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Contents

1. Introduction to risk
2. Types of Risk
2.1. Credit risk
2.2. Operational risk
2.3. Market risk
2.4. Liquidity risk
2.5. Sovereign risk
2.6. Systematic risk
2.7. Systemic Risk
3. Questions for practice

Introduction to Risk

1. Introduction

In simple terms, risk is the possibility of something bad happening. Risk

involves uncertainty about the effects/implications of an activity with
respect to something that humans value, often focusing on negative,
undesirable consequences.

Uncertainty/doubt/skepticism/suspicion/mistrust mean lack of sureness

about someone or something. uncertainty may range from a falling short of
certainty to an almost complete lack of conviction or knowledge especially
about an outcome or result.

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 There is a very simple relation between the uncertainty and risk. It’s an old
adage, which says that “Uncertain times gives the higher probability of the
happening of a negative event”. It means that, when the future is not clear,
and the look of future events is gloomy, higher will be probability of loss or a
negative outcome.

As risk is directly proportionate to return, the more risk a bank takes, it can
expect to make more money.

Lower risk implies lower variability in net cash flow with lower upside and
downside potential. Higher risk would imply higher upside and downside
potential.

Suppose you invest in bonds issued by RBI at 5% per annum. Here you do
not face any risk because RBI will always return the money back.

Even if RBI goes into loss, RBI has the power to print more money. So, this is
risk free investment. But here the return of 5% would be lower than what
you would get from other investments which are risky.

Zero-Risk would imply no variation in net cash flow. Return on zero-risk

investment would he low as compared to other opportunities available in
the market.

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 2. Types of risk

Types of
Risk

Operational Liquidity Market Sovereign Systematic Systemic

Credit Risk
Risk Risk Risk Risk Risk Risk

2.1 Credit risk

Credit risk can be defined as a potential of a borrower or counterparty to

fail to meet its obligations with respect to the agreed terms. Credit risk is
also known as “default risk”.

For example, between 2008 and 2010, many Indian banks granted huge
loans to the Kingfisher airline. But the same airline in 2012 defaulted on the
principal and interest payment. And after 90 days of non-repayment, the
loan was tagged as a Non-Performing Asset (NPA). Thus, it created huge
credit risk for the banks.

2.2 Operational risk

The Operational risk can be defined as the risk of loss resulting from
inadequate or failed internal processes, people and system. It arises due to
the bad intensions of staff, hacking of system and failure to meet the
required regulatory compliance.
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 For example, a fraud of INR 14,400 Crore took place at PNB (Punjab National
Bank). There were many failures of internal controls in the bank such as bank
employees issued fake Letter of Credits (LOC). This unanticipated operational
risk caused a very large financial loss to the Punjab National Bank.

2.3 Market risk

Market risk is the risk of losses on financial investments caused by adverse

price movements. It is due to the unpredictability of equity markets,
commodity prices, interest rates. Market risk is also known as “price risk”.

For Example, during Global Financial Crisis (2008), when the global housing
asset bubble busted, the value of houses dropped historically. Which
resulted in huge losses to the investors. Thus, market risk arises when there
is high upside or downside movement of prices of a specific asset.

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 2.4 Liquidity risk

Liquidity risk refers to the ability of a financial institution to access cash to

meet their funding obligations. In the case of banks, financial obligations
include allowing customers to withdraw their demand deposits.

For example, IL&FS Financial Services, defaulted in payment obligations of

bank loans. The defaults triggered a liquidity crisis in the financial services
market because IL&FS and its subsidiaries owe ₹99,354 crore to different
companies.

2.5 Sovereign risk

Sovereign Risk is the risk that occurs when a government cannot repay its
debt. It is a situation when a government defaults on the loans taken.

For example, the debt crisis of the Greek government during which occurred
as an aftermath of the financial crisis of 2008, crises occurred because of
improper management of funds and lack of flexibility in the monetary
policies, as a result, the performance of the Greek economy plunged, and
the confidence of the global investors eroded.

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 2.6 Systematic risk

Systematic risk refers to the risk inherent to the entire market or market segment. It
affects the overall market, not just a particular stock or industry. Systematic risk, also
known as “un-diversifiable risk”.

For example – In the last 2 years, the world is facing a major health crisis due to the
presence of COVID-19. The risk exerted out of lockdowns is universal and many
businesses around the world are seeing a fall in their respective incomes. Thus,
COVID-19 can be termed as systematic risk because it is pervasive in nature.

2.7 Systemic risk

Systemic risk is the possibility that an event at the company level could
trigger severe instability or collapse an entire industry or economy. In a
financial context, it denotes the risk of a cascading failure in the financial
sector, caused by linkages within the financial system, resulting in a severe
economic downturn.

For example - In 2008, the collapse of Lehman Brothers caused a huge panic
and triggers in the entire financial system of the world business
environment.

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 Questions for practice
Question 1 - In Banking Sector, Market risk arises mainly due to ? (RBI Phase 2 – 2019)

Option A – Political Factors

Option B – Internal Factors
Option C – External factors
Option D – Natural Calamities
Option E – None of the above

Answer – Option C

Question 2 – Operational Risk in an organization arises from which of the following reasons?
(RBI Phase 2 – 2019)

Option A – New regulatory norms

Option B – Inadequate internal control process.
Option C – Inadequate external control process
Option D – Strict internal control process
Option E – None of the above

Answer – Option B

Question 3 – Systematic Risk is also known as ?

Option A – Diversifiable risk
Option B – Market Risk
Option C – Controllable risk
Option D – Un-diversifiable risk
Option E – None of the above

Answer – Option D

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