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Risk Awareness

Risk Awareness in Banking

Why are we talking about risks more often than ever before?

Risk Taking is different from Risk Management, which deals with various types of risks confronting banks in their day-today operations. These risks are required to be identified, assessed, quantified, avoided or pursued, managed, monitored, controlled so that the banks conquer them and convert the threats to opportunities. Slackness and neglect could cause the bank heavy loss of money and fame. It is in this context the risk management as a concept is now being widely talked about. Since the evolution of banking as an industry, banks have been confronting and handling risks that bother them.

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Why then there is so much emphasis of late necessitating wholehearted attention and concern of bankers and bank supervisors worldwide?

The Background behind the urge to create the awareness and to ensure sound conduct of Banking business is perhaps influenced by the spurt in volume, velocity, complexity in this business lately. Banking is no more mere deposit taking, lending unit. Consequent upon the opening of the global economy new innovative products, instruments, technological advancement, speed have all come to stay.

The expanded field is relatively new. Innovative products are not "risk tested". Banker's experiences in these are relatively short. Option trading, derivatives market are comparatively high voltage points for bankers, banking derivatives market are comparatively high voltage points for bankers, banking supervisors to anticipate and guide the new entrants. The demands and dictates of the banking public virtually pushed the banks to enter bravely dictated by the fierce competition and thinning margin on fund base lending.

Banks having had to cope up with the new environment and products just to stay in business are forced to realign and readjust quickly. Those who are aggressive not only made money but a few of them lost name and fame.

What is Risk?

Risk is defined as peril, a danger. It becomes dangerous or deadly when it strikes. We have learnt to keep it aside by precautionary measures. Air, sea navigation is risky. Making and storing explosives are risky. Skiing, diving, surfing, and mountaineering are all risky sports but are still being pursued. So are numerous other activities. Learning to live with them is a way of life because they are not only thrilful but are also gainful.

Is Banking really a risky activity?

Throughout the world millions of people are gainfully employed and billions of profit are earned in this industry which also acts as a catalyst in sparking economic activity. This industry is time tested and age old. Why then so much talked about now about the risk in this business lately as if it is a RISKY BUSINESS? Till two decades ago there was not so much talk about, botheration about nor focus about as is obtaining today. Monetary authorities through out the world are so much concerned now that the guidelines, working papers, discussion materials are pouring almost on weekly basis. Awareness is sought to be created now to the inherent risks to which the industry is subjected. The Background behind the urge to create the awareness and to ensure sound conduct of Banking business is perhaps influenced by the spurt in volume, velocity, complexity in this business lately. Banking is no more mere deposit taking, lending unit. Consequent upon the opening of the Global economy new innovative products, instruments, technological advancement, speed have all come to stay. The expanded field is relatively new. Innovative products are not "risk tested". Bankers' experiences in these are relatively short. Option trading, derivatives market are comparatively high voltage points for bankers, banking supervisors to anticipate and guide the new entrants. The demands and dictates of the banking public virtually pushed the banks to enter bravely dictated by the fierce competition and thinning margin on fund base lending.

Banks having had to cope up with the new environment and products just to stay in business are forced realign and readjust quickly. Those who are aggressive not only made money but a few of them lost name and fame. The inherent risks were neither known nor identified till the disaster struck them. were neither known nor identified till the disaster struck them.

Banks in India are also to swim with the tide as Indian economy witnessed opening itself to the global economy. De-regulation, de-control, liberalization measures were introduced slowly and in stages, In a short time the banks in India were forced to realign and readjust to the dictates of the market so that they are not way behind. Meanwhile the spurt in banking activities in the new environment took its toll in a few banks abroad. The sudden growth in which many banks were involved exposed themselves to the new kind of risks. The diversity and complexity in the nature of the business also produced risks of varied nature exposing them also to Credit, Market, Operational risks.

Indian Banking witnessed a sea change of reforms and regulatory guidelines when the Government was committed to open out the economy to the global trade. De-control and De- regulation measures were also accompanied by Financial sector reforms. Basle committees capital norms together with prudential guidelines for lending, provision requirements, asset classification, Balance sheet transparency, disclosure norms were introduced. Though it was not easy for indian banks to conform to these changes they had to quickly adjust so that they could remain in business. They are more or less in compliance now. A few banks, which had problems, had to be capitalised by the Govt. and they were subjected to closer scrutiny and surveillance. They are slowly coping up Transparency, disclosures, balancesheet management, competitiveness amidst fierce competition, de-regulated interest structure from the administered interest regime etc threw open lot challenges affecting the bottom line besides pressure for making tall provisions and providing adequate capital.

Existence, survival and profit making necessitate Risk taking and risk areas are already expanded due to the diversity and complexity in baking environment and banking products. If risks that are obvious, inherent, and invisible are not identified, avoided, managed, monitored and contained the entire profits will be wiped out, capital eroded and the very existence will be threatened. If such a crisis occurred, all other associated players, investors and name and fame will be threatened. It is in this context a sound RISK MANAGEMENT SYSTEM is sought to be put in place, bank specific and activity specific.

The Panic in the industry necessitating extensive talk about the risk management was due to several adverse developments in the recent past in a few banks abroad. To appreciate the magnitude of risk and the need for better appreciation of the risk management concept it is worth while to go through some classic cases where the risks virtually devoured the units.

The case of the LONG TERM CAPITAL MANAGEMENT (LTCM)

LTCM was one of the largest organizations. It handled huge funds it had; lent to them and raised by them. The collapse of LTCM brought to light reckless lending practices of many Western banks and substantial use of leverage by these funds giving them considerable power to move financial markets. This collapse brought to light several misdemeanor. Countries like Malaysia, Hongkong felt that the hedge funds were doing aggressive speculation and destroy their currencies and de-stabilise their economies. The hedge fund was making huge profits from speculating on the currencies or stocks of developing countries. Federal Reserve Bank of Newyork and 16 other local U.S. banks were to come to the rescue of LTCM. The equity of LTCM, which stood at US $4 billion, was eroded by US $ 2 billion losses. Banks have to pump nearly US $ 3.5 billion in capital to keep the firm float. But for this LTCM would have collapsed.

An apparently unbeatable team led by senior Wall Street officials and staffed by Nobel prize-winning economists managed LTCM. Bankers had such a confidence in this "Dream-Team" that they lent and invested in LTCM massively to enable LTCM to build a total market exposure of US Dollar 200 billion (Leverage of 40 times, that is against each one dollar they lent 40 dollars).

The high leverage was obtained by procuring money by operating what is known as MERRY-GO ROUND method. Assets were used to as collaterals to borrow money with which more assets were bought which again served as collateral for fresh borrowing and so on. The involvement in LTCM resulted in a loss set aside by Union bank of Switzerland to the extent of US dollar 682 billion. Bank of Italy had invested US dollar 250 million, Sumitomo bank 100 million, Dresdner bank. Was expecting a loss of US dollar 143 million. Several other banks, Investment banks, Hedge fund operators (Everest capital 1.3 billion, Convergence Asset management losing values by nearly 30%) were severely embarrassed.

SUMITOMO CORPORATION revealed that they lost US Dollar 1.8 billion in Copper Futures trading. Several U.S. banks had lent huge funds for their futures trading scandal and were severely embarrassed besides losing large sums.

ENRON debacle and ARGENTINAS debt trap and default opened the eyes of the supervisory regulators throughout the world. Enron trotted into one of the world's most complex troubles and made a colossal billion-dollar mess. Their hedging strategies worked well but crumbled in the recessionary period. Prices fell, forcing Enron to take net long position. Their prime asset crumbled. Enron looming bankruptcy revealed wider financial implications and exposed U.S. financial regulatory system. Banks associated with Enron stood badly exposed

THE COLLAPSE OF THE BARRINGS brought to light several risk areas familiar and unfamiliar. This case stood as a classic example for Market and Operational risks in the Banking industry.

Barrings was a ban, 200 years old. Its dealer in Singapore was Mr. Nick Leeson. He went uncontrolled and supervised that single handedly he crashed the bank. He took a notional position of US Dollar 27 billion as against the bank's capital of US dollar 615 million. Barrings could not meet the margin calls of Singapore Monetary exchange and Osaka stock exchange. Earlier the bank remitted 354 million US dollars as demanded by Leeson. This was in December1994. In early 1995 he made a further demand for funds to the order of US Dollar 835 million. Without any worthwhile examination and probing the banks head office remitted the same. There was no proper delegation of duties as Leeson was managing the show entirely. It was too late when the Bank realized that huge losses had virtually crippled their liquidity and more than eroded their capital. They had to be closed.

These are some of the illustrative samples of thoughtless risk exposures assumed by the banks. Inter play of some of the risks alone or on combination with others can cause collapse of any weak bank with no worthwhile risk management practices. Risk exposures such as Market risk, Liquidity risk and Operational risk had their combination and took its toll. Worldcom, Xerox, Globalcrossing were instances of accounting scandals bringing out the need for a systematic approach to risks and risk management systems.

Banking supervisors and Monetary authorities throughout the world are seriously concerned as such failures notably bring down the concerned unit but also host of other players associated with it including the local economy. Basle committee had issued their first consultative paper in January 2001 and second consultative paper as a new Capital accord for implementation in 2005. It is felt that Basles 1988 accord was not adequate in so far as the capital adequacy is concerned and the effectiveness of supervision of banks. In today's dynamic and complex financial system security and soundness can only be achieved through the inter play of efficient business management by banks, market discipline and effective supervision. Greater importance is being attached to the banks internal control systems and management, to the reviews by supervisors, and to market discipline. A risk adequate capital cushion is what is aimed at. Along with the move to providing economic capital, greater emphasize is made on risk management systems in the banks, risk based supervision, risk avoidance, risk measuring, risk monitoring and risk based internal audit system. It is hoped that in the light of galloping diversification of the financial systems globally with complexity, banks will have to continue to exist, compete, grow, and improve the bottom line and shareholder's value. The only solution seems to be to aim at bottom line and shareholder's value. The only solution seems to be to aim at soundness and security by installing risk based supervision, bank specific, activity specific product and complexity specific.