JAIIB::
Different Types of Banking Risk
The banks are exposed to (1) Liquidity risk (2) Interest rate risk (3)Market risk (4) Credit risk (default risk)
and (5) Operational risk. These risks can be further broken up in various other types of risk as under:
1. Liquidity risk
This is the risk arising fromfunding of long termassets by short termliabilities or funding short term assets by
long termliabilities.
(a) Funding liquidity risk: It is the inability to obtain funds tomeet cash flow obligation when these
arise.(Payment of a termdeposit which was used to fund a termloan and a TL which has notmatured as yet,
fully).
(b) Funding risk : The risk arises fromneed to replace net outflows due to unanticipated withdrawal or nonrenewal
of deposits.
(c)Time risk : This risk arises fromneed to compensate for non-receipts of expected inflows of funds i.e.
performing assets turning into nonperforming assets due to which recovery has not come and deposit that
funded that loan is to be returned.
(d) Call risk : This risk arises due to crystallization of contingent liabilities.
2. Interest rate risk
This is the risk arising fromadversemovement of interest rates during the period when the asset or liability
was held by the bank. This risk affects the net interestmargin ormarket value of equity.
(a) Gap ormismatch risk: It arises frommismatch fromholding assets and liabilities and off balance sheet
items with differentmaturities. For example, an assetmaturing in 4 years; funded froma liabilitiesmaturing in
2 years' period.
(b) Yield curve risk : In a floating interest rate situation, banksmay adopt two ormore benchmark rates for
different instruments. Different assets based on these different benchmark rates,may not yield a parallel
return (as theremay be variations in the yield of the benchmark).
Hence their yield curve would be different. For example, if a deposit is raised on a floating rate linked to 91
days treasury bill and another deposit is raised on a floating rate linked to 382 days, the cost to the bankmay
be different for these two deposits.
(a) Basis risk : The interest rates on different assets or liabilitiesmay change in differentmagnitude which is
called basis risk. For example in a declining interest rate scenario, the rate of interest on assetsmay be
declining in a differentmagnitude than the interest rate on the corresponding liability, whichmay create
variation in net interest income.
(b) Embedded option risk :When a liability or asset is contracted (i.e. a deposit is obtained or a loan is
given) with a call option for a customer (i.e. option to obtain payment of deposit beforematurity ormake
payment of the loan before becoming due), itmay give rise to embedded option risk. Itmay affect the net
interestmargin.
(c) Reinvestment risk: When bank gets back the repayment of a loan or an investment, there is
uncertainty about the interest rate at which the cash inflow can be reinvested. Hence, anymismatch in cash
flows exposes the bank to variation in net interest income.
(a) Net interest position risk:Whenmarket interest declines and a bank hasmore earning assets than
paying liabilities, the bank is exposed to reduction in NII, which is called net interest position risk.
3. Market risk or price risk : It is the risk that arises due to adverse movement of value of the
investments / trading portfolio, during the period when the securities are held by a bank. The
price risk arises when an investment is sold before maturity.
(a) Foreign Exchange risk :When rate of different currencies fluctuate and lead to possible loss to the
bank, this is called a forex risk.
(b) Market liquidity risk:When bank is not able to conclude a large transaction in a particular instrument
around the current market price (say bank could not sell a share at a higher price which could have been
done but for poormarket liquidity this could not be done), this is called, market liquidity risk.
4. Default risk or credit risk : The risk to a bank when there is possibility of default by the counter
party (say a borrower) tomeet its obligation. Credit risk is prevalent in case of loans.
(a) Counter-party rkk : Counter party risk is a variant of credit risk. It arises due to non-performance of the
trading partners due to their counterparty's refusal or inability to perform. It is basically related to trading
activity rather than credit activity.
(b) Country risk: When non-performance by a counter party is due to restrictions imposed by the
country of the counter party (non-performance due to extemal factors).
5. Operational risk : It is the risk that arises due to failed internal processes, people or systems or from
external events. It includes a no. of risk such as fraud risk, communication risk, documentation risk,
competence risk,model risk, cultural risk, external events risk, legal risk, regulatory risk, compliance risk,
system risk etc. It does not include strategic risk or reputation risk.
(a) Transaction risk : It arises fromfraud or failed business processes or inability tomaintain business
continuity andmanage information.
(b) Compliance risk: It is the risk of legal or regulatory sanction or financial loss or reputation loss that a
bankmay suffer as a result of bank's failure to comply with applicable laws or regulations.
6. Other risks : Thesemay include strategic risk or reputation risk.
(a) Strategic risk : Arises due to adverse business decision, improper implementation of decisions etc.
Reputation risk: It is the risk that arises fromnegative public opinion. It can expose an institution to litigation,
financial loss or decline in customer base
Different Types of Banking Risk
The banks are exposed to (1) Liquidity risk (2) Interest rate risk (3)Market risk (4) Credit risk (default risk)
and (5) Operational risk. These risks can be further broken up in various other types of risk as under:
1. Liquidity risk
This is the risk arising fromfunding of long termassets by short termliabilities or funding short term assets by
long termliabilities.
(a) Funding liquidity risk: It is the inability to obtain funds tomeet cash flow obligation when these
arise.(Payment of a termdeposit which was used to fund a termloan and a TL which has notmatured as yet,
fully).
(b) Funding risk : The risk arises fromneed to replace net outflows due to unanticipated withdrawal or nonrenewal
of deposits.
(c)Time risk : This risk arises fromneed to compensate for non-receipts of expected inflows of funds i.e.
performing assets turning into nonperforming assets due to which recovery has not come and deposit that
funded that loan is to be returned.
(d) Call risk : This risk arises due to crystallization of contingent liabilities.
2. Interest rate risk
This is the risk arising fromadversemovement of interest rates during the period when the asset or liability
was held by the bank. This risk affects the net interestmargin ormarket value of equity.
(a) Gap ormismatch risk: It arises frommismatch fromholding assets and liabilities and off balance sheet
items with differentmaturities. For example, an assetmaturing in 4 years; funded froma liabilitiesmaturing in
2 years' period.
(b) Yield curve risk : In a floating interest rate situation, banksmay adopt two ormore benchmark rates for
different instruments. Different assets based on these different benchmark rates,may not yield a parallel
return (as theremay be variations in the yield of the benchmark).
Hence their yield curve would be different. For example, if a deposit is raised on a floating rate linked to 91
days treasury bill and another deposit is raised on a floating rate linked to 382 days, the cost to the bankmay
be different for these two deposits.
(a) Basis risk : The interest rates on different assets or liabilitiesmay change in differentmagnitude which is
called basis risk. For example in a declining interest rate scenario, the rate of interest on assetsmay be
declining in a differentmagnitude than the interest rate on the corresponding liability, whichmay create
variation in net interest income.
(b) Embedded option risk :When a liability or asset is contracted (i.e. a deposit is obtained or a loan is
given) with a call option for a customer (i.e. option to obtain payment of deposit beforematurity ormake
payment of the loan before becoming due), itmay give rise to embedded option risk. Itmay affect the net
interestmargin.
(c) Reinvestment risk: When bank gets back the repayment of a loan or an investment, there is
uncertainty about the interest rate at which the cash inflow can be reinvested. Hence, anymismatch in cash
flows exposes the bank to variation in net interest income.
(a) Net interest position risk:Whenmarket interest declines and a bank hasmore earning assets than
paying liabilities, the bank is exposed to reduction in NII, which is called net interest position risk.
3. Market risk or price risk : It is the risk that arises due to adverse movement of value of the
investments / trading portfolio, during the period when the securities are held by a bank. The
price risk arises when an investment is sold before maturity.
(a) Foreign Exchange risk :When rate of different currencies fluctuate and lead to possible loss to the
bank, this is called a forex risk.
(b) Market liquidity risk:When bank is not able to conclude a large transaction in a particular instrument
around the current market price (say bank could not sell a share at a higher price which could have been
done but for poormarket liquidity this could not be done), this is called, market liquidity risk.
4. Default risk or credit risk : The risk to a bank when there is possibility of default by the counter
party (say a borrower) tomeet its obligation. Credit risk is prevalent in case of loans.
(a) Counter-party rkk : Counter party risk is a variant of credit risk. It arises due to non-performance of the
trading partners due to their counterparty's refusal or inability to perform. It is basically related to trading
activity rather than credit activity.
(b) Country risk: When non-performance by a counter party is due to restrictions imposed by the
country of the counter party (non-performance due to extemal factors).
5. Operational risk : It is the risk that arises due to failed internal processes, people or systems or from
external events. It includes a no. of risk such as fraud risk, communication risk, documentation risk,
competence risk,model risk, cultural risk, external events risk, legal risk, regulatory risk, compliance risk,
system risk etc. It does not include strategic risk or reputation risk.
(a) Transaction risk : It arises fromfraud or failed business processes or inability tomaintain business
continuity andmanage information.
(b) Compliance risk: It is the risk of legal or regulatory sanction or financial loss or reputation loss that a
bankmay suffer as a result of bank's failure to comply with applicable laws or regulations.
6. Other risks : Thesemay include strategic risk or reputation risk.
(a) Strategic risk : Arises due to adverse business decision, improper implementation of decisions etc.
Reputation risk: It is the risk that arises fromnegative public opinion. It can expose an institution to litigation,
financial loss or decline in customer base
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