While reducing risk is often helpful, trying to remove it completely can be damaging. If banks matched all their positions perfectly, they would struggle to turn a profit because they wouldn’t be adding any real value. The key is to take the right kind of risks—those that offer a return—while avoiding exposure to potentially unlimited losses.
Comparisons
For clarity, let's look at three examples. By comparing these, we can gain insights into when risk is potentially beneficial and when it is not.
Fixed-Rate Retail Bonds: When customers purchase a fixed-rate retail bond, banks immediately face an interest rate risk. We build up the risk, wait until it reaches a significant level, and then hedge it. This flexible process requires judgment and isn't purely mechanical, but the risks are largely under our control.
Funding Fixed-Rate Loans with Variable Rate Deposits: In this scenario, banks fund a fixed-rate loan book using variable-rate retail deposits. In this case, the retail deposit rate is an administered rate. The risk is controllable but significant.
Prepayments and Extensions in Mortgage Portfolios: Managing prepayments and extensions is particularly challenging. Customers tend to prepay when interest rates drop and extend when rates rise, creating uncertainty. The risk is difficult and costly to hedge.
These examples illustrate the varying degrees of manageability. When considering risk appetite we need to think about which risks make sense. Are they:
Market-Offsettable: Where a liquid and continuous market allows you to back out exposures if needed.
Non-Hedgeable: Where the market doesn’t offer a way out and you can only reduce exposure by limiting volumes or building features into products to cap the downside.
Driven by tempting margins some firms take on more non-hedgeable exposures from the outset hoping things will work out fine.
In this situation ask "Are we taking enough of the right type of risk?"
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