May 21, 2019
The financial service industry has gone through a significant transformation over the last few decades. The rapid transformation and changing regulatory environments has resulted in a highly complex ecosystem. Stakeholders from different backgrounds who play influential roles in the banking industry bring new complexities. As a result, banking institutions need to adjust risk management procedures to accommodate risks that come with new players. Monitoring and managing these risks guarantee a safe transformation in banking.
Credit risk is a common banking risk that can be expressed in two ways:
The uncertainty involved in the repayment of banks dues.
Failure by borrowers to meet payment obligation regarding terms agreed upon with the bank.
Banks suffer heavy losses from credit risk when borrowers fail to pay credit at maturity due to low income, business failure, or unwillingness to pay. Credit risk can be mitigated by correctly monitoring and evaluating default rates.
With technological advancements in the banking industry comes cybersecurity risk. Hackers have the tactics to penetrate security firewalls and steal personal, as well as financial data. Banking institutions need to invest in top-notch online security programs that are impenetrable. Cyber risk is the most prevalent IT risk in the financial service industry, and the aim is to keep electronic information private, safe, and undamaged. The risks arise from a range of internal and external factors, and it is as much a people problem as it is a technological problem.
Bank shares going down due to market movements is a common risk in the financial service industry. Market risks can be classified as interest risk which arises from the change in interest rates that lead to losses. This risk can be mitigated with a sound liability management system. Equity risk is a result of the change in stock prices, and it affects banks that have accepted equity against the disbursement of loans. Commodity risk arises from the change in commodity prices, and the massive fluctuations are as a result of continuous variations in demand and supply. Meanwhile, foreign exchange risk occurs due to the change in the value of the bank’s assets or liabilities.
Liquidity risk refers to the risk of a bank not being able to finance its day-to-day operations. Imprudent management of liquidity risk can ruin a bank as it has severe consequences for the bank’s reputation as well. Liquidity risk due to rising non-performing assets (NPA) can also arise when the bank gives credit to borrowers who default at maturity.
Compliance risk arises when a banking institution violates rules and regulation put in place by regulatory organizations. Failure to comply puts the bank at risk of legal or regulatory sanctions or material financial loss. The bank’s reputation is likely to be severely affected, and for this reason, banking institutions should formulate, communicate, and manage compliance policies across all business units.
Since banking institutions are businesses like any other, they require future-proof business strategies as well. Business risk arises from the bank’s inability to generate profits at its target levels. It is the most common among all risks that prevail in the banking sector. Business risk arises from the bank’s business strategy in the long term. Failure to adapt to the changing environment as quickly as rival businesses can lead to loss of market share of the institution getting acquired.
Even though an open banking ecosystem streamlines operations since its motive is to enhance customer experience, such an environment also encourages fraud. A fully digitized banking ecosystem is easily accessible, which poses a significant risk to the institution’s cybersecurity. Open bank risks can result in financial as well as reputational damage.
From a centralized banking system, the failure of internal processes poses operational risks. Core banking solutions can fail due to inefficient and inadequate internal controls. Other causes of operational risk include human intervention, failure of IT systems, and inaccurate data transmission.
This risk mainly arises from the public’s loss of confidence in a banking institution. The causes of reputational risk are many – a bank’s image can be tarnished with or without evidence of wrongdoing. Formation and maintenance of public perception is an essential aspect of successfully running a banking institution.
Systematic risk is different from the other risks faced by banking institution since it affects more than one institution at a time. Systematic risk can bring down the entire financial system to a standstill even though it does not lead to individual losses in the beginning; it’s a threat to the entire financial service industry, and hence, a severe risk.
Banking institutions, just like any other type of businesses, face risks. Banks exercise careful supervision over certain risks through efficient internal & external controls, systems, and processes. Also, tech-driven audits and compliance help banks to keep risks in check. However, some risks, such as systemic risk – which banks have little control over – can only be mitigated if banks have a strong capital base. Coming up with the right solutions allows banking institutions to stay in business and retain the trust of the public.