Risks in Banking and their management

Current turmoil in some US and European Banks has raised questions (in minds of general public) about various risks being faced by Banks, especially in the Indian context, and what measures Banks adopt for mitigation of such risks

 

Risk in Banking

According to Wikipedia, The Oxford English Dictionary (OED) 3^rd edition defines risk as: “(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.” Risks are inherent in business of banking. A bank which does not take fair amount of risk cannot grow. Excessive risk may result in faster growth in the short term but at the same time could lead the Bank to a situation which may not be good for its stakeholders.

 

As Banks primarily deal with money, perception of risk regarding Bank’s business or stability acquires added significance. Trust is the essential factor in business of banking and therefore it’s very important for Banks to see that the trust factor remains intact and for this purpose, Banks have to be very careful about managing risks. This includes proper identification of risk and initiation of correct measures to mitigate the risk.

Financial and non-Financial Risks

Risks in Banking, can be classified into financial and non-financial risks. Financial risks are those which are connected directly with a Bank’s business decisions like credit risk, Liquidity risk or market risk. These risks may directly impact Bank’s earnings and may lead to impairment of Bank’s capital in such a way that it is unable to fulfil its business objectives. Non-financial risks are determined by external factors and relate to Banks’ operations. They may impact its business growth or market share, for example operational risk or geographical risk etc

 

Credit Risks

Business of banking and risks go together and out of all the risks, delinquencies and stress in the loan portfolio remain the most worrisome scenario for any Banker. Credit risk is probably the most important of all the risks, as it has the capability of causing maximum damage to a Bank’s balance sheet. Credit risks denote a possibility of a customer not repaying Bank’s loan or interest thereupon, either intentionally or circumstantially. Inability to pay has a time factor also i.e. delayed payments beyond a threshold may also trigger a risky situation for the Bank.

Crux of a credit risk management structure is to minimize the risk and keep it within acceptable levels. The process consists of following stages –

a) Distribution of Bank’s total loan portfolio between different industries, fixing quantitative sectoral ceilings and capping exposure limits for individual corporate groups so as to diversify Bank’s credit portfolio;

b) Selection of customers at the front end. A bank conducts an elaborate credit appraisal exercise looking into the customer’s past history, his qualifications and capability, market reputation, financial soundness and viability of the proposed project.

c) Filtration of a loan proposal at multiple levels depending on its size, so that any large exposure is scrutinised by senior and experienced bankers.

d) Pricing of loans based on their credit rating. Those with lower ratings are charged more, as the Bank has to set aside additional capital for weaker borrowers.

e) Review of all loan accounts at periodic intervals through various audit processes for early detection of any possible delinquencies.

 

It is not possible to eliminate credit risks altogether as they are inherent in the business of banking, so Banks strive to lower their risk as far as possible.

 

Market Risks

Market risks may be defined as the possibility of Bank being exposed to losses on account of unexpected variations in market parameters like interest rates, foreign currency exchange rates. Any volatility in these parameters may adversely affect Bank’s income and may also lead to capital erosion. Apart from earning profits through lending, Banks also invest in securities either under regulatory compulsion or as short term treasury investments. Banks are exposed to market risks for both credit as well as investment portfolios.

Although the market risk management framework is meant to tackle any change in Bank’s market environment, but it essentially takes care of Interest rate fluctuations. There is a variance between maturities of a Bank’s assets and liabilities meaning loans and deposits. Interest rates may fluctuate unpredictably. A reduction in loan rates consequent to changes in RBI’s monetary policy may have to be transmitted faster while it may not be possible to correspondingly reduce interest rates on deposits (have to wait till deposits mature). This makes it challenging for the Bank to manage its average net interest margin i.e. difference between interest earned and paid and to prevent any losses. For this, Banks have to balance maturities of its assets and liabilities.

 

Another type of risk relates to market investments, which are initially booked at the acquisition price and periodically have to be marked-to-market. This may result in gains or losses for the Bank. Therefore market risk is also sometimes described as risk during the period required to liquidate a particular transaction. This aspect was recently amplified in the case of US based Silicon Valley Bank, where the Bank ran into deep trouble on account of abnormal increase in interest rates impacting its investment portfolio.

Liquidity Risks

A Bank accepts deposits from customers having surplus funds and lends the same to those who require these funds. Banks earn profits on this intermediation. But all the deposits which are accepted are not used for lending as per regulatory prescription. Banks are required to maintain core liquidity in the form of Cash Reserve Ratio (CRR), which is used to meet demand from customers who wish to withdraw their funds. Additional funds are parked in Government securities (as Statutory Liquidity Ratio–SLR) for extra cushion. But it also means that theoretically, if all the customers want to withdraw their deposits at the same time, Banks will not be in a position to return the deposits. Any such eventuality may trigger a Liquidity crisis for the Bank. Recent crisis faced by US regional Banks is an example.

Liquidity risk is a situation where the Bank is not able to meet its obligation to its depositors i.e. when the depositors request for withdrawal as per contracted terms, Such a situation may also arise since maturities of Bank deposits do not match with maturity period of loans. A large portion of Bank deposits is in the form of demand deposits i.e. Current account and savings bank (commonly known as CASA) and Banks actively mobilise such accounts due to low interest cost. But the same funds are deployed in loans which cannot be recovered instantly This mismatch between maturities of sources and uses of funds, where short term liabilities are deployed towards long term assets, can create a liquidity risk for the Bank, if not managed properly.

Even delay in payment to a depositor can spread rumors about financial health of the Bank with a cascading effect where more people, who don’t have any immediate fund requirements, also try to withdraw their deposit, as they may be worried about safety of their funds. This may trigger what is known as a run on the Bank. In such a situation, even a well-managed Bank may find it difficult to meet immediate cash withdrawal requirements.

 

Operational Risks

The Basel Committee on Banking Supervision defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk”. (International Convergence of Capital Measurement and Capital Standards (the revised Basel II framework), November 2005, Paragraph 644)

Operational risks cover all facets of a bank’s business. These risks may arise from absence of adequate internal control guidelines and procedures for conducting Bank’s business or non-compliance of such guidelines by operational staff. It also covers risks triggered by unexpected external factors. Operational risk also includes legal risk i.e. risk of loss caused on account of penalties imposed by the Regulator or a court of law. Thus Operational risks include any risk apart from credit or market risk which may be caused by failure of internal control processes.

 

Geographical Risks

Geographical or Country risk, refers to cross border lending risks. Globalisation has brought about seamless trade opportunities, but at the same time it has increased business risks. In this case, risk shifts from an individual counter party to a country as a whole. Banks have their own country risk assessment models, where exposure norms on various countries are continuously evaluated. So its possible that some countries may not be acceptable to some Banks, but other Banks may be willing to take exposure.

Just like an individual, a country may also face liquidity problems, especially in international currencies like US Dollars. This means that a particular country may not have adequate foreign exchange reserves, to meet its import commitments. This may affect residents of such a country, in their international transactions. Today this scenario is evident in Russia , as the country has been affected by sanctions from US and its European allies

Reputational Risks

Banks, like any other business, build brands with great effort not only for identification and business promotion but also to build trust with its customers. Its imperative for a Bank to maintain its reputation. Any action which impinges on Bank’s trustworthiness can be a reputational risk for the Bank.

Reputational risk is one of the most difficult risks to handle due to its intangible nature. It relates to a loss of confidence in the Bank which may be guided by public perception of an actual wrongdoing on part of the Bank or just a belief that the Bank has been indulging in malpractices, which could be just a rumor. Therefore brand building is very important for Banks.

Customers trust Banks with their savings and wealth, only if they believe that the Bank is safe and follows sound business practices. Any whiff of bad news about a Bank or even a rumour may trigger a run on the Bank. We have seen this with Global Trust Bank in August 2004, ICICI Bank in April 2003 and September 2008 and with Yes Bank as late as March 2020. A crisis like LIBOR manipulation scandal singed Barclays Bank badly in June 2012.

In a country like India, where general public does not cross check news and gets carried away by rumors very easily, the window available to the Bank for salvaging its reputation is very narrow, may be few hours or days. Therefore Banks have to remain very vigilant and activate suitable risk mitigation measures very promptly, otherwise its very difficult to save a run on the bank.

 

Management of Risks

Risk management in Banks, is a continuous process. RBI had issued guidelines in October, 1999 advising all Banks to establish integrated risk management systems. At that time RBI had laid down broad contours for management of credit, liquidity, interest rate, foreign exchange and operational risks..

Risk Management involves forecasting risks, their proper identification and drawing up a strategy to overcome the hindrance. It may not be possible to eliminate risk completely, but its impact can be minimized. Development of risk management systems does not aim at risk elimination, but for adoption of policies and financial tools to keep various risks within acceptable or manageable levels.

Risk Management systems in Banks have to be conceptualized keeping future probabilities in mind and implemented in an integrated manner.  Establishment of a Risk management structure in a Bank comprises of the following steps –

a)  Identification and assessment of circumstances which can lead to a risk situation;

b)  Measurement and quantification of risk ;

c) Control through various financial tools including fixation of exposure ceilings, diversification of business portfolio and appropriate securitization of exposure;

d)  Monitoring with development of appropriate testing models;

e)  Integration and alignment of risk models with Bank’s strategies and decision making process so that a proper risk culture develops at all the levels in the bank

 

Various risk scenarios, as discussed above, are not dealt with, in isolation but as part of an interlinked system.

 

RBI’s role in Risk Management

RBI, as the central regulator has a very vital role in supervising and guiding Banks towards adoption of best Risk management practices. In this context, RBI has a dual role. One, a continuous assessment of Banks themselves from overall Risk perspective mainly asset liability management and secondly issuing guidelines for Banks to adopt sound risk management guidelines for internal day to day business in credit, market and operational areas

In 1988, the Basel Committee on Banking Supervision (formed by Bank for International Settlements – BIS) recommended using Capital adequacy, Assets quality, Management quality, Earnings and Liquidity (CAMEL) as criteria for assessing a Financial Institution. The sixth component, sensitivity to market risk (S) was added to CAMEL in 1997. Since 1999, RBI has been using CAMELS rating model for assessing Banks in India.