Different Risk Types, Part 2
Introduction
The recent unfolding banking crisis in the USA and now Europe has brought to the fore how important ‘risk’ is to a financial institution and what happens if risk is not managed adequately.
This is part 2 of an examination of some of the different types of risk that have been discussed on the news recently. These are very different to the narrower definition of ‘risk’ used in the consumer credit risk industry.
Evalueserve identifies 9 different types of risk in the banking industry.
Financial Risks:
- Credit Risk
- Market Risk
- Liquidity Risk
- Model Risk
- Environmental, Social and Governance (ESG) Risk
Non-Financial Risks
- Operational Risk
- Financial Crime
- Supplier Risk
- Conduct Risk”
In addition to these I have also added:
- Competitive Risk
- Reputational Risk
5 Types of Financial Risk:
Credit Risk
Credit risk, one of the biggest financial risks in banking, occurs when borrowers or counterparties fail to meet their obligations. When calculating the involved credit risk, lenders need to foresee and predict the possibility of them making back the loan, principal, interest, and all.
Market Risk
Market risk is the risk of losing value on financial instruments on the back of adverse price moments driven by changes in equities, interest rates, credit spreads, commodities, and FX.
Liquidity Risk
Liquidity refers to a bank’s ability to meet its collateral and cash obligations while avoiding major losses. Liquidity risk is the risk of incurring losses where certain commodity or investment cannot be traded without impacting its market price.
Model Risk
Model use at large banks is growing by more than 20% each year (IDC), which in turn leads to greater model risk. Banks must manage model accuracy to prevent significant financial losses when assumptions grow, models are misused, or other forms of malfunction occur.
Environmental, Social and Governance (ESG) Risk
Environmental, social, and governance events, from climate change to diversity and inclusion policies, can have material impact on the value of investments. Banks must proactively measure and manage these risks, integrating ESG data, scoring models, and climate models into the investment process and credit risk evaluations.”
4 Types of Non-Financial Risk:
Operational Risk
Operational risk is the risk of losses incurred by inadequate internal processes, people, and systems, or from external events.
Financial Crime
Money laundering, corruption, fraud are examples of financial crime, leading to economic benefits for individuals through illegal ways. Banks need to make sure they develop fool proof techniques to avoid the losses posed by financial crime.
Supplier Risk
Banks often have large, global supply chains. In the event that suppliers disrupt business continuity or put customer data at risk, banks are increasingly held responsible by regulators.
Conduct Risk
Conduct risk occurs when banks incur financial loss due to inaccurate management choices or decisions by the employees and team members.
With the many risks banks and financial organisations face, time is of the essence especially as global economies and markets try to recover from the uncertainty brought on by the pandemic.”
2 Additional Types of Business Risk:
Competitive Risk
“Competitive risk is the risk associated with the fact that there are often competing companies on the market, each of which seeks to obtain the highest position and consumer ratings on it in order to gain maximum benefits for themselves. Indicators of successful overcoming of competitive risk are the increase in market share, sales, the degree of penetration of the company into international markets, etc.
The reasons for competitive risk are as follows:
- level of technological, technical development of the company relatively to its competitors,
- changing consumer preferencesand expectations,
- vendor problems,
- managementmisunderstandings,
- exit barriers,
- lack of company’s management experience etc.
The management system for any kind of risk includes the following components:
- risk identification,
- risk assessment,
- risk monitoring,
- risk response.
To add to this definition in the banking environment, Risk Response is highly topical. This is often manifested by banks taking a knee-jerk reaction to a negative economy and ‘tightening credit’.
Bob Hope sums up this often used strategy with the immortal quote:
“A bank is a place that will lend you money if you can prove that you don’t need it.”
Reputational Risk
This is also linked to Conduct Risk.
“Reputational risk is the damage that can occur to a business when it fails to meet the expectations of its stakeholders and is thus negatively perceived. It can affect any business, regardless of size or industry.
Reputational risk happens when the expectations of stakeholders – such as your customers, employees, third party suppliers, investors, and regulatory bodies – are higher than the reality of what your business delivers. But what can cause this disparity? And what types of reputational risk are there? Key areas to be aware of are:
- Poor workplace operations and conduct– The actions of employees, including upper management, and any third parties you work with can affect your reputation. Poor behaviour of your CEO – or even a single employee – could lead to your business receiving negative media coverage and other harmful consequences.
- Inadequate quality of services and products – Shortcomings in your systems, processes, and products can contribute to a damaged reputation. For example, in manufacturing, a faulty product that must be recalled could lose you the trust of your stakeholders. In financial services, a mishandling or breach of sensitive customer data could also lead to a loss of confidence in your business.
- Failing to adapt – According to Harvard Business Review, reputational risk can occur when businesses don’t keep up with the changing beliefs of their stakeholders.Expectations can change over the years, and they can vary in different regions and countries. You must be able to understand your stakeholders at all times. It is also important to stay up to date with regulatory and industry expectations, so that you can quickly and effectively adapt to any changes.
Another way of looking at reputational risk is that it can stem from other risks faced by your organisation. To properly protect your reputation, you must ensure you have all areas of risk management covered.
For example, poor operational risk management can mean that things go wrong in the workplace. Similarly, inadequate management of compliance risks can increase the likelihood of your business not meeting industry and regulatory standards, which could lead to fines or criminal penalties.
All these types of reputational risk can have serious consequences for your business.”
Summary
When starting to research this series of articles I never realised that there were in fact so many different types of risk and indeed the 17 that have been identified, just scratch the surface of this highly complicated topic.
Alan Greenspan succinctly sums up the importance of managing risk:
“Indeed, better risk management may be the only truly necessary element of success in banking.”
Paul Getty summed up the public’s perception of risk management:
“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”
About the Author
Stephen John Leonard is the founder of ADEPT Decisions and has held a wide range of roles in the banking and risk industry since 1985.
About ADEPT Decisions
We disrupt the status quo in the lending industry by providing lenders with customer decisioning, credit risk consulting and advanced analytics to level the playing field, promote financial inclusion and support a new generation of financial products.
