The business of banking is confronted with multiple numbers of risks viz. credit risk, liquidity risk, operational risk, reputation risk, legal risk, market risk, strategic risk, country risk, counter-party risk, contractual risk, Access risk, 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.
1. Credit Risk:
Credit risk arises when a bank borrower or counter-party fails to meet his obligations according to a specified schedule in terms of a 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.
2. Counterparty risk:
The counterparty risks (also known as default risks) arise in the transactions of derivatives trading which take place between two parties under a prior agreement with a set of terms and conditions. The parties involved in the trading are referred to as counter-parties (viz. buyer and seller). The counterparty risk is linked with the 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 time from the performance of assets like financial futures, swaps, bonds, equities, options (call/put) forwards, etc.]
In the case of outsourcing financial services, counterparty Risk may arise due to non-adherence by the service providers to the performance requirements (e.g.: submission of incorrect data on borrowers’ income level may lead to inappropriate underwriting or credit assessments by the Regulated Entities like banks)
3. Fraud Risk:
The term ‘fraud risk’ does not have a 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. Fraud incidences are increasing in general and in loan portfolios in particular.
4. Liquidity risk:
If a bank has adequate liquidity, it means that the 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 the 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 cause liquidity risks to the banks.
5. Funding risk:
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 ₹ one crore and below should, necessarily, have a premature withdrawal facility.)
6. Time Risk:
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 the income and economic value of banks due to loss of capital and or profit.
7. Call Risk:
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 obligations towards contingent liability thereby missing an opportunity to earn some more profit.
8. Operational risk:
Operational Risk may arise due to technology failure, error, fraud, inadequate processes, and lack of financial capacity to fulfill obligations and/or provide remedies.
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, systems, and external events.
Some of the examples of operational risk are fraud, system failure, error in financial transactions, failure to discharge demand of contractual obligations due to insufficient funds, etc.
9. Legal risk:
There is no standard definition of 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 punitive damages, or the expenses of litigation. Legal risk arises as consequences of regulatory or legal actions that result in liability to the bank either on account of omissions and commissions of the bank’s employees.
Legal Risk includes but is not limited to exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements due to commissions and omissions of the service provider.
9. Reputation Risk:
The reputation risk may arise due to poor services provided by the bank or its outsourced third-party service provider or failure in the preservation and protection of confidential customer information.. 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 customers from fraud may result in a reputation risk. It may also creep up due to failure to provide a stated service, a breach in security/confidentiality, or non-compliance with legal requirements.
10. Asset-backed risk:
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.
11. Strategic risk:
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, and inadequate resource allocation for the strategic goal. Strategic risk may also arise when the management fails to judge changes in the business environment and responds late to the new requirements. It may also arise conduct of business by the service provider in a manner inconsistent with the overall strategic goals of the Bank/Regulated Entities.
12. Exit Strategy Risk:
Exit Strategy Risk could arise from over-reliance on one firm, the loss of relevant skills in the RE itself preventing it from bringing the activity back in-house, and where the Regulated Entity/Bank has entered into contracts wherein speedy exits would be prohibitively expensive or disruptive.
Some of the reasons for a speedy exit from the contract by the banks may be because of fraud committed by the service provider; Leakage of information/data; Breach of confidentiality or code of conduct by the service provider; Blacklisting of the service provider by GoI, RBI, SEBI, or any other regulator/supervisory authority.
13. Market Risk:
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 the 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”.
14. Contractual Risks:
Contractual Risks arise from whether or not the RE has the ability to enforce the contract.
15. Interest rate risks:
Interest rate risk is the risk where the value of the investment changes as a result of the change in interest rates. The volatility in interest rates mostly affects the value of bonds than equities.
16. Foreign Exchange Rate Risks:
The foreign exchange rate risk arises when the financial instruments are held in foreign currency. The value of foreign currency assets 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 assets depreciates in relation to domestic currency.
17. Equity risk (Capital Market Risk):
Equity risk is generally referred to as a risk that arises due to volatilities mainly in stock prices and options. RBI has accepted the general framework suggested by the Basel 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 as a risk weight each of 100% on the open position limits in forex and gold.
18. Country Risk:
Country risk refers to the risk when a country freezes the outflow of its foreign currency. This would result in dishonor of all financial commitments of that country in foreign currency. The events of dishonor of financial commitments would cause a cascading effect on the 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 affect the value of assets.
19. Country Risk may also arise due to economic, political, social, or legal climate thereby creating added risks when the service provider is a foreign-based entity or the outsourcing happens in a foreign country.
20. Political Risk:
Political risk refers to the abrupt change of investment policies of a sovereign state or the foreign policy decision of a country that harms the investments made by 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 a traumatic effect on the Sterling Pounds and other currencies).
21. Concentration risk:
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 a single-name concentration or industry concentration. The lender must reduce this risk by diversifying the borrower pool.
22. 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 the entire banking sector or economy on certain happenings. The global financial crisis that began in 2007 is an example of Systemic Risk which burst the myth of ‘too big to fall’. During that period many banks, despite maintaining adequate capital requirements, experienced severe stress on account of the sub-prime lending crisis.
SYSTEMIC CYBER RISK :
In February 2016, hackers targeted the central bank of Bangladesh and exploited vulnerabilities in SWIFT, the global financial system’s main electronic payment trying to steal $1 billion. While most transactions were blocked, $101 million still disappeared. The heist was a wake-up call for the finance world that SYSTEMIC CYBER RISKS in the financial system had been severely underestimated.
According to the Bank for International Settlements, the financial sector is most targeted by hackers, after the healthcare sector. Finance businesses handle and manage large amounts of financial data, making them prime targets for cybercriminals. Through fraudulent transactions, cyberattacks can result in significant financial losses for the customer and the banks. Attackers who steal sensitive data from a banking institution may sell it.
Concentration and Systemic Risk may arise due to a lack of control of individual Regulated Entities over a service provider, more so when the overall banking/financial services industry has considerable exposure to one service provider.
23. Compliance Risk:
Compliance risk arises where privacy, 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 that have not complied or the account opened in contravention of various directions and instructions issued by it, which includes failure to obtain adequate documents for opening accounts, failure to carry out identification procedures, and failure to examine the control structure of entities.
Compliance risks may also arise due to privacy, confidentiality, and statutory laws/prudential regulations not adequately complied with by the service provider.
24. Portfolio risk:
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 rates, trade restrictions, economic sanctions, and Government policies.
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