The Measurement and Management of risks in Banks

By Shraddha Singh, Symbiosis Noida

Editor’s Note: The objective of the research study is to analyse and examine the solutions of risk management preferred by banks. Further, this research seeks to address various solutions to risk management specifically in the banking sector and also whether the solutions of risk management cover all types of risks.

INTRODUCTION

During the process of performing the various functions and financial intermediation, banks affront with different kinds of financial and non-financial risks. Financial Risk is defined as a probability of loss, liability or any other negative impact on the banks by external and internal factors of the sector which can be avoided by preventive action by Banks. These risks can be credit risk, liquidity risk etc.  All these risks severely affects the bank may be dependent or independent of each other.

TYPES OF RISKS AND THEIR MANAGEMENT

Risk Management includes identification, measurement and assessment for minimizing the affect of the risk on the financial status of Banks. Their main objective is to reduce the risks by using pre laid reforms by Banks. Some of the Risks which bank faces are:

  • Liquidity Risk– This risk affects the capital of Bank when it fails to meet its obligations. Banks provides deposits and loans from which it inherent the liquidity risk. When matured assets and liabilities of the Banks mature and it mismatched with each other, it creates liquidity Risk. Here the liquidity Risk Management comes into the effect. It increases the assets in order to overcome the liabilities.

Liquidity Risk is managed by following norms:

  • By good frame work of Decision Making.
  • Creating funding strategies at every level.
  • Operation limits of banks should be set
  • Liquidity to be done after analyzing all the aspects.
  • Credit Risk– When the borrowers failed to pay the amount of money to bank which they took it as a credit. To overcome this risk Bank’s needs to understand possibility of risk on credit provided by them. Also by reducing loss of loan and by accommodating sophisticated credit risk management.

Successful Credit risk management includes:

  • Efficient data- Bank should have accurate and appropriate data on the delays of payment of credit by borrowers.
  • Adequate control on Credits given to borrowers.
  • Supervising the transaction of loans done in the Bank and ensure, identity and monitor any possibility which could arises the risk.
  • Market Risk– This risk includes the interest rates and foreign currency which can causes the alteration in the market price of a commodity. It focuses on some factors like sensitivity of financial institutes on the negative changes in interest rates, foreign rates and commodity prices, appropriate analyzing the foreign operations and trading sectors.
  • Operational Risk- This type of the risk having adverse impact on the capital of Bank through failure of internal system in the Banks like inadequate  process and management, ignorance of foreseeable events of risk by the Banks.
  • Legal Risks- This risk includes the loss caused to the Banks by breach of any contractual obligations or imposing the penalties by the regulatory body. Management of this risk is done by ensuring the legal spheres of the Bank, legitimate interest rates and strictly follows of laws.

RISK EVALUATION/ MEASUREMENT

Risks are needs to be measured to obtain control over the risks. It assesses the risk management, risk exposure in the financial sector like banking. Risk measurement maximizes the extent of risk profile of the Bank.  The best way to predict, measure and forecast of the risk by the previous data of the Bank.

Literature Review

  1. Anthony and David (1997)[i]. The paper examines the risk management systems through a review conducted in various financial institutions. Also the risk suffered by insurance sector is also covered under the analysis. The paper reports various risk management techniques undertaken by the financial institutions and what all are measures which are taken while practicing these techniques. Problems has also been discussed and analysed by the authors. The investigation comes with the result that insolvencies in the bank are increasing and decreasing with little time gap due to which measuring the risk in liquidity flow tends to hurdle the bankers. This resulted into inadequate risk management practices. Suggestion of the cover the main point that financial institutions constantly should upgrade their financial risk management system with changes in peak of insolvencies and malfeasances on part of their officers and directors of the financial institutions.
  2. Arunkumar[ii] (2010). Every financial sector involves risk, similar banking sector has various strategies to manage risk in the sector. Banks having appropriate risk management policies could not exist in this vibrant market. Credit risk is the biggest risk in the sector. Almost every bank has policies for it but some of the policies are not successful. This risk has been spread in India since liberalization was introduced. Indian Banks do not have accurate norms of risk management according to the current situation of the economy. There is an urgent requirement to boost up this sector with effective policies to protect it from any risk.
  3. Barfield and Venkat[iii]– This research paper discusses Liquidity risk to banks. This risk arises when the bank has to return the money to its stakeholders. Liquidity requires a long term planning for its management. Clear set policies should be there and banks should follow strictly. Liquidity risk vanish all the profit made by bank so it needs to be kept away. For many banks this risk is invisible since they cannot recognize them, also their policies are not made such effective to handle all types of risks. Here assets and liabilities of banks play a vital role in liquidity risk. So this risk needs to be monitored as it is a critical factor in banking sector.
  4. Briance and Ole[iv] (1985), analyses the functioning of country-risk assessment. This provide the bank its record that how much lending and loaning has been done. Through this all the banks comes to know their short falling which may lead to the risk. Prior analysis of the risk helps all the bank to work together. Banks now can implement various tools and policies, can carry out staff assessment so that skilled staff can be recruited who can work effectively to help in deciding various strategies for managing the risk. This in turn help the high levelled managers for directing and implementing and categorizing the as and when required.
  5. Cardon, Coche, Manganelli[v] (2004)- The paper focuses on the foreign exchange reserve as the risk for European Banks. Monetary policies of Banks are required in the foreign exchange rates arrangement. Management of the policy is most important as the most of the banks deals with import-export trade. Any change in the value of foreign currency has an adverse effect on local banks. Many banks invest in those sectors which has any activity of foreign trade. Risk is huge and the norms for facing the situation should be equivalent strong. The framework should be designed to bear with high degree of strain and pressure of instability of foreign reserves.
  6. Cebenoyan and Strahan[vi] (2004)– Loan given by the banks are more prone to credit risk which affects capital structure, lending and etc. Loans are the most risky facility provided by the banks. If the money lender failed to pay the amount of loan to bank it causes monetary losses to them. Lending huge capital are likely to have failure repayment of the loan. Even after liquefying the mortgage of the property does not fulfil the amount of money loss bear by the banks. Policies for credit crisis should base grounds of credit availability to reduce the credit crisis risk as the loan sale market in very dynamic.
  7. D Tripati Rao, Prodipta[vii] (2008), examines how the operational risk affects the bank management. The main focus lies on making aware the bank management about the reasons due to which operational risk arises. The manager of the bank needs to examine in depth the reasons and causes behind the operational risk. Various specific methods for measuring this risk and thus opting for a suitable model to curb it out so that future endeavors of banks may not get effected. A survey for the same has been conducted by the authors taking in consideration the Indian banks. The conclusion came up with the point that Indian Banks are in its nascent stage and lacks in operating an effective management system for such risk transfer.
  8. Danske[viii] (2013)– This paper incorporate other various risk like Insurance risk , environment risk other than the common prevailing risks in the banking area. It is basically on the Risk management strategies of the Danske Bank Group which has spread its roots in many European countries. The Bank has developed its strategies in the different countries on analyzing the economic conditions of that country. With of IT widely it has created its risk management policies. A systematic transaction of the banks is being taken care of through a panel of Experts. There is a self-centralized system which finds the loopholes and failed application of the policies with in the bank itself.
  9. Edward, John and Pal[ix] (1998), analyses and witnesses the hike in use of analytical resources so as to make a more effective management of credit risk. The escalation in it use has been reported in case where the credit- related losses has been recorded. The factors which resulted into this development and act as motivator’s refinement of techniques which has been used previously. New innovative ideas to perform analytical solution. Improvement of databases also play a biggest role in translating the risk which relates to expected losses. Using all these improved techniques impugned the Bank managers to effectively deals with credit risk which arises.
  10. Elsinger, Lehar and Summer[x] – The complicated structure and functioning of Banks creates another difficulty for banks in designing the risk management policies. Some of the levels of Banks are invisible which are more prone to risk as compared to other section of the banking sectors. This paper stress upon the insolvency risk as compared to other risks. Some of the risks are, interest rate shocks, foreign currency rate and Stock market movement as the more notorious risk than other risks. These risks are uncertainty and not easily predictable. Since the banks are interconnected with each other if one bank is affected by any one risk then this could have a great impact on another bank too. So the policies should be strictly followed to attain stability in the sector.
  11. Erick, Patrick and James[xi] (2004), analyses how measurement of fair-value income causes impact to bank equity risk analysis. There is great variation in income measurement which is fully fair to piecemeal fair value. There is great difference in both these kinds of risks. Each Bank management needs to clearly understand the said difference so as to overcome the risk arising of various and to strategies their policies to overcome this. Income plays a key role in analyzing the kind of risk arising out of market cost of a particular good. To act as an active manager. They must need to first find the income related risk which in future helps in recording the fair- value gains and losses ultimately to access risk and value.
  12. Evan, Til and Philip (2009)[xii], examines how the liquidity risk can be managed. The author analyses that depositing of the transactions in advance help the banks to reduce the liquidity risk. To prove this it is reported by the authors that bank who has larger transactions deposits are not vulnerable to this risk. But a contrary situation also arises. Banks which are exposed to the various loan-liquidity risk are vulnerable to the liquidity risk. It is also reported that the banks are aware of these above circumstances therefore it is marked that depositing and lending transactions has now become powerful. This helped the banks to overcome the liquidity risk.
  13. Francesco Saita[xiii] (1999). The paper analyses the various issues and problems faced by the financial institutions while implementing the value-at-risk measures in the capital allocation process. Detail of capital allocation process has been discussed by the author and also the impact of it on risk- adjusted performance. The paper also discusses about Value-at-Risk measure which is used to monitor credit and counterparty, legal and reputational risk. The conclusion drawn by the author is that there is no solution for avoiding the risk involved in implementation of various techniques. Each financial institute must choose techniques according to the characteristics of their financial institute. The degree of centralization must also be taken into account. The analysis done by the author bring out the fact that it is difficult to measure the potential loss to its exact value as experienced by the various financial institution.
  14. George and Anthony[xiv] (2002). The paper addresses and examines how the financial firms manage the risks which arises during the operational period. The author defines the when risk emerges and how they are managed or transferred. The conclusion drawn by the author cover these points that risk can be mitigated by adopting various strategies. Further analysis brought down by the author states these strategies i.e. Risk elimination by simple business practices, Risk transfer to some other competitors or participants or Managing the risk actively at firm level. The paper in its conclusion part provides some guidelines to the bankers that procedure for risk management should be initiated nearest to the assumption of risk and a comprehensive risk management system must be installed to evaluate business and firm level performance.
  15. Hashagen, Harman, Conover[xv] (2009)– The paper is on the risk management to help in credit crisis. Improvement in the framework of the market can help in better application of the riak measures. For evaluating these risk require a strong relation of the organization with the other business sector. A sharp eye view on the business world is directly connected with the risk evolving for the bank sector. A stimulus reaction by Banks on any activity of the market including credit crisis could have best application of the risk measures.
  16. Helmut, Alfred and Martin[xvi] (2006), analyses the systemic risk to the whole of banking system. Various sources of systemic risk has been analyzed by integrating the credit portfolios and the market. This helps in measuring the probabilities of the systemic risk. The model used by author helps in exposing that most of the banks are unaware of the aggregate risk and portfolio exposures by the banks is the main sole cause for the systemic risk. Also the bankruptcy appears to be the source of such risk but at low level. This low level can be determined when the bankruptcy costs are low. Thus, bank must first able to analyses the above mentioned sources which could cause systemic risk in order to implement the tools to manage the risk.
  17. John and Naval[xvii] (1986). As risk measurement and management remain unsettled in banking system, the author analyses and examines the stationarity for the same. By the author analysis it is examined that equity market is a measure to determine the stationarity of the risk at various levels. Lack of viability for given time period is what stationarity of the risk as defined by the authors. There should be a correct measurement of risk for its measurement which depends on the theoretical consideration and the perceptions as carried out by the investors about the risk. At each level of the working presuming the risk prior itself, the management system of the bank should defines its various policies to combat the same.
  18. Jyske[xviii] (2012) – This research paper deals with the Banks internal and external risks and their management and procedure of risk measures. Banks are exposed to many risk which weakens its structure. The main focus in this paper is given to the legislative policies ruling over the Banks. As they determine the functioning according to the economic situation of the society. The advancement of risk strategies requires a strong base of Capital and the process of decision making process by banks regarding their operations.           Further the paper analysis the liquid assets belonging to the Banks and evaluation and forecasting the occurrence of the risk in the market.
  19. Lauer, Diss and Tarazi[xix] (2011)– This research paper discusses the Mitigation of Risk in the Banking sector of several countries . Risk management policies in the different countries have been analyzed in it. The basic focus is on the risk identification, assessment and monitoring. These all steps need to be done in a systematic order without leaving any loopholes on the design of the policies. The procedure of supervising the management of risk by banks is done by bank’s agent business which alerts the Bank about any failure of the policies. It has been successfully adopted by many Banks to be protected from the market Risk.
  20. Mehra[xx]– With advancement of the economy, many banks have some dangers in this sectors. This paper deals with of operational risk management in Indian Banks. It analysis the risk prevailing in Banking sector and approach used by various bank to overcome it. Awareness about this threat in old private sector banks and in small size public Banks face is still very less as compared to other well developed Banks in India. Implementation of the policies of risk management should be strictly followed. RBI owes a responsibility to help in development of these Banks.
  21. Mihaela, Dima and Orzea[xxi]– Banks are the one of important institute on which many other different sectors depends upon. Any change in the Banking sector could have adverse impact on the other related sectors. Banks faces a tougher competition to attain stability but due to some financial and non-financial factors the disturbance is created in this sector. To cope up with the risk, risk management policies are being adopted to have a complete control over the functioning of the banks. The main threat is bankrupt status of financial institutes. It gradually declines the monetary position of the banks and at that stage it’s difficult to overcome the situation. That is why the risk management policies have been opted by them
  22. Pate and George (2009) – The paper is on the operational risk as it is different from credit and market risk. Operational risk involves the internal factors within the Banks which can be threatening. Any operation taken up by banks should according to their levels of sophistication and methodologies the bank has. Good panel experts are required before taking up any operation of the banks.
  23. Pyle[xxii] (1997) – The paper deals with the reason for requirement of risk management in the banking sector. Since the financial firms deals with the monetary and economic factors in its business. Even though banks recognizes these risk but due to the inadequate policies they failed to deal with this trouble. A regulatory authority is required with specific risk management policies which are uniformly applicable to all Banks. Banks requires to estimate the liquid asset in possession by its creditors, customers and etc. By understanding the field which can cause risk and after that specific policies should be made.
  24. Raghavan[xxiii] (2003)- This research paper is on the risk present in the financial sector and their effect on the Banks. Banks faces a lot competition and at the same time financial risks too. These risk are uncertain and the banks could face them at any point of time so they need to be well equipped with the policies to handle these risk. The risk involves – Credit risk, Market Risk, Operational risk and etc. Different risks require different policies to deal with them. Effectiveness of the measure of risk can be through Information system by regularly evaluating the data and make changes in the policies with change in the market. Application of the Risk measure must be done in appropriate manner with the help of Market experts.
  25. Richard A. Crowell[xxiv], examines the applicability of BETA which is one of the most common tool for measuring the risk. The issue talked here is that despite being so much effective in measuring the risk, it is used by only limited number of managers. Ways in which BETA can be used is discussed by the author so as to provide relevant information which may in future turn out to be helpful to the bank managers. It helps in: Controlling portfolio risk, in distinguishing the market timing and stock selection skills and in the analysis of security. It draws attention toward the securities which are often at risk and is thus the greatest need for the manager’s attention.
  26. Robert A. Rennie[xxv] (1961), suggested various proposals for the successful application of various practices and technic to measure the risk which arises. The author analyzed that firstly the decision making process should be worked out keeping the point that It greatly affects what risk is to be manage and measured. Secondly, a probability of risks must be taken in advance which the system thinks can arise. Also the scientific technologies and electrical engineering should be used. It helps in measuring the risk corporate risk in a vivid manner. These all helps in recording the characteristic of each risk which in longer terms helps in developing various models so that the risk can be managed.
  27. Robert and John[xxvi] (1984).The paper discuss in detail about the various types of risks. It mainly analyses the three types of risks i.e. non-economical and economical. Also a straightforward analytical framework to reduce the risks. The framework consist of several special tools and techniques which a manger should use to at their various operational chains. Both the risk is being faced by the managers which at times exclude it for future inventories which result into more bank having more money for lending. The future endeavors which sort to get the more accurate management and measurement helps in the smooth running of the banks.
  28. Santomero[xxvii] (1997) – The paper is for the commercial banks in Northern America and the practice management of the risk in these commercial banks. It basically focuses on the financial risk in the sector and evaluation of these risks. The risks are connected to the prices and the position of the market at a stage. The methodology opted is the subsection of the pertaining risks to to handled carefully. Expertise is a essential requirement in the risk management to operate these policies effectively. Regulation of the government helps increasing the accountability of these risks in the banking sectors.
  29. Valeriya and Jürgen[xxviii] (2009), examines whether borrowing of one bank from the other to a large extent lowers the risk which arises. This borrowing helps the bank to create interbank relation. As a result of this when risk arises when one bank can help out other to manage and eradicate the risk. This process works in a way that the borrower bank can transfer the transaction to other bank when liquidity risk arises as a result of this for the time being risk eradicates and the borrower bank gets the time to strategies the various tools required to overcome that risk permanently. This helps both the banks to act as a supporter and manager for each other. Each bank should therefore make an interbank relation.
  30. Viara V. Acharya, Lasse H. Pederson, Matthew Richardson and Thomas Philippon[xxix] (2010). The paper examines systemic risk faced by various financial institutions further stating that systematic risk can be measured as institutions systematic expected shortfall (SES). An empirical demonstration of ability of SES to examine the risk emerged during the financial crisis of 2007-2009. The analysis draws the conclusion that Systemic- Expected shortfall increase during a crisis. Role of leverage has also been investigated. It came out with the result that short-term debt had the most devastating effect in the crisis of 2007-09. Commercial banks that have an approach to insured deposits were relatively stable in the crisis when deposits were in a demandable position with short term tenure too.

RESULT AND DISCUSSION

The solution of the Risk management covers mainly the three threats which most of the bank faces are Credit risk, Market risk and operation risks so these risks are solved by the following methods

  • Identifying the Risk

 Firstly the bank should identify the risk by extracting the data such as clients date  client payment history, value of the loan, rate of recovery it can mainly used in identifying the credit risk.

Secondly to indentify the risk related to market. The data which needs to be extracted is rate sensitive assets, cash wallet, Exposure in equity.

Thirdly Operational risk can be identified by analyzing internal loss data, failure of the bank and its impact in the business.

  • Measuring the risk

Credit risk can be measured the bank needs to measure the expected loss which is based on quantitative measure.

Market risk is consist of

  1. Equity risk
  2. Commodity risk
  3. Interest rate risk
  4. Foreign exchange rate risk

It can be measured by Value at risk methodology which involves running a simulation package which is a risk analysis engine.

Operational risk – It can be measured by advance measurement approach. Where the historic internal loss data of bank is analyzed.

  • Risk mitigation

Where the credit risk crosses the predefined loss of the bank. This mitigation module is used. It involves risk analysation dashboard which act as a traffic signal alerts and draw the attention towards the risky components which needs to be measured.

CONCLUSION

Risk management and measurement in banks is very important. Though its need is enriching day by day but only some of the banks uses suitable risk management and measurement techniques effectively. In near future not only banks but also companies will need to adopt risk management techniques. It is analyzed that banks need risk to be management foe effective mitigation and capital allocation. In order to gain advantage banks should develop an effective robust system and should also improve systems in which various risks are to be reported.

New technologies for risk data analysis, separate module for managing the risk such as liquidity risk, credit risk etc. should be setup by the banks. Then only banks can effectively mitigate the risks.

Edited by Hariharan Kumar 

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