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S.

K SOMAIYA COLLEGE OF ARTS, SCIENCE & COMMERCE
VIDYAVIHAR (EAST), MUMBAI - 400077

PROJECT ON:
“RISK MANAGEMENT IN BANKS”

MASTERS OF COMMERCE
(BANKING & FINANCE)

PART 2 (SEM -4)
(2017-2018)

Submitted:
In Partial Fulfillment of the requirements
For the Award of the Degree of
MASTERS OF COMMERCE
(BANKING & FINANCE)
BY

KRISHNA BHANUSHALI
ROLL NO: 6

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DECLARATION

I KRISHNA BHANUSHALI student of class in MCOM (BANKING & FINANCE)
PART 2 (SEM-4), ROLL NO.6, academic year 2017-2018 Studying at S.K. SOMAIYA
COLLEGE OF ARTS, SCIENCE AND COMMERCE, hereby declare that the work done
on the project Entitled “RISK MANAGEMENT IN BANKS” is true and original and any
Reference used in this project is duly acknowledged.

DATE:
PLACE: MUMBAI -----------------------------
SIGNATURE OF STUDENT
(KRISHNA BHANUSHALI)

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CERTIFICATE
This is to certify that MRS.KRISHNA BHANUSHALI, studying in MCOM (BANKING
& FINANCE) PART 2 (SEM-4), ROLL NO.6, academic year 2017-2018 at
S.K.SOMAIYA COLLEGE OF ARTS, SCIENCE & COMMERCE has completed the
project on ‘RISK MANAGEMENT IN BANKS’ under the guidance of PROF. PRAVIN
MALU
The information submitted herein is true and original to the best of my knowledge.

___________________ ______________________
Prof. PRAVIN MALU DR. SANGEETA KOHLI
[PROJECT GUIDE] [PRINCIPAL]

____________________ _________________
EXTERNAL EXAMINER [CO-ORDINATOR]

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Thank You. hereby declare that information provided in this project is true as per the best of my knowledge. 6 for her project.PRAVIN MALU has guided KRISHNA BHANUSHALI. DECLARATION BY GUIDE I the undersigned PROF. I. PRAVIN MALU) Project Guide 4 | Page . ROLL NO. (PROF. Yours Faithfully. She has completed the project on RISK MANAGEMENT IN BANKS successfully.

I have taken every care to check mistake and misprint yet it is difficult to claim perfection. Although. I am also thankful to my project guide PRAVIN MALU for his valuable guidance and for providing an insight to the subject. SANGEETA KOHLI. the principal of our college. I am eternally grateful to almighty god for giving me the spirit to put in my best effort towards my project. I owe my sincere gratitude to DR. 5 | Page .K Somaiya College for the numerous books made me available for the handy reference. will be thankfully acknowledged by me. ACKNOWLEDGEMENT It gives me immense pleasure to present a project on ‘RISK MANAGEMENT IN BANKS’ As a MCOM student it is a great honour to undergo a project work at an graduate level and I would like to thank the University of Mumbai for giving me such a golden opportunity. omission and suggestion brought to my notice. I am also obliged to the library staff of S. Any error.

INDEX: Sr. no Particulars Page number 1) Introduction 07-9 2) Definition of risks 10-13 3) Risks in banking business 14 4) Types of risks 15-21 5) Risk management practises in 22-24 India 6) Role of RBI in risk management 25-26 7) The BASEL Committee on 27-33 Banking Supervision 8) Global finance crisis and the 34-35 Indian economy 9) Conclusion 36 10) References 37 Risks and Risk Management in the Banking Sector INTRODUCTION: 6 | Page .

the banking sector is considerably strong at present but at the same time. financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Thus the need for an efficient risk management framework is paramount in order to factor in internal and external risks. risk plays a major part in the earnings of a bank. The more risk averse a bank is. but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. Hence. banking is considered to be a very risky business. The higher the risk. the foundation of a sound economy depends on how sound the Banking sector is and vice versa. introduction of innovative products. Financial institutions must 7 | Page . the safer is their Capital base The Banking sector has a pivotal role in the development of an economy. hence. The financial sector in various economies like that of India are undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. It is the key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilisation so as to attain maximum productivity (Sharma.Risk management in Indian banks is a relatively newer practice. the higher the return. and financial instruments as well as innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management. The 2007–present recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. In banks and other financial institutions. quality. an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Hence. However. Indian Banks have been making great advancements in terms of technology. 2003). In fact. it is essential to maintain a parity between risk and return. The various aspects of increasing global competition to Indian Banks by Foreign banks. In India. such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. as well as stability such that they have started to expand and diversify at a rapid rate. increasing Deregulation. management of Financial risk incorporating a set systematic and professional methods especially those defined by the Basel II becomes an essential requirement of banks. In times of volatility and fluctuations in the market.

However. while 15 percent work in analytics. As risk is directly proportionate to return. brand reputation and above all dangerous leverage. Therefore. However. Today. banks will help risk functions avoid being overwhelmed by the new demands. but they must do so consciously (Carey. McKinsey research suggests that by 2025. Risk management in banking has been transformed over the past decade. respectively . In case something goes wrong. it should be borne in mind that banks are very fragile institutions which are built on customers’ trust. it can expect to make more money. be they technological advances. largely in response to regulations that emerged from the global financial crisis and the fines levied in its wake. In fact.The change expected in the risk function’s operating model illustrates the magnitude of what lies ahead. Unsound risk management practices governing bank lending often plays a central role in 80 financial turmoil. the future undoubtedly holds more regulation—both financial and nonfinancial—even for banks operating in emerging economies. 2001). greater risk also increases the danger that the bank may incur huge losses and be forced out of business. Thus. Banks.981 . bank management must take utmost care in identifying the type as well as the degree of its risk exposure and tackle those effectively. Moreover. today. a bank must run its operations with two goals in mind – to generate profit and to stay in business (Marrison. the more risk a bank takes. But important trends are a foot that suggest risk management will experience even more sweeping change in the next decade . or banking scandals. 2004).No one can draw a blueprint of what a bank’s risk function will look like in 2025—or predict all forthcoming disruptions. macroeconomic shocks. maintaining a trade-off between risk and return is the business of risk management. banks can collapse and failure of one bank is sufficient to send shock waves right through the economy (Rajadhyaksha. Moreover. try to ensure that their risk taking is informed and prudent. 2005). The trends furthermore suggest that banks can take some initiatives now to deliver short-term results while preparing for the coming changes. But the fundamental trends do permit a broad sketch of what will be required of the risk function of the future. While the magnitude and speed of regulatory change is unlikely to be uniform across countries. bankers must see risk management as an ongoing and valued activity with the board setting the example. By acting now. risk management in the banking sector is a key issue linked to financial system stability. about 50 percent of the function’s staff are dedicated to risk- related operational processes such as credit administration. therefore.take risk. most notably seen during the Asian financial crisis of 1997. 8 | Page . these numbers will be closer to 25 and 40 percent.

Kumar. An activity which may give profits or result in loss may be called a risky 9 | Page . banks are being required to assist in crackdowns on illegal and unethical financial transactions by detecting signs of money laundering. and financial inclusion could eventually be applied in the same way. Governments are exerting regulatory pressure in other forms. sanctions busting. environmental standards. But the future of internal bank models for the calculation of regulatory capital. for example. Regulations relating to employment practices. and to facilitate the collection of taxes. especially for low-risk portfolios such as mortgages or high-quality corporate loans. fraud. Governments are also demanding that their banks comply with national regulatory standards wherever they operate in the world. and tax collection. is still being decided.Much of the impetus comes from public sentiment. and the financing of terrorism. Banks operating abroad must already adhere to US regulations concerning bribery. too. fraud. Increasingly. Most parts of the prudential regulatory framework devised to prevent a repetition of the 2008 financial crisis are now in place in financial markets in developed economies. Definition of Risk A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings (Vasavada. 2005). which is ever less tolerant of bank failures and the use of public money to salvage them. Rao & Pai. as well as the potential use of a standardized approach as a floor (Basel IV). The proposed changes could have substantial implications.

In 2014. as customers will expect intuitive. Although the terms risk and uncertainty are often used synonymously. On the contrary. Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. They also earned banks an attractive 22 percent return on equity. Chandrasekhar & Patwardhan 2005). risk is related to a situation in which the decision- maker knows the probabilities of the various outcomes. Chatterjee. but many then steadily extend their services. Risk may mean that there is a possibility of loss or damage which. or fintechs. and raised fears of a worldwide economic meltdown due to financial contagion. 2009). may or may not happen. seamless experiences. most of Southeast Asia and Japan saw slumping currencies. risk is a quantifiable uncertainty. which generated a 6 percent return on equity. much higher than the gains they received from the provision of balance sheet and fulfillment. It may be financial loss or loss to the reputation/ image (Sharma. Uncertainty is the case when the decision-maker knows all the possible outcomes of a particular act. In the simplest words. 2003). risk may be defined as possibility of loss. adverse in relation to planned objective or expectations (Kumar. Risks may be defined as uncertainties resulting in adverse outcome. As the crisis spread. devalued stock markets and other asset prices. Technological innovation has ushered in a new set of competitors: financial- technology companies. there is difference between the two (Sharan.1 The seamless and simple apps and online services that fintechs offer are beginning to break banks’ heavy gravitational pull on customers. and a precipitous rise in private debt. after exhaustive efforts to support it in the face of a severe financial over extension that was in part real estate driven. they will have to up their game. but they do want to take over the direct customer relationship and tap into the most lucrative part of the value chain—origination and sales. Asian Financial Crisis: The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997. In short. these activities accounted for almost 60 percent of banks’ profits. At the time.proposition due to uncertainty or unpredictability of the activity of trade in future. access to services at any time on any device. 10 | P a g e . it can be defined as the uncertainty of the outcome. If banks want to keep their customers. personalized propositions. Most fintechs start by asking customers to transfer a single piece of their financial business. In other words. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht. cutting its peg to the USD. but does not have an idea of the probabilities of the outcomes. They do not want to be banks. Risk refers to ‘a condition where there is a possibility of undesirable occurrence of a particular result which is known or best quantifiable and therefore insurable’ (Periasamy. 2008). and instant decisions.

quality. It may be possible eventually to create the “segment of one. set a high customer-service bar for banks—and present new challenges for their risk functions. The risk function will have to work closely with each business to meet these kinds of customer expectations while containing risk to the bank. working jointly with operations and other functions. instant component of every key customer journey. where most of the requested data can be drawn from public sources. Amazon and eBay trade information. increasing Deregulation. For banks to deliver at this level. and United Parcel Service shipment volumes. and financial instruments as well as innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management. Risk management will need to become a seamless.Banks’ responses to higher customer expectations will be automated: an instant response to retail and corporate credit decisions. Some are designing account-opening processes. The 2007–present recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. it draws upon a wide range of customer information from data sources such as PayPal transactions. Kabbage does not require loan applicants to fill out lengthy documents to establish creditworthiness. While it remains to be seen how such fintechs perform in the longer term. Technology also enables banks and their competitors to offer increasingly customized services. introduction of innovative products. they will have to be redesigned from the perspective of customer experience and then digitized at scale. Indian Banks have been making great advancements in terms of technology. however. as well as stability such that they have started to expand and diversify at 11 | P a g e . This degree of customization is expensive for banks to achieve because of the complexity of supporting processes. banks are learning from them. for example.” tailoring prices and products to each individual. rapid online account-opening process. The financial sector in various economies like that of India are undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. for example. a small-business lender that operates in the United Kingdom and the United States. The various aspects of increasing global competition to Indian Banks by Foreign banks. Instead. To find ways to provide these highly customized solutions while managing the risk will be the task of the risk function. to protect consumers from inappropriate pricing and approval decisions. Fintechs such as Kabbage. Regulatory constraints might well be imposed in this area. and a simple.

maintaining a trade-off between risk and return is the business of risk management. Thus. the banking sector is considerably strong at present but at the same time. The higher the risk. But important trends are a foot that suggest risk management will experience even more sweeping change in the next decade . the foundation of a sound economy depends on how sound the Banking sector is and vice versa.981 . 2005). 2004). In fact. largely in response to regulations that emerged from the global financial crisis and the fines levied in its wake. a bank must run its operations with two goals in mind – to generate profit and to stay in business (Marrison. In banks and other financial institutions. the safer is their Capital base The Banking sector has a pivotal role in the development of an economy. it is essential to maintain a parity between risk and return. Banks. about 50 percent of the function’s staff are dedicated to risk- 12 | P a g e . In India. However. today. As risk is directly proportionate to return. However. Moreover. greater risk also increases the danger that the bank may incur huge losses and be forced out of business. The more risk averse a bank is. hence. Financial institutions must take risk. brand reputation and above all dangerous leverage. therefore. Hence. the more risk a bank takes. However. Therefore. risk management in the banking sector is a key issue linked to financial system stability. banks can collapse and failure of one bank is sufficient to send shock waves right through the economy (Rajadhyaksha. banking is considered to be a very risky business.a rapid rate. It is the key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilisation so as to attain maximum productivity (Sharma. try to ensure that their risk taking is informed and prudent. Risk management in banking has been transformed over the past decade. bankers must see risk management as an ongoing and valued activity with the board setting the example. the higher the return. such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. In case something goes wrong. it can expect to make more money. most notably seen during the Asian financial crisis of 1997. but they must do so consciously (Carey. risk plays a major part in the earnings of a bank. management of Financial risk incorporating a set systematic and professional methods especially those defined by the Basel II becomes an essential requirement of banks. bank management must take utmost care in identifying the type as well as the degree of its risk exposure and tackle those effectively. Unsound risk management practices governing bank lending often plays a central role in 80 financial turmoil. 2001). 2003). Moreover.The change expected in the risk function’s operating model illustrates the magnitude of what lies ahead. Today. it should be borne in mind that banks are very fragile institutions which are built on customers’ trust. In fact.

related operational processes such as credit administration. or banking scandals. By acting now. while 15 percent work in analytics. Mobile banking. The trends furthermore suggest that banks can take some initiatives now to deliver short-term results while preparing for the coming changes. the banking sector has witnessed tremendous competition not only from the domestic banks but from foreign banks alike. macroeconomic shocks. respectively . banks will help risk functions avoid being overwhelmed by the new demands. Credit Cards. 13 | P a g e . competition in the banking sector has emerged due to disintermediation and deregulation. McKinsey research suggests that by 2025. introduced facilities like ATMs. these numbers will be closer to 25 and 40 percent. The liberalised economic scenario of the country has opened various new avenues for increasing revenues of banks. In order to grab this opportunity. But the fundamental trends do permit a broad sketch of what will be required of the risk function of the future. Risk in Banking Business In the post LPG period. be they technological advances.No one can draw a blueprint of what a bank’s risk function will look like in 2025—or predict all forthcoming disruptions. In fact. Indian commercial banks have launched several new and innovated products.

2003). providing various delivery channels. risk exposure of banks has also increased considerably. Type of Risks Risk may be defined as ‘possibility of loss’. the two most important developments that have made it imperative for Indian commercial banks to give emphasise on risk management are discussed below Deregulation: The era of financial sector reforms which started in early 1990s has culminated in deregulation in a phased manner. Banks like any other commercial organisation also intend to take risk. In the backdrop of all these developments i. In short. deregulation in the Indian economy and product/ technological innovation. However. Technological innovation: Technological innovations have provided a platform to the banks for creating an environment for efficient customer 82 services as also for designing new products. In fact. But higher risks may also result into higher losses.e. it is technological innovation that has helped banks to manage the assets and liabilities in a better way. Insurance etc. and maintain appropriate capital to take care of any eventuality. the importance of risk management of banks has been elevated by technological developments. higher the gain would be. reducing manual intervention in back office functions etc.Internet banking etc. This has made it imperative for banks to pay more attention to risk management. as commonly referred. measure and price risk. 1997). banks are prudent enough to identify. reducing processing time of transactions. However. The major risks in banking business or ‘banking risks’. Deregulation has given banks more autonomy in areas like lending. banks are required to manage their own business themselves and at the same time maintain liquidity and profitability. which need to be managed professionally so that the opportunities provided by the technology are not negated. Thus. which is inherent in any business. investment. the emergence of new financial instruments. are being designed/ upgraded and served to attract more customers to their fold. it is seen that Mutual Funds. which may be financial loss or loss to the image or reputation. As a result of these developments. In fact. this has forced banks to focus their attention to risk management (Sharma. Higher the risk taken. are listed below 14 | P a g e .. deregulation and heightened capital market volatility (Mishra. Apart from the traditional banking products. interest rate structure etc. all these developments have also increased the diversity and complexity of risks.

In 15 | P a g e . (b) Time Risk: Time risk arises from the need to compensate for nonreceipt of expected inflows of funds i.. 2005). It may also arise when a bank may not be able to undertake profitable business opportunities when it arises. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail). For banks. thereby making the liabilities subject to rollover or refinancing risk (Kumar et al. Interest Rate risk Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected due to changes in the interest rates. funding liquidity risk is crucial. It can be also defined as the possibility that an institution may be unable to meet its maturing commitments or may do so only by borrowing funds at prohibitive costs or by disposing assets at rock bottom prices. (c) Call Risk: Call risk arises due to crystallisation of contingent liabilities. performing assets turning into non-performing assets.e.. Liquidity Risk  Interest Rate Risk  Market Risk  Credit or Default Risk  Operational Risk Type of Risks Type of ‘Banking Risks’ Liquidity Interest Rate Market Credit/Default Operational Risk 83 Liquidity Risk Funding Risk Time Risk Call Risk Interest Rate Risk Gap Risk Yield Curve Basis Embedded Reinvested Net Interest Position Risk Option Risk Market Risk Forex Risk Market Liquidity Risk Credit Risk Counterparty Risk Country Risk Operational Risk Transaction Risk Compliance Risk Liquidity Risk: The liquidity risk of banks arises from funding of long-term assets by short-term liabilities. The liquidity risk in banks manifest in different dimensions. (a) Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations.

The basis risk is quite visible in volatile interest rate scenarios (Kumar et al. Thus. liabilities and Off- Balance Sheet (OBS) positions. term loans and exercise of call/put options on bonds/ debentures and/ or premature withdrawal of term deposits before their stated 16 | P a g e ..other words..e. which is rather frequent. call market rates. thereby creating exposure to unexpected changes in the level of market interest rates. would affect the NII. 2003). IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s assets. In a raising rate scenario both. (d) Embedded Option Risk: Significant changes in market interest rates create the source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans. An example would be when a liability raised at a rate linked to say 91 days T Bill is used to fund an asset linked to 364 days T Bills. The loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk.. (b) Yield Curve Risk: Banks. MIBOR etc. 2005). may price their assets and liabilities based on different benchmarks. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities then any non-parallel movements in the yield curves. in a floating interest scenario. 2005). fixed deposit rates. For example. the basis has moved against the banks. the risk of an adverse impact on Net Interest Income (NII) due to variations of interest rate may be called Interest Rate Risk (Sharma. treasury bills’ yields. asset interest rate may rise in different magnitude than the interest rate on corresponding liability. maturity dates or re-pricing dates. in a rising interest rate scenario. It is the exposure of a Bank’s financial condition to adverse movements in interest rates. banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. When the variation in market interest rate causes the NII to expand. The following are the types of Interest Rate Risk (a) Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities and Off-Balance Sheet items with different principal amounts. thereby creating variation in net interest income. i. the banks have experienced favourable basis shifts and if the interest rate movement causes the NII to contract. (c) Basis Risk: Basis Risk is the risk that arises when the interest rate of different assets. liabilities and off-balance sheet items may change in different magnitude. 91 days and 364 days T Bills may increase but not identically due to non-parallel movement of yield curve creating a variation in net interest earned (Kumar et al. Interest rate Risk can take different forms. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities.

bond prices and yields are inversely related. This is because market interest received on loan and to be paid on deposits move in different directions. due to market movements. The price risk is closely associated with the trading book. Its impact is on the earnings of the bank or its impact is on the economic value of the banks’ assets. or a combination of the two.. It is also referred to as Price Risk. (a) Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position either spot or forward. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments. (f) Net Interest Position Risk: Net Interest Position Risk arises when the market interest rates adjust downwards and where banks have more earning assets than paying liabilities.. which is created for making profit out of short-term movements in interest rates. Market Risk The risk of adverse deviations of the mark-to-market value of the trading portfolio. the greater will be the embedded option risk to the banks’ Net Interest Income. The faster and higher the magnitude of changes in interest rate. 17 | P a g e . (ii) Pricing risk for all other assets/ portfolio that are held in the trading book of the bank and (iii) Foreign Currency Risk. and currencies. Price risk occurs when assets are sold before their stated maturities. In the financial market. commodities. Such banks will experience a reduction in NII as the market interest rate declines and the NII increases when interest rate rises.e. 2005). during the period required to liquidate the transactions is termed as Market Risk (Kumar et al. Any mismatches in cash flows i. The term Market risk applies to (i) that part of IRR which affects the price of interest rate instruments. The result is the reduction of projected cash flow and the income for the bank. liabilities and OBS positions. The embedded option risk is experienced in volatile situations and is becoming a reality in India. equities.maturities. in an individual foreign currency. inflow and outflow would expose the banks to variation in Net Interest Income. e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with regard to interest rate at which the future cash flows could be reinvested.

Credit Risk depends on both external and internal factors. 88 There are two variants of credit risk which are discussed below (a) Counterparty Risk: This is a variant of Credit risk and is related to non- performance of the trading partners due to counterparty’s refusal and or inability to perform. loans are the largest and most obvious source of credit risk. more so in the Indian scenario where the NPA level of the banking system is significantly high (Sharma. credit risk can be defined as the risk that the interest or principal or both will not be paid as promised and is estimated by observing the proportion of assets that are below standard. Credit Risk can’t be avoided but has to be managed by applying various risk mitigating processes 18 | P a g e . The internal factors include 1. The major external factors 1. Malaysia. Credit risk is borne by all lenders and will lead to serious problems. 4. which emerged due to rise in NPAs to over 30% of the total assets of the financial system of Indonesia. The Asian Financial crisis. 2003). Deficiency in credit policy and administration of loan portfolio. etc. It is the most significant risk. Deficiency in appraising borrower’s financial position prior to lending. Default or Credit Risk Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms. etc. The state of economy 2. foreign exchange rates and interest rates. South Korea and Thailand. 2. highlights the importance of management of credit risk. In other words. For most banks. (b) Country Risk: This is also a type of credit risk where non-performance of a borrower or counterparty arises due to constraints or restrictions imposed by a country.(b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price. 3. Here. Bank’s failure in post-sanction follow-up. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk. Swings in commodity price. the reason of non-performance is external factors on which the borrower or the counterparty has no control. Excessive dependence on collaterals. if excessive.

(b) Compliance Risk: Compliance risk is the risk of legal or regulatory sanction. Profitability Ratio etc. failed business processes and the inability to maintain business continuity and manage information. financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws. codes of conduct and standards of good practice. Higher level of automation in rendering banking and financial services 2. review/ renewal. Increase in global financial inter-linkages Scope of operational risk is very wide because of the above mentioned reasons..1. regulations. Alertness on the part of operating staff at all stages of credit dispensation – appraisal.e. 89 By applying a regular evaluation and rating system of all investment opportunities. Credit rating is main tool of measuring credit risk and it also facilitates pricing the loan. operational loss has mainly three exposure classes namely people. 5. There should be provision for flexibility to allow variations for very special circumstances. Thus. Debt Service Coverage Ratio. Debt Equity Ratio. people and systems or from external events’. Operational Risk Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes. Banks should assess the credit worthiness of the borrower before sanctioning loan i. 19 | P a g e . Two of the most common operational risks are discussed below (a) Transaction Risk: Transaction risk is the risk arising from fraud. 2. disbursement. postsanction follow-up can also be useful for avoiding credit risk. 3. It is also called integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing. There should be maximum limit exposure for single/ group borrower. Banks should fix prudential limits on various aspects of credit – benchmarking Current Ratio. credit rating of the borrower should be done beforehand. 4. both internal and external. banks can reduce its credit risk as it can get vital information of the inherent weaknesses of the account. Managing operational risk has become important for banks due to the following reasons 1. processes and systems.

would affect the NII. may price their assets and liabilities based on different benchmarks. For example. call market rates. This is because market interest received on loan and to be paid on deposits move in different directions. which is rather frequent. term loans and exercise of call/put options on bonds/ debentures and/ or premature withdrawal of term deposits before their stated maturities.e. 20 | P a g e . liabilities and off-balance sheet items may change in different magnitude.. MIBOR etc. (c) Basis Risk: Basis Risk is the risk that arises when the interest rate of different assets. An example would be when a liability raised at a rate linked to say 91 days T Bill is used to fund an asset linked to 364 days T Bills. (d) Embedded Option Risk: Significant changes in market interest rates create the source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans. the greater will be the embedded option risk to the banks’ Net Interest Income. The loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios (Kumar et al.. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. treasury bills’ yields. 91 days and 364 days T Bills may increase but not identically due to non-parallel movement of yield curve creating a variation in net interest earned (Kumar et al.. 2005). When the variation in market interest rate causes the NII to expand. Thus. inflow and outflow would expose the banks to variation in Net Interest Income. thereby creating variation in net interest income.e. The result is the reduction of projected cash flow and the income for the bank.. banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities then any non-parallel movements in the yield curves. in a floating interest scenario. i. Any mismatches in cash flows i.(b) Yield Curve Risk: Banks. In a raising rate scenario both. the basis has moved against the banks. in a rising interest rate scenario. e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with regard to interest rate at which the future cash flows could be reinvested. The embedded option risk is experienced in volatile situations and is becoming a reality in India. The faster and higher the magnitude of changes in interest rate. the banks have experienced favourable basis shifts and if the interest rate movement causes the NII to contract. asset interest rate may rise in different magnitude than the interest rate on corresponding liability. 2005). fixed deposit rates.

Initially. 2003). liabilities and OBS positions. This happens despite adequate knowledge of the situation. the Indian banks have used risk control systems that kept pace with legal environment and Indian accounting standards. Risk Management Practices in India Risk Management. (b) Reputation Risk: Reputation Risk is the risk arising from negative public opinion. risk. Therefore. Such banks will experience a reduction in NII as the market interest rate declines and the NII increases when interest rate rises. the challenge of Indian banks is to establish a coherent framework for measuring and managing risk consistent with corporate goals and responsive to the 21 | P a g e . is actually a combination of management of uncertainty. arises due to lack of information and this uncertainty gets transformed into risk (where estimation of outcome is possible) as information gathering progresses. risk management provides solution for controlling risk. according to the knowledge theorists. incentive system to manage agency problems in risk- reward framework and cultural systems to deal with equivocality. Other Risks Apart from the above mentioned risks. equivocality and error (Mohan. That is why. This risk is a function of the compatibility of an organisation’s strategic goals. Uncertainty . improper implementation of decisions or lack of responsiveness to industry changes. 2005) (a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions. financial loss or decline in customer base. This risk may expose the institution to litigation. As information about markets and knowledge about possible outcomes increases. Its impact is on the earnings of the bank or its impact is on the economic value of the banks’ assets. following are the other risks confronted by Banks in course of their business operations (Kumar et al. banking as well as other institutions develop control systems to reduce errors. the resources deployed against these goals and the quality of implementation. banks are exposed to mark-to-market accounting (Mishra.(f) Net Interest Position Risk: Net Interest Position Risk arises when the market interest rates adjust downwards and where banks have more earning assets than paying liabilities..where outcome cannot be estimated even randomly. 1997). Equivocality arises due to conflicting interpretations and the resultant lack of judgment. the business strategies developed to achieve those goals. information systems to reduce uncertainty. But with the growing pace of deregulation and associated changes in the customer’s behaviour.

After the evolution of the BIS prudential norms in 1988. management of credit. the focus of the statutory regulation of commercial banks by RBI until the early 1990s was mainly on licensing. which functions under the aegis of the RBI. assets quality. The Basel Committee on Banking Supervision of the Bank for International Settlements (BIS) has recommended using capital adequacy. earnings and liquidity (CAMEL) as criteria for assessing a Financial Institution. and also the targeted appraisals by the Reserve Bank. In 1988. CAMELS 92 framework is a common method for evaluating the soundness of Financial Institutions. most of the developing countries are using CAMEL instead of CAMELS in the performance evaluation of the FIs. Therefore. are now 22 | P a g e . sensitivity to market risk (S) was added to CAMEL in 1997 (Gilbert. 2004). Asset Quality. and ensured that the prudential norms were applied over the period and across different segments of the financial sector in a phased manner. However. At the same time. In India. banks should maintain vigil on the convergence of regulatory frameworks in the country. the business practices. The sixth component. the supervision had to focus essentially on solvency issues. The supervisory jurisdiction of the BFS now extends to the entire financial system barring the capital market institutions and the insurance sector. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS). it was in the year 1999 that RBI recognised the need of an appropriate risk management and issued guidelines to banks regarding assets liability management. The CAMELS Model consists of six components namely Capital Adequacy. the need of the hour is to follow certain risk management norms suggested by the RBI and BIS. administration of minimum capital requirements. The Central Banks in some of the countries like Nepal. 2000). pricing of services including administration of interest rates on deposits as well as credit. Management. The periodical on-site inspections. Kenya use CAEL instead of CAMELS (Baral. reserves and liquid asset requirements (Kannan. Finally. 2005). In these circumstances.developments in the market. to suit the demanding needs of a strong and stable financial system. management quality. market and operational risks. The Reserve Bank of India has been using CAMELS rating to evaluate the financial soundness of the Banks. Liquidity and Sensitivity to Market risk. it also took care to keep in view the socio-economic conditions of the country. the RBI took a series of measures to realign its supervisory and regulatory standards and bring it at par with international best practices. Meyer & Vaughan. Earnings Quality. changes in the international accounting standards and finally and most importantly changes in the clients’ business practices. As the market is dynamic. payment systems prevalent in the country and the predominantly agrarian nature of the economy.

Asset quality. additional off site surveillance. liquidity and interest rate risks.e. A high-risk sensitive bank will be subjected to more intensive supervision by shorter periodicity with greater use of supervisory tools aimed on structural meetings.supplemented by off-site surveillance which particularly focuses on the risk profile of the supervised institution. operational soundness and management prudence. The off-site monitoring system consists of capital adequacy. 93 Earnings. It focuses on core assessments in accordance with the statutory mandate. Thus. the RBI has moved towards more stringent capital adequacy norms and adopted the CAMEL (Capital adequacy. The main supervisory issues addressed by Board for Financial Supervision (BFS) relate to on-site and off-site supervision of banks. Compliance and Systems & Control) in respect of foreign banks has been put in place from 1999. As a result. i. regular on site inspection etc. liquidity.. Asset Quality. 23 | P a g e . the thrust lies upon Risk . in view of the recent trends towards financial integration. Apart from this. on the basis of RBS. Moreover. Liquidity) based rating system for evaluating the soundness of Indian banks.Based Supervision (RBS). asset quality. it has become necessary for the BFS to supplement on-site supervision with off-site surveillance so as to capture ‘early warning signals’ from off-site monitoring that would be helpful to avert the likes of East Asian financial crisis (Sireesha. connected lending. The Reserve Bank’s regulatory and supervisory responsibility has been widened to include financial institutions and non- banking financial companies. Thus. banks are rated on this basis. currency. The on-site supervision system for banks is on an annual cycle and is based on the ‘CAMEL’ model. Since then. solvency. globalisation. considering the changes in the Banking industry.. 2008). This will be undertaken in order to ensure the stability of the Indian Financial System. a risk profile of individual Bank will be prepared. Management. A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital. large credit and concentration. earnings and risk exposures viz. competition. the fundamental and technical analysis of stock of banks in the secondary market will serve as a supplementary indicator of financial performance of banks.

Management. At the same time. Asset Quality. The CAMELS Model consists of six components namely Capital Adequacy. The Central Banks in some of the countries like Nepal. the RBI took a series of measures to realign its supervisory and regulatory standards and bring it at par with international best practices. Kenya use CAEL instead of CAMELS (Baral. The Basel Committee on Banking Supervision of the Bank for International Settlements (BIS) has recommended using capital adequacy. CAMELS 92 framework is a common method for evaluating the soundness of Financial Institutions. Liquidity and Sensitivity to Market risk. pricing of services including administration of interest rates on deposits as well as credit. In 1988. assets quality. reserves and liquid asset requirements (Kannan. the focus of the statutory regulation of commercial banks by RBI until the early 1990s was mainly on licensing. In these circumstances. After the evolution of the BIS prudential norms in 1988. 2004). most of the developing countries are using CAMEL instead of CAMELS in the performance evaluation of the FIs. it also took care to keep in view the socio-economic conditions of the country. 2005).Role of RBI in Risk Management in Banks The Reserve Bank of India has been using CAMELS rating to evaluate the financial soundness of the Banks. In India. payment systems prevalent in the country and the 24 | P a g e . 2000). However. the supervision had to focus essentially on solvency issues. Meyer & Vaughan. earnings and liquidity (CAMEL) as criteria for assessing a Financial Institution. sensitivity to market risk (S) was added to CAMEL in 1997 (Gilbert. Earnings Quality. administration of minimum capital requirements. management quality. the business practices. The sixth component.

Moreover. Thus. 2008). Thus. a risk profile of individual Bank will be prepared. considering the changes in the Banking industry. A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital. management of credit. The Reserve Bank’s regulatory and supervisory responsibility has been widened to include financial institutions and non- banking financial companies. Liquidity) based rating system for evaluating the soundness of Indian banks. market and operational risks. which functions under the aegis of the RBI. liquidity and interest rate risks. banks are rated on this basis. the thrust lies upon Risk . earnings and risk exposures viz. are now supplemented by off-site surveillance which particularly focuses on the risk profile of the supervised institution. Asset Quality. connected lending. The periodical on-site inspections. globalisation. asset quality. liquidity. Management. The on-site supervision system for banks is on an annual cycle and is based on the ‘CAMEL’ model. Compliance and Systems & Control) in respect of foreign banks has been put in place from 1999. The off-site monitoring system consists of capital adequacy.. in view of the recent trends towards financial integration.predominantly agrarian nature of the economy. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS). the fundamental and technical analysis of stock of banks in the secondary market will serve as a supplementary indicator of financial performance of banks.Based Supervision (RBS). it was in the year 1999 that RBI recognised the need of an appropriate risk management and issued guidelines to banks regarding assets liability management. and also the targeted appraisals by the Reserve Bank. the RBI has moved towards more stringent capital adequacy norms and adopted the CAMEL (Capital adequacy. large credit and concentration. currency. Asset quality. it has become necessary for the BFS to supplement on-site supervision with off-site surveillance so as to capture ‘early warning signals’ from off-site monitoring that would be helpful to avert the likes of East Asian financial crisis (Sireesha. The supervisory jurisdiction of the BFS now extends to the entire financial system barring the capital market institutions and the insurance sector. on the basis of RBS. operational soundness and management prudence. 93 Earnings.e. It focuses on core assessments in accordance with the statutory mandate.. competition. Apart from this. to suit the demanding needs of a strong and stable financial system. Finally. solvency. Since then. As a result. i. A high-risk sensitive bank will be subjected to more intensive supervision by shorter periodicity with greater use of 25 | P a g e . and ensured that the prudential norms were applied over the period and across different segments of the financial sector in a phased manner. The main supervisory issues addressed by Board for Financial Supervision (BFS) relate to on-site and off-site supervision of banks.

it formulates broad supervisory standards and guidelines and recommends the statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements – statutory or otherwise – which are best suited to their own national systems (NEDfi Databank Quarterly. Switzerland. United Kingdoms and the United States. regular on site inspection etc. however. As this Committee usually meets at the Bank of International Settlement (BIS) in Basel. the Central Bank Governors of the Group of Ten countries formed a Committee of banking supervisory authorities. The 94 Committee’s members came from Belgium. In addition. These decisions cover a very wide range of financial issues. The Committee reports to the central bank Governors of the Group of Ten countries and seeks the Governors’ endorsement for its major initiatives. the Netherlands. since the Committee contains representatives from institutions. In this way. One important objective of the Committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles – that no foreign banking establishment should escape supervision 26 | P a g e . and its conclusions do not. Germany. which are not central banks. Sweden. Italy. Luxembourg. This will be undertaken in order to ensure the stability of the Indian Financial System. Rather. The Basel Committee does not possess any formal supra-national supervisory authority. Countries are represented by their central banks and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. 2004). Japan. this Committee came to be known as the Basel Committee. have legal force. Spain. France. the decision involves the commitment of many national authorities outside the central banking fraternity. and were never intended to. the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation of member countries’ supervisory techniques. additional off site surveillance.supervisory tools aimed on structural meetings. Canada. The BASEL Committee on Banking Supervision At the end of 1974. Switzerland.

guarantor or collateral (Lastra. is divided into Tier 1 (equity capital plus disclosed reserves minus goodwill) and Tier 2 (asset revaluation reserves. The weights represent a compromise between differing views. and are not ‘stated truths’ about the risk profile of the asset portfolio. the BASEL Committee decided to introduce a capital measurement system (BASEL I) commonly referred to as the Basel Capital Accord. BASEL I In 1988. The basic achievement of Basel I has been to define bank capital and the socalled bank capital ratio. To achieve this. The numerator. available in the event of liquidation. Capital. Some of the risk weights are rather ‘arbitrary’ (for example. Since 1988. Subordinated debt (with a minimum fixed term to maturity of five years. 50 % for residential mortgages. 20 % for Organisation for Economic Cooperation and Development (OECD) inter-bank claims. the Committee has issued a long series of documents since 1975. Towards the end of 1992. 100 % for all commercial and consumer loans). 20 per cent. There are five credit risk weights: 0 per cent. The denominator of the Basel I formula is the sum of risk- adjusted assets plus off-balance sheet items adjusted to risk. but rather the result of bargaining on the basis of historical data available at that time on loan performance and judgments about the level of risk of certain parts of counterpart. general loan loss reserves. undisclosed reserves. this system provided for the implementation of a credit risk measurement framework with minimum capital standard of 8%.and the supervision should be adequate. this framework has been progressively introduced not only in member 95 countries but also in virtually all other countries with active international banks. 10 per cent. 0 % for government or central bank claims. Tier 1 capital ought to constitute at least 50 per cent of the total capital base. hybrid capital instrument and subordinated term debt). The risk 27 | P a g e . 2004). but not available to participate in the losses of a bank which is still continuing its activities) is limited to a maximum of 50 per cent of Tier 1. 50 per cent and 100 per cent and equivalent credit conversion factors for off-balance sheet items. Basel I is a ratio of capital to risk-weighted assets.

In principle. The spirit of the new Accord is to encourage the use of internal systems for measuring risks and allocating capital.Minimum capital requirements Pillar 2 . The new Accord also wishes to align regulatory capital more closely with economic capital. Interestingly. despite the rather ‘arbitrary’ nature of the definition of Tier 2 capital.Supervisory review process Pillar 3 . the new approach (Basel II) is not intended to raise or lower the overall level of regulatory capital currently held by banks. BASEL II (Revised International Capital Framework) Central bank Governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries endorsed the publication of ‘International Convergence of Capital Measurement and Capital Standards: a Revised Framework’. there is no strong theory for the ‘target’ ratio 8 per cent of capital (tier 1 plus tier 2) to risk-adjusted assets plus off-balance sheet items. but to make it more risk sensitive. the new capital adequacy framework commonly known as Basel II. It is a standard broadly accepted by the industry and by the authorities in both developed and developing countries.Market discipline 28 | P a g e .5 per cent. The Committee intends that the revised framework would be implemented by the end of year 2006. The proposed capital framework consists of three pillars Pillar 1 . The 8% figure has been derived based on the median value in existing good practice at the time (US/UK 1986 Accord): the UK and the USA bank around 7. Switzerland 10 per cent and France and Japan 3 per cent etc. Basel I was a 96 simple ratio. the risk weights and the 8 % target ratio.weights have created opportunities for regulatory arbitrage.

preferential weights ranging from 0% to 150% would be assigned to assets based on the external credit rating agencies. it is 9%). Under Internal Rating Based (IRB) Approach. in addition to appropriate 29 | P a g e . which will cover capital requirements for credit. Foundation Internal Rating Based (IRB) and Advanced IRB are suggested. a range of approaches such as Standardised. while under Advanced IRB approach. a risk-weight of 5% should be applied for Government and other approved securities for the purpose of capital adequacy. RBI is required to set rules for estimating the value of Loss Given Default (LGD) and Exposure at Default (EAD). For this purpose.5% risk-weight for capital adequacy for market risk on SLR and non-SLR securities with effect from March 2000 and 2001 respectively. In case of Foundation IRB approach. banks would be allowed to estimate their own Probability of Default (PD) instead of standard percentages such as 20%. market and operational risks. 50%. The minimum capital adequacy ratio would continue to be 8% of the risk-weighted assets (as per RBI. The Reserve Bank of India has prescribed 2. two approaches namely Foundation IRB and Advanced IRB are suggested. Estimating Capital required for Credit Risks For estimating the capital required for credit risks. approved by the national supervisors in accordance with the criteria defined by the Committee. Under the Standardised Approach.Pillar 1: Minimum Capital Requirements Pillar 1 of the new capital framework revises the 1988 Accord’s guidelines by aligning the minimum capital requirements more closely to each bank’s actual risk of economic loss. banks would be allowed to use their own estimates of LGD and EAD. Estimating Capital required for Market Risks The Narasimham Committee II on Banking Sector Reforms had recommended that in order to capture market risk in the investment portfolio. 100% etc.

Further the banks in India are required to apply the 2. three approaches namely Basic Indicator. 30 | P a g e . The Internal measurement approach allows individual banks to use their own data to determine capital required for operational risk Thus. Standardised and Internal measurement have been provided. the regulatory requirements cover three types of risks. The multiplicatory factor of 12. trading and sales. under BASEL II. plus 12.5 times (reciprocal of 8 % minimum risk based capital ratio) the sum of the capital charges for market risk and operational risk. The capital charge for operational risk is arrived at based on fixed percentage for each business line. Estimating Capital required for Operational Risks For operational risk. banks have to hold capital for operational risk equal to the fixed percentage divides the bank’s activities into 8 business lines – corporate finance. calculation of capital is based on the risk weighted assets. In case of capital requirement for credit risk. However. the denominator of the minimum capital ratio will consist of three parts – the sum of all risk weighted assets for credit risk. for calculating capital requirement for operational and market risk.5 has been introduced in order to enable banks to create a numerical link between the calculation of capital requirement for credit risk and the capital requirement for operational and market risks.risk-weights for credit risk.5 (Market + Operational Risks) Ratio (CAR) for Credit Risk 99 Hence. the capital charge itself is calculated directly. retail banking. asset management and retail brokerage.5% risk-weight for capital charges for market risk for the whole investment portfolio and 100 % risk-weight on open gold and forex position limits. Under the Basic Indicator approach. payment and settlement. agency services. credit risk. market and operational risks. Regulatory Capital = Desired Capital Risk weight Asset × 12. commercial banking.

but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks. the supervisory review process is intended not only to ensure that banks have adequate capital to support all the risks in their business.Pillar 2: Supervisory Review Process Pillar 2 of the new capital framework recognises the necessity of exercising effective supervisory review of banks’ internal assessments of their overall risks to ensure that bank management is exercising sound judgment and had set aside adequate capital for these risks.g.  Those factors not taken into account by the Pillar 1 process e.g. Thus. 31 | P a g e . There are three main areas that might be particularly suited to treatment under Pillar 2. they will help to create implicit incentives for organisations to develop sound control structures and to improve those processes. To be more specific  Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions. when supervisors engage banks in a dialogue about their internal processes for measuring and managing their risks. business cycle effects. interest rate risk  Factor external to the bank e. the proposed Operational risk in Pillar 1 may not adequately cover all the specific risks of any given institution).g. Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.  The committee expects that.

It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation. The Committee recommends that all sophisticated internationally active banks should make the full range of core and supplementary information publicly available. Core disclosures are those which convey vital information for all institutions while Supplementary disclosures are those required for some. they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not (NEDfi Databank Quarterly. when market place participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures. For the purpose. The Committee believes that. it has recommended disclosure on semi-annual basis and for internationally active banks on a quarterly basis. 32 | P a g e . Thus. The Committee also has emphasised the importance of timeliness of information.Pillar 3: Market Discipline Pillar 3 leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting. 2004). adequate disclosure of information to public brings in market discipline and in the process promotes safety and soundness in the financial system. The Committee proposes two types of disclosures namely Core and Supplementary.

Indian banks escaped the contagion because they were highly regulated at home and not too integrated with the global financial system in terms of sharing the risks inherent in the trillions of dollars of worthless financial products (Venu. the financial sector.. exports and exchange rates. Excellent regulations by RBI and the decision not to allow investment banking on the US model were the two main reasons that helped to overcome the adverse situation. 2009). 2008).. including the U. the Euro Zone and Japan.Global Financial Crisis and the Indian Banking Sector The impact of the global crisis has been transmitted to the Indian economy through three distinct channels. over the years. certain relaxations were permitted in the case of large banks which were considered ‘too big to fail’ and this relaxation ultimately triggered the crisis. but prudence and proper risk management systems. was lucky to avoid the first round of adverse affects because its banks were not overly exposed to subprime lending (Vashisht and Pathak. but the global financial crisis and its aftermath forced banks to introspect about the kind of financial sector architecture India should have in the years ahead apart from quantification of risk and appropriate risk management models. Interestingly. Thus. Only one of the larger private sector banks. In short. was partly exposed but it managed to counter the crisis through a strong balance sheet and timely government action.S. the ICICI Bank. there were significant developments in the area of quantification of risk and presently. India. Although academic research advocates the use of VaR for 33 | P a g e . viz. in U. Fortunately. eventually it was proved that it is not the size that matters. Interestingly. both in the public and private sector. the Indian Economy is being affected by the spill-over effects of the global financial crisis only (Chidambaram 2008). Further. the focus has shifted to statistical aspects of risk management – especially to risk modeling and other computational techniques of risk measurement. RBI has also enforced the prudential and capital adequacy 101 norms without fear or favour. Indian commercial banks are professionally managed and proper risk management systems are put in place. Contrary to the situation in India. like most of the emerging economies. while the developed world. have plunged into recession.S. 2010). the financial sector has emerged without much damage and this was possible due to our strong regulatory framework and in part on account of state ownership of most of the banking sector (Kundu. it can be said that strict regulation and conservative policies adopted by the Reserve Bank of India have ensured that banks in India are relatively insulated from the travails of their western counterparts (Kundu 2008). In fact. RBI regulations are equally applicable to all the Indian Banks. Although.

private sector banks need strong and effective risk control systems. 2008). The Basel II ‘Internal Rating Based’ methodology provides a portfolio model for credit risk management but bank managements will have to focus on the determinants of credit risk factors. 34 | P a g e . remarkable headway is yet to be seen.market risk assessment. accuracy and so on. models for assessing and managing other types of risk in the banking business need to be developed and simultaneously data availability and reliability issues with respect to the models need to be resolved. in respect of credit risk. Although researches are on to develop risk management models that can be used universally for assessing and managing risk. 2006). Therefore. As far private sector banks are concerned. it was seen that irrational loan advances. the 102 integration of credit risk to market risk. data integrity issues like consistency of data over long periods. and investments are prominent more than public sector banks. the dependency between risk factors. Likewise. However. the in-built risk control systems that are being followed presently are equally strong for public and foreign sector banks (Subramanyam and Reddy. there is no single ‘best practice’ model for credit risk capital assessment (Gopinath.

so that systemic risk and financial turmoil can be averted in the country. proper assessment of risk is an integral part of a bank’s risk management system. RBI has opted for on-site and off-site surveillance methods for effective risk management in the Indian Banking sector. and is intended to be applied to banks worldwide. offer a more flexible approach through a menu of options. the introduction of Basel II norms and its subsequent adoption by RBI is a significant measure that promises to promote sound risk management practices. Banks are focusing on the magnitude of their risk exposure and formulating strategies to tackle those effectively. Moreover. as risk is indispensable for banking business. Apart from this. 35 | P a g e .Conclusion Thus. promote a comprehensive coverage of risks. the RBI has adopted a series of steps to ensure that individual banks tackle risks effectively by setting up risk management cells and also through internal assessment of their risk exposure. BASEL II seeks to enhance the risk sensitivity of capital requirements. In the context of risk management practices.

WIKIPEDIA.COM 36 | P a g e .References: 1) "Risk Management Framework for Indian Banks" 2) "RISK MANAGEMENT IN INDIAN BANKS: SOME EMERGING ISSUES" 3) WWW.