Types of Risks

As much as there have been many definitions on risk, there are also many variations in terms of risk categories. Pyle (1997) categorises risks based on their value of loss. He views major sources of value loss as coming from market risk, credit risk, operational risk, and performance risk.

According to (Santomero (1997), risks in business fall into two categories, namely market and financial risk. He views market risks as a law of nature which can only be known precisely by God, which contrasts with systematic risk as man cannot control market risk. Meanwhile, he terms financial risk unsystematic, the opposite of the market risk.

Risk taxonomy may be seen as artificial as distinguishing lines are unclear (Christofferson, 2011). For the sake of this discussion, this section will briefly go through a general consensus of the description of the five broad types of risks; credit risk, market risk, liquidity risk, operational risk and reputational risk.

Credit risk

Credit risk is the probability that parties will default on financial contractual obligations. It is defined as “changes in portfolio value due to the failure of counter parties to meet their obligations or due to changes in market’s perception of their ability to continue to do so” (Pyle, 1997). Crouhy et al. (2006, 14) defines credit risk as “the risk of loss following a change in the factors that drive the credit quality of an asset”.

Credit risk is also affected by counter party ratings, the size of the banking and trading book, the legal system, collateral quality, maturity of credit facility, and the internal control system (Alam and Shanmugam, 2007). Thus, according to Alam and Shanmugam (2007), credit risk is far more important and difficult to measure and control compared to any other risks.

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Market risk

Market risk arises out of possible adverse movements in market prices of commodities, stocks, bonds, currencies, derivatives. Christofferson (2012) defines market risk as the risk to the bank’s financial portfolio due to market price movements. On the other hand, Bessis (2002) defines market risk from the perspective of losses in balance sheet positions, also resultant from market price movement. Like most risk experts, Bessis (2002) views risk as subject to interest rate risks and equities in the trading book as well as exchange rate and commodities risk throughout the bank.

Bessis (2002) views market risk in relation to risk measure. He looks at it from two perspectives which are the internal and the external views. According to him, there is a difference between the internal and external views of market risk measure where, from the internal perspective of the bank managers, a measure should allow active efficient management of a bank’s risk position. The external view is derived from the regulators, which is to ensure the bank’s potential for catastrophic net worth loss is accurately measured and that the bank’s capital is adequate to cover losses.

Liquidity risk

Bessis (2002) considers liquidity risk from the aspects of funding, market and assets. Funding liquidity is related to risk based on market perception. As for the market liquidity, it depends on the volume of trade. Its vulnerabilities owe much to its inability to raise money at acceptable costs. As for asset liquidity, it is caused by insufficient liquidity in the market to liquidate the assets. On quite a similar note, Crouhy et al (2006) regards liquidity risk as a component of both the funding and the asset of liquidity risk, considering funding liquidity risk is inherently linked to a firm meeting its cash demands. As for the assets, it is triggered by an inability to liquidate assets due to inadequate market demand.

Operational risk

Operating risks are the risk of loss resulting from inadequate or failed internal processes, people, and systems from external events, which includes fraud, damage to physical assets, business disruption, and legal risk. “Operating risks are risks

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stemming from failed internal processes, people, and systems from external events” (Basel Committee, 2001). The definition refers to defects which may prove fatal to the institution (Bessis, 2002). Jobst (2007), however, views legal risk to come under operational risks since he views that operational risk stem from a failure to comply with laws, standards, and contractual obligations.

Some contingency plans that help manage operational risks include the creation of a system for registering and reporting undesirable incidents. These would be analysed continuously in order to limit the chances of them happening again or at all.

Reputational risk

Reputational risk is the risk of a bank being perceived negatively from events affecting it (Bessis, 2002). As a risk type, it came to prominence slightly later, i.e.

after accounting scandals in the late 1990s. Based on a survey released in 2004, 34% of international bank respondents believe that reputational risk is the biggest risk compared to market and credit risks (Crouhy et al., 2006).

Crouhy et al. (2006) asserts that reputational risk is particularly relevant in emerging issues such as from scandals in Enron and WorldCom to name a few. On that, the attention of regulators and investors is focused on strategic and business risks instead of quantifying risk in the market and credit risks. As reputational risk is a real threat to financial institutions, they need to gain credibility from their customers, regulators, and creditors at the very least (Crouhy et al., 2006). Crouhy et al. (2006) reasons that the development of new products places pressure on how accounting and tax rules are interpreted and whether or not certain transactions are legal, thus affecting the financial institutions’ reputation. As financial institutions are under increasing pressure to demonstrate their ethical, social, and environment responsibility, there is even more reason for them to clearly monitor and manage their reputation risks.