Rubcov B.Y., Yakovenko O.G., Goncharova Y.S.
Oles Honchar Dnipropetrovsk National University, Ukraine
RISK CLASSIFICATION IN PROVIDING BANKING SERVICES
Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Such constraints pose a risk as these could hinder a bank’s ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.
Regardless of the sophistication of the measures, banks often distinguish between expected and unexpected losses. Expected losses are those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio) and are typically taken into consideration in some manner. Unexpected losses are those associated with unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests, Losses due to a sudden down turning in economy or falling interest rates). Banks rely on their capital as a buffer to absorb such losses.
The risks associated with the provision of banking services differ by the type of service rendered. For the sector as a whole, the risks can be broken into six generic types: systematic or market risk, credit risk, counterparty risk, liquidity risk, operational risk, and legal risks.
Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely. In fact, systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk, when their assets can change in value as a result of broad economic factors. As such, systematic risk comes in many different forms. For the banking sector, however, two are of greatest concern, namely variations in the general level of interest rates and the relative value of currencies.
Because of the bank’s dependence on these systematic factors, most try to estimate the impact of these particular systematic risks on performance, attempt to hedge against them and thus limit the sensitivity to variations in undiversifiable factors. Accordingly, most will track interest rate risk assiduously. They measure and manage the firm’s vulnerability to interest rate variation, even though they cannot do so perfectly. At the same time, international banks with large currency positions closely monitor their foreign exchange risk and try to manage, as well as limit, their exposure to it.
In a similar fashion, some institutions with significant investments in one commodity such as oil, through their lending activity or geographical franchise, deal with commodity price risk. Others with high single-industry concentrations may monitor specific industry concentration risk as well as the forces affecting the fortunes of the industry.
Credit risk arises from non-performance of commitment by a borrower. Consequently, credit risk is predictable, but it is very difficult to avoid this risk completely. This can affect the lender holding of the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest for the bank.
The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but it is complicated to eliminate it altogether. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for banks that work in local markets and ones that take on highly illiquid assets. In such cases, the credit risk is not easily transferred, and accurate estimates of loss are difficult to obtain.
Counterparty risk comes from non-performance of commitment by a trading partner. The non-performance may arise from a counterparty’s refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk.
Counterparty risk is like credit risk, but it is generally viewed as a more transient financial risk associated with trading than standard creditor default risk. In addition, counterparty’s failure to settle a trade can arise from other factors beyond a credit problem.
Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.
In any case, risk management here centers on liquidity facilities and portfolio structure. Recognizing liquidity risk leads the bank to recognize liquidity itself as an asset, and portfolio design in the face of illiquidity concerns as a challenge.
Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly.
Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, environmental regulations have radically affected real estate values and imposed serious risks to lending institutions in this area. A second type of legal risk arises from the activities of an institution’s management or employees. Fraud, violations of regulations or laws, and other actions can lead to catastrophic loss, as recent examples in the thrift industry have demonstrated.
Literature:
1. Commercial Bank Risk Management: an Analysis of the Process by Anthony M. Santomero.
2. Risk management. Guidelines for Commercial Banks & DFIs.
3. Treacy, W.F., and M. Carey. 1998. "Credit Risk Rating at Large U.S. Banks." Federal Reserve Bulletin.