Risk is an event or injury that can cause damage to an institutions income

and/or reputation
Risk is like energy that cannot be created or destroyed but can only be
passed on or managed
Each bank as well as every banker needs to appreciate and understand that
risk is unavoidable and it can only be managed

The Changing Forms of Risks

Risk is associated with every business activity
Risk is more prominent and pronounced in respect of financial sector in
general and banks in particular
New concepts like anticipate/prevent/monitor/mitigate/ have substituted the
earlier ethos of inspect/ detect/ react
The emphasis is now more on processes and not on people alone
Characteristics of Risk
Risk is probabilistic and generic
Risk are ascertainable, although not always quantifiable
Risk has a direct relationship with return
Types of Risk
Risks are divided in two types:
Financial Risk
Non Financial Risk
Types of Financial Risks
1. Credit Risk
Credit Risk occurs when customers default or fail to comply with their
obligation to service debt, triggering a total or partial loss
Components of credit risk are individual loans, market conditions and
geographical/industry/group concentrations

 Risk issues get reflected in loan losses, rising NPA and concentrations
Causes of Credit Risk
The primary cause of credit risk is poor credit monitoring
Lack of proper communication
Narrowly defined responsibilities
Over emphasis on group decision
Inadequate appraisal
Over reliance on the realizable value of collateral
Over reliance on decision making tools
Lack of data integrity
Non availability of data in time
Faulty or Inadequate credit rating system or methodology
2. Liquidity Risk
Liquidity risk is when the bank is unable to meet a financial commitment
arising out of a variety of situations.
These include: usage of non-funded credit line, maturing liabilities
(withdrawal or non-renewal of deposits) or disbursement to customers.
2. Liquidity Risk
From the point of investment, liquidity risk is the situation when the investor
is not able to exit an investment either on account of default by the
counterparty or absence of market.
Banks take care of this risk through liquidity policy and its implementation by
Asset Liability Management Committee.
3. Interest Rate Risk
Interest rate risk occurs due to movements in interest rates
Interest rate risk is the possibility that assets or liabilities have to be re-priced
on account of changes in the market rates and its impact on the income of
the bank

 Different Components of the risk

Basis (change in the basis points in market quotes)
Yield (change/shift in the yield)
Price (change in pricing policy methodology or price itself)
Reinvestment (impact of interest rate changes on income from re-invested
interest)
Embedded option (impact of prepaid loan or pre-mature withdrawal of deposit
on earnings) and
Gap (the difference between rate sensitive assets (RSA) and rate sensitive
liabilities (RSL ))
4. Foreign Exchange Risk
Foreign Exchange or forex risk relates to likely loss due to variations in
earnings on account of indexation of revenues and changes in assets and
liabilities labeled in foreign currency
The movements in the currencies give rise to forex risk
Responsibilities lies with dealers, back-office functionaries and supervisory
staff to ensure that specified risk in forex business is addressed to.
5. Market Risk
Market risk signifies the adverse movement in the market value of trading
portfolio during the period required to liquidate the transaction
Assessment of market risk is made with reference to instability or volatility of
market parameters like interest rates, stock exchange indices, exchange
rates
6. Counter-party Risk
Counter party risk is associated with the inability or unwillingness of the
customer or a counter party to meet the commitments in relation to
lending/trading/hedging/settlement or any other financial transaction
It is the risk of failure of counter party due to sudden and unforeseen
circumstances
When the counter party is a bank or a financial institution the same risk is
referred to as solvency risk

 Strategies to manage Counter Party Risk

Maintaining close watch on counter party performance
Ensuring the right kind of mix in business composition
Adoption/adherence to concentration limits
Obtaining and using of market information
7. Regulatory and Legal Risk
Regulatory risk refers to the adverse impact of the existing or new rules or
statutes
Lenders liability, customer/employee suits and liability on account of
environmental compliance are examples of legal risks
Causes of such legal risks are lack of faith, misleading information, conflict of
interests, vendor non-performance, poor financial performance, unethical
behaviour and lack of transparency
8. Operational Risk
Operational risk refers to the malfunctioning of information and/or reporting
system and of internal monitoring mechanism
Technical level operational risk arises due to deficiency or malfunctioning of
information system
It relates to breakdown in internal controls/corporate governance, error, fraud
and failure to perform in a timely manner
Operational risk may be defined as the risk of monetary losses resulting from
inadequate or failed internal processes, people and systems or from external
events.
Examples of operational risk losses include:
Internal Frauds: insider trading, misappropriation of assets
External Frauds: theft, natural disaster like terrorism or system related
failures like M&A related disruption and other technological
breakdowns
Methods to manage operational risk
Supervision and control of high order

 Training of personnel
Regular interval and independent audits
Development of personnel policies with ethical codes
Constant training on risk management
Management of Operational Risk at technological Level
Arrangement of password and other security measures
Creation of succession for technology staff
Formulation and testing of disaster recovery plans
9. Environmental Risk
The environmental risk is defined as the likelihood, or probability, of injury,
disease, or death resulting from exposure to a potential environmental hazard
Environmental risk areas refer to the types of environmental values that
would be threatened as a result of pollution or events on facility
Example: Bhopal Gas Tragedy
Environmental Risk Areas
Water pollution
Waste Management
Site Contamination
Air pollution including odour and noise pollution

Types of Non-Financial Risks

1. Business Risk
These are the risks that the bank willingly assumes to create a competitive
advantage and add value to the shareholders
Business or operating risk pertains to the product market in which the bank
operates, and includes technological innovations, marketing and product
design

 A bank with a pulse on the market and driven by technology as well as high
degree of customer focus could be relatively protected against this risk
2. Strategic Risk
Strategic risk results from a fundamental shift in the economy or political
environment. For example-nationalization of banks
Strategic Risks usually affect the entire industry and it is much more difficult
to protect oneself against the same

THE RISK MANAGEMENT PROCESS

1. Indentify risk by each functional area and/or corporate policy

To properly identify risks, the bank must recognize and understand existing
risk or risks that may arise from new business initiatives.

Risk identification should be a continuous process, and risks should be

understood at both transaction and portfolio levels

2. Categorize risk by Risk Profile

High risk

Medium risk

Low Risk

3. Anticipate the direction the risk is expected to take within the next twelve months

The direction of risk will influence Managements strategy and the Audit/
Compliance Departments review strategy, including the extent to which
expanded procedures might be used

Risk is decreasing, aggregate risk should decline over the next 12 months,
with increase risk higher the aggregate risk and if the risk is stable the
aggregate risk will remain unchanged

4. Elaborate on systems established to monitor risk and the frequency of monitoring

Banks should monitor risk levels to ensure timely review of risk positions and
exceptions.

Monitoring reports should be timely, accurate, and informative and should be

distributed to appropriate individuals, and to ensure action, when needed.

5. State policy and/or procedure to control the risk identified

Banks should establish and communicate risk limits through policies,

standards, and procedures that define responsibility and authority.

These limits should serve as a means to control exposures to the various risks
associated with the banks activities.

The limits should be tools that management can use to adjust when
conditions or risk tolerance changes