Risk Management in Banking Sector.
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The significant transformation of the banking industry in India is clearly evident from the changes that have occurred in the financial markets, institutions and products. While deregulation has opened up new vistas for banks to argument revenues, it has entailed greater competition and consequently greater risks. Cross- border flows and entry of new products, particularly derivative instruments, have impacted significantly on the domestic banking sector forcing banks to adjust the product mix, as also to effect rapid changes in their processes and operations in order to remain competitive to the globalized environment. These developments have facilitated greater choice for consumers, who have become more discerning and demanding compelling banks to offer a broader range of products through diverse distribution channels. The traditional face of banks as mere financial intermediaries has since altered and risk management has emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The benefits of globalization have been well documented and are being increasingly recognized. Integration of domestic markets with international financial markets has been facilitated by tremendous advancement in information and communications technology. But, such an environment has also meant that a problem in one country can sometimes adversely impact one or more countries instantaneously, even if they are fundamentally strong.
There is a growing realisation that the ability of countries to conduct business across national borders and the ability to cope with the possible downside risks would depend, interalia, on the soundness of the financial system. This has consequently meant the adoption of a strong and transparent, prudential, regulatory, supervisory, technological and institutional framework in the financial sector on par with international best practices. All this necessitates a transformation: a transformation in the mindset, a transformation in the business processes and finally, a transformation in knowledge management. This process is not a one shot affair; it needs to be appropriately phased in the least disruptive manner.
The banking and financial crises in recent years in emerging economies have demonstrated that, when things go wrong with the financial system, they can result in a severe economic downturn. Furthermore, banking crises often impose substantial costs on the exchequer, the incidence of which is ultimately borne by the taxpayer. The World Bank Annual Report (2002) has observed that the loss of US $1 trillion in banking crisis in the 1980s and 1990s is equal to the total flow of official development assistance to developing countries from 1950s to the present date. As a consequence, the focus of financial market reform in many emerging economies has been towards increasing efficiency while at the same time ensuring stability in financial markets.
From this perspective, financial sector reforms are essential in order to avoid such costs. It is, therefore, not surprising that financial market reform is at the forefront of public policy debate in recent years. The crucial role of sound financial markets in promoting rapid economic growth and ensuring financial stability. Financial sector reform, through the development of an efficient financial system, is thus perceived as a key element in raising countries out of their 'low level equilibrium trap'. As the World Bank Annual Report (2002) observes, ‘ a robust financial system is a precondition for a sound investment climate, growth and the reduction of poverty ’.
Financial sector reforms were initiated in India a decade ago with a view to improving efficiency in the process of financial intermediation, enhancing the effectiveness in the conduct of monetary policy and creating conditions for integration of the domestic financial sector with the global system. The first phase of reforms was guided by the recommendations of Narasimham Committee.
• The approach was to ensure that ‘the financial services industry operates on the basis of operational flexibility and functional autonomy with a view to enhancing efficiency, productivity and profitability'.
• The second phase, guided by Narasimham Committee II, focused on strengthening the foundations of the banking system and bringing about structural improvements. Further intensive discussions are held on important issues related to corporate governance, reform of the capital structure, (in the context of Basel II norms), retail banking, risk management technology, and human resources development, among others.
Since 1992, significant changes have been introduced in the Indian financial system. These changes have infused an element of competition in the financial system, marking the gradual end of financial repression characterized by price and non-price controls in the process of financial intermediation. While financial markets have been fairly developed, there still remains a large extent of segmentation of markets and non-level playing field among participants, which contribute to volatility in asset prices. This volatility is exacerbated by the lack of liquidity in the secondary markets. The purpose of this paper is to highlight the need for the regulator and market participants to recognize the risks in the financial system, the products available to hedge risks and the instruments, including derivatives that are required to be developed/introduced in the Indian system.
The financial sector serves the economic function of intermediation by ensuring efficient allocation of resources in the economy. Financial intermediation is enabled through a four-pronged transformation mechanism consisting of liability-asset transformation, size transformation, maturity transformation and risk transformation.
Risk is inherent in the very act of transformation. However, prior to reform of 1991-92, banks were not exposed to diverse financial risks mainly because interest rates were regulated, financial asset prices moved within a narrow band and the roles of different categories of intermediaries were clearly defined. Credit risk was the major risk for which banks adopted certain appraisal standards.
Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements of this transformation process have been
1. The deregulation of coupon rate on Government securities.
2. Substantial liberalization of bank deposit and lending rates.
3. A gradual trend towards disintermediation in the financial system in the wake of increased access of corporates to capital markets.
4. Blurring of distinction between activities of financial institutions.
5. Greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks.
6. Emergence of new private sector banks and other financial institutions, and,
7. The rapid advancement of technology in the financial system.