Question

Identify the types and sources of bank risk and explain how to control them.

Answer 1

Normally the bank faces the following type of risks :  

• Liquidity risk is the risk of potential occurrence of adverse effects on the bank’s financial result and capital due to the bank’s inability to meet the due liabilities caused by the withdrawal of the current sources of funding, that is, the inability to raise new funds (funding liquidity risk), aggravated conversion of property into liquid assets due to market disruption (market liquidity risk);
• Credit risk is the risk of the potential occurrence of adverse effects on the bank’s financial result and capital due to debtor’s default to meet its obligations to the bank.
• Residual risk is the possibility of occurrence of adverse effects on the bank’s financial result and capital due to the fact that credit risk mitigation techniques are less efficient than expected or their application does not have sufficient influence on the mitigation of risks to which the bank is exposed;
• Dilution risk is the possibility of occurrence of adverse effects on the bank’s financial result and capital due to the reduced value of purchased receivables as a result of cash or non-cash liabilities of the former creditor to the borrower;
• Settlement/Delivery risk is the possibility of occurrence of adverse effects on the bank’s financial result and capital arising from unsettled transactions or counterparty’s failure to deliver in free delivery transactions on the due delivery date;
• Counterparty credit risk is the possibility of occurrence of adverse effects on the bank’s financial result and capital arising from counterparty’s failure to settle their liabilities in a transaction before final settlement of transaction cash flows, or, settlement of monetary liabilities in the transaction in question;
• Market risks entail foreign exchange risk, price risk on debt securities, price risk on equity securities, and commodity risk;
• Interest rate risk is the risk of the possible occurrence of adverse effects on the bank’s financial result and capital on account of banking book items caused by changes in interest rates;
• Foreign exchange risk is the risk of the possible occurrence of adverse effects on the bank’s financial result and capital on account of changes in foreign exchange rates;
• Concentration risk is the risk which arises directly or indirectly from the bank’s exposure to the same or similar source of risk, or, same or similar type of risk;
• Bank exposure risks comprise risks of bank’s exposure towards a single person or a group of related persons.
• Bank’s investment risks comprise risks of its investments into non-financial sector entities and in fixed assets and investment property.
• Country risk is a risk relating to the country of origin of the person to which the bank is exposed, that is, the risk of negative effects on the bank’s financial result and capital due to the bank’s inability to collect receivables from such person for reasons arising from political, economic or social circumstances in such person’s country of origin.
• Operational risk is the risk of possible adverse effects on the bank’s financial result and capital caused by omissions (unintentional and intentional) in employees’ work, inadequate internal procedures and processes, inadequate management of information and other systems, as well as by unforeseeable external events. Operational risk also includes legal risk.
• Legal risk is the risk of loss caused by penalties and sanctions originating from court disputes due to breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body.
• Risk of compliance of the bank’s operations is the possibility of occurrence of adverse effects on the bank’s financial result and capital as a consequence of failure to comply its operations with the law and other regulations, standards of operations, anti-money laundering and counter-terrorist financing procedures, and other procedures as well as other acts governing the bank’s operations, particularly encompassing the risk of sanctions by the regulatory authority, risk of financial losses and reputational risk.
• Reputational risk relates to the possibility of the occurrence of losses due to adverse effects on the bank’s market positioning.
• Strategic risk is the possibility of occurrence of adverse effects on the bank’s financial result and capital due to the absence of appropriate policies and strategies, their inadequate implementation, as well as changes in the environment where the bank operates or absence of appropriate response of a bank to those changes.

Control Mechanisms:

• Risk management strategy and policies, as well as procedures for risk identification and measurement, i.e. for risk assessment and risk management;
• Appropriate internal organisation, i.e. bank’s organizational structure;
• Effective and efficient risk management process covering all risks the bank is exposed to or may potentially be exposed to in its operations;
• Adequate internal controls system authorising approvals & sanctioning powers as per their role & designation.
• Appropriate information system & proper top-down & bottom-up flow of reports.
• Adequate process of internal capital adequacy assessment.
• Identification & timely compliance with legal obligations to avoid penalties.
• Conducting audits periodically & timely rectifications of non-compliances identified during the audit.
• Efficient management for identification of NPAs and adequate steps to prevent conversion of potential NPAs to NPAs.