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 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.

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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 a 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.