AN ANALYSIS OF RISK MANAGEMENT: ROLE IN …euroasiapub.org/wp-content/uploads/2016/09/17IMMay-3691-1.pdf · MBA, APSET Assistant Professor ... known or best quantifiable. ... Time

IJRIM Volume 6, Issue 5 (May, 2016) (ISSN 2231-4334)

International Journal of Research in IT & Management (IMPACT FACTOR – 5.96)

International Journal of Research in IT & Management

Email id: [email protected],http://www.euroasiapub.org

145

AN ANALYSIS OF RISK MANAGEMENT: ROLE IN BANKING SECTOR

Ms. SMRITI NAGARIA1,

MBA, APSET

Assistant Professor

St. Joseph’s Degree & PG College

(Affiliated to OU- Approved by AICTE)

5-9-1106, Basheerbagh

King Koti Road, Hyderabad - 500 076

ABSTRACT

Risk is inherent in any business activity where it is rightly said that it refers to uncertainty of

outcomes which is at times unavoidable. Management of risk becomes essential for successful

operations of the business."Risk Management is a culture, not a cult. It only works if everyone lives it,

not if it’s practiced by a few high priests” which means risk management refers to the practice of

identifying potential risks in advance, analyzing them and taking precautionary steps to

reduce/curb them . It may have an impact on bank or financial institutions having a direct effect on

losses, customers and business partners. Banks play a vital role in economic development of a

country as it is the nerve centre of all commerce and trade which provides instruments for

developing internal as well as external trade. “An Institution, such as the banking system, which

touches and should touch the lives of millions, has necessarily to be inspired by a larger social purpose

and has to subserve national priorities and objectives.” A well-developed banking system provides a

firm and durable foundation for the economic development of the country. Banking risk is that risk

that banks is confronted within their current operations and not only risk specific to regular

banking activities. To overcome banking risk banks have developed strategies which include

procedure for managing risk and minimization of potential exposure. The objective is to understand





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the various techniques involved to conduct risk management and concludes by emphasizing on the

role of RBI in risk management of bank.

Key Words: Risk, business activity, unavoidable, economic development and strategies

INTRODUCTION

Risk in itself is not bad; risk is essential to progress, and failure is often a key part of learning. But we must learn to balance the possible negative consequences of risk against

the potential benefits of its associated opportunity.

Risk is present everywhere which creates obstacle in achievement of certain objectives. Risk refers

to a condition where there is possibility of undesirable occurrence of a particular result which is

known or best quantifiable. As risk is unplanned it has an effect on financial position of a concern

.Risk should be managed effectively to survive in the competitive world.

Bank which is a financial institution that accepts deposits and provide loans, safeguard money

and valuables and renders services also faces risk in its operations. It is essential for banks as a

whole to measure and manage risk volumes accurately. Banks monitors risk at all levels throughout

its operations and has established risk management department to supervise risk where

committees are formed consisting of members who take responsibility for various kinds with a goal

of strengthening risk management and control. In addition to establishing a risk management

department banks are also regulated by RBI in order to protect safety of public savings, ensure

equal opportunity with fairness in public access to credit and other financial services, provide

Government with credit, tax revenue and to help sectors of the economy to meet special needs i.e.

loans.





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Set up risk

management system

Formulate risk

management policies

and procedures

Involve of

the board of directors

and high level management

Effective Risk

Management

3

4

Establish a unit to operate

risk management

2

1

Supporting Factors for Risk Management

There are two important developments which made banks to emphasize on risk management

which are:

1) Deregulation - This has given autonomy in areas of lending, investment and interest rate

structure.

2) Technological Innovation - This has helped banks to manage assets and liabilities in a better

way providing delivery channels and reducing processing time of transactions.

These developments has increased diversity and complexity of risk which needs to be managed

professionally, Banks like any other organization intends to take risk which is inherent in any

business. The major risks in banking business is:

1)Liquidity Risk - refers to the risk that financial institutions may be unable to meet its

commitments owing to decline in credit worthiness. In order to manage liquidity, risk banks

periodically examines the structure of funds sources and uses to implement measures needed to

improve the structure. Liquidity risk in bank manifest in different dimensions:





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(i) Funding Risk - is the inability to obtain funds to meet cash flow obligation

(ii) Time Risk - This arises from the need to compensate for non receipt of expected inflow of

funds.

(iii) Call Risk - arises when a bank may not be able to undertake profitable business opportunities

when it arises.

2) Interest Rate Risk - refers to exposure of bank's financial condition to adverse movements of

interest rates. Types of Interest Rate Risks:

(i) Basis Risk - arises when interest rates of assets, liabilities and off balance sheet items may

change in different magnitude.

(ii)Reinvested Risk - takes place due to uncertainty with regard to interest rates at which future

cash flow could be reinvested.

(iii) Gap or Mismatch Risk - refers to holding assets, liabilities and off balance sheet items with

different principal amounts and maturity dates.

3)Market Risk - results from adverse movements in level of volatility of market price of interest

rate instruments, equities, commodities and currencies.

4) Credit Risk - refers to the potential of bank borrower or counterparty who fails to meet its

obligation in accordance with the terms where interest or principal or both will

not be paid as promised. This is the most significant risk in banks as they give the

highest priority on ensuring soundness of its assets and works to ensure its

credit risk management capabilities. The fundamental pillar of bank credit risk

management system is its credit rating system and self assessment system.

Two variants of credit risk are:

(i) Counter Party Risk - This is associated with trading rather than standard risk.

(ii) Country Risk - This is due to restriction imposed by a country.

5) Operational Risk - It results from inadequate internal processes, people, and systems.





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Common operational risks are:

(i) Transaction Risk - It takes place due to failed business processes and inability to manage

information.

(ii) Compliance Risk - It is due to inability of the bank to comply with applicable laws, regulations,

code of conduct and standard of good practice.

6) Strategic Risk - arises from adverse business decisions or lack of responsiveness to industrial

changes.

7) Reputation Risk - arises from negative public opinion.





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PRINCIPLES OF RISK MANAGEMENT

1) Establish a language system to discuss and categorize risk

2) Develop a big picture view of risk exposure and focus on the most important risk factors

3) Centralize ownership of processes and decentralize decision making

4) Define the process from top and clearly define roles and responsibilities

5) Quantify risk exposure, cost and benefits of managing risk

6) Embed IT system to facilitate risk management system

7) Embed a risk management culture

RISK MANAGEMENT PROCESS

It is an iterative process where each step contributes progressively to organizational improvement

by providing management with a greater insight into risks and their impact.

Process of Risk Management

ESTABLISH THE CONTEXT

Before understanding risk and the way to deal it is essential to understand the context in

which it exists. Establish the content by considering:

The strategic context – the environment within which the organization operates





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The organizational context – the objectives, core activities and operations.

IDENTIFY THE RISKS

The purpose of this step is to identify what could go wrong (likelihood) and what is the

consequence (loss or damage).

ANALYSE AND EVALUATE THE RISKS

This involves analyzing the likelihood and consequences of each identified risk and deciding

which risk factors will potentially have the greatest effect and should, therefore, receive

priority with regard to its management.

TREAT THE RISKS

Risk treatment involves identifying the range of options for treating the risk, evaluating

those options, preparing the risk treatment plans and implementing those plans. It is about

considering the options for treatment and selecting the most appropriate method to

achieve the desired outcome. Options for treatment need to be proportionate to the

significance of the risk, and the cost of treatment commensurate with the potential benefits

of treatment. The treatment options should include accepting, avoiding, reducing,

transferring, retaining and financing the risk.

MONITOR AND REVIEW

Monitoring and review ensure that the important information generated by the risk

management process is captured, used and maintained.

TECHNIQUES OF RISK MANAGEMENT

There are a number of common techniques that are used by risk managers to help them identify

possible risks to the organization. These techniques are often used in combination to ensure that

all potential risks are identified within the organization.

Value at Risk (VAR) - A tool which is used by firms and regulators to measure the amount

of assets needed to cover possible losses. It also estimates the amount of investment which

is lost in a given normal market condition.





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Risk Adjusted Rate of Return on Capital - an integrated risk management tool that

measure financial performance, provides a constant view of profitability across businesses

and also estimates capital requirement for market, credit and operational risk.

GAP Analysis - used to compare actual performance with potentially determined

performance. It tells what a business is doing currently and where it wants to go in future

and involves determining the difference between business requirement and current

capabilities

Securitization - process of transforming illiquid or group of assets into security which is

secured by collection of mortgage which also helps in reducing bank risk exposure.

Sensitivity Analysis- useful to determine actual outcome of a particular variable which is

different from what was previously assumed.

Internal Rating System - This is used by bank to estimate capital for various exposures and

bank use their own estimated risk parameters for the purpose of calculating regulatory

capital.

RISK MANAGEMENT AT BANK - ROLE OF RESERVE BANK OF INDIA The Reserve Bank of India in 1988 has been using CAMELS rating to evaluate the financial

soundness of the Banks. In India, the focus of the statutory regulation of commercial banks by RBI

until the early 1990s was mainly on licensing, administration of minimum capital requirements,

pricing of services including administration of interest rates on deposits as well as credit, reserves

and liquid asset requirements. In 1999 RBI recognized the

need of an appropriate risk management and issued guidelines to banks regarding assets, liability

management, management of credit, market and operational risks. The entire supervisory

mechanism has been realigned since 1994 under the directions of a newly constituted Board for

Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the demanding

needs of a strong and stable financial system. The CAMELS Model consists of six components

namely Capital Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to

Market risk. A process of rating of banks on the basis of CAMELS in respect of Indian banks and





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CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect of foreign banks has

been put in place from 1999.

Components of CAMEL Model

CAMEL COMPONENTS AND THEIR SIGNIFICANCE :

o Capital Adequacy - Financial Status based on Country's Balance of Payment

o Asset Quality - Economic and financial strength based on a country's combined natural, human and general economic resources

o Management Quality - A Government's fiscal, monetary credit policies and politics and how well these are implemented

o Earning Potential - Internal and external variables that affect how well a country is achieving its capabilities

o Liquidity - A Nation's Foreign Exchange cash flow prospects

FUTURE INITIATIVES THAT CAN BE TAKEN BY BANKS These five initiatives that not only have a strong short-term business case, but will also help build what

we see as the essential components of a high-performing risk function by 2025.





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Digitize Core Processes- This will minimize manual interventions and digitize core risk

processes such as credit application and underwriting by approaching business lines with

suggestions rather than waiting for the businesses to come to them. Increased efficiency,

lower costs, a superior customer experience and improved sales will be the short-term gains.

Experiment with Advanced Analytics and Machine Learning. This would enhance the

accuracy of predictive models where some financial institutions have already achieved

significant model improvements leading to better credit-risk decisions.

Enhance Risk Reporting - This has replaced paper based reports with an interactive tablet

solution that offers information in real time and enables users to do root cause analyzes and

enable banks to make faster decisions and identify potential risks more quickly.

Collaborate for Balance Sheet Optimization - The processes performed with the support

of analytical optimization tools, often suggests ways to improve return on equity by anywhere

between 50 and 400 basis points while still fulfilling all regulatory requirements.

Put the Enablers in Place - It goes without saying that high-performing risk functions depend

on a high-performing data infrastructure. Attracting talented employees will itself be a

challenge, as many potential candidates could be lured to technology firms unless banks

strengthen their value propositions. A strong risk culture in which detection, assessment, and

mitigation are part of the daily job of all bank employees will be central to the success of the

risk function. Despite the push toward automation and more sophisticated analytical and

technical capabilities, only human intervention will ensure they are applied appropriately and

ethically.

Instruments banks can use in order to manage risk :

Diversification

Hedging





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Internal Insurance

Holding Capital

RISK MANAGEMENT FUTURE PERSPECTIVE Risk management in banks has changed substantially over the past ten years. The regulations that

emerged from the global financial crisis and the fines that were levied in its wake triggered a wave

of change in risk functions. Six structural trends which are mentioned below outlines how risk

functions may look in 2025 and highlights what senior risk managers can and should do now to

start preparing their functions to deal with these trends.

Six structural trends will transform bank risk management over the next ten years

Continued expansion of the breadth and depth of regulation

Changing customer expectations

Technology and analytics as a risk muscle

Additional (nonfinancial) risk types are emerging

Better risk decisions through the elimination of biases

Need for strong cost savings

CONCLUSION

Risk in banking business is unavoidable and one must identify which risk is to be avoided or hedged

by preventing organization from incurring losses which affects their goodwill. Risk is indispensable

and integral part of banking business. Banks are formulating strategies to tackle it effectively and

along with this RBI too have adopted steps to ensure banks set up risk management cell and

through internal assessment of risk exposure.





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REFERENCES

1)Alina Mihaela Dima, Ivona Orzea , “RISK MANAGEMENT IN BANKING”, AcademyPublish.org – Risk Assessment and Management. 2)Prof. Rekha Arunkumar, “RISK MANAGEMENT IN COMMERCIAL BANKS”(A CASE STUDY OF PUBLIC AND PRIVATE SECTOR BANKS) 3)Thirupathi Kanchu, M. Manoj Kumar, “RISK MANAGEMENT IN BANKING SECTOR”- AN EMPIRICAL STUDY, International Journal of Marketing, Financial Services & Management Research, ISSN 227-3622Vol.2 No. 2, February (2013).

4)Heinz-Peter Berg, “RISK MANAGEMENT: PROCEDURES, METHODS AND EXPERIENCES” ,

RT&A # 2(17) (Vol.1) 2010, June 79 ,

http://ww.gnedenko-forum.org/Journal/2010/022010/RTA_2_2010-09.pdf.

5) Websites:

www.wikipedia.com

www.investopedia.com

www.google.com

www.scribd.com

http://www.wikipedia.com/

http://www.investopedia.com/

http://www.scribd.com/

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AN ANALYSIS OF RISK MANAGEMENT: ROLE IN …euroasiapub.org/wp-content/uploads/2016/09/17IMMay-3691-1.pdf · MBA, APSET Assistant Professor ... known or best quantifiable. ... Time