The business of banking is confronted with multiple numbers of risks viz. credit risk, liquidity risk, operational risk, reputational risk, legal risk, market risk, strategic risk, country risk, counter -party risk, contractual risk, Access risk, and systemic risk and so on. Nevertheless, like in any other business risk taking in banking is also inevitable as it also presents possibilities of a rewarding result. Let’s examine here how various types of risks arise in the banking sector.
Credit risk arises when a bank borrower or counter -party fails to meet his obligations according to specified schedule in terms of predetermined agreement either due to genuine problems or willful default. The precise credit risk management system differs from bank to bank depending upon the nature of their major flow of credits. Banks have to analyze overall credit risk at the individual, customer and portfolio levels and evaluate the exposure to sensitive sectors like equity shares, real estate business and other high-risk industries as perceived by the bank, while sanctioning the credit limits.
Counter- party risk:
The counterparty risks (also known as default risks) arise in the transactions of derivatives trading which take place between two parties’ under prior agreement with set of terms and conditions. The parties involved in the trading are referred as counter- parties (viz. buyer and seller). The counterparty risk is linked with inability or unwillingness of a customer or counterparty to meet his commitments relating to trading, hedging, settlement and other financial transactions under the agreement.[Derivatives are specific types of instruments that derive their value over the time from the performance of assets like financial futures, swaps, bonds, equities, options (call/put) and forwards etc.]
The term ‘fraud risk’ does not have the universal definition. However, in banking terms ‘fraud risk’ means the risk of criminal conduct of a party that involves the use of dishonest or deceitful means to make a personal gain and make the loss to the bank. The fraud incidences are increasing in general and in loan portfolios in particular.
If a bank is having adequate liquidity, it means that bank is in a position to efficiently discharge its financial obligations both at expected and unexpected short-term financial demand. Liquidity risk arises when a bank fails to meet its contractual obligation in its daily operations due to inadequate funds flow. The Liquidity risk is mitigated through advance assessment of need of funds and coordinating with various sources of funds available to the bank under normal and stressed conditions. There are three different circumstances viz. Funding risks, Time risks, and call risks which normally causes liquidity risk to the banks.
It normally arises due to unanticipated withdrawal or non-renewal of term deposits by the customers. This results in asset-liability management issues, especially under the Liquidity Coverage Ratio (LCR) requirement under the Basel III framework. According to the new guidelines of RBI, banks will have the discretion to offer differential interest rates based on whether the term deposits are with or without-premature-withdrawal-facility. (However, as per new guidelines all term deposits of individuals (held singly or jointly) of ₹ 15 lakh and below should, necessarily, have premature withdrawal facility.)
The inability of the bank to convert its assets or securities to cash at an appropriate time due to non-receipt of expected inflow of funds for the reason that of performing asset turning into NPA. The time risk causes substantial changes in income and economic value of banks due to loss of capital and or profit.
Another type of liquidity risk is ‘Call Risk’ which arises due to ‘Crystallization’ of contingent liability. Here banks use their surplus money meant for other investments is diverted towards discharging obligation towards contingent liability thereby missing an opportunity to earn some more profit.
Basel Committee on banking supervision has adopted a common industry definition of operational risk. Operational risk is defined as the risk of direct or indirect loss resulting from breakdowns in internal procedures, people, system and external events.
Examples of operational risk are frauds, system failure, error in financial transactions, failure to discharge demand of contractual obligations due to insufficient funds etc.
There is no standard definition for Legal risk. Basel II classified Legal risk as a subset of Operational Risk. Yet, Legal risk can be explained as a loss to the business where the bank is subjected to fines, penalties or punitive damages or the expenses of litigation. Legal risk arises as consequences of regulatory or legal actions which results in liability to the bank either on account of omissions and commissions of the bank’s employees or its outsourced service provider.
The reputation risk may arise due to poor services provided by the bank or its outsourced third party service provider. Reputation risk may also occur due to poor interaction with the customers which is contrary to the overall standards expected from a reputed bank. The loss caused to the bank or its customer from a fraud may result in a reputation risk. It may also creep up due to failure in providing a stated service, a breach in security/confidentiality or non-compliance with legal requirements.
Asset-backed- risk, is the potential of losing the value of the asset which is held by the bank as a security. Banks make provisions on those assets to meet future unforeseen losses.
The Strategic risk might arise due to the conduct of business inconsistent with the strategic goal of the organization. The exposure to loss due to the wrong strategy such as making poor business decisions, the poor execution of decisions, inadequate resource allocation for the strategic goal. The Strategic risk may also arise when the management fails to judge changes in the business environment and responding late to the new requirements.
The ‘Market risk’ is an umbrella term used for multiple types of risk associated with adverse changes in market variables that include Liquidity Risk, Interest rate risk, Foreign exchange rate risk and equity price risk. Market risk causes substantial changes in income and economic value of banks. The Bank of International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”.
Interest rate risk:
Interest rate risk is the risk where value of the investment changes as a result of the change in interest rates. The volatility in interest rate mostly affects the value of bonds than the equities.
Foreign exchange rate risk:
The foreign exchange rate risk arises when the financial instruments held in foreign currency. The value of foreign currency asset changes as and when the exchange rate of that foreign currency fluctuates. In certain events, the bank may lose money on its foreign currency assets if the value of foreign currency asset depreciates in relation to domestic currency.
Equity risk (Capital market risk):
Equity risk is generally referred to a risk that arises due to volatilities mainly in stock prices and options. RBI has accepted the general frame- work suggested by Basle Committee and initiated various steps in moving towards prescribing capital market risk on each type of investment. The first step in this direction, a risk weight of 2.5% has been prescribed for investment in Government and other approved securities as well a risk weight each of 100% on the open position limits in forex and gold.
Country risk refers to the risk when a country freezes outflow of its foreign currency. This would result into dishonor of all financial commitments of that country in foreign currency. The events of dishonor of financial commitments would cause the cascading effect on performance of other instruments like stocks, bonds, mutual funds, options and futures issued in that country. Thus, the investments made from other countries are exposed to transfer or conversion risk and thereby affects the value of assets.
Political risk refers to the abrupt change of investment policies of a sovereign state or the foreign policy decision of a country which harms the investments made from other countries.( Ex: The people of Britain voted for a British exit, or Brexit, from the EU in a historic referendum on June 23, 2016, which had traumatic effect on Sterling Pounds and other currencies).
The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank’s core operations. It may arise in the form of single name concentration or industry concentration. The lender must reduce this risk by diversifying the borrower pool.
Systemic Risk: The systemic risk is the erosion of a bank’s liquidity position due to disruptions in a bank’s regular sources of funding. Such erosion could trigger severe instability or collapse of entire banking sector or economy on certain happenings. The global financial crisis that began in 2007 is the example of Systemic Risk which burst the myth of ‘too big to fall’. During that period many banks, despite maintaining adequate capital requirement, experienced severe stress on account of the sub-prime lending crisis.
Compliance risk arises where privacy, the consumer, and prudential laws are not adequately complied with by the bank or its service provider resulting in fines, penalties or punitive damages from regulators. RBI has been imposing heavy penalties on banks who have not complied or the account opened in contravention of various directions and instruction issued by it, which includes failure to obtain adequate documents for opening accounts, failure to carry out identification procedures, failure to examine control structure of entities.
The portfolio risk is associated with investments in stocks and bonds that may diminish returns or incur the loss to the investors. Portfolio risk arises in banks mainly due to the state of the economy, wide fluctuation in commodity/equity prices, foreign exchange rates, interest rate, trade restrictions, economic sanctions and Government policies.
Reference: (Click to read the underlined heads)
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- RBI releases 45 early warning signals about wrongdoings/frauds in loan accounts
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