RISK MANAGEMENT IN COMMERCIAL BANKS

(A CASE STUDY OF PUBLIC AND PRIVATE SECTOR BANKS)

Prof. Rekha Arunkumar

Faculty (Finance), MBA Programme
UBLIC AND PRIVATE SECTOR BANKS)
ABSTRACT:
• “Banks are in the business of managing risk, not avoiding
it…………………..”
• Risk is the fundamental element that drives financial behavior. Without
risk, the financial system would be vastly simplified. However, risk is
omnipresent in the real world. Financial Institutions, therefore, should
manage the risk efficiently to survive in this highly uncertain world. The
future of banking will undoubtedly rest on risk management dynamics.
Only those banks that have efficient risk management system will
survive in the market in the long run. The effective management of
credit risk is a critical component of comprehensive risk management
essential for long-term success of a banking institution.
• Credit risk is the oldest and biggest risk that bank, by virtue of its very
nature of business, inherits. This has however, acquired a greater
significance in the recent past for various reasons. Foremost among
them is the wind of economic liberalization that is blowing across the
globe. Better credit portfolio diversification enhances the prospects of
the reduced concentration credit risk as empirically evidenced by
direct relationship between concentration credit risk profile and NPAs
of public sector banks.
• “……………………A bank’s success lies in its ability to assume and
• Aggregate risk within tolerable and manageable limits”.
1. PREAMBLE:
1.1 Risk Management:
• The future of banking will undoubtedly rest on risk management
dynamics. Only those banks that have efficient risk management
system will survive in the market in the long run. The effective
management of credit risk is a critical component of comprehensive
risk management essential for long-term success of a banking
institution.
• The corner stone of credit risk management is the establishment of a
framework that defines corporate priorities, loan approval process,
credit risk rating system, risk-adjusted pricing system, loan-review
mechanism and comprehensive reporting system.
1.2 Significance of the study:
• The fundamental business of lending has brought trouble to individual
banks and entire banking system. It is, therefore, imperative that the
banks are adequate systems for credit assessment of individual
projects and evaluating risk associated therewith as well as the
industry as a whole.
• Credit Risk, that is, default by the borrower to repay lent money,
remains the most important risk to manage till date.
• Better and effective strategic credit risk management process is a
better way to manage portfolio credit risk. The process provides a
framework to ensure consistency between strategy and
implementation that reduces potential volatility in earnings and
maximize shareholders wealth.
• Beyond and over riding the specifics of risk modeling issues, the
challenge is moving towards improved credit risk management lies in
addressing banks’ readiness and openness to accept change to a
more transparent system, to rapidly metamorphosing markets, to
more effective and efficient ways of operating and to meet market
requirements and increased answerability to stake holders.
1.3 Credit Risk Management (CRM) dynamics:

• Researchers and risk management practitioners have constantly tried

to improve on current techniques and in recent years, enormous
strides have been made in the art and science of credit risk
measurement and management. Much of the progress in this field
has resulted from the limitations of traditional approaches to credit
risk management and with the current Bank for International
Settlement’ (BIS) regulatory model.
• The two distinct dimensions of credit risk management can readily be
identified as preventive measures and curative measures.
• Preventive measures include risk assessment, risk measurement and
risk pricing, early warning system to pick early signals of future
defaults and better credit portfolio diversification.
• The curative measures, on the other hand, aim at minimizing post-
sanction loan losses through such steps as securitization, derivative
trading, risk sharing, legal enforcement etc.
2. THE PROBLEM OF NON-PERFORMING
ASSETS
• Loans and Advances as assets of the bank play an important part in
gross earnings and net profits of banks. The share of advances in the
total assets of the banks forms more than 60 percent and as such it is
the backbone of banking structure.
3. MANAGEMENT OF CREDIT RISK - A
PROACTIVE APPROACH
3.1 Introduction:
• Risk is the potentiality that both the expected and unexpected events
may have an adverse impact on the bank’s capital or earnings.
• The expected loss is to be borne by the borrower and hence is taken
care by adequately pricing the products through risk premium and
reserves created out of the earnings.
• It is the amount expected to be lost due to changes in credit quality
resulting in default.
• Banks are confronted with various kinds of financial and non-financial
risks viz., credit, market, interest rate, foreign exchange, liquidity,
equity price, legal, regulatory, reputation, operational etc.
• These risks are highly interdependent and events that affect one area
of risk can have ramifications for a range of other risk categories.
• Thus, top management of banks should attach considerable
importance to improve the ability to identify measure, monitor and
control the overall level of risks undertaken.
3.2 Credit Risk:
• The major risk banks face is credit risk. It follows that the major risk
banks must measure, manage and accept is credit or default risk. It is
the uncertainty associated with borrower’s loan repayment. For most
people in commercial banking, lending represents the heart of the
Industry. Loans dominate asset holding at most banks and generate
the largest share of operating income.
3.3 Components of credit risk:

• The credit risk in a bank’s loan portfolio consists of three components

1) Transaction Risk
2) Intrinsic Risk
3) Concentration Risk
1) Transaction Risk: Transaction risk focuses on the volatility in credit
quality and earnings resulting from how the bank underwrites
individual loan transactions. Transaction risk has three dimensions:
selection, underwriting and operations.
2) Intrinsic Risk: It focuses on the risk inherent in certain lines of
business and loans to certain industries Commercial real estate
construction loans are inherently more risky than consumer loans.
Intrinsic risk addresses the susceptibility to historic, predictive, and
lending risk factors that characterize an industry or line of business.
3) Concentration Risk: Concentration risk is the aggregation of
transaction and intrinsic risk within the portfolio and may result
from loans to one borrower or one industry, geographic area, or
lines of business. Bank must define acceptable portfolio
concentrations for each of these aggregations.
3.4 Strategic credit risk management
• This is the underlying premise of an integrated proactive approach to
risk management and entails a four step process:
Step 1. Establishing corporate priorities
Step 2. Choosing the credit culture.
Step 3. Determining credit risk strategy
Step 4. Implementing risk controls