Chapter 1. General theory

1.1 Risk management: definition, history and its role in banking

Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulated environment, banks could not afford to take risks. But of late, banks are exposed to same competition and hence are compelled to encounter various types of financial and non-financial risks.

Risk management – is the process of measuring or assessing the actual or potential dangers of a particular situation. Risks have two components: uncertainty and exposure. In other words they come from uncertainty in financial markets, project failures ( at any phase in design, development, production, or sustainment life cycles),legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause.

The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk.

Evolution of risk management:

• Used long before 1960’s

• Emerged as a discipline during the early 1990’s

• By the mid of 1990’s there appeared regulatory initiatives, concerns about derivatives and released Risk Metrics.

• Typically used to describe techniques for addressing insurable risks.

How was like risk management several years ago? First, risk was reduced through safety, quality control and hazard education. Moreover, purchasing traditional insurance products was the main solution to the problem of sudden financially negative changes. Derivatives were also used to hedge. But now they are treated as a problem as much as a solution. Mostly, recent risk management focuses on reporting, oversight and segregation of duties within the organization.

Risk management provides a clear and structured approach to identifying risks. Having a clear understanding of all risks allows banks to measure and prioritize them and take the appropriate actions to reduce losses. Risk management has other benefits for banks, including:

• Saving resources: Time, assets, income, property and people are all valuable resources that can be saved if fewer claims occur.

• Protecting the reputation and public image of the bank.

• Preventing or reducing legal liability and increasing the stability of operations.

• Protecting people from harm.

• Protecting the environment.

• Enhancing the ability to prepare for various circumstances.

• Reducing liabilities.

• Assisting in clearly defining insurance needs.

An effective risk management practice does not eliminate risks. However, having an effective and operational risk management practice shows an insurer that your organization is committed to loss reduction or prevention. It makes a bank a better risk to insure.

Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to manage the limited risks. Business is the art of extracting money from other’s pocket, sans resorting to violence. But profiting in business without exposing to risk is like trying to live without being born. Every one knows that risk taking is failure prone as otherwise it would be treated as sure taking.

Hence risk is inherent in any walk of life in general and in financial sectors in particular. Of late, banks have grown from being a financial intermediary into a risk intermediary at present. In the process of financial intermediation, the gap of which becomes thinner and thinner, banks are exposed to severe competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Business grows mainly by taking risk. Greater the risk, higher the profit and hence the business unit must strike a trade off between the two. The essential functions of risk management are to identify, measure and more importantly monitor the profile of the bank. While Non-Performing Assets are the legacy of the past in the present, Risk Management system is the pro-active action in the present for the future. Managing risk is nothing but managing the change before the risk manages. While new avenues for the bank has opened up they have brought with them new risks as well, which the banks will have to handle and overcome.