In the previous article we discussed about the leading role of RBI towards strengthening commercial banks with adequate skills and strategies for management of diverse risks faced by them

RBI has defined that the broad parameters of risk management function in all its schemes (guidelines) should encompass:

1. organisational structure;

2. comprehensive risk measurement approach;

3. risk management policies approved by the Board which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk;

4. guidelines and other parameters used to govern risk taking including detailed structure of prudential limits;

5. strong MIS for reporting, monitoring and controlling risks;

6. well laid out procedures, effective control and comprehensive risk reporting framework;

7. separate risk management framework independent of operational Departments and with clear delineation of levels of responsibility for management of risk; and

8. periodical review and evaluation.

A major issue in establishing an appropriate risk management organisation structure is choosing between a centralised and decentralised structure. The global trend is towards centralising risk management with integrated treasury management function to benefit from information on aggregate exposure, natural netting of exposures, economies of scale and easier reporting to top management.

• The primary responsibility of understanding the risks run by the bank and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors

• The Board should set risk limits by assessing the bank's risk and risk-bearing capacity.

• At organisational level, overall risk management should be assigned to an independent Risk Management Committee or Executive Committee of the top Executives that reports directly to the Board of Directors. The purpose of this top level committee is to empower one group with full responsibility of evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. At the same time, the Committee should hold the line management more accountable for the risks under their control, and the performance of the bank in that area.

• The functions of Risk Management Committee should essentially be to identify, monitor and measure the risk profile of the bank. The Committee should also develop policies and procedures, verify the models that are used for pricing complex products, review the risk models as development takes place in the markets and also identify new risks. The risk policies should clearly spell out the quantitative prudential limits on various segments of banks' operations.

• Internationally, the trend is towards assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk).

• The Committee should design stress scenarios to measure the impact of unusual market conditions and monitor variance between the actual volatility of portfolio value and that predicted by the risk measures. The Committee should also monitor compliance of various risk parameters by operating Departments.

• A prerequisite for establishment of an effective risk management system is the existence of a robust MIS, consistent in quality. The existing MIS, however, requires substantial upgradation and strengthening of the data collection machinery to ensure the integrity and reliability of data.

The risk management is a complex function and it requires specialised skills and expertise. Banks have been moving towards the use of sophisticated models for measuring and managing risks. Large banks and those operating in international markets should develop internal risk management models to be able to compete effectively with their competitors. As the domestic market integrates with the international markets, the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. At a more sophisticated level, the core staff at Head Offices should be trained in risk modelling and analytical tools. It should, therefore, be the endeavour of all banks to upgrade the skills of staff.

Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework for management of risks in India. The design of risk management functions should be bank specific, dictated by the size, complexity of functions, the level of technical expertise and the quality of MIS. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise.

Internationally, a committee approach to risk management is being adopted. While the Asset - Liability Management Committee (ALCO) deal with different types of market risk, the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk. Thus, market and credit risks are managed in a parallel two-track approach in banks. Banks could also set-up a single Committee for integrated management of credit and market risks. Generally, the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures.

Currently, while market variables are held constant for quantifying credit risk, credit variables are held constant in estimating market risk. The economic crises in some of the countries have revealed a strong correlation between unhedged market risk and credit risk. Forex exposures, assumed by corporates who have no natural hedges, will increase the credit risk which banks run vis-à-vis their counterparties. The volatility in the prices of collateral also significantly affects the quality of the loan book. Thus, there is a need for integration of the activities of both the ALCO and the CPC and consultation process should be established to evaluate the impact of market and credit risks on the financial strength of banks. Banks may also consider integrating market risk elements into their credit risk assessment process.