Bank Risk Management: How Financial Institutions Protect Themselves from Insolvency

Igor Izraylevych

5 min read

Bank risk management

Risk is an inherent part of every business and this includes financial institutions; in fact, a strong argument can be made that running a bank is the riskiest venture of them all. 

Therefore, it’s no surprise that the job of risk management has always been an integral part of a bank’s internal processes. 

The banking industry continues to modernize its operations by digitizing and integrating their disparate systems as well as allowing outside access to data via Open Banking. This has made the importance and complexity of risk management increase exponentially. 

In this article, we’ll take a look at the various types of risks a bank can face as well as the bank risk management techniques used to reduce it as much as possible without stifling their growth. 

We’ll also explore the various components that are a part of today’s risk management software tools and the role it plays in a bank’s compliance and decision-making processes.

Types of Risk Management

Since there are a wide variety of risks inherent in the banking industry, there are consequently many facets to the job of risk management that need individual focus and attention. 

There are essentially two basic types of risk: 

  1. The ones that the financial institutions take upon themselves when lending or making investments. 
  2. The ones foisted upon them that occur due to outside forces or events. 

All of these risks need to be collectively assessed, monitored, and mitigated when necessary on a continuous basis. This is why the role of risk management is so critically important.

Credit Risk

The issuing of credit is central to a bank’s business model and a key part of its revenue stream. Consequently, credit default risk is perhaps one of the greatest dangers a bank may face. 

After all, if the people, entities, or organizations that borrow from the bank do not repay this money that was given to them, it could quickly cause the bank to completely collapse. 

However, issuing credit is of course also a very important revenue stream, as higher interest rates can be charged to those with a less-than-perfect score, making them a tempting target for loan offers. 

Therefore credit risk management involves assessing the health of the lending portion of the bank and its ability to offer lines of credit to a wide variety of its customers. 

Liquidity Risk 

Liquidity risk is another major category of risk for the banking industry. 

The amount of liquidity risk a bank has involves its ability to pay debts. This can be with the cash it has on hand or by quickly raising enough money by selling off assets in times of crisis. 

Liquidity risk management is very complicated as it involves many financial factors both internally and externally that can compound and convolute the issue. Because of this, banks are required to regularly perform stress tests to ensure they can meet their short-term debts if it were to become necessary (this was brought about because of the financial crisis of 2008).

Market Risk

Market risk are the uncertainties associated with sudden unexpected changes in the overall market that can negatively impact the bank’s finances. 

For example, a drop in the exchange rate between currencies or a downtick in interest rates can affect their ability to profit from the various financial transactions that help fatten their bottom line.

It is therefore an inherent part of a risk manager’s job to be able to assess the bank’s overall market risk and diversify when necessary to reduce exposure to these types of events.

Operational Risk

Operational risk is a category that covers all the vulnerabilities that are associated with the inner workings of the bank. 

These types of risks can come from incidents such as accidental human error during a banking transaction as well as deliberate actions of fraud to steal money from within. 

It also covers the entire spectrum of cyber crimes, which is a rapidly growing threat as nefarious entities use tools like phishing and ransomware to break in and then hold the systems hostage until a fee is paid. 

Operational risk management is still a relatively new area of risk governance, having only been in existence since the early 2000s when the Basel Committee on Banking Supervision identified and defined it as its own specific discipline. 

Techniques of Risk Management

When it comes to dealing with this enormous spectrum of risks that every bank faces during the course of doing business, there are some general techniques that can be used to reduce damage or exposure to them. 

It should be noted that these techniques are not specific to banking and can be put into action by any type of organization or company. 

Avoidance

Not allowing or engaging in a risky venture. For a bank, an example might be not loaning money to borrowers with bad credit.

Retention

Accepting the risk. As we mentioned earlier in the article, a certain amount of risk is inevitable in banking and indeed desirable for its long-term growth.

Control

When a loan goes bad or another unforeseen event causes troubles, the goal is to mitigate the damages or loss as much as possible. This is where liquidity risk can sometimes come into play.

Transfer

The risk is taken over by a third party or an insurance policy. An example in the world of banking would be the Federal Deposit Insurance Corporation (FDIC) which insures an individual investor’s deposits. 

Methods of Risk Management

Risk management can be considered both art and science as it involves pairing hard financial data along with human instinct to make good decisions. 

There is no one “perfect” way to manage risk, and since much of it is based upon future events, always has an element of the unknowable.

Still, there are strategies and ideas that every risk manager should use during their day-to-day routine. 

First and foremost is identifying the various risks facing the bank

These can come from both internal decisions, such as lending to unworthy borrowers to unexpected events in the market. 

Risk managers may want to visualize these potential problems, scenarios, and outcomes by using tools like creating decision trees, SWOT analysis, or using process mapping.

Various risks that have been identified can also be given a numerical value to indicate their threat level; for example, an event with a 5 would be categorized as a serious risk and another with a one would be considered minimal. 

A good risk manager uses a wide variety of these tools to keep their finger on the proverbial pulse of the bank, ensuring it is healthy and ready to react/rebound quickly if something does indeed go wrong.

Risk Management Software

In 2006, the Basel II accord made it a requirement that all banks use some form of risk management software. Thanks to this important legislation (and coupled with the development of tools such as artificial intelligence and machine learning), there is now a wide array of choices available all over the world. 

These programs can take the myriad of data that is continuously being generated and present or process it to help risk managers make better decisions. This also allows those in charge to see the big picture of their institution in real-time.

There are many common features of this software, some of which are outlined below:

Compliance

Compliance includes consumer protection laws as well as board and management oversight; it also involves the ability for the bank to audit itself to ensure the measures it is taking are working. This software is always kept up to date with national and international requirements and can help the bank stay on the right side of regulations, reducing or eliminating potential fines. 

Digital Repository

Another important feature is serving as a digital repository for all the various risks a bank faces, collecting relevant data and visualizing it in charts or graphs. They usually have a digital dashboard that can present these insights in an easy-to-digest fashion.

Powerful Monitoring, Filtering, and Sorting 

This software is designed to assess everything from IT and phishing risks to internal fraud and potential employee lawsuits. It allows a risk manager to tag, filter, and sort based on levels of risk as well as create workflows to better deal with them.

Report Generation

Reports can be quickly created which can be shared with other executives. This enables the team to see potential outcomes of various scenarios as well as make better, more informed decisions.

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Conclusion

Bank risk management is a core part of a bank’s internal processes and indeed could not survive without it. 

A risk manager’s job is to understand all the various threats a bank faces daily and keep it all in check. 

There are a wide variety of risks both internal as well as external that can cause a bank to fail; there are tools to help visualize and organize these so those in charge can be as informed as possible about the bank’s overall health. 

If you are a risk manager and are looking for recommendations on software, talk with an S-PRO expert today.

Igor Izraylevych