1.
Introduction
INTRODUCTION
The significant transformation of the banking industry in India is clearly evident from the
changes that have occurred in the financial markets, institutions and products. While
deregulation has opened up new vistas for banks to argument revenues, it has entailed greater
competition and consequently greater risks. Cross- border flows and entry of new products,
particularly derivative instruments, have impacted significantly on the domestic banking
sector forcing banks to adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive to the globalized environment. These
developments have facilitated greater choice for consumers, who have become more
discerning and demanding compelling banks to offer a broader range of products through
diverse distribution channels. The traditional face of banks as mere financial intermediaries
has since altered and risk management has emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The benefits of
globalization have been well documented and are being increasingly recognized. Integration
of domestic markets with international financial markets has been facilitated by tremendous
advancement in information and communications technology. But, such an environment has
also meant that a problem in one country can sometimes adversely impact one or more
countries instantaneously, even if they are fundamentally strong.
There is a growing realisation that the ability of countries to conduct business across national
borders and the ability to cope with the possible downside risks would depend, interalia, on
the soundness of the financial system. This has consequently meant the adoption of a strong
and transparent, prudential, regulatory, supervisory, technological and institutional
framework in the financial sector on par with international best practices. All this necessitates
a transformation: a transformation in the mindset, a transformation in the business processes
and finally, a transformation in knowledge management. This process is not a one shot affair;
it needs to be appropriately phased in the least disruptive manner.
The banking and financial crises in recent years in emerging economies have demonstrated
that, when things go wrong with the financial system, they can result in a severe economic
downturn. Furthermore, banking crises often impose substantial costs on the exchequer, the
incidence of which is ultimately borne by the taxpayer. The World Bank Annual Report
(2002) has observed that the loss of US $1 trillion in banking crisis in the 1980s and 1990s is
equal to the total flow of official development assistance to developing countries from 1950s
to the present date. As a consequence, the focus of financial market reform in many emerging
economies has been towards increasing efficiency while at the same time ensuring stability in
financial markets. From this perspective. financial sector reforms are essential in order to
avoid such costs. It is, therefore, not surprising that financial market reform is at the forefront
of public policy debate in recent years. The crucial role of sound financial markets in
promoting rapid economic growth and ensuring financial stability. Financial sector reform,
through the development of an efficient financial system, is thus perceived as a key element
in raising countries out of their 'low level equilibrium trap'. As the World Bank Annual
Report (2002) observes, a robust financial system is a precondition for a sound investment
climate, growth and the reduction of poverty'.
Financial sector reforms were initiated in India a decade ago with a view to improving
efficiency in the process of financial intermediation, enhancing the effectiveness in the
conduct of monetary policy and creating conditions for integration of the domestic financial
sector with the global system. The first phase of reforms was guided by the recommendations
of Narasimham Committee. The approach was to ensure that 'the financial services industry
operates on the basis of operational flexibility and functional autonomy with a view to
enhancing efficiency, productivity and profitability'. The second phase, guided by
Narasimham Committee II, focused on strengthening the foundations of the banking system
and bringing about structural improvements. Further intensive discussions are held on
important issues related to corporate governance, reform of the capital structure, (in the
context of Basel II norms), retail banking, risk management technology, and human resources
development, among others.
Since 1992, significant changes have been introduced in the Indian financial system. These
changes have infused an element of competition in the financial system. marking the gradual
end of financial repression characterized by price and non-price controls in the process of
financial intermediation. While financial markets have been fairly developed, there still
remains a large extent of segmentation of markets and non- level playing field among
participants, which contribute to volatility in asset prices. This volatility is exacerbated by the
lack of liquidity in the secondary markets. The purpose of this paper is to highlight the need
for the regulator and market participants to recognize the risks in the financial system, the
products available to hedge risks and the instruments, including derivatives that are required
to be developed/introduced in the Indian system. The financial sector serves the economic
function of intermediation by ensuring efficient allocation of resources in the economy.
Financial intermediation is enabled through a four-pronged transformation mechanism
consisting of liability-asset transformation, size transformation, maturity transformation and
risk transformation. Risk is inherent in the very act of transformation. However, prior to
reform of 1991-92, banks were not exposed to diverse financial risks mainly because interest
rates and the exchange rate were administered.
The Indian banking industry is undergoing a significant transformation, marked by changes
in financial markets, institutions, and products. Deregulation has presented banks with new
opportunities to increase revenues, but this has also led to heightened competition and greater
risks. The rise in cross-border financial flows and the introduction of innovative products,
particularly derivative instruments, have significantly influenced the domestic banking sector.
This has compelled banks to modify their product mix and rapidly adapt their processes and
operations to stay competitive in an increasingly globalized environment. These
developments have ultimately expanded choices for consumers, who have become more
sophisticated and demanding, pushing banks to offer a wider range of products through
diverse distribution channels. Consequently, the traditional perception of banks as mere
financial intermediaries has changed, with risk management now a defining characteristic.
Globalization is a dominant force in the contemporary world, and its benefits are widely
acknowledged. The integration of domestic markets with international financial markets has
been greatly facilitated by advancements in information and communications technology.
However, this interconnectedness also implies that economic or financial difficulties in one
country can quickly and significantly affect other countries, even those with strong
underlying fundamentals.
There's a growing recognition of the crucial role a country's financial system plays in its
ability to conduct international business and withstand potential risks. This realization has
driven the need for robust and transparent prudential, regulatory, supervisory, technological,
and institutional frameworks in the financial sector, aligning with international best practices.
This necessitates a comprehensive transformation encompassing mindset, business processes,
and knowledge management. This transformation is not a one-time event but an ongoing
process that must be carefully phased in to minimize disruption.
The financial crises experienced by emerging economies in recent years have starkly
illustrated the potential for severe economic downturns when financial systems encounter
problems. Moreover, banking crises often impose substantial costs on governments, which
ultimately are borne by taxpayers. A World Bank report highlighted the massive losses
incurred in banking crises during the 1980s and 1990s, emphasizing that these losses equaled
the total flow of official development assistance to developing countries over several
decades. This has led many emerging economies to prioritize financial market reform,
focusing on enhancing efficiency while simultaneously ensuring financial market stability.
From this perspective, financial sector reforms are essential to mitigate the adverse
consequences of financial instability. It is therefore not surprising that financial market
reform has become a central topic in public policy discussions.
Sound financial markets are crucial for promoting rapid economic growth and maintaining
financial stability. Financial sector reform, aimed at developing an efficient financial system,
is thus viewed as a key strategy for enabling countries to overcome economic stagnation. As
the World Bank has observed, a robust financial system is a prerequisite for a favorable
investment climate, economic growth, and poverty reduction.
India initiated financial sector reforms a decade prior to the publication of this document with
the goals of improving the efficiency of financial intermediation, enhancing the effectiveness
of monetary policy, and fostering the integration of the domestic financial sector with the
global financial system. The first phase of these reforms was guided by the recommendations
of the Narasimham Committee. The primary approach was to ensure that the financial
services industry operates with operational flexibility and functional autonomy, thereby
enhancing efficiency, productivity, and profitability.
The second phase of India's financial sector reforms, guided by the Narasimham Committee
II, focused on strengthening the foundations of the banking system and implementing
structural improvements. Furthermore, ongoing discussions are addressing critical issues such
as corporate governance, reform of the capital structure (in the context of Basel II norms),
retail banking, risk management technology, and human resources development.
Since 1992, the Indian financial system has undergone significant changes. These changes
have introduced a greater degree of competition into the financial system. This marks a
gradual shift away from financial repression, which was characterized by price and non-price
controls in the process of financial intermediation. While financial markets in India have
achieved a certain level of development, there remains considerable segmentation and an
uneven playing field among participants, contributing to volatility in asset prices. This
volatility is further exacerbated by insufficient liquidity in the secondary markets.
The purpose of this paper is to emphasize the need for both regulators and market participants
to acknowledge the various risks present in the financial system. It also aims to highlight the
importance of products that can hedge these risks and the necessity of developing and
introducing appropriate financial instruments, including derivatives, within the Indian
financial system.
The financial sector fulfills the crucial economic function of intermediation by facilitating the
efficient allocation of resources within the economy. Financial intermediation is achieved
through a four-pronged transformation mechanism, encompassing liability-asset
transformation, size transformation, maturity transformation, and risk transformation. Risk is
an inherent element in the very act of this transformation. However, prior to the financial
reforms of 1991-92, banks in India were not exposed to the same level of diverse financial
risks, largely because interest rates and exchange rates were administratively controlled.
The paper then shifts its focus to defining risk, posing the fundamental question, "What is
risk?" and seeking a practical definition. It acknowledges that risk can have different
interpretations for different individuals. Examples of risk include financial risks (such as
exchange rate and interest rate fluctuations), risks associated with mergers and acquisitions,
risks related to the effective use of information technology, and risks that could lead to
commercial liability or damage to a company's brand image. Given that risk is an inherent
part of business, accepted as a trade-off between potential rewards and potential threats, it
implies that taking on risk can also lead to benefits. In other words, accepting risk is often
necessary to achieve anticipated gains.
Therefore, a pragmatic definition of risk encompasses both potential threats that may
materialize and opportunities that can be exploited. This definition is particularly relevant in
the contemporary business environment, which presents organizations with both challenges
and opportunities. An organization's success depends on its ability to effectively manage
these risks to gain a competitive advantage.
The paper then addresses the concept of risk management, asking the key question, "What is
risk management?" and clarifying that it does not imply the elimination of risk. Instead, risk
management is presented as a discipline focused on dealing with the possibility of future
events causing harm. It provides strategies, techniques, and a structured approach for
identifying and addressing any threats that could hinder an organization's ability to achieve its
objectives. Risk management can involve a straightforward process of asking and answering
three fundamental questions.
These three basic questions are: 1. "What can go wrong?" 2. "What will we do (both to
prevent the harm from occurring and in the aftermath of an 'incident')?" and 3. "If something
happens, how will we pay for it?" It is reiterated that risk management does not aim to
eliminate risk altogether. Rather, it empowers organizations to manage their risks effectively,
bringing them to manageable levels without significantly impacting profitability. This
necessitates a well-planned balancing act between risk levels and potential profits.
In addition to managing risks to keep them within acceptable bounds, risk management
should also ensure that one type of risk does not transform into another, potentially more
damaging, risk. This transformation can occur due to the interconnectedness among various
risks. Therefore, a crucial aspect of managing any risk involves thoroughly understanding the
nature of the underlying transaction to identify and assess all the risks to which it is exposed.
Risk management is a more developed field in the Western world. This maturity is largely
attributed to lessons learned from significant corporate failures, most notably the collapse of
Barings Bank. Furthermore, regulatory requirements have been established that mandate
organizations to implement effective risk management practices. In India, while risk
management is still in its early stages of development, there has been considerable discussion
about the need to adopt comprehensive risk management practices.
When considering the objectives of the risk management function, two distinct viewpoints
emerge. One perspective emphasizes managing risks to maximize profitability and identify
opportunities within those risks. The other perspective prioritizes minimizing risks and
potential losses, focusing on protecting the organization's assets.
The management of an organization must make a conscious decision about whether the risk
management function should primarily "manage" or "mitigate" risks. "Managing" risks
involves finding an appropriate balance between risks and controls and making informed
management decisions regarding opportunities and threats facing the organization. Both over-
controlling and under-controlling risks are undesirable, as the former can lead to higher costs,
while the latter increases the organization's vulnerability to potential losses.
"Mitigating" or "minimizing" risks, conversely, implies taking action to reduce all risks, even
if the cost of risk reduction is excessive and outweighs the potential benefits as determined by
a cost-benefit analysis. Furthermore, this approach may result in missed opportunities for the
organization. In the context of the risk management function, the identification and
management of risk are particularly critical for the financial services sector, more so than for
industries focused on consumer products. A survey revealed that a significant percentage of
respondents explicitly stated that their risk management function is mandated to optimize
risk.
Risks in banking manifest themselves in numerous ways, arising from the diverse activities
that banks undertake, often across multiple locations and involving many individuals. As
financial intermediaries, banks engage in the core activities of borrowing and lending funds,
which inherently exposes them to various risks. The volatility that characterizes the operating
environment of banks can amplify the impact of these risks. The paper further discusses the
various types of risks that arise due to financial intermediation and emphasizes the
importance of asset-liability management. It also introduces the Gap Model as a tool for risk
management.
Risks can be classified into different categories based on their origin and nature. The most
prominent financial risks that banks face are identified, taking into account practical
considerations such as the limitations of models and theories, the influence of human factors,
the presence of market frictions (e.g., taxes and transaction costs), and limitations on the
quality and availability of information, as well as the costs associated with acquiring this
information.
Market risk is defined as the risk of losses due to changes in financial market prices and
rates, which can reduce the value of a bank's positions. For funds, market risk is often
measured relative to a benchmark index or portfolio, and this is referred to as "risk of
tracking error." Market risk also encompasses "basis risk," which describes the potential for a
breakdown in the relationship between the price of a product and the price of the instrument
used to hedge that price exposure. The market-VaR (Value at Risk) methodology is used to
capture various components of market risk, including directional risk, convexity risk,
volatility risk, and basis risk.
Credit risk is defined as the risk that changes in the credit quality of a counterparty will
negatively affect the value of a bank's position. The most extreme form of credit risk is
default, where a counterparty is unwilling or unable to meet its contractual obligations.
However, banks are also exposed to the risk of a counterparty's credit rating being
downgraded by a rating agency. Credit risk is relevant only when the bank holds an asset,
meaning the position has a positive replacement value. In such cases, if the counterparty
defaults, the bank may lose the entire market value of the position or, more commonly, the
portion of the value that it cannot recover after the credit event. It is important to note that
credit exposure from derivative instruments is dynamic, with replacement values that can
fluctuate between negative and positive over time depending on market conditions.
Therefore, banks must assess not only the current exposure but also the potential future
exposure throughout the duration of the deal.
Liquidity risk comprises two components: funding liquidity risk and trading-related liquidity
risk. Funding liquidity risk refers to a financial institution's ability to obtain the necessary
cash to refinance its debt obligations, meet cash requirements, satisfy margin and collateral
calls from counterparties, and, in the case of funds, fulfill capital withdrawals. Factors
influencing funding liquidity risk include the maturities of liabilities, the reliance on secured
funding sources, the terms of financing, and the diversity of funding sources, including access
to public markets like the commercial paper market. Funding can also be secured through
cash or cash equivalents, available credit lines, and "buying power." Trading-related liquidity
risk, often simply referred to as liquidity risk, is the risk that an institution cannot execute a
transaction at the prevailing market price due to a temporary lack of demand in the market. If
the transaction cannot be postponed, it may result in significant losses on the position. This
type of risk is generally difficult to quantify and can impair an institution's ability to manage
and hedge market risk, as well as its capacity to cover funding shortfalls through asset
liquidation.
Operational risk refers to potential losses stemming from inadequate or failed internal
processes, systems, and people, as well as external events. These losses can arise from
management failures, faulty controls, fraud, and human error. Many of the substantial losses
recently associated with derivatives trading are a direct consequence of operational failures.
Derivatives trading is inherently more susceptible to operational risk than cash transactions
because derivatives are leveraged instruments. This leverage enables traders to make
substantial commitments and generate significant future exposure with relatively small
amounts of cash. Therefore, stringent controls are essential for banks to mitigate the risk of
incurring large losses. Operational risk includes fraud, such as when a trader or employee
intentionally falsifies or misrepresents the risks involved in a transaction. Technology risk,
particularly computer system risk, also falls under the category of operational risk.
Legal risk arises from various sources. For instance, a counterparty may lack the legal or
regulatory authority to engage in a specific transaction. Legal risks typically become apparent
when a counterparty or investor experiences losses on a transaction and attempts to avoid
their obligations by suing the bank. Another aspect of regulatory risk is the potential impact
of changes in tax laws on the market value of a position.
Human factor risk is a specific form of operational risk. It encompasses losses resulting from
human errors, such as mistakenly pressing the wrong button on a computer, accidentally
deleting files, or entering incorrect values for model parameters.
DEFINITION OF RISK
What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means different things to
different people. For some it is "financial (exchange rate, interest-call money rates), mergers
of competitors globally to form more powerful entities and not leveraging IT optimally" and
for someone else "an event or commitment which has the potential to generate commercial
liability or damage to the brand image". Since risk is accepted in business as a trade off
between reward and threat, it does mean that taking risk bring forth benefits as well. In other
words it is necessary to accept risks, if the desire is to reap the anticipated benefits. Risk in its
pragmatic definition, therefore, includes both threats that can materialize and opportunities,
which can be exploited. This definition of risk is very pertinent today as the current business
environment offers both challenges and opportunities to organizations, and it is up to an
organization to manage these to their competitive advantage.
What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some future event will
cause harm. It provides strategies, techniques, and an approach to recognizing and
confronting any threat faced by an organization in fulfilling its mission. Risk management
may be as uncomplicated as asking and answering three basic questions:
1. What can go wrong?
2. What will we do (both to prevent the harm from occurring and in the aftermath of an
"incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the organization to bring their
risks to manageable proportions while not severely affecting their income. This balancing act
between the risk levels and profits needs to be well-planned. Apart from bringing the risks to
manageable proportions, they should also ensure that one risk does not get transformed into
any other undesirable risk. This transformation takes place due to the inter-linkage present
among the various risks. The focal point in managing any risk will be to understand the
nature of the transaction in a way to unbundle the risks it is exposed to.
Risk Management is a more mature subject in the western world. This is largely a result of
lessons from major corporate failures, most telling and visible being the Barings collapse. In
addition, regulatory requirements have been introduced, which expect organizations to have
effective risk management practices. In India, whilst risk management is still in its infancy,
there has been considerable debate on the need to introduce comprehensive risk management
practices.
Objectives of Risk Management Function
Two distinct viewpoints emerge
One which is about managing risks, maximizing profitability and creating opportunity out of
risks
And the other which is about minimising risks/loss and protecting corporate assets.
The management of an organization needs to consciously decide on whether they want their
risk management function to 'manage' or 'mitigate' Risks. Managing risks essentially is about
striking the right balance between risks and controls and taking informed management
decisions on opportunities and threats facing an organization. Both situations, i.e. over or
under controlling risks are highly undesirable as the former means higher costs and the latter
means possible exposure to risk.
Mitigating or minimising risks, on the other hand, means mitigating all risks even if the cost
of minimising a risk may be excessive and outweighs the cost-benefit analysis. Further, it
may mean that the opportunities are not adequately exploited. In the context of the risk
management function, identification and management of Risk is more prominent for the
financial services sector and less so for consumer products
Risk management in the Indian banking system is a crucial aspect of financial stability and
economic growth. The banking sector is exposed to various risks, including credit risk,
market risk, operational risk, and liquidity risk. Effective risk management strategies help in
minimizing losses and ensuring compliance with regulatory norms set by the Reserve Bank
of India (RBI) and Basel Accords.
The significant transformation of the banking industry in India is clearly evident from the
changes that have occurred in the financial markets, institutions and products. While
deregulation has opened up new vistas for banks to argument revenues, it has entailed greater
competition and consequently greater risks. Cross- border flows and entry of new products,
particularly derivative instruments, have impacted significantly on the domestic banking
sector forcing banks to adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive to the globalized environment. These
developments have facilitated greater choice for consumers, who have become more
discerning and demanding compelling banks to offer a broader range of products through
diverse distribution channels. The traditional face of banks as mere financial intermediaries
has since altered and risk management has emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The benefits of
globalization have been well documented and are being increasingly recognized. Integration
of domestic markets with international financial markets has been facilitated by tremendous
advancement in information and communications technology. But, such an environment has
also meant that a problem in one country can sometimes adversely impact one or more
countries instantaneously, even if they are fundamentally strong.
There is a growing realisation that the ability of countries to conduct business across national
borders and the ability to cope with the possible downside risks would depend, interalia, on
the soundness of the financial system. This has consequently meant the adoption of a strong
and transparent, prudential, regulatory, supervisory,
technological and institutional framework in the financial sector on par with international best
practices. All this necessitates a transformation: a transformation in the mindset, a
transformation in the business processes and finally, a transformation in knowledge
management. This process is not a one shot affair; it needs to be appropriately phased in the
least disruptive manner.
The banking and financial crises in recent years in emerging economies have demonstrated
that, when things go wrong with the financial system, they can result in a severe economic
downturn. Furthermore, banking crises often impose substantial costs on the exchequer, the
incidence of which is ultimately borne by the taxpayer. The World Bank Annual Report
(2002) has observed that the loss of US $1 trillion in banking crisis in the 1980s and 1990s is
equal to the total flow of official development assistance to developing countries from 1950s
to the present date. As a consequence, the focus of financial market reform in many emerging
economies has been towards increasing
efficiency while at the same time ensuring stability in financial markets.
From this perspective, financial sector reforms are essential in order to avoid such costs. It is,
therefore, not surprising that financial market reform is at the forefront of public policy
debate in recent years. The crucial role of sound financial markets in promoting rapid
economic growth and ensuring financial stability. Financial sector reform, through the
development of an efficient financial system, is thus perceived as a key element in raising
countries out of their 'low level equilibrium trap'. As the World Bank Annual Report (2002)
observes, a robust financial system is a precondition for a sound investment climate, growth
and the reduction of poverty'.
Financial sector reforms were initiated in India a decade ago with a view to improving
efficiency in the process of financial intermediation, enhancing the effectiveness in the
conduct of monetary policy and creating conditions for integration of the domestic financial
sector with the global system. The first phase of reforms was guided by the recommendations
of Narasimham Committee
2. Need for the Study
The need for risk management in Indian banking arises due to:
Rising Non-Performing Assets (NPAs): Indian banks, especially public sector
banks, have faced high NPAs affecting profitability.
Regulatory Compliance: Compliance with RBI guidelines, Basel norms, and other
financial regulations is mandatory.
Technological & Cyber Risks: The adoption of digital banking increases the risk of
cyber fraud and data breaches.
Global Financial Volatility: Indian banks are impacted by international financial
crises and global market fluctuations.
Customer Confidence: Proper risk management enhances trust among customers and
stakeholders.
3. Importance of the Study
Helps banks in identifying, assessing, and mitigating risks.
Ensures financial stability and economic growth.
Aids in improving asset quality and reducing NPAs.
Strengthens compliance with Basel norms and RBI guidelines.
Protects against operational, credit, market, and liquidity risks.
Enhances profitability and efficiency of banks.
4. Objectives of the Study
The main objectives of the study are:
1. To analyze different types of risks in the Indian banking sector.
2. To assess the effectiveness of risk management practices in Indian banks.
3. To examine the role of Basel norms and RBI regulations in risk management.
4. To evaluate the impact of risk management on bank performance.
5. To suggest measures to improve risk management frameworks in Indian banks.
5. Hypothesis
The study may consider the following hypotheses:
H₀ (Null Hypothesis):
Risk management practices do not have a significant impact on the financial performance of
Indian banks.
H₁ (Alternative Hypothesis):
Effective risk management practices have a significant positive impact on the financial
performance of Indian banks.
6. Research Methodology
A. Research Design
The study will use descriptive and analytical research methods.
B. Data Collection
1. Primary Data:
o Surveys and interviews with banking professionals.
o Questionnaires distributed to bank employees and customers.
2. Secondary Data:
o RBI reports, bank annual reports.
o Research papers, books, and financial journals.
o Basel norms and banking regulations.
C. Sample Size & Sampling Method
Selection of 10-20 Indian banks (public, private, and foreign banks).
Stratified random sampling for selecting bank branches.
D. Data Analysis Techniques
Statistical tools like SPSS, regression analysis, correlation.
Comparative analysis of risk management practices across banks.
Case studies of failed and successful risk management strategie
