Chapter 2 – Risks in Banking Business

From the risk management point of view, banking business lines may be grouped broadly under the following major heads

• Banking Book
• Trading book (trading portfolio)
• Off balance sheet exposures.

Banking Book

The banking book for the purpose of risk management include all types of loans and deposits & borrowings, that emerge from commercial and retail banking transactions. These assets and liabilities have following features:

• Normally held until maturity
• Accrual system of accounting is applied
• Not subject to Market to Market exercise
• Capital charge on Credit Risk, not on Market Risk

Trading Book

The banking, book for the purpose of risk management, includes marketable assets i.e. investments both

for SLR and non-SLIt purpose in govt. securities and other securities. These are generally held as fixed income securities, equities, foreign exchange assets etc. The important features of these assets include:

• These assets are generally not held till maturity (except a small portion called HTM-held till maturity in Govt. securities) . These are disposed of before maturity after holding for some time.
• In order to ensure that their valuation is in line with current market value (vis-a-vis book value) of such securities, they are marked to market, which affects the profit and loss position, since provisions are required to be made where market value is lower than book value.
• Trading book is exposed to adverse movement in market prices of the securities which leads to Market risk.
• Investments having lower demand in the market also face liquidation problem leading to liquidation risk.
• In addition, there may be problem with redemption by the issuer (may be, by the time these securities mature, the financial position of the issuer may not be as sound as at the time of issue), which leads to credit risk. Hence trading book is exposed to market risk including liquidation risk, credit risk and default risk.

Off-balance sheet exposures

These exposures include bank guarantees, letters of credit, lines of credit etc. and derivative instruments such as swaps, “(Wires, forward contracts, foreign exchange contracts, options etc. These are in the nature of contingent exposures. Banks may also have contingent revenue generations called contingent receivables. These exposures can turnout to be find based exposure, in case of the counter parties fails to settle their obligations. Hence, the off-balance sheet exposures are exposed to liquidity risk, interest rate risk, market risk, default or credit risk and operational risk.

Definition of Banking Risk

The banks are exposed to following types of risks:

1. Liquidity risk
2. Interest rate risk,
3. Market risk
4. Credit risk (default risk)
5. Operational risk

These risks can be further broken up in various other types of risk as under:

1. Liquidity risk

This is the risk arising from funding of long term assets by short term, liabilities or funding short term assets by long term liabilities.

• Funding risk : The risk arises from need to replace net outflows due to unanticipated withdrawal or non-renewal of deposits.
• Time risk : This risk arises from need to compensate for non-receipts of expected inflows of funds i.e. performing assets turning into non-performing assets, borrower not paying their EMI on due dates
• Call risk : This risk arises due to crystallization of contingent liabilities.

2. Interest rate risk

This is the risk arising from adverse movement of interest rates during the period when the asset or liability was held by the bank. This risk affects the net interest margin or market value of equity.

• Gap or mismatch risk: It arises from mismatch from holding assets and liabilities and off balance sheet items with different maturities. For example, an assets maturing in 4 years, funded from a liabilities maturing in 2 years’ period.
• Yield curve risk : In a floating interest rate situation, banks may adopt two or more benchmark rates for different instruments. Different assets based on these different benchmark rates, may not yield a parallel return (as there may be variations in the yield of the benchmark). Hence their yield curve would be different. For example, if a deposit is raised on a floating rate linked to 91 days treasury bill and another deposit is raised on a floating rate linked to 382 days, the cost to the bank may be different for these two deposits.
• Basis risk : The interest rates on different assets or liabilities may change in different magnitude which is called basis risk. For example in a declining interest rate scenario, the rate of interest on assets may be declining in a different magnitude than the interest rate on the corresponding liability, which may create variation in net interest income.
• Embedded option risk : When a liabilities or assets is contacted i.e. a deposit is obtained or a loan is given) with a call option for a customer (i.e. option to obtain payment of deposit before maturity or make payment of the loan before becoming due), it may give risk to embedded option risk. It may affect the net interest margin.
• Reinvestment risk: When bank gets back the repayment of a loan or an investment, there is uncertainty about the interest rate at which the cash inflow can be reinvested. Hence, any mismatch in cash flows exposed. the bank to variation in net interest income.
• Net interest position risk: When market interest decline and a bank has more earning assets than paying liabilities, the bank is exposed to reduction in NIT, which is called net interest position risk.

3. Market risk or price risk

It is the risk that arises due to adverse movement of value of the investments / trading portfolio, during the period when the securities are held by a bank. The price risk arises when an investment is sold before maturity.

• Foreign Exchange risk : When rate of different currencies fluctuate and lead to possible loss to the bank, this is called a forex risk.
• Market liquidity risk: When bank is not able to conclude a large transaction in a particular instrument around the current market price (say bank could not sell a share at a higher price which could have been done but for poor market liquidity this could not be done), this is called, market liquidity risk

4. Default risk or credit risk

The risk to a bank when there is possibility of default by the counter party (say a borrower) to meet its obligation. Credit risk is prevalent in case of loans.

• Counterparty risk : Counter party risk is a variant of credit risk. It arises due to non-performance of the trading partners due to counterparty’s refusal or inability to perform. It is basically related to trading activity rather than credit activity.
• Country Risk: -When non-performance by the counter party due to restrictions imposed by the country of the counter party (non-performance due to external factors).

5. Operational risk :

It is the risk that arises due to failed internal processes, people or systems or from external events. It includes a no. of risk such as fraud risk, communication risk, documentation risk, competence risk, model risk, cultural risk, external events risk, legal risk, regulatory risk, compliance risk, system risk etc. It however does not include strategic risk or reputation risk.

• Transaction risk : It arises from fraud or failed business processes or inability to maintain business continuity and manage information.
• Compliance risk: It is the risk of legal or regulatory sanction or financial loss or reputation loss that a bank may suffer as a result of bank’s failure to comply with applicable laws or regulations.

6. Other risks :

These may include strategic risk or reputation risk.

Strategic risk : It arises on account of adverse business decision, improper implementation of decisions etc.

Reputation risk: It is the risk that arises from negative public opinion. It can expose an institution to litigation, financial loss or decline in customer base.