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What Is Risk Management in Indian Banking Sector and The Role of RBI
What Is Risk Management in Indian Banking Sector and The Role of RBI
ofRBI
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WhatisRisk?
Riskreferstoaconditionwherethereisapossibilityofundesirableoccurrenceofaparticularresultwhich
isknownorbestquantifiableandthereforeinsurable.Ariskcanbedefinedasanunplannedeventwithfinancial
consequencesresultinginlossorreducedearnings.Anactivitywhichmaygiveprofitsorresultinlossmaybecalled
ariskypropositionduetouncertaintyorunpredictabilityoftheactivityoftradeinfuture.
Inotherwords,itcanbedefinedastheuncertaintyoftheoutcome.Asriskisdirectlyproportionatetoreturn,the
moreriskabanktakes,itcanexpecttomakemoremoney.
TypeofRisks
Themajorrisksinbankingbusinessascommonlyreferredcanbebroadlyclassifiedinto:
LiquidityRisk
InterestRateRisk
MarketRisk
CreditorDefaultRisk
OperationalRisk
LiquidityRisk
Theliquidityriskofbanksarisesfromfundingoflongtermassetsbyshorttermliabilities,therebymakingthe
liabilitiessubjecttorolloverorrefinancingrisk.
Theliquidityriskinbanksmanifestindifferentdimensions
(a)FundingRisk:FundingLiquidityRiskisdefinedastheinabilitytoobtainfundstomeetcashflowobligations.For
banks,fundingliquidityriskiscrucial.Thisarisesfromtheneedtoreplacenetoutflowsduetounanticipated
withdrawal/nonrenewalofdeposits(wholesaleandretail).
(b)TimeRisk:Timeriskarisesfromtheneedtocompensatefornonreceiptofexpectedinflowsoffundsi.e.,
performingassetsturningintononperformingassets.
(c)CallRisk:Callriskarisesduetocrystallisationofcontingentliabilities.Itmayalsoarisewhenabankmaynotbe
abletoundertakeprofitablebusinessopportunitieswhenitarises.
2.InterestRateRisk
InterestRateRiskariseswhentheNetInterestMarginortheMarketValueofEquity(MVE)ofaninstitutionis
affectedduetochangesintheinterestrates.
IRRcanbeviewedintwowaysitsimpactisontheearningsofthebankoritsimpactontheeconomicvalueofthe
banksassets,liabilitiesandOffBalanceSheet(OBS)positions.InterestrateRiskcantakedifferentforms.
3.MarketRisk
Theriskofadversedeviationsofthemarktomarketvalueofthetradingportfolio,duetomarketmovements,during
theperiodrequiredtoliquidatethetransactionsistermedasMarketRisk.Thisriskresultsfromadversemovements
inthelevelorvolatilityofthemarketpricesofinterestrateinstruments,equities,commodities,andcurrencies.Itis
alsoreferredtoasPriceRisk.
ThetermMarketriskappliesto(i)thatpartofIRRwhichaffectsthepriceofinterestrateinstruments,(ii)Pricingrisk
forallotherassets/portfoliothatareheldinthetradingbookofthebankand(iii)ForeignCurrencyRisk.
(a)ForexRisk:Forexriskistheriskthatabankmaysufferlossesasaresultofadverseexchangeratemovements
duringaperiodinwhichithasanopenpositioneitherspotorforward,oracombinationofthetwo,inanindividual
foreigncurrency.
(b)MarketLiquidityRisk:Marketliquidityriskariseswhenabankisunabletoconcludealargetransactionina
particularinstrumentnearthecurrentmarketprice.
4.DefaultorCreditRisk
Creditriskismoresimplydefinedasthepotentialofabankborrowerorcounterpartytofailtomeetitsobligationsin
accordancewiththeagreedterms.Formostbanks,loansarethelargestandmostobvioussourceofcredit
risk.Itisthemostsignificantrisk,moresointheIndianscenariowheretheNPAlevelofthebankingsystemis
significantlyhigh.
Now,letsdiscussthetwovariantsofcreditrisk
(a)CounterpartyRisk:ThisisavariantofCreditriskandisrelatedtononperformanceofthetradingpartnersdue
tocounterpartysrefusalandorinabilitytoperform.Thecounterpartyriskisgenerallyviewedasatransientfinancial
riskassociatedwithtradingratherthanstandardcreditrisk.
(b)CountryRisk:Thisisalsoatypeofcreditriskwherenonperformanceofaborrowerorcounterpartyarisesdue
toconstraintsorrestrictionsimposedbyacountry.Here,thereasonofnonperformanceisexternalfactorsonwhich
theborrowerorthecounterpartyhasnocontrol
CreditRiskdependsonbothexternalandinternalfactors.
TheinternalfactorsincludeDeficiencyincreditpolicyandadministrationofloanportfolio,Deficiencyinappraising
borrowersfinancialpositionpriortolending,ExcessivedependenceoncollateralsandBanksfailureinpostsanction
followup,etc.
ThemajorexternalfactorsarethestateofEconomy,Swingsincommodityprice,foreignexchangeratesandinterest
rates,etc.
CreditRiskcantbeavoidedbutcanbemitigatedbyapplyingvariousriskmitigatingprocesses
Banksshouldassessthecreditworthinessoftheborrowerbeforesanctioningloani.e.,Creditratingofthe
borrowershouldbedonebeforehand.Creditratingisthemaintoolofmeasuringcreditriskanditalso
facilitatespricingtheloan.
Byapplyingaregularevaluationandratingsystemofallinvestmentopportunities,bankscanreduceitscredit
riskasitcangetvitalinformationoftheinherentweaknessesoftheaccount.
BanksshouldfixprudentiallimitsonvariousaspectsofcreditbenchmarkingCurrentRatio,DebtEquity
Ratio,DebtServiceCoverageRatio,ProfitabilityRatioetc.
Thereshouldbemaximumlimitexposureforsingle/groupborrower.
Thereshouldbeprovisionforflexibilitytoallowvariationsforveryspecialcircumstances.
Alertnessonthepartofoperatingstaffatallstagesofcreditdispensationappraisal,disbursement,review/
renewal,postsanctionfollowupcanalsobeusefulforavoidingcreditrisk.
5.OperationalRisk
BaselCommitteeforBankingSupervisionhasdefinedoperationalriskastheriskoflossresultingfrominadequateor
failedinternalprocesses,peopleandsystemsorfromexternalevents.Managingoperationalriskhasbecome
importantforbanksduetothefollowingreasons
Higherlevelofautomationinrenderingbankingandfinancialservices
Increaseinglobalfinancialinterlinkages
Scopeofoperationalriskisverywidebecauseoftheabovementionedreasons.
Twoofthemostcommonoperationalrisksarediscussedbelow
(a)TransactionRisk:Transactionriskistheriskarisingfromfraud,bothinternalandexternal,failedbusiness
processesandtheinabilitytomaintainbusinesscontinuityandmanageinformation.
(b)ComplianceRisk:Complianceriskistheriskoflegalorregulatorysanction,financiallossorreputationlossthat
abankmaysufferasaresultofitsfailuretocomplywithanyoralloftheapplicablelaws,regulations,codesof
conductandstandardsofgoodpractice.Itisalsocalledintegrityrisksinceabanksreputationiscloselylinkedtoits
adherencetoprinciplesofintegrityandfairdealing.
6.OtherRisks
Apartfromtheabovementionedrisks,followingaretheotherrisksconfrontedbyBanksincourseoftheirbusiness
operations
(a)StrategicRisk:StrategicRiskistheriskarisingfromadversebusinessdecisions,improperimplementationof
decisionsorlackofresponsivenesstoindustrychanges.
(b)ReputationRisk:ReputationRiskistheriskarisingfromnegativepublicopinion.Thisriskmayexposethe
institutiontolitigation,financiallossordeclineincustomerbase.
RiskManagement
RiskManagementisactuallyacombinationofmanagementofuncertainty,risk,equivocalityanderror.
Uncertaintywheretheoutcomescannotbeestimatedevenrandomly,arisesduetolackofinformationandthis
uncertaintygetstransformedintorisk(wheretheestimationofoutcomeispossible)asinformationgathering
progresses.
Initially,theIndianbankshaveusedriskcontrolsystemsthatkeptpacewithlegalenvironmentandIndianaccounting
standards.Butwiththegrowingpaceofderegulationandassociatedchangesinthecustomersbehaviour,banksare
exposedtomarktomarketaccounting.
Therefore,thechallengeofIndianbanksistoestablishacoherentframeworkformeasuringandmanaging
riskconsistentwithcorporategoalsandresponsivetothedevelopmentsinthemarket.Asthemarketis
dynamic,banksshouldmaintainvigilontheconvergenceofregulatoryframeworksinthecountry,changesinthe
internationalaccountingstandardsandfinallyandmostimportantlychangesintheclientsbusinesspractices.
Therefore,theneedofthehouristofollowcertainriskmanagementnormssuggestedbytheRBIandBIS.
RoleofRBIinRiskManagementinBanks
Here,wewilldiscusstheroleofRBIinRiskManagementandhowthetoolscalledCAMELSwasusedbyRBIto
evaluatethefinancialsoundnessoftheBanks.CAMELSisthecollectivetoolofsixcomponentsnamely
CapitalAdequacy
AssetQuality
Management
EarningsQuality
Liquidity
SensitivitytoMarketrisk
TheCAMELwasrecommendedforthefinancialsoundnessofbankin1988whilethesixthcomponentcalled
sensitivitytomarketrisk(S)wasaddedtoCAMELin1997.
InIndia,thefocusofthestatutoryregulationofcommercialbanksbyRBIuntiltheearly1990swasmainlyon
licensing,administrationofminimumcapitalrequirements,pricingofservicesincludingadministrationofinterestrates
ondepositsaswellascredit,reservesandliquidassetrequirements.
RBIin1999recognisedtheneedofanappropriateriskmanagementandissuedguidelinestobanksregarding
assetsliabilitymanagement,managementofcredit,marketandoperationalrisks.Theentiresupervisorymechanism
hasbeenrealignedsince1994underthedirectionsofanewlyconstitutedBoardforFinancialSupervision(BFS),
whichfunctionsundertheaegisoftheRBI,tosuitthedemandingneedsofastrongandstablefinancialsystem.
AprocessofratingofbanksonthebasisofCAMELSinrespectofIndianbanksandCACS(Capital,AssetQuality,
ComplianceandSystems&Control)inrespectofforeignbankshasbeenputinplacefrom1999.
ByMadhviBansal