Basic Concept of Risk

Financial Risk is one of the major concerns of every business across fields and geographies. This is the reason behind the Financial Risk Manager FRM Exam gaining huge recognition among financial experts across the globe. FRM is the top most credential offered to risk management professionals worldwide. Financial Risk again is the base concept of FRM Level 1 exam. Before understanding the techniques to control risk and perform risk management, it is very important to realize what risk is and what the types of risks are.

Risk is defines as an event having averse impact on profitability and/or reputation due to several distinct source of uncertainty.It is necessary that the managerial process captures both the uncertainty and potential adverse impact on profitability and/or reputation.

Risk is a part of any business’s lexicon, and understanding and subsequently managing it is the most important concern. In banking as well, risk is inherent in the business. Given the impor­tance of risk management, it is no wonder that it is today receiving scrutiny from the world’s top banking regulators.

Bank of Interna­tional Settlements (BIS), the Federal Reserve in the United States, Bundesbank in Germany, and Reserve Bank of India have indi­cated their concern at the risk-taking activities of banks.

These regulatory bodies have expressed concern since not only the environment has become a lot riskier with exchange rates and interest rates being extremely volatile, but a large amount of bank capital has been spread internationally seeking returns.

Banks’ exposure to Asian and Latin American countries’ corporates is extremely high in comparison to earlier years. As currencies and corporates reel under pressure (the South Asian crisis being an example), the regulators are understandably concerned about the banks’ ability to withstand these pressures.

Add to that mix, well publicized bank collapses (Barings) as well as losses incurred on account of faulty option pricing models (NatWest Markets) it is no wonder that there has been a slew of regulations covering capital and reporting requirements

Organizations and institutions like banks put tangible assets (such as funds, technology, processes, and people) and intangible assets such as reputation, brand and information) at risk to achieve their objectives.

Whether the organization is for-profit, or not-for- y profit the task of management is to manage these risks in the uncertain environment. Organizational management has thus become synonymous with risk management.

The Concept of Risk

The Oxford Dictionary of Word Origin states the following on risk: “We know well enough what the immediate source of word risk was. The English borrowed French risque in the 17th century. That in turn came from Italian rischo, which was based on the Latin verb rischare meaning ‘to run into danger’.

Beyond that, we get into uncertain territory. According to one theory it was a nautical term, referring to ships that ran the risk of sailing too close to dangerous rocky coasts. Evidence that supports this idea includes Greek rhiza meaning a cliff and the Latin verb resecare meaning ‘to cut of short’ (a rocky cliff being land that has been ‘cut off short’), both of which have been claimed as the source of rischare.

Risk taking comes naturally to banks. Banks engage themselves in the process of financial intermediation by taking risks to earn more than what they pay to the depositors. Risk is an event or injury that can cause damage to an institution’s income and/or reputation. It is like energy that cannot be created or destroyed but can only be passed on or managed.

There is a direct relation­ship between risk and reward and the quest for profit maximiza­tion has given rise to accelerated risk taking for enhanced re­wards. Whatever be the type of risk, the impact is primarily financial. Ultimately risk manifests in the form of loss of income and reputation.

Each bank as well as every banker needs to understand and appreciate that risk is unavoidable. The existence and quantum of risk associated with each transaction cannot be ascertained with certainty.

Whatever models have been developed for risk man­agement, are primarily on the basis of observed occurrences of the past, which may or may not be repeated in future. Risk is inherent to business. Since it cannot be eliminated, it has to be managed.

Characteristics of Risk

Banking is intermediation for funds. Intermediation involves risk. In order to make profits and earn a spread banker takes a position in the investment market or in loan business. Evidently it is risk that leads to some profits. As said earlier there is a close relation­ship between risk and reward. There are many reasons for busi­ness firms/companies to take risks primary need being profit motivation. Risks are of different types, but have certain common characteristics.

Financial Risk has to be differentiated from loss. Normally, the risks involved in business are fairly known. The risk is probabilistic and generic. Risks in financial markets are events that are likely to happen. The uncertainty is more in respect of time of risk and its impact.

There is nothing that can be completely failing or succeed­ing hundred percent. There is always a chance element reflected in probability. The risk is generic. For example one can make a statement that “the possibilities of chemical units in a particular industrial area succeeding are minimal”. No one can state with certainty that a particular chemical unit would succeed or fail.

Risks are ascertainable, although not always quantifiable. Risk has a direct relationship with return, i.e., higher the risk higher the return and vice versa. Precisely because of this, risks are needed for the conduct of business. The types of risks discussed below are interrelated; they are collectively exhaustive but not mutually exclusive.

The Changing Forms of Risk

Risk is associated with every business activity. It is more promi­nent and pronounced in respect of financial sector in general and banks in particular. In a repressed financial system risk is not apparent. Risk management in such a situation may not be well organized. With globalization, the unorganized efforts towards risk management have now been substituted by systematic and formal policy endeavours.

New concepts like ‘anticipate/prevent/ monitor mitigate’ have substituted the earlier ethos of ‘inspect/ detect/react’. The emphasis is now more on processes and not on people alone. The changed scenario for risk management has thrown up many challenges for banks. In this background it would be interesting to understand various types of risk in a banking environment.