RISK MANAGEMENT IN BANKS

The business of banking today is synonymous with active risk management than it was ever before. The success and failure of a banking institution heavily depends on the strength of the risk management system in the current environment. This is true as the very business of banking is risk-taking as an intermediary, i.e. interposing between savers (depositor) on one hand and the borrower on the other hand, thereby accepting the risks of intermediation.

Risk Management: Meaning & Components A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. Therefore, a risky proposition is one with potential profit or a looming loss. Risk stems from uncertainty or unpredictability of the future. In commercial and business risk generates profit or loss depending upon the way in which it is managed. Risk can be defined as the volatility of the potential outcome. Risk is the possibility of something adverse happening. Risk management is the process of assessing risk, taking steps to reduce risk to an acceptable level and maintaining that level of risk.

The essential components of any risk management system are –

* Risk Identification: i.e. the naming and defining of each type of risk associated with a transaction or type of product or service; * Risk Measurement: i.e. the estimation of the size, probability and timing of potential loss under various scenarios; * Risk Control: i.e. the framing of policies and guidelines that define the risk limits not only at the individual level but also for particular transaction

Process of Risk Management * Identify all areas of risk * Evaluate these risks * Set various exposure limits * Type of business * Mismatches * Counter parties * Issue clear policy guidelines / directives

Types of Risks:

* Credit Risk - This is the risk of non-recovery of loan or the risk of reduction in the value of asset. The credit risk also includes the pre-payment risk resulting in loss of opportunity to the bank to earn higher interest income. Credit Risk also arises due excess exposure to a single borrower, industry or a geographical area. The element of country risk is also present which is the risk of losses being incurred due to adverse foreign exchange reserve situation or adverse political or economic situations in another country

* Interest Rate Risk - This risk arises due to fluctuations in the interest rates. It can result in reduction in the revenues of the bank due to fluctuations in the interest rates which are dynamic and which change differently for assets and liabilities. With the deregulated era interest rates are market determined and banks have to fall in line with the market trends even though it may stifle their Net Interest margins

* Liquidity Risk - Liquidity is the ability to meet commitments as and when they are due and ability to undertake new transactions when they are profitable.

* Foreign Exchange Risk - Risk may arise on account of maintenance of positions in forex operations and it involves currency rate risk, transaction risks (profits/loss on transfer of earned profits due to time lag) and transportation risk (risks arising out of exchange restrictions)

* Regulatory Risks - It is defined as the risk associated with the impact on profitability and financial position of a bank due to changes in the regulatory conditions, for example the introduction of asset classification norms have adversely affected the banks of NPAs and balance sheet bottom lines.

* Technology Risk - This risk is associated with computers and the communication technology which is being increasingly introduced in the banks. This entails the risk of obsolescence and the risk of losing business to better technologically developed banks.

* Market Risk - This is the risk of losses in off and on balance sheet positions arising from movements in market prices.

* Strategic Risk - This is the risk arising out of certain strategic decisions taken by the banks for sustaining themselves in the present day scenario for example decision to open a subsidiary may run the risk of losses if the subsidiary does not do good business.
CASE STUDY: BANK OF BARODA, LONDON, UNITED KINGDOM

INTRODUCTION:
BANK OF BARODA has significant International presence with a network of 57 Offices in 19 countries including 38 branches of the bank and 17 branches of its seven subsidiaries besides 2 representative offices in Malaysia and China and a network of more than 2700 branches in India. In U.K. since 1990 the bank has been using the Misys-Equation core banking application to support its activities at its London Main Office and other branches.

PROBLEM:
Bank of Baroda U.K conducts its clearing through NatWest/Royal Bank of Scotland. The bank receives all clearing information such as cheques, giro credits and direct debits from NatWest on a daily basis as printed statements along with the related instruments. The process involves classifying each payment and posting the resultant transactions into Misys Equation core banking product manually. Checks have to be made in respect of stopped cheque, blocked account, inactive account, closed account and incorrect accounts. Moreover, the account numbers held at NatWest do not exactly match with that in the Misys-Equation database. Manual entries were error prone requiring additional verification. This process therefore, called for considerable effort and use of human resources contributed to operational risk.

SOLUTION:
Risk Management has provided a solution to automate the entire process end to end with the necessary validations at every level of the data pass through. The objective being the reduction of manual effort to a minimum and improvement in the accuracy of posted transactions and operational efficiency. Both Microsoft and IBM technologies are used with suitable data transfer methodology to IBM AS/400.

An MS Windows based front-end provides a user-friendly interface to process downloaded data from NatWest, carry out necessary checks to ensure data integrity and to transfer the data to AS/400.

IBM AS/400 operations menu guides the user to process the transferred data, categorising the transactions as 'OK' to post and 'Exceptions' based on established business validation rules and to tally the credit/Debit totals with those from NatWest. The automatic mapping function enables correction of incorrect account numbers. All the Branches including the Main Office have access to menu options to view and correct the exceptions. A specially written automatic posting program handles the posting of accounting entries into Misys-Equation.

BENEFITS:
Implementation of the automated clearing system increased the speed of processing, drastically reduced manual errors, eliminated delays in posting customer accounting entries and kept up-to-date individual customer accounts. The solution is centrally managed from the Head Office and use of the AS/400 platform on which the banking application runs, allows branches to handle their part of the data effectively while not worrying about uploading and managing their branch specific clearing data.

CASE STUDY: JP Morgan Chase, USA

INTRODUCTION:
JP Morgan Chase & Co. is an American multinational banking corporation of securities, investments and retail. It is a major provider of financial services, with assets of US$2 trillion and according to Forbes magazine is the world's largest public company. The hedge fund unit of JPMorgan Chase is one of the largest hedge funds in the United States. It was formed in 2000, when Chase Manhattan Corporation merged with J.P. Morgan & Co.

PROBLEM:
JP's business strategy for its large corporate commercial portfolio remained primarily one of origination for distribution. Bulk of the wholesale loan originations were distributed into the marketplace. Residual holds averaged less than 10%. The commercial loan portfolio declined by 9% in 2003, due to a combination of continued weak loan demand, ongoing goal of reducing commercial credit concentrations and refinancing into more liquid capital markets. JP Morgan Chase (JP) was exposed to credit risk through its lending, trading and capital market activities.

SOLUTION:
JP's credit risk management (CRM) practices were designed to preserve the independence and integrity of the risk assessment process. JP had taken various steps to ensure that credit risks were adequately assessed, monitored and managed. In early 2003, the Credit Risk Policy and Global Credit Management functions were combined to form Global CRM consisting of the five primary functions – Credit Risk Management, Credit Portfolio Group, Policy & Strategic Group, Special Credits Group and Chase Financial Services (CFS) Consumer Credit Management Risk.

To measure commercial credit risk, JP estimated the likelihood of default; the amount of exposure in case of default and the loss severity given a default event. Based on these factors and related market-based inputs, JP estimated both expected and unexpected losses for each segment of the portfolio. Expected losses were statistically based estimates of credit losses over time. They were used to set risk-adjusted credit loss provisions. Such losses could be factored into the pricing and covered as a normal and recurring cost of doing business. Unexpected losses represented the potential volatility of actual losses relative to the expected level of losses and formed the basis for the credit risk capital-allocation process. JP's allowance for credit losses was intended to cover probable credit losses, including losses where the asset was not specifically identified or the size of the loss had not been determined. At least quarterly, the Risk Management Committee reviewed the Allowance for credit losses relative to the risk profile of JP's credit portfolio and current economic conditions.

BENEFITS:
JP's total credit exposure was $730.9 billion as on 31st December 2003, a 2% increase when compared to 2002. The increase reflected a $41.5 billion in consumer exposure, partially offset by a $30.2 billion decrease in commercial exposure. As on 31st December 2003, 83% of the total commercial credit exposure of $383 billion was considered investment-grade, an improvement from 80% in 2002