In times of volatility and fluctuations in the market, 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. Hence, 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. Thus, the need for an efficient risk management framework is paramount in order to factor in internal and external risks.
Indian Banks have been making great advancements in terms of technology, quality, quantity as well as stability such that they have started to expand and diversify at a rapid pace. However, such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. Risks play a major part in the earnings of a bank and other financial institutions. Higher the risk, higher is the return. Hence, it is most essential to maintain parity between risk and return. Management of Financial risk incorporating a set systematic and professional method especially those defined by the Basel II norms are an essential requirement of banks. The more risk averse a bank is, the safer is their Capital base.
Banks, in the process of financial intermediation, are confronted with various kinds of financial and non-financial risks, viz., credit risk, interest rate risk, foreign exchange rate risk, liquidity risk, equity price risk, commodity price risk, legal risk, regulatory risk, reputation risk, operational risk, etc. These risks are highly independent/interdependent events that affect the bank/financial institution.
RISK MANAGEMENT FUNCTION
The broad parameters of risk management function should cover:
- Organisational structure
- Comprehensive risk measurement approach
- Risk management policies approved by the board, which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk
- Guidelines and other parameters used to govern risk taking, including detailed structure of prudential limits
- Strong MIS for reporting, monitoring and controlling risks
- Well laid out procedures, effective control and comprehensive risk reporting framework
- Separate risk management organisation/ framework independent of operational departments and with clear delineation of levels of responsibility for management of risk
- Periodical review and evaluation.
Risk Management Structure
Each bank should set risk limits after assessing its risks and the risk-bearing capacity. At organisational level, the task of overall risk management is assigned to an independent Risk Management Committee. The purpose of this top level committee is to empower one group with full responsibility of evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. The functions of Risk Management Committee are essentially to identify, monitor and measure the risk profile of the bank. The committee also develops policies and procedures, verifies the models that are used for pricing complex products, reviews the risk models as development takes place in the markets and also identifies new risks.
Loan Review Mechanism (LRM)
It is an effective tool for constant evaluation of the quality of loan book and for bringing about qualitative improvements in credit administration. Banks have, therefore, used Loan Review Mechanism (LRM) for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The main objectives of LRM could be to:
- promptly identify loans which develop credit weaknesses and initiate timely corrective action,
- evaluate portfolio quality and isolate potential problem areas,
- to provide information for determining adequacy of loan loss provision,
- assess the adequacy of and adherence to loan policies and procedures, and to monitor compliance with relevant laws and regulations,
- to provide top management with information on credit administration, including credit sanction process, risk evaluation and post-sanction follow-up.
Accurate and timely credit grading is one of the basic components of an effective LRM. Credit grading involves assessment of credit quality, identification of problem loans, and assignment of risk ratings. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions.
TYPES OF RISKS
The Reserve Bank of India guidelines issued in October, 1999 has identified and categorized the majority of risk into three major categories, viz. :
- Credit Risk
- Market Risk
- Operational Risk
The type of risks can be fundamentally subdivided in primarily of two types :
- Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further sub-divided into Credit Risk and Market Risk. Both Credit and Market Risk may be further sub-divided.
- Non-Financial risks would entail risk faced by the bank in its regular workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk, and Legal Risk.
Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank’s dealings with an individual, corporate, bank, financial institution or a sovereign.
Credit risk may take the following forms:
- Direct lending: Principal and/or interest amount may not be repaid.
- Guarantees or letters of credit: Funds may not be forthcoming from the constituents Upon crystallization of the liability.
- Treasury operations: The payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases.
- Securities trading businesses: Funds/securities settlement may not be effected.
- Cross-border exposure: The availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.
Credit risk can be further classified in the following types:
- Credit default risk – The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
- Concentration risk – The risk associated with any single borrower or group of borrowers with the potential to produce large enough losses to threaten a bank’s core operations. It may arise in the form of single borrower concentration or industry concentration.
- Country risk – The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/ conversion risk) or when it defaults on its obligations (sovereign risk).
Read the complete chapter on Risk Management And BASEL Accord in e-Book – Principles & Practices of Banking by N K Gupta. The book is available in e-book format and is available at Bankerz at deep discounted prices .. Know more..