Unit-2 Risk in Banking Business

Contents Meaning and nature of financial risk Credit risk, Operational risk Market risk Liquidity risk For-ex risk Country risk Risk identification Risk measurement and Risk mitigation.

Financial risk?

Meaning and Nature of Financial Risk Banking is the management of risk Risk management in banking involves the process of evaluating the risks faced by a bank and minimizing the costs accordingly. Banks, in the process of financial intermediation, are confronted with various kinds of Financial and Non-financial risks, viz., credit risk, interest rate risk, foreign exchange rate risk, liquidity risk, equity price risk, commodity price risk, legal risk, regulatory risk, reputation risk, operational risk, etc. Financial risk refers to losses arising from financial variables and operating risks concerning losses arising from variables that have impact on the operations of a business (Banks, 2005, p.3). Financial risks comprising of credit risk, liquidity risk, market risk, for-ex risk, and Country risk and so on.

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.

Continue…… Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign. Credit risk may take the following forms: Direct lending: Principal and/or interest amount may not be repaid. Guarantees or letters of credit: Funds may not be forthcoming from the constituents upon crystallization of the liability. Treasury operations: The payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases. Securities trading businesses: Funds/securities settlement may not be effected. Cross-border exposure: The availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.

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. (Fabris, 2006:67).

Market Risk Today , the market values of assets, liabilities, and net worth of financial service providers are constantly in a state of flux due to uncertainties concerning market rates or prices. Market risk is composed of both price risk and interest rate risk. Price risk is the risk to earnings or capital related to market-making, dealing, or taking positions in securities, derivatives, foreign exchange, or other financial instruments. Price risk is damaging when interest rates increase.

Most widely used measures of interest-rate risk exposure are: Interest rate risk refers to the impact of changing interest rates on a financial institution’s margin of profit. Most widely used measures of interest-rate risk exposure are: Interest-sensitive assets/interest sensitive liabilities: when interest-sensitive assets exceed interest-sensitive liabilities in a particular maturity range, a financial firm is vulnerable to losses from falling interest rate. In contrast, when rate-sensitive liabilities exceed rate-sensitive assets, losses are likely to be incurred if market interest rate rise. For depository institutions, uninsured deposits/total deposits, where uninsured deposits are usually government and corporate deposits that exceed the amount covered by insurance and are usually so highly sensitive to changing interest rate that they will be withdrawn if yields offered by competitors rises even slightly higher.

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.

For-ex Risk This is the risk to earnings or capital due to change in foreign exchange rates. When any foreign currencies weaken against the home currency, the market value of investments denominated in foreign currencies decline.

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

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.

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 Risk mitigation

Continue… 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.

Continue… 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.

Continue….. 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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