Risk Management In Banking Companies

Shelly Kaundal
November 26, 2012 — 1,482 views  
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CREDIT RISK MANAGEMENT

Credit risk is defined as the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise the bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherit in the entire portfolio as well as the risk in individual or credits or transactions.

For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of the bank, including in the banking book and the trading book and both on and off the balance sheet. Banks are increasingly facing credit risk (or counter party risk) in various financial instruments other than loans including acceptances, inter bank transactions, trade financing, foreign exchange transactions, financial future, swaps, bonds, equities, options and in the extension of commitments and guarantees, the settlement of transactions.

BASAL II ON CREDIT RISK

The basal community on banking supervisionrelease a consultative document on New Capital Adequacy Framework with the view to replacing 1988 Accord. The document proposes three pillars for the new accord-

1. Minimum Capital Requirements, 2.Supervisory review 3.Market discipline

A new accord continues with the minimum capital adequacy ratio of 8% of risk waited assets. Arrange of options to estimate capital as proposed in the document include a standardised approach. Under this approach, preferential risk weights in the range of 0%, 20%, 50%, 100%, and 150% are envisaged to be assigned on the basis of external credit assessments. Under foundation Internal Rating Based (IRB), community proposes certain minimum compliance.wiz.a comprehensive credit rating system with capability to quantify Probability of Default (PD) while assigning preferential risk weights, with the information supplied by national supervisor on loss given default (LGD) an exposure at default. Adoption a New Capital Accord by banks in the proposed state requires complete change in the existing risk management systems.

RISK MANAGEMENT IN BANKING COMPANIES

Risk Management in bank operations includes risk identification, measurement and assessment, and its objective is to minimise negative effects risks can have on the financial result and capital of the bank. Banks are required to form a special organisational unit for the purpose of risk management. The risk to which the bank is particularly exposed in its operations are market risk(interest rate risk, foreign exchange risk, risk from change in market price of securities, financial derivatives and commodities), credit risk, liquidity risk, exposure risk, investment risk, operational risk, legal risk, strategic risk. These risks are highly inter-independent. Events that affect one area of risk can have ramifications for a range of other risk categories.

MARKET RISK MANAGEMENT

Banks are exposed to market risk via their trading activities and their balance sheets. Two types of risks are considered the market risks for the bank such as interest rate risk and foreign exchange risk. Banks face the foreign exchange risk due to exchange rate fluctuations and interest rate is the most common risk all the banks manage because all the financial products issued by bank are interest rate sensitive.

1. INTEREST RATE RISK

Interest Rate Risk is a risk of negative effects on the financial result and capital of the bank caused by changes in interest rate. The overarching objective of the interest rate risk management is to ensure a cash flow mechanism that is devoid of major mismatches in both assets and liability segments. As financial intermediaries, banks encounter interest rate risk in several ways such as-

Re-Pricing Risk: The primary form of interest rate risk rises from timing differences in the maturity(for fixed rate) and re-pricing(for floating rate) of assets, liabilities off-balance-sheet(OBS)positions. They can expose a banks “income and assets” underlying economic value of unanticipated fluctuations as interest rate tends to be too frequent and volatile.

Yield Curve Risk: Re-Pricing mismatches can also expose a bank to change in slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse on bank’s income or economic value of their asset porfolio.

Basic Risk: The risk that the interest rate for different assets and liabilities may change in different magnitudes is called basic risk. Such risk arises due to imperfect correlation in the adjustment of the rates earned and paid on different instruments with other wise similar re-pricing characteristics.

Embedded option Risk: An option provides the holder the right (but not the obligation) to buy, sell or in some manner alter the cash flow of the instrument or financial contract. Options may be stand alone instruments such as exchange –trade options and over- the-counter (OTC) contracts, or they may be embedded within otherwise standard instruments. While banks use exchange-trade and OTC-options in both trading and non-trading accounts, instruments with embedded options are generally most important in non-trading activities.

Re-investment Risk: uncertainty about future interest rate gives rise to re-investment risk as future cash flow will be re-invested at a rate unknown at present. Ordinary yield curve, without bootstrapping, does not take into account the re-investment risk.

OPERATIONAL RISK

It isone of the new planks of the Basel-II capital accord. Operational risk is defined as ‘the risk of the loss resulting adequate or failed internal processes, people and system or from external events.’ This definition includes legal risk, but excludes strategic risk and reputational risk. On the other hand, the Reserve bank of India has defined operational risk, as ‘any risk, which is not categorised as market or credit risk, or the risk of loss arising from various type of human and technical errors’.

Sources of operational risk

(i)                 Wrong /delayed decision and lack of accountability, control and proper auditing ,

(ii)               Inadequate MIS ,

(iii)             Incompetency of staff and lack of proper training and job rotation,

(iv)             Lack of succession planning and development of second lines,

(v)               Lack of contingency planning,

(vi)             Non compliance with circulars, policies and regulatory requirement,

(vii)           Obsolete policies,

(viii)         Involvement of the staff in the fraud and forgeries,

(ix)              Failure of electronic instruments ,like computer systems, software and telecommunication equipment,

(x)                Legal flaws in execution of security documents for advances

(xi)              Deterioration of bank image due to poor services,  staff behaviour, frauds, high NPAs, etc

At present, banks account for their losses due to operational risk by debiting it to their P&L account without allocating any capital charge for it, unlike in case of credit and market risk. Under Basel-II, operational risk needs to be assessed separately from three approaches namely (1) Basic Indicator Approach, (2) Standar5dised Approach and (3) Internal Management Approach. Under Basel-II framework of operational risk management, banks are encouraged to move along the spectrum of available approaches as they develop more sophisticated operational risk management system and practices.

LIQUIDITY RISK MANAGEMENT

Liquidity risk is the potential inability to meet the banker’s liability as they become due. It arises when banks are unable to generate cash to meet fund withdrawal, commitment credit or increase in assets. It originates from the mismatches pattern of assets and liabilities. Measuring and managing liquidity needs are vital for effective operations of commercial banks the cause and effect of liquidity risk are primarily linked to the assets and liabilities of the bank. The bank should continuously monitor its liquidity position in a long run and also on a day- to day basis. There are two approaches that relates these two situational analysis such as (1) Fundamental Approach and(2) Technical Approach .

Fundamental Approach: This approach is used in the long run. In this approach the banks try to manage the liquidity risk by controlling its assets –liability positions. A prudent way to tackling this situation could be by adjusting the maturity of assets and liabilities or by diversifying and broadening the sources of the funds.

Technical Approach: This approach focuses on the liability position of the bank in the short run. Liquidity in the short run is primarily linked to the cash flow arising due to the operational transaction. The bank should know its cash requirements and the cash inflows and adjust these two to ensure safe level for its liquidity position.

The Risk Management scenario will strengthen owing to the liberalization, regulation and integration with global markets. Management of risks will be carried out proactively and quality of credit will improve, leading to a stronger financial sector. The future will see a structural change in the banking sector marked by consolidation and a shake-out within the sector. The smaller banks would not have sufficient resources to withstand the intense competition of the sector. Banks would evolve to be a complete and pure financial services provider, catering to all the financial needs of the economy. Flow of capital will increase and setting up of bases in foreign countries will become commonplace.

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Shelly Kaundal