Risks Associated with the Banking Business

Risks Associated with the Banking Business

Let's have a view on the risks associated with the banking business.

There are three kinds of Risks associated with the Banking:

1. Credit RiskThe risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. Credit risk includes pre-settlement .....
2. Market Risk
3. Operational RiskThe risk that deficiencies in information systems or internal controls could result in unexpected losses.

The above words are self explanatory. The Basel II guidelines have stipulated approaches to assess the risks involved.

Credit Risk:

Credit risk is risk of loss arising from a borrower who does not make payments as promised. This event would be called "Default" and the person/ company/ entity would be called "Defaulter".

• So credit risk can also be called "Default Risk".

The banks have two approaches for risks assets calculations in Basel II and as stipulated by the RBI accordingly:

1. Standardized Approach: The risk weightage are assigned by the RBI as mentioned in the table above. The Banks have to follow it without any discretion to modify. The approach is based upon the external rating agencies. The Reserve Bank of IndiaThe Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934 with ..... has identified 4 external domestic agencies for this approach. They are as follows:
   1. CRISIL     
   2. ICRA
   3. Care
   4. Fitch

   Apart from this, there are international agencies such as Moody's, Fitch, Standard and Poor's etc.

2. Internal rating based Approach :

   This is basically an alternative to standardized approach. The Banks do the internal assessment of the Counterparties and exposures. Banks need RBI's nod to do this.

Market Risk:

Market risk is the possible losses due to movement in the market prices. There are four standard market risk factors viz. stock prices, interest ratesWhen a person borrows some money from another person, this money comes at an interest which can also be called the "Opportunity Cost" of the ....., foreign exchangeRegulated market place where capital market products are bought and sold through intermediaries. rates, and commodity prices. Apart from there are associated market risks as follows:

1. EquityThe ownership interest in a company of holders of its common and preferred stock. risk, the risk that stock prices and/or the implied volatilityVolatility equates to the variability of returns from an investment. It is an acceptable substitute for risk; the greater the volatility, the greater is the ..... will change.
2. Interest rate riskThe risk that movements in the interest rates may lead to a change in expected return. , the risk that interest rates and/or the implied volatilityThe value of the price or rate volatility variable that would equate current option price and fair value. Alternatively, the value of the volatility variable ..... will change.
3. Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
4. Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

Here again, the Basel committee has suggested two broad methodologies for computation of the capital charges of the market risks. They are standardized and internal. The standardized approach involves two methods viz. maturity method and duration method.

Operation Risk:

Operational Risk refers to the risk of loss from inadequate or failed internal processes, people, systems or external events including

• Incompetent management
• Improper planning
• Staff fraud
• Noncompliance
• Programming errors
• System Failure
• Increased competition
• Deficiency in loan documentations.