RISKS FACTORS IN THE BANKING SECTOR
There are many risks factors prevail in the banking sector but the risk factors considered major are four and described here.
- Credit Risk
It is the biggest risk factor for banks that arises from the possibility of non-payment, not receiving payments or delay payments of loans by the borrowers. Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. Its defaults can occur on mortgages, credit cards, and fixed-income securities.
The profitability of a bank is extremely sensitive to credit risks. Hence, even if credit risk rises by a small amount, the profitability of the bank can get extremely impacted. To tackle this risk, bank has credit management policy and committee, Risk rating, Risk pricing, portfolio management, Loan review mechanism and other laws and tools related to overcome the risks.
- Operational Risk
Generally, operational risk is defined as any risk, which is not categorized as market or credit risk, or the risk of loss arising from various types of human or technical error. It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks. Operational risk has some form of link between credit and market risks. An operational problem with a business transaction could trigger a credit or market risk.
Internal controls and the internal audit are used as the primary means to mitigate operational risk. Banks could also explore setting up operational risk limits, based on the measures of operational risk. The contingent processing capabilities could also be used as a means to limit the adverse impacts of operational risk. Insurance is also an important mitigator of some forms of operational risk. Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk.
One of the major tools for managing operational risk is the well-established internal control system, which includes segregation of duties, clear management reporting lines and adequate operating procedures. Most of the operational risk events are associated with weak links in internal control systems or looseness in complying with the existing internal control procedures.
- Market Risk
Market risk arising from adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks.
Market risk takes the form of: (1) Liquidity Risk (2) Interest Rate Risk (3) Foreign Exchange Rate Risk (4) Commodity Price Risk and (5) Equity Price Risk.
Management of market risk is major concern of top management of banks. The Boards clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The Asset-Liability Management Committee should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board.
- Liquidity Risk
Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defense mechanism from losses on fire sale of assets.
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk. It goes in three ways- (1) Funding risk (2) Time risk (3) Call risk.
Other Risk
Reputational Risk
Reputation is an extremely important intangible asset in the banking business that enables them to generate more business more profitably and easily. Banks like JP Morgan bank, Chase bank, Citibank, Bank of America etc have all been in the business for hundreds of years and have great reputations.
Customers like their money to be deposited at places which they believe follow safe and sound business practices. Banks can save their reputation by ensuring that they never participate in any unfair or manipulative business practices. Also, banks need to continuously ensure that their public relations efforts project them as a friendly and honest bank.
Systemic Risk
It arises because of the fact that the financial system is one intricate and connected network. So, the failure of one bank leads possibility to cause the failure of many other banks. This is because banks are counterparties to each other in a lot of transactions. Hence, if one bank fails, the credit risk event for the other banks becomes a reality.
They have to write off certain assets as a result of the failure of their counterparty. This writing off often leads to the bankruptcy of other banks and an unstoppable domino seems to take over. The very nature of banking system therefore makes them prone to systemic risks.
Systemic risks do not affect an individual bank rather they affect the entire system.
Frequently Asked Questions (FAQ)
What type of risk factors prevailed in banking?
There are mainly four risks prevails in the banking sector.
- Credit Risk
- Operational Risk
- Market Risk
- Liquidity Risk
Which Risk is considered as biggest Risk and why?
Credit Risk is considered biggest Risk, because the profitability of a bank is extremely sensitive to credit risks. Even if credit risk rises by a small amount, the profitability of the bank can get extremely impacted.
What is operational Risk in Banks?
Operational risk is any risk, which is not categorized as market or credit risk, or the risk of loss arising from various types of human or technical error.
When does Market Risk occur?
Market risk arises from adverse changes in market variables.
When does Liquidity Risk occur?
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities.
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