Banks pay substantial amounts to monitors the risk that the take. Once of the primary concerns of a bank’s “risk manager” is to compute the value at risk. Why is the value at risk so important for a bank (or any financial institution)?
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Fianancial business nowadays is all about risk management. Whenever a bank lends out money, there is the chance that they will not get that money back because taking out any loan itself involves risk on the part of the person taking that loan out. This is why banks should be very careful about lending sums of money, particularly big sums, to people if it looks as if they may not be able to repay it.
The value at risk or VaR is the probability of what the maximum decrease in the amount at stake can be. For example if a bank has given loans of a million dollars and the VaR is 10% it means there is a one in 10 probability that the entire amount of a million dollars is lost. Banks have to ensure that the amount available with them is sufficient to pay for any withdrawals by those who have deposited money in the bank. If the amount that is lost due to non-repayment of loans exceeds what would be withdrawn, a bank could be in very serious trouble. This is the reason why banks have to carefully evaluate the risk taken on by them. An inappropriate level of risk taken on by banks could lead to their bankruptcy, something that was seen during the Lehman crisis.
Risk for a bank is substantial. If a bank loans out money to people who are at a high risk of nonpayment the bank could lose everything. Banks who are choosier about who they lend to have a greater chance at return plus interest. Therefore, knowledge about risk is important given it heps one to decide if the loan is worthy of being made in hopes that it will be repaid.
Risk is important to compute, because the banks need to know whether they should even loan out money. The problem of our banks in the past is that they lent too much money. They did not calculate risks all that well. Think about it this way. If someone owes a bank 100,000 dollars and cannot pay, then that person has a problem. If an institution owes the bank 100,000,000 and cannot pay, then the bank has a problem
Value at risk is a measure that balances the potential for gain with the potential for loss. You might call it a "risk-reward" test. This is extremely important for banks in lending. They need to know how much they could stand to make from an investment compared to what the risks of loss are. This tells them how risky any given investment is.
Unless a bank knows the value at risk, it really cannot make loans in any kind of logical or rational way. In fact, it would be irresponsible (and possibly illegal) to make loans without having such knowledge. I recall that after the financial crash of 2008, the government forced banks to submit to "stress tests" for precisely this reason.
A bank lends out money and hopes to get it paid back with interest. However, if the bank lends out the money and it does not get paid back, the bank not only loses the interest paid on that amount by the borrower but also the initial amount.
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