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Risk Management in Banks

By Edited Nov 13, 2013 0 0

Financial Risk Management - A brief overview

Risk is the probability of financial loss. Its management happens in three steps: identify, measure, and implement management measures.

Financial crisis is caused by bad asset (loan) quality. NBFCs are not stringent in their lending norms. Another cause is asset-liability mismatch due to difference in maturity of deposits & loans. Fraud by traders also leads to financial crisis. 
 
To prevent fraud, large banks & NBFCs must have a central, independent & organization-wide risk management function, ensure existence of appropriate systems for regular collection & measurement of company-wide exposures, and have a strong reporting framework that facilitates early detection.
 
Risk is of the following types: Credit, market (interest rate, equity, currency, legal), operational, legal & liquidity, Credit, market & operational categories comprise over 90% of risk faced by financial institutions.
 
Credit risk is the probability of loan default. Market risk is the exposure due to movements in any market the institution trades in. Operational risk is due to manual error, system failure & fraud. Liquidity risk arises due to inability to pay funds when required.
 
Mapping 
  • Retail Banking – liquidity risk for liabilities, credit risk for loans
  • Corporate/wholesale banking – credit risk for loans, operational risk for transaction banking
  • Investment banking – market risk for underwriting
  • Financial Markets & Treasury – Market, credit risk for trading
  • ALM – Market risk (interest rate & liquidity)
Risk is measured using standard deviation. VaR or value at risk is a comprehensive measure for determining financial risk of an organization. VaR is important for senior management to have a complete picture of other measures like beta, duration etc. JPMC pioneered VaR and it was called the 4:15 report as it was delivered to Denis Weatherstone as a single page report this time every day.
 
VaR is mandated by certain regulators for banks & financial institutions. VaR statement is read as follows: We are x% confident that we will not lose more than $V over the next N days.
 
VaR methodologies are Variance/Covariance (JPMC metrics) & simulation (Monte Carlo using random sampling, historical simulation using past data).
 
Bank for international settlements (BIS) asked banks to recognize measure & manage credit risk. The Basel committee came up with the Basel norms for capital adequacy. BIS serves as a bank for central banks of various countries & fosters international monetary/financial cooperation.
 
Basel committee on banking supervision was formed to secure standardization across the global banking industry and to limit risks faced by the banking system. Basel I norms required minimum capital to be maintained by international banks which was linked directly to the risk faced by them.
 
Lending Activity
Risk Type
Weight
Own branch
No
0%
Another bank
Low
20%
Corporate of certain credibility
Medium
50%
Other entities
High
100%
 
BIS then asks banks to calculate their risk weighted assets (RWA). The BIS required banks to maintain atleast 8% of RWA as capital (includes profits & other reserves) as part of capital adequacy norms.
 
But Basel I ignored market risk & focused only on credit risk. Basel II covers market, credit & now operational risk as well. Basel III norms are currently under discussion.
 
Basel II framework is on three pillars: 
  • Minimum capital – describes the capital required to cover all kinds of risk.
  • Supervisory Review – supervisors (internal audit & external regulatory) need to review & audit the processes & assumptions behind risk capital allocation.
  • Market Discipline – this refers to public disclosure of information regarding capital adequacy. Basel norms are just guidelines not regulations.
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