Risk: Significance, Sources and Indicators (2024)

After reading this article you will learn about:- 1. Introduction to Risk 2. Sources of Risk 3. Indicators 4. Process 5. Measures for Identifying and Controlling Risks.

Introduction to Risk:

Risk taking is the core of any business activity. The risk assump­tion in manufacturing and financial situations is different from each other due to the very nature of these two sectors.

Broadly, the way these two sectors compare with each other is summarized as under:

The significance of risk and its management are comparatively more in financial sector in general and banks in particular be­cause of the very nature of the industry. The risks banks face in their normal course of operations can be generic (those that are common to all banks more or less alike) or specific (others that are specific to a bank or transaction).

Risk in lending to a particular industry, say, in troubled times to textiles is a generic risk. Lending to particular chemical industry is again a generic risk.

There may be risks that are specific to a particular unit. For example, pharmaceutical industry may be doing fine in majority of the accounts. However, a particular unit may not be performing or is not likely to perform well due to managerial deficiencies or similar reasons. Taking an exposure on such a unit is a specific risk. The location of units in a particular area or State can be a reason for increased risk.

When a plant is located in a far- flung area, there is a possibility of the unit becoming bad as the provision of immediate rescue supports in terms of all inputs may not be feasible. The ownership pattern or type can be another reason for risk differential.

Obviously, the capital- raising capacity of a public limited company would be more than a proprietary or partnership firm. A capital- intensive unit in the corporate sector would be less risky than one in partnership or proprietary category.

At times banks may take exposure in areas about which they know less than required. There are industry specific peculiarities that the lender has to be aware of. Ship- breaking industry is an example. The ships are sold on ‘as is and where is’ basis only at ship breaking centers like Along on the western coast of India.

The material generated through broken ships is auctioned and sold on hard cash basis. The sale of ships is in US dollars while the realizations spread over the breaking period are in rupees. The timing of the industry is 3 to 11 pm, seven days a week. When a lender finances such a transaction, ignorance of material facts can enhance risk. This can be referred to as sector specific risk.

In the process of decentralization of decision making, the branch level functionaries may be given wider powers. At times more than what they can fathom. Unrealizable targets may be set with lucrative rewards attached for performance. Such measures enhance the possibility of risk due to laxity on credit quality.

Sources of Risk:

There are a variety of situations that give rise to risk.

They are discussed below:

1. Decision/Indecision:

Taking or not taking a decision at the right time is generally the first cause of risk. Suppose a banker takes deposits and decides not to put money in statutory liquidity requirements, the bank would be called upon to pay penalties. Indecision in selling a Government security when the market is upswing is also a risk as it causes loss of revenue. The risk of revenue loss is on account of indecision.

2. Business Cycles/Seasonality:

There are certain exposures that are affected by seasonality or business cycles. Lending to sugar industry in India disregarding the fact that the production of sugar is restricted to six/seven months in a year, may give rise to risky situations.

3. Economic/Fiscal Changes:

The Government’s economic and taxation policies are sources of risk. The levying of import duty on certain capital goods can escalate the funding cost and bank finance requirement. While the borrower’s repay­ing capacity remains the same, such a situation enhances the exposure adding to the risk. The changes in Government policies can impact the cash inflow for the borrowing cus­tomer thereby limiting his repayment capacity.

4. Market Preferences:

Over the years, the consumer demands and preferences particularly from the youth segment, are changing substantially. The preference for a motorcycle over a scooter is an example. Lending to scooter dealers or manufacturers will have to be cautious due to this market trend.

5. Political Compulsions:

A Government may force the banks to lend in areas where the rewards may not be proportional.

6. Regulations:

The impact of change in regulations is similar to the changes in Government policies. In developed countries like the USA, there are certain anti- boycott laws prescribing restrictions. The anti-boycott laws specifically refer to boy­cotts involving one foreign Government against another foreign Government and participation of people in the US in those boycotts.

Indian banks operating in the USA do have to assess the regulatory risks. With the passing of USA Patriot Act, the processes for anti-money laundering have been strengthened. Compliance of a variety of regulations is also a source of risk.

7. Competition:

In order to remain competitive banks assume risks for enhancing the returns. In the quest to achieve better result there could be a tendency to assume risks highly unrelated to the return. The selection of the right counter party, lack of proper risk assessment, failure to appreciate the borrower rating, etc., all contribute in risk acceleration. Competition remains a major source of risk for banks as for all other sectors.

8. Technology:

Technology is both, a solution and a cause of risk. Deals worth millions are made in treasury operations through advanced technology supports. The process of maker-checker is scrupulously followed while entering into such deals. Still, machines can go wrong. The reflection of inaccurate values like dates, amounts, interest rates, etc., can cause a huge risk. It is a part of operational risk wherein technology itself becomes the source of risk.

9. Non-availability of Information:

Technology is an enabler for decision support for rational and data-based decision mak­ing. More often than not, in the absence of information support, banks do take decisions. The banks fix exposure limits per party or per industry. Exposures exceed these prudential limits in the absence of real time information, thereby multiplying the risk exposures.

In reality, the risk drivers are:

1. Changes in external environment, including regulatory as­pects,

2. Deficiencies in systems and procedures,

3. Errors, either intentional or otherwise,

4. Inadequate information and absence of required flows,

5. Unsuitable technology supports,

6. Communication gap or failure,

7. Lack of leadership, and

8. Excessive and unreasonable incentives.

Indicators of Risk:

Risks very rarely occur as accidents. There are symptoms that indicate the possibility of risk. These indicators can be used to take pre-emptive actions. These actions may not eliminate the risks but they would at least facilitate to minimize their impact.

Some of the indications are given below.

1. Lack of supervision of lending/investment activities by designated officers.

2. Lack of specific lending or treasury policies or failure to enforce the existing policies.

3. Lack of code of conduct or failure to enforce existing code.

4. Dominant figure allowed to exerting influence without re­straint.

5. Lack of separation of duties.

6. Lack of accountability.

7. Lack of written policies and/or internal controls.

8. Circumvention of established policies and/or controls.

9. Lack of independent members of management and / or Board.

10. Entering into transactions where the institution lacks exper­tise.

11. Excessive growth through low quality loans.

12. Unwarranted concentrations.

13. Volatile sources of funding such as short-term deposits from out of area brokers.

14. Too much emphasis on earnings at the expense of safety and soundness.

15. Compromising credit policies.

16. High rate high risk investments.

17. Underwriting criteria allowing high risk loans.

18. Lack of documentation or poor documentation.

19. Lack of adequate credit analysis.

20. Failure to properly obtain and evaluate credit data, collat­eral, etc.

21. Failure to properly analyze and verify financial statement data.

22. Too much emphasis on character and collateral and not enough emphasis on credit.

23. Lack of proper mix in asset portfolio.

24. Unresolved exceptions or frequently recurring exceptions on exception reports.

25. Out of balance conditions.

26. Funds used for purposes other than the purpose recorded.

27. Lax policies on payment of checks against uncollected funds.

28. The institution is a defendant in a number of lawsuits alleging improper handling of transactions.

The Process of Risk:

The risk management function would address issues relating to measuring, monitoring and management of the aforementioned risks.

The process involves the following sequential steps:

The identification would involve:

(i) Identify Risk by each Functional Area and/or Corporate Policy:

To properly identify risks, the bank must recognize and under­stand existing risks or risks that may arise from new business initiatives. Risk identification should be a continuing process, and risks should be understood at both the transaction and portfolio levels.

(ii) Categorize Risk by Risk Profile.

(iii) Anticipate the Direction the Risk is Expected to take within the Next Twelve Months:

Direction of risk is the probable change in the aggregate level of risk over the next twelve months and is characterized as decreas­ing, stable, or increasing. The direction of risk will influence Management’s strategy and the Audit/Compliance Department’s review strategy, including the extent to which expanded proce­dures might be used.

If the risk is decreasing, aggregate risk should decline over the next twelve months. If the risk is stable, the aggregate risk should remain unchanged. If the risk is increasing, aggregate risk should be expected to be higher in the next twelve months.

(iv) Elaborate on Systems Established to Monitor Risk and the Frequency of Monitoring:

Banks should monitor risk levels to ensure timely review of risk positions and exceptions. Monitoring reports should be timely, accurate, and informative and should be distributed to appropri­ate individuals, to ensure action, when needed.

(v) State Policy and/or Procedure to Control the Risk Identified:

Banks should establish and communicate risk limits through policies, standards, and procedures that define responsibility and authority. These limits should serve as a means to control exposures to the various risks associated with the bank’s activities.

The limits should be tools that management can use to adjust when conditions or risk tolerances change. Banks should also have a process to authorize and document exceptions or changes to risk limits when warranted.

The process would also incorporate:

Determination of tolerance levels involves:

1. Knowing tolerance level,

2. Defining tolerance levels in policies and procedures, and

3. Deciding profitability targets.

Management of acceptable risks includes:

1. Formulation and adoption of policies and procedures,

2. Involvement of senior management committee,

3. Adherence to policies and procedures,

4. Establishing MIS, and

5. Documenting courses of action when risk is excessive and planning for profitability.

The major risks faced by a financial institution /bank include credit risk, market risk and operational risk. A risk management function would seek to address and mitigate all the risks men­tioned above which are faced by a bank.

Any risk measure would need to fulfill at least one of the two requirements: it needs to convey information about the (a) impact of risk factor on the profitability of the bank (usually measured as net interest income) or (b) on the economic value of the bank.

Measures for Identifying and Controlling Risks:

The various methods used for risk measurement are as follows:

1. Market Risk:

A bank is said to face market risk if a change in the market rate scenario (interest rate or exchange rate) results in variations in its net interest earnings or in its value.

Market risk for a bank arises due to the following factors:

(i) Gap:

The existence of different maturity profiles of a bank’s assets and liabilities result in interest rate maturity gaps, which exposes a bank to interest rate risk. This risk is also termed as the mismatch or repricing risk. This risk is measured as the difference between the amounts of assets maturing and that of the liabilities. The gap or the difference is both the source for the risk as also an appropriate rudimentary measure.

(ii) Basis:

When the maturity profiles of the assets and the liabilities of a bank are matched, the bank could still carry interest rate risk arising due to basis risk.

Basis risk refers to the risk of bank’s assets and liabilities being priced on different basis, e.g., while both the assets and the liabilities could be priced for 1 year floating rates— the relevant asset rate could be the cut off 364 day T-Bill, while the liabilities could be priced off the 1 year SBI CD rate.

(iii) Embedded Option:

Even with well-matched final maturities, a bank could face inter­est rate risk if all of its products (both on the asset and/or the liability side) carry embedded options such as put and call options, e.g., a financial services company with long assets and liabilities can face tremendous interest rate risk as the fear of reputation downgrading can cause depositors in large numbers to exercise the option to withdraw deposits on a pre-mature basis.

These add substantially to the risk of the bank as these affect the bank at inopportune times. A depositor would exercise the option of closing a deposit account when interest rates in the market are high and the bank would need to incur higher costs to replace the deposit.

Similarly, a client would repay his loan to the bank at a time when the rates in the market are lower than the ones contracted leaving the bank to deploy funds at a lower rate.

(iv) Net Interest Position:

The bank’s net interest margin (net interest income divided by average earning assets) can vary not only with gaps and exercised options but also with variation in the bank’s net interest position. In case a bank has more interest earning assets than interest bearing liabilities (possibly, assets are funded out of shareholders’ funds), it is said to carry a positive net interest position (NIP).

In such a case, the bank maintains a higher capital adequacy ratio and is conservative on deposit/loan taking activities. In this case while it earns interest on all its assets, it does not have to book interest costs, as the source of a large amount of these assets is shareholders’ funds. A positive NIP adds to the bank’s net interest margin (NIM).

The bank’s net interest margin could thus come under pressure when its net interest position alters. In case the bank takes on liabilities exactly equal to its earning assets, the net spread and the NIM would be equal.

(v) Yield Curve:

Repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank’s income or underlying economic value.

For instance, the underlying economic value of a long position in 10-year govern­ment bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.

Market risk is measured by certain parameters, and more often than not most banks use a combination of all these parameters both to understand the risks they are facing and also to commu­nicate the same to the top management.

2. Gap Analysis:

This is the most preliminary interest rate risk measure. It indicates the gap between repricing assets and liabilities and hence indi­cates the interest rate sensitivity of the entire balance sheet. It would indicate the impact of a change in interest on the net interest income of the bank.

A typical gap statement would divide time into buckets of different time periods. These buckets repre­sent the values of maturing and repricing of assets and liabilities.

The gap statement works out the differences between maturing/ repricing rate of sensitive assets and liabilities. The gap is trans­lated into an income impact by the simple formula of change in net interest income (NII) equaling the gap multiplied by the assumed change in interest rates. It can also be indicated as Δ NII, where

Δ NII = Change in Interest Rate X (Gap).

A gap statement based risk analysis and its impact on NII has certain inadequacies. The repricing assumes at the same percent­age although in reality the interest changes in assets/liabilities across the balance sheet are not uniformly the same. The inability to drill down to have different interest rate variations creates difficulties.

Further, the inability to drill down refers to the gap statement having pre-defined buckets and gaps being constructed or computed on these predefined buckets. Where a bucket of one month to register a gap of, say, Rs. 100 crore, the bank would not be able to grasp from this gap statement as to whether the gap is over one day (with the remaining 29 days having a balanced profile) or it is spread over four weeks.

Same case may happen on liabilities side as well. Depending on the maturity within a range of 1 to 30 days in one month bucket, the Nil would be impacted. This reality does not get reflected in the gap statement or repricing thereof.

There is also a possibility that rates exhibit a lag effect (interest on deposits and loans do not change simultaneously). A gap statement however does not have the capability to model these technicalities.

3. NII Risk:

Instead of computing NII through the gap statement, some banks prefer to directly compute Nil under different interest rate sce­narios in order to obtain the bank’s interest rate sensitivity. As already mentioned, the NII at risk computed based on the gap statement possesses certain drawbacks.

Moreover, the gap com­puted NII at risk reflects the level of risk in the balance sheet on a static level. It does not take into account the impact of new loans and deposit growth. These issues are addressed by computing NII in a dynamic fashion (taking into account future growth projec­tions) and subsequently analyzing the impact of interest rate changes on the NII.

However, as banks have expanded increas­ingly into activities that generate fee-based, i.e., non-interest in­come, a broader focus on overall net income- incorporating both interest and non-interest income and expenses has become more common. The non-interest income arising from many activities, such as loan servicing and various assets securitization programs can be highly sensitive to market interest rates.

For example, some banks provide the servicing and loan administration function for mortgage of loan pools in return for a fee, based on the volume of assets it administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages prepay.

In addition, even traditional sources of non- interest income such as transaction processing fees are becoming more interest rate sensitive. This increased sensitivity has led both bank managements and supervisors to take a comprehensive view of the potential effects of changes in market interest rates on bank earnings. This helps banks factor these broader effects into their estimated earnings under different interest rate environ­ments.

The measures mentioned above are for computing the risk towards the profitability of the bank. As mentioned earlier, the second requirement is a measure for risk towards the value or the economic capital of the bank. Economic capital is the amount of capital that banks set aside as a buffer against potential losses from their business activities.

Duration:

Duration is a measure of the interest rate sensitivity of an instru­ment/product. It is defined as the weighted average time to maturity with the weights being the present values of the respec­tive cash flows. Though this concept was originally meant for trading portfolio of bonds/debentures of banks, it has now been extended to the entire balance sheet.

The duration of any bond or portfolio is, as was mentioned earlier, an indicator of its rate sensitivity. Duration is a source of interest rate risk. Duration (D) is expressed in years. If interest rates increase 1%, present value of cash flows decrease about D%. This gives rise to a risk of loss/gain in value (assets, liabilities, surplus) due to random interest rate shifts. Both liability and asset cash flows have durations.

They react similarly to interest rate changes. If duration for assets and liabilities is equal, the surplus will not be subjected to interest rate risk from the liabilities (or their supporting assets). More specifi­cally, the percentage change in price is equal to the modified duration times the change in interest rate. Numerically, it is indicated below.

Change in Price/Price = Durational + Yield) X Change in yields or

Percentage change in price = Modified duration X change in rates, where modified duration is given as Durational + yield).

The duration concept is called Macaulay’s Duration after Frederick Macaulay, the man to discover the significance of this measure for interest rate sensitivity. Modified Duration is often referred to as Mod. Duration.

The Duration of equity essentially measures the impact of a percentage change in interest rates on the value of equity. Here, equity is defined as the difference between assets and liabilities. The excess of assets over liabilities is reflected as for equity.

An example, if the duration of equity of a bank is 10 years, then an adverse change in interest rate of 1 % would reduce the value of the bank’s equity by approximately 10% and a 10% change would almost wipe out the bank’s equity.

The Duration of equity is the difference between the duration of assets and that of liabilities. The duration of the total portfolio of assets is the weighted sum of the duration of individual assets with the weights being the market values.

The market value of equity is computed as the difference between the market value of assets and liabilities. As gap is an approximate indicator of NII at risk; Duration too has its shortcomings as an indicator of the bank’s equity at risk (its validity is best for small changes in interest rates).

Most banks now prefer to arrive at the market value of equity at risk by computing the market value of equity at different interest rates and, hence arrive at the impact arising out of variation in interest rates.

The sensitivity of a bank’s economic value to fluctuations in interest rates is a particularly important consideration of share­holders, management and supervisors alike. The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates.

By extension, the economic value of a bank can be viewed as the present value of bank’s expected “net cash flows”, defined as the expected cash flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on a balance sheet position. In this sense, the economic value perspective reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates.

Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective.

This comprehensive view is important since changes in near-term earnings – the typical focus of the earnings perspective – may not provide an accurate indication of the impact of interest rate movements on the bank’s overall position.

Measures for interest rate risk focus on the two areas that a bank should be concerned about: its short-term profitability (through Gap and NII at risk) and its long-term viability or economic capital (through duration and market value of equity at risk). While the first is usually the immediate area of concern to bank manage­ment, the second attracts considerable attention from the regula­tory authorities.

4. Liquidity Risk:

Of all the risks inherent in banking, the most difficult to measure is liquidity risk. The situation is particularly accentuated in the Indian context when the liquidity management activities of the corporates get passed on to the banks.

Though the situation has improved in the past few years, following RBI’s directive to shift towards lending in the form of short-term and self-liquidating advances to corporate instead of cash credit facilities, there is still considerable uncertainty left in this area.

The factors for giving rise to liquidity risk are:

1. Commitments:

A bank can over-commit on disbursem*nts or delivery and subsequently face risk on meeting these commitments. A sudden drawal on underwriting obliga­tions, a call on account of a line of credit extended to a client, a guarantee which devolves upon the bank could expose the bank to liquidity risk.

2. Liquid Products:

The bank could be long on illiquid contracts and at the same time find the market to be shallow. Over the counter contracts are particularly affected by this phenom­enon.

3. Markets:

The bank could have presence in under-developed markets that are not liquid enough for trades to be fruitfully carried out.

The risk manager has to plan for the known demands on the bank regarding scheduled deposit repayments, tax payments and known loan repayments. However, his/her skill lies in forecasting un­known demands like loan growth and unknown receipts (e.g., prepayments).

An additional complexity is introduced by ele­ments of seasonality and cyclically that affect a bank’s opera­tions. The absence of data and systematic studies in the past to monitor and analyze the flow of funds in the economy necessitates the risk manager to rely on “soft” analyses and assumptions to address this issue.

Some of the measures like various liquidity ratios adopted by analysts while evaluating a bank include:

1. The ratio of liquid assets of a bank to its total assets identifies the proportion of a bank’s assets that are invested in cash and cash equivalents and can be liquidated in order to meet the requirements. (Liquid assets refer to cash and near cash assets including bank deposits, government securities, re­purchase agreements, short-term investments, etc.)

2. Ratio of liquid assets to demand deposits and short-term borrowings measure the ability of a bank to meet its deposit and borrowing repayment obligations.

3. The ratio of net loans to total deposits measures the quan­tum of deposits raised that have been lent out as loans (Net loans are gross outstanding minus specific provisions held for non-performing loans).The ratio is similar to the credit- deposit ratio that is routinely tracked by the Indian banks.

4. The ratio of non-deposit liabilities to total liabilities identifies the proportion of total assets that have been funded through non-deposit liabilities. Non-deposit liabilities refer to bor­rowings which are inherently more volatile than deposits. There can also be a sub -classification of the deposits to compute the ratio of corporate deposits to total assets.

5. Credit Risk:

Very often the greatest risk faced by the bank, credit risk, is also traditionally the most tracked risk. The risk of counter-party defaults has a number of measures, some of which are indicated below.

1. Exposures as a percentage to total outstanding: In order to diversify their holdings in a variety of industries, companies and countries, banks follow measures like exposure to an industry vis-a-vis the total outstanding. Other measures would be variations of the numerator. Company outstand­ing, group outstanding, geographical region outstanding, country outstanding could replace industry.

2. Credit ratings also serve as an indicator of the credit risk being carried by the bank.

3. The ratio of impaired loans to total loans also serves as an indicator of the credit risk. In its more detailed format, not just the impaired loans (non-performing assets) but also the asset classification (standard, substandard, doubtful and loss) is used as credit risk indicator.

6. Operational Risk:

Operational risk can be defined as the risk of monetary losses resulting from inadequate or failed internal processes, people, and systems or from external events.

Losses from external events, such as a natural disaster that damages a bank’s physical assets or electrical or telecommunications failure that disrupt business, are relatively easier to define than losses from internal problems, such as employee fraud and product flaws.

Because the risks from internal problems will be closely tied to a bank’s specific products and business lines, they should be more bank-specific than the risks due to external events. Operational risk is intrinsic to finan­cial institutions and thus should be an important component of their bank-wide risk management systems. Operational risk in­cludes legal risks, but excludes reputational and strategic risks.

Examples of operational risk losses include: internal frauds (in­sider trading, misappropriation of assets) or external frauds like theft, natural disasters like terrorism or system related failures like M&A related disruption and other technological breakdowns. However, operational risk is harder to quantify and model than market and credit risks.

Over the past few years, improvements in management information systems and computing technology have opened the way for improved operational risk measurement and management. Over the coming few years, financial institu­tions and their regulators will continue to develop their ap­proaches for operational risk management and capital budgeting.