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August 31, 2017

Banking Awareness in Simple Language - Lesson 23

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Dear Gr8 Ambitionists, I am Krishna. I shared Banking Awareness lessons in simple language for IBPS PO and Clerical exams of the year 2016. I want to continue the same for upcoming IBPS PO VII, Clerks VII and Regional Rural Bank exams too. I will continue from where I stopped. I have shared 22 lessons so far. So today I am continuing with the 23rd lesson. I request you to read all these 22 lessons from below links before proceeding to this lesson 23. Happy Reading :)

Banking Awareness Lessons in Simple Language

In our previous Banking Awareness Lesson 22, we have learnt about namely CBS, Payment & Settlement System in India, IFSC, MICR, CTS, NFS, SFMS and important years of the evolution of Payments System in India. In today's lesson we shall learn about Bank Risks and Risk Management. As you need to review all the 22 lessons above, today's lesson will be short and simple.

Banking Awareness 2017 : Bank Risks & Risk Management

Bank Risks

In the course of their operations, banks need to face various types of risks that may have potentially negative effect on their business. There are 8 types of risks.  We can classify these risks in three categories. They are :
  1. Major Risks
    1. Credit Risk
    2. Market Risk
    3. Operatically Risk
  2. Other Significant Risks
    1. Liquidity Risk
    2. Business Risk
    3. Reputational Risk
  3. Unrelated Risks 
    1. Systematic Risk
    2. Moral Hazard
Now let's learn about them in detail

Major Risks

Credit Risk

The BCBS (Basel Committee on Banking Supervision) defines credit risk as the potential that bank borrower or counterpart, will fail to meet its payment obligations regarding the terms agreed with the bank. Let's try to understand this in simple words, If a borrower does not repay a loan, the lender may lose the principle of the loan or the interest associated with it. It arises because the borrower expects to use future cash flows to pay current debts.

A credit risk is the danger of default on an obligation that may emerge from a borrower neglecting to make required installments.

Credit risk is most likely caused by loans, acceptances, interbank transactions, trade financing etc.

Market Risk

BCBS defines market risk as the risk of loses in on or off balance sheet position that arise from movement in market prices. Market risk arises due to the factors affecting the overall performance of the financial market, it is also known as the systematic risk.

Operational Risk

BCBS defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people & systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk. Simply, the Operational risk is the risk not arising from financial, systematic or market-wide risk. It is the risk remaining after determining systematic and financing risk and includes risk resulting from breakdowns in internal procedures.

As per BIS (Bank of International Settlements) operational risk is the risk of loss, resulting from failed internal process, people and systems or from external events.

Operational managements are of following types
  • Human risk: loss because of a human error, done unconsciously or willingly.
  • IT/System risk: Losses due to failure of systems, failure of software, etc.
  • Processes risk: Loss caused due to improper information, leaking of information.

Other Significant Risks

Liquidity Risk:

Liquidity means a bank has the ability to meet payment obligations primarily from its depositors and has enough money to give loans. "So, the liquidity risk is the risk of a bank not being able to have enough cash to carry out its day to day operations". 

Business Risk:

It is the risk arising from a bank's long-term business strategy. It can also arise from a bank choosing the wrong strategy which might lead to its failure.

Reputation Risk:

It is the risk of damage to a bank's image & public standing that occurs due to some dubious actions taken by the bank. It leads to the public's loss of confidence in a bank.

Reputational risk is the major hidden risk than can pose a threat to the survival of the bank. The reputational risk arises from the actions of errant employees.

Unrelated Risks :

Systematic Risk:

It refers to the risk that the entire financial system might come to a standstill. Systematic risk is the name of the most nightmarish scenario you can think of. 

Systematic risk consists of day to day fluctuations in a stock’s price

Moral Hazard:

It is most interesting risk that we will cover. We read and heard the phrase "too-big-to-fail" in the media. "Too-big-to-fail" is nothing but moral hazard in a scene. 

Moral Hazard refers to a situation where a person, a group (or persons) or an organization is likely to have tendency or willingness to take a high level risk, even if its economically unsound.  It emerges when both the parties have inadequate data about each other.

Risk Management

Risk Management in Indian banks  is a relatively newer practice, but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. Risk management in bank operations includes risk identification,
measurement and assessment, and its objective is to minimize negative effects risks can have on the financial result and capital of a bank. Banks are therefore required to form a special organizational unit in charge of risk management. Also, they are required to prescribe procedures for risk identification, measurement and assessment, as well as procedures for risk management.

The Reserve Bank of India (RBI) has issued several guidelines on Bank Risk Management System. They are
  • Activities of Asset-Liability Committee (ALCO) and credit policy committee should be integrated.
  • Banks have to fix a definite time frame for moving over to value at risk.
  • Banks have to provide a contingency plan to meet adverse swings in liquidity conditions.
  • Banks should evaluate portfolio quality on an on-going basis instead of near balance sheet date.
  • Banks to set up a comprehensive risk rating systems for counter parties.
  • By Mar 2001 banks with international presence have to develop methodologies for estimating and maintaining economic capital.
  • For managing liquidity risk banks should place limits on inter bank borrowings.
  • For off balance sheet exposure the current and potential credit exposure to be measured on a daily basis.
  • Investment proposals to be included in the total risk evaluation.
  • Investment proposals to be subjected to same credit risk analysis as in the case of loan proposals.
That's all for now friends. In our next Banking Awareness lesson, we shall learn about Capital Market. Happy Reading :)

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