A Guide to Risk Management in Banking

Published/Updated May 20, 2022


Like any other business sector, banks are vulnerable to a variety of hazards. Given the banking sector’s importance to the overall economy, however, governments around the world regulate banking quite highly. As a result, it’s essential for banks to understand how they must manage risk.

This guide provides an overview of risk management in banking, looking at the types of risk management in banking, detailing risk management practices, and explaining how to use enterprise risk management software in banks.

Risk Management in Banking

Banks must prioritize their risk management process to stay on top of numerous critical risks they face every day. Banks’ risk management goes far beyond compliance, as banks must be aware of strategic, operational, pricing, liquidity, and reputational risks. These risks to banks are dynamic, requiring a powerful and flexible risk management program.

Having a clear and formal risk management plan provides a foundation of visibility. In addition, standardized risk management processes make it easier to identify systemic issues that affect the entire bank.

A comprehensive risk management plan serves as a roadmap for improving performance by revealing critical dependencies and control effectiveness. With proper implementation of a risk management program, banks will better allocate time and resources to what matters most.

Recent industry trends suggest that risk management will undergo even more far-reaching changes in the coming years. Accordingly, banks should pursue initiatives in the short term consistent with the changes that lie farther ahead. By acting now, banks can assure that their risk management functions are not overwhelmed by the new requirements.

Common Threats & Vulnerabilities in the Banking Industry

Banks worldwide have high risk exposure. To govern all those risks at a holistic, enterprise-wide level, executives must know the potential risks to each business unit. Then executives can use specific metrics to assess whether the probability of the risks and their ensuing effects will exceed the bank’s risk appetite, and jeopardize the bank’s capacity for success.

Let’s now take a look at those broad categories of risk.

Business Disruptions and System Failures

Hardware or software system failures, power outages, and telecommunications disruptions can interrupt the operations of any financial firm and lead to losses. These operational risks can also harm business continuity, reputation, and regulatory compliance position.

As the landscape of financial services becomes more complex, banks and other financial firms must control operational risk by adjusting their risk management strategies, systems, and procedures.

Insider Vulnerabilities

Insider vulnerabilities are a cybersecurity risk in all industries, and especially in the banking sector. According to IBM’s X-Force Intelligence Index 2021, 60 percent of insider incidents are related to malicious insiders; about 40 percent are related to negligence.

In some cases, hackers target the email accounts of high-level executives such as CEOs, and trick the company into sharing sensitive information. Other common cybersecurity issues can result from misconfigured systems or servers with security gaps.

Technology Gaps

Banking websites and apps pose a weakness in the overall network architecture. Cross-site scripting (XSS) assaults are common in this sector; they allow attackers to execute malicious code on a website or application. The malicious script can rewrite the web page’s content, to access user cookies and other sensitive information.

Banking consumers need to feel confident that their finances are secure. Organizations must consider initiatives to prevent and mitigate cyber risks in their websites and apps to be competitive.

Types of Risks to Consider in Banking

Financial institutions are exposed to an immense amount of risk, so risk identification and categorization are essential when creating risk management plans. These processes provide information on the current state of its stake and potential risk events.

Credit Risk

Credit risk refers to the risk of non-payment or non-compliance with contractual obligations by a borrower. For example, credit risk measures the potential that the borrower will default or not be able to pay. The default would result in disrupted cash flows and increased collection costs.

Bank revenues come mainly from interest rates. Hence, loans are a significant source of both income and credit risk. Although credit risk is inherent in lending, you can take several steps to minimize it.

Credit risk (and the ensuing losses) comes from poor lending practices, such as the concentration of lending to a specific type of borrower or sector. To assure credit risk is minimized, you must spread lending across a diverse range of borrowers, including different types of businesses and individuals.

Market Risk

Market risks refer to the risk that an investment will lose value due to economic and market factors. This means it’s crucial to analyze ongoing challenges within the market.

For example, bankers around the country keep track of home prices, to better understand their risks around mortgage lending. If a bank issues a mortgage on a home, and that home then declines in value to be worth less than the mortgage (precisely what happened in the United States before the global financial crisis of 2008), the bank could be stuck with a low-value property it doesn’t want and might need to book a loss on the mortgage loan it originally issued.

Operational Risk

Operational risk is the risk of loss arising from the failure of systems, controls, procedures, or internal policies due to employee errors, breaches, or any external event that disrupts a financial institution’s processes.

Operational risk management is a process that involves risk assessment, decision-making about risk, and adopting internal controls to prevent or mitigate risk events. A financial institution must determine its risk profile and build a register of risks to develop an effective risk management program, employ risk reduction initiatives, and improve information security.

Reputational Risk

In banking and financial services, reputational risk refers to a reduced market value due to a discredited brand image and lost trust in the industry. Let’s say there’s a news story about a bank’s management being tainted by corruption. This could harm its customer connections, lower its stock price, and give competitors an advantage.

Reputational-related losses reflect a reduction in expected revenues and an increase in financing and recruitment costs. Reputational risk is often a consequence of management processes rather than one-time events, requiring risk control approaches substantially different from operational risk.

Third-Party Risk

The banking industry is highly interconnected. Unfortunately, greater interconnectedness with various third parties brings more significant hazards. Attack vectors proliferate as more network connections are created among entities.

The banking sector also faces unique threats, given how tempting banks are as targets for attackers and fraudsters. As banks continue to rely on third parties, they must properly manage relationships with them, including consumer protection, information security, and other operational risks.

This increased reliance on external providers, however, results in more significant exposure to cybersecurity risks and vulnerabilities. Regulators and policymakers increasingly worry about risk management practices for third-party relationships.

To manage third-party risk effectively, you should follow a continuous lifecycle for all supply chain relationships. This includes risk management planning, due diligence, ongoing monitoring, internal audits, and more.

How to Manage Risks in the Banking Sector

Being aware of the risks to which banks are exposed requires a flexible risk management program and robust risk assessments. This program requires that the management of regulatory changes be prominent within the bank’s risk management program.

Risks stem from the uncertainty of financial losses, and they can cripple a business if not managed properly. Mechanisms must be put into place to address threats and vulnerabilities with a robust risk management philosophy to minimize the potential adverse effects on the institution’s financial health.

Categorize Risks and Prioritize

All risks are not created equal. Banks must consider credit, market, and operational risks. Within the three primary areas, additional stratification is incorporated to assess the likelihood of occurrence and potential harm.

At any given time, however, one or more risk elements may be more relevant than others. Financial institutions must employ tools and resources to monitor such changes in risk profile in real-time, to give each risk the attention it deserves at that moment.

Decentralize Decision-Making

Risk management is most effective when applied consistently across the organization, guided by policies and procedures developed by subject matter experts who have the training and experience for their specific country, area, and customer mix.

Clear processes and reliable systems empower front-line officers with decision-making tools to guide their daily interactions with customers. Decentralized decision-making by senior management and front-line workers enables prompt responses and reduces ambiguity.

Define Roles and Responsibilities

Leaders of the organization define the behavior of an organization. Risk management in a bank is everyone’s responsibility, not just that of the risk department. Senior management must adopt a vision, behave consistently, and demonstrate that prudent risk management is the cornerstone of success.

Quantify Risk Exposure

In the case of credit derivatives, risks are not quantified, and no one knows how much there is and what will happen when the contracts mature. Proper risk management drives consistent and rigorous risk assessments and quantification of instruments. It is imperative to disclose the potential downsides when promising above-average returns.

Implement IT Systems to Facilitate Risk Management Processes

The value of IT is continuously increasing for banking organizations, in various ways. IT solutions provide productivity solutions for consumers and the business. Cumbersome and complex activities can be streamlined with IT tools to assure consistency and reduce errors.

IT systems can assist the enterprise in risk management with automated monitoring tools and artificial intelligence (AI). These tools provide compliance monitoring, perform market analysis, facilitate communication, and so much more.

Creating a Scalable Risk Management Plan for Banks

A well-defined and structured risk management strategy improves your visibility. In addition, a robust risk management plan highlights essential dependencies and the effectiveness of controls, and provides a roadmap for increasing performance.

That said, all plans should be standardized, scalable, meaningful, and actionable. You can apply the same process for defining the steps within your risk management plan across the board.

  • Risk identification. Banks should create an organization-wide risk identification process to develop a meaningful risk management program.
  • Assessment and analysis methodology. Uniform assessment of risk is the hallmark of a healthy risk management system.
  • Mitigate risks. You must continually address significant risks and concerns to protect the bank fully.
  • Monitor. Risk monitoring should be an ongoing, active process.
  • Connect. Identify relationships among risks, business units, and risk mitigation activities to provide a cohesive picture of the bank.
  • Report. Insightful reporting on the progress of the risk management program demonstrates whether it’s effective. Develop a risk report that centralizes information and provides a dynamic view of the bank’s risk profile.

Integrate Reciprocity ROAR into Your Risk Management Plan

Reciprocity ROAR is a risk management and compliance solution. It provides easy-to-use operational risk management templates to help you assess risk at a global level.

As part of the Reciprocity ROAR product suite, ZenComply’s workflow management capabilities provide an audit trail of activities and initiatives. A centralized dashboard continuously displays your control effectiveness, making it easy to verify compliance. Your organization is always audit-ready with a single source of truth.

Reciprocity ROAR’s integrated platform can speed communications with internal and external stakeholders to quickly provide the necessary documentation, reducing follow-up requests from external auditors.

ZenRisk enables you to streamline risk management in banking by automating the tedious and time-consuming tasks that often monopolize your day. With the integrated Reciprocity ROAR platform, you can take much of the burden out of operational risk management and focus on the mission-critical elements.

Ready to learn more? Schedule a demo today.