Answer to Question #228317 in Management for Peter Masih

Question

Risk mitigation is one of the main function/concern of bank in volatile economy. In
course of business banks face different types of risks which may vary from one bank to
another.
a. Which are the major risks banks are exposed to and how they mitigate it? (5 Marks)
b. Suppose the regulator asks one of the losses making Bank XYZ to close a few
branches to reduce cost thereby make the bank more sustainable/profitable. But XYZ
Bank refuses to close its few branches, citing some risk/s involved in the process. What
are the risks XYZ Bank perceives if it closes a few branches. (5 Marks)

Answer 1

Mitigating risks in banks

Risk mitigation is one of the main function/concern of bank in volatile economy. In

course of business banks face different types of risks which may vary from one bank to

another.

a. Which are the major risks banks are exposed to and how they mitigate it? (5 Marks)

The most common risks associated with banks include; business risks, liquidity risk, market

risks, liquidity risks, operational risks, and credit risks. Since banks are big institutions, continual

exposure to risks might cause it to collapse and eventually affect millions of customers. As such,

banks with the cooperation of the government create wise decisions making strategies to

encourage wise decision making and prudent management. Banks are exposed to the following

risks;

Business risks; Banks are large business institutions in the modern world dealing in business

with different other large business institutions. Banks have a lot of strategies to choose for their

longevity in business. Therefore, strategic objectives are therefore geared towards long term

business life. As such, any mistake or miscalculation can expose the business to collapse. The

banks are always at the risk of choosing the wrong objectives which might cost its business

viability. Banks should therefore, work closely with advisory teams and their bankers to avoid

risks of business collapse.

Liquidity risk; liquidity refers to the ability of the banks to access funds to meet the financial

operations of the bank. Providing deposits to their customers is one such example. Therefore,

when a bank is unable to provide cash to its customers in a convenient manner results to

unforeseeable risks to the bank. Customers may rush to withdraw their deposits and a snowball

effect might be experienced. Liquidity risks are the product of banks loss of confidence in their

customers, misutilization of asset-liability period, overdependence on short term income sources.

Therefore, banks are regulated in order to avoid liquidity risks. One such regulation requirement

includes, the need for banks to have enough cash deposits that enable it to survive even for

periods when there is less cash inf low to the business.

Market risk; activities of the banks in capital markets pose risks to the bank. Heavy investment

of the bank in sales and trading and capital markets. Risks occurs due the fluctuations in credit

spreads, interest rates, commodity prices, and capital markets. Fluctuations in commodity prices

also affects the banks in case they had invested in companies that produce commodities. Banks

mitigate market risks by having investments that are inversely related, doing joint investments

with other banks or hedging with other banks, and diversification of investments.

Operation risk; loss due to damages caused by processes, systems and people. Interruptions and

risks are also other operation risks that might cause the bank business to go under. Operation risk

are higher for trading and sales operation and relatively lower for uncomplicated business

operations such as asset management and retail banking. Transactional mistakes and internal

fraud are common human errors in banking. Fraud at a larger scale occurs when the security of a

bank is compromised and hacker teal money and softcopy assets. Ways banks can mitigate

against operational risk is to have a serious auditing of the business operations and beefing up

online security to protect against hackers.

Credit risks; when customers default on debts and late repayment of borrower’s loans define

credit risks. Banks can lower credit risk by diversification since it cannot wholly protect itself

because of the nature of their operations. Banks can also, use the services of agencies that are

involved in credit rating to thoroughly vet individuals and institutions before offering loans.

b. The following are the risks XYZ Bank unpredictably faces in case it closes a few branches;

Reputational risk; this is a common risk where the public losses trust in a bank when it

prematurely closes a few branches. A possible negative perception of the bank can cause people

to lose confidence in the bank without any noticeable wrongdoing by the bank. It simply means

the brand value of the bank goes down and its reputation is at risk.

Unsystematic risks; the risk affects a small number of XYZ Bank assets. Unsystematic risk,

brings uncertainty to a company since there is a change in management. Therefore, closing

XYZ’s few branches could result to unsystematic risks stemming from change of management.

Without a proper access to such changes, it can adversely affect the business.

Systematic risks; systematic risks affect the entire banking industry that XYZ Bank is involved

in. when XYZ Bank closes a few branches the overall risk of the industry affecting its operations

increases. Having more branches can caution the bank from major losses since its assets and

losses will be spread in many branches. Systematic risks include actions of wars, inflation and

change of interest rates. When XYZ Bank minimizes asset and other valuable investments, the

risk of the bank suffering more from external factors increases.

Systemic risk; this is a common risk that XYZ Bank might involve themselves in when they

prematurely close a few branches. The risk might bring the whole financial system to a dead end.

The action of XYZ Bank could affect their counterparts and partners in the financial and banking

industry. The effect is that the failure of XYZ bank could ripple down the entire financial system

since all the sectors are related at different levels. Therefore, it is impossible for XYZ bank to

shut down a few branches since the effects will adversely affect the market.