Banks face three major types of risks: Credit Risk, Market Risk and Operational Risk.
Banks are in the business of accepting deposits and lending: they operate mainly with depositors’ funds. Unfortunately, not all the monies lent, and the interest due thereon, is recovered. The borrower may default in his obligations to pay periodic interest or the principal sum or both as per the terms and conditions governing the loan due to occurrence of one or more of credit loss events e.g. he may suffer loss in business and become bankrupt or he may simply refuse to pay. The banks’ actual returns on their average outstandings in the loan book, almost always, turn out to be lower than the contractual rates applicable thereon. Banks are also required to periodically write off loss assets or accept less than 100% of the money lent or interest accrued thereon as part of a compromise deal. The interest actually collected is thus required to be adjusted to absorb losses incurred in the shape of loan write offs to calculate Risk Adjusted Return on Capital (RAROC). Needless to mention, if a bank’s portfolio of loan assets contains a high percentage of NPAs, it cannot earn enough interest to meet its costs of operations including write offs; it may also not be in a position to meet its obligation to its depositors. Hence, much attention is being given to management of Credit Risk. The concept of RAROC, i.e. Risk Adjusted Return on Capital highlights this aspect and helps bankers price their loan products appropriately, based on past loan loss data, so that they can earn enough interest to take care of the expected delinquencies.
Apart from transaction risk or the risk of default as described above, credit risk may also arise due to high exposure levels or concentration of a particular business activity in the loan portfolio or severe debilitating impact of area-specific developments on a concentration of a particular type of industry in a geographical location, or simply the failure of the counter-party to fulfil its part of a trade transaction because of adverse changes or non-materialisation of the assumptions made by at the time of entering into the deal.
Conventional CR control measures include sound and scientific appraisal and assessment techniques, including fixing of individual and group exposure limits, as well as proper post-sanction follow up. Banks regularly use Financial Analysis and Credit Rating Models, or the more sophisticated Credit Scoring Models to take a credit decision such as how much exposure they will be willing to take on a particular firm/group or in a particular industry/business. Banks also prefer to have standard Credit Risk mitigating measures in place e.g. Credit Enhancement in the form of institutional or personal or third party guarantees, mortgages, charge on inventory, receivables and machinery etc., as well as pledge of securities, shares and other valuable assets. The feeling of being a secured creditor lends comfort and forms an important part of the conventional CR management. Similarly, creation of Trust and Retention Accounts, as part of an Escrow Mechanism, provides some degree of comfort in revenue earning infrastructure project.
We are now increasingly hearing of the use of hedging techniques like Credit Derivatives where returns on loans or the value of advances or both are being guaranteed by a third party for a fee. Interestingly, some of these products display the characteristics of Asset Securitisation in offering the facility of “Off – Balance Sheet Financing” thereby helping in reducing the need for economic capital.
Banks have to apply specific risk weights to different categories of risky assets to calculate the needed amount of risk capital to meet Basel Committee norms on Capital Adequacy. The CAR (Capital Adequacy Ratio) acts as a limiting factor for the size of Balance Sheet, preventing a bank from acquiring too high a portfolio of assets without adequate risk capital. This, however, in no way reduces the need to take extra-ordinary care while sanctioning and handling new loans.
Market Risk may be defined as the possibility of loss to a bank caused by the volatility in market variables. MR covers the interest rate risk, exchange fluctuation risk, equity price risk and commodity price risk. Banks also usually include Liquidity Risk in Market Risk, because liquidity is essential to manage Market Risk.
In the course of their normal business, bankers sometimes become holders for value in respect of valuables like foreign exchange, securities (stock), commodities or goods, or futures therein. Bankers also sometimes acquire positions to engage in what is known as proprietary trading. The market value of these assets experience volatility, sometimes very wild volatility, which may bring in a large bonus, in the shape of a huge windfall. However, even if such acquisitions are made after scientific appraisals, predictions sometimes do go awry, leading to unexpected fall in the value of the assets held. The larger the value of such assets and the greater the observed volatility therein, greater is the Market Risk embedded in the balance sheet. Forex dealers avoid such risks by keeping nil or minimal open positions in foreign currency and by obtaining forward cover. Dealers dispose of securities, wherever possible, by keeping track of expected movements and by implementing cut loss limits.
Interest Rate Risk is a part of every banker’s regular worry. The PLR, on the basis of which the rates charged to borrowers is usually fixed, is normally aligned to the Bank Rate, whereas the deposits may be repriced on the maturity dates based on LIBOR or MIBOR. This approach of adopting different bases for deposits and advances gives rise to Basis Risk. In the case of a fixed interest rate contract, interest on the existing deposits is paid at the contractual rate for the term of the deposit even if the rate falls and banks have no option to force either pre-mature repayment or reduce the interest rate. On the asset side, in the case of a fixed interest rate loan, borrowers demand a rate cut in a falling interest rate scenario; else they may shift to another bank if there are no significant pre-payment penalties. Thus, the average cost of deposits falls much more slowly whereas interest earnings on loans start falling immediately on the announcement of a rate cut, thereby affecting Net Interest Margin. The risk of loss of earnings on account of the option of pre-mature termination of contract being with the depositors or borrowers is called the Embedded Options risk. The banks may hedge this form of interest rate risk by swapping, say, fixed rate loans with floating rate loans, to reduce the volatility in their earnings.
Another less appreciated impact comes from the inverse relationship between interest rates and the value of portfolio investment. When the market rate of interest falls, the sale value of fixed coupon securities in the portfolio goes up, representing capital gain. Since banks in India usually invest almost 50% of their funds in Government securities, they rake in the moolah when the interest rates move southward, but they have to be aware of the catastrophic impact on their profit and loss account in the event of interest rates hardening. Banks employ several risk indicators including Value at Risk (VaR), which indicates the downside risk in the event of interest rates going up by 1%.
Liquidity Risk arises in a situation where a bank is likely to be short of liquid funds at a critical juncture, to meet its maturing obligations or expected/ unexpected demands from the public for cash or to meet its CRR obligations. Liquidity Risk may have serious implications. Those who do not have the needed liquidity because their funds are locked in illiquid assets, which can be converted into cash only at a considerable loss, find themselves in a quandary when market offers wonderful money making opportunities.
Much of the ALCO’s time goes into liquidity planning, setting guidelines on the basis of “ GAP “ analysis in regard to acceptable risk parameters (which affect the ultimate size and composition of the bank’s balance sheet) as well as the maturity structure of assets and liabilities, and whether the bank should go in for interest rate swaps, and also whether it should consider “off-balance sheet” financing to reduce the need for economic capital. Decisions on pricing of all deregulated products – both deposits and loans, is the prerogative of the ALCO.
The Basle Committee has proposed, in its 3-pillar approach for Risk Management, that risk capital for Market Risk should be separately provided for.