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BW Businessworld

The Chance Arbitrage

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At a recent conference on international finance and banking, Reserve Bank governor D. Subbarao emphasised the need to upgrade risk management architectures for Indian banks in a rapidly globalising and fiercely competitive banking environment. It was in this context, BW-PwC carried out a risk-quotient survey to get a snapshot of the risk management practices among banks. The survey also sought banks' views on sources of risk, effectiveness of compliance processes, exposure to risky assets, and their preparedness in terms of capital requirement under Basel II advanced approaches. We received 19 complete responses from nine public sector banks (PSBs), seven private sector banks and three foreign banks in India.

Risk Exposure And Their Sources
The responding banks had more than a 50 per cent exposure to off-balance sheet assets vis-à-vis total loans, with derivative instruments contributing about 30 per cent of these assets. The exposure is skewed towards foreign banks in whose case the ratio is more than 75 per cent. More than 50 per cent of this consists of derivative instruments. And that makes them more vulnerable to market volatilities. This shows that the importance of risks from off-balance sheet exposures cannot be neglected. On an average, the banks have 2 per cent of their advances restructured where there is a serious possibility of them turning to non-performing assets. The responses show that the exposure to sensitive sectors including real estate, capital markets is more than 10 per cent, on an average, for all the banks surveyed.

India's Best Banks 2009The public sector banks mostly use derivative instruments to manage their own risks (seven out of nine responses) and helping clients to manage their risks (7/9), while a few (4/9) tend to use it as a tool to enhance profitability (reducing income volatility). Private and foreign banks also show a similar trend, with most of them either helping clients or managing their own risks.

On a scale of 1-5, IT-related risks, with an average score of 1.7, is the highest risk the banks seem to face. Key sources of risks are: business, operational, market-related and IT-related. However, banks are not unduly concerned about these risks, leading one to surmise, that either the risk management systems are yet to be tested intensively or they actually are quite robust for these banks.

IT-related risks: Technology dependence and payment systems have emerged as key sources of risks faced by foreign banks, with a score of 2.3 and 2.0 out of 5, respectively. These banks are more advanced using technology, increasing chances of technology-related frauds. High dependence on technology is also an emerging area of concern for PSBs (1.9 out of 5), while private banks seem to be less concerned.

Market-related risks: Market movements in interest rates are a key source of risk among the market-determined factors that the banks in India are grappling with, followed by credit spreads. While the average score of 2.2 for interest rate risk, and 1.9 for credit spreads on a scale of 5, may not be very high, but these may be a cause of concern as the RBI tightens monetary policy. Credit growth has not picked up as expected, and if interest rates harden, banks will be caught in a cleft stick: credit growth versus net interest margins. Credit spreads are a larger concern area for both private and foreign banks than public sector banks, possibly because of their fund sources and effective costs.

Operations risks: The responses from the foreign banks show that money laundering and business continuation (2 out of 5) are areas of concern. While back office operations for foreign banks (1.7 out of 5) and private banks (1.6 out of 5) appear as the next big source of operational risks, PSBs seem to be more comfortable with operation risks, scoring below 1.5.

Business risks: On a closer look, credit risks (2.0 out of 5) emerge as the biggest business risk for private banks, while frauds and competition from new entrants (2.0 out of 5) appear more risky for foreign banks. Responses from PSBs show, they are relatively less vulnerable. Liquidity risk is the least of the concerns, though it was one of the highest concern areas last year.

Risk And Compliance
The banks believe their risk management departments can anticipate risks, demonstrate that the risks are under control, and risk management is tightly integrated with their operational activities. The banks justify the expenditure on risk management.

 The banks have been putting in place systems to address compliance needs. Their seriousness about compliance processes is indicated by the fact that all the responding banks said that the processes seemed to provide a single enterprise view of the risk-related information available. A single enterprise view of risk is important for corporate governance. It helps focus on the areas of concern from an organisation perspective. Last year, 24 per cent of the banks who had responded did not indicate they had a single enterprise view of risk information. While banks have been taking risk management more seriously, a pervasive risk culture needs to be inculcated.

The banks believe they are equipped to execute their compliance processes, and can adapt quickly to local regulatory needs. The responses suggest that the processes for managing compliance have improved accuracy in financial information and have enhanced preventive controls. But 15.8 per cent of the respondents say this has not reduced the overall cost of compliance.

It appears, that the banks are close to completing the development of systems and procedures to increase the effectiveness of compliance processes, with 42 per cent (eight out of 19) indicating the same.

Capital Requirement And Basel II
The responses show that the banks are not unduly worried about capital requirement, with 47.4 per cent (nine out of 19) indicating they do not need capital in the foreseeable future, and 52.6 per cent (10 out of 19) saying they need capital, but not urgently. Almost all the banks are in various stages of implementing advanced approaches in operational and credit risk and some have actually implemented, except for one, in the area of operational risk.

In conclusion, it can be said that Indian banks have been taking incremental steps to enhance their risk management and compliance systems and are quite confident of handling the different sources of risks. At the same time, enterprise wide risk management systems backed by stronger corporate governance practices, is the need of the hour and would particularly help those banks who are looking to expand overseas.

Roy is associate director of financial services and Majumder is senior consultant financial services at PwC India


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