Risk Managment in Commercial Banks

“Banks are in the business of managing risk, not avoiding it……… ……… …….. ” Risk is the fundamental element that drives financial behaviour. Without risk, the financial system would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain world. The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run.

The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy.

Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of public sector banks. “……… bank’s success lies in its ability to assume and ……… ……A aggregate risk within tolerable and manageable limits”. First Author; Prof. Rekha Arunkumar Ph. D. , from University of Mysore (awaiting result by September ’ 05), PGDCA, M. Com. , B. B. M.

, Faculty in Finance (10 years of experience), MBA Programme, Bapuji Institute of Engineering & Technology (affiliated to Visveswaraya Technical University) Davangere – 4. Karnataka Second Author; Dr. G. Kotreshwar Ph. D. , M. Com. , ICWAI. , Professor of Commerce (25 years of experience) University of Mysore, Manasagangotri Mysore – 6. 1 COMPLETE PAPER RISK MANAGEMENT IN COMMERCIAL BANKS (A CASE STUDY OF PUBLIC AND PRIVATE SECTOR BANKS) “Banks are in the business of managing risk, not avoiding it…… … …… .. ” …. … 1. PREAMBLE: 1.

1 Risk Management: The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons.

Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy. Competition from within and outside the country has intensified. This has resulted in multiplicity of risks both in number and volume resulting in volatile markets. A precursor to successful management of credit risk is a clear understanding about risks involved in lending, quantifications of risks within each item of the portfolio and reaching a conclusion as to the likely composite credit risk profile of a bank.

The corner stone of credit risk management is the establishment of a framework that defines corporate priorities, loan approval process, credit risk rating system, risk-adjusted pricing system, loan-review mechanism and comprehensive reporting system. 1. 2 Significance of the study: The fundamental business of lending has brought trouble to individual banks and entire banking system. It is, therefore, imperative that the banks are adequate systems for credit assessment of individual projects and evaluating risk associated therewith as well as the industry as a whole.

Generally, Banks in India evaluate a proposal through the traditional tools of project financing, computing maximum permissible limits, assessing management capabilities and prescribing a ceiling for an industry exposure. As banks move in to a new high powered world of financial operations and trading, with new risks, the need is felt for more sophisticated and versatile instruments for risk assessment, monitoring and controlling risk exposures.

It is, therefore, time that banks managements equip themselves fully to grapple with the demands of creating tools and systems capable of assessing, monitoring and controlling risk exposures in a more scientific manner. Credit Risk, that is, default by the borrower to repay lent money, remains the most important risk to manage till date. The predominance of credit risk is even reflected in the composition of economic capital, which banks are required to keep a side for protection against various risks.

According to one estimate, Credit Risk takes about 70% and 30% remaining is shared between the other two primary risks, namely Market risk (change in the market price and operational risk i. e. , failure of internal controls, etc. ). Quality borrowers (Tier-I borrowers) were able to access the capital market directly without going through the debt route. Hence, the credit route is now more open to lesser mortals (Tier-II borrowers). With margin levels going down, banks are unable to absorb the level of loan losses. There has been very little effort to develop a method where risks could be identified and measured.

Most of the banks have developed internal rating systems for their borrowers, but there has 2 been very little study to compare such ratings with the final asset classification and also to fine-tune the rating system. Also risks peculiar to each industry are not identified and evaluated openly. Data collection is regular driven. Data on industry-wise, region-wise lending, industry-wise rehabilitated loan, can provide an insight into the future course to be adopted. Better and effective strategic credit risk management process is a better way to manage portfolio credit risk.

The process provides a framework to ensure consistency between strategy and implementation that reduces potential volatility in earnings and maximize shareholders wealth. Beyond and over riding the specifics of risk modeling issues, the challenge is moving towards improved credit risk management lies in addressing banks’ readiness and openness to accept change to a more transparent system, to rapidly metamorphosing markets, to more effective and efficient ways of operating and to meet market requirements and increased answerability to

stake holders. There is a need for Strategic approach to Credit Risk Management (CRM) in Indian Commercial Banks, particularly in view of; (1) (2) (3) (4) Higher NPAs level in comparison with global benchmark RBI’ s stipulation about dividend distribution by the banks Revised NPAs level and CAR norms New Basel Capital Accord (Basel –II) revolution According to the study conducted by ICRA Limited, the gross NPAs as a proportion of total advances for Indian Banks was 9. 40 percent for financial year 2003 and 10. 60 percent for financial year 20021.

The value of the gross NPAs as ratio for financial year 2003 for the global benchmark banks was as low as 2. 26 percent. Net NPAs as a proportion of net advances of Indian banks was 4. 33 percent for financial year 2003 and 5. 39 percent for financial year 2002. As against this, the value of net NPAs ratio for financial year 2003 for the global benchmark banks was 0. 37 percent. Further, it was found that, the total advances of the banking sector to the commercial and agricultural sectors stood at Rs. 8,00,000 crore. Of this, Rs. 75,000 crore, or 9. 40 percent of the total advances is bad and doubtful debt.

The size of the NPAs portfolio in the Indian banking industry is close to Rs. 1,00,000 crore which is around 6 percent of India’ s GDP2. The RBI has recently announced that the banks should not pay dividends at more than 33. 33 percent of their net profit. It has further provided that the banks having NPA levels less than 3 percent and having Capital Adequacy Reserve Ratio (CARR) of more than 11 percent for the last two years will only be eligible to declare dividends without the permission from RBI3. This step is for strengthening the balance sheet of all the banks in the country.

The banks should provide sufficient provisions from their profits so as to bring down the net NPAs level to 3 percent of their advances. NPAs are the primary indicators of credit risk. Capital Adequacy Ratio (CAR) is another measure of credit risk. CAR is supposed to act as a buffer against credit loss, which is ICRA Limited, (2004), “Report 1 : Global Benchmarking”, IBA Bulletin, special issue, January 2004, pp. 30 2 ICRA Limited, (2004), Op. cit. pp. 36 3 Parasmal Jain, (2004), “Basel II Accord : Issues and Suggestions”, IBA Bulletin, June 2004, pp. 9-10. 1