The Financial System The Banking Industry Finance Essay - Free Essay Example

As a matter of fact deregulation in the financial sector had widened the product range in the developed market. Some of the new products introduced are credit cards, housing finance, derivatives and various off balance sheet items. Thus new vistas created multiple sources for banks to generate higher profits than just to be a traditional financial intermediation. Simultaneously they opened new areas of risks also. During the past decade, the Indian banking industry continued to respond to the emerging challenges of competition, risks and uncertainties. Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. This study has been done to bring into the sight of reader the supervisory norms that conform to the bank practices, with an intention to strengthen the stability of the banking system by implementing RISK MANEGEMENT. Risk Management The etymology of the word Risk is traced to the Latin word Rescum meaning Risk at sea or that which cuts. Risk is an unplanned event with financial consequences resulting in loss or reduced earnings. It stems from uncertainty or unpredictability of the future. Therefore, a risky proposition is one with potential profit or a looming loss. Hence, Risk Management is an attempt to identify, to measure, to monitor and to manage uncertainty. It does not aim at risk elimination but enables the banks to bring their risks to manageable proportions while not severely affecting their income. Risk Management Structure: Establishing an appropriate risk management organization structure is choosing between a centralized and decentralized structure. The primary responsibility is of understanding the risks run by the bank and ensuring that the risks are appropriately managed and vested with the Board of Directors. Steps for implementing Risk Management in Banks Establishing a risk management long term vision and strategy It depends on bank vision, focus, positioning and resource commitments. Risk Identification This is carried out to assess the current level of risk management processes, structure, technology and analytical approach at the bank. Typically banks distinguish the following risk categories: Credit risk Market risk Operational risk Defining Roadmap Based on the target risk management strategy / gap analysis bank develops unique work plans with quantifiable benefits for achieving sustainable competitive advantage. Those are: a. Risk Based Supervision requirements b. Basel II compliance c. Using risk strategy in the decision making process Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans, the relative importance of market, credit and operational risk in each line of activity is determined. Integrate Risks Management / Strategy into bank internal decision making process The objective is to integrate risk management into business decision making process which evolves risk culture through awareness. Types of Risks Credit Risks: Credit Risk is defined by the losses in the event of default of borrower to repay his obligations or in event of deterioration of the borrowers credit quality. Operational Risks: It is the risk of loss resulting from failed or inadequate systems, people and processes or from external events. Market Risks: Market Risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange equities as well as volatilities of prices. Regulatory Risks: It is the risk in which firms earnings value and cash flows is influenced adversely by unanticipated changes in regulation such as legal requirements and accounting rules. RBI suggests that (guidelines are in ANNEXURE 1): Banks must equip themselves with an ability to identify, to measure, to monitor and to control the various risks with New Capital Adequacy provisions in due course. For managing credit risk, portfolio approach must be ad opted. Appropriate credit risk modeling in the future must be adopted. For measurement of market risk banks are advised to develop expertise in internal models RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks operating in international markets. Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based supervision. One of the five specific areas is effective Risk Management Architecture is to ensure adequate internal risk management practices. The limits to sensitive sectors like advances against equity shares, real estates which are subject to a high degree of asset price volatility as well as to specific industries which are subject to frequent business cycles should be restricted. Similarly, high-risk industries as perceived by the bank should be placed under lower portfolio limit. AIMS AND OBJECTIVES OF THE REASEARCH: The following objectives have been fixed for this study: To examine credit risk faced by banks and its need. To analyze the guidelines set up by RBI for banks. To evaluate the measures to monitor risks. SIGNIFICANCE OF THE STUDY: Good risk management is good banking and good banking is essential for profitable survival of institution. It brings stability in earnings and increases efficiency in operations. The present study proposes to: Enhance shareholders value with Value creation Value preservation Capital optimization Enhance capital allocation. Improvement of portfolio identification and action plans. Integration of risk management within corporate governance framework. Improved Information Security. Corporate Reputation. In real world risk management creates value. Hence, it is an essential part of a financial institution as it involves stakeholders interest among others. STRUCTURE OF DISSERTATION The entire project has been divided into nine chapters. The first chapter contains discussion on the meaning and concept of risk, risk management Aims and objectives of the Research, Significance of this research and profiles of the banks. Second chapter deals with literature review on risk management. Chapter third contains the Research Methodology. In the fourth chapter analyses of credit risk and its management is undertaken. Basel II norms and Risk Based Supervision Requirements are discussed in fifth chapter. A major finding of survey responses and profitability analysis, which is the central point of financial analysis, is included in sixth chapter. Chapter seventh presents the study with some concluding remarks and recommendations. Eighth chapter defines Reflection on learning. CHAPTER 2 LITERATURE REVIEW According to the Basel (1999a), credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed term. And the Monetary Authority of Singapore (2006) has defined it to be the risk arising from the uncertainty of an obligors ability to perform its contractual obligations, where the term obligor refers to any party that has either direct or indirect obligations under the contract. (Jackson and Perraudin, 1999), think of it to be the largest element of risk in the books of most banks and if not managed in a proper way, can weaken individual banks or even cause many episodes of financial instability by impacting the whole banking system. Thus to the banking sector, credit risk is definitely an inherent and crucial part. Bank Credit- Risk and Profitability attempts to highlight the significance of risk and profitability aspect of bank credit. Growth and Development of any business organization depends on its r isk management and profit generating capacity. Both risk and profit have time dimension which leads to future projections which have an element of uncertainty gives rise to risk and in turn affects profits. For ensuring long term survival of banks risk dimensions of banking is to be addressed appropriately thats why banking risks is grouped under three heads: (a) credit risk, (b) operational risk and (c) market risk. Deposit and credit constitute the core of banking activity and substantial portion of expenditure and income is associated with it. As far as deposit is concerned, it is considered to be safe area of business, barring few stray instances of operational risks like human errors, frauds and forgeries. Credit is the real activity that is to be managed to generate profitability by keeping three cardinal principles of banking in mind: liquidity, solvency and profitability. With the thinning of spreads in the deregulated and liberalized economy risk management has become al l the more crucial. So proper mechanism has to be placed for and anticipation and identification of risks since every credit decision involves risk. One cannot avoid risk altogether. Hence Risks and profits have a direct relationship though not proportionate Further risks are co related and exposure to one risk leads to another so real mantra for prudent banking lies in successfully managing risks in proactive and integrated manner. (Singh, 2001) William Beaver and George Parker did a pioneering work on the concept of risk management in their book entitled Risk Management problems and solutions. The authors categorize risk under two segments product and capital and lay down an overview of risks. According to them risk associated with one category has symbiotic relationship with the other. They also focus on the innovative side of financial instruments i.e. derivative and the markets that trade and price them. (Beaver W. et al., 1995) Re-engineering in Banking System describes that traditional banking activity still remain the mainstay of banking business. The greater globalization of banking operations and expansion of financial activities in an increasingly market driven environment have made risk management critical and indispensable. Risk is intrinsic to banking business. The growing sophistication in banking operations, derivative trading, securities underwriting, on-line electronic banking and improvements in information technology have led to increased diversity and complexity of risks being encountered by banks. The major risks confronting banks and financial institutions are credit risk, interest rate risk, foreign exchange risk and liquidity risk. Of these, credit risk remains predominant for banks. Besides these financial risks, banks are exposed to other risk such as operating risks and legal risks. Irrespective of the nature of risk the best way for banks to protect themselves is to identify the risk, accurately measure them, price them and m aintain appropriate levels of reserves and capital. Keeping this in view the RBI has issued guidelines for risk management systems in banks which has placed the primary responsibility of laying down risk parameters and establishing risk management and control system on Board of Directors of the bank. (Kamesan, 2009) Research Post Mortem Is Passed, Its Time to Think Ahead emphasizes that in rapidly changing business environment no business can afford to remain static. Risk taking is an integral part of any business enterprise. So its important that every bank puts in place the technical system and management process not only to identify the risks but also to effectively measure and control it. Retooling risk management practices with modeling techniques backed by analysis is the need of hour. Key risk indicators are identified for ascertaining operational risks aspect of the banks as what amount of capital is required for long term solvency of the banks. Transaction level risk ass essment is another indicator which banks have to focus on. Hence the RBI is encouraging banks to be proactive in risk management with a view to build up adequate reserves to guard against any possible reversal of interest rates. Banks are directed to maintain certain level of investment fluctuation reserves. (Reddy, 2008) Research Risk Management with focus on Indian Financial Sector focuses on risks inherent in the financial sector including risks relating to decision making process, organizational structure, management procedures, human resources and culture. It explores major financial risks faced in capital and debt markets and explains the need for articulating risk policy and profile of the organization, measurements of risks and risk management in regard to Indian context. It also emphasizes on suitably creating risk management models that suits the goal of organization and has greater feasibility of implementation. (Dr. Asha Prasuna Dr. Siva Kumar, 2009) A.K. Mishra i n their book entitled Innovative Risk Management tools for Indian Banks describes that industry has undergone drastic changes in last three decades. Horizontal expansion of financial market, deregulation across the globe in financial markets and stiff competition have led the banks to multiply their activities. Increased activities in the industry have exposed the bank to more uncertainties and more risks. Banks in general face the following risks: credit, market, interest rate risk, liquidity risk and operational risk. Risk originates in the forms of customer default, funding a gap or adverse movements of markets. (Mishra, 1998) As suggested by Al-Tamimi (2002), in managing risk, commercial banks can follow comprehensive risk management process which includes 8 steps: exposure identification; data gathering and risk quantification; management objectives; product and control guidelines; risk management evaluation; strategy development; implementation; and performance evaluation. According to IFSB, the primary aim of releasing its risk management standard stems from the recognition that although certain issues are of equal concern to all financial institutions (IFSB, 2005), some risks are localized to IBs and as such these principles serve to complement the BCBS guidelines in order to cater the specificities of IBs (IFSB, 2005). A study conducted by Boston Consulting Group (2001) found that the sole determining success factors is not the technical development but the ability to understand risk strategically and also the ability to handle and control risk organizationally. Secondly, in order to realize a risk based management philosophy, the attitude and mindset of the employees need to be changed whereby they must be made to understand that managing risk is crucial for success. There are few conceptual studies on risk identification of financial institutions (e.g. Kromschroder and Luck, 1998; Luck 1998; Tchankova, 2002; Barton et al., 2002) and few empirical studies that include risk identification of banks (e.g. Al-Tamimi, 2002; Al-Tamimi and Al-Mazrooei, 2007). Risk identification is the first stage of risk management (Tchankova, 2002) and a very important step in risk management (Al-Tamimi and Al-Mazrooei, 2007). The first step in organizing the implementation of the risk management function is to establish the crucial observation areas inside and outside the corporation (Kromschroder and Luck, 1998). There are many other approaches for risk identification, for instance, scenario analysis or risk mapping. An organization can identify the frequency and severity of the risks through risk mapping which could assist the organization to stay away from high frequency and low severity risks and instead focus more on the low frequency and high severity risk. Risk identification process includes risk-ranking components where these ranking are usually based on impact, severity or dollar effects (Barton et al. 2002). There are m any conceptual studies made on risk analysis and assessment by reference to measurement and mitigation of risk. In practice, it is useful to classify the different risks according to the amount of damage they possibly cause (Fuser et al, 1999). Rajagopal (1996) made an attempt to overview the banks risk management and suggests a model for pricing the products based on credit risk assessment of the borrowers. He concluded that good risk management is good banking, which ultimately leads to profitable survival of the institution. A proper approach to risk identification, measurement and control will safeguard the interests of banking institution in long run. Risk management involves risk identification, risk measurement (and quantification) and mitigation. However, a point to note here is the perception of what constitutes risk to a firm may differ from institution to institution, time to time, and industry to industry. This section identifies the theoretical meaning of risk man agement as defined by different scholars. From Emmett (1997) definition, it is clear that risk is a condition of the real world; it crafts from an undesirable event. Undesirable event in this context is described as an adverse deviation from a desired outcome that is expected and hoped for. As it is the major goal of a firm to maximize benefits from cash flows and market status, managers usually achieve their objective through series of activities ranging from product sales, deposit acceptance, provision of funds to clients, etc. As long as profit is a goal, risk is inevitable for financial institutions. Industrial concerns and product companies are well characterized as risk averters. Thus, financial institutions are prompted to seek out risk to make money. The difference in taking reasonable risk is the key to financial firms profitability and asset growth. Risk permeates everything they do (Casserley, 1991). At the core of this, scholars are in accordance with the fact that risk in financial institutions cannot be fully eliminated. However, what stands as an argument is how efficient a bank can manage its risk exposures- minimizing risk, at the same time ensuring profit maximization. Should it be through capital augmentation, allocation, or aggressive asset pricing? Ozturk (2007) defines risk management as the process by which managers satisfy their risk taking needs by identifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce and which to increase and by what means, and establishing procedures to monitor the resulting risk position. In other words, risk management is the process of assessing operational dangers of a particular position, measuring its magnitude, and mitigating such exposures in order not to deter the institutional goals of the banking firm. Before the 1980s, risk management functions attracted little attention. This has changed in recent times, occasioned by an influx of mathematicians, actuaries, behavioral scientists and marketers which have developed new approaches to managing risk in banks. The changing dynamics of banking activities, the subjected environments within which banks operate, and the volatility of the world economy imply that risk analysis and management must also adjust with time (McNamee, 1997). Risk management is becoming more complicated with the trend towards an integrated global financial system. It is no longer sufficient for risk managers to be attentive to happenings in international markets; efficiency of overseas risk managers has become a co-factor. An example is the subprime mortgage crisis in US 2007 which turned to a global syndrome. Risk Management is a course at the center of financial intermediaries operations which entails identifying, measuring, and managing risks to ensure that: a) Individuals understand the intrigues of taking and managing risks. b) Risk exposure of an institution is within an accep table limit defined by the regulatory body. c) Risk taking decisions of an institution is in line with the business strategy and defined objectives of the Board of directors. d) Risk taken is worth its accruable benefits and is to the best interest of the institution. e) Sufficient capital is available to cushion for possible losses from taking a risk. Horcher (2005), who defines six types of credit risk, including default risk, counterparty pre-settlement risk, counterparty settlement risk, legal risk, country or sovereign risk and concentration risk, However, since legal risk is more likely to be considered as independent or belonging to operational risk nowadays (HSBC 2006 annual report, Casu, Girardone and Molyneux 2006, etc) and concentration risk, together with adverse selection as well as moral hazard, is more reasonably to be thought of as an important issue in managing credit risk rather than a type of the risk itself (Duffie and Singleton 2003). Survival Str ategies through Gap Analysis describes the survival strategies through gap analysis and emphasis that risk management does not aim at risk elimination but enables the banks to bring their risks to manageable proportions not severely affecting their income. The focal point in managing risk is to understand the nature of transaction in a way to unbundle the risks it is exposed to. As all transactions of the banks revolve around raising and deploying the funds, asset liability management (ALM) gains more significance. The purpose of ALM is to enhance the asset quality, quantify the risk associated with assets and liability and further manage them. The most common parameters in ALM are net interest margin, market value of equality and economic equity ratio. Gap analysis is based on the sensitivity of assets and the liabilities to the interest rate fluctuations, classified into different maturity buckets. The rate sensitive gap is the difference between rate sensitive assets and rate sen sitive liabilities which enable the banks to assess the impact of rate fluctuations and net interest margin. (Bohini, 2000) Risk Based Supervision (RBS) describes a new approach, which was developed by RBI Governor along with the assistance of Price Water House Coopers (PWC), an international consultant. The main objective of RBS is to optimize utilization of supervisory resources and minimize the impact of crisis situation in the financial system. In his research, he discusses the features of RBS, issues involved in RBS and bank level preparation for introduction of RBS. He emphasized on adopting CAMELS / CALCS approach to supervisory risk assessments and ratings. Moreover the effectiveness of RBS depends upon: Quality and reliability of data Soundness of system and technology Appropriateness of risk control mechanism Supporting human resources and organizational backup (Kamath, 2010) A pioneering research Risk Based Supervision A new tool with supervisor for managing risks in banks not only tries to identify systemic risks caused by the economic environment in which banks operate, but also managements ability to deal with them. Risk based supervision (RBS) focuses on the quality of risk management and monitors the risk profile of banks on an on-going basis in relation to their business and exposures. Moreover it further optimizes utilization of supervisory resources besides encouraging banks to practice risk management tools. It is necessary due to autonomy of banks, increased competition, automation, globalization and market transparency. Finally the article stresses on the importance of banks preparedness for effectiveness of RBS policies. (Sood, 2009) Basel Accord II: Implications for the Indian Banking System puts emphasis on adoption of Basel Accord II as it focuses on achieving a high degree of bank level management, regulatory control and market disclosure. Rather than viewing Basel II as one more costly burden, banks should s eize the opportunity to strengthen organization information flows, reports and processes resulting in more informed decision making, better credit pricing, increased transparency of credit granting and enhanced clarity of the responsibilities. Basel II is initially targeted at all internationally active financial institutions and it is expected that most banks will adhere to the Foundation IRB approach, for competitive reasons. Once a bank applies the IRB approach in one county or in one business line it will implement the same approach across all significant portfolios. The three pillars of complementary change that Basel II proposes are capital requirements, supervisory review process and market discipline. (Nachane, 2009) Andrew Powell in his report Basel II and developing countries: Sailing through the sea of standards discussing the issues that developing countries might face while adopting Basel II. It describes Basel I and II as sea of standards and attempts to provide nav igational tools for developing countries to choose the most appropriate approach suitable for them. It stresses that the standardized approach might serve as a starting point for the developing countries, but it might not adequately link capital to risk. They might need to adopt advanced internal rating-based approach which might take many years of work. Thus the report proposes a centralized ratings-based approach as a transition measure. (Powell, 2004) In Implementation of Basel II-Implications for the World Bank and the IMF, IMF and World Bank personnel discuss Basel II as a new global capital standard. It lays great emphasis on a strong supervisory foundation as a precondition for Basel II. Key issues are highlighted which might lead to delays in implementation in various countries. The implications of Basel II include higher capital requirements for loans to emerging markets, portfolio adjustments and incentives to develop credit rating agencies. Increased procyclicality mig ht arise as a consequence of assigning higher risk weights in an economic downturn. The report also discusses the risk of selective implementation of Basel II where unjustified assigning of lower risk weights to certain assets like residential mortgages, retail and SME lending in a country might leave their financial system vulnerable. (IMF and World Bank report, 2005) G.S.Sethi (2008) in his research article on Operational Risk Management defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal process or from external vents. It is seen that most big bank failures worldwide have been due to operational failures. There are two types of operational failure risks, people risks- Frauds and incompetent and process risk Transaction risk, operational control risk and technology risk. The risk of fraud by itself may not seem to be as threatening now as it used to be given during the year 2008, the reported fraud amounted to Rs.580. 49 crores and this constitutes a mere 0.05% of total assets of the banking industry excluding RRBs at Rs.12,38,900 crores. But its fallout apart from monetary loss is huge in terms of other indirect risk i.e. reputational risk and legal risk. For fraud to take place, presence of two ingredients is necessary: the will to commit fraud and opportunity available to commit fraud. From point of view of the organization, it is difficult in the short term to control the will of the potential fraudster to commit fraud. It is by having proper systems and procedures and more importantly to have adherence to them that incidence of frauds can be controlled if not eliminated totally. Incompetence of the people at any level in the organization poses a grave risk to strategic decision making, operational efficiency and reputation or even to the existence of the organization in the longer run. This may require attention right from the recruitment through training, placements, compensation package s and growth potential. Improvement of work culture and environment is must to counter and check incompetence and consequential risks arising there from. (Sethi, 2008) David Belmont in his book entitled Adding Value through Risk covers another treatise on risk management. The author stresses that risk management adds value to financial institutions through economic capital allocations and risk management information for areas such as capital budgeting, capital structured decisions and risk adjusted performance evaluation which is used for strategic decisions. As banks are now extending complete risk management systems to comply with New Basel Accord. It is these risk-adjusted measures that have to be utilized by banks for making strategic decisions to create value for shareholders. (Belmont, 2010) Froot and Stein (1998) found that credit risk management through active loan purchase and sales activity affects banks investments in risky loans. Banks that purchase and sell loans hold more risky loans (Credit Risk and Loss loans and commercial real estate loans) as a percentage of the balance sheet than other banks. Again, these results are especially striking because banks that manage their credit risk (by buying and selling loans) hold more risky loans than banks that merely sell loans (but dont buy them) or banks that merely buy loans (but dont sell them). Treacy and Carey (1998) examined the credit risk rating mechanism at US Banks. The paper highlighted the architecture of Bank Internal Rating System and Operating Design of rating system and made a comparison of bank system relative to the rating agency system. They concluded that banks internal rating system helps in managing credit risk, profitability analysis and product pricing. Duffee and Zhou (1999) model the effects on banks due to the introduction of a market for credit derivatives; particularly, credit-default swaps. Their paper examined that a bank can use swaps to temporarily transfer c redit risks of their loans to others, reducing the likelihood that defaulting loans trigger the banks financial distress. They concluded that the introduction of a credit derivatives market is not desirable because it can cause other markets for loan risk-sharing to break down. Ferguson (2001) analyzed the models and judgments related to credit risk management. The author concluded that proper risk modeling provides a formal systematic and disciplined way for firms to measure changes in the riskiness of their portfolio and help them in designing proper strategic framework for managing changes in their risk. Bagchi (2003) examined the credit risk management in banks. He examined risk identification, risk measurement, risk monitoring, risk control and risk audit as basic considerations for credit risk management. The author concluded that proper credit risk architecture, policies and framework of credit risk management, credit rating system, monitoring and control contributes in su ccess of credit risk management system. Muninarayanappa and Nirmala (2004) outlined the concept of credit risk management in banks. They highlighted the objectives and factors that determine the direction of banks policies on credit risk management. The challenges related to internal and external factors in credit risk management are also highlighted. They concluded that success of credit risk management require maintenance of proper credit risk environment, credit strategy and policies. Thus the ultimate aim should be to protect and improve the loan quality. Louberge and Schlesinger (2005) aim to propose a new method for credit risk allocation among economic agents. Their paper considers a pool of bank loans subject to credit risk and develops a method for decomposing the credit risk into idiosyncratic and systematic components. The paper shows how financial contracts might be redesigned to allow for banks to manage the idiosyncratic component for their own account, while all owing systematic component to be retained, passed off to capital market or shared with borrower. Bandyopadhyay (2006) aims at developing an early warning signal model for predicting corporate default in emerging market economy like India. He also presented the method for directly estimating probability of default using financial and non-financial variable. For predicting corporate bond default multiple discriminant analysis is used and logistic regressions model is employed for estimating Probability of Default (PD). The author concluded that by using Z score model, banks and investors in emerging markets like India can get early warning signals about the firms solvency status and reassess the magnitude of default premium they require on low grade securities. The PD estimate from logistic analysis would help banks to estimate credit risk capital and set corporate pricing on a risk adjusted return basis. This model has high classification power of sample and high prediction power in terms of its ability to detect bad firm in sample. On making the review of the previously conducted studies, it is clear that majority of the studies that focus on credit risk management practices in banks provide conceptual framework. Hence, empirical studies on credit risk framework of banks in India are yet to be effected. Moreover, no study has made a size-wise and sector-wise comparison of the credit risk management among banks in India. The present study is an attempt to address the above issues pertaining to the credit risk management framework of banks in India. CHAPTER 3 RESEARCH METHODOLOGY MEANING OF RESEARCH Research is the combination of two words, Re and Search. Re means again over again while Search means to examine closely and carefully, to test and try. It describes a careful and systematic study in the field of knowledge, undertaken to establish facts or principles. Research is an organized and systematic way of finding and analyzing answers to questions. RESEARCH DEFINITION Research is a process of steps used to collect and analyze information to increase our understanding of a topic or issue. It consists of three steps: framing of a question, collect data to answer the question and present an answer to the question (Creswell, 2001). RESEARCH PROCESS Finding the research problem Literature review Data collection Data Interpretation Preparation of research report METHODS OF RESEARCH Historical method: To rebuild the past with an objective and accurately. Descriptive method: To describe an area of interest accurately. Developmental method: To investigate patterns and sequences of growth and/or change as a function of time. Research Instrument: Since the data was primary, Questionnaire is chosen as the research instrument. Sampling: The sample consists of all the SBI and ICICI banks in Delhi region. Data Requirement SAMPLE SIZE In this project being aware of time and cost constraints sample size was limited to 100 banks. Research Design A research design is the arrangement of conditions for collection and analysis of data in a manner that aims to combine relevance to the research purpose with economy in procedure. It constitutes the framework for the collection, measurement and analysis of data. It provides the empirical and logical basis for getting knowledge and drawing conclusions. The research design in the study is of exploratory research. Various methods are utilized in order to gain the information and to interpret it in most rational and objective manner. The entire list of sample unit is known as sample frame. Table 3.1: Research Design Types of Research Design Exploratory Research Design Source of Data Primary data : Questionnaire, Survey method Secondary data : Internet, Magazines and Newspapers Research Equipment Questionnaire Sampling Technique Ratio analysis, Gap analysis, Lending to private sector Sample Size 100 banks Area of Research Delhi Method of Data Collection DATA COLLECTION There are two methods of data collection. Internal sources External sources Internal sources Internal sources are all the companies own records, registers, documents, etc. External sources All other sources of information are external sources of data. Another was of classifying the sources of information. Primary sources Secondary sources Primary Sources Questionnaire has been prepared on the basis of Likert Scale and sent to selected two banks to ascertain their degree of readiness for risk management on various parameters and information is collected through in depth personal interview of senior officers and employees of two banks. Secondary Sources Information has also been obtained through desk research such as (a) Annual reports of the banks (b) Indian Bank Association Bulletin (c) RBI Bulletin (d) Report on trends and progress of banking in India OTHER SOURCES: Elements: Banks and their employees Sampling unit: Banks Extent: Delhi Survey Time: 6 Months Other factors that contribute to the sample plan are as follows: Sample size: 100 banks questioned. Area covered: Delhi Approached: 200 employees were approached to complete the sample size. Method for Data Analysis RATIO ANALYSIS (ANNEXURE 2) To evaluate the financial condition, performance and profitability banks requires certain yardsticks .The following various accounting tools have been used. Core Deposits / Total Assets Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits Volatile Liabilities / Total Assets Where Volatile liabilities = Demand + Term deposits of other banks Short term Assets / Total Assets Where short term assets = Cash Bank Balance + Receivable + Bills Receivable + short term / demand advances Credit Deposit Ratio: Higher deposit ratio indicates poor liquidity position of a bank vice versa. The ratio is calculated as follows: Loans and Advances / Total Deposits Cost of Funds: Total Interest Expense / Interest bearing liabilities; where interest bearing liabilities = Deposits + Borrowings Net Interest Margin : Net Interest Income / Earning Assets; where Net Interest Income = Total Interest Income Total Interest Expenses Earning Assets = All Interest earning assets (Total Assets Cash Balances Fixed Assets Other Asset) The impact of volatility on the short-term profits is measured by Net Interest Margin. Spread = Yield Cost of funds Return on Average Assets (ROA): This ratio is relationship between the net profit (after tax and interest) and the total assets of the bank. It is calculated as follows: ROA = (Net profit after tax + Interest) / Total assets Return on Equity (ROE): Shareholders are the real owner of the organization, so they are more interested in profitability and performance of an organization. This is calculated as follows: ROE = Net profit after interest, tax and preference dividend / Equity Shareholders Funds Capital Adequacy Ratio (TABLE 6.1) This ratio strengthens the capital base of bank. The paid up capital reserves of bank form an adequate percentage of assets of banks, their investments, loans and advances. All these items are assigned weights according to prescribed risks and the ratio so computed is known as capital adequacy ratio. Overhead Efficiency: Overhead Efficiency = Non-Interest Income / Non-Interest Expense Profit Margin: Profit margin = Net Income / Total Revenue Burden / Spread Where Burden is the Net Non-Interest Income and Spread is the Net Interest Expense Gap Analysis (ANNEXURE 3) A structured questionnaire has been used for this research which was carefully designed keeping the entire objective in mind. CONTACT METHOD Contact method used in this project is personal interview. The methods of collecting information through personal interviews are usually carried out in a structured way. Table 3.2: Conducting the Research CONDUCTING THE RESEARCH PHASE DESCRIPTION OBJECTIVE TIME Phase 1 Secondary Research-Study results of past research Understanding the Banking segment 5 Week Phase 2 Questionnaire drafting, dummy survey Finding out the parameters which affect their risk readiness 7 Week Phase 3 Primary Research-Banks Survey Perception and behavior of Indian Banking segment 7 Week Phase 4 Data analysis Report preparation Finding out the factors affecting the readiness to Risk. 5 Weeks Methodological Review However, the researcher has made every possible effort to a great extent level to show how selected sample of banks analyze the credit risk. But the study at the disposal of a researcher on this level is limited. In addition to other factor such as time that plays a very important role in every field of todays life has also an important bearing on research work. The main limitations of the present study are as follows: Present research is geographically restricted to one country; hence the result cannot be exploited to other places. The sample size is small due to insufficient time allotment. The seriousness of the respondent and the ability to justify the answers were also one among the limitations. The study is restricted only to two banks. All data and information collected is true to some specific period of time. The study hasnt got the wider scope as only two banks are being considered for evaluating risk management. It was difficult to have group discussi ons with experts due to their busy schedules. CHAPTER 6 FINDINGS AND DISCUSSIONS An in-depth analysis on the risk management systems of the two banks was done. Different measures undertaken by the two banks were examined with special focus on the guidelines issued by RBI in the recent years. As suggested by RBI, banks have paid special attention in developing effective risk management architecture. Some of the parameters measuring the degree of readiness for risk management based on the analysis of annual reports and responses to the questionnaire and the personal meetings with senior risk professionals in banks are as follows: Exposure to Sensitive Sectors SBI seems to be ahead of ICICI Bank in limiting exposures to key sensitive sectors like capital markets, real estate and commodities. Moreover over the last 3 years, SBI has successfully reduced their exposure contrary to ICICI Bank, whose exposure has been soaring. Maintaining Capital Adequacy Ratio Both the banks are maintaining a capital adequacy well above 10%, which is higher than Basel II recommendations (8%) as well as RBI guidelines (9%) (Table 6.1) Internal Credit Rating Model Both the banks follow internal credit rating model. It demonstrates the adoption of scientific approach to credit risks in Indian Banking sector. Compilation of Migration and Default Statistics Its only SBI which track probability of default and rating migration and same is in case of tracking loss given default. However, there were no comments on this from ICICI Bank. Moreover, both banks report that contingent liabilities fall within purview of their risk management processes. On the matter of Exposure Limits all the banks surveyed define it in terms of counter party, group and industry Frequency of Loan account review In this parameter ICICI Bank and SBI both review loans after every three months or six months. As regular analysis of the loan portfolio feeds into banks lending strategy. Evaluating Credit Risk at Portfolio level To have a comprehensive understanding of credit risk, banks evaluate credit risk at portfolio level. ICICI bank carries out such analysis whereas in public sector banks this analysis is carried out only by SBI. This is in line with the RBI guidelines to adopt portfolio approach for managing credit risk. RAROC for pricing of Loans Both the banks use RAROC (Risk Adjusted Return on Capital) for pricing of loans. The same has also been outlined by RBI in their guidelines from time to time. NII (Net Interest Income) Sensitivity Analysis Both banks are carrying out regular NII Sensitivity Analysis. ALCO decides product pricing Banks surveyed report that their ALCO (Asset Liability Committee) decides product pricing. Periodic Review of Liquidity Position Both the banks periodically review their liquidity position under normal and stress scenarios. The result from this study shows that in addition to credit risk, interest rate risk is also important in Indian banking system. The potential impact of interest rate shocks upon equity capital of surveyed banks in system seems to be economically significant. Daily Mark-to-Market of Trading Portfolio In this area a substantial divergence of practices is found between private sector banks and public sector banks. Both the banks that have been taken in this study are carrying out Mark to Market trading portfolio. Where as many public or private banks are not doing this. Daily VaR (Value at Risk ) of Investment Portfolio SBI and ICICI Banks calculate a daily Value at Risk (VaR) of trading portfolio whereas many other banks in public and private sectors have fixed their own timeframe for moving to Value at Risk and Duration approach for measurement of interest rate risk. Limits on Derivative transactions This is one of the essential components of market risk control. Both the banks have placed limits on derivative transactions. This is all due to strong monitoring and control system that derivative activity takes place in these banks. They should maintain a certain level of investment fluctuation reserve to guard against any possible reversal of interest rate. Between the two banks in our sample no bank proves to have significant reverse exposures in the sense that they stand to earn profits in event of when interest rate goes up. They both seemed to fairly hedged w.r.t interest rate risk. While putting the risk management in place SBI finds it difficult to collect reliable data. The challenge is mainly in the area of operational risk where there is dearth of reliable historic data and not a great deal of clarity of the measurement of risk. ICICI bank has sophisticated technologies. CHAPTER 7 CONCLUSIONS AND RECOMMENDATIONS The different variances of credit risks faced by the bank were examined in great detail throughout this report. A countrys financial health is greatly dependent on the condition of their banking system. The constant changing business environment along with recent bouts of recession makes risk management critical for supporting a countrys growth. Recent examples from the financial crisis in the US clearly outline the importance of risk management systems. Along with risk management systems, an efficient supervision is also required on the part of the regulators. The present chapter is divided into two sections. First part consists of major Conclusions of study and second part comprises of its Recommendations. Conclusions initiate further refinements in the existing structure while recommendations provide better guidelines in the efficient working of the organization. Key conclusions from the study are as follows: There is much greater awareness across the banking sector abo ut the need for risk management and the various categories of risk which banks are exposed to. A separate credit risk department distinct from credit function has been set up in both the surveyed banks. Core Deposits/Total Assets showed the better liquidity position of PSU banks while private sector also has been improving upon its ratio. Volatile Liabilities/Total Assets also showed that lesser credit and liquidity risk faced by SBI than ICICI. It should stop relying more on large deposits made by other banks so that the exposure to liquidity risk would be less. Short term assets/Total Assets: this ratio showed a very steady figure. Here the standard deviation for private banks is very large. Investments/Total Assets: This shows a better position of public banks as invest mainly in less risky areas as government securities. Indian banks seem to be maintaining the minimum capital adequacy ratio proposed under Basel II. Exposure to sensitive sectors is not managed w ell by ICICI, which might be the general theme in case of private banks. Degree of readiness for integrated risk management among banks differs widely. As there are banks which have several years risk data and sophisticated risk models, there are also other banks, which have started the process of systematic capturing of risk data. Moreover each bank going for risk management implementation is faced with question of whether to outsource and if so how much and to whom. Selection processes for vendors are long drawn and implementation gets delayed on account of time taken to freeze requirements and fine-tunes specifications. Banks are facing significant challenge in rolling out IT networks. The banks on the software front could not entail investments in databases, data warehousing and in sophisticated statistical models as aggregation and analysis of the vast amount of data is needed for successful risk management system. Training for supervisory cadres is not given in ban ks for understanding the critical issues raised under Basel II. Banks surveyed dont have expertise in risk modeling. Thats why they seek the services of global consultants like KPMG, Price house water coopers, TCS and many more. These consultants identify the gaps in system and help banks in devising risk return model. Risk management solutions have been mainly used to calculate credit risk. Its in the area of operational risk that most firms will make fresh investments. The following recommendations are worth mentioning: Risk Management System should be in place to deal with current and potential risks. Timeliness is recommended for progress of the components of risk management. Quarterly progress reports should be made which is an effective way of keeping track of progress made by each bank. Regulatory and legal issues need to be taken into account while setting up the risk management system. There should be an active participation of senior management and main line functional staff in setting up of risk management system, which will enhance the acceptability of adopting the risk management measures by the employees. Remedial actions required to reduce exposure to sensitive sectors Some of the guidelines outlined by RBI are yet to be worked upon by the banks. Specific issues include absence of appropriate credit risk modeling and lack of expertise in developing internal models. Today banks are facing an array of new and more complex risks due to increasing pace of change in technology, globalization, mergers and acquisitions, downsizing and regulatory . CHAPTER 8