impact. Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the bank’s capital or its earnings. The expected loss is to be borne b y the borrower and hence is taken care of by adequately pricing the products through risk premium and reserves created out of the earnings. It is the amount expected to be lost due to changes in credit quality resulting in default. Whereas, the unexpected loss on account of the individual exposure and the whole portfolio is entirely borne by the bank itself and hence care should be taken. Thus, the expected losses are covered by reserves/provisions and the unexpected losses require capital allocation. i. Credit Risk: Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. Although it's impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk. ii. Market Risk: Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk," and cannot be eliminated through diversification, though it can be hedged against in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks. Systematic, or market risk tends to influence the entire market at the same time. iii. Operational risk is the risk associated with the operations of an organization. It is defined as “risk of loss r esulting from inadequate or failed internal process, people and systems or from external events.” It includes legal risk. It excludes strategic and reputational risks, as the same are not quantifiable. Operational risk includes the risk of loss arising from fraud, system failures, trading error and many other 3. Types of Risk
internal organizational risks as well as risk due to external events such as fire, flood etc. the losses due to operation risk can be direct as well as indirect. Direct loss means the financial losses resulting directly from an incident or an event. E.g. forgery, fraud etc. indirect loss means the loss incurred due to the impact of an incident. iv. Solvency Risk: Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency is essential to staying in business as it demonstrates a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive and pay off its short-term obligations, such short-term liquidity should not be confused with solvency. A company that is insolvent has significant risk of entering bankruptcy.
You've reached the end of your free preview.
Want to read all 24 pages?
- Summer '16
- Basel II