20-05-2013, 04:57 PM
Risk Management Systems in Banks
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Introduction
Banks in the process of financial intermediation are confronted with various kinds of financial
and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price,
commodity price, legal, regulatory, reputational, operational, etc. These risks are highly
interdependent and events that affect one area of risk can have ramifications for a range of other
risk categories. Thus, top management of banks should attach considerable importance to
improve the ability to identify, measure, monitor and control the overall level of risks
undertaken.
The broad parameters of risk management function should encompass:
i) organisational structure;
ii) comprehensive risk measurement approach;
iii) risk management policies approved by the Board which should be consistent with the
broader business strategies, capital strength, management expertise and overall
willingness to assume risk;
iv) guidelines and other parameters used to govern risk taking including detailed structure of
prudential limits;
v) strong MIS for reporting, monitoring and controlling risks;
vi) well laid out procedures, effective control and comprehensive risk reporting framework;
vii) separate risk management framework independent of operational Departments and with
clear delineation of levels of responsibility for management of risk; and
viii) periodical review and evaluation.
Risk Management Structure
A major issue in establishing an appropriate risk management organisation structure is
choosing between a centralised and decentralised structure. The global trend is towards
centralising risk management with integrated treasury management function to benefit from
information on aggregate exposure, natural netting of exposures, economies of scale and easier
reporting to top management. The primary responsibility of understanding the risks run by the
bank and ensuring that the risks are appropriately managed should clearly be vested with the
Board of Directors. The Board should set risk limits by assessing the bank’s risk and riskbearing
capacity. At organisational level, overall risk management should be assigned to an
independent Risk Management Committee or Executive Committee of the top Executives that
reports directly to the Board of Directors. The purpose of this top level committee is to empower
one group with full responsibility of evaluating overall risks faced by the bank and determining
the level of risks which will be in the best interest of the bank. At the same time, the Committee
should hold the line management more accountable for the risks under their control, and the
performance of the bank in that area. The functions of Risk Management Committee should
essentially be to identify, monitor and measure the risk profile of the bank. The Committee
should also develop policies and procedures, verify the models that are used for pricing complex
products, review the risk models as development takes place in the markets and also identify new
risks.
Credit Risk
General
Lending involves a number of risks. In addition to the risks related to creditworthiness of
the counterparty, the banks are also exposed to interest rate, forex and country risks.
Credit risk or default risk involves inability or unwillingness of a customer or counterparty
to meet commitments in relation to lending, trading, hedging, settlement and other financial
transactions. The Credit Risk is generally made up of transaction risk or default risk and
portfolio risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit
risk of a bank’s portfolio depends on both external and internal factors. The external factors are
the state of the economy, wide swings in commodity/equity prices, foreign exchange rates and
interest rates, trade restrictions, economic sanctions, Government policies, etc. The internal
factors are deficiencies in loan policies/administration, absence of prudential credit concentration
limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in
appraisal of borrowers’ financial position, excessive dependence on collaterals and inadequate
risk pricing, absence of loan review mechanism and post sanction surveillance, etc.
Instruments of Credit Risk Management
Credit Risk Management encompasses a host of management techniques, which help the banks
in mitigating the adverse impacts of credit risk.
Credit Approving Authority
Each bank should have a carefully formulated scheme of delegation of powers. The banks
should also evolve multi-tier credit approving system where the loan proposals are approved by
an ‘Approval Grid’ or a ‘Committee’. The credit facilities above a specified limit may be
approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers and invariably one
officer should represent the CRMD, who has no volume and profit targets. Banks can also
consider credit approving committees at various operating levels i.e. large branches (where
considered necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider
delegating powers for sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for
better rated / quality customers. The spirit of the credit approving system may be that no credit
proposals should be approved or recommended to higher authorities, if majority members of the
‘Approval Grid’ or ‘Committee’ do not agree on the creditworthiness of the borrower. In case of
disagreement, the specific views of the dissenting member/s should be recorded.
The banks should also evolve suitable framework for reporting and evaluating the quality
of credit decisions taken by various functional groups. The quality of credit decisions should be
evaluated within a reasonable time, say 3 – 6 months, through a well-defined Loan Review
Mechanism.
Prudential Limits
In order to limit the magnitude of credit risk, prudential limits should be laid down on various
aspects of credit:
a) stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio
or other ratios, with flexibility for deviations. The conditions subject to which deviations
are permitted and the authority therefor should also be clearly spelt out in the Loan
Policy;
b) single/group borrower limits, which may be lower than the limits prescribed by Reserve
Bank to provide a filtering mechanism;
c) substantial exposure limit i.e. sum total of exposures assumed in respect of those single
borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of
capital funds. The substantial exposure limit may be fixed at 600% or 800% of capital
funds, depending upon the degree of concentration risk the bank is exposed;
d) maximum exposure limits to industry, sector, etc. should be set up. There must also be
systems in place to evaluate the exposures at reasonable intervals and the limits should be
adjusted especially when a particular sector or industry faces slowdown or other
sector/industry specific problems. The exposure limits to sensitive sectors
Risk Pricing
Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting,
borrowers with weak financial position and hence placed in high credit risk category should be
priced high. Thus, banks should evolve scientific systems to price the credit risk, which should
have a bearing on the expected probability of default. The pricing of loans normally should be
linked to risk rating or credit quality. The probability of default could be derived from the past
behaviour of the loan portfolio, which is the function of loan loss provision/charge offs for the
last five years or so. Banks should build historical database on the portfolio quality and
provisioning / charge off to equip themselves to price the risk. But value of collateral, market
forces, perceived value of accounts, future business potential, portfolio/industry exposure and
strategic reasons may also play important role in pricing. Flexibility should also be made for
revising the price (risk premia) due to changes in rating / value of collaterals over time. Large
sized banks across the world have already put in place Risk Adjusted Return on Capital
(RAROC) framework for pricing of loans, which calls for data on portfolio behaviour and
allocation of capital commensurate with credit risk inherent in loan proposals. Under RAROC
framework, lender begins by charging an interest mark-up to cover the expected loss – expected
default rate of the rating category of the borrower. The lender then allocates enough capital to
the prospective loan to cover some amount of unexpected loss- variability of default rates.
Generally, international banks allocate enough capital so that the expected loan loss reserve or
provision plus allocated capital covers 99% of the loan loss outcomes.
Loan Review Mechanism (LRM)
LRM is an effective tool for constantly evaluating the quality of loan book and to bring about
qualitative improvements in credit administration. Banks should, therefore, put in place proper
Loan Review Mechanism for large value accounts with responsibilities assigned in various areas
such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit
grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and
scope of LRM normally vary based on banks’ size, type of operations and management practices.
It may be independent of the CRMD or even separate Department in large banks.