The recent global financial crisis caused numerous serious problems around the world. Many countries like the United States, Spain and Greece suffered very heavy strikes during this financial crisis. The Australian banking system is no exception, has been impacted. Some financial institutions grasp this crisis into good opportunities, however other commercial banks are exposed to big challenge and face many risks like credit and liquidity risk. Given this situation, APRA outlines the regulations to ensure and consolidate the safety for Australian banking system, such as Liquidity and Credit quality. This report will analyse the difference between credit risk and liquidity risk ...view middle of the document...
Banks usually hold less cash than bonds and shares since cash cannot earn interest and profit. Basically, liquidity risk always runs with systematic bank panics. Once a bank fails to meet their obligations and clients cannot withdraw cash, general public panics are spread and almost all depositors are eager for withdrawing their funds. On this occasion, banks can through inter-bank system to lend liquid funds from other banks. If the whole banking system is not able to raise enough liquid funds to satisfy depositors, this becomes an omen of liquidity problem.
1.3.1 Different side of the balance sheet
Credit risk is involves the asset side of balance sheet. Since loans and interests are the assets for banks, if credit risk occurs, banks will have problems with their asset side of balance sheet.
However, liquidity risk can arise in both liability and asset side of the balance sheet. For liability-side reason, if clients want to withdraw their deposits at the same time, banks may have difficulties to meet the obligations to satisfy depositors. For asset-side reason, loan commitment also causes liquidity risk. Loan commitment allows borrowers to withdraw funds at anytime during fixed period at a predetermined rate. However, banks never know the exact day when borrowers prefer to withdraw. If borrowers decide to withdraw in the same day, banks may face liquidity risk because of no liquid assets.
Credit risk means banks cannot regain the principal and interest from borrowers. FI is the risk-taker and default triggers a total or partial loss of any amount lent to the counterparty (Bessis, 2010). As for liquidity risk, which often cause panic because the general public, saying depositors as risk-takers. Once liquidity risk occurs, banks have difficulties in raising funds to meet their obligations.
1.3.3 Source of risk
Credit risk means FI makes loans to borrowers because borrowers have good quality and credit rating. However, borrowers’ credit rating is deteriorating and they do not have enough funds to repay loans, thus, banks face credit risk and this risk comes from depositors default.
Liquidity risk involves the FI itself. “It is generated by the difference between the sizes of assets and liabilities, and the discrepancies between their maturities” (Bessis, 2002, p.119). If banks can manage assets size and maturities well, they can avoid facing liquidity risk.
1.3.4 Accompanying risks
Bessis (2010) believes credit risk splits up into default risk, migration risk, exposure risk, counterparty risk and recovery risk. Once credit risk occurs, borrowers may default, and their credit rating may decline. Moreover, there is a decline in the credit standing of the issuer of a bond or stock.
Liquidity risk often happens with funding risk. “Funding risk depends upon how risky the market perceives the issuer and its funding policy” (Bessis, 2012, p.31). Banks have high possibility to face liquidity...