What are the different types of financial risks? Explain
Financial risks are the most direct threats to a bank’s profitability and capital. There are four main types.
A. Liquidity Risk
Liquidity risk arises because banks fund long-term assets with short-term liabilities. If depositors suddenly demand their money back or new funding dries up, the bank may not be able to meet its obligations. It has three specific forms:
Funding Risk: Arises from unexpected withdrawal or non-renewal of deposits.
Time Risk: Arises when expected loan repayments do not arrive — performing loans turn non-performing.
Call Risk: Arises when contingent liabilities crystallize, or when the bank cannot take up a profitable opportunity due to lack of funds.
B. Interest Rate Risk (IRR)
This is the risk that changes in interest rates will hurt the bank’s earnings or the economic value of its assets and liabilities. It takes several forms:
Gap / Mismatch Risk: Assets and liabilities mature or reprice at different times, creating exposure to rate changes.
Yield Curve Risk: When assets and liabilities are priced using different benchmarks, non-parallel shifts in the yield curve affect Net Interest Income (NII).
Basis Risk: Interest rates on different assets and liabilities change by different amounts, disrupting the bank’s margins.
Embedded Option Risk: When rates change significantly, borrowers prepay loans or withdraw deposits early — reducing the bank’s projected cash flows.
Reinvestment Risk: Uncertainty about the rate at which future cash flows can be reinvested.
C. Market Risk
Market risk is the risk of loss from adverse movements in market prices — interest rates, equities, commodities, and exchange rates — particularly in the bank’s trading book.
Price Risk: Occurs when assets are sold before maturity. Bond prices and yields move in opposite directions — a rise in rates means a fall in bond prices.
Forex Risk: The risk of loss from adverse exchange rate movements when the bank holds open positions in foreign currencies.
Market Liquidity Risk: When a bank cannot sell a large position quickly without significantly moving the market price.
D. Credit Risk
Credit risk is the risk that a borrower or counterparty will not repay what they owe. Loans are the largest source of credit risk for most banks. Two specific variants:
Counterparty Risk: The trading partner refuses or is unable to fulfil a contract — more relevant in trading activities than traditional lending.
Country Risk: The borrower is unable to repay because their government imposes restrictions or controls on foreign payments.
