Bachelor's thesis (Turku University of Applied Sciences) Degree Program in Business Management

7 MANAGING INVESTMENT RISKS IN COMMERCIAL 
BANKING 
7.1 Preface 
The concept of “risk” is often understood as a dangerous possibility of losses 
resulting from certain outward or inward factors, in particular 
– social and 
political phenomena or various human activities (Hiriyappa, 2008, p. 17).
As an economic category, risk represents an event with a certain probability of 
occurrence. Therefore, risk management processes focus not only on possible 
forecasting strategies, but also on the most efficient methods of avoiding or 
undertaking certain risks in order to minimize their subsequent negative effects.
Due to the nature of the industry and the fragile stability of its dependence from 
all of the economic participants of financial markets, risks are not only 
considered to be the basis of any investment operation, but are often seen as 
the foundation of the banking system itself, as “with increased pressure on 

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TURKU UNIVERSITY OF APPLIED SCIENCES THESIS | Artem Vorobyev 
private banks to increase shareholder’s returns, banks have had to assume 
higher risks” (Casu, Girardone and Molyneux, 2006, p. 259).
As has already been outlined in previous chapters, banks are most successful 
when they take reasonable risks that could be controlled within their financial 
capacity and competence, as riskier investments that promise greater rewards 
impose banks to higher possibilities of failure.
It is also wise to understand that, while banks more than often invest in order to 
achieve better profitability results, they are constantly in danger of breaking the 
fragile balance of their liquidity operations. Thus, investment risks in commercial 
banking are not only concerned with the possible tendencies of incurring losses, 
but also with the concept of bank’s solvency as a whole.
Apart from financial operations, banks should try to increase their liquidity 
values in order to cover any unpredicted expenses and losses while providing a 
reasonable amount of profit for shareholders (Casu, Girardone and Molyneux, 
2006, p. 259). The aim of achieving these seemingly contradictory goals lies at 
the basis of bank's investment policies and risk management strategies. 
As the main purpose of current chapter is to consider the theory of investment 
risks in commercial banking and determine various risk management 
techniques, I will analyse most effective methods of risk management and 
describe the implementation of these methods in contemporary commercial 
banking. In addition to the above mentioned objectives, this chapter intends to 
identify risk management issues related to commercial banking and single out 
the ways to improve banking investment practices. 
7.2 The role of risk management activities in commercial banking 
It should have already become obvious that one of the major characteristic of 
investment operations in commercial banking is connected to the idea of 
estimating every investment decision from the point of view of several key for 
commercial banking concepts: profitability 
– liquidity – and the corresponding 
level of risk. 

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TURKU UNIVERSITY OF APPLIED SCIENCES THESIS | Artem Vorobyev 
Having identified a risk as a probability of failure, it is now possible to conclude 
that separate investment projects are subject to different risk values, depending 
on the category of profitability, time-period involved and business field in 
question.
In general, it is safe say that an investment risk expresses the possibility of 
unforeseen financial losses in the course of investment activities of commercial 
banks. The process of probability estimations of investment risk involved allows 
banks to identify the key factors and consequences behind every investment 
risk and, therefore, figure out a way of dealing with each potential threat 
(Mertens, 2005, p. 374). 
It is a well-known fact that successful implementation of majority of investment 
projects in any financial market is coupled with a risk of losing a part of invested 
capital or even the whole value of the initial investment. Moreover, there is a 
straight correlation between the levels of income and the risks that the investor 
is willing to undertake: the higher the level of return 
– the higher the risk.
This thought leads us to a crucial assumption that it is extremely important to 
have an accurate idea concerning the whole system of investment risks. 
Profitability of various investment activities of commercial banks depends on a 
number of business factors and organizational conditions among which the 
leading role belongs to such crucial tendencies, like: the general level of 
economic stability in the region; other important participants of equity markets 
(investment companies, funds, etc.); financial instruments involved; regulation 
and directive approaches that are in force. 
So what is the main function that risk management has to perform in order to 
increase the effectiveness of banking investment strategies? One of the most 
crucial objectives deals with the following dilemma: how to increase the 
maximum level of income at a given risk level or how to minimize investment 
risks at a certain level of income (Hiriyappa, 2008). 

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TURKU UNIVERSITY OF APPLIED SCIENCES THESIS | Artem Vorobyev 
7.3 Investment risks in commercial banking 
In order to get a wider perspective on different types of investment risks in 
commercial banking, let us briefly refer to the following figure. 
Investment Risks
Systematic
risks
Nonsystematic
Risks 
Interest-rate 
Risk
Exchange-rate 
Risk
Inflation Risk
Political Risk
Market Risk
Financial Risk
Default Risk
Liquidity Risk
Low interest-
rate risk
Figure 10 Systematic and nonsystematic risk approaches to investment risk management in 
commercial banking (Casu, Girardone and Molyneux, 2006) 
As you can see from the chart, on the first and most general level, all 
investment risks could be separated into systematic and non-systematic, 
depending on their operating areas and subjects of influence (Cooray, 2003; 
Casu, Girardone and Molyneux, 2006, p. 269).

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TURKU UNIVERSITY OF APPLIED SCIENCES THESIS | Artem Vorobyev 
Non-systematic investment risks represent all possibilities of losses that can 
affect only separate securities or small groups of financial assets. In principle, 
such risks are also known as risks attributed to certain types of financial 
instruments. It is interesting to note that above mentioned diversification method 
of investment portfolio organization is often seen as a good response to 
minimize the effects of non-systematic risks (Cooray, 2003). 
Systematic risks are often seen as risks that are inherent to a particular financial 
market, as well as a set of financial assets or instruments: whole market or its 
considerable part is exposed to their influence. Due to this prominent feature, 
systematic risks are sometimes viewed as risks directed at entire investment 
portfolio (Cooray, 2003).
While being caused by potential economic uncertainties that dominate the 
financial market and general development tendencies that are typical for it, 
systematic risks influence securities of almost all issuers that operate in the 
given market. Due to the nature of risks themselves, in case of systematic risks 
the diversification method cannot provide required level of safety and it is 
significantly more difficult to avoid losses from investments that are more liable 
to this particular group (Cooray, 2003).
In order to identify effective ways of managing investment risks, it is necessary 
to take a closer look at the way some of them can influence the operations of 
commercial banking and try to examine the causes of such impact.
7.3.1 Counter-party credit (default) risk 
One of most common investment risks, the counter-party risk, deals with the 
possibility of outstanding payments on certain financial obligations (principle 
and interest payments).
In other words, it revolves around the payments that will not be carried out in 
case of counter-