RISK MANAGEMENT IN FINANCE SECTOR

By-
Ajay Shukla & Tejas Dongre
MBA II, JDC Bytco IMSR, Nashik

ABSTRACT

The research paper is based on study conducted on the Risk Management with reference to
finance sector. For undertaking analysis of the risk management practices in finance sector we
have had personal interview and discussion round with finance professionals from various areas
within finance as banking, capital market, taxation.

It helped us to find information on:

 Need for Risk Management
 Types of Risks
 Risk Management (Techniques)

OBJECTIVES
 To study various types of potential risks.
 To study the need and importance of risk management with reference to finance sector.
 To study various tools of risk management and its application in finance sector.

RESEARCH METHODOLOGY

Research methodology was done on the basis of primary as well as secondary data.
Primary data – primary data was collected by interviewing financial professionals who included
Portfolio Managers, practicing CA’s and bankers.

Secondary data – secondary data was collected from various magazines, reference books,
journals as a well as the internet.

INTRODUCTION
While risk has always been part of financial activity, the 1990's saw risk management become a
key business function within banks and other financial institutions. Major reasons for its growth
in importance were the massive losses incurred by some huge global companies during the
1990's, which shocked financial institutions into placing more emphasis on risk management and
controls.
However, industry globalization and consolidation, product complexity and the increasingly
sophisticated requirements of customers were already leading to a greater emphasis on ensuring
that losses were not incurred due to adverse market conditions, counter party failure, or
inappropriate controls, systems or people.
These factors led to increased regulation, and banking and financial institutions now have to
adhere to the principles of banking regulation advocated by the Basel Capital Accord. They must
strengthen internal controls, enhance disclosure and transparency of financial information and
ensure effective supervision, in order to maintain the sound operation of the banking and
financial markets. This includes identifying and quantifying various risks in advance, as well as
establishing and carrying out effective risk management.

What is risk?
“The chance that an investment's actual return will be different from the expected return,
including the ultimate risk of losing all of one's original investment.”

What is risk management?

“Risk management is the process of assessing risks and taking steps to either eliminate or to
reduce them (as far as is reasonably practicable) by introducing control measures.”

What does financial sector mean?

“A category of stocks containing firms that provides financial services to commercial and retail
customers. This sector includes banks, investment funds, insurance companies and real estate.”

Findings

Person Discussion and Interview (for questionnaire check annexure) was arranged to research
about the practices prevailing in financial sector to handle the element of risk i.e. Risk
Management. For the same, we choose individuals from diversified fields and the list includes:
1. Mr. Hitesh Patel- Practicing CA
2. Mr Devey – Private Portfolio Manager
3. Mr. A.V. Joshi- FCA Ex Banker-Bank of Baroda

The information collected is clubbed and presented as follows

Need for Risk Management

1) Present structure of joint stock companies, wherein owners are not the mangers, hence
risks increase; therefore proper tools are required to achieve the desired results by
covering the risks.
2) The financial sector has come out of simple deposit and lending function.
3) The world has become very complex so the financial transactions and instruments.
4) Increase in the number of cross border transactions which caries its own risks.
5) Emerging markets
6) Terrorism Remittances

Types of risks
On macro level
1) Systematic risk – The risk that cannot be reduced or predicted in any manner and it is
almost impossible to predict or protect you against this type of risk.

2) Unsystematic risk – The risk that is specific to an assets feature and can usually be
eliminated through a process called diversification.
On micro level
1) Market Risk - Market risk is the risk that arises from fluctuation in the values of, or
income from, assets.

2) Group Risk - Group risk is the potential impact of risks arising in the parts of a firms
group as well as those resulting from its own activities.

3) Credit Risk - Credit risk occurs whenever a firm is exposed to loss if another party fails to
perform its obligations.

4) Operational Risk - The risk of loss, resulting from inadequate or failed internal processes,
people or systems, or from external events.
5) Liquidity Risk - The risk that a firm does not maintain sufficient financial resources to
meet its liabilities as they fall due.

6) Reputational Risk - The risk that arises as a result of negative publicity having a
detrimental effect on shareholder value and position in its market place.

7) Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency.

8) Interest Rate Risk - This risk arises due to fluctuations in the interest rates.

9) Legal risk - The risk of loss caused by penalties or sanctions originating from court
disputes due to breach of contractual and legal obligations, and penalties and sanctions
pronounced by a regulatory body.

10) Strategic risk - The risk of loss caused by a lack of a long-term development component
in the bank’s managing team.

11) Business Risk - The uncertainty of income caused by the nature of a companies
business measured by a ratio of operating earnings (income flows of the firm).

12) Financial Risk - The risk borne by equity holders due to a firm’s use of debt.

13) Country Risk - The risk of investing funds in another country whereby a major
change in the political or economic environment could occur.

14) Technology Risk - This risk is associated with computers and the communication
technology.

Risk management
How to manage credit risk
 1) Exposure Ceilings - Prudential Limit is linked to Capital Funds – say 15% for individual
borrower entity, 40% for a group.

2) Review/Renewal - Multi-tier Credit Approving Authority, constitution wise delegation of

powers.

3) Risk Rating Model - Set up comprehensive risk scoring system on a six to nine point
scale. Clearly define rating thresholds and review the ratings periodically preferably at
half yearly intervals.

4) Risk based scientific pricing - Link loan pricing to expected loss. High-risk category
borrowers are to be priced high.

5) Portfolio Management - Stipulate quantitative ceiling on aggregate exposure on specific

rating categories, distribution of borrowers in various industry, business group and
conduct rapid portfolio reviews.

6) Loan Review Mechanism - Identify loans with credit weakness. Determine adequacy of
loan loss provisions. Ensure adherence to lending policies and procedures. Regular,
proper & prompt reporting to Top Management should be ensured.

How to manage market risk

1) Diversify across asset classes.
2) Diversify across asset class variants.
3) Diversify across securities or investments within each asset class.
4) Diversify across financial institutions and fund families.
5) Diversify across industries and sectors.
6) Diversify across fund managers.
7) Diversify across time horizons and levels of liquidity.

How to manage Foreign Exchange Risk

1) Diversification - Diversification works best when investors purchase uncorrelated assets.
Correlation describes the tendency for assets and prices to shift together in unison.

2) Currency derivatives - Currency derivatives function as foreign exchange risk

management tools because they allow investors to lock in predetermined exchange rates
for set periods of time. Currency derivatives include forwards, options and futures
contracts.

3) Currency swap - Currency swaps exchange payments in different currencies between two
trading partners. For efficiency, currency swaps feature netting, where the winning party
receives one payment at the end of the swap term. Netting balances the differences in
currency valuations that occur during the swap agreement.

How to manage interest-rate risk

 1) Matching Assets and Liabilities - Interest rate risk is the difference in time, credit, and
rate between an asset and the liability used to fund the asset.

2) Asset Matching Considerations - After writing loans, banks must determine a hard
estimate of ability to pay, whether there might be delays in payments and whether credit
quality might change thus changing the pricing of the loan. On this basis, a bank will
determine how much of the loan to fund.

3) Making the Interest Rate Balance Work - The important issue is that the balance of assets
and loan demand and the accurate prediction of interest rates will greatly impact the
earnings of the bank. While banks must meet regulatory issues over loan making,
liquidity and loan diversification, these concerns must be weighed against the banking
profitability.

4) Diversify maturities - The traditional way to hedge against interest rate risk is to spread
fixed income investments across the entire yield curve, from very short dated maturities
to very long-term bonds.

5) Buy fixed for floating swaps - In practice, instead of actually swapping, the difference
between the two capital sources at the end of the agreement is calculated and paid to the
party to which it’s due.

6) Use real rate strategy - Part of reducing risk knows when it is most present. A way to
ascertain this is using real interest rates, the nominal interest rates minus the rate of
inflation.

How to manage liquidity risk

1) Short-Term Liabilities - Short-term liabilities represent deposits and debt instruments.

2) Notational Liabilities - If notational or off balance sheet items such as stand by Ic’s are
activated new short-term liabilities are created that must be paid.

3) Short-Term Assets - Short-term assets must be readily available to cover all obligations
arising from short-term liabilities.

4) Shock Test - The application of shock analysis scenarios to the short term needs of the
bank are used to determine liquidity risk policy.

5) Liquidity Risk Plan - Each bank must maintain a liquidity risk plan in order to detail the
actions that the bank would undergo in the event of a liquidity crisis.

CONCLUSION:

For any business to grow and stay in the market, management style is a key and Risk
management is basically the management style of managing the risks.
Risk is inherent in every business and every organization has to manage it according to its size
and nature of operation because without it no organization can survive in long run. In addition to
that the quantum of risk is higher in finance sector than any other sector.

BIBLIOGRAPHY

Risk management in Banks - ICFAI

Risk management – Verma S B. Deep & Deep Publications
Financial Risk Management- By Dun & Bradstreet, Tata McGraw Hill
Risk Management and & Derivatives- Rene` M Stulz
www.google.com

ANNEXURE
Questionnaire
1) What are the risks faced by your organization?
2) What is the need of risk management?
3) How do you manage these risks?
4) Is there any committee for managing risks?
5) Which instruments do you use to manage risk?