Simply put, risk is likelihood of an undesirable or unexpected event or things going wrong. Risk is inherent to any business, including banks and therefore it is critical to have effective risk management in place. A borrower defaulting, or bank running out of liquidity to pay back to the depositors, or interest rates changing the payoffs from loans are some of the types of risks banks run.
Most Important Risks in Banking
- Credit or default risk
- Market risk (interest rate, forex rate)
- Operational risk
- Liquidity risk
Apart from these, there are other risks such as reputational risk. For instance, if the customers lose trust in the bank they would quickly want to withdraw their deposits from the bank, it might run out of money.
Credit risk or default risk that the borrower might fail to pay the interest or repay the entire amount back to the bank. The banking book is the portfolio of assets (primarily loans) the bank holds, does not actively trade, and expects to hold until maturity when the loan is repaid fully. A bank’s credit risk is the aggregate credit risk of the assets in its banking book.
The risk of losses which a bank might incur due to the interest rates, forex rates, and equity, commodity, derivates rates. Market risk tends to focus on a bank’s trading book. The trading book is the portfolio of financial assets such as bonds, equity, foreign exchange, and derivatives held by a bank to either facilitate trading for its customers or for its own account or to hedge against various types of risk.
Operational risk is the risk of loss due to failure of people, processes and systems. Operational risks are managed by having relevant policies, detailed procedures and most importantly, well-trained and experienced staff.
Liquidity risk covers two important risks. It covers the risk of not being able to deal in a market due to lack of liquidity, and funding risk, which is not having adequate funds in place when they are needed.
Bank Treasury Risk Management
Treasuries in commercial/retail banks are likely to manage the net interest rate risk in their banking book directly with market counterparties by operating a derivatives trading desk.
Treasury takes on the role of monitoring and regulating the management of interest rate risk in the banking book, while retaining its group-wide liquidity and capital management activities.
An example of an integrated bank treasury function:
Asset and liability management is concerned with
- Managing the impact of interest rate risk in the bank’s balance sheet
- Maintaining the desired liquidity structure of a bank
- Other factors affecting the structure and composition of a bank’s balance sheet
- Circumstances impacting the stability of income the bank generates over time
The fundamentals of bank risk management may be easy to define but are far more difficult to apply case-by-case. Each situation is unique, built around the roles and capabilities of individuals and the structure, activities and objectives of the institution. Bank Treasury Risk Management (BTRM) is a six-month part-time course designed to empower individuals working in, or intending to work in, every aspect of bank risk management and asset-liability management (ALM). BTRM delivers learning of practical value, developed and taught by highly experienced practitioners.