Free Custom «Stock Market Risks» Essay Paper

Reckless Lending: Chijoriga (2011) notes that commercial banks have got into the habit of lending recklessly, which in return increases the risks associated with non - serviced loans. The main driving force towards this recklessness in lending by commercial banks is a fact that there is a lot of liquidity in banking institutions affecting the bank management to find it profitable to lend out money, since the interests acquired in such a way are high neglecting the basic lending policies (Chijoriga, 2000; Basel, 2004; Liou & Smith, 2006 as cited in Chijoriga, 2011, p. 133). Commercial banks are not looking for the possibility of loans never being serviced; hence, they bank on continued employment of their loaners. When an employee leaves a particular employer, commercial banks are left wondering how they are going to recover their money, especially, unsecured loans, which are becoming more popular today.

The situation concerning a modern commercial banking loan sector is such that issued loans have a maximum repayment period of two years, although there are those that are set for three years (36 months repayment period) (Chijoriga, 2011, p. 133 & 134). Although this is set for the minimization of spread risk, this can cause a disadvantage to a commercial bank, because if a loaner is incapacitated within that period because of the increased cost of living, it means that a loaner will be more likely to stop repayment of a loan, since a commercial bank demands a huge amount to be extracted from their salary leaving them with very little to use.

 

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Another contributing factor to reckless lending is an increase in competition. This means that most commercial banks would like to remain marketable increasing the liquidity level of a bank making it easier for loaners to have access to loans from their institutions. This increases the risk of bank collapsing, in the event that most loans are not repaid on time. It is a fact that most banking institutions rely on depositors to ensure the liquidity flow within a bank. If there are more lending and less deposits in a bank, a commercial bank can experience a run caused by the fact that a customer of a commercial bank, who wants to make withdrawal, cannot do so due to a shortage of money in a bank.

This makes commercial banks to have riskier loans as argued by Kahn and Winton (2004, p. 2531). In addition to this, there is a lack of good classification of what entails risky loans and who should follow up on these risky loans. Since there is a mismanagement of risky loans, shareholders have lost profits, because risky loans have less return than interests (Kahn & Winton, 2004, p. 2533). Just before the 1997 financial crisis, about two thirds of 91 financial companies in Thailand were owned by banks or their affiliates making them vulnerable in the event of a crisis (Kahn & Winton, 2004, p. 2559). Another example is found in Fitzpatrick and Hardaker (1997 as cited in Kahn & Winton, 2004, p. 2559), which capture the state of Australian financial company sector. It was found that in the period of the 1997 financial crisis, four commercial banks and their affiliates did dominate this sector increasing the effect of the crisis.

Chandra and Rishabh (2010) add to this notion by saying that most failures that commercial banks experience is mainly attributed to banks primarily relying on bad loans (p. 24). Because of this, when the interest rate increases, both interest loans and bonds portfolio suffer losses (2010, p. 24).

Macro and Micro Variables of Bank Failures: There are other risk factors that have been found to be risky to the progress of commercial banks. Among these, two broad categories have been distinguished, which are macro-variables and micro-variables. Among other things concerning macro variables, deregulation can have devastating effects on commercial banks (Chijoriga, 2011, p. 133). For example, a bank can be deregulated because of malpractices. This means that loans will not be recovered in time or will never be recovered at all. This is because all functioning of a commercial bank will either be reduced to a bare minimal or halt the meaning that it is not permitted to perform further transactions, until its deregulation is dealt with. On the other hand, its credit and debit facilities are left unattended bringing losses to a commercial bank.

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Stock Market Risks: An example in the United States as reported in Restrepo (2005) is taken to analyze this section. It is noted that, while using the authority given to commercial banks pursuant to the National Banking Act, they were able to gain access to the business of security underwriting (Restrepo, 2005, p. 270). According to the McFadden Act of 1927, commercial banks were officially allowed to affiliate with security firms, which was a great opening to a wide stock market (Restrepo, 2005, p. 270). Because of their entry in a security sector and immense investments in this sector for succeeding two consecutive years, it was found that stock market prices greatly increased, since commercial banks remained active at that time (Restrepo, 2005, p. 270). This became booming business in the U.S., since more banks found affiliates they heavily relied on. However, by 1929, a stock market had reached some sort of a climax and there was a stock market crash in the same year as reported in Restrepo (2005, p. 270). Commercial banks had great losses, which resulted in the fact that by 1933, over 11,000 commercial banks had already failed to form mergers to remain afloat and this led to a great reduction in the number of commercial banks in the region by a margin of 40 %, which was not anticipated previously (Benston, 1990 as cited by Restrepo (2005, p. 270)).

Another contributing factor was a fact that it was not possible to sell all stocks leading to monetary losses as argued by Brealey and Myers (2003, as cited in Restrepo (2005, p. 270)). Since most money at that time came from funding of commercial banks, there was a loss in underwriting; the same was transferred to commercial banks thus creating a large default (Restrepo, 2005, p. 270).

There were also banks that had provided loans to their security affiliates to invest in a stock market; they were also exposed to the same risks (Restrepo, 2005, p. 280). At the same time, when there was a looming risk of failure in a stock market, some commercial banks issued rescue loans to their security affiliates giving commercial banks double exposure to the risks of acquiring money as reported in Restrepo (2005, p. 280).

Conclusion

To sum it up, it is evident that there are many risks in a banking sector. Our research is focused on the risks associated with credits and liquidity being of great importance. This is mainly because, in this research, there is a focus on the modalities of rating commercial banks, taking into account liquidity and credits as leading factors in their classification. With this risk assessment, it is clear that while classifying banks, there should be a balanced classification of banks with a high score on the basis of their risk assessment criteria and management. At the same time, the classification should be based on the risks assessed above. There is also a logical tailor-made classification for the Middle East.