“Risk Management in Banks: The AHP way” By: Diksha Arora PG Candidate, Class of PGDM-2010 BIMTECH, India Abstract Risk is inherent in every walk of life. Banks are, by definition, in the business of taking and managing risk. The paper deals with the study of Risks associated with commercial banks like risk revolving on capital, credit risk, market risk, liquidity risk, earnings risk, business strategy risk, environmental risk, operational risk, group risk, internal control risk, organizational risk, management risk and compliance risk.
In the global scenario, the degree to which the models have been incorporated into the Risk Management and economic capital allocation process varies greatly between banks. Through this paper an attempt was made to construct an optimal model using Analytical Hierarchy Programming to find the risk rating of a bank. This model will bring uniformity and help in assessing performance of a bank vis-a-vis another which also forms a part of RBI supervision. Introduction The etymology of the word “Risk” can be traced to the Latin word “Rescum” meaning Risk at Sea or that which cuts.
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Risk is inherent in every walk of life. Banks are, by definition, in the business of taking and managing risk. With growing competition and fast changes in the operating environment impacting the business potentials, banks are compelled to encounter various kinds of financial and non-financial risks. Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i. e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. The various risks that a bank is bound to confront is divided into two ategories namely business risks and control risks. Business risk involves the risks arising out of the operations of the bank, the business it is into and the way it conducts its operations. It consists of 8 types of risks namely capital, credit, market, earnings, liquidity, business strategy and environmental, operational and group risk. Control risk measures the risk arising out of any lapses in the control mechanism such as the organizational structure and the management and the internal controls that exist in the bank.
Controls risk further consists of internal controls, management, organizational and compliance risk. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken. The three main categories of risks which have a mention in the capital accord are: Credit Risk, Market Risk and Operational Risk.
Credit risk, a major source of loss, is the risk that customers fail to comply with their obligations to service debt. Major credit risk components are exposure, likelihood of default, or of a deterioration of credit standing, and the recoveries under default. Modelling default probability directly with credit risk models remains a major challenge, not addressed until recent years. Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables.
Market risk management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy. Operational risk involves breakdown in internal controls, personnel and corporate governance leading to error, fraud, and performance failure, compromise on the interest of the bank resulting in financial loss.
Putting in place proper corporate governance practices by itself would serve as an effective risk management tool. The practical difficulties lie in agreeing on a common classification of events and on the data gathering process. Risk management in banking designates the entire set of risk management processes and models allowing banks to implement risk-based policies and practices. They cover all techniques and management tools required for measuring, monitoring and controlling risks.
The spectrum of models and processes extends to all risks: credit risk, market risk, interest rate risk, liquidity risk and operational risk, to mention only major areas. For centuries bankers as well as their regulators have assessed and managed risk intuitively, without the benefit of a formal and generally accepted framework or common terminology. No longer is it sufficient to understand just the primary risks associated with a product or service. They have to constantly monitor and review their approach to credit, the main earning asset in the balance sheet.
Regulators make the development of risk-based practices a major priority for the banking industry, because they focus on ‘systematic risk’, the risk of the entire banking industry made up of financial institutions whose fates are intertwined by the density of relationships within the financial system. Banking failures have been numerous in the past, both in India and internationally. Banking failures make risk material and convey the impression that the industry is never far away from major problems.
Regulators have been very active in promoting pre-emptive policies for avoiding individual bank failures and for helping the industry absorb the shock of failures when they happen. To achieve these results, regulators have totally renovated the regulatory framework. They are promoting and enforcing new guidelines for measuring and controlling the risks of individual players. From the banks point of view risk based practices are so important, because banks being ‘risk machines’, they take risks, they transform them, and they embed them in banking products and services.
Banks take risk-based decisions under an ex-ante perspective and they do risk monitoring under an ex-post perspective, once the decisions are made. There are powerful; motives to implement risk based practices to provide a balanced view of risk and return from a management point of view; to develop competitive advantages, to comply with increasingly stringent regulations. It is easy to lend and obtain attractive revenues from risky borrower. The price to pay is a risk that is higher than the prudent bank’s risk.
The prudent bank limits risk and therefore both future losses and expected revenues by restricting business volume and screening out risky borrowers. It might avoid losses but it might suffer from lower market share and lower revenues. However, after a while, the risk-taker might end with an ex-post performance lower than the prudent bank due to higher losses materializing. Risks remain intangible and invisible until they materialize into losses. Simple solutions simply do not really help to capture risks. All these factors led to the commencement of this study. Literature review
Shashi Bhattarai and Shivjee Roy Yadav (2009) review application of Analytic Hierarchy Process (AHP) in the finance sector with specific reference to banking. Their paper also describes feedback from bankers’ community in Nepal on utility of AHP as a decision support tool in the situation of global financial crisis. The relationship between problem loans and the economic cycle is also analysed by Salas and Saurina (2002). Using panel data, they report that the business cycle (proxied by the current and lagged growth of GDP) has a negative and significant impact on bad loans.
They also find that credit risk was significantly influenced by individual bank level variables, after controlling for macro-economic conditions. In 2001 Boston Consulting Group study confirmed the general impression that North American banks have a clear lead on most of their European and Asian competitors. Institutions in the U. S. and in Australia too for that matter were pursuing risk management not to comply with regulatory requirements but to enhance their own competitive positions. Arpa et al. , (2001) study the effects of the business cycle on risk provisions and earnings of Austrian banks in the 1990s.
They conclude that risk provisions increase in period of falling real GDP growth, confirming the pro-cyclical tendencies in bank behaviour. Moreover, rising real estate prices lead to higher provisions, whereas falling inflation depresses them. They also find that some macro-economic variables such as interest rates, real estate and consumer prices are useful in explaining the profitability of Austrian banks. Meyer and Yeager (2001) employ a set of county macro-economic variables to test if rural bank performance is affected by the local economic framework.
They fit an OLS model when the return on assets and the net loan losses are the dependent variables and a to bit specification for the non-performing loans. They find that none of the county-level coefficients is significant, suggesting that county economic activity does not have a relevant effect on bank performance; in contrast, state-level data are significant. Eichengreen and Arteta (2000) carefully analyse the robustness of the empirical results on banking crises using a sample of 75 emerging markets in the period 1975-1997 and considering a huge range of explanatory variables mentioned in previous works.
Their findings confirm that unsustainable boom in domestic credit is a robust cause of financial distress; macro-economic policies leading to rapid lending growth and financial overheating generally set the stage for future problems. Domestic interest-rate liberalization often accompanies these excessive lending activities. On the other hand, they point out that there is little evidence of any particular relationship between exchange-rate regimes and banking crises; the role of the legal and regulatory framework is also uncertain.
Gambera (2000), using bivariate VAR systems, tries to understand how economic development affects bank loan quality. He points out that, since systemic financial conditions help predict the soundness of the single intermediaries; it may be interesting to predict the systemic financial conditions themselves. In particular, he uses the ratio of delinquencies to total loans and the ratio of non-performing loans to total loans as alternative dependent variables and he estimates a bivariate system for each series of macro-economic variables.
Survey on the “Implementation of the Capital Adequacy Directive” by the Banking Federation of the European Union, April 1998 (covering 17 countries) revealed that very few banks are using sophisticated models for managing their risks. Most banks which use it at first place use it for internal risk management purposes only. Ajit and Bangar (1998) present a tabulation of the performance of private sector banks vis-a-vis public sector banks over the period 1991-1997, using a number of indicators: profitability ratio, interest spread, capital adequacy ratio, and the net NPA ratio.
The conclusion is that Indian private banks outperform public sector banks. What is of interest, however, is that they find Indian private banks have higher returns to assets in spite of lower spreads. Shaffer (1998) shows that adverse selection has a persistent effect on the banks which are new entrants in a market. Salas and Saurina (1999b) have modelled the problem loans ratio of Spanish banks in order to gauge the impact of loan growth policy on bad loans.
According to their empirical estimation results (which were achieved using a panel data of commercial and savings banks from 1985-1997), the cycle (measured through the current and lagged-one-year GDP growth rates) has a negative and significant impact on problem loans. The current impact is much more important. It is also shown that problem loans ratio differs by type of loan. Households and firms have different levels of bad loans. On an average, the former is lower than the latter. Among households, mortgages have very low delinquency levels compared to consumer loans, credit loans or overdrafts.
Demirguc-Kunt and Detragiache (1998) estimate a logit model of banking crises over the period 1980-1994 in order to understand the features of the economic environment in the periods preceding a banking crisis and, therefore, to identify the leading indicators of financial distress. The 1998 study by Demirgue-Kunt and Huizinga (DKH) is a cross-country study of variations in bank performance, using two performance indicators separately regressed on a set of explanatory factors; the interest spread (used as an efficiency indicator) and bank profitability. The data set is t bank-level for 80 countries over the period 1988-95. The most important finding pertains to the differences in the impact of foreign ownership between developed and developing countries. In developing countries foreign banks have greater interest margins and profits than domestic banks. In industrial countries, the opposite is true. The first finding bears out the better NPA performance by foreign banks in India by country of origin. Among the macro variables reported by DKH that affect bank profitability positively although not net interest margins (the efficiency indicator), is per capita GDP.
These results suggest that per capita GDP may be less a correlate of banking efficiency or superior banking technology, and more a correlate of banking opportunities and the operating environment generally. The Sarkar, Sarkar and Bhaumik (1998) cross-bank study for India regresses two profitability and four efficiency measures (one of which is the net interest margin) on pooled data for two years, 1993-94 and 1994-95, for a total of 73 banks, using single-equation OLS estimation for each.
The study focuses exclusively on an examination of the prediction from the property rights literature about the superiority of private ownership in terms of performance. Private banks are divided into traded and non-traded categories; the control variables include the (log of) total bank assets, the proportion of investment in government securities, the proportion of loans made to the priority sector, the proportion of semi-urban and rural branches and the proportion of non interest income to total income.
Berger and Deyoung (1997) address a little examined intersection between the problem loan literature and the bank efficiency literature. They employ Granger-casualty techniques to test four hypotheses regarding the relationship among loan quality, cost efficiency, and bank capital. The data suggest that the intertemporal relationships between problem loans and cost efficiency ran in both directions for U. S. commercial banks between 1985 and 1994.
The data suggest that high levels of nonperforming loans Granger-cause reductions in measured cost efficiency, consistent with the hypothesis that the extra costs of administering these loans reduces measured cost efficiency (‘bad luck’). The data also suggest that low levels of cost efficiency Granger-cause increases in nonperforming loans, consistent with the hypothesis that cost-inefficient managers are also poor loan portfolio managers (‘bad management’). In the paper by Mario Quayliariello (1997), the relationship between bank loan quality and business cycle indicators is studied for Italy.
A distributed lag model (which is estimated using ordinary least squares) and bivariate Granger-causality tests are used in order to evaluate the importance of macro-economic factors in predicting the quality of bank loans measured by the ratio of non-performing loans to total loans. The main target of the research is to understand the contribution that macro-data can offer in capturing the evolution of credit quality and to select a reasonably manageable set of indicators which can act as early warning signals of the banking system fragility.
Kaminsky and Reinhart (1996) in their well-known paper on twin-crises study about 25 episodes of banking crises and 71 balance of payments crises in the period 1970-1995. Regarding the influence of business cycle on the episode of financial instability and the possibility to identify macro-variables that act as early warning, they find that recessionary conditions such as economic activity decline, weakening of the export sector, high real interest rates, falling stock market, usually precede banking as well as currency crises.
They also find that Credit expansions, an abnormally high money growth and the decline in the terms-of-trade anticipate many of the banking crises. Objective of the Present Study Risk, in one kind or the other, is inherent in every business. Furthermore, risk taking is essential to progress, and failure is often a key part of learning. Although some risks are inevitable, it does not mean that attempting to recognize and manage them will harm opportunities for creativity. Risks pose new challenges to every company.
From employment practices to electronic commerce, from social and political pressures to the vagaries of the weather, the hazards that exist in today’s business climate are as diverse as the companies that face them. Like any other business organization, banks too face risks inherent to the company and the industry in which they exist. This paper has been undertaken with the objective to critically examine the current risk management practices as directed by RBI and supervision process undertaken by RBI. On the basis of which, an attempt has been made to develop an AHP model for the same. Data and Methodology
The current study covers 3 banks and their names have been masked. Judgement sampling method has been used to collect the data. The study required both primary and secondary data. Primary data was collected with the help of questionnaires and series of interview schedules. Secondary data has been collected through published reports, RBI circulars and bulletins. Analysis and Findings Risk management: According to the RBI circular issued on risk management by the RBI the broad parameters of risk management function should encompass: • organizational structure • comprehensive risk measurement approach risk management policies approved by the Board which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk • guidelines and other parameters used to govern risk taking including detailed structure of prudential limits • strong MIS for reporting, monitoring and controlling risks • well laid out procedures, effective control and comprehensive risk reporting framework • separate risk management framework independent of operational Departments and with clear delineation of levels of responsibility for management of risk • Periodical review and evaluation
The banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. It has been argued that risks facing all financial institutions can be segmented into three separable types, from a management perspective.
These are: Risks that can be transferred to other participants, Risks that can be eliminated or avoided by simple business practices, Risks that must be actively managed at the firm level The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts: [pic] Figure: Steps for implementation of risk management systems The banking industry has long viewed the problem of risk management as the need to control four of the given risks which make up most, if not all, of their risk exposure, viz. credit, interest rate, foreign exchange and liquidity risk. While they recognize counterparty and legal risks, they view them as less central to their concerns. Accordingly, the study of bank risk management processes is essentially an investigation of how they manage all these risks. Irrespective of the nature of risk, the best way for banks to protect themselves is to identify the risks, accurately measure and price it, and maintain appropriate levels of reserves and capital, in both good and bad times.
However, this is often easier said than done, and more often than not, developing a holistic approach to assessing and managing the many facets of risks remains a challenging task for the financial sector. Credit risk management: Credit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at an individual level or at an entity level or at the level of a country. The credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines.
The outputs of these models also play increasingly important roles in banks’ risk management and performance measurement processes, customer profitability analysis, risk-based pricing, active portfolio management and capital structure decisions. The commonly used techniques are econometric technique, neural networks, optimisation models, rule based and hybrid systems. The domains to which they are applied are credit approval, credit rating determination and risk pricing.
The various models covering these techniques and domain are Altman’s Z-score model (1968), KMV model for measuring default risk, CreditMetrics, CreditRisk+ and Logit & probit models. Some examples of credit risk are: • In August of 1999, Iridium, the satellite telecom company, defaulted on two syndicated loans of $1. 5 billion that it had borrowed to launch the satellites, but could not repay due to unexpected low earnings. • In 1974, a small German bank, Bankhaus Herstatt, had a string of losses in forex dealings.
It went bankrupt at the end of a trading day in Germany. Because, it was the end of the trading day in Germany, it had already received $620 million worth of forex payments from its US trading counter parties, but because the US markets were still open, Herstatt had not yet been required to deliver $620 million for its side of the trades. At the time that it went bankrupt, it stopped all payments, and US banks lost virtually all of the $620 million.
Drivers of effective credit risk management: These are effective credit risk management as a value-enhancing activity, consolidating credit lines, efficient use of economic and regulatory capital, ensuring that the bank has a safe level of capital, pricing loans to earn attractive risk-adjusted profits, applying economic capital’s trio of core decision making criteria, use of derivatives to reshape credit profile and technology.
Market risk management: Market risk is defined as the uncertainty in the future values of the Group’s on and off balance sheet financial items, resulting from movements in factors such as interest rates, equity prices, and foreign exchange rates. The drivers of market risk are equity and commodities prices, foreign exchange rates, interest rates, their volatilities and correlations. Market risk can be classified into directional and non-directional risks. Market risk can be measured and managed through the use of Maturity gap analysis, Duration analysis, Convexity, Value-at-Risk (VAR), Stress Testing and the Greeks.
In Indian market, being an emerging market, liquidity and inefficiency are the major concerns in the forex, debt and stock markets. Panic and knee jerk reactions are also common (e. g. effect on stock markets during Indo-Pak tension and the recent Government change). All these factors contribute to the market risk of the bank. Some examples of market risk exposure are: • On March 31, 1997 the BSE SENSEX had lost 302. 64 points, one of the biggest losses in a single day. • In October 5, 1998 the BSE SENSEX fell a whopping 224 points and undoubtedly this day is the Black Monday in the history of Indian stock exchanges.
To analyze the market risk management techniques, an exercise of informal discussion and unstructured questionnaire was conducted at the banks under study. Few highlights are given as: • The banks have been making progress in the area of Asset Liability Management. But they are still far from achieving the level, which has been attained in banks abroad. • All of the banks have set up ALM function and established the requisite organizational framework consisting of the ALCO and the support groups. The composition, scope and functions of these bodies are in accordance with the guidelines. Banks have also made an attempt to integrate ALM and management of other risks to facilitate integrated risk management. • Banks are complaint with the regulatory requirements of the RBI regarding the preparation of statements. They have also laid out policies and maintain records as required by the guidelines. Many of them have also achieved 100% coverage of business by ALM. • Private Banks and foreign banks have made the most progress. Some of them had a head start in ALM. They have not made the progress that could possibly have been made considering that their problems are not of the magnitude of some other banks.
Asset liability management: ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. In recent years in India, most of the interest rates have been deregulated; government securities are sold in auctions and banks are also, with a few exceptions free to determine the interest rates on deposits and advances. Hence the ALM function is not simply about risk protection. It should also be about enhancing the net worth of the institution through opportunistic positioning of the balance sheet.
The more leveraged an institution is, the more critical the ALM function within the enterprise. The ALM process allows an institution to take on positions, which are otherwise deemed too large without such a function. There are various techniques of risk management to address the different types of risk. ALM primarily aims at managing interest rate risk and liquidity risk. Operational risk management: Many banks have defined operational risk as any risk not categorised as market or credit risk and some have defined it as the risk of loss arising from various types of human or technical error.
The majority of banks associate operational risk with all business lines, including infrastructure, although the mix of risks and their relative magnitude may vary considerably across businesses. Indeed, the acquisition of meaningful data, cleared of market and credit factors, is providing a major stumbling block to the overall application of risk management approaches to operational risk. Operational risk management techniques come in two basic varieties—bottom –up or top down approaches take aggregate targets such as net income or net asset value, to analyse the operational risk factors and loss events that cause fluctuations in the target.
Some examples of operational risk are: • A US government bond trader at the New York branch of a Japanese bank was able to switch securities out of customers’ accounts to cover credit losses which mounted to over $1 billion in 10years. • In 1997, Nat West lost $127 million and had to greatly reduce its trading operations because its options traders had been using the wrong data for implied volatility in their pricing models, and was therefore taking risks that they did not see. Study of risk management system at banks under study
Most of the banks do not have dedicated risk management team, policy, procedures and framework in place. Those banks have risk management department, the risk manager’s role is restricted to pre fact and post fact analysis of customer’s credit and there is no segregation of credit, market, operational and strategic risks. There are few banks which have articulated framework and risk quantification. The traditional lending practices, assessment of credits, handling of market risks, treasury functionality and culture of risk-rewards are bane of public sector banks. Whereas private ector banks and financial institutions are somewhat better in this context. The sheer size and wide coverage of banks is a big hurdle to integrate and generate a cost effective real time operational data for mapping the risks. Most of the financial institutions processes are encircled to ‘functional silos’ follows bureaucratic structure and yet to come up with a transparent and appropriate corporate governance structure to achieve the stated strategic objectives. The major conclusions as listed below have been arrived on the basis of the documents supplied and informal discussion held with the officials of the bank.
Since the year 1998 RBI has been giving serious attention towards evolving suitable and comprehensive models for Risk-management. It has laid stress on integrating this new discipline in the working systems of the Banks. In view of this, the risk management division in most of the banks was established in or after 1998 only. All the details regarding the risk management framework is presented by the bank in a policy document called ICAAP. The risk management structure followed at all banks is a combination of centralized and decentralized form.
Though risk department forms the heart of the organization because if it fails the bank will gasp for breath. But this department is a victim of ignorance in today’s scenario. After conducting the study it was found that the banks have lowest number of workforce assigned to this department. Within the department, maximum stress is given to credit risk and other risks are still neglected. The bank does not have sufficient skill set for driving risk management function. The benefits in the next two years, on account of maintaining a separate “risk management function” include following: • Improvement in productivity Enabling risk adjusted performance • Improved assessment of product profitability • Use of risk sensitive approach in business processes • Better pricing of products and consumer segments • Developing skills for risk transfer products • Competitive advantage • Fraud reduction/deduction • Better understanding and scrutiny of all functionalities of the bank. Apart from those risks mentioned under the Basel accord, banks hardly pay attention to other categories of risks. Some of the risks not addressed by most of the banks are: • Interest rate risk in the banking book • Settlement risk Reputational risk • Strategic risk • Legal and compliance risk • Risk of under estimation of credit risk under the standardized approach • Model risk • Residual risk of securitization The bank can also be exposed to a different category of risk apart from the financial risks called the environmental risk. For example, if a major portion of their credit concentration loans are in Mumbai’s central suburban area. If some calamity or unforeseen event happens in that area like extensive rainfall incident that took place in 2006-07, it would certainly affect their loan portfolio.
Separate IT division exists in most of the banks to support Risk Management Department. Complete IT based implementation of risk management system will take at least 1 or 2 more years. Data collection is the biggest challenge faced. The banks still depend heavily on manually prepared returns for its MIS. The returns for other departments are prepared through different software and this causes difficulty in integration. But on the other side, banks have always looked at technology as a key facilitator to provide better customer service and ensured that its ‘IT strategy’ follows the ‘Business strategy’ so as to arrive at “Best Fit”.
Many banks have made rapid strides in this direction and achieved almost 100% branch computerisation. A pioneering effort of the bank in the use of IT is the implementation of Core Banking Solution (CBS) which facilitates “anytime, anywhere” banking. Also, on account of CBS, the bank faces a technology risk. The private sector banks and the foreign banks have relatively fewer branches. They achieve greater levels of computerization and coverage of business. This helps them in better asset liability management where the decisions should be based on timely accurate information.
The public sector banks have also made progress in the area of computerization but have not achieved complete coverage of business. Further, while coverage of business is high, the number of branches covered is still low. It may therefore mean that the public sector banks will take more time to achieve complete coverage of business by computerization as the number of branches to be covered will be high whereas the percentage of business covered will be lower. At Indian banks securitization occurs at a very low level.
Unlike US based banks the approaches used in Indian banks are less advanced and more conservative in nature due to stringent RBI guidelines. Therefore there has not been a drastic impact of the subprime crisis on the Indian banking industry. Attention has been drawn towards liquidity risk management which has emerged to be one of the most crucial risk management forms. Sooner or later the banks expect Basel III that will include liquidity risk under pillar 1. Banks do not feel any risk fatigue.
In fact high degree of realisation exists where it is believed that a control from a number of regulatory bodies has protected the system from the failures like that of subprime crisis. But on the other hand banks do not carry the exercise of forensic audit also. Basel II compliance efforts have led to improvement in their risk management system. The bank is now able to measure residual risks. With Basel-II compliance the bank was able to articulate the need for external ratings and data integrity. The main challenges faced by the operational risk management department are: Quantification of operational risk • Reporting of the near miss events. • Less stress on operational risk by the top management • Less available manpower in operational risk management department The customer profile of all banks consists mainly of individuals and Corporate. For a large scale bank number of corporate clients is more. The top revenue earners of all banks are Corporate. All the banks use all the tools like feedback, service control and they satisfy customer complaints to achieve customer satisfaction.
Also, the competitive advantage of banks can range from Human Resource base to its marketing abilities. Banks make use of a diversified media for advertisements which helps them to reach out to the masses more effectively and efficiently. The threats Exposed to the Banks consists of: • Competition • Less of customers • Volatility in the market share • Attention • Threat of new entrants It is seen that competition is exposed to all the banks equally and is the most important threat that they are exposed to. Strategies adapted by banks to overcome risks include: Integrative growth • Intensive growth • Downsizing older business • Diversification Banks have given following as reasons for high incidence of NPAs • Improper Loan Appraisal System by Banks • Poor Risk Management Techniques as a Contribution to NPA’s • Lack of Strong Legal Framework to initiate action • Incorrect Evaluation of the Credit Worthiness of the borrower • Poor Loan Monitoring • Poor Recovery Mechanisms Analysing the reasons that has led to loans becoming unpopular with the banking industry: • High Incidences of Non – Performing Assets High Costs of Servicing • Greater Political Interference • Stricter Formalities to be compiled with • Falling demand & the Pressure on the Banks The reason as why targets set for loans have not reached by banks includes: • Projects Placed were not Feasible or Risky in the Respective Category • Inadequate Security Provided by the Borrowers • Large No. of Borrowers Whose Credit Worthiness is not Satisfactory • Fear of NPA’s Opinion of Banks for the Trend towards Investments in government securities include: • Large Availability of Government Securities in the Market. Possible fall in the Interest rates in Future and thus building up a better portfolio as of tomorrow • Investments give maximum contend, as Risk is reduced very much as compared to that of loans and Advances • There is at least an amount of satisfaction that some Income may be leaped with least or no risk at all • Regulating requirement: SLR In the note attached with the guidelines it is mentioned that with liberalization, the risks associated with banking operations has increased requiring ‘strategic management’. Management strategy depends on the corporate objective.
The objective can be deposit mobilization, branch expansion, long-term viability etc. Some of these may be conflicting. For instance profitability may have to be sacrificed for branch expansion. Each of these objectives would affect asset liability management. Unless the hierarchy of objectives is clear, any rational asset liability management and pricing decisions would be difficult. The banks under study have mentioned a definite objective in their ALM policy. The banks, which adopted ALM before the issue of the guidelines, had done so in a period ranging from 2 years to 3 months ahead of the issue of guidelines.
These banks have therefore had the opportunity to make more progress in the implementation of ALM. Having taken the initiative to introduce ALM, it is assumed that the asset liability management function must have plenty of support from the management. All the banks under survey adopted ALM after the issue of guidelines. In fact, all the public sector banks introduced ALM in compliance with the guidelines and therefore have had less time compared to the others to evolve their systems. The foreign banks had the advantage of guidance from their head offices abroad where ALM systems were already in place.
Stress testing framework based on scenario and simulation techniques which is based on historical data to ensure plausibility is applied at few banks but not all. The guidelines outline the possible scope of ALM in banks which include Liquidity RM, Interest rate RM, Management of other risks, Funding and capital planning; Profit planning and growth projection and Trading RM. The ALM in most banks has this scope. Certain banks do not have a trading book and therefore do not have trading risk management. Since all of these activities have come under the purview of ALM, the asset liability management function assumes greater importance.
Not all banks have clearly defined policies for management of other risks apart from those under pillar 1. Profit planning and growth projection found place in none of the bank’s policy. All of the banks surveyed have an ALCO in conformity with the guidelines. The RBI guidelines state that the ALCO should be headed by the CEO/Managing Director of the bank. This is to ensure top management support to the ALM function. All the banks under study had this principle in place. The guidelines state that that the heads of Credit, Investment, Fund Management/ Treasury, International Banking and Economic Research can be members of the ALCO.
The head of IT should be included in the committee. The banks while adhering to this composition have also included other departments’ representatives. One of the banks has also adopted a system where other departments are invited based on the agenda of the meeting. By involving various departments in the ALCO, the banks have ensured that the ALM function has large coverage extending over their many operational areas. ALCO support groups are also in existence in almost all the banks surveyed whereas the composition of the support groups varies. All of the banks have conducted training programmes on ALM.
Many have been internally developed and conducted. Some banks have opted to train all of their officers in this field. But while such training as has been imparted would raise the awareness among the staff about what ALM is, knowledge of the details of the ALM process and requirements in their own bank is lacking. Raising the level of such awareness would help in better data collection at the branch level and especially help those banks where full computerisation has not been achieved. RBI had asked banks to achieve 100% coverage of assets and liabilities by April 1st 2002.
Some of the banks have achieved this target. Some of these banks consist of those using the ABC approach. Given the difficulty in forecasting, the coverage while compliant with RBI guidelines, would not result in much accuracy. The majority of the banks have opted for specific software for ALM. Such software can greatly assist in scenario analysis and simulation as well as generation of statements. This type of software would require far more frequent data collection than exists currently. It would also necessitate the building of a database.
Information requirements: The banks are trying to upgrade the frequency of the data collection. It is probably the main factor in the ALM. Until the banks are able to achieve daily data collection, the ALM function will not be very effective. Decisions will continue to be made on stale data and the bank’s management will not be able to adapt quickly to changes in the external environment. Indian banks have a very significant proportion of assets and liabilities with no fixed maturity. On the assets side this includes practically all of the working capital finance.
Much of this contractually repayable on demand but in practice it is subject to more or less automatic rollovers, even when in the form of loans. On the liabilities side the principal items with no fixed maturity are the current and savings bank accounts. Now the banks approach this problem through behavioural analysis. It is the process of capturing the assets and liabilities as per the buckets given by RBI. As on March 31, 2008, for the scheduled banks together current account and savings bank deposits formed about 28% of external liabilities: again the bulk of the loans and advances (40% of assets) was probably working capital finance.
This is a large and significant proportion of the assets and liabilities. All of the banks surveyed follow the classification of assets and liabilities recommended by the RBI. They use the maturity gap model. Opportunities for Banks from Basel II • Measuring, Managing and Monitoring Risk in a scientific manner • Align risk appetite and business strategy • Risk Based Pricing • Effective Portfolio Management • Optimum utilization of Capital • Enhance shareholders’ value by generating risk adjusted return on capital Benefits of moving to advanced approaches • Relief in Capital Charge Risk based Pricing – focus on identified business areas. Competitive pricing in niche areas. • Image/Prestige • International recognition/benefits in dealing with Foreign banks • Risk Control Action Points for Effective Implementation • Grooming and Retaining Talent • Percolating risk culture across the organization through frequent communications, organizing seminars and training. • Setting up of Data Warehouse to provide risk management solutions. • Integrating risk management with operational decision making process by conducting periodic use tests. Periodic back testing and stress testing of the existing models to test their robustness in the changing environment and make suitable amendments, if required. • Putting in place a comprehensive plan of action to capture risks not captured under Pillar I, through ICAAP framework • Handling interrelationship between businesses. Linkage needs to be established between Funds Transfer Pricing, Asset and Liability Management, Credit risk, Market risk and Operational risk so that cost allocation can be done in a scientific manner. For Pillar III requirements, banks should disclose information that are easily understood by the market players and gradually move to disclosure of information requiring advanced concepts and complex analysis. • Adopting RAROC framework and moving from regulatory capital to economic capital. Challenges faced by banks 1. General issues • Guidance, motivation and support from senior management are essential to help ensure success of Basel II project. • Good risk management involves a high degree of cultural changes. Embedding good risk mgmt practices into day to day business will be difficult. Sophisticated risk management techniques require human resources with appropriate skill sets and training. • The models under advanced approaches require lot of historical data, collection of data is a formidable task. • Banks to customize and tailor make the risk products 2. Legal& Regulatory infrastructure • Steps required for adoption of internationally accepted accounting standards, consistent, realistic and prudent rules for asset valuation and loan loss provisions reflecting realistic repayment expectations. Legal systems will require changes for speedier and effective liquidation of collaterals • The laws governing supervisory confidentiality and bank secrecy would require modifications to permit disclosure envisaged under pillar III. • Operational autonomy, corporate governance etc needs to be addressed. 3. Derivatives& mitigation products • Credit derivative products yet to be introduced in India. Evolution of developed market for credit derivative is required to mange credit risk effectively and to get full benefit of risk mitigation. Rigorous legal and regulatory framework and less developed secondary market for bonds/ loans etc is a major impediment in development of credit derivative markets. 4. MIS and IT • 100% internal IT development is costly • System integration, dedicated software for risk assessment, enterprise wide integrated data warehouse pose challenge. • Lack of data driven culture: Historical issues in getting reliable data, only data that was necessary to ease operational processes was captured, structured, data-backed decision-making has not been very prevalent. • Short data history and lesser no. f data points in LGD, EAD and high impact low frequency events in operational risk may give distorted results. 5. Credit rating agencies • Limited no of agencies and insignificant level of penetration • At present default rates are disclosed by CRISIL only and other agencies are yet to declare, which may create difficulties in mapping and compliance with disclosure criterion if they want to be accredited by RBI. • In India banks/ FI’s are having stake in rating agencies that may impact their independence. • Banks are awaiting detailed guidelines from the regulator involving regulatory discretion under IRB approach.
Risk based supervision: The Basel Committee on Banking Supervision has advocated a risk-based supervision of banks as stability of the financial system has become the central challenge to bank regulators and supervisors throughout the world. This has been put into practice in various countries. This is a robust and sophisticated supervision with adoption of the CAMELS/CALCS approach essentially based on risk profiling of banks. The focus of RBS is on the assessment of inherent risks in the business undertaken by a bank and efficacy of the systems to identify measure, monitor and control the risks.
In pursuance of that risk profile, RBI prepares a customized supervisory program. It is a systems based inspection approach. CAMELS: (Applicable to all domestic banks) Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems & Controls. CALCS: (Applicable to Indian operations of banks incorporated outside India) Capital Adequacy, Asset Quality, Liquidity, Compliance and Systems. The objective of prudential regulation and supervision is a banking system that is safe and sound. Safety and soundness are difficult to define because there are no limits to how safe or sound a bank can be.
Banks may fail due to any of the following reasons: run out of liquidity, run out of capital or run out of both. RBS, would use a range of tools to prepare the risk profile of each bank including CAMELS rating, off-site surveillance and monitoring (OSMOS) data, prudential returns and market intelligence reports, ad-hoc data from external and internal auditors, information from other domestic and overseas supervisors, on-site findings, sanctions applied, structured meetings with bank executives at all various levels, inter face dialogue with the auditors etc.
A monitorable action plan (MAP), to mitigate risks to supervisory objectives posed by individual banks would be drawn up for follow-up. RBI is already using MAPs to set out the improvements required in the areas identified during the current on-site and off-site supervisory process. If actions and timetable set out in the MAP is not met, RBI would consider issuing further directions to the defaulting banks and even impose sanctions and penalties. Objectives of risk based supervision: • RBI follows a carrot and stick system for implementation of Risk Management and Supervisory controls in Banks. The approach is expected to optimize utilisation of supervisory resources. • It is to minimise impact of crisis situation in the financial system. • Construction of a Risk Matrix for each institution. • Continuous monitoring & evaluation of risk profile of the supervised institutions. • Facilitates implementation of new capital adequacy frame work Benefits of RBS: The RBS holds out a package of benefits of the supervisor, the supervised entities and the depositor as shown below: 1. Supervisor Deeper understanding of the risks associated with the banks and • Facilitate optimum use of scarce supervisory resources and direct supervisory attention to those banks and those areas within the banks, which cause more supervisory concern 2. Supervised entity • it will enhance the bank’s own capability for risk management and risk control • it will provide a built-in incentive of lesser supervisory intervention for the good performer 3. Depositor • The increased attention to risk factors both by the supervisor and the bank itself will reduce the risk of insolvency and provide for greater comfort for deposit protection.
Effectiveness of RBI supervision: For the purpose of study, impact of supervision on bank’s performance has been assessed in terms of a few parameters Level of NPAs: The trend of improvement in the asset quality of banks continued during the period of study. Moreover, gross NPAs (in absolute terms) of nationalized banks and old private sector banks have continued to decline. A reason for this progress can be the stringent and conservative approach by RBI. The following graph shows the movement of NPAs. [pic] Source: Basic Statistical Returns of Scheduled Commercial Banks in India Bringing improvement in weak banks: Here, the cases of four public sector banks (Indian Bank, United Bank of India, UCO Bank and Dena Bank) have been taken for study. The problem in the first three banks started in the 1996-97, when they began showing very poor performance in terms of profits. Supervisory and regulatory actions were taken to arrest the deterioration of these banks and through a process of recapitalization, enough capital was also infused. Narrow banking was recommended for these banks, wherein all advances are stopped and the investments are limited to those in G-Securities, which assure safe returns.
Currently these banks are under control. Similarly, problems cropped up in Dena Bank in 2000, which were brought under control immediately. The bank’s internal management and controls contributed to the success. Supervision was also one of the qualifiers for the same. Other evidences showing the CRAR levels, the Operating Profit / Working Funds, Net NPAs / Net Advances and Return on Assets of the three banks indicate a gradual improvement in the overall health of the three banks (though the improvement in the case of Indian Bank is marginal). Profitability of Banks: To judge the effect of profitability of banks Net Profit / Loss as a percentage of Total Assets has been taken for study. The following table shows the figures for the scheduled commercial banks. Reflecting the buoyant growth in noninterest income on the one hand and a relatively subdued growth in operating expenses on the other, operating profits of SCBs have increased over the years. Though the operating profits increased across all bank groups, the increase was more pronounced in respect of new private sector and foreign banks.
This increase in profitability can be attributed to efficient operations of banks along with good RBI supervision. • Improvement in Capital Adequacy: The CRAR data of all the banks (private, public and foreign) provided in the Reports on Trend and Progress of banking in India of the last few years show that there is a considerable improvement in the capital adequacy of the banks. The improvement was, however, more pronounced in respect of new and old private sector banks, followed by SBI and associates. As at end-March 2008, the CRAR of nationalised banks at 12. per cent was below the industry average (13. 0 per cent), while that of all other groups was above the industry level. • Improvement in Inspection and Supervision Method: There has been an improvement in the periodicity of the inspections. Earlier the private and foreign banks were inspected once in two years, but now they are inspected annually. Similarly, the public sector banks were inspected once in four years (besides the Annual Financial Reviews), but now, they are also being inspected every year. Quarterly visits are being made to the weak banks and also the new banks.
The supervisory process has acquired a certain level of robustness and sophistication with the adoption of the CAMELS / CALCS approach to supervisory risk assessments and rating. • Internal Control and Management: A strong internal control mechanism has been developed in the banks, wherein RBI has taken up special in-house monitoring of certain areas of weakness in the banks, viz. Inter-branch / Inter-bank reconciliation and balancing of books. The quantum of outstanding entries has been brought down drastically, thus reducing the fraud prone areas.
Besides this, the emphasis laid down by the supervisors on the computerization of the various branches has been successful as a number of branches of both public and private sector banks have been computerized. Disclosure Norms: With stricter disclosure norms, more and more information is being brought out to the public. This has not only helped the shareholders, who are now in a better position to assess the performance of the banks, but has also helped in keeping the management under a kind of check.
Risk management scenario in the future Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks.
The standardized approach was to be implemented by 31st March 2007, and the forward-looking banks placed their MIS for the collection of data required for the calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years. Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach Major finding: Devising a model for calculation of bank’s rating based on its risk management practices Models exist for assigning credit rating to borrowers. This helps the bank to identify potential borrowers by determining their credit worthiness. Higher the rating of the prospect, higher is his worthiness and lesser are the chances of loss to the bank. Hence banks extend loans to the higher rated borrowers. But this model caters to the need of the bank so that chances of loss are minimized. But there are times when banks also fail to perform.
Potential customers find it difficult to determine in which bank they should deposit their money or take loan from. Hence, it is also desired that bank should also be assigned a rating so that it comes to the rescue of the borrowers. RBI is also practicing the same but it does not publish the ratings of these banks. It assigns the ratings to all the banks under its jurisdiction but keeps it for the discussion with the top management. Here, in this section, an attempt has been made to give the various banks a rating which would help to determine healthiness of the bank.
Due to the limited scope of the study, the rating model suggested henceforth, is purely based on a bank’s risk management framework. Risk management practices by banks cover almost all the perspectives as they have to manage the risk associated with their each and every business line. For this purpose a model has been proposed using which a bank will be assigned such a rating. This rating would describe how successful a bank is as compared to its peer banks. It is a multicriteria decision problem. Two possible ways of solving it are: analytical hierarchy process (AHP) and goal programming.
Here, AHP has been used. Further a C++ program has been developed to make it more user friendly. This software will enable the regulator to just enter the rating of individual risks and the final risk rating of the bank would be generated. The multiple criterions faced in this problem are with regards to various risks faced by banks. Banks have to manage all the risks. But some risks are important than the others. So a comparison of all risks has been made to come to a set of criterions. These criterions should be met and suffice to one solution. The solution should be true representative of all the criterions.
AHP has been done in three ways in the given section. The same solution for each verifies the integrity of the model proposed. The three methods used under AHP are arithmetic mean transformation method, geometric mean transformation and Eigen value transformation. Banking industry faces two kinds of risks as shown namely business risk and controls risk. In this problem, the criterion/goals are: In case of business risk category (after driving conclusion from above mentioned analysis) 1. Capital risk is the most crucial type of risk faced by banks. 2. Credit and operational risk are at second level and are equally important. 3.
Next most crucial risk faced after capital credit and operational risk is market risk. Earnings risk is also equally important as market risk. 4. Liquidity risk is the next most important risk 5. Least important/ crucial risks are business and group risk. It can be depicted as: [pic] Figure: Hierarchy of business risk In the case of controls risk category: (after driving conclusion from above mentioned analysis) 1. Internal controls risk the most crucial risk faced. 2. Management and compliance risk are the next most important risks. 3. Risk associated with organization is the least important of all. It can be depicted as: [pic]
Figure: Hierarchy of controls risk Use the coding of risks as: 1 – Both are equally important. 2 – First is slightly more important than second. 3 – First is moderately more important than second. 4 – First is strongly more important than second. 5 – First is very strongly more important than second. Here, First = Read L. H. S. i. e. Row cell Second = Read R. H. S. i. e. Column cell 1 Arithmetic mean transformation method For this purpose a two phase procedure is followed. In the first phase, mapping of risks is done wherein all the risks are compared with each other. Step1, 2, and 3 deals with this in business risk category.
Step 4, 5, and 6 deal with in the controls risk category. In the second phase after using statistical tools on the results of the first phase, weighted average of individual ratings of risks associated with banks is done. The step by step procedure is explained as under. [pic] Figure: Flowchart for arithmetic model Geometric Model: [pic] Figure: Flowchart for geometric model Eigen model [pic] Figure: Flowchart for Eigen value model Mathematically all these models are shown in Exhibits. Suggestions by banks to RBI: Some suggestions were given by the bank officials through the mode of an informal discussion.
They are: • Banks are of the opinion that it would ease the processes if regulator comes up with industry wise correlation. • RBI guidelines are broader in nature. They should be more indicative. • The document requirement for complying by the guidelines of RBI and Basel are highly centered according to international banks. Some scenarios are not at all relevant to Indian markets. Hence there is a need to revise the framework of guidelines with an Indian perspective so that the fatigue of writing so many documents can be done away with. • RBI has modified the CRAR from 8% to 9%.
This makes capital a limiting factor. Hence it restricts the natural growth of the bank. Hence the regulator should reconsider this. • The terms used in the guidelines issued are directly picked from the documents in Basel or those finding implementation in foreign countries. The terms should be explained more correctly to all the banks. Conclusion Worldwide, there is an increasing trend towards centralizing risk management with integrated treasury management to benefit from information synergies on aggregate exposure, as well as scale economies and easier reporting to top management.
Keeping all this in view, the Reserve Bank has issued broad guidelines for risk management systems in banks. This has placed the primary responsibility of laying down risk parameters and establishing the risk management and control system on the Board of Directors of the bank. However, it is to be recognized that, in view of the diversity and varying size of balance sheet items as between banks, it might neither be possible nor necessary to adopt a uniform risks management system. The design of risk management framework should, therefore, be oriented towards the bank’s own equirement dictated by the size and complexity of business, risk philosophy, market perception and the existing level of capital. While doing so, banks may critically evaluate their existing risk management system in the light of the guidelines issued by the Reserve Bank and should identify the gaps in the existing risk management practices and the policies and strategies for complying with the guidelines. Credit risk management: Risk management has assumed increased importance of regulatory compliance point of view. Credit risk, being an important component of risk, has been adequately focused upon.
Credit risk management can be viewed at two levels—at the level of an individual asset or exposure and at the portfolio level. Credit risk management tools, therefore, have to work at both individual and portfolio levels. Traditional tools of credit risk management include loan policies, standards for presentation of credit proposals, delegation of loan approving powers, multi-tier credit approving systems, prudential limits on credit exposures to companies and groups, stipulation of financial covenants, standards for collaterals, limits on asset concentrations and independent loan review mechanisms.
Monitoring of non-performing loans has, however, a focus on remedy rather than advance warning or prevention. Banks assign internal ratings to borrowers, which will determine the interest spread charged over PLR. These ratings are also used for monitoring of loans. A more scientific & Quantitative approach is the need of the hour. Market risk management: Asset Liability Management as a risk management technique is gaining in popularity as banks are beginning to recognize the need for proper risk management.
The challenge for the banks therefore is to put in place the necessary infrastructure that can help them derive the utmost benefit fro