Equity Exposure Risk Management
20.1 EQUITY EXPOSURE IDENTIFICATION
A bank's exposure to equities is a high-risk portfolio due to the daily fluctuation in equity prices that can generate substantial loss within a short period of time. Because of the high-return feature of equity exposure, banks often invest large amount in equities to make a quick profit, ignoring the high risk involved in it. To prevent excessive speculation or loss of significant capital under volatile circumstances, bank regulators sometimes put a cap on the total equity exposure of commercial banks and also prohibit them from short selling of equities. They expect banks to be cautious in taking exposure in the capital market, since their role is not to destabilize the market through excessive speculative trading in equities with the help of public funds.
An appropriate definition of equity exposure is essential for measuring all forms of direct and indirect risks. Usually, equity exposure relates to direct investment in corporate equities, but it should include all equity-related instruments to prevent banks from engaging in speculative trading with the public money through indirect routes. Besides, declining equity prices increase the incidence of defaults by clients who deal in equities or have taken loans for acquiring equities and enhance the banks’ credit risk from those clients. Since equity exposure contains a high potential to inflict large losses, it should include all forms of lending ...