Evolution ,Origin &Development of

Risk Management Concepts

OBJECTIVE
To comprehend:
The concept of RISK
Evolution, origin, development of risk
management concepts.
Evolution ,Origin &Development of
Risk Management Concepts
Risk management is fast emerging as a
science and taking larger and prominent
space in the field of bank management.
Risk management is not a new concept.
Risk Management hitherto has been through
intuition, premonition and perception.
A structured approach to Risk Management
has been elusive to the Banks for
considerably long time.
Evolution ,Origin &Development of
Risk Management Concepts
The first step towards an organized Risk Management arose
through Basel initiatives.
The advent of Basel II has certainly brought to focus the
pressure on Capital through differential risk weights.
Risk is imminent in every activity and more so in the case of
financial sector where we deal with money day in and day
out.
In every successful enterprise diligent risk management is
seen as a distinct and integral part of their functioning .
For Banks the capital accord of 1988 or Basel I reinforced
this diligence
It homogenized the independent efforts of each Bank in
managing their risks into a standard framework.
Evolution ,Origin &Development of
Risk Management Concepts
The inadequacies of Basel I, especially its broad
brush approach with regard to credit risk
apparently encouraged banks to go in for riskier
assets in search for higher returns on capital.
A dire need was felt at the global level to
introduce a more rigorous framework of
standards and practices, which would lead banks
into firmer grounds of Risk Management.
What is Risk?
The word risk is derived from an Italian word risicare
which means to dare
This means that risk is more a choice than a fate.
Risk is not something to be faced but a set of
opportunities open to choice
Bank for International Settlement (BIS) defines Risk is
the threat that an event or action will adversely affect
an organization's ability to achieve its objectives and
successfully execute its strategies
A wider definition of risk is Risk is nothing but the
certainty of an exposure to uncertainty
What is Risk Management ?
Managing the risks commences with the task of
identifying all the possible risks in our activities.
The next task would be to list out the controls in
place against each of the identified risks.
Making an assessment of the controls in place verses
the identified risks for adequacy
The risk identification and assessment is a dynamic
exercise and must be carried out at regular intervals
aiming at continuous refinement of our procedure in
tune with risks perceived.
Risk need to be measured to not only ascertain their
financial impact on our resources but also to aid in
pricing our products.
System to be in place to monitor/review the above
process.
Classification of Risks
Risk is an integral part of the banking
business.
Banks are exposed to various types of risks
depending on the activities pursued by them.
Broadly banks are exposed to three major
categories of risks.
Namely credit risk, market risk, operational
risk
Credit Risk
Credit risk is defined as the inability or unwillingness of the customer or
counter-party to meet commitments in relation to lending, trading,
hedging, settlement and other financial transactions.
Credit risk emanates from a banks dealings with an individual,
corporate,bank,financial institution, or a sovereign.
In the case of direct lending: Principal/and or interest amount may not be
repaid.
In the case of Guarantees and Letters of credit: Funds may not be
forthcoming from the constituents upon crystallization of liability.
In the case of Treasury operations: The series of payments due from
counter parties under respective contracts may not be forthcoming or
cease.
In the case of securities trading business: Funds/securities settlement may
not be effected.
In the case of cross border exposure :The availability and free transfer of
foreign currency funds may either cease or restrictions may be imposed by
the country where exposure is taken.
Market Risk
Market risk is defined as the possibility of
loss to a bank caused by changes in the
market variables such as interest rate, foreign
exchange rate, equity price and commodity
price
It is the risk to the Banks earnings and capital
due to changes in the market level of interest
rates or prices of securities, foreign exchange
and equities.
Operational Risk
It is defined as the risk of loss arising from failed
or inadequate internal processes,systems,people
or from external events
All losses from human and technical failures fall
under this category.
These are highly probabilistic in nature and not
easy to quantify.
It has shot into prominence because of the series
of catastrophes observed in the financial sector in
the 1990s owing to failures in internal controls.
History of Risk Management in Banks
1970s and BCBS
The first major Bank event that opened the eyes of financial sector was
that of Bank Herstatt of Germany,which was forced by German
regulators into liquidation.
The G-10 countries and Luxembourg formed a committee under the
auspices of BIS, called Basel Committee on Banking Supervision(BCBS)
to promote stability in the global banking system.
The committee meets regularly four times a year.
It has about thirty technical working groups and task forces ,which also
meet regularly.
The two main objectives of the committee at the time of formation
were
I. No foreign Banking system should escape supervision
II. Supervision must be adequate for all Banks operating internationally
History of Risk Management in Banks
BCBS engaged itself in formulating standards,
guidelines and best practices with the
expectation that respective central banks will
implement them to best suit their national
systems,.
Pursuing the goal of creating a level competitive
field for all Banks,BCBS published a credit risk
framework to guide the allocation of capital
reserves for all internationally active Banks.
This popularly came to be known as Basel I
accord.
Basel I
Basel accord I was implemented in India
through the Narasimham Committee.
RBI stipulated capital adequacy ratio of 9% to
meet the following objectives.
A. Strengthened the capital base of Banks
B. Create clear and uniform guidelines for all
Banks world over
C. Reduced competitive distortion among banks
Basel I
In the 1990s many loss incidents were witnessed
in the financial sector.
Failure of Barings Bank,BCCI,Sumitomo Bank and
Daiwa Bank are some of the examples;
In January 1996 BCBS came out with amendment
to 1988 accord to incorporate market risks.
Accordingly RBI introduced Asset Liability
Management for Banks in India to address
Liquidity and interest rate risks with effect from
1.04.1999
Basel II
Towards the end of 20
th
century banking
operations witnessed significant changes like :
Deregulated environment
Liberalization ,Privatization and Globalization
Technology boost leading to introduction of
sophisticated and complex products.
Expansion and foray into new types of
activities.
Basel II
Basel I though a revolutionary move of earlier times ,it
suffered from many short comings.
The short comings of Basel I are:
Non-recognition of operational risk
Ignoring of the Risk management advancements
Capital reserve inaccuracies
In 1999,BCBS came out with fresh proposals to align the
capital held by banks more closely with the risks faced by
them.
This new proposal was approved on 26.06.2004 and is
popularly known as Basel II and is in place by 2006 in G-10
countries and in India in 2008.