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11490p841 851


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11490p841 851

  1. 1. MANAGEMENT Risk Management In Banks R.S. Raghavan < E X E C U T I V E S U M M A R Y > ◆Risk is inherent in any walk of life in gen- in detail. Main features of these risks as eral and in financial sectors in particular. well as some other categories of risks Till recently, due to regulated environ- such as Regulatory Risk and ment, banks could not afford to take risks. Environmental Risk. Various tools and But of late, banks are exposed to same techniques to manage Credit Risk, competition and hence are compeled to Market Risk and Operational Risk and its encounter various types of financial and various component, are also discussed in non-financial risks. Risks and uncertain- detail. Another has also mentioned rele- ties form an integral part of banking which vant points of Basel’s New Capital by nature entails taking risks. Accord’ and role of capital adequacy, There are three main categories of Risk Aggregation & Capital Allocation risks; Credit Risk, Market Risk & and Risk Based Supervision (RBS), in Operational Risk. Author has discussed managing risks in banking sector. effectively controlled and rightly managed. Each trans-BACKGROUND action that the bank undertakes changes the risk profile he etymology of the word “Risk” can be of the bank. The extent of calculations that need to be T traced to the Latin word “Rescum” performed to understand the impact of each such risk on meaning Risk at Sea or that which cuts. the transactions of the bank makes it nearly impossible Risk is associated with uncertainty and to continuously update the risk calculations. Hence, pro- reflected by way of charge on the funda- viding real time risk information is one of the key chal-mental/basic i.e. in the case of business it is the Capital, lenges of risk management exercise.which is the cushion that protects the liability holders of Till recently all the activities of banks were regulatedan institution. These risks are inter-dependent and and hence operational environment was not conduciveevents affecting one area of risk can have ramifications to risk taking. Better insight, sharp intuition and longerand penetrations for a range of other categories of risks. experience were adequate to manage the limited risks.Foremost thing is to understand the risks run by the bank Business is the art of extracting money from other’sand to ensure that the risks are properly confronted, pocket, sans resorting to violence. But profiting in busi- ness without exposing to risk is like trying to live without being born. Every one knows that risk taking is failure-The author is member of the Institute. The views expressed herein prone as otherwise it would be treated as sure taking.are the personal views of the author and do not necessarily Hence risk is inherent in any walk of life in general and inrepresent the views of the Institute. financial sectors in particular. Of late, banks have grown 841CHARTERED ACCOUNTANT FEBRUARY 2003
  2. 2. MANAGEMENTfrom being a financial intermediary into a risk intermedi- entirely is to be borne by the bank itself and hence is to beary at present. In the process of financial intermediation, taken care of by the capital. Thus, the expected losses arethe gap of which becomes thinner and thinner, banks are covered by reserves/provisions and the unexpectedexposed to severe competition and hence are compelled losses require capital allocation. Hence the need for suffi-to encounter various types of financial and non-financial cient Capital Adequacy Ratio is felt. Each type of risks isrisks. Risks and uncertainties form an integral part of measured to determine both the expected and unex-banking which by nature entails taking risks. pected losses using VaR (Value at Risk) or worst-case Business grows mainly by taking risk. Greater the type analytical model.risk, higher the profit and hence the business unit muststrike a trade off between the two. The essential func-tions of risk management are to identify, measure and III CREDIT RISKmore importantly monitor the profile of the bank. While Credit Risk is the potential that a bankNon-Performing Assets are the legacy of the past in the borrower/counter party fails to meet the obligations onpresent, Risk Management system is the pro-active agreed terms. There is always scope for the borrower toaction in the present for the future. Managing risk is default from his commitments for one or the other rea-nothing but managing the change before the risk man- son resulting in crystalisation of credit risk to the bank.ages. While new avenues for the bank has opened up they These losses could take the form outright default or alter-have brought with them new risks as well, which the natively, losses from changes in portfolio value arisingbanks will have to handle and overcome. from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the busi- ness of lending funds to the operations linked closely toII. TYPES OF RISKS market risk variables. The objective of credit risk man- When we use the term “Risk”, we all mean financial agement is to minimize the risk and maximize bank’s riskrisk or uncertainty of financial loss. If we consider risk in adjusted rate of return by assuming and maintainingterms of probability of occurrence frequently, we mea- credit exposure within the acceptable parameters.sure risk on a scale, with certainty of occurrence at one Credit risk consists of primarily two components, vizend and certainty of non-occurrence at the other end. Quantity of risk, which is nothing but the outstandingRisk is the greatest where the probability of occurrence loan balance as on the date of default and the quality ofor non-occurrence is equal. As per the Reserve Bank of risk, viz, the severity of loss defined by both ProbabilityIndia guidelines issued in Oct. 1999, there are three of Default as reduced by the recoveries that could bemajor types of risks encountered by the banks and these made in the event of default. Thus credit risk is a com-are Credit Risk, Market Risk & Operational Risk. As we bined outcome of Default Risk and Exposure Risk. Thego along the article, we will see what are the components elements of Credit Risk is Portfolio risk comprisingof these three major risks. In August 2001, a discussion Concentration Risk as well as Intrinsic Risk andpaper on move towards Risk Based Supervision was Transaction Risk comprising migration/down gradationpublished. Further after eliciting views of banks on the risk as well as Default Risk. At the transaction level,draft guidance note on Credit Risk Management and credit ratings are useful measures of evaluating credit riskmarket risk management, the RBI has issued the final that is prevalent across the entire organization whereguidelines and advised some of the large PSU banks to treasury and credit functions are handled. Portfolioimplement so as to guage the impact. A discussion paper analysis help in identifying concentration of credit risk,on Country Risk was also released in May 02. default/migration statistics, recovery data, etc. Risk is the potentiality that both the expected and In general, Default is not an abrupt process to happenunexpected events may have an adverse impact on the suddenly and past experience dictates that, more oftenbank’s capital or earnings. The expected loss is to be than not, borrower’s credit worthiness and asset qualityborne by the borrower and hence is taken care of by ade- declines gradually, which is otherwise known as migra-quately pricing the products through risk premium and tion. Default is an extreme event of credit migration.reserves created out of the earnings. It is the amount Off balance sheet exposures such as foreign exchangeexpected to be lost due to changes in credit quality result- forward cantracks, swaps options etc are classified in toing in default. Where as, the unexpected loss on account three broad categories such as full Risk, Medium Risk andof the individual exposure and the whole portfolio in Low risk and then translated into risk Neighted assetsCHARTERED ACCOUNTANT 842 FEBRUARY 2003
  3. 3. MANAGEMENTthrough a conversion factor and summed up. reviews with credit decision-making process. The management of credit risk includes a) measure- f) Loan Review Mechanism This should be done indepen-ment through credit rating/ scoring, b) quantification dent of credit operations. It is also referred as Creditthrough estimate of expected loan losses, c) Pricing on a Audit covering review of sanction process, compliancescientific basis and d) Controlling through effective status, review of risk rating, pick up of warning signalsLoan Review Mechanism and Portfolio Management. and recommendation of corrective action with the objective of improving credit quality. It should target allA) Tools of Credit Risk Management. loans above certain cut-off limit ensuring that at least The instruments and tools, through which credit risk 30% to 40% of the portfolio is subjected to LRM in amanagement is carried out, are detailed below: year so as to ensure that all major credit risks embeddeda) Exposure Ceilings: Prudential Limit is linked to in the balance sheet have been tracked. This is done to Capital Funds – say 15% for individual borrower bring about qualitative improvement in credit adminis- entity, 40% for a group with additional 10% for infra- tration. Identify loans with credit weakness. Determine structure projects undertaken by the group, adequacy of loan loss provisions. Ensure adherence to Threshold limit is fixed at a level lower than lending policies and procedures. The focus of the credit Prudential Exposure; Substantial Exposure, which is audit needs to be broadened from account level to the sum total of the exposures beyond threshold limit overall portfolio level. Regular, proper & prompt should not exceed 600% to 800% of the Capital reporting to Top Management should be ensured. Funds of the bank (i.e. six to eight times). Credit Audit is conducted on site, i.e. at the branch thatb) Review/Renewal: Multi-tier Credit Approving has appraised the advance and where the main opera- Authority, constitution wise delegation of powers, tive limits are made available. However, it is not Higher delegated powers for better-rated customers; dis- required to visit borrowers factory/office premises. criminatory time schedule for review/renewal, Hurdle B. Risk Rating Model rates and Bench marks for fresh exposures and periodic- Credit Audit is conduced on site, i.e. at the branch ity for renewal based on risk rating, etc are formulated. that has appraised the advance and where the mainc) Risk Rating Model: Set up comprehensive risk scor- operative limits are made available. However, it is ing system on a six to nine point scale. Clearly define not required to risk borrowers’ factory/office rating thresholds and review the ratings periodically premises. As observed by RBI, Credit Risk is the major preferably at half yearly intervals. Rating migration is component of risk management system and this should to be mapped to estimate the expected loss. receive special attention of the Top Management of thed) Risk based scientific pricing: Link loan pricing to bank. The process of credit risk management needs expected loss. High-risk category borrowers are to be analysis of uncertainty and analysis of the risks inherent priced high. Build historical data on default losses. in a credit proposal. The predictable risk should be con- Allocate capital to absorb the unexpected loss. Adopt tained through proper strategy and the unpredictable the RAROC framework. ones have to be faced and overcome. Therefore anye) Portfolio Management The need for credit portfolio lending decision should always be preceded by detailed management emanates from the necessity to opti- analysis of risks and the outcome of analysis should be mize the benefits associated with diversification and taken as a guide for the credit decision. As there is a sig- to reduce the potential adverse impact of concentra- nificant co-relation between credit ratings and default tion of exposures to a particular borrower, sector or frequencies, any derivation of probability from such his- industry. Stipulate quantitative ceiling on aggregate torical data can be relied upon. The model may consist of exposure on specific rating categories, distribution of minimum of six grades for performing and two grades borrowers in various industry, business group and for non-performing assets. The distribution of rating of conduct rapid portfolio reviews. The existing frame- assets should be such that not more than 30% of the work of tracking the non-performing loans around advances are grouped under one rating. The need for the the balance sheet date does not signal the quality of adoption of the credit risk-rating model is on account of the entire loan book. There should be a proper & reg- the following aspects. ular on-going system for identification of credit — Disciplined way of looking at Credit Risk. weaknesses well in advance. Initiate steps to preserve — Reasonable estimation of the overall health status of the desired portfolio quality and integrate portfolio an account captured under Portfolio approach as 843CHARTERED ACCOUNTANT FEBRUARY 2003
  4. 4. MANAGEMENT contrasted to stand-alone or asset based credit man- cific to the activities in which the borrower is engaged. agement. Assessment of financial risks involves appraisal of the— Impact of a new loan asset on the portfolio can be financial strength of a unit based on its performance and assessed. Taking a fresh exposure to the sector in finacial indicators like liquidity, profitability, gearing, which there already exists sizable exposure may sim- leverage, coverage, turnover etc. It is necessary to study ply increase the portfolio risk although specific unit the movement of these indicators over a period of time as level risk is negligible/minimal. also its comparison with industry averages wherever pos-— The co-relation or co-variance between different sec- sible. A study carried out in the western corporate world tors of portfolio measures the inter relationship reveals that 45% of the projects failed to take off simply between assets. The benefits of diversification will be because the personnel entrusted with the test were found available so long as there is no perfect positive co- to be highly wanting in qualitatively managing the project. relation between the assets, otherwise impact on one The key ingredient of credit risk is the risk of default would affect the other. that is measured by the probability that default occurs— Concentration risks are measured in terms of addi- during a given period. Probabilities are estimates of tional portfolio risk arising on account of increased future happenings that are uncertain. We can narrow the exposure to a borrower/group or co-related borrow- margin of uncertainty of a forecast if we have a fair ers. understanding of the nature and level of uncertainty— Need for Relationship Manager to capture, monitor regarding the variable in question and availability of qual- and control the over all exposure to high value cus- ity information at the time of assessment. tomers on real time basis to focus attention on vital The expected loss/unexpected loss methodology few so that trivial many do not take much of valuable forces banks to adopt new Internal Ratings Based time and efforts. approach to credit risk management as proposed in the— Instead of passive approach of originating the loan Capital Accord II. Some of the risk rating methodologies and holding it till maturity, active approach of credit used widely is briefed below: portfolio management is adopted through secuitisa- a. Altman’s Z score Model involves forecasting the tion/credit derivatives. probability of a company entering bankruptcy. It sep-— Pricing of credit risk on a scientific basis linking the arates defaulting borrower from non-defaulting bor- loan price to the risk involved therein. rower on the basis of certain financial ratios con-— Rating can be used for the anticipatory provisioning. verted into simple index. Certain level of reasonable over-provisioning as best b. Credit Metrics focuses on estimating the volatility of practice. asset values caused by variation in the quality of Given the past experience and assumptions about the assets. The model tracks rating migration which is thefuture, the credit risk model seeks to determine the pre- probability that a borrower migrates from one risksent value of a given loan or fixed income security. It also rating to another risk rating.seeks to determine the quantifiable risk that the promised c. Credit Risk +, a statistical method based on the insurancecash flows will not be forthcoming. Thus, credit risk industry, is for measuring credit risk. The model is basedmodels are intended to aid banks in quantifying, aggre- on acturial rates and unexpected losses from defaults. Itgating and managing risk across geographical and prod- is based on insurance industry model of event risk.uct lines. Credit models are used to flag potential prob- d. KMV, through its Expected Default Frequency (EDF)lems in the portfolio to facilitate early corrective action. methodology derives the actual probability of default The risk-rating model should capture various types of for each obligor based on functions of capital struc-risks such as Industry/Business Risk, Financial Risk and ture, the volatility of asset returns and the current assetManagement Risk, associated with credit. value. It calculates the asset value of a firm from theIndustry/Business risk consists of both systematic and market value of its equity using an option pricingunsystematic risks which are market driven. The system- based approach that recognizes equity as a call optionatic risk emanates from General political environment, on the underlying asset of the firm. It tries to estimatechanges in economic policies, fiscal policies of the gov- the asset value path of the firm over a time horizon.ernment, infrastructural changes etc. The unsystematic The default risk is the probability of the estimatedrisk arises out of internal factors such as machinery break- asset value falling below a pre-specified default point.down, labour strike, new competitors who are quite spe- e. Mckinsey’s credit portfolio view is a multi factor modelCHARTERED ACCOUNTANT 844 FEBRUARY 2003
  5. 5. MANAGEMENT which is used to stimulate the distribution of default managing liquidity, interest rate, foreign exchange and probabilities, as well as migration probabilities condi- equity as well as commodity price risk of a bank that needs tioned on the value of macro economic factors like the to be closely integrated with the bank’s business strategy. unemployment rate, GDP growth, forex rates, etc. Scenario analysis and stress testing is yet another tool In to-days parlance, default arises when a scheduled used to assess areas of potential problems in a given port-payment obligation is not met within 180 days from the folio. Identification of future changes in economic con-due date and this cut-off period may undergo downward ditions like – economic/industry overturns, market riskchange. Exposure risk is the loss of amount outstanding events, liquidity conditions etc that could haveat the time of default as reduced by the recoverable unfavourable effect on bank’s portfolio is a conditionamount. The loss in case of default is D* X * (I-R) where precedent for carrying out stress testing. As the underly-D is Default percentage, X is the Exposure Value and R ing assumption keep changing from time to time, out-is the recovery rate. put of the test should be reviewed periodically as market Credit Risk is measured through Probability of risk management system should be responsive and sen-Default (POD) and Loss Given Default (LGD). Bank sitive to the happenings in the market.should estimate the probability of default associated withborrowers in each of the rating grades. How much the a) Liquidity Risk:bank would lose once such event occurs is what is known Bank Deposits generally have a much shorter con-as Loss Given Default. This loss is also dependent upon tractual maturity than loans and liquidity managementbank’s exposure to the borrower at the time of default needs to provide a cushion to cover anticipated depositcommonly known as Exposure at Default (EaD). withdrawals. Liquidity is the ability to efficiently accom- The extent of provisioning required could be esti- modate deposit as also reduction in liabilities and to fundmated from the expected Loss Given Default (which is the loan growth and possible funding of the off-balancethe product of Probability of Default, Loss Given sheet claims. The cash flows are placed in different timeDefault & Exposure & Default). That is ELGD is equal buckets based on future likely behaviour of assets, liabil-to PODX LGD X EaD. ities and off-balance sheet items. Liquidity risk consists Credit Metrics mechanism advocates that the of Funding Risk, Time Risk & Call Risk.amount of portfolio value should be viewed not just interms of likelihood of default, but also in terms of credit Funding Risk : It is the need to replace net out flowsquality over time of which default is just a specific case. due to unanticipated withdrawal/non-Credit Metrics can be worked out at corporate level, at renewal of depositleast on an annual basis to measure risk- migration and Time risk : It is the need to compensate for non-resultant deterioration in credit portfolio. receipt of expected inflows of funds, The ideal credit risk management system should i.e. performing assets turning into non-throw a single number as to how much a bank stands to performing assets.lose on credit portfolio and therefore how much capital Call risk : It happens on account of crystalisationthey ought to hold. of contingent liabilities and inability to undertake profitable business oppor- tunities when desired.IV MARKET RISK Market Risk may be defined as the possibility of loss The Asset Liability Management (ALM) is a part ofto bank caused by the changes in the market variables. It the overall risk management system in the banks. Itis the risk that the value of on-/off-balance sheet posi- implies examination of all the assets and liabilities simul-tions will be adversely affected by movements in equity taneously on a continuous basis with a view to ensuringand interest rate markets, currency exchange rates and a proper balance between funds mobilization and theircommodity prices. Market risk is the risk to the bank’s deployment with respect to their a) maturity profiles, b)earnings and capital due to changes in the market level of cost, c) yield, d) risk exposure, etc. It includes productinterest rates or prices of securities, foreign exchange and pricing for deposits as well as advances, and the desiredequities, as well as the volatilities, of those prices. Market maturity profile of assets and liabilities.Risk Management provides a comprehensive and Tolerance levels on mismatches should be fixed fordynamic frame work for measuring, monitoring and various maturities depending upon the asset liability pro- 845CHARTERED ACCOUNTANT FEBRUARY 2003
  6. 6. MANAGEMENTfile, deposit mix, nature of cash flow etc. Bank should It is the risk that the Interest rat of differenttrack the impact of pre-payment of loans & premature Assets/liabilities and off balance items mayclosure of deposits so as to realistically estimate the cash change in different magnitude. The degree offlow profile. basis risk is fairly high in respect of banks that cre- ate composite assets out of composite liabilities.b) Interest Rate Risk Embedded option Risk: Interest Rate Risk is the potential negative impact on Option of pre-payment of loan and Fore- closurethe Net Interest Income and it refers to the vulnerability of deposits before their stated maturities consti-of an institution’s financial condition to the movement tute embedded option riskin interest rates. Changes in interest rate affect earnings, Yield curve risk:value of assets, liability off-balance sheet items and cash Movement in yield curve and the impact of thatflow. Hence, the objective of interest rate risk manage- on portfolio values and income.ment is to maintain earnings, improve the capability, Reprice risk:ability to absorb potential loss and to ensue the adequacy When assets are sold before maturities.of the compensation received for the risk taken and Reinvestment risk:effect risk return trade-off. Management of interest rate Uncertainty with regard to interest rate at whichrisk aims at capturing the risks arising from the maturity the future cash flows could be reinvested.and re-pricing mismatches and is measured both from Net interest position risk:the earnings and economic value perspective. When banks have more earning assets than pay- Earnings perspective involves analyzing the impact of ing liabilities, net interest position risk arises inchanges in interest rates on accrual or reported earnings in case market interest rates adjust downwards.the near term. This is measured by measuring the changes in There are different techniques such as a) the tradi-the Net Interest Income (NII) equivalent to the difference tional Maturity Gap Analysis to measure the interest ratebetween total interest income and total interest expense. sensitivity, b) Duration Gap Analysis to measure interest In order to manage interest rate risk, banks should rate sensitivity of capital, c) simulation and d) Value atbegin evaluating the vulnerability of their portfolios to Risk for measurement of interest rate risk. The approachthe risk of fluctuations in market interest rates. One such towards measurement and hedging interest rate riskmeasure is Duration of market value of a bank asset or varies with segmentation of bank’s balance sheet. Banksliabilities to a percentage change in the market interest broadly bifurcate the asset into Trading Book andrate. The difference between the average duration for Banking Book. While trading book comprises of assetsbank assets and the average duration for bank liabilities held primarily for generating profits on short term differ-is known as the duration gap which assess the bank’s ences in prices/yields, the banking book consists of assetsexposure to interest rate risk. The Asset Liability and liabilities contracted basically on account of relation-Committee (ALCO) of a bank uses the information con- ship or for steady income and statutory obligations andtained in the duration gap analysis to guide and frame are generally held till maturity/payment by counter party.strategies. By reducing the size of the duration gap, banks Thus, while price risk is the prime concern of bankscan minimize the interest rate risk. in trading book, the earnings or changes in the economic Economic Value perspective involves analyzing the value are the main focus in banking book.expected cash in flows on assets minus expected cash out Value at Risk (VaR) is a method of assessing the marketflows on liabilities plus the net cash flows on off-balance risk using standard statistical techniques. It is a statisticalsheet items. The economic value perspective identifies measure of risk exposure and measures the worst expectedrisk arising from long-term interest rate gaps. The vari- loss over a given time interval under normal market condi-ous types of interest rate risks are detailed below: tions at a given confidence level of say 95% or 99%. ThusGap/Mismatch risk: VaR is simply a distribution of probable outcome of future It arises from holding assets and liabilities and off losses that may occur on a portfolio. The actual result will balance sheet items with different principal not be known until the event takes place. Till then it is a ran- amounts, maturity dates & re-pricing dates dom variable whose outcome has been estimated. thereby creating exposure to unexpected changes As far as Trading Book is concerned, bank should be in the level of market interest rates. able to adopt standardized method or internal modelsBasis Risk: for providing explicit capital charge for market risk. 846CHARTERED ACCOUNTANT FEBRUARY 2003
  7. 7. MANAGEMENT exchange rate change, will alter the expected amount ofc) Forex Risk principal and return on the lending or investment. Foreign exchange risk is the risk that a bank may suf- In the process there can be a situation in which sellerfer loss as a result of adverse exchange rate movement (exporter) may deliver the goods, but may not be paid orduring a period in which it has an open position, either the buyer (importer) might have paid the money inspot or forward or both in same foreign currency. Even advance but was not delivered the goods for one or thein case where spot or forward positions in individual cur- other reasons.rencies are balanced the maturity pattern of forward As per the RBI guidance note on Country Risktransactions may produce mismatches. There is also a Management published recently, banks should reckonsettlement risk arising out of default of the counter party both fund and non-fund exposures from their domestic asand out of time lag in settlement of one currency in one well as foreign branches, if any, while identifying, measur-center and the settlement of another currency in another ing, monitoring and controlling country risk. It advocatestime zone. Banks are also exposed to interest rate risk, that bank should also take into account indirect countrywhich arises from the maturity mismatch of foreign cur- risk exposure. For example, exposures to a domestic com-rency position. The Value at Risk (VaR) indicates the risk mercial borrower with large economic dependence on athat the bank is exposed due to uncovered position of certain country may be considered as subject to indirectmismatch and these gap positions are to be valued on country risk. The exposures should be computed on a netdaily basis at the prevalent forward market rates basis, i.e. gross exposure minus collaterals, guarantees etc.announced by FEDAI for the remaining maturities. Netting may be considered for collaterals in/guarantees Currency Risk is the possibility that exchange rate issued by countries in a lower risk category and may be per-changes will alter the expected amount of principal and mitted for bank’s dues payable to the respective countries.return of the lending or investment. At times, banks may RBI further suggests that banks should eventuallytry to cope with this specific risk on the lending side by put in place appropriate systems to move over to internalshifting the risk associated with exchange rate fluctua- assessment of country risk within a prescribed period saytions to the borrowers. However the risk does not get by 31.3.2004, by which time the new capital accordextinguished, but only gets converted in to credit risk. would be implemented. The system should be able to By setting appropriates limits-open position and gaps, identify the full dimensions of country risk as well asstop-loss limits, Day Light as well as overnight limits for incorporate features that acknowledge the links betweeneach currency, Individual Gap Limits and Aggregate Gap credit and market risks. Banks should not rely solely onLimits, clear cut and well defined division of responsibili- rating agencies or other external sources as their onlyties between front, middle and back office the risk element country risk-monitoring foreign exchange risk can be managed/monitored. With regard to inter-bank exposures, the guidelines suggests that banks should use the country ratings ofd) Country Risk international rating agencies and broadly classify the This is the risk that arises due to cross border transac- country risk rating into six categories such as insignifi-tions that are growing dramatically in the recent years cant, low, moderate, high, very high & off-credit.owing to economic liberalization and globalization. It is the However, banks may be allowed to adopt a more con-possibility that a country will be unable to service or repay servative categorization of the countries.debts to foreign lenders in time. It comprises of Transfer Banks may set country exposure limits in relation toRisk arising on account of possibility of losses due to the bank’s regulatory capital (Tier I & II) with suitablerestrictions on external remittances; Sovereign Risk associ- sub limits, if necessary, for products, branches, maturityated with lending to government of a sovereign nation or etc. Banks were also advised to set country exposure lim-taking government guarantees; Political Risk when politi- its and monitor such exposure on weekly basis beforecal environment or legislative process of country leads to eventually switching over to real tie monitoring. Banksgovernment taking over the assets of the financial entity should use variety of internal and external sources as a(like nationalization, etc) and preventing discharge of lia- means to measure country risk and should not rely solelybilities in a manner that had been agreed to earlier; Cross on rating agencies or other external sources as their onlyborder risk arising on account of the borrower being a res- tool for monitoring country risk. Banks are expected toident of a country other than the country where the cross disclose the “Country Risk Management” policies inborder asset is booked; Currency Risk, a possibility that their Annual Report by way of notes. 847CHARTERED ACCOUNTANT FEBRUARY 2003
  8. 8. MANAGEMENTV OPERATIONAL RISK VI REGULATORY RISK Always banks live with the risks arising out of human When owned funds alone are managed by an entity, iterror, financial fraud and natural disasters. The recent hap- is natural that very few regulators operate and supervisepenings such as WTC tragedy, Barings debacle etc. has high- them. However, as banks accept deposit from publiclighted the potential losses on account of operational risk. obviously better governance is expected of them. ThisExponential growth in the use of technology and increase in entails multiplicity of regulatory controls. Many Banks,global financial inter-linkages are the two primary changes having already gone for public issue, have a greaterthat contributed to such risks. Operational risk, though responsibility and accountability. As banks deal withdefined as any risk that is not categorized as market or credit public funds and money, they are subject to various reg-risk, is the risk of loss arising from inadequate or failed inter- ulations. The very many regulators include Reserve Banknal processes, people and systems or from external events. of India (RBI), Securities Exchange Board of IndiaIn order to mitigate this, internal control and internal audit (SEBI), Department of Company Affairs (DCA), are used as the primary means. More over, banks should ensure compliance of the Risk education for familiarizing the complex operations applicable provisions of The Banking Regulation Act,at all levels of staff can also reduce operational risk. Insurance The Companies Act, etc. Thus all the banks run the riskcover is one of the important mitigators of operational risk. of multiple regulatory-risk which inhibits free growth ofOperational risk events are associated with weak links in business as focus on compliance of too many regulationsinternal control procedures. The key to management of leave little energy and time for developing new business.operational risk lies in the bank’s ability to assess its process Banks should learn the art of playing their business activ-for vulnerability and establish controls as well as safeguards ities within the regulatory controls.while providing for unanticipated worst-case scenarios. Operational risk involves breakdown in internal con-trols and corporate governance leading to error, fraud, per- VII ENVIRONMENTAL RISKformance failure, compromise on the interest of the bank As the years roll by and technological advancementresulting in financial loss. Putting in place proper corporate take place, expectation of the customers change andgovernance practices by itself would serve as an effective enlarge. With the economic liberalization and globaliza-risk management tool. Bank should strive to promote a tion, more national and international players are operat-shared understanding of operational risk within the orga- ing the financial markets, particularly in the banking field.nization, especially since operational risk is often inter- This provides the platform for environmental changewined with market or credit risk and it is difficult to isolate. and exposes the bank to the environmental risk. Thus, Over a period of time, management of credit and mar- unless the banks improve their delivery channels, reachket risks has evolved a more sophisticated fashion than customers, innovate their products that are service ori-operational risk, as the former can be more easily measured, ented, they are exposed to the environmental risk result-monitored and analysed. And yet the root causes of all the ing in loss in business share with consequential scams and losses are the result of operational riskcaused by breakdowns in internal control mechanism andstaff lapses. So far, scientific measurement of operational VIII BASEL’S NEW CAPITAL ACCORDrisk has not been evolved. Hence 20% charge on the Capital Bankers’ for International Settlement (BIS) meet atFunds is earmarked for operational risk and based on sub- Basel situated at Switzerland to address the commonsequent data/feedback, it was reduced to 12%. While mea- issues concerning bankers all over the world. The Baselsurement of operational risk and computing capital charges Committee on Banking Supervision (BCBS) is a com-as envisaged in the Basel proposals are to be the ultimate mittee of banking supervisory authorities of G-10 coun-goals, what is to be done at present is start implementing the tries and has been developing standards and establish-Basel proposal in a phased manner and carefully plan in that ment of a framework for bank supervision towardsdirection. The incentive for banks to move the measure- strengthening financial stability through out the world.ment chain is not just to reduce regulatory capital but more In consultation with the supervisory authorities authori-importantly to provide assurance to the top management ties of a few non-G-10 countries including India, corethat the bank holds the required capital. principles for effective banking supervision in the form of minimum requirements to strengthen current super-CHARTERED ACCOUNTANT 848 FEBRUARY 2003
  9. 9. MANAGEMENT MANAGEMENTvisory regime, were mooted. where certain minimum capital adequacy has to be main- The 1988 Capital Accord essentially provided only one tained in the face of stiff norms in respect of incomeoption for measuring the appropriate capital in relation to recognition, asset classification and provisioning. It isthe risk-weighted assets of the financial institution. It clear that multi pronged approach would be required tofocused on the total amount of bank capital so as to reduce meet the challenges of maintaining capital at adequatethe risk of bank solvency at the potential cost of bank’s fail- levels in the face of mounting risks in the banking sector.ure for the depositors. As an improvement on the above, In banks asset creation is an event happening subse-the New Capital Accord was published in 2001, to be imple- quent to the capital formation and deposit mobilization.mented by the financial year 2003-04. It provides spectrum Therefore, the preposition should be for a given capitalof approaches for the measurement of credit, market and how much asset can be created? Hence, in ideal situationoperational risks to determine the capital required. and taking a radical view, stipulation of Asset Creation The spread and nature of the ownership structure is Multiple (ACM), in lieu of capital adequacy ratio, wouldimportant as it impinges on the propensity to induct addi- be more appropriate and rational. That is to say, insteadtional capital. While getting support from a large body of of Minimum Capital Adequacy Ratio of 8 percent (imply-shareholders is a difficult proposition when the bank’s ing holding of Rs 8 by way of capital for every Rs 100 riskperformance is adverse, a smaller shareholder base con- weighted assets), stipulation of Maximum Asset Creationstrains the ability of the bank to garner funds. Tier I capi- Multiple of 12.5 times (implying for maximum Assettal is not owed to anyone and is available to cover possi- Creation Multiple of 12.5 time for the given capital of Rsble unexpected losses. It has no maturity or repayment 8) would be more meaningful. However as the assets haverequirement, and is expected to remain a permanent been already created when the norms were introduced,component of the core capital of the counter party. While capital adequacy ratio is adopted instead of asset creationBasel standards currently require banks to have a capital multiple. At least in respect of the new banks (startingadequacy ratio of 8% with Tier I not less than 4%, RBI has from zero), Asset Creation Multiple (ACM) may bemandated the banks to maintain CAR of 9%. The main- examined/thought of for strict implementation.tenance of capital adequacy is like aiming at a moving tar- The main differences between the existing accordget as the composition of risk-weighted assets gets and the new one are summarized below:-changed every minute on account of fluctuation in therisk profile of a bank. Tier I capital is known as the core Existing Accord New Accordcapital providing permanent and readily available support 1. Focus on single risk 1. More emphasis on banks’to the bank to meet the unexpected losses. measure own internal metodology In the recent past, owner of PSU banks, the govern- supervisory Review and mar-ment provided capital in good measure mainly to weaker ket discipline.banks. In doing so, the government was not acting as aprudent investor as return on such capital was never a 2. One size fits all 2. Flexibility, menu ofconsideration. Further, capital infusion did not result in approaches, incentive for bet-any cash flow to the receiver, as all the capital was required ter risk be reinvested in government securities yielding low 3. Broad brush structure 3. More risk sensitivity.interest. Receipt of capital was just a book entry with theonly advantage of interest income from the securities. The structure of the New Accord – II consists of three pillars approach as given below. Pillar Focus areaCAPITAL ADEQUACY I Pillar - Minimum Capital Requirement Subsequent to nationalization of banks, capitaliza- II Pillar - Supervisory review processtion in banks was not given due importance as it was felt III Pillar - Market Disciplinenecessary for the reason that the ownership of the banksrested with the government, creating the required confi- i) Minimum Capital Requirementdence in the mind of the public. Combined forces of The capital Adequacy Ratio is the percentage of bank’sglobalization and liberalization compelled the public Capital Funds in relation to the Risk Weighted Assets of thesector banks, hitherto shielded from the vagaries of mar- bank. In the New Capital Accord, while the definition ofket forces, to come to terms with the market realities Capital Fund remains the same, the method of calculation 849CHARTERED ACCOUNTANT FEBRUARY 2003
  10. 10. MANAGEMENTof Risk Weighted Assets has been modified to factor mar- cost of Economic Capital & expected losses that mayket risk and operational risk, in addition to the Credit Risk prevail in the worst-case scenario and then equates thethat alone was reckoned in the 1988 Capital Accord. Banks capital cushion to be provided for the potential loss.may adopt any of the approach suitable to them for arriving RAROC is the first step towards examining the institu-at the total risk weighted assets. Various approaches, to be tion’s entire balance sheet on a mark to market basis, ifchosen from under each of the risk are detailed below: only to understand the risk return trade off that have been made. As banks carry on the business on a wide area net-Credit Risk Menu: work basis, it is critical that they are able to continuously1) Standardized Approach: The bank allocates a risk monitor the exposures across the entire organization and weight to each assets as well as off balance sheet items aggregate the risks so than an integrated view is taken. and produces a sum of R W A values (RW of 100% The Economic Capital is the amount of the capital may entail capital charge of 8% and RW of 20% may (besides the Regulatory Capital) that the firm has to put entail capital charge of 1.6%.) at risk so as to cover the potential loss under the extreme The risk weights are to be refined by reference to a market conditions. In other words, it is the difference in rating provided by an external credit assessment insti- mark-to-market value of assets over liabilities that the tution that meets certain strict standards. bank should aim at or target. As against this, the regula-2) Foundation Internal Rating Based Approach : Under tory capital is the actual Capital Funds held by the bank this, bank rates the borrower and results are translated against the Risk Weighted Assets. into estimates of a potential future loss amount which After measuring the economic capital for the bank as forms the basis of minimum capital requirement. a whole, bank’s actual capital has to be allocated to indi-3) Advanced Internal Rating Based Approach: In vidual business units on the basis of various types of Advanced IRB approach, the range of risk weights risks. This process can be continued till capital is allo- will be well diverse. cated at transaction/customer level. Market Risk Menu: 1) Standardized Approach 2) Internal Models Approach X. RISK BASED SUPERVISION (RBS) Operational Risk Menu: The Reserve Bank of India presently has its supervi- sory mechanism by way of on-site inspection and off-site1) Basic Indicator Approach (Alpha) monitoring on the basis of the audited balance sheet of a Hence, one indicator for operational risk is identified bank. In order to enhance the supervisory mechanism, such as interest income, Risk Weighted Asset etc. the RBI has decided to put in place, beginning from the2) Standardized Approach (Beta) last quarter of the financial year 02-03, a system of Risk This approach specifies different indicators for dif- Based Supervision. Under risk based supervision, super- ferent lines/units of business and the summation of visors are expected to concentrate their efforts on ensur- different business lines such as Corporate Finance, ing that financial institutions use the process necessarily Retail Banking Asset Management, be done. to identify, measure and control risk exposure. The RBS3) Internal Measurement Approach (Gamma) is expected to focus supervisory attention in accordance Based on the past internal loss data estimation, for with the risk profile of the bank. The RBI has already each combination of business line, bank is required structured the risk profile templates to enable the bank to to calculate an expected loss value to ascertain the make a self-assessment of their risk profile. It is designed required capital to be allocated/assigned. to ensure continuous monitoring and evaluation of risk profile of the institution through risk matrix. This may optimize the utilization of the supervisory resources ofIX RISK AGGREGATION & CAPITAL ALLOCATION the RBI so as to minimize the impact of a crises situation Capital Adequacy in relation to economic risk is a nec- in the financial system. The transaction based audit andessary condition for the long-term soundness of banks. supervision is getting shifted to risk focused audit.Aggregate risk exposure is estimated through Risk Risk based supervision approach is an attempt to over-Adjusted Return on Capital (RAROC) and Earnings at come the deficiencies in the traditional point-in-time, transac-Risk (EaR) method. Former is used by bank with interna- tion-validation and value based supervisory system. It is for-tional presence and the RAROC process estimates the ward looking enabling the supervisors to diferentiate betweenCHARTERED ACCOUNTANT 850 FEBRUARY 2003
  11. 11. MANAGEMENTbanks to focus attention on those having high-risk profile. Investment and Operational areas. Integration of systems The implementation of risk based auditing would that includes both transactions processing as well as riskimply that greater emphasis is placed on the internal systems is critical for implementation.auditor’s role for mitigating risks. By focusing on effec- In a scenario where majority of profits are derivedtive risk management, the internal auditor would not from trade in the market, one can no longer afford toonly offer remedial measures for current trouble-prone avoid measuring risk and managing its implicationsareas, but also anticipate problems to play an active role thereof. Crossing the chasm will involve systematicin protecting the bank from risk hazards. changes coupled with the characteristic uncertainty and also the pain it brings and it may be worth the effort. The engine of the change is obviously the evolution of theXI CONCLUSION market economy abetted by unimaginable advances in Risk management underscores the fact that the survival technology, communication, transmission of relatedof an organization depends heavily on its capabilities to uncontainable flow of information, capital and com-anticipate and prepare for the change rather than just waiting merce through out the world. Like a powerful river, thefor the change and react to it. The objective of risk manage- market economy is widening and breaking down barri-ment is not to prohibit or prevent risk taking activity, but to ers. Government’s role is not to block that flow, but toensure that the risks are consciously taken with full knowl- accommodate it and yet keep it sufficiently under controledge, clear purpose and understanding so that it can be mea- so that it does not overflow its banks and drown us withsured and mitigated. It also prevents an institution from suf- the associated risks and undesirable side effects.fering unacceptable loss causing an institution to fail or To the extent the bank can take risk more con-materially damage its competitive position. Functions of risk sciously, anticipates adverse changes and hedgesmanagement should actually be bank specific dictated by the accordingly, it becomes a source of competitive advan-size and quality of balance sheet, complexity of functions, tage, as it can offer its products at a better price than itstechnical/ professional manpower and the status of MIS in competitors. What can be measured can mitigation isplace in that bank. There may not be one-size-fits-all risk more important than capital allocation against inade-management module for all the banks to be made applicable quate risk management system. Basel proposal pro-uniformly. Balancing risk and return is not an easy task as risk vides proper starting point for forward-looking banksis subjective and not quantifiable where as return is objective to start building process and systems attuned to riskand measurable. If there exist a way of converting the sub- management practice. Given the data-intensive naturejectivity of the risk into a number then the balancing exercise of risk management process, Indian Banks have a longwould be meaningful and much easier. way to go before they comprehend and implement Banking is nothing but financial inter-mediation Basel II norms, in to-to.between the financial savers on the one hand and the The effectiveness of risk measurement in banksfunds seeking business entrepreneurs on the other hand. depends on efficient Management Information System,As such, in the process of providing financial services, computerization and net working of the branch activi-commercial banks assume various kinds of risks both ties. The data warehousing solution should effectivelyfinancial and non-financial. Therefore, banking prac- interface with the transaction systems like core bankingtices, which continue to be deep routed in the philosophy solution and risk systems to collate data. An objectiveof securities based lending and investment policies, need and reliable data base has to be built up for which bankto change the approach and mindset, rather radically, to has to analyze its own past performance data relating tomanage and mitigate the perceived risks, so as to ulti- loan defaults, trading losses, operational losses etc., andmately improve the quality of the asset portfolio. come out with bench marks so as to prepare themselves As in the international practice, a committee approach for the future risk management activities. Any risk man-may be adopted to manage various risks. Risk agement model is as good as the data input. With theManagement Committee, Credit Policy Committee, Asset onslaught of globalization and liberalization from theLiability Committee, etc are such committees that handle last decade of the 20th Century in the Indian financialthe risk management aspects. While a centralized depart- sectors in general and banking in particular, managingment may be made responsible for monitoring risk, risk Transformation would be the biggest challenge, ascontrol should actually take place at the functional depart- transformation and change are the only certainties ofments as it is generally fragmented across Credit, Funds, the future. ■ 851CHARTERED ACCOUNTANT FEBRUARY 2003