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of banking. Also it presents some of the measures that banks take in order to take care of these risks. The article starts with what “Risk” in general means, the risks that are faced by the banks, and some remedies. “RISK”, this word has been derived from the Italian word “Risicare” which means “to dare”. It is often used in the same breath as “uncertainty” which is incorrect. Uncertainty refers to unknown, whereas Risk is that portion of uncertainty, which is measurable. Risk can be expected, measured and hence an attempt to manage it can be made. This is where the Art or Science of Risk Management comes into the picture. Banks and Financial Institutions that lend loans perform the essential task of taking funds from those who have a surplus to those who are in need of it. Thus banks and FI’s act as the financial intermediataries. This is where the risk lies. 1. They hold assets that are potentially subject to credit or default risk. 2. There may be a mismatch in the maturity of assets and liabilities. 3. Thus may get exposed to the Interest Rate Risk. They are all related to each other. Then why do banks take this risk? The answer to this question lies in the fact that Risk is an integral part of any business environment. Risk has two distinct phases: Risk as an opportunity and risk as a hazard. In risk as an opportunity there is a relation between risk and return. Greater the risk greater is the potential return and necessarily greater can be the loss. This is what entices people or organisations to take the risk, do the business. Thus risk management is about maximizing the probability of maximum returns and minimizing the probability of loss, and identifying those risks which are a hazard and avoid them. What are the types of risks that banks face?
Credit Risk: This represents the major risk faced by the banks on account of the nature of their business activity, which include dealing with or lending to a corporate, individual, another bank, financial institution or a country.
This can be further classified into Borrower risk and Portfolio risk. Borrower Risk: It can defined as the possibility that a borrower will fail to obligations in accordance with agreed terms. meet his
Once it gets realised then it is no more a risk. Also risk tends to change with time. Surplus liquidity could also represent a loss to the bank in the ways of earning missed. Banks define its overall credit risk management strategy. (III) Liquidity Risk: Liquidity risk is the possibility that the bank is unable to pay its liabilities as and when it is due or may have to fund the liabilities that costs higher than the normal cost. on the returns and costs. Systemic Risk. 2. (II) Market Risk: Market risk is the potential of decrease in income or market value of an asset arising due to changes in market variables. and something which is not a risk now may become a risk in future. Thus banks have take these aspects into consideration and articulate risk management philosophy. The above mentioned risks can be broadly classified under Credit Market Risk and Operational Risks. something we can only estimate. which forms the starting point for a credit policy.Portfolio Risk: This risk may arise due to concentration of credit/investment to particular sector or service. something that is a risk now may not be a risk in future. This happens due to mismatch in the timings of inflow and outflow of funds. 3. and also identify from time to time the risk bearing capacity of the bank (Risk Limits). This risk may arise out of Operational Risk. . to achieve the desired goal. Cost & yield arises from both the sides of balance sheet. so policies are made to maximize the spread and minimize the burden. come out with policies keeping in mind the present economic scenario and the possible future scenarios. How to manage these risks? To answer this question we must understand the other aspects of risk. such as Interest Rate. and Solvency Risk. Risk is always pertaining to future. Foreign Exchange Rate etc. The foundations of risk management lie in the following 1. Banks exercise control on their assets and liabilities. hence an Earning Risk.
Financial institutions ensure that risk management practices keep pace with the growth and changing risk profile of home equity portfolios. Given the home equity products’ long-term nature and the large credit amount typically extended to a consumer. a significant change in a borrower’s income or debt levels can adversely alter the borrower’s ability to pay. The total score at the end of the rating decides how much loan the Individual or the company can avail.The credit risk management strategy of banks rely heavily on the credit rating system which gives the banks a fair idea of the borrowers repaying capacities. . the aggregate risk of the country of incorporation is also considered. Size usually provides a measure of diversification and competition power. While past performance is a good indicator of future performance. These parameters are different for Individuals. regardless of how conservative their financial posture is. How much verification these underwriting factors require depends upon the individual loan’s credit risk.the most creditworthy entity in that country. In cases of foreign companies. In case of Individual borrowers. It divides the balance sheet into the two broad types of interest rate sensitive assets and liabilities (floating rate and fixed rate) and to align the interest rate profiles of each balance sheet component to the appropriate benchmark. Exchange Rate Risk: The Agreement establishing the Bank explicitly prohibits it from taking direct currency exchange exposures by requiring liabilities in any one currency (after swap activities) to be matched with assets in the same currency. Each industry has an upper limit on the rating .issuers cannot have a higher rating. Interest Rate Risk: Banks manage this risk by matching the sensitivity of its assets and liabilities. Management actively assess a portfolio’s vulnerability to changes in consumers’ ability to pay and the potential for declines in home values. companies or countries. or to state it conversely the chances of the borrower defaulting on the repayment of the loan. the risk of the industry to which the company belongs is calculated i. industry risk. an evaluation of repayment capacity considers a borrower’s income and debt levels and not just a credit score. in which different parameters are considered before coming to a final score. profitability. Credit scores are based upon a borrower’s historical financial performance. cash flow and other financial ratios. In the case of companies.e. Typically foreign companies are assigned a lower rating than the governments. management skills. capital structure. Credit rating is a tool. Home loan products are one of the biggest sections.
unexpected events or unenforceability of contracts. (iii) The recently introduced mobility program to ensure staff rotation. .Liquidity Risk: As a long-term development lender. thereby renewing motivation and avoiding risks associated with monotony of activities. the Bank holds sufficient liquid assets to enable it to continue normal operations even in the unlikely event that it is unable to obtain fresh resources from the capital markets for an extended period of time. (iv) The elaboration of a Delegation of Authority matrix. system or human failures. The Bank’s policy requires maintaining a prudential minimum of liquidity based on projected net loan transfers. Bank is exposed to various types of operational risk. the Bank Group has implemented wide-ranging reforms intended not only to improve the efficiency with which the Bank Group executes its mandate. (ii) Increased attention to training. but also to strengthen the overall internal control environment. supervision. including the staff rules and the code of conduct/ethics. (iii) Organizational changes and realignments. contingent liabilities and debt service payments. including the potential losses arising from internal activities or external events caused by breakdowns in information. business continuity. Operational Risk: Operational risk is defined as losses due to process. The following reforms have been included: Personnel related: (i) The recruitment of new staff with the competencies required to remedy identified skills gaps. physical safeguards. This class of risks has unlimited downside and can expose an institution to serious financial and reputational losses. settlement systems and procedures and the execution of legal fiduciary and agency responsibilities. Systems related. These reforms are broadly classified into Personnel related. Over the last several years. Process related reforms: (i) The update/formulation and dissemination of various rules and regulations. (v) The development of a 5-year strategic plan to align the allocation of resources to organizational priorities. transaction processing. communication. Process related. to equip staff with the skills necessary to perform effectively. (ii) Business process reengineering across the entire Bank.
SUMMIT/Numerix).e. Also in this fast changing world. thereby permitting most important Bank documents to be electronically stored and retrievable.php3 .e.htm www. Reference: www.php www.html http://annualreport. SAP). External Events. This plan is continuously updated and tested to assure ongoing readiness. Management of risk and profitability are therefore inextricably linked.org. can stay in the market.coolavenues. products and services. As various risks are interdependent. banks who are on there toes.com/know/fin/aashika_1.e. Each of the reform measures described above has contributed towards improving the overall operational risk profile of the Bank Group. The future of risk management involves banks taking measures to embrace new and innovative technologies. thanks to globalization of world economy and the ever increasing pace of technologies. which will satisfy them and the stake holders.org/publ/bcbs82.com/CreditRisk. as only then can they gain good profits. and accordingly facilitating the preservation of institutional memory. (iii) The implementation of a major document archiving and retrieval system (i.com/2004/ar/riskreport/liquidityrisk. the DARMS project).induced changes: The Bank has a proven business continuity and disaster preparedness plan. (ii) The management of the Bank’s treasury activities in a state-of-the art software environment (i. including the following: (i) The consolidation of most of the transaction processing activities under a single integrated enterprise-wide software (i.System-related reforms: There has been a significant renewal of the information technology environment of the Bank Group.bis. an integrated approach to all the risks faced by a bank is considered most appropriate. who proactively update there risk management techniques and tap the opportunities as and when they come.rbi. to assure the immediate continuity of all essential operations in the aftermath of a disaster and the eventual continuity of all other operations.in/scripts/BS_SpeechesView.aspx?Id=304 www.deutsche-bank.margrabe.
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