RISK MANAGEMENT IN BANKS
The business of banking today is synonymous with active risk management than it was ever before. The success and failure of a banking institution heavily depends on the strength of the risk management system in the current environment. This is true as the very business of banking is risk-taking as an intermediary, i.e. interposing between savers (depositor) on one hand and the borrower on the other hand, thereby accepting the risks of intermediation.
Risk Management: Meaning & Components
A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. Therefore, a risky proposition is one with potential profit or a looming loss. Risk stems from uncertainty or unpredictability of the future. In commercial and business risk generates profit or loss depending upon the way in which it is managed. Risk can be defined as the volatility of the potential outcome. Risk is the possibility of something adverse happening. Risk management is the process of assessing risk, taking steps to reduce risk to an acceptable level and maintaining that level of risk.
The essential components of any risk management system are –
* Risk Identification: i.e. the naming and defining of each type of risk associated with a transaction or type of product or service;
* Risk Measurement: i.e. the estimation of the size, probability and timing of potential loss under various scenarios;
* Risk Control: i.e. the framing of policies and guidelines that define the risk limits not only at the individual level but also for particular transaction
Process of Risk Management
* Identify all areas of risk
* Evaluate these risks
* Set various exposure limits
* Type of business
* Counter parties
* Issue clear policy guidelines / directives
Types of Risks:
* Credit Risk - This is the risk of non-recovery of loan or the risk of reduction in the value of asset. The credit risk also includes the pre-payment risk resulting in loss of opportunity to the bank to earn higher interest income. Credit Risk also arises due excess exposure to a single borrower, industry or a geographical area. The element of country risk is also present which is the risk of losses being incurred due to adverse foreign exchange reserve situation or adverse political or economic situations in another country
* Interest Rate Risk - This risk arises due to fluctuations in the interest rates. It can result in reduction in the revenues of the bank due to fluctuations in the interest rates which are dynamic and which change differently for assets and liabilities. With the deregulated era interest rates are market determined and banks have to fall in line with the market trends even though it may stifle their Net Interest margins
* Liquidity Risk - Liquidity is the ability to meet commitments as and when they are due and ability to undertake new transactions when they are profitable.
* Foreign Exchange Risk - Risk may arise on account of maintenance of positions in forex operations and it involves currency rate risk, transaction risks (profits/loss on transfer of earned profits due to time lag) and transportation risk (risks arising out of exchange restrictions)
* Regulatory Risks - It is defined as the risk associated with the impact on profitability and financial position of a bank due to changes in the regulatory conditions, for example the introduction of asset classification norms have adversely affected the banks of NPAs and balance sheet bottom lines.
* Technology Risk - This risk is associated with computers and the communication technology which is being increasingly introduced in the banks. This entails the risk of obsolescence and the risk of losing business to better technologically developed banks.
* Market Risk - This is the risk of losses in off and on balance sheet positions arising from movements...