Risks Associated with the Banking Business

There are three kinds of risks associated with the banking viz. Credit Risk, Market Risk and Operational Risk.

Credit Risk

Credit risk is risk of loss arising from a borrower who does not make payments as promised. This event would be called “Default” and the person/ company/ entity would be called “Defaulter”. Due to this, credit risk is also known as “Default Risk”.

Market Risk

Market risk is the possible losses due to movement in the market prices. There are four standard market risk factors viz. stock prices, interest rates, foreign exchange rates, and commodity prices. Apart from there are associated market risks as follows:

  • Equity risk, the risk that stock prices and/or the implied volatility will change.
  • Interest rate risk, the risk that interest rates and/or the implied volatility will change.
  • Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
  • Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

Operation Risk

Operational Risk refers to the risk of loss from inadequate or failed internal processes, people, systems or external events including

  • Incompetent management
  • Improper planning
  • Staff fraud
  • Noncompliance
  • Programming errors
  • System Failure
  • Increased competition
  • Deficiency in loan documentations.

Approaches for risk assets calculation

Banks have several approaches for risks assets calculations. They have been summarized in the below table:

Credit Risk Standard Approach, Foundation Internal rating Based approach, Advance approach. Internal rating Based
Market Risk Standard Approach (comprising maturity method & duration method), Internal risk based approach
Operational, Risk Basic Indicator Approach, Standard Approach, Advance measurement Approach

In terms of Credit Risk, it would be appropriate to discuss the two approaches here:

Standardized Approach / External Rating Approach

Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk.  The Banks have to follow it without any discretion to modify. The Reserve Bank of India has identified 4 external domestic agencies for this approach. They are as follows:

  2. ICRA
  3. Care
  4. Fitch

Apart from this, there are international agencies such as Moody’s, Fitch, Standard and Poor’s etc.

Internal rating based Approach

This is basically an alternative to standardized approach. The Banks do the internal assessment of the Counterparties and exposures. Banks need RBI’s nod to do this.