Risk Management In Banking. Drawing The Map For The Rocky Path
The banking industry is strongly associated with risk as an essential part of it. While taking risks, banks generate profit. But sometimes, the stakes are too high, and the loss potential is huge either due to legal consequences, financial fraud, or a variety of other reasons.
In everyday operations, banks contend with risks. Some of them are chosen deliberately, others are an inherent part of the banking domain. The sources of risk are numerous, from launching new loan products onto the market to employing unscrupulous people.
To survive and thrive, the banking business should find the right balance between risk-taking and risk mitigation. That is the role of risk management in banks—the topic of the article RNDpoint’s team offers you.
Table of Contents
What is enterprise risk management in banks and its stages
Risk management in banking is the process of risk mitigation aimed at limiting harmful impacts on banks and financial organizations. The cause of risk occurrence can be any action or inaction that increases the exposure to factors leading to revenue reduction, causing losses, or reputation damage.
The ultimate goal of risk management in banks is to ensure that the financial organization and its employees take action to reduce the impact of harmful factors.
Every decision made in a bank performs a certain type of risk management. The decision-making process itself may be defined as the process of evaluating and comparing risks and benefits to find out the most beneficial and least risky set of actions.
The risk management process is like an unstoppable merry-go-round. You can’t leave it without damaging limbs or even losing the head. A never-ending balance between benefits and risks is the basis of any business, especially a financial one.
No matter what risk factor occurs, the process of risk management should consist of certain stages to mitigate its impact. The risk management process should start with constant risk monitoring and end with it while going through stages of risk identification, assessment, choosing relevant measures for mitigation, and measuring results.
Figure 1 shows the cycle of the risk management process and all its stages to fulfill a successful enterprise risk management policy in a bank.
Figure 1. Stages of the risk management process.
Importance of risk management in banks. Why it matters?
Implementation of a risk management process reminds of setting up a fire alarm. It takes time, effort, and money. And there’s always the hope that the alarm never goes off.
It’s essential for banks to have such a fire alarm and deal with inconvenience and costs upfront, but get sound and effective protection in the future, if the risk occurs.
A well-tailored risk management framework in banks is of great importance for:
- Understanding and analyzing financial and non-financial risks, and building strategies for their mitigation or elimination.
- Identification of risks a bank can accept, setting up the level of risk tolerance, formulation of a set of risk measuring methods, and understanding the limits of tolerance levels.
- Ongoing monitoring and checking of all transactions for suspicious activities, either in real-time or in batch.
- Keeping the level of risks within the bank’s risk appetite.
- Forecasting and evaluation of potential losses in the future.
- Taking preventive measures aimed at dealing with possible problems, if they occur.
- Protection of both a bank and its employees from unexpected financial impacts.
There is never too much money, time, and effort spent on managing risk in banks. The better a bank protects itself from possible threats, the more potential losses it avoids. Increasing costs on risk management now are revenue from money that will not be lost in the future.
How banks carry out risk management
A risk management strategy is a core element of the risk management lifecycle. After identification of risks and assessment of their likelihood of happening and the effect they could make, it’s necessary to define the ways of treating them.
The choice of the risk management approach is called a risk management strategy that is sometimes called risk treatment.
There are four main risk treatment strategies, namely:
- risk acceptance
- risk transference
- risk avoidance
- risk reduction
There is no right or wrong risk treatment strategy. Each is suitable for specific types of risks, and choosing the most effective one at the appropriate moment is the main goal of the risk management strategy.
Let’s find out what the four approaches embrace.
1. Risk acceptance
The approach is not based on reducing the impact of a risk or avoiding it at all. The cost of risk mitigation sometimes exceeds the losses that the risk itself can cause. In such cases, it is more reasonable to accept the risk of $20,000 instead of spending $200,000 for risk prevention.
But risk acceptance comes with a gamble. It’s necessary to be sure that the risk is really acceptable to deal with when it occurs in the future. Because of this, the risk acceptance approach should only be applied to the risks with a low chance of happening or with minimal impact on a bank.
2. Risk transference
The choice of the risk transference approach does not mean the entire risk eradication. The possible risk still exists. But the responsibility for the elimination of impact is shifted from one bank to another.
In finance, you may adopt a hedging strategy to protect your assets or investments.
3. Risk avoidance
The approach is aimed at the complete elimination of the possibility of the risk occurring. If after analysis of the risk associated with some action or activity, a bank considers them too risky, they are simply rejected.
Only risks with a major impact on a bank should be treated by avoiding them. But avoiding any risk a bank can come across is a way of missing positive opportunities. That is why thorough risk analysis is needed to make the most accurate and informed judgment about risk factors.
4. Risk reduction
When it comes to risk management, risk reduction is the most common risk treatment approach. It is well known as risk lowering as well. The choice of this approach requires a bank to shape actions and measures for making risks more manageable.
The method of risk reduction is carried out by lowering the probability of the risk happening. In the sphere of finance, banks may come across risks caused by new regulations.
For instance, the implementation of a digital tool can help banks to meet new regulatory requirements and reduce the risks of non-compliance. That is an example of a risk reduction approach.
Risks in the banking sector. Classification
Risk managers in banks have always been preoccupied with building and maintaining sustainable risk management strategies and frameworks to mitigate a greater number of risk types.
Beyond traditional types of risks—credit, market, operational risk, etc.—the impact of environmental, social, model, and governance risks are on the rise. To cap it all, there are a bunch of non-financial risks with hard-to-quantify impacts.
Figure 2 shows six types of traditional risks banks face while operating in the financial industry.
Figure 2. Traditional risks in the banking sector.
Let’s take a look at the most significant financial risks that banks have to deal with. They’re credit, market, and operational ones. Figure 3 illustrates the major financial risks and their constituents.
Figure 3. Main risks for banks.
Credit risk
Lending money means that there is always a possibility that the loan will not be paid back. Borrowers and companies that fail to repay their debts become the largest source of risk for banks. This is credit risk.
There is a way to reduce credit risk for banks. When processing a loan application, they assess five parameters known as the five C’s: credit history, capital, capacity, collateral, and conditions.
- Credit history, or character, is a borrower’s records about debts repaid.
- Capacity stands for the ability to repay a loan by comparing the borrower’s income and job stability with the loan amount, also referred to as the debt-to-income ratio.
- To secure a loan to be paid back, a lender can have assets such as a car or a house as collateral.
- The assessment of the investments, savings, and other assets is made by a bank to calculate the capital that the borrower has.
- The conditions, or the purpose, of a loan, are determined so that a bank can decide if it lends money or not.
The assessment of these parameters determines the interest rate a bank will charge a borrower. If a client is considered risky because of bad credit history, the offered loan will be more expensive.
Market risk
Market risk for banks is the possibility of experiencing losses caused by factors that influence the performance of investments in the market of finance.
This type of risk is particularly characteristic of investment banks that are exposed to influence from changes in the financial market because they hold the majority of their financial assets and shares for their customers and themselves.
The sources of market risk can be numerous, from changing the price of a good to fluctuations in interest and currency exchange rates.
Operational risk
The losses that come from human errors, bad internal processes, security breaches, or external events are referred to as operational risks. Employee mistakes, fraudulent activity, financial crimes, and physical events are the most frequent sources of triggering operational risk.
There are five categories of operational risk:
- People risk is related to downturns in human capital and human resource management. This embraces the lack of ability to attract, motivate, develop, and retain qualified human resources and often leads to human errors, fraudulent actions, or other unethical behavior, both inside and outside a bank.
- Process risk refers to failed internal banking processes leading to financial losses and negative staff performance, including failures of internal projects and flaws in banking product determination.
- Systems risk is caused by failures of internal systems’ implementation. This includes core banking systems, inter-branch connections, information technology systems, management information, power backup systems, other technical systems, etc.
- External events risk is related to the external events occurring outside the bank’s control and embracing both natural disasters and events made by people.
- Legal and compliance risk is caused by non-compliance with external and internal regulations and laws, including non-compliance with financial regulations, tax laws, Anti-Money Laundering (AML) or Know Your Customer (KYC) requirements, and other regulations.
Enterprise risk management for financial institutions
For many banks, there is a problem that they are too busy with financial risks while missing the bigger picture. Rapid innovation in technologies led to the emergence of new threats in artificial intelligence, cybersecurity, blockchain, and other areas.
That’s where “enterprise risk management” can come to help. As it is clear from the name, enterprise risk management focuses on controlling the widest possible variety of risks, from purely financial to non-financial ones.
Banks with a sophisticated understanding of financial threats are not always experienced enough with non-traditional risks. Though, such risks can have a deeper impact on a bank’s financial performance.
Implementation of an effective and comprehensive enterprise risk management strategy is a tough call, especially for banks that are calcified along traditional lines of risk management.
Banks, embracing enterprise risk management today, will be in the position of a quick response to unforeseen threats tomorrow. They will escape the risk of making a new number of mistakes due to the complex analysis of risk factors.
Enterprise risk management enables banks and other lending organizations to make connections between risk factors for understanding that the complex whole is much more than the sum of its constituent parts.
Components of enterprise risk management framework for banks
Any strategy for enterprise risk management should be value-driven, comprehensive, and distributed across the entire bank or financial company. Due to the right risk management framework in the armory, banks can detect risks early before they lead to full-sized catastrophes.
For banks, there are four key elements of an enterprise risk management framework.
Identify
The first component deals with the identification of areas of risk. Risk identification is a foundational step of risk management in banking institutions. Understanding risk is a pledge of accurate risk measurement, estimation of impact, control, and mitigation.
Risk identification encompasses:
- Stress test scenario for clear vision, if risk factors can be appropriately handled and a bank has enough capital to withstand an impact.
- Disaster tests help financial institutions to ensure their stability in times of natural disasters.
- Risk modeling is used for the identification of areas requiring closer attention. Piece-by-piece analysis of various scenarios enables a precise understanding of the risks and their possible consequences for the creation of preemptive controls and protocols.
- Risk ownership implies that special people or a team should own and manage aspects of the risk. These experts should have risk management control and be responsible for addressing the problem timely to prevent bigger issues.
- Strategic plan for identifying the risks that may curb the achievement and execution of those objectives.
Assess
A robust risk assessment is key to lose mitigation. Accurate calculation of inherent and residual levels of risk makes it possible to determine the appropriate steps toward risk reduction within a defined risk appetite.
It is vital for a bank to review the risk inherent in its services and products, entity base, customers, and geographical position. Further quantification of this risk allows for calculating and assigning risk scores.
Mitigating controls are measures and procedures designed for the reduction of inherent risks in a bank to an acceptable level. Residual risk is the risk volume or level, remaining after inherent risk reduction due to risk controls implementation.
Risk management procedures, policies, and controls in a bank can mitigate the inherent risks of high-risk services, products, customers, systems, and processes. But the residual risk level in financial institutions can remain unchanged.
If the residual risk rating is too high, the adjustment of risk management measures should be made.
Respond
Respond is an element of the risk management framework, allowing to put the proper mechanisms of risk control in place for mitigating high-risk areas. A well-structured risk management framework implemented in a bank significantly reduces all risks across all activities.
The ability of a banking organization to counter its threats is a vital factor. With no well-tailored credit risk management system, a bank will get lower profits because of loan losses.
Here is the list of strategies to respond to the threat:
- Credit risk policies are used to ensure that risk management processes are properly developed for the identification of sources of credit risk, assessment of their magnitude, and proper mitigation of risks, including credit concentration limits, approved loan products, product eligibility, approval of large transactions, and portfolio segmentation.
- Loan origination standards implementation to specify criteria of underwriting and purchase that determine types of factors considered for loan approval.
- Investment portfolio management and loan administration for specifying operating procedures across credit and portfolio management to identify and manage non-performing loans and investments, including assistance for customers in periods of financial hardship.
Monitor
After the implementation of the appropriate strategies and controls for risk mitigation, banking institutions should carry out the monitoring of these controls.
Monitoring controls are built to ensure effective ongoing supervision of activities performed by external and internal parties, impacting operations and customer experience.
Management of risks. Safe steps to the future
Risk matters. Banks must accept risks as an inseparable part of their activities if they want to thrive and prosper while meeting customer and market needs. But they must manage the risks properly and recognize them timely.
Even if risks are temporarily ignored, they will eventually occur. Understanding that fact will benefit banks and lending institutions all across the board. But it’s necessary to adopt increasingly sophisticated risk management practices in the years ahead for that.
At ABLE Platform, we believe our article will make banks deploy diverse and agile risk management strategies and allow them to shape a strong and dynamic understanding of risks and mechanisms for managing them.
Contact us for more details about risk management and digital tools that automate it.
