An investor's guide to banking risks (Part 4 of 14)

Must-know: The 8 types of bank risks

By Saul Perez Sep 1, 2014 11:37 am EDT

Banks and risk

Banks have to take risks all the time. Any bank has to take on risk to make money. This includes full-service banks like JPMorgan (JPM ), traditional banks like Wells Fargo (WFC ), investment banks like Goldman Sachs (GS ) and Morgan Stanley (MS ), or any other financials included in an ETF like the Financial Select Sector SPDR Fund (XLF ).

How risk arises

The risk arises from the occurrence of some expected or unexpected events in the economy or the financial markets. Risk can also arise from staff oversight or mala fide intention, which causes erosion in asset values and, consequently, reduces the bank’s intrinsic value.

The money lent to a customer may not be repaid due to the failure of a business. Also, money may not be repaid because the market value of bonds or equities may decline due to an adverse change in interest rates. Another reason for no repayment is that a derivative contract to purchase foreign currency may be defaulted by a counter party on the due date. These types of risks are inherent in the banking business.

Eight types of bank risks

There are many types of risks that banks face. We’ll look at eight of the most important risks.

1. Credit risk
2. Market risk
3. Operational risk
4. Liquidity risk
5. Business risk
6. Reputational risk
7. Systemic risk
8. Moral hazard

Out of these eight risks, credit risk, market risk, and operational risk are the three major risks. The other important risks are liquidity risk, business risk, and reputational risk. Systemic risk and moral hazard are unrelated to routine banking operations, but they do have a big bearing on a bank’s profitability and solvency.

All banks set up dedicated risk management departments to monitor, manage, and measure these risks. The risk management department helps the bank’s management by continuously measuring the risk of its current portfolio of assets, or loans, liabilities, or deposits, and other exposures. The department also communicates the bank’s risk profile to other bank functions and takes steps, either directly or in collaboration with other bank functions, to reduce the possibility of loss or to mitigate the size of the potential loss.