Types of Risk in Banking Sector

Risk in Banking Sector

There are six major types of risk in the banking sector which may affect a bank’s operations, profitability, and solvency. These risks in banking are explained below:

Interest Rate Risk

Interest rate risk is the chance that an unexpected change in interest rates will negatively affect investment value. One of the primary sources of profit for a bank is converting the liabilities from deposits and borrowings into assets such as loans and securities. A company can increase its profits by paying a lower interest on its liabilities than it earns on its investments. the difference between these rates is known as the net interest margin. Banks make money by borrowing at short-term rates and lending at long-term rates.

For example, a bank pays depositors 1 per cent interest and lends their money to home buyers through mortgages at 5 per cent. The difference of 4 per cent is the bank’s profit. Short-term interest rates rise to per cent and long-term interest rates rise to 8 per cent. The bank is still collecting 5 per cent on its loan but now must pay depositors 6 per cent, losing money at a rate of 1 per cent.

However, the terms of its liabilities are usually shorter than that of assets. In other words, the interest rate paid on deposits and short-term borrowings is sensitive to short-term rates, while the interest rate earned on long-term liabilities is fixed.

This creates interest rate risk, which is particularly for banks, as there is a possibility that interest rates will increase. This could cause the bank to pay higher costs for its liabilities, ultimately reducing its profitability.

Sources of Interest Rate Risk

Financial institutions such as banks encounter interest rate risk in several ways. Broadly, these can be described as:

1. Re-Financing Risk
2. Re-Invennend Risk
3. Re-Pricing Risk
4. Basis Risk
5. Embedded Option Risk
6. Yield Curve Risk

Re-Financing Risk

Refinancing risk is the risk that a borrower is not able to redeem an existing loan with the proceeds of a new loan (and an extra equity payment) at loan maturity. The recovery risk relates to the loan being unable to be refinanced and the underlying properties need to be sold or foreclosed to provide funds for redemption.  The extension risk refers to the possibility that redemption of the loan does not occur at maturity but instead at a later time. 

Refinancing risk is the uncertainty of the cost of a new source of funds that is being used to finance a long-term fixed-rate asset. This risk occurs when an F1 is holding assets with maturities greater than the maturities of its liabilities.

For example, if a bank holds a ten-year fixed-rate loan funded by a 2-year time deposit. In this situation, the bank faces a risk of borrowing new deposits or refinancing at a potentially higher rate in two years. Thus, interest rate increases would reduce interest income. The bank would benefit if the rates were full as the cost of renewing the deposits would decrease, while the earning rate on the assets would not change in this case, net interest income would increase.

Re-Investment Risk

Re-investment or refunding risk arises when interest rates at Investment maturities (or debt maturities) result in funds being re-invested (or refinanced) at current market rates that are worse than forecast or anticipated. The inability to forecast the rollover rate with certainty has the potential to impact the overall profitability of the investment or project.

Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have matured, This risk occurs when an II holds assets with maturities that are less than the maturities of its liabilities.

For example, a short-term money market investor is exposed to the possibility of lower interest rates when current holdings mature, Investors who purchase callable bonds are also exposed to reinvestment risk. If callable bonds are redeemed by the issuer due to a decrease in interest rates, the investor will have proceeds to re-invest at lower rates in the future

Similarly, a borrower that issues commercial paper to finance longer-term projects faces the risk of encountering higher interest rates upon the rollover or refinancing date. As a result, matching the funding duration with that of the underlying project helps to reduce exposure to refunding risk.

Re-investment risk is defined as “the variability in the returns from re-investment from a given strategy due to changes in market rates”.

Re-investment risk, a challenge all investors face when bond yields are falling, is the risk that future cashflows – either coupons or the final return of principal need to be re-invested in lower-yielding securities.

For example, say an investor constructs a portfolio of bonds with five-year maturities at a time when prevailing yields are 5%. The investor commits $100,000 of principal, to generate $5,000 a year in annual income. During those five years, prevailing rates fall to 2%. Once the bonds mature, the investor has to put the cash back to work at lower rates.

Now, that $100,000 portfolio only generates $2,000 in income each year rather than the original $5,000. Additionally, if the investor chose to re-invest the income rather than take it in the form of income, he or she would have been compelled to do so at lower rates as the period progressed.

Following are the two types of re-investment risk – interest rate and maturity risk. The first has to do with the risk of re-investing interest payments at lower interest rates than existed at the time of investment, and the second means having too much of an investor portfolio invested in one maturity, exposing yourself to the possibility of having to re-invest most or all of the investor money at lower interest rates (or the opposite- owning too much of a long maturity bond and watching the value of the investor bond decline as yields rise with no money to re-invest.

Re-Pricing Risk

This risk arises from holding assets and liabilities with different principal amounts, maturity or, re-pricing dates, thereby creating exposure to unexpected changes in the interest rates. For example:

Liability 3 Months deposit

Asset

5 Years hond

Result

Liability sensitive as after every three months deposits will have to be rolled over and every rollover will be subject to interest rates prevailing at the tune of roll-over

3 Years deposit

3 Years bond with 6 months reset, Le, floating rate bond where interest will be fixed afresli every six montha on a set date

Asset sensitive. The cost of liabilities is constant for 3 years while earnings on asset are subject to vagaries of interest rate movement.

Asset sensitive. Treasury bills when rolled over alles

2 Years deposit

364 Days treasury bill

5 Years deposit

3 Years term loan

364 days may give a different yield as rollover will be subject to rates prevailing at that time. The proper matching of assets and liabilities is essential to maintain a balanced financial position. 

Basis Risk

Even where assets and liabilities are properly matched in terms of re-pricing risk, one is exposed to the risk that the correlation between the change in interest rate on assets may not be the same as the change of interest rate on liabilities, thereby affecting the underlying spread at the time of re-pricing. Therefore, the risk that the interest rate of different assets and liabilities may change in different magnitudes is called basis risk. To illustrate the point, let us take the following example:

Re-Pricing Liabilities

90 Days certificate of deposits

Re-Pricing Assets

Result

90 Days commercial paper

At re-pricing certificate of deposit rates may fall by just 0.5% pa, while interest rates on C.P. may fall by 1% р.а.

When interest rates change, these differences can give rise to unexpected changes in the cashflows and earnings spread between assets, liabilities and off-balance sheet instruments of similar maturities or, re-pricing frequencies.

Embedded Option Risk

Large changes in the level of interest encourage the premature withdrawal of deposits on the liability side or, pre-payment of loans on the asset side. Bonds with put and call options may also be redeemed before their original maturity as the holder will like to exercise the put option if interest rates in the meantime have edged up while the issuer will exercise the call option if interest rates have fallen.

Every time a deposit is withdrawn or, a loan is prepaid, it creates a mismatch and gives rise to re-pricing risk. Since customers on both sides of the balance sheet of the bank enjoy this embedded option, their abrupt decision/behaviour based on interest rate movement may give rise to re-pricing risk where it did not exist in the first instance. To protect themselves from this risk, banks impose penalties for early withdrawal of deposits.

Yield Curve Risk

Yield curve risk refers to the risk of experiencing an adverse shift in market interest rates when investing in fixed-income securities. The risk is associated with either a steepening or flattening of the yield curve, which occurs as a result of changing yields among comparable bonds with different maturities.

When market yields change, it has a direct impact on the prices of fixed-income instruments. When market interest rates rise, the price of a bond will decrease, and vice versa.

Market Risk

Market risk is the risk of price changes that affect any firm that trades assets and liabilities. Risk may arise because of fluctuations in interest rates, exchange rates or any other prices of financial assets that are traded rather than held on the balance sheet. Thus, market risk refers to the potential for changes in portfolio value because of fluctuations in various market variables. Market risk can be reduced by using appropriate hedging techniques such as futures, options, and swaps. Additionally, implementing controls to limit the amount of exposure assumed by market makers can also reduce potential risks. 

Types of Market Risk

The following are the types of market risk:

1) Price Risk: Price is a market-driven measure of value. A seller intends to get the maximum price for the commodity or security it wants to sell and a buyer’s interest is to pay the least possible price for the same. A seller who wants to sell it in the future is thus concerned about the potential fall in price and s reduction in the realisation or profits of the transaction. A buyer may have different concerns. This possibility, of not realising the expected price, may be called the price risk.

Types of Price Risk

Some of the types of price risk are given below:

1) Symmetrical versus Unsymmetrical: Symmetrical risk implies that the movement of an asset price in either direction leads to a corresponding impact (positive or negative) on the position value. In an unsymmetrical risk, however, the impact is unequal. This can be illustrated with an example. Consider an institution holding an equity security in its portfolio. An increase or decrease in the price of an equal dimension would result in a corresponding change in the value of the position held by the institution, multiplied by the number of securities held.

ii) Absolute Risk versus Relative Risk: Absolute risk is measured concerning the initial investment. Relative risk is measured relative to the benchmark index. For example, an investment of 10,000 may decline in value to 9,500 as a result of a fall in prices. Thus, there is an absolute negative return of 5%.

iii) Asset Liquidity Risk: There may be a large number of stocks listed on a stock market. However, not many of these are traded regularly. A similar circumstance may be seen in bonds where certain maturities are favourites of the market and regularly traded while others are not touched at all. In the case of assets which are not very liquid, it may not be possible to execute a large transaction at the market price.

iv) Credit Spread Risk: Credit spread is the difference between the yield on corporate bonds and treasury bonds. It reflects the compensation that bondholders should get for undertaking the extra credit risk inherent in corporate bonds. Credit spread risk is the risk that yields on duration-matched credit-sensitive bonds and treasury bonds could move differently.

v) Volatility Risk: This is a type of price risk that results not from changes in levels of prices but their volatility. Volatility refers to the degree of unpredictable change in a financial variable over some time. For example, the valuation of option contracts depends on the volatility of the underlying asset

vi) Systemic Risk: Systemic risk can arise in the context of a failure of a major market system or institution, sometimes called the ‘domino effect’, which hurts several other institutions. Systemic risks have consequences for the whole market and not just one or two institutions. For example, such risks could be the failure of central clearing and payment systems.

2) Foreign Exchange Risk: Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. The risk is that adverse fluctuations in exchange rates may result in a loss to the institutions. Foreign exchange risk arises from two main factors: currency mismatches in an institution’s assets and liabilities, both on and off-balance sheet, that are not subject to a fixed exchange rate with the foreign currency as well as currency cash flow mismatches. Such risk continues until and unless the foreign exchange position is covered.

Types of Foreign Exchange Risk

The types of foreign exchange risk are as follows:

i) Transition Exposure: Translation exposure, also known as Accounting Exposure, arises because MNCs may wish to translate financial statements of foreign affiliates into their home currency to prepare consolidated financial statements or to compare financial results. As investors all over the world are interested in home currency values, the foreign currency balance sheet and income statement are restated in the parent country’s reporting currency.

i) Economic Exposure: Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. The economic exposure concept is more closely associated with managerial decision-making rather than accounting practices. A company can have economic exposure to say Pound/Rupee rates even if it does not have any transaction of translation exposure in the British currency. The situation would arise when the company’s competitors are using British imports. If the Pound weakens, the company loses its competitiveness (or vice versa if the Pound becomes strong).

iii) Transaction Exposure: Transaction exposure can be defined as “the sensitivity of realised domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes”. In other words, this exposure refers to the extent to which a company’s future domestic cash flow is affected by changes in exchange rates. It arises from the possibility of incurring foreign exchange gains or losses on transactions already entered into and denominated in a foreign currency.

3) Country Risk: A domestic banking institution may transform itself into an international one when it stan lending across its borders or invests in instruments issued by foreign organisations. When the bank starts doing so, the first risk that it encounters is country risk. This is also called sovereign risk. Several factors have a bearing on the level of risk associated with a particular country.

Types of Country Risk

Following are the types of country risk:

1) Sovereign Risk: Sovereign Risk means the risk those commercial banks’ sovereign borrowers or counterparties are unable or unwilling to repay their debts or refuse to fulfil their contracts or obligations either directly or indirectly, such as a debt moratorium policy.

ii) Transfer Risk: Transfer risk means the risk that non-resident counterparties are unable to secure foreign exchange to repay their debts to commercial banks due to certain restrictions, for example, when the host country government imposes capital control or foreign exchange control measures.

ii) Contagion Risk: Contagion Risk means the risk that arises when changes in certain factors in one country affect other countries in the region whose residents are bank’s counterparties, for example, the downgrading of the credit rating of one country has an effect on the debt repayment or business undertaking with residents in other countries in the same region.

iv) Macroeconomie Risk: Macroeconomic Risk means the risk that arises when non-resident counterparties are unable to or do not repay their debt or are unable to fulfil their obligations as a result of changes in economic policies of their countries, i.e., raising interest rates to preserve currency value or changes in tax policy.

v) Indirect Country Risk: Indirect Country Risk means the risk that arises from uncertainties in economic, social, political or other external factors in other countries which cause significant impacts on the Thai debtors’ ability to repay their debts. Nevertheless, in case where the commercial banks we not ready for indirect country risk management, they are allowed to carry out the adjustment for 1 year from the day this policy statement comes into force.