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CAIIB BFM CONCEPT OF RISK- WHAT ARE THE VARIOUS RISK IN BANKS

CAIIB BFM CONCEPT OF RISK- WHAT ARE THE VARIOUS RISK IN BANKS

RISK MANAGEMENT

It is usually absorbed that whenever we do something as per our plans there remains a deviation due to the unpredictability of the future. There are so many uncertainties, mainly due to the external factors, which influence the process that has been planned to reach the objective. 

Risk is defined as uncertainty that could adversely affect the objective. 

Financial risk is defined as uncertainty that good adversely affects profitability or could result in loss. 

Uncertainty along with the elements of risks impacts the business’s cash flow. It could be favorable or unfavorable, where, the unfavorable uncertainty is the risk for business. 

Types of Risks: Risk is found at transaction and Portfolio level: 

  • Transaction Level: At this level, there are credit, market and operational risks that are managed at the unit level. 
  • Portfolio Level: Although liquidity and interest risk are found at the transaction level, they get managed at the portfolio level.

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Lower risk: Having a lower risk means there are fewer chances of any variability in the business’s net cash flow. 

Higher risk: Having a higher risk means there is an increased chance of getting any variability in the business’s net cash flow. 

Zero Risk: Having a zero is means there is no chance of variation in the net cash flow. An investment whose risk is zero, its return would also be low when compared to other market opportunities. 

Capital: Capital acts as a shock observer or cushion for any losses in the future. If the business has high risk, then the capital requirement would also be high which would lead to high RAROC (Risk Adjusted Return on Capital).

BASIC RISK MANAGEMENT FRAMEWORK

A Framework has already been devised to manage the risk. The basic considerations that need to be taken into account while altering or designing a Framework for risk management:

Management of risk: Risk management falls under the preview of top management. Although the process of risk management starts from the top management what are the major challenge is to get this incorporated in the risk and business policies while ensuring consistency between the both. 

In today’s time, it is usually practiced to set risk limits on basis of economic measures while keeping in view risk-adjusted return and capital. 

The main task in risk management tips is to maintain a balance in risk and return within the constraint of capital that is available.

PROCESS OF RISK MANAGEMENT: Management of risk identifying and quantifying the risk itself. After the risk has been identified and measured, we can start with deciding which risk can be accepted at a higher level and which can only be e accepted at a low level and how the high risk can be mitigated (fully or partially).

Risk management: Risk management requires a skill set and objectivity towards the control aspect of the business as well as a separate setup. In order to manage risk and frame a framework, a well-articulated process that covers the below ideas is required: 

  1. Organization for Risk Management
  2. Risk Identification
  3. Risk Measurement
  4. Risk Pricing
  5. Risk Monitoring and Control
  6. Risk Mitigation

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Organization for Risk Management: The persons that look over the risk management in the organization, usually, are mentioned below:

  • Board of Directors
  • Board Committee on Risk Management
  • Senior-level executives Committee
  • Risk management support group 

 

Risk Identification: Almost all business transactions have one or more elements of risk. It could be the risk of interest rate, operational, liquidity, market, credit, or default risk in the various dimensions inside a transaction. As mentioned earlier, even though all these risks are at the transaction level, some risks are handled at the portfolio level only while credit, operational, and market risks I considered at both transaction and Portfolio levels. 

 

Risk Measurement: The measurement of risk means to quantify the risk. It is done in respect of earnings, default loss, and market value that arise on account of various risk elements. These measures can be classified into three categories on the basis of: 

  • Sensitivity 
  • Volatility
  • Downside potential sensitivity 

Sensitivity: It is the change in a variable because of a change in a single parameter of the market. Only relevant market parameters that affect the target variable are considered for sensitivity. 

Volatility: This takes into consideration the stability or instability of random variables. It is also possible to combine target variable sensitivity with the underline parameters that are unstable. It is a popular statistical measure that considers the relevance with random variables, for example, market value, default loss, etc. 

Downside Potential: Risk materializes in the form of deviation in earnings. Use only possible losses while ignoring the profit. It is mostly used by Banks, Financial Institutions, and the Reserve Bank of India. It measures risk by keeping in account the following 2 components:

  1. Potential losses
  2. Probability of Occurrence.

VaR i.e Value at Risk is a downside Risk Measure

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Risk Pricing: Bank is impacted by the risk present in the banking transactions in the ways that a bank has to maintain specified capital as per the regulatory requirements, it comes with a cost. This cost is in the form of dividends that need to be paid to the banks’ equity shareholders. 

Therefore, every banking transaction should generate a needed surplus to meet the cost of capital. Keeping in view of the cost, the transaction pricing must take into account the following factors: 

  • Cost of Deployable Funds
  • Capital Charge
  • Operating Expenses
  • Profit Margin or Return on Net worth
  • Loss Probabilities

Risk Monitoring and Control: The main task in managing a business, from the risk management point of view, is to enhance Risk Adjusted Return on Capital (RAROC). 

As the approach of office management focuses only on the facilitation of simultaneous implementation of risk and business policies in a consistent manner, it cannot be done in isolation. 

One has to see that there remains a proper balance in the risk and return. In order to achieve the same, banks usually put in the following things in place:

  • An organizational structure.
  • The comprehensive approach of risk measurement.
  • Risk Management Policies that are adopted at the corporate level & are consistent with the business strategies, management expertise, capital strength, and risk appetite.
  • Guidelines and other parameters are also used to control & manage the risk-taking capacity or ability including a detailed structure of prudential limits, discretionary limits, and risk-taking functions.

Risk Mitigation: Because risk arises due to uncertainties because of various elements of risk, this risk can be reduced by following strategies that have the potential to altogether eliminate or reduce the uncertainties associated with the elements of risk. This reduction in risk is known as ‘Risk Mitigation.

In this way, a proper framework to handle/reduce/mitigate the risk can be framed or set up. One can simply, alter anything in the above-mentioned process as per their business needs or requirements.

If you liked this article & want a further part of this BFM unit (Risk Management), then let us know in the comment section. 

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