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.

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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 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.

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.

Credit Risks

Credit risk is the risk that arises from the possibility of non-payment of loans by the
borrowers. Although credit risk is largely defined as risk of not receiving payments, banks
also include the risk of delayed payments within this category.

Often times these cash flow risks are caused by the borrower becoming insolvent. Hence,
such risk can be avoided if the bank conducts a thorough check and sanctions loans only to
individuals and businesses that are not likely to run out of income over the period of the loan.
Credit rating agencies provide adequate information to enable the banks to make informed
decisions in this regard.

The profitability of a bank is extremely sensitive to credit risks. Hence, even if credit risk
rises by a small amount, the profitability of the bank can get extremely impacted. Therefore,
to deal with such risks banks have come up with a wide variety of measures. For instance,
banks always hold a certain amount of funds in reserves to mitigate such risks.

The moment a loan is made, a certain amount of money is appropriated to the provision
account. Also, banks have started utilizing tools like structured finance to mitigate such risks.
Securitization helps remove the concentrated risk from the bank’s books and diffuse it
amongst the various investors in the capital markets. Credit derivatives like credit default
swap have also come into existence to help banks survive in the event of a credit default.

Unpaid loans were, are and will always be a byproduct of conducting the banking business.
Modern banks have realized this and are prepared to handle the situation without becoming
insolvent until a catastrophic loss occurs.

Market Risks

Apart from making loans, banks also hold a significant portion of securities. Some of these
securities are held because of the treasury operations of the bank i.e. as a means to park
money for the short term. However, many securities are also held as collateral based on
which banks have given loans to their customers. The business of banking is therefore
intertwined with the business of capital markets.

Banks face market risks in various forms. For instance if they are holding a large amount of
equity then they are exposed to equity risk. Also, banks by definition have to hold foreign
exchange exposing them to Forex risks. Similarly banks lend against commodities like gold,
silver and real estate which exposes them to commodity risks as well.

In order to be able to mitigate such risks banks simply use hedging contracts. They use
financial derivatives which are freely available for sale in any financial market. Using
contracts like forwards, options and swaps, banks are able to almost eliminate market risks
from their balance sheet.

Operational Risks

Banks have to conduct massive operations in order to be profitable. Economies of scale work
in the favor of larger banks. Hence, maintaining consistent internal processes on such a large
scale is an extremely difficult task.

Operational risk occurs as the result of a failed business processes in the bank’s day to day
activities. Examples of operational risk would include payments credited to the wrong
account or executing an incorrect order while dealing in the markets. None of the
departments in a bank are immune from operational risks.

Operational risks arise mainly because of hiring the wrong people or alternatively they could
also occur if there is a breakdown of the information technology systems. A lapse in the
internal processes being followed could also lead to catastrophic errors. For instance, Barings
Bank ended up bankrupt because of its failure to implement appropriate internal controls.
One trader was able to bet so much in the derivatives market that the equity of Barings Bank
was wiped out and the bank simply ceased to exist.

Moral Hazard

The recent bailout of banks by many countries has created another kind of risk called the
moral hazard. This risk is not faced by the bank or its shareholders. Instead, this risk is faced
by the taxpayers of the country in which banks operate. Banks have become accustomed to
taking excessive risk. If their risk pays off, they get to keep the returns. However, if their risk
backfires, then the losses are borne by taxpayers in the form of bailouts. This too big to fail
model has caused banks to become reckless in their pursuit of profit. Although central banks
are using audits to ensure that safe business practices are followed, banks nowadays indulge
in risky business the moment they are not under regulatory oversight.

Liquidity Risk

Liquidity risk is another kind of risk that is inherent in the banking business. Liquidity risk is
the risk that the bank will not be able to meet its obligations if the depositors come in to
withdraw their money. This risk is inherent in the fractional reserve banking system.
Therefore, in this system, only a percentage of the deposits received are held back as
reserves, the rest are used to create loans. Therefore, if all the depositors of the institution
came in to withdraw their money all at once, the bank would not have enough money. This
situation is called a bank run. This has happened countless times over the history of modern
banking.

Modern day banks are not very concerned about liquidity risk. This is because they have the
backing of the central bank. In case there is a run on a particular bank, the central bank
diverts all its resources to the affected bank. Therefore, the depositors can be paid back when
they demand their deposits. This restores depositor’s confidence in the banks finances and the
run on the bank is averted.

Many modern day banks have faced bank runs. However, none of them have become
insolvent due to a bank run post the establishment of central banks.

Business Risk

The banking industry today is considerably advanced and diversified. Banks today have a
wide variety of strategies from which they have to choose. Once such strategy is chosen,
banks need to focus their resources on obtaining their strategic goals in the long run.

Hence, there is always a risk that a given bank may choose the wrong strategy. As a result of
this wrong choice, the bank may suffer losses and end up being acquired or may simply
collapse. Consider the case of banks such as Washington Mutual and Lehman Brothers.
These banks chose the subprime route to growth. Their strategy was to be the preferred lender
to people who have less than perfect credit scores. However, the whole area of subprime
lending went bust and since these banks had heavy exposures to such loans, they suffered dire
consequences too.

Banks have no possible way to mitigate the risks that are created by following inappropriate
business objectives. Which objectives were right and which were wrong? This question can
only be answered in hindsight. When Lehman Brothers was focusing their resources on
subprime lending, it must have seemed like the strategically right thing to do!

Reputational Risk

Reputation is an extremely important intangible asset in the banking business. Banks like JP
Morgan bank, Chase bank, Citibank, Bank of America etc have all been in the business for
hundreds of years and have stellar reputations. These reputations enable them to generate
more business more profitably.
Customers like their money to be deposited at places which they believe follow safe and
sound business practices. Hence, if there is any news in the media which projects a given
bank in a negative light, such news negatively impacts the banks business. For instance
Citibank was recently viewed as manipulating the Forex rates via conducting false trades
with its own trading partners. When regulators found out about Citibank’s predatory tactics,
they levied huge fines on the bank.

Apart from the fines Citibank also lost reputation as a bank that follows fair trade practices
when the customers found out that they tend to resort to market manipulation. Many
prospective customers may have shifted their business away from Citibank as a result of this
discovery causing monetary loss as a result of reputation loss.

Banks can save their reputation by ensuring that they never participate in any unfair or
manipulative business practices. Also, banks need to continuously ensure that their public
relations efforts project them as a friendly and honest bank.

Systemic Risk

Systemic risk arises because of the fact that the financial system is one intricate and
connected network. Hence, the failure of one bank has the possibility to cause the failure of
many other banks as well. This is because banks are counterparties to each other in a lot of
transactions. Hence, if one bank fails, the credit risk event for the other banks becomes a
reality.

They have to write off certain assets as a result of the failure of their counterparty. This
writing off often leads to the bankruptcy of other banks and an unstoppable domino seems to
take over. Systemic risk is an extremely bad scenario to be in. For instance when the
subprime crisis happened in 2008, it seemed like the entire global financial system would
collapse.

The very nature of banking system therefore makes them prone to systemic risks. Systemic
risks do not affect an individual bank rather they affect the entire system. Hence, there is very
little that an individual bank can do to protect itself in the event that such a risk materializes.

Thus, the management of banks requires a lot of skill since multiple types of risks need to be
mitigated. Some of these risks can be avoided whereas for the others the best that banks can
do is to minimize their damage.