owned by their customers. However, in practice, credit unions tend to be small, closely connected to their local community, and focused on meeting the needs of low-income groups. Frequently, customers may borrow from a credit union only if they also have a savings account there. Although credit unions are seen all over the world and are an important feature of the financial landscape, there are no credit unions that have the size of, say, Rabobank or that compete in international markets.

      An example of a credit union is the Croydon, Merton, and South Sutton Credit Union that operates in an area of southwest London in the United Kingdom.

       1.2.6 Micro-finance Institutions

      Micro-finance institutions (MFIs) exist to extend small amounts of money to low-income customers, usually in developing countries. The amounts lent can be as little as USD 20, though they can sometimes reach a few thousand dollars. The purpose of these loans is to enable customers to rise out of poverty and become more economically self-reliant, for example by buying materials with which to manufacture simple goods that can then be sold in a local marketplace. MFIs often try to replace unscrupulous lenders that exploit customers and charge exorbitant rates of interest. Much MFI activity is directed to women.

      The most famous example of an MFI is Grameen Bank, which was set up in Bangladesh in the 1970s to lend money to poor people in small villages. Grameen has since become a large institution, though it retains its strategy of making small loans to underprivileged, largely rural borrowers.

      Micro-finance lending now occupies a central position in economic development programs worldwide, with significant networks in South America, Asia, and sub-Saharan Africa. Some large commercial banks provide funding to MFIs as part of their corporate responsibility programs or even as part of their regular lending programs.

       1.2.7 Central Banks

      Central banks are the principal monetary authority of a country (or, occasionally, a group of countries) and are crucial to the functioning of all banks, financial markets, and the economy. Central banks manage the amount of money and credit in an economy – usually in an effort to contain inflation rates and/or to foster economic growth. They typically accomplish this through their daily activities of buying and selling government debt, determining and maintaining core interest rates, setting reserve requirement levels, and issuing currency. Some central banks are also charged with maintaining certain foreign exchange rate levels for the home currency. Central banks also arrange payments between banks.

      Historically, central banks have usually combined this role as the principal monetary authority with two other roles: oversight of the banking system as a whole (macroprudential supervision) and the regulation and supervision of individual banks (microprudential supervision). Even before the global financial crisis, there were moves to separate these functions (for example, the British government took banking supervision away from the Bank of England in 1997 and gave it to the newly created Financial Services Authority), and in the aftermath of the crisis there has been intense discussion among politicians and bank regulators about how these roles should be assigned. Views differ on how to divide the responsibilities, and no clear consensus has formed on the right way to do it.

      The body that is given responsibility for microprudential supervision usually has responsibility not only for bank regulation but also for bank supervision. Regulation refers to the process of writing rules that govern how banks operate and behave (for example, setting minimum levels of capital, or requiring banks to set aside a proportion of their deposits as a reserve) whereas supervision refers to the enforcement of those rules (for example, by examining a bank's financial statements or sending inspectors to speak to a bank's management).

      Examples of central banks include the Central Bank of Bahrain, the Bank of Japan, the People's Bank of China, and the Federal Reserve System.

      INTEREST RATES AND INFLATION RATES

      An interest rate is the price of credit, or the rate a lender charges a borrower for using borrowed funds. The inflation rate is the change in the purchasing value of money.

      Bank B lends EUR 1,000,000 to Compagnie Petit, a French corporation, for one year. In exchange for the corporation using these funds, the bank charges 6 % interest rate per year. At the end of the year, Compagnie Petit must pay EUR 60,000 in interest to the bank as well as repay the original EUR 1,000,000.

      At the beginning of the year, Jean Molineaux paid EUR 100 for various groceries at the store. At the end of the year, the same groceries at the same store cost EUR 105. Since the price of the same groceries increased by 5 % during the year, the purchasing power of the money declined by approximately 5 %. This decline in purchasing power is the inflation rate.

1.3 Banking Risks

      There are multiple definitions of risk. Everyone has a definition of what risk is, and everyone recognizes a wide range of risks. Some of the more widely discussed definitions of risk include the following:

      • The likelihood an undesirable event will occur

      • The magnitude of loss from an unexpected event

      • The probability that “things won't go well”

      • The effects of an adverse outcome

      Banks face several types of risk. All the following are examples of the various risks banks encounter:

      • Borrowers may submit loan repayments late or fail to make repayments.

      • Depositors may demand the return of their money at a faster rate than the bank has reserved for.

      • Market interest rates may change and hurt the value of a bank's loans.

      • Investments made by the bank in securities or private companies may lose value.

      • A bank may discover that it has acted in a way that is contrary to a law or regulation and be fined by its regulator or by a court of law.

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