Financial & Non-Financial Risks in Banking: Types, Impacts & Mitigation

Core Concepts: Definitions & Classifications

1. What is Risk in Banking?

Risk is the uncertainty of loss arising from banking operations. Banks face risks from:

• Market fluctuations (interest rates, exchange rates)
• Customer behavior (defaults, fraud)
• Operational failures (system crashes, human error)
• Regulatory changes (new laws, penalties)

mindmap
  root((Banking Risks))
    Financial
      Interest Rate Risk
      Credit Risk
      Liquidity Risk
      Market Risk
    Non-Financial
      Operational Risk
      Compliance Risk
      Reputational Risk
      Strategic Risk

2. Financial Risks: Types & Impacts

A. Interest Rate Risk (IRR)

Definition: Risk arising from adverse movements in interest rates, affecting the market value of assets/liabilities and net interest income (NII).

How It Works

• Rising rates: Liabilities (deposits) re-price faster than assets (loans), squeezing net interest margin (NIM).
• Falling rates: Assets (fixed-rate loans) lose value, while liabilities (floating-rate deposits) become cheaper to fund.

Example in Nepal:

• NMB Bank offers a 5-year fixed-rate loan at 8% but funds it with 6-month CDs at 6%. If rates rise to 9%, NMB must pay 9% on new deposits but earns only 8% on loans → NIM compression.

Measurement Tools

B. Credit Risk

Definition: Risk of loan defaults or counterparty failure, leading to losses on principal/repayment.

Stages of Credit Risk in Nepal

stateDiagram-v2
  [*] --> Initial: Loan approved
  Initial --> Monitoring: Regular reviews
  Monitoring --> Early Warning: Delinquency (30-60 days late)
  Early Warning --> Default: 90+ days late
  Default --> Recovery: Asset seizure/sale
  Recovery --> [*]

Real-World Example:

• Global IME Bank faced ₹1.2B in NPLs (non-performing loans) in 2022 due to SME defaults during COVID-19. The bank used collateral recovery and restructuring to mitigate losses.

Mitigation Strategies

C. Liquidity Risk

Definition: Inability to meet short-term obligations due to asset illiquidity or deposit outflows.

Liquidity Ratios (Nepal Context)

Worked Example: Kathmandu Retail Bank’s Liquidity Crisis

• Scenario: A ₹500M deposit outflow occurs due to rumors of bank failure.
• Bank’s Liquidity Position:
  • Cash Reserves: ₹100M
  • Government Securities (G-Secs): ₹200M (can be sold in 7 days)
  • Interbank Borrowings: ₹150M (available at 8% +)
• Solution:
  1. Sell ₹150M G-Secs (realized ₹140M after fees).
  2. Borrow ₹100M interbank (total funds: ₹240M).
  3. Meet ₹500M outflow? No → Liquidity shortfall of ₹260M.
  • Mitigation: Bank must increase LCR by holding more high-quality liquid assets (HQLA).

D. Market Risk

Definition: Risk from adverse movements in market prices (FX, equity, commodity).

Types of Market Risk in Nepal

Mitigation: Hedging with Derivatives

• FX Forward Contracts: Lock in USD/NPR exchange rate for future payments.
  • Example: Ncell enters a 3-month USD/NPR forward at ₹120 to hedge a $1M loan. If spot rate rises to ₹130, Ncell saves ₹10/USD.
• Options: Buy put options on NEPSE stocks to limit downside.

3. Non-Financial Risks: The Silent Threats

A. Operational Risk

Definition: Risk from internal failures (processes, systems, fraud).

Causes in Nepalese Banks

Mitigation:

• Automated Controls: AI fraud detection (used by NMB).
• Dual Authorization: ₹10M+ transactions require two signatures.

B. Compliance Risk

Definition: Risk of violating laws/regulations, leading to fines or sanctions.

Key Nepalese Regulations

Example:

• Standard Chartered Nepal was fined ₹50M in 2023 for violating KYC norms (onboarding undocumented borrowers).

C. Reputational Risk

Definition: Loss of customer trust due to scandals, poor service, or mismanagement.

Real-World Case: NMB’s Reputation Crisis

• Issue: ₹3B loan fraud (2019) involving fake SMEs.
• Impact:
  • ₹2B deposit outflow in 3 months.
  • Stock price dropped 15%.
• Recovery:
  • Transparency reports (published monthly NPL updates).
  • CSR initiatives (free financial literacy workshops).

4. Risk Management Frameworks in Nepalese Banks

A. Risk Appetite Statement (RAS)

Every bank defines its risk tolerance in a Risk Appetite Statement (RAS). Example: NIC Asia Bank’s RAS

B. Stress Testing

Definition: Simulating worst-case scenarios to test resilience.

Example: Nepal Rastra Bank’s 2023 Stress Test

5. Regulatory Bodies & Compliance in Nepal

## In the Real World

1. Ncell’s FX Hedging

   • Idea Used: Foreign Exchange (FX) Risk Mitigation
   • How: Ncell uses USD/NPR forward contracts to hedge $500M in foreign debt for its 5G expansion. If the NPR weakens, the forward contract locks in a fixed exchange rate, preventing repayment shocks.

2. Khalti’s Liquidity Management

   • Idea Used: Liquidity Risk & High-Frequency Payments
   • How: Khalti processes ₹50B/month in transactions. To manage liquidity spikes, it:
     • Holds ₹10B in RNB’s liquidity facility.
     • Uses real-time settlement with Nepal Bank Ltd to avoid cash shortages.

3. NMB’s Credit Risk Model

   • Idea Used: Credit Scoring & Collateralization
   • How: NMB uses a proprietary credit scoring model (similar to FICO) to assess SME loans. For ₹10M+ loans, it requires:
     • 25% cash collateral (gold/shares).
     • Monthly financial audits of the borrower.

4. Daraz Nepal’s Operational Risk

   • Idea Used: Fraud Detection in E-Commerce
   • How: Daraz uses AI-driven fraud detection to flag:
     • Suspicious bulk orders (e.g., ₹500K in 10 minutes).
     • Chargeback fraud (disputed transactions).

## Fully Worked Example: Everest Bank’s Risk Exposure

Scenario: Everest Bank has the following balance sheet (all figures in ₹million):

Market Conditions:

• Current policy rate: 7%
• Expected rate hike: +2% (new rate = 9%)

Step 1: Calculate Duration Gap

Interpretation:

• Positive gap (+2.21 years) → Bank is asset-sensitive.
• If rates rise by 2% (200bps):
  • Equity will INCREASE (good for shareholders).
  • Net Interest Margin (NIM) will WIDEN.

Step 2: Calculate DV01 Impact

Impact of 2% Rate Hike:

• Net gain: ₹39M × 2 = ₹78M (equity increases by ₹78M).

Step 3: Liquidity Risk Assessment

Recommendation:

• Increase HQLA (e.g., buy more G-Secs).
• Reduce loan growth to improve liquidity buffers.

## Exam Tip

How to Score Full Marks in TU/PU Exams

1. Define Clearly

   • Always start with precise definitions (e.g., "Interest rate risk is the uncertainty in net interest income due to adverse movements in interest rates.").
   • Example: For liquidity risk, write:

     "Liquidity risk is the inability of a bank to meet its short-term obligations due to insufficient high-quality liquid assets (HQLA), leading to runs or forced asset sales."

2. Use Nepalese Examples

   • Examiners love real-world cases. Cite:
     • NMB’s NPL crisis (2022)
     • Ncell’s FX hedging
     • Everest Bank’s liquidity shortfall (2021)
   • Avoid generic examples (e.g., "Barclays Bank" → use NIC Asia instead).

3. Show Calculations (Even If Not Asked)

   • For duration gap, always compute:
     • Asset duration
     • Liability duration
     • Gap impact on equity
   • For liquidity, compute:
     • Current ratio
     • LCR
     • LDR

4. Compare & Contrast

   • Table format works best for comparisons:

     Risk Type	Financial Risk?	Mitigation Tool	Nepalese Example
     Credit Risk	✅ Yes	Collateral, Credit Scoring	NMB’s gold-backed loans
     FX Risk	✅ Yes	Forward Contracts	Ncell’s USD/NPR hedging
     Operational Risk	❌ No	Automated Controls	NIC Asia’s AI fraud detection

5. Link to ALM & ALCO

   • Always relate risks to Asset-Liability Management (ALM) and the Asset-Liability Committee (ALCO).
   • Example Answer Snippet:

     "The positive duration gap at Everest Bank indicates an asset-sensitive position, meaning the ALCO should monitor rising rates carefully. If rates fall, the bank’s equity will suffer, requiring hedging strategies like interest rate swaps."

6. Common Pitfalls to Avoid

   • ❌ Assuming all deposits are rate-sensitive (only time deposits are; demand deposits are sticky).
   • ❌ Ignoring regulatory caps (e.g., LDR ≤80%, NPL ≤3%).
   • ❌ Mixing financial and non-financial risks in the same paragraph.

7. Short-Answer Tips

   • Define + Example:

     "Market risk is the potential loss arising from movements in market prices (FX, equities, commodities). For example, NMB’s equity portfolio lost ₹500M in 2020 due to NEPSE’s 30% crash."

   • Mitigation Strategies:

     *"Banks mitigate credit risk via:

     1. Collateralization (e.g., gold loans at Standard Chartered Nepal),
     2. Credit scoring models (e.g., NIC Asia’s FICO-like system), and
     3. Loan covenants (e.g., minimum cash reserves at Everest Bank)."*