Banking Business

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Risk Management in Banks and NBFCs

Risk is the probability of financial loss. Its not a certainty. This is important, in order to measure and
manage risk.
Risks can arise both from causes internal to a business (such as employee fraud) or externally from
the environment - causes not directly related to operations (e.g. exchange rate risk for IT companies).
The key then, is to be aware and take steps to manage risks.

Risk Management Process

Risk management is a three stage process and is shown below:
1. Identify the risk
2. Measure the risk
3. Implement risk management measures

Risk Management in Financial Institutions

Risk Management for financial institutions like banks and NBFCs gathers large significance, as there are a
lot of parties/processes dependent on them.
If a bank fails, hundreds of thousands of depositors money is at stake; the entire chunk of payments
which is due to be paid to other banks via the deferred net settlement process, is at stake hence other
banks are affected; this bank will have borrowed from other FIs they in turn will have problems paying
back their obligations.

Typical Causes of Financial Crises

The root causes of financial crises have been classified as follows:
Asset (Loan) Quality: The U.S subprime crisis in 2008-09, caused by poor credit risk management by
banks and financial institutions, is a case in point. There are also lessons from Latin America and Indian
NBFCs. Indian NBFCs have been found wanting in not having stringent lending norms. This resulted in a
lot of Non Performing Assets (NPAs) during the economic downturn.
Asset-Liability Mismatch: Banks and financial institutions have assets and liabilities of different
maturities. This exposes them to Interest Rate Risk and Liquidity Risk.
Fraud: Poor risk management processes have also resulted in frauds in large institutions. A few
examples come to mind. Nick Leeson was, the trader who single handedly brought down Barings Bank
with his huge trading loss. In his case, he was both the trader and the person who monitored the
trading!

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Lets discuss the risk management process in detail.

Identifying Risk
The first step in the risk management process is to identify the sources of risk. Credit Risk, Market Risk
and Operational Risk encompass over 90% of the risk faced by financial institutions today.
Market Risk - Risk of loss due to price movements in any market the institution is trading in, such as
currency, stocks, bonds, commodities etc.
Credit Risk - Risk of loan default

Operational Risk - Risk of incurring losses due to manual errors, fraud or system failure
Liquidity Risk - Risk of not having liquid funds when needed. Liquidity risk exists typically in emerging
markets.
Let us now map each of these risks more specifically to each division of a bank/financial institution to
make it more relevant.
Current Account and Savings Account (CASA) - Liquidity Risk: The institution should have enough
funds to give loans and repay depositors.
Loans Credit Risk: The institution should ensure that loans given are recoverable from the parties
and there are minimum defaults.
Cheque Clearing Operational Risk: The institution should ensure that the clearing process takes
place smoothly without any manual errors. Else they would be exposed to operational losses.
Letter of Credit Credit Risk: As the institution is providing a guarantee, they are exposed to default
risk, similar to loans.
Cash Management Service (CMS) Operational Risk: Here again, as this activity is operation intensive,
the institution is exposed loss due to system failure, manual errors etc.

Trading Market Risk & Operational Risk: As this involves the front office activity of trading in
market variables such as stocks and bonds and the back office activity.
Underwriting Market Risk: As the institution agrees to buy unsubscribed amount in case of public
issues and issuance of other financial instruments.
Asset Liability Management Market Risk & Liquidity Risk: Both loans and deposits are subjected
to market risk and liquidity risk.

Measuring Risk
The next stage in risk management process is to measuring the risk. We all knew that risk can be defined
as probability of occurrence and deviation from expectation.

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There are a number of other risk parameters such as Duration used for bonds, Beta- used for
equities, Factor sensitivity - used for currencies etc.
Let us discuss briefly about a comprehensive measure of risk called Value at Risk (VaR).
Value at Risk (VaR)
VaR is an attempt to provide a single number summarizing the total risk in a portfolio of financial assets.
It has become widely used by corporate treasurers and fund managers as well as by financial institutions.
Some of the impetus for the use of VaR has also come from the regulators. Regulators now require all
banks to calculate VaR. They use VaR in determining the capital a bank is required to keep, to reflect the
risks it is bearing.
Remember, risk measures are statistical estimates which can never be made with 100% confidence.
The full statement of VaR therefore reads as follows We are X% confident that we will not lose
more than V rupees over the next N days.
There are various methodologies for computing VaR.

Variance -Covariance Methodology

o J.P Morgan's Risk Metrics
o FEDAI methodology for currencies in India
Simulation Methodology
o Historical Simulation (using past data)
o Monte Carlo (using random sampling)

Basel Norms for Capital Adequacy

The Bank for International Settlements (BIS) is an international organization that fosters international
monetary and financial cooperation, and serves as a bank for central banks of various countries.
The Basel Committee on Banking Supervision was formed in order to secure standardisation across the
global banking industry, to limit risks faced by the banking system.
Basel I Norms
Basel I norms defined the minimum capital required to be maintained by internationally active banks.
This capital required, was linked directly to the risk faced by them in their operations.
The norms established a standard of risk weights applied to different c assets. So, riskier lending (such as
unsecured loans to borrowers of doubtful credit history) attracted higher risk weights, and hence, higher
capital requirements.
For our example above, the risk weights suggested to banks were as follows

Lending
Lending
Lending
Lending

to
to
to
to

your own branch 0%

another bank 20%
a corporate of certain credibility 50%
other entities 100%

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For example, Citi Bank, Mumbai has done the following transactions.
Transactions

Risk Wt. (%)

RWA (Asset Value*Risk Wt.)

Lends INR 100 crore to ABN Amro Bank.

20

INR 20 crore

Lends INR 100 crore to Citibank, Delhi.

INR 0 crore

Lends INR 100 crore to L&T.

50

INR 50 crore

Lends INR 100 crore to Nopayback Chit Fund

100

INR 100 crore

Total Risk Weighted Assets

INR 170 crore

BIS then asked the banks to calculate their Risk Weighted Assets (RWA). Then BIS said that a the
minimum amount of capital a bank must have is 8% of the RWA. In our example the amount of capital
would be 8% of 170 cr = INR 13.6 cr
Basel II Framework
The Basel committee has come up with a latest framework. The latest framework is based on three
pillars.
Pillar I Minimum Capital: This part of Basel II covers the Capital Adequacy norms. It defines
different ways of measuring Credit, Market and Operational Risk, and how much capital banks must have
in order to protect against each.
Pillar II Supervisory Review: This part of the Basel II process provides for Supervisors to the first
pillar. This means, that every bank should have an internal audit division that checks that the method of
risk measurement chosen is most appropriate; that the tracking and measurement is being done
correctly.
Pillar III Market Discipline: The third pillar of the Basel II norms recommend that banks need to
become more transparent by disclosing information. What information? Well, the methods they are using
to calculate risk, what is the quantum of risk being faced using these methods and hence what is the
capital being maintained.

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