Definition of Risk
An activity which may give profits or result in loss may be called a risky proposition due to uncertainty or unpredictability of the activity of trade in future. In other words, it can be defined as the possibility of loss.
Example- Ram bought a piece of land today assuming he will sell it at higher price 1 year later is a activity which has risk in it because there is no guarantee that prices will increase next year. He might make a loss if prices decline next year.
As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money.

Risk in Banking Business
The two most important developments that have made it imperative for Indian commercial banks to give emphasize on risk management are discussed below:
1. Deregulation: The era of financial sector reforms which started in early 1990s has culminated in deregulation in a phased manner. Deregulation has given banks more autonomy in areas like lending, investment, interest rate structure etc. As a result of these developments, banks are required to manage their own business themselves and at the same time maintain liquidity and profitability. This has made it imperative for banks to pay more attention to risk management

2. Technological innovation: Technological innovations have provided a platform to the banks for creating an environment for efficient customer services as also for designing new products. In fact, it is technological innovation that has helped banks to manage the assets and liabilities in a better way, providing various delivery channels, reducing processing time of transactions, reducing manual intervention in back office functions etc. However, all these developments have also increased the diversity and complexity of risks, which need to be managed professionally so that the opportunities provided by the technology are not negated.

Type of Risks
The major risks in banking business or ‘banking risks’, as commonly referred, are listed below –
1. Liquidity Risk
2. Interest Rate Risk
3. Market Risk
4. Credit or Default Risk
5. Operational Risk

Liquidity Risk
Liquidity risk arises when bank does not have enough money to pay back to its lenders. For example there is a rumor that PNB does not have enough money in its accounts. This would lead to large number of people withdrawing money the next day which can result in PNB not having money to pay back.
1. Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail). The example of PNB above is example of Funding Risk
2. Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows of funds i.e., performing assets turning into non-performing assets. People defaulting on loans can leads to Time risk.
3. Call Risk: Any future contingency such as bank losing a legal battle resulting in huge fines to the bank can result in outflow of money which is called Call Risk.

Interest Rate Risk
Interest Rate Risk arises due to movement in Interest rates.
Example: Bank has given money for 20 years at 8% Rate but borrowed it for 5 years at 7.5 %. Here the bank is assuming that after 5 years it would again borrow at 7.5 %. But if after 5 years the borrowing rate is increased to 9%. In such a case bank would make loss due to Interest rate movements.

Market Risk (Also known as Price Risk)
The market risk arises due to unfavorable movement in market prices in the investments done by bank.
Suppose bank has invested in Equities (Stock market) but stock market crashes then banks would make a loss. Banks generally invests in products which are related to price of Commodities, Shares, Currency movement (You will learn this concept in Derivatives in detail). So investment in such products can lead to market risk. Interest rate risk is also a type of market risk.
Example of Currency Risk: This is also called Forex Risk. Suppose bank has invested 1000 Dollars in US bank. When it invested each dollar was of Rs. 60 which means bank invested Rs. 60,000. But after certain days the dollar becomes of Rs. 58 which means bank will get only Rs. 58,000 on that day.

Default or Credit Risk
Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms
1. Counterparty Risk: This is a variant of Credit risk and is related to non-performance of the trading partners due to counterparty’s refusal and or inability to perform. It is more or less same as Time Risk in the Liquidity Risk section.
2. Country Risk: This is also a type of credit risk where non-performance of a borrower or counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance is external factors on which the borrower or the counterparty has no control.

Credit Risk can’t be avoided but has to be managed by applying various risk mitigating processes.
1. Banks should assess the credit worthiness of the borrower before sanctioning loan i.e., credit rating of the borrower should be done beforehand.
2. There should be maximum limit exposure for single/ group borrower.

Operational Risk
Operational loss has mainly three exposure classes namely people, processes and systems. In other words in arise due to bad intentions of staff, hacking of systems or wrong systems in place to meet the compliance
1. Transaction Risk: Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information.
2. Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, and codes of conduct and standards of good practice. It is also called integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing.

Other Risks
1. Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals and the quality of implementation.
2. Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss or decline in customer base.
3. Systematic Risk: The risk inherent to the entire market or an entire market segment. Systematic risk, also known as undiversifiable risk. It affects the overall market, not just a particular stock or industry. For example if you invest all you money in equities then there is a risk that if equity markets crash, all your investments will go into loss. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy. For example, putting some assets in bonds and other assets in stocks can mitigate systematic risk because an interest rate shift that makes bonds less
valuable will tend to make stocks more valuable, and vice versa, thus limiting the overall change in the portfolio’s value from systematic changes. Interest rate changes, inflation, recessions and wars all represent sources of systematic risk because they affect the entire market.