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faaiz January 4th, 2008 04:46 PM

Risk Management in Banks
Risk Management in Banks

The face of banking in India is changing rapidly. The enhanced role of the banking sector in the Indian economy, the increasing levels of deregulation along with the increasing levels of competition have facilitated globalisation of the India banking system and placed numerous demands on banks. Operating in this demanding environment has exposed banks to various challenges and risks.

Traditional Risk Management Systems

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. So we need to determine an approach to examine large-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:
Standards and reports
Position limits or rules
Investment guidelines or strategies
Incentive contracts and compensation

In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives.

Types of Risk

The banking industry has long viewed the problem of risk management as the need to control four of the above risks which make up most, if not all, of their risk exposure, viz., credit, interest rate, foreign exchange and liquidity risk. While they recognize counterparty and legal risks, they view them as less central to their concerns.

Value Based Risk Management Systems

Value-at-risk (VaR)

Value-at-risk (VaR) is a measure of the worst expected loss over a given time interval under normal market conditions at a given confidence level. Value-at-risk is widely used by banks, securities firms and other trading organizations. Such firms could track their portfolios' market risk by using historical volatility as a risk metric.

Use of Derivatives

There has been a significant increase in the use of derivatives in the risk management.

Credit Default Swaps - Credit derivatives are being used by almost all the banks now. Out of a total of $250 trillion of derivative contracts traded round the world, more than 50% are in form of credit derivatives. Then banks are using swaps for match their asset - liability mismatch.

Interest Rate Swaps - A bank having a fixed income and floating outflow can go in for a swap to get fixed outflow. Similarly, swaps can be arranged to hedge currency risks. Universal banking system is now spreading fast. This is diversifying the bank's operational risk.

Stress Testing

It is another modern risk management practice which has found wide acceptability in Indian Banking System. Determining the required buffer size of capital is an important risk management issue for banks, which the Basle Committee (2002) suggests should be approached via stress testing.

Stress testing permits a forward-looking analysis and a uniform approach to identifying potential risks to the banking system as a whole. Stress tests done on German banks found that, "it is not only the capital and reserves base which is crucial for the long-term stability of the banks, however. The institutions also have to make further progress in their efforts to achieve a sustained improvement in their profitability and in limiting their credit and market risks." All these dynamics are well captured by Stress Testing models.

RBI has said that, "Banks should identify their major sources of risk and carry out stress tests appropriate to them. Some of these tests may be run daily or weekly, some others may be run at monthly or quarterly intervals. This stress testing would also form a part of preparedness for Pillar 2 of the Basel II framework."

Basel Committee

Basel 1

In July 1988, the Basel Committee came out with a set of recommendations aimed at introducing minimum levels of capital for internationally active banks. These norms required the banks to maintain capital of at least 8 per cent of their risk-weighted loan exposures. Different risk weights were specified by the committee for different categories of exposure. For instance, government bonds carried risk-weight of 0 per cent, while the corporate loans had a risk-weight of 100 per cent.

Basel II

To set right these aspects, the Basel Committee came up with a new set of guidelines in June 2004, popularly known as the Basel II norms. These new norms are far more complex and comprehensive compared to the Basel I norms. Also, the Basel II norms are more risk-sensitive and they rely heavily on data analysis for risk measurement and management. They have given three pillars which act as guideline for implementation of Basel II.

Pillar 1

Basel II norms provide banks with guidelines to measure the various types of risks they face - credit, market and operational risks and the capital required to cover these risks.

Pillar II (Supervisory Reviews)

ensures that not only do the banks have adequate capital to cover their risks, but also that they employ better risk management practices so as to minimise the risks. Capital cannot be regarded as a substitute for inadequate risk management practices. This pillar requires that if the banks use asset securitisation and credit derivatives and wish to minimise their capital charge they need to comply with various standards and controls. As a part of the supervisory process, the supervisors need to ensure that the regulations are adhered to and the internal measurement systems are standardised and validated.

Pillar III (Market Discipline)

This market discipline is brought through greater transparency by asking banks to make adequate disclosures. The potential audiences of these disclosures are supervisors, bank's customers, rating agencies, depositors and investors. Market discipline has two important components:

Market signalling in form of change in bank's share prices or change in bank's borrowing rates

Responsiveness of the bank or the supervisor to market signals

What they Mean for banks

Basel II norms are expected to have far-reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks' risk-management systems, supervisory review process and market discipline.

Active Risk Management

The new norms bring to fore not only the issues of bank-wide risk measurement but also of active risk management. This will help in better pricing of the loans in alignment with their actual risks. The beneficiary will be the customer with high credit-worthiness and ratings as they will be able to get cheaper loans.

Higher Risk Sensitivity

Higher risk sensitivity of the norms provides no incentive to lend to borrowers with declining credit quality. During economic downturns, corporate profits and ratings tend to decline. This can lead to banks pulling the plugs on lending to corporates with falling credit ratings, at a time when these companies will be in desperate need of credit. The opposite is expected during economic booms, when corporate credit worthiness improves and banks will be more than willing to lend to corporates.

Lower Risk Weight Available Only for a Few Corporate

With better risk measurement practices in place the capital allocation for loans to quality borrowers are going to decrease. Banks can use this capital for other purposes to increase profits. But the population of rated corporate is small in India and most of them would have to be assigned a risk weight of 100 per cent.
The benefit of lower risk weight of 20 per cent and 50 per cent would, therefore, be available only for loans to a few corporates. The cover required for bad loans will increase exponentially with deteriorating credit quality, which can lead to an increase in capital requirement.

Trends in Indian Banks

Oriental Bank of Commerce - The practices being employed by the bank are directed by the principle of defined risk assessment and measurement including VaR Analysis, Stress Testing, etc. For management of Exchange Rate Risk in Forex, Day Light Limit for Trading Activities, Overnight Position Limits, Inter-bank Liability Limits, and other limits have been imposed for effective control. The Bank in consultation with NIBM, Pune, has finalized Credit Rating Framework for various Credit Products incorporating Risk parameters for such categories of Loans & Advances to provide finer analytical techniques for better Market Risk Management.

Other banks like ICICI, IDBI and Bank of India have also implemented risk management practices in accordance with the Basel II norms.

The Way Forward for India

Continue to deepen the collaborative dialogue between industry and regulators, to deepen shared understanding of the challenges and opportunities for strengthening risk management capability in Indian banks. We also need acceptance of pragmatic solutions to the challenges of Basel II implementation. We need to make sure that bureaucracy and costs are minimised, & business benefits maximised. Our main goal is improved risk management, not regulatory compliance. In this context, banks need to upgrade their credit assessment and risk management skills and retrain staff, develop a cadre of specialists and introduce technology driven management information systems

rohini_gupta1412 February 24th, 2008 01:53 PM

Re: Risk Management in Banks
:SugarwareZ-229: hey grea job thanx buddy.

ashu9801 February 29th, 2008 11:45 PM

Re: Risk Management in Banks
thanks for sharing this information... risk management is becoming the hot area in market nowadays.

PADDY143 June 23rd, 2008 04:25 PM

Re: Risk Management in Banks
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AJAY_RAWAT July 13th, 2008 11:38 PM

Re: Risk Management in Banks

rahul_thorat27 November 18th, 2008 02:25 PM

Re: Risk Management in Banks
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rahul_thorat27 November 18th, 2008 02:26 PM

Re: Risk Management in Banks
i hope this would be a very knowledgeable document thks...........

krisun14 November 29th, 2008 01:31 PM

Re: Risk Management in Banks
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ssimi137 December 1st, 2008 05:30 PM

Re: Risk Management in Banks
ya... great information:SugarwareZ-073:
do u hav a proper report on it?

kaditya December 14th, 2008 01:34 AM

Re: Risk Management in Banks
Is there a project on the activities performed by this team in a bank.....

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