Risk management by commercial banks -- Time to hammer out the chinks

R. G. Bhatnagar

ONE of the important decisions taken recently by the RBI panel on banking supervision,
under the chairmanship of its deputy governor, Mr Y. V. Reddy, was on the risk
management strategies of commercial banks. The group took a hard look at the present
pra ctices and concluded that the situation called for a greater understanding by bank
managements and boards of the risks involved in their operations.

Financial markets the world over have undergone far-reaching changes in the last
decade, spurred by deregulation and liberalisation, as well as rapid developments in
communication and Internet technologies. Banks in India have, however, generally not
pai d enough attention to the potential risks and to evolve mechanisms and systems to
control and manage them in line with the global standards and procedures.

It is, therefore, not surprising that the banks are frequently confronted by financial
scams, frauds and wilful defaults having a much wider ramification for the entire system
than may appear in the first instance. The pay-order scam triggered by the Mad havpura
Mercantile Cooperative Bank is the latest instance where a number of commercial banks,
including Bank of India, State Bank and Punjab National Bank, have been exposed to
substantial financial losses.

As the banks no longer operate in a protected and regulated environment, there is an

imperative need for them to develop and improve their capability to understand the
changes in their economic environment and other circumstances having a critical bearin
g on their activities.

Risk management is a comprehensive process adopted by an organisation that seeks to

minimise the adverse effects it is exposed to due to various factors -- economic, political
or environmental, some of them inherent to the business, others unforeseen and
unexpected. Typically, the risks faced by a bank have four major inter-related
components:

Credit risk

*Environmental and financial risk which, inter alia, arises from changes in the
macroeconomic environment, interest rate fluctuations and market exposures.

*Operations risk, covering other aspects of day-to-day business, including personnel

management, industrial relations and human resources development.

*Strategic risks, which are associated with the way an institution is managed, including
the strategy for marketing, meeting new competition, improving customer satisfaction
and product development

Credit risk: Time and again, the fundamental business of lending has brought trouble to
individual banks and entire banking systems. It is, therefore, imperative that the banks
have adequate systems for credit assessment of individual projects and evalua ting risks
associated therewith as well as the industry as a whole. Generally, banks in India
evaluate a proposal through the traditional tools of project financing, computing
maximum permissible limits, assessing management capabilities and prescribing a ceiling
for an industry exposure.
As banks move into a new high-powered world of financial operations and trading, with
new risks, the need is felt for more sophisticated and versatile instruments for risk
assessment, monitoring and controlling risk exposures

Credit risk cannot, however, be divorced from market risk. For example, the economic
upheaval in some countries revealed a strong correlation between unhedged market
risks and credit risks. Again, the volatility in the prices of commodities and securitie s
underlying a credit portfolio significantly affects a bank's loan book.

Further, the forex exposures of corporates and banks, if unhedged, can play havoc with
their asset management efforts. In fact, various risks that banks are required to manage
are highly interdependent, and events affecting one risk area have ramificatio ns for a
range of other risk categories.

It is, therefore, time that bank managements equip themselves fully to grapple with the
demands of creating tools and systems capable of assessing, monitoring and controlling
risk exposures in a more scientific manner. In this regard, many international banks have
evolved credit metrics in their endeavour to refine and upgrade their risk measurements
tools.

According to New York's JP Morgan, ``Credit metrics is the first readily available portfolio
model for evaluating credit risk. This approach enables a bank to consolidate credit risk
across its entire organisation and provides a statement of value-at-ris k (VAR) due to
credit caused by upgrades, downgrades and defaults.''

Financial risk: In any integrated globalised economy, wild fluctuations in financial

parameters are bound to have far-reaching consequences for the bottomlines of banks
and companies. For instance, a change in the interest rate can suddenly make borrowin
g money very inexpensive or very costly. Many other economic factors, such as changes
in the prices of oil or the political upheaval in the country or the region can also affect
business.

Banks' managements and corporate financial managers, as such, need to make sure that
potential economic fluctuations do not threaten their organisations. Fortunately, mind-
boggling advances in information technology, the spread of personal computers and their
networking have considerably facilitated this task. A variety of tools is now available to
help manage the risk of such events occurring. Some important products include futures,
forwards, options and swaps. Apart from these, the results of academi c financial
research in recent years have helped open up entire new vistas of possibilities in the
form of new products and refining the existing ones.

Before adopting a particular risk management strategy, the organisations should,

however, clearly understand the mechanism and the implications of the proposed step,
failing which they might end up exposing themselves to greater risk.

Risk provisioning: In addition to risk management, a new approach to risk provisioning is

warranted. The need for prudential norms correlating the capital of a bank to the
quantum of risk-bearing assets it can create can hardly be disputed. In simple ter ms, it
means stipulating how much capital banks should set aside against their loans.

The Basle Committee is giving serious thought to the capital structure of banks so that
they are better able to withstand financial shocks. According to Claes Norgren, the
Chairman of the Task Force set up by Basle Committee on the `Future of Capital Reg
ulation', ``the proposed new framework is designed to better align regulatory capital
requirements to underlying risks, and to recognise the improvements in risk
measurement and control.''
Prescribing a minimum capital adequacy framework, though essential for strengthening
the banking structure, is not sufficient to ensure financial soundness. Whereas the
minimum capital requirements are designed to align the capital to underlying risks, i t
would not serve the desired purpose unless there is an institutional mechanism to review
the norms and the internal assessment process on an on-going basis.

This is to ensure that a bank's capital position and operational strategy is consistent with
its overall risk profile. It also presupposes an early intervention by the authority if the
capital does not provide a sufficient buffer against risks. Any appro ach aimed at better
aligning capital requirements to underlying risk exposure must also comprise a more
scientific approach and methodology for determining weightages for different types of
risks including sovereign risks.

In an ideal environment, regulatory capital reflects the riskiness of a proposal. This is,
however, not that simple. It is also necessary to develop an approach which would result
in reducing risk weights for quality corporate credit and introduce a high er risk weight
for certain low quality exposures.

It is hoped that the Basle Committee would be able to devise a sound and consistent
approach and a working model(s) to mitigate the credit risks of the banks. This can form
a basis for a standardised approach for prescribing capital adequacy norms for mo st of
the banks.

No effective monitoring and market discipline is, however, feasible unless reliable and
timely data and information are available which would enable the market participants to
make well founded and timely assessment of their risk profile. This presuppose s
transparency, better disclosures, timely reporting of relevant data, scientific data
processing and extensive interaction amongst banks and industry groups. The RBI must
issue more detailed guidelines on related issues, including disclosure of capital structure,
risk exposures and modalities for working out capital adequacy ratios.

Finally, the all-important area of training qualified personnel to handle the sophisticated
risk-management strategies and their monitoring and follow-up should receive the
attention of bank managements. Skills at the level of bankers and the concerned s
upervisory authority have to be upgraded considerably for the successful implementation
of various risk management procedures. The market regulators would have to develop
competence among their personnel to guide this new development along sound lines.