No matter the country, the banking sectors play a crucial role in managing the economy. One must, hence, know about the risks associated with the banking sector, what risk management is, and what are the different types of risk management for the Indian Banking Sector.
Before we begin, let’s first understand what the risk management process is.
The risk management meaning is quite simple, it refers to ‘a situation where an unexpected occurrence of a particular outcome is established or better quantifiable and thus insurable.’ A risk can be described as an unplanned occurrence, resulting in loss or reduced earnings with financial consequences.
Due to the ambiguity or unpredictability of the trade operation in the future, a process that can provide benefits or result in loss can be considered a risky proposition. It can be defined further as the uncertainty of the result. The risk management process is a multi-layered procedure where accuracy and precision over risk controls is the game-changer.
Since risk is directly proportional to the return, the more risk a bank takes, the more money it may expect to make. The method of recognition, assessment, and control is known as the risk management process. But risks differ for different sectors, apart from those risks that are prevalent for all businesses and organizations.
As generally referred to, the significant risks in the banking industry can be narrowly divided into:
Interest Rate Risk
Credit or Default Risk
Let’s understand these different types of risk management in detail.
The Bank liquidity risk management process safeguards the funding of long-term assets by short-term liabilities during the project risk management process, thereby subjecting the liabilities to rollover or refinancing.
The liquidity risk in banks demonstrate in various aspects -
Funding Risk:Funding Liquidity Risk is characterized as failing to receive funds to satisfy cash flow obligations. The funding and risk management process of the liquidity risk is critical for banks. This stems from the need to substitute net outflows due to unanticipated withdrawal / non-renewal (wholesale and retail) deposits.
Time Risk:Time risk emerges from the need to compensate for the non-receipt of anticipated fund inflows, i.e., the execution of assets that transform into non-performing assets.
Call Risk:Owing to the crystallization of contingent liabilities, call risk exists. It can also occur because, when it happens, a bank may not pursue viable business opportunities.
Interest-rate risk occurs when interest rate adjustments influence an institution’s Net Interest Margin or Market Value of Equity (MVE).
IRR can be interpreted in two ways - its impact is on the Bank’s earnings or its effect on the Bank’s asset, liability, and off-balance sheet (OBS) positions’ economic value.
The risk management process of adverse deviations of the trading portfolio’s mark-to-market value due to market fluctuations is referred to as a market risk during the time needed to liquidate the transactions. It is the product of adverse fluctuations in the degree of volatility of interest rate instruments, equities, commodities, and currencies at market rates. It is also known as Price Risk.
The term Market risk refers to:
the portion of the IRR that influences the price of interest rate instruments
the risk of pricing for all other assets/portfolios kept in the Bank’s trading book, and
the risk of foreign currency.
Forex risk is the risk that, as a result of adverse exchange rate changes, a bank can suffer losses during a time when it has an open position in an individual foreign currency, either spot or forward, or a combination of the two.
Market liquidity risk occurs when a bank is not able to conclude a significant trade in a given instrument close to the current market price.
Credit risk is defined more specifically as the capacity of a bank borrower or counterparty to fail to fulfill its obligations under the agreed terms. Loans for most banks are the primary and most obvious source of credit risk. It is the most critical danger in the Indian scenario, where the NPA level of the banking system is considerably high.
Now, let’s consider the two variations of credit risk –
Counterparty Risk:This is a credit risk variant linked to the non-performance of the trading partners due to the dismissal of the counterparty and or failure to perform. In general, counterparty risk is seen as a temporary financial risk associated with trading rather than average credit risk.
Country Risk:This is a credit risk variant linked to the non-performance of the trading partners due to the dismissal of the counterparty and or failure to perform. In general, counterparty risk is seen as a temporary financial risk associated with trading rather than normal credit risk.
Credit risk is dependent on both external and internal factors.
Internal factors of the risk management process for banking sectors include deficiency in credit policy and loan portfolio management, deficiency in evaluating the financial condition of the borrower before lending, undue reliance on collateral, and failure of the Bank in post-sanction follow-up, etc.
External factors of the project risk management process for banking sectors are the state of the economy, oil price fluctuations, foreign exchange rates, and interest rates, and so on. Credit risk cannot be minimized but can be mitigated by the implementation of various risk reduction processes.
Banks should determine the borrower’s creditworthiness before sanctioning the loan, i.e., the borrower’s credit rating should be done in advance. Credit rating is the critical instrument for credit risk assessment and also promotes the pricing of the loan.
Banks can reduce their credit risk by implementing a routine assessment and rating scheme to all investment opportunities since they can gain critical details on the inherent vulnerabilities of the account.
Banks should set prudential limits on different dimensions of credit – Current Ratio benchmarking, Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio, etc.
Single/group borrowers should have a maximum exposure limit. Flexibility should be given to allow for adjustments for very different circumstances. Operating staff’s alertness at all levels of credit dispensation – evaluation, disbursement, review/renewal, post-sanction follow-up can also be useful in preventing credit risk.
The Basel Committee for Banking Supervision has described the operational risk of the risk of loss arising from insufficient or failed internal processes, individuals, and systems or external events. The operational project risk management process has become relevant for banks because of the following reasons –
A higher level of automation for banking and financial services
Increase in interconnected global financial linkages
For the reasons stated above, the spectrum of operational risk is vast.
Here are two of the most popular operating threats:
Transaction Risk:Transaction risk is the risk of fraud, both internal and external, business processes that have failed, and the failure to maintain business continuity and manage information.
Compliance Risk:Compliance risk is the risk of legal or regulatory penalty, financial loss, or loss of reputation that a bank may incur due to failure to comply with any or all of the rules, regulations, codes of conduct, and standards good practice that applies. It is also called integrity risk because the credibility of a bank is closely related to its adherence to integrity standards and fair dealing.
In reality, the Risk Management process is a combination of uncertainty, risk, equivocality, and error management. Uncertainty – where the results cannot be calculated even arbitrarily, occurs due to a lack of knowledge. This uncertainty is converted into risk (where outcome prediction is possible) as the collection of information advances.
Initially, the Indian banks have used risk controls that kept pace with the legal environment and Indian accounting standards. But with the growing rate of deregulation and associated changes in the customer’s behavior, banks are exposed to mark-to-market accounting.
Therefore, the challenge for Indian banks is to create a coherent risk management process and system that stays consistent with corporate objectives and sensitive to market developments. Since the market is competitive, banks should keep a watchful eye on the country’s integration of regulatory systems, shifts in international accounting standards, and, eventually and most critically, changes in the business practices of clients.
TRC Corporate Consulting facilitates and supports your organization to turn operational challenges into growth possibilities that enable sustainability and generates long-term gains. Our risk management process innovates the competencies of conventional project risk management techniques and risk controls to deliver practical solutions for your business.
At TRC, our risk management process experts offer the following:
Creating management plans for probable risks and prospects
Procedures to identify risks and reduce chances of occurrence
Use of risk management process and information for risk identification, managing it and evaluating data
Formation of a register for probable risks and handling the risk management process
Creation and presentation of risk management reports, including process reports, reviews, feedback, and discussions.
Businesses partner with TRC Corporate Consulting to devise and implement risk management process and risk controls for the following:
Project risk management
Risk Controls Measure
Our tested and proven risk management process can help you achieve a competitive advantage and deliver sustainable business growth. For any questions related to our risk management services, contact us!