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Risk and its types in risk management in
the financial sector
Managing risk is one of
the top topics for discussion in the
financial industry. The notion of risk
has a growing significance in the modern
financial industry. The operating
environment in today’s business requires
highly integrated and systematic
approach for risk management.
Risk – By default, risk
can be divided into two components –
exposure and uncertainty. When both
these components are present, then risk
does not exist. In a financial
institution, a financial risk is the
probability that an action or event’s
outcome could have adverse impacts.
These outcomes lead to loss of capital
or earnings or could result in
constraints being imposed on the
financial institution’s ability of
satisfy the business objectives. These
constraints could impose risks such as
hindering the ability of a bank to
benefit from opportunities in order to
improve its business or to carry out the
ongoing business.
Types of risks –
Generally, risks are defined based on
the negative impact they have on the
profits from the various sources. Almost
all the banks or financial institutions
need to face and manage the following
risks –
-
Liquidity Risk
-
Market Risk
-
Credit Risk
-
Legal Risk
-
Country Risk
-
Operational Risk
-
Reputational Risk
-
Compliance Risk
Generally speaking, there
exist 4 risks according to Guidelines
for Risk Management which affects the
financial industry. They are Operational
Risk, Liquidity Risk, Market Risk and
Credit Risk. Following in the
explanation of these risks:
Credit Risk – A credit
risk is incurred due to counter-party
defaults. This type of risk occurs due
to investing activities, lending
activities and due to the buying or
selling of financial assets for others.
This type of risk is related to
financial transactions, that is:
-
Default by a borrower in making a
repayment, and
-
Default in fulfilling the agreement by
another bank or financial institution
with respect to syndicated arrangements.
Credit risks are very
critical in the banking sector and need
to be managed with upmost care. Credit
risks require highest level of
subjective judgement in spite of
constant efforts for quantifying and
improving credit decision processes.
Market risk – The term
market risk defines the unpredictability
of market value or income because of the
fluctuations that occur in underlying
market issues such as credit spreads,
currency, and interest rates. For
commercial financial institutions,
market risk arises due to mismatches
that occur between an asset’s risk
profile and its funding. Marker risk
also includes interest rate risks in all
its components: commodity risk, exchange
risk and equity risk.
Liquidity risk – The term
liquidity risk defines the risk of being
unable to meet commitments or being
unable to offset or wind positions by a
company within the time constraints.
This is because it will lead to
non-liquidation of assets at rational
costs when required.
Operational Risk – An
operational risk occurs due to
insufficiency in the organisation,
conception and implementation of
processes for recording event with
respect to the operation of a bank in
the information system or accounting
system. |
