Q Paper on RISKS IN BANKS- the uncertainty of the potential returns in investments and or the potential financial loss Home, - RISKS IN BANKS RISKS IN BANKS 1 Risk can be defined as the uncertainty of the potential returns in investments and or the potential financial loss that are associated with the investment decisions made by the bank. In this case, the actual returns of the investment will be different from the expected returns (Karen, 2009). The characteristics of risks are: they are uncertain, unpredictable, untimely and probable of occurring. Types of the risks include: (Aboli, 2015) • Credit risk-This is the risk that arises as a result of the loan borrowers defaulting in paying back the loans. • Liquidity risk-This risk involves assets and also those securities that cannot be sold and or purchased quickly enough so as to minimize the expenses in the volatile market. • Interest risks- this is the risks that are associated with fluctuation in the rates charged on the loans i.e. high or low interests which may or may not favour the bank. • Currency risks- these are the risks that occur as a result of the differences in the foreign currencies used for exchanging currencies in the bank. • Price risks-This is the risks that the price of the financial instruments traded by the bank decreases hence resulting to losses • Operational risk-This is the risk and or uncertainty of loss that results from and or occurs as a result of the failed internal processes, systems and also people. This can be in form of the poor technology, incompetency of employees, etc. 2 a) Discuss the presence of operational risks in banks The operational risks are the prospect of loss emerging due to various reasons and these include: • Errors committed by the employees • Failures of systems, fraud and other forms criminal activity • Any event disruptions of the business and failure of the system These operational errors are caused by the errors committed by the employees, failure systems, fraud or other criminal activity as well as any other event which disrupts process of a business. The increasing number of operational loss events that are seen to be of high profile across the world has made many banks to perceive management of the operational risks as part of their integral and or core risk management activity. The management of a particular and certain operational risk is not a new approach or practice, and this has not been a new significant strategy for the banks to uphold the integrity of its internal controls, minimization of the errors recording of transactions, prevention of frauds, etc. b) Explain the various approaches used by banks in Operational risk One of the approaches is that banks should build an effective operation risk management capability that is effective by fully assessing the existing risk profile and then construct a database and map of all internal events of the OR. The bank will be compelled to form key risk indicators which serve as the early warning signs of potential problems. After this the management of the bank will make publication of the KRI’s within the bank and uses others part of the ongoing surveillance of the operating risk management. Another step is that the bank articulates its overall appetite for risk. This in some way an exercise in the setting goals for financial measures for instance amount of capital the bank is willing and allowed by regulators to have a risk, but it is same matter of establishing the cultural as well as government priorities of the bank. The management of the bank will set the tone with its decisions. Also, banks should train its employees to anticipate what could go wrong, especially when a business unit is preparing to prepare for something that is new for instance introducing a product, change customer interface, alter the way employees are compensated (Huber and Funaro, 2018). c) Advantages and disadvantages of different approaches to operational risk Advantages One of the advantages of these approaches is that by use of the digitalization systems to control risk operation enable the banking sector become more customer-centric and these customers will continue to make good use of digital channels, banks will be in high position to gain greater visibility into what their customers, employees and information technology systems are doing and better insights into what could go wrong. Another advantage is that by training the workforce, the banks can be able to reduce or eliminate human intervention in many transactions hence containing the risks of errors caused by employees and fraud. Disadvantages One of the disadvantages is that many banks have tough time understanding, measuring and managing the factors in the bank which are interconnected which contribute to operational risk. These include the behavior of the employees, organizational process as well as information technology systems. Most of the banks find it challenging creating cultural, governance and management structures that can systematically control these risks. The systems used by the banks in managing these risks are prone to hacking and breaching. When these are hacked, the critical information used by banks can be hacked. These systems to some extend turn out to be too slow while others crash, and in case these challenges emerge the bank customers cannot access the banks services such as withdrawing their money from the ATMs. 3 Capital acts as a cushion in managing the impacts of risks faced by banks by providing effective mitigation to such risks. For instance, capital is essential is mitigating the bank against such risks such as the credit risks. These risks occur as a result of the default of the loan borrowers in making the repayments for the loans borrowed and thus making the bank incur losses thus affecting its financial position. In this case, availability of the capital will enhance continuation of the bank business of lending loans to their customers by providing the extra credit to be offered to customers as loans. On the other hand, the availability of adequate capital facilitates funding of the bank business and operations when it suffers against such risks as liquidity risks which occur as a result of the bank’s assets and also those securities that cannot be sold and or purchased quickly enough to minimize the expenses in the volatile market. Capital, therefore, cushions the bank against these risks as it will enhance availability of enough funds to fund the bank if its assets and securities are not disposed quickly. This implies that the capital enables the bank to meet its financial obligations that occur as a result of risks thus reducing and or managing their impact on the bank’s operations and existence thus facilitating continuity.