FREE BANK PROMOTION NOTES FOR 2022 | RISK MANAGEMENT
It is referred to a condition where the possibility of an undesirable occurrence exists which could result in a particular occurrence which is already known and could be quantified and therefore, insurable.
Definition of Risk: It can be defined as an event which is unplanned but have consequences of financial nature which could result in loss of profits or reduction in earnings.
TYPE OF RISKS
The risks of banking business can be classified into the following categories:
- Liquidity Risk
- Interest Rate Risk
- Market Risk
- Credit or Default Risk
- Operational Risk
This kind of risk arises on account of the fact that long-term assets are financed by short-term liabilities which makes the liabilities subject to a roll over or leads to the risk of refinancing.
In banks, liquidity risk can manifest in the following different dimensions:
- Funding Risk: The risk that the bank could be unable to obtain funds so as to meet its cash flow obligations is known as funding risk. It is crucial for banks for this risk to arise on account of the need to replace net outflows which happened due to unanticipated withdrawals or because deposits were not renewed.
- Time Risk: This risk rises on account of providing compensation because the expected inflows actually are not received. In other words, it can be said that the performing asset has turned into a non performing asset.
- Call Risk: This risk arises on account of the crystallization of liability which is contingent in nature. It could also arise in a situation when the bank is not able to make a profitable business when the opportunity arises.
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INTEREST RATE RISK
It refers to the risk that arises on account of changes that happen in the interest rates leading to adverse effects in the net interest margin or market value of equity of the institution.
There are two ways to view IRR:
- The impact of interest rate on the earnings of the bank
- The impact of interest rate on the economic value of the bank’s assets, liabilities and off-balance sheet items. This type of risk can take different forms.
The risk that adverse deviation can occur because of Mark to market value in the trading portfolio because of market movements, when it is required to liquidate the transactions is called market risk.
It is a result of its moments in the level of the market prices or the volatility in the market prices of interest rate instruments, commodities, equities or currencies. This is also called price risk.
Market risk can be used to be applied to:
- That part of interest rate risk that affects the prices of the instruments of interest rate.
- Pricing risk associated with all other Assets of portfolios which are held in the bank’s trading book
- Foreign currency risk
Forex Risk: The risk that a bank could suffer because there are adverse movements in the exchange rates during a period where the bank has an open position either in spot or forward options or in the combination of two, in an individual foreign currency.
DEFAULT OR CREDIT RISK
This can be defined as the possibility that a borrower of a bank or the counterparty become unable to meet its obligation as per the terms and conditions. For most of the banks, loans form the largest source of credit risk. It is highly significant because in the Indian scenario of higher level of NPAs.
Two variants of credit risk:
- Counterparty Risk: The type of credit risk which depends on the non-performance of trading partners because the counterparty has refused to do its part or is unable to do so. It is mostly viewed as more of a financial risk related to trading activities instead of the standard credit risk.
- Country Risk: The kind of risk which depends on the non-performance of the borrower or counterparty because some restrictions on constraint have been imposed by a country. In this case the reason for non-performance depends on the external factors which are beyond the control of the counterparty or the borrower.
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CREDIT RISK DEPENDS ON BOTH EXTERNAL AND INTERNAL FACTORS.
Credit risk depends on a number of factors which can be categorised into external and internal.
The internal factors include:
- deficiencies in the areas of credit policy and its administration,
- deficiencies in appraisal of the financial position of borrower before approving the loans,
- dependence on collateral securities more than what is needed &
- failure to implement the follow-ups after the sanction of loans.
The external factors include:
- Situation of economy
- Changes in the prices of commodities
- Changes in the rates of foreign exchange and interest
RISK MITIGATION PROCESSES
It should be remembered that creditors cannot be altogether removed but it can be mitigated by the application of risk mitigation processes such as:
- Before loans are sanctioned, proper assessment of the credit worthiness of the borrower should be done by the bank. i.e it has to be done beforehand for this to work out. Credit rating is a tool of measurement of credit risk and it also helps in pricing the loan.
- Regular evaluation in having a rating system for all the investment opportunities, the credit risk can be reduced by the banks because they will get vital information about any inherent weaknesses present in India opportunities.
- Credit risk can also be reduced by fixing Prudential limits on the various aspects of a credit i.e. ensuring the maintenance of:
- Current ratio
- Profitability ratio
- Debt equity ratio
- Debt service coverage ratio
- Limits should be set for the risk exposures that are allowed for single or group borrowers.
- Provision should be made to allow flexibility in some special circumstances.
- Operating staff should be a lot at all the stages of dispensation of credit i.e during appraisal, disbursement, review, follow-ups.
Operational risk has been defined by the Basel committee as ‘risk that Alton lost because of the failure or inadequacy of the internal processes, people and Systems or even due to external events.
It is important to manage the operation of risk because of the reasons mentioned below:
- Automation for the rendering of banking and financial services has increased.
- There has been an increase in the interlinkages at global level
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COMMON OPERATIONAL RISKS:
(a) Transaction Risk: This kind of risk arises on account of fraud, whether internal or external, failure of business processes and the inability of banks to maintain business continuity and management of information.
(b) Compliance Risk: The risk that the bank may suffer financial loss or reputation loss due to legal or regulatory sanction, because of noncompliance with applicable laws, regulations, code of conduct & standards of good practice. It is also sometimes known as integrity risk because it is the reputation of a bank which is linked with the principles of integrity and fair dealing.
Other than the above risks, there are other risks which are faced by the bank in their regular business operations:
(a) Strategic Risk: Risk which arises on account of the fact that some adverse business decisions have been taken, there have been improper or wrong implementation of the decisions or the banks’ responses to industry are lacking.
(b) Reputation Risk: The Risk which arises on account of negative public opinion is known as reputation risk which could lead to litigations, financial losses or decline in customer base of the bank.