Risk Management In Banking Companies

RISK MANAGEMENT IN BANKING COMPANIESexpose a bank to change in slope and shape of the
Risk Management in bank operations includes riskyield curve. Yield curve risk arises when unanticipated
identification, measurement and assessment, and itsshifts of the yield curve have adverse on bank’s
objective is to minimise negative effects risks canincome or economic value of their asset porfolio.
have on the financial result and capital of the bank.Basic Risk: The risk that the interest rate for
Banks are required to form a special organisationaldifferent assets and liabilities may change in different
unit for the purpose of risk management. The risk tomagnitudes is called basic risk. Such risk arises due to
which the bank is particularly exposed in itsimperfect correlation in the adjustment of the rates
operations are market risk(interest rate risk, foreignearned and paid on different instruments with other
exchange risk, risk from change in market price ofwise similar re-pricing characteristics.
securities, financial derivatives and commodities),Embedded option Risk: An option provides the holder
credit risk, liquidity risk, exposure risk, investment risk,the right (but not the obligation) to buy, sell or in
operational risk, legal risk, strategic risk. These riskssome manner alter the cash flow of the instrument
are highly inter-independent. Events that affect oneor financial contract. Options may be stand alone
area of risk can have ramifications for a range ofinstruments such as exchange –trade options and
other risk categories.over- the-counter (OTC) contracts, or they may be
CREDIT RISK MANAGEMENTembedded within otherwise standard instruments.
Credit risk is defined as the potential that a bankWhile banks use exchange-trade and OTC-options in
borrower or counter party will fail to meet itsboth trading and non-trading accounts, instruments
obligations in accordance with agreed terms. The goalwith embedded options are generally most important
of credit risk management is to maximise thein non-trading activities.
bank’s risk-adjusted rate of return by maintainingRe-investment Risk: uncertainty about future interest
credit risk exposure within acceptable parameters.rate gives rise to re-investment risk as future cash
Banks need to manage the credit risk inherit in theflow will be re-invested at a rate unknown at
entire portfolio as well as the risk in individual orpresent. Ordinary yield curve, without bootstrapping,
credits or transactions.does not take into account the re-investment risk.
For most banks, loans are the largest and mostOPERATIONAL RISK
obvious source of credit risk; however, other sourcesIt isone of the new planks of the Basel-II capital
of credit risk exist throughout the activities of theaccord. Operational risk is defined as ‘the risk of
bank, including in the banking book and the tradingthe loss resulting adequate or failed internal
book and both on and off the balance sheet. Banksprocesses, people and system or from external
are increasingly facing credit risk (or counter partyevents.’ This definition includes legal risk, but
risk) in various financial instruments other than loansexcludes strategic risk and reputational risk. On the
including acceptances, inter bank transactions, tradeother hand, the Reserve bank of India has defined
financing, foreign exchange transactions, financialoperational risk, as ‘any risk, which is not
future, swaps, bonds, equities, options and in thecategorised as market or credit risk, or the risk of
extension of commitments and guarantees, theloss arising from various type of human and technical
settlement of transactions.errors’.
BASAL II ON CREDIT RISKSources of operational risk
The basal community on banking supervisionrelease a(i)                 Wrong /delayed decision
consultative document on New Capital Adequacyand lack of accountability, control and proper auditing
Framework with the view to replacing 1988 Accord.,
The document proposes three pillars for the new(ii)               Inadequate MIS ,
accord-(iii)             Incompetency of staff and
1. Minimum Capital Requirements, 2.Supervisorylack of proper training and job rotation,
review 3.Market discipline(iv)             Lack of succession planning
A new accord continues with the minimum capitaland development of second lines,
adequacy ratio of 8% of risk waited assets. Arrange(v)               Lack of contingency
of options to estimate capital as proposed in theplanning,
document include a standardised approach. Under this(vi)             Non compliance with circulars,
approach, preferential risk weights in the range ofpolicies and regulatory requirement,
0%, 20%, 50%, 100%, and 150% are envisaged to(vii)           Obsolete policies,
be assigned on the basis of external credit(viii)         Involvement of the staff in the
assessments. Under foundation Internal Rating Basedfraud and forgeries,
(IRB), community proposes certain minimum(ix)              Failure of electronic
compliance.wiz.a comprehensive credit rating systeminstruments ,like computer systems, software and
with capability to quantify Probability of Default (PD)telecommunication equipment,
while assigning preferential risk weights, with the(x)                Legal flaws in execution
information supplied by national supervisor on lossof security documents for advances
given default (LGD) an exposure at default. Adoption(xi)              Deterioration of bank image
a New Capital Accord by banks in the proposeddue to poor services,  staff behaviour, frauds, high
state requires complete change in the existing riskNPAs, etc
management systems.At present, banks account for their losses due to
MARKET RISK MANAGEMENToperational risk by debiting it to their P&L account
Banks are exposed to market risk via their tradingwithout allocating any capital charge for it, unlike in
activities and their balance sheets. Two types ofcase of credit and market risk. Under Basel-II,
risks are considered the market risks for the bankoperational risk needs to be assessed separately
such as interest rate risk and foreign exchange risk.from three approaches namely (1) Basic Indicator
Banks face the foreign exchange risk due toApproach, (2) Standar5dised Approach and (3)
exchange rate fluctuations and interest rate is theInternal Management Approach. Under Basel-II
most common risk all the banks manage because allframework of operational risk management, banks
the financial products issued by bank are interest rateare encouraged to move along the spectrum of
sensitive.available approaches as they develop more
1. INTEREST RATE RISKsophisticated operational risk management system
Interest Rate Risk is a risk of negative effects onand practices.
the financial result and capital of the bank caused byLIQUIDITY RISK MANAGEMENT
changes in interest rate. The overarching objective ofLiquidity risk is the potential inability to meet the
the interest rate risk management is to ensure abanker’s liability as they become due. It arises
cash flow mechanism that is devoid of majorwhen banks are unable to generate cash to meet
mismatches in both assets and liability segments. Asfund withdrawal, commitment credit or increase in
financial intermediaries, banks encounter interest rateassets. It originates from the mismatches pattern of
risk in several ways such as-assets and liabilities. Measuring and managing liquidity
Re-Pricing Risk: The primary form of interest rate riskneeds are vital for effective operations of
rises from timing differences in the maturity(for fixedcommercial banks the cause and effect of liquidity
rate) and re-pricing(for floating rate) of assets,risk are primarily linked to the assets and liabilities of
liabilities off-balance-sheet(OBS)positions. They canthe bank. The bank should continuously monitor its
expose a banks “income and assets”liquidity position in a long run and also on a day- to
underlying economic value of unanticipatedday basis. There are two approaches that relates
fluctuations as interest rate tends to be too frequentthese two situational analysis such as (1) Fundamental
and volatile.Approach and(2) Technical Approach .
Yield Curve Risk: Re-Pricing mismatches can also