Unit-2 Risk in Banking

Business
 What is Risk?
• Risk refers to the possibility that the outcome of an action or event could bring adverse impacts
on the bank’s capital, earnings or its viability.
• Risk can be defined as the chance that an investment’s actual return will be different than
expected.
• Risk includes the possibility of losing some or all of the original investment. Different versions of
risk are usually measured by calculating the standard deviation of the historical returns or
average returns of a specific investment.
• A high standard deviation indicates a high degree of risk.
• According to size and nature of investment the level of risk can be different.
• The risk arises from the occurrence of some expected or unexpected events in the economy or
the financial markets.
• Risk can also arise from staff oversight or malafide intention, which causes erosion in asset values
and, consequently, reduces the bank’s intrinsic value.
• The money lent to a customer may not be repaid due to the failure of a business. Another reason
for no repayment is that a derivative contract to purchase foreign currency may be defaulted by a
counter party on the due date. These types of risks are inherent in the banking business.
 Meaning and Nature of Financial Risk
• Financial risk refers to the potential for financial loss or negative impact on an
individual's or organization's financial well-being due to various factors and
uncertainties in the financial markets and economic environment.
• It's an integral aspect of finance and investment, and understanding and
managing financial risk is crucial for making informed financial decisions.
• Financial risk is the possibility that shareholders will lose money when they
invest in a company that has debt.
• Financial risk is the general term for many different types of risks related to the
finance industry. It include market risks (interest rate risk, price risk, and
foreign exchange risk), credit risk, liquidity risk etc.
 TYPES OF MAJOR RISK BANKING BUSINESS
In the banking business, there are several major types of risks that financial institutions face
due to their operations, activities, and exposure to the broader economic environment. Here
are some of the key types of risks in banking:
1. Credit Risk
2. Market Risk: (Interest Rate Risk, Equity Price Risk, Foreign Exchange Risk and Commodity risk)
3. Liquidity Risk
4. Operational Risk
5. Reputation Risk
6. Compliance and Regulatory Risk
7. Country Risk
8. Strategic Risk
Managing these risks is essential for the stability, profitability, and long-term success of banking
institutions. Banks employ risk management strategies, such as setting risk limits, diversifying
portfolios, stress testing, and establishing robust internal controls, to mitigate the impact of
these risks.
1. 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.
• Banks are in the business of lending money, and credit risk is an inherent part of
their operations. If borrowers default on their loans, banks can incur financial
losses, which can impact their profitability, liquidity, and overall stability.
 Mitigation of Credit risk
Mitigating bank credit risk involves implementing strategies and practices to reduce the potential
negative impact of borrower defaults on a bank's financial health and stability. Here are several key
approaches that banks use to mitigate credit risk:
1.Effective Credit Underwriting:
1. Thoroughly assess the creditworthiness of borrowers before extending loans.
2. Consider factors such as credit history, income, collateral, and the purpose of the loan.
3. Implement strict lending standards and avoid lending to borrowers with high credit risk
profiles.
2.Risk Diversification:
1. Avoid overexposure to a specific industry, sector, or type of loan.
2. Diversify the loan portfolio to spread risk across various borrowers and sectors.
3. By diversifying, banks reduce the impact of a downturn in a particular industry on their
overall portfolio.
3.Risk-Based Pricing:
1. Charge higher interest rates to borrowers with higher credit risk.
2. Adjust interest rates based on the borrower's creditworthiness to compensate for the
increased risk.
4. Collateral and Guarantees:
1. Require borrowers to provide collateral or guarantees that can be used to recover the outstanding
debt in case of default.
2. Carefully assess the value and quality of collateral to ensure it adequately covers the loan amount.
5. Early Warning Systems:
3. Implement systems to monitor the financial health of borrowers throughout the life of the loan.
4. Set up triggers that signal potential distress, allowing the bank to take timely action.
6. Loan Loss Reserves:
5. Set aside provisions for loan losses based on the bank's assessment of credit quality.
6. Ensure that loan loss reserves are adequately funded to cover potential losses.
7. Effective Monitoring and Collection Processes:
7. Continuously monitor the repayment behavior of borrowers.
8. Establish efficient collection processes to address delinquent accounts promptly.
8. Regulatory Compliance:
• Adhere to regulatory guidelines and requirements related to credit risk management.
• Maintain sufficient capital reserves as mandated by regulatory authoritie
9. Continuous Training and Skill Development:
• Ensure that credit officers and analysts are well-trained and up-to-date with industry best practices.
2. 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
3. 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.
4. 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.
5. 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
6. 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.
7. 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.
8. 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.
THANK YOU!