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Assignment: International Risk Management: National Law University, Jodhpur
Assignment: International Risk Management: National Law University, Jodhpur
RUCHIKA
ASSOSIATE PROFESSOR
&
NATIONAL LAW UNIVERSITY, JODHPUR
KUMAR MISHRA(616)
VIVEK
BANKING AND
CONTENT AT A GLANCE:
INTRODUCTION5
MEANING.6
FINANCIAL RISK MANAGER.7
HISTORY AND DEVELOPMENT OF THE FRM..7
THE IMPORTANT ROLES WITHIN A FINANCIAL MANAGEMENT SYSTEM..9
RISK..11
TYPES OF RISK.13
RISK MANAGEMENT STEPS AND TOOLS.16
PROCESS OF RISK MANAGEMENT....17
RISK IDENTIFICATION:.18
MONITORING THE RISK19
TECHNIQUES OF RISK MANAGEMENT20
FINANCIAL RISK IN US MARKET...24
CHALLENGES IN THE INDIAN CONTEXT....31
CONCLUSION....34
BIBLIOGRAPHY36
First of all and above of all we would like to give our heartily thanks to our respected
teacherDR.Rituparna Das for accepting our Topic INTERNATIONAL FINANCIAL RISK
MANAGEMENT and for giving us a chance to prove ourselves competent to deal with such an
prominent issue of great importance. It would not be possible without his precious guidance and
support. The proper guidance paved the way on which we walked to achieve this goal. Again we
would like to thank library staff for their support and co-operation by which we cannot be able to
complete our assignment.
Last but not the least, we would like to give many thanks to our friends as they supported and
helped us in various ways in making this assignment.
Dated:30th JAN- 2015
RUCHIKA SINGH
TEK CHAND MEENA
VIVEK KUMAR MISHRA
FMRS
LL.M. IIndSEMESTER
NATIONAL LAW UNIVERSITY, JODHPUR
ABSTRACT
The fast changing financial environment exposes the banks to various types of risk. The concept
of risk and management are core of financial enterprise. The financial sector especially the
banking industry in most emerging economies including India is passing through a process of
change. Rising global competition, increasing deregulation, introduction of innovative products
and delivery channels have pushed risk management to the forefront of today's financial
landscape. Ability to gauge the risks and take appropriate position will be the key to success.
This paper attempts to discuss in depth, the importance of risk management process and throws
light on challenges and opportunities regarding implementation of Basel-II in Indian Banking
Industry.
INTRODUCTION:
Financial risk management is an area which gained much prominence post the recent financial
crisis. The genesis of the financial crisis is the abuse of various innovative financial products.
The global financial meltdown has thrown the focus on the need to create a new breed of finance
experts, who are adept at creating and managing the risks of innovative financial products such
as derivatives. The recent financial crisis is largely the result of managers not being able to
completely understand and manage operational risks of the new generation of derivatives. It is
believed that future finance managers must be fully equipped with the mathematical and
conceptual theories and best practices that go into the creation and management of such
innovative products. The need for sophisticated financial markets specialists is felt not only for
intermediaries like banking, investment banking, insurance industries but also service providers
of these financial intermediaries like software and BPO industries. This Programme aims to
develop cutting-edge knowledge and skills expected by the intermediaries and service providers
of intermediaries.
Most finance courses and textbooks implicitly assume that firms operate in only a single country
and that differences between countries are irrelevant. However, since the end of World War II,
the foreign activities of firms have grown substantially, and this growth, if anything, appears to
be accelerating. Firms of all types and sizes now face decisions about how to best obtain and
deploy resources abroad. Furthermore, significant differences between countries have persisted,
and these give rise to considerable variation in the prevalence of market imperfections. Market
imperfection makes the chances of risk in economy and risk is defined as anything that can
create hindrances in the way of achievement of certain objectives. It can be because of either
internal factors or external factors, depending upon the type of risk that exists within a particular
situation.
Exposure to that risk can make a situation more critical. A better way to deal with such a
situation; is to take certain proactive measures to identify any kind of risk that can result in
undesirable outcomes. In simple terms, it can be said that managing a risk in advance is far better
than waiting for its occurrence.
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
are willing to accept and follow that policy. They should also monitor the risks taken, and release
reports on the results of these risks to help with analyzing them.
FINANCIAL RISK MANAGER:
The Financial
Risk
Manager (FRM)
designation
is
an
international professional
certification offered by the Global Association of Risk Professionals. To be awarded the FRM
designation, candidates must complete rigorous two-part, practice-oriented examination that
covers the major topics in financial risk management, demonstrate two years' professional work
experience in financial risk management, and meet other requirements.
The FRM is a qualification for risk management professionals, particularly those who are
involved in analyzing, controlling, or assessing potential credit risk,market risk, and liquidity
risk as well as non-market related financial risks. FRM holders perform a broad variety of
functions related to risk management withininvestment banks, asset management firms, as well
as in corporations and government agencies. Top employers of FRM holders include global
financial services firms Deutsche Bank, HSBC, and UBS, as well as auditing firms KPMG, Ernst
& Young (EY) and PricewaterhouseCoopers (PwC). The FRM designation specification is
disclosed on the U.S. Financial Industry Regulatory Authority (FINRA) education website where
the FRM certificate program is shown on the FINRA guide to designations. The FRM
and PRMIA's PRM are often compared as being the two definitive risk management designations
in the industry.
HISTORY AND DEVELOPMENT OF THE FRM:
GARP1 first awarded the FRM designation in 1997.
Candidate enrollment in the FRM program has grown rapidly: between 2001 and 2010,
registration increased at a compound annual rate of more than 25%2.
1 Global Association of Risk Professionals
2"GARP Announces 100,000th registrant for FRM Exam". garp.org. Retrieved 201110-01
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Growth has occurred not just in the United States but also in Europe and Asia: today, more than
70% of FRM holders reside outside of the United States. Top territories of residence for FRM
holders include the United Kingdom, Switzerland, Singapore, and Hong Kong.
While the financial crisis of 20072010 resulted in a dramatic downturn in overall financial
services employment, the effect has been opposite in the field of risk management:
the bankruptcy of Lehman Brothers and the collapse of other large financial institutions
underscored the need to accurately price the risk inherent in 21st century financial products and
markets. The financial crisis has given a greater role to financial risk professionals, and driven
further demand for skilled financial risk managers and the FRM designation.
As of February 2012, GARP has more than 125,000 registrations for the FRM Exam from 129
countries around the world. There are over 28,000 Certified FRMs practicing worldwide 3. The
FRM is a globally recognized benchmark certification program for financial risk managers, and
is considered to be the de facto global qualification in the practice of financial risk management.
WHEN TO USE FINANCIAL RISK MANAGEMENT:
Finance theory (i.e., financial economics) prescribes that a firm should take on a project when it
increases shareholder value. Finance theory also shows that firm managers cannot create value
for shareholders, also called its investors, by taking on projects that shareholders could do for
themselves at the same cost.
When applied to financial risk management, this implies that firm managers should not hedge
risks that investors can hedge for themselves at the same cost. This notion was captured by
the hedging irrelevance proposition: In a perfect market, the firm cannot create value by hedging
a risk when the price of bearing that risk within the firm is the same as the price of bearing it
outside of the firm. In practice, financial markets are not likely to be perfect markets.
This suggests that firm managers likely have many opportunities to create value for shareholders
using financial risk management. The trick is to determine which risks are cheaper for the firm to
manage than the shareholders. A general rule of thumb, however, is that market risks that result
in unique risks for the firm are the best candidates for financial risk management.
The concepts of financial risk management change dramatically in the international
realm. Multinational Corporations are faced with many different obstacles in overcoming these
challenges. There has been some research on the risks firms must consider when operating in
many countries, such as the three kinds of foreign exchange exposure for various future time
horizons: transactions exposure4, accounting exposure5, and economic exposure6.
INDEPENDENCE AND CONFLICT OF INTEREST:
In financial risk management, it is important that the financial risk management department and
the employees who work within it are not supervised by those responsible for making the
decisions for the company involving financial risk. This avoids risks of conflicts of interest
between the financial risk management department and members of the board of directors or
senior management who might try to influence policy with threatened or implied job actions if
members of the department do not do what they are asked to do. Employees in the financial risk
management department should not transfer to a department that makes the financial investment
decisions for the company. This is another policy to avoid conflicts of interest.
4 http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=EFA8D4FB63329F2
C94F48279646551BF?contentType=Article&contentId=1649008(contrary to conventional
wisdom it may be rational to hedge translation exposure. Empirical evidence of agency costs
and the managerial tendency to report higher levels of translated income, based on the
early adoption of Financial Accounting Standard No. 52).
5 Aggarwal, Raj, "The Translation Problem in International Accounting: Insights for Financial
Management." Management International Review 15 (Nos. 2-3, 1975): 67-79. (Proposed
accounting framework for evaluating and developing translation procedures for multinational
corporations).
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INVESTMENT OPPORTUNITIES:
Another aspect the financial management system relates to finding opportunities that can
complement or benefit the organization. A business can only exploit these opportunities if the
organization efficiently and effectively finds the opportunities and has the ability to pay for the
desired acquisitions. By carefully considering the different aspects of the financial management
system, a business can evaluate its overall financial health and determine its ability to invest in
potential opportunities.
RISK:
A business also must carefully evaluate risk. A primary goal of the financial management system
is to minimize risks for the organization by implementing strategies that help the business to
counteract unforeseen liabilities. The financial management system should include adequate
insurance for property, equipment and key employees. Additionally, budgeting for quarterly and
yearly working capital helps to minimize potential financial risk for the organization. Further,
controlling debt and establishing a credit system with suppliers and financial institutions helps to
minimize financial risk by allowing the business operational flexibility in the event the business
experiences cash flow problems.
POLICIES:
By implementing sound financial risk management policies, companies understand they can't
rely on luck to run their businesses and make money. For a company, the road to riches often
goes through a series of operational adjustments. These relate to policies aimed at checking
customers' credit scores and financial profiles, as well as monitoring the state of the economy to
reviewing periods of uncertainty and slowdown. Financial risk management procedures also
involve the continual evaluation of business partners' accounting statements along with
profitability and solvency ratios.
TOOLS:
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KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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Companies rely on various tools and state-of-the-art technology to track and remedy financial
risks .The tools of the trade include risk management applications; credit adjudication and
lending management system software, also known as CALMS; financial analysis software; and
information retrieval or search applications. Other tools include mainframe computers, customer
relationship management software and enterprise resource planning programs.
The instruments and tools, through which credit risk management is carried out, are detailed
below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15% for individual
borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by
the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial
Exposure, which is the sum total of the exposures beyond threshold limit should not exceed
600% to 800% of the Capital Funds of the bank (i.e. six to eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of
powers, Higher delegated powers for better-rated customers; discriminatory time schedule for
review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal.
c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale.
Clearly define rating thresholds and review the ratings periodically preferably at half yearly
intervals. Rating migration is to be mapped to estimate the expected loss.
d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers
are to be priced high. Build historical data on default losses. Allocate capital to absorb the
unexpected loss. Adopt the RAROC framework.
e) Portfolio Management The need for credit portfolio management emanates from the necessity
to optimize the benefits associated with diversification and to reduce the potential adverse impact
of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative
ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various
industry, business group and conduct rapid portfolio reviews.
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KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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f) Loan Review Mechanism- this should be done independent of credit operations. It is also
referred as Credit Audit covering review of sanction process, compliance status, review of risk
rating, pickup of warning signals and recommendation of corrective action with the objective of
improving credit quality. It should target all loans above certain cut-off limit ensuring that at least
30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit
risks embedded in the balance sheet have been tracked. Based on risk rating, etcare formulated.
TYPES OF RISK:
Risk can be referred as the chances of having an unexpected or negative outcome. Any action or
activity that leads to loss of any type can be termed as risk. There are different types of risks that
a firm might face and needs to overcome. Widely, risks can be classified into three
types: Business Risk, Non-Business Risk and Financial Risk.
1. Business Risk: These types of risks are taken by business enterprises themselves in order
to maximize shareholder value and profits. As for example: Companies undertake high
cost risks in marketing to launch new product in order to gain higher sales.
2. Non- Business Risk: These types of risks are not under the control of firms. Risks that
arise out of political and economic imbalances can be termed as non-business risk.
3. Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss
to firms. Financial risk generally arises due to instability and losses in the financial
market caused by movements in stock prices, currencies, interest rates and more.
TYPES OF FINANCIAL RISKS:
Financial risk is one of the high-priority risk types for every business. Financial risk is caused
due to market movements and market movements can include host of factors. Based on this,
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity
Risk, Operational Risk and Legal Risk.
MARKET RISK:
Market Risk may be defined as the possibility of loss to bank caused by the changes in the
market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely
affected by movements in equity and interest rate markets, currency exchange rates and
commodity prices.
This type of risk arises due to movement in prices of financial instrument. Market risk can be
classified as Directional Risk and Non - Directional Risk. Directional risk is caused due to
movement in stock price, interest rates and more. Non- Directional risk on the other hand can be
volatility risks.
CREDIT RISK:
Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on
agreed terms. There is always scope for the borrower to default from his commitments for one or
the other reason resulting in crystalisation of credit risk to the bank. This type of risk arises when
one fails to fulfill their obligations towards their counter parties.These losses could take the form
outright default or alternatively, losses from changes in portfolio value arising from actual or
perceived deterioration in credit quality that is short of default.
Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually
arises due to difficult foreign exchange policies. Settlement risk on the other hand arises when
one party makes the payment while the other party fails to fulfill the obligations.
The objective of credit risk management is to minimize the risk and maximize bank s risk
adjusted rate of return by assuming and maintaining credit exposure within the acceptable
parameters.
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15
Loan Review Mechanism This should be done independent of credit operations. It is also
referred as Credit Audit covering review of sanction process, compliance status, review
of risk rating, pickup of warning signals and recommendation of corrective action with
the objective of improving credit quality. It should target all loans above certain cut-off
limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so
as to ensure that all major credit risks embedded in the balance sheet have been tracked.
LIQUIDITY RISK:
Bank Deposits generally have a much shorter contractual maturity than loans and liquidity
management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is
the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan
growth and possible funding of the off-balance sheet claims.
This type of risk arises out of inability to execute transactions. Liquidity risk can be classified
into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to
insufficient buyers or insufficient sellers against sell orders and buy orders respectively.
OPERATIONAL RISK:
Always banks live with the risks arising out of human error, financial fraud and natural disasters.
The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential
losses on account of operational risk. Exponential growth in the use of technology and increase
in global financial inter-linkages are the two primary changes that contributed to such risks.
Operational risk, though defined as any risk that is not categorized as market or credit risk, is the
risk of loss arising from inadequate or failed internal processes, people and systems or from
external events. In order to mitigate this, internal control and internal audit systems are used as
the primary means.
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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This type of risk arises out of operational failures such as mismanagement or technical failures.
Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to lack
of controls and Model risk arises due to incorrect model application.
Risk education for familiarizing the complex operations at all levels of staff can also reduce
operational risk. Insurance cover is one of the important mitigators of operational risk.
Operational risk events are associated with weak links in internal control procedures. The key to
management of operational risk lies in the banks ability to assess its process for vulnerability
and establish controls as well as safeguards while providing for unanticipated worst-case
scenarios.
LEGAL RISK:
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company
needs to face financial loses out of legal proceedings, it is legal risk.
RISK MANAGEMENT STEPS AND TOOLS:
The risk management steps are:
1. Establishing goals and context (i.e. the risk environment),
2. Identifying risks,
3. Analysing the identified risks,
4. Assessing or evaluating the risks,
5. Treating or managing the risks,
6. Monitoring and reviewing the risks and the risk environment regularly, and
7. Continuously communicating, consulting with stakeholders and reporting.
PROCESS OF RISK MANAGEMENT:
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To overcome the risk and to make banking function well, there is a need to manage all kinds of
risks associated with the banking. Risk management becomes one of the main functions of any
banking services risk management consists of identifying the risk and controlling them, means
keeping the risk at acceptable level. These levels differ from institution to institution and country
to country. The basic objective of risk management is to stakeholders; value by maximising the
profit and optimizing the capital funds for ensuring long term solvency of the banking
organisation.
To overcome the risk and to make banking function well, there is a need to manage all kinds of
risks associated with the banking. Risk management becomes one of the main functions of any
banking services risk management consists of identifying the risk and controlling them, means
keeping the risk at acceptable level. These levels differ from institution to institution and country
to country. The basic objective of risk management is to stakeholders; value by maximising the
profit and optimizing the capital funds for ensuring long term solvency of the banking
organisation. In the process of risk management following functions comprises:
Risk identification
Risk control
RISK IDENTIFICATION:
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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risk then the specific risk needs additional control measures or improvements in the effectiveness
of the existing controls.
The decision of whether a risk is acceptable or not acceptable is taken by the relevant manager. A
risk may be considered acceptable if for example:
The risk is sufficiently low that treatment is not considered cost effective, or
A treatment is not available, e.g. a project terminated by a change of government, or
A sufficient opportunity exists that outweighs the perceived level of threat.
MONITORING THE RISK:
It is important to understand that the concept of risk is dynamic and needs periodic and formal
review. The currency of identified risks needs to be regularly monitored. New risks and their
impact on the organization may to be taken into account. This step requires the description of
how the outcomes of the treatment will be measured.
Milestones or benchmarks for success and warning signs for failure need to be identified.
The review period is determined by the operating environment (including legislation), but as a
general rule a comprehensive review every five years is an accepted industry norm. This is on the
basis that all plant changes are subject to an appropriate change process including risk
assessment.
The review needs to validate that the risk management process and the documentation is still
valid. The review also needs to consider the current regulatory environment and industry
practices which may have changed significantly in the intervening period.
The organisation, competencies and effectiveness of the safety management system should also
be covered. The plant management systems should have captured these changes and the review
should be seen as a back stop.
The assumptions made in the previous risk assessment (hazards, likelihood and consequence),
the effectiveness of controls and the associated management system as well as people need to be
monitored on an on-going basis to ensure risk are in fact controlled to the underlying criteria.
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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assets decrease more than that of liabilities resulting in the decrease in the market value of
equities and expected net-interest income and vice versa. (Cumming and Beverly, 2001)
c)VALUE AT RISK (VAR):
It is one of the newer risk management tools. The Value at Risk (VaR) indicates how much a firm
can lose or make with a certain probability in a given time horizon. VaR summarizes financial
risk inherent in portfolios into a simple number. Though VaR is used to measure market risk in
general, it incorporates many other risks like foreign currency, commodities, and equities.(Jorion,
2001)
d)RISK ADJUSTED RATE OF RETURN ON CAPITAL (RAROC):
It gives an economic basis to measure all the relevant risks consistently and gives managers tools
to make the efficient decisions regarding risk/return tradeoff in different assets. As economic
capital protects financial institutions against unexpected losses, it is vital to allocate capital for
various risks that these institutions face. Risk Adjusted Rate of Return on Capital (RAROC)
analysis shows how much economic capital different products and businesses need and
determines the total return on capital of a firm. Though Risk Adjusted Rate of Return canbeused
to estimate the capital requirements for market, credit and operational risks, it is used as an
integrated risk management tool (Crouhy and Robert, 2001).
e) SECURITIZATION:
It is a procedure studied under the systems of structured finance or credit linked notes.
Securitization of a banks assets and loans is a device for raising new funds and reducing banks
risk exposures. The bank pools a group of income-earning assets (like mortgages) and sells
securities against these in the open market, thereby transforming illiquid assets into tradable asset
backed securities. As the returns from these securities depend on the cash flows of the underlying
assets, the burden of repayment is transferred from the originator to these pooled assets.
f)SENSITIVITY ANALYSIS:
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IT IS VERY USEFUL WHEN attempting to determine the impact, the actual outcome of a
particular variable will have if it differs from what was previously assumed. By creating a given
set of scenarios, the analyst can determine how changes in one variable(s) will impact the target
variable.
g) INTERNAL RATING SYSTEM:
An internal rating system helps financial institutions manage and control credit risks they face
through lending and other operations by grouping and managing the credit-worthiness of
borrowers and the quality of credit transactions.
RISK MONITORING:
In risk monitoring the bankers have to fix up the parameters on which the transaction is to be
tested to be sure that there is no risk to viable existence of the financial unit or investment of the
bank.
RISK MANAGEMENT IN BANK: BASEL COMMITTEE APPROACH:
In order to help the banks to recognize the different kinds of risks and to take adequate steps to
overcome the under capitalization of banks assets and lessen the credit and operational risks
faced by banks. Banks of International Settlement (BIS) set up Basel Committee on banking
supervision in 1988, which issued guidelines for updating risk management in banks. These
guidelines brought about standardization and universalization among the global banking
committee for risk management and seek to protect the interest of the depositors/shareholders of
the bank. As per the guidelines issued, capital adequacy was considered panacea for risk
management and all banks were advised to have Capital Adequacy Ratio (CAR) at at least 8%.
CAR is the ratio of capital to risk weighted assets and it provides the cushion to the depositors in
case of bankruptcy. In January 1999, the Basel Committee proposed a new capital accord, which
is known as Basel II.
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A sound framework for measuring and quantifying the risk associated with banking operations
put by it. The emphasis of New Basel Accord is on flexibility, efficient operations and higher
revenues for banks with full acknowledgement of risks. The New Accord makes clear distinction
between the credit risk, market risk and operational risk stipulating assessment of risk weightage
covering all the three categories separately. Also it provides a range of options for determing the
capital requirements for credit risk and operational risk. Banks are required to select approaches
that are most appropriate for their operations and financial markets. The finalised Basel II Accord
was released in June 2004. The mid term review of annual policy for the year 2006-07 from the
Reserve Bank of India (RBI) revealed that the intended date for adoption of Basel II, i.e. March
2007, had to be postponed by two years, taking into consideration the stake of preparedness of
the banking system in the country. This accord is based on three pillars, viz.
Pillar I: Minimum Capital Requirement
Pillar II: Supervisory Review
Pillar III: Market Discipline
MINIMUM CAPITAL REQUIREMENT (PILLAR I):
The Minimum Capital Requirement (MCR) is set by the capital ratio which is defined as (Total
Capital - Tier I + Tier II + Tier III) / credit risk + market risk + operational risk). Basel I provided
for only a credit risk charge. A market risk was implemented in 1996 amendments. In the initial
stage, all banks are required to follow standardized approach in credit risk, basicindicator
approach in operational risk and standardized duration approach in market risk. Migration to
higher approaches will require RBI permission. Higher approaches are more risk sensitive and
may reduce capital requirement for banks following sound risk management.
SUPERVISORY REVIEW PROCESS (PILLAR II):
The supervisory review process is required to ensure adequacy as well as to ensure integrity by
the risk management processes. The Basel Committee has started four key principles of
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supervisory review as under: Bank should have a process for accessing its overall capital
adequacy in relation to its risk profile, as well as, a strategy for maintaining its capital levels.
Supervisors expect banks to operate above the minimum regulatory capital ratios and
ensure banks hold capital in excess of the minimum.
Supervisory shall review bank, internal capital adequacy assessment and strategy, as well
as compliance with regulatory capital ratios.
Supervisors shall seek to intervene at an early stage to prevent capital from falling below
prudent levels. The Reserve Bank of India being the supervisor of the banking operation
in India is expected to evaluate how well banks are assessing their capital needs relative
to their risks. When deficiencies are identified, prompt and decisive actions are expected
to be taken by the supervisors to reduce the risk.
MARKET DISCIPLINE (PILLAR III):
Effective market discipline requires retable and timely information that enables counter parties to
make well established risk assessment. Pillar III relates to periodical disclosures to regulator,
Board of Bank and market about various parameters which indicates the risk profile of the bank.
Reserve Bank of India has stipulated that banks should provide all Pillar III disclosures, both
quantitative and qualitative as at the end March each year along with the annual financial
statement. The banks are required to put such disclosures on its websites. Market discipline
promotes safety and soundness in banks and financial system and facilitates banks conducting
their business in a safe, sound and efficient manner.
FINANCIAL RISK IN US MARKET:
After the start of the global financial crisis, low interest rates and other central bank policies in
the United States remain critical to encourage economic risk-takingincreased consumption by
households, and greater willingness to invest and hire by businesses. However, this prolonged
monetary ease also may have encouraged excessive financial risk-taking.
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Persistently low global interest rates have prompted investors to search for higher returns in a
wide range of markets, such as stocks, and investment-grade and high-yield bonds. This has
resulted in escalating asset prices, and enabled issuers to sell assets with a reduced degree of
protection for investors (we give you an example below). The combined trends of more
expensive assets and a weakening quality of issuance could pose risks to stability.
financial risk taking in corporate debt markets is rising and markets have begun to overvalue
many assets. Spreads in the high-yield and leveraged loan markets are not far from levels seen
before the financial crisis. The quality of new loans issued is also declining, especially in the
leveraged loan market where the amount of leverage in new deals is rising. The number of
covenant-lite deals which give lenders less control over issuers has increased. For example,
many new deals allow borrowers to issue more debt in the future without obtaining prior
permission from lenders.
Meanwhile, the risk that many investors could sell their holdings all at once is now even higher
than before the crisis. Mutual funds, exchange traded funds, and households hold about 30
percent of corporate bonds as of the end of June 2014.The worry is that such retail investors
could start selling suddenly if the value of their assets deteriorates unexpectedly.
The financial risk posed by the American stock market to the United States and the rest of the
world arises from negative surprises that move from the real to the financial sector. Over time the
foundation for financial problems are laid when financial sector and asset price conditions
diverge from the underlying real sector economic and political conditions. At some point, asset
prices realign with the real sector. The realignment is a crisis if the asset price adjustment
significantly increases unemployment, reduces growth, or destabilizes political processes.
Generally, this occurs when some informational or liquidity shock surprises the financial sector
and triggers a sudden and large price adjustment.
Such adjustments are asymmetric in the sense that the price declines occur much more rapidly
than prices rose - gray-haired market participants like to observe in such cases, "Prices fall three
times faster than they rise."
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KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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Developed nation policymakers will not likely have to deal with a US stock market decline that
precipitates a global downturn. Most likely, guided by active, informed markets and sound
government policies, the major economies will rebalance growth as needed and reprice assets
gradually, making fears of an American stock market crash moot. There are, nevertheless, sound
reasons for concern.
Over time the foundation for financial problems are laid when financial sector and asset price
conditions diverge from the underlying real sector economic and political conditions. At some
point, asset prices realign with the real sector. The realignment is a crisis if the asset price
adjustment significantly increases unemployment, reduces growth, or destabilizes political
processes. Generally, this occurs when some informational or liquidity shock surprises the
financial sector and triggers a sudden and large price adjustment.
The US stock market as exposed to two sources of real sector risk: (1) Diminishing returns to
Asian and European import-substitution and export-led-growth strategies and the mechanics of
US current and capital account flows. (2) The aging of industrialized economy populations and
the significant undersaving of households and underfunded of public retirement support
programs. These are generally thought of as very long-term processes that could have no
immediate effect on markets. In our judgment, this perception is wrong.
The first risk source encompasses the production-consumption and investment-savings
relationships that sustained the US and its allies throughout the Cold War decades and are
reflected in US current and capital account flows. The second risk source includes imbalances
resulting from the undersaved condition of American households and the underfunded condition
of national retirement and healthcare commitments. Because of declines in industrialized country
birth and growth rates without comparable reductions in pension and healthcare benefits, all the
major industrialized countries face generational accounting imbalances.
IMPORT AND EXPORT STRATEGIES FOR GROWTH:
There is general agreement that import-substitution and later export-led growth strategies were
key ingredients of the recovery and economic development plans of WWII-scarred Japan and
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KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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Germany and other western-ally countries surrounding the former-USSR and China. This is
particularly clear in Asia from the 1950s into the early 1990s. Japan first, followed by the Asian
Tigers and the NICs in the "flying geese formation" successively pursued national plans to
substitute domestic production of basic goods for imports and then moved up the production
chain to maximize growth through exports to the developed world.
There is also general agreement that the United States served initially as a capital provider and
then as the linchpin importer/consumer-of-last-resort to support these recovery and development
strategies. The US through grants, development loans, and defense arrangements met the early
capital needs of its Cold War allies in the 1950s. At the same time, the de-emphasis of saving and
encouragement of consumption, even to the point of providing tax deductions for consumer
credit interest expenses, supported the evolving export-led growth strategies of US allies. The
high-production, high-savings strategies of the recovering and developing countries were
matched by a US high-consumption, low-savings strategy.
There is also general agreement that this system of export-to-the-US and US-buy-from-its-allies
started to break down in the 1990s. In his excellent paper for the working group, Robert Blecker
thoroughly describes the diminishing returns to export-led growth and pinpoints the zeroing out
of the strategy as occurring some time in the mid-1990s.8Blecker rightly, in our judgment,
criticizes as incomplete, the explanations of the US and other G7 governments that the Asian
downturns of the mid-1990s were the result of "crony capitalism" and inadequate financial
supervision and a lack of transparency. The downturns were, of course, in part due to these
factors, but the important question is how "Asian miracle workers" became "crony capitalists" in
a matter of three or four years. Something is missing.
IMPLICATIONS FOR THE UNITED STATES:
First, if the allies' Cold War export/consumption paradigm was optimal for winning, it was so
because it raised and kept the real incomes of the developing country allies higher than they
would have been in the absence of the strategy. That is, the strategy succeeded in keeping voter
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allegiances in those countries from migrating to the promises of Communism by providing and
promising as much or more wellbeing.
The second implication of the PCW hypothesis is that just as capital markets repriced the Asian
economic and political frameworks, they will also reprice the US consumption commitment. In
our judgment, that repricing actually began several years ago but has been masked by the effects
of the Asia-to-US wealth transfer and key productivity increases in the US.
A frequent reason why markets move steadily in one direction is because rational, contrarian
concerns are assuaged by a steady flow of information indicating that the concerns are being
addressed.There is broad, though certainly not complete, agreement that Boomer households are
not financially well prepared for retirement and will at some point need to reduce consumption
and increase savings. They have borrowed from the future to finance current consumption, and
as a consequence, their current net worth, expected earnings, and private and public pensions are
not sufficient to meet their retirement income requirements.
GLOBAL EFFECTS OF GENERATIONAL DELEVERAGING:
If insufficient private savings and unfunded pay-go public pensions are not corrected before
demographic aging sets in, the casualties will likely include per capita living standards, fiscal
balances, and equity market values. A 1998 G-10 report said that aging will have the following
adverse macroeconomic consequences.
As the ratio of consumers to producers rises, per capita living standards will fall unless relative
workforce declines are offset by increases in labor productivity and the effective supply and
utilization of labor.
Baby Boom dissaving in retirement would decrease the pool of capital available to finance
continued high labor productivity growth.
Fiscal balances will precipitously deteriorate as revenues paid by the large, high-earning Baby
Boom generation decline as they enter retirement. Budget deficits will rise, depleting national
savings and putting upward pressure on interest rates and downward pressure on growth.
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KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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Rapidly aging countries like Japan and Italy are also running large current account surpluses, but
a decline in savings rates as these countries age further could reduce the amount of global
savings. For the US, this means the pool of capital that has financed US investment and
consumption is going to shrink, with negative implications for bond prices and the dollar.
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"herd" response on the part of asset managers. And, fourth, there was "contagion" -- losses in
emerging market positions forced asset sales across the board, which in turn triggered further
asset liquidations.
The workings of the fourth explanation - forced asset liquidations - is an example of the
expression of asymmetric herding and contagion responses to unquantified and undiscounted
risk. The tails of event distributions contained much higher probabilities than market makers
expected. When the probabilities were revealed, the asset managers tried to sell the weak assets,
but instantly found that there was almost no market for them. They sold what they could of their
weak, emerging market and speculative assets, but ultimately they had to sell some of their high
quality high-tech stocks, corporate bonds, and European stocks and bonds. They sold everything,
and they sold fast, until their total positions were down to acceptable levels. They also confirmed
one of the harshest realities of market finance -- not only can everyone not get out the door at
once, but the door gets smaller as people go through it.
The losses in Russia were in the billions, so the loss-driven selling was in the many billions and
touched every market.
The selling reached such a scale that it eventually required reductions in the largest position,
possibly, in history - the dollar/yen carry trade. This trade involved borrowing in yen at about 2
percent, and investing the proceeds in US and European stocks and bonds paying 7 percent or
more. To scale back the trade, US and European stocks and bonds had to be sold for dollars and
d-marks, and then the dollars and d-marks sold for yen to pay back Tokyo-based banks. The
result was a 20 percent drop in large-cap stock and non-government bond prices and an offsetting
20 percent rise in the yen against the dollar - all in about 60 days.
The resulting credit contraction drove companies back onto bank balance sheets and appeared to
slow investment in the United States. The Federal Reserve in several stages cut rates 75 basis
points to stem the worst effects of the contraction through year-end. European rate reductions
followed, intended to address longer-term economic trends in the new European Monetary Union
countries.
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Implementation of the new framework will require substantial resources and commitment
on the part of both banks and supervisors. Banks are required to make enormous
improvements in the areas of policies, organisational structure, MIS, tools for analysis,
process, specified training of staff etc. It will involve huge cost both for the banks as well
as for supervisors.
The new norms will increase the capital requirements in all the banks due to introduction
in multiple risk weights with preferential treatment for high rated assets. Although the
capital requirement for credit risk may go down due to adoption of more risk sensitive
techniques such as securitization, derivatives, melting services, equity holdings, venture
capital and guarantees etc.
Risk management is extremely data-intensive. Accurate, reliable and timely availability
of data is crucial for proper risk management. Banks need to implement substantial
changes to their internal systems to prepare for appropriate data collection and revised
reporting requirements. These changes may require systems integration, modification and
introduction of new software. Banks need to assess the capabilities of their present
systems and review the necessary system changes required.
To provide the basis for forecasting and building of models in respect of various
activities, such as loaning, security and foreign exchange transactions, a lot of historical
data is required. In the Indian context major handicap is the absence of data series,
particularly, related to the transactions in individual loan accounts.
The new capital accord assigns risk-weight of sovereign at 0-50%. These 13 also a higher
risk weight to the small and medium enterprises. In India, the PSBs have more than 40
percent of their lending to priority sector. The implementation of Basel II can adversely
affect the priority sector lending.
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Even the G-10 countries are finding it difficult to implement the Basel II accord in all the
banks. Therefore, longer time may be required for its implementation in some or all the
banks in India.
In India, credit rating is restricted to issues and not to the issuers. While Basel II gives
some scope to extend the rating of issues to issuers. This would be an approximation and
it would be necessary for the system to move to the rating of issuers. Encouraging rating
of issuers would be a challenge.
Yet another requirement for establishing risk management system is trained and skilled
manpower. The managers should understand both the theory and practice of risk. To
reach such on understanding undoubtedly involves a continuous learning process in the
new technologies. Inducting a continuous learning process in the line managers and
educating them in risk management is a task to be addressed on priority by the banks for
the smooth adoption of the risk management principles and practices and Basel-II
recommendations across the banks. Skill development for risk management approaches,
both at the bank level and at supervisors level, would be a tough task ahead.
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CONCLUSION:
Risk is an opportunity as well as a threat and has different meanings for different users. The
banking industry is exposed to different risks such as forex volatility, risk, variable interest rate
risk, market play risk, operational risks, credit risk etc. which can adversely affect its profitability
and financial health.
Risk management has thus emerged as a new and challenging area in banking. Basel II intended
to improve safety and soundness of the financial system by placing increased emphasis on bank's
own internal control and risk management process and models. The supervisory review and
market discipline. Indeed, to enable the calculation of capital requirements under the new accord
requires a bank to implement a comprehensive risk management framework.
Over a period of time, the risk management improvements that are the intended result may be
rewarded by lower capital requirements. However, these changes will also have wide-ranging
effects on a bank's information technology systems, process, people and business, beyond and
regulatory compliance, risk management and finance function.
The task of integrating Basel II is challenging. Indian banks have come a long way since
independence and more so after LPG era, however, still they have to cover some distance so as to
be bench marked with the best banks globally. But one thing is for sure that the reform process is
on and the Indian banks are in the right direction. They have adopted best structures, processes
SUBMITTED BY: RUCHIKA SINGH(605), TEK CHAND MEENA(614), VIVEK
KUMAR MISHRA(616), NATIONAL LAW UNIVERSITY, JODHPUR |
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and technologies available worldwide and have moved from strength to strength. Still the future
poses various challenges for the banking industry.
Further we can say the followings also:
Risk management underscores the fact that the survival of an organization depends
heavily on its capabilities to anticipate and prepare for the change rather than just waiting
for the change and react to it.
The objective of risk management is not to prohibit or prevent risk taking activity, but to
ensure that the risks are consciously taken with full knowledge, clear purpose and
understanding so that it can be measured and mitigated.
Functions of risk management should actually be bank specific dictated by the size and
quality of balance sheet, complexity of functions, technical/ professional manpower and
the status of MIS in place in that bank.
Risk Management Committee, Credit Policy Committee, Asset Liability Committee, etc
are such committees that handle the risk management aspects.
The banks can take risk more consciously, anticipates adverse changes and hedges
accordingly; it becomes a source of competitive advantage, as it can offer its products at a
better price than its competitors.
Regarding use of risk management techniques, it is found that internal rating system and
risk adjusted rate of return on capital are important.
The effectiveness of risk measurement in banks depends on efficient Management
Information System, computerization and net working of the branch activities.
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