By S Venkat Raman
CEO & Chief Rating Officer, CariCRIS
Before one gets to manage risks, it is useful to identify
the various generic kinds of risks that businesses face.
These risks also vary in their complexity and impact, and
moreover can often be inter-related. It is difficult to consider
any one classification framework as all encompassing or superior.
The various risks that may face an organisation include strategic
risks, financial risks, operational risks and reputation risks.
We will limit our discussion in these articles, as is more
pertinent to financial institutions and banks, to credit,
market and operational risks.
Credit risk is the risk that a borrower or counter party to
a bank fails to honour its obligations in accordance with
This situation could arise from either an inability or willingness
of the counter party to honour contractual obligations.
In other words, credit risk can also be described as default
risk. For most financial institutions, while loans may subsume
the single largest source of credit risk, it is possible that
credit risk can arise from different sources, as can be seen
from the examples below:
n A bank makes a loan to a corporate client. Because it is
possible that the client will fail to make timely principal
or interest payments, the bank faces credit risk
n A corporation executes an interest rate swap with a counter
party. If interest rates move in the corporations favour,
the counter party will owe the corporation a net obligation.
Because the counter party could fail to perform on such an
obligation, the corporation faces pre-settlement credit risk
We will examine credit risk and its assessment and management
in much more detail in subsequent articles in this series.
Market risk is the possibility that the value of an asset
or a portfolio of assets may change due to change in the underlying
economic factors such as interest rates, foreign exchange
prices, commodity prices, equity prices etc.
For instance, for a bank, market risk may arise on account
of transactions entered into for facilitating a clients
For an investor, market risk exposure arises out of risk of
loss in value of investments, (either directly, or indirectly
through derivative products) from adverse movements in the
market value of assets.
For manufacturing companies, market risk could depend on the
specific attributes of business transactions, such as say
potential fluctuation in prices of contracted raw materials.
The primary forms in which market risk can manifest in financial
institutions are interest rate risk, foreign exchange risk,
equity price risk and commodity risk.
Interest rate risk arises for a bank because of the interest
sensitive assets that a bank tends to carry, or in other words,
those assets whose intrinsic value can change with a change
in the market interest rates.
Banks in most progressive financial systems are required to
mark to market all the assets in their portfolio, except those
held to maturity.
Everything else being equal, an increase in interest rates
leads to a diminution in the value of a banks fixed-rate
investments and vice versa.
The mismatch between the maturity of their assets and liabilities
in a bank, can create liquidity risk (which refers to the
availability of funds to meet maturating liabilities) and
also an interest rate risk (the risk that funds though available
can be accessed only at a higher cost than that of the maturing
Banks manage market risk primarily by reducing the net exposure
to the underlying price factor.
For example, by applying floating rather than fixed interest
rates on both its assets and liabilities, a bank can reduce
its vulnerability to interest rate changes in an economy.
Banks deploy methods such as maturity gap analysis, duration
analysis, value-at-risk analysis for assessing market risk
and also subject such analysis to stress testing.
Generally, operational risk is defined as any risk, which
is not categorised as market or credit risk, arising from
various types of human or technical error.
BIS defines operational risk as the risk of direct or indirect
loss resulting from inadequate or failed internal processes,
people and systems or from external events.
Operational risk is not really a new feature for business;
time tested functions such as internal audits and compliance
are mainly aimed at controlling this risk.
The most important type of operational risk involves breakdowns
in internal controls and corporate governance.
Such breakdowns can lead to financial loss through error,
fraud, or failure to perform in a timely manner or cause the
interest of the bank to be compromised.
Settlement or payments risk and loss due to business interruption,
administrative and legal risks, are other examples.
Although some large international banks have made considerable
progress in developing more advanced techniques for allocating
capital with regard to operational risk, existing methods
are relatively simple and experimental.
The process of operational risk assessment needs to address
the likelihood (or frequency) of a particular operational
risk occurring, the magnitude (or severity) of the effect
of the operational risk on business objectives and the options
available to manage and initiate actions to reduce/mitigate
Operational risk assessment should be conducted on bank-wide
basis and should be reviewed at regular intervals
Integrated risk management
While risks may be categorised and seen in silos
for efficiency in measuring and monitoring such risks, in
reality, risks are interlinked.
An operational problem with a business transaction could trigger
a credit or market risk; similarly loss arising out of market
price movements can easily lead to bankruptcy and credit defaults.
Therefore, it is important to view risks with an integrated
Successful quantification of integrated risk may be still
a distance away or may never be realised.
However, a co-ordinated approach by the different risk functions
and operating departments in a bank can ensure that the overall
objective of a bank of maximising returns while minimising
risk can be achieved.
CariCRIS is the Caribbeans Regional Credit Rating
Agency. This article forms part of a series on issues surrounding
risk and risk management.
E-mail: [email protected]
or call 868-627-8879