Risk Management in the Indian Banking Industry

Introduction

In the past couple of year’s the world has witnessed a major economic downturn which has shocked few of the most powerful economies and the main reason for that was the subprime crisis which led to failure of top global banks and financial institutions. Thus to avoid such circumstances in future it is really vital for financial institutions and banks to manage their risk and maximise their stakeholders profit and wealth.

The world of finance has always had an intuitive understanding of risk. The risks that emerge from the increased variety and complexities of banking business, as well as from the various new drivers of growth has pushed the contours of risk management in banks much beyond what would probably have existed in the more traditional forms of banking activity of accepting deposits and lending in relatively stable environments. Internationally, the last two decades or so have witnessed significant changes in the profile of the banking sector, as well the nature of risk management in banks. What perhaps has changed the nature of risk management, particularly are, inter-alia, advances in technology that have aided quantitative approaches to risk management, like models etc., and the increasing volumes of transactions in derivatives and other structured products that are so complex that they are often labelled “exotic”. India too has responded to this change, tempered with a gradualist, non disruptive approach, that has stood us in good stead over the years.

1.1 Background

The Indian Financial System is tasting success of a decade of financial sector reforms. The economy is surging and has gathered the critical mass to convert it into a force to reckon with. The regulatory framework in India has sparked growth and key structural reforms have improved the asset quality and profitability of banks. Growing integration of economies and the markets around the world is making global banking a reality. Widespread use of internet banking has widened frontiers of global banking, and it is now possible to market financial products and services on a global basis. In the coming years globalization would spread further on account of the likely opening up of financial services under WTO. India is one of the 104 signatories of Financial Services Agreement (FSA) of 1997. Thereby giving India’s financial sector including banks an opportunity to expand their business on a quid pro quo basis.

It is said that banking is a risky business and bankers are known to take risks. The basic business concept is embedded in the axim ‘No Risk- No Profit’. However, the statement – Higher the Risk, Higher the Profit – may not hold good all the time. Since risk taking is a part of the banker’s business, it will be prudent to identify or atleast try to identify and understand the risks that exist in every transaction. Any practising banker will know, the risks, when translated into reality will straightaway hit the profit and loss account on the debit side. There are hidden risks and risks which I call ‘looming’ risks that are waiting to happen. The difference between the holding rate and market rate of a security kept in the bank’s trading book is a looming risk. We as bankers have experienced this risk and some of us have paid dearly from our profits. There is, unfortunately, no provision to shift the securities from one category to another on a daily basis.

Any risk cannot be mitigated or managed without its identification and measurement. Risk measurement is a sophisticated task that needs modern technological tools coupled with razor-sharp minds. Thus it is really important to identify risks associated with banking sector and ways to manage such risks to retain higher profits and growth prospects.

1.2 Purpose of research study

The purpose of this study is to highlight the importance of risk management in everyday changing business environment; study emphasize that how the strategies of the risk management works, and implemented within the whole business world, especially in Indian Banking industry. There has always been a concern about market position, financial issues and market share and credit risks of the organisation in present economic scenario. Researcher identified that at least for stability, and at most to get the lion shares for being a market leader, management of every organisation always need to keep an eye on changing market, and take quickly risky decisions whenever required.

1.3 Areas of Research Study

In this study, researcher identify tools, techniques and management models to clarify aim of risk management in business world, where individuals, people, group of people and managers are basis of study, those who try or struggle to cope with risks in workplace within and outside organisation. There are three types of organisation in which this study was carried out, first of those who are large scale or Global Banks, secondly medium scale or nationalised Banks and lastly small scale corporate banks. These organisation are working in there geographical boundary with different sizes, capital resources and different working conditions.

This study also points out how decision makers plan and develop backup plan to cope or recover from any failure or disaster, as it is understood by the above importance that risk management in general now become vital for every organisation to become successful. Further more this study also shows that it has become best practice of successful organisation in process of decision making and continuous improvement.

1.4 Rationale

Basis of choosing this area of study was the personal and professional interest of researcher. As researcher intend to apply tools and technique of this study in professional life near in future.

Here it is very much necessary to know that researcher belongs to India, and so this study will help to apply knowledge in different processes of business in banks where he will join as professional after MBA (Finance) so will play a vital part in that organisation by applying tools and techniques, get by this degree.

1.5 Research Aims and Objectives

The main aims and objective of this dissertation is to proper application, implementation and try established approach of studies within organisations and try:

• To identify various risks which Indian banks are facing
• To prioritize the key risk(s)
• To discover solutions and alternatives ways
• To Implement the solution(s) for further Improvement(s)

These all objectives will be addressed in the literature review following this chapter which will include all the information available in practical and academic sense justifying the need and scope of this research subsequently followed by the findings of this research.

Limitations

Cost of printing research materials, transportation will be a major limitation as this would be required to gather data and information and go places in order to do so. However, I will try to seek for financial assistance from corporate and voluntary institution to be able to conduct the research.

Another concern would be time frame required for interviews to know the requirements and access to the documentary data in order to compare and compete with the existing service providers. This can be worked out by getting access to some information providing companies but may involve a subsequent charge to do so.

LITERATURE REVIEW

The last decade has seen many positive developments in the Indian banking sector. The policy makers, which comprise the Reserve Bank of India (RBI), Ministry of Finance and related government and financial sector regulatory entities, have made several notable efforts to improve regulation in the sector. The sector now compares favourably with banking sectors in the region on metrics like growth, profitability and non-performing assets (NPAs). A few banks have established an outstanding track record of innovation, growth and value creation. This is reflected in their market valuation. However, improved regulations, innovation, growth and value creation in the sector remain limited to a small part of it. The cost of banking intermediation in India is higher and bank penetration is far lower than in other markets. India’s banking industry must strengthen itself significantly if it has to support the modern and vibrant economy which India aspires to be. The main factor for critical success of Indian banking industry lies within appropriate measures for risk management to increase the profitability and growth rate of the banks.

Risk management Scenario

Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks. The standardized approach would be implemented by 31st March 2007, and the forward-looking banks would be in the process of placing their MIS for the collection of data required for the calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years.

Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach. Although many banks would be working towards the IRB Approach, the authors are of the opinion that RBI would have allowed a few banks to implement and follow the IRB Approach by the year 2015. Indian banks would be moving upward on the strategic continuum of risk scoring models as can be seen in the diagram on the previous page.

Risk Management Department’s Role

The Risk Department is of prominence within the banks as they are expected to be playing an extremely critical role in the management of the risks of the bank. Streamlining of information and data flow through the Risk Department would be essential in calculation and management of risks.

Calculation of Risk

Calculation of risk would be an essential requirement in the banks as they would be in the process of calculating not only the Credit Risk but also the Market Risk and the Operational Risks that the bank would be facing. The capital to be set off for advances made by the bank would depend largely upon the fair and accurate calculation of these risks. In 2005 five credit risk models have received global acceptance as benchmarks for measuring stand-alone as well as portfolio credit risk. They are: –

I. Altman’s Z Score Model

II. Merton Model

III. KMV Model for measuring default risk

IV. Credit Metrics

V. Credit Risk+

These models would get more sophisticated and the banks would have more options as other models would gain acceptance. For Market Risks the banks would be employing other models such as VaR, Monte Carlo Simulation etc. As for the Operational Risks the banks would be following internal risk frameworks in assessing significant operational risks and their mitigation.

Financial risks associated with financial institutions and Indian Banks and its Impact

Increased cross-border transactions will augment the dimensions of risks that Indian financial institutions face in their domestic markets. Market risk—the risk of losses in on- and off-balance sheet positions arising from movements in market prices—changes with cross-border transactions. Similarly, credit and liquidity risks, the risk in derivatives transactions, legal risk, and the risk of regulatory arbitrage include new dimensions:3

Market risks such as interest rate and foreign exchange risks become more complex as financial institutions and corporate gain access to new securities and markets, and foreign participation changes the dynamics of domestic markets. For instance, banks will have to quote rates and take un-hedged open positions in new and possibly more volatile currencies. Similarly, changes in foreign interest rates will affect banks’ interest sensitive assets and liabilities. Foreign participation can also be a channel through which volatility can spill-over from foreign to domestic markets.

Credit risk will include new dimensions with cross-border transactions. For instance, transfer risk will arise when the currency of obligation becomes unavailable to borrowers. Settlement risk (or Herstatt risk) is typical in foreign exchange operations because several hours can elapse between payments in different currencies due to time zone differences. Cross-border transactions also introduce domestic market participants to country risk, the risk associated with the economic, social, and political environment of the borrower’s country, including sovereign risk.

Liquidity Risk will include the risk from positions in foreign currency denominated assets and liabilities. Potentially large and uneven flows of funds, in different currencies, will expose the banks to greater fluctuations in their liquidity position and complicate their asset-liability management as banks can find it difficult to fund an increase in assets or accommodate decreases in liabilities at a reasonable price and in a timely fashion.

Risk in derivatives transactions are the main tool for hedging risks. Risks in derivatives transactions include both market and credit risks. For instance, OTC derivatives transactions include counterparty credit risk. In particular, counterparties that have liability positions in OTC derivatives may not be able to meet their obligations, and collateral may not be sufficient to cover that risk.

Operational risk may increase with FCAC.4 For instance, legal risk stemming from the difference between domestic and foreign legal rights and obligations and their enforcements becomes important with fuller capital account convertibility. For instance, differences in bankruptcy codes can complicate the assessment of recovery values. Similarly, differences in the legal treatment of secured transactions for repos can lead to unanticipated losses.

Regulatory issues include the risk of regulatory arbitrage as differences in regulatory and supervisory regimes among countries may create incentives for capital to flow from countries with higher standards to those with lower ones.

The preparedness of financial institutions to adequately manage the above risks depends largely on how well they manage existing financial risks. Financial institutions’ ability to identify, measure, and manage risk will vary depending on the quality of internal risk management and control policies—“the first line of defense.” Thus it is vital to understand risk management handling by the Indian Banks to overcome the various risks Indian Banking sector is exposed to.

RESEARCH APPROACH & METHODOLOGY

Research Methodology is one of the important parts of research paper which implies the use of different methods to meet the objectives discussed earlier. It includes the aim and objectives figured out for the study discussing various research methodologies and simultaneously explaining the methodology based on which the research is carried out. Easterby-Smith et al (1997) identified three main reasons why research philosophy is important. Firstly, it helps to clarify the overall research strategy to be used. Secondly, knowledge of research philosophy will enable and assist the researcher to evaluate different methodologies and avid inappropriate use and unnecessary work. Thirdly, it may help the researchers to be creative and innovative in either selection or adaption of methods that were previously outside his or her experience.

Research Philosophy

The nature of research is vital in choosing appropriate research approach. If the motive of the research is to evaluate, deductive approach will be used whereas for exploratory motive, approach will be of inductive nature. After reviewing above mentioned research philosophies, Positivism (Deductive and objective) research philosophy proved out to be best for this as it aims to understand the quantifiable data collected and then analyse it statistically to evaluate the responses and draw lead to a confirmation/conclusion based on these. Since the nature of research is more objective than subjective and also it is used to identify risk management within Indian banks in financial context, thus deductive approach comes into play. Thus it will confirm that how effectively does banks incorporates risk management to succeed in current economic scenario.

Research Strategy / Design

Main Aims and objective of this Dissertation is to proper application, implementation and try established approach of studies with in organisations and try:

• To identify various risks which Indian banks are facing
• To prioritize the key risk(s)
• To discover solutions and alternatives ways
• To Implement the solution(s) for further Improvement(s)

Research strategy and design is a framework to plan how the research questions will be answered with clear objectives considering the constraints (for example access to data, time, location and money, ethical issues) as well.

After an insight and review to the above approaches, the approach suitable for this study is Deductive and objective in nature one as it involves collection of data in the first step of the research and then analysing the data through statistical methods and draw confirmation giving a new insight to understand concept of risk management by Indian banking sector. Based on the objective, research will conducted by use of a questionnaire and then analysing the responses and evaluating the significance of risk management by the banks and financial institutions.

Method of Data Collection

Mixed method research will be used which combines Quantitative and qualitative data approaches. This will involve sequential use of these methods as first we will need quantitative method involving questionnaire to collect data from high profile bank authorities to know their virtue towards risk management and measure taken by bank to manage various risks. Semi-structured interview with managerial level bank authorities will be conducted and internet-mediated questionnaire will also be used to reach out to some of the consumers regarding their buying preferences to collect data.

Primary Data

Questionnaire

I will be using a questionnaire involving quantitative method to determine the virtue of bank professionals towards risk management. Also online questionnaire will be created to get responses from a wider range of banking professionals and managers to identify various risks and measure to combat the same in respect to banking industry. This data can then be analysed quantitatively and lead towards a sustainable result.

Interviews

I will be using interview to get data from the senior management employees related to the banking sector. This will help to reach the objectives of the research in thorough way. I shall frame out a different interview for different professionals but the basic layout being the same. The Data Protection Act (1998) will be taken into account by storing respondents’ details separately from interviews and also treating the responses with confidentiality.

During the interview process, response and questions may be recorded for proper interpretation and analysis on interviewee’s permission. There are other ways to gather information other than interview but having interviewed people leads to the reliability of data and better understanding. It will also give much opportunity to those who cannot read or understand the terminology properly to interact with me in their local languages.

Secondary Data

Documents

Documentary evidence will be used to collect secondary data on the growing use of internet as a means for promoting business and convenience for the users. This will include the use of written materials, correspondence, notices, transcripts of business firms as well as journals, articles and news paper reports.

Mostly, written documents are used to make available qualitative data and more emphasis will be laid on written documents in order to get information on

However, use will be made of non-written documents like voice and video recordings of previous interviews and workshops, organization’s databases to generate information. Bulk of this information will be coming from the database of banks and their reports published over Mintel International Group Ltd., FAME (Financial Analysis Made Easy), Capitaline, Finance India, etc which carries out research related to global financial institutions and related markets.

Sample Sizes

Jankowicz (1991) states “sampling can be defined as the deliberate choice of a number of people, the sample, who are to provide the data necessary to draw conclusions from, about a larger group, the population whom these people represent”. A well planned sample survey is necessary for any piece of research. The sample size may vary from getting involved as many as 50 bank managers from various banks to fill the questionnaire which will also include internet questionnaire. The number of interviews will depend on the willingness of the participant but will cater one interview each for different banks.

For documents collected in an electronic version including corporate emails and web based information, more time will be spent to arrange them for analysis. This helps to guarantee that the data are duly anonymised, stored aptly and devoid of typographical errors.

Consequently, careful analysis will be made of the languages used, comprehending the gist of the manuscript and finally identifying the reflection of responses received.

To help explore and analyze data collected austerely, all data collected will be categorized according to meanings associated with each data. Grounded theory will also be used to spawn meaning to the information gathered from the respondents. When analyzing the data, I will be looking for links and differences and all data will be coded according to the theory derived.

During the process of analysis, I shall look for similar responses made, variances, commonalties and connections in order to generate logical and comprehensive interpretation of the data. Due to the low volume of interview to be conducted, I shall use manual method of the computer system to code and salvage by copy and paste.

Timing

All ethical issues will be carefully taken into consideration without violation to ensure that the bank professional will be willing to cooperate in any subsequent research.

I therefore wish to conclude that the recommendations could be applicable to various banking organisations across the globe to deliver higher risk management solutions with the aim to succeed and expanding their core business.