Banks and the banking system play a significant role in the economic development of any country. Banks are crucial because they are directly exposed in the market, they deal with the money i.e. liquidity in the market and they act as the intermediaries between various individuals and firms. Due to such functionality, banks and banking systems are also prone to various banking risks.
Risk arises from the occurrence of some expected and unexpected events in the economy or the financial markets. Some of the widely discussed definitions of risk include:
- The chances an undesired event will occur
- The loss from an unexpected event
- The likelihood that “things won’t go right”
- The impact of any unfavorable outcome
Basel III Accord has categorized the bank risk into three types:
- Credit Risk
- Market Risk
- Operational Risk
Banks are always dealing with funds. Credit risk is the potential loss a bank faces when a borrower fails to meet its obligation. The borrower may fail to pay the interest on the loan or the amount borrowed in accordance with agreed terms. Credit risk is the single largest risk most of the modern banks face . In common terms, Credit Risk is also termed as “Default Risk”. Default risks are also a big concern for depositors as credit risk is the risk where the bank will not be able to repay the funds when they ask for them.
In 2007, the subprime mortgage borrowers defaulted Rs. $10 billion to large Swiss Banks. During this crisis, banks across the globe suffered from this risk.
Market risk is the risk of losses to the bank arising from movements in market prices as a result of changes in interest rates, foreign exchange rates, and equity and commodity prices.
Interest Rate Risk
Interest Risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the bank’s equity. Investors can reduce interest rate risk by buying bonds that mature at different dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other instruments.
Equity Risk is the potential loss due to unfavourable change in the equity investment i.e. price of stock. Banks can make equity investment in various companies to maintain/manage their investment portfolio, exposing them to the risk of the changing value of those equity investment shares.
During the 1990s, investment in tech-based companies and the internet sector increased rapidly. To cash in these opportunities, heavy investment was done in similar businesses. From March 2000 to October 2002, the dot-com bubble burst and a stock price of many tech-based and internet sector firms crashed leading to loss of 50% or more to shareholders.
Foreign Exchange Risk
Foreign Exchange Risk is the risk due to currency exchange rate fluctuation. Banks have the function of payment services which involve foreign exchange i.e. banks buy and sell foreign currency and involve in various intermediaries transactions(international trade) on the behalf of their customers.
There is regular fluctuation of the foreign exchange rate which may lead to either gain or loss in foreign exchange transactions which is uncertain.
Commodity Risk is the potential disadvantage due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities i.e. wheat, corn, soybeans etc., industrial commodities i.e. metals, and energy commodities i.e. natural gaese, crude oil. The value of the commodity fluctuates a great deal due to changes in demand and supply just like foreign currency. Commodity market is mature in developed countries and banking institutions do participate in commodity-related transactions.
Operational Risk is the uncertainty of loss resulting from insufficient, incompetent and failed internal process, people and system or from any external environment events. Operational Risks includes legal risks, human error, intentional frauds, technical errors, gap in operation etc.
Operational Risks are the least cared and understood and most challenging risk to measure, handle and monitor. Banking saw an increase in the number of operational risk events that severely impacted both business prospects and profitability.
Apart from all these main three risks, there are other risks banks face and must be managed. Some of such risks are:
Liquidity Risk is the ability of a firm or company to pay its debts without suffering catastrophic losses. This means the bank lacks marketability in the investments i.e. cannot be bought or sold quickly enough to prevent or minimize a loss. It is also about the ability to meet its continuing obligations, including financing its assets.
In 2007, Northern Rock, a bank focused on financing real estate in the United Kingdom, requested the Bank of England for an energy fund as the bank didn’t have sufficient depositors to fund new loans from deposits.
Business Risk is the potential cost a firm faces due to the decrease in its competitive position. The ability of doing business for a bank is reduced and banks are not able to cope up with the changing market.
In the mid-1990s, BestBank of Boulder, in order to expand its business, issued credit cards to many low-quality borrowers(subprime). This led to a huge loss of about USD 232 million. This is the classic example of business risk.
Reputation risk is a risk of loss resulting from damages to a firm’s reputation i.e. bank’s standing in public opinion. There are various evident examples in the market where a company has faced loss due to its reputation among the public. For banks, loss of customer confidence can lead to the withdrawal of many potential investments and proposals by the investors.
In 1991, Salomon Brothers , then the fifth largest investment bank in the U.S. misguided their investment into government debts and multiple negative and illegal impacts from the misguidance was noticed which led to decreased public confidence in the bank. Eventually, loss was incurred due to the failed reputation of the bank.
- Apostolik, R., Donohue, C., & Went, P. (2009). An Overview of Banking, Banking Risks and Risk-Based Banking Regulation . Hoboken, New Jersey: John Wiley & Sons, Inc.