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RISK MANAGEMENT

 

The last few years have witnessed sea changes in the Indian banking sector.   Indian banking and financial system has been gradually liberalised.    Interest rates have been deregulated, new players, new instruments and new institutions have been introduced.   Moreover, prudential regulations have been expanded and supervision has been strengthened at various levels.   In the sphere of external financial policy, the exchange rate is market driven, there has been a progressive liberalisation of FDI and FII investment, and there are now only minimum restrictions on inflow of capital into the economy, or its repatriation and servicing.

In the new liberalized economy in India, Banks and regulators in recent years have been making sustained efforts to understand and measure the increasing risks they are exposed to.  With the Indian economy becoming global, the Banks are realising the importance of different types of risks.     Some of the risk are credit risks, market risks, operational risks, reputational risks and legal risks, using quantitative techniques in risk modeling.  RBI issued the first set of guidelines to Banks  on Risk Management on October 20, 1999. 

 

 

What is Risk

A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. Therefore, a risky proposition is one with potential profit or a looming loss. Risk stems from uncertainty or unpredictability of the future. In commercial and business risk generates profit or loss depending upon the way in which it is managed. Risk can be defined as the volatility of the potential outcome.  Risk is the possibility of something adverse happening.   Risk management is the process of assessing risk, taking steps to reduce risk to an acceptable level and maintaining that level of risk.

 Thus, we can say that after the risks have been identified, risk management attempts to lessen their effects.   This is done  by applying a range of management techniques.  For example, the risk may be lessened by  taking out insurance or using derivatives  or re-plan the whole project.

 

 Thus, the essential components of any risk management system are

  • Risk Identification i.e the naming and defining of each type of risk associated with a transaction or type of product or service;
  • Risk Measurement i.e. the estimation of the size ,probability and timing of potential loss under various scenarios;
  • Risk Control-i.e. the framing of policies and guidelines that define the risk limits not only at the individual level but also for particular transaction

Having understood what is risks we will now state the aspect of measuring risks. Measurement of risk is a very important step in risk management process. Some risk can be easily quantified like exchange risk, interest rate risk etc. While some risks like country risk, operational risk etc. cannot be mathematically deduced. They can only be qualitatively compared and measured. Some risks like gap risk in forex operations can be measured using modern mathematical and statistical tool like value at risk etc. Therefore it is important to identify and appreciate the risk and quantify it. Only then the next step management of risk can be attempted. The management is a process consisting of the following steps.

 

 

Different Types of Risks :

 

(1)  Credit Risk - This is the risk of non recovery of loan or the risk of reduction in the value of asset.    The credit risk also includes the pre-payment risk resulting in loss of opportunity to the bank to earn higher interest interest income. Credit Risk also arises due  excess exposure to a single borrower, industry or a geographical area.     The element of country risk is also present which is the risk of losses being incurred due to adverse foreign exchange reserve situation or adverse political or economic situations in another country

     (2)  Interest Rate Risk-This risk arises due to fluctuations in the interest rates.   It can result in reduction in the revenues of the bank due to fluctuations in the interest rates which are dynamic and which change differently for assets and liabilities.   With the deregulated era interest rates are market determined and banks have to fall in line with the market trends even though it may stifle their Net Interest margins

 

           (3) Liquidity Risk-Liquidity is the ability to meet commitments as and when they are due and ability to undertake new transactions when they are profitable. Liquidity risk may emanate in any of the following situations-

            (a) net outflow of funds arising out of withdrawals/non renewal of deposits

            (b) non recovery of cash receipts from recovery of loans

            (c) conversion of contingent liabilities into fund based commitment and

            (d) increased availment of sanctioned limits

        (4) Foreign Exchange Risk  -  Risk may arise on account of maintenance of positions in forex operations and it involves currency rate risk, transaction risks (profits/loss on transfer of earned profits due to time lag) and transportation risk (risks arising out of exchange restrictions)

 (5)   Regulatory Risks-   It is defined as the risk associated with the impact on profitability and financial position of a bank due to changes in the regulatory conditions, for example the introduction of asset classification norms have adversely affected the banks of NPAs and balance sheet bottom lines. 

 (6)  Technology Risk -  This risk is associated with computers and the communication technology which is being increasingly introduced in the banks.  This entails the risk of obsolescence and  the risk of losing business to better technologically

(7)   Market Risk-This is the risk of losses in off and on balance sheet positions arising from movements in market prices.

 (8)  Strategic Risk-This is the risk arising out of certain strategic decisions taken by the banks for sustaining themselves in the present day scenario  for example decision to open a subsidiary may run the risk of losses if the subsidiary does not do good business.

 The essential components of any risk management system are

       (i)  Risk Identification-i.e the naming and defining of each type of risk associated with a transaction or type of product or service

       (ii)  Risk Measurement-i.e. the estimation of the size ,probability and timing of potential loss under various scenarios

       (iii)  Risk Control-i.e. the framing of policies and guidelines that define the risk limits not only at the individual level but also for particular transactions


In risk management exercise the top management has to lay down clear cut policy guidelines in quantifiable and precise terms - for different layers line personnel business parameters, limits etc. It is very important for the management to plant at the macro level what the organisations is  looking in for in any business proposition or venture and convert these expectations into micro level factors and requirements for field level functionaries only then they will be able to convert these expectations into reality. A very important assumption is made but normally omitted or over looked is provision of infra-structural support and conductive climate. Ultimately top management has a greater role to play in any risk management process