Risk Management: A Safety Net For Banking

Risk management is all about being proactive rather than reactive. The survival of an organisation depends heavily on its ability to anticipate and prepare for change rather than simply waiting for change and then reacting to it. The Indian banking industry was among few around the world that managed to ride out the financial whirlwind post the Lehman Brothers crisis. This underscores the risk management ability of our banking sector.

The credit for this must go to our regulator, whose norms have been always been a couple of notches more stringent than the Basel regulations, a set of international banking regulations put forth by the Basel Committee on Banking Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimising credit risk.

Banks in India have responded well to the Basel I and Basel II norms and are now preparing for Basel III. The real challenge is the quality of capital prescribed in the Basel III norms. Till Basel II, banks could have managed the capital with Tier I and Tier II. Now, they have to ensure not only the quantity but also the quality of capital. Common equity and retained earnings should now become the predominant component of Tier I capital instead of debt-like instruments well above the current 50 per cent rule. The minimum Tier I capital requirement has also been increased from 2 per cent to 4.5 per cent, with additional conservation buffer of 2.5 per cent. Banks have to be sure that they are able to raise capital from the markets. The moment they go public, they have to adhere to many disclosures and have to become sensitive towards the financial performance that they are expected to deliver on a quarterly and yearly basis.

One good thing that has happened in the banking industry is that all the nationalised banks have gone public. More and more transparency has been introduced in the banking industry. As a result of that, everyone is fully sensitised to the need of the hour.

Beside this, banks have to lay additional thrust on human resources, but nothing has happened on that front so far. Banks, especially public sector banks, are churning the retirees with new inductees. The benefit of new inductees is that they are typically tech savvy, but of course, at the same time banks are losing the experience of those who are retiring. Banks will need to maintain equilibrium. This means that proper induction of new employees is needed, and a lot of thrust needs to be put on skill development. If all that is taken care of, there is a good chance that the risk can be contained.

Due to the operational risks associated with the use of technology, information security is an area that is gaining importance. Issues related with information security, data integrity and storage as also communication channels have acquired challenging dimensions in the electronic environment. IT management systems in banks have to be robust enough to meet these new challenges effectively on a continuing basis.

Going forward, banks will need to move towards the higher capital standards mandated by the Basel III, maintain stricter liquidity and leverage ratios and a more cautious approach to risk. This may entail improve efficiency even as the cost of doing business goes up. They will need to refine their skills for enterprise-wide risk management. In addition, banks need to have in place a fair and differentiated risk pricing of products and services since capital comes at a cost. This involves costing, a quantitative assessment of revenue streams from each product and service and an efficient transfer-pricing mechanism that would determine capital allocation.