Risk Management in Banking Sector

DECLARATION

I hereby declare that this project report titled Risk Management in Banking Sector submitted

by me to Banarsidas Chandiwala Institute of Professional Studies, Dwarka is a Bonafide

work undertaken during the period from January 2012 to April 2012 by me and has not been

submitted to any other University or Institution for the award of any degree diploma /

certificate or published any time before.

(Signature of the Student) Date: / / 2012

Shikha Sharma 10961203912

BONAFIDE CERTIFICATE

This is to certify that as per best of my belief the project entitled “Risk

Management in Banking Sector” is the Bonafide research work carried out by shikha

sharma student of MBA, BCIPS, Dwarka, New Delhi during January –April

2012, in partial fulfilment of the requirements for the Degree of Master of

Business Administration.

She has worked under my guidance.

--------------------Name Research Project Guide

Date:

Counter signed by -------------Name : Dr. Satish Taneja Director Date:

Executive summary

Risk management underscores the fact that the survival of an organization depends heavily

on its capabilities to anticipate and prepare for the change rather than just waiting for the

change and react to it. The objective of risk management is not to prohibit or prevent risk

taking activity, but to ensure that the risks are consciously taken with full knowledge, purpose

and clear understanding so that it can be measured and mitigated. It also prevents an

institution from suffering unacceptable loss causing an institution to suffer or materially

damage its competitive position. Functions of risk management should actually be bank

specific dictated b the size and quality of balance sheet, complexity of functions,

technical/professional manpower and the status of MIS in place in that bank.

Risk: in the simplest form, risk can be defined as “the chance that an investment’s actual

return will be different than expected. The word risk is derived from an Italian word

“Risicare” which means “to dare” an expression of danger of a deviation in the actual result

from expected. According to banks for international settlement (BIS) has defined as: “ risk is

the threat that an event or action will adversely affect an organization’s ability to achieve its

objectives and successfully execute its strategies”.

Risk management: risk management refers to the practise of identifying potential risks in

advance, analyzing them and taking precautionary steps to reduce the risk. In simple words,

risk management is a two step process – determining what risk exist and then handling those

risk in best suited manner. Risk management can be performed in the following steps:

Identify, characterize threats

Assess the vulnerability of critical assets to specific threats

Determine the risk

Identify the ways to reduce those risks

Prioritize risk reduction measures based on strategy.

The study intends to examine the risk management in banking sector on the following

aspects:

Awareness of regulations

Organizational structure

Reporting ability

Compliance with Basel II

Capital allocation

Basel II action plan

Technology

Descriptive research design is used for the study. The method adopted for sampling is

probability sampling. Data has been collected through primary and secondary data. Primary

data was collected by means of a survey which was done through the structured

questionnaire.

Whereas the secondary data included various research papers, books, journals as well as

internet. MS- Excel was used as statistical tool for analysis of data and bar graphs were used

for the presentation of data.

Introduction

Risk: In the simplest form, risk can be defined as “the chance that an investment’s actual

return will be different than expected. The word risk is derived from an Italian word

“Risicare” which means “to dare” an expression of danger of a deviation in the actual result

from expected. According to banks for international settlement (BIS) has defined as: “ risk is

the threat that an event or action will adversely affect an organization’s ability to achieve its

objectives and successfully execute its strategies”.

Risk management: Risk management refers to the practise of identifying potential risks in

advance, analyzing them and taking precautionary steps to reduce the risk. In simple words,

risk management is a two step process – determining what risk exist and then handling those

risk in best suited manner. Risk management can be performed in the following steps:

Identify, characterize threats

Assess the vulnerability of critical assets to specific threats

Determine the risk

Identify the ways to reduce those risks

Prioritize risk reduction measures based on strategy.

Types of risk

It is very difficult to define risk. Risk is often related to the occurrence of an event that

one cannot predict which has a significant effect on the bank’s balance sheet or on

portfolio of an asset management firm. Doing an investment is a sacrifice of certain and

immediate advantage in the hope of uncertain future benefits. We can say that risk is

exposure to uncertainty. The banking industry is exposed to financial risk, and its

primary objective should be to control this uncertainty as much as they can in relationship

with a risk tolerance.

Risks are manifold and multidimensional. They are needed to be listed and defined as

best as they can be if we want to measure, follow and monitor. Risk can be broadly

classified in two types:

Systematic risk

It is also termed as non-diversifiable because it cannot be avoided. It is inherent in almost all

investment avenues. As long as one does investment he gets influenced with these risk

factors. These are universal factors and these influence the performance of all investment

avenues. It is the risk that is caused by externals factors such as economic, political and

sociological conditions. It affect the functioning of the entire market. There are four types of

systematic risks.

1. Market risk: Jack Francis has defined market risk as that portion of the total

variability of returns that is caused by the alternating forces of bull and bear market.

When the stock market moves upward, it is known as bull market. On the other hand,

when the stock market moves downward then it is known as bear market.

Prices of securities depend upon the activities of the operators, speculators in the

market. When brokers form a cartel to get benefit out of price rigging or hammering,

then overall the stock market gets affected. Market risk is affected by macro level

factors, changes in government policies. It is denoted by β. There are two forces that

affect the market are:

Tangible events: earthquake, war, political uncertainty and decrease in value

of money are some examples of tangible assets.

Intangible events: It is related to market psychology. Political unrest or fall

of government affects the market sentiments.

2. Interest rate risk: Interest rate in an economy tends to fluctuate either on account of

regulatory framework or due to market forces. If the general interest rate rises then it

Types of risk

Systematic risk Unsystematic risk

pushes up the investor expected rate of return from investment due to which

prevailing share prices become unattractive. Another effect of increase in expected

rate of return is that low yield debentures or bonds become unattractive at the

prevailing price due to which the prices of these also tumble down. Thus interest rate

also account for major part of systematic risk for investment activities. The causes of

interest rate risk are as follows:

Change in government monetary policies

Change in interest rate of treasury bills

Change in interest rate of government bonds.

3. Purchasing power risk: Inflation causes loss of purchasing power due to which real

gain from investment are very low as compared to monetary gains. Inflation affects

the price of shares as well as debentures. Due to the rising inflation, the return

expected by the future earnings at a higher discount rates, which pulls the price

further down. Inflation also influences the real yield from bonds which happens to be

much lower than nominal interest rate. The declining yield affects the market price of

bonds adversely. There are mainly two types of inflation:

Demand pull inflation: The demand for goods and services remain higher

than supply.

Cost push inflation: There is a risk in price due to increase in cost of

production.

4. Default risk: The uncertainty associated with the payment of financial obligation

with the payment of financial obligation when they come due. Put simply, the risk of

non- payment. It is available with each and every investment.

Unsystematic risk

This kind of risk is created due to industry or company specific factors performance of a

company, merger or acquisition, industry specific announcement by the government which

might affect a particular industry. This type of risk can be reduced or eliminated through

diversification. Since it can be minimized or eliminated, it is called diversifiable risk. There

are two types of unsystematic risk:

1. Business risk: business risk gets created due to operation of a company. A

company might not be able to sell its product due to imperfectness in operating

activities. As a result, the company might incur losses, which certainly has an

adverse effect on share prices of such company. Business risk originates due to

operating leverage and wrong planning about operations of a company. It can be

measured with the help of degree of operating leverage. It can be classified as:

Internal business risk: It is the risk that is associated with the operational

efficiency of a company.

External business risk: It is the risk that is the result of operating

conditions imposed on the firm by the external environment.

2. Financial risk: It occurs due to wrong financial planning. A company having high

desire of debt certainty has high financial leverage which has an adverse affect on

the earnings of the company. The unfavourable effect of high financial leverage is

observed at the time of declining EBIT, which sometimes might erode the capital

of the company too. Hence companies with high financial leverage are considered

as high risky.

Basel Accords

The Basel accords refer to the banking supervision accords – Basel I, Basel II and Basel III -

issued by the Basel committee on banking supervision (BCBS). They are called the Basel

Accords as the BCBS maintains its secretariat at the bank for international settlements in

Basel, Switzerland and the committee normally meets there. The Basel accord is a set of

recommendations for regulations in the banking industry.

Basel I accord

Basel I is the round of deliberation by central bankers from around the world, and in 1988,

the Basel committee on banking supervision in Basel Switzerland, published a set of

minimum capital requirements for banks. This is also known as the 1988 Basel accord, and

was enforced by law in G-10 countries in 1992. It provided level playing field by stipulating

the amount of capital that needs to be maintained by internationally active banks.

Basel II accord

Basel II was developed with the intent to supersede the Basel I accords. Basel II is the second

of the Basel accord which are recommendations on banking laws and regulations issued by

Basel committee on banking supervision. The new proposal is based on three mutually

reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that

banks have to face. The new risk sensitive approach seeks to strengthen the safety and

soundness of the industry by focussing on:

Risk based minimum capital requirement

Risk based supervisory review

Risk disclosure to enforce market discipline

Basel II framework

Basel II uses a “three pillars” concept. The Basel I accord dealt with only part of each of

these pillars. The new proposal is based on three mutually reinforcing pillars that allow banks

and supervisors to evaluate properly the various risk that banks face and realign regulatory

capital more closely with underlying risks.

The First Pillar

The first pillar deals with the maintenance of regulatory capital calculated for three major

components of risk that a bank faces: credit risk, operational risk and market risk. Other risk

are not considered fully quantifiable at this stage. As the Basel II recommendation are phased

in by the banking industry it will move from standardized requirements to more refined and

specific requirements that have been developed for each risk category by each individual

bank. The first pillar maintains that banks should maintain minimum capital requirements of

8% of risk assets according to new framework.

The Second Pillar

There is a regulatory response to the first pillar, giving regulators better ‘tools’ over those

previously available. It also provides a framework for dealing with systematic risk, pension

risk, concentration risk, liquidity risk which the accord combines under the title of residual

risk. Banks can review their risk management system.

The Third Pillar

This pillar aims to complement the minimum capital requirement and supervisory review

process by developing a set of disclosure requirements which will allow the market

participant to gauge the capital adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of

the bank by others, including investors, analysts, customers, other banks and rating agencies,

which lead to good corporate governance. The aim of pillar 3 is to allow market discipline to

operate by requiring institutions to disclose details on scope of application, capital risk

exposure, risk assessment process and capital adequacy of the institutions.

Basel’s New Capital Accord

Banker’s for international settlement (BIS) meet at Basel situated in Switzerland to address

the common issues concerning bankers all over the world. The Basel committee on banking

supervision is a committee of banking supervisory authorities of G-10 countries. It has been

developing standards and established framework for banking supervision towards

strengthening of financial stability throughout the world.

The 1988 Capital Accord essentially provided only one option for measuring the appropriate

capital in relation to the risk weighted assets of the financial institutions. As an improvement

on the above, the new capital accord was published in 2001, to be implemented by the

financial year 2003-04. It provides for spectrum of approaches for the measurement of credit,

market and operational risk to be determine the capital required.

The spread and nature of the ownership structure is important. While getting support from

large body of shareholders is difficult proposition when the bank’s performance is adverse, a

smaller shareholder base constraints the ability of the bank to garner funds. Tier 1 capital is

not owned by anyone and is available to cover possible unexpected losses. It has no maturity

or repayment requirement. While Basel standards currently required banks to have a Capital

Adequacy ratio of 8% with tier 1 not less than 4% RBI has mandated the banks to maintain

car of 9%. The maintenance of capital adequacy is like aiming at a moving target as the

composition of risk weighted assets gets changed every minute on account of fluctuation in

the risk profile of a bank. Tier 1 capital is known as the core capital providing permanent and

readily available support to the bank to meet the unexpected losses.

Capital Adequacy

Subsequent to nationalisation of banks, capitalization in banks was not given due importance

as it was felt necessary for the reason that the ownership of the banks rested with the

government, creating the required confidence in the mind of the public. Combined forces of

globalization and liberalization compelled the public sector banks, hitherto shielded from the

vagaries of market force, to come to terms with the market realities where certain minimum

capital adequacy has to be maintained in the face of stiff norms in respect of income

recognition, asset classification and provisioning.

Risk Aggregation and Capital Allocation

Capital adequacy in relation to economic risk is necessary condition for long term soundness

of the banks. Aggregate risk exposure is estimated through risk adjusted return on

capital(RAROC) and earnings at risk(EAR) method. Former is used by banks with

international presence and the RAROC process estimates the cost of economic capital and

expected losses that may prevail in the worst case scenario and then equates the capital

cushion to be provided for the potential loss. After measuring the economic capital for the

bank as a whole, bank’s actual capital has to be allocated to individual business units on the

basis of various types of risks. This process can be continued till capital is allocated at

transaction level.

Risk Based Supervision

In order to enhance the supervisory mechanism, the RBI has decided to put in place, a system

of risk based supervision. Under Risk Based Supervision, supervisors are expected to

concentrate their efforts on ensuring that financial institution use the process necessarily to

identify measure and control risk exposure. The RBS is expected to focus supervisory

attention in accordance with the risk profile of the bank. The RBI has already structured the

risk profile template to enable the banks to make a self assessment of their risk profile. It is

designed to ensure continuous monitoring and evaluation of risk profile of the institution

through risk matrix. This may optimize the utilisation of the supervisory resources of the RBI

so as to minimize the impact of a crisis situation in the financial system. The transaction

based audit and supervision is getting shifted to risk focussed audit. Risk based supervision

approach is an attempt to overcome the deficiencies in the traditional point in time,

transaction validation and value based supervisory system. It is forward looking enabling the

supervisors to differentiate between banks to focus on those having high risk profile. The

implementation of risk based risk based auditing would imply that greater emphasis is placed

on the internal auditor’s role for mitigating risks. By focussing on effective risk management,

the internal auditor would not only offer remedial measures for current trouble-prone areas,

but also anticipate problems to play an active role in protecting the bank from risk hazard.

Keys for effective risk management

To direct risk and influence the shape of a firm’s risk profile, management should use

all the available options. Using financial incentives and penalties to influence risk

taking behaviour is effective tool management.

Sharing of information by keeping confidentiality intact is also helpful to find out

different ways for controlling the risk as valuable inputs may be received through this

sharing. Even information on creditworthiness of counterparts that are known to take

substantial risk can also help.

Diversification is extremely important. As it lowers the variance in investor

portfolios, improves corporate ability to raise debt, reduces employment risks and

heightens operating efficiency.

Governance should never be ignored. Careful structuring of the alliance in advance of

the deal and continual adjustment thereafter help to build a constructive relationship.

One should not trust while in business. Personal chemistry is good but is no substitute

for monitoring mechanism, co-operation incentives and organizational alignment.

Without support system within the organization itself, external alliance are doomed to

fail.

Computation of capital requirement

Capital requirement for credit risk: the new accord provides for the following alternate

methods for computing capital requirement for credit risk.

Credit risk – The Standardized Approach: The Standardized Approach is conceptually the

same as the present accord, but is more risk sensitive. The bank allocates a risk weight to

each of its assets and off balance sheet positions and produces a sum of risk weighted assets

values. A risk weight of 100% means that an exposure is included in the calculation of risk

weighted assets value, which translate into a capital charge equal o 9% of that value. Under

the new accord, the risk weights are to be refined by reference to a rating provided by an

external credit assessment institution that meets strict standards.

The Internal Rating Based Approach (IRB): Under the IRB approach, banks will be allowed

by the supervisors to use their internal estimates of risk components to assess credit risk in

their portfolios, subject to strict methodological and disclosure standards. A bank estimates

each borrower’s creditworthiness and the results are translated into estimates of a future

potential loss amount, which forms the basis of minimum capital requirements. In this, the

banks have 2 options as under

a) Foundation internal rating based approach

b) Advanced internal rating based approach

The difference between foundation IRB and advanced IRB has been shown in the following

table:

Data input Foundation IRB Advanced IRB

Probability of

default

Provided by banks- based on own

estimates


estimates

Loss given default Supervisory values set by the

committee


estimates

Exposure at

default

Supervisory values set by the

committee


estimates

Effective maturity Supervisory values set by the

committee


estimates

Market risk approaches

RBI has issued detailed guidelines for computation of capital charge on market risk. The

guidelines seek to address the issues involved in computing capital charges for interest rate

related instruments in the trading books. The trading book will include:

Securities included under the held for trading category

Securities included under the available for sale category

Open gold positions limits

Open foreign exchange positions limits

Trading position in derivatives and derivatives entered into hedging trading books

exposures

Operational Risk Approaches

Basic Indicator Approach: Under the Basic Indicator Approach, banks are required to

hold capital for operational risk equal to the average over the three years of fixed

percentage ( denoted as alpha) of annual gross income. Gross income is defined as net

interest income plus net non-interest income excluding realized profit/loss from the sale

of securities in the banking book and extraordinary and irregular items.

Standardized Approach: Under the Standardized Approach, bank’s activities are

divided into eight business lines. Within each business line, gross income is considered as

a broad indicator for the likely scale of operational risk. Capital charge for each business

line is calculated by multiplying gross income by a factor (denoted beta) assigned to that

business line. Total capital charge is calculated as the three year average of the simple

summations of the regulatory capital across each of the business line in each year.

Advanced Measurement Approach: Under Advanced Measurement Approach, the

regulatory capital will be equal to the risk measures generated by the bank’s internal risk

measurement system using the prescribed quantitative and qualitative criteria.

Benefits of Basel II

1. Better allocation of capital and reduced impact of moral hazard through

reduction in the scope for regulatory arbitrage: By assessing the amount of capital

required for each exposure or pool of exposures, the advanced approach does away

with the simplistic risk buckets of current capital rules.

2. Improved signal quality of capital as an indicator of solvency: The proposed rule

is designed to more accurately align regulatory capital with risk, which will improve

the quality of capital as an indicator of solvency.

3. Encourages banking organizations to improve the credit risk management: One

of the principal objectives of the proposed rules is to more closely align capital

charges and risk. For any type of credit, risk increases as either the probability of

default or the loss given default increases.

4. More efficient use of required bank capital: Increased risk sensitivity and

improvements in risk measurement will allow prudential’s objectives to be achieved

more efficiently.

5. Incorporates and encourages advances in risk measurement and risk

management: The proposed rules seeks to improve upon existing capital regulations

by incorporating advances in risk measurement and risk management.

6. Recognizes new developments and accommodate continuing innovation in

financial products by focusing on risk: The proposed rule also has the benefit of

facilitating recognition of new developments in financial products by focussing on the

fundamental behind the risk rather than on static product categories.

7. Better alignment of capital and operational risk and encourages banking

organizations to mitigate operational risk: Introducing an explicit capital

calculation for operational risk eliminates the implicit and imprecise “buffer” that

covers operational risk under current capital rules.

Limitations of Basel II

1. Lack of sufficient public knowledge: Knowledge about bank’s portfolio and

their future risk weight, since this will also depend on whether banks will use the

Standardized or IRB Approaches.

2. Lack of precise knowledge: As to how operational risk costs will be charged.

The banks are expected to benefit from sharpening up some aspects of their risk

management practises preparation and for the introduction of the operational risk

charge.

3. Lack of consistency: At least at this stage, as to how insurance activities will be

accounted for one treatment outlined in capital accord is that banks deduct equity

and other regulatory capital investment in insurance subsidiaries and significant

minority investments in insurance entities. An alternatives to this treatment is to

apply risk weight to insurance investments.

Issues and Challenges

1) Capital requirement: The new norms will almost invariably increase capital

requirement in all banks across the board. Although capital requirement for credit

risk may go down due to adoption of more risk sensitive models – such advantage

will be more than offset by additional capital charge for operational risk and

increased capital requirement for market risk.

2) Profitability: Competition among banks for highly rated corporate needing lower

amount of capital may exert pressure on already thinning interest spread. Further,

huge implementation cost may also impact profitability for smaller banks.

3) Risk Management Architecture: The new standards are amalgam of

international best practises and calls for introduction of advanced risk

management system with wider application throughout the organization.

4) Rating requirement: Although there are a few credit rating agencies in india –

the level of rating penetration is very low. Further, rating is a lagging indicator of

the credit risk and the agencies have poor track record in this respect.

5) Choice of alternative approaches: The new framework provides for alternate

approaches for computation of capital requirement of various risks. However

competitive advantage of IRB approach may lead to domination of this approach

among big banks.

6) Absence of historical database: Computation of probability details, loss given

default, migration mapping and supervisory validation require creation of

historical database, which is a time consuming process.

Impact of Basel II implementation on the Indian Banking Industry

1) Changes in Capital Risk Weighted Assets Ratio(CRAR): Most of the banks have

already adhering to the Basel II guidelines. However the government has indicated

that a cushion should be maintained by the public sector banks and therefore their

CRAR should be above 12%. Basel I focussed largely on credit risk, whereas Basel II

has 3 risk to be considered viz. Credit risk, Operational risk and Market risks. As

Basel II considers all these 3 risks, there are chances of a decline in the capital

adequacy ratio.

2) High Cost for Upgradation of Technology: Full implementation of the Basel II

framework would require Upgradation of the bank wide information system through

better branch connectivity, which would entail huge costs and may raise IT security

issues. The implementation of Basel II can also raise issues relating to development of

HR skills and database management.

3) Rating Risks: Problem embedded in Basel II norms include rating agencies. Whether

the country has adequate number of rating agencies to discharge the functions in

Basel II complaint banking system, is a question of consideration. Further, to what

extent the rating agencies can be relied upon is also a matter of debate.

4) Improved Risk Management and Capital Adequacy: One aspect that hold back the

critics of Basel II is the fact that it will tighten the risk management process, improve

capital adequacy and strengthen the banking system.

5) Curtailment of Credit to Infrastructure Projects: The norms require a higher

weightage for project finance, curtailing credit to this very crucial sector. The long

term impacts for this could be disastrous.

6) Basel II: Advantage to Big Banks: It would be far easier for the larger banks to

implement the norms, raising their quality of risk management and capital adequacy.

This combined with the higher cost of capital for smaller players would queer the

pitch in favour of the former. The larger banks would also have a distinct advantage in

raising capital in equity markets. Emerging markets banks can turn this challenge into

an advantage by active implementation and expanding their horizons outside the

country.

Literature Review

Managing risk is one of the basic tasks to be done, once it has been identified and known. The risk and return are directly related to each other, which means that increasing one will subsequently increase the other and vice versa. And, effective risk management leads to more balanced trade-off between risk and reward, to realize a better position in the future . The prime reason to adopt risk management practices is to avoid the probable failure in future. But, in realistic terms, risk management is clearly not free of cost. In fact, it is expensive in both resources and in institutional disruption. But the cost of delaying or avoiding proper risk management can lead to some adverse results, like failure of a bank and possibly failure of a banking system.

The risk arises from uncertainty of a particular situation and certainty of being exposed to that situation. Risk Management as commonly perceived does not mean to minimize risk; in fact, its goal is to optimize the risk-reward trade off. And, the role of risk management is to assure that an institution does not have any need to engage in a business that unnecessarily imposes risk upon it. Also, it should not absorb any such risks that have the tendency to be transferred to other participants. Rather it should only accept those risks that are uniquely a part of the array of bank’s services. In this regard, risk management aspects such as Understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring, risk management practices and credit risk analysis of the banks have to be considered for assessing their risk management approach . There are two broad approaches for developing risk management strategies. One approach is to identify risks one by one and handle each separately. There are various types of risks a bank has to deal with. These are broadly divided into credit risk, market risk, liquidity risk, operational risk etc. Again, all the risks can be divided into further sub-classes. This is sometimes referred to as risk decomposition. There are a number of techniques to assess the different kind of risks. The other approach for framing risk management is called risk aggregation.

According to theoretical study on an integrated risk measurement framework, there are arithmetically three types of risk, viz. market risk, credit risk and operational risk to arrive at the overall risk estimate. In USA, Federal Reserve has approved the procedure for adoption for internal risk management.

However, it has been observed that one cannot take Risk Metrics value and add it to Credit Metrics value and obtain a risk statistic that combines credit and market risk. It has also been observed that the methodologies for generating scenarios might not be compatible.

It has been decided that different categories of risk are interdependent and overlapping. As such the risks must not be viewed and assessed in isolation not only because a single transaction might have a number of risks associated with it but also because one type of risk triggers other risks. In such a case combination of individual risk might not be exactly the same as the overall risk of banking business. Again, arithmetical aggregation does not take into account the power of diversification arising out of existence of negative correlation among different kinds of risks. We do not subscribe to the idea of combining different

functional Risk management becomes one of the main functions of any banking services risk management consists of identifying the risk and controlling them, means keeping the risk at acceptable level. These levels differ from institution to institution and country to country.

Most of the literature on the subject is focused on the pro-cyclic predilection of Basel II. Gordy (2003), Repullo and Suaerez (2008) and Powell (2002) among others focus on the weakness of the Pillar I of the Basel II on the embedded pro-cyclic nature. Banks accumulate provisions against loan default, which protect against expected losses that are likely to vary over time. Provisions are, therefore, different from capital, which would provide a buffer against unexpected losses. Decisions about provisions and capital are unlikely to be independent. For instance, Laeven and Majnoni (2004) explore the relationship between capital and provisions and find that banks tend to delay provisioning for bad loans, thereby possibly are impacted by the economic cycle. Despite the minimum requirement of 8 percent many banks actually retain a capital higher than that as a buffer. The need for this arises from the inability to anticipate unexpected losses from deterioration of asset quality. There is a growing body of empirical literature on the determinants of banks‘ capital buffers, for instance, Furfine (2000) for US banks, Rime (2003) for Swiss banks, Ayuso et al. (2004) for Spanish banks, and Lindquist (2004) for Norwegian banks. Jackson (1999) finds that following introduction of the Basel Accord there was an increase in major bank‘s risk-weighted capital ratio in the G-10 countries. The average CRAR of these banks rose from 9.3 percent in 1988 to 11.2 percent in 1996. Jackson (1999) also finds that undercapitalized banks raised new equity capital, whereas weakly capitalised banks reduced their high risk weighted assets and lending. Danielsson J et al., (2001) find that credit rating agencies are unregulated and the qualities of their risk estimates are unobservable. Stijn Claessens et al. (2008) show that developing countries‘ assets are subject to more volatility and procyclicity than developed countries. They argue that if banks follow similar models, their reaction to market signal will be mirrored leading to systemic effects. However, Illing and Graydon (2005) argue that changes in minimum required capital and provisions would be countercyclical, so they would increase during recessions and fall during economic booms. Stijn Classens et al., (2008) caution that adopting the Basel-II standards would reduce capital inflows and external financing to developing countries. Kleff and Weber (2003) analyze the determinants of bank capital ratios of German savings banks, and cooperative banks and find that banks with lower capitalization raise capital to maintain the CRAR. However, profitability is an important determinant of bank capital especially the larger savings banks that rely on retained earnings. Nag and Das (2002) and Ghosh and Nachane. (2003) find that for India in the post reform period, public sector banks have shifted their 5 portfolio to reduce capital requirements. Also the adopt portfolio to reduce capital requirements. Also the adoption of stricter risk management practices and minimum capital requirements have had a dampening effect on overall credit supply. Their findings resonate with that of Laeven and Majnoni (2004). Sarma and Nikaldo (2007) find that Indian banking system performed reasonably well during the Basel I regime, maintaining an average CAR of about 12 per cent, which is higher than the internationally accepted level of 8 per cent and the RBI‘s minimum requirement of 9 per cent.

Most of these discussions however, focus on the macro perspective. There is scanty attention paid to understand the strategy individual banks adopt to comply with the regulatory capital requirement prescribed by the BCBS. Charls Schwab: revealed very practical, authoritative and easy-to-follow tips and suggestions for good investment in the stock market. According to him growth is the heart of successful investment He suggested that before investing, one should be clear about the goal. He opined that the biggest risk is not in investing but in doing nothing and watching inflation eating away the savings. A very useful suggestion of the author is not to draw upon the income from investment but to reinvest it. A low risk approach will yield low return. So the author urged the investor to be aggressive, subject to his personal limits.CRISIL Report on Risk Management: stated that the loss potential from market risk will increase in the absence of strong risk management tools. The banks which adopt a proactive approach to upgrading risk management skills which are currently unsophisticated as compared to internationally best practices, would have a competitive edge in future. The report commented that in the increasingly deregulated and competitive environment, the risk management strategies of banks would hold the key to differentiation in their credit worthiness.

Raghavan R.S.: reviewed the need for a risk management system, which should be a daily practice in banks. He opined that bank management should take upon in serious terms, risk management systems, which should be a daily practice in their operations. He is very much sure that the task is of very high magnitude, the commitment to the exercise should be visible, failure may be suicidal as we are exposed to market risks at international level, which is not under our control as it was in the insulated economy till sometime back.

Amran: explored the availability of risk disclosures in the annual reports of Malaysian companies. The study was aimed to empirically test the characteristics of the sampled companies. The level of risk faced by these companies with the disclosure made was also assessed and compared. The findings of the research revealed that the strategic risk came on the top, followed by the operations and empowerment risks being disclosed by the selected companies. The regression analysis proved significantly that size of the companies did matter. The stakeholder theory explains well this finding by stating that "As company grows bigger, it will have a large pool of stakeholders, who Would be interested in knowing the affairs of the company." The extent of risk disclosure was also found to be influenced by the nature of the industry. As explored within this study, infrastructure and technology industries influenced the companies to have more risk information disclosed.

Research Methodology

Research is defined as the systematic design, collection, analysis and reporting of data and

finding relevant solution to a specific situation.

3.1 Research design

Research design – descriptive research design is used for the study.

Descriptive research studies are those studies which systematically define a situation, problem,

phenomenon, service or program, or provide information or describe attitude towards an issue.

3.2 Sampling

Sample universe: banks in Dwarka

Sample size: 10

Sampling method: random sampling

3.3 Data Collection

Primary data

Primary data was collected by means of survey. Survey was done through structured questionnaire. The filled up questionnaire were later analyzed to obtain the required questionnaire.

Secondary data

In order to have a proper understanding of the topic, an in depth study was done from various research papers, journals, books as well as from the internet.

Method of data collection

In this project, we used questionnaire as the method of data collection. Questionnaire was given to the persons concerned with a request to answer the questions and return the questionnaire.

3.4 Statistical tool

MS-Excel was used as a statistical tool for analysis of data. Graphs were made for presenting

the data with the help of the information from the filled questionnaires.

Analysis and Interpretation

Source: All the below analysis and interpretation is done from the survey conducted in

banks


1. What is your assessment of your readiness for the new basel proposal with respect to

capital requirements?

Credit risk Market risk Operational risk

Fully prepared 9 8 8

Partially

prepared

1 2 2

Not yet prepared

Credit risk Market risk Operational risk0

1

2

3

4

5

6

7

8

9

Fully preparedPartially preparedNot yet prepared

2. Have you done a gap analysis between the current risk management practise and new



Yes 8 7 8

No 2 3 2


1

2

3

4

5

6

7

8

Yes No

3. What degree of priority do you address to the new basel framework?


Very important 9 9 10

Important 1 1

Not important


1

2

3

4

5

6

7

8

9

10

Very importantImportant Not important

4. How do you view basel II regulation: as an opportunity to enhance the risk

management process or as a regulatory constraint?


Opportunity 9 8 10

Constraint 1 2


1

2

3

4

5

6

7

8

9

10

Opportunity Constraint

Observations:

The majority of banks consider themselves to be fully prepared.

A majority of banks have performed a gap analysis between their current risk

management practice and the new capital requirements.

Only one bank does not view Basel II implementation as high priority.

The banks largely believe that Basel II will provide them an opportunity to

enhance risk management.

Interpretation

Although the Basel II regulations are considered important to very important by a

strong majority of banks, some are only partly prepared for the implementation.

The banks aim to look beyond the regulatory aspects and aim to benefit from the new

regulations as a means to enhanced risk management.


5. Do you have an assigned credit risk, market risk and operational risk manager in your

bank?


Yes 10 8 7

No 2 3


1

2

3

4

5

6

7

8

9

10

Yes No

6. To whom does risk manager report?


Chief executive

officer

3 6 5

Chief financial

officer

Assets and liability

manager

4 1 2

Credit risk officer 3 3 3

Others specify

Chief ex

ecutive

off...

Chief finan

cial o

ffi...

Assets a

nd liabilit

y...

Credit r

isk officer

Others sp

ecify

0

1

2

3

4

5

6

Credit riskMarket risk Operational risk

7. What is the assigned manager’s time dedicated to this activity?


0 – 20% 2 4 2

20 – 50% 2 1 2

>50% 6 5 6


1

2

3

4

5

6

0 – 20%20 – 50%>50%

8. How many people work in these departments?


1 – 3 1 3 2

3 – 5 7 5 5

5 – 10 1 1 2

>10 1 1 1

1 – 3 3 – 5 5 – 10 >100

1

2

3

4

5

6

7


9. Do you have a risk committee?


Yes 5 6 7

No 5 4 3


1

2

3

4

5

6

7

Yes No

Observation:

Almost all of the participating banks have risk management department.

Most of the industry’s risk managers’ report to the chief executive officer,

asset and liability manager and chief risk officer accounting for the balance in

equal proportions.

Slightly more attention is paid to credit and operational risk than to market

risk, as 40% of the banks operating do not have risk committee.

Interpretation

Despite the relatively small size banks, they are generally well aware of the risk

management function, and for this purpose, risk managers spend over half their time

performing these functions.

Reporting ability

10. Are you producing reporting for


Regulatory purpose 3 5 4

Monitoring 7 9 8

Decision making

purpose

7 5 4


1

2

3

4

5

6

7

8

9

Regulatory purposeMonitoring Decision making purpose

11. Does external reporting drive your internal reporting?


Very significantly 5 4 3

Significantly 4 5 5

Not at all

significantly

1 1 2

Very significantly Significantly Not at all significantly 0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5


12. How frequent is your internal reporting?


Daily 2 1

Weekly 1 2

Monthly 7 8 6

Annually 1 1 1

Daily Weekly Monthly Annually 0

1

2

3

4

5

6

7

8


Observation:

All the risk reporting is compiled largely for monitoring and decision making purpose

than regulatory purpose.

All the banks produce internal report.

Most of the banks produce internal report monthly.

Most of the banks said external reporting affect their decision making process

Interpretation

Reporting for all risk still needs to be developed.

Compliance with Basel II

13. Which approach will best suit your organization?


Standard 8 9 7

Foundation

Advanced 2 1 3

Don’t know

Standard Foundation Advanced Don’t know0

1

2

3

4

5

6

7

8

9

Credit risk

Market risk

Operational risk

14. Have you performed a cost/benefit analysis for each approach proposed by basel II?


Yes 10 8 9

No 2 1


1

2

3

4

5

6

7

8

9

10

Yes No

15. In your situation, could regulatory capital consumption be motivation for:


Stopping activities 2 1 2

Developing activities 5 7 6

Acquiring activities 1 1

None 1 1 1

Sto

pping activiti

es

Developing a

ctivities

Acquiring a

ctivities None

0

1

2

3

4

5

6

7


Observations:

Most of the banks believe that the standard approach is the most appropriate for their

purpose.

On the whole, a cost/ benefit analysis has been done for each approach. It appears that

the banks have completed their cost/ benefit analysis for their elected approach.

Regulatory capital consumption is motivated for developing activities.

Interpretation:

Most of the banks would prefer to adopt the standard approach, but only few of those

who would like to implement the advanced approach and they will implement.

The banks would prefer to adopt the standard approach should try to adopt advanced

approach.

Capital Allocation

16. Have you estimated the regulatory capital consumption for each of your individual

businesses?


Yes 10 9 10

No 1


1

2

3

4

5

6

7

8

9

10

Yes No

17. Will you outsource activities with high capital consumption?


Yes 4 3 6

No 6 7 4


1

2

3

4

5

6

7

Yes No

18. Will you insure selected risk?


Yes 5 7 6

No 5 3 4


1

2

3

4

5

6

7

Yes No

19. Do you intend allocating economic capital by business line?


Yes 7 9 8

No 3 1 2


1

2

3

4

5

6

7

8

9

Yes No

20. Will you make use of basel II requirement to implement an economic capital

allocation throughout your business line?


Yes 9 8 8

No 1 1


1

2

3

4

5

6

7

8

9

Yes No

Observation:

Most of the banks do not outsource activities with high capital consumption.

Half of the banks insure selected risk

Banks with less sophisticated approaches are likely to use the regulatory capital as the

basis for internal capital allocation.

Interpretation

Very few banks plan to outsource activities with high capital consumption, but the

majority will insure their credit risks, while nearly half will plan to insure their

market and operational risks.

A strong majority of local banks will allocate economic capital according to

business lines, while a stronger majority will use the Basel II requirements to

implement that capital allocation process.


21. Have you established an action plan to achieve the basel II requirements?


Yes 10 10 10

No


1

2

3

4

5

6

7

8

9

10

Yes No

22. How will you execute this action plan?


Internal resources 7 5 8

External resources 1 4 1

Both 5 3 3


1

2

3

4

5

6

7

8

Internal resourcesExternal resources Both

23. What will the largest spending area be?


Technology 8 7 8

Communication 1 4 1

Others (specify)

Don’t know

Other (specify) ------------------------------------------

Technology Communication Others (specify) Don’t know0

1

2

3

4

5

6

7

8


24. How far are you in the implementation of your action plan?


Not realized

Partially realized 5 6 7

Fully realized 5 4 3


1

2

3

4

5

6

7

Not realized Partially realized Fully realized

Observations:

All the banks established by an action plan to achieve the Basel II requirements.

Most of the banks execute the action plan with internal resources than external

resources.

Largest spending area is technology.

Half of the bank’s implementation of action plan is partially realized and half fully

realized.

Interpretation:

The banks have generally determined an action plan to help them to meet Basel II

requirements. they have partially completed he action plans.

Those banks that have not yet begun implementation tend to be smaller banks,

with simpler business models, which require less time and resources to meet the

Basel II requirements.

Technology

1. Does your current IT infrastructure allow you to meet the Basel II requirements?


Yes 10 8 9

No 2 1


1

2

3

4

5

6

7

8

9

10

Yes No Series3

2. Will you develop an IT solution for risk management?


Yes 6 7 7

No 4 3 3


1

2

3

4

5

6

7

Yes No

3. Have you completed a review of potential IT solution available?


Technology 5 3 6

Consulting 4 7 4


1

2

3

4

5

6

7

Technology Consulting

4. What difficulties do you foresee?


Integration

capabilities

3 1 1

Database design 1 1

Models 1 1

Budget 1

Data gathering 4 6 4

Human resource 3 3 3

Others (specify)

Integrati

on capab

ilities

Database

design

Models

Budget

Data ga

thering

Human re

source

Others (sp

ecify)

0

1

2

3

4

5

6


Observation:

More than half of the banking industry will use their IT infrastructure in its current

format.

Difficulties that banks foresee are more on data gathering and human resource.

Interpretation:

The banks should train their employees, in order to overcome the difficulties in

implementing Basel II norms.

The banks should develop sufficient infrastructure to gather the required data.

Findings and Suggestions

Credit risk is generally well contained, but there are still problems associated with

loan classification, loan loss provisioning and the absence of consolidated accounts.

Market risk and operational risk are clear challenge, as they are relatively new to the

areas that were not well developed under the original Basel capital accord.

The new regulations will allow banks to introduce substantial improvements in their

overall risk management capabilities, improving risk based performance

measurement, capital allocation as portfolio management techniques.

Future complexity is expected because banks diversify their operations. It is expected

that banks will diversify their operations to generate additional income sources,

particularly fee-based income to improve returns.

Basel II leads to increase in data collection and maintenance of privacy and security in

various issues.

The banks that would prefer to adopt the standard approach should try to adopt

advanced approach.

Suggestions

The banks should review Basel II components and develop a vision, strategy and

action plan for what is expected to be suitable framework based on how the banking

system evolves over time.

The banks need regular engagement for sustained support. A qualified long-term

advisor would be preferable.

A workshop should be planned to produce a road map to Basel II compliance.

Training and additional assistance to make it easier for the banking system to comply

with new guidelines on market and operational risk.

Data privacy and security needs more attention.

Conclusions

Implementation of Basel II has been described as a long journey rather than a destination by

itself. Undoubtedly, it would require commitment of substantial capital and human resources

on the part of both the banks and supervisors. RBI has decided to follow a consultative

process while implementing Basel II norms and move in gradual, sequential and co-ordinate

manner. For this purpose, dialogue has already been initiated with the stakeholders. As

envisaged by the Basel committee, the accounting profession too, will make a positive

contribution in this respect to make Indian banking system still stronger.

Questionnaire

Institutional information

1. Name of your bank

2. Please indicate the name of the contact person for this

questionnaire and his/her position in the bank

Name:

Position:

3. To which of the following types does your bank belongs o Public sector

o Private sector

o Foreign bank

4. Where is your head office located


5. What is your assessment of your readiness for the new basel proposal with respect to



Fully prepared

Partially

prepared

Not yet prepared

6. Have you done a gap analysis between the current risk management practise and new



Yes

No

7. What degree of priority do you address to the new basel framework?


Very important

Important

Not important

8. How do you view basel II regulation: as an opportunity to enhance the risk

management process or as a regulatory constraint?


Opportunity

Constraint


9. Do you have an assigned credit risk, market risk and operational risk manager in your

bank?


Yes

No

10. To whom does risk manager report?


Chief executive

officer

Chief financial

officer

Assets and liability

manager

Credit risk officer

Others specify

11. What is the assigned manager’s time dedicated to this activity?


0 – 20%

20 – 50%

>50%

12. How many people work in these departments?


1 – 3

3 – 5

5 – 10

>10

13. Do you have a risk committee?


Yes

No

Reporting ability

14. Are you producing reporting for


Regulatory purpose

Monitoring

Decision making

purpose

15. Does external reporting drive your internal reporting?


Very significantly

Significantly

Not at all

significantly

16. How frequent is your internal reporting?


Daily

Weekly

Monthly

Annually

Compliance with basel II

17. Which approach will best suit your organization?


Standard

Foundation

Advanced

Don’t know

18. Have you performed a cost/benefit analysis for each approach proposed by basel II?


Yes

No

19. In your situation, could regulatory capital consumption be motivation for:


Stopping activities

Developing activities

Acquiring activities

None

Capital allocation

20. Have you estimated the regulatory capital consumption for each of your individual

businesses?


Yes

No

21. Will you outsource activities with high capital consumption?


Yes

No

22. Will you insure selected risk?


Yes

No

23. Do you intend allocating economic capital by business line?


Yes

No

24. Will you make use of basel II requirement to implement an economic capital

allocation throughout your business line?


Yes

No


25. Have you established an action plan to achieve the basel II requirements?


Yes

No

26. How will you execute this action plan?


Internal resources

External resources

Both

27. What will the largest spending area be?


Technology

Communication

Others (specify)

Don’t know

Other (specify) ------------------------------------------

28. How far are you in the implementation of your action plan?


Not realized

Partially realized

Fully realized

Technology

29. Does your current IT infrastructure allow you to meet the Basel II requirements?


Yes

No

30. Will you develop an IT solution for risk management?


Yes

No

31. Have you completed a review of potential IT solution available?


Technology

Consulting

32. What difficulties do you foresee?


Integration

capabilities

Database design

Models

Budget

Data gathering

Human resource

Others (specify)

Place :

Date: Signature

Date post:	28-Dec-2015
Category:	Documents
Upload:	shikha-sharma
View:	68 times
Download:	3 times

Risk Management in Banking Sector

Documents