The banking industry is by far one of the largest industries in the world. In the US, insurance, real estate, and financial industry account for 20% of the total GDP. In order to keep the economy smoothly flowing, it is essential that banking industry operates seamlessly. However, the truth is that the banking sector is far from stable, as banks face numerous risks which threaten not only their profits but also the economic balance as a whole. As a result, it is essential that banks perform proper risk analysis and mitigate such perils for smooth operations. Keeping risks unchecked can lead the world towards financial meltdown as witnessed in the 2008 global crisis. So what are the kind of risks faced by the banks that needs to be regularly monitored?
Credit risk can be defined as a risk that a borrower or the counterparty will fail to meet their obligations by agreed terms. Such risks occur due to borrowers inability to pay back loans arising out of interbank transactions, trade financing, foreign exchange transactions, swaps, bonds, financial futures, options, guarantees, and the settlement of transactions. To simplify the matter, a $100 borrowed and not paid back will result in banks taking the loss in full. Additionally, banks will have to redress the money from their lenders who can be government, other banks, or the general public. Such losses in large amount can cause a serious dent in the economy. The banking industry usually declares the high rate of interest for borrowers who are associated with high credit risk. Banks need to perform timely risk analysis at an individual level to protect its wealth.
“Mutual fund investments are subject to market risks.” You may have heard this statement a thousand times over in the banking industry. So what is a market risk? It is the risk that causes losses in the bank’s trading books due to changes in interest rates, credit spreads, equity prices, foreign-exchange rates, commodity prices, and other indicators. However, this type of risks only troubles players who are into investment banking space since they are active in the capital markets. Market risks are hard to assess as some factors are highly volatile like commodity prices, whereas some are stable, but small deviations can cause big consequences like interest rates. Proper risk analysis can be carried out by dividing it as per their potential cause, i.e., interest rate risk, equity risk, currency risk, and commodity risk.
Losses that could arise from failed or inadequate internal processes, people, and systems or from external events is termed as operational risk. It also includes legal risk but does not incorporate strategic or reputation risk. Humans are prone to making errors and mistakes, and such errors can occur in the banking industry due to improper operational risk analysis. Filling incorrect information while clearing a financial instrument can cause loss of time to rectify that error and in some cases loss of money due to improper crediting of balance. Apart from human risk, operational risk can also occur due to system risk or process risk.
Liquidity risk arises when banks perform inadequate risk analysis relating to marketability of an investment which cannot be sold quickly enough to prevent a loss. In simple terms, it is a risk that disables a bank from carrying out their day-to-day cash transactions. Even though it may seem like a theoretical example, it happened in Northen England when one of the bank was taken over by the government due to its inability to repay the investors during the 2008 global crisis.
Businesses in the banking industry may be unable to meet its anticipated profit targets due to various reasons. Sometimes they may even incur a loss in place of making a profit. In case of banks and financial institution, missing the target can have severe implications as banks will have to shuffle their investment and public money. Business risk arises due to the failure of bank’s long-term strategy and errors in estimation and forecasting of profit metrics. A proper business risk management strategy can ensure sustainability even in the harshest economic environment. Conducting thorough risk analysis by guaranteeing flexibility and adaptability to the market condition can help banks avoid business risk.
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