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Financial risk management:1

Mohan Manohar January 22, 2013
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Introduction:

Going by experience and common sense, it seems that there cannot be any human activity that does not expose the people involved in that activity to some form of risk or the other. Whether it is the common activity of taking food and the possibility that bits of it may get lodged in the windpipe, or it relates to taking a vital investment decision, everywhere we find that risk is unavoidable. Therefore, we can say, “risk taking is a way of life”. It is said: “ a person who does not take risk in life, risks everything in life”.

In this article, we shall discuss some of the basic concepts of financial risks faced by banks and how effectively they are being managed.

Till the late eighties, banks in India were following more or less a traditional approach, confining themselves to the basic banking, namely, getting deposits from the public and lending to the business and industry to make a profit out of the differential in interest. In the recent years, the following factors have forced the banks to look beyond traditional banking to broad-base their activities and also for product innovation.

Deregulation
Liberalisation
Globalisation
Disintermediation
Increasing bankruptcies/conditions of financial distress in the corporate sector
Entry of new banks
Growth of technology
New products introduced by competitors

Broad-basing and innovation essentially mean taking new responsibilities and exposures, which have in-built uncertainties. Banks, while adapting to the changing environment, have to necessarily build a structure which will ensure that they pass through all the uncertainties by guarding themselves against the possible losses.

What is the broad meaning of risk (acceptable to the banks/financial institutions)?

The loss suffered by an organisation (in normal circumstances) can be broadly classified into expected loss and unexpected loss. Based on past experience, a statistical measure of loss expected to be incurred in similar situations in future can be rationally thought of. However, unexpected losses are difficult to measure. Unexpected losses are also caused by probable events but their occurrence is uncertain. Nevertheless, unexpected loss can be calculated if the probability distribution of expected loss is known.

Risks have been classified in a number of ways, depending on the basis of classification. For instance, risks can be divided into balance sheet risks and off-balance sheet risks. Risks can also be classified as systemic and non-systemic or controllable and non-controllable. Systemic risks are basically risks associated with the system within which the organisation functions. For an industrial unit, risks associated with the related industry segment are systemic risks since all similarly placed industrial units within that segment are uniformly exposed to the same risks. Systemic risks are largely non-controllable. In contrast, non-systemic risks are organisation-specific and can be controlled in good measure.

Whether it is traditional banking or modern banking, what are the financial risks that banks face in their operations?

Funds lent or invested may not be recovered – Risk of Default, Transaction Risk, Counter-party Risk or simply, Credit Risk.
Funds lent or invested are recovered, but not when due – Liquidity Risk or Re-pricing Risk
Funds lent or invested may lose value over a period of time because of certain economic factors – Market Risk (Interest Rate Risk, Exchange Risk, Price Risk)
Certain operational mishaps or acts of God (and also acts of man!) may turn into financial loss – Operational Risk

Before proceeding to discuss the risks confronting banks in the Indian context, let us briefly peep into the international arena, because Indian banking industry is in the process of adapting itself to changes at the global level.

The Latin American debt crisis of 1980s, the global property downturn of 1990s, the Asian financial crisis of 1997 – all took a heavy toll on the banking and financial industry. After each crisis, the predictable reaction of the industry was to tighten the standards in the disbursement of advances, thereby restricting the growth in lending.

If we look at the response of the banking industry to the changing environment in the economy, it is almost similar through out the world. When excessive opportunity for growth is seen in a particular segment, all banks participate with enthusiasm as if there would be no end to the potential. The moment the cycle turns, they immediately react with strong corrective measures to ensure that the same situation does not affect them again. But, unfortunately, different events strike them in different ways at different times. We can see a cycle, as explained hereunder, which needs to be corrected.

                                               Assume non-viable exposures        

                Go for aggressive marketing                                Slip into loss

                        Lose market share                                Impose restrictions

                                                Shy away from normal risks

With a view to taking care of such situations and to ensure that the banking industry globally is able to withstand any financial crisis, the Basel Committee on Banking Supervision suggested Capital Standards in 1988 and after acceptance of the Standards by most of the countries, it became a Capital Accord, coming into force in 1992. This mainly achieved two purposes:

1) To withstand any sudden financial shock of loss, a bank should have adequate capital to serve as a cushion. At that time, credit risk was perceived as a major risk. Therefore, Basel Committee suggested that a minimum capital to risk-weighted assets ratio of 8% be uniformly maintained by all commercial banks, in particular by the internationally active banks.

2) As the standard was to be made applicable to all the countries, the term Capital also was defined and made applicable uniformly.

Initially, only credit risk was covered by the Accord. Subsequently, in 1996, the Accord was partially amended to include market risk. The amendment which came into force at the end of 1997. It separates bank’s assets into two categories, namely, the trading book (financial instruments intentionally held for short-term sale and typically marked-to-market), and the banking book (other instruments, meant to be held to maturity). A capital charge for market risk of trading book and the currency and commodity risk of the banking book was also added. Almost simultaneously, it was realised that there was a need to issue specific guiding principles for management of operational risk also.

On a review of the Accord, the Basel Committee noted two important factors:

a) The uncertainty faced by banks is not confined to only credit risk. Banks may incur loss on account of operational risks for which also they need to have adequate capital.
b) In the existing Accord, the committee has not made any distinction between a highly rated borrower and a not-so-well rated borrower while specifying risk weights for assessing credit risk. The Accord follows more or less a broad-brush approach as there is no incentive for banks to go in for high quality financial exposures and also no disincentive for those banks who indulge in risky financial exposures.

To take care of these aspects, the Basel Committee released a consultative paper in June 1999, which proposed a new approach, built around the following three mutually reinforcing pillars of performance:

Economic Capital (Minimum Capital Requirements)
Supervisory Review Process, and
Market Discipline.

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Mohan Manohar

Mohan Manohar is a blogger from India who founded Ittech back in 2007. He is passionate about all things tech and knows the Internet and computers like the back of his hand.

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