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WhatisRiskManagement
inIndianBankingSector
andtheroleofRBI

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F re e IB P S P O P re lim s 2 0 1 6 O n lin e M o c k T e s t

PostedinRBIGradeB,RBIGradeBOnOctober23,2015

Bankingsectorsplaysapivotalroleinthemanagementofthe
economyofacountry.YouastheaspirantsofRBIGradeBOfficer
needstoknowaboutwhataretheRisksofBankingsector,Risk
ManagementandwhatistheroleofRBIintheriskmanagement.

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WhatisRisk?

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Riskreferstoaconditionwherethereisapossibilityof
undesirableoccurrenceofaparticularresultwhichisknownor
bestquantifiableandthereforeinsurable.Ariskcanbedefined
asanunplannedeventwithfinancialconsequencesresultinginloss

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orreducedearnings.Anactivitywhichmaygiveprofitsorresultin
3

lossmaybecalledariskypropositionduetouncertaintyor
unpredictabilityoftheactivityoftradeinfuture.
Inotherwords,itcanbedefinedastheuncertaintyoftheoutcome.

G o o g le A d S id e B a r1

Asriskisdirectlyproportionatetoreturn,themoreriskabanktakes,
D o w n lo a d A P P C o n ta in e r

itcanexpecttomakemoremoney.

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TypeofRisks
Themajorrisksinbankingbusinessascommonlyreferredcanbe
broadlyclassifiedinto:
LiquidityRisk
InterestRateRisk

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MarketRisk

+91

CreditorDefaultRisk
OperationalRisk

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LiquidityRisk

Theliquidityriskofbanksarisesfromfundingoflongtermassetsby
shorttermliabilities,therebymakingtheliabilitiessubjecttorollover

G o o g le A d S id e B a r2

orrefinancingrisk.
F B P a g e L in k

Theliquidityriskinbanksmanifestindifferentdimensions
(a)FundingRisk:FundingLiquidityRiskisdefinedastheinability
toobtainfundstomeetcashflowobligations.Forbanks,funding
liquidityriskiscrucial.Thisarisesfromtheneedtoreplacenet
outflowsduetounanticipatedwithdrawal/nonrenewalofdeposits
(wholesaleandretail).
(b)TimeRisk:Timeriskarisesfromtheneedtocompensatefor
nonreceiptofexpectedinflowsoffundsi.e.,performingassets
turningintononperformingassets.
(c)CallRisk:Callriskarisesduetocrystallisationofcontingent
liabilities.Itmayalsoarisewhenabankmaynotbeableto
undertakeprofitablebusinessopportunitieswhenitarises.
2.InterestRateRisk
InterestRateRiskariseswhentheNetInterestMarginorthe
MarketValueofEquity(MVE)ofaninstitutionisaffecteddueto
changesintheinterestrates.
IRRcanbeviewedintwowaysitsimpactisontheearningsofthe

F a c e b o o k A d T a rg e tin g P ix e l

bankoritsimpactontheeconomicvalueofthebanksassets,
G ra d e U p In B e tw e e n A p p In s ta lA d

liabilitiesandOffBalanceSheet(OBS)positions.InterestrateRisk
cantakedifferentforms.
3.MarketRisk

G o o g le R e ta rg e tin g

G ra d e U p S M S A c tio n

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Theriskofadversedeviationsofthemarktomarketvalueofthe
tradingportfolio,duetomarketmovements,duringtheperiod

G ra d e U p S M S L in k :b o to m Wid g e t

requiredtoliquidatethetransactionsistermedasMarketRisk.This
S tic k y W id g e t

riskresultsfromadversemovementsinthelevelorvolatilityofthe
marketpricesofinterestrateinstruments,equities,commodities,

Y e lo w B a rF o rT e s tS e rie s

andcurrencies.ItisalsoreferredtoasPriceRisk.
A fte rF irs tIm a g e A d B a n k

ThetermMarketriskappliesto(i)thatpartofIRRwhichaffectsthe
priceofinterestrateinstruments,(ii)Pricingriskforallotherassets/

P o s tC o n te n tL a s tA d

portfoliothatareheldinthetradingbookofthebankand(iii)Foreign
B o to m F o o te rA d

CurrencyRisk.
(a)ForexRisk:Forexriskistheriskthatabankmaysufferlosses
asaresultofadverseexchangeratemovementsduringaperiodin
whichithasanopenpositioneitherspotorforward,ora
combinationofthetwo,inanindividualforeigncurrency.
(b)MarketLiquidityRisk:Marketliquidityriskariseswhenabank
isunabletoconcludealargetransactioninaparticularinstrument
nearthecurrentmarketprice.
4.DefaultorCreditRisk

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Creditriskismoresimplydefinedasthepotentialofabankborrower
orcounterpartytofailtomeetitsobligationsinaccordancewiththe
agreedterms.Formostbanks,loansarethelargestandmost
obvioussourceofcreditrisk.Itisthemostsignificantrisk,more
sointheIndianscenariowheretheNPAlevelofthebankingsystem
issignificantlyhigh.
Now,letsdiscussthetwovariantsofcreditrisk
(a)CounterpartyRisk:ThisisavariantofCreditriskandisrelated
tononperformanceofthetradingpartnersduetocounterpartys
refusalandorinabilitytoperform.Thecounterpartyriskisgenerally

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viewedasatransientfinancialriskassociatedwithtradingrather
thanstandardcreditrisk.
(b)CountryRisk:Thisisalsoatypeofcreditriskwherenon
performanceofaborrowerorcounterpartyarisesduetoconstraints
orrestrictionsimposedbyacountry.Here,thereasonofnon
performanceisexternalfactorsonwhichtheborrowerorthe
counterpartyhasnocontrol
CreditRiskdependsonbothexternalandinternalfactors.
TheinternalfactorsincludeDeficiencyincreditpolicyand
administrationofloanportfolio,Deficiencyinappraisingborrowers
financialpositionpriortolending,Excessivedependenceon
collateralsandBanksfailureinpostsanctionfollowup,etc.
ThemajorexternalfactorsarethestateofEconomy,Swingsin
commodityprice,foreignexchangeratesandinterestrates,etc.
CreditRiskcantbeavoidedbutcanbemitigatedbyapplying
variousriskmitigatingprocesses
Banksshouldassessthecreditworthinessoftheborrower

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beforesanctioningloani.e.,Creditratingoftheborrower

shouldbedonebeforehand.Creditratingisthemaintoolof
measuringcreditriskanditalsofacilitatespricingtheloan.
Byapplyingaregularevaluationandratingsystemofall
investmentopportunities,bankscanreduceitscreditriskasit
cangetvitalinformationoftheinherentweaknessesofthe
account.
Banksshouldfixprudentiallimitsonvariousaspectsofcredit
benchmarkingCurrentRatio,DebtEquityRatio,DebtService
CoverageRatio,ProfitabilityRatioetc.
Thereshouldbemaximumlimitexposureforsingle/group
borrower.

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Thereshouldbeprovisionforflexibilitytoallowvariationsfor
veryspecialcircumstances.
Alertnessonthepartofoperatingstaffatallstagesofcredit
dispensationappraisal,disbursement,review/renewal,post
sanctionfollowupcanalsobeusefulforavoidingcreditrisk.
5.OperationalRisk
BaselCommitteeforBankingSupervisionhasdefinedoperational
riskastheriskoflossresultingfrominadequateorfailedinternal
processes,peopleandsystemsorfromexternalevents.Managing
operationalriskhasbecomeimportantforbanksduetothefollowing
reasons
Higherlevelofautomationinrenderingbankingandfinancial
services
Increaseinglobalfinancialinterlinkages
Scopeofoperationalriskisverywidebecauseoftheabove
mentionedreasons.
Twoofthemostcommonoperationalrisksarediscussedbelow
(a)TransactionRisk:Transactionriskistheriskarisingfromfraud,

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bothinternalandexternal,failedbusinessprocessesandthe
inabilitytomaintainbusinesscontinuityandmanageinformation.
(b)ComplianceRisk:Complianceriskistheriskoflegalor
regulatorysanction,financiallossorreputationlossthatabankmay
sufferasaresultofitsfailuretocomplywithanyorallofthe
applicablelaws,regulations,codesofconductandstandardsof
goodpractice.Itisalsocalledintegrityrisksinceabanksreputation
iscloselylinkedtoitsadherencetoprinciplesofintegrityandfair
dealing.
6.OtherRisks

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Apartfromtheabovementionedrisks,followingaretheotherrisks
confrontedbyBanksincourseoftheirbusinessoperations
(a)StrategicRisk:StrategicRiskistheriskarisingfromadverse
businessdecisions,improperimplementationofdecisionsorlackof
responsivenesstoindustrychanges.
(b)ReputationRisk:ReputationRiskistheriskarisingfrom
negativepublicopinion.Thisriskmayexposetheinstitutionto
litigation,financiallossordeclineincustomerbase.
RiskManagement
RiskManagementisactuallyacombinationofmanagementof
uncertainty,risk,equivocalityanderror.Uncertaintywherethe
outcomescannotbeestimatedevenrandomly,arisesduetolackof
informationandthisuncertaintygetstransformedintorisk(wherethe
estimationofoutcomeispossible)asinformationgathering
progresses.
Initially,theIndianbankshaveusedriskcontrolsystemsthatkept
pacewithlegalenvironmentandIndianaccountingstandards.But
withthegrowingpaceofderegulationandassociatedchangesinthe
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customersbehaviour,banksareexposedtomarktomarket
accounting.
Therefore,thechallengeofIndianbanksistoestablisha
coherentframeworkformeasuringandmanagingrisk
consistentwithcorporategoalsandresponsivetothe
developmentsinthemarket.Asthemarketisdynamic,banks
shouldmaintainvigilontheconvergenceofregulatoryframeworksin
thecountry,changesintheinternationalaccountingstandardsand
finallyandmostimportantlychangesintheclientsbusiness
practices.

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Therefore,theneedofthehouristofollowcertainriskmanagement
normssuggestedbytheRBIandBIS.
RoleofRBIinRiskManagementinBanks
Here,wewilldiscusstheroleofRBIinRiskManagementandhow
thetoolscalledCAMELSwasusedbyRBItoevaluatethefinancial
soundnessoftheBanks.CAMELSisthecollectivetoolofsix
componentsnamely
CapitalAdequacy
AssetQuality
Management
EarningsQuality
Liquidity
SensitivitytoMarketrisk
TheCAMELwasrecommendedforthefinancialsoundnessofbank
in1988whilethesixthcomponentcalledsensitivitytomarketrisk
(S)wasaddedtoCAMELin1997.
InIndia,thefocusofthestatutoryregulationofcommercialbanksby
RBIuntiltheearly1990swasmainlyonlicensing,administrationof

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minimumcapitalrequirements,pricingofservicesincluding

administrationofinterestratesondepositsaswellascredit,
reservesandliquidassetrequirements.
RBIin1999recognisedtheneedofanappropriateriskmanagement
andissuedguidelinestobanksregardingassetsliability
management,managementofcredit,marketandoperationalrisks.
Theentiresupervisorymechanismhasbeenrealignedsince1994
underthedirectionsofanewlyconstitutedBoardforFinancial
Supervision(BFS),whichfunctionsundertheaegisoftheRBI,to
suitthedemandingneedsofastrongandstablefinancialsystem.
AprocessofratingofbanksonthebasisofCAMELSinrespectof
IndianbanksandCACS(Capital,AssetQuality,Complianceand

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Systems&Control)inrespectofforeignbankshasbeenputinplace
from1999.
ByMadhviBansal

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