Banks and Bank Risks – Operational

and Liquidity Risks

Categories of Banking Risk
In banking and finance, the term 'risk' is generally associated with financial losses, but it
is more accurately described as uncertainty about the returns that will be earned on an
asset. It is an inherent part of a bank's business to bear certain risks in order to generate
returns for its shareholders.

Banks are exposed to a significant number of risks, which can be categorised into:

• credit risk
• operational risk
• liquidity risk
• market risk

How a bank defines these risks is important as the definitions are the basis for both the
qualitative and quantitative assessment of the bank’s exposure to the risks. As a result,
the generally accepted definitions have been continually refined over the years, helped
in no small part by supervisory authorities imposing capital charges and related
requirements against these risks.

In this tutorial, we will focus on operational and liquidity risks.

Do You Know? - Asymmetry of Risks

Banks’ risk exposures are asymmetric. For example, in relation to credit risk, the upside
of an exposure is generally a small positive yield, whereas the downside can be a loss of
up to 100% of the exposure.

This perceived asymmetry in risks means that banks tend to focus on identifying and
managing the key risk drivers that are more likely to result in losses. For example, when
conducting stress tests of their portfolios, they focus on the negative aspects of an
exposure. In the case of:

• credit risk, stress tests focus more on economic recessions than recoveries
• equity prices, stress tests focus more on stock market crashes than booms
• interest rates, stress tests focus more on increases than decreases

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What Is Operational Risk?
Operational risk is defined by the Basel Committee on Banking Supervision (BCBS) as
"the risk of loss resulting from inadequate or failed internal processes, people and
systems, or from external events." This definition includes legal risk, but excludes
reputational and strategic risk. Operational risk in banks can be further broken down into
‘sub-types’, including:

• information technology
• cyber
• fraud
• compliance
• money laundering
• legal
• outsourcing
• business continuity
• conduct
• terrorism

Some of these are often touted as separate risk types and the management of some,
such as compliance, money laundering and business continuity risk, often involves
separate and dedicated risk management units in a bank. These risks are nonetheless
part of the operational risk universe, despite the distinct labels and specialised oversight
groups.

Legal Risk
Legal risk is the risk that unenforceable contracts (in whole or in part), lawsuits, adverse judgments or
other legal proceedings will disrupt or adversely affect the operations or condition of a bank. It can
arise due to a variety of factors, from broad legal or jurisdictional issues to something as simple as a
missing provision in an otherwise valid agreement.

Reputational Risk
Reputational risk refers to the risk of possible damage to a bank’s brand and reputation, and the
associated risk to earnings, capital or liquidity arising from any association, action or inaction that
could be perceived by the bank’s stakeholders as inappropriate, unethical or inconsistent with its
values and beliefs.

Strategic Risk
Strategic (or business) risk incorporates the risk arising from an inadequate business strategy or from
an adverse shift in the assumptions, parameters, goals and other features that underpin a strategy. It
is therefore a function of:

• a bank's strategic goals

• the business strategies developed to achieve these goals
• the resources deployed in pursuit of these goals
• the quality of implementation of these resources

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Cyber Risk
Cyber risk refers to the risk of financial loss, business disruption or damage to the reputation of an
organisation from an event affecting its information assets or its computer and communication
resources.

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Operational Risk
A bank is exposed to operational risk from the moment it first opens its doors for
business. While this has always been the case, a combination of economic and
regulatory events in recent decades has served to raise the profile of operational risk.

Operational risk first came to the fore in the 1990s as a result of several well-publicised
operational risk failures, including the actions of a rogue trader that led to the collapse of
Barings Bank. More recently, the Libor scandal resulted in operational risk losses of
billions of dollars as of the end of 2015. These and many other operational risk events
highlight the continued danger posed by this risk. On the regulatory front, the BCBS
made its views clear when it introduced a capital charge to protect against this form of
risk in Basel II, published in 2004.

Libor
Libor is a benchmark rate that some of the world's leading banks charge each other for short-term
loans. It stands for London Interbank Offered Rate.

Basel II
Basel II is the international standard published by the BCBS that defines minimum capital
requirements for internationally active banks. Finalised in 2004, it was a follow-up to the first such
standard that was released by the BCBS in 1988 (Basel I). A further, comprehensive update of the
standard was published in 2010 (Basel III).

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Operational Risk Events
The following are a representative sample of high-profile operational risk events that
occurred in the banking industry in the aftermath of the financial crisis that began in
2007.

Conduct

Goldman Sachs, April 2016 – US authorities announced a USD 5.06 billion settlement
with Goldman Sachs related to its conduct in the residential mortgage-backed securities
market between 2005 and 2007.

Cyberattacks

Bangladesh Bank, February 2016 – Hackers succeeded in stealing USD 81 million from
Bangladesh Bank’s account with the Federal Reserve Bank of New York using the
Bangladesh central bank's credentials to transfer money to accounts in the Philippines.
The hackers’ attempt to steal almost USD 1 billion in total was thwarted by the discovery
of irregularities in some of their messages.

Money Laundering

HSBC, December 2012 – A US Senate investigation of HSBC’s failure to prevent

criminals from laundering money through the bank’s operations in Mexico and the United
States resulted in HSBC paying fines of USD 1.92 billion.

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Liquidity Risk
Liquidity relates to a bank’s ability to fund increases in assets and meet obligations as
they come due, without incurring unacceptable losses. It is crucial to the ongoing viability
of any banking organisation.

The fundamental role of banks in maturity transformation of short-term deposits into

long-term loans makes them inherently vulnerable to liquidity risk. For example, ideally a
bank would like to invest at the highest available yield and fund this investment at the
lowest possible cost. This often means borrowing very short-term (for example, by taking
deposits) and lending for a longer term (for example, by underwriting mortgages).

Borrowing short and lending long, however, creates a funding mismatch, which might
mean that a bank does not have sufficient liquidity to meet its commitments as they
come due. Much of the risk arises from the fact that a bank’s cash flows – both incoming
and outgoing – are uncertain because they are influenced by external events and the
behaviour of others.

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Nature of Liquidity Risk
There are two key dimensions to liquidity risk.

Funding Liquidity Risk

Funding liquidity risk is the risk that a bank will be unable to efficiently meet both
expected and unexpected current and future cash flow and collateral needs without
affecting either its daily operations or financial condition. Funding liquidity risk has
multiple causes. For example, the market’s perception of a bank’s credit quality may not
be favourable, leading to an increase in its cost of funds relative to competitor banks or,
at the extreme, the inability to obtain sufficient funds from the market at any cost. A
bank’s credit rating is therefore a crucial driver when it comes to funding liquidity.

A bank can also experience funding liquidity risk when its funding policy is inappropriate.
For example, a bank that comes to the market with frequent or unexpected funding
requirements may not be sending out the right signals, which may diminish the
willingness of other institutions to lend to the bank. In addition, the overuse of a
particular source of funding may result in an increase in funding cost relative to
competitors for that type of funding.

Market (Asset) Liquidity Risk

Market liquidity risk is the risk that a bank cannot easily sell an asset or unwind a
position at the market price. There is no single factor that gives rise to market liquidity
risk. It can arise from insufficient trading volume (market depth) or excess concentration
(market breadth) from having too few participants in the market for a particular asset.
Insufficient market depth or breadth can be characteristic for some assets, while the
market for other assets that are generally deep and broad can experience problems
during a systemic crisis. Whatever the cause, the less liquid the market for a given
asset, the longer it takes to sell off a position in that asset, especially if the position is
large.

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Dimensions of Liquidity Risk
The two dimensions of liquidity risk are closely related. For example, a bank whose cash
inflows are insufficient to meet its payment obligations (or cash outflows) at a particular
point in time may find that its only option is to sell assets or pledge them as collateral to
generate the necessary funds. If market conditions for these assets are unfavourable at
that time, the bank may have to settle for a lower price or less funding than it would
otherwise expect to obtain.

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Liquidity Value of Different Assets
Holding a pool of highly liquid assets is one of the tools banks use to help ensure they
are sufficiently liquid to meet their obligations not only in normal times, but also in times
of stress. Because of their high liquidity value, these assets can be more readily sold
when needed, or pledged as collateral to obtain additional funding (for example, from the
central bank).

However, different assets have different liquidity values, so not all are suitable for a
bank’s liquidity pool. The following table lists various assets and their relative liquidity
value.

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Review Question
Classify the following statements about liquidity risk in banks as True or False.

• Government securities are the most liquid of all assets a bank can hold.
(True/False)

• The inability of a bank to obtain sufficient funds from the market at a cost
comparable to those of its peers is an example of market liquidity risk.
(True/False)

• The fundamental role of banks in maturity transformation makes them inherently

vulnerable to liquidity risk. (True/False)

Cash and a bank’s balances with the central bank are the most liquid of all assets. To be
considered highly liquid, government securities must meet certain criteria, for example,
having been issued by governments with low credit risk. The inability of a bank to obtain
sufficient funds from the market at a cost comparable to those of its peers is an example
of funding liquidity risk, not market liquidity risk.

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