Major Types of Risks
Operational Risk human errors, technical faults, infrastructure breakdown, faulty
systems and procedures or lack of internal controls
Operational risk can be controlled by:
a. providing state of art systems and specified contingency
plans,
b. disaster control procedures, and sufficient back-up
arrangements for man and machine,
c. A duplication process at a different site (mirroring).
Exchange Risk on account of fluctuations in exchange rates and/or when
mismatches occur in assets/ liabilities and receivables/payables
Credit Risk arises due to inability or unwillingness of the counter party to meet
the obligations at maturity of the underlying transaction. Credit risk is
further classified into pre-settlement risk and settlement risk.
Pre-settlement risk: failure of the counter party before maturity of
the contract thereby exposing the other party to cover the
transaction at the ongoing market rates. This entails the risk of only
market differences and is not an absolute loss for the bank
Settlement risk: risk of failure of the counter party during the
course of settlement, due to the time zone differences, between the
two currencies to be exchanged.One party to a foreign exchange
transaction could pay out the currency it sold but not received the
currency it bought. This principal risk in the settlement of foreign
exchange transaction is variously called foreign exchange
settlement risk or temporal risk or Herstatt risk( after failure of
Bankhaus Herstat of Germany in 1974)
Methods to mitigate settlement risk are:
a. applying credit lines (limits) to each counter party to reduce
the risk.
b. settlement systems, operating on a single time basis, as also
on real-time gross settlement basis, are put in place.
c. time zone differences could be eliminated, if the global books
are linked to a single time zone, say GMT closing.
Liquidity Risk Potential for liabilities to drain from the bank at a faster rate than
assets. The mismatches in the maturity patterns of assets and
liabilities give rise to liquidity risk.
When a party to a foreign exchange transaction is unable to meet its
funding requirement or execute a transaction at a reasonable price,
it creates Liquidity Risk
It is also the risk of the party not being able to exit or offset positions
quickly at a reasonable price.In a deal of US dollar purchase against rupee, if the party selling US
Dollar is short of funds in the nostro account, then it may not be
possible for him to generate/borrow or buy USD to fund the USD
account. Liquidity risk is said to have arisen.
Liquidity risk mitigation is done by:
a. control the mismatches between maturities of assets and
liabilities
b. fixing limits for maturity mismatches and reduce open
positions
Gap Risk/Interest
Rate Risk
arises due to adverse movement of interest rates or interest rate
differentials
If the purchase and sale take place for different value, while the
bank may
completely stand hedged on exchange front, it creates a mismatch
between its assets and liabilities referred to as GAP
These gaps are to be filled by the bank by paying/receiving
appropriate forward differentials. These forward differentials are in
turn a function of interest rates and any adverse movement in
interest rates would result in adverse movement of forward
differentials thus affecting the cash flows on the underlying open
gaps or mismatches. Therefore, it is the risk arising out of adverse
movements in implied interest rates or actual interest rate
differentials
Interest rate risk also occurs when different bases of interest rates
are applied to assets and corresponding liabilities.
Volatility in interest rates is due to:
a. The increasing capital flows in the global financial markets
b. the economic disparities between nations and the increased
use of interest rates as a regulatory tool for macro- economic
controls
Mitigation of interest rate risk is done by:
a. undertaking appropriate swaps, or
b. matching funding actions or
c. through appropriate risk mitigating interest rate derivatives
Market Risk due to adverse movement of market variables when the players are
unable to exit the positions quickly
Legal Risk On account of non-enforceability of contract against a counter party.Legal risk also includes compliance and regulations related risks,
arising out of non-compliance of prescribed guidelines or breach of
governmental rules, leading to wrong understanding of rules and
penalties by the enforcing agencies.
Systemic Risk possibility of a major bank failing and the resultant losses to counter
parties reverberating into a banking crisis.
Country Risk
/Political Risk
counter party situated in a different country unable to perform its
part of the contractual obligations despite its willingness to do so
due to local government regulations or political or economic
instability in that country.
A country giving very high returns is generally:
a. Faces high country risk
b. Not too many countries or instutions are ready to invest in
that country. Hence they try to attract these institutions by
giving high returns
Sovereign Risk sub-risk in the overall country risk in that certain state-owned entities
themselves quoting their sovereign status claim immunity from any
recovery proceedings of fulfillment of any obligations they had
originally agreed to.
Sovereign risk can be reduced by
a. inserting disclaimer clauses in the documentation
b. making the contracts and the sovereign counter parties
subject to a third country jurisdiction
Operational Risk human errors, technical faults, infrastructure breakdown, faulty
systems and procedures or lack of internal controls
Operational risk can be controlled by:
a. providing state of art systems and specified contingency
plans,
b. disaster control procedures, and sufficient back-up
arrangements for man and machine,
c. A duplication process at a different site (mirroring).
Exchange Risk on account of fluctuations in exchange rates and/or when
mismatches occur in assets/ liabilities and receivables/payables
Credit Risk arises due to inability or unwillingness of the counter party to meet
the obligations at maturity of the underlying transaction. Credit risk is
further classified into pre-settlement risk and settlement risk.
Pre-settlement risk: failure of the counter party before maturity of
the contract thereby exposing the other party to cover the
transaction at the ongoing market rates. This entails the risk of only
market differences and is not an absolute loss for the bank
Settlement risk: risk of failure of the counter party during the
course of settlement, due to the time zone differences, between the
two currencies to be exchanged.One party to a foreign exchange
transaction could pay out the currency it sold but not received the
currency it bought. This principal risk in the settlement of foreign
exchange transaction is variously called foreign exchange
settlement risk or temporal risk or Herstatt risk( after failure of
Bankhaus Herstat of Germany in 1974)
Methods to mitigate settlement risk are:
a. applying credit lines (limits) to each counter party to reduce
the risk.
b. settlement systems, operating on a single time basis, as also
on real-time gross settlement basis, are put in place.
c. time zone differences could be eliminated, if the global books
are linked to a single time zone, say GMT closing.
Liquidity Risk Potential for liabilities to drain from the bank at a faster rate than
assets. The mismatches in the maturity patterns of assets and
liabilities give rise to liquidity risk.
When a party to a foreign exchange transaction is unable to meet its
funding requirement or execute a transaction at a reasonable price,
it creates Liquidity Risk
It is also the risk of the party not being able to exit or offset positions
quickly at a reasonable price.In a deal of US dollar purchase against rupee, if the party selling US
Dollar is short of funds in the nostro account, then it may not be
possible for him to generate/borrow or buy USD to fund the USD
account. Liquidity risk is said to have arisen.
Liquidity risk mitigation is done by:
a. control the mismatches between maturities of assets and
liabilities
b. fixing limits for maturity mismatches and reduce open
positions
Gap Risk/Interest
Rate Risk
arises due to adverse movement of interest rates or interest rate
differentials
If the purchase and sale take place for different value, while the
bank may
completely stand hedged on exchange front, it creates a mismatch
between its assets and liabilities referred to as GAP
These gaps are to be filled by the bank by paying/receiving
appropriate forward differentials. These forward differentials are in
turn a function of interest rates and any adverse movement in
interest rates would result in adverse movement of forward
differentials thus affecting the cash flows on the underlying open
gaps or mismatches. Therefore, it is the risk arising out of adverse
movements in implied interest rates or actual interest rate
differentials
Interest rate risk also occurs when different bases of interest rates
are applied to assets and corresponding liabilities.
Volatility in interest rates is due to:
a. The increasing capital flows in the global financial markets
b. the economic disparities between nations and the increased
use of interest rates as a regulatory tool for macro- economic
controls
Mitigation of interest rate risk is done by:
a. undertaking appropriate swaps, or
b. matching funding actions or
c. through appropriate risk mitigating interest rate derivatives
Market Risk due to adverse movement of market variables when the players are
unable to exit the positions quickly
Legal Risk On account of non-enforceability of contract against a counter party.Legal risk also includes compliance and regulations related risks,
arising out of non-compliance of prescribed guidelines or breach of
governmental rules, leading to wrong understanding of rules and
penalties by the enforcing agencies.
Systemic Risk possibility of a major bank failing and the resultant losses to counter
parties reverberating into a banking crisis.
Country Risk
/Political Risk
counter party situated in a different country unable to perform its
part of the contractual obligations despite its willingness to do so
due to local government regulations or political or economic
instability in that country.
A country giving very high returns is generally:
a. Faces high country risk
b. Not too many countries or instutions are ready to invest in
that country. Hence they try to attract these institutions by
giving high returns
Sovereign Risk sub-risk in the overall country risk in that certain state-owned entities
themselves quoting their sovereign status claim immunity from any
recovery proceedings of fulfillment of any obligations they had
originally agreed to.
Sovereign risk can be reduced by
a. inserting disclaimer clauses in the documentation
b. making the contracts and the sovereign counter parties
subject to a third country jurisdiction
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