RISK MANAGEMENT IN BANKS AND FINANCIAL INSTITUTIONS (FIS)

The term Risk and the types associated to it would refer to mean financial risk or uncertainty of financial loss. The Reserve Bank of India (RBI) being a regulatory body has identified and categorized the risk encountered by banks and financial institutions (FIs) into three major categories viz Credit risk, market risk and Operational risk. These types of risks are subdivided primarily into Financial and Non-Financial Risks. Credit Risk and Market risks both known as Financial Risk involve all those aspects which deal mainly with financial aspects. On-Financial risks would entail all the risks faced by the bank or FIs in its regular workings known as Operational Risk. Operational risk is the prospect of loss resulting from inadequate or failed procedures, systems or policies like Employee errors, systems failures or Fraud and any event that disrupts business processes. Basel being a historical international meetings place is a city on the Rhine River in northwest Switzerland. The Basel Committee on Banking Supervision (BCBS) constituted by banking supervisory authorities established in 1974 by the central bank governors of the Group of Ten countries. As per the guidelines of Basel Committee, the following risk parameters needs attention.

Risk identification

Successful risk management relies on a common understanding within the organization to identify the risks it is exposed to. The operational risk might be loosely associated with administration and IT systems. In fact the Basel Committee has suggested that operational risk is a risk of loss resulting from inadequate or failed internal processes, people &systems and from external events. 100% risk elimination is neither desirable nor possible every effort must be made to identify the critical risks. A multi-faceted approach is needed to consider the risks inherent in the industry and those that are unique to the firm’s own processes. This approach must take into account industry practice as well as existing controls and the knowledge of management and staff.

How effective is our risk mitigation and framework.

It is important to identify and quantify the effectiveness of the mitigating controls. While some controls are tangible such as economic hedges others are less tangible and rely on people completing processes correctly. Measurement of the effectiveness of processes their documentation and level of compliance must be part of any risk management review. Consistent methods must be applied throughout an organization to ensure risk management standards are maintained in all areas. This framework should form part of a common risk philosophy embedded in the organization’s culture. There are various approaches to facilitate risk management and each has its own strengths and weaknesses. In practice some risks are managed very well when compared to their level of significance called excessive risks. Others are not well mitigated when taking into account their significance called negligent risks.

Continual self-assessment

The framework forms the basis of continual self-assessment of risk analysis and mitigation. Once the process has been conducted it can be implemented by the organization itself as necessary. The RIM framework can also be applied to special projects such as a major change project, an acquisition, or responding to a crisis. Implementing a RIM practice over the project helps to manage new risks. The risk and mitigation analysis can be a cornerstone for discussion with the regulator in assessing capital adequacy for operational risk. It will also allow management to be better informed as to the nature and extent of the risks being borne by the shareholder’s capital. As discussed above, the internal credit ratings have been gaining importance especially for determining regulatory capital requirements and for portfolio management. Basel II is based on “three pillars” concept first is minimum capital requirements addressing a risk. The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces for credit risk, operational risk, and market risk. Second is supervisory review a regulatory response to the first pillar giving regulators better tools over those previously available? It also provides a framework for dealing with systemic risk, pension risk, concentration risk, and other risks which combines under residual risk. Third is a market discipline and aim of this Pillar is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution.

Components of capital funds

Capital funding is the money that lenders and equity holders provide to a business. A company’s capital funding consists of both debt (bonds) and equity (stock). The business uses this money for operating capital. The capital funds for the Banks and financial institutions are being discussed under two heads i.e. the capital funds of Indian banks and the capital funds of foreign banks operating in the country.  The Capital Funds would include the components of Tier I capital and Tier II capital. Tier 1 capital is the core measure of a bank’s financial strength from a regulator’s point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings) but may also include non-redeemable& non-cumulative preferred stock. Similarly, Tier II capital includes Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the Banks and Financial Institutions. These instruments together with other components of Tier II capital should not exceed 100% of Tier I capital. Undisclosed Reserves can be included in capital if they represent accumulations of post-tax profits and are not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses.

Risk-weighted asset (RWA) is a bank’s assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. The capital to risk-weighted assets ratio or capital adequacy ratio of a bank promotes and measures its financial stability. The capital to risk-weighted assets ratio is calculated by adding a bank’s tier 1 capital and tier 2 capital and dividing the total by its total risk-weighted assets. Risk Weighted Assets for example in case of Credit Risk held for trading and available for sale securities would qualify to be categorized as Trading Book. While computing the credit risk the securities held under trading book would be excluded and hence the risk-weighted assets for credit risks would be as under:-

An indicative list of institutions which may be deemed to be financial institutions for capital adequacy purposes are Banks, Mutual funds, Insurance companies, Non-banking financial companies, Housing finance companies, Merchant banking companies and Primary dealers. The Banks and Financial Institutions are required to maintain the Minimum requirement of Capital Funds known as CRAR on an ongoing basis which is 9%.In recognition of the wide diversity of banking activities and the difficulties of measuring price risk for options an alternative approaches are permissible for calculation viz, the simplified approach described and intermediate approaches. In the simplified approach the banks and financial institutions are using standardized methodology and calculating capital charges that incorporate both general market risk and specific risk. While as in alternative approach, the delta-plus method is using sensitivity parameters or “Greek letters” associated with options to measure their market risk and capital requirements.

Shabir Ahmad Shah is executive in Financial Institution & writes on Socio-Economic Issues.