3.1   
Risks faced by the banks

A bank is exposed to several types of risks. We discuss
them for our reference:

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1. Credit Risk:

It
is the risk that the consumer or borrower will fail to meet its obligations as
and when they arise under the agreed upon terms. Credit risk is categorised
further as:

 

a)   Transaction risk-

It
is the risk in relation to a particular transaction with a specific counterparty.

b)  
Portfolio risk-

It
is the risk arising when the credits are concentrated to a particular sector or
when lending is made to a few big borrowers in a large group.

 

2. Market risk:

It
is the risk arising due to adverse market movements. It could affect the
financial condition of the bank severely. The market risks have been
categorised as:

 

a)  Interest rate risk

It
is the risk which arises due to changes in the interest rate structure. Such
changes put pressure on the net interest margin of the bank. The various types
of interest rate risk are enumerated below:

 

                  
i.       
Gap/Mismatch risk-

It
arises when the bank is holding assets and liabilities along with off balance
sheet items with different principal amounts, re –pricing and maturity dates.
It creates exposure to the unexpected changes in the level of market interest
rates.

                
ii.       
Basis risk-

It
arises when the interest rates of different assets and liabilities change in
different magnitude.

              
iii.       
Embedded option risk-

It
arises when there is an option of pre-payment of loans and foreclosure of
deposits before their stated maturities.

              
iv.       
Yield curve risk-

It
arises due to movements in yield curve and the impact it creates on portfolio
values and income.

                
v.       
Reprice risk-

It
arises when assets are sold before maturity dates.

              
vi.       
Reinvestment risk-

It
is caused due to uncertainty surrounding the interest rate at which the future
cash flows could be reinvested.

            
vii.       
Net interest position risk-

It
arises when the banks have higher earning assets than paying liabilities and in
case market interest rates adjust downwards.

 

b)  Foreign Exchange
risk:

The
foreign exchange or forex risk can be classified into following three types:

 

 

                  
i.       
Transaction risk-

It
is observed when movements in price of a currency upwards or downwards causes
loss on a particular transaction to the institution.

                
ii.       
Translation risk-

It
arises in cases of adverse exchange rate movements and changes in level of
investments or borrowings in the foreign currency.

              
iii.       
Country risk-

Sometimes,
foreign Government or regulators impose restrictions on transfer of funds
resulting in country specific risk.

 

3.   Liquidity risk:

The risk arising when potential for liabilities to
drain from the bank is higher than the assets. For instance, the depositors
might take out their money at a faster pace than lenders borrowing money.
Liquidity risk has been further categorised as:

 

a)  Funding liquidity
risk:

It
arises when a bank may not be able to meet the current and future cash flows
and collateral needs without affecting their daily operations or its financial
condition.

b)  Market liquidity
risk:

The
risk that a bank will not be able to offset or eliminate a position at the
prevailing market price because of inadequate market depth or disruption.

 

4.   Operational risk:

This type of risk arises when there is a failure of
banking operations due to activities like natural disaster, human errors and
frauds, omission, etc.

 

 

5.   Systemic risk:

The type of risk occurring when the failure of one
financial institution may lead to a chain reaction and threaten the financial
stability of the whole financial system.

 

6.   Strategic risk:

It is the risk which may arise from a fundamental shift
in the economic or political environment of the institution. This risk affects
the entire industry and it is critical to protect yourself.

 

7.   Business risk:

The type of risk which the bank willingly takes on, to
create a competitive advantage in the industry and also to add value to its
stakeholders. Technological innovations, marketing and product design are few
of the examples.

 

8.   Reputation risk:

The risk arising due to negative publicity regarding
the business practices of an institution lead to reputation risk. Despite such
publicity is true or not, it leads to decline in customer base, costly
litigation and revenue losses.