RISK MANAGEMENT IN BANKS

Banking sectors plays a pivotal role in the management of the economy of a country. It is the key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilization so as to attain maximum productivity. In fact, the foundation of a sound economy depends on how sound the Banking sector is and vice versa.

Risk Management in Banking Industry in India: Today, The Indian Economy is in the process of becoming a world class economy. The Indian banking industry is making great advancement in terms of quality, quantity, expansion and diversification and is keeping up with the updated technology, ability, stability and thrust of a financial system, where the commercial banks play a very important role, emphasize the very special need of a strong and effective control system with extra concern for the risk involved in the business. Globalization, Liberalization and Privatization have opened up a new method of financial transaction where risk level is very high. In banks and financial institutions risk is considered to be the most important factor of earnings. Therefore they have to balance the relationship between risk and return. In reality we can say that management of financial institution is nothing but a management of risk.

What is Risk? Risk refers to ‘a condition where there is a possibility of undesirable occurrence of a particular result which is known or best quantifiable and therefore insurable’. A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. 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 uncertainty of the outcome. As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money.

Type of Risks in Bank: The major risks in banking business as commonly referred can be broadly classified into:

1. Liquidity Risk
2. Interest Rate Risk
3. Market Risk
4. Credit or Default Risk
5. Operational Risk
6. Other Risk

1. Liquidity Risk: The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

The liquidity risk in banks manifest in different dimensions –

(a) 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).

(b) 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.

(c) Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise when a bank may not be able to undertake profitable business opportunities when it arises.

2. Interest Rate Risk: Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected due to changes in the interest rates. IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s assets, liabilities and Off-Balance Sheet (OBS) positions. Interest rate Risk can take different forms.
3. Market Risk: The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities, and currencies. It is also referred to as Price Risk.

The term Market risk applies to

(i) That part of IRR which affects the price of interest rate instruments,

(ii) Pricing risk for all other assets/ portfolio that are held in the trading book of the bank,

(iii) Foreign Currency Risk.

(a) Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position either spot or forward, or a combination of the two, in an individual foreign currency.

(b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

4. Credit or Default 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. For most banks, loans are the largest and most obvious source of credit risk. It is the most significant risk, more so in the Indian scenario where the NPA level of the banking system is significantly high.

Now, let’s discuss the two variants of credit risk –

(a) Counter party 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. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.

(b) 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 counter party has no control.

Credit Risk depends on both external and internal factors.

The internal factors include Deficiency in credit policy and administration of loan portfolio, Deficiency in appraising borrower’s financial position prior to lending, Excessive dependence on collaterals and Bank’s failure in post-sanction follow-up, etc.

The major external factors are the state of Economy, Swings in commodity price, foreign exchange rates and interest rates, etc.

Credit Risk can’t be avoided but can be mitigated by applying various risk-mitigating processes –

• Banks should assess the credit-worthiness of the borrower before sanctioning loan i.e., Credit rating of the borrower should be done beforehand. Credit rating is the main tool of measuring credit risk and it also facilitates pricing the loan.
• By applying a regular evaluation and rating system of all investment opportunities, banks can reduce its credit risk as it can get vital information of the inherent weaknesses of the account.
• Banks should fix prudential limits on various aspects of credit – bench-marking Current Ratio, Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.
• There should be maximum limit exposure for single/ group borrower.
• There should be provision for flexibility to allow variations for very special circumstances.
• Alertness on the part of operating staff at all stages of credit dispensation – appraisal, disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit risk.

5. Operational Risk: Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Managing operational risk has become important for banks due to the following reasons:
   • Higher level of automation in rendering banking and financial services,
   • Increase in global financial inter-linkages,
   • Scope of operational risk is very wide because of the above-mentioned reasons.

Two of the most common operational risks are discussed below: –

(a) 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.

(b) 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, 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.

6. Other Risks: Apart from the above-mentioned risks, following are the other risks confronted by Banks in course of their business operations –

(a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes.

(b) 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.

Risk Management in India: Risk Management is actually a combination of management of uncertainty, risk, equivocality and error. Uncertainty – where the outcomes cannot be estimated even randomly, arises due to lack of information and this uncertainty gets transformed into risk (where the estimation of outcome is possible) as information gathering progresses.

Initially, the Indian banks have used risk control systems that kept pace with legal environment and Indian accounting standards. But with the growing pace of deregulation and associated changes in the customer’s behaviour, banks are exposed to mark -to-market accounting.

Therefore, the challenge of Indian banks is to establish a coherent framework for measuring and managing risk consistent with corporate goals and responsive to the developments in the market. As the market is dynamic, banks should maintain vigil on the convergence of regulatory frameworks in the country, changes in the international accounting standards and finally and most importantly changes in the clients’ business practices.