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 risksWith 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.
While “supervisory review” relates to the effective ways of supervision of banks by the Regulator and “market discipline” deals with strengthening of disclosures by banks and safe and sound banking practices, the concept of “Economic Capital” seeks to further refine and sophisticate the system of assessing various risks faced by banks and maintaining adequate capital in relation to the totality of the risks assessed. The third and final consultative document enshrining the New Capital accord was released by the Basel Committee for comments on April 29, 2003. The new accord is to be finalised by the end of the current year whereafter it will be implemented by internationally banks by December 2006.
As against the broad-brush approach in the existing Accord, the New Accord contains the following suggestions:
The Economic Capital will be calculated for financial risks as well as operational risks because operational risks will mostly turn into financial losses. The risks arise mainly on account of the following: –
Exposures on account of lending operations.
Exposures on account of market operations viz. investment and trading in securities and operations in forex markets.
Exposures on account of general banking operations, where any failure on account of internal process, people, systems or technology or external events may result in substantial financial losses (as well as other losses e.g. reputation loss)
Capital Adequacy will be measured as follows:-
Total capital/( Credit Risk + Market Risk + Operational Risk) > 8%
Risk quantification is not just a regulatory requirement. Banks should put in place a system to understand, measure and manage/control their exposures to developments in the market and to counter-parties. From a psychological angle also, their ‘response’ will be more appropriate and need-driven when banks know their situation. The approach to measuring each type of risk is to assess both the expected loss and unexpected losses using appropriate analytical methods/models and empirical data-bases or Monte-Carlo simulation. Unlike the existing Accord under which banks have to provide adequate capital only for counter-party risks, now banks will have to provide capital to cover all possible losses and calculated in a more rational and data-based manner.
Calculating Credit Risk Capital
For calculation of regulatory capital for credit risks, the Basel Committee has suggested the following approaches which may be implemented by banks in a phased manner.
a. The Standardised Approach
Under this approach, the counter-parties are to be grouped into Sovereigns, Banks and Corporates and instead of assigning a uniform risk weight to all the borrowers, differential risk weights will be assigned to them on the basis of external risk assessments by the credit rating agencies
For Sovereigns, the risk weights will range from 0% to 100% and for Banks and Corporates, the range will be from 20% to 150%. This approach will ensure that a bank knows the quality of its exposures to strengthen its capital base according to the risks it takes. It will also be a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas, it can make timely corrections.b. Internal Ratings Based (IRB) Approaches
In comparison to the Standardised Approach, the internal ratings based approach is more sophisticated because in respect of each exposure, banks are asked to foresee the possibility of a shift in the asset quality over a period of time. This can be done by working out the probability of default, the probability of loss in the event of default and the exposure at default, for individual credit exposures as well as the portfolio, with correlations between different exposures in the portfolio duly accounted for.
Probability of default (PD): Banks have to calculate the movement of asset quality over a period of time and work out the likelihood of default. Computation of the PD will give an indication as to how the assets will behave in future for a given a set of specific conditions and whether they are likely to gain or lose quality over a given time horizon. This will enable the banks to predict the behavioural pattern of assets and accordingly, they can redistribute their assets to avoid or mitigate future losses.Loss Given Default (LGD): Loss given default or loss in the event of default (LIED) is a measure of the probability of loss. The quantum of loss in the event of default is calculated after taking into account the security available etc. This will provide a tool to the banks to make an assessment of loss that may occur in the event of the default taking place. In this process, banks are to carry out the analysis taking into account factors such as recoveries expected until the default as well as the realisable value of the security that would be available at the time of default, which are the two main factors which must be considered. This will help them review their portfolio and also their own financial decision making strategies.
Exposure at Default (EAD): The exposure in the books in the event of default is calculated. This enables the banks to quantify the exposure which may be at default, as distinct from the exposure which will not pose any problem of recovery.
The capital to be maintained will be arrived at after taking into account all the three factors. For calculating the quantum of risk capital required to meet unexpected losses, banks need to develop models and build a database for a minimum period of seven years. The Basel Committee has also suggested that the IRB approach can be either the “basic” approach or an “advanced” approach. Under the basic approach, while each bank can have its own model for calculating PD, the Central Bank of the country will stipulate models for calculating LGD and EAD uniformly for all the banks. Under the advanced approach, each bank can have its own models for PD, LGD and EAD, subject to the Central Bank satisfying itself as to the correctness and accuracy of the model.
Calculating Market Risk Capital
Besides credit exposures, Banks also take financial exposure by way of investments and trading in securities and money market and forex market operations. These operations, if not properly regulated, have the potential of turning into loss events for the banks. To take care of /manage such risks, the Committee has suggested the implementation of “Asset-Liability Management” (ALM). Also, prudential norms for each exposure, fixing position limits for taking open position in any particular exposure over a time horizon, and cut loss limits to ensure that actual loss does not go beyond a point in the hope of making up the losses, have been suggested by the Committee for implementation.
In India, RBI has already introduced most of the risk management measures indicated by the Basel Committee, as Indian Banking Sector has to align itself with the international best practices.
The objective of market risk management is not only to get maximum benefit from market operations but also to build safeguards to contain losses resulting from adverse interest rate and price movements.
