RISK MANAGEMENT IN BANKS

Abstract
This article presents some of the risks that are involved in the business of banking. Also it presents
some of the measures that banks take in order to take care of these risks. The article starts with what
“Risk” in general means, the risks that are faced by the banks, and some remedies.

“RISK”, this word has been derived from the Italian word “Risicare” which means “to dare”. It is
often used in the same breath as “uncertainty” which is incorrect. Uncertainty refers to unknown,
whereas Risk is that portion of uncertainty, which is measurable. Risk can be expected, measured and
hence an attempt to manage it can be made. This is where the Art or Science of Risk Management
comes into the picture.

Banks and Financial Institutions that lend loans perform the essential task of taking funds from those
who have a surplus to those who are in need of it. Thus banks and FI’s act as the financial
intermediataries. This is where the risk lies.

1. They hold assets that are potentially subject to credit or default risk.
2. There may be a mismatch in the maturity of assets and liabilities.
3. Thus may get exposed to the Interest Rate Risk.
They are all related to each other.

Then why do banks take this risk?

The answer to this question lies in the fact that Risk is an integral part of any business environment.
Risk has two distinct phases: Risk as an opportunity and risk as a hazard. In risk as an opportunity
there is a relation between risk and return. Greater the risk greater is the potential return and
necessarily greater can be the loss. This is what entices people or organisations to take the risk, do the
business. Thus risk management is about maximizing the probability of maximum returns and
minimizing the probability of loss, and identifying those risks which are a hazard and avoid them.

What are the types of risks that banks face?

(I) Credit Risk: This represents the major risk faced by the banks on account of the nature of
their business activity, which include dealing with or lending to a corporate, individual,
another bank, financial institution or a country.
This can be further classified into Borrower risk and Portfolio risk.
Borrower Risk: It can defined as the possibility that a borrower will fail to meet his
obligations in accordance with agreed terms.
 Portfolio Risk: This risk may arise due to concentration of credit/investment to particular
sector or service.

(II) Market Risk: Market risk is the potential of decrease in income or market value of an
asset arising due to changes in market variables, such as Interest Rate, Foreign Exchange
Rate etc.

(III) Liquidity Risk: Liquidity risk is the possibility that the bank is unable to pay its
liabilities as and when it is due or may have to fund the liabilities that costs higher than
the normal cost. This happens due to mismatch in the timings of inflow and outflow of
funds. Surplus liquidity could also represent a loss to the bank in the ways of earning
missed, hence an Earning Risk. This risk may arise out of Operational Risk, Systemic
Risk, and Solvency Risk.

The above mentioned risks can be broadly classified under Credit Market Risk and Operational
Risks.

How to manage these risks?

To answer this question we must understand the other aspects of risk. Risk is always pertaining to
future, something we can only estimate. Once it gets realised then it is no more a risk. Also risk
tends to change with time, something that is a risk now may not be a risk in future, and something
which is not a risk now may become a risk in future.
Thus banks have take these aspects into consideration and articulate risk management philosophy,
come out with policies keeping in mind the present economic scenario and the possible future
scenarios, and also identify from time to time the risk bearing capacity of the bank (Risk Limits).

The foundations of risk management lie in the following

1. Banks exercise control on their assets and liabilities, on the returns and costs, to achieve the
desired goal.
2. Cost & yield arises from both the sides of balance sheet, so policies are made to maximize the
spread and minimize the burden.
3. Banks define its overall credit risk management strategy, which forms the starting point for a
credit policy.
The credit risk management strategy of banks rely heavily on the credit rating system which gives the
banks a fair idea of the borrowers repaying capacities, or to state it conversely the chances of the
borrower defaulting on the repayment of the loan.

Credit rating is a tool, in which different parameters are considered before coming to a final score.
These parameters are different for Individuals, companies or countries.

In case of Individual borrowers, Home loan products are one of the biggest sections. Financial
institutions ensure that risk management practices keep pace with the growth and changing risk
profile of home equity portfolios. Management actively assess a portfolio’s vulnerability to changes in
consumers’ ability to pay and the potential for declines in home values. Given the home equity
products’ long-term nature and the large credit amount typically extended to a consumer, an
evaluation of repayment capacity considers a borrower’s income and debt levels and not just a credit
score. Credit scores are based upon a borrower’s historical financial performance. While past
performance is a good indicator of future performance, a significant change in a borrower’s income or
debt levels can adversely alter the borrower’s ability to pay. How much verification these
underwriting factors require depends upon the individual loan’s credit risk.

In the case of companies, the risk of the industry to which the company belongs is calculated i.e.
industry risk. Each industry has an upper limit on the rating - issuers cannot have a higher rating,
regardless of how conservative their financial posture is. Size usually provides a measure of
diversification and competition power, management skills, profitability, capital structure, cash flow
and other financial ratios. In cases of foreign companies, the aggregate risk of the country of
incorporation is also considered. Typically foreign companies are assigned a lower rating than the
governments- the most creditworthy entity in that country.

The total score at the end of the rating decides how much loan the Individual or the company can
avail.

Interest Rate Risk: Banks manage this risk by matching the sensitivity of its assets and liabilities. It
divides the balance sheet into the two broad types of interest rate sensitive assets and liabilities
(floating rate and fixed rate) and to align the interest rate profiles of each balance sheet component to
the appropriate benchmark.

Exchange Rate Risk: The Agreement establishing the Bank explicitly prohibits it from taking direct
currency exchange exposures by requiring liabilities in any one currency (after swap activities) to be
matched with assets in the same currency.
Liquidity Risk: As a long-term development lender, the Bank holds sufficient liquid assets to enable
it to continue normal operations even in the unlikely event that it is unable to obtain fresh resources
from the capital markets for an extended period of time. The Bank’s policy requires maintaining a
prudential minimum of liquidity based on projected net loan transfers, contingent liabilities and debt
service payments.

Operational Risk: Operational risk is defined as losses due to process, system or human failures,
unexpected events or unenforceability of contracts. This class of risks has unlimited downside and can
expose an institution to serious financial and reputational losses. Bank is exposed to various types of
operational risk, including the potential losses arising from internal activities or external events
caused by breakdowns in information, communication, physical safeguards, business continuity,
supervision, transaction processing, settlement systems and procedures and the execution of legal
fiduciary and agency responsibilities.

Over the last several years, the Bank Group has implemented wide-ranging reforms intended not only
to improve the efficiency with which the Bank Group executes its mandate, but also to strengthen the
overall internal control environment. These reforms are broadly classified into Personnel related,
Process related, Systems related.

The following reforms have been included:

Personnel related:
(i) The recruitment of new staff with the competencies required to remedy identified skills gaps;
(ii) Increased attention to training, to equip staff with the skills necessary to perform effectively;
(iii) The recently introduced mobility program to ensure staff rotation, thereby renewing motivation
and avoiding risks associated with monotony of activities.

Process related reforms:

(i) The update/formulation and dissemination of various rules and regulations, including the staff rules
and the code of conduct/ethics;
(ii) Business process reengineering across the entire Bank;
(iii) Organizational changes and realignments;
(iv) The elaboration of a Delegation of Authority matrix;
(v) The development of a 5-year strategic plan to align the allocation of resources to organizational
priorities.
System-related reforms:
There has been a significant renewal of the information technology environment of the Bank Group,
including the following:
(i) The consolidation of most of the transaction processing activities under a single integrated
enterprise-wide software (i.e. SAP);
(ii) The management of the Bank’s treasury activities in a state-of-the art software environment (i.e.
SUMMIT/Numerix);
(iii) The implementation of a major document archiving and retrieval system (i.e. the DARMS
project), thereby permitting most important Bank documents to be electronically stored and
retrievable, and accordingly facilitating the preservation of institutional memory.

External Events- induced changes:

The Bank has a proven business continuity and disaster preparedness plan, to assure the immediate
continuity of all essential operations in the aftermath of a disaster and the eventual continuity of all
other operations. This plan is continuously updated and tested to assure ongoing readiness.
Each of the reform measures described above has contributed towards improving the overall
operational risk profile of the Bank Group.

Management of risk and profitability are therefore inextricably linked. As various risks are
interdependent, an integrated approach to all the risks faced by a bank is considered most appropriate.

The future of risk management involves banks taking measures to embrace new and innovative
technologies, products and services. Also in this fast changing world, thanks to globalization of world
economy and the ever increasing pace of technologies, banks who are on there toes, who proactively
update there risk management techniques and tap the opportunities as and when they come, can stay
in the market, as only then can they gain good profits, which will satisfy them and the stake holders.

Reference:
www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=304
www.bis.org/publ/bcbs82.htm
www.margrabe.com/CreditRisk.html
http://annualreport.deutsche-bank.com/2004/ar/riskreport/liquidityrisk.php
www.coolavenues.com/know/fin/aashika_1.php3