Explain the risks in the financial institutions. How they can be managed? or What are the core risks in banking? Discuss key elements of a sound risk management system as prescribed in Risk Management Guidelines for Banks by BB:

The banking industry has been tremendously changing the lives of ordinary people. The banks have become much more advanced, and the security aspect has been improved to a large extent.

However, with the increase in growth of the banks, banking operations have become much more complicated. The risks involved with the adoption of disruptive technologies called for the change in regulatory environments and business procedures.

 In banking, various risks can impact the financial stability and operations of financial institutions. These risks can be broadly categorized into core risk types. Here are some of the core risks in banking:

Risks Involved in the Banking Industry:

 1. Credit Risk: One of the most significant threats faced by banks is credit risk. In simpler words, credit risk is defined as the inability of a borrower or a counterparty to meet contractual obligations. In other words, when a borrower fails to pay the appropriate amount to the lender due to any financial crisis. The banks have suffered huge losses in the past from credit risks, and are still prone to such losses.

 Although credit losses are primarily defined by the inability of the borrower to repay loans to the lenders, it also includes the delay in payments of the borrower. That means if any borrower does not make timely payments, then such types of cases also come under credit risks.

·        Ways of managing credit Risk: Such types of losses commonly occur due to borrower insolvency. Hence, banks should conduct proper investigations before granting the loans and should only sanction loans to individuals and businesses that are not likely to run out of their income during the payment period.

 2. Market Risk: Market risks are defined as the risks involved in the fall of a company's share or decrease in the value of the stock of third-party companies where the bank has invested. We all know that apart from sanctioning loans, the banks also hold a certain amount of shares in the market. In that case, if by any means, the share price of the banks decreases, then they will suffer huge losses, and these types of losses generally come under market risk.

The market risks can vary depending on the type of commodity a bank holds. in the case of gold, silver, or real estate, they are exposed to commodity risks, etc. similar is the case with equity risk.

•         Ways of managing Market Risk: To mitigate market risks, banks usually leverage hedging contracts. They use contracts like forwards, options, swaps, and many more, to eliminate the various market risks.

  3. Business Risk: Business risks are a significant result of credit risk. To put it simply, when a bank fails to generate profits during a specific period, then it is called business risk. Many times, a business takes a loan from a bank and then fails to repay it. In such a scenario, the banks lace losses due to business risk.

 The result of business loss is either being acquired by some other banks or collapse in big banks. Examples of such banks that suffered huge losses due to the wrong business strategy are Washington Mutual and Lehman Brothers.

•         Ways of managing Business Risk: Although there are no sure-shot methods of eliminating business risk, the adoption of the right strategy might do the work.

 4. Security Risk: Now that's a considerable risk that has been on the top of the list for the global market, irrespective of their domains. Cybersecurity has been impacting the financial industry for quite a few years, and the problem is still prevalent in the banking sector. We witnessed many cases where hackers penetrated the security layers of some big banks and stole a large sum out of it.

Banking institutions are still making considerable investments in the security aspect to make their customer's data and their systems more secure than ever. The industry is leveraging the latest technological advancements of Al, ML, Blockchain, big data, etc. to yield positive results in terms of security.

•         Ways of managing security Risk: The banks need to invest in top-notch fintech software and mobile apps that are way more secure and impenetrable. They should keep their private information safe using a technologically advanced electronic medium. 

5. Compliance Risk: When a bank does not follow proper regulatory standards put down by the financial institutions, then such type of risk is known as Compliance risk. These are usually a not much greater risk but surely have some significant outcomes. When a bank does not comply with proper regulations formed by the banking institutions in their certain branch, then they face financial and legal losses.

The banks get severely affected by these losses and suffer losses in their daily banking targets. They had to bear legal penalties and might face significant challenges from the regulatory committee.

•         Ways of managing compliance Risk: To mitigate such types of risks, the banks should formulate, regulate, and manage all the regulations and compliance policies across all their branches.

6. Operational Risk: When there is a failure in the internal processes of the bank due to inefficient systems, then it is termed as operational risk. We all know that banks have to perform a wide array of banking operations like daily transactions, cross-border transfers, cash deposits, and much more. However, there are times when the internal systems or the central system slows down. In such a scenario, the bank faces losses due to operational risk. Not only that, when there are some other mistakes like payment transfer in the wrong account, or execution of an incorrect order, etc. also falls under operational risk. It is noteworthy here that banks do not directly get affected because of the operational risks.

•         Ways of managing operational Risk: The operational risks can be minimized by automating the workflows so that the human interventions reduce. Also, the banks should use software from a trustworthy development company to ensure smooth operations.

7. Reputational Risk: Reputational risk is a significant result of the operational risk and, to some extent, the security risk. In other words, when a company fails to provide security to their customers, or when they perform inefficiently in processing their requests, then they suffer loss in users. People began spreading rumors about the bank, and the bank's image gets spoiled The news channels interrogate the people and make false perspectives about the banks. In such a scenario, the daily revenue of the bank drastically reduces, and hence they suffer huge losses. They lose their stellar reputation in the global market, and their profits decrease.

•         Ways of managing reputational Risk: The banks should ensure smooth functioning and should provide safety and security to all of its customers. They should never participate in any unfair practices and should ensure customer satisfaction in every possible way.

8. Liquidity Risk: Liquidity risks arise because of the increase in the non-profitable assets in the bank. That is, if there is an increase in the credit losses and losses due to business risk, then liquidity risk arises. Due to the rise in the liquidity risk, the bank becomes insufficient to meet the obligations if any depositor comes to withdraw its money. Looking back in history, the losses due to liquidity risk was a significant concern of all the banks at that time. However, the present-day scenario has been completely changed. Now the banks have new regulations of keeping a minimum amount of reserved cash to mitigate liquidity risk. That implies that the depositors can be paid even during the time of credit for business loss.

•         Ways of managing liquidity Risk: The banks should follow proper regulations of the central banks and should keep a minimum requisite amount in the banks to eliminate the chances of losses due to liquidity risk.

9. Systematic Risk: Whenever there are some external issues involved with the bank like employee's strike, market fluctuation, non-stability of the government, and so on, then it is termed as Systematic risk. The systematic uncertainty is beyond the control of management since it entirely depends on the various external factors. The losses due to systematic risks are unpredictable and cannot be wholly avoided. Banks suffer huge losses due to systematic risk and may have to write off certain assets to compensate for their losses.

•         Ways of managing Systematic Risk: The systematic risks are entirely unpredictable, and so they cannot be eliminated. However, with smart skills, they can be minimized up to a certain extent.

 

10. Moral Hazard: Moral hazard is an entirely new type of risk when compared to the other mentioned risks. It came to light recently in the global market. The moral hazard occurs when a bank takes some risk, even when they know that someone else has to bear the losses. In other words, when a bank invests in a risky business, and it backfires, then it is the taxpayers who have to bear all the losses.

Although the central bank has been tracking the banks and their operations very carefully, some of them still take dreadful risks when not under the regulatory oversight. They get to indulge in the illegal practices and create an imbalance on the taxpayers when their planning fails

•         Ways of managing moral hazard: The central bank should pay more attention to the activities of the banks to eliminate the losses caused by moral hazards. The banks should also not indulge in risky businesses and should follow the proper path.