A risk is a situation involving exposure to danger. It may be various types. But in the banking sector, we can specifically classify the risks into eight major types. It is very important to understand the nuances of risks, for better understanding as well as for banking exams. Let’s understand these in a simple way. The eight types of risk in banking are as follows:
- Credit Risk
- Market Risk
- Operational Risk
- Liquidity Risk
- Business Risk
- Reputational Risk
- Systematic Risk
- Moral Hazard
1). Credit Risk
According to the Basel Committee on Banking Supervision (BCBS), a bank is exposed to Credit Risk when a bank’s borrower or any counterparty fails to meet its payment obligation, regarding the terms and conditions agreed with the bank while availing credit. Credit Risk involves both the uncertainty involved in loan repayment as well as the delay in repayments. All types of banks which forward loans to its customers face credit risk. Payments bank doesn’t face Credit Risk, as these are not eligible to forward loans and credit card to its customers.
When a person or entity defaults on its payments for the loan availed, it may be due to various reasons. It may be due to inadequate income from the business for which loan was availed or complete failure of the business. But in some cases, Credit Risk may be due to the wilful default (when a person has sources to repay the loan but not repaying) by the concerned person or entity on payments.
Whatever be the reason for exposing to the Credit Risk, once a bank faces credit risk it has to take some remedial actions. One of them is loan provisioning by the banks. Loan provisioning is a process in which bank set aside some money from the profits earned, to pay to itself against the loan defaulted or NPA. Loan provisioning is crucial to keep the capital of bank unaffected.
2). Market Risk
According to the Basel Committee on Banking Supervision (BCBS), the market risk arises due to movement in market prices of the concerned bank at the stock market. Market risk is faced by a bank which is listed on stock exchange. The market risk may be further classified into subcategories as:
- Interest Rate risk
- Equity risk
- Foreign Exchange risk
- Commodity risk
a). Interest Rate risk
It arises due to fluctuations in the interest rate in the economy, may be due to changes in monetary policy rates etc. In terms of banking language, the management of interest rate risk is called Asset-Liability Management (ALM).
b). Equity Risk
Equity risk occurs due to change in stock prices of the company in which bank has some shareholding. When a bank forwards loan to companies it can accept some shareholding in the company as a collateral. But when the value of shares falls in the stock market, then equity risk is faced by the bank.
c). Foreign Exchange Risk
It occurs due to a change in the value of assets and liabilities of the bank due to fluctuations in the exchange rate of currency. Let a bank has taken some loan from some international organisation in dollars, but if the value of rupees falls against the dollar, then banks need to pay more rupees for the same amount of loan. This is somewhat we call foreign exchange risk.
d). Commodity Risk
Anything like gold, silver, coal, iron, steel, natural gas, petroleum products, etc are called commodities. If a bank is holding shares of a company which deals in these type of commodities, commodity risk is faced by a bank when there is a change in demand and supply of these commodities. If the demand of commodities falls, prices will also decrease and ultimately it will affect the bank because the bank is a shareholder in the concerned company.
3). Operational Risk
According to the Basel Committee on Banking Supervision (BCBS), an Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This includes legal risks but excludes strategic and reputational risks”.
An operational risk may occur due to various reasons. Some of the most important are the misuse of power by the authorized person, incompetency of the bank officer to handle the situation, the failure of information technology systems, hacking of the bank’s network, some programming error within the banking software, etc.
4). Liquidity Risk
Liquidity is something related to money. When a bank has enough money to carry out its day to day operations, such as making payment to depositors on demand, forwarding loan to its customers, then we say it has enough liquidity. But when a bank doesn’t have enough money for all such operations, then the bank faces liquidity risk.
To protect the banks against bank run (depositors want their money back but a bank is unable to repay) in this type of situation, Reserves Bank of India has made some provision to rescue banks. To protect banks against liquidity risk RBI has prescribed Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) norms on the banks. RBI also provides credit to banks under Repo (Repurchase option) facility to meet banks their short-term liabilities.
5). Reputational Risk
When the image of the bank deteriorates in the public, then the bank faces reputational risk. More the brand value of a bank lesser will be the reputational risk. The reputation of a bank falls when it is unable to honour its commitments to the government, regulator or to the public at large. Bad customer service, inappropriate behaviour of staff, and delay in making decisions are some of the factors which increases the reputational risk of the bank.
Like in India, State Bank of India has a bigger brand image in the public, so there is a lesser reputational risk with the SBI. Negative publicity about the bank also increases the reputational risk to the bank.
6). Business Risk
Business risk occurs when a bank is dynamic enough to take decisions on its strategy. If a bank is unable to change its strategy as per the changing competition in the market, it can lose its market value. Bad Strategy may also lead to merger or closer of the bank.
7). Systematic Risk
It is an indirect risk faced by banks due to the worst changes in the economic state of the nation. If the economy of the country effects, it gives some vibrations to the banking system also. When the entire economy of the country comes to a standstill, then bank exposes to systematic risk. It happened in 2008 due to financial crises at that time.
8). Moral Hazard
It refers to the situation when a person or entity has the willingness or tendency to take high-level risks, even if the concerned person or entity is not capable to bear the losses (if it occurs, due to the risk taken). In another way, moral hazard may also be defined as the situation in which some other person or entity is affected by the decisions taken by any third party.
Moral Hazard can be controlled if a bank has a strong board of directors to take remedial decisions when required. The regulatory authority of banks (RBI in India) can also help to control the moral hazard through moral suasion and direct action (fine or penalties) when required.