Risks Associated with the Banking Business

Let’s have a view on the risks associated with the banking business.

There are three kinds of Risks associated with the Banking:

1. Credit Risk
2. Market Risk
3. Operational Risk

The above words are self explanatory. The Basel II guidelines have stipulated approaches to assess the risks involved.

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”.

• So credit risk can also be called “Default Risk”.

The banks have two approaches for risks assets calculations in Basel II and as stipulated by the RBI accordingly:

1. Standardized Approach: The risk weightage are assigned by the RBI as mentioned in the table above. The Banks have to follow it without any discretion to modify. The approach is based upon the external rating agencies. The Reserve Bank of India has identified 4 external domestic agencies for this approach. They are as follows:
   1. CRISIL     
   2. ICRA
   3. Care
   4. Fitch
   Apart from this, there are international agencies such as Moody’s, Fitch, Standard and Poor’s etc.
2. 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.

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:

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

Here again, the Basel committee has suggested two broad methodologies for computation of the capital charges of the market risks. They are standardized and internal. The standardized approach involves two methods viz. maturity method and duration method.

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.