Unit-2 Risk in Banking Business

Contents
• Meaning and nature of financial risk
• Credit risk,
• Operational risk
• Market risk
• Liquidity risk
• For-ex risk
• Country risk
• Risk identification
• Risk measurement and
• Risk mitigation.
Financial risk?
Meaning and Nature of Financial Risk
• Banking is the management of risk
• Risk management in banking involves the process of evaluating the risks faced by
a bank and minimizing the costs accordingly.
• Banks, in the process of financial intermediation, are confronted with various
kinds of Financial and Non-financial risks, viz., credit risk, interest rate risk,
foreign exchange rate risk, liquidity risk, equity price risk, commodity price risk,
legal risk, regulatory risk, reputation risk, operational risk, etc.
• Financial risk refers to losses arising from financial variables and operating risks
concerning losses arising from variables that have impact on the operations of a
business.
• Financial risks comprising of credit risk, liquidity risk, market risk, for-ex risk, and
Country risk and so on.
Credit Risk
• Credit risk is the primary cause of bank failures, and it is the most visible risk
facing bank managers.
• Credit risk is the likelihood that a debtor or financial instrument issuer is
unwilling or unable to pay interest or repay the principal according to the
terms specified in a credit agreement resulting in economic loss to the bank.
• Credit risk arises from non-performance by a borrower. For most banks, loans
are the largest and most obvious source of credit risk; however, credit risk
could stem from activities both on and off balance sheet. It may arise from
either an inability or an unwillingness to perform in the pre-committed
contracted manner.
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• Credit risk emanates from a bank's dealings with an individual, corporate, bank,
financial institution or a sovereign.
• Credit risk may take the following forms:
a) Direct lending: Principal and/or interest amount may not be repaid.
b) Guarantees or letters of credit: Funds may not be forthcoming from the
constituents upon crystallization of the liability.
c) Treasury operations: The payment or series of payments due from the counter
parties under the respective contracts may not be forthcoming or ceases.
d) Securities trading businesses: Funds/securities settlement may not be
effected.
e) Cross-border exposure: The availability and free transfer of foreign currency
funds may either cease or restrictions may be imposed by the sovereign.
Mitigation of Credit risk
- Thoroughly check a new customer’s credit record.
- Use that first sale to start building the customer relationship
- Establish credit limits.
- Make sure the credit terms of your sales agreements are clear
- Use credit risk insurance.
Operational Risk
• Operational risk is the risk of negative effects on the financial result and
capital of the bank caused by omissions in the work of employees, inadequate
internal procedures and processes, inadequate management of information
and other systems, and unforeseeable external events.
• The most important type of operational risk involves breakdowns in internal
controls and corporate governance. Such breakdowns can lead to financial
loss through error, fraud, or failure to perform in a timely manner or cause
the interest of the bank to be compromised.
• According to the Basel Accord, the management of this risk should be carried
out through four steps: identification, assessment, control and monitoring.
Mitigation of operational risk
- Managing Equipment Failures
- Keep Strong Business to Business Relationships
- Having Adequate Insurance
- Know the Regulations
8. Market risk
According to The Basel Committee on Banking Supervision, market risk can be
defined as the risk that arise from movement in market prices. The four
components of market risk are:
a. Interest risk: potential losses due to a change in interest rates. Requires
Banking Asset/Liability management.
b. Equity risk: potential losses due to change in stock prices as banks accept
equity against disbursing loans.
c. Commodity risk: potential losses due to change in commodity (agricultural,
industrial, energy) prices. Massive fluctuations occur in these prices due to
continuous variations in demand and supply. Banks may hold them as part of
their investments, and hence face losses.
d. Foreign Exchange risk: potential loss due to change in the value of the bank’s
assets or liabilities resulting from exchange rate fluctuations as banks transact
with their customers/other stakeholders in multiple currencies.
• Interest rate risk refers to the impact of changing interest rates on a financial
institution’s margin of profit.
• Most widely used measures of interest-rate risk exposure are:
• Interest-sensitive assets/interest sensitive liabilities:
• when interest-sensitive assets exceed interest-sensitive liabilities in a particular
maturity range, a financial firm is vulnerable to losses from falling interest rate.
• In contrast, when rate-sensitive liabilities exceed rate-sensitive assets, losses are likely
to be incurred if market interest rate rise.
• For depository institutions, uninsured deposits/total deposits, where
uninsured deposits are usually government and corporate deposits that
exceed the amount covered by insurance and are usually so highly sensitive to
changing interest rate that they will be withdrawn if yields offered by
competitors rises even slightly higher.
Liquidity Risk
• Liquidity risk is the risk to earnings or capital related a bank’s ability to
meet its obligations to depositors and the needs of borrowers by turning
assets into cash quickly with minimal loss, being able to borrow funds
when needed, and having funds available to execute profitable securities
trading activities.
• Faced with liquidity risk a financial institution may be forced to borrow
emergency funds at excessive cost to recover its immediate cash needs,
reducing its earnings.
Country Risk
• Country risk is the risk of negative effects on the financial result and capital of
the bank due to bank’s inability to collect claims from such entity for reasons
arising from political, economic or social conditions in such entity’s country of
origin.
• Country risk includes political and economic risk, and transfer risk.
• Country risk arises when a foreign entity or a counter party, private or
sovereign, may be unwilling or unable to fulfill its obligations for reasons,
other than the usual reasons or risks which arise in relation to all lending and
investment
Compliance Risk
• This is related with the compliance of legislations and regulations.
• compliance risk arises due to the non-compliance of prescribed guidelines or
breach of government rules or misuse of rules, which is followed by penalties
from law enforcing agencies.
• For example, NRB has issued a new regulation to bank and financial
institutions to increase the paid up capital. Banks failing to meet such capital
requirements may be forced to merge, or may be penalized with other
corrective actions taken by NRB.
Business/Strategic risk
Business risk is the risk arising from a bank’s business strategy in the long term.
When a bank fails to adapt to the changing environment as quickly as their
competitors, it faces the risk of losing market share, getting acquired, or
shutting shop. Technology is changing the banking landscape at an incredibly
rapid pace. The millennial generation would need a drastic change and
development in banking interfaces, which would primarily be led by four clicks
on their mobile phones as opposed to long queues in the bank branches.
Reputational risk
Reputational risk implies the public’s loss of confidence in a bank due to a
negative perception or image that could be created with/without any evidence
of wrongdoing by the bank. Reputational value is often measured in terms of
brand value. Reputational risk could stem from the inability of the bank to honor
government/regulatory commitments, Nonobservance of the code of conduct
under corporate governance, Mismanagement/Manipulation of customer
records, Ineffective customer.
Risk Management Process
• Because of the vast diversity in risk that banking institutions take, there is
no single prescribed risk management system that works for all.
• Each banking institution should tailor its risk management program to its
needs and circumstances. Regardless of the risk management program
design, each program should cover:
• Risk identification
• Risk assessment/ measurement
• Risk mitigation
• Risk monitoring
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Risk identification:
• This includes identifying different sources of risks
• In order to properly manage risks, an institution must recognize and
understand risks that may arise from both existing and new business
initiatives.
• for example, risks inherent in lending activity include credit, liquidity, interest
rate and operational risks.
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Risk Measurement:
• Once risks have been identified, they should be measured in order to determine their
impact on the banking institution’s profitability and capital.
• To the maximum possible extent banks should establish systems/models that quantify their
risk profile; however, in some risk categories such as operational risk, quantification is quite
difficult and complex.
• Wherever it is not possible to quantify risks, qualitative measures should be adopted to
capture those risks.
• Accurate and timely measurement of risk is essential to effective risk management
systems.
• An institution that does not have a risk measurement system has limited ability to control
or monitor risk levels.
• Banking institutions should periodically test their risk measurement tools to make sure
they are accurate.
• Good risk measurement systems assess the risks of both individual transactions and
portfolios.
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Risk mitigation:
• After measuring risk, an institution should establish and communicate risk limits through
policies, standards, and procedures that define responsibility and authority.
• These limits should serve as a means to control exposure to various risks associated with
the banking institution’s activities.
• Institutions may also apply various mitigating tools in minimizing exposure to various risks.
• Institutions should have a process to authorize and document exceptions or changes to risk
limits when warranted.
• A sound risk management system should have the following elements:
• active board and senior management oversight; (BMO)
• adequate policies, procedures and limits; (PPL)
• adequate risk measurement, monitoring and management information system (MIS);
and
• comprehensive internal controls. (ICs)
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Risk monitoring
Monitoring risks means developing reporting system i.e. information
management system that identify adverse changes in the risk profiles
of significant products, services and activities and monitoring changes
in controls that have been put in place to minimize adverse
consequences.