Risk in Banking Sector
Paper presentation On Risk in banking sector. Abstract: The structure of the paper is three-fold, where we begin by what is risk in banking scenario and its effects on internal operations of a bank, followed by the various types of risk in Indian banks and what can be done or the measurements taken and finally the future look.
Introduction: The Indian Financial System is tasting success of a decade of financial sector reforms. The economy is surging and has gathered the critical mass to convert it into a force to reckon with.The regulatory framework in India has sparked growth and key structural reforms have improved the asset quality and profitability of banks. Growing integration of economies and the markets around the world is making global banking a reality. The RBI requires all banks to comply with the standardized approach of the BASEL II accord by 31st March, 2007. This paper attempts to project the implications of this transition and its effects on the internal operations of a bank followed by its effects on the banking industry and the economy.What is Risk? For the purpose of these guidelines financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts.
Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives Regardless of the sophistication of the measures, banks often distinguish between expected and unexpected losses.Expected losses are those that the bank knows with reasonable certainty will occur (e. g. , the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Unexpected losses are those associated with unforeseen events (e. g. Losses due to a sudden down turn in economy or falling interest rates).
Types of risk in banks: In the course of their operations, banks are invariably faced with different types of risks that may have a potentially negative effect on their business.The risks to which a bank is particularly exposed in its operations are: liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and risk from change in market price of securities, financial derivatives and commodities), exposure risks, investment risks, risks relating to the country of origin of the entity to which a bank is exposed, operational risk, legal risk, reputational risk and strategic risk. Liquidity risk: is the risk of negative effects on the financial result and capital of the bank caused by the bank’s inability to meet all its due obligations.Credit risk: is the risk of negative effects on the financial result and capital of the bank caused by borrower’s default on its obligations to the bank. Market risk: includes interest rate and foreign exchange risk. Interest rate: risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates. Foreign exchange: risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates.
A special type of market risk is the risk of change in the market price of securities, financial derivatives or commodities traded or tradable in the market. Exposure risks: include risks of bank’s exposure to a single entity or a group of related entities, and risks of banks’ exposure to a single entity related with the bank. Investment risks: include risks of bank’s investments in entities that are not entities in the financial sector and in fixed assets.Operational risk: is the risk of negative effects on the financial result and capital of the bank caused by omissions in the work of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events. Legal risk: is 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.Reputational risk: is the risk of loss caused by a negative impact on the market positioning of the bank. Strategic risk: is the risk of loss caused by a lack of a long-term development component in the bank’s managing team.
Risk management: Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels. a) Strategic level: It encompasses risk management functions performed by senior management and BOD. For instance definition of risks, formulating strategy and policies for managing risk etc; b) Macro Level: It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management. c) Micro Level: It involves ‘On-the-line’ risk management where risks are actually created.This is the risk management activities performed by individuals who take risk on organization’s behalf such as front office and loan origination functions.
Risk management in bank operations includes risk identification, measurement and assessment, and its objective is to minimize negative effects risks can have on the financial result and capital of a bank. Banks are therefore required to form a special organizational unit in charge of risk management. Also, they are required to prescribe procedures for risk identification, easurement and assessment, as well as procedures for risk management. The future: Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks Conclusion:By taking measures the smaller banks would not have sufficient resources to withstand the intense competition of the sector. Banks would evolve to be a complete and pure financial services provider, catering to all the financial needs of the economy.
Flow of capital will increase and setting up of bases in foreign countries will become commonplace. Finally, the economy will stand to benefit as the banking sector develops. Savings will be mobilized in the right direction and the required funds needed for the country’s development will be made available.