An Investor’s Guide to Bank Risks
Banking cannot run without taking risks. Banking risks are defined as exposure to the uncertainty of outcome. How effectively a bank can navigate through risks will determine how successful it will be in the long run. Not understanding the different banking risks can have serious consequences.
Risks arise when an unexpected event in the financial market or economy happens. This can also emerge from staff oversight, which can lead to erosion in asset values and reduction in the bank’s intrinsic value.
6 Major Banking Risks
1. Market Risk — This is the most prominent risk for banks involved in investment banking. This is the risk of losses in balance sheet positions arising from movement in market prices. Major components of market risk will include commodity risk, foreign exchange risk, equity risk, and interest risk. Market risk can be measured through different techniques like sensitivity analysis and value at risk.
2. Credit Risk — This is defined as the potential that a bank borrower won’t meet its payment obligations based on the terms agreed with the bank. This will include both uncertainty involved in repayment of dues on time and repayment of the bank’s dues. The default often happens because of insufficient income or business bankruptcy. But there are instances when it may be wilful or intentional — the borrower is unwilling to fulfil its obligation even with adequate income.
3. Operational Risk — This is the risk of loss caused by failed or inadequate internal processes, systems and people or from external events. This happens in all daily bank activities. An erroneous order punched into a trading terminal and checks mistakenly cleared are some of the operational risk examples. This risk happens in any bank departments. Also, it arises from 3 sources: people risk, information technology risk, and process-related risks.
4. Liquidity Risk — This is the bank’s risk of having insufficient cash to perform its daily operations. Often, this results in a bank run, wherein the depositors rush to the bank to pull out their money.
5. Reputational Risk — This is the risk of damage to the image and public standing of the bank, which happens because of some uncertain actions carried out by the bank. And this can lead to the public’s loss of confidence and trust in a bank.
6. Business Risk — This is the risk that arises from the long-term business strategy of the bank. This deals with banks that are unable to keep up with the evolving competition dynamics. This risk can also emerge from a bank opting for the wrong strategy, resulting in its failure.
These 6 types of risks are inherent in a banking system. A bank can have control over some types by establishing strong systems and processes. Some risks can also be controlled by conforming to strict audits and compliance.