2.

3 Some major risks in the Banking industry

As every business is faced with certain types of risk, banks also have many risks which they have

to manage. When banks fail to effectively manage these risks, they could easily become

insolvent and that can weaken the bank’s financial conditions. Banks are exposed to competition

and hence encounter various types of financial and non-financial risks.

Financial services dealing with so many daily actions and reactions by human beings are exposed

to a variety of risks (Young, 2006). The greatest risk, however is not taking one, as the chances

for rewards move towards zero. Even though the major discussion is on operational risk, the

impact of other type of risks can affect a bank’s operation which makes it important for these

risks to be briefly discussed. This is because there are different types of risks to which financial

institutions are exposed to, depending on the environment in which they are assessed.

2.3.1 Credit Risk

This type of risk arises from the inability or unwillingness of a counterparty to honour its credit

obligations in accordance with agreed terms. Credit risk is the risk that a business, or an

individual, fails to honors terms specified in a credit agreement. For instance, in a situation

where a banks’ debtor fails to repay a facility on time, may lead to insufficient cash flow for the

bank. The banks must therefore make sure loan facilities are given to credit worthy individuals

and businesses to reduce the risk of default. Collateral can also be used as a guarantee for prompt

repayments and can used to service the remaining balance should in case the debtor defaults.
2.3.2 Market Risk

This type of risk is as a result of adverse changes in interest rates, foreign currency rates, equity

price and other relevant market rates, price and volatilities. Market risk can generally be defined

as the risk changes in a market determined price or interest rate (Culp and Neves, 1998). Market

risk is influenced by certain economic factors such as interest rate risks, liquidity risk, and

foreign exchange risk. This is means that market risk is the possibility of loss to the bank due to

market variables (Kimei 2007).

2.3.2.1 Liquidity Risk: This refers to potential loss in profits resulting from a financial

institution’s inability to meet its financial obligations when they become due. Liquidity is

necessary for the banks to provide funds for growth and tackle unexpected expenditures.

Liquidity risk arises where there is no cash to meet the current needs of depositors and

borrowers. It arises from the institution’s failure to maintain adequate reserves to service funding

requirements.

2.3.2.2 Interest rate risk: Financial intuitions’ earnings and capital position can be affected by

fluctuations in interest rates. This is the risk arising from possible interest rate differentials in

positions mismatch embedded in the balance sheet of the bank. Interest rate risk is the risk

incurred by banks as a result of mismatching the maturities of their rate sensitive assets and rate

sensitive liabilities. Thus it is the risk of loss due to change in interest rates.

2.3.2.3 Foreign exchange risk: Is a result of unexpected currency fluctuations that impact on the

value of the foreign exchange exposure of a financial institution. This risk arises when a financial

institution transacts in more than one currency. Typically, foreign exchange risk can occur when

settlement of a transaction is in a foreign currency (transaction exposure) or as a consequence of

having assets or investment s in foreign currency (translation exposure).

This occurs when negatively publicity regarding a bank’s business practices leads to a loss of

revenue. This is the risk resulting from adverse perception, whether true or not, of the image of

an organization. Such risk is of significant negative public opinion that results in a critical loss

of funding or customers. It may involve actions that create a lasting negative image on the

institution’s operations. Service or product problems, mistakes, malfeasance, or fraud may cause

reputational risk. Reputation risk may not only affect the bank’s image but its affiliation with

other institutions. This risk is very damaging especially if the institution operate in a very small

market. Once the reputation is gone, so will be the eventual demise of the bank.

2.3.4 Operational risk

The Basel Committee on Banking Supervision defines operational risk in the New Basel Capital

Accord (2003, p.5) 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 reputational risk. Operational risk is inherent in all banking products, activities,

processes and systems, and the effective management of operational risk has always been a

fundamental element of a bank’s risk management program. Operational risk is caused by

internal and external frauds, employment practices and work place safety, client, products and

business practices, damage to physical assets, business disruption and system failures, execution,

delivery and process management, highly automated technology, emergence of e-commerce, and

outsourcing. As a result, sound operational risk management is a reflection of the effectiveness

of the board and senior management in administering its portfolio of products, activities,

processes, and systems.

This arises from the potential that unenforceable contracts, lawsuits, or adverse judgements can

disrupt or otherwise negatively affect the operations or conditions of the organization. Legal risk

is the risk of financial or reputational loss arising from: regulatory or legal action; disputes for or

against the company; failure to correctly document, enforce or adhere to contractual

arrangements; inadequate management of non-contractual rights; or failure to meet non-

contractual obligations. According to McCormick (2004), legal risk is the risk of loss to an

institution which is primarily caused by a defective transaction; or a claim (including a defense

to a claim or a counterclaim) being made or some other event occurring which results in a

liability for the institution or other loss (for example, as a result of the termination of a contract)

or; failing to take appropriate measures to protect assets (for example, intellectual property)

owned by the institution; or change in law.

2.4 Risk Management

Capital is said to be more complicated as the firm and economies also become sophisticated with

time. The main factor to this sophistication is risk. Risk can be viewed as ‘a possible harm or

chance of danger’. Thus risk can be described as a quantitative measure of an expected

outcome, the process that involves the likelihood of an adverse event occurring.

The banking industry is increasingly dynamic and as such a clear articulation of the risks is

necessary for the consistent application of risk management techniques across the industry. Risk

is owned by all employees of an organization. Risk management is a very important concept for

any business as most financial decisions revolve around the corporate cost of holding risk. This

issue is particularly important to banks since risk constitutes their core business processes. Risk
management is the process by which managers satisfy these needs by identifying key risks,

obtaining consistency, choosing which risks to reduce, which to increase and by what means, and

establishing procedures to monitor resulting risk positions and responding to the risks

appropriately.

Risk management can also be defined as the identification, analysis and economic control of

those risks which threaten the assets or earning capacity of an organization. This implies that risk

management is a managerial function aimed at protecting the organization, its people, assets and

profits, against the consequences of pure risk, more particular aimed at reducing the severity and

variability of losses. The response to risks depends on the perceived magnitude, and involves

controlling, accepting, avoiding or transferring them to a third party. The occurrence of a risk

event could result in losses which affects both profitability and business value. Effective risk

management aims to reduce the frequency of risk events and also reduce the severity of impact

on the organization. The objective of risk management in organizations is to mitigate reduction

in value or wealth of the organization and has the objective of increasing the wealth of the

business.

Irrespective of the type of risk under consideration, the general risk management process would

involve identification of all significant risks; evaluation of the potential frequency and severity of

losses; developing and selecting methods for managing risks; implementing the risk management

methods chosen; monitoring the performance and suitability of the risk management methods

and strategies on a regular basis. This will enable the risk manager detect new risks and

increased risk levels at an early stage. Risk management contributes to an improved control

environment and leads to the prevention of hazardous situations that could impact on the

operations or reputation of the institution.

On June 26th, 1974, the troubled German bank Herstatt was ordered into liquidation by the

German authorities. Earlier that day, several German banks had paid Deutsche Marks to Herstatt,

believing they would receive U.S. dollars later in the same day. However, because of time zone

differences, the German banks never received their dollars. It was only early morning in New

York when Herstatt was liquidated and all outgoing U.S. dollar payments were suspended. This

messy incident brought about the interconnectedness of the banking system around the world.

The national banking legislations were too limited in their geography to be able to handle such

incidents. In response, the eleven G-10 nations (Belgium, Canada, France, Germany, Italy,

Japan, The Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) and

Luxembourg decided to form a council to improve the quality of banking standards and

supervision within the member states. Thus, a committee was formed in 1974, informally known

as the Basel Committee, consisting of each country’s central banker and representatives of her

banking supervisory authorities. The committee meets four times a year in Basel, Switzerland.

Soon after its inception, the Basel Committee began efforts to harmonize the international banking
system. In July of 1988, after six years of deliberation, the initial twelve nations plus Spain released a
capital accord, commonly referred to as Basel I (Basel Committee 1998). Basel 1 focused on credit risk,
that is, the risk that the borrower does not pay the agreed upon amount (principal and/or interest). Basel I
proposed minimum capital requirements to be set aside for internationally active banks to protect against
credit risk. One of the criticisms of Basel I was its narrow scope. Credit risk, although being very
important, is not the only risk banks face. Another major risk is the market risk, which is the risk that the
portfolio of the bank’s market investments