Risk Management in Banking Sector
Risk Management in Banking Sector
Banking sectors play a pivotal role in the management of the country. Hence our banking system faces risk in day to day. For efficient economy our banking should be risk free. The risks face by banking sector as follows as
Interest Rate Risk
Credit or Default Risk
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.
(a) Funding Risk: 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 from the need to compensate for nonreceipt of expected inflows of funds i.e., performing assets turning into non-performing assets.
(c) Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise when it arises.
The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. 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. 87 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: Forex 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. en a bank may not be able to undertake profitable business opportunities when it arises.
Interest Rate Risk
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
Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms. For most banks, loans are the largest and most obvious source of credit risk. It is the most significant risk, more so in the Indian scenario where the NPA level of the banking system is significantly high.
Now, let’s discuss the two variants of credit risk –
(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 standard credit risk.
(b) Country Risk: This is also a type of credit risk where non-performance of a borrower or counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance 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 Deficiency in credit policy and administration of loan portfolio, Deficiency in appraising borrower’s financial position prior to lending, Excessive dependence on collaterals and Bank’s failure in post-sanction follow-up, etc.
The major external factors are the state of Economy, Swings in commodity price, foreign exchange rates and interest rates, etc.
Credit Risk can’t be avoided but can be mitigated by applying various risk-mitigating processes
Banks should assess the credit-worthiness of the borrower before sanctioning loan i.e., Credit rating of the borrower should be done beforehand. Credit rating is the main tool of measuring credit risk and it also facilitates pricing the loan.
By applying a regular evaluation and rating system of all investment opportunities, banks can reduce its credit risk as it can get vital information of the inherent weaknesses of the account.
Banks should fix prudential limits on various aspects of credit – benchmarking Current Ratio, Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.
There should be maximum limit exposure for single/ group borrower.
There should be provision for flexibility to allow variations for very special circumstances.
Alertness on the part of operating staff at all stages of credit dispensation – appraisal, disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit risk
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-linkages
Scope of operational risk is very wide because of the above 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.
Apart from the above mentioned risks, following are the other risks confronted by Banks in course of their business operations
(a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organisation’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals and the quality of implementation.
(b) Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss or decline in customer base. e (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.