risk management indian banking industry

7/31/2019 Risk Management Indian Banking Industry

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Future of Risk Management in Indian

Banking Industry

The Indian Economy is booming on the back of strong economic policies and a healthyregulatory regime. The effects of this are far-reaching and have the potential to ultimatelyachieve the high growth rates that the country is yearning for. The banking system lies at thenucleus of a country's development robust reforms are needed in India's case to fulfill that. TheBASEL II accord from the Bank of International Settlements attempts to put in place soundframeworks of measuring and quantifying the risks associated with banking operations. The paper seeks to showcase the changes that will emerge as a result of banks adopting

the international norms.

The structure of the paper is three-fold, where we begin by projecting the risk managementscenario and its effects on internal operations of a bank, followed by the changes brought aboutin the banking sector of India and finally the macro effects on the economy. This enables one todiscern the complete scenario that will emerge in the years ahead.

The Risk Management scenario will strengthen owing to the liberalization, regulation andintegration with global markets. Management of risks will be carried out proactively and quality

of credit will improve, leading to a stronger financial sector.

The calculation of risk will be done by credit scoring models such as Altman's Z Score Model &Merton Model but in a more sophisticated and developed manner. The management informationsystems (MIS) will be put in place and the level of efficiencies will increase more thanproportionately. Risk based pricing will be used for all credit facilities extended by banks. Thetreasury departments of banks are poised to benefit from the BASEL II accord as would beshowcased in the paper.

The future will see a structural change in the banking sector marked by consolidation and ashake-out within the sector. The smaller banks would not have sufficient resources to withstandthe intense competition of the sector. Banks would evolve to be a complete and pure financialservices provider, catering to all the financial needs of the economy. Flow of capital will increaseand setting up of bases in foreign countries will become commonplace.

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Finally, the economy will stand to benefit as the banking sector develops. Savings will bemobilized in the right direction and the required funds needed for the country's development willbe made available.

1.0 Introduction

The Indian Financial System is tasting success of a decade of financial sector reforms. Theeconomy 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 improvedthe asset quality and profitability of banks.

Growing integration of economies and the markets around the world is making global banking areality.

Widespread use of internet banking has widened frontiers of global banking, and it is nowpossible to market financial products and services on a global basis. In the coming yearsglobalization would spread further on account of the likely opening up of financial servicesunder WTO. India is one of the 104 signatories of Financial Services Agreement (FSA) of 1997.Thereby giving India's financial sector including banks an opportunity to expand their businesson a quid pro quo basis.

As in different sectors, competition is driving growth in the banking sector also. The RBIrequires all banks to comply with the standardized approach of the BASEL II accord by 31stMarch, 2007. The quantification and accounting of various risks would result in a more robustrisk management system in the industry.

This paper attempts to project the implications of this transition and its effects on the internaloperations of a bank followed by its effects on the banking industry and the economy.

2.0 RISK Management Scenario in the Future

Risk management activities will be more pronounced in future banking because of liberalization,deregulation and global integration of financial markets. This would be adding depth anddimension to the banking risks. As the risks are correlated, exposure to one risk may lead toanother risk, therefore management of risks in a proactive, efficient & integrated manner will bethe strength of the successful banks. The standardized approach would be implemented by 31st



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March 2007, and the forward-looking banks would be in the process of placing their MIS for thecollection of data required for the calculation of Probability of Default (PD), Exposure at Default(EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD datafor five years and LGD and EAD data for seven years.

Presently most Indian banks do not possess the data required for the calculation of their LGDs.Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgradedsubstantially if the banks want to migrate to the IRB Approach.

Although many banks would be working towards the IRB Approach, the authors are of theopinion that RBI would have allowed a few banks to implement and follow the IRB Approach bythe year 2015. Indian banks would be moving upward on the strategic continuum of risk scoringmodels as can be seen in the diagram on the previous page.

2.1 BASEL II Effects on Internal Operations

Once implemented, the BASEL II norms would greatly influence the internal operations of abank the effects of which, would be clearly visible in 2015. In this section, we analyze the extentof change brought about by the norms.



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2.11 Risk Management Department's Role

The Risk Department would gain prominence within the banks as they would be playing anextremely critical role in the management of the risks of the bank. Streamlining of informationand data flow through the Risk Department would be essential in calculation and management of

risks.

2.111 Calculation of Risks & CAR

Calculation of risk would be an essential requirement in the banks as they would be in theprocess of calculating not only the Credit Risk but also the Market Risk and the OperationalRisks that the bank would be facing. The capital to be set off for advances made by the bankwould depend largely upon the fair and accurate calculation of these risks. In 2005 five creditrisk models have received global acceptance as benchmarks for measuring stand-alone as well as

portfolio credit risk. They are: -

I. Altman's Z Score ModelII. Merton ModelIII. KMV Model for measuring default riskIV. Credit MetricsV. Credit Risk+

These models would get more sophisticated and the banks would have more options as othermodels would gain acceptance. For Market Risks the banks would be employing other modelssuch as VaR, Monte Carlo Simulation etc. As for the Operational Risks the banks would be

following internal risk frameworks in assessing significant operational risks and their mitigation.

2.112 Risk-Based Pricing

Risk-based Pricing is the technique of charging different interest rates from two differentcustomers on the same type of loans, depending on the risk attributed to each of them. Under thismethod credit scores are calculated for individuals, taking into consideration various factorswhich are assumed to represent the individual's willingness and capacity to repay the loaninstallments. As the banks would be in the process of moving toward the IRB Approach theywould be armed with the knowledge of the risks associated with the various types of exposures.This knowledge would help the banks in passing on the charge arising from higher credit risk to

the customers. The authors are of the opinion that Risk-Based Pricing would be the norm of thebanking industry in another ten years.

2.12 Technology (MIS)



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Indian banks would invest in development of Information Systems as MIS would play anessential role in the calculation of LGD, EAD and PD. As the banks are expected to integratevarious financial services to provide a one-stop shop to the customers, MIS would be helpful tothe banks in cross-selling and other marketing-related activities. The settings up of such systemsare expected to reach completion by 2015 for most banks.

2.13 Strengthening of Treasury Operations

The spreads relating to core banking business of credit and deposit interest rates would narrowdown. Also, if the bank enjoys low PD and LGD it would have larger amount of funds availableto it, as its regulatory capital requirements would come down. The banks would have to searchfor alternative profit generating avenues in the form of float fund management, therebystrengthening their treasury operations, which will be a thrust area in the coming years.

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Human Resource Development

More emphasis would be given to the human resources of the bank as Basel II would requirebanks to calculate and manage risks continuously. One of the key requirements of the newAccord is monitoring... the risk of direct or indirect loss resulting from inadequate or failedinternal processes, people and systems... The composition of skills required to perform in thenew environment would undergo a change.

This change will force banks to invest in educating its work force in various risk-scoring models

and enabling them to acquire skills to tap the full potential that the market offers. TheOperational Risk requirements of Basel II Accord extend deep into corporate procedures thatmay not seem obviously connected to financial risk management. HR systems, for example, mustensure that procedures and documents surrounding such tasks as staffing, education and systemmaintenance, are properly recorded and documented, and that organization charts and lines ofresponsibility can be tracked and reported as required. Banks would be required to address issuessuch as manpower planning, selection and deployment of staff and training them in RiskManagement and Risk Audit. Hence, it is assumed that the banks that would have sound HRpolicies and practices in place.

2.15 Emphasis on Corporate Governance

In the future, there would be greater emphasis on corporate governance in banks becausebanking supervision cannot function as well if sound corporate governance is not in place and,consequently, banking supervisors have a strong interest in ensuring that there is effectivecorporate governance at every banking organization. Supervisory experience underscores the



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necessity of having the appropriate levels of accountability and checks balances within eachbank.

2.2 BASEL II Effects on Banking Industry

The banking sector in will continue on the growth trajectory and would further integrate into theglobal financial system.

2.21 Consolidation

The trend in the Indian banking industry suggests that the industry is moving from a "largenumber of small players" towards a "small number of large players". There would be three

reasons for the consolidation in the industry: -

I. Increased competition from foreign as well as domestic banks after deregulation andliberalization of the Indian banking industry. It would be very difficult for smaller banks tocorrectly price their loans and they would lose out on customers with low probability of defaultto larger banks, who would offer them lower interest rates and they would end up with customerswith high probability of default, which would be offered higher interest rates by the larger banks.The only way the banks would be able to survive would be by growing in size, and mergers andacquisition would be the preferred path to growth. This trend has already started as can be seenby the spurt of mergers that have taken place during recent times (Times Bank and HDFC Bank(2000-01), ICICI Bank with Bank of Madura(2002) and subsequently with ICICI Ltd.(2002),

Benares State Bank and BoB(2003), Global Trust Bank with Oriental bank of Commerce(2005).)

II. To attain the benefits of IRB Approach like lower capital adequacy requirements, betterimage, etc., the banks would require investment in its risk management models as well asinformation systems. It could be difficult for a small sized bank to undertake these investments.

III. Integration of financial services, for example insurance, brokering, consultancy etc. will takeplace making the banks a delivery channel for a host of financial products and services.

2.22 Increased Capital in the Market



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The authors are of the view that in the future the banks would follow the strategy of low defaultsand narrower spreads. This would bring down their CAR requirements, freeing up more fundsthat could be invested in the economy. Another point to be noticed is that the banks would havein place more sophisticated credit scoring models and they would be able to invest in moreprofitable and less risky avenues thereby improving the efficiency of the capital markets.

2.23 Systemic Risk

Although the banks would benefit by having more free funds available, taking a macro view ofthe system we might see the systemic risk going down. The rationale behind this statement is thatthe bank's risk models would have developed and become more sophisticated. They would notonly take into account various characteristics of the borrower but also the future economiccondition. The banks would become more robust and efficient thereby contributing to thereduction of systemic risk.

2.24 International Scope

With better utilization of capital, rollover of bank's funds through securitization and efficiency inoperations, Indian banks would become competitive in the international markets. Theconsolidation of banks would give them the requisite size and compliance with the Basel IIAccord would give them greater efficiencies in management thereby making them competent forthe international market. As per Indian Banks' Association report "Banking Industry Vision2010", there would be greater presence of international players in Indian financial system andsome of the Indian banks would become global players in the coming years. So, one can envisionIndian banks going global in search of new markets, customers and profits.

The following points provide further insight on the expected banking scenario. Although, notdirect consequences of the BASEL norms these structural changes will be a fall-out of thereforms in the banking sector.

The implementation of the 2nd phase of the RBI's roadmap to reform in 2009, would allowforeign bank ownership of any local private bank, within an overall limit of 74%. These foreignbanks would bring with them technological and management skills and improved efficiency.

RBI's role in the banking industryRBI would be in the process of shifting to risk-based supervision (RBS) wherein the focus of itssupervisory attention on the banks is in accordance with the risk each bank poses to itself and thesystem. The inceptions of RBS will require banks to reorient their original setup towards RBSand put in place an efficient Risk Management architecture, internal auditing focusing on risk,strengthening MIS and set up of compliance units.



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Slimming & Trimming of the Indian BanksEmphasis would be given to automation and outsourcing of different services would be done soas to enable the banks to tackle the increasing volumes of business effectively. Customer-Bankercontact will be reduced to the bare minimum as it would be a paperless banking era, dominatedby plastic money, electro-banking, and tele-banking.

2.3 BASEL II Effects on Economy

The Indian households have not shown great faith in the country's financial systems, this isshown by the enormous gold consumption that the country has. Indians possess around $200Billion of gold, equal to nearly half of the country's bank deposits. The Indian governmentreckons that approximately $150 Billion is required over the next ten years to upgrade thecountry's infrastructure. The government has proposed to use its foreign-exchange reserves tofinance these investments, but this would add only $3-$5 billion annually. Domestic savings are

the only plausible source of extra funding.

The authors believe that this is due to the lack of transparency and household's perception of theIndian financial system as being weak. Basel II encourages more transparency and goodcorporate governance policies as disclosures are required to be made by the banks, under PillarIII (Market Discipline). This would help in gaining the trust of Indian households who would inturn increase their participation in the financial assets, which would benefit the country as thesavings would be pooled to finance more important and productive investments.

There would be increased availability of funds for the rural markets as the banks would increasetheir penetration in the rural sectors. This would be done as the banks would have excess funds athand, due to reduced Capital Adequacy Requirements by employing good credit risk models inplace.

Both the corporate and consumer clients would be enjoying decreased interest rates andincreased availability of funds.

3:0 Conclusion

India's growth potential over the next 10 years sets the country at the forefront of the developingworld. The authors firmly believe that Indian banks would capitalize on the opportunity availableto them and the continuations of the reforms initiated over one decade ago will unleash theirpotential and bring India to a more advanced stage of development.



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Concluded.

The Future Banking Services

Banking industry is going through a rapid transition phase all over the world. Small banksare facing a fierce competition from the big players. Virtual banks in Internet arechallenging the traditional banking system and global boundaries are being smashed day-after-day that gives birth to a small global village. Plato said once "The unexamined life isnot worth living". So let us understand what will be thefuture of retail banking after25-30 years? What are the services you can expect from them?

The scale of the global opportunities, the complexity of the competitive arena, and therelentless performance discipline imposed by the capital markets will force all the bankseither to specialize and become world class in their chosen field, or exit. There will be nosmall banks in national or regional level as they would either be taken over by the multi-

national banks or they would exit from the business, forced by the global competition.Banks will be the one-stop shop for all your personal finance needs. Nevertheless, banks willadopt the loyalty-based competitiveness to make you bank with them assuring highest levelof customer satisfaction.

Banking Network: The number of ATMs will be very high and all the banks will be sharingthe each others ATM network due to space problem and to reduce the cost of operation.Presently, traditional banking costs the banks more than a Dollar per person, ATM bankingcosts 27 Cents and Internet banking costs below 4 Cents approximately. Banks will tryreduce the banking costs more but there will always be a high demand for face-to-faceinteraction from customer side - indicates Mckinsey Quarterly Research.

Service Offerings: Banks will be a one-stop shop for all your personal finance needs. Youwill get all insurance products and broking services to trade in the share market apart fromall the possible banking services. Balancing customer needs in retail banking distribution willbe a crucial factor for the success of the banks. Regulatory hassles will be too less and thereis a high possibility that Investment banks, Insurance companies and Retail Banks willintegrate their operation in parts to serve the customers better. Wireless financial services,an important part of m-commerce will offer consumers a new level of convenience in anincreasingly busy world with high-speed technology. BCG estimates that within few years,hundreds of millions of people worldwide will use m-commerce applications, generatingbusiness-to-consumer revenues of up to $100 billion.

Social Responsibility: Banks will take the role of social institutions and will act as socialadvisors. Personal finance advisory services will be available in your mobile devise from

time to time, indicates Boston Consulting Groups research. Banks will be the most powerfulsocial institutions, as they will hold the individuals money. The level of personalization willbe too high and you will be offered services like day-to-day spending management. You canactually pre-program your yearly budget at a particular time and thus your mobile devicewill alert you if you exceed your days spending.

Loyalty Based Competition: The concept of Boston Consultancy Groups Time basedcompetitiveness may face a challenge from the concept of Loyalty based competitiveness.In other words, when all the banks start offering the highest level of customer satisfaction,



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customers will be confused and then banks will try to create the ultimate loyalty program tomake sure, you will stick to the bank for quite a long time. The quest for loyalty will re-shape the customer satisfaction and you will experience far better privilege than now-a-days with bundle of benefits at less cost.

All the banks in future will fight with uncertainty and complexity due to the rapid global

changes. The uncertainty creates fear and complexity creates confusion. Therefore, they willtry to be the excellent customer oriented banks to serve you better to ensure their survival.



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Banking on the future

By Patricia Howell, senior analyst, Financial Insights, IDC CanadaBanking may be driven by relationships, but it is through

technology that the goods are delivered. To put this in perspective, consider that Canadianorganizations will spend in excess of $39 billion (all amounts in Canadian dollars) oninformation technology (IT) goods and services in 2006. Financial Services represents 18percent, or $6.9 billion, of that spend, making it the single largest vertical market for IT goodsand services. Canadian banks dominate the domestic financial services patch, representing $4.3billion, or 62 percent, of the vertical's IT product and services spending in 2006 (44 percent ofthat can be attributed to the big five banks: CIBC, BMO, TDCT, RBC, and Scotiabank).

Canadian banks have always been and will continue to be shaped by advances and investment intechnology. But what form will the bank of the future take? This is a question that bankexecutives have grappled with for years, and the vision varies depending on the strategic

objectives of each institution.

Banks are perpetually looking to increase productivity and drive cost efficiency. With theexception of emerging markets, the banking industry is mature, and its players must continue togrow or become marginalized. This is especially important to banks in Canada and worldwide ina rising interest rate environment where the costs of funds rise more rapidly than asset yields.While this is not new, the realities of operating in a mature market are starting to hit home as"the low hanging fruit" associated with expense reduction is quickly being consumed. Thisleaves banks in the often-uncomfortable position of having to spend more to save more. Thechallenge is how to optimize operational efficiencies given legacy investments and demands forimproved capabilities. Banks will seek to address this challenge on many fronts, including

fundamental changes in their foundations and using emerging technologies to support their needsfor continued organic growth.

Changes to the foundations

The "industrialization of banking" is an idea that has been borrowed from the manufacturingindustry. By transforming or industrializing their business operations, banks are extending theintegration of business process management beyond individual departments or lines of businessacross the enterprise to improve service quality and increase productivity. Applying a frameworkfor workflow and underlying business rules can help to improve, normalize, and unify internalprocesses (e.g., exception management). This will fuel the integration of bank workflow

processes with customers, partners, and counter-parties.

Dynamic IT, or Service-Oriented Architecture (SOA), focuses on transforming the managementof IT and rebuilding IT infrastructure to support business processes. Spanning back, middle, andfront offices, the development of SOA, to support real-time requirements as well as centralizedtransaction warehouses, will connect previously autonomous check, electronic funds transfer(EFT), and product processing systems with customer information. Information normalization



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and messaging technologies will dynamically serve up content to staff and customers throughfront- and middle-office systems.

Aging core banking systems are proving to be the "Achilles heel" of many banks, driving upcosts and severely impacting their agility and flexibility. While a wholesale rush to core banking

replacement is not anticipated, the idea has started to resonate in Canadian banking circles.Whether considering a major "heart and lung transplant" or a much less invasive surgery, thecomplexity of these initiatives will likely keep them on an institution's agenda for many years tocome.

Top of page

Investing for organic growth

Deprived of the ability, at least for now, to grow through mergers and acquisitions, and realizingthat they cant cut their way to profitable growth, Canadian banks are also looking to technology

to enable new sources of revenue. One of the manifestations of this focus on organic growth isinvestment in channel technology, particularly branches and the Internet. Although banks havebeen investing heavily in their Internet channels since the late 1990s, they were not leveraging acoordinated or integrated channel strategy. At the time, branches were less important, but nowbranch renewal initiatives that take advantage of face-to-face customer contact are moreimportant than ever. Banks are expanding their branch networks to gain greater marketpenetration and expand their share of customer wallet.

As they search for new sources of fee-based revenues, new product and service development willbe critical. On the corporate side of the business, banks are looking for ways to provide straight-through processing of payments and information-based services. This has been triggered by

supply chain events with corporate customers, and banks are using this as a means to deepenrelationships and generate new revenue streams.

The Canadian banking sector is striving for increased efficiencies and organic growth whilestruggling to defend their turf against new market entrants and manage the ever-increasingcomplexity of the financial services industry. Technology has long been a key enabler within theindustry, and going forward, from near-term operational tactics to long-term transformationalinitiatives, Canadian banks will continue to invest in IT in order to achieve their goals.

Thursday, 11 February 2010.



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For any country to witness sustainable growth and development, the banking industry must bevibrant and capable of equitable distribution of funds so that all the sectors of the economy haveaccess to it. Unfortunately, for a very long time, the future of banking has been left to chance andthis has caused the country a great loss. More worrisome is the crisis of confidence occasioned

by incessant corporate governance abuses by the practitioners of the noble profession.

The situation was compounded by the global economic crisis which has had great negativeimpact on the operations of the local banks. Indeed, a recent study that covered many countriessuggests that output losses during banking crises were put at about 10 percent of annual GrossDomestic Product (GDP) on the average. In addition, bank lending and profitability have oftenremained subdued for years afterwards. Considering the huge consequences of a banking crisis,the future of banking cannot be left for bankers alone to decide.

An element of the importance of the banking industry is best expressed by the fact that manybusinesses in Nigeria started shedding jobs before banks did last December, and their revenue

and earnings began to shrink even before those of banks. In fact, the consequences of bankingcrisis are usually worse outside the industry.

Indeed, it is for this reason, more than anything else, that BusinessDay is today organising aconference in Lagos with both international and local experts in attendance to discuss the futureof banking in Nigeria after the recent intervention by the Central Bank of Nigeria, (CBN)

With issues such as options for recapitalising bailed-out banks, risk management, corporategovernance and regulation, insuring depositors' funds among others to be deliberated upon byaccomplished professionals in their various disciplines, a new path is expected to be charted forthe banking industry.

It is on record that CBN's swift response to the crisis, through injection of funds, lendingguarantees and funding lines, and appointment of interim management to run the identifiedtroubled banks, has no doubt brought some sanity into the system.

We must collectively strive to correct the failings of the last year. The understanding of thefailings is very critical, and the future of banking reforms must be clear and relevant. This is whythe deliberations and resolutions from today's conference are expected to go a long way inproviding further solutions to the crisis in the industry.

However, there is need for the deliberations to be based on the need to correct the four planks ofthe present crisis, which are poor risk management, poor corporate governance, concentratedtrade finance lending, and poor regulation.

Indeed, the next line of action by CBN should be adequately discussed. For instance, the need forclose monitoring of the activities of the interim management it appointed and the need for aclearly defined job description so as to smoothen its eventual exit from the banks.



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Of particular importance is the need for an inbuilt exit arrangement that bothers on continuousbalance sheets reconstruction, dealing with impaired assets, the operations of the AssetManagement Company (AMC), and options for recapitalisation, among others.

The apex bank will assist in minimising the complications and uncertainty in the industry today

by describing very clearly its resolution strategy, or at least, the principles that will guide thisstrategy, as absence of such description could continue to generate some measure of uncertainty,make its exit plan difficult, and of course, discourage new private sector recapitalisation andinvestments.

But besides the exit plan, the CBN will do well to improve the regulatory infrastructure of thebanking industry. Interestingly, it has accepted that it had lapses as well and is prepared tocorrect those lapses and, hopefully, in record time.

MUMBAI: Reserve Bank of India Deputy Governor, K C Chakrabarty on Monday said Indian banking

system may increasingly face the problem of staff- attrition in the period ahead and banks will have to

gear up to tackle the issue.

"We are going to see rise in attrition rate. There is a need for adequate focus on HR management...

banks need to take adequate care of their manpower," Chakrabarty said at Bancon conference here.

Banks did not put adequate attention to improve their human resource talent, Chakrabarty said, forbetter efficiency, banks need to educate their staff to enhance their skills.

McKinsey Associate Partner, Supriyo Sinha said that nearly 63,000 employees of public-sector banks will

retire from the service over the next three years and banks will have to devise ways to overcome this

challenge.


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