Risks in Banking Sector, Overview, Types with Detailed Explanation

Risk in the Banking Sector

In this article, we have delved into the various types of risks prevalent in the banking sector, a topic that holds significant importance for upcoming banking and government examinations such as RBI Grade B, SEBI, NABARD, SBI PO etc. Understanding the concept of risk in the banking sector also enables students to answer the questions from this topic in their respective interviews. So, from interview point of view this topic also holds great importance. This article provides a concise overview of the different risk categories, their underlying concepts, and definitions specific to the banking industry.

By thoroughly understanding the information presented in this piece, readers can gain valuable awareness and knowledge about the subject matter, which will undoubtedly prove beneficial in the General Awareness section of various banking and government recruitment examinations. The article aims to equip readers with a comprehensive understanding of the risks inherent in banking operations, encompassing the fundamental concepts and precise definitions of each risk type.

Risks in Banking Context: Overview

Let’s first understand the concept of risks in banking sector in a layman language. In the banking context, a risk represents the uncertainty surrounding future earnings and potential outcomes in the event of failure. Risks can stem from inadvertent staff errors or malicious intent, resulting in the depreciation of asset values and ultimately diminishing the intrinsic worth of the bank. 

In other words, Risks in the banking sector refer to the potential for unfavorable deviations from expected outcomes, arising from various uncertainties inherent to banking activities. These risks represent the possibility of losses or adverse impacts due to the divergence between actual and anticipated returns or results. Some of the major risks in banking sector encountered in the Indian banking are credit risk, market risk, operational risk, liquidity risk, business risk, reputational risk, and systemic risk. 

For Example: The Punjab National Bank (PNB) faced a fraud amounting to Rs. 11,400 crores. The risk category impacted by this incident includes credit risk, operational risk, and reputational damage.

Types of Risks in Banking Sector

The banking sector is exposed to various types of risks, which can have significant impacts on its operations, financial stability, and overall performance. Understanding and effectively managing these risks is crucial for maintaining a sound and resilient banking system. Here’s an overview of major risks in the banking sector, along with detailed explanations:

• Liquidity Risk
• Interest Rate Risk
• Market Risk
• Credit or Default Risk
• Operational Risk

Liquidity Risk

Banks face liquidity risk when they finance long-term assets using short-term liabilities, exposing those liabilities to rollover or refinancing challenges. This risk entails the potential for an institution to be incapable of fulfilling its maturing obligations, or to do so only by borrowing funds at exorbitant rates or by selling assets at significantly reduced prices. The liquidity risk in banks manifest in different dimensions –

• Funding Liquidity Risk:  Funding Liquidity Risk is defined as the inability to
  obtain funds to meet cash flow obligations. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail).
• Time Risk: Time risk arises from the need to compensate for nonreceipt of expected inflows of funds i.e., performing assets turning into non-performing assets.
• Call Risk: Call risk arises due to crystallization of contingent liabilities. It may also arise when a bank may not be able to undertake profitable business opportunities when it arise.

Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected due to changes in the interest rates. IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s assets, liabilities and Off-Balance Sheet (OBS) positions. The following are the types of Interest Rate Risk –

• Gap or Mismatch Risk: A gap or mismatch risk arises from holding
  assets and liabilities and Off-Balance Sheet items with different principal amounts, maturity dates or re-pricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.
• Basis Risk: Basis Risk is the risk that arises when the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude.
• Embedded Option Risk: Significant changes in market interest rates
  create the source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans, term loans and exercise of call/put options on bonds/ debentures and/ or premature withdrawal of term deposits before their stated maturities.
• Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with regard to interest rate at which the future cash flows could be reinvested.
• Net Interest Position Risk:  Net Interest Position Risk arises when the market interest rates adjust downwards and where banks have more earning assets than paying liabilities. Such banks will experience a reduction in NII as the market interest rate declines and the NII increases when interest rate rises.

Market Risk

The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities, and currencies.

• Forex Risk:  Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position either spot or forward, or a combination of the two, in an individual foreign currency.
• Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

Operational Risk

Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’. Thus, operational loss has mainly three exposure classes namely people, processes and systems.

Transaction Risk

It stems from either fraudulent activity, ineffective business procedures, or the incapacity to sustain business operations and handle information proficiently.

Compliance Risk

Compliance risk refers to the potential for a bank to face legal penalties, financial setbacks, or damage to its reputation due to its inability to adhere to relevant laws, regulations, codes of conduct, and standards of ethical practice. It is also known as integrity risk because a bank’s reputation is closely associated with its commitment to principles of integrity and equitable behavior.

Other Risks in Banking Sector

Strategic Risk

Strategic risk emerges from unfavorable business choices, inadequate execution of decisions, or failure to adapt to shifts within the industry. It hinges on how well an organization aligns its strategic objectives with its business strategies, allocates resources, and executes its plans effectively.

Reputation Risk

Reputation risk stems from unfavorable public perception, potentially leading to legal action, financial repercussions, or a reduction in the institution’s customer base.

Risk Management Practices In India

Risk management, as described by knowledge theorists, encompasses the management of uncertainty, risk, equivocality, and error. Uncertainty, characterized by an inability to predict outcomes even randomly, stems from insufficient information. As information gathering progresses, uncertainty transitions into risk, where outcomes can be estimated. With increasing knowledge about markets and potential outcomes, risk management offers strategies for mitigating risk. Equivocality arises from conflicting interpretations and a resulting lack of clear judgment. Given the dynamic nature of the market, banks must remain vigilant about the alignment of regulatory frameworks within the country, shifts in international accounting standards, and notably, changes in clients’ business practices. Thus, it is imperative to adhere to specific risk management guidelines recommended by both the RBI and BIS.

Role of RBI in Risk Management in Banks

The Reserve Bank of India employs the CAMELS rating system to assess the financial stability of banks. This model comprises six key components: Capital Adequacy, Asset Quality, Management, Earnings Quality, Liquidity, and Sensitivity to Market Risk. 

In 1988, the Basel Committee on Banking Supervision, a part of the Bank for International Settlements (BIS), suggested the utilization of capital adequacy, asset quality, management quality, earnings, and liquidity (CAMEL) as benchmarks for evaluating a financial institution. In CAMELS framework Rating 1 is best whereas rating 5 is worst. CAMELS stands for-

C-Capital Adequacy: Evaluates the bank’s capital sufficiency via analysis of capital trends, risk management capabilities, economic conditions, loan quality, growth strategies, and other relevant factors.

A-Asset Quality: Evaluates the quality of loans extended by the bank.

M-Management: Evaluates the institution’s ability to manage financial pressure effectively.

E-Earnings: Assesses the institution’s capacity to generate suitable returns for expansion, maintaining competitiveness, and bolstering capital.

L-Liquidity: Evaluates a company’s liquidity by considering the availability of short-term assets that can be swiftly converted into cash.

S-Sensitivity: Addresses the impact of specific risk exposures on institutions by overseeing the management of credit concentrations.

Importance of Risk Management in Banking Sector

The core objective of risk management practices within the banking sector is to boost the value proposition for stakeholders by maximizing profitability and optimally allocating capital resources. This approach ensures the long-term financial stability and solvency of the banking institution. By striking a balance between prudent risk-taking and effective risk mitigation strategies, banks can enhance their ability to generate sustainable returns while maintaining a robust financial footing, ultimately benefiting all parties with vested interests in the organization’s success.