BANK’s RISKS

1) Risk may be defined as “Possibility of loss”.

2) Three types: credit, market and operational risks; based on Basel two. Also, we have other risks
such as liquidity, business, reputational, systemic and moral hazard.

a) Credit Risk
Potential that a bank borrower, or counter party, will fail to meet its payment obligations regarding the
terms agreed with the bank.

Caused by loans, acceptances, interbank transactions, trade financing, foreign exchange transactions,
financial futures, swaps, bonds, equities, options, etc.

1) Counterparty risk

Is the risk to each party of a contract that the counterparty will not live up to its contractual obligations.

2) Country risk

Is a risk associated with investing in a foreign country.

In this default by a borrower or non-repayment of due arises due to constraints or restrictions imposed
by a country.

This includes political, exchange rate, economic, sovereign and transfer risk, which is a risk of capital being
locked up or frozen by government action.

b) Market risk
This risk results from the adverse movements in the level or volatility of the market prices of interest rate
instruments, equities, commodities and currencies.

Its also referred to as Price Risk.

The Bank for International Settlements (BIS) defines market risks as the risk of losses in on or off-balance
sheet position that arise from movement in market prices.

This risk is mainly prevalent in Investment Banks because they are active in capital markets.

1) Interest rate risk: potential losses due to fluctuations in interest rate. The immediate impact of
changes in interest rates in on the Net Interest Income (NII)1.
2) Equity risk: potential losses due to fluctuations in stock price.
3) Currency risk: potential losses due to international currency exchange rates. Also called ‘FOREX
Risk’.

1
NII = Interest earned – Interest paid
 4) Commodity risk: potential losses due to fluctuations in prices of agricultural, industrial and energy
commodities like wheat, copper and natural gas respectively.

c) Operational risk
According to BIS, this risk is defined 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 strategic and reputation risk.

1) Human risk: potential losses due to human error, done willingly or unconsciously.
2) IT/System risk: potential losses due to system failures and programming errors.
3) Processes risk: potential losses due to improper information processing, leaking or hacking of
information and inaccuracy of data processing.

d) Liquidity risk
Probability of loss arising from a situation where:

1) There will not be enough cash and/or cash equivalents to meet the needs of depositors and
borrowers.
2) Sale of illiquid assets will yield less than their fair value.
3) Illiquid assets will not be sold at the desired time due to lack of buyers.

e) Business risk
The possibility that a company will have lower than expected profits, or that it will experience a loss rather
than a profit.

In the banking sector, this risk is associated with the failure of a bank’s long-term strategy, estimated
forecasts of revenue and number of other things related to profitability.

The entire industry is unpredictable. Long term strategies must have backup plans (BCP) to avoid business
risks.

f) Reputational risk
The Federal Reserve Board defines this risk as the potential loss in reputational capital based on either or
perceived losses in reputational capital.

This risk can be triggered by bank’s activities, rumor about the bank, willing or unconscious non-
compliance with regulations, data manipulation, bad customer services, etc.
 g) Systemic risk
Is the risk that does not affect a single bank or financial institution, but it affects the whole industry.

This are associated with cascading failures where the failure of a big entity can cause the failure of all
others in the industry.

h) Moral Hazard
Is a risk that occurs when a big rank or large financial institution takes risks, knowing that someone else
will have to face the burden of those risks.

Paul Krugman described moral hazard as ‘Any situation in which one person makes the decision about
how much risk to take, while someone else bears the cost if things go badly’.

Mark Zandi described moral Hazard as a root cause of the crisis in 2008 and 2009.

For the Economic Times, moral hazard is a situation in which one party gets involved in a risky event
knowing that it is protected against the risk and the other party will incur the cost. It happens in an
incomplete information (asymmetry information) scenario.