UNIT 4

RISK MANAGEMENT
OUTLINE OF THE STUDY
• Risk and Its Types
• Assets classification on the basis of Risk.
• Concept of NPA and its implications on bank
profitability
• Regulatory norms for classifying an asset as NPA
• Precautions before classifying Assets into NPA.
 RISK AND ITS TYPES
• Banks are literally exposed to many different types of risks. A successful banker is one
that can mitigate these risks and create significant returns for the shareholders on a
consistent basis. Mitigation of risks begins by first correctly identifying the risks, why
they arise and what damage can they cause. We have listed the major types of risks
that are faced by every bank. They are as follows:
• Credit Risks
• Market Risks
• Operational Risks
• Moral Hazard
• Liquidity Risk
• Business Risk
• Reputational Risk
• Systemic Risk
 CREDIT RISKS
• Credit risk is the risk that arises from the possibility of non-payment of loans by
the borrowers. Although credit risk is largely defined as risk of not receiving
payments, banks also include the risk of delayed payments within this category.
• Often times these cash flow risks are caused by the borrower becoming
insolvent. Hence, such risk can be avoided if the bank conducts a thorough
check and sanctions loans only to individuals and businesses that are not likely
to run out of income over the period of the loan. Credit rating agencies provide
adequate information to enable the banks to make informed decisions in this
regard.
• The moment a loan is made, a certain amount of money is appropriated to the
provision account. Also, banks have started utilizing tools like structured finance
to mitigate such risks. Securitization helps remove the concentrated risk from
the bank’s books and diffuse it amongst the various investors in the capital
 MARKET RISKS
• Apart from making loans, banks also hold a significant portion of
securities. Some of these securities are held because of the treasury
operations of the bank i.e. as a means to park money for the short
term. However, many securities are also held as collateral based on
which banks have given loans to their customers. The business of
banking is therefore intertwined with the business of capital markets.
• Banks face market risks in various forms. For instance if they are
holding a large amount of equity then they are exposed to equity risk.
Also, banks by definition have to hold foreign exchange exposing
them to Forex risks. Similarly banks lend against commodities like
gold, silver and real estate which exposes them to commodity risks as
well.
 OPERATIONAL RISKS
• Operational risk occurs as the result of a failed business
processes in the bank’s day to day activities. Examples of
operational risk would include payments credited to the
wrong account or executing an incorrect order while dealing
in the markets. None of the departments in a bank are
immune from operational risks.
• Operational risks arise mainly because of hiring the wrong
people or alternatively they could also occur if there is a
breakdown of the information technology systems. A lapse in
the internal processes being followed could also lead to
catastrophic errors.
 MORAL HAZARD
• The recent bailout of banks by many countries has created another
kind of risk called the moral hazard.
• This risk is faced by the taxpayers of the country in which banks
operate. Banks have become accustomed to taking excessive risk.
If their risk pays off, they get to keep the returns.
• However, if their risk backfires, then the losses are borne by
taxpayers in the form of bailouts. This too big to fail model has
caused banks to become reckless in their pursuit of profit.
• Although central banks are using audits to ensure that safe
business practices are followed, banks nowadays indulge in risky
business the moment they are not under regulatory oversight.
 LIQUIDITY RISK
Liquidity risk is another kind of risk that is inherent in the
banking business. Liquidity risk is the risk that the bank will not
be able to meet its obligations if the depositors come in to
withdraw their money.
This risk is inherent in the fractional reserve banking system.
Therefore, in this system, only a percentage of the deposits
received are held back as reserves, the rest are used to create
loans.
 LIQUIDITY RISK

• If all the depositors of the institution came in to withdraw

their money all at once, the bank would not have enough
money. This situation is called a bank run. This has
happened countless times over the history of modern
banking.
 BUSINESS RISK
• The banking industry today is considerably advanced and diversified.
Banks today have a wide variety of strategies from which they have to
choose. Once such strategy is chosen, banks need to focus their resources
on obtaining their strategic goals in the long run.
• Hence, there is always a risk that a given bank may choose the wrong
strategy. As a result of this wrong choice, the bank may suffer losses and
end up being acquired or may simply collapse.
• Consider the case of banks such as Washington Mutual and Lehman
Brothers. These banks chose the subprime route to growth.
• Their strategy was to be the preferred lender to people who have less
than perfect credit scores. However, the whole area of subprime lending
went bust and since these banks had heavy exposures to such loans, they
suffered dire consequences too.
 REPUTATIONAL RISK
• Customers like their money to be deposited at places which they
believe follow safe and sound business practices. Hence, if there is
any news in the media which projects a given bank in a negative light,
such news negatively impacts the banks business. For instance
Citibank was recently viewed as manipulating the Forex rates via
conducting false trades with its own trading partners. When
regulators found out about Citibank’s predatory tactics, they levied
huge fines on the bank.
• Apart from the fines Citibank also lost reputation as a bank that
follows fair trade practices when the customers found out that they
tend to resort to market manipulation. Many prospective customers
may have shifted their business away from Citibank as a result of this
discovery causing monetary loss as a result of reputation loss.
SYSTEMIC RISK
• Systemic risk is an extremely bad scenario to be in. For
instance when the subprime crisis happened in 2008, it
seemed like the entire global financial system would
collapse.
• The very nature of banking system therefore makes
them prone to systemic risks. Systemic risks do not
affect an individual bank rather they affect the entire
system. Hence, there is very little that an individual
bank can do to protect itself in the event that such a
risk materializes.
 CONCEPT OF NPA
• Assets for a bank are the loans it has given and investment
made by the bank. Most important assets for banks are loans
given by it. Similarly, banks make investment in government
securities by purchasing them.
• Usually, the health as well as the financial condition of a bank
is measured through the proportion of bad assets or Non
Performing Assets with it.
• Simply, NPA indicates the amount of loan that was not
returned by the customer. An asset becomes non-performing
when it ceases to generate income for the bank.
 CONCEPT OF NPA
• As per the current norm, if a loan is overdue during the last 90 days, it will
be categorized as a Non Performing Asset (NPA). A loan whose interest and
/ or installment of principal have remained ‘overdue due’ for a period of 90
days is thus considered as NPA.
• Overdue is a situation where the loan is not paid by the due date fixed by
the bank.
• From the banks’ health point of view, higher the NPA, lower will be its
health. Attempt to strengthen a bank is mainly concentrated on NPA
management.
• Some of the assets of the banks may not have returned or were not repaid
for a considerable point of time. Here, to measure the seriousness of
repayment delay, assets are classified into different categories.
ASSETS CLASSIFICATION ON THE BASIS OF
RISK
The loan accounts in Banks are classified into four categories. Out of
these four categories, the following three categories are considered
as NPAs :-
(a) Sub-Standard Assets
(b) Doubtful Assets
(c) Loss Assets
The fourth category of loan accounts, which is not included in NPA
category is Standard Assets. Standard Asset is one which does not
disclose any problems and which does carry only normal risk
attached to the business.
 STANDARD ASSET
• If the borrower regularly pays his dues regularly
and on time; bank will call such loan as its
“Standard Asset”. As per the norms, banks have to
make a general provision of 0.40% for all loans
and advances except that given towards
agriculture and small and medium enterprise
(SME) sector.
 SUB-STANDARD ASSETS
• If the borrower does not pay dues for 90 days after end
of a quarter; the loan becomes an NPA and it is termed
as “Special Mention Account”. If this loan remains
SMA for a period less than or equal to 12 months; it is
termed as Sub-Standard Asset. In this case, bank has to
make provisioning as follows:
• 15% of outstanding amount in case of Secured loans
• 25% of outstanding amount in case of Unsecured loans
 SUB-STANDARD ASSETS
• Earlier a sub-standard asset was one, which was classified as NPA for a
period not exceeding two years. With effect from 31 March 2001, a sub-
standard asset was one, which has remained NPA for a period less than or
equal to 18 months.
• With effect from 31 March 2005 the norms have been further tightened
and a sub-standard asset would be one, which has remained NPA for a
period less than or equal to 12 months.
• In such cases, the current net worth of the borrower/ guarantor or the
current market value of the security charged is not enough to ensure
recovery of the dues to the banks in full.
• In other words, such an asset will have well defined credit weaknesses that
jeopardise the liquidation of the debt and are characterised by the distinct
possibility that the banks will sustain some loss, if deficiencies are not
corrected.
 DOUBTFUL ASSETS
• Earlier a doubtful asset was one, which remained NPA for a period
exceeding two years. With effect from 31 March 2001, an asset is to
be classified as doubtful, if it had remained NPA for a period
exceeding 18 months.
• With effect from March 31, 2005, the norms have been further
tightened, and an asset would be classified as doubtful if it remained
in the sub-standard category for 12 months.
• A loan classified as doubtful has all the weaknesses inherent in
assets that were classified as sub-standard, with the added
characteristic that the weaknesses make collection or liquidation in
full, – on the basis of currently known facts, conditions and values –
highly questionable and improbable.
 DOUBTFUL ASSETS
• If sub-standard asset remains so for a period of 12 more months; it
would be termed as “Doubtful asset”.
• This remains so till end of 3rd year. In this case, the bank need to make
provisioning as follows:
• Up to one year: 25% of outstanding amount in case of Secured loans;
100% of outstanding amount in case of Unsecured loans
• 1-3 years: 40% of outstanding amount in case of Secured loans; 100%
of outstanding amount in case of Unsecured loans
• more than 3 years: 100% of outstanding amount in case of Secured
loans; 100% of outstanding amount in case of Unsecured loans
 LOSS ASSETS:
• A loss asset is one where loss has been identified by the bank or
internal or external auditors or the RBI inspection but the amount has
not been written off wholly. In other words, such an asset is
considered uncollectible and of such little value that its continuance as
a bankable asset is not warranted although there may be some salvage
or recovery value.
• If the loan is not repaid even after it remains sub-standard asset for
more than 3 years, it may be identified as unrecoverable by internal
/ external audit and it would be called loss asset. An NPA can
declared loss only if it has been identified to be so by internal or
external auditors.
• However, only those advances are classified as loss assets where no
security is available. In accounts where some security / ECGC /DICGC
cover is available, these accounts are not reported under loss assets.
 CONCLUSION
• Thus, we can conclude that in terms of RBI guidelines, as and when an
asset becomes a NPA, such advances would be first classified as a sub-
standard one for a period that should not exceed 12 months and
subsequently as doubtful assets.
• However, it needs to be noted that the asset classification is only for
the purpose of computing the amount of provision that needs to be
made with respect to bank advances, and it is not for the purpose of
presentation of advances in the banks balance sheet. The Third
Schedule to the Banking Regulation Act, 1949, solely governs
presentation of advances in the balance sheet
REGULATORY NORMS FOR CLASSIFYING AN ASSET AS NPA
• The R B I introduced the NPA norms relying on the Narsimham
Committee recommendations & prudential norms for Income
Recognition, Asset Classification and provisioning for the advance
portfolio of the banks with the intention for proper disclosure of
profit & loss and reflect the financial health of bank.
• The classification of assets has to be done on the basis of objective
criteria and based on record of recovery rather than on any
subjective considerations.
• The provisioning should be made on the basis of classification of
assets based on the period for which the assets has remained non
performing and the availability of security and the realisable value
thereof.
 REGULATORY NORMS FOR CLASSIFYING AN ASSET AS NPA
Type of loan Identification

Term Loan Account is treated Interest and/ or instalment remains over due for a
period of more than 90 days.
Cash Credit Account is treated as NPA if it remains out of order for a period of
& Overdraft more than 90 days. An account is treated as out of order if,
accounts •The outstanding balance remains continuously in excess of
sanctioned/drawing power limit or
•Though the outstanding balance is less than the sanctioned
limit/drawing power.
•There are no credits continuously for more than 90 days in the
account i.e. the account is non-operative.
•The credits during the aforesaid period in accounts are not
sufficient to cover the interest debited during the same period.
Type of loan Identification

Liquidity Remains outstanding for more than 90 days in respect of

facility securitization transaction.

Agricultural In case of Short duration crops, the instalment of principle

Advances or interest thereon remains overdue for two crop seasons
• In case of long duration crops, the instalment of principle
or interest thereon remains overdue for one crop season.

Bill Bill remains over due for a Discounted period of more than
Purchased/ 90 days.
Discounted
PRECAUTIONS BEFORE CLASSIFYING
ASSETS INTO NPA
• Accounts should not be classified as NPA merely due to existence of some deficiencies
of temporary nature such as non-availability of adequate drawing power, balance
outstanding exceeding the limit, non submission of stock statements (Stock statement
older than 90 days temporary deficiency & becomes NPA on 90 days thereafter) subject
to overall performance of conduct is satisfactory.
• An account where the regular/Adhoc credit limits has not been reviewed/renewed
within 90 days from the due date/date of ad-hoc sanction will be treated as NPA.
• The accounts are regularised before Balance Sheet date by repaying overdues through
genuine sources (Not by sanction of additional facilities or transfer of funds between
accounts) then these accounts need not be treated as N.P.A. However, such
classification should be handled with due care and without any subjectivity.
PRECAUTIONS BEFORE CLASSIFYING ASSETS INTO
NPA
• In case of consortium advances – classification be done on the recoverability of
advance in the books of account of the individual member bank. Bank needs to
arrange to get their share of recovery or obtain an express consent from the Lead
Bank.
• Asset Classification to be borrower-wise and not facility-wise. If one facility of
borrower is NPA, all the facilities of that borrower are to be treated as NPA under
the same category of classification. It may be noted that if a borrower has cash
credit & term loan and if one becomes NPA, both these facilities will have to be
treated as NPA and classified either as substandard/doubtful/as the case of first
NPA facility.
• Credit facility backed by Central Government guarantee though overdue may be
treated as NPA only when the Govt. repudiates its guarantee when invoked.
 IMPLICATIONS ON BANK’S PROFITABILITY
• Lenders suffer lowering of profit margins.
• Stress in banking sector causes less money available to fund other projects, therefore,
negative impact on the larger national economy.
• Higher interest rates by the banks to maintain the profit margin.
• Redirecting funds from the good projects to the bad ones.
• As investments got stuck, it may result in unemployment.
• In the case of public sector banks, the bad health of banks means a bad return for a
shareholder which means that government of India gets less money as a dividend. Therefore
it may impact easy deployment of money for social and infrastructure development and
results in social and political cost.
• Investors do not get rightful returns.
• Balance sheet syndrome of Indian characteristics that is both the banks and the corporate
sector have stressed balance sheet and causes halting of the investment-led development
process.
• NPAs related cases add more pressure to already pending cases with the judiciary.