MANAGEMENT

Risk Management
In Banks
R.S. Raghavan

< E X E C U T I V E S U M M A R Y >
◆Risk is inherent in any walk of life in gen- in detail. Main features of these risks as
eral and in financial sectors in particular. well as some other categories of risks
Till recently, due to regulated environ- such as Regulatory Risk and
ment, banks could not afford to take risks. Environmental Risk. Various tools and
But of late, banks are exposed to same techniques to manage Credit Risk,
competition and hence are compeled to Market Risk and Operational Risk and its
encounter various types of financial and various component, are also discussed in
non-financial risks. Risks and uncertain- detail. Another has also mentioned rele-
ties form an integral part of banking which vant points of Basel’s New Capital
by nature entails taking risks. Accord’ and role of capital adequacy,
There are three main categories of Risk Aggregation & Capital Allocation
risks; Credit Risk, Market Risk & and Risk Based Supervision (RBS), in
Operational Risk. Author has discussed managing risks in banking sector.

effectively controlled and rightly managed. Each trans-

BACKGROUND action that the bank undertakes changes the risk profile
he etymology of the word “Risk” can be of the bank. The extent of calculations that need to be

T
traced to the Latin word “Rescum” performed to understand the impact of each such risk on
meaning Risk at Sea or that which cuts. the transactions of the bank makes it nearly impossible
Risk is associated with uncertainty and to continuously update the risk calculations. Hence, pro-
reflected by way of charge on the funda- viding real time risk information is one of the key chal-
mental/basic i.e. in the case of business it is the Capital, lenges of risk management exercise.
which is the cushion that protects the liability holders of Till recently all the activities of banks were regulated
an institution. These risks are inter-dependent and and hence operational environment was not conducive
events affecting one area of risk can have ramifications to risk taking. Better insight, sharp intuition and longer
and penetrations for a range of other categories of risks. experience were adequate to manage the limited risks.
Foremost thing is to understand the risks run by the bank Business is the art of extracting money from other’s
and to ensure that the risks are properly confronted, pocket, sans resorting to violence. But profiting in busi-
ness without exposing to risk is like trying to live without
being born. Every one knows that risk taking is failure-
The author is member of the Institute. The views expressed herein prone as otherwise it would be treated as sure taking.
are the personal views of the author and do not necessarily Hence risk is inherent in any walk of life in general and in
represent the views of the Institute. financial sectors in particular. Of late, banks have grown

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from being a financial intermediary into a risk intermedi- entirely is to be borne by the bank itself and hence is to be
ary at present. In the process of financial intermediation, taken care of by the capital. Thus, the expected losses are
the gap of which becomes thinner and thinner, banks are covered by reserves/provisions and the unexpected
exposed to severe competition and hence are compelled losses require capital allocation. Hence the need for suffi-
to encounter various types of financial and non-financial cient Capital Adequacy Ratio is felt. Each type of risks is
risks. Risks and uncertainties form an integral part of measured to determine both the expected and unex-
banking which by nature entails taking risks. pected losses using VaR (Value at Risk) or worst-case
Business grows mainly by taking risk. Greater the type analytical model.
risk, higher the profit and hence the business unit must
strike a trade off between the two. The essential func-
tions of risk management are to identify, measure and III CREDIT RISK
more importantly monitor the profile of the bank. While Credit Risk is the potential that a bank
Non-Performing Assets are the legacy of the past in the borrower/counter party fails to meet the obligations on
present, Risk Management system is the pro-active agreed terms. There is always scope for the borrower to
action in the present for the future. Managing risk is default from his commitments for one or the other rea-
nothing but managing the change before the risk man- son resulting in crystalisation of credit risk to the bank.
ages. While new avenues for the bank has opened up they These losses could take the form outright default or alter-
have brought with them new risks as well, which the natively, losses from changes in portfolio value arising
banks will have to handle and overcome. from actual or perceived deterioration in credit quality
that is short of default. Credit risk is inherent to the busi-
ness of lending funds to the operations linked closely to
II. TYPES OF RISKS market risk variables. The objective of credit risk man-
When we use the term “Risk”, we all mean financial agement is to minimize the risk and maximize bank’s risk
risk or uncertainty of financial loss. If we consider risk in adjusted rate of return by assuming and maintaining
terms of probability of occurrence frequently, we mea- credit exposure within the acceptable parameters.
sure risk on a scale, with certainty of occurrence at one Credit risk consists of primarily two components, viz
end and certainty of non-occurrence at the other end. Quantity of risk, which is nothing but the outstanding
Risk is the greatest where the probability of occurrence loan balance as on the date of default and the quality of
or non-occurrence is equal. As per the Reserve Bank of risk, viz, the severity of loss defined by both Probability
India guidelines issued in Oct. 1999, there are three of Default as reduced by the recoveries that could be
major types of risks encountered by the banks and these made in the event of default. Thus credit risk is a com-
are Credit Risk, Market Risk & Operational Risk. As we bined outcome of Default Risk and Exposure Risk. The
go along the article, we will see what are the components elements of Credit Risk is Portfolio risk comprising
of these three major risks. In August 2001, a discussion Concentration Risk as well as Intrinsic Risk and
paper on move towards Risk Based Supervision was Transaction Risk comprising migration/down gradation
published. Further after eliciting views of banks on the risk as well as Default Risk. At the transaction level,
draft guidance note on Credit Risk Management and credit ratings are useful measures of evaluating credit risk
market risk management, the RBI has issued the final that is prevalent across the entire organization where
guidelines and advised some of the large PSU banks to treasury and credit functions are handled. Portfolio
implement so as to guage the impact. A discussion paper analysis help in identifying concentration of credit risk,
on Country Risk was also released in May 02. default/migration statistics, recovery data, etc.
Risk is the potentiality that both the expected and In general, Default is not an abrupt process to happen
unexpected events may have an adverse impact on the suddenly and past experience dictates that, more often
bank’s capital or earnings. The expected loss is to be than not, borrower’s credit worthiness and asset quality
borne by the borrower and hence is taken care of by ade- declines gradually, which is otherwise known as migra-
quately pricing the products through risk premium and tion. Default is an extreme event of credit migration.
reserves created out of the earnings. It is the amount Off balance sheet exposures such as foreign exchange
expected to be lost due to changes in credit quality result- forward cantracks, swaps options etc are classified in to
ing in default. Where as, the unexpected loss on account three broad categories such as full Risk, Medium Risk and
of the individual exposure and the whole portfolio in Low risk and then translated into risk Neighted assets

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through a conversion factor and summed up. reviews with credit decision-making process.
The management of credit risk includes a) measure- f) Loan Review Mechanism This should be done indepen-
ment through credit rating/ scoring, b) quantification dent of credit operations. It is also referred as Credit
through estimate of expected loan losses, c) Pricing on a Audit covering review of sanction process, compliance
scientific basis and d) Controlling through effective status, review of risk rating, pick up of warning signals
Loan Review Mechanism and Portfolio Management. and recommendation of corrective action with the
objective of improving credit quality. It should target all
A) Tools of Credit Risk Management. loans above certain cut-off limit ensuring that at least
The instruments and tools, through which credit risk 30% to 40% of the portfolio is subjected to LRM in a
management is carried out, are detailed below: year so as to ensure that all major credit risks embedded
a) Exposure Ceilings: Prudential Limit is linked to in the balance sheet have been tracked. This is done to
Capital Funds – say 15% for individual borrower bring about qualitative improvement in credit adminis-
entity, 40% for a group with additional 10% for infra- tration. Identify loans with credit weakness. Determine
structure projects undertaken by the group, adequacy of loan loss provisions. Ensure adherence to
Threshold limit is fixed at a level lower than lending policies and procedures. The focus of the credit
Prudential Exposure; Substantial Exposure, which is audit needs to be broadened from account level to
the sum total of the exposures beyond threshold limit overall portfolio level. Regular, proper & prompt
should not exceed 600% to 800% of the Capital reporting to Top Management should be ensured.
Funds of the bank (i.e. six to eight times). Credit Audit is conducted on site, i.e. at the branch that
b) Review/Renewal: Multi-tier Credit Approving has appraised the advance and where the main opera-
Authority, constitution wise delegation of powers, tive limits are made available. However, it is not
Higher delegated powers for better-rated customers; dis- required to visit borrowers factory/office premises.
criminatory time schedule for review/renewal, Hurdle B. Risk Rating Model
rates and Bench marks for fresh exposures and periodic- Credit Audit is conduced on site, i.e. at the branch
ity for renewal based on risk rating, etc are formulated. that has appraised the advance and where the main
c) Risk Rating Model: Set up comprehensive risk scor- operative limits are made available. However, it is
ing system on a six to nine point scale. Clearly define not required to risk borrowers’ factory/office
rating thresholds and review the ratings periodically premises. As observed by RBI, Credit Risk is the major
preferably at half yearly intervals. Rating migration is component of risk management system and this should
to be mapped to estimate the expected loss. receive special attention of the Top Management of the
d) Risk based scientific pricing: Link loan pricing to bank. The process of credit risk management needs
expected loss. High-risk category borrowers are to be analysis of uncertainty and analysis of the risks inherent
priced high. Build historical data on default losses. in a credit proposal. The predictable risk should be con-
Allocate capital to absorb the unexpected loss. Adopt tained through proper strategy and the unpredictable
the RAROC framework. ones have to be faced and overcome. Therefore any
e) Portfolio Management The need for credit portfolio lending decision should always be preceded by detailed
management emanates from the necessity to opti- analysis of risks and the outcome of analysis should be
mize the benefits associated with diversification and taken as a guide for the credit decision. As there is a sig-
to reduce the potential adverse impact of concentra- nificant co-relation between credit ratings and default
tion of exposures to a particular borrower, sector or frequencies, any derivation of probability from such his-
industry. Stipulate quantitative ceiling on aggregate torical data can be relied upon. The model may consist of
exposure on specific rating categories, distribution of minimum of six grades for performing and two grades
borrowers in various industry, business group and for non-performing assets. The distribution of rating of
conduct rapid portfolio reviews. The existing frame- assets should be such that not more than 30% of the
work of tracking the non-performing loans around advances are grouped under one rating. The need for the
the balance sheet date does not signal the quality of adoption of the credit risk-rating model is on account of
the entire loan book. There should be a proper & reg- the following aspects.
ular on-going system for identification of credit — Disciplined way of looking at Credit Risk.
weaknesses well in advance. Initiate steps to preserve — Reasonable estimation of the overall health status of
the desired portfolio quality and integrate portfolio an account captured under Portfolio approach as

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contrasted to stand-alone or asset based credit man- cific to the activities in which the borrower is engaged.
agement. Assessment of financial risks involves appraisal of the
— Impact of a new loan asset on the portfolio can be financial strength of a unit based on its performance and
assessed. Taking a fresh exposure to the sector in finacial indicators like liquidity, profitability, gearing,
which there already exists sizable exposure may sim- leverage, coverage, turnover etc. It is necessary to study
ply increase the portfolio risk although specific unit the movement of these indicators over a period of time as
level risk is negligible/minimal. also its comparison with industry averages wherever pos-
— The co-relation or co-variance between different sec- sible. A study carried out in the western corporate world
tors of portfolio measures the inter relationship reveals that 45% of the projects failed to take off simply
between assets. The benefits of diversification will be because the personnel entrusted with the test were found
available so long as there is no perfect positive co- to be highly wanting in qualitatively managing the project.
relation between the assets, otherwise impact on one The key ingredient of credit risk is the risk of default
would affect the other. that is measured by the probability that default occurs
— Concentration risks are measured in terms of addi- during a given period. Probabilities are estimates of
tional portfolio risk arising on account of increased future happenings that are uncertain. We can narrow the
exposure to a borrower/group or co-related borrow- margin of uncertainty of a forecast if we have a fair
ers. understanding of the nature and level of uncertainty
— Need for Relationship Manager to capture, monitor regarding the variable in question and availability of qual-
and control the over all exposure to high value cus- ity information at the time of assessment.
tomers on real time basis to focus attention on vital The expected loss/unexpected loss methodology
few so that trivial many do not take much of valuable forces banks to adopt new Internal Ratings Based
time and efforts. approach to credit risk management as proposed in the
— Instead of passive approach of originating the loan Capital Accord II. Some of the risk rating methodologies
and holding it till maturity, active approach of credit used widely is briefed below:
portfolio management is adopted through secuitisa- a. Altman’s Z score Model involves forecasting the
tion/credit derivatives. probability of a company entering bankruptcy. It sep-
— Pricing of credit risk on a scientific basis linking the arates defaulting borrower from non-defaulting bor-
loan price to the risk involved therein. rower on the basis of certain financial ratios con-
— Rating can be used for the anticipatory provisioning. verted into simple index.
Certain level of reasonable over-provisioning as best b. Credit Metrics focuses on estimating the volatility of
practice. asset values caused by variation in the quality of
Given the past experience and assumptions about the assets. The model tracks rating migration which is the
future, the credit risk model seeks to determine the pre- probability that a borrower migrates from one risk
sent value of a given loan or fixed income security. It also rating to another risk rating.
seeks to determine the quantifiable risk that the promised c. Credit Risk +, a statistical method based on the insurance
cash flows will not be forthcoming. Thus, credit risk industry, is for measuring credit risk. The model is based
models are intended to aid banks in quantifying, aggre- on acturial rates and unexpected losses from defaults. It
gating and managing risk across geographical and prod- is based on insurance industry model of event risk.
uct lines. Credit models are used to flag potential prob- d. KMV, through its Expected Default Frequency (EDF)
lems in the portfolio to facilitate early corrective action. methodology derives the actual probability of default
The risk-rating model should capture various types of for each obligor based on functions of capital struc-
risks such as Industry/Business Risk, Financial Risk and ture, the volatility of asset returns and the current asset
Management Risk, associated with credit. value. It calculates the asset value of a firm from the
Industry/Business risk consists of both systematic and market value of its equity using an option pricing
unsystematic risks which are market driven. The system- based approach that recognizes equity as a call option
atic risk emanates from General political environment, on the underlying asset of the firm. It tries to estimate
changes in economic policies, fiscal policies of the gov- the asset value path of the firm over a time horizon.
ernment, infrastructural changes etc. The unsystematic The default risk is the probability of the estimated
risk arises out of internal factors such as machinery break- asset value falling below a pre-specified default point.
down, labour strike, new competitors who are quite spe- e. Mckinsey’s credit portfolio view is a multi factor model

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which is used to stimulate the distribution of default managing liquidity, interest rate, foreign exchange and
probabilities, as well as migration probabilities condi- equity as well as commodity price risk of a bank that needs
tioned on the value of macro economic factors like the to be closely integrated with the bank’s business strategy.
unemployment rate, GDP growth, forex rates, etc. Scenario analysis and stress testing is yet another tool
In to-days parlance, default arises when a scheduled used to assess areas of potential problems in a given port-
payment obligation is not met within 180 days from the folio. Identification of future changes in economic con-
due date and this cut-off period may undergo downward ditions like – economic/industry overturns, market risk
change. Exposure risk is the loss of amount outstanding events, liquidity conditions etc that could have
at the time of default as reduced by the recoverable unfavourable effect on bank’s portfolio is a condition
amount. The loss in case of default is D* X * (I-R) where precedent for carrying out stress testing. As the underly-
D is Default percentage, X is the Exposure Value and R ing assumption keep changing from time to time, out-
is the recovery rate. put of the test should be reviewed periodically as market
Credit Risk is measured through Probability of risk management system should be responsive and sen-
Default (POD) and Loss Given Default (LGD). Bank sitive to the happenings in the market.
should estimate the probability of default associated with
borrowers in each of the rating grades. How much the a) Liquidity Risk:
bank would lose once such event occurs is what is known Bank Deposits generally have a much shorter con-
as Loss Given Default. This loss is also dependent upon tractual maturity than loans and liquidity management
bank’s exposure to the borrower at the time of default needs to provide a cushion to cover anticipated deposit
commonly known as Exposure at Default (EaD). withdrawals. Liquidity is the ability to efficiently accom-
The extent of provisioning required could be esti- modate deposit as also reduction in liabilities and to fund
mated from the expected Loss Given Default (which is the loan growth and possible funding of the off-balance
the product of Probability of Default, Loss Given sheet claims. The cash flows are placed in different time
Default & Exposure & Default). That is ELGD is equal buckets based on future likely behaviour of assets, liabil-
to PODX LGD X EaD. ities and off-balance sheet items. Liquidity risk consists
Credit Metrics mechanism advocates that the of Funding Risk, Time Risk & Call Risk.
amount of portfolio value should be viewed not just in
terms of likelihood of default, but also in terms of credit Funding Risk : It is the need to replace net out flows
quality over time of which default is just a specific case. due to unanticipated withdrawal/non-
Credit Metrics can be worked out at corporate level, at renewal of deposit
least on an annual basis to measure risk- migration and Time risk : It is the need to compensate for non-
resultant deterioration in credit portfolio. receipt of expected inflows of funds,
The ideal credit risk management system should i.e. performing assets turning into non-
throw a single number as to how much a bank stands to performing assets.
lose on credit portfolio and therefore how much capital Call risk : It happens on account of crystalisation
they ought to hold. of contingent liabilities and inability to
undertake profitable business oppor-
tunities when desired.
IV MARKET RISK
Market Risk may be defined as the possibility of loss The Asset Liability Management (ALM) is a part of
to bank caused by the changes in the market variables. It the overall risk management system in the banks. It
is the risk that the value of on-/off-balance sheet posi- implies examination of all the assets and liabilities simul-
tions will be adversely affected by movements in equity taneously on a continuous basis with a view to ensuring
and interest rate markets, currency exchange rates and a proper balance between funds mobilization and their
commodity prices. Market risk is the risk to the bank’s deployment with respect to their a) maturity profiles, b)
earnings and capital due to changes in the market level of cost, c) yield, d) risk exposure, etc. It includes product
interest rates or prices of securities, foreign exchange and pricing for deposits as well as advances, and the desired
equities, as well as the volatilities, of those prices. Market maturity profile of assets and liabilities.
Risk Management provides a comprehensive and Tolerance levels on mismatches should be fixed for
dynamic frame work for measuring, monitoring and various maturities depending upon the asset liability pro-

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file, deposit mix, nature of cash flow etc. Bank should It is the risk that the Interest rat of different
track the impact of pre-payment of loans & premature Assets/liabilities and off balance items may
closure of deposits so as to realistically estimate the cash change in different magnitude. The degree of
flow profile. basis risk is fairly high in respect of banks that cre-
ate composite assets out of composite liabilities.
b) Interest Rate Risk Embedded option Risk:
Interest Rate Risk is the potential negative impact on Option of pre-payment of loan and Fore- closure
the Net Interest Income and it refers to the vulnerability of deposits before their stated maturities consti-
of an institution’s financial condition to the movement tute embedded option risk
in interest rates. Changes in interest rate affect earnings, Yield curve risk:
value of assets, liability off-balance sheet items and cash Movement in yield curve and the impact of that
flow. Hence, the objective of interest rate risk manage- on portfolio values and income.
ment is to maintain earnings, improve the capability, Reprice risk:
ability to absorb potential loss and to ensue the adequacy When assets are sold before maturities.
of the compensation received for the risk taken and Reinvestment risk:
effect risk return trade-off. Management of interest rate Uncertainty with regard to interest rate at which
risk aims at capturing the risks arising from the maturity the future cash flows could be reinvested.
and re-pricing mismatches and is measured both from Net interest position risk:
the earnings and economic value perspective. When banks have more earning assets than pay-
Earnings perspective involves analyzing the impact of ing liabilities, net interest position risk arises in
changes in interest rates on accrual or reported earnings in case market interest rates adjust downwards.
the near term. This is measured by measuring the changes in There are different techniques such as a) the tradi-
the Net Interest Income (NII) equivalent to the difference tional Maturity Gap Analysis to measure the interest rate
between total interest income and total interest expense. sensitivity, b) Duration Gap Analysis to measure interest
In order to manage interest rate risk, banks should rate sensitivity of capital, c) simulation and d) Value at
begin evaluating the vulnerability of their portfolios to Risk for measurement of interest rate risk. The approach
the risk of fluctuations in market interest rates. One such towards measurement and hedging interest rate risk
measure is Duration of market value of a bank asset or varies with segmentation of bank’s balance sheet. Banks
liabilities to a percentage change in the market interest broadly bifurcate the asset into Trading Book and
rate. The difference between the average duration for Banking Book. While trading book comprises of assets
bank assets and the average duration for bank liabilities held primarily for generating profits on short term differ-
is known as the duration gap which assess the bank’s ences in prices/yields, the banking book consists of assets
exposure to interest rate risk. The Asset Liability and liabilities contracted basically on account of relation-
Committee (ALCO) of a bank uses the information con- ship or for steady income and statutory obligations and
tained in the duration gap analysis to guide and frame are generally held till maturity/payment by counter party.
strategies. By reducing the size of the duration gap, banks Thus, while price risk is the prime concern of banks
can minimize the interest rate risk. in trading book, the earnings or changes in the economic
Economic Value perspective involves analyzing the value are the main focus in banking book.
expected cash in flows on assets minus expected cash out Value at Risk (VaR) is a method of assessing the market
flows on liabilities plus the net cash flows on off-balance risk using standard statistical techniques. It is a statistical
sheet items. The economic value perspective identifies measure of risk exposure and measures the worst expected
risk arising from long-term interest rate gaps. The vari- loss over a given time interval under normal market condi-
ous types of interest rate risks are detailed below: tions at a given confidence level of say 95% or 99%. Thus
Gap/Mismatch risk: VaR is simply a distribution of probable outcome of future
It arises from holding assets and liabilities and off losses that may occur on a portfolio. The actual result will
balance sheet items with different principal not be known until the event takes place. Till then it is a ran-
amounts, maturity dates & re-pricing dates dom variable whose outcome has been estimated.
thereby creating exposure to unexpected changes As far as Trading Book is concerned, bank should be
in the level of market interest rates. able to adopt standardized method or internal models
Basis Risk: for providing explicit capital charge for market risk.

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exchange rate change, will alter the expected amount of
c) Forex Risk principal and return on the lending or investment.
Foreign exchange risk is the risk that a bank may suf- In the process there can be a situation in which seller
fer loss as a result of adverse exchange rate movement (exporter) may deliver the goods, but may not be paid or
during a period in which it has an open position, either the buyer (importer) might have paid the money in
spot or forward or both in same foreign currency. Even advance but was not delivered the goods for one or the
in case where spot or forward positions in individual cur- other reasons.
rencies are balanced the maturity pattern of forward As per the RBI guidance note on Country Risk
transactions may produce mismatches. There is also a Management published recently, banks should reckon
settlement risk arising out of default of the counter party both fund and non-fund exposures from their domestic as
and out of time lag in settlement of one currency in one well as foreign branches, if any, while identifying, measur-
center and the settlement of another currency in another ing, monitoring and controlling country risk. It advocates
time zone. Banks are also exposed to interest rate risk, that bank should also take into account indirect country
which arises from the maturity mismatch of foreign cur- risk exposure. For example, exposures to a domestic com-
rency position. The Value at Risk (VaR) indicates the risk mercial borrower with large economic dependence on a
that the bank is exposed due to uncovered position of certain country may be considered as subject to indirect
mismatch and these gap positions are to be valued on country risk. The exposures should be computed on a net
daily basis at the prevalent forward market rates basis, i.e. gross exposure minus collaterals, guarantees etc.
announced by FEDAI for the remaining maturities. Netting may be considered for collaterals in/guarantees
Currency Risk is the possibility that exchange rate issued by countries in a lower risk category and may be per-
changes will alter the expected amount of principal and mitted for bank’s dues payable to the respective countries.
return of the lending or investment. At times, banks may RBI further suggests that banks should eventually
try to cope with this specific risk on the lending side by put in place appropriate systems to move over to internal
shifting the risk associated with exchange rate fluctua- assessment of country risk within a prescribed period say
tions to the borrowers. However the risk does not get by 31.3.2004, by which time the new capital accord
extinguished, but only gets converted in to credit risk. would be implemented. The system should be able to
By setting appropriates limits-open position and gaps, identify the full dimensions of country risk as well as
stop-loss limits, Day Light as well as overnight limits for incorporate features that acknowledge the links between
each currency, Individual Gap Limits and Aggregate Gap credit and market risks. Banks should not rely solely on
Limits, clear cut and well defined division of responsibili- rating agencies or other external sources as their only
ties between front, middle and back office the risk element country risk-monitoring tool.
in foreign exchange risk can be managed/monitored. With regard to inter-bank exposures, the guidelines
suggests that banks should use the country ratings of
d) Country Risk international rating agencies and broadly classify the
This is the risk that arises due to cross border transac- country risk rating into six categories such as insignifi-
tions that are growing dramatically in the recent years cant, low, moderate, high, very high & off-credit.
owing to economic liberalization and globalization. It is the However, banks may be allowed to adopt a more con-
possibility that a country will be unable to service or repay servative categorization of the countries.
debts to foreign lenders in time. It comprises of Transfer Banks may set country exposure limits in relation to
Risk arising on account of possibility of losses due to the bank’s regulatory capital (Tier I & II) with suitable
restrictions on external remittances; Sovereign Risk associ- sub limits, if necessary, for products, branches, maturity
ated with lending to government of a sovereign nation or etc. Banks were also advised to set country exposure lim-
taking government guarantees; Political Risk when politi- its and monitor such exposure on weekly basis before
cal environment or legislative process of country leads to eventually switching over to real tie monitoring. Banks
government taking over the assets of the financial entity should use variety of internal and external sources as a
(like nationalization, etc) and preventing discharge of lia- means to measure country risk and should not rely solely
bilities in a manner that had been agreed to earlier; Cross on rating agencies or other external sources as their only
border risk arising on account of the borrower being a res- tool for monitoring country risk. Banks are expected to
ident of a country other than the country where the cross disclose the “Country Risk Management” policies in
border asset is booked; Currency Risk, a possibility that their Annual Report by way of notes.

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V OPERATIONAL RISK VI REGULATORY RISK

Always banks live with the risks arising out of human When owned funds alone are managed by an entity, it
error, financial fraud and natural disasters. The recent hap- is natural that very few regulators operate and supervise
penings such as WTC tragedy, Barings debacle etc. has high- them. However, as banks accept deposit from public
lighted the potential losses on account of operational risk. obviously better governance is expected of them. This
Exponential growth in the use of technology and increase in entails multiplicity of regulatory controls. Many Banks,
global financial inter-linkages are the two primary changes having already gone for public issue, have a greater
that contributed to such risks. Operational risk, though responsibility and accountability. As banks deal with
defined as any risk that is not categorized as market or credit public funds and money, they are subject to various reg-
risk, is the risk of loss arising from inadequate or failed inter- ulations. The very many regulators include Reserve Bank
nal processes, people and systems or from external events. of India (RBI), Securities Exchange Board of India
In order to mitigate this, internal control and internal audit (SEBI), Department of Company Affairs (DCA), etc.
systems are used as the primary means. More over, banks should ensure compliance of the
Risk education for familiarizing the complex operations applicable provisions of The Banking Regulation Act,
at all levels of staff can also reduce operational risk. Insurance The Companies Act, etc. Thus all the banks run the risk
cover is one of the important mitigators of operational risk. of multiple regulatory-risk which inhibits free growth of
Operational risk events are associated with weak links in business as focus on compliance of too many regulations
internal control procedures. The key to management of leave little energy and time for developing new business.
operational risk lies in the bank’s ability to assess its process Banks should learn the art of playing their business activ-
for vulnerability and establish controls as well as safeguards ities within the regulatory controls.
while providing for unanticipated worst-case scenarios.
Operational risk involves breakdown in internal con-
trols and corporate governance leading to error, fraud, per- VII ENVIRONMENTAL RISK
formance failure, compromise on the interest of the bank As the years roll by and technological advancement
resulting in financial loss. Putting in place proper corporate take place, expectation of the customers change and
governance practices by itself would serve as an effective enlarge. With the economic liberalization and globaliza-
risk management tool. Bank should strive to promote a tion, more national and international players are operat-
shared understanding of operational risk within the orga- ing the financial markets, particularly in the banking field.
nization, especially since operational risk is often inter- This provides the platform for environmental change
wined with market or credit risk and it is difficult to isolate. and exposes the bank to the environmental risk. Thus,
Over a period of time, management of credit and mar- unless the banks improve their delivery channels, reach
ket risks has evolved a more sophisticated fashion than customers, innovate their products that are service ori-
operational risk, as the former can be more easily measured, ented, they are exposed to the environmental risk result-
monitored and analysed. And yet the root causes of all the ing in loss in business share with consequential profit.
financial scams and losses are the result of operational risk
caused by breakdowns in internal control mechanism and
staff lapses. So far, scientific measurement of operational VIII BASEL’S NEW CAPITAL ACCORD
risk has not been evolved. Hence 20% charge on the Capital Bankers’ for International Settlement (BIS) meet at
Funds is earmarked for operational risk and based on sub- Basel situated at Switzerland to address the common
sequent data/feedback, it was reduced to 12%. While mea- issues concerning bankers all over the world. The Basel
surement of operational risk and computing capital charges Committee on Banking Supervision (BCBS) is a com-
as envisaged in the Basel proposals are to be the ultimate mittee of banking supervisory authorities of G-10 coun-
goals, what is to be done at present is start implementing the tries and has been developing standards and establish-
Basel proposal in a phased manner and carefully plan in that ment of a framework for bank supervision towards
direction. The incentive for banks to move the measure- strengthening financial stability through out the world.
ment chain is not just to reduce regulatory capital but more In consultation with the supervisory authorities authori-
importantly to provide assurance to the top management ties of a few non-G-10 countries including India, core
that the bank holds the required capital. principles for effective banking supervision in the form
of minimum requirements to strengthen current super-

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MAANNAAGGEEMMEENNTT
visory regime, were mooted. where certain minimum capital adequacy has to be main-
The 1988 Capital Accord essentially provided only one tained in the face of stiff norms in respect of income
option for measuring the appropriate capital in relation to recognition, asset classification and provisioning. It is
the risk-weighted assets of the financial institution. It clear that multi pronged approach would be required to
focused on the total amount of bank capital so as to reduce meet the challenges of maintaining capital at adequate
the risk of bank solvency at the potential cost of bank’s fail- levels in the face of mounting risks in the banking sector.
ure for the depositors. As an improvement on the above, In banks asset creation is an event happening subse-
the New Capital Accord was published in 2001, to be imple- quent to the capital formation and deposit mobilization.
mented by the financial year 2003-04. It provides spectrum Therefore, the preposition should be for a given capital
of approaches for the measurement of credit, market and how much asset can be created? Hence, in ideal situation
operational risks to determine the capital required. and taking a radical view, stipulation of Asset Creation
The spread and nature of the ownership structure is Multiple (ACM), in lieu of capital adequacy ratio, would
important as it impinges on the propensity to induct addi- be more appropriate and rational. That is to say, instead
tional capital. While getting support from a large body of of Minimum Capital Adequacy Ratio of 8 percent (imply-
shareholders is a difficult proposition when the bank’s ing holding of Rs 8 by way of capital for every Rs 100 risk
performance is adverse, a smaller shareholder base con- weighted assets), stipulation of Maximum Asset Creation
strains the ability of the bank to garner funds. Tier I capi- Multiple of 12.5 times (implying for maximum Asset
tal is not owed to anyone and is available to cover possi- Creation Multiple of 12.5 time for the given capital of Rs
ble unexpected losses. It has no maturity or repayment 8) would be more meaningful. However as the assets have
requirement, and is expected to remain a permanent been already created when the norms were introduced,
component of the core capital of the counter party. While capital adequacy ratio is adopted instead of asset creation
Basel standards currently require banks to have a capital multiple. At least in respect of the new banks (starting
adequacy ratio of 8% with Tier I not less than 4%, RBI has from zero), Asset Creation Multiple (ACM) may be
mandated the banks to maintain CAR of 9%. The main- examined/thought of for strict implementation.
tenance of capital adequacy is like aiming at a moving tar- The main differences between the existing accord
get as the composition of risk-weighted assets gets and the new one are summarized below:-
changed every minute on account of fluctuation in the
risk profile of a bank. Tier I capital is known as the core Existing Accord New Accord
capital providing permanent and readily available support 1. Focus on single risk 1. More emphasis on banks’
to the bank to meet the unexpected losses. measure own internal metodology
In the recent past, owner of PSU banks, the govern- supervisory Review and mar-
ment provided capital in good measure mainly to weaker ket discipline.
banks. In doing so, the government was not acting as a
prudent investor as return on such capital was never a 2. One size fits all 2. Flexibility, menu of
consideration. Further, capital infusion did not result in approaches, incentive for bet-
any cash flow to the receiver, as all the capital was required ter risk management.
to be reinvested in government securities yielding low 3. Broad brush structure 3. More risk sensitivity.
interest. Receipt of capital was just a book entry with the
only advantage of interest income from the securities. The structure of the New Accord – II consists of
three pillars approach as given below.
Pillar Focus area
CAPITAL ADEQUACY I Pillar - Minimum Capital Requirement
Subsequent to nationalization of banks, capitaliza- II Pillar - Supervisory review process
tion in banks was not given due importance as it was felt III Pillar - Market Discipline
necessary for the reason that the ownership of the banks
rested with the government, creating the required confi- i) Minimum Capital Requirement
dence in the mind of the public. Combined forces of The capital Adequacy Ratio is the percentage of bank’s
globalization and liberalization compelled the public Capital Funds in relation to the Risk Weighted Assets of the
sector banks, hitherto shielded from the vagaries of mar- bank. In the New Capital Accord, while the definition of
ket forces, to come to terms with the market realities Capital Fund remains the same, the method of calculation

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of Risk Weighted Assets has been modified to factor mar- cost of Economic Capital & expected losses that may
ket risk and operational risk, in addition to the Credit Risk prevail in the worst-case scenario and then equates the
that alone was reckoned in the 1988 Capital Accord. Banks capital cushion to be provided for the potential loss.
may adopt any of the approach suitable to them for arriving RAROC is the first step towards examining the institu-
at the total risk weighted assets. Various approaches, to be tion’s entire balance sheet on a mark to market basis, if
chosen from under each of the risk are detailed below: only to understand the risk return trade off that have been
made. As banks carry on the business on a wide area net-
Credit Risk Menu: work basis, it is critical that they are able to continuously
1) Standardized Approach: The bank allocates a risk monitor the exposures across the entire organization and
weight to each assets as well as off balance sheet items aggregate the risks so than an integrated view is taken.
and produces a sum of R W A values (RW of 100% The Economic Capital is the amount of the capital
may entail capital charge of 8% and RW of 20% may (besides the Regulatory Capital) that the firm has to put
entail capital charge of 1.6%.) at risk so as to cover the potential loss under the extreme
The risk weights are to be refined by reference to a market conditions. In other words, it is the difference in
rating provided by an external credit assessment insti- mark-to-market value of assets over liabilities that the
tution that meets certain strict standards. bank should aim at or target. As against this, the regula-
2) Foundation Internal Rating Based Approach : Under tory capital is the actual Capital Funds held by the bank
this, bank rates the borrower and results are translated against the Risk Weighted Assets.
into estimates of a potential future loss amount which After measuring the economic capital for the bank as
forms the basis of minimum capital requirement. a whole, bank’s actual capital has to be allocated to indi-
3) Advanced Internal Rating Based Approach: In vidual business units on the basis of various types of
Advanced IRB approach, the range of risk weights risks. This process can be continued till capital is allo-
will be well diverse. cated at transaction/customer level.
Market Risk Menu:
1) Standardized Approach
2) Internal Models Approach X. RISK BASED SUPERVISION (RBS)
Operational Risk Menu: The Reserve Bank of India presently has its supervi-
sory mechanism by way of on-site inspection and off-site
1) Basic Indicator Approach (Alpha) monitoring on the basis of the audited balance sheet of a
Hence, one indicator for operational risk is identified bank. In order to enhance the supervisory mechanism,
such as interest income, Risk Weighted Asset etc. the RBI has decided to put in place, beginning from the
2) Standardized Approach (Beta) last quarter of the financial year 02-03, a system of Risk
This approach specifies different indicators for dif- Based Supervision. Under risk based supervision, super-
ferent lines/units of business and the summation of visors are expected to concentrate their efforts on ensur-
different business lines such as Corporate Finance, ing that financial institutions use the process necessarily
Retail Banking Asset Management, etc.to be done. to identify, measure and control risk exposure. The RBS
3) Internal Measurement Approach (Gamma) is expected to focus supervisory attention in accordance
Based on the past internal loss data estimation, for with the risk profile of the bank. The RBI has already
each combination of business line, bank is required structured the risk profile templates to enable the bank to
to calculate an expected loss value to ascertain the make a self-assessment of their risk profile. It is designed
required capital to be allocated/assigned. to ensure continuous monitoring and evaluation of risk
profile of the institution through risk matrix. This may
optimize the utilization of the supervisory resources of
IX RISK AGGREGATION & CAPITAL ALLOCATION the RBI so as to minimize the impact of a crises situation
Capital Adequacy in relation to economic risk is a nec- in the financial system. The transaction based audit and
essary condition for the long-term soundness of banks. supervision is getting shifted to risk focused audit.
Aggregate risk exposure is estimated through Risk Risk based supervision approach is an attempt to over-
Adjusted Return on Capital (RAROC) and Earnings at come the deficiencies in the traditional point-in-time, transac-
Risk (EaR) method. Former is used by bank with interna- tion-validation and value based supervisory system. It is for-
tional presence and the RAROC process estimates the ward looking enabling the supervisors to diferentiate between

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banks to focus attention on those having high-risk profile. Investment and Operational areas. Integration of systems
The implementation of risk based auditing would that includes both transactions processing as well as risk
imply that greater emphasis is placed on the internal systems is critical for implementation.
auditor’s role for mitigating risks. By focusing on effec- In a scenario where majority of profits are derived
tive risk management, the internal auditor would not from trade in the market, one can no longer afford to
only offer remedial measures for current trouble-prone avoid measuring risk and managing its implications
areas, but also anticipate problems to play an active role thereof. Crossing the chasm will involve systematic
in protecting the bank from risk hazards. changes coupled with the characteristic uncertainty and
also the pain it brings and it may be worth the effort. The
engine of the change is obviously the evolution of the
XI CONCLUSION market economy abetted by unimaginable advances in
Risk management underscores the fact that the survival technology, communication, transmission of related
of an organization depends heavily on its capabilities to uncontainable flow of information, capital and com-
anticipate and prepare for the change rather than just waiting merce through out the world. Like a powerful river, the
for the change and react to it. The objective of risk manage- market economy is widening and breaking down barri-
ment is not to prohibit or prevent risk taking activity, but to ers. Government’s role is not to block that flow, but to
ensure that the risks are consciously taken with full knowl- accommodate it and yet keep it sufficiently under control
edge, clear purpose and understanding so that it can be mea- so that it does not overflow its banks and drown us with
sured and mitigated. It also prevents an institution from suf- the associated risks and undesirable side effects.
fering unacceptable loss causing an institution to fail or To the extent the bank can take risk more con-
materially damage its competitive position. Functions of risk sciously, anticipates adverse changes and hedges
management should actually be bank specific dictated by the accordingly, it becomes a source of competitive advan-
size and quality of balance sheet, complexity of functions, tage, as it can offer its products at a better price than its
technical/ professional manpower and the status of MIS in competitors. What can be measured can mitigation is
place in that bank. There may not be one-size-fits-all risk more important than capital allocation against inade-
management module for all the banks to be made applicable quate risk management system. Basel proposal pro-
uniformly. Balancing risk and return is not an easy task as risk vides proper starting point for forward-looking banks
is subjective and not quantifiable where as return is objective to start building process and systems attuned to risk
and measurable. If there exist a way of converting the sub- management practice. Given the data-intensive nature
jectivity of the risk into a number then the balancing exercise of risk management process, Indian Banks have a long
would be meaningful and much easier. way to go before they comprehend and implement
Banking is nothing but financial inter-mediation Basel II norms, in to-to.
between the financial savers on the one hand and the The effectiveness of risk measurement in banks
funds seeking business entrepreneurs on the other hand. depends on efficient Management Information System,
As such, in the process of providing financial services, computerization and net working of the branch activi-
commercial banks assume various kinds of risks both ties. The data warehousing solution should effectively
financial and non-financial. Therefore, banking prac- interface with the transaction systems like core banking
tices, which continue to be deep routed in the philosophy solution and risk systems to collate data. An objective
of securities based lending and investment policies, need and reliable data base has to be built up for which bank
to change the approach and mindset, rather radically, to has to analyze its own past performance data relating to
manage and mitigate the perceived risks, so as to ulti- loan defaults, trading losses, operational losses etc., and
mately improve the quality of the asset portfolio. come out with bench marks so as to prepare themselves
As in the international practice, a committee approach for the future risk management activities. Any risk man-
may be adopted to manage various risks. Risk agement model is as good as the data input. With the
Management Committee, Credit Policy Committee, Asset onslaught of globalization and liberalization from the
Liability Committee, etc are such committees that handle last decade of the 20th Century in the Indian financial
the risk management aspects. While a centralized depart- sectors in general and banking in particular, managing
ment may be made responsible for monitoring risk, risk Transformation would be the biggest challenge, as
control should actually take place at the functional depart- transformation and change are the only certainties of
ments as it is generally fragmented across Credit, Funds, the future. ■

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