Basel III: A Step Ahead in Banking Risk Management

Introduction

As banks no longer operate in a protected and regulated environment, there is an imperative need for them to develop and improve their capability to understand the changes in their economic environment and other circumstances having a critical bearing on their business activities. Risk is the potentiality of the events expected or unexpected to have an adverse affect on the earnings of the financial institution and the risk management is the process of identifying, measuring, monitoring and controlling risk. The risk arises due to uncertainties which in turn arise due to changes taking place in prevailing economic, social and political environment and due to lack of non-availability of the information concerning such changes. Globalization, privatization and liberalization have opened upon new methods of financial transaction where risk level is very high. Each transaction taken by bank changes the risk profile of the bank. Hence, providing real time risk information is one of the key challenges of the risk management exercise. In the process of financial intermediation, banks are exposed to severe competition and hence are compelled to encounter various types of financial and non-financial risks. Figure 1, ‘Type of Risks’ shows a broad bifurcation of various types of risks.

Figure 1.

Type of Risks

• 1.

  Credit Risk: The risk that the borrower will not be able to meet the obligations under the terms of the original agreement. There is always a scope for the borrower to default from his commitments for one or the other reason resulting in the crystallization of credit risk to the bank. Such risks can also arrive from the reduction in the portfolio value arising from actual or perceived deterioration in credit quality. Thus, credit risk is a combined outcome of default risk and exposure risk (Indian Institute of Banking and Finance, 2009).

• 2.

  Market Risk: It is the risk of incurring losses on account of movement in the market prices on all the positions held by banks. It is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or price of securities, foreign exchange and equities as well as the volatilities of those prices. Liquidity risk is defined as the inability to obtain funds to meet cash flow obligations. It can be in the form of (i) funding risk which may arise from the need to replace net outflows due to unanticipated withdrawal or non-renewal of deposits (ii) time risk which arises from the need to compensate the change of performing assets into non performing one and (iii) call risk which arises due to crystallization of contingent liabilities. Interest rate risk refers to the potential impact on net interest income or net interest margin caused by unexpected changes in market interest rates. Forex (Foreign Exchange) risk is the risk of loss that bank may suffer on account of adverse exchange rate movements (Indian Institute of Banking and Finance, 2009).

• 3.

  Operational Risk: It is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Strategic risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes (Indian Institute of Banking and Finance, 2009).