Risk Management in Banks: Reference

Risk Management in Banks: Reference to Indian Banks Industry

"The Indian Financial System is tasting success of a decade of financial sector reforms. The economy is surging and has gathered the critical mass to convert it into a force to reckon with. The regulatory framework in India has sparked growth and key structural reforms have improved the asset quality and profitability of banks" (Agarwal & Sirohy, 2010).

The fact of the matter is this: the global market is fast integrating into a single stage for all markets though the spread if internet banking, a global banking system a highly likely possibility (Agarwal & Sirohy, 2010). In fact, internet banking is at the forefront of the global banking system, widening its expanse and possibly making it the ultimate step in the marketing structure for financial services not only in India (which is the focus of this research) but also in the world. There has been more and more global focus on and around haw global banks is going to expand even more due to globalization. The contribution of acts like the Financial Services Agreement (FSA) first drafted in 1997 has led to numerous financial sectors growing in their respective industries on a quid pro quo foundation. India and its financial sector is one that has taken this opportunity and used it to the fullest in recent years (Agarwal & Sirohy, 2010).

In this paper, we will focus on risk management issues and aspect in banks, with specific focus in the Indian Banking Industry. The paper will focus on different aspects of the banking industry with primary focus being on credit risk management with a two-fold approach i.e. firstly focusing on the theoretical aspects of Risk management approach and the analyzing the overall implementation of this approach in Indian banking sector. Hence, we will analyze the impact of the theoretical framework of the risk management procedures on the internal organizations of the banks as well as highlight the impacts that the growth has had on the economy overall. The paper will also use graphs and figures to illustrate growth of the Indian Banking Industry and support the theory presented.

"The Indian Economy is booming on the back of strong economic policies and a healthy regulatory regime. The effects of this are far-reaching and have the potential to ultimately achieve the high growth rates that the country is yearning for. The banking system lies at the nucleus of a country's development robust reforms are needed in India's case to fulfill that" (Agarwal & Sirohy, 2010).

The fact of the matter is that the credit risk management structure will work its best if and when freedom is given to the financial sector to structure and interact on the global front with global financial sectors. Researchers believe that with the banking industry going global and working on such a large scale will result in the structure and management of risks being implemented on a proactive level and the overall service package and quality of the credit services will enhance over time (Agarwal & Sirohy, 2010).

Credit Risk Management

Risk is an integral part of any and all businesses in the private or the public sector. Risk can surface in any form across any and all departments like customer services, marketing, human resources or recruitment, pricing, strategy, security, reputation, legitimacy, technology and/or any other form of regulation. "However, for banks and financial institutions, credit risk is the most important factor to be managed" (Cool Avenues Knowledge Management Team, 2010). When explaining what credit risk really is, it is important to note that credit risk is based completely on the breaking of the agreed terms of a contract by a borrower or counterparty. This could include not only going against the agreed terms but also the inability to fulfill whatever necessary tasks they were required to do according to the terms. "Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country" (Cool Avenues Knowledge Management Team, 2010).

Before we talk about the credit risk in Indian Banks, we must analyze the following figures (for the years 2008 and 2007 respectively) below to truly understand the major players in the Indian Banking Industry (Mukherjee, Nath and Pal, 2002).

Before analyzing the risk management techniques, it is important to understand the overall structure and framework of the Indian Banking Industry. The table (Table 2) below exhibits the types and formats of banks that exits in the Indian Financial Sector ranging from commercial to rural banks and focusing on the numeric frequencies (i.e. increase or decrease) over a period of six financial years.

It is interesting to note here how some of the banks lost their market share (for instance, the Canara Bank, the Punjab National Bank and the State Bank Group) within a space of twelve months only.

Fast forwarding to a couple of years, and analyzing the figure for the HDFC bank (below) in the years in 2009. The overall year proved to be extremely trying for the bank and its investments with nearly 80% of the total earned in gains, the consolidations of the stocks were more visible in the last two-two n a half months. Perhaps the stage where risk management techniques came into play for the HDFC was the dip right at the start of November followed by the higher percentage earned at the start of December. Of course, increasing credit investment and stocks is the aim of every bank so what they should be wary of when faced with a similar circumstance is to make sure that they avoid such irregularities through effective risk management. Maintaining steadier middle ground is really important here (Mukherjee, Nath and Pal, 2002).

The overall ratios and rates that the HDFC Bank is recording (see figure below) being based out of the New York City are very positive, especially in the current financial quarters. The banking sector shows a total of 32% increase in the total profits that HDFC experienced as part of the second leading private sector lender in the state. The bank experienced dynamic loan increases and growths and had the perfect risk management procedure to maintain the level of loan growth in the coming financial quarters. This is where the banks based in India can learn from the HDFC bank based in New York as the primary way that the banks in India can increase their overall loan traffic is through focusing their marketing and structural strategies in and around the retail loan domains and advances (Mukherjee, Nath and Pal, 2002).

India's financial structure is strongly supported by various other small sector organizations that improve the flow of credit investments and loans every year. One such organization is known as 'Bandhan' and is based out of Calcutta. Bandhan has quickly grown into one of the most extensive and profitable microfinance organizations in the world. In fact, Bandhan has beaten the norms for most microfinance organization because of its speedy growth while others in the same category seem to grow at a much slower rate. When looking for statistical proof, Bandhan's growth is very obvious with clients numbering to more than 750,000 clients, more than 400 franchises, nearly $120M earned in payments, employing more than 2000 personnel; not only that, they have an average growth of more than 30,000 clients in a month. When you do the math here, in half a decade's time, Bandhan has gone from being a completely new company to one that services over 3,750,000 people! The table below shows their growth in the aspects where credit investments and loans play the biggest part (Mukherjee, Nath and Pal, 2002).

In an important relative study, the researchers examined the connection between the overall standard of performance and the standard of strategy that is implemented in the Indian commercial banks in the current era. All of the results attained in the study were formulated using the financial records and releases of a selected sample of Indian Banks. The study explained how the ability of the bank to use its capital and resources in risk management helps to not only creates a higher percentage of loans but also improves the efficiency. This particular aspect is absolutely critical when dealing with risk management strategies because the higher the efficiency of the workforce, the easier would be implementation of risk management strategies. In the study, the researchers concluded that it was the public sectors banks that reported higher efficiency as opposed to the private or foreign Indian Banks which is why their style of business was consistently able to outperform them in the flexible and evolving financial sector of the country (Mukherjee, Nath and Pal, 2002). Below is a table that statistically proves their findings:

Hence, taking the lead from the study conducted by Mulherjee, Nath and Pal in 2002, in this study we aimed to understand and statistically highlight the profits made by the banks that directly resulted from their loans investments and risk management strategies. Hence, we decided to take differnet bank groups and companies (previously highlighted in the pie-charts) and compared the net growth of these selected bank groups in the finanical years of 2006 and 2007. Note that these net profits were claculated with the number of increase or decrease in the overall loans investments in these bank groups.

An important thing to note here is that while bank credit is increasing in India, the overall impact that its has on the GDP and the economy is still not at the extent that some of the other countries experience. India's current bank credit holds to 80% of the GDP of the country, in fact the entire Asian block with Thailand and China does not record higher than 100% of the GDP. When comparing that to Hong Kong (with 180% of the GDP and rising), it becomes obvious that the bank creidt management needs to revised for superior perfrmance.

Risk Management for Indian Banks

"Risk management is relatively new and emerging practice as far as Indian banks are concerned and has been proved that it's a mirror of efficient corporate governance of a financial institution. Globalization and significant competition between foreign and domestic banks, survival and optimizing returns are very crucial for banks and financial institutions. However, selecting the efficient customer and providing innovative and value added financial products and services are another paramount factors. In a volatile and dynamic market place for achieving sustainable business growth and shareholder's value, it is essential to develop a link between risks and rewards of all products and services of the bank. Hence, the banks should have efficient risk management framework to mitigate all internal and external risks" (Nallamothu & Ahmed, 2010).

In order to better manage bank credit risk, it is important to understand the various ways and situations in which credit risk can emerge. Some of the more common aspects or situations that occur in the form of credit risk include the following (Cool Avenues Knowledge Management Team, 2010):

If the transaction was designed in a direct lending format, then there is a higher chance that the funds originally transferred would not be returned or repaid; this could lead to losses of credit investments

If and when the liabilities of the clients or customers are crystallized, especially in the instances of the liabilities in question being guarantees or letters of credit, the customer or client will not be willing to come forward and pay back the funds received; this could lead to losses of credit investments

When talking about the financial freezes in the treasury products, there is an expectation of a cease of repayments or the parties involved not being willing to pay back the funds based on the original terms of agreement or contracts; this could lead to losses of credit investments

Contracts will also face minimal changes if and when security industry exchange business dealings with other industries they are already in business with; this could end up being a loss in investments as there will be minimal to no addition in credits taken for the new contracts

If and when there is an international dealing made, apart from internet banking, with maximum focus being on the cross-border exposure, this situation can result in the restriction, termination and deficiency of currency transfers between the two countries involved; this again causes numerous credit and accounting issues for both parties involved but particularly for the banks that lend or loan the money;

The fact of the matter is that with the banks improving and escalating their transactions and markets to a global scale means that they have to actually implement a far diverse internal structure. This in turn means that they will need to employ far more efficient and intricate strategies to counter the various formats of unprecedented credit risks that they might face. Aside from the credit risks involved in global banking, there are quite a few other hurdles and risks that banks will have to prepare for, for instance the operational risks that come with being a commercial-based operative; the business risks faced by the commercial borrowers, the various topographical/political/cultural/religious/legislative risks associated with expanding into an unknown or foreign territory; even the reputation risks involved can turn out to be make or break for bank groups or companies involved in global banking. However, all of these can be preemptively countered by conducting thorough market researches before establishing global business settlements; credit risk management, however, is not that easy to prepare for (Cool Avenues Knowledge Management Team, 2010).

"Credit risk management enables banks to identify, assess, manage proactively, and optimize their credit risk at an individual level or at an entity level or at the level of a country. Given the fast changing, dynamic world scenario experiencing the pressures of globalization, liberalization, consolidation and disintermediation, it is important that banks have a robust credit risk management policies and procedures which is sensitive and responsive to these changes" (Cool Avenues Knowledge Management Team, 2010).

What Indian banks need to understand, when taking on the global banking structure, is that credit risk management is based around the efficiency and quality of the strategies that they have employed. The quality of the strategies will help if adjusting and altering the changes needed based on the customer and shareholder returns on investments. Hence, the best example currently in global banking is the United States that, according to many banking industry analysts, has been able to record an average of 56% and higher in the financial years from 1989-1997 for the shareholder returns on credits or loans provided. They achieved this with a low loan loss strategy; the team at Cool Avenues Knowledge Management Team explains that the "low loan loss banks stage a quicker share price recovery than their peers, and in a credit downturn, the market rewards the banks with the best credit performance with a moderate price decline relative to their peers" (Cool Avenues Knowledge Management Team, 2010).

India's banking structure has undergone its reddy years in the past decades, and when talking about shareholder returns on credits and loans for them, it is important that the invetsments in these reddy years and understood with regards to the overall inflation rates of the country, its interets rates on credits and loans as well as the global exchange rate of the India Rupee (Cool Avenues Knowledge Management Team, 2010).

Using Credit Risk Management as Building Blocks of Business

Indian banks need to integrate their corporate objectives with their credit risk management structures in order to have strong and sustaining building blocks of business. In order to incorporate the corporate goals with risk management the following aspects have to be paid attention to:

1 - Strategy and Policy

Strategy and policy refers to the way in which the business is conducted on a regular basis. It will also include business aspects like the overall appetite and demand for credit and loans in the clientele as well as the overall structure and guidance needed for credit investments to enable the clients make an informed, analytical and clear decision on the format of credit risk and investment they want to make (Cool Avenues Knowledge Management Team, 2010).

"It is essential that each bank develops its own credit risk strategy or enunciates a plan that defines the objectives for the credit-granting function. This strategy should spell out clearly the organization's credit appetite and the acceptable level of risk - reward trade-off at both the macro and the micro levels" (Cool Avenues Knowledge Management Team, 2010).

Considering the above statement, it is necessary for the bank to develop their strategy around their own willingness to step forth and provide loan and credit investment opportunities designed around the economic, political, market and infrastructure framework of the country they are established in. The currency of the country and the maturity of the market also play a huge part in the development of the bank's strategy. Hence, this would include the through assessment of many volatile aspects like:

Segmentation and recognition of the target audience based on consumer behaviors and the competitive business sectors,

The preference of the specialization of the industry and competition in it,

The overall financial investments needed for the possibility of sustaining credit investments and reducing chances of debts or non-repayment (Cool Avenues Knowledge Management Team, 2010).

The overall policy approach of banks stepping in the global banking industry should be to completely realize the extent of organizational tasks required for not only incorporating risk management and measurement strategies but also include all the functional techniques, recording techniques, legislation and guidelines required internally and externally in relation to risk management. The overall policies require for loan investments must also expand outside the box of merely understanding and implementing sustainable credit activities. They should allow a constant source of networking to other banks as well as ensure that loan losses don't surface due to 'poor loan structuring and perfunctory risk assessments' (Cool Avenues Knowledge Management Team, 2010).

"An organization's risk appetite depends on the level of capital and the quality of loan book and the magnitude of other risks embedded in the balance sheet. Based on its capital structure, a bank will be able to set its target returns to its shareholders and this will determine the level of capital available to the various business lines" (Cool Avenues Knowledge Management Team, 2010).

2 - Organization

The organization of credit risk management deals with lucid delegation of tasks and responsibilities so that there is a clear chain of command and protocol to follow for the employees and the suppliers of the banks (Cool Avenues Knowledge Management Team, 2010).

3 -- Operations and Functional Structures

There is a need for a Chief Operating Officer (COO) who can handle the functional structures, both tangible and intangible. The job requirements for the COO will also include managing a senior executive and middle executive branch on the bank as well as recruit and train individuals for the necessary development of mechanisms and techniques needed in the smooth operations of the business (Cool Avenues Knowledge Management Team, 2010).

Hence, all Indian banks should be structured to have:

Customized strategy and polices that manage the high risk departments of the bank from capital resources to huge financial transactions

Sound implementation systems for all strategies

Rating and monitoring structures for credit risks on all clients based on prior behavioral patterns

A structure to adjust prices for credit and loans in accordance to market changes

Using the Boards' approval processes for credit sanctions

A conventional structure to analyze and stipulate the compliance of the non-performing advances

Regular assessments and re-assessments of credit risks in the changing market (Cool Avenues Knowledge Management Team, 2010)

Credit Policies and Procedures

According to the experts in the Cool Avenues Knowledge Management Team, the most recent studies have shown that for Indian banks the following credit policies and procedures must be inclusive of the following aspects in a majority of their credit and loan tansactions (Cool Avenues Knowledge Management Team, 2010):

1. "Banks should have written credit policies that define target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management (Cool Avenues Knowledge Management Team, 2010).

2. Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic plant visits, and at least quarterly management reviews of troubled exposures/weak credits (Cool Avenues Knowledge Management Team, 2010).

3. Business managers in banks will be accountable for managing risk and in conjunction with credit risk management framework for establishing and maintaining appropriate risk limits and risk management procedures for their businesses (Cool Avenues Knowledge Management Team, 2010).

4. Banks should have a system of checks and balances in place around the extension of credit which are: