Risk management in banks

RISK MANAGEMENT IN BANKS
Swayam Siddhi College of Mgt & Research
SSCMR Presentor : Prof. Rahul Shah

INTRODUCTION
• Risk!!!!!!! Whenever we hear this word we start panicking &
thinking what type of risk it could be i.e. either it is physical risk
or financial risk. As per the survey it’s been found a person or an
individual has always feared of loosing something of value which
majorly consists of finance. And if we see today not only an
individual but also organizations fears about loosing their money.
As we all know without taking risk no one can grow or earn more
but due to modernization and liberalization and growing
competition, the rate of risk and uncertainty has also increased.
And this has not only created trouble for an individual but also to
the banking sectors and financial institutions. In order to sustain
and grow in the market, banks have to mitigate or curb these
risks. Thus, risk management concept has come into the picture
which will provide guidelines or will act as a roadmap for a
banking organization to reduce the risk factor.

What is RISK Management in Bank?
We all come across with the word risk in our life but have you
ever wondered where this word originates from??? What is
the origin of this word??? So, firstly we will discuss what is
Risk??
The word “Risk” can be linked to the Latin word “Rescum”
which means Risk at Sea. Risk can be defined as of losing
something of value or something which is weighed against
the potential to gain something of value. Values can be of any
type i.e. health, financial, emotional well being etc. Risk can
also be said as an interaction with uncertainty. Risk
perception is subjective in nature, people make their own
judgment about the severity of a risk and it varies from
person to person. Every human-being carries some risk and
define those risks according to their own judgment.

What is Risk Management?
As we all are aware what is risk? But how one can tackle with risk when they
face it?? So, the concept of Risk Management has been derived in order to
manage the risk or uncertain event. Risk Management refers to the exercise or
practice of forecasting the potential risks thus analyzing and evaluating those
risks and taking some corrective measures to reduce or minimize those risks.
Today risk management is practiced by many organizations or entities in order
to curb the risk which they can face it in near future. Whenever an organization
makes any decision related to investments they try to find out the number of
financial risk attached with it. Financial risks can be in the form of high
inflation, recession, volatility in capital markets, bankruptcy etc. The quantum
of such risks depends on the type of financial instruments in which an
organization or an individual invests.
So, in order to reduce or curb such exposure of risks to investments, fund
managers and investors practice or exercise risk management. For example an
individual may consider investing in fixed deposit less risky as compared to
investing in share market. As investment in equity market is riskier than fixed
deposit, thus through the practice of risk management equity analyst or
investor will diversify its portfolio in order to minimize the risk.

How important Risk Management is for Banks?
Till now we have seen how risk management works and how much it is
important to curb or reduce the risk. As risk is inherent particularly in
financial institutions and banking organizations and even in general, so
now we will see how Risk Management is important for banking
institutions. Till date banking sectors have been working in regulated
environment and were not much exposed to the risks but due to the
increase of severe competition banks have been exposed to various
types of risks such as financial risks and non-financial risks.
The function and process of Risk Management in Banks is complex, so
the banks are trying to use the simplest and sophisticated models for
analyzing and evaluating the risks. In a scientific manner, banks should
have expertise and skills to deal with the risks which are involved in
the process of integration. In order to compete effectively, large-scale
banking organizations should develop internal risk management
models. At a more desired level, Head offices staff should be trained in
risk modeling and analytic tools to conduct Risk Management in Banks.

Risk Management in Indian Banks
Practice of Risk Management in Banks is newer in Indian banks but due to the
growing competition, increased volatility and fluctuations of markets the risk
management model has gained importance. Due to the practice of risk
management, it has resulted in the increased efficiency in governing Indian banks
and has also increased the practice of corporate governance. The essential feature
of risk management model is to minimize or reduce the risks of the products and
services which are offered by the banks therefore, in order to mitigate the internal
& external risks there is a need of efficient risk management framework.
Indian banks have to prepare risk management models or framework due to the
increasing global competition by foreign banks, introduction of innovative
financial products and instruments and increasing deregulation’s.
Banking sector of India has made a great advancements in terms of technology,
quality etc. and have started to diversify and expand its horizons at a rapid rate.
However, due to the increasing globalization and liberalization and also increasing
advancements leads these banks to encounter some risks. Since in banks risks
plays a major role in the earnings therefore higher the risk, higher will be the
returns. Hence it is essential to maintain equality between risk and return.

Types Of Risks

Credit Risk:
Credit risks involve borrower risk, industry risk and portfolio risk.
As it checks the creditworthiness of the industry, borrower etc.
It is also known as default risk which checks the inability of an
industry, counter-party or a customer who are unable to meet the
commitments of making settlement of financial transactions.
Internal and external factors both influences credit risk of bank
portfolio.
Internal factors consist of lack of appraisal of borrower’s financial
status, inadequate risk pricing, lending limits are not defined
properly, absence of post sanctions surveillance, proper loan
agreements or policies are not defined etc.
Whereas external factor comprises of trade restrictions, fluctuation
in exchange rates and interest rates, fluctuations in commodities
or equity prices, tax structure, government policies, political system
etc.

Tools Of Credit Risk Management
The instruments and tools, through which credit risk management is
carried out, are detailed below:
 Exposure Ceiling: Prudential Limit is linked to Capital Funds – say
15% for individual borrower entity, 40% for a group with additional
10% for infrastructure projects undertaken by the group, Threshold
limit is fixed at a level lower than Prudential Exposure; Substantial
Exposure, which is the sum total of the exposures beyond threshold
limit should not exceed 600% to 800% of the Capital Funds of the
bank (i.e. six to eight times).
 Review/Renewal: Multi-tier Credit Approving Authority, constitution
wise delegation of powers, Higher delegated powers for better-rated
customers; discriminatory time schedule for review/renewal, Hurdle
rates and Bench marks for fresh exposures and periodicity for
renewal based on risk rating, etc are formulated.

 Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point
scale. Clearly define rating thresholds and review the ratings periodically preferably at
half yearly intervals. Rating migration is to be mapped to estimate the expected loss.
 Risk based scientific pricing: Link loan pricing to expected loss. High-risk category
borrowers are to be priced high. Build historical data on default losses. Allocate capital
to absorb the unexpected loss. Adopt the RAROC framework.
 Portfolio Management: The need for credit portfolio management emanates from the
necessity to optimize the benefits associated with diversification and to reduce the
potential adverse impact of concentration of exposures to a particular borrower, sector
or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating
categories, distribution of borrowers in various industry, business group and conduct
rapid portfolio reviews. The existing framework of tracking the non-performing loans
around the balance sheet date does not signal the quality of the entire loan book. There
should be a proper & regular on-going system for identification of credit weaknesses
well in advance. Initiate steps to preserve the desired portfolio quality and integrate
portfolio reviews with credit decision-making process.

 Loan Review Mechanism: This should be done independent of credit operations.
It is also referred as Credit Audit covering review of sanction process, compliance
status, review of risk rating, pick up of warning signals and recommendation of
corrective action with the objective of improving credit quality. It should target all
loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio
is subjected to LRM in a year so as to ensure that all major credit risks embedded
in the balance sheet have been tracked. This is done to bring about qualitative
improvement in credit administration. Identify loans with credit weakness.
Determine adequacy of loan loss provisions. Ensure adherence to lending policies
and procedures. The focus of the credit audit needs to be broadened from account
level to overall portfolio level. Regular, proper & prompt reporting to Top
Management should be ensured. Credit Audit is conducted on site, i.e. at the
branch that has appraised the advance and where the main operative limits are
made available. However, it is not required to visit borrowers factory/office
premises.

Risk Rating Model
Credit Audit is conduced on site, i.e. at the branch that has appraised the
advance and where the main operative limits are made available. However, it
is not required to risk borrowers’ factory/office premises. As observed by
RBI, Credit Risk is the major component of risk management system and
this should receive special attention of the Top Management of the bank. The
process of credit risk management needs analysis of uncertainty and
analysis of the risks inherent in a credit proposal. The predictable risk
should be contained through proper strategy and the unpredictable ones
have to be faced and overcome. Therefore any lending decision should
always be preceded by detailed analysis of risks and the outcome of analysis
should be taken as a guide for the credit decision. As there is a significant
co-relation between credit ratings and default frequencies, any derivation of
probability from such historical data can be relied upon. The model may
consist of minimum of six grades for performing and two grades for non-
performing assets. The distribution of rating of assets should be such that
not more than 30% of the advances are grouped under one rating.

The need for the adoption of the credit risk-rating model is on account of the following aspects.
 Disciplined way of looking at Credit Risk.
 Reasonable estimation of the overall health status of an account captured under Portfolio approach
as contrasted to stand-alone or asset based credit management.
 Impact of a new loan asset on the portfolio can be assessed. Taking a fresh exposure to the sector in
which there already exists sizable exposure may simply increase the portfolio risk although specific
unit level risk is negligible/minimal.
 The co-relation or co-variance between different sectors of portfolio measures the inter relationship
between assets. The benefits of diversification will be available so long as there is no perfect positive
corelation between the assets, otherwise impact on one would affect the other.
 Concentration risks are measured in terms of additional portfolio risk arising on account of
increased exposure to a borrower/group or co-related borrowers.
 Need for Relationship Manager to capture, monitor and control the over all exposure to high value
customers on real time basis to focus attention on vital few so that trivial many do not take much of
valuable time and efforts.
 Instead of passive approach of originating the loan and holding it till maturity, active approach of
credit portfolio management is adopted through secuitisation/credit derivatives.
 Pricing of credit risk on a scientific basis linking the loan price to the risk involved therein.
 Rating can be used for the anticipatory provisioning. Certain level of reasonable over- provisioning
as best practice.
Risk Rating Model

Some of the risk rating methodologies used widely is briefed below:
 Altman’s Z score Model involves forecasting the probability of a
company entering bankruptcy. It separates defaulting borrower
from non-defaulting borrower on the basis of certain financial
ratios converted into simple index.
 Credit Metrics focuses on estimating the volatility of asset values
caused by variation in the quality of assets. The model tracks rating
migration which is the probability that a borrower migrates from
one risk rating to another risk rating.
 Credit Risk +, a statistical method based on the insurance industry,
is for measuring credit risk. The model is based on acturial rates
and unexpected losses from defaults. It is based on insurance
industry model of event risk.
Risk Rating Model

 KMV, through its Expected Default Frequency (EDF) methodology derives the actual
probability of default for each obligor based on functions of capital structure, the
volatility of asset returns and the current asset value. It calculates the asset value of
a firm from the market value of its equity using an option pricing based approach
that recognizes equity as a call option on the underlying asset of the firm. It tries to
estimate the asset value path of the firm over a time horizon. The default risk is the
probability of the estimated asset value falling below a prespecified default point.
 Mckinsey’s credit portfolio view is a multi factor model which is used to stimulate
the distribution of default probabilities, as well as migration probabilities
conditioned on the value of macro economic factors like the unemployment rate,
GDP growth, forex rates, etc. In to- days parlance, default arises when a scheduled
payment obligation is not met within 180 days from the due date and this cut-off
period may undergo downward change. Exposure risk is the loss of amount
outstanding at the time of default as reduced by the recoverable amount. The loss in
case of default is D* X * (I-R) where D is Default percentage, X is the Exposure Value
and R is the recovery rate.
Risk Rating Model

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 and 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.
Scenario analysis and stress testing is yet another tool used to assess areas of
potential problems in a given portfolio. Identification of future changes in
economic conditions like – economic/industry overturns, market risk events,
liquidity conditions etc that could have unfavourable effect on bank’s portfolio is
a condition precedent for carrying out stress testing. As the underlying
assumption keep changing from time to time, output of the test should be
reviewed periodically as market risk management system should be responsive
and sensitive to the happenings in the market.
Market Risk

Market Risk
1. 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.
Funding Risk: It is the need to replace net outflows due to unanticipated
withdrawal/nonrenewal of deposit
Time Risk: It is the need to compensate for non-receipt of expected inflows of
funds, i.e. performing assets turning into nonperforming assets.
Call Risk: It happens on account of crystallisation of contingent liabilities and
inability to undertake profitable business opportunities when desired.

2. Interest Rate Risk
Interest Rate Risk is the potential negative impact on the Net Interest Income and
refers to the vulnerability of an institution’s financial condition to the movement
in interest rates. Changes in interest rate affect earnings, assets value, liability
off-balance sheet items and cash flow. Hence, the goal 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 of risk return trade-off. Management of interest rate risk
aims at capturing the risks from the maturity and re-pricing mismatches and is
measured both from the earnings and economic value perspective.
The various types of interest rate risks are detailed below:
 Gap/Mismatch Risk: It arises from holding assets and liabilities and off
balance sheet items with different principal amounts, maturity dates & re-
pricing dates thereby creating exposure to unexpected changes in the level
of market interest rates.
Market Risk

 Basic Risk: It is the risk that the Interest rate of different Assets/liabilities
and off balance items may change in different magnitude. The degree of
basis risk is fairly high in respect of banks that create composite assets out of
composite liabilities.
 Embedded Option Risk: Option of pre-payment of loan and Fore- closure of
deposits before their stated maturities constitute embedded option risk.
 Yield Curve Risk: Movement in yield curve and the impact of that on
portfolio values and income.
 Reprice Risk: When assets are sold before maturities.
 Reinvestment Risk: Uncertainty with regard to interest rate at which the
future cash flows could be reinvested.
 Net interest Position Risk: When banks have more earning assets than
paying liabilities, net interest position risk arises in case market interest
rates adjust downwards.
Market Risk

3. 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 centre 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.
Currency Risk is the possibility that exchange rate changes will alter the expected amount of
principal and return of the lending or investment. At times, banks may try to cope with this
specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to
the borrowers. However the risk does not get extinguished, but only gets converted in to credit
risk.
By setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as
overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and
well defined division of responsibilities between front, middle and back office the risk element
in foreign exchange risk can be managed/monitored.
Market Risk

4. 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.
As per the RBI guidance note on Country Risk Management published recently, banks should
reckon both fund and non-fund exposures from their domestic as well as foreign branches,
if any, while identifying, measuring, monitoring and controlling country risk. It advocates
that bank should also take into account indirect country risk exposure.
Market Risk

Operational Risk
For a better risk management practice, it has become essential to
manage the operational risk.
Operational risk arise due to the modernization of banking sector and
financial markets which gave rise to structural changes, increase in
volume of transactions and complex support systems.
Operational risk cannot be categorized as market risk or credit risk as
this risk can be described as risk related to settlement of payments,
interruption in business activities, legal and administrative risk.
As operational risk involves risk related to business interruption or
problem so this could trigger the market or credit risks. Therefore,
operational risk has some sort of linkages with credit or market risks.

Operational Risk
There is no uniform approach in measuring the operational risk of
banks. Till date simple and experimental methods are used but foreign
banks have introduced some advance techniques to manage the
operational risk.
For measuring operational risk, it requires estimation of the probability
of operational loss and also potential size of the loss.
Banks can make use of analytical and judgmental techniques to
measure operational risk level.
Risk of operations can be: audit ratings, data on quality, historical loss
experience, data on turnover or volume etc. Some international banks
has developed rating matrix which is similar to bond credit rating.
Operational risk should be assessed & reviewed at regular intervals.
For quantifying operational risk, Indian banks have not evolved any
scientific methods and are using simple benchmark system which
measures business activity.

Risk Based Supervision
The Reserve Bank of India presently has its supervisory mechanism by way of
on-site inspection and offsite monitoring on the basis of the audited balance
sheet of a bank. In order to enhance the supervisory mechanism, the RBI has
decided to put in place, beginning from the last quarter of the financial year 02-
03, a system of Risk Based Supervision. Under risk based supervision,
supervisors are expected to concentrate their efforts on ensuring that financial
institutions use the process necessarily to identify, measure and control risk
exposure. The RBS is expected to focus supervisory attention in accordance
with the risk profile of the bank. The RBI has already structured the risk profile
templates to enable the bank to make a self-assessment of their risk profile. It is
designed to ensure continuous monitoring and evaluation of risk profile of the
institution through risk matrix. This may optimize the utilization of the
supervisory resources of the RBI so as to minimize the impact of a crises
situation in the financial system. The transaction based audit and supervision is
getting shifted to risk focused audit.
Risk based supervision approach is an attempt to overcome the deficiencies in
the traditional point-in-time, transaction validation and value based
supervisory system. It is forward looking enabling the supervisors to
diferentiate between banks to focus attention on those having high-risk profile.

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.

THANK YOU….!

Risk management in banks

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