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Financial Risk Management

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. B

ut, unfortunately, different events strike them in different ways at different times. We can see a cycle, as explained here under, 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.

Real Time management

Plenty of thoughts to ponder upon and I was 8 years old boy seating at the verandah and waiting for daddy to reach home so that I could go with daddy to market. Daddy reached home from tour by office vehicle and the driver, carried daddy’s suitcase to home and then he asked daddy for permission, and daddy gave him permission and then he went away. Elders feel at ease while talking with daddy, as daddy has always been in principles and always obey elders and always punctual to the tune of it’s fullest.Similarly in one such incident of sweeper management and as most of the time they had been drunk and they used to reach at office late.

Daddy deeply thought about it as the cleanness at the office premises is the need of   hour, then daddy inquired about the messenger and then knew that he had one step brother , he is a good person having the disciplined life style and also very obedient. Then, daddy appointed him as this appointment is of temporary nature and appointment and removal of them is on the hands of chief manager and for this the work goes on smoothly for some time. 

Then, after 10 minutes daddy called new sweeper to his office premises and as usual daddy gave him the tiffin, he sanctioned for him and then asked him, what he did tell him, he said, simply he told his step brother to go out from this place, as he was now been appointed and he said to him to search for a newer job, as this was easier for him to correspond as compared to daddy told him, as he could take daddy’s good words as some sort of not good for him and for this daddy called upon sweeper’s step brother , and appointing him instead and then he told his brother , instead of daddy and that was the real management decision as with this , the first sweeper understand that , his brother is now been appointed and now it is the time for him to leave and in this manner he could not find the real intimations that had been given to him through daddy , though in some other manners and that is the real management. The other model is multi attribute model, it depends upon management lessons and its various attributes that has been there with it and how these could make decision making more interesting with time and knowledge.


Plenty of thoughts to ponder upon and I was 8 years old boy seating at the verandah and waiting for daddy to reach home so that I could go with daddy to market. Daddy reached home from tour by office vehicle and the driver, carried daddy’s suitcase to home and then he asked daddy for permission, and daddy gave him permission and then he went away. Elders feel at ease while talking with daddy, as daddy has always been in principles and always obey elders and always punctual to the tune of it’s fullest.Similarly in one such incident of sweeper management and as most of the time they had been drunk and they used to reach at office late. Daddy deeply thought about it as the cleanness at the office premises is the need of   hour, then daddy inquired about the messenger and then knew that he had one step brother , he is a good person having the disciplined life style and also very obedient. Then, daddy appointed him as this appointment is of temporary nature and appointment and removal of them is on the hands of chief manager and for this the work goes on smoothly for some time. 

Then, after 10 minutes daddy called new sweeper to his office premises and as usual daddy gave him the tiffin, he sanctioned for him and then asked him, what he did tell him, he said, simply he told his step brother to go out from this place, as he was now been appointed and he said to him to search for a newer job, as this was easier for him to correspond as compared to daddy told him, as he could take daddy’s good words as some sort of not good for him and for this daddy called upon sweeper’s step brother , and appointing him instead and then he told his brother , instead of daddy and that was the real management decision as with this , the first sweeper understand that , his brother is now been appointed and now it is the time for him to leave and in this manner he could not find the real intimations that had been given to him through daddy , though in some other manners and that is the real management. .  The other model is multi attribute model, it depends upon management lessons and its various attributes that has been there with it and how these could make decision making more interesting with time and knowledge.

It was a marvelous winter evening with less dew and more coolness in the evening. More and more breeze flowing across the arena with more coolness in the offering. There were cool breeze just piercing into body and it seemed that winter is now creeps in to climate and this made the entire season a cool and windy feeling. Plenty of thoughts to ponder upon and I was 8 years old boy seating at the verandah and waiting for daddy to reach home so that I could go with daddy to market. Daddy reached home from tour by office vehicle and the driver, carried daddy’s suitcase to home and then he asked daddy for permission, and daddy gave him permission and then he went away.

As chief manager, daddy do not show ego or other ambitions to drivers or award staffs as daddy believe that all are same and no one is above the institution even he himself is not above institution. He gives the deserved respect to persons and with this they also could not deny the work that had been given to them and also daddy sanctions for foods as with him the sanctioning power is on the higher side and for this at normal situations, they could leave the office at 5 PM instead they had been staying for eight to nine PM.

Daddy always been friendly to elders and for this they also feel at ease when talking with daddy and with this the entire congenial atmosphere of environment goes for ever an for this the entire relationships that matters the most have been there and they carry on good will gestures and other intimation and for this the work environment become more and more congenial and nice. Elders feel at ease while talking with daddy, as daddy has always been in principles and always obey elders and always punctual to the tune of it’s fullest. The smart ideas and brilliant management ideas are always some bookish knowledge but it did at times feel that, the real management comes from brilliant mind that had been there always with some of most of the smarts ideas that has been very simply put forward, the real smart management that had been in practice by great entrepreneurs and officers like my daddy has been practicing is of immense understanding and wonderful achievements.

Even as a manager if you show respect to a messenger, the proper humanity etiquette then he would listen to you at stretch, and do your work at full length as an officer you would depend upon him from time to time, in order to find out the large ledgers and other information that to be distributed to different desks, if the messenger concerned had good rapport with you then he could do the work for you. Here what sort of management lesson one could learn from , it is not any sort of management matrices’ but the real man to man understanding and empathy is the need of the hour and that is making the whole process more and more light and good.

Similarly in one such incident of sweeper management and as most of the time they had been drunk and they used to reach at office late. This makes problem of plenty , as in normal time they had to reach office at 8 AM and clean each and every part of it before public came to office but what makes that particular messenger is that he came at noon and also many a times did not clean premises. Public complained and even they complained to higher authorities and higher authorities phoned to daddy to ask about the situations, and if daddy talked to him politely, due to heavily drunk he used to abuse and rebuke and also shouted loud and gathered many persons and in case of strong statement could not be given to him considering nature of his work , and if strong steps would be taken then he could bring all members of his village and that could make the entire atmosphere more and more shocking and also at the front of a mob anything could happen.

Daddy deeply thought about it as the cleanness at the office premises is the need of   hour, then daddy inquired about the messenger and then knew that he had one step brother , he is a good person having the disciplined life style and also very obedient. Then, daddy appointed him as this appointment is of temporary nature and appointment and removal of them is on the hands of chief manager and for this the work goes on smoothly for some time. Then after seven days of continuous absent, the first sweeper came and then he saw all the office premises are clean and he suspected some foul play. As usual he shouted and threatened to do anything, as he was always drunk, then daddy allowed him to rebuke and abuse for over 30 minutes and then daddy called his step brother through the phone, within five minutes his step brother reached at the spot, and he himself confronted his brother and then after 10 minutes the first sweeper went out from premises never to come out again. Then, after 10 minutes daddy called new sweeper to his office premises and as usual daddy gave him the tiffin, he sanctioned for him and then asked him, what he did tell him, he said, simply he told his step brother to go out from this place, as he was now been appointed and he said to him to search for a newer job, as this was easier for him to correspond as compared to daddy told him, as he could take daddy’s good words as some sort of not good for him and for this daddy called upon sweeper’s step brother , and appointing him instead and then he told his brother , instead of daddy and that was the real management decision as with this , the first sweeper understand that , his brother is now been appointed and now it is the time for him to leave and in this manner he could not find the real intimations that had been given to him through daddy , though in some other manners and that is the real management.

What it gains from it that , in case of any sort of futuristic dubious situations , one should always exercise one’s mind to its fullest potential so that , in case any sort of not so good situations one can refer it and administer it indirectly, in this way a major problem averted. There will be many problems as such will come into you at various stages and it is for you to decide and implement it from time to time. The solutions could be nearer to you at various instances and from it different facets of series of administration comes out and it is for you to decide which path to choose from and how and in what so ever manner you would like to pass these on.

This technique does not applies to each cases as from time to time you have to review these and find out in what manner these should be applicable according to your most fluent estimation and the decision time and the intelligent that has been with you goes on forever and you have to find out the real solution to get it on with real parameters and as the manager the sole criteria of decision making has been always with you, as the manager from time to time you will have to make the decision and that could go beyond your imagination . It is also true that in order to bring out positive decision making, the fact of the matter is that it is more difficult that it ever , it has been always the major concern was how to improve the decision making and how to make it more and more concerned and good for the betterment of the organization. There is the theoretical justification on the basis of bounded rationality that can be seen from the authors but how it can be more and more pronounce can never ever be known to all of us.

In this manner entire spectrum of ideas and related functionality could ever be controlled with basic management equations. It is true that in order to reach at a decision making utility one has to find out the management traditions to reach these out and in other manner one had to find out the personal experience ways to make it happen and how these could make most of it. The later one can be perceived as liner model where the single mind could decide the fate of it and with it more and more decision making process can over write the passionate and forward making attributes. This depends upon the intelligence of the user and also other attributes that are in built within it .  The other model is multi attribute model, it depends upon management lessons and its various attributes that has been there with it and how these could make decision making more interesting with time and knowledge.

Exceptional case always there and in certain terms even at cases in liner model and also multi attribute model there can be circumstances where one could not find the successful formula and that could come under decision-tree analysis of uncertain outcomes and in this manner, each time you would take any decisions also be assured that it might not work at some point of time so you have to be extra careful and also very positive on these aspects.  

There is another model being named as Bayesian model analysis, where artificial intelligence and decision making came to at one point of action where, the decision makers combined all these aspects of portioning of images, and then found out the real value of it, with plenty of steps into action analysis and other forms of attributes creeping into mind as well as other decision making matrices, all has been in consistent partner with the other.

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