Modern banking system and different types of associated risk!
- Ravendra Kumar | Senior Consultant
- Sep 1, 2024
- 5 min read
Global economies have grown enormously, driven by the dissemination of knowledge and the ambition to become significant economic powerhouses. This transformation is primarily fueled by advancements in technology, globalization, demographic shifts, and policy decisions. Over the past 20 years, the global economy has seen massive growth, led by India and China, lifting millions out of poverty and integrating them into the mainstream. However, this period also witnessed the 2008 economic crisis and the global shutdown due to COVID-19 in 2019. Despite the COVID-19 crisis, most developing nations experienced a V-shaped recovery, prompting a large segment of the population to seek new ways to interact within society and the economy. The widespread accessibility of smartphones and the internet has fostered financial inclusion and enhanced liquidity through digital payments. However, these advancements bring new challenges, rendering the financial system more vulnerable and fragile.
“The digital revolution has catalyzed increases in the access and use of financial services across the world, transforming ways in which people make and receive payments, borrow, and save,” said World Bank Group President David Malpass. “Creating an enabling policy environment, promoting the digitalization of payments, and further broadening access to formal accounts and financial services among women and the poor are some of the policy priorities to mitigate the reversals in development from the ongoing overlapping crises.”
The modern banking system faces various risks, both traditional and emerging due to the evolution of financial systems. Major risks today include credit risk, market risk, liquidity risk, operational risk, reputational risk, compliance risk, interest rate risk, cybersecurity risk, and ESG risk. Regulations vary globally in scope and applicability. Key regulatory bodies such as the Basel Committee on Banking Supervision (BCBS), the Financial Accounting Standards Board (FASB), and the Federal Reserve are responsible for drafting and implementing these regulations.
As this is the first article in the series of risk- I would like to keep this short and crisp while taking about the different types of risk associated with the banks.
1. Credit Risk
Definition: The risk that a borrower or counterparty will fail to meet its obligations according to the agreed terms. Hence counterparty risk can be considered as a type of credit risk.
Impact: Non-repayment of loans can lead to financial losses for the bank, affecting its profitability and capital adequacy.
Management: Credit risk is managed through credit scoring, collateral requirements, loan covenants, credit derivatives, and diversification of the loan portfolio.
2. Market Risk
Definition: The risk of losses in on- and off-balance-sheet positions arising from movements in market prices, such as interest rates, exchange rates, and equity prices.
Impact: Changes in market prices can lead to losses on trading positions, affect the value of assets and liabilities, and impact the bank’s earnings and capital.
Management: Market risk is managed using tools like Value at Risk (VaR), stress testing, and hedging strategies using derivatives.
3. Liquidity Risk
Definition: The risk that a bank will not be able to meet its short-term financial obligations due to the inability to convert assets into cash or access funding.
Impact: Liquidity shortages can force a bank to sell assets at a loss or fail to meet its obligations, leading to insolvency.
Management: Liquidity risk is managed by maintaining adequate liquid assets, performing cash flow forecasting, and adhering to regulatory requirements like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
4. Operational Risk
Definition: The risk of loss resulting from inadequate or failed internal processes, people, systems, or external events.
Impact: Operational risks can lead to financial losses, legal penalties, and reputational damage.
Management: Operational risk is managed through robust internal controls, risk assessments, disaster recovery plans, and insurance.
5. Reputational Risk
Definition: The risk of damage to a bank’s reputation, leading to a loss of customers, revenue, or shareholder value.
Impact: Reputational damage can result from poor customer service, regulatory fines, fraud, or unethical behavior, leading to a loss of trust and business.
Management: Reputational risk is managed by maintaining high ethical standards, strong corporate governance, and effective communication strategies.
6. Compliance Risk
Definition: The risk of legal or regulatory sanctions, financial loss, or reputational damage due to non-compliance with laws, regulations, or internal policies.
Impact: Failure to comply with regulations can lead to fines, legal penalties, and damage to the bank’s reputation.
Management: Compliance risk is managed by establishing a robust compliance program, continuous monitoring, employee training, and regular audits.
7. Interest Rate Risk
Definition: The risk of loss resulting from changes in interest rates, which can affect a bank’s net interest margin, the value of assets and liabilities, and overall profitability.
Impact: Fluctuations in interest rates can lead to mismatches between the interest earned on assets and the interest paid on liabilities, affecting the bank’s earnings.
Management: Interest rate risk is managed through asset-liability management (ALM), interest rate swaps, and hedging strategies.
8. Foreign Exchange Risk (Currency Risk)
Definition: The risk of loss due to adverse movements in exchange rates affecting the value of a bank’s foreign currency holdings.
Impact: Currency fluctuations can lead to losses on foreign currency assets and liabilities, impacting the bank’s profitability.
Management: Foreign exchange risk is managed through currency hedging, matching foreign currency assets and liabilities, and monitoring exposure limits.
9. Strategic Risk
Definition: The risk of loss arising from adverse business decisions, improper implementation of decisions, or a lack of responsiveness to industry changes.
Impact: Poor strategic decisions can lead to loss of market share, reduced profitability, and long-term financial instability.
Management: Strategic risk is managed by conducting thorough market research, scenario planning, and regularly reviewing and adjusting the bank’s strategic plan.
10. Country Risk (Sovereign Risk)
Definition: The risk of loss due to a country’s inability or unwillingness to meet its financial obligations, which can affect the bank’s international operations.
Impact: Sovereign defaults or political instability in a foreign country can lead to losses on loans or investments in that country.
Management: Country risk is managed through diversification of international exposure, political risk insurance, and careful assessment of country risk profiles.
11. Cybersecurity Risk
Definition: The risk of financial loss, disruption, or reputational damage resulting from a cyberattack or data breach.
Impact: Cyberattacks can lead to loss of sensitive information, financial theft, operational disruptions, and damage to customer trust.
Management: Cybersecurity risk is managed by implementing robust cybersecurity measures, regular security audits, employee training, and incident response planning.
12. Model Risk
Definition: The risk of loss resulting from errors in the design, implementation, or use of models used for decision-making in areas like credit risk, market risk, and capital management.
Impact: Inaccurate models can lead to poor decision-making, financial losses, and regulatory scrutiny.
Management: Model risk is managed by conducting rigorous model validation, stress testing, and ensuring that models are based on sound assumptions and data.
13. Environmental, Social, and Governance (ESG) Risk
Definition: The risk of financial loss or reputational damage arising from environmental, social, and governance issues, such as climate change, social unrest, or poor corporate governance.
Impact: ESG risks can affect the bank’s operations, investment portfolio, and overall reputation.
Management: ESG risk is managed by integrating ESG considerations into risk management frameworks, adopting sustainable finance practices, and engaging in responsible corporate governance.
In the last, now we have high level understanding of what is the banking risk and what are the different types. In the upcoming articles we will be covering some of these risks in details from the learning perspective.
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