Analysis of the four banking risks: what they consist of and how to manage them

Banking activity is never risk-free. Risk is an innately inborn element of its operationality in time. Based on our experience, accumulated over many years of work, dialogue and daily relationships with small, medium and large credit institutions, banks are subject to four main risk profiles:

• credit and counterparty credit risk;
• operational risk;
• market risk;
• liquidity risk.

Due to their exposure to such wide risk range, banks are equipped with sound risk assessment and management infrastructures. Meanwhile, they are bound to respect national, community and international compliance provisions, such those established by, for example, the Bank of Italy, the European Union and the Financial Stability Board (FSB).

Why do banks need to pay attention to risks?

Considering the large size of some banks, overexposure to risk can degenerate into banking failures and have a domino effect on millions of account holders.

A bank’s capacity to manage risk also affects investors’ decisions. However high is the revenue stream of a financial institution, the lack of a sound risk management can lead to a drop in profits and losses on loans. Therefore, it is more likely that major investors redirect their own investments towards a bank which is able to return profits minimising the risk of economic losses.

Below is a detailed analysis of the four major risks potentially faced by banks.

 Credit and counterparty credit risk

Credit and counterparty credit risk is the main risk for banks. It occurs when borrowers can no longer comply with contractual payment obligations previously agreed upon.

Insolvency can be linked to both capital repayment and the payment of interests accrued. Some examples are housing loans, credit cards and fixed income securities.

Failures to comply with binding contracts also occur in other sectors, such as derivatives and guarantees provided at loan origination.

While banks cannot totally protect themselves from credit risk, as it is inherently linked to the activity of the loan itself, they can certainly reduce their exposure in different ways.

Considering that deterioration of a party or contractor of a loan is often hard to foresee, banks can cut down their exposure through diversification. Moreover, to reduce risk exposure, credit institutions may lend money to customers with robust credit history, conclude transactions with reliable counterparties or hold guarantees to support loans.

Operational risk

According to the definition included in the Bank of Italy’s online glossary, operational risk comes from ‘inadequate or failed internal processes, personnel or systems, or from external events; risk of losses arising from errors or damages caused by staff, systems or processes’. The severity scale can go from low operativity risk level (in case of simple commercial transaction, i.e., retail banking or asset management) to higher operativity risk levels (in case of selling and trading).

The losses caused by human mistakes may include internal frauds or errors made during a transaction. An example could be a cashier accidentally giving an extra 50 Euros banknote to a customer.

On a wider scale, frauds may occur when breaching a bank’s cybersecurity. This allows hackers to steal information on the institution’s customers and ultimately blackmail the bank itself, requesting large sums of money. In such case, the damage related to capital loss would be followed by a reputational damage for the institution, which could adversely impact its capacity to attract future capitals.

Market risk

Still drawing from the definition in the Bank of Italy’s glossary of banking terminology, at the service of consumers, market risk is ‘the risk of incurring losses due to adverse changes in foreign exchange rates and financial activity prices.’

Therefore, market risk mainly arises from the activities of banks in capital markets. It is linked to the unpredictability of equity markets, prices of raw materials, interest rates as well as credit spreads.

As the energy market crisis is still ongoing, let us narrow down for the moment the focus on raw materials. Why can their prices represent a risk for banks? Because banks may invest in companies producing raw materials. Every time the value of the goods changes, the value of the company and the value of the investment change too. Changes in raw materials prices are caused by changes in supply and demand, which are frequently hard to predict.

Accordingly, it is important to diversify investments to reduce market risk. Other ways to decrease banks’ investments include covering the investments themselves with other inversely correlated investments.

Liquidity risk

Liquidity risk refers to the capacity of banks to access liquidity to comply with funding obligations, which include allowing customers to withdraw their deposits.

According to the Bank of Italy, liquidity risk generally manifest itself in the form of a failure to fulfil certain payment commitments, which may be caused by a failure to raise funds (‘funding liquidity risk’) or by restrictions on asset liquidation (‘market liquidity risk’).

Below are listed the reasons why a bank could experience liquidity issues:

• over-reliance on short-term funds;
• excessive balance sheet concentration on non-liquid assets;
• bad risk management due to assets-liabilities mismatch;
• loss of trust in the bank by its account holders.

If all or most of the assets of a bank are bound to long-term loans or investments, the credit institution could experience discrepancies in the duration of assets-liabilities.

There are regulations aimed at reducing liquidity problems. These include the requirement for banks to hold sufficient liquid assets to survive over a period of time even without inflows of external funds.