Types of Banks Risk
The types of Banks Risk are as follows:
Financial risk is the risk of losses inherent in financial transactions. There are numerous types of financial risks faced by banks. Following are the risks which are classified as under financial risks:
1. Interest Rate Risks: Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment. A bank’s main source of profit is converting the liability of deposits and borrowings into assets of loans and securities.
However, the terms of its liabilities are usually shorter than the terms of its assets. In other words, the interest rate paid on deposits and short-term borrowings are sensitive to short-term rates, while the interest rate earned on long-term liabilities is fixed. This creates interest rate risk, which, in the case of banks, is the risk that interest rates will rise, causing the bank to pay more for its liabilities, and, thus, reducing its profits.
2. Currency Risk:
- Transaction Risk: It is the risk that exchange rates will change unfavorable over time. It can be hedged against using forward currency contracts.
- Translation Risk: It is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency. The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, Which results in differential inflation rates.
3. Liquidity Risk: Liquidity risk is probability of loss arising from a situation where;
- There will not be enough cash and/ or cash equivalents to meet the needs of depositors and borrowers,
- Sale of illiquid assets will yield less than their fair value, or
- Illiquid assets will not be sold at the desired time due to lack of buyers.
4. Credit Risk: According to the Bank for International Settlements (BIS), credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk is most likely caused by loans, acceptances, Interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. In simple words, if person A borrows loan from a bank and is not able to repay the loan because of inadequate income, loss in business, death, unwillingness or any other reasons, the bank faces credit risk. Similarly, if you do not pay your credit card bill, the bank faces a credit risk. Hence, to minimize the credit risk on the bank’s end, the rate of interest will be higher for borrowers if they are associated with high credit risk. Factors like unsteady income, low credit score, employment type, collateral assets and others determine the credit risk associated with a borrower.
Non-financial risks relate to a broad range of operating risks that a company is likely to face in the normal course of its business- and, as the name suggests, exclude all financial exposures. The precise non- financial risks a firm may encounter depend on the industry in which it operates and the specific construct of its business; as a result, there is a systemic element and an idiosyncratic element to such non-financial exposures.
Operational Risk: Operational risk is the risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems. This arises due to the failure of banks to properly execute their various operational procedures. Untimely collection of revenues, inability in meeting the set guidelines and the like fall in this category. Many types of operational risk, such as the destruction of property, are covered by insurance. However, good management is required to prevent losses due to faulty business practices, since such losses are not insurable.