As we all know, banks deal in money, where risk is inherent which cannot be completely removed but can only be reduced. With the recent fraud in Punjab National Bank (PNB), it can be assumed that its blight will affect several other Indian banks. This is a clear example of operational risk faced by banks.
In this article, we have discussed some major types of risks that are faced by every bank in a common man’s language.
Types of Risk in Banks
What do you mean by “Risk” in banks?
Risk in the bank means “future uncertainty” of earning and outcome in case of failure.
For example –
1. Recent fraud of Rs. 11,400 crores in the Punjab National Bank (PNB). The type of risk bank affected in this case is (a) Credit risk and (b) Operational risk (c) reputation loss.
2. Videocon Group gets Rs. 3250 crore loans from ICICI Bank but failed to repay Rs. 2810 crore. In 2017, ICICI classified this as an NPA and the current outstanding is Rs 2,810 crore. With the large amount involved the reputation of the bank is at stake. This is a clear example of reputation risk for Bank.
3. Rising NPA (Non-Performing Asset) of bank and failure to repay loan result (a) substantial credit loss (b) reputation loss and (c) operational risk too for Bank.
So, by example (1), (2) and (3) we can conclude that - All (1), (2) and (3) led to the loss of earnings and in the long-run failure of the banking system.
Understanding types of Risk with the concept - Let's discuss the various types of risk in the banking sector.
Credit Risk
1. Credit risk - Failure to repay the money back, by a borrower to the creditor.
Let us understand the concept:
Let us assume - Sahil is a businessman and lives in Bhopal, Madhya Pradesh. He is an urgent need of 20 lakh rupees to set up a paper mill. He visited Bank of Baroda branch for a business loan.
The Bhopal branch of Bank of Baroda sanctioned Rs. 20 lakh loan amounts to Sahil. The duration of the loan is 15 years.
Due to some financial crisis, at the end of 15 years, Sahil fails to repay both the loan and interest amount. This 20 lakh rupee is just a loan amount for Sahil, but it is an asset for Bank of Baroda.
So, here the result is - Loss of credit to Bhopal Branch of BOB, due to non-repayment of an amount. This type of risk is called “Credit risk".
Definition - Unable to repay the loan amount, at maturity by a borrower to the lender which lead to loss to the lender is called ‘credit loss’. For a borrower, it is the only loan but for a Bank, it is an asset. Credit loss rise results NPA (or non-performing assets).
Operational Risk
2. Operational risk - Centralised computer failure or failure of internal processes in banks.
Let us understand the concept:
Bank of India (BOI) is a Public-Sector Bank in India. BOI provides a wide range of services to its customers like:
- RTGS (Real-time gross settlement)
- NEFT (National Electronic Fund Transfer)
- Other online modes of fund transfer
- Account update through computer etc.
Sudden failure of the centralised computer system or Core Banking Solution (CBS) where each computer is connected to one central computer, which controls all working and failure of the central computer results in what?
- Substantial loss and halt of essential services offered to Customers like RTGS, NEFT, online account update etc. This type of risk called “Operational risk”.
Another example of Rs 11,400 crore fraud in PNB
The well-known fraud of Punjab National Bank has brought attention to how banks manage operational risk. Due to the complete failure of the bank’s audit process, some culprits used to continue there as usual business transactions without being noticed at any point.
Some of the reasons which lead to the fraud are -
- Failure of the internal audit process.
- Involvement of few employees with the clients could take control of such large amounts of money for such a long time.
- No transfer. How employees remain in a position for a long time without job rotation/transfers.
- Access to SWIFT was given to a limited officer without proper management.
- Lack of audit in the case of settlement of funds on Nostro accounts.
Definition - Risk that originates due to failure in core banking solution or failure of internal processes is called Operational risk.
Market Risk
3. Market risk - Due to market movements, sometimes banks share goes down (assume SBI share down by 50 points, this is also a risk for SBI).
Let us understand the concept
Let us assume – IDFC is a private sector bank in India. The share price of IDFC on 4th April 2018 is 90 rupees per share. On 6th April 2018 share price fall to 75 rupees per share due to –
- Bharat Bandh by SC/ST people
- Rising instability of PSBs let NIFTY bank share fall which leads to an impact on IDFC share price also.
The sudden reduction in the price of the share which is associated with the investment of Banks in a market. Such risk is called “Market Risk”.
Another example of Market risk
IDFC invested Rs 20 lakh in shares of Coal India assume (i.e. equity investment). But due to uncertain reason, shares of Coal India fall drastically, which results in the devaluation of investment of IDFC i.e. of Rs. 20 lakhs. This risk associated with equity (or investment in stocks of other company) is called “Market Risk”.
Definition - Fall in the prices of shares of the company or fall in the prices of shares of other company in which the company has invested is called Market risk.
Market risk is mostly due to a loss in equity investment. Fluctuation in interest rate can also result in market risk.
Systematic Risk
4. Systematic risk – The risk that is caused by external factors. Systematic risk is also called ‘market risk’ or ‘non-diversifiable risk’. It is the part of the risk that is beyond the control of a bank such as management, the strike of the employees, market fluctuation, non-stability of the government, fraud in the bank, etc. It is a kind of risk which is unpredictable and cannot be completely avoided.
Let us understand the concept:
Let us assume – The NDA led government loses the 2019 General Lok Sabha election, due to this the stock market will be crash and the global investor will not invest in the Indian market for a certain duration fearing loss of their investment.
Also, Indian will also invest less in the share market for a certain duration. So, the less investment in the stock market led to a decrease in the share price of almost all the companies, which will lead to less flow of money in the market. This will impact the whole market.
Another example of Market risk
Strike in a Bank – If a bank strike caused by all the employees of the banks on the national level and the strike is extended for a longer duration then its impact would severely affect all the firms and individuals in a similar manner.
Definition - The above all situation is an uncertain risk and the loss is bigger. This is called Systematic risk.
Business Risk
5. Business risk - Banks inability to generate profits at its target levels.
Let us understand the concept -
Let us assume - Bank of Baroda invested Rs. 50 lakhs in a start-up named ABC which works on food supply management.
The total duration of the loan is 10 years. But company ABC failed to generate adequate revenue and profit at the end of 10 years, the result fails to repay amount and interest collected in 10 years to BOB.
This led to what? Risk called Business risk. Loss of amount invested i.e. 50 rupees lakh for BOB. R. 50 lakh is an asset for BOB.
“Business risk” is most common among all risks prevailing in the banking sector these days.
Definition - “Failure of non-payment” of a loan by a businessman to Banks or creditors at maturity led to the origin of risk called business risk.
Reputation Risk
6. Reputation risk - When risk arising from negative public opinion due to big fraud or scam and inability of the bank to control operational risk.
- no repayment of loan
- large debt
- rising NPA
All such case creates a negative image of banks. (You can take above example of PNB & ICICI Bank). This negative image led to damage to the reputation of the bank. This type of risk called “reputation risk “
Definition: Credit loss + Business loss = reputation loss for Bank. This reputation loss is a risk called reputation risk.
Liquidity Risk
7. Liquidity risk - Availability of cash risk, due to rising NPA, bank fear to give credit or loans, which result in less flow of money in the market and it results in less liquidity.
Due to a substantial risk of non-repayment of credit, the credit capacity of the bank reduces (take an example of BOB in the past example). Due to the absence of sufficient liquidity (cash inflow) banks were unable to provide the loan to their genuine customer. This risk is called “Liquidity risk”.
Definition - Liquidity risks are a consequence of large credit loss and business loss of investment by the bank.
The above all seven are the most common risks which banks faces and among all most common is a 'CREDIT Risk'.
At last - As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money.
Thank You.
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