A bank is exposed to a wide variety of risks in its business activities. As discussed in the Join the Meeting section, managing risk is a key ingredient in the successful operation of a bank. From the day a bank is granted its charter until its front door closes on its last business day, a bank faces a wide variety of risks. These risks include credit, liquidity, market, operational, legal and reputational risk.

A bank has a number of options to reduce its risk exposures:

• Avoid a risk by not engaging in an activity. For example, a bank can avoid Internet fraud being perpetrated on its customers' accounts by not offering online consumer banking services.
• Sell the risk. A bank can lessen its loan loss exposure to a large loan customer by participating or selling part of the customer's loan(s) to other banks.
• Reduce risk exposure by buying insurance. A bank can buy property and liability insurance to reduce its losses from unanticipated random events such as a tornado or a customer slipping and hurting him or herself inside the bank.
• Accept the risk. In doing so, the bank is essentially saying that the activity represents a profitable opportunity and that the bank has the ability to effectively manage the risk the activity poses.

When a bank pursues a business opportunity and accepts the associated risks, the banks often uses a number of risk management strategies.

Pricing

Part of risk management entails pricing or getting a return commensurate with the risk posed by an activity. For example, a farm operator may request a loan for the purchase of a new piece of machinery, but has little money to use as a down payment. Based on experience and supporting industry data, the bank knows that borrowers with smaller down payments default more often on their loans than those who put more money down. When the farm operator requests a loan, the bank already has some knowledge of the default rate on loans with little money down. As a result, the bank charges a higher interest rate on the loan to compensate itself for the greater risk the farmer's machinery loan represents. If the bank's pricing for risk is done properly, the expected return from the farmer's loan, with its higher potential loss, would be the same as the return on a machinery loan to a more creditworthy borrower. The income from higher interest rates should help offset the greater likelihood of principal and interest loss on riskier loans and still provide the bank with a return similar to that on its less risky loans.

Capital

Another part of risk management is maintaining a strong capital position in order to absorb possible loss from taking on more risk. For example, a bank specializing in credit card lending, where a borrower's promise to pay is the only support for credit granted, may keep higher capital than a bank that makes auto loans, where the borrower's promise to pay is accompanied by a claim on the car in case of loan default.

A Risk Management System

A final piece of risk management entails having in place the necessary systems, processes and procedures (collectively referred to here as a risk management system) to identify, assess and control risks by keeping them at levels acceptable to the board of directors and senior management. More formally, risk management is defined as identification, analysis and measurement of risks (hazards/ opportunities/ uncertainties) and selection of the best method of treating the risk.

To limit its vulnerability to such risks, the bank uses an assortment of tools. These tools provide a system of checks and balances that limit a bank's risk taking, safeguard its assets, promote its efficient and effective operation and enhance the accuracy and reliability of its financial reporting. Together these tools constitute the bank's risk management system, a system that helps protect it from events that may cause it harm. The components are essentially the same regardless of the type of business.

The effectiveness of a risk management system is affected by the organizational culture in which it operates. What do you know about the risk control environment at your bank?

Lesson Objectives

After you complete this lesson, you should be able to:

• Define corporate governance and list important responsibilities of directors under the governance system.
• List key features of a bank's risk management system.
• Outline the basic elements of policy statements and state the reasons why policies are an important risk control tool.
• State why risk measurement, monitoring and management information are important to directors.
• Explain why internal controls are an important part of a bank's risk control system.