Govind Gurnani, Former AGM, Reserve Bank of India
Risk Management In The Banking Sector : Simpli ed
The banking sector has a huge role to play in the development of the
economy. Certainly, it is the driver of the economic growth of the
country. It plays an important role in identifying the idle resources for
their e cient utilisation to attain maximum productivity. However, this
process involves risk. Banks are highly regulated in order to promote
nancial stability, foster competition, and protect consumers. And since
the risk is directly proportional to returns, the more risk a bank take, the
higher it can generate pro ts. Hence, it is very important to manage the
risks and identify if they are worth taking.
Risk management refers to identifying, assessing, and mitigating risks
that banks face in their day-to-day operations. It is a comprehensive
approach involving various risk management tools, techniques, and
methodologies to manage risks e ectively.The objective of risk
management in banking is to minimise the impact of risks on the bank’s
operations, nancial performance, and reputation.
1. Credit Risk Management
Credit risk refers to the possibility of losses associated with diminution
in the credit quality of borrowers or counterparties. In a bank’s portfolio,
losses stem from outright default due to the inability or unwillingness of
a customer or counterparty to meet commitments concerning lending,
trading, settlement, and other nancial transactions.
In simple terms, banks experience credit risk when assets in a bank’s
portfolio are threatened by loan defaults. Credit risk is a sum of default
risk and portfolio risks.
Default risk happens due to the inability or unwillingness of a borrower
to return the promised loan amount to the lender. Whereas, portfolio
risks depend upon several internal and external factors.
Internal factors can be bank policy, absence of prudential limits on
credit, lack of a loan review mechanism within the company, and
more. External factors may include the state of the economy, forex
rates, trade restrictions, economic sanctions, and more.
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The presence of credit risk deteriorates the expected returns and
creates more than expected losses for banks.
Tools For Credit Risk Management
1⃣ Creating multi-tier credit approving system at origination of loan
assets
2⃣ Setting up prudential credit limits for lending in di erent sectors
3⃣ Risk rating of borrower’s credit worthiness
4⃣ Risk pricing of loan products based on borrower’s credit score
5⃣ Analytics for risk detection and control
6⃣ Loan review mechanism
2. Market Risk Management
Market Risk Management refers to the process of identifying &
measuring the risk of losses in balance sheet & o -balance sheet items
arising from changes in market prices viz. equity prices, interest rates,
exchange rates, credit spreads & commodity prices. Banks are required
to maintain a minimum amount of capital to account for this risk.
Example▪ The failure to prudently measure risks associated with
traded instruments caused major losses in banks during global nancial
crises.
▪ In 2013, when the US Fed indicated that it would look to taper its
bond purchases, there was a massive sell-o globally & even Indian
markets were not spared.
Measures of Market Risk (MR)
Value at Risk (VaR) : A measure of the worst expected loss on a
portfolio of instruments resulting from market movements over a given
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time & a per-de ned con dence level. As VaR model does not give a
complete picture of exposure to MR, it is used as a complementary to
stress testing.
Stress Testing : It refers to measure of the average of all potential
losses arising from bank’s market risk factors exceeding the VaR at a
given con dence level, which makes up for VaR’s shortcomings in
capturing the risk of extreme losses.
3. Liquidity Risk Management
The main objective of liquidity risk management is to ensure su cient
reliable liquidity at all times and in the all circumstances. E ective
liquidity risk management (LRM)helps ensure a bank’s ability to meet
cash ow obligations, which are uncertain as they are a ected by
external events and other agent’s behaviour. LRM is of paramount
importance because a liquidity shortfall at a single institution can have
system-wide repercussions.
Liquidity risk refers to the risks resulted from an entity’s failure to pay
debts and obligations when come due because of its inability to convert
assets into cash.
Characteristics Of Liquidity Risk
First, it is di cult to measure liquidity risk due to uncertain cash ow
obligations, which depends on external events and on other agent’s
behaviour.
Second, the liquidity risk is likely unpredictable because a secondary
event often occurs following another type of risk event.
Third, the severity of liquidity risk can grow rapidly and system wide
connected.
Lastly, there is a tipping point beyond which recovery is impossible
once a system faces liquidity crises.
Types Of Liquidity Shortages In The Banks
➡ Central Bank Liquidity
➡ Market Liquidity
➡ Funding Liquidity
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Central bank liquidity is the term used to refer to deposits of nancial
institutions at the central bank. It is synonymous with reserves, or
settlement balances. These reserve balances are held by nancial
institutions to meet reserve requirements, if any, and to achieve nal
settlement of all nancial transactions in the payments system.
Individual institutions can borrow and lend these funds in the interbank
market, but, for the system as a whole, the only source of these funds
is the central bank itself.
Market liquidity refers to the ability to buy and sell assets in
reasonably large quantities without signi cantly a ecting price. This use
of the term “liquidity” is closest to the common, textbook de nition: the
ease with which an asset can be converted into means of payment viz
cash.
Funding liquidity refers to the ability of an individual or institution to
raise cash, or its equivalent, again in reasonably large quantities, either
via asset sales or by borrowing. As such, market and funding liquidity
are closely linked.
The above types of liquidity shortages do not always occur in isolation.
Important interdependencies exist and the occurrence of one can lead
to another with dynamics that often reinforce one another.
Tools For Managing Liquidity In The Banks
▪ Availing Repo & Variable Rate Repo facilities & Marginal Standing
Facility from the central bank by the banks.
▪ Availing intra day facility against reserves with the central bank.
▪ Sale of Govt securities under open market operations to the central
bank.
▪ By borrowing funds from interbank market.
The Basel Committee has prescribed maintenance of two liquidity ratios
at 100 % level viz.Liquidity Coverage Ratio (LCR) & Net Stable Funding
Ratio (NSFR) & Comprehensive Liquidity Assessment Review (CLAR)
for managing the liquidity risk.
LCR refers to the ratio of bank’s stock of high quality assets to the
estimated total net cash out ows over a 30 days period.
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NSFR requires banks to maintain enough stable funding to cover the
potential use of funds over a one year horizon.
CLAR tests a bank’s ability to meet funding obligations under periods
of stress.
4. Operational Risk Management
Operational risk refers to the risk of loss due to errors, breaches,
interruptions or damages, either intentional or accidental, caused by
people, internal processes, systems or external events.
Banks that take a comprehensive approach to operational risk
management (ORM) recognise four broad areas that requires attention :
1⃣ People
Even in a digital age, employees and the customers with whom they
interact can cause substantial damage when they do things wrong,
either by accident or on purpose. Problems can arise from a
combination of factors, including intentional and illegal breaches of
policies and rules, sloppy execution, lack of knowledge and training,
and unclear and sometimes contradictory procedures. Unauthorised
trading, for example, can cause billions in direct losses and
multimillions more in regulatory, legal and restructuring costs.
2⃣ Information Technology (IT)
Systems can be hacked and breached; data can be corrupted or stolen.
The risks banks face extend to the third-party IT providers that so many
banks now rely on for cloud-based storage and other services. Systems
can slow down or crash, leaving customers unable to access ATMs or
mobile apps. Even the speed of technological change presents an
operational risk. With the cyber landscape evolving so rapidly, banks
can have trouble keeping up with new threats.
3⃣ Organisational Structure
By setting aggressive sales targets and rewarding employees for how
well they meet them, the bank management can encourage, and, in
some cases, explicitly condone inappropriate risk taking. Such activity,
when exposed, can lead to management changes, shareholder losses
and regulatory nes.
4⃣ Regulation
The fourth area that vexes ORM planners is regulation. Since the global
nancial crisis, regulators have increased the number and complexity of
rules that banks must follow. The banks that operate in multiple
jurisdictions can face overlapping, inconsistent and con icting
regulatory regimes. Lapses can be expensive and embarrassing,
triggering regulatory sanctions and customer defections. As is the case
with technology, the speed and magnitude of regulatory change can be
daunting. Even as banks are trying to contain costs, they must invest in
the people, systems and processes that foster compliance.
Types Of Operational Risks
The top operational risks in banks include:
Cybersecurity risks: Cyber risks including ransomware & phishing
have become more frequent posing a major risk to banks.
Third-party risks: Increasingly, the banks have to identify & evaluate
the risks associated with vendors, suppliers & contractors that their
third-party vendors use.
Business Disruption & System Failures: Hardware/software system
failures, power failures & disruption in telecommunications can interrupt
business operations & cause nancial loss.
Steps In Operational Risk Management
▪ Identi cation of risks
▪ Assessment of risks
▪ Develop a scale to measure risks
▪ Risks monitoring
▪ Strategise a policy to avoid potential risk
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5. Interest Rate Risk Management
Measuring and assessing interest rate risk is essential for e ective risk
management in the banks. Various methods can be used to quantify the
potential impact of interest rate uctuations on a bank’s nancial
position and performance.
Gap Analysis
Gap analysis is a commonly used method for measuring interest rate
risk. It involves comparing the repricing of assets and liabilities within
speci ed time periods, which helps identify potential mismatches that
could a ect a bank’s net interest income.
Using gap analysis, banks can assess their exposure to repricing risk
and develop strategies to mitigate the potential impact of interest rate
changes.
However, this method may not fully capture the complexity of a rm's
interest rate risk exposure, particularly when considering yield curve
risk and optionality risk.
Duration Analysis
Duration analysis is another method for assessing interest rate risk, focusing on
the sensitivity of a bank’s assets and liabilities to changes in interest
rates.Duration measures the weighted average time until an instrument's cash
flows are received, which can help estimate the potential impact of interest rate
changes on the value of assets and liabilities.
By comparing the duration of assets and liabilities, banks can gauge their
exposure to interest rate risk and develop strategies to manage this risk, such as
duration matching. However, duration analysis may not fully capture the effects
of non-parallel shifts in the yield curve or the impact of embedded
options.
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Simulation Analysis
Simulation analysis involves using computer models to estimate the
potential impact of various interest rate scenarios on a bank’s nancial
position and performance.This method can help rms assess their
exposure to di erent types of interest rate risk, including repricing risk,
yield curve risk, and optionality risk.
By simulating the potential impact of interest rate changes under
various scenarios, banks can better understand their interest rate risk
exposure and develop appropriate risk management strategies.
However, the accuracy of simulation analysis depends on the quality of
the underlying models and assumptions.
Value at Risk
Value at Risk (VaR) is a statistical technique used to estimate the
potential losses a bank could incur due to changes in market factors,
including interest rates.
VaR calculates the maximum potential loss a bank could experience
within a speci ed time period and con dence level. Using VaR, banks
can quantify their interest rate risk exposure and develop strategies to
manage this risk. However, VaR has limitations, as it may not fully
capture the potential losses in extreme market events and may
underestimate the tail risk associated with interest rate uctuations.
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