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Risk Management in the Banking Industry
Risk management is an essential part of helping the bank grow while keeping an eye on the potential consequences if something goes wrong.
16th July 2013
The perception of risk management is fundamentally changing within today’s institutions. It is no longer purely used as a control mechanism but as a critical input into the basic business question that if the revenues out of this transaction will compensate me for the additional risks i am taking on? Risk management is an essential part of helping the bank grow while keeping an eye on the potential consequences if something goes wrong. This could be external factors such as a recession or a stock market crash or internal factors such as IT failure. In simpler terms Risk Management takes two things into consideration:
- The likelihood of something bad happening or
- The likely cost of something happening
Once the associated risk has been identified, say with a business deal or a transaction, it will decide whether or not if the risk is too high to approve. If the risk factor stands high for the particular business venture or investment opportunity the bank is basically not allowed to proceed with that piece of business.
“Risk management is a very big area of banking; it has a controlling role in the business. For example we make sure that the bank does not take too much money from the client, or push them into liabilities. Basically we want to know if they can repay the debt “, says Diana, a Risk Management Specialist in Frankfurt.
Risk Management Roles
Credit Risk Management
This is a bank’s internal credit approval and monitoring function, it looks at how risky transactions are going to be and if they are worth the risk. For example, it will set the levels of ‘risk adjustment’ on credit arrangements, which means it sets higher rates of interest to a company with a poor credit rating to avail a loan.
Market Risk Management
Investment banks buy and sell securities on the stock markets (bond and shares); prices of securities fluctuate heavily in the stock market, if the price goes down, a loss will be made and vice versa. There are many types of security available and trading across different countries is complex. Hence, there are various risks in trading such as
- Equity risk – that stock prices will change
- Interest rate risk- that interest rates will change
- Currency risk –that foreign exchange rates will change
- Commodity risk- that the price of a commodity will change
Investment Risk Management
If the bank acquires another company due to amalgamation or absorption there will be a whole new set of risks associates with the new company with regard to profit sharing, tax arrangements, employee share benefit programs etc. The new company will also need to have its risk processes aligned with the parent company.
Operational Risk Management
This department covers the risks associates with the day to day functioning of the banks. There are different types of operational risk, which assumes significance due to recent burst of banking frauds, technological failures including ATM heists, hacking etc. Some of them are:
Internal Fraud- Tax evasions, bribery
Employment practices and workplace safety- Health and safety
Clients products and business practice- Defective products and improper trade practices
Business disruption and systems failures -Including software or hardware failures.
Different sectors operate differently with its own pressures and working practices, to be successful in these areas, banks have to adhere to the risk management principles to avoid financial disruptions and violations which will in turn lead to a counter effect on the investors, creditors and other stake holders of the banks.
Risk management assumes importance considering the economic crisis in Europe, U.S. U.K. which have hit the governments, banks, creditors and more importantly the citizens of the country whose lives are struck hard by unemployment, inflation leading to public outrage and showing the poor control and regulatory measures of the central banks of respective states. Greece, Portugal, Italy are some classic examples of poor risk management compliance and control.
The core business of a bank is to manage risk and provide a return to the shareholders in line with the accepted risk profile. The credit crisis and ensuing global recession seem to indicate that the banking sector has failed to tend to its core business. If the banks had exercised effective credit controls, then credit default swaps would not have been bought up with so much eagerness. If the banks had attended to risk management, then there would not be flood in the U.S. market of cheap short term interest rate mortgages that led to the so called housing bubble and the wave of bankruptcies and foreclosures.
Risk management can be most effective when it is applied consistently across the banking sector with policies and procedures developed by “Risk Experts” which include experts in economics and banking compliances, CPA’s, Industry honchos who have the training and experience for their country, area and client mix.
Use of Information Technology in Risk Management
The value of IT appears to be increasing over time to banking organisations as the environment grows more complex. IT systems and practices if properly developed and used can assist the company in risk management by providing control and compliance, monitoring technology, databases, market research, analysis and communication tools. A risk management culture can be embedded in the organization through training, communication and incentives.
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