FINANCIAL AND NON FINANCIAL RISK

Financial Risk:

(a) Credit Risk:

Credit risk occurs when customers default or fail to comply with their obligation to service
debt, triggering a total or partial loss. It also gets reflected in downgrading of the counter
party. It is difficult to appraise the cumulated credit risk over a portfolio of transactions of
either loans or market instruments because of diversification effect.

The sub components of credit risk are individual loans, market conditions and geographical/
industry/group concentrations. Risk issues get reflected in loan losses, rising non-performing
assets and concentrations.

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The primary cause of credit risk is poor credit management. It has been observed that lack of
proper communication, narrowly defined responsibilities and over emphasis on group
decision making are some generic causes of such a situation

(b) Liquidity Risk:

Liquidity risk is when the bank is unable to meet a financial commitment arising out of a
variety of situations. These include usage of non-funded credit line, maturing liabilities (with-
drawal or non-renewal of deposits) or disbursement to customers. Ill-managed liquidity could
cost in terms of losing a good customer or loss due to distress sale of investments or high cost
of raising resources.

Such a situation may invite wrath of regulators as also penalties. Loss of reputation is another
danger that may have to be faced. As such, Liquidity risk is fatal, although similar situations
may also arise due to failure to manage other risks as wel

Interest rate risk occurs due to movements in interest rates. This risk is the possibility that
assets or liabilities have to be re-priced on account of changes in the market rates and its
impact on the income of the bank. Such situations arise when rates fall or rise, fixed interest
rates become variable after maturity or after fixed period or variable interest rates become
fixed between two revision dates.

It should be remembered that the period between two revisions for interest rates on assets and
liabilities is not uniform or constant. Instances of this kind as well as market-driven and
regulations-driven changes give rise to interest rate risk.

The components of the risk are:

1. basis (change in the basis points in market quotes),

2. yield (change/shift in the yield),

3. price (change in pricing policy methodology or price itself),

4. reinvestment (impact of interest rate changes on income from re-invested interest),

5. embedded option (impact of prepaid loan or pre-mature withdrawal of deposit on earnings)

6. gap (the difference between rate sensitive assets and rate sensitive liabilities)

(d) Foreign Exchange Risk:

Foreign Exchange or forex risk relates to likely loss due to variations in earnings on account
of indexation of revenues and changes in assets and liabilities labelled in foreign currency.
This is primarily a market risk. The movements in the currencies dealt with give rise to forex
risk.

The development/ adoption/implementation on open positions, monitoring forward maturity

Specific guideline or policy prescriptions are developed in respect of ethical and operational
issues. Responsibilities of dealers, back-office functionaries and supervisory staff to ensure
that attendant risk in forex business is addressed to are to be specified

(e) Market Risk:

Market risk signifies the adverse movement in the market value of trading portfolio during
the period required to liquidate the transaction. Generally Market risk is considered for
liquidation period only. Market risk could be higher if there is deficiency in monitoring the
market portfolio. However, such risk is more of operational nature than market risk.

Assessment of market risk is made with reference to instability or volatility of market

(g) Regulatory and Legal Risks:

Regulatory risk refers to the adverse impact of the existing or new rules or statutes.
Generally, the loss is considered as potential and not actual due to a variety of possible
regulatory actions. Litigations like lenders’ liability, customer/employee suits and liability on
account of environment compliance are examples of such legal risks. Banks are also exposed
to fiduciary or contract or shareholders’ liability suits.

h) Operational Risk:

Operational risk refers to the malfunctioning of information and/or reporting system and of
internal monitoring mechanism. The risk is two pronged. At technical level, it exists due to
deficiency or malfunctioning of information system. The error in the process of recording
transaction is the primary cause of risk.
At the operational/organizational level, lacunae in monitoring/ reporting and absence of
rules/regulations are the reasons for operational risk. Supervision and control of high order,
training of personnel, regular internal and independent audits, development of personnel
policies with ethical codes, constant training on risk management, etc. are the strategies
adopted at operational level.

(i) Environmental Risk:

In 1984 the American Chemical Society stated:

“Society is constantly faced with the fundamental questions of “What are the risks associated
with certain products and processes, how serious are they, and how well can they be
estimated?” … “How do these risks affect us as a society and as individuals?” “How do risks
from exposure to chemicals compare with other risks we take everyday?” These questions
remain relevant today.

The environmental risk is defined as the likelihood, or probability, of injury, disease, or death
resulting from exposure to a potential environmental hazard. Environmental risk areas refer
to the types of environmental values that would be threatened as a result of pollution, or
events on campus

Non-Financial Risks:

Non-financial risks to which banks are exposed to are: business risk and strategic risk.

The description of each of them is given below:

(a) Business Risk:

These are the risks that the bank willingly assumes to create a competitive advantage and add
value for shareholders. Business or operating risk pertains to the product market in which the
bank operates, and includes technological innovations, marketing and product design.
Products designed by the bank may be made superfluous by technological advancement.

An example would be door-to- door deposit marketing that could prove very costly in
comparison with internet driven banking. A bank with a pulse on the market and driven by
technology as well as a high degree of customer focus could be relatively protected against
this risk

b) Strategic Risk:

This results from a fundamental shift in the economy or political environment. An example
for this would be the nationalization of Indian banks.

Similarly in the international arena, the negative sentiment against derivative transactions in
which all derivative dealers were caught after the fall of Barings and other highly publicized
derivative disasters including the disasters of Gibson Greetings, Orange County etc., strategic
risks usually affect the entire industry and are much more difficult to protect oneself.

Particular risk
What is the Particular Risk?

This is the risk incidence that exposes a specific person or entity and not everyone in a
society or in the industry. It is one single or small group of individuals or entities those have
to bear the loss of any particular risk. It originates from individual events and its effects are
personalized.

Examples of Particular Risk

 If your neighbor John’s money was stolen, the total effect of the loss is only for John
and his family alone and not for you or other neighbors. John bears the total incidence
of loss of the stolen money. The theft of money can therefore be referred as a
particular risk.

 If Brown.co had released a batch of defect products due to a deficiency in its factory
machinery, the claim expenses from customers is a loss specific to Brown.co. The
effect is a strain on its Profit and Loss Statement and other companies in the industry
are not affected by any means. This operational deficiency in Brown.co is a particular
risk

Particular Risk vs. Fundamental Risk

A student with the clear understanding on fundamental risk should now be able to understand
that particular risk is the opposite of fundamental risk. Particular risk is specific and effects
are personalized, in contrast to fundamental risk that affects a wider group at the same
incidence.

Examples of Fundamental Risk:

 If it rains cats and dogs and the town is flooded, it is you and all your neighbors going
to suffer from the floods. The effects of struggle and loss of properties is common to
every one of you and this is not a specific problem. Flood is therefore a fundamental
risk.

 If the economy is at a depression, unemployment persists all parts of the nation and it
is not only your business going to experience the struggle of reaching out the
customers due to low income level, but all businesses would feel the same due to
overall reduced customer spending
Fundamental Risk in Insurance Insurance is a Risk
Management Method. Finance assignment help would enable you to better
understand these finance terms. Insurance is a way of getting total or part
protection from the financial loss caused by a risk event. Insurance can also
be explained as risk sharing with a third party through a contract, where a
premium is paid to the insurer on a regular interval and in turn the insurer
covers up the risk exposure.

It is important to know that not all risks can be covered by insurance. There are Insurable
Risks and Uninsurable Risks