RISK IDENTIFICATION AND MEASUREMENT IN BANKS
Risk Measurement
Risk management entails identifying, measuring, and assessing risks to minimize their impact on a
bank's financial status. The major objective is to mitigate or reduce risks by implementing
pre-planned bank reforms.
Source: [Link]
Risks must be measured to gain control over them. Risk evaluation assesses risk management and
risk exposure in the financial sector, such as banking. Risk measurement maximizes the extent of the
bank's risk profile. The best way to predict, measure and forecast risk is based on the bank's previous
data.
Risk Evaluation/Management relies on quantitative measures of risk. The risk measures
seek to capture variations in earnings, market value, losses due to default, etc., (referred
to as target variables), arising out of uncertainties associated with various risk elements.
Quantitative measures of risks can be classified into three categories:
Based on Sensitivity
Based on Volatility
Based on Downside Potential
Risk Measurement Tools:
Sensitivity: Sensitivity captures the deviation of a target variable due to the unit movement of
a single market parameter. That is the impact on the total risk due to variation in one variable.
It measures how sensitive a product or service is to a change in one of the variables
and what impact it would make on the product or service as a whole.
Volatility (Fluctuation): It is possible to combine the sensitivity of target variables with the
instability of any random variable. It is a common statistical measure of dispersion
around the average of any random variable such as earnings, mark-to-market values,
market value, losses due to default, etc. Usually, the higher the volatility, the riskier the
security.
Downside Potential: Risk materializes only when earnings deviate adversely. Volatility
captures both upside and downside deviations. Downside potential only captures possible
losses ignoring the profit potential. It is the adverse deviation of a target variable.
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Risk Pricing:
Risks in banking transactions impact banks in two ways:
Firstly, banks have to maintain the necessary capital, at least as per regulatory requirements.
(In other words, what is the Risk-Weighted Capital banks must hold, as stipulated by Basel – the
world over and Respective Central Banks – of each country. All banks must ensure that they
hold adequate capital as per regulatory requirements)
The cost of capital arises from the need to pay investors in the Bank’s equity, in the
form of dividends and for the internal generation of capital necessary for business growth.
Each banking transaction should be able to generate the necessary surplus to meet these
costs. The pricing of a transaction must take into account the factors discussed in this para.
A core element of risk management is risk-return pricing. In a risk-return scenario, debtors or
borrowers with weaker financial positions, and thus classified as ‘high credit risk’ should be
priced high. Banks should develop scientific credit risk pricing methods, which should be based
on the expected ‘probability of default’ (PD).
Typically, loan pricing should be based on the risk rating or credit quality of the
borrower. The probability of default (PD), can be calculated based on the loan portfolio's past
performance or behavior, which is a function of loan loss provision/charge offs over the last five
years or so. To equip themselves to price the risk, banks should establish historical databases
on portfolio quality and provisioning/charge off.
A core element of risk management is risk-return pricing. In a risk-return scenario, debtors or
borrowers with weaker financial positions, and thus classified as ‘high credit risk’ should be priced
high. Banks should develop scientific credit risk pricing methods, which should be based on the
expected ‘probability of default’ (PD).
However, collateral value, market forces, perceived account value, future business potential,
portfolio/industry exposure, and strategic reasons; may all play a role in pricing. Flexibility should also
be provided for revising the price in response to changes in the value of collaterals/ratings over time.
Nonetheless, there is a need to compare the prices quoted by competitors for borrowers with the
same rating/quality. As a result, any attempt to cut or reduce prices to gain market share would result
in ‘Risk Mispricing’ and 'Adverse Selection.'
Pricing, therefore, should take into account the following:
Cost of Deployable Funds
Operating Expenses
Loss Probabilities
Capital Charge
Profit Margin or Return on Net Worth
Banks face a dilemma in balancing their assets (loans) and liabilities (deposits) and price
their products accordingly, considering all of the above factors.
Risk management and measurement are critical in the banking industry. Even though its
demand is growing by the day, only a small percentage of banks employ effective risk management
and measurement techniques.
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Risk management will be required shortly, not just for banks but also for businesses. It has been
determined that banks require risk management to effectively mitigate risk and allocate capital.
Banks should establish an effective, robust system and improve mechanisms for reporting various
risks.
Banks should establish new technologies for risk data analysis, as well as separate modules for
managing risks such as liquidity risk, credit risk, and so on. Only then will banks be able to mitigate
risks effectively.
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