One of the most misunderstood terms, especially when one relates it to banking, is that little word "risk". Risk and banking seem to automatically go together just like a hand with a glove or Jack pairs with Jill.
In the post "2008 Financial Crisis", putting the words "risk" and "bank" together conjures up the image of a monolithic bank rampaging through the economy wreaking havoc as it goes.
This image is of course totally unfair. Banks, like any other firm or even individuals are exposed to many different forms of risk. Banks too in their own right are a source of a number of risks as well. However this is outside of our present scope.
This article will explain what risk is and some of the different types of risk that banks and other financial institutions are exposed to in their everyday business activities.
Let us start our journey with a visit to the dictionary. Once upon a time this mean a trip to the bookshelf, but today thanks to the wonders of technology the "word" is at ones fingertips. The definition of "Risk" being "exposure to the chance of injury or loss" is typical (with thanks to Dictionery.com).
There may be other variations on this theme, but what we have is good enough. The key elements of "risk" are EXPOSURE to the CHANCE of LOSS . In other words the possibility that something will cause a financial or other loss. This is the basis for understanding the different types of risks that banks face.
Let us take a look at a typical bank. In its very simplest form, banks take in deposits and lend this out in the form of loans. Should the borrower not repay his or her loan the bank is faced with Credit risk. This is the possibility that a borrower will be able to make payment of the amount due. Credit risk is absolute. It's the chance that the borrower will never be able to repay the loan. Credit Risk implications bankruptcy.
Liquidity risk is on the other hand not absolute. It is the possibility that a borrower will be unable to make payment of the amount due at the time that it is due. However the reason for this could be timing issues. It does not imply that the borrower is insolvent as he may be able to repay the loan at a later time.
Between them, Credit risk and Liquidity risk are the major business risks that banks face because they are part and parcel of the business of banking.
In recent years there has been a growing realization that Operational risk is another source of danger to a bank. This was given voice and form in the Basel Accords, where Operational Risk has been defined as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events".
Operational risk can be subdivided into seven distinct categories. In what follows we examine each of these categories and briefly explain what types of risks they cover.
- Internal Fraud. Typically this covers fraud by bank staff such as the stealing of assets, theft of client information, covering up errors, intentional mismarking of positions, bribery etc.
- External Fraud. Where non-bank staff are involved such as in computer hacking, third-party theft, forgery.
- Employment Practices and Workplace Safety. Discriminatory staff policies, workers compensation claims, employee health and safety issues.
- Clients, Products and Business Practice. This is a very wide field and generally covers market manipulation, antitrust issues, improper trading activities, bank product defects, fiduciary sections, account churning. The sub-prime Mortgage debacle is a clear example of a product defect.
- Damage to Physical Assets. This covers things like natural disasters, terrorism and vandalism – anything that results in actual damage or destruction of the bank's physical assets.
- Business Disruption and Systems Failures. Power failures, computer software and hardware failures. A hurricane or a flood that results in banking services being disrupted also falls into this category.
- Execution, Delivery and Process Management. This covers things like data capture errors, accounting errors, failure to meet legal reporting requirement, negligent loss of client assets.
There are other risks too, such as legal, reputational, market – the list goes on. But that is another story (and perhaps another article).