Risk Management System in Business
Risk is inherent and absolutely unavoidable in banking. Risk is the potential loss an asset or a portfolio is likely to suffer due to a variety of reasons. As a financial intermediary, bank assumes or restructures risks for its clients. A simple example for this would be acceptance of deposits. A more sophisticated example is an interest rate swap. A bank while operating on behalf of the customers as well as on its own behalf, has to face various types of risks associated with those transactions. Prudent banking lies in identifying, assessing and minimizing these risks. In a competitive market environment, a bank’s rate of return will be greatly influenced by its risk management skills.
RISKS IN BANKING Risks in banking are many.
These risks can be broadly classified into three categories. They are:
(I) Balance sheet risks.
(II) Transaction risks, and
(III) Operating and Liquidity risks.
The Balance Sheet Risks generally arise out of the mismatch between the currency, maturity and interest rate structure of assets and Liquidities resulting in,
1) Interest Rate mismatch risk
2) Liquidity Risk, and
3) Foreign Exchange Risk,
The Transaction Risks essentially involve two types of risks. They are:-
(i) CREDIT RISK which is the risk of loss on lending/investment, etc. due to counter party default.
(ii) PRICE RISKS which include the risks of loss due to change in value of Assets and Liabilities.
The factors contributing to price risks are:
(a) Market Liquidity Risk: This is the risk of lack of liquidity of an instrument or asset or the loss one is likely incur while liquidating the assets in the market due to the fluctuations in prices.
(b) Issuer Risk: The financial strength and standing of the institution/sovereign that has issued the instrument can affect price as well as reliability. The risk involved with the instruments issued by corporate bodies would be an ideal example in this context.
© Instruments Risks: The nature of instrument creates risks for the investor.
With many hybrid instruments in the market, and with fluctuation in market conditions, the prices of various instruments may react differently from one another. (d) Changes in commodity prices, interest rates and exchange rates may affect the realisable value or yield of many assets when transactions take place.
The Operating and Liquidity Risk encompasses two types of risks, viz.,
(i) Risk of loss due to technical failure to execute or settle a transaction, and
(ii) Risk of loss due to adverse changes in the cash flows of transactions.
RISK MANAGEMENT : OBJECTIVES The objectives of risk management for any organisation can be summarised as under:
a) Survival of the organisation,
b) Efficiency in Operations,
c) Identifying and achieving acceptable levels of worry,
d) Earnings stability, e) Uninterrupted operations,
f) Continued growth, and
g) Preservation of reputation.
RISK MANAGEMENT: COMPONENTS:
Risk management may be defined as the process of identifying and controlling risk. It is also described at times as the responsibility of the management to identify, measure, monitor and control various items of risks associated with bank’s position and transaction. The process of risk management has three clearly identifiable steps, viz., Risk identification, Risk measurement and Risk Control.
After identification and assessment of risk factors, the next step involved is risk control. The major alternatives available in risk control are:
i) Avoid the exposure
ii) Reduce the impact by reducing frequency of severity
iii) Avoid concentration in risky area
iv) Transfer the risk to another party
v) Employ risk management instruments to cover the risks.
Good risk management is good banking. And good banking is essential for profitable survival of the institution. A professional approach to identification, measurement and control of risk will safeguard the interests of the banking institution in the long run. RBI Guidelines on Risk Management System in Banks The Reserve Bank of India has issued detailed guidelines for risk management system in banks. The guidelines broadly cover management of credit, market and operational risks. The broad framework for management of liquidity and interest rate risks were covered by the guidelines on Asset-Liability Management (ALM) system. According to the guidelines the management of credit risk should receive the prime attention of the top management. The banks should put in place the loan policy, approved by the board of directors covering the methodologies for measurement, monitoring and control of credit risk. Banks should also evolve comprehensive risk rating system that serves as a single point indicator of diverse risk factors of counterparties in relation to credit and investment decisions.
The activities of asset-liability management committee and credit policy committee for management of credit and market risks need to be integrated. Banks should evaluate portfolio quality on an ongoing basis rather than near about balance sheet date. The proposals for investment should be subjected to the same degree of credit risk analysis as loan proposals. The risk evaluation should also include total exposure, including investments. As regards off-balance sheet exposures, the current and potential credit exposures may be measured on a daily basis. Banks should evolve a suitable framework to provide a centralised overview of the aggregate exposure on other banks, endeavour to develop an internal matrix that reckons the counterparty and country risks. To manage liquidity risk, banks have been asked to consider putting in place prudential limits on inter-bank borrowings, especially call fundings, core deposits to core assets, off-balance sheet commitments, swapped funds, etc. Banks have been asked to evaluate liquidity profile under bank-specific and market crisis scenarios.
They have also been asked to prepare contingency plans to measure the ability to withstand sudden adverse swings in liquidity conditions. Banks have been asked to fix a definite timeframe for moving over to value at risk (VaR) and duration approaches for measurement of interest rate risk. The guidelines also mention that it would be desirable to adopt international standards on providing explicit capital cushion for the market risk to which banks are exposed. Banks should also adopt proper systems for measurement, monitoring and control of operational risk that is emerging in the wake of phenomenal increase in the volume of financial transactions. Banks operating in international markets have been asked to develop suitable methodologies for estimating and maintaining economic capital. The other banks have been asked to formulate a medium-term strategy to comply with these requirements. The guidelines on risk management have placed the primary responsibility of laying down risk parameters and establishing the risk management and control system on the board of directors.
They have, however, stated that the implementation of the integrated risk management could be assigned to a risk management committee or a committee of top executives that reports to the board. The risk management guidelines also require banks to constitute a high-level credit policy committee to deal with issues pertaining to credit sanction, disbursement and follow-up procedures and to manage and control credit risk on a whole bank basis. The Reserve Bank has further asked banks to concurrently set up an independent credit risk management department to enforce and monitor compliance of the risk parameters and prudential limits set by the board/credit policy committee. The Reserve Bank has, however, stated that due to the diversity and varying size of balance sheet items between banks, it may neither be possible nor necessary to adopt uniform risk management system. The design of risk management framework should therefore be oriented towards the bank’s own requirement dictated by the size and complexity of business, risk philosophy, market perception and the existing level of capital. In other words, banks can evolve their own systems compatible with the type and size of operations as well as risk perception. Further Readings: Doc Player , Wikipedia , Investopedia
Originally published at https://www.mohanmekap.com on August 15, 2020.