Page 193 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Indian Financial System

Notes 9.5.1 Transformation Services and Risks

Banks incur risks while undertaking transformation services. In the past three decades, banks
abroad assumed new roles and accepted new forms of financial intermediation by undertaking
currency and interest rate swaps and of dealing in financial futures, options and forward
agreements. These new instruments reflect considerable flexibility in responding to market
situations and adjusting continually assets and liabilities both on and off balance sheet, while
enhancing profitability.

9.6 Risk Management

Risk is inherent in banking and is unavoidable. The basic function of bank management is risk
management. In the words of Alan Greenspan, former Chairman of the Federal Reserve Board
of US (Conference at Federal Reserve Bank of Chicago, May 12, 1994), "traditional banking can
be viewed at an elemental level as simply the measurement, management and acceptance of
risk" and banking involves understanding, processing and using massive amounts of information
regarding the credit risks, market risks and other risks inherent in a vast array of products and
services, many of which do not involve traditional lending, deposit taking and payment services.
Banks in the process of providing financial services assume various kinds of risks, credit, interest
rate, currency, liquidity and operational risks. To some extent, these risks could be managed
through sound business practices and the others through a combination of product design and
pricing. In the past banks concentrated on asset management with liquidity and profitability
being regarded as two opposing considerations. As a result, banks ended up distributing assets
in such a way that for given liquidity level, the return was the maximum.

9.6.1 Overall Risk of a Bank

A bank's overall risk can be defined as the probability of failure to achieve an expected value
and can be measured by the standard deviation of the value.

9.6.2 Types of Risk

Banks have to manage four types of risk to earn profits for maximizing shareholder wealth.
These are credit risk, interest rate risk, liquidity risk and operational risk. In addition there is a
systematic risk arising due to various disruptions in the working of a major bank, which in no
time could spread to other banks or the whole financial system. Credit risk arises when a bank
cannot get back the money from loan or investment. Interest rate risk arises when the market
value of a bank asset, loan or security falls when interest rates rise. The solvency of the bank
would be threatened when the bank cannot fulfill its promise to pay a fixed amount to depositors
because of the decline in the value of the assets caused by an increase in interest rate. Liquidity
risk arises when the bank is unable to meet the demands of depositors and needs of the borrowers
by turning assets into cash or borrow funds when needed with minimal loss. Finally, operational
risk arises out of an inability to control operating expenses, especially non-interest expenses
such as salaries and wages. In a competitive environment, high operational expenses would
jeopardize the banks prospects to survive. Empirical analysis reveals that banks risk exposure
depends upon volatility of interest rates and asset prices in the financial market, the banks
maturity gaps, the duration and interest elasticity of its assets and liabilities and the ability of
the management to measure and control the exposure.

188 LOVELY PROFESSIONAL UNIVERSITY