Types Of Risks In Banking
Without taking the risk, banks, the important financial institution, cannot be in running order (Matthews & Thompson, 2014). In business term, the bank is defined as an institution authorized by a government which provides financial services, for example, accepting deposits, paying interest, making loans, etc., to facilitate and provide benefit to an individual consumer, business, and organization (BusinessDictionary, 2019; Dimitriu, 2012), those considered as its customers. Generally, banks can be classified into eight different types; (1) Commercial banks, (2) Retail banks, (3) Investment banks, (4) Central banks, (5) Credit unions, (6) Online banks, and (8) Mutual banks (Pritchard, 2019). Through this essay, only commercial banks and retail banks will be mentioned. Commercial banks are the financial institution that grants loans, accepts deposits, and offers basic financial products (CFI, 2019), by focusing more on business customers as they need more complex services than individuals and have different desires (Pritchard, 2019). While retail banks work with individual consumers and small businesses (Lexico, 2019), by offering basic financial services. This is probably the reason why people are most familiar with retail banks. Another reason may because of their numerous branches located in populated areas (Pritchard, 2019). The common barrier of bank operation is the risks, any expected or unexpected events in the economy or the financial markets, include internal factors and external factors, that can be the source of discontinuations of particular objectives’ performance (Islam & Khan, 2016; Perez, 2019). Banking institutions’ risk-taking behavior has been impacted by the Global Financial Crisis (GFC) of 2007–2009. Moreover, the changes in the banking environment also influence the role of banks’ competitive and risk-taking behaviour in their functioning strategies (Badaraua & Lapteacr, 2019) that are also aﬀected by the risk-taking behaviour of banks (Alshatti, 2015; Boadi, et al., 2016; Bhattarai, 2016). There are three main risks that the commercial bank and retail bank are facing, include (1) Credit risk, (2) Market risk, and (3) Operational risk. These risks will be described and the processes of the possible solutions will be indicated to be operated by such banks to overcome these hazards.
The oldest and biggest risk of banks is defined as credit risk (Arunkumar & Gowdara, 2006). As it is the risk faced by all types of banks which include commercial banks and retail banks. The Basel Committee on Banking Supervision or BCBS defines credit risk as the potential of a bank borrower to not operate its payment obligations according to the contract of agreement with the bank (Perez, 2019). Banks are damaged by massive losses from credit risk when borrowers do not follow the contract to pay credit at maturity due to low income, business failure, or unwillingness to pay (Medici, 2019). So, they can create the largest risk to banks. (BankofEngland, 2019).
Generally, individuals and businesses can grant loans from the banks to buy something at a high price, such as a car and house, and make investments which also include education, business expansion, and product development. To have enough money for being able to make loans for their customers, banks use the method of borrowing from individuals, normally from their deposits, and firms, or even from other banks. And according to the bank contract of obligation, the borrowers have to make a repayment of a specific amount of money at given times in the future. As mentioned, individuals and businesses can make investments that are larger than their affordability by borrowing, which results in the creation of leverage. The leverage can be the benefits for the borrowers as being financial support for their businesses, but it also hedges the borrowers’ risks. In case of unfortunate, if their investments cannot proceed well and create enough return, the leverage enhances the losses (Admati & Hellwig, 2013), not only the losses of borrowers themselves but also the banks which are the lenders. A study of bank failures in New England found that most of the loans were not being repaid in time (Sabrani, 2012). As the nation’s large banking company that encountered a huge problem was the Bank of New England Corporation (Quint, 1991).
At the present time, banks state the procedures to eliminate this kind of risk. When the loan contract is applied by borrowers, they will make a consideration at five C’s which include (1) Credit history; the track record for debt repaying, (2) Capacity; the ability of borrowers to repay a loan by contemplating from their stability in career and the comparison between debt income, (3) Collateral; the asset of borrowers, such as house or car, will be occupied by banks if they cannot operate a repayment of loans, (4) Capital; any savings, investments, and other assets that might be under the ownership of borrowers will be considered by banks whether they can continually make repayment in case that they lose their jobs, and (5) Conditions; the approval of lending money is conditional on the purpose of the loan as it has an effect on banks’ consideration (BankofEngland, 2019). By way of explanation, the accuracy of monitoring and evaluating the rates of default can create the potential of credit risk moderation (Medici, 2019). Furthermore, the interest rate that borrowers will be charged, is corresponded with how risky they are, as the determination of banks’ assessment (BankofEngland, 2019).
The eliminating of bank shares due to market motions can be explained as another one of the common risks in the financial service industry. (Medici, 2019). The risk of losses in balance sheet positions that surface from movement in market prices is defined by BCBS as market risk (Perez, 2019). In detail, market risk also can be defined as the risk that comes up with an explanation of loss in banks trading book according to the changes in interest rates, stock prices, foreign exchange rates, and commodity prices, a fact which they are considered as four standard market risk factors, following by the issuing of the devaluation of both investment portfolio and trading portfolio of the banks (Islam & Khan, 2016).
To clarify the effects of changing in mentioned four market risk factors; (1) Interest rates; the movement of interest rate can generate the potential loss because the assets of bank usually have a remarkably longer maturity than its liabilities, (2) Stock prices which can be defined as equity risk as well; an unfavourable change in the stock price can be the cause of loss by reason of the effected stocks that banks utilize them as their investments for the most part, (3) Foreign exchange rates; the fluctuations in exchange rate can bring about the problem as banks commonly generate a foreign exchange transaction for their customers, either individuals or businesses, and (4) Commodity prices; disadvantageous change in commodity prices also result in trouble for the banks, mostly for the banks that invest in agricultural commodities, industrial commodities, and energy commodities, as the fluctuation of commodities’ value will give rise to the negative effects on demand and supply (Perez, 2019). As an overall illustration, if global oil prices instantly decrease, the banks that have bought shares in an oil company will lose money (BankofEngland, 2019).
Therefore, market risk measurement can be performed by the value-at-risk or VaR model, one of the measuring techniques, which is the industry standard of market risk management (Perez, 2019; Matthews & Thompson, 2014). The purpose of VaR is to calculate the probable maximum loss that banks might encounter on their whole trading book (JPMorgan, 1995). But there is still a limitation. According to the experience of the global banking crisis, although market risk can be ordinarily managed through the VaR model, the hypothesises of the VaR model are quite restrictive in some cases (Matthews & Thompson, 2014). Another tool for measuring the market risk is sensitivity analysis which analyses how a specific dependent variable will be impacted by different values of an independent variable (Perez, 2019). Besides the method of measurement, to reduce the risk, the alternative way can be the practice of asset allocation and diversification, in the reason of different portions of the market show a tendency to underperform at different times (Islam & Khan, 2016).
Operational risk takes place in all bank activities and emerges in almost all bank departments; credit, investment, treasury, and information technology. It is explained by BCBS as the risk of loss that arises from insufficient or degenerated internal processes, people, and systems, or external circumstances (Perez, 2019). As mentioned, the operational risk can be occurred by many causes and most of them may be unknown and unexpected, it is not easy to predict a comprehensive list of causes. In general, most operational apparent from one of these following three sources, include (1) People risk: the cases of personnel incompetency or wrong positioning, and also misuse of authorities, (2) Information technology risk: the failure of the information technology or IT system, the hacking by non-members, and the programming errors, and (3) Process-related risks; the probabilities of mistakes in information processing, data transmission, data retrieval, and inaccuracy of outcome (Perez, 2019).
Gigantic losses can occur from this kind of risk. Over the last decade, around £30 billion has been paid by banks for the incorrect selling of payment protection insurance (PPI). Customers were sold the insurance even though they were not being eligible for or desiring it. This action originally aimed to cover debt repayments in unavoidable circumstances when the customer was unable to pay because of illness, losing their job, or death, for example (BankofEngland, 2019). Another case of the bank’s collapse that occurred from the operational risk is the fall of Barings, one of Britain’s oldest banks, in 1995. The trading losses of Nick Leeson, one of Barings’ traders in Singapore, were concealed for several years. Without any supervision, as the result of weakness and inefficiency of the internal auditing and control measures, his trades were authorized and entered into the bank’s system, and his supervisors were notified after the losses became massive. At that time, there was no probability to keep the trades and the losses a secret. This situation was the evidence to support that the failure of a bank’s internal control processes was the main cause of the bank’s stumble (Perez, 2019).
The operational management for the organisations, the banks are in focus, includes the challenges of (1) Rising costs of compliance; the development of an operational risk management model is complex and time-consumed, (2) Access to appropriate information and reporting; the effective management requires a diversity of information and variety of sources, (3) Development of loss databases; a well-structured framework requires the development of business-line databases to catch loss events attributable to operational risk, (4) Lack of systematic measurement of operational risk: many businesses take that their institutions are measuring operational risk but actually it is incompletely, (5) Implementing operational risk management systems, and (6) Tone at the top; the effective risk management is driven by the top management and then by the bottom line (MetricStream, 2019).
As same as any other types of business, commercial banks and retail banks which are closed to individuals and businesses, also encounter risks (Medici, 2019). The banks’ maintenance of losses and the value to be within accepted margins is involved in risk management (Matthews & Thompson, 2014). Hence, risk management is the complement tool of the banks (Matthews & Thompson, 2014). As there are different types of risk that banks are facing, and those have different causes; (1) Credit risk; the result the action of not follow the obligation to make a repayment within a specific period of time of the borrowers, both individuals and businesses, (2) Market risk; the outcome of the fluctuation of market prices, and (3) Operational risk; the effect of unwell performance of either internal elements or external situations, banks have to generate the methods and processes of risk management that suitable with each kind of risks and each specific occasion. Additionally, the sequence of increasing complexity and competition of the financial market is the various risks have played a huge role in financial institutions (Islam & Khan, 2016). The future of banking will lay on risk management dynamics. The only way for banks to continually survive in the market for a long term is to have an efficient risk management system (Arunkumar & Gowdara, 2006), by they have to adjust the procedures of the system to accommodate any new situations of risks arise in the upcoming days (Medici, 2019). As it is not about how to avoid or escape the risks, but the ability to manage, adapt, and cope with them.