Risk Management in Banks:

Risk is possibility of loss that may arise due to uncertainties. Bank risk is usually referred as the potential loss to a bank due to the occurrence of Particular event.

Uncertainties lead to variations in net Cash flow, which can be favourable (Positive) or Un-favourable (negative). Un-favourable variation reduce profits or cause loss. Lower variation in net cash flow-Lower Risk, Higher variation in net cash flow-Higher Risk, No variation in cash flow- No Risk.

Banking Risk Management Process

Following are the steps in Risk Management process:

Risk identification

Risk Measurement

Risk Pricing

Risk Mitigation

Risk Monitoring and Control

1. Risk Identification:

A process of identifying various types of risk associated with the transaction. It is a process of determining risk/(s) that could potentially prevent the enterprise from achieving its objectives. It is a process of identifying and assessing threats to an organisation, its operations, and its workforce. The purpose of risk identification is to reveal what, where, when, why and how something could affect a company's ability to operate. It also includes risk analysis and risk evaluation.

Risk analysis:

This step involves establishing the possibility that a risk event might occur and the potential outcome of each event.

Risk evaluation:

Risk evaluation compares the magnitude of each risk and rank them according to prominence and consequences.

Types of Risks in Banks:

1. Market Risk

2. Credit risks

3. Liquidity Risk

4. Operational risk

5. Legal Risk

6. Regulatory Risk

7. Reputation Risk

  8. Business Risk

 

2. Risk Measurement:

Risk measurement means to quantify the risk element. Risk measurement techniques differ from risk to risk.

For Example in case of credit risk, it is through credit rating.

For market risk, techniques like sensitivity analysis, volatility, standard deviation etc

For operational Risk, certain advance measurement techniques are there.

3. Risk Pricing:

 

Risk pricing means factoring risk into pricing. for example when lenders offer different consumers different interest rates or other loan terms, based on the estimated risk that the customer will fail to pay back their loans.

 

Factors influencing pricing in case of loans:

1. Cost of funds

2. operating expenses

3. loss probability

4. Capital Cost (CRAR)

5. Profit Margin (ROE/ROA)

High risk : High Price

Low Risk : Low price

4. Risk Mitigation:

It is through initiation of steps to reduce the risk, wherever possible.

For Example:

Credit Risk can be mitigated by:

1. Pre- sanction appraisal

2. Proper Documentation

3. Obtaining Margin

4. Obtaining Collateral security or guarantees

5. Fixing exposure ceiling

6. Credit rating

Liquidity Risk can be mitigated by :

Proper asset-liability management

Interest Rate risk can be mitigated by:

Entering into interest rate swaps, forward rate agreements.

Forex Risk can be mitigated by:

Forward agreements etc.

Operational risk can be mitigated by:

1. Compliances
2. Insurance

5. Risk monitoring and control:

Risk monitoring and control essential to understand the change in risk profiles.

Action for risk control:

1. Appropriate organizational structure
2. Adoption of appropriate and comprehensive risk measurement approach
3. Setting up of comprehensive risk rating system
4. Adoption of risk management policies, consistent with broader business strategy.

Types of Risk:

1. Liquidity Risk

Liquidity risk is the risk that an entity may be unable to meet short term liabilities. it is the risk of incurring losses resulting from the inability to meet payment obligations in a timely manner when they become due or from being unable to do so at a sustainable cost.It can be also defined as the possibility that an institution may be unable to meet its maturing commitments or may do so only by borrowing funds at prohibitive costs or by disposing assets at rock bottom prices.The liquidity risk in banks manifest in different dimensions –

a) Funding Risk: Funding liquidity risk is the risk that a bank will be unable to pay its debts when they fall due i.e. bank cannot meet the demand of customers wishing to withdraw their deposits. Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail).

            (b) Time Risk:

            Time risk arises when a bank not being able to finance its day to day operations. failure to manage this risk could lead to severe

           consequences for the bank 's reputation as well as bond prices and rating of banks in money market. from the need to compensate for

          on receipt of expected inflows of funds i.e., performing assets turning into non-performing assets.

       (c) Call Risk: Call risk arises due to crystallization of contingent liabilities. It may also arise when a bank may not be able to undertake                                 profitable business opportunities when it arises.

      2. Interest rate risk:

       Potential adverse impact on Net Interest Margin (NIM) or Net Interest income (NII) or Market value of equity caused by interest rate        movements.Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected            due to changes in the interest rates.In other words, the risk of an adverse impact on Net Interest Income (NII) due to variations of                  interest rate may be called Interest Rate Risk . It is the exposure of a Bank’s financial condition to adverse movements in interest rates.

NII : It is the difference between the revenue that is generated from bank’s assets and the expenses    associated with paying liabilities. To stabilize short term profits, banks have to minimize fluctuations in the            NII

NII = Interest Income(-)Interest expenses

                 NIM= NII/average Total Assets or working Fundsx 100

  

         For Example:

Interest income =140/-

Interest expenses= 120/-

Average assets = 1600/-

NII= 140 (-) 120 = 20/-

NIM= 20/1600x100= 1.25%

The following are the types of Interest Rate Risk –

(a) Gap or Mismatch Risk:A gap or mismatch risk arises from holding assets and liabilities and Off-Balance Sheet items with different principal amounts, maturity dates or re-pricing dates, thereby creating exposure to unexpected changes in the level of market interest rates. Gap or mismatch indicates the gap between re-pricing assets and liabilities or we can say rate sensitive assets and liabilities.

example:

Rate sensitive Asset are 500/- (rate 8%) and rate sensitive liabilities are 600/- (rate 4%)

 

NII= 40 + 38.5 (-) 24 +13.2 = 41.30/-

NIM = 41.30/850X 100 = 4.85%

Gap = 600 (-) 500= (-) 100

Rate sensitive Asset are 500/- (rate 9%) and rate sensitive liabilities are 600/- (rate 5%)

NII= 45 + 38.5 (-) 30 +13.2 = 40.30/-

NIM = 40.30/850X 100 = 4.74%

Gap = 600 (-) 500= (-) 100

(b) Yield Curve Risk: Banks, in a floating interest scenario, may price their assets and liabilities based on different benchmarks, i.e., treasury bills’ yields, fixed deposit rates, call market rates, MIBOR etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities then any non-parallel movements in the yield curves, which is rather frequent, would affect the NII. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income.

c) Basis Risk: It arises due to assets and liabilities priced on different basis. Basis Risk is the risk that arises when the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude. For example, in a rising interest rate scenario, asset interest rate may rise in different magnitude than the interest rate on corresponding liability, thereby creating variation in net interest income. For example a 5-years, Rs. 2 cr. floating rate term loan is funded by 2 year, floating rate FDR.or Example:

Term loan 200/- (rate 11%) and FD200 /- (rate 8%)

            Spread = 3%

NII = 22 (-) 16 = 6

NIM= 6/200X100 = 3%

(d) Embedded Option Risk: Significant changes in market interest rates create the source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans, term loans and exercise of call/put options on bonds/ debentures and/ or premature withdrawal of term deposits before their stated maturities. The embedded option risk is experienced in volatile situations and is becoming a reality in India. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’ Net Interest Income. The result is the reduction of projected cash flow and the income for the bank.

          (e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with regard to interest rate at which the future cash flows              could be reinvested. Any mismatches in cash flows i.e., inflow and outflow would expose the banks to variation in Net Interest Income.            This is because market interest received on loan and to be paid on deposits move in different directions.

(f) Net Interest Position Risk: Net Interest Position Risk arises when the market interest rates adjust downwards and where banks have more earning assets than paying liabilities. Such banks will experience a reduction in NII as the market interest rate declines and the NII increases when interest rate rises. Its impact is on the earnings of the bank or its impact is on the economic value of the banks’ assets, liabilities and off balance sheet positions.

           3. Market Risk

           Market risk also called systematic risk cannot be eliminated through diversification, though it can be hedged against in other ways.                 Sources of market risk include recession, political turmoil, change in interest rates, natural disasters and terrorist attacks. Example                 corona virus.This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments,

           equities, commodities, and currencies. It is also referred to as Price Risk.Price risk occurs when assets are sold before their stated                 maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading                 book, which is created for making profit out of short-term movements in interest rates.The term Market risk applies to

               (i) that part of IRR which affects the price of interest rate instruments,

               (ii) Pricing risk for all other assets/ portfolio that are held in the trading book of the bank and

               (iii) Foreign Currency Risk.

              (a) Forex Risk:orex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period                       in which it has an open position either spot or forward, or a combination of the two, in an individual foreign currency.   

               b) Market Liquidity Risk:

       Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.        4. Credit/Default Risk:

          Credit risk is the risk on account of default by the borrower in meeting its repayment obligations. Credit risk is  the risk of default on a debt            that may arise from a borrower failing to make required payments. There are two variants of credit risk which are discussed below –

(a) Counterparty Risk:This is a variant of Credit risk and is related to non-performance of the trading partners due to counterparty’s refusal and

            or inability to perform. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than                               standardcredit risk.

(b) Country Risk:

            This is also a type of credit risk where nonperformance of a borrower or counterparty arises due to constraints or restrictions imposed by              a country. Here, the reason of nonperformance is external factors on which the borrower or the counterparty has no control.

             Credit Risk depends on both external and internal factors.

         The internal factors include –

         1. Deficiency in credit policy and administration of loan portfolio.

         2. Deficiency in appraising borrower’s financial position prior to lending.

         3. Excessive dependence on collaterals.

         4. Bank’s failure in post-sanction follow-up, etc.

          The major external factors –

          1. The state of economy

           2. Swings in commodity price, foreign exchange rates and interest rates, etc.

        5. Operational Risk

        The risk of direct and indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.

        Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal                    processes, people and systems or from external events’.

       Thus, operational loss has mainly three exposure classes namely people, processes and systems.

      Managing operational risk has become important for banks due to the following reasons –

        1. Higher level of automation in rendering banking and financial services

        2. Increase in global financial inter-linkage

                Scope of operational risk is very wide because of the mentioned reasons. Two of the most common operational risks are discussed                 below –

      (a) Transaction Risk:

        Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business              continuity and manage information.

     (b) Compliance Risk:

           Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to         comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice. It is also called integrity risk                since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing.

       6. Legal Risk:

            Risk arising due to non-compliance of law of the land. Legal risk may arise in cases like continuing services of outsourced vendors even             after expiry of contract, not following labour laws, non compliance to tax laws etc.

          7. Regulatory risk

        This happened when the banks fail to comply the regulatory guidelines issued by regulators like SEBI, RBI etc.

       Example: Non adherence to CRR/SLR requirements, KYC guidelines, violation of Priority sector lending etc.

          8.Business Risk/Strategic Risk

          It arises due to failure of long term or short term strategies implemented by the entities. Example: Completion, demand not adequate.

           An entity has spent huge amount to launch a new product but product failedas consumer did not find it suitable for them.

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