Risk Management in Banking Sector Essay

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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 ystem, 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 were regulated, financial asset prices moved within a narrow band and the roles of different categories of intermediaries were clearly defined.

Credit risk was the major risk for which banks adopted certain appraisal standards. Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements of this transformation process have been 1. The deregulation of coupon rate on Government securities. 2. Substantial liberalization of bank deposit and lending rates. 3.

A gradual trend towards disintermediation in the financial system in the wake of increased access of corporates to capital markets. 4. Blurring of distinction between activities of financial institutions. 5. Greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks. 6. Emergence of new private sector banks and other financial institutions, and, 7. The rapid advancement of technology in the financial system.

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 industry. What are the primary objectives of your risk management function? When specifically asked in a survey conducted, 33% of respondents stated that their risk management function is indeed expressly mandated to optimise risk.

Risks in Banking

Risks manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks. The case discusses the various risks that arise due to financial intermediation and by highlighting the need for asset-liability management; it discusses the Gap Model for risk management.

❖ Typology of Risk Exposure

Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to taking into consideration practical issues including the limitations of models and theories, human factor, existence of frictions such as taxes and transaction cost and limitations on quality and quantity of information, as well as the cost of acquiring this information, and more.

Market risk is that risk that changes in financial market prices and rates will reduce the value of the bank’s positions. Market risk for a fund is often measured relative to a benchmark index or portfolio, is referred to as a “risk of tracking error” market risk also includes “basis risk,” a term used in risk management industry to describe the chance of a breakdown in the relationship between price of a product, on the one hand, and the price of the instrument used to hedge that price exposure on the other. The market-Var methodology attempts to capture multiple component of market such as directional risk, convexity risk, volatility risk, basis risk, etc.

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