4 Types of Financial Risk

Introduction 

 

Banking industry is the backbone of an economy and the health of any economy is directly related to the financial health of its banks.

 

Banks provide a vast variety of services to both the retail sector as well as the corporate sector. Due to the vast variety of services provided by the banking industry, there are a myriad of risks involved in the banking industry. 

 

It is crucial to minimize these risks in order to maintain the health of the banks and essentially, the health of the economy. It is important to be aware of these risks in order to minimize them. 

 

For example, the COVID-19 pandemic has caused various interruptions in the economy and consequently generates lots of risks. Learn about the impact of COVID-19 on the global economy.

 

In this blog, we’ll go through the four major types of financial risk faced by the banking industry including credit risk, market risk, operational risk and liquidity risk and their subtypes in detail.

---

Types of risks in the Banking Industry 

---

1. Credit Risk 

 

Credit risk refers to the possibility of a loss resulting from a borrower’s failure to repay a loan and meet contractual obligations, this includes the delays in the payment of the loan as well. 

 

Credit defaults have always been one of the biggest concerns in the banking industry as is evident by the catastrophic 2007-08 financial crisis which began due to the inherent credit risk in the financial sector.

 

The impact of the credit risk on the financials of a bank is determined by the structure of a bank’s balance sheet, in particular the capital base of the bank signifies the extent to which losses can be sustained and insolvency can be avoided in the case of loan defaults higher than what is accounted for in the balance sheet. 

 

(Must read: What is credit rating?)

 

The risk faced by the banks depends on the leverage of the bank, a high leverage bank will face high risk and a low leveraged bank will face a low-risk. Leverage is determined by dividing the total assets by the total capital of a bank. 

 

This means that a bank having assets worth 10 times its capital will be more leveraged than a bank having assets worth 5 times its capital and in case of a crisis the less-leveraged bank would have more capital as a safeguard as compared to the more-leveraged bank.

 

Even though the high risk or the high-leveraged financial institutions look promising for investors due to their offering of higher Return on Equity (ROE) than the low risk or the low-leveraged financial institutions which offer higher Return on Assets (ROA), in the case of realization of the risks faced by the banks, their is a higher probability of high-risk financial institutions to become insolvent.

 

(Also read: 4 Types of bonds)

 

The regulations imposed on the banking industry by various regulatory organizations, the primary of which is the Basel Committee, limit its leverage.

 

The lack of such regulations in the shadow banking industry, which includes institutions like NBFCs resulted in making it more attractive for potential investors who were intimidated by the exceedingly high Return on Equity/ Capital they got in the period prior to the crisis. 

 

The exceedingly high level of leverage taken by such institutions was one of the primary reasons of the financial crisis of 2008-09, part responsible for the creation of the credit bubble and then the eventual burst evident by the collapse of the shadow banking industry.

 

(Read about: Mutual Funds in India)

 

Types of Credit Risk:

 

• Counterparty Credit Risk: The counterparty credit risk covers the default risk as well as credit migration risk of the counterparty reflected in mark-to-market losses on the expected counterparty risk. 

 

Counterparty risk may arise in the context of OTC derivatives and Securities Financing Transactions.

 

• Credit Concentration Risk: The concentration of credit risk is the risk as a distribution of exposures to a few customers and trading partners where potential default by a relatively small group of counterparties or large individual counterparties is driven by a common underlying cause. 

 

This includes concentration of borrowers, concentration by economic sector, concentration of counterparties in trading activities, etc. 

 

• Country Risk: Country risk refers to potential losses that may be generated by an economic, political, etc. event that occurs in a specific country, where the event can be controlled by that country, i.e. by its Government, but not by the credit grantor/investor.

 

 

2. Market Risk

 

Market risk refers to the possibility that a bank’s investments in securities might fail to deliver the returns expected, or the securities might fall in value.

 

Market risk is faced by all the market participants and proper hedging mechanisms have to be set up by banks to protect themselves from the market risk prevalent throughout the year. 

 

Types of Market Risk

 

• Equity Risk: Equity risk refers to the risk associated with the values of the stock prices, stock indices and the associated volatility.

 

• Interest Rate Risk: Interest-rate risk refers to the possibility that market interest rates might increase, obliging a bank to pay higher interest to their depositors, while the interest received from borrowers remains unchanged for loans with interest rates that the bank cannot alter immediately. 

 

• Currency Risk: Currency/Exchange-rate risk refers to the risk of losses involved due to movements in the foreign exchange rates and is faced by banks holding assets and liabilities in different currencies.

 

• Commodity Risk: Commodity risk refers to the risk associated with the values of the commodity prices and the associated volatility. 

 

(Referred blog: Largest stock exchange in the world)

 

 

3. Operational Risk

 

Operation risk refers to the risk of losses associated with the operations of a bank’s resources. This includes the risk involved due to terrorist activities, natural disasters, negligence and human error, fraudulent behaviour on the part of the employees of the bank,etc. There is not much that can be done in order to limit this risk.

 

Types of Operational Risk

 

• Internal Fraud: Internal fraud includes misappropriation of assets, tax evasion, intentional mismarking of positions, bribery etc.

 

• External Fraud: External fraud includes theft of information, hacking damage, third-party theft and forgery etc. 

 

• Employment Practices and Workplace Safety: Employment practices and workplace safety includes discrimination, workers compensation, employee health and safety etc. 

 

• Clients, Products, and Business Practice: Clients, products, and business practice includes market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning etc.

 

• Damage to Physical Assets: Damage to physical assets includes natural disasters, terrorism, vandalism etc. 

 

• Business Disruption and Systems Failures: Business disruption and systems failures include utility disruptions, software failures, hardware failures etc.

 

• Execution, Delivery, and Process Management: Execution, delivery, and process management include data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets etc. 

 

(Must read: Corporate Governance overview) 

 

 

4. Liquidity Risk

 

Liquidity risk refers to the possibility that a bank might not hold sufficient assets in liquid form, either cash or deposits that can be converted to cash at very short notice, to be able to meet the demands of its depositors for immediate withdrawal of their funds. 

 

This may result in run on banks in certain situations and result in sudden bankruptcy, run on banks can be both short lived and long lived and the factor of panic in an economy plays a huge role towards run on banks. 

 

An example of the same is the great depression of 1932. In order to avoid such situations and limit liquidity risk, banks can increase the amount of liquid assets in its balance sheet.

 

Types of Liquidity Risk

 

• Funding Risk: Funding liquidity risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is crucial and it arises from the need to replenish net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail). 

 

• Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows of funds i.e., performing assets turning into non-performing assets. 

 

• Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise when a bank is not able to undertake profitable business opportunities when it arises.

 

(Recommended blog: What is Inflation? Demand-pull and Cost-push)

 

Final Notes

 

Apart from the four main types of risks faced by banks discussed above, banks also face the risk of moral hazard and adverse selection, business/ strategic risk, reputational risk, systemic risk and residual risk.

 

Understanding the various risks faced by banks is necessary to come up with risk management or risk mitigation strategies and techniques to combat the various risks faced by such institutions. 

 

Risk management is one of the most important verticals in a bank and at times, the Chief Risk Officer (CRO) is given authority even over the Chief Executive Officer (CEO).