To counter risks and streamline their processes, financial institutions need a well-structured risk management infrastructure.
FERMONT, CA: Inherently, the banking sector is risk-prone. Financial risks can vary across aspects of credit, operation, market, and liquidity. By applying a robust risk management strategy, banks may reduce risks across their verticals. Investors are heavily influenced by a bank's ability to counter threats. In addition, because of loan losses, a bank without a proper risk management system will experience lower profits. Here, along with the strategies to counter them, are the three risk-prone aspects in the banking sector.
Management of Credit Risk
Credit risk refers to the failure of the borrower to uphold the bank's contractual obligations. For example, a borrower can default on a loan's principal payment. Credit cards, mortgages, and fixed-income securities may also result in defaults. By reducing exposure in several ways, banks can minimize credit risks. For example, it is a fact that market conditions can suddenly affect any industry. Diversification allows the bank to distribute the risk factor across multiple sectors. Thus, diversified credit returns from other sectors can compensate for a credit downturn associated with a particular industry.
Management of Operational Risks
Operational risks relate to potential losses due to interruptions or inadequate systems, workers, or processes. While the operational risk for retail banking and asset management is low, risks for operations like trading and sales are higher. Banks are also always at risk as a result of internal fraud or cyber-attacks. Not only do such incidents cause banks to lose capital, but it also causes irreparable damage to their reputation. The incorporation of technology and the streamlining of processes to meet modern security challenges can minimize operational risks.
Management of Liquidity Risks
Liquidity risk is a severe threat referring to the inability of a bank to access cash for funding purposes. Besides, liquidity issues can lead to a snowball effect. For example, if a bank procrastinates while providing cash to customers, customers may lose confidence in the bank. Customers are going to rush to take their deposits, creating additional pressure on the bank. Liquidity risk can be offset by ensuring ample cash to survive even if a sufficiently large number of customers wish to withdraw their deposits.
Understanding the potential of risks and adhering to the risk management principles, as mentioned above, will allow financial firms to improve risk mitigation.