Credit risk, operational risk, market risk, and liquidity risk are the four most significant threats facing banks.
FREMONT, CA: Among the most significant risks for banks are credit risk, operational risk, market risk, and liquidity risk. Banks are responsible for managing a variety of risks and are required to follow government regulations since they are exposed to a variety of risks. For example, the Office of Superintendent of Financial Institutions (OSFI) in Canada sets regulations to protect depositors from risks.
Bank Risks: Why Are They Important?
Several banks are large, which can cause overexposure to risk and result in bank failures. In order to encourage prudent decision-making and management, governments must understand the risks posed to banks.
The ability of a bank to manage risk affects investors' decisions as well. Despite a bank's ability to generate large revenues, loss on loans can lower profits due to poor risk management. Investing in a bank at an acceptable risk of losing money and providing profits is more likely to attract value investors.
Credit Risk
Banks are most exposed to credit risk. Contractual obligations are not met by borrowers or counterparties. One example is when borrowers fail to pay a loan's principal or interest. A mortgage default can occur, a credit card default, or a fixed income default. Derivatives and guarantees can also fail to meet obligational contracts.
Because of their business model, banks cannot completely reduce their exposure to credit risk. The risk of deterioration in an industry or issuer is often unpredictable, so banks diversify to reduce their exposure.
In this way, banks will be less likely to overexpose themselves during a credit downturn. The risk exposure of the company can be reduced by lending money to creditworthy individuals, transacting with top-quality counterparties, or owning collateral.
Operational Risk
A risk of operational loss occurs when people, systems, or processes make mistakes, are interrupted, or cause damage. Retail banking and asset management have a low operational risk, while sales and trading have a higher risk. Internal fraud and errors during transactions are examples of human error-related losses. Tellers sometimes mistakenly give customers extra $50 bills.
A breach of a bank's cybersecurity can lead to fraud on a larger scale. Hackers can steal customer information and money from banks, and blackmail them for additional funds. Customers lose trust in banks when such a situation occurs. It may be more difficult for the bank to attract deposits or business in the future if its reputation is damaged.
Market Risk
Capital market activities pose the majority of a bank's market risk. The reason for this is the unpredictability of equity markets, commodity prices, interest rates, and credit spreads. A bank that heavily invests in capital markets or engages in sales and trading is more exposed.
A bank might invest in companies that produce commodities, which also affects commodity prices. Commodity values change as do company values and investments. A shift in supply and demand can cause a change in commodity prices that is sometimes difficult to predict. So, to decrease market risk, diversification of investments is important. Hedging investments with another, inversely related investment is another way for banks to reduce their investment.
