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Banking Sector Risks

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Banking Sector Risks

shape Introduction

The Banking Industry has evolved significantly and has undergone significant transformation due to several factors including business model transformation, adoption of advanced technologies, changing regulatory environments, wars between nations, etc. Modern banking sector is a highly complex and evolving ecosystem, where stakeholders of different backgrounds — internet, tech companies, startups are playing an increasingly influential role. Banking Sector Risks lists the important risks in the banking industry.

A risk could be defined as the uncertainty of an event to occur in the future. In the banking context, it’s the exposure to the uncertainty of an outcome, in the market. Several banks had lost billions due to imprudent risk-taking abilities. For the banking industry, the risks come with new types of entities, new technologies, ever-growing complexities of national and international regulations, as well as changing consumer behavior. The banking industry requires significant resources and investments to address financial and other risks naturally occurring as a result of the changes. With the advent of technology and with several banking apps, chief risk and compliance officers play a critical role in monitoring and managing the different risks to ensure a safe banking experience, and to ensure continuity of their businesses.

A successful banker/banking organization is one that can mitigate/control the risks and damage and create significant returns for the shareholders on a consistent basis. Knowledge of risks is required for Mitigation of risks.

shape Risks

There are mainly 11 types of banking sector risks that a bank can face. These are as follows:

  • Credit Risk

  • Market Risk

  • Operation Risk

  • Liquidity Risk

  • Business Risk

  • Reputational Risk

  • Systemic risk

  • Moral hazard

  • Compliance risk

  • Cybersecurity Risk

  • Open Banking Risk

Credit Risk:

  • 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.

  • 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:

  • Market risk arises due to the factors affecting the overall performance of the financial market, it is also known as the systematic risk.

Operationl Risk:

  • 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 the failed internal process, people and systems or from external events.

Liquidity Risk:

  • Risk due to the lack of marketability of an investment that cannot be bought or sold quickly.

  • The inability of a bank to provide cash.

Business Risk:

  • Business hazard is the likelihood of an organization to have lower than foreseen benefits or experience a misfortune instead of taking a benefit.

  • Business hazard is impacted by various components, including deals volume, per-unit value, input costs, rivalry, the general monetary atmosphere and government controls.

Reputational Risk:

  • Reputational risk is a threat or danger to the good name of a business.

  • It occurs through a number of ways, directly as the result of the actions of the company itself, due to the actions of an employee.

  • To avoid reputational risk a company also needs to be socially responsible and environmentally conscious.

  • Reputational risk is the major hidden risk that can pose a threat to the survival of large companies.

  • The reputational risk arises from the actions of errant employees.

Systemic risk:

  • Systematic Risk is the ups and downs of returns caused by macroeconomic factors that affect all risky assets.

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

Moral hazard:

  • Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will responsible the cost.

  • It arises when both parties have incomplete information about each other.

  • It emerges when both parties have inadequate data about each other.

  • It occurs when the borrower knows that someone else will pay for the mistake he makes.

  • This, in turn, gives him the incentive to act in a riskier way.

  • This economic concept is known as moral hazard.

Compliance Risk:

  • Compliance Riskis defined as the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities

  • U.S. Bancorp agreed to pay $613 million in penalties to state and federal authorities for violations of the Bank Secrecy Act and a faulty AML program. This was a result of the banks’ failure to adopt and implement an effective compliance program with adequate internal controls, testing, and training

  • It is imperative for banks to establish an infrastructure to organize and analyze data and efficiently manage legal documentation

Cybersecurity Risk:

Cybersecurity risk is the most prevalent IT risk in the banking industry. It refers to the risk undertaken by a financial institution to keep electronic information private and safe from damage, misuse or theft primarily by hackers. The crucial key to mitigating the cybersecurity risk is to ensure that the controls are applied across all business units and divisions to ensure that no permissions to access are granted unintentionally/without prior knowledge. Customer Data should be protected at all times with enhanced security features.

Some of the primary factors that result in cybersecurity risks are:

  • Missing transaction business controls
  • Poor password policies
  • Inadequate logical access controls

  • Open Banking Risk:

    Open Banking Risk is similar to open source where the banking ecosystem functions as a single platform for a number of players like the regulators and government agencies, data providers, third-party providers, customers, to engage in an open infrastructure with an end motive to enhance the customer experience. Thus, customer data is more accessible to the players. While customer data enables digital products and also enhances the ability to build superior products, open source always has room for customer data breach.

    To mitigate Open banking Risk, banks need to be agile in complying with PSD2 and GDPR directives laid down by independent government agencies, and the financial regulatory bodies to avoid exposing themselves to a pleothara of systemic risks which could lead to financial as well as damages to the reputation of the banks..