WhatisRiskManagementinIndianBankingSectorandtherole

ofRBI
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WhatisRisk?

Riskreferstoaconditionwherethereisapossibilityofundesirableoccurrenceofaparticularresultwhich
isknownorbestquantifiableandthereforeinsurable.Ariskcanbedefinedasanunplannedeventwithfinancial
consequencesresultinginlossorreducedearnings.Anactivitywhichmaygiveprofitsorresultinlossmaybecalled
ariskypropositionduetouncertaintyorunpredictabilityoftheactivityoftradeinfuture.

Inotherwords,itcanbedefinedastheuncertaintyoftheoutcome.Asriskisdirectlyproportionatetoreturn,the
moreriskabanktakes,itcanexpecttomakemoremoney.

TypeofRisks

Themajorrisksinbankingbusinessascommonlyreferredcanbebroadlyclassifiedinto:

LiquidityRisk
InterestRateRisk
MarketRisk
CreditorDefaultRisk
OperationalRisk

LiquidityRisk

Theliquidityriskofbanksarisesfromfundingoflongtermassetsbyshorttermliabilities,therebymakingthe
liabilitiessubjecttorolloverorrefinancingrisk.

Theliquidityriskinbanksmanifestindifferentdimensions

(a)FundingRisk:FundingLiquidityRiskisdefinedastheinabilitytoobtainfundstomeetcashflowobligations.For
banks,fundingliquidityriskiscrucial.Thisarisesfromtheneedtoreplacenetoutflowsduetounanticipated
withdrawal/nonrenewalofdeposits(wholesaleandretail).

(b)TimeRisk:Timeriskarisesfromtheneedtocompensatefornonreceiptofexpectedinflowsoffundsi.e.,
performingassetsturningintononperformingassets.

(c)CallRisk:Callriskarisesduetocrystallisationofcontingentliabilities.Itmayalsoarisewhenabankmaynotbe
abletoundertakeprofitablebusinessopportunitieswhenitarises.

2.InterestRateRisk

InterestRateRiskariseswhentheNetInterestMarginortheMarketValueofEquity(MVE)ofaninstitutionis
affectedduetochangesintheinterestrates.

IRRcanbeviewedintwowaysitsimpactisontheearningsofthebankoritsimpactontheeconomicvalueofthe
banksassets,liabilitiesandOffBalanceSheet(OBS)positions.InterestrateRiskcantakedifferentforms.

3.MarketRisk
Theriskofadversedeviationsofthemarktomarketvalueofthetradingportfolio,duetomarketmovements,during
theperiodrequiredtoliquidatethetransactionsistermedasMarketRisk.Thisriskresultsfromadversemovements
inthelevelorvolatilityofthemarketpricesofinterestrateinstruments,equities,commodities,andcurrencies.Itis
alsoreferredtoasPriceRisk.

ThetermMarketriskappliesto(i)thatpartofIRRwhichaffectsthepriceofinterestrateinstruments,(ii)Pricingrisk
forallotherassets/portfoliothatareheldinthetradingbookofthebankand(iii)ForeignCurrencyRisk.

(a)ForexRisk:Forexriskistheriskthatabankmaysufferlossesasaresultofadverseexchangeratemovements
duringaperiodinwhichithasanopenpositioneitherspotorforward,oracombinationofthetwo,inanindividual
foreigncurrency.

(b)MarketLiquidityRisk:Marketliquidityriskariseswhenabankisunabletoconcludealargetransactionina
particularinstrumentnearthecurrentmarketprice.

4.DefaultorCreditRisk

Creditriskismoresimplydefinedasthepotentialofabankborrowerorcounterpartytofailtomeetitsobligationsin
accordancewiththeagreedterms.Formostbanks,loansarethelargestandmostobvioussourceofcredit
risk.Itisthemostsignificantrisk,moresointheIndianscenariowheretheNPAlevelofthebankingsystemis
significantlyhigh.

Now,letsdiscussthetwovariantsofcreditrisk

(a)CounterpartyRisk:ThisisavariantofCreditriskandisrelatedtononperformanceofthetradingpartnersdue
tocounterpartysrefusalandorinabilitytoperform.Thecounterpartyriskisgenerallyviewedasatransientfinancial
riskassociatedwithtradingratherthanstandardcreditrisk.

(b)CountryRisk:Thisisalsoatypeofcreditriskwherenonperformanceofaborrowerorcounterpartyarisesdue
toconstraintsorrestrictionsimposedbyacountry.Here,thereasonofnonperformanceisexternalfactorsonwhich
theborrowerorthecounterpartyhasnocontrol

CreditRiskdependsonbothexternalandinternalfactors.

TheinternalfactorsincludeDeficiencyincreditpolicyandadministrationofloanportfolio,Deficiencyinappraising
borrowersfinancialpositionpriortolending,ExcessivedependenceoncollateralsandBanksfailureinpostsanction
followup,etc.

ThemajorexternalfactorsarethestateofEconomy,Swingsincommodityprice,foreignexchangeratesandinterest
rates,etc.

CreditRiskcantbeavoidedbutcanbemitigatedbyapplyingvariousriskmitigatingprocesses

Banksshouldassessthecreditworthinessoftheborrowerbeforesanctioningloani.e.,Creditratingofthe
borrowershouldbedonebeforehand.Creditratingisthemaintoolofmeasuringcreditriskanditalso
facilitatespricingtheloan.
Byapplyingaregularevaluationandratingsystemofallinvestmentopportunities,bankscanreduceitscredit
riskasitcangetvitalinformationoftheinherentweaknessesoftheaccount.
BanksshouldfixprudentiallimitsonvariousaspectsofcreditbenchmarkingCurrentRatio,DebtEquity
Ratio,DebtServiceCoverageRatio,ProfitabilityRatioetc.
Thereshouldbemaximumlimitexposureforsingle/groupborrower.
Thereshouldbeprovisionforflexibilitytoallowvariationsforveryspecialcircumstances.
 Alertnessonthepartofoperatingstaffatallstagesofcreditdispensationappraisal,disbursement,review/
renewal,postsanctionfollowupcanalsobeusefulforavoidingcreditrisk.

5.OperationalRisk

BaselCommitteeforBankingSupervisionhasdefinedoperationalriskastheriskoflossresultingfrominadequateor
failedinternalprocesses,peopleandsystemsorfromexternalevents.Managingoperationalriskhasbecome
importantforbanksduetothefollowingreasons

Higherlevelofautomationinrenderingbankingandfinancialservices
Increaseinglobalfinancialinterlinkages
Scopeofoperationalriskisverywidebecauseoftheabovementionedreasons.

Twoofthemostcommonoperationalrisksarediscussedbelow

(a)TransactionRisk:Transactionriskistheriskarisingfromfraud,bothinternalandexternal,failedbusiness
processesandtheinabilitytomaintainbusinesscontinuityandmanageinformation.

(b)ComplianceRisk:Complianceriskistheriskoflegalorregulatorysanction,financiallossorreputationlossthat
abankmaysufferasaresultofitsfailuretocomplywithanyoralloftheapplicablelaws,regulations,codesof
conductandstandardsofgoodpractice.Itisalsocalledintegrityrisksinceabanksreputationiscloselylinkedtoits
adherencetoprinciplesofintegrityandfairdealing.

6.OtherRisks

Apartfromtheabovementionedrisks,followingaretheotherrisksconfrontedbyBanksincourseoftheirbusiness
operations

(a)StrategicRisk:StrategicRiskistheriskarisingfromadversebusinessdecisions,improperimplementationof
decisionsorlackofresponsivenesstoindustrychanges.

(b)ReputationRisk:ReputationRiskistheriskarisingfromnegativepublicopinion.Thisriskmayexposethe
institutiontolitigation,financiallossordeclineincustomerbase.

RiskManagement

RiskManagementisactuallyacombinationofmanagementofuncertainty,risk,equivocalityanderror.
Uncertaintywheretheoutcomescannotbeestimatedevenrandomly,arisesduetolackofinformationandthis
uncertaintygetstransformedintorisk(wheretheestimationofoutcomeispossible)asinformationgathering
progresses.

Initially,theIndianbankshaveusedriskcontrolsystemsthatkeptpacewithlegalenvironmentandIndianaccounting
standards.Butwiththegrowingpaceofderegulationandassociatedchangesinthecustomersbehaviour,banksare
exposedtomarktomarketaccounting.

Therefore,thechallengeofIndianbanksistoestablishacoherentframeworkformeasuringandmanaging
riskconsistentwithcorporategoalsandresponsivetothedevelopmentsinthemarket.Asthemarketis
dynamic,banksshouldmaintainvigilontheconvergenceofregulatoryframeworksinthecountry,changesinthe
internationalaccountingstandardsandfinallyandmostimportantlychangesintheclientsbusinesspractices.

Therefore,theneedofthehouristofollowcertainriskmanagementnormssuggestedbytheRBIandBIS.

RoleofRBIinRiskManagementinBanks
Here,wewilldiscusstheroleofRBIinRiskManagementandhowthetoolscalledCAMELSwasusedbyRBIto
evaluatethefinancialsoundnessoftheBanks.CAMELSisthecollectivetoolofsixcomponentsnamely

CapitalAdequacy
AssetQuality
Management
EarningsQuality
Liquidity
SensitivitytoMarketrisk

TheCAMELwasrecommendedforthefinancialsoundnessofbankin1988whilethesixthcomponentcalled
sensitivitytomarketrisk(S)wasaddedtoCAMELin1997.

InIndia,thefocusofthestatutoryregulationofcommercialbanksbyRBIuntiltheearly1990swasmainlyon
licensing,administrationofminimumcapitalrequirements,pricingofservicesincludingadministrationofinterestrates
ondepositsaswellascredit,reservesandliquidassetrequirements.

RBIin1999recognisedtheneedofanappropriateriskmanagementandissuedguidelinestobanksregarding
assetsliabilitymanagement,managementofcredit,marketandoperationalrisks.Theentiresupervisorymechanism
hasbeenrealignedsince1994underthedirectionsofanewlyconstitutedBoardforFinancialSupervision(BFS),
whichfunctionsundertheaegisoftheRBI,tosuitthedemandingneedsofastrongandstablefinancialsystem.

AprocessofratingofbanksonthebasisofCAMELSinrespectofIndianbanksandCACS(Capital,AssetQuality,
ComplianceandSystems&Control)inrespectofforeignbankshasbeenputinplacefrom1999.

ByMadhviBansal