This article is written by Amit Garg of National University of Study and Research in Law, Ranchi. The author through this article brings out the requirements laid down by the RBI to deal with risks.

A bank is a place that accepts deposit and grants loan. A bank charges interest on the loans lent and pays interest on the deposits received. The difference in the interest received and interest paid is the source of income for the bank. Each country has large number of banks that conduct the function of accepting and lending money. But, a country has only one central bank that governs the functioning of all the banks situated within the country and regulate their business. In India, all the banks are regulated by the Reserve Bank of India (RBI). There are large number of activities performed by the RBI in order to regulate the economy of a country and the banks.

Some of the major activities performed by the Reserve Bank of India are as follows:

• Issue of Bank Notes.
• Banker to the Government.
• Custodian of Cash Reserves of Commercial Banks.
• Custodian of Foreign Exchange Reserves.
• Lender to the Last Resort.
• Central Clearance and Account Settlement.
• Controller of Credit.

Types of Risks

The risks that the bank faces can be broadly classified as:

1. Credit risk
2. Market risk
3. Interest rate risk
4. Liquidity risk
5. Operational risk

In order to deal with these risks that the banks have been surrounded by, the Reserve Bank of India provides for some guidelines that needs to be followed by the banks. These guidelines help in better dealing with the risk concerned and will help in the progress of the economy. Each risk has been discussed below.

Credit Risk

Lending money to any other individual involves risk as to the return of the amount lent. The risk so associated with lending of money is known as credit risk. Credit risk, in simple words can be explained as unwillingness of a person to pay the amount borrowed from the bank which exposes the bank to a risk of loss. In addition to the risk involved in lending money, banks are exposed to the risk of the interest amount, forex and country risks. A significant magnitude of credit risk is inherent in investment banking. Investment banking is when the banks decide to invest a particular sum of money for a particular purpose.

Market Risk

Market risk arises from adverse changes in various market variables like currencies, interest rate instruments, equities, commodity price, etc. These factors play a vital role in functioning of the economy and effects the economy at both the level, i.e., macro and micro. The changes in these variables is very volatile, therefore, RBI needs to step up to maintain soundness of the banks.

There are two types of market risk:

1. Foreign Exchange Risk – It is that risk where bank may suffer losses as a result of adverse exchange rate movements in a small period of time.
2. Equity Price Risk – It is a financial risk which arises from holding equity in particular investment.

Interest Rate Risk

Interest Rate Risk arises when there is potential impact on the Net Interest Margin by unexpected changes in the interest rates. It can be expressed in two ways:

• Its impact on the earnings of the bank.
• Its impact on the economic value of the bank’s assets, liabilities and Off-Balance Sheet positions.

Liquidity Risk

A bank faces liquidity risk when it does not have enough cash in hand to meet its daily requirements. This may arise due the bank lending all the money they have as loans. It also arises when the bank funds long term assets from short term liabilities. Various ratios adopted by banks to evaluate the liquidity of the banks are (1) Loans to Total Assets, (2) Loans to Core Deposits, (3) Purchased Funds to Total Assets, and (4) Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments.

Operational Risk

Basel Committee defines operational risk as the “risk of change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems or from external events (including legal risk), differ from the expected losses”. These risks are not willingly incurred and nor are they revenue driven.

Guidelines by the RBI

The activities that the commercial banks undertake which includes financial intermediation, has a lot of risk factor which may be financial or non-financial directly affecting the normal functioning of a bank. The factors affecting the functioning of the banks are credit, interest rate, foreign exchange rate, liquidity, etc. In order to reduce the risk raised by these factors and ensure proper functioning of the banks, Reserve Bank of India attaches considerable importance to improve the ability to identify and tackle such risks. RBI has laid down guidelines that the commercial banks must follow in order to avoid the danger of loss caused by various risks as mentioned above. The guidelines as provided by the RBI for Risk Management are discussed below.

Credit Risk Management

The management of credit risk is of foremost importance and the banks must lay special emphasis on its management. The banks must articulate the management of credit risk in their Loan Policy. The guidelines in order to deal with the credit risk are:

• Measurement of risk through credit rating/scoring. Banks must have a comprehensive credit scoring system that shall take into consideration diverse risk factors and result in a single point indicator of credit worthiness.
• Quantifying the risk through estimating expected losses, i.e., the amount of loss a bank shall endure in a specific time period.
• Risk pricing on a specific basis. Banks must evolve a scientific system to price the risk where the person with weak financial position is priced higher than the person with good financial position.
• Controlling the risk through effective Loan Review Mechanism (LRM). Loan Review Mechanism evaluates the quality of loan book and brings about qualitative improvements in credit administration. The main objectives of LRM are:
  1. to identify the loans that possess credit weakness and to take corrective action.
  2. provide information related to the adequacy of loan loss provision.
  3. to isolate the potential problem areas.
  4. to assess the adequacy of and adherence to, loan policies and procedures, and to monitor compliance with relevant laws and regulations.
  5. to provide top management with information on credit administration, including credit sanction process, risk evaluation and post-sanction follow-up.
• A Credit Policy Committee must be formed in order to analyse and control the risk.
• Bank must develop a suitable framework in order to report and evaluate the quality of credit decision taken by the functional groups.
• In case of investing an amount for a particular purpose, the banks must subject such approval to same degree of credit analysis as to that of loans.
• Portfolio Management is a technique that enables us to gauge asset quality. It is very helpful in determining the non- performing loans and much efficient than the older system of checking the same through balance sheet.

Inter-Bank Exposure

Each bank is exposed to a certain degree of risk and in order to maintain a check on each bank, a centralized overview of the aggregate exposure on other banks must be evaluated as this shall help in proper estimation of the current economic conditions and thus a better planning towards the risk that a particular bank may face. The exposure limit can be set up for each of the banks based upon an assessment that shall take into consideration financial performance, operating efficiency, management quality, past experience, etc.

Cash Reserve Requirements

In order to maintain liquidity with the banks and to prevent them from running out of cash or liquidity risk, the Reserve Bank of India has laid down certain requirements that the banks must fulfill to remain afloat. These requirements are:

• Cash Reserve Ratio – Cash Reserve Ratio is certain amount of total deposit that the banks are asked to park them with the RBI. These deposits with the RBI carry no interest. This a measure by which banks will not have to look for other sources in times of cash crunch and they and utilize their own savings.
• Statutory Liquid Ratio – Statutory Liquid Ratio is that requirement for the commercial banks where they have to keep a certain percentage of the total deposits with themselves in form of cash, gold reserves, government securities, etc. which is not available to general public for the purpose of loan.

Prudential Limits

There are certain prudential limits that the banks must place in order to avoid liquidity crisis. Some of the limits are:

• Cap on inter-bank borrowings, especially call borrowings
• Purchased funds vis-à-vis liquid assets
• Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and Loans
• Duration of liabilities and investment portfolio
• Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time bands
• Commitment Ratio tracks the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure
• Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Fund Transfer Pricing

Fund Transfer Mechanism is a process designed to assess the financial impact of different sources of funds that will be helpful in evaluating profitability. It analyses the cost of various funds available in the market and helps in ascertaining of profits which shall help in reducing risk of unfavourable returns or even losses. FTP works by assigning various assets and liabilities to the functional units. As each unit attracts a source of fund, this helps in evaluating the cost of each source of fund and the return each funding source shall provide.

Operational Risk Management

Operational Risk can sometimes become handy. In order to escape from the risk associated with the operations of the bank, the banks must regularly conduct internal control (segregation of duties, clear management reporting lines and adequate operating procedures) and internal audit. The banks can utilize contingent processing capabilities to reduce the impact of operational risk. The banks must regularly develop policies and procedures that help in combating operational risk and the policies should address product review process, involving business, risk management and internal control functions.

Capital Adequacy

In order to maintain long term soundness of the banks, the banks must evaluate their capital adequacy based on the economic risk that surrounds the bank. While considering the economic risk, the banks must take account of both the qualitative and quantitative factors. They must take care of internal as well as future capital needs apart from established minimum capital requirements.

Conclusion

There are a lot of risks that the banks come across throughout the period of their functioning. In order to effectively come over these risks and to maintain sound functioning, the banks must follow the guidelines provided by the RBI. These guidelines are not binding on the banks but if they follow the guidelines, they will definitely gain positive results as the economic environment is uncertain and dynamic. The RBI in order to cope with the dynamic environment keeps on releasing notifications that provides for new guidelines to tackle the risks posed by the changing environment.