In this blog, we present to you all a topic, Types of Risks in Banks which is very important for the upcoming Banking and Government Exams like RBI Grade B, RBI Assistant, SEBI, NABARD, SIDBI, SBI PO, IBPS PO, IBPS Clerk, etc. We will be discussing a brief overview of the Types of Risks in Banks, the Concept of risks, and the definition of different types of risks in the bank industry. We hope after reading this blog you become aware of the topic which in turn will help you in the General Awareness section of various Banking and Government Examinations. Read about the Types of Risks in Banks – Concepts and Definition below.
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Types of Risks in Banks – Concepts and Definition
What are the Risks?
A bank faces many different types of risks and these need to be managed very carefully. The risks in Banks arise due to the occurrence of some expected or unexpected events in the economy or the financial markets. Risks can also arise from staff oversight or mala fide intention, which causes erosion in the values of assets thus leading to a reduction in the bank’s intrinsic value.
Types of Risks in Banks
Broadly speaking, Risks in the Banking sector are of two types namely Systematic Risks and Unsystematic Risks. Lets us define these two types of risks in Banks and understand the concept behind them.
1. Systematic Risks:
- It is the risk inherent to the entire market or a market segment, and it can affect a large number of assets.
- Systematic risk is also known as Undiversifiable Risk or Volatility and market risk.
- Systematic risk affects the overall market and not just a stock or industry in particular.
- This type of risk is both unpredictable and impossible to avoid completely.
- Examples of it include interest rate changes, inflation, recessions, and wars.
2. Unsystematic Risks:
- It is the risk that affects a very small number of assets.
- It is also called Nonsystematic Risk, Specific Risk, Diversifiable Risk, and Residual Risk.
- This type of risk refers to the uncertainty inherent to a company or industry investment in particular.
- Examples include a change in management, a product recall, a regulatory change that could drive down company sales, and a new competitor in the marketplace with the potential to take away market share from a company in which you’ve invested.
- It is possible to avoid Unsystematic Risks through diversification.
In addition to these broad categories of Risks, there are several other specific risks that the banking sector faces.
3. Credit of Default Risk:
It is the risk in which a borrower is unable to pay the interest or principal on its debt obligations. The Basel Committee on Banking Supervision defines credit risk as to the potential that a bank borrower, or counter-party, will fail to meet its payment obligations regarding the terms agreed with the bank. It includes both uncertainties involved in repayment of the bank’s dues and repayment of dues on time.
4. Market Risk:
The Basel Committee on Banking Supervision defines market risk as to the risk of losses in on-balance or off-balance sheet positions that arise from movement in market prices. Market risk is the most prominent for banks present in investment banking.
The four components of market risk:
- Interest Risk: It causes potential losses due to movements in interest rates. This risk arises because a bank’s assets usually have a significantly longer maturity than its liabilities. In the banking language, management of interest rate risk is also called asset-liability management (ALM).
- Equity Risk: It causes potential losses due to changes in stock prices as banks accept equity against disbursing loans. Banks can accept equity as collateral for loans and purchase ownership stakes in other companies as investments from their free or investible cash. Any negative change in stock price either leads to a loss or diminution in investments’ value.
- Commodity Risk: It causes 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. The commodities’ values fluctuate a great deal due to changes in demand and supply. Any bank holding them as part of an investment is exposed to commodity risk.
Foreign Exchange Risk: It causes 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 or other stakeholders in multiple currencies. Banks transact in foreign exchange for their customers or the banks’ accounts. Any adverse movement can diminish the value of the foreign currency and cause a loss to the bank.
5. Liquidity Risk:
It can be defined as the risk of a bank not being able to finance its day to day operations. Failure to manage this risk could lead to severe consequences for the bank’s reputation as well as the bond pricing and ratings of the bank in the money market.
6. Country Risk:
Country risk refers to the risk that a country won’t be able to honour its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country.
7. Operational Risk:
The Basel Committee on Banking Supervision defines operational risk as to the risk of loss resulting from inadequate or failed internal processes, people, and systems or external events.
All banks face operational risks in their day to day operations across all their departments including treasury, credit, investment, information technology.
There are three main causes of this risk:
- Human Intervention & Error
- Failure of the IT/internal software & systems.
- Failure of Internal Processes to transmit data & information accurately
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. Advertisements play a significant role in forming & maintaining the public perception, which is the key reason for banks spend millions in content marketing dollars.
The reputational risk could stem from:
- The inability of the bank to honour government/regulatory commitments
- Nonobservance of the code of conduct under corporate governance
- Mismanagement/Manipulation of customer records
- Ineffective customer service/after-sales services
9. Systemic Risk:
This risk includes the possibility of bringing down the entire financial system to a standstill. This is caused due to a domino effect where the failure of one bank could ripple down the failure of its counter-parties/other stakeholders, which could, in turn, threaten the entire financial services industry.
Risks such as systemic risk, which the banks have little or no control over, can only be mitigated if banks have a strong capital base, to ensure a sound infrastructure.
This was all from us in this blog-post of Types of Risks in Banks.
You can read more notes on Banking Awareness as well as download the free E-Books for your preparation for Banking & Government Examinations.
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