Thursday 23rd June 2005

 

Types of risk in a financial institution

 
 
 
 
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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

Credit risk is the risk that a borrower or counter party to a bank fails to honour its obligations in accordance with agreed terms.

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 corporation’s 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

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 client’s requirement.

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 liabilities).

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.

Operational risk

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.

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 perspective.

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 Caribbean’s 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

 

 

 

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