Banking Risk Management in India

and RBI Supervision

Diksha Arora1

PG Candidate, Class of PGDM-2010

BIMTECH, India

Ravi Agarwal2

Associate Professor of Finance

BIMTECH, India

This Draft: August 2009

JEL classification: E58, G21, G28

Keywords: Banking supervision, Bank risks, Risk management

1
www.dikshaarora.com, Birla Institute of Management Technology (BIMTECH), Greater Noida,
India
2
Corresponding author, Ravi.Agarwal@bimtech.ac.in, Birla Institute of Management Technology,
Greater Noida, India.

First author has developed a C++ program to arrive at a final risk matrix of a bank. Authors are
grateful to the management and staff of Reserve Bank of India, New Delhi Regional office for their
suggestions and support. All the errors are of authors. Kindly do not quote without permission.

Electronic copy available at: http://ssrn.com/abstract=1446264

I. Introduction
The etymology of the word "Risk" can be traced to the Latin word "Rescum" meaning Risk at Sea or
that which cuts. Risk is inherent in every walk of life. Banks are, by definition, in the business of
taking and managing risk. With growing competition and fast changes in the operating environment
impacting the business potentials, banks are compelled to encounter various kinds of financial and
non-financial risks. Risk is associated with uncertainty and reflected by way of charge on the
fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the
liability holders of an institution.

The various risks that a bank is bound to confront is divided into two categories namely business risks
and control risks. Business risk involves the risks arising out of the operations of the bank, the
business it is into and the way it conducts its operations. It consists of 8 types of risks namely capital,
credit, market, earnings, liquidity, business strategy and environmental, operational and group risk.
Control risk measures the risk arising out of any lapses in the control mechanism such as the
organizational structure and the management and the internal controls that exist in the bank. Controls
risk further consists of internal controls, management, organizational and compliance risk. These risks
are highly interdependent and events that affect one area of risk can have ramifications for a range of
other risk categories. Thus, top management of banks should attach considerable importance to
improve the ability to identify measure, monitor and control the overall level of risks undertaken.

The three main categories of risks which have a mention in the capital accord are: Credit Risk, Market
Risk and Operational Risk. Credit risk, a major source of loss, is the risk that customers fail to comply
with their obligations to service debt. Major credit risk components are exposure, likelihood of
default, or of a deterioration of credit standing, and the recoveries under default. Modelling default
probability directly with credit risk models remains a major challenge, not addressed until recent
years. Market Risk may be defined as the possibility of loss to bank caused by the changes in the
market variables. Market risk management provides a comprehensive and dynamic frame work for
measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as
commodity price risk of a bank that needs to be closely integrated with the bank's business strategy.
Operational risk involves breakdown in internal controls, personnel and corporate governance leading
to error, fraud, and performance failure, compromise on the interest of the bank resulting in financial
loss. Putting in place proper corporate governance practices by itself would serve as an effective risk
management tool. The practical difficulties lie in agreeing on a common classification of events and
on the data gathering process.

Risk management in banking designates the entire set of risk management processes and models
allowing banks to implement risk-based policies and practices. They cover all techniques and
management tools required for measuring, monitoring and controlling risks. The spectrum of models
and processes extends to all risks: credit risk, market risk, interest rate risk, liquidity risk and
operational risk, to mention only major areas. For centuries bankers as well as their regulators have
assessed and managed risk intuitively, without the benefit of a formal and generally accepted
framework or common terminology. No longer is it sufficient to understand just the primary risks
associated with a product or service. They have to constantly monitor and review their approach to
credit, the main earning asset in the balance sheet.

Regulators make the development of risk-based practices a major priority for the banking industry,
because they focus on ‘systematic risk’, the risk of the entire banking industry made up of financial
institutions whose fates are intertwined by the density of relationships within the financial system.
Banking failures have been numerous in the past, both in India and internationally. Banking failures
make risk material and convey the impression that the industry is never far away from major
problems. Regulators have been very active in promoting pre-emptive policies for avoiding individual
bank failures and for helping the industry absorb the shock of failures when they happen. To achieve

Electronic copy available at: http://ssrn.com/abstract=1446264

 these results, regulators have totally renovated the regulatory framework. They are promoting and
enforcing new guidelines for measuring and controlling the risks of individual players.

From the banks point of view risk based practices are so important, because banks being ‘risk
machines’, they take risks, they transform them, and they embed them in banking products and
services. Banks take risk-based decisions under an ex-ante perspective and they do risk monitoring
under an ex-post perspective, once the decisions are made. There are powerful; motives to implement
risk based practices to provide a balanced view of risk and return from a management point of view;
to develop competitive advantages, to comply with increasingly stringent regulations. It is easy to
lend and obtain attractive revenues from risky borrower. The price to pay is a risk that is higher than
the prudent bank’s risk. The prudent bank limits risk and therefore both future losses and expected
revenues by restricting business volume and screening out risky borrowers. It might avoid losses but it
might suffer from lower market share and lower revenues. However, after a while, the risk-taker
might end with an ex-post performance lower than the prudent bank due to higher losses
materializing. Risks remain intangible and invisible until they materialize into losses. Simple
solutions simply do not really help to capture risks. All these factors led to the commencement of this
study.

II. Literature Review

Kaminsky and Reinhart (1996) in their well-known paper on twin-crises study about 25 episodes of
banking crises and 71 balance of payments crises in the period 1970-1995. Regarding the influence of
business cycle on the episode of financial instability and the possibility to identify macro-variables
that act as early warning, they find that recessionary conditions such as economic activity decline,
weakening of the export sector, high real interest rates, falling stock market, usually precede banking
as well as currency crises. They also find that Credit expansions, an abnormally high money growth
and the decline in the terms-of-trade anticipate many of the banking crises.

Berger and Deyoung (1997) address a little examined intersection between the problem loan literature
and the bank efficiency literature. They employ Granger-casualty techniques to test four hypotheses
regarding the relationship among loan quality, cost efficiency, and bank capital. The data suggest that
the intertemporal relationships between problem loans and cost efficiency ran in both directions for
U.S. commercial banks between 1985 and 1994. The data suggest that high levels of nonperforming
loans Granger-cause reductions in measured cost efficiency, consistent with the hypothesis that the
extra costs of administering these loans reduces measured cost efficiency ('bad luck'). The data also
suggest that low levels of cost efficiency Granger-cause increases in nonperforming loans, consistent
with the hypothesis that cost-inefficient managers are also poor loan portfolio managers ('bad
management').

In the paper by Mario Quayliariello (1997), the relationship between bank loan quality and business
cycle indicators is studied for Italy. A distributed lag model (which is estimated using ordinary least
squares) and bivariate Granger-causality tests are used in order to evaluate the importance of macro-
economic factors in predicting the quality of bank loans measured by the ratio of non-performing
loans to total loans. The main target of the research is to understand the contribution that macro-data
can offer in capturing the evolution of credit quality and to select a reasonably manageable set of
indicators which can act as early warning signals of the banking system fragility.

Demirguc-Kunt and Detragiache (1998) estimate a logit model of banking crises over the period
1980-1994 in order to understand the features of the economic environment in the periods preceding a
banking crisis and, therefore, to identify the leading indicators of financial distress.

The 1998 study by Demirgue-Kunt and Huizinga (DKH) is a cross-country study of variations in bank
performance, using two performance indicators separately regressed on a set of explanatory factors;
the interest spread (used as an efficiency indicator) and bank profitability. The data set is at bank-
level for 80 countries over the period 1988-95. The most important finding pertains to the differences
in the impact of foreign ownership between developed and developing countries. In developing
countries foreign banks have greater interest margins and profits than domestic banks. In industrial
countries, the opposite is true. The first finding bears out the better NPA performance by foreign
banks in India by country of origin. Among the macro variables reported by DKH that affect bank
profitability positively although not net interest margins (the efficiency indicator), is per capita GDP.
These results suggest that per capita GDP may be less a correlate of banking efficiency or superior
banking technology, and more a correlate of banking opportunities and the operating environment
generally.

The Sarkar, Sarkar and Bhaumik (1998) cross-bank study for India regresses two profitability and
four efficiency measures (one of which is the net interest margin) on pooled data for two years, 1993-
94 and 1994-95, for a total of 73 banks, using single-equation OLS estimation for each. The study
focuses exclusively on an examination of the prediction from the property rights literature about the
superiority of private ownership in terms of performance. Private banks are divided into traded and
non-traded categories; the control variables include the (log of) total bank assets, the proportion of
investment in government securities, the proportion of loans made to the priority sector, the
proportion of semi-urban and rural branches and the proportion of non interest income to total
income.

Ajit and Bangar (1998) present a tabulation of the performance of private sector banks vis-à-vis public
sector banks over the period 1991-1997, using a number of indicators: profitability ratio, interest
spread, capital adequacy ratio, and the net NPA ratio. The conclusion is that Indian private banks
outperform public sector banks. What is of interest, however, is that they find Indian private banks
have higher returns to assets in spite of lower spreads.

Survey on the “Implementation of the Capital Adequacy Directive” by the Banking Federation of the
European Union, April 1998 (covering 17 countries) revealed that very few banks are using
sophisticated models for managing their risks. Most banks which use it at first place use it for internal
risk management purposes only.

Shaffer (1998) shows that adverse selection has a persistent effect on the banks which are new
entrants in a market. Salas and Saurina (1999b) have modelled the problem loans ratio of Spanish
banks in order to gauge the impact of loan growth policy on bad loans. According to their empirical
estimation results (which were achieved using a panel data of commercial and savings banks from
1985-1997), the cycle (measured through the current and lagged-one-year GDP growth rates) has a
negative and significant impact on problem loans. The current impact is much more important. It is
also shown that problem loans ratio differs by type of loan. Households and firms have different
levels of bad loans. On an average, the former is lower than the latter. Among households, mortgages
have very low delinquency levels compared to consumer loans, credit loans or overdrafts.

Gambera (2000), using bivariate VAR systems, tries to understand how economic development
affects bank loan quality. He points out that, since systemic financial conditions help predict the
soundness of the single intermediaries; it may be interesting to predict the systemic financial
conditions themselves. In particular, he uses the ratio of delinquencies to total loans and the ratio of
non-performing loans to total loans as alternative dependent variables and he estimates a bivariate
system for each series of macro-economic variables.

Eichengreen and Arteta (2000) carefully analyse the robustness of the empirical results on banking
crises using a sample of 75 emerging markets in the period 1975-1997 and considering a huge range
of explanatory variables mentioned in previous works. Their findings confirm that unsustainable
boom in domestic credit is a robust cause of financial distress; macro-economic policies leading to
rapid lending growth and financial overheating generally set the stage for future problems. Domestic
interest-rate liberalization often accompanies these excessive lending activities. On the other hand,
they point out that there is little evidence of any particular relationship between exchange-rate
regimes and banking crises; the role of the legal and regulatory framework is also uncertain.

Meyer and Yeager (2001) employ a set of county macro-economic variables to test if rural bank
performance is affected by the local economic framework. They fit an OLS model when the return on
 assets and the net loan losses are the dependent variables and a tobit specification for the non-
performing loans. They find that none of the county-level coefficients is significant, suggesting that
county economic activity does not have a relevant effect on bank performance; in contrast, state-level
data are significant.

Arpa et al., (2001) study the effects of the business cycle on risk provisions and earnings of Austrian
banks in the 1990s. They conclude that risk provisions increase in period of falling real GDP growth,
confirming the pro-cyclical tendencies in bank behaviour. Moreover, rising real estate prices lead to
higher provisions, whereas falling inflation depresses them. They also find that some macro-economic
variables such as interest rates, real estate and consumer prices are useful in explaining the
profitability of Austrian banks.

In 2001 Boston Consulting Group study confirmed the general impression that North American banks
have a clear lead on most of their European and Asian competitors. Institutions in the U.S. and in
Australia too for that matter were pursuing risk management not to comply with regulatory
requirements but to enhance their own competitive positions.

The relationship between problem loans and the economic cycle is also analysed by Salas and Saurina
(2002). Using panel data, they report that the business cycle (proxied by the current and lagged
growth of GDP) has a negative and significant impact on bad loans. They also find that credit risk was
significantly influenced by individual bank level variables, after controlling for macro-economic
conditions.

III. Objective of the Present Study

Risk, in one kind or the other, is inherent in every business. Furthermore, risk taking is essential to
progress, and failure is often a key part of learning. Although some risks are inevitable, it does not
mean that attempting to recognize and manage them will harm opportunities for creativity. Risks pose
new challenges to every company. From employment practices to electronic commerce, from social
and political pressures to the vagaries of the weather, the hazards that exist in today's business climate
are as diverse as the companies that face them. Like any other business organization, banks too face
risks inherent to the company and the industry in which they exist. This paper has been undertaken
with the objective to critically examine the current risk management practices as directed by RBI and
supervision process undertaken by RBI.

IV. Data and Methodology

The current study covers 3 banks and their names have been masked. Judgement sampling method has
been used to collect the data. The study required both primary and secondary data. Primary data was
collected with the help of questionnaires* and series of interview schedules. Secondary data has been
collected through published reports, RBI circulars and bulletins.

V. Analysis and Findings

Risk management: According to the RBI circular issued on risk management by the RBI the broad
parameters of risk management function should encompass:
 organisational structure
 comprehensive risk measurement approach
 risk management policies approved by the Board which should be consistent with the broader
business strategies, capital strength, management expertise and overall willingness to assume risk
 guidelines and other parameters used to govern risk taking including detailed structure of
prudential limits
 strong MIS for reporting, monitoring and controlling risks
 well laid out procedures, effective control and comprehensive risk reporting framework

*
Authors can be sent requests for an unabridged version of the questionnaire.
 separate risk management framework independent of operational Departments and with clear
delineation of levels of responsibility for management of risk
 Periodical review and evaluation
The banking industry recognizes that an institution need not engage in business in a manner that
unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other
participants. Rather, it should only manage risks at the firm level that are more efficiently managed
there than by the market itself or by their owners in their own portfolios. It has been argued that risks
facing all financial institutions can be segmented into three separable types, from a management
perspective. These are: Risks that can be transferred to other participants, Risks that can be eliminated
or avoided by simple business practices, Risks that must be actively managed at the firm level

The management of the banking firm relies on a sequence of steps to implement a risk management
system. These can be seen as containing the following four parts:
Steps for
implementation of
Risk Mangement
systems

Investment
Standards and Position limits or Incentive contracts
guidelines or
reports, rules, and compensation.
strategies,

Figure: Steps for implementation of risk management systems

The banking industry has long viewed the problem of risk management as the need to control four of
the given risks which make up most, if not all, of their risk exposure, viz., credit, interest rate, foreign
exchange and liquidity risk. While they recognize counterparty and legal risks, they view them as less
central to their concerns. Accordingly, the study of bank risk management processes is essentially an
investigation of how they manage all these risks. Irrespective of the nature of risk, the best way for
banks to protect themselves is to identify the risks, accurately measure and price it, and maintain
appropriate levels of reserves and capital, in both good and bad times. However, this is often easier
said than done, and more often than not, developing a holistic approach to assessing and managing the
many facets of risks remains a challenging task for the financial sector.

Capital Adequacy in relation to economic risk is a necessary condition for the long-term soundness
of banks. Aggregate risk exposure is estimated through Risk Adjusted Return on Capital (RAROC)
and Earnings at Risk (EaR) method. Former is used by bank with international presence and the
RAROC process estimates the cost of Economic Capital & expected losses that may prevail in the
worst-case scenario and then equates the capital cushion to be provided for the potential loss.

The Economic Capital is the amount of the capital (besides the Regulatory Capital) that the firm has
to put at risk so as to cover the potential loss under the extreme market conditions. In other words, it is
the difference in mark-to-market value of assets over liabilities that the bank should aim at or target.
As against this, the regulatory capital is the actual Capital Funds held by the bank against the Risk
Weighted Assets. After measuring the economic capital for the bank as a whole, bank's actual capital
has to be allocated to individual business units on the basis of various types of risks.

Credit risk management: Credit risk management enables banks to identify, assess, manage
proactively, and optimise their credit risk at an individual level or at an entity level or at the level of a
country. The credit risk models are intended to aid banks in quantifying, aggregating and managing
risk across geographical and product lines. The outputs of these models also play increasingly
important roles in banks' risk management and performance measurement processes, customer
profitability analysis, risk-based pricing, active portfolio management and capital structure decisions.
The commonly used techniques are econometric technique, neural networks, optimisation models,
rule based and hybrid systems. The domains to which they are applied are credit approval, credit
rating determination and risk pricing. The various models covering these techniques and domain
are Altman's Z-score model (1968), KMV model for measuring default risk, CreditMetrics,
CreditRisk+ and Logit & probit models. Some examples of credit risk are:
 In August of 1999, Iridium, the satellite telecom company, defaulted on two syndicated loans of
$1.5 billion that it had borrowed to launch the satellites, but could not repay due to unexpected
low earnings.
 In 1974, a small German bank, Bankhaus Herstatt, had a string of losses in forex dealings. It went
bankrupt at the end of a trading day in Germany. Because, it was the end of the trading day in
Germany, it had already received $620 million worth of forex payments from its US trading
counter parties, but because the US markets were still open, Herstatt had not yet been required to
deliver $620 million for its side of the trades. At the time that it went bankrupt, it stopped all
payments, and US banks lost virtually all of the $620 million.

Drivers of effective credit risk management: These are effective credit risk management as a value-
enhancing activity, consolidating credit lines, efficient use of economic and regulatory capital,
ensuring that the bank has a safe level of capital, pricing loans to earn attractive risk-adjusted profits,
applying economic capital’s trio of core decision making criteria, use of derivatives to reshape credit
profile and technology.

Market risk management: Market risk is defined as the uncertainty in the future values of the
Group’s on and off balance sheet financial items, resulting from movements in factors such as interest
rates, equity prices, and foreign exchange rates. The drivers of market risk are equity and
commodities prices, foreign exchange rates, interest rates, their volatilities and correlations. Market
risk can be classified into directional and non-directional risks. Market risk can be measured and
managed through the use of Maturity gap analysis, Duration analysis, Convexity, Value-at-Risk
(VAR), Stress Testing and the Greeks. In Indian market, being an emerging market, liquidity and
inefficiency are the major concerns in the forex, debt and stock markets. Panic and knee jerk reactions
are also common (e.g. effect on stock markets during Indo-Pak tension and the recent Government
change). All these factors contribute to the market risk of the bank. Some examples of market risk
exposure are:
 On March 31, 1997 the BSE SENSEX had lost 302.64 points, one of the biggest losses in a single
day.
 In October 5, 1998 the BSE SENSEX fell a whopping 224 points and undoubtedly this day is the
Black Monday in the history of Indian stock exchanges.

To analyze the market risk management techniques, an exercise of informal discussion and
unstructured questionnaire was conducted at the banks under study. Few highlights are given as:
 The banks have been making progress in the area of Asset Liability Management. But they are
still far from achieving the level, which has been attained in banks abroad.
 All of the banks have set up ALM function and established the requisite organizational framework
consisting of the ALCO and the support groups. The composition, scope and functions of these
bodies are in accordance with the guidelines.
 Banks have also made an attempt to integrate ALM and management of other risks to facilitate
integrated risk management.
 Banks are complaint with the regulatory requirements of the RBI regarding the preparation of
statements. They have also laid out policies and maintain records as required by the guidelines.
Many of them have also achieved 100% coverage of business by ALM.
 Private Banks and foreign banks have made the most progress. Some of them had a head start in
ALM. They have not made the progress that could possibly have been made considering that their
problems are not of the magnitude of some other banks.

Factors affecting the effective implementation are:

 Lack of timely, accurate information.
 The number of branches in banks are huge and the level of computerization is low
 Limited use of advanced techniques of ALM and the adoption of sophisticated ALM specific
software. Such
 Absence of a good control framework for ALM
 Banks have also not established any way of measuring the performance of ALM function or
conducted any studies about impact of ALM.
 Training of staff is inadequate..
 Articulation of the interest rate view is quite difficult.
 Many of the banks have instituted ALM in order to comply with RBI guidelines and have not
adopted the spirit of the guidelines.
 Some of the banks have not laid down clear policies and have failed to establish a hierarchy of
objectives.
 Some of the banks also provide their ALCO with a large amount of information rather than
specific analytical reports.

Asset liability management: ALM is concerned with strategic balance sheet management involving
risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. In
recent years in India, most of the interest rates have been deregulated; government securities are sold
in auctions and banks are also, with a few exceptions free to determine the interest rates on deposits
and advances. Hence the ALM function is not simply about risk protection. It should also be about
enhancing the net worth of the institution through opportunistic positioning of the balance sheet. The
more leveraged an institution is, the more critical the ALM function within the enterprise. The ALM
process allows an institution to take on positions, which are otherwise deemed too large without such
a function. There are various techniques of risk management to address the different types of risk.
ALM primarily aims at managing interest rate risk and liquidity risk.

Operational risk management: Many banks have defined operational risk as any risk not
categorised as market or credit risk and some have defined it as the risk of loss arising from various
types of human or technical error. The majority of banks associate operational risk with all business
lines, including infrastructure, although the mix of risks and their relative magnitude may vary
considerably across businesses. Indeed, the acquisition of meaningful data, cleared of market and
credit factors, is providing a major stumbling block to the overall application of risk management
approaches to operational risk. Operational risk management techniques come in two basic varieties—
bottom –up or top down approaches take aggregate targets such as net income or net asset value, to
analyse the operational risk factors and loss events that cause fluctuations in the target. Some
examples of operational risk are:
 A US government bond trader at the New York branch of a Japanese bank was able to switch
securities out of customers’ accounts to cover credit losses which mounted to over $1 billion in
10years.
 In 1997, Nat West lost $127 million and had to greatly reduce its trading operations because its
options traders had been using the wrong data for implied volatility in their pricing models, and
was therefore taking risks that they did not see.

Study of risk management system at banks under study

Most of the banks do not have dedicated risk management team, policy, procedures and framework in
place. Those banks have risk management department, the risk manager’s role is restricted to pre fact
and post fact analysis of customer’s credit and there is no segregation of credit, market, operational
and strategic risks. There are few banks which have articulated framework and risk quantification.
The traditional lending practices, assessment of credits, handling of market risks, treasury
functionality and culture of risk-rewards are bane of public sector banks. Whereas private sector
banks and financial institutions are somewhat better in this context.

The sheer size and wide coverage of banks is a big hurdle to integrate and generate a cost effective
real time operational data for mapping the risks. Most of the financial institutions processes are
encircled to ‘functional silos’ follows bureaucratic structure and yet to come up with a transparent and
appropriate corporate governance structure to achieve the stated strategic objectives. The major
conclusions as listed below have been arrived on the basis of the documents supplied and informal
discussion held with the officials of the bank.

Since the year 1998 RBI has been giving serious attention towards evolving suitable and
comprehensive models for Risk-management. It has laid stress on integrating this new discipline in
the working systems of the Banks. In view of this, the risk management division in most of the banks
was established in or after 1998 only. All the details regarding the risk management framework is
presented by the bank in a policy document called ICAAP.

The risk management structure followed at all banks is a combination of centralized and decentralized
form. Though risk department forms the heart of the organisation because if it fails the bank will gasp
for breath. But this department is a victim of ignorance in today’s scenario. After conducting the study
it was found that the banks have lowest number of workforce assigned to this department. Within the
department, maximum stress is given to credit risk and other risks are still neglected. The bank does
not have sufficient skill set for driving risk management function.

The benefits in the next two years, on account of maintaining a separate “risk management function”
include following:
 Improvement in productivity
 Enabling risk adjusted performance
 Improved assessment of product profitability
 Use of risk sensitive approach in business processes
 Better pricing of products and consumer segments
 Developing skills for risk transfer products
 Competitive advantage
 Fraud reduction/deduction
 Better understanding and scrutiny of all functionalities of the bank.

Apart from those risks mentioned under the Basel accord, banks hardly pay attention to other
categories of risks. Some of the risks not addressed by most of the banks are:
 Interest rate risk in the banking book
 Settlement risk
 Reputational risk
 Strategic risk
 Legal and compliance risk
 Risk of under estimation of credit risk under the standardized approach
 Model risk
 Residual risk of securitization
The bank can also be exposed to a different category of risk apart from the financial risks called the
environmental risk. For example, if a major portion of their credit concentration loans are in
Mumbai’s central suburban area. If some calamity or unforeseen event happens in that area like
extensive rainfall incident that took place in 2006-07, it would certainly affect their loan portfolio.

Separate IT division exists in most of the banks to support Risk Management Department. Complete
IT based implementation of risk management system will take atleast 1 or 2 more years. Data
collection is the biggest challenge faced. The banks still depend heavily on manually prepared returns
for its MIS. The returns for other departments are prepared through different software and this causes
difficulty in integration. But on the other side, banks have always looked at technology as a key
facilitator to provide better customer service and ensured that its ‘IT strategy’ follows the ‘Business
strategy’ so as to arrive at “Best Fit”. Many banks have made rapid strides in this direction and
achieved almost 100% branch computerisation. A pioneering effort of the bank in the use of IT is the
implementation of Core Banking Solution (CBS) which facilitates “anytime, anywhere” banking.
Also, on account of CBS, the bank faces a technology risk. The private sector banks and the foreign
banks have relatively fewer branches. They achieve greater levels of computerization and coverage of
business. This helps them in better asset liability management where the decisions should be based on
timely accurate information. The public sector banks have also made progress in the area of
computerization but have not achieved complete coverage of business. Further, while coverage of
business is high, the number of branches covered is still low. It may therefore mean that the public
sector banks will take more time to achieve complete coverage of business by computerization as the
number of branches to be covered will be high whereas the percentage of business covered will be
lower.

At Indian banks securitization occurs at a very low level. Unlike US based banks the approaches used
in Indian banks are less advanced and more conservative in nature due to stringent RBI guidelines.
Therefore there has not been a drastic impact of the subprime crisis on the Indian banking industry.
Attention has been drawn towards liquidity risk management which has emerged to be one of the
most crucial risk management forms. Sooner or later the banks expect Basel III that will include
liquidity risk under pillar 1. Banks do not feel any risk fatigue. In fact high degree of realisation exists
where it is believed that a control from a number of regulatory bodies has protected the system from
the failures like that of subprime crisis. But on the other hand banks do not carry the exercise of
forensic audit also.

Banks are also striving hard to develop framework for estimating LGD (Loss Given Default) and
EAD (Exposure At Default) and also the framework for identifying concentration risk. A data
warehouse is being established for effective data management and use of application tools for
quantification of risks. In addition to default rating, facility rating is also being implemented at some
of the banks. Collaterals are used as risk mitigants generally by the banks. They comprise of the
financial collaterals (i.e. bank deposits, govt. /postal securities, life policies, gold jewellery, units of
mutual funds etc.), various categories of movable and immovable assets/landed properties etc. The
risk attached to use of such mitigants include the loss due to change in value of the collateral used.
Most banks do not use credit derivatives for credit risk mitigation. Also, Insurance is not used as the
prime risk management tool to hedge against risk by all the banks. They use their own techniques for
managing each category of risk. For example, all the banks have adopted hedging strategies to hedge
against forex risk. Some of the prominent ones are ECGC cover and forward cover. The banks are
also in the practice of using Forward contract, swap and options.

Basel II compliance efforts have led to improvement in their risk management system. The bank is
now able to measure residual risks. With Basel-II compliance the bank was able to articulate the need
for external ratings and data integrity.

Asset Liability Committee focuses mainly on the asset and liability management of the bank. The
committee decides the key drivers of market risk management keeping in view the dynamic external
environment. One of the major objectives of ALCO is to maximize the shareholder’s value and to
protect the bank from the impact arising from changes in interest rate. ALCO overall manages the
liquidity risk and interest rate risk by analyzing the following reports:
 Statement of structural liquidity
 Statement of interest rate sensitivity
 Statement of dynamic liquidity reports
 Analysis of earnings at risk
 Impact of interest rate movements on market value of equity through duration gap analysis
 Contingency funding plan
 Interest rate and bucket wise reports of total advances portfolio and bulk deposits.

The main challenges faced by the operational risk management department are:
 Quantification of operational risk
 Reporting of the near miss events.
 Less stress on operational risk by the top management
 Less available manpower in operational risk management department

The customer profile of all banks consists mainly of individuals and Corporate. For a large scale bank
number of corporate clients is more. The top revenue earners of all banks are Corporates. All the
banks use all the tools like feedback, service control and they satisfy customer complaints to achieve
customer satisfaction. Also, the competitive advantage of banks can range from Human Resource base
to its marketing abilities. Banks make use of a diversified media for advertisements which helps them
to reach out to the masses more effectively and efficiently.

The threats Exposed to the Banks consists of:

 Competition
 Less of customers
 Volatility in the market share
 Attention
 Threat of new entrants
It is seen that competition is exposed to all the banks equally and is the most important threat that they
are exposed to.

Strategies adapted by banks to overcome risks include:

 Integrative growth
 Intensive growth
 Downsizing older business
 Diversification

Banks have given following as reasons for high incidence of NPAs

 Improper Loan Appraisal System by Banks
 Poor Risk Management Techniques as a Contribution to NPA's
 Lack of Strong Legal Framework to initiate action
 Incorrect Evaluation of the Credit Worthiness of the borrower
 Poor Loan Monitoring
 Poor Recovery Mechanisms

Analysing the reasons that has led to loans becoming unpopular with the banking industry:
 High Incidences of Non - Performing Assets
 High Costs of Servicing
 Greater Political Interference
 Stricter Formalities to be compiled with
 Falling demand & the Pressure on the Banks

The reason as why targets set for loans have not reached by banks include:
 Projects Placed were not Feasible or Risky in the Respective Category
 Inadequate Security Provided by the Borrowers
 Large No. of Borrowers Whose Credit Worthiness is not Satisfactory
 Fear of NPA's

Opinion of Banks for the Trend towards Investments in government securities include:
 Large Availability of Government Securities in the Market.
 Possible fall in the Interest rates in Future and thus building up a better portfolio as of tomorrow
 Investments give maximum contend, as Risk is reduced very much as compared to that of loans
and Advances
 There is at least an amount of satisfaction that some Income may be leaped with least or no risk at
all
 Regulating requirement: SLR
In the note attached with the guidelines it is mentioned that with liberalization, the risks associated
with banking operations has increased requiring 'strategic management'. Management strategy
depends on the corporate objective. The objective can be deposit mobilization, branch expansion,
long-term viability etc. Some of these may be conflicting. For instance profitability may have to be
sacrificed for branch expansion. Each of these objectives would affect asset liability management.
Unless the hierarchy of objectives is clear, any rational asset liability management and pricing
decisions would be difficult. The banks under study have mentioned a definite objective in their ALM
policy. The banks, which adopted ALM before the issue of the guidelines, had done so in a period
ranging from 2 years to 3 months ahead of the issue of guidelines. These banks have therefore had the
opportunity to make more progress in the implementation of ALM. Having taken the initiative to
introduce ALM, it is assumed that the asset liability management function must have plenty of
support from the management. All the banks under survey adopted ALM after the issue of guidelines.
In fact, all the public sector banks introduced ALM in compliance with the guidelines and therefore
have had less time compared to the others to evolve their systems. The foreign banks had the
advantage of guidance from their head offices abroad where ALM systems were already in place.
Stress testing framework based on scenario and simulation techniques which is based on historical
data to ensure plausibility is applied at few banks but not all.

The guidelines outline the possible scope of ALM in banks which include Liquidity RM, Interest rate
RM, Management of other risks, Funding and capital planning; Profit planning and growth projection
and Trading RM. The ALM in most banks has this scope. Certain banks do not have a trading book
and therefore do not have trading risk management. Since all of these activities have come under the
purview of ALM, the asset liability management function assumes greater importance. Not all banks
have clearly defined policies for management of other risks apart from those under pillar 1. Profit
planning and growth projection found place in none of the bank’s policy. All of the banks surveyed
have an ALCO in conformity with the guidelines. The RBI guidelines state that the ALCO should be
headed by the CEO/Managing Director of the bank. This is to ensure top management support to the
ALM function. All the banks under study had this principle in place. The guidelines state that that the
heads of Credit, Investment, Fund Management/ Treasury, International Banking and Economic
Research can be members of the ALCO. The head of IT should be included in the committee. The
banks while adhering to this composition have also included other departments' representatives. One
of the banks has also adopted a system where other departments are invited based on the agenda of the
meeting. By involving various departments in the ALCO, the banks have ensured that the ALM
function has large coverage extending over their many operational areas. ALCO support groups are
also in existence in almost all the banks surveyed whereas the composition of the support groups
varies.

Functions of ALCO include determining product pricing, decide on maturity profile, set risk levels
and ensure adherence, decide on business strategy, review results and progress of decisions, articulate
current interest rate view, and determination of PLR. The functions of the ALCO in all the banks
comply with those specified in the guidelines. But the effectiveness of the performance of the ALCO
will depend on various other factors such as the information collected, the coverage of business, and
the ability to adapt to the changing environment quickly. Therefore while the banks may be compliant
with the guidelines in relation to functions of the ALCO, it may have no bearing on the effectiveness
of the ALM function. But none of the banks have instituted any system for the appraisal of the ALM
function. Empirical studies have not been conducted by any of the banks though one bank has
indicated its intention to conduct such a study soon. Such studies would help in improving the ALM
function. Many of the banks have prioritised the move to newer techniques of ALM. But establishing
appraisal and control frameworks would improve the current functioning of ALM. All of the banks
have conducted training programmes on ALM. Many have been internally developed and conducted.
Some banks have opted to train all of their officers in this field. But while such training as has been
imparted would raise the awareness among the staff about what ALM is, knowledge of the details of
the ALM process and requirements in their own bank is lacking. Raising the level of such awareness
would help in better data collection at the branch level and especially help those banks where full
computerisation has not been achieved. RBI had asked banks to achieve 100% coverage of assets and
liabilities by April 1st 2002. Some of the banks have achieved this target. Some of these banks consist
of those using the ABC approach. Given the difficulty in forecasting, the coverage while compliant
with RBI guidelines, would not result in much accuracy. The majority of the banks have opted for
specific software for ALM. Such software can greatly assist in scenario analysis and simulation as
well as generation of statements. This type of software would require far more frequent data
collection than exists currently. It would also necessitate the building of a database. Information
requirements: The banks are trying to upgrade the frequency of the data collection. It is probably the
main factor in the ALM. Until the banks are able to achieve daily data collection, the ALM function
will not be very effective. Decisions will continue to be made on stale data and the bank's
management will not be able to adapt quickly to changes in the external environment.

The guidelines outline analysis, monitoring and reporting of the risk profile, preparation of forecasts
showing effects of possible changes in market conditions and recommending action to ALCO (Asset
Liability committee) as the functions of the ALCO support groups. While many of the banks claim to
include these as functions of the Support Groups, it is seen that these are handled by individuals in
charge of the ALCO function in the Treasury/Investment Department. Also the preparation of
forecasts for the ALCO is bound to be limited in a situation where none of the banks conduct scenario
analysis or simulation. The forecasts' accuracy would be limited and they are probably based on
behavioral profiles of various assets and liabilities than possible market conditions. All of the banks
exhibit integration between ALCO and other risk management functions. In all of the banks the
members of the ALCO also constitute the Risk Management Committee. This implies that there is co-
ordination between the management of various risks and there is no conflict in risk management
practices. In all of the banks the ALCO reviews all of the statements that are prepared. In some banks
the ALCO is guided by the recommendations of the Support Groups and is not inundated by
information that has not been analysed. Also since the statements are based on data collected on a
fortnightly basis at best, they do not facilitate the most effective decision making.

Techniques used for managing interest rate exposure are Gap Analysis, Duration Analysis, Value at
Risk, simulation and sensitivity analysis. For the management of liquidity risk exposure, banks rely on
the preparation of the various statements mandated by the RBI. Analysis of these statements as well as
the gap statements is done. But the effectiveness is constrained by the lack of timely information.
Recognizing the limited capabilities of the banks in terms of MIS, computerisation etc. at the time of
issue of the guidelines, RBI had advocated the use of gap analysis. But RBI expected the banks to
adopt more advanced techniques as their capabilities improved. It is now found that many of the
banks including those that had a head start are still using the simpler techniques. Inspite of having
achieved 100% coverage of business through computerisation, many banks have not moved on to
more complex techniques. The primary reason is that even with computerisation, banks have not been
able to collect required information at more frequent intervals - a prerequisite for effective scenario
analysis.

The guidelines issued by RBI state that the establishment of a scientifically evolved internal transfer
pricing mechanism would enhance the management of margin and interest rate risk. It would also
provide a rational framework for pricing assets and liabilities. Most of the banks surveyed had
evolved a system of transfer pricing. The most rational system would involve multiple transfer prices
on the basis that all deposits are lent to the head office and funds needed to fund advances are
borrowed from the head office. For example each type of liability at a branch would have a different
transfer price depending on its total cost - interest, non-interest and reserves. Such a sophisticated and
rational transfer pricing mechanism would be very difficult to use in the absence of bank wide
computer systems so that all data are centrally available and the needed calculations are made
electronically. This is especially mammoth task for public sector banks but given their low return on
capital employed and volatility of interest rates, they would have to evolve their systems to such a
level.
Another set of guidelines had put forth the need to analyse the impact of embedded options. This was
to be supported by behavioural analysis of maturities and empirical studies. Many of the banks have
undertaken such analysis but the Indian banking may not have reached a level of stability that will
permit past correlation to be used reliably for estimating the present and forecasting the future.
Therefore while banks are conducting behavioural analysis of maturities of time deposits, etc. they
may be far from accurate.

Indian banks have a very significant proportion of assets and liabilities with no fixed maturity. On the
assets side this includes practically all of the working capital finance. Much of this contractually
repayable on demand but in practice it is subject to more or less automatic rollovers, even when in the
form of loans. On the liabilities side the principal items with no fixed maturity are the current and
savings bank accounts. Now the banks approach this problem through behavioural analysis. It is the
process of capturing the assets and liabilities as per the buckets given by RBI. As on March 31, 2008,
for the scheduled banks together current account and savings bank deposits formed about 28% of
external liabilities: again the bulk of the loans and advances (40% of assets) was probably working
capital finance. This is a large and significant proportion of the assets and liabilities. All of the banks
surveyed follow the classification of assets and liabilities recommended by the RBI. They use the
maturity gap model.

After studying the credit risk models of various banks following recommendations are proposed:
1. Banks which have been using a credit risk model should move towards RORAC based pricing.
2. Credit derivatives though still not common Indian, offer immense opportunity to Indian banks to
take control of their NPAs and reduce exposure to certain sectors. However, certain regulatory
questions need to be addressed here.
 Exposure through CD should be included for calculation of Company / Group / Sector
exposure limits.
 If the reference asset is priority sector lending / export financing, then the protection seller
should be eligible for all the benefits that are available under these special categories of
assets.
 Taking into consideration the maturities and pricing the CD appropriately can address the
problem of maturity mismatch of the CD and the reference asset.
 Insurance companies and mutual funds should also be included as protection sellers.
 Disclosure of CD transactions should be made mandatory for listed companies.
 Securitization is fast gaining acceptance in Indian markets. CDs can be coupled in some
securitization deals, whereby the growth of securitization could possibly signal the entry of
the related credit derivative products.
3. For unlisted SMEs: For them the Pragmatic Altman’s Z-Score model wherein the estimated
figures for the following year are considered and a tentative Z-Score is calculated. Other
indigenous models, like the one developed by CRISIL can also be used.
4. For private sector banks: For the Indian private sector banks, which have a credit rating
methodology in place should move towards credit risk modeling. In this context, the KMV’s EDF
calculator could be an ideal choice because:
 It makes use of equity value and market capitalization of the company, which are real time
indicators of the firm’s value and can be tracked easily for publicly, listed companies.
 It is widely deployed by multinational banks across the globe, which is an indicator of its
worthiness.
5. For public sector banks: The Indian experience informs us that there are such public sector banks,
which don’t even have a credit rating system in place and disburse corporate loan on a random
basis, adding to the NPA problem. For such novices, a credit rating system and its uses are
mentioned below.
Assignment of Ratings Uses of Ratings

Factors
considered in Rating
rating criteria  Loan pricing and
 Financial  Written/fo profitability analysis
analysis rmal  Portfolio monitoring
 Industry elements  Assessing attractiveness
analysis  Subjective Preliminary of customer relationship
 Quality of /informal rating proposed  Evaluating rater
financial data elements for loan effectiveness
 Analytical Approva
 Rater’s approval  Internal capital
tools/models l process
own process allocation and return on
 External ratings assign-s Credit
experienc Relationship capital analysis
final
 Firm size/value e and manager and Rating  Frequency of loan
rating
 Mngmnt judgment credit staff monitoring
 Terms of
facility
 Other Loan credit review Watch processes Loan review
considerations  Ongoing review by  Quarterly process  Review of adequacy of
initial rater focused on loans that underwriting &
 Periodic review of exhibit current or monitoring from
each customer prospective problems random sample
relationship  Aimed at identifying  Sample weighted
 Aimed at reviewing best Path to improve towards higher risk
profitability/desirabili or exit credit at loans
ty lowest cost  Loan review judgment
 Generally conducted  Conducted by same is final say
by the same authority authorities to improve
that approves loan loan

The diagram gives a schematic representation of the risk rating process. To begin with, the
factors considered in assigning the credit ratings are aggregated, for instance the financial data,
industry analysis, facility, etc. After this, fixed weights can be assigned to each of these
parameters and a rating criteria can be decided based on subjective and objective
considerations. Now the relationship manager assigns a preliminary credit rating and the loan
approval finalizes the credit rating. The Credit rating should be constantly reviewed by the
relationship manager (one who assigns the credit rating) so that any downgrade would lead to
adequate action being taken on the part of the bank. Adequate action could manifest itself in the
form of a higher interest rate or non-renewal of loan.

Opportunities for Banks from Basel II

 Measuring, Managing and Monitoring Risk in a scientific manner
 Align risk appetite and business strategy
 Risk Based Pricing
 Effective Portfolio Management
 Optimum utilization of Capital
 Enhance shareholders’ value by generating risk adjusted return on capital

Benefits of moving to advanced approaches

 Relief in Capital Charge
 Risk based Pricing – focus on identified business areas. Competitive pricing in niche areas.
 Image/Prestige
 International recognition/benefits in dealing with Foreign banks
 Risk Control
Action Points for Effective Implementation
 Grooming and Retaining Talent
 Percolating risk culture across the organization through frequent communications, organizing
seminars and training.
 Setting up of Data Warehouse to provide risk management solutions.
 Integrating risk management with operational decision making process by conducting periodic
use tests.
 Periodic back testing and stress testing of the existing models to test their robustness in the
changing environment and make suitable amendments, if required.
 Putting in place a comprehensive plan of action to capture risks not captured under Pillar I,
through ICAAP framework
 Handling interrelationship between businesses. Linkage needs to be established between Funds
Transfer Pricing, Asset and Liability Management, Credit risk, Market risk and Operational risk
so that cost allocation can be done in a scientific manner.
 For Pillar III requirements, banks should disclose information that are easily understood by the
market players and gradually move to disclosure of information requiring advanced concepts and
complex analysis.
 Adopting RAROC framework and moving from regulatory capital to economic capital.

Challenges faced by banks

1. General issues
 Guidance, motivation and support from senior management is essential to help ensure success
of Basel II project.
 Good risk management involves a high degree of cultural changes. Embedding good risk
mgmt practices into day to day business will be difficult.
 Sophisticated risk management techniques require human resources with appropriate skill sets
and training.
 The models under advanced approaches require lot of historical data, collection of data is a
formidable task.
 Banks to customize and tailor make the risk products
2. Legal& Regulatory infrastructure
 Steps required for adoption of internationally accepted accounting standards, consistent,
realistic and prudent rules for asset valuation and loan loss provisions reflecting realistic
repayment expectations.
 Legal systems will require changes for speedier and effective liquidation of collaterals
 The laws governing supervisory confidentiality and bank secrecy would require modifications
to permit disclosure envisaged under pillar III.
 Operational autonomy, corporate governance etc needs to be addressed.
3. Derivatives& mitigation products
 Credit derivative products yet to be introduced in India. Evolution of developed market for
credit derivative is required to mange credit risk effectively and to get full benefit of risk
mitigation.
 Rigorous legal and regulatory framework and less developed secondary market for bonds/
loans etc is a major impediment in development of credit derivative markets.
4. MIS and IT
 100% internal IT development is costly
 System integration, dedicated software for risk assessment, enterprise wide integrated data
warehouse pose challenge.
 Lack of data driven culture: Historical issues in getting reliable data, only data that was
necessary to ease operational processes was captured, structured, data-backed decision-
making has not been very prevalent.
  Short data history and lesser no. of data points in LGD, EAD and high impact low frequency
events in operational risk may give distorted results.
5. Credit rating agencies
 Limited no of agencies and insignificant level of penetration
 At present default rates are disclosed by CRISIL only and other agencies are yet to declare,
which may create difficulties in mapping and compliance with disclosure criterion if they
want to be accredited by RBI.
 In India banks/ FI’s are having stake in rating agencies that may impact their independence.
 Banks are awaiting detailed guidelines from the regulator involving regulatory discretion
under IRB approach.

Risk based supervision: The Basel Committee on Banking Supervision has advocated a risk-based
supervision of banks as stability of the financial system has become the central challenge to bank
regulators and supervisors throughout the world. This has been put into practice in various countries.
This is a robust and sophisticated supervision with adoption of the CAMELS/CALCS approach
essentially based on risk profiling of banks. The focus of RBS is on the assessment of inherent risks in
the business undertaken by a bank and efficacy of the systems to identify measure, monitor and
control the risks. In pursuance of that risk profile, RBI prepares a customized supervisory program. It
is a systems based inspection approach.

CAMELS: (Applicable to all domestic banks) Capital Adequacy, Asset Quality, Management,
Earnings, Liquidity and Systems & Controls.
CALCS: (Applicable to Indian operations of banks incorporated outside India) Capital Adequacy,
Asset Quality, Liquidity, Compliance and Systems.

The objective of prudential regulation and supervision is a banking system that is safe and sound.
Safety and soundness are difficult to define because there are no limits to how safe or sound a bank
can be. Banks may fail due to any of the following reasons: run out of liquidity, run out of capital or
run out of both.

RBS, would use a range of tools to prepare the risk profile of each bank including CAMELS rating,
off-site surveillance and monitoring (OSMOS) data, prudential returns and market intelligence
reports, ad-hoc data from external and internal auditors, information from other domestic and overseas
supervisors, on-site findings, sanctions applied, structured meetings with bank executives at all
various levels, inter face dialogue with the auditors etc. A monitorable action plan (MAP), to mitigate
risks to supervisory objectives posed by individual banks would be drawn up for follow-up. RBI is
already using MAPs to set out the improvements required in the areas identified during the current on-
site and off-site supervisory process. If actions and timetable set out in the MAP is not met, RBI
would consider issuing further directions to the defaulting banks and even impose sanctions and
penalties.

Objectives of risk based supervision:

 RBI follows a carrot and stick system for implementation of Risk Management and Supervisory
controls in Banks.
 The approach is expected to optimize utilisation of supervisory resources.
 It is to minimise impact of crisis situation in the financial system.
 Construction of a Risk Matrix for each institution.
 Continuous monitoring & evaluation of risk profile of the supervised institutions.
 Facilitates implementation of new capital adequacy frame work

Benefits of RBS: The RBS holds out a package of benefits of the supervisor, the supervised entities
and the depositor as shown below:
1. Supervisor
 Deeper understanding of the risks associated with the banks and
  Facilitate optimum use of scarce supervisory resources and direct supervisory attention to
those banks and those areas within the banks, which cause more supervisory concern
2. Supervised entity
 it will enhance the bank’s own capability for risk management and risk control
 it will provide a built-in incentive of lesser supervisory intervention for the good performer
3. Depositor
 The increased attention to risk factors both by the supervisor and the bank itself will reduce
the risk of insolvency and provide for greater comfort for deposit protection.

Comparison of Traditional Supervision and Risk-Based Supervision:

 At the risk of oversimplifying the differences in approaches to supervision, traditional supervision
focuses more on quantifying problems and minimizing risks in individual banks, while risk-based
supervision focuses more on the quality of risk-management systems and the recognition of
systemic risks to the banking system caused by the economic environment.
 The traditional approach tends to limit a bank's ability to serve the economic community's needs
by limiting the risks a bank can take, whereas risk-based supervision allows banks to take risks so
long as the banks demonstrate the ability to manage and price for risks.
 Traditional supervision tends to apply a cookie-cutter approach to supervision in which all banks
are treated alike, often at the lowest common denominator. Risk-based supervision treats banks
differently depending on each bank's demonstrated ability to manage risks. It does not penalize
well-managed banks by making them operate under standards designed to keep weak, poorly
managed banks solvent.
 There are appropriate places for each approach. When bank supervisors are dealing with
institutions that are known, or thought, to have serious problems that may threaten solvency, there
is then a need to quantify problems, which can best be accomplished using traditional forms of
supervision. However, the worse the condition of a bank, the greater the need to quantify the
problems with precision. In healthy banks, where the likelihood of failure is not an issue, there is
less need to quantify problems with great precision hence RBS used.
 The CAMELS approach uses supervisory tools such as on-site inspection and off-site surveillance
for all banks and is broad based whereas RBS involves preparing the risk profile of each bank and
the scope of supervision is determined by the risk that the supervisory authority associates with
each bank.
 While the supervisory cycle is annual in the case of the current approach it is again dependent on
the risk perception of the authorities in the case of RBS.
 RBS focuses on the bank not only from the transaction point of view but also in terms of the
policies and procedures designed and the effectiveness of their implementation. There would be
greater need to pay attention to the correctness and integrity of the data and information supplied
by the banks, which go into the compilation of the risk profile.
 The inspection under the current approach is generally conducted with reference to the audited
balance sheets of the banks while it is not necessary to do so in the case of RBS.

Effectiveness of RBI supervision: For the purpose of study, impact of supervision on bank’s
performance has been assessed in terms of a few parameters
 Level of NPAs: The trend of improvement in the asset quality of banks continued during the
period of study. Moreover, gross NPAs (in absolute terms) of nationalised banks and old private
sector banks have continued to decline. A reason for this progress can be the stringent and
conservative approach by RBI. The following graph shows the movement of NPAs.
 80000 70313
70000 64897
60000 57546
51243 55843
50000 50296
40000
30000
20000
10000 9.1 7.2 4.9
0 3.5
2.7
2.4
2003 2004 2005 2006
2007
2008

Net NPA % of Advances

Source: Basic Statistical Returns of Scheduled Commercial Banks in India

 Bringing improvement in weak banks: Here, the cases of four public sector banks (Indian
Bank, United Bank of India, UCO Bank and Dena Bank) have been taken for study. The problem
in the first three banks started in the 1996-97, when they began showing very poor performance in
terms of profits. Supervisory and regulatory actions were taken to arrest the deterioration of these
banks and through a process of recapitalization, enough capital was also infused. Narrow banking
was recommended for these banks, wherein all advances are stopped and the investments are
limited to those in G-Securities, which assure safe returns. Currently these banks are under
control. Similarly, problems cropped up in Dena Bank in 2000, which were brought under control
immediately. The bank’s internal management and controls contributed to the success.
Supervision was also one of the qualifiers for the same. Other evidences showing the CRAR
levels, the Operating Profit / Working Funds, Net NPAs / Net Advances and Return on Assets of
the three banks indicate a gradual improvement in the overall health of the three banks (though
the improvement in the case of Indian Bank is marginal).
 Profitability of Banks: To judge the effect of profitability of banks Net Profit / Loss as a
percentage of Total Assets has been taken for study. The following table shows the figures for the
scheduled commercial banks. Reflecting the buoyant growth in noninterest income on the one
hand and a relatively subdued growth in operating expenses on the other, operating profits of
SCBs have increased over the years. Though the operating profits increased across all bank
groups, the increase was more pronounced in respect of new private sector and foreign banks.
This increase in profitability can be attributed to efficient operations of banks along with good
RBI supervision.
 Improvement in Capital Adequacy: The CRAR data of all the banks (private, public and
foreign) provided in the Reports on Trend and Progress of banking in India of the last few years
show that there is a considerable improvement in the capital adequacy of the banks. The
improvement was, however, more pronounced in respect of new and old private sector banks,
followed by SBI and associates. As at end-March 2008, the CRAR of nationalised banks at 12.5
per cent was below the industry average (13.0 per cent), while that of all other groups was above
the industry level.
 Improvement in Inspection and Supervision Method: There has been an improvement in the
periodicity of the inspections. Earlier the private and foreign banks were inspected once in two
years, but now they are inspected annually. Similarly, the public sector banks were inspected once
in four years (besides the Annual Financial Reviews), but now, they are also being inspected
every year. Quarterly visits are being made to the weak banks and also the new banks. The
supervisory process has acquired a certain level of robustness and sophistication with the adoption
of the CAMELS / CALCS approach to supervisory risk assessments and rating.
 Internal Control and Management: A strong internal control mechanism has been developed in
the banks, wherein RBI has taken up special in-house monitoring of certain areas of weakness in
the banks, viz. Inter-branch / Inter-bank reconciliation and balancing of books. The quantum of
outstanding entries has been brought down drastically, thus reducing the fraud prone areas.
Besides this, the emphasis laid down by the supervisors on the computerization of the various
branches has been successful as a number of branches of both public and private sector banks
have been computerized.
 Disclosure Norms: With stricter disclosure norms, more and more information is being brought
out to the public. This has not only helped the shareholders, who are now in a better position to
assess the performance of the banks, but has also helped in keeping the management under a kind
of check.

Comparison of different approaches taken by some selected countries: Just as approaches to

banking regulation and supervision differ from country to country, approaches to supervisory risk
assessment and early warning also differ in various respects depending upon country-specific factors.
These include the extent, scope and frequency of on-site supervision; the off-site monitoring
mechanism; the extent, nature and reliability of regulatory reporting; the availability of other reliable
sources of information; the availability of historical data on bank distress and failure; the level of
technological advancement; and the availability of necessary budgetary and human resources. The
various risk based supervision approaches used by various developed countries are shown below:

Country Supervisory System System Type

Authority
France Banking ORAP (Organisation and Off-site Supervisory bank
Commission Reinforcement of Preventive rating system
Action)
SAABA(Support System for Early Warning model-Expected
Banking Analysis) loss
Germany German Federal BAKIS (BAKred Information Financial ratio and peer group
Supervisory Systeme) analysis system
Office
Italy Bank of Italy PATROL Off site Supervisory bank rating
system
Early Warning System Early Warning model- failure
and timing to failure prediction
Netherlands Netherlands RAST (Risks Analysis Support Comprehensive bank risk
Bank Tool) assessment system
Observation System Financial ratio and peer group
analysis system
United Financial RATE (Risk assessment, Tools Comprehensive bank risk
Kingdom Services of Supervision and Evaluation) assessment system
Authority
Bank of TRAM (Trigger Ratio Early Warning model
England Adjustment Mechanism)
United All three CAMELS On site examination rating
States supervisory
authorities
Federal Reserve Individual Bank Monitoring Financial ratio and peer group
System Screens analysis system
SEER Rating (System for Early warning model-Rating
estimating Exam Ratings) Estimation
SEER Risk Rank Early warning model-Failure
prediction
FDIC CAEL Off site Supervisory bank rating
 system
GMS (Growth Monitoring Simple Early warning model-
System) tracking high growth banks
SCOR (Statistical CAMELS Early warning model-Rating
Off-site Rating) downgrade estimation
OCC Bank Calculator Early warning model-Failure
prediction
Figure: Table showing supervision process at different countries

Initiatives required in case of RBI supervisory process:

 Technological upgradation- Information technology can be used to improve the supervision
method and also to reduce costs, increase volumes and speed and facilitate customized products.
The financial system is being strengthened with the introduction of Delivery vs. Payment (DvP)
system, Electronic Clearing Systems, etc. Still pro-active measures, like OSMOS returns from
banks on a real time basis need to be taken to further strengthen the supervision method.
 Human Resource Development and Manpower Planning- The core function of HRD is to
facilitate performance improvement measured not only in terms of financial indicators of
operational efficiency, but also in terms of the quality of financial services. Skills, attitudes and
knowledge of the personnel need continuous upgradation.
 Greater Vigilance - Though the financial sector is being increasingly deregulated and greater
autonomy is being given to the various participants, yet it is important to ensure that there is
increased vigilance over their adherence to the norms.
 Legal reforms - Legal reforms, without delay is required in the areas of insolvency, breach of
contract, defaults, and enforcement of security. Certain amendments (e.g. in the Stamps Act as
suggested by Narsimham Committee II), which have been suggested by various committees, need
to be made at the earliest.
 NPAs - As at the end of June 1997, out of 1100 cases filed and transferred to DRTs involving Rs.
8866.67 crore, 1045 cases had been decided and a meagre amount of Rs. 178.08 crore was
removed. The number of Debt Recovery Tribunals (DRTs) must be increased and they must be
given more powers so that they can expedite the recovery process. If feasible a time frame should
also be designed, within which the DRTs have to settle a specified number of cases.
 Relation between the regulated and the regulator - Greater transparency and mutual and
frequent consultation between the regulated and the regulator are required. An important step in
this direction has been the proposed introduction of the Prompt Corrective Action (PCA). This
PCA will establish a rule-based system for taking corrective actions to arrest deterioration of
banks and financial institutions beyond a certain point.
 Teamwork - A dedicated and strong team of supervisors is required to ensure proper delivery of
the supervisory responsibilities. Individuals need to be assigned greater responsibility, as is the
case with Financial Services Authority, United Kingdom.
 The capital charge on operational risk as given by the new Basel accord should be
substantiated as to how it is arrived at especially given the fact that the type of operational risk in
India is different form that in the European or American banks.
 Risk Based Supervision (RBS) - It is learnt that RBI is moving towards a system of Risk Based
Supervision, wherein, RBI would focus its supervisory attention on the banks in accordance with
the risk each bank poses to itself as well as to the system. The successful implementation of the
process of RBS entails adequate preparation, both on the part of the Reserve Bank and the
commercial banks.
 Consolidated Supervision - Keeping up with the international trends, it is important to introduce
a consolidated approach to supervision. For this, RBI needs to equip the commercial banks with
the required infrastructure and skills.
 Monthly Returns - Under the OSMOS system, presently data are called for from the banks on a
quarterly basis. As a step ahead of this, returns should now be made monthly at least for data, like
important financial ratios, CRAR, NPAs, etc. In future, this reporting system should graduate to
become a system on a real time basis, wherein data should be made available on-line.
 Universal Banking - India needs to get prepared for the phenomenon of universal banking. Since
ICICI has already made a move it is necessary that RBI ensure whether all the specified
guidelines, issued in the circular specifying norms for all entities desiring to venture into universal
banking are being complied with or not.
These suggestions once implemented will go a long way in improving the overall system of
supervision over the financial sector.

Risk management scenario in the future

Risk management activities will be more pronounced in future banking because of liberalization,
deregulation and global integration of financial markets. This would be adding depth and dimension
to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk,
therefore management of risks in a proactive, efficient & integrated manner will be the strength of the
successful banks. The standardized approach was to be implemented by 31st March 2007, and the
forward-looking banks placed their MIS for the collection of data required for the calculation of
Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks
are expected to have at a minimum PD data for five years and LGD and EAD data for seven years.
Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also
the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if the
banks want to migrate to the IRB Approach

Major finding: Devising a model for calculation of bank’s rating based on its risk management
practices
Models exist for assigning credit rating to borrowers. This helps the bank to identify potential
borrowers by determining their credit worthiness. But there are times when banks also fail to perform.
Potential customers find it difficult to determine in which bank they should deposit their money or
take loan from. Hence, it is also desired that bank should also be assigned a rating so that it comes to
the rescue of the borrowers. RBI is also practicing the same but it does not publish the ratings of these
banks. It assigns the ratings to all the banks under its jurisdiction but keeps it for the discussion with
the top management. Here, in this section, an attempt has been made to give the various banks a
rating which would help to determine healthiness of the bank. Due to the limited scope of the study,
the rating model suggested henceforth, is purely based on a bank’s risk management framework. For
this purpose a model has been proposed using which a bank will be assigned such a rating. This rating
would describe how successful a bank is as compared to its peer banks. It is a multicriteria decision
problem. Two possible ways of solving it are: analytical hierarchy process (AHP) and goal
programming. Here, AHP has been used and formulated in MS-Excel*. Further a dot net program*
has been developed to make it more user friendly. This software will enable the regulator to just enter
the rating of individual risks and the final risk rating of the bank would be generated.

The multiple criterions faced in this problem are with regards to various risks faced by banks. But
some risks are important than the others. So a comparison of all risks has been made to come to a set
of criterions. These criterions should be met and suffice to one solution. AHP can be done in three
ways- arithmetic mean transformation method, geometric mean transformation and Eigen value
transformation. The same solution for each verifies the integrity of the model proposed. Banking
industry faces two categories of risks namely business risk and controls risk. In this problem, the
criterion/goals are:
In case of business risk category
 Capital risk is the most crucial type of risk faced by banks.
 Credit and operational risk are at second level and are equally important.
 Next most crucial risk faced after capital credit and operational risk is market risk. Earnings risk
is also equally important as market risk.
 Liquidity risk is the next most important risk
 Least important/ crucial risks are business and group risk.
In the case of controls risk category:
 Internal controls risk the most crucial risk faced.
  Management and compliance risk are the next most important risks.
 Risk associated with organization is the least important of all.

Suggestions by banks to RBI: Some suggestions were given by the bank officials through the mode
of an informal discussion. They are:
 Banks are of the opinion that it would ease the processes if regulator comes up with industry wise
correlation.
 RBI guidelines are broader in nature. They should be more indicative.
 The document requirement for complying by the guidelines of RBI and Basel are highly centered
according to international banks. Some scenarios are not at all relevant to Indian markets. Hence
there is a need to revise the framework of guidelines with an Indian perspective so that the fatigue
of writing so many documents can be done away with.
 RBI has modified the CRAR from 8% to 9%. This makes capital a limiting factor. Hence it
restricts the natural growth of the bank. Hence the regulator should reconsider this.
 The terms used in the guidelines issued are directly picked from the documents in Basel or those
finding implementation in foreign countries. The terms should be explained more correctly to all
the banks.

VI. Conclusion
Worldwide, there is an increasing trend towards centralizing risk management with integrated treasury
management to benefit from information synergies on aggregate exposure, as well as scale economies
and easier reporting to top management. Keeping all this in view, the Reserve Bank has issued broad
guidelines for risk management systems in banks. This has placed the primary responsibility of laying
down risk parameters and establishing the risk management and control system on the Board of
Directors of the bank. However, it is to be recognized that, in view of the diversity and varying size of
balance sheet items as between banks, it might neither be possible nor necessary to adopt a uniform
risks management system. The design of risk management framework should, therefore, be oriented
towards the bank's own requirement dictated by the size and complexity of business, risk philosophy,
market perception and the existing level of capital. While doing so, banks may critically evaluate their
existing risk management system in the light of the guidelines issued by the Reserve Bank and should
identify the gaps in the existing risk management practices and the policies and strategies for
complying with the guidelines.

Credit risk management: Risk management has assumed increased importance of regulatory
compliance point of view. Credit risk, being an important component of risk, has been adequately
focused upon. Credit risk management can be viewed at two levels—at the level of an individual asset
or exposure and at the portfolio level. Credit risk management tools, therefore, have to work at both
individual and portfolio levels. Traditional tools of credit risk management include loan policies,
standards for presentation of credit proposals, delegation of loan approving powers, multi-tier credit
approving systems, prudential limits on credit exposures to companies and groups, stipulation of
financial covenants, standards for collaterals, limits on asset concentrations and independent loan
review mechanisms. Monitoring of non-performing loans has, however, a focus on remedy rather than
advance warning or prevention. Banks assign internal ratings to borrowers, which will determine the
interest spread charged over PLR. These ratings are also used for monitoring of loans. Recently, RBI
has taken measurable steps for sound Credit Risk Management but there is still long way to go. A
more scientific & Quantitative approach is the need of the hour.

Market risk management: Asset Liability Management as a risk management technique is gaining
in popularity as banks are beginning to recognize the need for proper risk management. The challenge
for the banks therefore is to put in place the necessary infrastructure that can help them derive the
utmost benefit from ALM. The banks’ progress in Asset Liability Management will depend on the
initiatives of their management rather than on RBI supervision. Given the existing hurdles, the
evolution of ALM in commercial banks will be a slow process. ALM has evolved since the early
1980's. Techniques of ALM have also evolved. The growth of OTC derivatives markets has facilitated
a variety of hedging strategies. A significant development has been securitization, which allows firms
to directly address asset-liability risk by removing assets or liabilities from their balance sheets. Thus,
the scope of ALM activities has widened. Today, ALM departments are addressing (non-trading)
foreign exchange risks as well as other risks. Corporations have adopted techniques of ALM to
address interest-rate exposures, liquidity risk and foreign exchange risk. Thus it can be safely said that
Asset Liability Management will continue to grow in future and an efficient ALM technique will go a
long way in managing volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and
liabilities so as to earn a sufficient and acceptable return on the portfolio.

Operational risk management: The best defense against operational risk is to have effective systems
and controls. These need to be appropriate to the risks and as easy as possible to understand,
implement and monitor. There is a strong common interest here between the regulator and a bank’s
senior management. An intensified interest by the latter in everyday operational losses is likely to
reduce the possibility of large losses, improve general risk awareness in a company and the regulator
will feel that the interests of the consumer are being better safeguarded. When considering operational
risk, the regulator faces a similar dilemma to the bank: where are the main risks, how can they best be
controlled, and what level of capital can reasonably be required? In future, it is likely these questions
will become even more pertinent. This is not least because regulators, in line with some banks, are
carving out capital to be held specifically against market, credit and operational risk. But it is also
because regulators have come to think that operational risk may not be significantly correlated with
either of the other two types of risk categories. However, as was the case with the original regulatory
capital ratio set by the Basle Committee, the only real touchstone for this is some sort of reference to
current aggregate capital. Another option for the regulator would be to refer to benchmark loss
experiences. The problem here is that the data are often not obtainable – availability differs from
country to country and business to business – and may not be suitable for operational risk throughout
the bank. The regulator could, alternatively, rely on internal economic capital allocation. Perhaps what
is needed most is time. One thing is clear, and it is that there are more questions than answers around
operational risk for both banks and regulators. Consequently, both parties will need, in the immediate
future, to enter into an open and technical discussion of the way forward.

Supervision process: Before 1950s regulation and supervision by RBI was not that stringent as the
banking activity was limited to collection of deposits and issue of loans. Moreover, there was no
separate comprehensive enactment for the banking sector. With the introduction of the Banking
Companies Act, 1949, (later Banking Regulations Act, 1949) the scope of RBI supervision broadened
over the years, necessary changes in the supervisory system have been made to meet with the new
challenges emerging in the financial sector. In the wake of rapid changes in the financial sector such
as emergence of Universal Banking, introduction of Securitization, integration of various markets, etc.
a lot of preparations for further strengthening the supervisory mechanism is required, not only on the
part of RBI but by individual banks also. World over the way financial markets are integrating day by
day, risk is continuously increasing. RBI, keeping in view international best practices has already
taken certain initiatives in this regard and there is a proposal to introduce shortly, the system of
Consolidated Supervision too, along with Risk Based Supervision. The impact on bank’s key ratios
due to banking supervision reveals good results and walking on the same continuum few issues can be
stressed upon like technology upgradation, corporate governance, market intelligence etc.
 References
 Ajit, D. and Bangar, R.D (1998): The Role and Performance of Private Sector Banks in India-
1991-92 to 1996-97, Political Economy Journal of India 7:1 and 2, 7-20
 Arpa M., Giulini I., Ittner A. and Pauer F.(2001), The Influence of Macro-economic Developments
on Austrian Banks: Implications For Banking Supervision, BIS Papers, n. 1, Basel
 Bessis, Joel (2002), Risk Management in Banking, Wiley; 2nd edition
 Berger, A.N. and DeYoung, R. (1997), Problem Loans and Cost efficiency in Commercial Banks.
Journal of Banking and Finance 21, 849-870
 Berger, A. N. and Udell, G. F.(1998), The Economics of Small Business Finance: The Roles of
Private Equity and Debt Markets in The Financial Growth Cycle, Journal of Banking and
Finance, 22, pp.613-673
 Berger, A. N. and Udell, G. F. (1993), Securitization, Risk, and the Liquidity Problem in Banking,
Structural Change in Banking, M. Klausner and L. White editors, Irwin Publishers, Illinois
 BIS Publication (2001), The Second Consultative Document, The New Basel Capital Accord
 _______(2001), Standardised Approach to Credit Risk, Supporting Document to the New Basel
Capital Accord
 BCBS (2001), Working Paper on the Regulatory Treatment of Operational Risk
 _______(2000) Principles for Management of Credit Risk
 _______(1996) Amendment to the Capital Accord to incorporate Market risks
 _______(2000) Range of practice in Banks’ Internal Ratings Systems, Discussion Paper
 _______(2001) Potential Modifications to the Committee’s Proposal
 Caouette, John B. (1998), Altman Edward I. & Narayan, Paul Managing Credit Risk, The Next
Great Financial Challenge, Wiley
 Coyle, Brian (2000), Credit Risk Management: Measuring Credit Risk, Global Professional
Publishing, USA
 Demirguc-Kunt, A., Detragiache E. and Gupta, P. (2000), Inside the Crisis: An Empirical
Analysis of Banking Systems in Distress, IMF Working Paper No. 156, Washington D.C
 Demirguc-Kunt A. and Detragiache E. (1998),The Determinants of Banking Crises in Developing
and Developed Countries, in IMF Staff Papers, Vol. 45, n. 1, Washington D.C.
 Demirguc-Kunt, Asli and Huizinga, Harry (1998), Determinants of Commercial Bank Interest
Margins and Profitability: Some International Evidence, World Bank, WPS 1900
 Eichengreen B, and Arteta C. (2000), "Banking Crises in Emerging Markets: Presumptions and
Evidence". in Haas School of Business, University of California Berkeley, Center for
International and Development Economic Research, Workign Papers, n.115
 Elmer Funke Kupper (2000), Risk Management in Banking, Discussion Paper Gambera M.
(2000), "Simple Forecasts of Bank Loan Quality in the Business Cycle", in Federal Reserve Bank
of Chicago, Supervision and Regulation Department, Emerging Issues Series SandR-2000-3,
Chicago, www.chicagofed.org
 Gleason, James T. (2000), Risk: The new management imperative in finance, Bloomberg Press
 Kaminsky G.L., and Reinhart C.M. (1996), "The Twin Crises: the Causes of Banking and
Balance-of-Payments Problems", in Board of Governors of the Federal Reserve System,
International Finance Discussion Papers, n.544, March, www.federalreserve.gov
 Mays, Elizabeth (1998), Credit Risk Modelling: Design and Application, CRC
 Mario Quagliariello, Are Macro-economic Indicators Useful in Predicting Bank Loan Quality?
Evidence from Italy
 Meyer A.P. and Yeager T.J. (2001), "Are small Rural Vulnerable to Local Economic
Downturns?”, in Federal Reserve Bank of St. Louis Review, St. Louis, (March-April)
 Rajaraman, I., S.Bhaumik and N.Bhatia (1999) NPA Variations across Indian Commercial Banks:
Some Findings, Economic and Political Weekly, 34: 3 and 4, 16-23
 RBI Guidance note on Credit risk Management (September 2001).
 RBI Guidelines, Risk Management Systems in Banks (October 1999)
 RBI Master Circular, Prudential Norms on Capital Adequacy (August 2001).
 RBI Master Circular, Exposure Norms
 Salas, V. and Saurina, J. (1999a), Deregulation, Market Power and Risk Behaviour in Spanish
Banks", (1999a)
 _______(1999b), Credit Risk in Two Institutional Regimes: Spanish Commercial and Savings
Banks
 _______(2002), Credit Risk in Two Institutional Regimes: Spanish Commercial and Savings
Banks, Journal of Financial Services Research, 22, 203-224
 Sarkar, Jayati, Subrata Sarkar and Bhaumik, Sumon K. (1996), Does Ownership Always Matter?
Evidence from the Indian Banking Industry, Journal of Comparative Economics, 26:2, June, 262-
81
 Saunders, Anthony (1998), Credit Risk Measurement: New approaches to Value at Risk and other
paradigms, Wiley, USA
 Shaffer, S. (1998), The Winner's Curse in Banking, Journal of Financial Intermediation, 7, pp.
359-392
 www.rbi.org.in, for various reports, guidance notes, circulars and other publications, accessed
between 15th April 2009 and 10th June 2009
 www.bis.org, for various reports, working papers and other publications, accessed between 15th
April 2009 and 10th June 2009
 www.caalley.net, accessed between 15th April 2009 and 10th June 2009
 www.riskglossary.com, for terminology on risk and risk management, accessed between 15th
April 2009 and 10th June 2009
 www.economictimes.indiatimes.com, for accessing various news articles and data, accessed
between 15th April 2009 and 10th June 2009