Types of Risks in Banks – Concepts and Definition

Honey Lalwani

2 months ago

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.

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.

Liquidity Risk

Arises from financing long-term assets with short-term liabilities or vice versa.
Funding Liquidity Risk: Difficulty in obtaining funds to fulfill cash flow obligations.
Funding Risk: Necessity to replace net outflows due to unexpected deposit withdrawals.
Time Risk: Compensating for delays in receiving anticipated fund inflows, potentially leading to NPAs.
Call Risk: Arises from the crystallization of contingent liabilities.

Interest Rate Risk

Results from adverse interest rate movements during the holding period of assets or liabilities.
Gap or Mismatch Risk: Discrepancies in maturities of assets, liabilities, and off-balance sheet items.
Yield Curve Risk: Variations in the yield curve due to different benchmark rates for various instruments.
Basis Risk: Changes in interest rates on assets or liabilities in different magnitudes.
Embedded Option Risk: Arises from contracts with customer call options, impacting the net interest margin.
Reinvestment Risk: Uncertainty about reinvesting cash inflows after loan or investment repayment.
Net Interest Position Risk: Exposure to reduced Net Interest Position in a declining market interest scenario.

Market or Price Risk

Arises from adverse movements in the value of investments in a trading portfolio.
Foreign Exchange Risk: Fluctuations in rates of different currencies, potentially causing losses.
Market Liquidity Risk: Inability to conclude large transactions in a specific instrument at the current market price.
Default or Credit Risk: Possibility of a borrower failing to meet obligations, more prevalent in loans.
Counterparty Risk: Non-performance of trading partners in trading activities.
Country Risk: Non-performance due to restrictions imposed by the counterparty’s country.

Operational Risk

Arises from failed internal processes, people, systems, or external events.
Includes sub-risks such as fraud risk, competence risk, system risk, legal risk, documentation risk, model risk, and external events risk.

Other Risks

Strategic Risk: Arises from adverse business decisions or improper implementation.
Reputation Risk: Originates from negative public opinion, potentially leading to litigation, financial loss, or a decline in customer base.

How to Measure Risks in Banks?

Measuring risks in banks is a critical aspect of risk management to ensure the stability and soundness of the financial institution. There are various methods and tools employed to assess and quantify risks in banks. Here are some common approaches:

Credit Risk:

Credit Scoring Models: Assess the creditworthiness of borrowers based on historical data, financial statements, and other relevant factors.
Credit Risk Models: Use statistical techniques to estimate the probability of default, loss given default, and exposure at default.

Market Risk:

Value at Risk (VaR): Estimates the potential loss in market value of a portfolio given a certain level of confidence over a specific time horizon.
Sensitivity Analysis: Examines how changes in market variables impact the bank’s portfolio.

Operational Risk:

Loss Data Analysis: Reviews historical data on operational losses to identify patterns and trends.
Key Risk Indicators (KRIs): Monitors predefined indicators that signal potential operational issues.

Liquidity Risk:

Gap Analysis: Assesses the maturity profile of assets and liabilities to identify potential funding gaps.
Stress Testing: Simulates adverse scenarios to evaluate the bank’s ability to withstand liquidity shocks.

Interest Rate Risk:

Earnings at Risk (EaR): Measures the potential impact of interest rate changes on a bank’s earnings.
Duration Analysis: Assesses the sensitivity of the portfolio to changes in interest rates.

Compliance and Legal Risks:

Regulatory Compliance Audits: Ensures adherence to regulatory requirements.
Legal Risk Assessments: Identifies and manages legal risks associated with contracts, litigation, and other legal matters.

Reputation Risk:

Customer Feedback and Surveys: Monitors customer satisfaction and feedback.
Media Monitoring: Keeps track of media coverage and public perception.

Concentration Risk:

Portfolio Diversification Analysis: Examines the concentration of risks across various segments.
Geographic and Industry Exposure Analysis: Assesses risk concentrations in specific regions or industries.

Cybersecurity Risk:

Vulnerability Assessments: Identifies weaknesses in the bank’s cybersecurity infrastructure.
Incident Response Planning: Prepares for and responds to cybersecurity incidents.

Recovery and Resolution Planning:

Contingency Planning: Develops strategies to address potential crises and ensure the bank’s resilience.

Banks often use a combination of quantitative models, stress testing, scenario analysis, and qualitative assessments to comprehensively measure and manage risks. Regular monitoring and updating of risk measurement methodologies are crucial to adapt to changing market conditions and regulatory requirements.

You can read more notes on Banking Awareness as well as download the free E-Books for your preparation for Banking & Government Examinations.