From the day a bank is granted its charter up until its final day of operation, it faces a wide variety of internal and external risks. These include credit, liquidity, market, operational, legal, and reputational risks. The following sets out short definitions for each of these risks:

Credit risk - The risk that a bank won’t receive the principal and interest it is owed.

Liquidity risk - The risk that when a bank needs to raise cash for its day-to-day operating needs it won’t be able to do so at a reasonable cost.

Market risk - Broadly refers to the risk that a bank’s earnings and capital might be adversely affected by changes in interest rates, exchange rates or securities prices. This course focuses on how the risk posed by changes in interest rates may adversely affect a bank’s net income and capital position.

Operational risk - The risk of loss or harm from unanticipated internal or external events that occur in the course of conducting business such as equipment breakdowns, “acts of God,” customer and employee fraud and undetected software errors.

Legal risk - The risk of loss or harm from unenforceable contracts, lawsuits or adverse judgments.

Reputational risk - The risk of loss or harm to a bank’s public image from negative publicity.

These risks are not unique to banks. Governments, businesses and even households encounter these risks. All of these organizations borrow and loan money and require funds to meet their operational or living needs. They are also subject to unpredictable changes in the economy, may face litigation or have their reputations questioned.

Although all six categories of risk must be properly managed if the bank is to prosper, this course concentrates mainly on three of them: credit, liquidity and market. These risks are referred to as portfolio risks since they result largely from the mix, or portfolio, of interest-earning assets and interest-bearing liabilities held by a bank. The remaining risks (operational, legal, reputational) are reviewed only to a limited extent.

Portfolio risks receive the most attention in this course because they relate to the bank’s basic lending and deposit-gathering activities. Their successful management is key to the bank’s ongoing profitability. Consequently, you will find that much of your time as a director will be spent identifying, monitoring and managing the bank’s portfolio risks.

For additional information on the six types of risk presented here, refer to The Federal Reserve Bank’s SR Letter 95-51