News

Press Center SAS in the News The Economic TimesBusiness India Business Today Business Standard The Financial Express The Times Of India The Hindu Hindu Business Line Dataquest India Infoline Ciol My Iris Sify News Domain-B CXOtoday Archives sas com

Banks are going all out to put in risk-management systems ahead of Basel-2, but the task is enormous. Regulation is largely perceived to be free of costs and as such, tends to be over-demanded by the public and over-supplied by the regulator. However, regulation involves a range of costs which are ultimately reflected in the price of financial intermediation. In fact, the focus in the current debate is whether regulation should be imposed externally through prescriptive and detailed rules or alternatively, by the regulator creating incentive compatible contracts that reward appropriate behavior. The main responsibility for risk management and compliant behavior has to be placed on the management of financial institutions. In the ultimate reckoning, it is necessary to recognize that there are distinct limits to what regulation and supervision can achieve. In particular, it does not provide a fool-proof of assured contract of safety and does not absolve either management or consumers of their responsibilities: Reserve Bank of India (RBI) Governor, Bimal Jalan at the Bank Economists’ Conference (Becon: December 27, 2002) Bangalore on ‘Strengthening Indian Banking & Finance: Progress and Prospects.’

In a rapidly changing business environment, no business can afford to remain static. It is well understood that risk-taking is an integral part of any business enterprise. It is important is that each bank needs to have in place the technical systems and management processes necessary to not only identify the risks associated with its activities, but also to effectively measure, monitor and control them. If Indian banks are to compete globally, the time is opportune for them to institute sound and robust risk management practices: valedictory address delivered by RBI Deputy Governor Rakesh Mohan, Becon’2002 (December 29, 2002).

The Basel Accord-2, which is to come into force from 2006 is expected to bring in concrete proposals for improving risk-management mechanisms in banks and financial companies. The risk approach under the Accord is three-dimensional with focus on credit, market and operational risk. The comprehensive nature of these formats is expected to change the processes and systems involved in risk-assessment. Banks, on their part, are sprucing up their risk strategies. State Bank of India is teaming up with KPMG while Union Bank of India has done so with Pricewaterhouse Coopers (now part of IBM). Bank of India is in the final stages of doing likewise with a consultant.

Says ICICI Bank joint general manager - structured products & portfolio management group Vishakha Mulye: "Retooling risk management practices with modeling techniques, backed by analysis and reporting are the need of the hour for assessing risks associated with various financial activities of institutions and banks. Unlike in the past, aggregations (of all risk factors) to arrive at an organizational risk factor will give a correct position of an institution in a given circumstance. The way relevant data has performed through analysis will lay a foundation for future policy."

Opines IDBI Bank head corporate risk management Pramod Vaidya: "New risk management needs have increased data-crunching requirements as decisions should be made based on predictable behavior of customers, which is not possible manually. About 1,100 key risk indicators have been identified for ascertaining operational risk aspects of banks." Of late, these issues have been engaging local bankers. It would be interesting to note that if one were to thumb through various editions of the RBI’s Trend and Progress of Banking in India Reports, one will seldom come across a term called return on capital!

To make matters simple, it would be worthwhile going through a report on risk management bought out by ICICIresearchcentre.org. Take risk-adjusted return on capital as a performance tool (Jammi Rao & Kalpana Prabhu): "Development of RAROC methodology began in the late 1970 at Bankers Trust. Their original interest was to measure the risk inherent in a bank’s credit portfolio, as well as the amount of equity capital necessary to limit the exposure of bank depositors and other debt-holders to a specified probability of loss. They felt the need to develop a system that would measure the performance of the bank’s traders, a system that would take into account that a trader who makes $1 million on US treasury bonds is using the bank’s capital differently than a trader who makes $1 million in positions in a volatile currency. They wanted to level out the differences in those trades so that they could be compared side by side to see how effective they were and how efficiently traders were using the firm’s money."

Says SAS India Pvt Ltd -- a leading provider of business intelligence solutions for the financial sector -- director, Arjun Erry, notes that various parameters come into play in proper assessment of risks associated with financial sector companies. "While the front and back-office operations have evolved over a period of time, this is the time when business intelligence systems have been recognised as a necessity for performing analytical functions. Risk management in the financial sector is gaining ground across the globe.

Old methods of sincerely resorting to a port-mortem to find out why a credit account did not perform up to expectations made earlier have started giving way for new procedures and processes, which envisage prediction of performance of an account based on their associated risks."

At Becon, Dr Jalan pointed out that a major drag on financial sector reforms in India is the slow progress in the management of non-performing assets (NPA). Although net-NPAs have undergone a steady decline since 1992-93, they are still high by the international standard of about 2 per cent. Cumulative provisions against loan losses at 43 per cent of gross NPAs is extremely low by international standards. From the regulator’s perspective, NPA management involves four steps -- assessment, provisioning, recovery and prevention. A menu-approach is adopted in India, which involves intensification of recovery with ongoing tightening of norms for assessment and provisioning. Banks are now being prepared for tightening norms for asset classification with convergence to international standards by March 2005.

The 90-day norm for recognition of loan-impairment will come into operation from 2004-05 and this is now applicable for all segments of the financial system. Phased provisioning and charging of interest on monthly rests are seen as immediate steps in the preparation. Dr Mohan, on his part (at Becon 2002), had said that in the current interest rate environment, banks are finding it more profitable to invest in government securities (G-Secs). In 2001-02, trading profits of public sector banks more than doubled to Rs 5,999 crore from Rs 2,250 crore in 2000-01. The net profits of these banks during these two years were Rs 4,317 crore and Rs 8,301 crore respectively and this includes an additional Rs 1,365 crore and Rs 1,547 crore from forex operations.

The RBI, for one, has been encouraging banks to be proactive in risk management. In this context, with a view to building up adequate reserves to guard against any possible reversal of interest rate environment in future, banks have been directed to maintain a certain level of investment fluctuation reserve. Emphasizing the changing need of the banking sector for risk management, Mr Vaidya says: "There are two important aspects of constant assessment for an operational bank -- what amount of capital is required for long-term solvency of a bank; and the other, transaction-level risk-assessment which banks have to focus on. When we aggregate all data and correlate information, it leads to a different logic altogether. Thus, to build a competitive edge while remaining solvent, is important."

KPMG Consulting Pvt Ltd assistant director Joy Uka is of the view that of of the three pillars of Basel Accord-2’s focus on credit, market and operational risks, market-risk management is better known to us as related benchmarks were being followed by local banks for quite sometime. But, credit-risk management calls for comprehensive approach and is difficult to implement. But it can be done by a systematic effort." Risk-based prediction function calls for collection, collating, processing and analyzing reams of data, and the parameters for arriving at a reasonable risk factor changes with each case. For example, offering credit to a cyclical industry player at a time when a particular industry is at its peak will definitely affect a bank’s interests.

Mr Erry adds that these specialized functions call for time-tested models suitable to each institution. The risk management framework developed by us constitutes three pillars -- development and maintenance of risk repository; analysis and modeling module, and, finally, a reporting system. Manual decisions are made based on the experience and intuition of the approving authority more than by studying the historical facts pertaining to the performance of the clients in the past. To address the challenge of changes in parameters for each case or account, it would be difficult to do it manually. And it calls for a specialized skill sets and systems and processes designed to produce results from the standardized and well-defined parameters.

Mr Vaidya says that there is a need to bring about a cultural change in organisations towards risk-culture: "Risk culture should be developed across the organisation. We should be fully conscious of the risks taken and assess it as we are getting paid for the risks we take today; or to avoid risks today itself by avoiding an exposure, how to mitigate the risk and increase the profitability of the organisation etc."

Unlike investment in G-Secs, credit and organisational risk could be controlled as its employees are the decisions-makers on such issues. "These kind of controls are also important in cutting costs involving possible litigation. While bankers were trying to get the Securitisation and Reconstruction Bill passed in Parliament, the influential borrower lobby had been pushing for a Lenders Liability Bill. That may come into being in a due course if not soon. Threats from new areas call for proactive measures to mitigate litigious effects!" points out Mr Vaidya.