INTRODUCTION TO RISK MANAGEMENT

Any activity involves risk, touching all spheres of life, whether it is personal or business. Any business
situation involves risk. To sustain its operations, a business has to earn revenue/profit and thus has to be
involved in activities whose outcome may be predictable or unpredictable. There may be an adverse
outcome, affecting its revenue, profit and/or capital. However, the dictum “No Risk, No Gain” hold good
here.

DEFINING RISK

The word RISK is derived from the Italian word Risicare meaning “to dare”. There is no universally
acceptable definition of risk. Prof. John Geiger has defined it as “an expression of the danger that the
effective future outcome will deviate from the expected or planned outcome in a negative way”. The Basel
Committee has defined risk as “the probability of the unexpected happening – the probability of suffering
a loss”.

The four letters comprising of the word RISK define its features.
R = Rare (unexpected)
I = Incident (outcome)
S = Selection (identification)
K = Knocking (measuring, monitoring, controlling)

RISK, therefore, needs to be looked at from four fundamental aspects:

 Identification
 Measurement
 Monitoring
 Control (including risk audit)

WHAT IS RISK MANAGEMENT?

The standard definition of management is that it is the process of accomplishing preset objectives;
similarly, risk management aims at fulfilling the same specific objectives. This means that an
organization/bank, whether it’s a profit-seeking one or a non-profit firm, must have in place a clearly laid
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down parameter to contain – if not totally eliminate the financially adverse effects of its activities. Hence,
the process of identification, measurement, monitoring and control of its activities becomes paramount
under risk management.
The organization/bank has to concentrate on the following issues:

 Fixing a boundary within which the organization/bank will move in the matter of risk-prone activities.
 The functional authorities must limit themselves to the defined risk boundary while achieving banks
objectives.
 There should be a balance between the bank’s risk philosophy and its risk appetite.

IMPORTANCE OF RISK MANAGEMENT

The Concern over risk management arose from the following developments:

 In February 1995, the Barings Bank episode shook the markets and brought about the downfall of the
oldest merchant bank in the UK. Inadequate regulation and the poor systems and practices of the bank
were responsible for the disaster. All components of risk management – market risk, credit risk and
operational risk – were thrown overboard.
 Shortly thereafter, in July 1997, there was the Asian financial crisis, brought about again by the poor
risk management systems in banks/financial institutions coupled with perfunctory supervision by the
regulatory authorities, such practices could have severely damaged the monetary system of the various
countries involved and had international ramifications.

By analyzing these two incidents, we can come to the following conclusions:

 Risks do increase over time in a business, especially in a globalized environment.

 Increasing competition, the removal of barriers to entry to new business units by many countries,
higher order expectations by stakeholders lead to assumption of risks without adequate support and
safeguards.
 The external operating environment in the 21st century is noticeably different. It is not possible to
manage tomorrow’s events with yesterday’s systems and procedures and today’s human skill sets. Hence
risk management has to address such issues on a continuing basis and install safeguards from time to
time with the tool of risk management.
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 Stakeholders in business are now demanding that their long-term interests be protected in a changing
environment. They expect the organization to install appropriate systems to handle a worst-case
situation. Here lies the task of a risk management system – providing returns and enjoying their
confidence.

CREDIT RISK MANAGEMENT

WHAT IS CREDIT RISK?

“Probability of loss from a credit transaction “is the plain vanilla definition of credit risk. According to
the Basel Committee, “Credit Risk is most simply defined as the potential that a borrower or counter-
party will fail to meet its obligations in accordance with agreed terms”.
The Reserve Bank of India (RBI) has defined credit risk as “the probability of losses associated with
diminution in the credit quality of borrowers or counter-parties”. Though credit risk is closely related
with the business of lending (that is BANKS) it is Infact applicable to all activities of where credit is
involved (for example, manufactures /traders sell their goods on credit to their customers).the first
record of credit risk is reported to have been in 1800 B.C.

CREDIT RISK MANGEMENT TECHNIQUES

Risk –taking is an integral part of management in an enterprise. For example, if a particular bank decides
to lend only against its deposits, then its margins are bound to be very slender indeed. However the bank
may also not be in a position to deploy all its lendable funds, since obviously takers for loans will be very
and occasional.

The basic techniques of an ideal credit risk management culture are:

 Certain risks are not to be taken even though there is the likelihood of major gains or profit, like
speculative activities.
 Transactions with sizeable risk content should be transferred to professional risk institutions. For
example, advances to small scale industrial units and small borrowers should be covered by the Deposit
& Credit Insurance Scheme in India. Similarly, export finance should be covered by the Export Credit
Guarantee Scheme, etc.
 The other risks should be managed by the institution with proper risk management architecture.

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Thus I conclude that credit management techniques are a mixture of risk avoidance, risk transfer and risk
assumption. The importance of each of these will depend on the organizations nature of activities, its size,
capacity and above all its risk philosophy and risk appetite.

FORMS OF CREDIT RISK

The RBI has laid down the following forms of credit risk:
 Non-repayment of the principal of the loan and /or the interest on it.
 Contingent liabilities like letters of credit/guarantees issued by the bank on behalf of the client and
upon crystallization---- amount not deposited by the customer.
 In the case of treasury operations, default by the counter-parties in meeting the obligations.
 In the case of securities trading, settlement not taking place when it’s due.
 In the case of cross – border obligations, any default arising from the flow of foreign exchange and /or
due to restrictions imposed on remittances out of the country.

COMMON CAUSES OF CREDIT RISK SITUATIONS

For any organization, especially one in banking-related activities, losses from credit risk are usually very
severe and non infrequent. It is therefore necessary to look into the causes of credit risk vulnerability.
Broadly there are three sets of causes, which are as follows:
 CREDIT CONCENTRATION
 CREDIT GRANTING AND/OR MONITORING PROCESS
 CREDIT EXPOSURE IN THEMARKET AND LIQUIDITY SENSITIVITY SECTORS.

CREDIT CONCENTRATION
Any kind of concentration has its limitations. The cardinal principle is that all eggs must not be put in the
same basket. Concentrating credit on any one obligor /group or type of industry /trade can pose a threat
to the lenders well being. In the case of banking, the extent of concentration is to be judged according to
the following criteria:
 The institution’s capital base (paid-up capital+reserves & surplus, etc).
 The institutions total tangible assets.
 The institutions prevailing risk level.

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The alarming consequence of concentration is the likelihood of large losses at one time or in succession
without an opportunity to absorb the shock. Credit concentration may take any or both of the following
forms:
 Conventional: in a single borrower/group or in a particular sector like steel, petroleum, etc.
 Common/ correlated concentration: for example, exchange rate devaluation and its effect on foreign
exchange derivative counter-parties.

INEFFECTIVE CREDIT GRANTING AND / OR MONITORING PROCESS:

A strong appraisal system and pre- sanction care are basic requisites in the credit delivery system. This
again needs to be supplemented by an appropriate and prompt post-disbursement supervision and
follow-up system. The history of finance is replete with cases of default due to ineffective credit granting
and/or monitoring systems and practices in an organization, however effective, need to be subjected to
improvement from time to time in the light of developments in the marketplace.

CREDIT EXPOSURE IN THE MARKET AND LIQUIDITY-SENSITIVE SECTORS:

Foreign exchange and derivates contracts, letter of credit and liquidity back up lines etc. while being
remunerative; create sudden hiccups in the organizations financial base. To guard against rude shock, the
organization must have in place a Compact Analytical System to check for the customer’s vulnerability to
liquidity problems. In this context, the Basel Committee states that, “Market and liquidity-sensitive
exposures, because they are probabilistic, can be correlated with credit-worthiness of the borrower”.

COMPONENTS (BUILDING BLOCKS) OF CREDIT RISK MANAGEMENT

The entire credit risk management edifice in a bank rests upon the following three building blocks, in
accordance with RBI guidelines:
1. FORMULATION OF CREDIT RISK POLICY AND STRATEGY:
All banks cannot use the same policy and strategy, even though they may be similar in many respects.
This is because each bank has a different risk policy and risk appetite. However one aspect that is
common for any bank is that it must have an appropriate policy framework covering risk identification,
measurement, monitoring and control. In such a policy initiative, there must be risk control/mitigation
measures and also clear lines of authority, autonomy and accountability of operating officials. As a matter
of fact, the policy document must provide flexibility to make the best use of risk-reward opportunities.
Risk strategy which is a functional element involving the implementation of risk policy is concerned more
with safe and profitable credit operations. it takes in to account types of economic / business activity to
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which credit is to be extended, its geographical location and suitability, scope of diversification, cyclical
aspects of the economy and above all means and ways of existing when the risk become too high.
2. CREDIT RISK ORGANISATION STRUCTURE:
Depending upon a banks nature of activity, and above all its risk philosophy and risk appetite , the
organization structure is formed taking care of the core functions of risk identification, risk
measurement, risk monitoring and risk control.
The RBI has suggested the following guidelines for banks:

 The Board of Directors would be in the superstructure, with a role in the overall risk policy formulation
and overseeing.
 There has to be a board-level sub-committee called the Risk Management Committee (RMC) concerned
with integrated risk management. That is, framing policy issues on the basis of the overall policy
prescriptions of the Board and coming up with an implementation strategy. This sub-committee,
entrusted with enterprise wide risk management, should comprise the chief executive officer and heads
of the Credit Risk Management and Market and Operational Risk Management Committee.
A Credit Risk Management Committee (CRMC) should function under the supervision of the RMC. This
committee should be headed by the CEO/executive director and should include heads of credit, treasury,
the Credit Risk Management Department (CRMD) and the chief economist.

CREDIT RISK OPERATION & SYSTEM FRAMEWORK:

Measurement and monitoring, along with control aspects, in credit risk determine the vulnerability or
otherwise of an organization while extending credit, including deployment of funds in tradable securities.
As per RBI guidelines, this should involve three clear phases:
 Relationship management with the clientele with an eye on business development.
 Transaction management involving fixing the quantum, tenor and pricing and to document the same in
conformity with statutory / regulatory guidelines.
 Portfolio management, signifying appraisal/evaluation on a portfolio basis rather than on an individual
basis (which is covered by the two earlier points) with a special thrust on management of non-
performing items.
In the light of all the above three phases, a bank has to map its risk management activities (identification,
measurement, monitoring and control). It has to emphasize on the following aspects:
 There should be periodic focused industry studies identifying, in particular, stagnant and dying sectors.

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 Hands-on supervision of individual credit accounts through half-yearly/annual reviews of financial,
position of collaterals and obligor’s internal and external business environment.
 Credit sanctioning authority and credit risk approving authority to be separate.
 Level of credit sanctioning authority is to be higher in proportion to the amount of credit.
 Installation of a credit audit system in–house or handed-out to a competent external organization.
 An appropriate credit rating system to operate.
 Pricing should be linked to the risk rating of an account --- higher the risk, higher the price.
 Credit appraisal and periodic reviews----- together with enhancement when necessary--- should be
uniform, but operate flexibly.
 There should be a consistent approach (keeping in view prudential guidelines wherever existing) in the
identification, classification and recovery of non-performing accounts.
 A compact system to avoid excessive concentration of credit should operate with portfolio analysis.
 There should be a clearly laid down process of risk reporting of data/information to the controlling /
regulatory authorities.
 A conservative long provisionary policy should be in place so that all non performing assets are
provided for, not only as per regulatory requirements but also with some additional cushioning (some
banks in India provide for a fixed percentage-----usually 0.25%------of standard assets).
 There should be detailed delegation of powers, duties and responsibilities of officials dealing with
credit.
 There should be sound Management Information System.

These make it clear that operations/systems in credit risk management become really effective tools only
when they are led by principles of consistency and transparency.

SCORES / GRADES IN CREDIT RATING:

The main aim of the credit rating system is the measurement or quantification of credit risk so as to
specifically identify the probability of default (PD), exposure at default (EAD) and loss given default
(LGD).Hence it needs a tool to implement the credit rating method (generally the point in time
method).The agency also needs to design appropriate measures for various grades of credit at an
individual level or at a portfolio level. These grades may generally be any of the following forms:
1. Alphabet: AAA, AA, BBB, etc.
2. Number: I, II, III, IV, etc.

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The fundamental reasons for various grades are as follows:
 Signaling default risks of an exposure.
 Facilitating comparison of risks to aid decision making.
 Compliance with regulatory of asset classification based on risk exposures.
Providing a flexible means to ultimately measure the credit risk of an exposure.

TYPES OF CREDIT RATING

Generally speaking credit rating is done for any type of exposure irrespective of the nature of an
obligor’s activity, status (government or non-government) etc. Broadly, however, credit rating done on
the following types of exposures.
 Wholesale exposure: Exposed to the commercial and institutional sector(C&I).
 Retail exposure: Consumer lending, like housing finance, car finance, etc.
The parameters for rating the risks of wholesale and retail exposures are different. Here are some of
them:
 In the wholesale sector, repayment is expected from the business for which the finance is being
extended. But in the case of the retail sector, repayment is done from the monthly/periodical income of
an individual from his salary/ occupation.
 In the wholesale sector, apart from assets financed from bank funds, other business assets/personal
assets of the owner may be available as security. In case of retail exposure, the assets that are financed
generally constitute the sole security.
 Since wholesale exposure is for business purposes, enhancement lasts (especially for working capital
finance) as long as the business operates. In the retail sector, however, exposure is limited to appoint of
time agreed to at the time of disbursement.
 “Unit” exposure in the retail category is quite small generally compared to that of wholesale exposure.
 The frequency of credit rating in the case of wholesale exposure is generally annual, except in cases
where more frequent ( say half yearly ) rating is warranted due to certain specific reasons ( for example,
declining trend of asset quality. However retail credit may be subjected to a lower frequency (say once in
two years) of rating as long as exposure continues to be under the standard asset category.