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The Indian Economy is booming on the back of strong economic policies and a healthy
regulatory regime. The effects of this are far-reaching and have the potential to ultimately
achieve the high growth rates that the country is yearning for. The banking system lies at the
nucleus of a country's development robust reforms are needed in India's case to fulfill that. The
BASEL II accord from the Bank of International Settlements attempts to put in place sound
frameworks of measuring and quantifying the risks associated with banking operations.

Risk is inherent part of Bank¶s business. Effective Risk Management is critical to any Bank for
achieving financial soundness. In view of this, aligning Risk Management to Bank¶s
organizational structure and business strategy has become integral in banking business. Over a
period of year, banks have taken various initiatives for strengthening risk management practices.
Banks have an integrated approach for management of risk and in tune with this, formulated
policy documents taking into account the business requirements / best international practices or
as per the guidelines of the national supervisor. These policies address the different risk classes
viz., Credit Risk, Market Risk and Operational Risk.

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The Indian Financial System is tasting success of a decade of financial sector reforms. The
economy is surging and has gathered the critical mass to convert it into a force to reckon with.
The regulatory framework in India has sparked growth and key structural reforms have improved
the asset quality and profitability of banks.

Growing integration of economies and the markets around the world is making global banking a
reality.

Widespread use of internet banking has widened frontiers of global banking, and it is now
possible to market financial products and services on a global basis. In the coming years
globalization would spread further on account of the likely opening up of financial services
under WTO. India is one of the 104 signatories of Financial Services Agreement (FSA) of 1997.
Thereby giving India's financial sector including banks an opportunity to expand their business
on a quid pro quo basis.

As in different sectors, competition is driving growth in the banking sector also. The RBI
requires all banks to comply with the standardized approach of the BASEL II accord by 31st
March, 2007. The quantification and accounting of various risks would result in a more robust
risk management system in the industry.
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The objective of this article is to envisage ideal framework of bank-wide risk management for
Indian Banks. The presence of accurate measures of bank-wide risk management practice
increase shareholder¶s returns and allows the risk-taking behavior of bank to be more closely
aligned with strategic objectives. Bank-wide risk management practice should aim to enhance
the drivers of shareholder¶s value such as: -

Ô Growth
Ô Risk adjusted performance measurement
Ô Consistency of earnings and
Ô ‰uality and transparency of management

The paper will further discuss:

Ô Operational risk
Ô Credit risk
Ô Market risk

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Most of the banks do not have dedicated risk management team, policy, procedures and
framework in place. Those banks have risk management department, the risk manager¶s role is
restricted to prefact and postfact analysis of customer¶s credit and there is no segregation of
credit, market, operational and strategic risks. There are few banks have articulated framework
and risk quantification. However, the outputs are far from the stressed or actual losses due to
usage of un-compatible implications.

The traditional lending practices, assessment of credits, handling of market risks *, treasury
functionality and culture of risk-rewards are hauls of public sector banks. Where as private sector
banks and financial institutions are some-what better in this context.

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)

The sheer size and wide coverage of banks is a big hurdle to integrate and generate a cost
effective real time operational data for mapping the risks. Most of the financial institutions
processes are encircled to µfunctional silos¶ follows bureaucratic structure and yet to come up
with a transparent and appropriate corporate governance structure to achieve the stated strategic
objectives.





 






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Establishment of dedicated risk management department * with the articulation of roles and
responsibilities pertaining to identifying, measuring, controlling, monitoring and managing bank-
wide risks and a comprehensive articulation of risk management framework comprising the
following: -

Ô ultimate accountability of the board of directors to the shareholders for management of

all risks
Ô risk committee comprising of CEO, one or two non executive board member, and senior
management from business units; and
Ô delegation of responsibility to risk committee.

The key responsibilities of the Board of Directors should be: -

Ô assess risks and maintain a sound system of internal control and risk management by
adopting a suitable framework;
Ô setting the risk management policies in place; and
Ô establishment of comprehensive system of control to ensure that the bank¶s risk are
mitigated and objective of shareholders and stake holders are attained.

The key responsibility of the Risk Committee should be: -

Ô oversee the risk management function, review and recommendation of policies of the
bank;
Ô approving limits and evaluating the overall effectiveness of bank¶s control and risk
management infrastructure;
Ô assess risk-reward profile with respect to risk appetite and recommendation of strategies;
and
Ô evaluation of risk profile for any new product, service, project, strategic investments and
bank¶s plan of mergers and acquisitions.

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‰ualitative measures ensure that all risk types are properly identified and may not take account
of risk quantification. The bank should place a formalized risk-reporting framework and should
have appropriate escalation procedures between risk takers to risk managers. ‰ualitative
measures cover the issues relevant to identifying quality of customer, compliance risks,
operational risks, money laundering, control and assurance profiles.
The consolidated risk reporting are classified as follows: -

Ô Reporting by Head of Risk Management Department * to CEO and Risk Committee.

Ô Reporting by risk managers to Head of Risk Management Department.
Ô Reporting by business units and support function to Risk Management Department.

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Bank should design performance measures that align the objectives of business unit managers
and executives with respect to mission and vision of Bank and the shareholders are central to the
value creation process. In order to ensure that value creation remains the ultimate objective of a
business unit, target performance measures (Risk adjusted performance management or RAROC
** approach) should be set. ‰uantification of bank¶s risks includes the maximum acceptable loss
in terms of credit, market risk and operational risk.

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‰uantification consists of applying value-at-risk (VaR *) and earning-at-risk (EaR) approach for
measuring and controlling quantifiable bank-wide risks (across risk types and business units).
However, quantification does not specifically address the following: -

Ô inadequate corporate governance processes

Ô reputational risk;
Ô regulatory risk and
Ô long-term strategic risk.

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Risk management activities will be more pronounced in future banking because of liberalization,
deregulation and global integration of financial markets. This would be adding depth and
dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to
another risk, therefore management of risks in a proactive, efficient & integrated manner will be
the strength of the successful banks. The standardized approach would be implemented by 31st
March 2007, and the forward-looking banks would be in the process of placing their MIS for the
collection of data required for the calculation of Probability of Default (PD), Exposure at Default
(EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD data
for five years and LGD and EAD data for seven years.
Presently most Indian banks do not possess the data required for the calculation of their LGDs.
Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded
substantially if the banks want to migrate to the IRB Approach.

Although many banks would be working towards the IRB Approach, the authors are of the
opinion that RBI would have allowed a few banks to implement and follow the IRB Approach by
the year 2015. Indian banks would be moving upward on the strategic continuum of risk scoring
models as can be seen in the diagram.

The paper will further discuss the effects of BASEL II on:

Ô economy
Ô banking industry
Ô internal operations