Risk and its types – with perspective of a Bank

By Raghunath Pradhan

Risk is pervasive. It prevails everywhere. The project may not be completed within a scheduled time due strike of employees or earthquake or non timely supply  and installation of plant and machinery. Likewise, it may not achieve targeted profit due to increased competition or due to defective packaging and so on.  All these factors/forces are known as risk factor. So, all likely risk factors needs to be analyzed comprehensively and required steps should be taken to mitigate such possible risk or transfer or avert them before initiating any task or fixing goal.

In economics profit is defined as reward for risk bearing. So, risk is inevitable part of any business. As said earlier, it is everywhere not in business only, it also prevail on one’s daily life as well. Risk is the possibility of happening unwanted incidence or failure to attain desired result due to varied reason. It is uncertainty that presents both loss and opportunity with the potentiality to erode or enhance value. It is likelihood adverse deviation in the actual result from an expected result. In general, there is direct relationship between risk and return. Higher the risk higher will be the return and vice versa.

Bank massively carries out its business with the capital of depositors. It  conducts its business on good faith and on belief. No bank can run its business eliminating its risk in toto. Further, they may not be in position to attain desired result simply assuming the risk. Before assuming the risk it must be analyzed and assume only such risk which is as per the appetite of the organization.  In general, whenever we talk about risk it is credit risk. Banks in Nepal still focus on credit risk while other risk such as market risk, operational risk is largely overlooked. Risk Management is still assumed as expense item. Banks in Nepal are yet see it as a value adding exercises.

Viewing the importance of Risk Management in the banking system, Nepal Rastra Bank has introduced “Risk Management Guidelines  2010” providing minimum standards on Risk Management practices for banks in Nepal. The guidelines have already been revised in 2018. The bank has also issued separate directives for managing the risk. As per the directives, banks are required to implement formulating Risk Management Structure for identifying, measuring, monitoring, controlling and reporting risk. Board of Directors of the bank is required to approve Risk Management Policy and Procedure defining risk appetite and risk tolerance limit which is subject to review and update as per requirement at least once in a year. Board of Directors and Senior Management of the bank is also required to have discussion and review risk report at least once in a quarter and as per requirement. Further, it is also required to have a Risk Management Committee under the coordinatorship of a nonexecutive director.  The member secretary of the committee shall be chief risk officer. The committee also comprises Chief of Operation Department and coordinator of Audit Committee as ex-officio member. The Committee shall meet at least once in a quarter. The regulator has also identified major risk and also defined tools for measuring/monitoring such risk. They are:

1. Credit Risk

Credit risk is the possibility of loss that the bank may suffer as a consequence of inability of the borrower who is operating in an environment having many uncertainties resulting to meet its repayment or commitment as per the agreed terms and conditions and commit default. So, credit risk increase the chances of higher amount of NPA thereby requiring provision at higher rate and finally default risk. Bank may mitigate the credit risk collateralizing its exposure and having the insurance of the collateral, mortgaged or hypothecated property besides establishing robust credit assessment and monitoring tools.

2. Operational Risk

Operational Risk is the risk of loss resulting from inadequate internal processes, people and systems or from external events. It is connected with possible losses of  assets or image of the bank caused by the intentional or accidental actions of its employees or third person.  It is the risk of doing right thing in wrong way. Like credit risk operational risk may also mitigate having insurance of bank’s property, placing robust mechanism of internal control system and maintaining loss event data and chalking out timely corrective action for controlling on the happening of such event and formulating Disaster Recovery and Business Continuity Plan.

3. Market Risk

Market risk generally refers to risks which result from price changes in the money and capital markets. It is also defined as the risk of losses in on-balance sheet an off-balance sheet positions arising from adverse movements in market prices. Risk pertaining to interest rate related instruments, Foreign Exchange Risk and risks pertaining to investment in equities and commodities are major constituents of market risk.

4. Liquidity Risk

Liquidity Risks is defined as the risk of incurring losses resulting from the inability to meet payment obligations in a timely manner when they become due or from being unable to do so without incurring unacceptable losses. 

Liquidity risk can be mitigated through conscious financial planning and analysis and by forecasting cash flow regularly and managing existing credit facilities. Classifying the assets and liabilities as per their maturity period under different time interval and its analysis also helps to mitigate liquidity risk. 

5. Interest Rate Risk

Interest rate risk is defined as the change in a bank’s portfolio value due to changes in interest rate. Interest rate risk management is concerned with measurement and control of risk exposures, both in trading book i.e. assets that are regularly traded and are liquid in nature and in banking book i.e. assets that are usually held till maturity and rarely traded.

6. Foreign Exchange Risk

Foreign exchange risk arises due to changes in exchange rates between currencies. It is also known as Exchange rate risk.

Besides above risk banks are also required to identify and address other risk such as reputation risk, strategic risk, legal risk, AML/CFT risk, environment social and climate change risk for running its business successfully.