Risk Management in Banks – Introducing Awesome Theory

Risk!!!!!!! Whenever we hear this word we start panicking & thinking what type of risk it could be i.e. either it is physical risk or financial risk. As per the survey it’s been found a person or an individual has always feared of loosing something of value which majorly consists of finance. And if we see today not only an individual but also organizations fears about loosing their money. As we all know without taking risk no one can grow or earn more but due to modernization and liberalization and growing competition, the rate of risk and uncertainty has also increased. And this has not only created trouble for an individual but also to the banking sectors and financial institutions. In order to sustain and grow in the market, banks have to mitigate or curb these risks. Thus, risk management concept has come into the picture which will provide guidelines or will act as a roadmap for a banking organization to reduce the risk factor.

Below article will focus on quotients like what is risk management? What type of risks banks face and how they manage through risk management process?

What is RISK Management in Bank?

We all come across with the word risk in our life but have you ever wondered where this word originates from??? What is the origin of this word??? So, firstly we will discuss what is Risk??

The word “Risk” can be linked to the Latin word “Rescum” which means Risk at Sea. Risk can be defined as of losing something of value or something which is weighed against the potential to gain something of value. Values can be of any type i.e. health, financial, emotional well being etc. Risk can also be said as an interaction with uncertainty. Risk perception is subjective in nature, people make their own judgment about the severity of a risk and it varies from person to person. Every human-being carries some risk and define those risks according to their own judgment.

What is Risk Management?

As we all are aware what is risk? But how one can tackle with risk when they face it?? So, the concept of Risk Management has been derived in order to manage the risk or uncertain event. Risk Management refers to the exercise or practice of forecasting the potential risks thus analyzing and evaluating those risks and taking some corrective measures to reduce or minimize those risks.

Today risk management is practiced by many organizations or entities in order to curb the risk which they can face it in near future. Whenever an organization makes any decision related to investments they try to find out the number of financial risk attached with it. Financial risks can be in the form of high inflation, recession, volatility in capital markets, bankruptcy etc. The quantum of such risks depends on the type of financial instruments in which an organization or an individual invests.

So, in order to reduce or curb such exposure of risks to investments, fund managers and investors practice or exercise risk management. For example an individual may consider investing in fixed deposit less risky as compared to investing in share market. As investment in equity market is riskier than fixed deposit, thus through the practice of risk management equit analyst or investor will diversify its portfolio in order to minimize the risk.

How important Risk Management is for Banks?

Till now we have seen how risk management works and how much it is important to curb or reduce the risk. As risk is inherent particularly in financial institutions and banking organizations and even in general, so this article will deals with how Risk Management is important for banking institutions. Till date banking sectors have been working in regulated environment and were not much exposed to the risks but due to the increase of severe competition banks have been exposed to various types of risks such as financial risks and non-financial risks.

The function and process of Risk Management in Banks is complex, so the banks are trying to use the simplest and sophisticated models for analyzing and evaluating the risks. In a scientific manner, banks should have expertise and skills to deal with the risks which are involved in the process of integration. In order to compete effectively, large-scale banking organizations should develop internal risk management models. At a more desired level, Head offices staff should be trained in risk modeling and analytic tools to conduct Risk Management in Banks.

• Risk Management in Indian Banking Sector

Practice of Risk Management in Banks is newer in Indian banks but due to the growing competition, increased volatility and fluctuations of markets the risk management model has gained importance. Due to the practice of risk management, it has resulted in the increased efficiency in governing Indian banks and has also increased the practice of corporate governance. The essential feature of risk management model is to minimize or reduce the risks of the products ad services which are offered by the banks therefore, in order to mitigate the internal & external risks there is a need of efficient risk management framework.

Indian banks have to prepare risk management models or framework due to the increasing global competition by foreign banks, introduction of innovative financial products and instruments and increasing deregulation’s.

Banking sector of India has made a great advancements in terms of technology, quality etc. and have started to diversify and expand its horizons at a rapid rate. However, due to the increasing globalization and liberalization and also increasing advancements leads these banks to encounter some risks. Since in banks risks plays a major role in the earnings therefore higher the risk, higher will be the returns. Hence it is essential to maintain equality between risk and return.

Classification of Risks in Banking sector

 

      1.  Credit Risk

• Credit risks involve borrower risk, industry risk and portfolio risk. As it checks the creditworthiness of the industry, borrower etc.
• It is also known as default risk which checks the inability of an industry, counter-party or a customer who are unable to meet the commitments of making settlement of financial transactions.
• Internal and external factors both influences credit risk of bank portfolio.
• Internal factors consist of lack of appraisal of borrower’s financial status, inadequate risk pricing, lending limits are not defined properly, absence of post sanctions surveillance, proper loan agreements or policies are not defined etc.
• Whereas external factor comprises of trade restrictions, fluctuation in exchange rates and interest rates, fluctuations in commodities or equity prices, tax structure, government policies, political system etc.

How banks manage this risk?

• Top management consent or attention should be received in order to manage the credit risk.
• Credit Risk Management Process include:

1. In a loan policy of banks, risk management process should be articulated.
2. Through credit rating or scoring the degree of risk can be measured.
3. It can be quantified through estimating expected and unexpected financial losses and even risk pricing can be done on scientific basic.

• Credit Policy Committee should be formed in each bank that can look after the credit policies, procedures and agreements and thus can analyze, evaluate and manage the credit risk of a bank on a wide basis.
• Credit Risk Management consists of many management techniques which helps the bank to curb the adverse effect of credit risk. Techniques includes: credit approving authority, risk rating, prudential limits, loan review mechanism, risk pricing, portfolio management etc.

     2. Market Risk

• Earlier, majorly for all the banks managing credit risk was the primary task or challenge.
• But due to the modernization and progress in banking sector, market risk started arising such as fluctuation in interest rates, changes in market variables, fluctuation in commodity prices or equity prices and even fluctuation in foreign exchange rates etc.
• So, it became essential to manage the market risk too. As even a minute change in market variables results into substantial change of economic value of banks.
• Market risk comprises of liquidity risk, interest rate risk, foreign exchange rate risk and hedging risk.

How banks manage this risk?

• The major concern for the top management of banks is to manage the market risk.
• Top management of banks should clearly articulate the market risk policies, agreements, review mechanisms, auditing & reporting systems etc. and these policies should clearly mention the risk measurement systems which captures the sources of materials from banks and thus has an effect on banks.
• Banks should form Asset-Liability Management Committee whose main task is to maintain & manage the balance sheet within the risk or performance parameters.
• In order to track the market risk on a real time basis, banks should set up an independent middle office.
• Middle office should consist of members who are market experts in analyzing the market risk. The experts can be: economists, statisticians and general bankers.
• The members of Middle office should be separated from treasury departments or in daily activities of treasury department.

    3. Operational Risk

• For a better risk management practice, it has become essential to manage the operational risk.
• Operational risk arise due to the modernization of banking sector and financial markets which gave rise to structural changes, increase in volume of transactions and complex support systems.
• Operational risk cannot be categorized as market risk or credit risk as this risk can be described as risk related to settlement of payments, interruption in business activities, legal and administrative risk.
• As operational risk involves risk related to business interruption or problem so this could trigger the market or credit risks. Therefore, operational risk has some sort of linkages with credit or market risks.

How banks manage this risk?

• There is no uniform approach in measuring the operational risk of banks. Till date simple and experimental methods are used but foreign banks have introduced some advance techniques to manage the operational risk.
• For measuring operational risk, it requires estimation of the probability of operational loss and also potential size of the loss.
• Banks can make use of analytical and judgmental techniques to measure operational risk level.
• Risk of operations can be: audit ratings, data on quality, historical loss experience, data on turnover or volume etc. Some international banks has developed rating matrix which is similar to bond credit rating.
• Operational risk should be assessed & reviewed at regular intervals.
• For quantifying operational risk, Indian banks have not evolved any scientific methods and are using simple benchmark system which measures business activity.

Recommended Articles

Here are some articles that will help you to get more detail about the Risk Management in Banks so just go through the link.

1. Why should I go for PRM (Professional Risk Manager)?
2. 10 Top Most Important Marketing Management Functions

Risk Management in Banks Infographic

Learn the juice of this article in just a single minute, Risk Management in Banks