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Dr. Krishn A.Goyal, Int. Eco. J. Res., 2010 1(1) 102-109

RISK MANAGEMENT IN INDIAN BANKS:SOME EMERGING ISSUES

Dr. Krishn A. Goyal , Convener & Head, Management Department, Bhupal

Nobles’(P.G.) College, UdaipurProf. Sunita Agrawal, Director, Pacific Business School, Udaipur (Raj.)

Abstract The fast changing financial environment exposes the banks to various types of risk. The conceptof risk and management are core of financial enterprise. The financial sector especially thebankingindustry in most emerging economies including India is passing through a process of change.Rising global competition, increasing deregulation, introduction of innovative products anddeliverychannels have pushed risk management to the forefront of today's financial landscape. Abilitytogauge 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 challengesandopportunities regarding implementation of Basel-II in Indian Banking Industry.Keywords: Basel-II,Capital Adequacy Ratio (CAR), Forex, Risk management\

Introduction Today, The Indian Economy is in theprocess of becoming a world classeconomy. The Indian bankingindustryismakinggreatadvancement in terms of quality,quantity,expansionanddiversification and is keeping up withthe updated technology, ability,stability and thrust of a financialsystem, where the commercial banks

play a very important role, emphasizethe very special need of a strong andeffective control system with extraconcern for the risk involved in thebusiness.Globalization,Liberalization and Privatization haveopened up a new methods of financial transaction where risk levelis very high. In banks and financialinstitutions risk is considered to bethe most important factor of earnings.

Therefore they have to balance the

relationship between risk and return.In reality we can say thatmanagement of financial institution isnothing but a management of risk.Managingfinancialrisksystematically and professionallybecomes an even more importanttask. Rising global competition,increasing deregulation, introduction

of innovative products and deliverychannelshavepushedriskmanagement to the forefront of today's financial landscape. Ability togauge the risks and take appropriateposition will be the key to success. Itcan be said that risk takers willsurvive, effective risk managers willproper and risk averse are likely toperish.

The risk arises due to uncertainties,which in turn arise due to changestaking place in prevailing economic,social and political environment andlackofnon-availabilityof informationconcerningsuchchanges.Risk is an exposure to a transactionwith loss, which occurs with someprobability and which can beexpected, measured and minimized.In financial institutions risk result

from variations and fluctuations inassets or liability or both in incomesfrom assets or payments and onliabilities or in outflows and inflowsof cash. Today, banks are facingvarious types of risks that financialintermediaries are exposed to, in thecourse of their business, which can bepresented through following chart:

IJER | DEC 2010Available [email protected]

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Various Types of Risks

Financial Risks

Credit Risk Counter Part or

Borrower Risk Intrinsic or

Industry Risk Portfolio or

Concentration Risk

Market Risk Interest Rate Risk

Liquidity Risk

Currency ForexRisk

Hedging Risk

Non-Financial Risks

Operational Risk

Strategic Risk

Funding Risk

Credit Risk: Credit risk is defined asthe possibility of losses associatedwith decrease in the credit quality of the borrower or the counter parties. Inthe bank's portfolio, losses stem fromoutside default due to inability orunwillingness of the customer or thecounterpartytomeetthecommitments, losses may also resultfrom reduction in the portfolio valuearising from actual or perceiveddeterioration in credit quality

Market Risk: Market risk is the riskof incurring losses on account of movements in market prices on allpositions held by the banks. Liquidityrisk of banks arises from funding of long term assets (advances) by shortterm sources (deposits) changes ininterest rate can significantly affectthe Net Interest Income (NII). Therisk of an adverse impact on NII dueto variations of interest rate may becalled interest rate risk. Forex risk is

the risk of loss that bank may sufferon account of adverse exchange ratemovementsagainstuncoveredpositioninforeigncurrency.Non-Financial Risk: Non-financialrisk refers to those risks that mayaffect a bank's business growth,marketability of its product andservices, likely failure of its strategies

Political Risk Legal Riskaimed at business growth etc. These

risks may arise on account of management failures, competition,non-availabilityofsuitableproducts/services, external factorsetc. In these risk operational andstrategic risk have a great need of consideration.Operational Risk: It may be definedas the risk of loss resulting frominadequate or failed internal processpeople and systems or because of external events.

Strategic Risk: Strategic risk is therisk that arises from the inability toimplement appropriate business plansand strategies, decisions with regardto allocation of resources oradaptability to dynamic changes inthe business/operating environment.

These are a number of other riskfactor through which operations risk,credit risk and market risk maymanifest. It should be recognised thatmany of these risk factors are

interrelated, one results to other.Process of Risk Management: Toovercome the risk and to makebanking function well, there is a needto manage all kinds of risksassociated with the banking. Riskmanagement becomes one of themain functions of any banking


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services risk management consists of identifying the risk and controllingthem, means keeping the risk atacceptable level. These levels differ

from institution to institution andcountry to country. The basicobjective of risk management is tostakeholders; value by maximisingthe profit and optimizing the capitalfunds for ensuring long termsolvency of the banking organisation.In the process of risk managementfollowing functions comprises:

• Risk identification

• Riskmeasurementquantification

• Risk control

• Monitoring and reviewing

Risk Identification: The riskidentificationinvolves 1.theunderstanding the nature of variouskinds of risks. 2. the circumstanceswhich lead a situation to become arisk situation and 3. causes due to

whichtheriskcanarise.RiskQuantification:Riskquantification is an assessment of thedegree of the risk which a particulartransaction or an activity is exposedto. Though the exact measurement of risk is not possible but the level of risk can be determined with the helpofriskratingmodels.Risk Control: Risk control is thestage where the bank or institutionstake steps to control the risk with the

help of various tools.

Tools for Risk Control

• Diversification of the business

• Insurance and hedging

• Fixation of exposure ceiling

• Transfer the risk to another partyat right time

• Securitisation and reconstruction

or

Risk Monitoring: In risk monitoringthe bankers have to fix up theparameters on which the transactionis to be tested to be sure that there is

no risk to viable existence of thefinancial unit or investment of thebank.Risk Management in Bank: BaselCommittee Approach: In order tohelp the banks to recognise thedifferent kinds of risks and to takeadequate steps to overcome the undercapitalisation of banks assets andlessen the credit and operational risksfacedbybanks.Banksof International Settlement (BIS) set upBasel Committee on bankingsupervision in 1988, which issuedguidelinesforupdatingriskmanagementinbanks.

These guidelines brought aboutstandardization and universalizationamong the global banking committeefor risk management and seek toprotecttheinterestofthedepositors/shareholders of the bank.As per the guidelines issued, capitaladequacy was considered panacea forrisk management and all banks wereadvised to have Capital AdequacyRatio (CAR) at at least 8%. CAR isthe ratio of capital to risk weightedassets and it provides the cushion tothe depositors in case of bankruptcy.In January 1999, the BaselCommittee proposed a new capitalaccord, which is known as Basel II.A sound framework for measuringand quantifying the risk associatedwith banking operations put by it.

The emphasis of New Basel Accord

is on flexibility, efficient operationsand higher revenues for banks withfull acknowledgement of risks. TheNew Accord makes clear distinctionbetween the credit risk, market riskand operational risk stipulatingassessment of risk weightagecovering all the three categories


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separately. Also it provides a rangeadoption of Basel II, i.e. March 2007,of options for determing the capitalhad to be postponed by two years,requirements for credit risk andtaking into consideration the stake of operational risk. Banks are requiredpreparedness of the banking system

to select approaches that are mostin the country. This accord is basedappropriate for their operations andon three pillars, viz.financial markets. The finalised Basel

PillarI:MinimumCapitalII Accord was released in June 2004.

Requirement The mid term review of annual

Pillar II: Supervisory Reviewpolicy for the year 2006-07 from theReserve Bank of India (RBI)Pillar III: Market Disciplinerevealed that the intended date for

Structure of Basel II Accord

Pillar I(Minimum Capital Requirement)

Pillar II(Supervisory Review)

Pillar III(Market Discipline)

Capital forcredit risk

— Standardized (SA)Approach

Capital foroperational risk

— Basic IndicatorApproach (BIA)

Capital forMarket risk

— Internal Rating based (IRAF)

Approach (foundation)

— Internal Rating basedApproach (advanced) (IRAA)

— The Standardized

Approach (TSA)

— Advanced MeasurementApproach (AMA)

Standardized Duration Approach(SDA)

Minimum

(Pillar I)

Capital Requirement

Modification Approach(MA)

The Minimum Capital Requirement(MCR) is set by the capital ratiowhich is defined as (Total Capital -

Tier I + Tier II + Tier III) / credit risk+ market risk + operational risk).Basel I provided for only a credit riskcharge. A market risk wasimplemented in 1996 amendments.In the initial stage, all banks arerequired to follow standardized

approach in credit risk, basic

indicator approach in operational risk

and standardized duration approachin market risk. Migration to higherapproacheswillrequireRBIpermission. Higher approaches aremore risk sensitive and may reducecapital requirement for banksfollowing sound risk management.

Supervisory Review Process (PillarII)

The supervisory review process isrequired to ensure adequacy as well


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as to ensure integrity by the riskmanagement processes. The BaselCommittee has started four keyprinciples of supervisory review as

under:

• Bank should have a process foraccessing its overall capitaladequacy in relation to its riskprofile, as well as, a strategy formaintaining its capital levels.

• Supervisors expect banks tooperate above the minimumregulatory capital ratios andensure banks hold capital in excessof the minimum.

• Supervisory shall review bank,

internalcapitaladequacyassessment and strategy, as well ascompliance with regulatory capitalratios.

• Supervisors shall seek to interveneat an early stage to prevent capitalfrom falling below prudent levels.

The Reserve Bank of India being thesupervisor of the banking operationin India is expected to evaluate howwell banks are assessing their capitalneeds relative to their risks. When

deficiencies are identified, promptand decisive actions are expected tobe taken by the supervisors to reducethe risk.Market Discipline (Pillar III)Effective market discipline requiresretable and timely information thatenables counter parties to make wellestablished risk assessment. Pillar IIIrelates to periodical disclosures toregulator, Board of Bank and marketabout various parameters which

indicates the risk profile of the bank.Reserve Bank of India has stipulatedthat banks should provide all PillarIII disclosures, both quantitative andqualitative as at the end March eachyear along with the annual financialstatement. The banks are required to

put such disclosures on its websites.Market discipline promotes safetyand soundness in banks and financialsystemandfacilitatesbanks

conducting their business in a safe,sound and efficient manner.

Challenges in the Indian contextBasel II is intended to improve safelyand soundness of the financial systemby placing increased emphasis onbank's own internal control and riskmanagement processes and models,the supervisory review process andmarket discipline. Indeed, to enablethecalculationofcapital

requirements under the new accordrequires a bank to implement acomprehensive risk managementframework. However, these changeswill also have wide ranging effectson bank's information technologysystems, processes, people andbusiness, beyond the regulatorycompliance, risk management andfinance functions. Though every bankhas to invest lot of time, manpowerand energy in the implementations of

Basel II, yet it helps the banks toassess the risks associated with thebusiness effectively. More so, itfacilitates the banks to producequantified and more realistic measureof the risk. Basel II enables the banksto handle business with moreconfidence and make better businessdecisions.But the techniques and the methodssuggested in the new accord wouldpose considerable implementationchallenges for the banks especially ina developing country like India; someof them are described as under:

• Implementation of the newframework will require substantialresources and commitment on thepart of both banks and supervisors.Banks are required to make


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enormous improvements in theareas of policies, organisationalstructure, MIS, tools for analysis,process, specified training of staff

etc. It will involve huge cost bothfor the banks as well as forsupervisors.

• The new norms will increase thecapital requirements in all thebanks due to introduction inmultiple risk weights withpreferential treatment for highrated assets. Although the capitalrequirement for credit risk may godown due to adoption of more risksensitive techniques such assecuritization, derivatives, meltingservices, equity holdings, venturecapital and guarantees etc.

• Risk management is extremelydata-intensive. Accurate, reliableand timely availability of data iscrucialforproperriskmanagement. Banks need toimplement substantial changes totheir internal systems to prepare

for appropriate data collection andrevised reporting requirements.These changes may requiresystems integration, modificationand introduction of new software.Banks need to assess thecapabilities of their presentsystems and review the necessarysystem changes required.

• To provide the basis forforecasting and building of modelsin respect of various activities,

such as loaning, security andforeign exchange transactions, alot of historical data is required. Inthe Indian context major handicapis the absence of data series,particularly, related to thetransactions in individual loanaccounts.

• The new capital accord assignsrisk-weight of sovereign at 0-50%.These 13 also a higher risk weightto the small and mediumenterprises. In India, the PSBshave more than 40 percent of theirlending to priority sector. Theimplementation of Basel II canadversely affect the priority sectorlending.

• Even the G-10 countries arefinding it difficult to implementthe Basel II accord in all thebanks. Therefore, longer time maybe 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 scopeto extend the rating of issues toissuers. This would be anapproximation and it would benecessary for the system to moveto the rating of issuers.Encouraging rating of issuerswould be a challenge.

•Yet another requirement for

establishing risk management systemis trained and skilled manpower. Themanagers should understand both thetheory and practice of risk. To reachsuch on understanding undoubtedlyinvolves a continuous learningprocess in the new technologies.Inducting a continuous learningprocess in the line managers andeducating them in risk management isa task to be addressed on priority bythe banks for the smooth adoption of

the risk management principles andpracticesandBasel-IIrecommendations across the banks.Skilldevelopmentforriskmanagement approaches, both at thebank level and at supervisors’ level,would be a tough task ahead.


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ConclusionRisk is an opportunity as well as athreat and has different meanings fordifferent users. The banking industry

is exposed to different risks such asforex volatility, risk, variable interestrate risk, market play risk,operational risks, credit risk etc.which can adversely affect itsprofitability and financial health.Risk management has thus emergedas a new and challenging area inbanking. Basel II intended to improvesafety and soundness of the financialsystembyplacingincreasedemphasis on bank's own internal

control and risk management processand models. The supervisory reviewand market discipline. Indeed, toenable the calculation of capitalrequirements under the new accordrequires a bank to implement acomprehensive risk managementframework. Over a period of time,the risk management improvementsthat are the intended result may berewardedbylowercapitalrequirements.However,thesechanges will also have wide-rangingeffects on a bank's informationtechnology systems, process, peopleand business, beyond and regulatorycompliance, risk management andfinancefunction.

The task of integrating Basel II ischallenging. Indian banks have comea long way since independence andmore so after LPG era, however, stillthey have to cover some distance soas to be bench marked with the bestbanks globally. But one thing is for

sure that the reform process is on andthe Indian banks are in the rightdirection. They have adopted beststructures,processesandtechnologies available worldwide andhave moved from strength to

strength. Still the future poses variouschallenges for the banking industry.

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