What is RISK Management in Bank?

We all come across with the word risk in our life but have you ever wondered where this word
originates from??? What is the origin of this word??? So, firstly we will discuss what is Risk??

The word “Risk” can be linked to the Latin word “Rescum” which means Risk at Sea. Risk can be
defined as of losing something of value or something which is weighed against the potential to
gain something of value. Values can be of any type i.e. health, financial, emotional well being etc.
Risk can also be said as an interaction with uncertainty. Risk perception is subjective in nature,
people make their own judgment about the severity of a risk and it varies from person to person.
Every human-being carries some risk and define those risks according to their own judgment..

What is Risk Management?

As we all are aware what is risk? But how one can tackle with risk when they face it?? So, the
concept of Risk Management has been derived in order to manage the risk or uncertain event. Risk
Management refers to the exercise or practice of forecasting the potential risks thus analyzing and
evaluating those risks and taking some corrective measures to reduce or minimize those risks.

Today risk management is practiced by many organizations or entities in order to curb the risk
which they can face it in near future. Whenever an organization makes any decision related to
investments they try to find out the number of financial risk attached with it. Financial risks can
be in the form of high inflation, recession, volatility in capital markets, bankruptcy etc. The
quantum of such risks depends on the type of financial instruments in which an organization or an
individual invests.

So, in order to reduce or curb such exposure of risks to investments, fund managers and investors
practice or exercise risk management. For example an individual may consider investing in fixed
deposit less risky as compared to investing in share market. As investment in equity market is
riskier than fixed deposit, thus through the practice of risk management equit analyst or investor
will diversify its portfolio in order to minimize the risk.

How important Risk Management is for Banks?

Till now we have seen how risk management works and how much it is important to curb or reduce
the risk. As risk is inherent particularly in financial institutions and banking organizations and even
in general, so this article will deals with how Risk Management is important
for banking institutions. Till date banking sectors have been working in regulated environment and
were not much exposed to the risks but due to the increase of severe competition banks have been
exposed to various types of risks such as financial risks and non-financial risks.

The function and process of Risk Management in Banks is complex, so the banks are trying to use
the simplest and sophisticated models for analyzing and evaluating the risks. In a scientific manner,
banks should have expertise and skills to deal with the risks which are involved in the process of

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integration. In order to compete effectively, large-scale banking organizations should develop
internal risk management models. At a more desired level, Head offices staff should be trained in
risk modeling and analytic tools to conduct Risk Management in Banks.

In their operations banks are particularly exposed to or may potentially be exposed to the following
risk:

Liquidity risk
- is the risk of potential occurrence of adverse effects on the bank’s financial result and
capital due to the bank’s inability to meet the due liabilities caused by the withdrawal of
the current source of funding, that is, the inability to raise new funds (funding liquidity
risk), aggravated conversion of property into liquid assets due to market disruption (market
liquidity risk).

Settlement/Delivery risk
- is the possibility of occurrence of adverse effects on the bank’s financial result and capital
arising from unsettled transactions or counterparty’s failure to deliver in free delivery
transactions on the due delivery date.

Credit risk
- is the risk of potential occurrence of adverse effects on the bank’s financial result and capital
due to debtor’s default to meet its obligations to the bank.

How Is Credit Risk Assessed?

Credit risks are calculated based on the borrowers' overall ability to repay. To assess credit risk
on a consumer loan, lenders look at the five C's: an applicant's credit history, his capacity to
repay, his capital, the loan's conditions and associated collateral.
Similarly, if an investor is thinking about buying a bond, he looks at the credit rating of the bond.
If it has a low rating, the company or government issuing it has a high risk of default.
Conversely, if it has a high rating, it is considered to be a safe investment. Agencies such as
Moody's and Fitch evaluate the credit risks of thousands of corporate bond issuers and
municipalities on an ongoing basis.

How Does Credit Risk Affect Interest Rates?

If there is a higher level of perceived credit risk, investors and lenders demand a higher rate of
interest for their capital. For example, if a mortgage applicant has a stellar credit rating and a
steady income flow from a stable job, he is likely to be perceived as a low credit risk and will
receive a low interest rate on his mortgage. In contrast, if an applicant has a lackluster credit
history, he may have to work with a subprime lender, a mortgage lender that offers loans with
relatively high interest rates to high-risk borrowers.
Similarly, bond issuers with less than perfect ratings offer higher interest rates than bond issuers
with perfect credit ratings. The issuers with lower credit scores need to use high returns to entice
investors to take a risk on their bonds

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Residual risk
- is the possibility of occurrence of adverse effects on the bank’s financial result and capital
due to the fact that credit risk mitigation techniques are less efficient than expected or their
application does not have sufficient influence on the mitigation of risks to which the bank
is exposed.

Dilution risk
-- is the possibility of occurrence of adverse effects on the bank’s financial result and
capital due to the reduced value of purchased receivables as a result of cash or non-cash
liabilities of the former creditor to the borrower.
-- is any portion, regardless of why, of your receivables that you did not collect. This is
important as the amount available from your line of credit with the bank is based on your
outstanding accounts receivablebalance. The bank wants to know the extent to which your
receivablesare likely to be turned into cash receipts. The greater the amount of dilution, the
greater the risk to the bank and the less will be your available borrowing base.

The following are common causes of dilution and suggestions for remedying them.

Discounts
- - Discounts offered to customers for faster repayment can increase your dilution rate. But
if these discounts account for a significant amount of dilution, you may consider other
methods of encouraging faster repayment
Collection costs
- The greater the fees directly paid to collect on your receivables, the less of
your receivables balance you will realize. This is worth examining to see if it has
a material impact on your dilution rate. You may even consider less costly collection
services.

Bad debt
- Receivables not collected due to the default or other negligence of the customer. Reduce this
through the establishment of tighter creditpolicies, such as more thorough credit checks
prior to extending trade credit to customers.

Offsets
- Sometimes a customer may also be a vendor. In the course of paying an invoice it may seem
attractive to you or them to net out the amount they owe you from the invoice’s total.
Although, you may want to end this practice depending on the amount of the dilution and
its subsequent impact on your borrowing base availability.

Counterparty risk
- is the risk to each party of a contract that the counterparty will not live up to its
contractual obligations. Counterparty risk is a risk to both parties and should be
considered when evaluating a contract.

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In most financial contracts, counterparty risk is also known as default risk.

Default risk is the chance that companies or individuals will be unable to make the required
payments on their debt obligations. Lenders and investors are exposed to default risk in virtually
all forms of credit extensions.

For example, if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation
that Joe will provide the cash, and Mike will pay those funds back. There is still the counterparty
risk assumed by both parties. Mike might default on the loan and not pay Joe back, or Joe might
stop providing the agreed-upon funds.

SOLUTIONS:

credit reports are often used to determine the counterparty credit risk for lenders to make auto
loans, home loans and business loans to customers. If the borrower has low credit, the creditor
charges a higher interest rate premium due to the risk of default, especially on uncollateralized
debt.

Market risk
- is the possibility for an investor to experience losses due to factors that affect the overall
performance of the financial markets in which he is involved. Market risk, also called
"systematic risk," cannot be eliminated through diversification, though it can be hedged
against. Sources of market risk include recessions, political turmoil, changes in interest
rates, natural disasters and terrorist attacks.

Companies in the United States are required by the SEC to detail how their productivity
and results may be linked to the performance of the financial markets. This is meant to
provide a reflection of how a company is exposed to financial risk. For example, a
company providing derivative investments or foreign exchange futures may be more
exposed to financial risk than companies who do not provide these types of investments.
This information helps investors and traders make decisions based on their own risk
management rules.

The two major categories of investment risk are market risk and specific risk. Specific
risk, also called "unsystematic risk," is tied directly to the performance of a particular
security and can be protected against through investment diversification. One example of
unsystematic risk is a company declaring bankruptcy, making its stock worthless to
investors.

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 Under these categories are different classifications that involve unique aspects of
financial markets. The most common types of market risks include interest rate risk,
equity risk, currency risk and commodity risk.

Interest rate risk

- covers the volatility that happens with changing interest rates due to fundamental factors,
such as Libor and other central bank announcements related to changes in monetary
policies. EQUITY RISK is the risk involved in the changing stock prices. An investor is
exposed to CURRENCY RISK if he is holding particular currencies facing volatile
movements, because of fundamental factors such as interest rate changes or
unemployment claims. COMMODITY RISK covers the changing prices of commodities
such as crude oil and corn.

Market Risk Due to Volatility

- Market risk exists because of price changes. The standard deviation of changes in prices
of stocks, currencies or commodities is referred to as price volatility. Volatility is rated in
annualized terms. It may be expressed as an absolute number, such as $10, or a
percentage of the initial value, such as 10%.

RISK is generally understood as “the possibility that something bad or unpleasant (such as an
injury or a loss) will happen.”

There are four major types of market risk:

• Interest Rate Risk
• Equity Price Risk
• Foreign Exchange Risk
• Commodity Price Risk

Interest Rate Risk

- is the risk that the value of a security will fall as a result of increase in interest rates.
However, in complex portfolios, many different types of exposures can arise.
Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much
interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the
market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate
of the bonds.
Basis risk: Banks can face basis risk if the interest-bearing assets and liabilities have different
bases such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some
circumstances different bases will move at different rates or in different directions, which can
cause erratic changes in revenues and expenses.

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Repricing risk: Banks can also face repricing risk, that is, the risk presented by assets and
liabilities that reprice at different times and rates. For instance, a loan with a variable rate will
generate more interest income when rates rise and less interest income when rates fall. If the loan
is funded with fixed rated deposits, the bank’s interest margin will fluctuate.
Yield curve risk: Yield curve risk is presented by differences between short-term and long-term
interest rates.
Under normal circumstances, the short-term rates are lower than long-term rates, and banks earn
profits by borrowing short-term money and investing in long-term assets. However, any change
in the yield curve can dramatically affect bank’s earnings.
Options risk: The optionality embedded in some assets and liabilities gives rise to options risk.
This can be seen in the prepayment speeds of the mortgage loans, with changing interest rates.
Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the
bank with uninvested cash when interest rates have declined. Alternately, rising interest rates
cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior,
lower interest rates. Option risk is difficult to measure and control.

Solution:
as your technology and advisory partner, experienced team can help you develop a real-time risk
management framework that employs a holistic, integrated approach to market risk. Solutions
help you achieve insight and transparency into your market risk exposures, from clearing and
settlement costs and uncertainties to with ever-shifting foreign exchange and interest rate
exposures. Provide robust scenario analysis, limits monitoring, comprehensive stress testing
capabilities and consistent, powerful real-time risk reporting across your entire enterprise—pre-
and post-trade, at both the desk and portfolio level.

Foreign exchange risk

is the risk of possible occurrence of adverse effects on the bank’s financial result and capital on
account of changes in foreign exchange rates.
Identifying and Managing Foreign Exchange Risk
• Identifying the Risk
-Businesses that trade internationally or have operations overseas are likely to be exposed
to foreign exchange risk arising from volatility in the currency markets. The most common
cause of foreign exchange exposure arises from having to make overseas payments for your
imports priced in a foreign currency or receiving foreign currency receipts for your exports.
However, exposure can also arise from .

The Four Point Plan

Point 1 – Understand your exposures
There are numerous factors to take into account when assessing your exposure to foreign
exchange rate risk, for example:

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 • What proportion of your business relates to imports or exports?
• What currencies are involved?
• What are the timings of payments?
• What impact would an adverse rate movement have on your profitability?
• Is the level of overseas business likely to change?
• Do you pay and receive in the same foreign currency – it may be possible to mitigate the
exchange risk by using a foreign currency bank account?

Point 2 – Understand the product

There are three alternative methods available to manage foreign exchange risk.

• Do nothing and buy or sell your currency in the spot market.

• Lock in to fixed rates
Use flexible products
Point 3 – Develop a strategy
Point 4 – Implement it

Concentration risk
• Concentration risk is the risk which arises directly or indirectly from the bank’s exposure to
the same or similar source of risk, or, same or similar type of risk;
• Concentration risk is a banking term denoting the overall spread of a bank's outstanding
accounts over the number or variety of debtors to whom the bank has lent money. This risk
is calculated using a "concentration ratio" which explains what percentage of the
outstanding accounts each bank loan represents

Types of concentration risk

• There are two types of concentration risk. These types are based on the sources of the risk.
Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers.
Such a risk is called name concentration risk. Another type is sectoralconcentration risk,
which can arise from uneven distribution of exposures to particular sectors, regions, industries
or products
How to reduce concentration risk
• Appreciate the importance of asset allocation, the art of spreading your money across the
main asset classes of shares, property, fixed interest and cash. Ensure your asset allocation
matches your tolerance to investment risk.
• Diversify within each asset class. Holding the big four banks is not a diversified share
portfolio. If property is your thing, buying four one-bedroom apartments in the same
building, or even in the same area, creates a huge concentration risk.
• Rebalance your portfolio to keep it broadly in line with your ideal asset allocation. This may
create a tax liability, but often it’s better to pay some tax than to carry too high a level of
concentration risk.

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 • Understand each investment and its role in your portfolio. Does share fund A hold similar
shares as share fund B? Do they both have the same strategy?
• Get a professional opinion. Even if you are confident in making your own investment
decisions it’s wise to run them by a licensed adviser.
Bank exposure risks
Bank exposure risks comprise risks of bank’s exposure towards a single person or a group of
related persons
Information system
A bank shall adopt and implement the strategy for development of the information system and a
security policy for that system. With the strategy of development of the information system the
bank shall ensure that this system is at all times commensurate with the nature, volume and
complexity of the bank’s activities
The information system security policy shall in particular refer to
1) manner of ensuring the security of the system;
2) principles and procedures for ensuring:
– confidentiality of data or that only authorised persons have access to them,
– integrity of data, and/or their accuracy and completeness
– availability of data to authorised persons as necessary, including procedures enabling
continuous performance of the bank’s business operations in the case of system errors or failure;
3) division of tasks and duties relating to information technology, data from the information
system and relevant documentation. A bank shall ensure that the accounting system, other data
processing systems, as well as the reporting system are an integral part of the bank’s information
system

Legal risk
- Is the risk of loss caused by penalties and sanctions originating from court disputes due
to breach of contractual and legal obligations and penalties and sanctions pronounce by a
regulatory body. It’s basic reason is BORROWER DIDN’T PAY, EXPENSES IS TOO
HIGH, THUS THERE’S NO INCOME. In that way we should be wise by our business.
We should always think the possibility of every things and stuff that we are doing.

Risk of compliance of the bank’s operation

- Is the possibility of occurrence of adverse effects on the bank’s financial result and
capital as a consequence of failure to comply its operations, anti-money laundering and counter-
terrorist financing procedures, and other procedures as well as other acts governing the bank’s
operations, particularly encompassing the risk of sanctions by the regulatory authority, risk of
financial losses and reputational risk.
Its BASIC PRINCIPLES OF OUR APPROACH TO THIS RISK are ;

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 - A focus on our core business
- Transparency & simplicity in all of our procedures & services
- Careful recruitment of staff followed by intensive training

Reputation risk
- is a company’s reputation is perhaps its most valuable asset. Reputational risk is the
possible loss of the organisation’s reputational capital. Imagine that the company has an
account similar to a bank account that they are either filling up or depleting. Every time
the company does something good, its reputational capital account goes up; every time
the company does something bad, or is accused of doing something bad, the account goes
down. The commercial bank examination, which is a supervisory manual published by
the Federal Reserve Board in the US to provide guidance in bank inspections, defines
reputational risk as the potential loss in reputational capital based on either real or
perceived losses in reputational capital. In fact, the manual states very clearly that a
company can lose its reputation whether allegations are true or
not.Example The pharmaceutical company, Merck knew that side effects from the
drug Vioxx could lead to heart problems in some patients. In fact, after the company
faced law suits related to the complications from taking this drug, a memo was
discovered showing that executives within the company knew about the side effects and
had warned senior managers about the dangers associated with taking Vioxx in some
patients. These warnings were ignored. If the company had understood the risk to its
reputation, it would have understood that in the long term, the money it was making
selling the drug was not worth the potential loss in reputational capital to the organisation
as a whole.

Strategic risk
- Is a possible source of loss that might arise from the pursuit of an unsuccessful business
plan. For example, strategic risk might arise from making poor business decisions, from
the substandard execution of decisions, from inadequate resource allocation, or from a
failure to respond well to changes in the business environment.
These risks may include:

Shifts in consumer demand and preferences

Legal and regulatory change
Competitive pressure
Merger integration
Technological changes
Senior management turnover
Stakeholder pressure

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 References
https://www.nbs.rs/internet/english/55/55_6/index.html

https://www.nbs.rs/internet/english/20/kpb/risk_management_by_banks.pdf

https://int.search.tb.ask.com/search/GGmain.jhtml?n=783a8721&p2=%5EBSB%5
Exdm011%5ES21892%5Eph&pg=GGmain&pn=1&ptb=C76BA54A-18F1-4E09-
B0C7-
A66E8E1E0C04&qs=&searchfor=legal+risk+solution&si=CI7h0oWy9NYCFdwD
KgodS3kLkA&ss=sub&st=sb&tpr=sbt
https://lynx.law/en/legal-risk-management-of-contracts-in-technology-projects/
https://www.educba.com/risk-management/wp-content/uploads/2014/04/pic2.png

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