AN ANALYSIS OF RISK MANAGEMENT: ROLE IN BANKING SECTOR

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1 (IMPACT FACTOR 5.96) AN ANALYSIS OF RISK MANAGEMENT: ROLE IN BANKING SECTOR Ms. SMRITI NAGARIA 1, MBA, APSET Assistant Professor St. Joseph s Degree & PG College (Affiliated to OU- Approved by AICTE) , Basheerbagh King Koti Road, Hyderabad ABSTRACT Risk is inherent in any business activity where it is rightly said that it refers to uncertainty of outcomes which is at times unavoidable. Management of risk becomes essential for successful operations of the business."risk Management is a culture, not a cult. It only works if everyone lives it, not if it s practiced by a few high priests which means risk management refers to the practice of identifying potential risks in advance, analyzing them and taking precautionary steps to reduce/curb them. It may have an impact on bank or financial institutions having a direct effect on losses, customers and business partners. Banks play a vital role in economic development of a country as it is the nerve centre of all commerce and trade which provides instruments for developing internal as well as external trade. An Institution, such as the banking system, which touches and should touch the lives of millions, has necessarily to be inspired by a larger social purpose and has to subserve national priorities and objectives. A well-developed banking system provides a firm and durable foundation for the economic development of the country. Banking risk is that risk that banks is confronted within their current operations and not only risk specific to regular banking activities. To overcome banking risk banks have developed strategies which include procedure for managing risk and minimization of potential exposure. The objective is to understand 145

2 (IMPACT FACTOR 5.96) the various techniques involved to conduct risk management and concludes by emphasizing on the role of RBI in risk management of bank. Key Words: Risk, business activity, unavoidable, economic development and strategies INTRODUCTION Risk in itself is not bad; risk is essential to progress, and failure is often a key part of learning. But we must learn to balance the possible negative consequences of risk against the potential benefits of its associated opportunity. Risk is present everywhere which creates obstacle in achievement of certain objectives. Risk refers to a condition where there is possibility of undesirable occurrence of a particular result which is known or best quantifiable. As risk is unplanned it has an effect on financial position of a concern.risk should be managed effectively to survive in the competitive world. Bank which is a financial institution that accepts deposits and provide loans, safeguard money and valuables and renders services also faces risk in its operations. It is essential for banks as a whole to measure and manage risk volumes accurately. Banks monitors risk at all levels throughout its operations and has established risk management department to supervise risk where committees are formed consisting of members who take responsibility for various kinds with a goal of strengthening risk management and control. In addition to establishing a risk management department banks are also regulated by RBI in order to protect safety of public savings, ensure equal opportunity with fairness in public access to credit and other financial services, provide Government with credit, tax revenue and to help sectors of the economy to meet special needs i.e. loans. 146

3 (IMPACT FACTOR 5.96) 4 1 Set up risk management system Involve of the board of directors and high level management Effective Risk Management Formulate risk management policies and procedures 2 Establish a unit to operate risk management 3 Supporting Factors for Risk Management There are two important developments which made banks to emphasize on risk management which are: 1) Deregulation - This has given autonomy in areas of lending, investment and interest rate structure. 2) Technological Innovation - This has helped banks to manage assets and liabilities in a better way providing delivery channels and reducing processing time of transactions. These developments has increased diversity and complexity of risk which needs to be managed professionally, Banks like any other organization intends to take risk which is inherent in any business. The major risks in banking business is: 1)Liquidity Risk - refers to the risk that financial institutions may be unable to meet its commitments owing to decline in credit worthiness. In order to manage liquidity, risk banks periodically examines the structure of funds sources and uses to implement measures needed to improve the structure. Liquidity risk in bank manifest in different dimensions: 147

4 (IMPACT FACTOR 5.96) (i) Funding Risk - is the inability to obtain funds to meet cash flow obligation (ii) Time Risk - This arises from the need to compensate for non receipt of expected inflow of funds. (iii) Call Risk - arises when a bank may not be able to undertake profitable business opportunities when it arises. 2) Interest Rate Risk - refers to exposure of bank's financial condition to adverse movements of interest rates. Types of Interest Rate Risks: (i) Basis Risk - arises when interest rates of assets, liabilities and off balance sheet items may change in different magnitude. (ii)reinvested Risk - takes place due to uncertainty with regard to interest rates at which future cash flow could be reinvested. (iii) Gap or Mismatch Risk - refers to holding assets, liabilities and off balance sheet items with different principal amounts and maturity dates. 3)Market Risk - results from adverse movements in level of volatility of market price of interest rate instruments, equities, commodities and currencies. 4) Credit Risk - refers to the potential of bank borrower or counterparty who fails to meet its obligation in accordance with the terms where interest or principal or both will not be paid as promised. This is the most significant risk in banks as they give the highest priority on ensuring soundness of its assets and works to ensure its credit risk management capabilities. The fundamental pillar of bank credit risk management system is its credit rating system and self assessment system. Two variants of credit risk are: (i) Counter Party Risk - This is associated with trading rather than standard risk. (ii) Country Risk - This is due to restriction imposed by a country. 5) Operational Risk - It results from inadequate internal processes, people, and systems. 148

5 (IMPACT FACTOR 5.96) Common operational risks are: (i) Transaction Risk - It takes place due to failed business processes and inability to manage information. (ii) Compliance Risk - It is due to inability of the bank to comply with applicable laws, regulations, code of conduct and standard of good practice. 6) Strategic Risk - arises from adverse business decisions or lack of responsiveness to industrial changes. 7) Reputation Risk - arises from negative public opinion. 149

6 (IMPACT FACTOR 5.96) PRINCIPLES OF RISK MANAGEMENT 1) Establish a language system to discuss and categorize risk 2) Develop a big picture view of risk exposure and focus on the most important risk factors 3) Centralize ownership of processes and decentralize decision making 4) Define the process from top and clearly define roles and responsibilities 5) Quantify risk exposure, cost and benefits of managing risk 6) Embed IT system to facilitate risk management system 7) Embed a risk management culture RISK MANAGEMENT PROCESS It is an iterative process where each step contributes progressively to organizational improvement by providing management with a greater insight into risks and their impact. Process of Risk Management ESTABLISH THE CONTEXT Before understanding risk and the way to deal it is essential to understand the context in which it exists. Establish the content by considering: The strategic context the environment within which the organization operates 150

7 (IMPACT FACTOR 5.96) The organizational context the objectives, core activities and operations. IDENTIFY THE RISKS The purpose of this step is to identify what could go wrong (likelihood) and what is the consequence (loss or damage). ANALYSE AND EVALUATE THE RISKS This involves analyzing the likelihood and consequences of each identified risk and deciding which risk factors will potentially have the greatest effect and should, therefore, receive priority with regard to its management. TREAT THE RISKS Risk treatment involves identifying the range of options for treating the risk, evaluating those options, preparing the risk treatment plans and implementing those plans. It is about considering the options for treatment and selecting the most appropriate method to achieve the desired outcome. Options for treatment need to be proportionate to the significance of the risk, and the cost of treatment commensurate with the potential benefits of treatment. The treatment options should include accepting, avoiding, reducing, transferring, retaining and financing the risk. MONITOR AND REVIEW Monitoring and review ensure that the important information generated by the risk management process is captured, used and maintained. TECHNIQUES OF RISK MANAGEMENT There are a number of common techniques that are used by risk managers to help them identify possible risks to the organization. These techniques are often used in combination to ensure that all potential risks are identified within the organization. Value at Risk (VAR) - A tool which is used by firms and regulators to measure the amount of assets needed to cover possible losses. It also estimates the amount of investment which is lost in a given normal market condition. 151

8 (IMPACT FACTOR 5.96) Risk Adjusted Rate of Return on Capital - an integrated risk management tool that measure financial performance, provides a constant view of profitability across businesses and also estimates capital requirement for market, credit and operational risk. GAP Analysis - used to compare actual performance with potentially determined performance. It tells what a business is doing currently and where it wants to go in future and involves determining the difference between business requirement and current capabilities Securitization - process of transforming illiquid or group of assets into security which is secured by collection of mortgage which also helps in reducing bank risk exposure. Sensitivity Analysis- useful to determine actual outcome of a particular variable which is different from what was previously assumed. Internal Rating System - This is used by bank to estimate capital for various exposures and bank use their own estimated risk parameters for the purpose of calculating regulatory capital. RISK MANAGEMENT AT BANK - ROLE OF RESERVE BANK OF INDIA The Reserve Bank of India in 1988 has been using CAMELS rating to evaluate the financial soundness of the Banks. In India, the focus of the statutory regulation of commercial banks by RBI until the early 1990s was mainly on licensing, administration of minimum capital requirements, pricing of services including administration of interest rates on deposits as well as credit, reserves and liquid asset requirements. In 1999 RBI recognized the need of an appropriate risk management and issued guidelines to banks regarding assets, liability management, management of credit, market and operational risks. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the demanding needs of a strong and stable financial system. The CAMELS Model consists of six components namely Capital Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to Market risk. A process of rating of banks on the basis of CAMELS in respect of Indian banks and 152

9 (IMPACT FACTOR 5.96) CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect of foreign banks has been put in place from Components of CAMEL Model CAMEL COMPONENTS AND THEIR SIGNIFICANCE : o Capital Adequacy - Financial Status based on Country's Balance of Payment o Asset Quality - Economic and financial strength based on a country's combined natural, human and general economic resources o Management Quality - A Government's fiscal, monetary credit policies and politics and how well these are implemented o Earning Potential - Internal and external variables that affect how well a country is achieving its capabilities o Liquidity - A Nation's Foreign Exchange cash flow prospects FUTURE INITIATIVES THAT CAN BE TAKEN BY BANKS These five initiatives that not only have a strong short-term business case, but will also help build what we see as the essential components of a high-performing risk function by

10 (IMPACT FACTOR 5.96) Digitize Core Processes- This will minimize manual interventions and digitize core risk processes such as credit application and underwriting by approaching business lines with suggestions rather than waiting for the businesses to come to them. Increased efficiency, lower costs, a superior customer experience and improved sales will be the short-term gains. Experiment with Advanced Analytics and Machine Learning. This would enhance the accuracy of predictive models where some financial institutions have already achieved significant model improvements leading to better credit-risk decisions. Enhance Risk Reporting - This has replaced paper based reports with an interactive tablet solution that offers information in real time and enables users to do root cause analyzes and enable banks to make faster decisions and identify potential risks more quickly. Collaborate for Balance Sheet Optimization - The processes performed with the support of analytical optimization tools, often suggests ways to improve return on equity by anywhere between 50 and 400 basis points while still fulfilling all regulatory requirements. Put the Enablers in Place - It goes without saying that high-performing risk functions depend on a high-performing data infrastructure. Attracting talented employees will itself be a challenge, as many potential candidates could be lured to technology firms unless banks strengthen their value propositions. A strong risk culture in which detection, assessment, and mitigation are part of the daily job of all bank employees will be central to the success of the risk function. Despite the push toward automation and more sophisticated analytical and technical capabilities, only human intervention will ensure they are applied appropriately and ethically. Instruments banks can use in order to manage risk : Diversification Hedging 154

11 (IMPACT FACTOR 5.96) Internal Insurance Holding Capital RISK MANAGEMENT FUTURE PERSPECTIVE Risk management in banks has changed substantially over the past ten years. The regulations that emerged from the global financial crisis and the fines that were levied in its wake triggered a wave of change in risk functions. Six structural trends which are mentioned below outlines how risk functions may look in 2025 and highlights what senior risk managers can and should do now to start preparing their functions to deal with these trends. Six structural trends will transform bank risk management over the next ten years Continued expansion of the breadth and depth of regulation Changing customer expectations Technology and analytics as a risk muscle Additional (nonfinancial) risk types are emerging Better risk decisions through the elimination of biases Need for strong cost savings CONCLUSION Risk in banking business is unavoidable and one must identify which risk is to be avoided or hedged by preventing organization from incurring losses which affects their goodwill. Risk is indispensable and integral part of banking business. Banks are formulating strategies to tackle it effectively and along with this RBI too have adopted steps to ensure banks set up risk management cell and through internal assessment of risk exposure. 155

12 (IMPACT FACTOR 5.96) REFERENCES 1)Alina Mihaela Dima, Ivona Orzea, RISK MANAGEMENT IN BANKING, AcademyPublish.org Risk Assessment and Management. 2)Prof. Rekha Arunkumar, RISK MANAGEMENT IN COMMERCIAL BANKS (A CASE PUBLIC AND PRIVATE SECTOR BANKS) STUDY OF 3)Thirupathi Kanchu, M. Manoj Kumar, RISK MANAGEMENT IN BANKING SECTOR - AN EMPIRICAL STUDY, International Journal of Marketing, Financial Services & Management Research, ISSN Vol.2 No. 2, February (2013). 4)Heinz-Peter Berg, RISK MANAGEMENT: PROCEDURES, METHODS AND EXPERIENCES, RT&A # 2(17) (Vol.1) 2010, June 79, 5) Websites: