An Approach to Risk Management: With Special Reference to Credit, Market and Operational Risks

- Shiba Raj Shrestha

1. Background The bank and financial institutions are exposed to conventional credit, market and operation risks, posed by changes in interest and exchange rates; liquidity risks associated with every financial settlement; system risks resulting from the use of computers and a variety of other risks. The deregulation and globalization of financial markets in conjunction with advance financial know-how have caused these risks to become more varied and complex, making businesses highly dependent on the quality of risk management for their success. Given this situation and being acutely aware of the importance of being able to accurately identify and analyze the location and extent of risk and to manage it appropriately, the bank and financial institutions are taking steps to refine and improve risk management systems and risk management capability. By doing so, everybody aims to ensure sound management and stable earnings. Establishing an adequate risk management structure and process to control risks involved in various products and lines of business has become an important issue for a safe and sound institution. As the effective risk management is central to good banking, the trade off between risk and return is one of the prime concerns of any investment decision - whether long or short term. From a banker's viewpoint, this aspect is of vital importance as the return expected out of a loan asset created should be commensurate with the risk attached to it. With the innovation of financial liberalization, deregulation of interest rates and other reforms, there has been a virtual transition from "price-takers" to "price-makers" in the loan market. Hence, risk-evaluation in bank lending is of great importance. Therefore, Nepalese banks and financial institutions are continuing to strengthen their systems and procedures to ensure that risks are accurately identified and assessed. In this regard, the banks and financial institutions must have an explicit risk strategy supported by organizational changes, risk-measurement techniques, fresh credit processes and systems. Only then the banks and financial institutions can identify, measure, monitor and manage various risks across their businesses. It is noteworthy that the Central Bank, viz., Nepal Rastra Bank has also issued directives to commercial banks on September 14, 2001 (2058 Bhadra 29) regarding minimization of risk pertaining to liquidity, interest rate, and foreign exchange exposure and loan disbursement. Definition of Risks The Committee on General Terminology of the American Risk and Insurance Association has defined risk as "uncertainty as to the outcome of an event when two or more possibilities exist". From a lender's viewpoint, this definition is aptly applicable as the probabilities of a success or failure of a venture may result in repayment of bank loans or otherwise. Alternatively, risk can be equated with the probability of variance of actual return from the expected one in respect of a project financed. The risk associated is obviously the resultant

2.

Director, Nepal Rastra Bank, Public Debt Management Department

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effect of a probable negative variance (i.e. actual return is less than probable one) in which case the unit assisted may not be in a position to pay back the loan. There are several types of risk in the banking and financial industry, but three major areas of risk are widely recognized, i.e., credit risk, market risk and operating risk. Credit risk is the potential financial loss resulting from the failure of customers to honour fully the terms of an investment or loan or contract. In other words, it is the exposure that results from a counter party's failure to deliver on an obligation. Market risk includes balance sheet risk and trading risk, such as potential risk to earnings and capital resulting from changes in interest rates, liquidity conditions, impact of foreign exchange rate fluctuations etc. In other words, it is the exposure of a position that results from changing market conditions. Operating risk arises from the natural disasters, errors in processing and settlement of transactions, safeguarding of assets, adherence to laws and regulations, system failure, fraud and forgery. In other words, it is the exposure that results when internal practices, policies, processes and systems do not perform as intended. It is not practically possible to assign a particular coefficient to each of the risk factors stated above as the degree of each varies from case to case. For the proper risk management, holding a range of investments, i.e., diversifications, can reduce the level of risk to which an investor is exposed. Integrated Approach in the Risk Management The banker or investor should have an integrated holistic approach towards all the risk factors mentioned above. Since the overall performance of any unit is judged in terms of financial indicators, all risks have some financial dimension. If high business risk prevailed due to non-availability of raw material, the firm may have a tendency to procure the same in bulk, overlooking the aspect of economic ordering quantity (EOQ). Meanwhile, the lending banks may come under a high financial risk. The distortion created thereby may jeopardize the repayment capability of the unit, which may result in higher level of default risk. Similarly, higher value of non-performing assets (NPAs) indicated in high cost base risk will not result in desired level of higher profit. Thereby, both financial risk and default risk will be high. With the expansion and growing complexity of financial market operations, it has become increasingly important that banks are capable of managing risks acknowledging that it is difficult to identify the numerous types of risk involved in financial activities. Fluctuation in any of the critical areas works as a leverage for creating instability in some of the parameters resulting in higher level of risk in any particular facet, which may or may not have a culminating effect on other risks. Further, risk level cannot be brought to zero. Therefore, what is required is a well-balanced optimum level of risk at each item so that the viability of the unit is not distorted. Fatigue Risk Model (FRM) well describes that at the center of all risks is the management, which consciously or otherwise determines or should determine how each of the risks is governed. The management approach towards risk is an important criterion in this regard i.e. risk-taker, risk-neutral or risk-averse. However, higher the risk more would be the stress on the performance of a unit due to financial and structural imbalances, which may ultimately lead to liquidation, takeover or bankruptcy. Evaluation of Risks It is important to evaluate risks to learn and understand its impacts in the business. The risks are ranked according to their potential impact on the business or project and each risk is assessed to determine its level of acceptability. A risk profile is developed which documents the outcome of the risk analysis and assessment process and identifies the risks that require necessary remedial actions. Then an evaluation is made as to the acceptability of each risk. This process of evaluation would lead to the following results, and the bank then can take appropriate actions as suggested in the following matrix.

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Minor risks that can be accepted or ignored; or Moderate risks that have a high likelihood or high impact and will need treatment; or Major risks, with a high likelihood and a high impact that will require significant levels of treatment.
High Impact Low Impact Moderate Risk Identify risk management actions Minor Risk Accept or reject Major Risk Develop detailed risk management plans Moderate Risk Identify risk management actions

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Low Probability High Probability Risk Classification Matrix The bank and financial institutions should document the outcome of the risk analysis and assessment in a risk profile that is reviewed. The risk profile of any investment decisionmaking should include: A description of the risk Potential causes of the risk Likelihood of the risk occurring Potential effect or consequences of the risk Ranking or severity of the risk The evaluation of the acceptability of risk. In some instances a risk can be so severe that the viability of the business or project or investment decision may need to be re-assessed. These risks must be highlighted in the risk profile and formally considered and resolved. Indicators for Evaluation of Risk Levels Operational Risk The inherent risk of the industry, within which the unit is operating, depends upon many crucial factors such as macro economic environment, recession in the market and fiscal and monetary policies of the government. Critical input risk measures the degree of availability of the support input to make a project successful. Non-availability of required raw materials, power, fuel, effluent disposal system, skilled/semi-skilled manpower, may render project a high-risk venture. In evaluating the Production process risk the appraiser should evaluate whether the production process is suitable for the proposed plan of action under the given location and infrastructural set up. Another important aspect is the capital output ratio of the proposed venture. A high capital output ratio implies inefficiency including a higher degree of risk. The proportion of fixed cost to total cost is another important factor. Higher the proportion, higher will be the sales required to achieve the break-even point and consequently greater will be the business risk. The viability of any business must have sound financial systems like budgetary control, cash flow planning and costing mechanism. A business enterprise without a sound Finance Department, managed by experts, naturally becomes a higher business risk venture. Financial Risk The primary indicator is, the conventional Debt-Equity Ratio, i.e. long-term debt/tangible net worth which should not be more than 1.5:1 for medium scale and 3:1 for small-scale industrial units. The drawback of the above approach has been the limitation caused by inclusion of only one portion of debt leaving out a substantial sum by way of short-term

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loans. Further, assets not financed by operational liabilities or by special reserves should be supported by either equity or long term debt. Cash Flow Estimates (GAP Analysis) provide another useful indicator for judging the degree of financial risk. Cash is the most important reservoir for a unit. An enterprise profit may not necessary represent cash surplus because the profit could be from the revaluation of assets or change in the methods of depreciation or valuation of stocks. Therefore, the unit must generate sufficient surplus cash to meet the debt obligations, payment of dividends and to plough back in the business. Default Risk The assessment of this risk is very important for a banker due to the variables of riskdetermination, i.e. amount of cash flow and timing of cash flow. In case there is a default in either of the two, it results loss to the banker. If the default amount is not recovered, there may have to be a write-off and if the same is recovered later, there is also a loss to the banker, i.e. the loss in the opportunity for further investment and also fall in the value of money. Therefore, it is important to evaluate the propensity, and ability of the borrower to repay the loan. The latter, to a certain extent, can be rationally and objectively assessed based on the business and financial risks described above, whereas the assessment of propensity or willingness is a highly subjective consideration. Judging the psychological convert personality of the entrepreneur is really a difficult task for a banker. Though a detailed discussion on the various aspects of personality appraisal is beyond the purview of this paper, it is worth mentioning that the strengths and weaknesses (traits) of the entrepreneur and his mental make-up are of vital importance to be scanned before any credit decision is taken. High degree of intuition and knowledge of psychological transaction are essential pre-requisites for such appraisal. The broad features of such analysis are based on the traits of an ideal entrepreneur. These are: integrity, leadership qualities, involvement, risk taking capacity, risk bearing capability, patience, innovativeness and creativity and high sense of ego etc. These traits are to be judged through a well-defined questionnaire and followed with observation, which can be tabulated on a credit-scoring model. In this way, the overall performance and personality traits of an entrepreneur can be judged, notwithstanding the limitations of subjectivity involved in the process. The deviation arising out of subjectivity can be reduced to a certain extent by having an appraisal team (2 - 3 members), each member of which will have an independent evaluation to be followed by a consensus. The organization set-up along with the effectiveness of the critical functions namely planning, organizing, staffing, directing, and controlling have to be analyzed to determine the efficacy of the organization. Management information system (MIS including FIS) and its effectiveness within the organization is another important indicator of the efficiency of an organization. An organization, which has developed an in-build system and operates systematically can shoulder the risk associated with the business undertaking The Board of Directors of any company has a very important role to play in the overall design and implementation of any project within the given time and cost structure. If the Board is composed of professional members, is independent and not involved in day-to-day management of the organization, this could be an indicator of low risk in the business. Similarly, the traits, strengths and weaknesses of the Chief Executive Officer (CEO), and the Finance Director should be analyzed in detail while evaluating the management risks of an organization.

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The morale of the labour force also directly contributes towards the organizational progress and productivity. Risk in financing is definitely high when there is a continuous industrial unrest, labour problems, or high turnover of middle/senior executives and when the employees have low motivation and frustration. Therefore, increasing employee turnover ratio and declining productivity ratio, i.e. profit or sales/number of employees definitely signifies higher degree of default risk. Cost Base Risk A firm has to incur substantial costs towards hiring human resources and also in procuring physical assets. These may not be productive at all times. An unconventional approach suggests bifurcation of costs into two categories: static and dynamic. The former represents those costs, which do not bring "positive value" to the firm, while the latter contributes to growth and profitability. Idle assets, whether fixed or current, speculative assets, unproductive human resources etc., contribute to increased cost structure without improving the profitability of an organization. The popular concept of "disinvestments" in the sick units' rehabilitation parlance is a by-product of the above approach. Therefore, the presence of a higher proportion of static or unproductive assets definitely increases the risk level of the units. Fiduciary Risk Fiduciary risk has not yet received much attention, although it deserves, from the Nepalese bankers. These facilities (such as Letter of Credit, Guarantee Issue etc.) are primarily nonfund based, i.e., at the initial stage no cash outflow is involved from the banker's point of view. Since, they are contingent liabilities, the capital of the borrower remains unaffected. Simultaneously, banks do earn sufficient income out of commission charges levied. Service cost is also low. As such, there has been a visible shift from fund to non-fund based facilities as it is considered mutually beneficial for both the parties involved. But, the attendant risk is definitely not on the lower side as it can result in unexpected outflow of funds due to invocation of bank guarantee or inability of the client to retire the bills under Letter of Credit on due date. Some indicators for evaluation of risk in this category are: managerial and resource capability of the entrepreneur, extent of correlation between fund and non-fund based facilities, profitability of the unit in general, total borrowing ratio after including the non-fund facilities and its impact on capital structure and estimation of cash flow projections. Project Financing and Risk Term lending has been a major form of credit portfolio of commercial banks in Nepal. It is being around one third of the total lending portfolio. Term lending normally range from 1 to 5 years and hence the risk associated is considerably more compared to normal short-term working capital finance. The risks with project lending can be summed up as follows: Resource risk It is the risk that the resources finally recovered may not turn out to be of the magnitude anticipated from the project survey. The lenders need to employ their own experts to assess the magnitude of recoverable resources and the feasibility of recovering them. Completion risk It is the risk that the construction of the project's facilities and necessary infrastructure will not be completed within a certain time frame. This could lead to a significant cost overrun not covered by finance arrangement. Marketing risk It is the risk that demand for and/or price of the resources may fall to such an extent during the loan repayment period that loan commitments cannot be met.

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Political risk It covers the risk of expropriation of the project's assets by the government without adequate compensation, repudiation of overseas loans by the government, changes in government, changes in government's attitude to the industry or to the provision of infrastructure, changes in government's attitudes to the export of resources to a particular country, changes in government's attitudes to overseas trade, etc. Operating risk It is the risk, which may threaten the operations of the project after its completion because of changing operating costs, e.g. inflation, labour costs, energy costs and industrial problems which may occur during the time of implementation. There are certain special techniques used to evaluation the risk associated with long-term project lending. Some of these techniques are discussed below. Sensitivity Analysis It is a technique used to determine which of the many variables are the most critical for the success or failure of a project. Variables that are commonly analyzed include raw material cost, sales value, selling price, other variable costs, project life, plant capacity, etc. After identification of the critical factors, the project appraiser asks the question, "What happens if we change one or more variables in the project?" This will help him/her to ascertain the intrinsic strength of the unit. For instance, what happens if the sales volume goes down by 5 per cent or if the price of raw materials goes up by 5 per cent or what happens if both of them occur together. Higher the sensitivity of operations and profitability of a unit to the variations in the critical factors, greater is the risk. Certainty Equivalent Method In this approach, the 'risky' cash flows are converted to a 'risk-less' or certain equivalent value. This conversion is normally done with a hypothetical assumption regarding the future inflow of funds. The greater the risk of an expected cash flow, the smaller will be the certainty equivalent value. Adjustment of Discount Rate Under this method, a premium equivalent to the risk element is added to the given discount rate and then net present value (NPV) is computed, which gives an indication of the extent of risk coverage. This gives a fairly good idea regarding the risk absorption capacity of the proposed unit. In order to decide the exact premium to be added the banker can take the help of capital asset pricing model (CAPM). Predetermined Pay-back Period Under this method, a predetermined maximum payback period is fixed and a project's cash flows are computed with reference to that period. However, for very high capital-intensive projects, this approach may not be realistic. Statistical Techniques Probability estimates of cash flow, dispersion/spread of returns, computation of variance or standard deviation of NPV, simulation modeling are some of the complex statistical techniques used for evaluating project risks. However, considering the time constraint these techniques are hardly used except for very large projects. Financial Analysis By applying various appraisal techniques, the degree or extent of risks in different categories can be evaluated to a reasonable extent. However, all risks are, to a certain extent, interdependent to each other. For example, high business risk leads to high financial risk and

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7.

also to high default risk. Again high financial risk leads to high default risk. Similarly high cost base risk leads to high financial risk and also to high default risk. Further, high fiduciary risk leads to high financial risk and also to high default risk. Thus, the loan appraiser's responsibility is to ensure an optimum balance in all 'five legs' of risk and reduce the risk by suggesting suitable alternatives to the entrepreneur. For example, a new entrepreneur may be advised to go in for rented/leased-land/building rather than to purchase the same, as it will substantially reduce the fixed cost. It will also bring down the break-even point and improve the safety margin of operations. Credit Review System The nature of credit review systems may vary based on an institution's size, complexity, and management practices. For example, a credit review system may include components of a review system; may include components of a traditional credit review function that is independent of the lending function, or it may place some reliance on credit officers. In addition, the use of the term "credit review system" can refer to various responsibilities assigned to credit administration, loan administration, problem loan workout, or other areas of the bank. These responsibilities may range from administering the internal problem loan reporting process to maintaining the integrity of the credit grading process (e.g., ensuring that changes are made in credit grades as needed) and coordinating the information necessary to assess the adequacy of the allowance for loan losses. Macro Level Strategy It is important that the policy makers review the 'risk aspects' of the bank as a whole. The policy makers may review the risk exposure in terms of own capital and free reserves (including subordinated debts), ceiling on lending in respect of fund and non-fund based facilities to a particular borrower or to a group company, relationship between fund and nonfund based facilities, exposure to a particular industry and diversification of risk in the portfolio and geographical areas, etc. The bank and financial institutions should apply a clearly defined policy with regard to credit risk assessment and should employ rigorous assessment and administration systems that regulate the scope of authority to judge credit decisions corresponding to borrowers credit-worthiness. By carrying out write-offs and provisions to reserves corresponding to the degree of credit risk carried, the bank and financial institutions would be able to maintain a healthy financial position. The credit officer should be familiar with credit policy guidelines. The bank and financial institutions should adopt a system that incorporates continuous monitoring and reporting of classification of loans, borrower's position and actions taken against any issue of credit management. An asset-liability management system could be introduced for the purpose of controlling market risk accurately. The ALM Committee may obtain an accurate grasp of the risk carried by the bank and financial institutions. On this basis, the ALM Committee decides investment and fund procurement policies and devises hedge positions employing derivatives transactions after making prediction regarding financial, economic and market movements. Moreover, by setting position limits and loss-cut rules for trading operations, the bank and financial institutions could ensure that the impact of possible losses on its financial statements is minimized. In Liquidity Risk Management process, a detailed forecasting could be made to ensure that there exist sufficient funds to manage the business. The fund position is established primarily through control of the investment of funds in the inter-bank market and provision against unforeseen circumstances by holding highly liquid securities.

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In the Exchange Rate Risk Management process, the Value at Risk (VAR) tries to determine how much the companys underlying cash flows are affected. The VAR tries to answer the question, If the rate actually moves up or down, how much Profit/Loss does the bank make? The likelihood of the rate moving up or down and the accuracy of the forecast made are also evaluated. It is imperative to know this before devising a hedging strategy. This will take into consideration the risks attached with each particular market and the likelihood of a transaction not going through smoothly. In Operating Risk Management process, reductions in operating risks are predicated in advance in employees operational capabilities of banks and financial institutions. Thus, the bank and financial institutions could mitigate these risks by providing guidance on processing routine work at regular intervals; conducting training targeted at specific jobs and job levels; and by enhancing the capabilities through the increased use of computers. In System Risk Management process, the bank and financial institutions may conduct frequent system tests to prevent from disaster and malfunction of the system. In a case of computer system, critically important computers should be backed up by identical parallel systems, making such computers interchangeable and establishing double communication circuits for all links between the computer center and the branches. In Auditing and Inspection Systems, the bank and financial institutions should ensure the correctness of all transactions and must take all reasonable steps to prevent the occurrence of any mistake. On-site inspections should be conducted at least once a year to ensure that all transactions are made according to the principles and norms established. Risk Treatment Plans Risk treatment plans may be developed to reduce, contain and control project/investment risk. Risk treatment plan has both tangible and intangible costs and care must be taken to ensure that the cost of treating a risk does not exceed its anticipated impact. The development of risk treatment plan is normally the responsibility of the CEO, although inputs for such plan may be received from the concerned stakeholders. The major types of risk treatment are: Reduce likelihood, where the project's environment is changed to reduce the probability of a risk occurring. Reduce consequences, where action is taken to minimize the impact of a risk if it develops. Contingency planning which should address significant risk areas where preventive action is either unavailable or the cost of prevention is prohibitive. Avoid risk, by not proceeding with the cause of the risk. Risk transfer, where the responsibility for a risk is transferred to another party such as a supplier. Risk acceptance, where the risk is minor, cannot be managed or the cost of risk treatment cannot be justified. Financial provision may be made to recover from the risk eventuating. A range of risk treatments may be available for each risk. The risk management team must assess the cost effectiveness of each option. It may be necessary to update the project's costbenefit analysis to reflect the anticipated costs of the preferred risk treatment. Management must be kept informed of the level of effort and cost that will be required to manage the project's risks. If an economic justification cannot be developed for taking action to manage a particular risk, management will need to either: Accept that the risk exists and that no or limited action will be taken at this time to manage it; or

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Determine that the cost of implementing the risk treatment is necessary given the strategic importance of the project; or Reassess the project to determine whether it should continue in its current form. An overall risk treatment plan should document the activities that are necessary to treat the project's risk. The risk treatment plan should include the following for each risk that is to be treated. Identify alternative risk treatments Assess the cost effectiveness of each treatment The methods to be used to treat the risk Who is responsible for the treatment of the risk A mechanism for measuring the effectiveness of the risk treatment An action plan if the risk treatment is ineffective A timetable for the completion of the risk treatment Develop risk-reporting mechanisms The risk treatment plan must be integrated with the overall project plan to ensure that any dependencies or potential resource conflicts between project tasks and risk treatments are identified and resolved. Where appropriate, the risk treatment plan should also be linked to other business plans within the agency such as the corporate risk management plan. Formal risk treatment reporting mechanisms should also be developed and incorporated in the regular project progress report to the CEO. Integrated Risk Management with Financial Engineering Excellence Credit Risk Analysis The bank and financial institutions should measure credit risk in terms of both credit loss and exposure across the categories or portfolios that are dictated by the credit risk policy of concerned agencies. The risk management capabilities of bank and financial institutions should have an edge in todays markets by creating integrated market and credit risk engine. The bank and financial institutions should take full account of netting, right to break and collateralization as mitigating factors within a loan portfolio. The inclusion of an incremental calculation engine and the common generation of hybrid add-on factors provide both speed in calculating intraday exposure and accuracy of reconciliation between intraday and overnight calculations. Generally the bank and financial institutions use the following analysis for minimizing credit risk: Credit Exposure Analysis (using brute force Monte Carlo simulation) Credit VAR Modeling (to highlight potential portfolio losses, taking into account both credit and market risk factors by incorporating the effects of credit rating migration and appropriate spread curves for pricing) Economic Capital Determination (using fully Credit metrics compliant methods) Economic Capital Allocation Techniques. Market Risk Analysis The measurement and control of market risk is essential within any bank and financial institutions, particularly the treasury (trading & hedging) operation. Forecasting, modeling and managing risk, while reducing funding cost or maximizing return have become more critical because of the volatile interest rate and currency markets. Thus, the bank and financial institutions should analyze market risk to provide extensive risk statistics and advanced analytical functionality to support the needs of front-office traders and risk managers in the middle-office including: Marked to Market (MtM) transaction and the portfolio level

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Risk Statistics i.e. duration, convexity, sensitivity Term Structure Management Cash-flow Modeling Optimization of the portfolio What-if analysis Benchmarking or matching of the portfolio Portfolio analysis (drilldown & extensive portfolio slice & dice) Generally, the bank and financial institutions use following methodologies for measuring market risk across the portfolio structures of the bank and financial institutions: Scenario Analysis Sensitivity Analysis Risk Decomposition Enhanced Parametric VAR based upon Risk Metrics Monte Carlo Simulation Stress Testing Liquidity Risk Analysis The bank and financial institutions should view the liquidity risk in two ways: Time to Close Calculations that highlight the additional risk resulting from market movements during the time taken to close out positions. In time to Close Calculations, the bank and financial institutions should specify the number of days it would take to close or unwind an illiquid position. It will then calculate the additional market risk that would be incurred during these periods. Cash obligations where the calculations are made considering expected and potential cash balances at any future dates. This is very relevant for non-linear portfolios containing complex options where cash flows and future cash balances have a nonnormal distribution. Concluding Remarks The principle of Risk Management is "greater the degree of diversification, the smaller is the degree of portfolio risk in individual assets". With more deregulation setting in, evaluation of risk appraisal is assuming more importance. Absolute quantitative Credit Deposit Ratio has no relevance if the assets are not performing ones. Hence, it is felt that appraisal techniques of bank lending in competitive areas has to be more attuned to towards risk evaluation. A major aspect of this work has been the development of more advanced methods for the quantitative measurement of risks. As one might expect, most progress has been made in the measurement of market risk; the extensive trading in financial instruments provides a good supply of price statistics and this is a considerable help when it comes to estimating market risks. Much work is now being done to construct models for a better management of credit risks, which are still the largest risk category for banks. The difficulties here are far greater than in the case of market risks. The estimation of key parameters for models is obstructed by a lack of statistics. Moreover, some advances have been made in the estimation of operational risks, i.e., the risk of losses arising from technical problems or inadequate internal controls. Previously, operational risks had attracted less attention than credit and market risks. It changes in the nature of banking operations that have brought them more to the fore. Financial legislation and regulation need to be sufficiently flexible to accommodate the rapid pace of developments in the financial sector. It tends to take considerably longer to amend rules than it vows to create new financial products. But, there has to be a foundation of minimum requirements for risk management. In addition, the authorities must be

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increasingly involved in ensuring that institutions themselves possess a basic competence in and understanding of the risks that have to be managed, as well as adequate systems for their management, rather than issuing detailed risk management instructions. In other words, it has become more important to inspect systems, defined in a wide sense, than to scrutinize particular commitments or market risks. Some supervision can be carried out with the market's assistance. The authorities can prescribe as well as encourage a more open presentation of the institution risks and profitability in different operations. Such a transparency emphasizes the banks' demands on each other as well as what customers require of their banks. Effective risk management allows a bank to reduce risks and potential NPAs. It also offers other benefits. Once banks understand their risks and their costs, they will be able to determine their most profitable businesses and, can determine the price for their products according to the risks. Therefore, the banks must have an explicit risk strategy supported by organizational changes, risk-measurement techniques and fresh credit processes and systems. Apart from these, the bank management should regularly review all asset quality issues including portfolio composition, big borrower exposures and developments in credit management policy and process. Improving risk management will not be easy or quick. However, Nepalese bankers have little choice. Hopefully, the banks adopt good risk management practices and will be able to reap both strategic and operational benefits. In recent years, risk management skills have been revolutionized by advanced financial innovations and technology. Those improvements on risk management have helped financial institutions to better manage their risks associated with increasingly complex financial instruments and the growing volume of financial transactions. An increasing number of financial institutions have developed and applied several risk models such as value-at-risk and credit risk model to quantify market and credit risks for many years. The quantifying model of operational risk is also under development, even though there are many arguments and difficulties on it. The new model-based approaches not only strengthen the financial institutions ability of risk measurement and management, but also contribute to more efficient resource allocation through better evaluation of risk. In result, the financial institutions can more thoroughly understand their risk exposure and hedge unwanted risk. Although risk models have been accepted by international banking industry and adopted by complex financial institutions for several years, there are still many criticisms. Some criticized that these models may understate the herding effect in at financial market if most of the financial institutions use the same model based on the same assumptions. The others criticized that these models may exacerbate the economic cycles and overestimate the benefits for the diversity of portfolios. However, the risk models have been improved further, such as addressing the liquidity issues in their models or taking account of liquidity risk in stress testing. One thing should be emphasized that more accurate risk measurement and better management do not mean the absence of loss. Every risk model has its limit. The small probability in the tails of distributions still may occur. No matter how perfect the risk model is, it should not replace, but rather supplement, the judgment and experience of the senior managers of financial institutions. The board of directors and senior managers of financial institutions will assume the final responsibility of risk management.

References:
1. Howells, Peter and Bain, Keith, "The Economics of Money, Banking and Finance - A European Text", Addison Wesley Longman Publication, 1998.

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Johnson, Hazel J., "Financial Institutions and Markets - A Global Perspective", McGraw Hill Series in Finance, 1993 Rajagopal, J., "Managing Credit Risk", Business Today, December 22, 1999, India Today Group, India. Samuels, B.C., "Managing Risk in Developing Countries", Princeton, NJ, 1990, Princeton University Press. Sharpe, William F., Alexander, Gordon J. and Bailey, Jeffer V., "Investments", International Edition (sixth), Prentice Hall, Inc., 1999. Solberg, R.L., "Soverign Rescheduling: Risk and Portfolio Management", 1988, London.

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