RISK MANAGEMENT IN COMMERCIAL BANKS

161 RISK MANAGEMENT IN COMMERCIAL BANKS Dr. Kapoor Singh Jorasia Assistant Professor, Swami Shraddhanand College, University of Delhi Abstract Risk is the primary elements that drive financial performance without risk; the financial system would be immensely simplified. However, risk is universal in the real world. Financial Institutions, consequently, should manage the risk competently to survive in this highly tentative world. The future of banking will definitely rest on risk management dynamics. Only those banks that have competent risk management arrangement will survive in the market in the long term. The effective management of credit risk is a critical module of Comprehensive risk management necessary for longterm success of a banking institution. Key words: Risk Management, Banking Sector, Credit risk, Market risk, Operating Risk Introduction Risk is defined as something that is creating obstacles to reach certain goals. This may be due to internal factors or external factors, depending on the type of risk that exists in a particular situation. To define risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. In carrying out their functions banks exposed to different types of risks, credit risk, Interest rate risk, Strategic risk, FOREX risk, Technology risk, Country risk etc. While banks and other financial institutions have faced difficulties for several reasons, the credit risk is the familiar causes of failure of banks, causing all regulatory authorities to prescribe minimum standards for credit risk management. The exposure to this risk can be the most critical situation. The best way to handle this situation is to identify a number of constructive measures each type of risk can lead to negative results. In short we can say that the managing risk is much better than waiting for its happening. Risk Management The future of the bank is likely to be based on a dynamic risk management. The banks that have effective risk management will survive long term in the market. Effective credit risk management is an important element of risk management for the long term success of the banking institutions. Credit risk is the inherent risk arising due to the nature of business in a

162 banking sector. This has however, acquired a greater consequence in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the world, India is no exclusion to this swing towards market driven economy. Competition within and outside the country has increased. This has led to many threats, both in the number and size of resulting in volatile markets. Indian banks have made significant progress in terms of technology, quality, as well as stability such that they have started to grow and diversify at high speed. However, such the extension brings these banks, the risks specific at the onset of growing Globalization and Liberalization. Banks and other financial institutions, risk plays a important role in the earnings of a bank. Higher risk, higher returns, hence, it is important to maintain a balance between risk and return. Objectives The following are the objectives of the study. 1. To identify the risks faced by the banking industry. 2. To examine the techniques adopted by banking industry for risk management. Review of Existing Literature To formulate the problem and to design the survey instruments, a review of existing literature was made. Gist of these previous studies pertaining to Credit Risk Management is prescribed as follows: Rajagopal (1996) made an attempt to overview the bank s risk management and suggests a model for pricing the products based on credit risk assessment of the borrowers. He concluded that good risk management is good banking, which ultimately leads to profitable survival of the institution. A proper approach to risk identification, measurement and control will safeguard the interests of banking institution in long run. Froot and Stein (1998) found that credit risk management through active loan purchase and sales activity affects banks investments in risky loans. Banks that purchase and sell loans hold more risky loans (Credit Risk and Loss loans and commercial real estate loans) as a percentage of the balance sheet than other banks. Again, these results are especially striking because banks that manage their credit risk (by buying and selling loans) hold more risky loans than banks that merely sell loans (but don t buy them) or banks that merely buy loans (but don t sell them). Treacy and Carey (1998) examined the credit risk rating mechanism at US Banks. The paper highlighted the architecture of Bank Internal Rating System and Operating Design of

163 rating system and made a comparison of bank system relative to the rating agency system. They concluded that banks internal rating system helps in managing credit risk, profitability analysis and product pricing. Duffee and Zhou (1999) model the effects on banks due to the introduction of a market for credit derivatives; particularly, credit-default swaps. Their paper examined that a bank can use swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the bank s financial distress. They concluded that the introduction of a credit derivatives market is not desirable because it can cause other markets for loan risksharing to break down. Financial Risk Financial risk arises when any business transaction is done by a bank, which is exposed to potential loss. This risk face by the bank can be further classified into following categories: a) Credit Risk- Management of credit risk is a key area for the banking sector and there are great opportunities for growth but some of financial institutions are facing problems. Therefore, the management of credit risk is an important tool for the survival of the banks. This is the risk of defaults on loans or risk of deterioration in the value of assets. Credit risk also includes the risk of loss resulting from the early repayment of the bank to earn higher interest income. Credit risk also arises due to excessive exposure of borrowers, industries or geographic areas. Element of country risk is also present, that the risk of loss, occurred due to the unfavorable position of foreign exchange reserves or adverse political or the economic situations in other country. The credit risk is the adverse impact on the financial result and capital of the Bank caused by borrowers default on its obligations to the Bank's policy.in other words; Management of credit risk is the risk assessment that comes in an investment. The risk is often on investment and capital allocation. The risks must be assessed so as to take the right investment decision and a decision must be made by the balancing between risk and return.

164 b) Interest Rate Risk- Interest rate risk is the potential negative impact on net interest income, and refers to the sensitivity of financial institutions to changes in interest rates. The interest rate changes affect earnings, value of assets, liability off-balance sheet items and cash flow. Earnings perspective is to examine the impact of changes in interest rates on accrual or reported earnings in the near future. This is measured by measuring the change in Net Interest Income (NII) is the difference between revenue between total interest income and total interest expense. c) Strategic Risk- This risk is arising out of certain strategic decision taken by the banks for sustain them in the present scenario. In most of the case, it is the risk of loss caused by a lack of long term development components in the banks managing team. d) FOREX Risk- This is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rate. The exchange rate risk is due to changes in exchange rates; the result is a negative impact on the financial assets and capital of the bank. Foreign exchange risk is the risk that the bank can suffer loss, due to unfavorable changes in exchange rates over time, which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one center and the settlement of another currency in another time zone. Banks also exposed to interest rate risk, which arises from the maturity inequality of foreign currency position.

165 e) Country Risk- this is the risk that arises as a result of cross-border transactions, which have increased significantly in recent years as a result of economic liberalization and globalization. There is possibility that the country will be unable to service and repay debts to foreign creditors on time. These transfers of risk occur due to the possibility of losses, due to the margins on external payments. Sovereign credit risk for the government of a sovereign nation, political risks, when the political environment or the legislative process in the country has led to the acquisition of assets from financial institutions, this country risk includes political and economic risks and the risk of transfer. Cross border risk arising on account of the borrower being a resident of a country other than the country where the cross border asset is booked; Currency Risk, a possibility that exchange rate change will alter the expected amount of principal and return on the lending or investment. f) Technology Risk - The risk is related to computers and communication technology, which is being gradually more introduced in the banks. This entails the risk of obsolescence and the risk of losing business to superior technologically. The essential elements of the risk management system are 1) Risk Identification - i.e. the naming and defining of each type of risk associated with a transaction or type of product or service. 2) Risk Measurement - i.e. estimate the size, the likelihood and duration of potential losses arising from the various scenarios. 3) Risk Control-i.e. formulation of policies and guidelines that define the risk limits, not only individually, but also in certain transactions Techniques of Risk Management GAP Analysis it is a tool to manage the risk of interest rate based on the Balance sheet, which focuses on the potential fluctuations in net interest income at specified intervals. In this method a maturity/ re-pricing schedule that distributes interest-sensitive assets, liabilities, and off-balance sheet positions into time bands according to their maturity (if fixed rate) or time remaining to their next re-pricing (if floating rate), is prepared. These schedules are then used sto generate indicators of interest-rate sensitivity of both earnings and economic value to changing interest rates. After selected time intervals, assets and liabilities grouped into time buckets after the maturity (for fixed rates) or first possible re-pricing time (for flexible rate s). The assets and liabilities that can be re-priced are called rate sensitive assets

166 (RSAs) and rate sensitive liabilities (RSLs) respectively. Interest sensitive gap (DGAP) reflects the differences between the volume of rate sensitive asset and the volume of rate sensitive liability and given by, GAP = RSAs RSLs The information on GAP gives the management an idea about impact on net income as a result of changes in interest rates. Positive GAP indicates that an increase in future interest rates will increase the interest income as the change in net interest income is greater than the change of interest expenses and vice versa. (Cumming and Beverly, 2001) a) Duration-GAP Analysis - It is another measure of interest rate risk and managing net interest income derived by taking into consideration all individual cash inflows and outflows. Duration is value and time weighted measure of maturity of all cash flows that indicates the average time required to recover the funds invested. Duration analysis can be viewed as the elasticity of the market value of an instrument with respect to interest rate. The duration gap (DGAP) reflects the differences in the time of assets and liabilities and cash flows, taking into account DGAP = DA -u DL. Where DA is the average duration of the assets, DL is the average duration of liabilities, and u is the liabilities/assets ratio. If interest rates increase by equivalent amount, Market value of assets falls more than liabilities, on the contrary, the decline in the market value of the equities and the expected net- interest income. (Cumming and Beverly, 2001) b) Value at Risk - It is one of the newer risk management tools. Value at Risk (VaR) shows how a company can lose or make with a certain probability in a given time horizon. VaR provides an overview of financial risks in the portfolio of a simple number. Although VaR is used to measure the market risk usually includes many other threats, such as currencies, commodities and equities. (Jorion 2001) c) Risk Adjusted Rate of Return on Capital (RAROC) - It gives an economic basis to measure all the relevant risks consistently and prepare managers to adjust strategy to make the efficient decisions regarding risk/return tradeoff in different assets. As the economic capital to protect financial institutions from unexpected losses, it is important to assign capital for the various threats that these institutions face. Risk Adjusted Rate of Return on Capital (RAROC) analysis shows that different Products and business need how much economic capital and determines the total return on capital of a firm. Though Risk Adjusted Rate of Return can be used to estimate the capital requirements for market, credit and operational risks, it is used as an integrated risk management tool (Crouhy and Robert, 2001)

167 d) Securitization - This is a procedure studied under the systems of structured finance or credit linked notes. Securitization of a bank s assets and loans is a device for raising new funds and reducing bank s risk exposures. The banks pool a group of income-earning assets (like mortgages) and sell securities in the open market. This is transformation of illiquid assets into tradable asset-backed securities. The income from securities depends upon the cash flows from the underlying asset prices, and burden of repaying is transferred from the originator to these pooled assets. e) Sensitivity Analysis - This is very useful when trying to determine the impact, the actual result of particular variable will have if it different from the previously assumed. By creating a given set of scenarios, Analyst determines how changes in the one variable (s) affects the size of the target variable. f) Internal Rating System - The internal rating system helps financial institutions to manage and control credit risk faced by banks and other business operation transactions arising due to from lending operations and thereby assessing and managing the credit worthiness of borrowers and the quality of credit transactions. Conclusions The following are the conclusions of the study: Risk emphasized that the survival of the organization depends on the ability to anticipate and adapt to change, rather than waiting for changes and react. The objective of risk management is not to prohibit or otherwise impede the activities of risk-taking, but to ensure that risks are taken in full awareness, a clear focus and understanding, so that it can be measured and limited. Risk functions is bank specific and depends upon the size and quality of bank balance sheets, complexity of functions, education / training and technical status of MIS place on the bank. Bank should form various committees like Risk Management Committee, Credit Policy Committee, and Asset Liability Committee to handle risk management aspects. Bank can take more conscious decision by anticipating adverse change and hedge the risk accordingly and, therefore, assume a higher risk of awareness to achieve competitive advantage so as to offer their product that is the source of competitive advantage in that they offer their products at a better price than the competitors.

168 Books References - Bidani S.N., (2002), Managing Non-Performing Assets in Banks, Vision Books publishers, Ref:#8-02-06-12, pp.71-74. - Eddie Cade, (1997), Managing Banking Risks, First Edition, Woodhead Publishing Ltd., In association with The Chartered Institute of Bankers, England, pp. 104 144. - James T. Gleason, (2001), Risk The New Management Imperative in Finance, Jaico Publishing house, pp. 13-19. & 113-121. - Johan E.Mckinley & John. R. Barrickman, (1994), Strategic Credit Risk Management, Robert Morris Association, Philadelphia, pp. 1-12, 20-27, 36-42, 62-68. - Joseph F. Sinkey, Jr., (1998), Commercial Bank Financial Management In the Financial Services Industry, Fifth Edition, Prentice-Hall International Inc., New Jersey. pp. 22-35, / 213-220 and 404-408. - Timolthy W.Koch, (1998), Bank Management, Library of Congress Cataloging-in- Publication Data, pp. 431-440. - Timothy W. Koch, (1998), Bank Management - Overview of credit policy and loan characterstics, Third Edition, The Dryden Press, Harcourt Brace College Publishers, pp. 431-440 and 629-630. Articles - Agarwal P. and Srikanth V (2002), A question of Reliability, Economic Times, July 24, 2002. - Konishi, M., Yasuda, Y., 2004. Factors Affecting Bank Risk Taking: Evidence from Japan. Journal of Banking and Finance 28: 215-232.

169 - Kwan, S and Eisenbeis, R, 1997. Bank Risk, Capitalization and Operating Efficiency. Journal of Financial Services Research 12, 117-131. - Matthews, K. and J. Thompson, 2008. The Economics of Banking. Chichester: Wiley, 2008; Chapter 3, pp.99-143. - McNamee, D., 1997. Risk Management Today and Tomorrow. Wellington, New Zealand : State Services Commission. - Neely, Michelle Clark, and David Wheelock, 1997. Why Does Bank Performance Vary Across States? Federal Reserve Bank of St. Louis Review, March/April, 27 40