Banking Risk Management in India and RBI Supervision

Abstract

There are three main categories of risks as mentioned in the new capital accord: Credit Risk, Market Risk and Operational Risk. Credit risk or Default risk, a major source of loss, is the risk that customers fail to comply with their obligations to service debt. Major credit risk components are exposure, likelihood of default, or of a deterioration of credit standing, and the recoveries under default. Modelling default probability directly with credit risk models remains a major challenge, not addressed until recent years. Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. Market risk management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank's business strategy. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, and performance failure, compromise on the interest of the bank resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective risk management tool. The practical difficulties lie in agreeing on a common classification of events and on the data gathering process.This paper commences with the study of Risks associated with commercial banks. The purpose of the study is to first identify all the possible risks faced by banks like risk revolving on capital, credit risk, market risk, liquidity risk, earnings risk, business strategy risk, environmental risk, operational risk, group risk, internal control risk, organizational risk, management risk and compliance risk. It will be followed by the understanding of the risk management process which includes the sound practices adopted by banks, the risk mitigation tools and models used for combating each category of risk. The second phase includes the study of the progress made by them in implementation of risk management guidelines issued by Reserve Bank of India highlighting particular difficulties and challenges faced by them. The last phase includes the understanding of the risk based supervision of banks by RBI. A risk-based approach enhances supervision in three ways. It focuses supervisory resources on the areas of highest risk within individual banks. It uses a common framework and common terminology, developed specifically for risk-based supervision, to assess risks and evaluate management practices, policies, and procedures in the context of managing risks; that is, optimizing returns while minimizing the adverse consequences of risk-taking. Finally, it incorporates an assessment of management's ability to deal with risks beyond the control of management, such as systemic risks and risks in the economic environment in which the bank operates.