Risk Management in Indian Banking Sector and the role of RBI.

By BYJU'S Exam Prep

Updated on: September 11th, 2023

Banking sectors play a pivotal role in the management of the economy of a country. You as the aspirants of RBI Grade B Officer needs to know what are the Risks of the Banking sector, Risk Management and what is the role of RBI in the risk management.

What is Risk?

Risk refers to ‘a condition where there is a possibility of undesirable occurrence of a particular result which is known or best quantifiable and therefore insurable’. A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. An activity which may give profits or result in loss may be called a risky proposition due to uncertainty or unpredictability of the activity of trade in future.

In other words, it can be defined as the uncertainty of the outcome. As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money.

Type of Risks – The major risks in the banking business as commonly referred can be broadly classified into:

  • Liquidity Risk
  • Interest Rate Risk
  • Market Risk
  • Credit or Default Risk
  • Operational Risk

1. Liquidity Risk

The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

The liquidity risk in banks manifest in different dimensions –

(a) Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail).

(b) Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows of funds i.e., performing assets turning into non-performing assets.

(c) Call Risk: Call risk arises due to the crystallisation of contingent liabilities. It may also arise when a bank may not be able to undertake profitable business opportunities when it arises.

2. Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected due to changes in the interest rates.

IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s assets, liabilities and Off-Balance Sheet (OBS) positions. Interest rate Risk can take different forms.

3. Market Risk

The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities, and currencies. It is also referred to as Price Risk.

The term Market risk applies to (i) that part of IRR which affects the price of interest rate instruments, (ii) Pricing risk for all other assets/ portfolio that is held in the trading book of the bank and (iii) Foreign Currency Risk.

(a) Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position either spot or forward, or a combination of the two, in an individual foreign currency.

(b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

4. Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms. For most banks, loans are the largest and most obvious source of credit risk. It is the most significant risk, more so in the Indian scenario where the NPA level of the banking system is significantly high.

Now, let’s discuss the two variants of credit risk –

(a) Counterparty Risk: This is a variant of Credit risk and is related to non-performance of the trading partners due to counterparty’s refusal and or inability to perform. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.

(b) Country Risk: This is also a type of credit risk where non-performance of a borrower or counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance is external factors on which the borrower or the counterparty has no control

Credit Risk depends on both external and internal factors.

The internal factors include Deficiency in credit policy and administration of loan portfolio, Deficiency in appraising borrower’s financial position prior to lending, Excessive dependence on collaterals and Bank’s failure in post-sanction follow-up, etc.

The major external factors are the state of Economy, Swings in commodity price, foreign exchange rates and interest rates, etc.

Credit Risk can’t be avoided but can be mitigated by applying various risk-mitigating processes –

  • Banks should assess the credit-worthiness of the borrower before sanctioning loan i.e., the Credit rating of the borrower should be done beforehand. Credit rating is the main tool for measuring credit risk and it also facilitates pricing the loan.
  • By applying a regular evaluation and rating system of all investment opportunities, banks can reduce its credit risk as it can get vital information of the inherent weaknesses of the account.
  • Banks should fix prudential limits on various aspects of credit – benchmarking Current Ratio, Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.
  • There should be maximum limit exposure for single/ group borrower.
  • There should be provision for flexibility to allow variations for very special circumstances.
  • Alertness on the part of operating staff at all stages of credit dispensation – appraisal, disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit risk.

5. Operational Risk

Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’. Managing operational risk has become important for banks due to the following reasons –

  • Higher level of automation in rendering banking and financial services
  • Increase in global financial inter-linkages
  • The scope of operational risk is very wide because of the above-mentioned reasons.

Two of the most common operational risks are discussed below –

(a) Transaction Risk: Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information.

(b) Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice. It is also called integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing.

6. Other Risks

Apart from the above-mentioned risks, following are the other risks confronted by Banks in course of their business operations –

(a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes.

(b) Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss or decline in customer base.

(c) Systematic Risk: It is a risk inherent to the entire market segment and is not sector specific it is also known as undiversifiable risk.

(d) Unsystematic Risk: It is kind of specific risk which comes with the industry you invest in also referred to diversifiable risk.

Risk Management is actually a combination of management of uncertainty, risk, equivocality and error. Uncertainty – where the outcomes cannot be estimated even randomly, arises due to lack of information and this uncertainty gets transformed into risk (where the estimation of outcome is possible) as information gathering progresses.

Initially, the Indian banks have used risk control systems that kept pace with legal environment and Indian accounting standards. But with the growing pace of deregulation and associated changes in the customer’s behaviour, banks are exposed to mark-to-market accounting.

Therefore, the challenge of Indian banks is to establish a coherent framework for measuring and managing risk consistent with corporate goals and responsive to the developments in the market. As the market is dynamic, banks should maintain vigil on the convergence of regulatory frameworks in the country, changes in the international accounting standards and finally and most importantly changes in the clients’ business practices.

Therefore, the need of the hour is to follow certain risk management norms suggested by the RBI and BIS.

Role of RBI in Risk Management in Banks

Here, we will discuss the role of RBI in Risk Management and how the tools called CAMELS was used by RBI to evaluate the financial soundness of the Banks. CAMELS is the collective tool of six components namely

  • Capital Adequacy
  • Asset Quality
  • Management
  • Earnings Quality
  • Liquidity
  • Sensitivity to Market risk

The CAMEL was recommended for the financial soundness of a bank in 1988 while the sixth component called sensitivity to market risk (S) was added to CAMEL in 1997.

In India, the focus of the statutory regulation of commercial banks by RBI until the early 1990s was mainly on licensing, administration of minimum capital requirements, pricing of services including administration of interest rates on deposits as well as credit, reserves and liquid asset requirements.

RBI in 1999 recognised the need for an appropriate risk management and issued guidelines to banks regarding assets liability management, management of credit, market and operational risks. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the demanding needs of a strong and stable financial system.

A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect of foreign banks has been put in place from 1999.

RBI Grade B

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