Risks and Their Management – Banking Sector
In my last article, I explained about NPAs and bad loans. In that context, I mentioned about PCA framework, which is a type of risk management framework. To understand this, first of all, we have to get familiar with the concept of risks and their management.
So what is a risk in the banking sector?
A risk may be defined as the probability of loss.
A more formal definition is,
An activity which ‘may’ give profit or loss is a risky proposition due to uncertainty or unpredictability of activity of trade in future.”
A risk is directly proportional to return on investment. Higher we take the risk, higher returns we may get.
Two historical developments in the context of banking:
- Deregulation: More autonomy to banks to lend, invest, decide interest rates etc.
- Technological innovation: Created efficient environment for the fast delivery of services, new products, these help manage assets and liabilities, but have also increased complexity and diversity of risk.
There are many types of risks, as mentioned in the diagram below:
Let’s discuss them one by one.
- Liquidity risk: It arises when a bank does not have enough money to pay back its lenders. How does a bank do its business? The money we deposit in our current or saving accounts (CASA) or capital accounts (Fixed deposit or recurring deposit, FDRD), banks do business by using that money. They distribute loans at a rate higher than they give us on CASA or FDRD; they invest in market shares to get much higher returns and make money out of that. But higher returns means higher risk, that means sometimes they suffer from huge losses too. In that condition, they cannot pay back to its lenders.
- Funding risk – Funding risk arises when banks don’t have enough fund to meet cash flow obligations. Suppose 80% of people in a town have done insurance of their houses from the same bank and an earthquake destroys all the houses. In that case, all the people will go to the bank to reclaim their insurance amount, which the bank may be unable to fulfil at that time. This is an example of a funding risk.
- Time risk – Time risk arises when performing assets start turning into non-performing assets, hence banks need to compensate the money which was expected to come back in the form of loan interest. People defaulting on a loan can lead to time risk. The example is Vijay Mallya.
- Call risk – Any future contingency which can cause a huge outflow of money gives rise to this type of risk. For example – bank losing a legal battle which may pose to a huge fine.
- Interest rate risk: This type of risk arises due to movement in interest, which can cause the borrowing rate of bank greater than its lending rate, in turn causing a loss for the bank. For example, a bank gives loan at the rate of 9 percent and borrows at 8 percent. After some time the rate of borrowing becomes 9.5 percent. If now the bank needs to borrow, it will have to suffer from loss. This situation gives rise to interest rate risk.
- Market risk: This risk arises due to unfavourable movement in market prices of commodities/shares/stocks/currency in which the bank has invested. Suppose one dollar equals 65 Indian rupees, and a bank has purchased something worth 50000 dollars. Now the value of Indian rupee improves to 60 a dollar. So by selling that commodity bank will suffer a loss of (65-60) X 50000 = 250000 INR. This is the example of market risk.
Interest rate risk is also a type of market risk.
- Credit risk or default risk: When a bank borrower or counterparty is unable to meet its obligation in accordance with their agreed terms, then this type of risk arises. It has two types –
- Counterparty risk – It is more or less same as time risk. This risk arises due to counterparty’s refusal and/or inability to perform as per contract.
- Country risk – If the non-performance of the trading partners is due to restrictions imposed by their country, then this type of credit risk arises.
These types of risk can be mitigated up to an extent by putting a cap on loan amounts, and by rules such as verifying the trustworthiness of the counterparty by credit rating agencies, etc.
- Operational Risk: Operational risk is an internal risk, which may arise due to the bad intention of staff, or hacking of system, or wrong processes. It has two types –
- Transaction risk – Transaction risk arises due to frauds, internal or external; or failed business processes due to the inability of staff to do their work properly.
- Compliance risk – If a bank fails to comply with any or all of the rules and regulation, code of conduct or standard practices, it may cause a huge loss of money in the form of fine and loss of reputation of the organisation due to legal action on them. So this risk is manageable. Also called integrity risk since a bank’s reputation is closely linked to its adherence to the principle of integrity and fair dealing.
- Other types of risk:
- Strategic risk: Risky business decisions, improper implementation of them and lack of responsiveness to latest market updates in industry lead to this type of risk. This risk may pose a problem to achieve an organisation its strategic vision. For example, if there are two banks, one of them allows their customers to do every banking activity online, whereas another bank is not updated enough to provide this online facility, then other bank’s business will hamper.
- Reputation risk: reputation risk is the risk arising from negative public opinion. For example, suppose a news publishes in the newspaper about a bank that it may default. Then all account holders will withdraw their money and no new person will open his/her account, posing to other risks for the bank.
- Systematic risk – risk which affects the entire market is called systematic risk. This risk is unavoidable, hence has to be endured by every organisation.
The risks are unpredictable and impossible to avoid completely. Hence various measures are taken time to time to minimise their intensity and ensure the steadiness and sustainability of an economy. When the economy is talked about, then there a need arises of interference of a central agency. In our case, RBI is that central agency. To mitigate the risks, various risk management frameworks are defined and implemented.
To be continued…
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