Chapter - 1

Risk Management
The Banking sector has a pivotal role in the development of an economy. It is the key driver
of economic growth of the country and has a dynamic role to play in converting the idle
capital resources for their optimum utilization so as to attain maximum productivity. In fact,
the foundation of a sound economy depends on how sound the Banking sector is and vice
versa.

In India, the banking sector is considerably strong at present but at the same time, banking is
considered to be a very risky business. Financial institutions must take risk, but they must do
so consciously. However, it should be borne in mind that banks are very fragile institutions
which are built on customers’ trust, brand reputation and above all dangerous leverage. In
case something goes wrong, banks can collapse and failure of one bank is sufficient to send
shock waves right through the economy . Therefore, bank management must take utmost care
in identifying the type as well as the degree of its risk exposure and tackle those effectively.
Moreover, bankers must see risk management as an ongoing and valued activity with the
board setting the example.

As risk is directly proportionate to return, the more risk a bank takes, it can expect to make
more money. However, greater risk also increases the danger that the bank may incur huge
losses and be forced out of business. In fact, today, a bank must run its operations with two
goals in mind – to generate profit and to stay in business. Banks, therefore, try to ensure that
their risk taking is informed and prudent. Thus, maintaining a trade-off between risk and
return is the business of risk management. Moreover, risk management in the banking sector
is a key issue linked to financial system stability. Unsound risk management practices
governing bank lending often plays a central role in financial turmoil, most notably seen
during the Asian financial crisis of 1997-981.

Definition of Risk
A risk can be defined as an unplanned event with financial consequences resulting in loss or
reduced earnings. An activity which may give profits or result in loss may be called a risky
proposition due to uncertainty or unpredictability of the activity of trade in future. In other
words, it can be defined as the uncertainty of the outcome.

Risk refers to ‘a condition where there is a possibility of undesirable occurrence of a

particular result which is known or best quantifiable and therefore insurable’. Risk may mean
that there is a possibility of loss or damage which, may or may not happen.

Risks may be defined as uncertainties resulting in adverse outcome, adverse in relation to

planned objective or expectations.

In the simplest words, risk may be defined as possibility of loss. It may be financial loss or
loss to the reputation/ image.
Although the terms risk and uncertainty are often used synonymously, there is difference
between the two. Uncertainty is the case when the decision-maker knows all the possible
outcomes of a particular act, but does not have an idea of the probabilities of the outcomes.
On the contrary, risk is related to a situation in which the decision-maker knows the
probabilities of the various outcomes. In short, risk is a quantifiable uncertainty.

Risk in Banking Business

In the post LPG period, the banking sector has witnessed tremendous competition not only
from the domestic banks but from foreign banks alike. In fact, competition in the banking
sector has emerged due to disintermediation and deregulation. The liberalised economic
scenario of the country has opened various new avenues for increasing revenues of banks. In
order to grab this opportunity, Indian commercial banks have launched several new and
innovated products, introduced facilities like ATMs, Credit Cards, Mobile banking, Internet
banking etc. Apart from the traditional banking products, it is seen that Mutual Funds,
Insurance etc. are being designed/ upgraded and served to attract more customers to their
fold.

In the backdrop of all these developments i.e., deregulation in the Indian economy and
product/ technological innovation, risk exposure of banks has also increased considerably.
Thus, this has forced banks to focus their attention to risk management. In fact, the
importance of risk management of banks has been elevated by technological developments,
the emergence of new financial instruments, deregulation and heightened capital market
volatility.

In short, the two most important developments that have made it imperative for Indian
commercial banks to give emphasise on risk management are discussed below –

(a) Deregulation: The era of financial sector reforms which started in early 1990s has
culminated in deregulation in a phased manner. Deregulation has given banks more
autonomy in areas like lending, investment, interest rate structure etc. As a result of these
developments, banks are required to manage their own business themselves and at the same
time maintain liquidity and profitability. This has made it imperative for banks to pay more
attention to risk management.

(b) Technological innovation: Technological innovations have provided a platform to the

banks for creating an environment for efficient customer services as also for designing new
products. In fact, it is technological innovation that has helped banks to manage the assets
and liabilities in a better way, providing various delivery channels, reducing processing time
of transactions, reducing manual intervention in back office functions etc. However, all these
developments have also increased the diversity and complexity of risks, which need to be
managed professionally so that the opportunities provided by the technology are not negated.

Type of Risks
Risk may be defined as ‘possibility of loss’, which may be financial loss or loss to the image
or reputation. Banks like any other commercial organisation also intend to take risk, which is
inherent in any business. Higher the risk taken, higher the gain would be. But higher risks
may also result into higher losses. However, banks are prudent enough to identify, measure
and price risk, and maintain appropriate capital to take care of any eventuality. The major
risks in banking business or ‘banking risks’, as commonly referred, are listed below –

 Liquidity Risk
 Interest Rate Risk
 Market Risk
 Credit or Default Risk
 Operational Risk

Liquidity Risk
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities,
thereby making the liabilities subject to rollover or refinancing risk. It can be also defined as
the possibility that an institution may be unable to meet its maturing commitments or may do
so only by borrowing funds at prohibitive costs or by disposing assets at rock bottom prices.
The liquidity risk in banks manifest in different dimensions

(a) Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet
cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to
replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale
and retail).

(b) Time Risk: Time risk arises from the need to compensate for non-receipt of expected
inflows of funds i.e., performing assets turning into non-performing assets.

(c) Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise
when a bank may not be able to undertake profitable business opportunities when it arises.

Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE)
of an institution is affected due to changes in the interest rates. In other words, the risk of an
adverse impact on Net Interest Income (NII) due to variations of interest rate may be called
Interest Rate Risk. It is the exposure of a Bank’s financial condition to adverse movements in
interest rates.

IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on
the economic value of the bank’s assets, liabilities and Off-Balance Sheet (OBS) positions.
Interest rate Risk can take different forms. The following are the types of Interest Rate Risk

(a) Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities
and Off-Balance Sheet items with different principal amounts, maturity dates or re-pricing
dates, thereby creating exposure to unexpected changes in the level of market interest rates.
(b) Yield Curve Risk: Banks, in a floating interest scenario, may price their assets and
liabilities based on different benchmarks, i.e., treasury bills’ yields, fixed deposit rates, call
market rates, MIBOR etc. In case the banks use two different instruments maturing at
different time horizon for pricing their assets and liabilities then any non-parallel movements
in the yield curves, which is rather frequent, would affect the NII. Thus, banks should
evaluate the movement in yield curves and the impact of that on the portfolio values and
income.

An example would be when a liability raised at a rate linked to say 91 days T Bill is used to
fund an asset linked to 364 days T Bills. In a raising rate scenario both, 91 days and 364 days
T Bills may increase but not identically due to non-parallel movement of yield curve creating
a variation in net interest earned.

(c) Basis Risk: Basis Risk is the risk that arises when the interest rate of different assets,
liabilities and off-balance sheet items may change in different magnitude. For example, in a
rising interest rate scenario, asset interest rate may rise in different magnitude than the
interest rate on corresponding liability, thereby creating variation in net interest income.

The degree of basis risk is fairly high in respect of banks that create composite assets out of
composite liabilities. The loan book in India is funded out of a composite liability portfolio
and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile
interest rate scenarios. When the variation in market interest rate causes the NII to expand,
the banks have experienced favourable basis shifts and if the interest rate movement causes
the NII to contract, the basis has moved against the banks.

(d) Embedded Option Risk: Significant changes in market interest rates create the source of
risk to banks’ profitability by encouraging prepayment of cash credit/demand loans, term
loans and exercise of call/put options on bonds/ debentures and/ or premature withdrawal of
term deposits before their stated maturities. The embedded option risk is experienced in
volatile situations and is becoming a reality in India. The faster and higher the magnitude of
changes in interest rate, the greater will be the embedded option risk to the banks’ Net
Interest Income. The result is the reduction of projected cash flow and the income for the
bank.

(e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with regard to
interest rate at which the future cash flows could be reinvested. Any mismatches in cash
flows i.e., inflow and outflow would expose the banks to variation in Net Interest Income.
This is because market interest received on loan and to be paid on deposits move in different
directions.

(f) Net Interest Position Risk: Net Interest Position Risk arises when the market interest
rates adjust downwards and where banks have more earning assets than paying liabilities.
Such banks will experience a reduction in NII as the market interest rate declines and the NII
increases when interest rate rises. Its impact is on the earnings of the bank or its impact is on
the economic value of the banks’ assets, liabilities and OBS positions.
Market Risk
The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to
market movements, during the period required to liquidate the transactions is termed as
Market Risk. This risk results from adverse movements in the level or volatility of the market
prices of interest rate instruments, equities, commodities, and currencies. It is also referred to
as Price Risk.

Price risk occurs when assets are sold before their stated maturities. In the financial market,
bond prices and yields are inversely related. The price risk is closely associated with the
trading book, which is created for making profit out of short-term movements in interest
rates.

The term Market risk applies to (i) that part of IRR which affects the price of interest rate
instruments, (ii) Pricing risk for all other assets/ portfolio that are held in the trading book of
the bank and (iii) Foreign Currency Risk.

(a) Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of adverse
exchange rate movements during a period in which it has an open position either spot or
forward, or a combination of the two, in an individual foreign currency.

(b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a
large transaction in a particular instrument near the current market price.

Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail
to meet its obligations in accordance with the agreed terms. In other words, credit risk can be
defined as the risk that the interest or principal or both will not be paid as promised and is
estimated by observing the proportion of assets that are below standard. Credit risk is borne
by all lenders and will lead to serious problems, if excessive. For most banks, loans are the
largest and most obvious source of credit risk. It is the most significant risk, more so in the
Indian scenario where the NPA level of the banking system is significantly high. The Asian
Financial crisis, which emerged due to rise in NPAs to over 30% of the total assets of the
financial system of Indonesia, Malaysia, South Korea and Thailand, highlights the
importance of management of credit risk.

There are two variants of credit risk which are discussed below –

(a) Counterparty Risk: This is a variant of Credit risk and is related to non-performance of
the trading partners due to counterparty’s refusal and or inability to perform. The
counterparty risk is generally viewed as a transient financial risk associated with trading
rather than standard credit risk.
(b) Country Risk: This is also a type of credit risk where non-performance of a borrower or
counterparty arises due to constraints or restrictions imposed by a country. Here, the reason
of non-performance is external factors on which the borrower or the counterparty has no
control.

Credit Risk depends on both external and internal factors. The internal factors include –

1. Deficiency in credit policy and administration of loan portfolio.

2. Deficiency in appraising borrower’s financial position prior to lending.

3. Excessive dependence on collaterals.

4. Bank’s failure in post-sanction follow-up, etc.

The major external factors –

1. The state of economy

2. Swings in commodity price, foreign exchange rates and interest rates, etc.

Credit Risk can’t be avoided but has to be managed by applying various risk mitigating
processes –

1. Banks should assess the credit worthiness of the borrower before sanctioning loan i.e.,
credit rating of the borrower should be done beforehand. Credit rating is main tool of
measuring credit risk and it also facilitates pricing the loan.

By applying a regular evaluation and rating system of all investment opportunities, banks can
reduce its credit risk as it can get vital information of the inherent weaknesses of the account.

2. Banks should fix prudential limits on various aspects of credit – benchmarking Current
Ratio, Debt Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.

3. There should be maximum limit exposure for single/ group borrower.

4. There should be provision for flexibility to allow variations for very special circumstances.

5. Alertness on the part of operating staff at all stages of credit dispensation – appraisal,
disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit
risk.

Operational Risk
Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss
resulting from inadequate or failed internal processes, people and systems or from external
events’. Thus, operational loss has mainly three exposure classes namely people, processes
and systems.
Managing operational risk has become important for banks due to the following reasons –

1. Higher level of automation in rendering banking and financial services

2. Increase in global financial inter-linkages

Scope of operational risk is very wide because of the above mentioned reasons. Two of the
most common operational risks are discussed below –

(a) Transaction Risk: Transaction risk is the risk arising from fraud, both internal and
external, failed business processes and the inability to maintain business continuity and
manage information.

(b) Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial
loss or reputation loss that a bank may suffer as a result of its failure to comply with any or
all of the applicable laws, regulations, codes of conduct and standards of good practice. It is
also called integrity risk since a bank’s reputation is closely linked to its adherence to
principles of integrity and fair dealing.

Other Risks
Apart from the above mentioned risks, following are the other risks confronted by Banks in
course of their business operations –

(a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions,
improper implementation of decisions or lack of responsiveness to industry changes. This
risk is a function of the compatibility of an organisation’s strategic goals, the business
strategies developed to achieve those goals, the resources deployed against these goals and
the quality of implementation.

(b) Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This
risk may expose the institution to litigation, financial loss or decline in customer base.

Risk Management Practices in India

Risk Management, according to the knowledge theorists, is actually a combination of
management of uncertainty, risk, equivocality and error. Uncertainty – where outcome cannot
be estimated even randomly, arises due to lack of information and this uncertainty gets
transformed into risk (where estimation of outcome is possible) as information gathering
progresses. As information about markets and knowledge about possible outcomes increases,

Risk management provides solution for controlling risk. Equivocality arises due to conflicting
interpretations and the resultant lack of judgment. This happens despite adequate knowledge
of the situation. That is why, banking as well as other institutions develop control systems to
reduce errors, information systems to reduce uncertainty, incentive system to manage agency
problems in risk-reward framework and cultural systems to deal with equivocality.
Initially, the Indian banks have used risk control systems that kept pace with legal
environment and Indian accounting standards. But with the growing pace of deregulation and
associated changes in the customer’s behaviour, banks are exposed to mark-to-market
accounting. Therefore, the challenge of Indian banks is to establish a coherent framework for
measuring and managing risk consistent with corporate goals and responsive to the
developments in the market. As the market is dynamic, banks should maintain vigil on the
convergence of regulatory frameworks in the country, changes in the international accounting
standards and finally and most importantly changes in the clients’ business practices.
Therefore, the need of the hour is to follow certain risk management norms suggested by the
RBI and BIS.

Role of RBI in Risk Management in Banks

The Reserve Bank of India has been using CAMELS rating to evaluate the financial
soundness of the Banks. The CAMELS Model consists of six components namely Capital
Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to
Market risk

In 1988, The Basel Committee on Banking Supervision of the Bank for International
Settlements (BIS) has recommended using capital adequacy, assets quality, management
quality, earnings and liquidity (CAMEL) as criteria for assessing a Financial Institution. The
sixth component, sensitivity to market risk (S) was added to CAMEL in 1997 (Gilbert, Meyer
& Vaughan, 2000). However, most of the developing countries are using CAMEL instead of
CAMELS in the performance evaluation of the FIs. The Central Banks in some of the
countries like Nepal, Kenya use CAEL instead of CAMELS (Baral, 2005). CAMELS

Framework is a common method for evaluating the soundness of Financial Institutions.

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 (Kannan, 2004). In these circumstances, the supervision had to
focus essentially on solvency issues. After the evolution of the BIS prudential norms in 1988,
the RBI took a series of measures to realign its supervisory and regulatory standards and
bring it at par with international best practices. At the same time, it also took care to keep in
view the socio-economic conditions of the country, the business practices, payment systems
prevalent in the country and the predominantly agrarian nature of the economy, and ensured
that the prudential norms were applied over the period and across different segments of the
financial sector in a phased manner.

Finally, it was in the year 1999 that RBI recognised 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 supervisory jurisdiction of the BFS now extends
to the entire financial system barring the capital market institutions and the insurance sector.
The periodical on-site inspections, and also the targeted appraisals by the Reserve Bank, are
now supplemented by off-site surveillance which particularly focuses on the risk profile of
the supervised institution. A process of rating of banks on the basis of CAMELS in respect of
Indian banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in
respect of foreign banks has been put in place from 1999.

Since then, the RBI has moved towards more stringent capital adequacy norms and adopted
the CAMEL (Capital adequacy, Asset quality, Management,

Earnings, Liquidity) based rating system for evaluating the soundness of Indian banks. The
Reserve Bank’s regulatory and supervisory responsibility has been widened to include
financial institutions and non-banking financial companies. As a result, considering the
changes in the Banking industry, the thrust lies upon Risk - Based Supervision (RBS). The
main supervisory issues addressed by Board for Financial Supervision (BFS) relate to on-site
and off-site supervision of banks.

The on-site supervision system for banks is on an annual cycle and is based on the ‘CAMEL’
model. It focuses on core assessments in accordance with the statutory mandate, i.e.,
solvency, liquidity, operational soundness and management prudence. Thus, banks are rated
on this basis. Moreover, in view of the recent trends towards financial integration,
competition, globalisation, it has become necessary for the BFS to supplement on-site
supervision with off-site surveillance so as to capture ‘early warning signals’ from off-site
monitoring that would be helpful to avert the likes of East Asian financial crisis (Sireesha,
2008). The off-site monitoring system consists of capital adequacy, asset quality, large credit
and concentration, connected lending, earnings and risk exposures viz., currency, liquidity
and interest rate risks. Apart from this, the fundamental and technical analysis of stock of
banks in the secondary market will serve as a supplementary indicator of financial
performance of banks.

Thus, on the basis of RBS, a risk profile of individual Bank will be prepared. A high-risk
sensitive bank will be subjected to more intensive supervision by shorter periodicity with
greater use of supervisory tools aimed on structural meetings, additional off site surveillance,
regular on site inspection etc. This will be undertaken in order to ensure the stability of the
Indian Financial System.