TYPE OF RISKS, CREDIT RISK MEASUREMENT ASSESSMENT & CREDIT RISK
MITIGATION
Risk is inherent in banking business, but the question before us is how we will
define risk and to identify what types of risk is being faced by banks.
Risk can be defined is the likelihood of an adverse deviation of the actual
result from an expected result. Banks that run on the principle of avoiding risks
cannot meet the legitimate credit requirements of the economy or the
shareholders’ expectations of reasonable, normal and adequate profits. On the
other hand, a bank that takes excessive risks is likely to run into difficulty .So a
balanced approach is required to be taken , where a calculative risk is required
to be taken by the banks.
Types of Risks faced by Banks
Banks face a number of risks in different areas of their operations, some of the
prominent risks faced by them are Credit Risk, market Risk, Operational Risk,
Liquidity Risk etc. One by one ,we will discuss some of the prominent risks faced
by the banks.
Credit Risk has been defined as “The possibility of losses associated with
diminution in the credit quality of borrowers or counterparties. In a bank’s
portfolio, losses stem from outright default due to inability or unwillingness of a
customer or counterparty to meet commitments in relation to lending, trading,
settlement and other financial transactions. Alternatively, losses result from
reduction in portfolio value arising from actual or perceived deterioration in
credit quality.”
Credit risk is the most common & predominant risk in banking and possibly the
most important in terms of potential losses. This risk relates to the possibility
that loans will not be paid or that investments will deteriorate in quality or go
into default resulting into potential loss for the bank. Credit risk is not confined
to the risk that borrowers are unable to pay; it also includes the risk of
payments of the bills being delayed beyond the maturity time, which can also
cause problems for the bank. some of the related risks to credit risk are
Counterparty Default Risk: This refers to the possibility that the other party
in an agreement will default.
Securitization Risk: Securitization is a process of distributing risk by
aggregating debt instruments in a pool and then issuing new securities backed
by the pool. There are two types of securities, viz. traditional and synthetic
securitizations. A traditional securitization is one in which an originating bank
transfers a pool of assets that it owns to an arm’s length special purpose
vehicle. A synthetic securitization is one in which an originating bank transfers
only the credit risk associated with the underlying pool of assets through the use
of credit-linked notes or credit derivatives while retaining legal ownership of
the pool of assets.
Concentration Risk: A concentration risk is any single exposure or group of
exposures with the potential to produce losses large enough (relative to a bank’s
capital, total assets, or overall risk level) to threaten a bank’s health or ability
to maintain its core operations.
Market Risk: Market risk generally refers to risks which result from changes in
market variable viz. price changes in the currency, money and capital markets
etc. Market risk also results from sensitivity to foreign exchange fluctuations
due to open foreign exchange positions and (in the broadest sense) open term
positions.
Interest Rate Risk (IRR): Interest rate risk (IRR) is defined as the change in
investors’ portfolio value due to interest rate fluctuations. The IRR
management system is concerned with measurement and control of risk
exposures, both in trading book (i.e. assets that are regularly traded and are
liquid in nature) and in banking book (i.e., assets that are usually held till
maturity and rarely traded).
Equity Price Risk: This risk arises due to fluctuations in market prices of equity
due to general market-related factors.
Foreign Exchange Risk: This risk arises due to fluctuations in exchange rates.
Operational Risk: The risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events is called Operational
Risk. This definition includes legal risks, but excludes strategic and reputation
risk.
Compliance / Legal Risk: Compliance/Legal risk includes, but is not limited to,
exposure to fines, penalties or punitive damages resulting from supervisory
actions, as well as private settlements. Legal/compliance risk arises from an
institution’s failure to enact appropriate policies, procedures, or controls to
ensure it conforms to laws, regulations, contractual arrangements, and other
legally binding agreements and requirements.
Documentation Risk: The unpredictability and uncertainty arising out of
improper or insufficient documentation which gives rise to ambiguity regarding
the characteristics of the financial contract is referred to as documentation risk.
Liquidity Risk: Liquidity risks arise from a bank’s inability to meet its
obligations when they fall due, and refer to situations in which a party is willing
but unable to find counterparty to trade an asset.
Term Liquidity Risk: The risk arises due to an unexpected prolongation of the
capital commitment period in lending transactions (unexpected delays in
repayments).
Withdrawal / Call Risk: The risk that more credit lines will be drawn or more
deposits withdrawn than expected is referred to as withdrawal or call risk. This
brings about the risk that the bank will no longer be able to meet its payment
obligations without constraints.
Structural Liquidity Risk: This risk arises when the necessary funding
transactions cannot be carried out (or can be carried only on less favourable
terms). This risk is sometimes also called funding liquidity risk.
Contingent Liquidity Risk: Contingent liquidity risk is the risk associated with
finding additional funds or replacing maturing liabilities under potential, future
stressed market conditions.
Market Liquidity Risk: This risk arises when positions cannot be sold within a
desired time period or can be sold only at a discount (market impact). This is
especially the case with securities/derivatives in illiquid markets, or when a
bank holds such large positions that they cannot be sold easily. These market
liquidity risks can be accounted for by extending the holding period in risk
measurements (e.g. the holding period for VaR) or by applying expected values
derived from experience.
Other Risks
Strategic Risk: Strategic risk refers to negative effects on capital and earnings
due to business policy decisions, changes in the economic environment,
deficient or insufficient implementation of decisions, or a failure to adapt to
changes in the economic environment.
Reputation Risk: Reputation risk refers to the potential adverse effects which
can arise from bank’s reputation deviating negatively from its expected level. A
bank’s reputation refers to its image in the eyes of the interested public
(investors/lenders, employees, customers, etc.) with regard to competence,
integrity and reliability).
Capital Risk: Capital risk results from an imbalanced internal capital structure
in relation to the nature and size of the bank, or from difficulties associated
with raising additional risk coverage capital quickly, if necessary.
Earning Risk: Earning risk arises due to inadequate diversification of a bank’s
earnings structure or its inability to attain a sufficient and lasting level of
profitability.
Outsourcing Risk: While there are many ways to categorize outsourcing risk,
four of the most convenient are operational disruption risk, data risk, quality
risk and reputation risk.
Though lot number of risks is faced by banks, but Basel Committee on Banking
Supervision (BCBS) in their Basel II accord has elaborated three types of risks
viz. Credit Risk, Operational Risk and Market Risk, under Pillar 1 (component on
Minimum Capital Requirements). However, their Pillar 2 (component on
Supervisory Review Process) involves bank management to develop systems that
support the internal capital assessment process and it should also allow for
setting targets for capital that are commensurate with the Bank’s particular risk
profile and control environment.
Risk Management today is more than Compliance of Regulatory Guidelines. It is
about building value by optimizing, rather than minimizing risk. Risk
management is not about avoiding risk. It helps banks to be aware of the risks
inherent in the business and take advantage of this knowledge to gain a
competitive edge and enhance shareholders value.
Risk creates opportunity >>> Opportunity creates value >>> Value creates
stakeholders’ wealth.
MITIGATION
Risk is inherent in banking business, but the question before us is how we will
define risk and to identify what types of risk is being faced by banks.
Risk can be defined is the likelihood of an adverse deviation of the actual
result from an expected result. Banks that run on the principle of avoiding risks
cannot meet the legitimate credit requirements of the economy or the
shareholders’ expectations of reasonable, normal and adequate profits. On the
other hand, a bank that takes excessive risks is likely to run into difficulty .So a
balanced approach is required to be taken , where a calculative risk is required
to be taken by the banks.
Types of Risks faced by Banks
Banks face a number of risks in different areas of their operations, some of the
prominent risks faced by them are Credit Risk, market Risk, Operational Risk,
Liquidity Risk etc. One by one ,we will discuss some of the prominent risks faced
by the banks.
Credit Risk has been defined as “The possibility of losses associated with
diminution in the credit quality of borrowers or counterparties. In a bank’s
portfolio, losses stem from outright default due to inability or unwillingness of a
customer or counterparty to meet commitments in relation to lending, trading,
settlement and other financial transactions. Alternatively, losses result from
reduction in portfolio value arising from actual or perceived deterioration in
credit quality.”
Credit risk is the most common & predominant risk in banking and possibly the
most important in terms of potential losses. This risk relates to the possibility
that loans will not be paid or that investments will deteriorate in quality or go
into default resulting into potential loss for the bank. Credit risk is not confined
to the risk that borrowers are unable to pay; it also includes the risk of
payments of the bills being delayed beyond the maturity time, which can also
cause problems for the bank. some of the related risks to credit risk are
Counterparty Default Risk: This refers to the possibility that the other party
in an agreement will default.
Securitization Risk: Securitization is a process of distributing risk by
aggregating debt instruments in a pool and then issuing new securities backed
by the pool. There are two types of securities, viz. traditional and synthetic
securitizations. A traditional securitization is one in which an originating bank
transfers a pool of assets that it owns to an arm’s length special purpose
vehicle. A synthetic securitization is one in which an originating bank transfers
only the credit risk associated with the underlying pool of assets through the use
of credit-linked notes or credit derivatives while retaining legal ownership of
the pool of assets.
Concentration Risk: A concentration risk is any single exposure or group of
exposures with the potential to produce losses large enough (relative to a bank’s
capital, total assets, or overall risk level) to threaten a bank’s health or ability
to maintain its core operations.
Market Risk: Market risk generally refers to risks which result from changes in
market variable viz. price changes in the currency, money and capital markets
etc. Market risk also results from sensitivity to foreign exchange fluctuations
due to open foreign exchange positions and (in the broadest sense) open term
positions.
Interest Rate Risk (IRR): Interest rate risk (IRR) is defined as the change in
investors’ portfolio value due to interest rate fluctuations. The IRR
management system is concerned with measurement and control of risk
exposures, both in trading book (i.e. assets that are regularly traded and are
liquid in nature) and in banking book (i.e., assets that are usually held till
maturity and rarely traded).
Equity Price Risk: This risk arises due to fluctuations in market prices of equity
due to general market-related factors.
Foreign Exchange Risk: This risk arises due to fluctuations in exchange rates.
Operational Risk: The risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events is called Operational
Risk. This definition includes legal risks, but excludes strategic and reputation
risk.
Compliance / Legal Risk: Compliance/Legal risk includes, but is not limited to,
exposure to fines, penalties or punitive damages resulting from supervisory
actions, as well as private settlements. Legal/compliance risk arises from an
institution’s failure to enact appropriate policies, procedures, or controls to
ensure it conforms to laws, regulations, contractual arrangements, and other
legally binding agreements and requirements.
Documentation Risk: The unpredictability and uncertainty arising out of
improper or insufficient documentation which gives rise to ambiguity regarding
the characteristics of the financial contract is referred to as documentation risk.
Liquidity Risk: Liquidity risks arise from a bank’s inability to meet its
obligations when they fall due, and refer to situations in which a party is willing
but unable to find counterparty to trade an asset.
Term Liquidity Risk: The risk arises due to an unexpected prolongation of the
capital commitment period in lending transactions (unexpected delays in
repayments).
Withdrawal / Call Risk: The risk that more credit lines will be drawn or more
deposits withdrawn than expected is referred to as withdrawal or call risk. This
brings about the risk that the bank will no longer be able to meet its payment
obligations without constraints.
Structural Liquidity Risk: This risk arises when the necessary funding
transactions cannot be carried out (or can be carried only on less favourable
terms). This risk is sometimes also called funding liquidity risk.
Contingent Liquidity Risk: Contingent liquidity risk is the risk associated with
finding additional funds or replacing maturing liabilities under potential, future
stressed market conditions.
Market Liquidity Risk: This risk arises when positions cannot be sold within a
desired time period or can be sold only at a discount (market impact). This is
especially the case with securities/derivatives in illiquid markets, or when a
bank holds such large positions that they cannot be sold easily. These market
liquidity risks can be accounted for by extending the holding period in risk
measurements (e.g. the holding period for VaR) or by applying expected values
derived from experience.
Other Risks
Strategic Risk: Strategic risk refers to negative effects on capital and earnings
due to business policy decisions, changes in the economic environment,
deficient or insufficient implementation of decisions, or a failure to adapt to
changes in the economic environment.
Reputation Risk: Reputation risk refers to the potential adverse effects which
can arise from bank’s reputation deviating negatively from its expected level. A
bank’s reputation refers to its image in the eyes of the interested public
(investors/lenders, employees, customers, etc.) with regard to competence,
integrity and reliability).
Capital Risk: Capital risk results from an imbalanced internal capital structure
in relation to the nature and size of the bank, or from difficulties associated
with raising additional risk coverage capital quickly, if necessary.
Earning Risk: Earning risk arises due to inadequate diversification of a bank’s
earnings structure or its inability to attain a sufficient and lasting level of
profitability.
Outsourcing Risk: While there are many ways to categorize outsourcing risk,
four of the most convenient are operational disruption risk, data risk, quality
risk and reputation risk.
Though lot number of risks is faced by banks, but Basel Committee on Banking
Supervision (BCBS) in their Basel II accord has elaborated three types of risks
viz. Credit Risk, Operational Risk and Market Risk, under Pillar 1 (component on
Minimum Capital Requirements). However, their Pillar 2 (component on
Supervisory Review Process) involves bank management to develop systems that
support the internal capital assessment process and it should also allow for
setting targets for capital that are commensurate with the Bank’s particular risk
profile and control environment.
Risk Management today is more than Compliance of Regulatory Guidelines. It is
about building value by optimizing, rather than minimizing risk. Risk
management is not about avoiding risk. It helps banks to be aware of the risks
inherent in the business and take advantage of this knowledge to gain a
competitive edge and enhance shareholders value.
Risk creates opportunity >>> Opportunity creates value >>> Value creates
stakeholders’ wealth.
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