Banks are vulnerable to a number of risks, and therefore, banks which assess and take steps to mitigate the impact of these risks stay healthy and perform better. In the recent years, the bank management is seen more an exercise in risk identification and risk management. The strategies for managing risk is called Risk Management.
Basel-II norms, formulated by the Basel committee have replaced Basel I norms. They are applicable to the banks all over the World. India has decided to accept and adopt these norms. The Basel II norms aligns regulatory capital requirements with bank’s risk profile. It is incumbent that each bank has robust internal procedure of risk management.
Risks involved in Banking Business
The banks are risk prone organization. There are multiple risks affecting the banks. Major risks in banking business are
1. Liquidity Risk
Liquidity risk arises due to mismatch between the terms of bank deposits and the terms of lending. The deposits from customers are the major source of funds for banks and it is observed that a large majority of the depositors choose shorter term to deposit their funds. Their priorities are easy accessibility to cash and maximum returns on their investments. It is a trade off between liquidity and return.
The borrowers need time to generate surplus to pay back their borrowings and hence it takes a longer term to effect the repayment. Banks have to strike a delicate balance between their borrowings (deposits) and lending so as to avoid a cash crunch situation at any time.
How crucial is liquidity risk to banks?
Liquidity risk is crucial for banks. Banks have no alternative but to lend long term with short term deposits and borrowings. The ability to manage the mismatch without serious cash crunch is very important, failing which it may cause run on the bank.
In other words, if a bank delays or defaults in its payments, the customers will turn panicky and flock the bank in large numbers to take away their deposits, thus deepening the crisis and ultimately leading to the closure of the bank
2. Interest Rate Risk
Interest Rate Risk is the negative impact on the bank’s financial dealings and earnings on account of adverse movements in interest rates.
Interest rate risk refers to the pointed impact on the net interest income or net interest margin caused by unexpected changes in market rate. It is important to note that it is the market which determines the interest rate. Regulator (RBI) and the individual banks merely react to it by responding to the call of the market.
Impact of interest rate risk
The impact of interest rates affecting deposits and advances varies between time scales. In a rising interest rate scenario, interest rate on loans may rise at a particular scale (say on an average of 1%) than the increase in interest rate on deposits (say on an average of 1.5%) resulting in adverse variation in net interest income.
The loan portfolio in banks is funded out of a composite portfolio of short term borrowings and deposits and therefore, exposed to considerable degree of risk, both duration risk and interest rate risk.
Interest rate risk affects in different ways. Its impact may be on the earnings of the bank or on the market value of the bank’s investments or both.
3. Market Risk
This risk is related to the interest rate risk and to the assets such as investments which are marked to the market. Changes in interest rates affect the yields and changes in yields have a bearing on the value of bonds and securities held by banks. Market risk is also referred to as Price Risk.
The market volatility has also an impact on equity and due to a variety of reasons many of them are short term in nature. In India, monsoon is a key factor influencing market behavior and market risk which in turn affect the market prices.
4. Credit Risk
Default or Credit risk is the possibility of a borrower from bank or the Counterparty failing to fulfill the obligations in accordance with terms agreed upon by both parties. Lending of the banks, exposures in foreign exchange market, guarantees and letters of credit issued are prone to defaults by the parties concerned.
The largest and most obvious source of credit risk is unpaid loans and advances.
5. Counterparty Risk
Apart from the risks in lending, banks are also vulnerable to behavior of counterparties such as foreign banks and institutions or trading members in derivatives trade. Their refusal or inability to honour the commitments affect the banks. In 2008-09, some of the parties involved in derivative trade refused to meet their obligations citing the reasons that their banks had not made full disclosures of the losses they have to suffer if the market faces a down slide.
In an nutshell, Counterparty risk is related to non-performance of the customers due to refusal of counterparties (usually trading members in derivatives trade) and or inability to perform. This type of risk is generally viewed as a financial risk associated with trading rather than credit risk.
6. Country Risk
Country risk is another type of Credit risk. Generally country risks occur when the borrower or country party were unable to perform due to restrictions imposed upon by the government.
In the international scenario, the economic conditions prevailing in a country and the restrictions imposed by them affect the banks. In 2008-2009, Zimbabwe faced a major financial crisis and financial dealings with them suffered a set back. Some years back, certain countries imposed a ban on remittance of funds to India and perhaps to other countries also with the result substantial trade dues were not recovered.
Here, reason for non-performance is external on which the borrower or the counterparty has no control.
7. Operational Risk
Banks also suffer from losses incurred due to inadequate or failed internal processes/systems and also those caused by external events. Loss due to frauds is a major component under this category. Risks due to failure to communicate or inappropriate communication, documentation errors, poor competence, adverse judicial decision, impact of certain regulatory stipulations can all be grouped under this category.
8. Foreign Currency Risk
Foreign currency risk is the risk associated with the movement of currency in the currency exchange. Banks may suffer from foreign currency risk where there is adverse exchange rate movements between two currencies.
The strength of domestic currency (eg. Rupee) depends on the volume of country’s foreign trade and economic status. While to some extent each country maintains its currency value, market forces and the demand and supply positions determine the ultimate rate of exchange.