hat are risks facing commercial banking institution sector by hamze dalha

1. What are risks facing commercial banking institution sector
Introduction
Whenever we analyze any banking company, we’re looking at two main
variables—the return a bank earns and the amount of risk.
 What does “risk” mean?
Risk is generally understood as “the possibility that something bad or
unpleasant (such as an injury or a loss) will happen.” Risk is pervasive
in most things that we do. When you drive, there’s a risk of getting into
an accident. When you play, there’s a risk of getting injured. However,
we often fail to recognize the importance of understanding risks to
civilization.
Introduction to banking risk
Banking risk can be defined as exposure to the uncertainty of outcome.
It’s applicable to full-service banks like JPMorgan (JPM), traditional
banks like Wells Fargo (WFC), investment banks like Goldman Sachs
(GS) and Morgan Stanley (MS), or any other financials included in an
ETF like the Financial Select Sector SPDR Fund (XLF). Let’s look at
the definition in some detail to understand its importance.
Defining “exposure”
Exposure denotes a position or stake in an outcome. Exposure is
important because if a bank has no exposure to a risk, it would be safe.
In such a scenario, a bank would be like a bystander who hasn’t placed
any bet in a casino, and the outcome will have no financial impact on the
bystander.

2. Defining “outcome”
An outcome is the consequence of a particular course of action. How
and when this outcome is recognised will become clearer as we look in
detail at the various categories of banking risk later in this series.
Defining “uncertainty”
Uncertainty is not knowing exactly what the potential outcome will be.
At best, you can make an estimate about the number of possible
outcomes. One of these many possible outcomes will be the most
probable. This most probable outcome is known as the “base case”
scenario. The greater the difference from the base case scenario, the
greater the risk, and vice-versa.
What to do when faced with risks?
All banks have different choices when faced with a transaction involving
risk. These choices include:
Avoiding the risk if it’s economically unviable
Accepting and retaining risk on an economically justifiable basis
Increasing, reducing, or eliminating risk, according to one’s
expectation of a return
Reducing risk by diversifying a bank’s portfolio of risks
Hedging risk, to a degree, by using financial instruments
Liquidating risk by transferring to another party
Banking can’t run without taking risks. Most banks are highly leveraged
financial risk-takers
Eight types of bank risks

3. There are many types of risks that banks face. We’ll look at eight of the
most important risks.
Credit risk, Market risk. Operational risk, Liquidity risk, Business
risk, Reputational risk, Systemic risk, and Moral hazard
Credit risk
The Basel Committee on Banking Supervision (or BCBS) defines credit
risk as the potential that a bank borrower, or counter party, will fail to
meet its payment obligations regarding the terms agreed with the bank.
It includes both uncertainty involved in repayment of the bank’s dues
and repayment of dues on time.
Dimensions of credit risk
The default usually occurs because of inadequate income or business
failure. But often it may be willful because the borrower is unwilling to
meet its obligations despite having adequate income.
Credit risk signifies a decline in the credit assets’ values before default
that arises from the deterioration in a portfolio or an individual’s credit
quality. Credit risk also denotes the volatility of losses on credit
exposures in two forms—the loss in the credit asset’s value and the loss
in the current and future earnings from the credit.
Banks create provisions at the time of disbursing loan). Net charge-off is
the difference between the amounts of loan gone bad minus any
recovery on the loan. An unpaid loan is a risk of doing the business. The
bank should position itself to accommodate the expected outcome within
profits and provisions, leaving equity capital as the final cushion for the
unforeseen catastrophe. An example of credit risk during recent times

4. During the subprime crisis, many banks made significant losses in the
value of loans made to high-risk borrowers—subprime mortgage
borrowers. Many high-risk borrowers couldn’t repay their loans. Also,
the complex models used to predict the likelihood of credit losses turned
out to be incorrect.
Major Banks all over the globe suffered similar losses due to incorrectly
assessing the likelihood of default on mortgage payments. This inability
to assess or respond correctly to credit risk resulted in companies and
individuals around the world losing many billions of U.S. dollars.
Market risk
The Basel Committee on Banking Supervision defines market risk as the
risk of losses in on- or off-balance sheet positions that arise from
movement in market prices. Market risk is the most prominent for banks
present in investment banking.
Interest rate risk
It’s the potential loss due to movements in interest rates. This risk arises
because a bank’s assets usually have a significantly longer maturity than
its liabilities. In banking language, management of interest rate risk is
also called asset-liability management (or ALM).
Equity risk
It’s the potential loss due to an adverse change in the stock price. Banks
can accept equity as collateral for loans and purchase ownership stakes
in other companies as investments from their free or investible cash.
Any negative change in stock price either leads to a loss or diminution in
investments’ value.
Foreign exchange risk

5. It’s the potential loss due to change in value of the bank’s assets or
liabilities resulting from exchange rate fluctuations. Banks transact in
foreign exchange for their customers or for the banks’ own accounts.
Any adverse movement can diminish the value of the foreign currency
and cause a loss to the bank.
Operational risk
The Basel Committee on Banking Supervision defines operational risk
“as the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. This definition includes
legal risk, but excludes strategic and reputation risk.
Operational risk occurs in all day-to-day bank activities. Operational risk
examples include a check incorrectly cleared or a wrong order punched
into a trading terminal. This risk arises in almost all bank departments—
credit, investment, treasury, and information technology.
Causes of operational risks
There are many causes of operational risks. It’s difficult to prepare an
exhaustive list of causes because operational risks may occur from
unknown and unexpected sources. Broadly, most operational risks arise
from one of three sources.
People risk: Incompetency or wrong posting of personnel and misuse
of powers
Information technology risk: The failure of the information
technology system, the hacking of the computer network by outsiders,
and the programming errors that can take place any time and can cause
loss to the bank
Process-related risks: Possibilities of errors in information
processing, data transmission, data retrieval, and inaccuracy of result or
output

6. Operational risk can lead to a bank’s collapse
The fall of one of Britain’s oldest banks, Barings, in 1995, is an example
of operational risk leading to a bank’s collapse. It was mainly due to
failure of its internal control processes. One of Barings’ traders in
Singapore, Nick Leeson, was able to hide his trading losses for more
than two years.
Liquidity risk
Liquidity by definition means a bank has the ability to meet payment
obligations primarily from its depositors and has enough money to give
loans. So liquidity risk is the risk of a bank not being able to have
enough cash to carry out its day-to-day operations.
Provision for adequate liquidity in a bank is crucial because a liquidity
shortfall in meeting commitments to other banks and financial
institutions can have serious repercussions on the bank’s reputation and
the bank’s bond prices in the money market.
Reputational risk
Reputational risk is the risk of damage to a bank’s image and public
standing that occurs due to some dubious actions taken by the bank.
Sometimes reputational risk can be due to perception or negative
publicity against the bank and without any solid evidence of
wrongdoing. Reputational risk leads to the public’s loss of confidence in
a bank.
Business risk
Business risk is the risk arising from a bank’s long-term business
strategy. It deals with a bank not being able to keep up with changing
competition dynamics, losing market share over time, and being closed
or acquired. Business risk can also arise from a bank choosing the wrong
strategy, which might lead to its failure.

7. Moral hazard
Moral hazard is the most interesting risk that we’ll cover. You must have
read or heard the phrase “too-big-to-fail” in the media. Too-big-to-fail is
nothing but moral hazard in a sense. Moral hazard refers to a situation
where a person, a group (or persons), or an organization is likely to have
a tendency or a willingness to take a high-level risk, even if it’s
economically unsound. The reasoning is that the person, group, or
organization knows that the costs of such risk-taking, if it materializes,
won’t be borne by the person, group, or organization taking the risk.
Ways to control moral hazard
Moral hazard can be controlled through a good organizational culture,
giving credence to high ethical standards. A bank must also have a
strong board of directors to oversee management and to take remedial
measures when needed. A well-crafted compensation policy to avoid
reckless risk-taking would also help reduce this risk. Finally, strong
regulations would also help control moral hazard.
Other risks
There are some other minor types of risks that a bank carries. These
aren’t as important as the previous risks discussed, but we’ll mention
them in this article.
Legal risk
A bank can be exposed to legal risk. Legal risk can be in the form of
financial loss arising from legal suits filed against the bank or by a bank
for applying a law wrongly.

8. Country risk
A bank that operates in many countries also faces country risk when
there’s a localized economic problem in a certain country. In such a
scenario, the bank’s holding company may need to bear losses in case it
exceeds the capital of a subsidiary in a country. The holding company in
certain cases may also need to provide capital.