A STUDY on RISK MANAGEMENT IN BANKS

(Report submitted to JNTU in partial fulfillment of the requirement for the award of Master of Business Administration) Submitted by

Roll No: DEPARTMENT OF MANAGEMENT STUDIES

Under the guidance of

Mrs.SAI REKHA DEPARTMENT OF MANAGEMENT STUDIES INSTITUTE OF AERONAUTICAL ENGINEERING

(Affiliated to JNTU Hyderabad and Approved by AICTE, Accredited by NBA) Dundigal (Village) Quthbullapur (Mandal), Hyderabad -500043 2009- 2011

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Topics

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INTRODUCTION

1.1

DEFINITIONS

1.2

REVIEW OF LITERATURE

OBJECTIVES OF THE STUDY

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SCOPE OF THE STUDY

11

SOURCES OF DATA

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LIMITATIONS OF THE STUDY

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CONCLUSION

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BIBLIOGRAPHY

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INTRODUCTION OF RISK MANAGEMENT IN BANKS

RISK : In the basic sense, Risk is the chance of financial loss. Assets having greater chances of losses are viewed as more risky than those with lesser chances of loss. The term risk is used interchangeably with a given with uncertianity to refer to the variability of returns associated asset. Risk is the possibility that the actual outcome may be different from the expected outcome. So, variance in the value of assets, liabilities and operating income due to unanticipated changes in some factors is called risk. RISK MANAGEMENT:

Risk management does not aim at risk elimination, but enables the organization to bring their risk to manageable proportions while not severely affecting their incomes. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing risk to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. These transformation takes place due to their inter linkage present among the various risks. The focal point in managing any risk will be to understand nature of the transaction in a way to unbundle the risk it is exposed to. Risk management is a more mature subject in the western world. This is largely a lesson from major corporate failures, most telling and visible being the Barings collapse. In addition, regulatory requirements have been introduced, which expect organizations to have effective risk management practices. In India, whilst risk management is still in its infancy, there has been considerable debate on the need to introduce comprehensive risk management practices.

RISK MANAGEMENT IN BANKING SECTOR

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 bearing on their business activities. Risk management is a comprehensive process adopted by an organization that seeks to mininize the adverse effects it is exposed due to various factors like economic,political or environmental. Some of them are inherent to the business, others unforseen and unexpected. Present practices/situation prevalent at commercial banks require a hard look and call for a greater understanding by bank managements and boards of the risks involved in their operations.

Risk Management Components:

The process of risk management has three identifiable steps viz. Risk identification, Risk measurement, and Risk control.

Risk Identification
Risk identification means defining each of risks associated with a transaction or a type of bank product or service. There are various types of risk which bank face such as credit risk, liquidity risk, interest rate risk, operational risk, legal risk etc.

Risk Measurement
The second step in risk management process is the risk measurement or risk assessment. Risk assessment is the essemination of the size probability and timing of a potential loss under various scenarios. This is the most difficult step in the risk management process and the methods, degree of sophistication and costs vary greatly. The potential loss is generally defined in terms of Frequency and Severity.

Risk Control
After identification and assessment of risk factors, the next step involved is risk control. The major alternatives available in risk control are: 1) Avoid the exposure 2) Reduce the impact by reducing frequency of severity 3) Avoid concentration in risky areas
4) Transfer the risk to another party. 2

TYPES OF RISKS OCCURS IN BANKS

The risks to which a bank is particularly exposed in its operations are: liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and risk from change in market price of securities, financial derivatives and commodities), exposure risks, investment risks, risks relating to the country of origin of the entity to which a bank is exposed, operational risk, legal risk, reputational risk and strategic risk.

Liquidity risk: Liquidity risk is the risk of negative effects on the financial result and capital of the bank caused by the banks inability to meet all its due obligations. Credit risk: Credit risk is the risk of negative effects on the financial result and capital of the bank caused by borrowers default on its obligations to the bank. Market risk: Market risk includes interest rate and foreign exchange risk. Interest rate risk: Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates. Foreign exchange risk: Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates. A special type of market risk is the risk of change in the market price of securities, financial derivatives or commodities traded or tradable in the market. Exposure risks: Exposure risk include risks of banks exposure to a single entity or a group of related entities, and risks of banks exposure to a single entity related with the bank. 3 Investment risks: Investment risk include risks of banks investments in entities that are not entities in the

financial sector and in fixed assets. Risks relating to the country of origin of the entity to which a bank is exposed (country risk) is the risk of negative effects on the financial result and capital of the bank due to banks inability to collect claims from such entity for reasons arising from political, economic or social conditions in such entitys country of origin. Country risk includes political and economic risk, and transfer risk. Operational risk: Operational risk is the risk of negative effects on the financial result and capital of the bank caused by omissions in the work of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events. Legal risk: Legal risk is the risk of loss caused by penalties or sanctions originating from court disputes due to breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body. Reputational risk : Reputational risk is the risk of loss caused by a negative impact on the market positioning of the bank. Strategic risk: Strategic risk is the risk of loss caused by a lack of a long-term development component in the banks managing team.

DEFINITION OF RISK MANAGEMENT

The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.

Policies, procedures and practices involved in identification, analysis, assessment, control, and avoidance, minimization, or elimination of unacceptable risks. A firm may use risk assumption, risk avoidance, risk retention, risk transfer, or any other strategies in proper management of future events.

The culture, processes and structures that are directed towards the effective management of potential opportunities and adverse effects. Risk management is a systematic approach to minimizing an organization's exposure to risk. A risk management system includes various policies, procedures and practices that work in unison to identify, analyze, evaluate, address and monitor risk. Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.

Management in risks in banks

The management of an organization has to decide whether they want to pursue their risk management function in order to manage or reduce risks. In the context of the risk management function, Identification and management of risk is more prominent for the financial services sector and less so far consumer products industry. Solvency and liquidity are the two irreducible conditions upon which society allows the banking industry to gear up. Problems with credit , liquidity , and fraud are the most common primary causes of bank failures, and combinations of these misfortunes are often seen. Managing credit risks: Credit risk is defined as the potential that a bank borrower will fail to meet obligations in accordance with agreed terms. The goal of credit risk management is to maximize a banks risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Credit rating is the main tool, which helps to measure the credit risk and facilities pricing of the account. It gives vital indications of weaknesses in the account. It also triggers portfolio management at the corporate level. Banks have developed sophisticated systems in an attempt to model the credit risk arising from important aspects of their business lines. Such models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines.

Some of the models include: a) b) c) d) e) f) Setting of concentration and exposure limits. Setting of hold targets on syndicated loans. Risk-based pricing. Improving risk/return profiles of the portfolio. Evaluation of risk-adjusted performance of business lines or managers using RAROC. Economic capital allocation.

Managing market risks: The important risk faced by the banks in normal operations is the credit risk and the market risk. Credit risk involves the risk that loans will not be repaid by the customers and the market risk is the risk of losses arising from adverse movements in market prices. 6 Value-at-Risk helps the organization to measure the risk in trading portfolios. These models are designed to estimate, for a given trading portfolio, the maximum amount that

a bank could lose over a specific time period with a given probability. But the RBI has laid certain guidelines regarding the application of the Value-at-Risk(VaR) framework in the Indian banks.

Managing interest rate risk: Due the the nature of its business, a bank should accept interest rate risk not by chance but by choice, it should ensure that the risk taken is manageable and it does not get transformed into any other undesirable risk. The sensitivity to interest rate fluctuations will arise due to the mixed effect of a host of other risks that comprise the interest rate risk. These risks when segregated fall into rate level risk, volatility risk, Prepayment risk, call/pit risk, Reinvestment risk, Basis risk and real interest rate risk. A bank is exposed to the interest rate risk, should quantify by means of suitable methodology. Some of the approaches used to tackle interest rate risk are Maturity gap method, rate adjusted gap, duration analysis, hedging, sensitivity analysis and simulation.

Managing Foreign Exchange risk: when the operations are in multi currencies, the organizations are exposed to foreign exchange risk. The main reason for this is the change in the exchange rate of different currencies. In the context of a bank, the foreign exchange risk may be defined as the risk that arises when 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. For a bank, therefore, the first major decision on forex risk management s for the management to fix its open foreign exchange position limits. Managing Liquidity Risk: There are various methods t available to tackle the liquidity risk. The bank should select a technique which suits its operating environment and business policies. This technique should lay down a liquidity plan that avoids in all possible circumstances the chances of a cash shortage/surplus. 7 Further, the alternative will have to work within the interest rate exposure limits set for the bank. However, considering the interest rate exposure limits will not suffice. The

management should also have generated the tolerance limits for the liquidity ratio based on the past performances. Working between these two limits, the bank should select the maturity patterns and risk profiles of its assets and liabilities in such a way that it strikes a balance between being overtly liquid and relatively illiquid. Managing Operational risk: Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems from external events. The essential role of the top management in managing operational risk through a welldesigned operational risk management set-up and different avenues that need to be pursued to manage operational risk have been deliberated upon. In the ultimate analysis, it is the unit heads, which are to implement the operational risk management practices for achieving the desired results under the policy guidelines issued by the risk management committee.

REVIEW OF LITRATURE FSA to investigate banks' risk management practices

Elizabeth Judge

The City regulator is to launch a formal inquiry into the financial crisis in a move that could see banking bosses being brought to account for their actions. The Financial Services Authority (FSA) inquiry is expected to cover issues including risk management processes, the amount of information available to shareholders and the behaviour of directors before the emergency rescues of the Royal Bank of Scotland and HBOS last year. The move follows a warning last month from Hector Sants, FSA chief executive, that bankers should not be complacent about his organization. In a speech to members of London's financial community, he said: There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA. The speech was hailed as drawing a line under the light-touch regulation that helped to build London into a financial powerhouse. Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers have been approached to pitch for a mandate to assist with the investigation. Two firms are expected to be appointed to avoid conflicts of interest. The inquiry is not expected to address one of the most controversial issues thrown up by the crisis - Sir Fred Goodwin's 703,000-a-year pension settlement. The Treasury took unprecedented steps to stabilise the British banking system last October when it took a majority stake in the Royal Bank of Scotland and committed an overall 37 billion to it, HBOS and Lloyds TSB.

OBJECTIVE OF THE STUDY

The following objectives have been fix for making these study on Risk management in banks. 1.To know the need for managing the risks in banking sectors. To know various types of risks faced by banks 2. To analyze different types of risks involved in banks such as

Credit risk Market risk, which includes interest rate risk Liquidity risk Operational risk

3.To know how to measure and monitor various risks. 4.To know newer methodologies to quantify risk in light of newer businesses and challenges.

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SCOPE OF STUDY
Risk is intrinsic to banking business as the major risks confronting banks are credit risk, interest rate risk, liquidity risk and operational risk. Irrespective of the nature of the risk the best way for banks to protect themselves is to identify risk, accurately measure, price it and maintain appropriate levels of reserves and capital. If Indian banks are to compete globally then they have to institute sound and robust risk management practices, which will improve efficiency of banks. The scope of this study involves analyzing and measuring major risks i.e credit risk, liquidity risk, interest rate risk and operational risk of banks (public and private sector). The present study evaluates key performance indicators of various banks in terms of credit deposit ratio, net interest margin, spread, overhead efficiency, Gap analysis and maturity ladder. While putting the risk management in place banks often find it difficult to collect reliable data. The challenge is mainly in the area of operational risk where there is dearth of reliable historic data and not a great deal of clarity on the measurement of such risk.

SIGNIFICANCE OF STUDY
Good risk management is good banking. And good banking is essential for profitable survival of institution. It brings stability in earnings and increases efficiency in operations. The present study proposes to:

Value preservation Value creation Capital optimization

Enhance capital allocation. Improvement of portfolio identification and action plans. An understanding of key business processes. Integration of risk management within corporate governance framework. Improved Information Security. Corporate Reputation. Instill confidence in the market place. Alleviate regulatory constraints and distortions thereof. 11

SOURCE OF DATA

Data for the present study is collected from two sources

Primary Source: The first hand information is collected with the responses and

interviews with the financial manager in relation to the product.

Secondary Source:

The secondary data is colleted from the published sources like journals, Magazines and various published books.

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LIMITATIONS OF STUDY
However, I have made every possible effort at my great extent level to show how selected sample of banks analyse the major risks i.e credit, market and operational risks. But the study at the disposal of a researcher on this level is limited. In addition to other factor such as time that plays a very important role in every field of todays life has also an important bearing on research work. The main limitations of the present study are as follows:

The limitation of the study is only to the study of Risk management in banks. All data and information collected is true to some specific period of time. All the detials could be extracted as the companies will be having the rule of Confidentiality. It was difficult to have group discussions with experts due to their busy schedules.

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CONCLUSION
Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulated Environment, banks could not afford to take risks. But of late, Banks are exposed to same competition and hence are compeled to encounter various types of financial and non-financial risks. Risks and uncertianties form an integral part of banking which by nature entails taking risks. There are three main categories risks; credit risk, market risk and operational risk. The main features of these risks as wll as some other categories of risks such as regulatory risk and environmental risk. Various tools and techniques to manage credit risk.market risk and opertional risk and its various components are also well discussed in detial, another also mentioned relevant points of role of capital adequency, risk aggregation and capital allocation and risk based supervision in managing risks in banking sector. 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, clear purpose and understanding so that it can be measured and mitigated. It also prevents institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position.

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BIBLOGRAPHY

R.S.Raghavan, Risk management in banks. Taxmann,Treasury and Risk management in banks(2009-10) L M Bhol and Jitndra mahakud, Financial institutions and markets. ISO/IEC Guide 73:2009 (2009). Risk management Vocabulary. International Organization for Standardization. ISO/DIS 31000 (2009). Risk management Principles and guidelines on implementation. International Organization for Standardization. "Committee Draft of ISO 31000 Risk management" (PDF). International Organization for Standardization. WWW.Businessdictionary.com WWW.Wikipedia.com

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