Risk Management

Risk Management

By

Priya Dhaulta
PGDBM 3rd Sem
Institute of Productivity & Management
Ghaziabad

A Bank takes birth with risk. Banking has been defined as 'Taking Deposits and Lending it'. Bank takes deposit with the ultimate rider that a depositor can withdraw the amount any time he wants. In case of lending, however the borrower or the counterparty has the ultimate option. The condition 'Payable when able' applies in case of most of the bank's exposures. If liquidity, to satisfy the above condition of deposits is to be maintained, lending per se will be risky, if not impossible. One cannot block the money if the same has to be returned to the depositor.

Besides loss on account of credit risk, there will be loss due to market risk like liquidity and interest rate risk and loss during the operation of various banking processes, termed as Operational Risk.Therefore, risk co-exists with banking definition and a bank survives by managing these risks.

As per the RBI Governor, Dr. Y.V. Reddy, 'banking in modern economies is all about risk management'. During his address, at the Bankers' Conference 2004. he has stated 'the successful negotiation on implementation of Basel II Accord is likely to lead to even sharper focus on the risk measurement and risk management at the institutional level. Thankfully, the Basel Committee has, through its various publications, provide useful guidelines on managing various facets of risks. The institution of sound risk management practices would be an important pillar for staying ahead of the competition'. This is amply demonstrated in the recent approval of RBI to allow HDFC Bank to have a Capital Market Exposure beyond 5% considering its risk management capabilities in this field.

Credit Risk Weights of assts prescribed by RBI is as:

Name of the Assets                              Risk Weights

Cash & Balances with RBI                     0%
Exposure to other banks                      20%
Investment in Govt. securities               0%
Investments in Non-SLR securities         100%
Loans to Corporates                            100%
Retail Loans                                       100%
Housing Loans against mortgage            50%
of Residential Housing Properties

View of BASEL I and BASEL II

Basel I	Basel II
1. Measurement of only one risk (Credit Risk).	Measurement of all the three major risks faced by the Bank e.g. Credit Risk, Market Risk and Operational Risk.
2. Broad brush structure (e.g. all banks have 20% risk weight and all corporates have 100% risk weight).	More risk sensitive (measurement of risk weights for all individual banks and corporates).
3. Fixed method of calculation.	Flexible Menu of approaches Incentives in capital for adopting advanced and more risk sensitive approaches.
4. One size fits all. (9% for all banks irrespective of its risk management capabilities).	Economic Capital will vary according to the assessed loss on account of various risks. It takes care of risk assessment and risk management capabilities of each bank.
5. Structure depends only on one pillar. Minimum Capital requirement.	There are three pillars – 1. Minimum capital requirement. 2. Supervisory Review 3. Market discipline (or the nature and extent of disclosure).
6. Building up of adequate capital was the main concern of banks management. Risk management was not gaining importance as risk weight of various assets were pre-determined.	Besides building up of capital, enhancing the skills of management and staff in risk management practices has gained momentous proportion.

Risks In Providing Banking Services

Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk , which is in fact a somewhat imprecise term. By its nature, this risk can be hedged,but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk.All investors assume this type of risk, whenever assets owned or claims issued can change in value as a result of broad economic factors. As such, systematic risk comes in many different forms. For the banking sector,however, two are of greatest concern, namely variations in the general level of interest rates and the relative value of currencies.

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. The real risk from credit is the deviation of portfolio performance from its expected value.

Liquidity risk can best be described as the risk of a funding crisis. While some would include the needto plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.In any case, risk management here centers on liquidity facilities and portfolio structure.

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failure sand compliance with various regulations.

Risk management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity, but to ensure that the risks are consciously taken with full knowledge, clear purpose and understanding so that it can be measured and mitigated. It also prevents an institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position. Functions of risk management should actually be bank specific dictated by the size and quality of balance sheet, complexity of functions, technical/ professional manpower and the status of MIS in place in that bank . Balancing risk and return is not an easy task as risk is subjective and not quantifiable where as return is objective and measurable. If there exist a way of converting the subjectivity of the risk into a number then the balancing exercise would be meaningful and much easier.

Priya Dhaulta
PGDBM 3rd Sem
Institute of Productivity & Management
Ghaziabad

Source: E-mail June 4, 2007

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