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CMA Raveendranath Kaushik *
Opening of the Indian Economy to Global Competition has no doubt resulted in development of the Economy but, the post globalization period has witnessed lot of challenges in taking and overcoming risk in each and every sector. Among different sectors of Indian Economy, it is the Financial Sectors which has felt the maximum heat of post globalization. Among the Financial Sectors, Banking Sector is one area where development and changes are taking place at very faster rate. In this process, the banks are forced to take up lot of challenges with in and from outside the environment in managing the operations more effectively. Banking sectors are more often prone to risk because they deal with the most liquid form of asset in the form of money and money’s worth. In process of development, banks are forced to take up completion, product mix, wide range of customer services, geographical expansion, technology innovations; new dimension of business etc has resulted in pushing banks to follow effective risk management policies. It becomes important to study the reasons and types of risk which is more commonly associated in banking sector and also to find out the ways and means to overcome the risk through a proper risk management policy. This paper tries to find out the most common types of risk associated with Banking Sector which has emerged during the post Globalization era and suggests with some of the important measures and tools which is used in the industry to minimize and mitigate risk at macro and micro level.
Post Liberalization era witnessed lot of changes in different sectors of the Economy, due to which the inter dependence and intra dependence among the various sectors in the development and growth have added not only more business but also lot of challenges. Banking sector which used to practice the traditional method of operations have drastically changed post 1990. Business of banking prior to liberalization had too much regulations and their operations was restricted only to few class of people and it became
* CMA Raveendranath Kaushik , Consultant and Guest Faculty, Bengaluru. E mail : firstname.lastname@example.org
difficult to extend its business of financial lending to the wide base of customers. Post liberalization, the concept of banking underwent a drastic change in its operations and also in its approach, the functions of banks were redefined and it became more and more customer centric. Increasing deregulations, introduction of innovative products, technology innovations, joint ventures with other sectors, strategies to bring changes in organizational structures, bank expansion etc has resulted in inviting lot of risk. Indian Banking Sector is one of the important Financial Service Sectors because of its uniqueness in terms of existence and controls it is important to understand the basic structure of existence of Indian Banking system. Figure 1 below shows the structure of banking sector as it exist today and we can find that the banks are classified based on factors like nature of control and management, geographical operations, lending patterns , legal existence and lending terms. Figure 1 – Structure of Indian Banking
Note; Figures in brackets indicate number of institutions
Source: Banking Statistics, RBI
Banking Industry since 1990 – Post Liberalisation era
It can be found from the below Table 1 below, the path of expansion of Banking Sector industry post liberalization. The enormous growth in the financial sector is because of entry of global competition which has resulted in creation of employment, growth of business and increase of population dependency on banking sectors. It clearly shows that increase in population has resulted in expansion of Bank Branches and the average population per bank has come down from 15000 before liberalization to 13000 after liberalization. This shows the tremendous growth in banking sector business during post liberalization period.
Table 1 – Bank Branches and Average Population per Bank
Source: Banks in India, 2010-11, RBI
Risk Management in Banking Sector
The growth in the banking sector business post liberalization has thrown lot of challenges, be it in the areas of operations, management, products, technology, expansion etc. Banks are finding it difficult to cope up with the challenges and are always prone to one or other sort of risk. Such risks are some what acting as hurdles in their growth and the top priority now a days for banking sector is to reduce and mitigate risk through a proper Risk Management policy.
Meaning of Risk “Risk is Exposure to Uncertainty”. So, there are two important words one is exposure and the other Uncertainty in Risk. Meaning of Risk Management ISO 3100 – “Risk Management is the identification, assessment and prioritization of risks followed by coordinated and economical application of resources to minimize, monitors, and controls the probability and/or impact of unfortunate events or to maximize the realization of opportunities”. The recent experience of 2007-08 financial crisis in which major banks like Layman Brothers, Global Trust Bank and AIG had to close major part of its global business because of not having a proper risk management policy.
Risks in Banking Sector
As per RBI guidelines issued in 1999, there are basically three types of risks encountered in Banking Sector and these are Credit Risk, Market Risk and Operational Risk. The changes in business dimension and competition has resulted in further more additional risks in the form of Liquidity Risk, Regulatory Risk, Environmental risk, Technology risk and Governance Risk. Credit Risk and Risk Management
Credit Risk is a risk which arises due to default of borrower not repaying the debt according to agreed terms. According to BCBS (Basel Committee on Banking Supervision) defines credit risk as the potential that a borrower or counter party will fail to meet its obligation in accordance with the agreed terms. Credit Risk is most common risk which occurs in banking business, these are some what which is known and if proper care is taken risk can be minimized.
Risk Management for Credit Risk can be done by following ways: 1. Ceiling Credit Limits of customers – Extending loans based on the credit worthiness of customers will help in reducing the risk. Each and every customer is rated on different parameters and accordingly credit limits are fixed. Rating agencies like CRISIL, ICRA, and CARE etc can provide vital financial information about the customers which can be used for fixing credit limits. 2. Portfolio Management – Diversifying the lending process will help in spreading over the credit to different channels. To some extent risk gets spread over and controls can be envisaged in right directions. 3. Risk Rating Model – Setting up of Risk rating system on a scale and frequent monitoring and reviewing the ratings on the scale will help in understanding the risk and preemptive decisions can be taken before the Risk triggers and causes maximum loss. 4. Credit Monitoring – Lending norms differs with types of banks. Commercial banks have their own sort of lending norms and Non commercials banks follow their own norms. This is resulting in lot of confusion in finding the approaches for fixing credit and evaluating customers. Strengthening Credit monitoring system at different levels in banking structure would reduce credit risk. Timely evaluating the risk through a monitoring policy can help in brining stability in lending and also help in timely recovery.
Market Risk and Risk Management
Market Risk in simple means the possibility of loss to bank caused by the changes in market variables. Market variables are interest rates, foreign exchange, prices of equity and commodity. This risk is something which is caused or influenced by external factors for which the Banks don’t have control. 1. Liquidity Risk and Management – It is the financial risk from the possible loss of liquidity. There can be either Specific Liquidity Risk which is applicable to a specific bank or it may be Systematic Liquidity risk which will affect all the
participants in markets. Credit and Monitory Policy announced by RBI caters to manage this Risk. Timely control on credit and deposits by changing SLR and CRR will help in managing the risk to some extent. But, internally each Banks can have a proper Asset –Liability Management Policy which aims at having time to time matching of Assets and Liabilities. It is very difficult to foresee and predict the behaviors of customers and managing liquidity risk is a very challenging task so, it is advisable to have a tolerance level fixed for each and every maturities based on the asset-liability mix. 2. Interest Rate Risk – This risk arises when the fixed and floating interest rates of Banks is not so sensitive to variations in market interest rates. Banks can manage such risk by first valuing returns on their portfolios held with that of market rates. Duration Gaps shows the indication for interest rate risk needs to be assessed at regular intervals and this can be used for taking up strategic decisions. In this process of identifying the duration gaps, bank can look-in to the various dimension of resulting risks like Yield curve risk, reinvestment risk, reprice risk etc.. 3. Exchange Risk – This is a risk caused due to potential loss in exchange rates. Such risk can be managed by going for future contracts and agreeing for a limit based rates. Policy with respect to exchange rates should be clear cut and out of the market experience and economic situation exchange rates should be agreed at time of setting terms. Operational Risk and Risk Management
BCBS defined Operation Risk as the risk of loss resulting from inadequate or failed internal process, people and systems or from external events. Such risk is in the form of avoidable risk and if preemptive plan of action is designed then such risk can be minimized.
Risk Management for Operation Risk 1. Backups – Just like how the financial service industries have BCP in its business modules even Banks can have similar type of Backups for its operations. So, when ever there is a system breakage or persons affected then immediately their backups can jump up in to action. 2. Internal Controls and Checklists – Having well designed internal controls and a system designed checklists will help in accomplishing the task according to set guidelines and procedures. Monitoring and reviewing the controls from time to time will act as a good Risk management process. 3. Internal Audit – Carrying on Internal Audit will help in detection of fraud and other issues before it does huge damage to the Banking sector. 4. Effective Corporate Governance – Corporate Governance is one of the effective and efficient tools which bring together management and other stake holders under one platform. A Strong Corporate Governance will help in bridging better relationships between different stakeholders and also it will help in resolving issues at initial stages.
Basel’s New Capital Accord – New Dimension to Risk Management
Bank of International Settlement (BIS) set up Basel Committee on banking supervision in 1988. The guidelines issued by Basel Committee brought standardization and universalisation among the global banking system for risk management. In 1988 it came out with a Capital accord which provided an option for measuring appropriate capital in to risk weighted assets. The Basel II accord which was released in 2004 made clear distinction between credit risk, market risk and operational risk The main objectives of Basel II accord is – 1. Make International Banking System more robust and strong. 2. International Banks to be given more visibility and structured guidelines for its operations. 3. Give more importance to Risk Management.
3 Pillars given in new Basel II Accord – a) 1 Pillar b) 2 Pillar c) 3 Pillar Focus area is Minimum Capital Requirement Supervisory Review process Market Discipline
As regulated by RBI, all Indian Banks are advised to keep a minimum capital adequacy of 9% of Risk Weighted Assets. Table 2 below shows the Minimum regulatory capital of some of the major banks as envisaged under Basel Disclosure for March 2011 Regulatory capital is that % of capital which the Banks are asked to maintain by the Regulator, here it is RBI.
Source: RBI Reports, 2010-2011
Enterprise Risk Management (ERM)
ERM includes the methods and process used by the banking sector to manage risk and seize the opportunities related to the achievement of their objectives. The framework of ERM involves identifying particular event or circumstance relevant to the objectives, assessing them, impact study, develop strategy and monitoring the progress. Integration of risk within and among the groups is possible under ERM. It focuses on strategy, operations, financial reporting and compliances.
Risk Based Supervision (RBS)
RBI with a view to see that all the banks self access their risk has introduced RBS where in it came out with a risk profile template and the banks are asked to populate the relevant period data in the template and do their own assessments and see to where they stand in terms of risk. This process has opened doors for new dimensional audit which is Risk Based Audit and it goes by the concept that self introspection and assessment is the best judgment which is available for the banking sector risk management.
Internal Capital Adequacy Assessment Process (ICAAP)
ICAAP is a self regulatory document of banks which is propounded by RBI for each of the Banks. Based on the availability of data, Banks are asked by RBI to prepare ICAAP document with the involvement and approval of their Board of Directors. This documents indicates the areas which are risk prone and also suggests with the control and process adopted by banks in risk management. Since it involves all the levels of management it is more participatory and transparent and also more effective tool to manage risk.
If we try to analyse the last decade of Banks performance with coming year then one can find that the last decade was the period of transformation of banking sectors to meet global needs with greater integration, adoption of core banking solutions and to some extent transparency in its operation but, the coming decade which is very important and even more challenging as the Banking sector will see enormous increase in its volume of operation mirrored by increase in use of Information Technology in its operation to cater customer demand and needs. This will give more space for inviting risks and it becomes important that banks take up well planned risk management policy in order to reduce or mitigate when ever risk occurs. Banking Sector should stop showing “Off Balance Sheet items” while reporting and it should shows all the risk assets and should be more transparent when it comes to items pertaining to internal reporting. Risk is inevitable in
business and it cannot be mitigated but, at least a proper risk management policy will help in minimizing the risk. Post liberalization growth and recent recession impact on the financial sectors should act as an eye opener for financial sector especially banking sector and they should come up with innovative ideas and systems to face any challenges caused due to risk. Coming days will not be so easy for financial sectors and that too banking sector which are exposed to frequent risk need to take up some vital challenges in order to survive in market and also to gain more and more customers. Unless and until banks takes this has a key area of management, risks and losses are certain and coming years can witness many more cases like Global Trust Bank, Layman Brothers, AIG etc. and in technology part they need to face challenges in form of hacking of software, stealing of ATM machines, lack of technology knowledge, Data warehouse management etc.. So, the advent of Globalization has given less time to plan activities it is transformation which is the biggest challenges which is need of this hour and the banks should look forward to implementing the changes at less risk.
RBI Statistics Report, 2010-12 Basle Accord II RBI Review Reports 1990 to 2010