Source:
E-mail dt. 7 June 2012
Risk
Management in Banking
Dr.
R. Karuppasamy M.Com., MBA, M.Phil.,
Ph.D., PLME
Director, Management
Studies, SNS College of
Technology, Coimbatore, Tamilnadu, India
and
Mr. C. Arul Venkadesh
MBA, PGDPM (IRLL), (PhD)
Assistant Professor – Department of
Management Sciences, CIET College, Coimbatore,
Tamilnadu, India
ABSTRACT
Risk
is inherent in any walk of life in general and in financial sectors in
particular. Till recently, due to regulate environment, banks could not afford
to take risks. But of late, banks are exposed to same competition and hence are
compelled to encounter various types of financial and non-financial risks.
Risks and uncertainties form an integral part of banking which by nature
entails taking risks. There are three main categories of risks; Credit Risk,
Market Risk & Operational Risk. Author has discussed in detail. Main
features of these risks as well as some other categories of risks such as
Regulatory Risk and Environmental Risk. Various tools and techniques to manage
Credit Risk, Market Risk and Operational Risk and its various components, are
also discussed in detail. Another has also mentioned relevant points of Basel’s
New Capital Accord’ and role of capital adequacy, Risk Aggregation &
Capital Allocation and Risk Based Supervision (RBS), in managing risks in
banking sector. The concept of risk and risk management are core of financial
enterprise. The importance of appropriate and effective risk management are
always stressed by regulators. Bank of International Settlements (BIS) through
Basel Accords has also stipulated risk.
Management
practices required for banks. This programme provides
an understanding of various types of risks faced by banks and financial
institutions and ways to mitigate such risks. Statistical methods to
quantify risks inherent in banking operations for both reporting and management
and newer methodologies to quantify risk would also be stressed.
INTRODUCTION
A
change of guard at the helm at the country's largest bank has led to a lot of
provisioning, with the result that there has been a sharp drop in the bottom
line as per its latest accounting statement. The yo-yoing profit figures point
at the need for more stability in accounting policy, including on quantifying
and managing risk. A recent working paper
on accounting opines that while measurement-based risk management in banking
internationally is essentially work-in-progress, the practice of gauging risks
seems basically of two types. The risk functions of some organisations
have a proclivity for 'quantitative enthusiasm', while others seem geared
towards 'quantitative scepticism'. The study finds
that in the first group, there is overt reliance on a system of standard
formulae to aggregate and keep tab of risk. And in the other group, what is
stressed is more qualitative interpretation of data and scenario analysis to
traverse the risk environment. The paper
adds that in stable situations, the focus on a formulaic attitude to risk
management has its merits in that it can conserve mental effort and keep organisational behaviour
consistent.
Risk
is 'organised' into three silos: market risk, credit
risk and operational risk. And it includes statistical estimates of credit
defaults, with market and operational risks also quantified. In sharp contrast,
at Goethebank, as also banks D and E, risk management
is characterised by much quantitative scepticism. Market
and credit risks are modelled, but the numbers are
not seen as reflecting the underlying economic reality. And operational risk is
seen as largely unmeasurable. So, Fraser and A, B and
C relied on complex quantitative models to measure and control risks, with the
risk function excluded from top managerial discussions on strategy and
operations.
When
we use the term “Risk”, we all mean financial risk or uncertainty of financial
loss. If we consider risk in terms of probability of occurrence frequently, we
measure risk on a scale, with certainty of occurrence at one end and certainty
of non-occurrence at the other end. Risk is the greatest where the probability
of occurrence or non-occurrence is equal. As per the Reserve Bank of India
guidelines issued in Oct. 1999, there are three major types of risks
encountered by the banks and these are Credit Risk, Market Risk &
Operational Risk. As we go along the article, we will see what the components
of these three major risks are. In August 2001, a discussion paper on move
towards Risk Based Supervision was published. Further after eliciting views of
banks on the draft guidance note on Credit Risk Management and market risk
management, the RBI has issued the final guidelines and advised some of the
large PSU banks to implement so as to guage the
impact. A discussion paper on Country Risk was also released in May 02. Risk is
the potentiality that both the expected and unexpected events may have an
adverse impact on the bank’s capital or earnings. The expected loss is to be
borne by the borrower and hence is taken care of by adequately pricing the
products through risk premium and reserves created out of the earnings. It is
the amount expected to be lost due to changes in credit quality resulting in
default. Whereas, the unexpected loss on account of the individual exposure and
the whole portfolio in entirely is to be borne by the bank itself and hence is
to be taken care of by the capital.
Thus, the expected losses are covered by reserves/provisions and the
unexpected losses require capital allocation. Hence the need for sufficient
Capital Adequacy Ratio is felt. Each type of risks is measured to determine
both the expected and unexpected losses using VaR (Value
at Risk) or worst-case type analytical model.
TYPES OF RISK
CREDIT RISK
Credit
Risk is the potential that a bank borrower/counter party fails to meet the
obligations on agreed terms. There is always scope for the borrower to default
from his commitments for one or the other reason resulting in crystalisation of credit risk to the bank. These losses could take the form outright
default or alternatively, losses from changes in portfolio value arising from
actual or perceived deterioration in credit quality that is short of default.
Credit risk is inherent to the business of lending funds to the operations
linked closely to market risk variables.
The objective of credit risk management is to minimize the risk and
maximize bank’s risk adjusted rate of return by assuming and maintaining credit
exposure within the acceptable parameters.
Credit
risk consists of primarily two components, viz., Quantity of risk, which is
nothing but the outstanding loan balance as on the date of default and the
quality of risk, viz., the severity of loss defined by both Probability of
Default as reduced by the recoveries that could be made in the event of
default. Thus credit risk is a combined outcome of Default Risk and Exposure
Risk. The element of Credit Risk is Portfolio risk comprising Concentration
Risk as well as Intrinsic Risk and Transaction Risk comprising migration/down
gradation risk as well as Default Risk. At the transaction level, credit
ratings are useful measures of evaluating credit risk that is prevalent across
the entire organization where treasury and credit functions are handled.
Portfolio
analysis help in identifying concentration of credit risk, default/migration
statistics, recovery data, etc. In general, Default is not an abrupt process to
happen suddenly and past experience dictates that, more often than not,
borrower’s credit worthiness and asset quality declines gradually, which is
otherwise known as migration. Default is an extreme event of credit migration.
Off balance sheet exposures such as foreign exchange forward contracts, swaps
options etc are classified in to three broad categories such as full Risk,
Medium Risk and Low risk and then translated into risk weighted assets through
a conversion factor and summed up. The management of credit risk includes a)
measurement through credit rating/ scoring, b) quantification through estimate
of expected loan losses, c) Pricing on a scientific basis and d) Controlling
through effective Loan Review Mechanism and Portfolio Management.
MARKET RISK
Market
Risk may be defined as the possibility of loss to bank caused by the changes in
the market variables. It is the risk that the value of on-/off-balance sheet
positions will be adversely affected by movements in equity and interest rate
markets, currency exchange rates an commodity prices.
Market risk is the risk to the bank’s earnings and capital due to changes in
the market level of interest rates or prices of securities, foreign exchange
and equities, as well as the volatilities, of those prices. Market Risk
Management provides a comprehensive and dynamic frame work for measuring,
monitoring and managing liquidity, interest rate, foreign exchange and equity
as well as commodity price risk of a bank that needs to be closely integrated
with the bank’s business strategy
a) Liquidity
Risk:
Bank
Deposits generally have a much shorter contractual maturity than loans and
liquidity management needs to provide a cushion to cover anticipated deposit
withdrawals. Liquidity is the ability to efficiently accommodate deposit as
also reduction in liabilities and to fund the loan growth and possible funding
of the off-balance sheet claims. The cash flows are placed in different time
buckets based on future likely behaviour of assets,
liabilities and off-balance sheet items. Liquidity risk consists of Funding
Risk, Time Risk & Call Risk.
b) Interest Rate
Risk
Interest
Rate Risk is the potential negative impact on the Net Interest Income and it
refers to the vulnerability of an institution’s financial condition to the
movement in interest rates. Changes in interest rate affect earnings, value of
assets, liability off-balance sheet items and cash flow. Hence, the objective
of interest rate risk management is to maintain earnings, improve the
capability, ability to absorb potential loss and to ensure the adequacy of the
compensation received for the risk taken and effect
risk return trade-off. Management of interest rate risk aims at capturing the
risks arising from the maturity and re-pricing mismatches and is measured both
from the earnings and economic value perspective
c) Forex Risk
Foreign
exchange risk is the risk that a bank may suffer loss as a result of adverse
exchange rate movement during a period in which it has an open position, either
spot or forward or both in same foreign currency. Even in case where spot or
forward positions in individual currencies are balanced the maturity pattern of
forward transactions may produce mismatches. There is also a
settlement
risk arising out of default of the counter party and out of time lag in
settlement of one currency in one center and the settlement of another currency
in another time zone. Banks are also exposed to interest rate risk, which
arises from the maturity mismatch of foreign currency position. The Value at Risk
(VaR) indicates the risk that the bank is exposed due
to uncovered position of mismatch and these gap positions are to be valued on
daily basis at the prevalent forward market rates announced by FEDAI for the
remaining maturities.
d) Country Risk
This
is the risk that arises due to cross border transactions that are growing
dramatically in the recent years owing to economic liberalization and
globalization. It is the possibility that a country will be unable to service
or repay debts to foreign lenders in time. It comprises of Transfer Risk
arising on account of possibility of losses due to restrictions on external
remittances; Sovereign Risk associated with lending to government of a
sovereign nation or taking government guarantees; Political Risk when political
environment or legislative process of country leads to government taking over
the assets of the financial entity (like nationalization, etc) and preventing
discharge of liabilities in a manner that had been agreed to earlier; Cross border
risk arising on account of the borrower being a resident of a country other
than the country where the cross border asset is booked; Currency Risk, a
possibility that exchange rate change, will alter the expected amount of
principal and return on the lending or investment.
In
the process there can be a situation in which seller (exporter) may deliver the
goods, but may not be paid or the buyer (importer) might have paid the money in
advance but was not delivered the goods for one or the other reasons.
RISK MANAGEMENT
Risk
Management is a discipline at the core of every financial institution and encompasses
all the activities that affect its risk profile. It involves identification, measurement,
monitoring and controlling risks to ensure that
a)
The individuals who take or manage risks clearly understand it.
b)
The organization’s Risk exposure is within the limits established by Board of
Directors.
c)
Risk taking Decisions are in line with the business strategy and objectives set
by BOD.
d)
The expected payoffs compensate for the risks taken
e ) Risk taking decisions are
explicit and clear.
f)
Sufficient capital as a buffer is available to take risk
The
acceptance and management of financial risk is inherent to the business of banking
and banks’ roles as financial intermediaries. Risk management as commonly
perceived does not mean minimizing risk; rather the goal of risk management is
to optimize risk-reward trade -off. Notwithstanding the fact that banks are in
the business of taking risk, it should be recognized that an institution need
not engage in business in a manner that unnecessarily imposes risk upon it: nor
it should absorb risk that can be transferred to other In
every financial institution, risk management activities broadly take place
simultaneously at following different hierarchy levels.
a) Strategic
level:
It encompasses risk management functions performed by senior management and
BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating
strategy and policies for managing risks
and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward
compensate for the risk
b) Macro Level: It encompasses
risk management within a business area or across business lines. Generally the
risk management activities performed by middle management or units devoted to
risk reviews fall into this category.
c) Micro Level: It involves
‘On-the-line’ risk management where risks are actually created. This is the
risk management activities performed by individuals who take risk on
organization’s behalf such as front office and loan origination functions. The
risk management in those areas is confined to following operational procedures
and guidelines set by management. Expanding business arenas, deregulation and
globalization of financial activities emergence of new financial products increased
level of competition has necessitated a need for an effective and structured
risk management in financial institutions.
A bank’s ability to measure, monitor, and steer risks comprehensively is
becoming a decisive parameter for its strategic positioning. The risk management framework and sophistication
of the process, and internal controls, used to manage risks, depends on the nature,
size and complexity of institutions activities. Nevertheless, there are some basic
principles that apply to all financial institutions irrespective of their size and
complexity of business and are reflective of the strength of an individual
bank's risk management practices.
CONCLUSION
Risk
management underscores the fact that the survival of an organization depends
heavily on its capabilities to anticipate and prepare for the change rather
than just waiting for the change and react to it. The objective of risk
management is not to prohibit or prevent risk taking activity, but to ensure
that the risks are consciously taken with full knowledge, clear purpose and
understanding so that it can be measured and mitigated. It also prevents an
institution from suffering unacceptable loss causing an institution to fail or
materially damage its competitive position. Functions of risk management should
actually be bank specific dictated by the size and quality of balance sheet,
complexity of functions, technical/ professional manpower and the status of MIS
in place in that bank. There may not be one-size-fits-all risk management
module for all the banks to be made applicable uniformly. Balancing risk and
return is not an easy task as risk is subjective and not quantifiable where as return is objective and measurable. If there exist
a way of converting the subjectivity of the risk into a number then the
balancing exercise would be meaningful and much easier.
REFERENCES