Assignment

On

List major risks in banking business in detail.

Submitted by – Submitted to –

Nimisha Bharara Ms. Nidhi Sareen

What are the Risks?

A bank faces many different types of risks and these need to be managed very carefully. The
risks in Banks arise due to the occurrence of some expected or unexpected events in the
economy or the financial markets. Risks can also arise from staff oversight or mala fide
intention, which causes erosion in the values of assets thus leading to a reduction the bank’s
intrinsic value.

Types of Risks in Banks

Broadly speaking, Risks in the Banking sector are of two types namely Systematic Risks and
Unsystematic Risks. Lets us define these two types of risks in Banks and understand the concept
behind them.

1. Systematic Risks:

 It is the risk inherent to the entire market or a market segment, and it can affect a large
number of assets.
 Systematic risk is also known as Undiversifiable Risk or Volatility and market risk.
 Systematic risk affects the overall market and not just a stock or industry in particular.
 This type of risk is both unpredictable and impossible to avoid completely.
 Examples of it include interest rate changes, inflation, recessions and wars.

2. Unsystematic Risks:

 It is the risk that affects a very small number of assets.

 It is also called Nonsystematic Risk, Specific Risk, Diversifiable Risk and Residual
Risk.
  This type of risk refers to the uncertainty inherent to a company or industry investment in
particular.
 Examples include a change in management, a product recall, a regulatory change that
could drive down company sales and a new competitor in the marketplace with the
potential to take away market share from a company in which you’ve invested.
 It is possible to avoid Unsystematic Risks through diversification.

In addition to these broad categories of Risks, there are several other specific risks that the
banking sector faces.

3. Credit of Default Risk:

It is the risk in which a borrower is unable to pay the interest or principal on its debt
obligations. The Basel Committee on Banking Supervision defines credit risk as to the
potential that a bank borrower, or counter-party, will fail to meet its payment obligations
regarding the terms agreed with the bank. It includes both uncertainties involved in repayment of
the bank’s dues and repayment of dues on time.

4. Market Risk:

The Basel Committee on Banking Supervision defines market risk as to the risk of losses in on-
balance or off-balance sheet positions that arise from movement in market prices. Market risk is
the most prominent for banks present in investment banking. 
The four components of market risk:
 Interest Risk: It causes potential losses due to movements in interest rates. This risk
arises because a bank’s assets usually have a significantly longer maturity than
its liabilities. In banking language, management of interest rate risk is also called asset-
liability management (ALM).
 Equity Risk: It causes potential losses due to changes in stock prices as banks accept
equity against disbursing loans. Banks can accept equity as collateral for loans and
purchase ownership stakes in other companies as investments from their free or investible
cash. Any negative change in stock price either leads to a loss or diminution in
investments’ value.
 Commodity Risk: It causes potential losses due to change in commodity (agricultural,
industrial, energy) prices. Massive fluctuations occur in these prices due to continuous
variations in demand and supply. Banks may hold them as part of their investments, and
hence face losses. The commodities’ values fluctuate a great deal due to changes in
demand and supply. Any bank holding them as part of an investment is exposed to
commodity risk.
 Foreign Exchange Risk: It causes potential loss due to change in the value of the
bank’s assets or liabilities resulting from exchange rate fluctuations as banks transact
with their customers or other stakeholders in multiple currencies. Banks transact in
 foreign exchange for their customers or the banks’ accounts. Any adverse movement can
diminish the value of the foreign currency and cause a loss to the bank.

5. Liquidity Risk:

It can be defined as the risk of a bank not being able to finance its day to day operations.
Failure to manage this risk could lead to severe consequences for the bank’s reputation as well as
the bond pricing and ratings of the bank in the money market.

6. Country Risk:

Country risk refers to the risk that a country won’t be able to honour its financial
commitments. When a country defaults on its obligations, it can harm the performance of all
other financial instruments in that country as well as other countries it has relations with.
Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a
particular country. 

7. Operational Risk:

The Basel Committee on Banking Supervision defines operational risk as to the risk of loss
resulting from inadequate or failed internal processes, people, and systems or external
events.
All banks face operational risks in their day to day operations across all their departments
including treasury, credit, investment, information technology.
There are three main causes of this risk:
 Human Intervention & Error
 Failure of the IT/internal software & systems.
 Failure of Internal Processes to transmit data & information accurately

8. Reputational Risk:

Reputational risk implies the public’s loss of confidence in a bank due to a negative perception

or image that could be created with/without any evidence of wrongdoing by the
bank. Reputational value is often measured in terms of brand value. Advertisements play a
significant role in forming & maintaining the public perception, which is the key reason for
banks spend millions in content marketing dollars.
The reputational risk could stem from:
 The inability of the bank to honour government/regulatory commitments
 Nonobservance of the code of conduct under corporate governance
 Mismanagement/Manipulation of customer records
 Ineffective customer service/after-sales services
 9. Systemic Risk:

This risk includes a possibility of bringing down the entire financial system to a
standstill. This is caused due to a domino effect where the failure of one bank could ripple down
the failure of its counter-parties/other stakeholders, which could, in turn, threaten the entire
financial services industry.
Risks such as systemic risk, which the banks have little or no control over, can only be
mitigated if banks have a strong capital base, to ensure a sound infrastructure.

Real world examples –

 The fraud of Rs. 11,400 crores in Punjab National Bank – The type of risk bank
affected in this case is Credit Risk, Operational Risk and Reputational Loss
 Videocon groups get Rs. 3250 crore loans from ICICI Bank – Failed to repay Rs.
2810 crore. In 2017, ICICI classified this as an NPA and the current standing is Rs. 2810.
With the large amount involved the reputation of the bank is at stake. This is a clear
example of reputation risk for Bank.
 Rising NPA (Non-Performing Asset) of bank and failure to repay loan result (a)
substantial credit loss (b) reputation loss and (c) operational risk for bank.

So, from the above examples, it can be concluded that these led to the loss of earnings and in
long run failure of the banking system.