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Working Capital Management

Notes risk in individual credits or transactions. Banks should also consider the relationships between
credit risk and other risks.
In recent years, credit risk measurement and management has taken centre stage in almost all
discussions involving financial institutions. Financial institutions have to look at how much
credit risk they face and how to manage risk. The key questions asked in credit risk are:

What are the chances that a borrower will default on its loan obligations?
What is the value of a risky loan?
Credit risk is the oldest risk among the various types of risks in the financial system, especially
in banks and financial institutions due to the process of intermediation. Managing credit risk
has formed the core of the expertise of these institutions. While the risk is well known, growth
in the markets, disintermediation, and the introduction of a number of innovative products and
practices have changed the way credit risk is measured and managed in today’s environment.

5.1 Risk Management

For the purpose of these guidelines financial risk in banking organization is possibility that the
outcome of an action or event could bring up adverse impacts. Such outcomes could either result
in a direct loss of earnings/capital or may result in imposition of constraints on bank’s ability to
meet its business objectives. Such constraints pose a risk as these could hinder a bank’s ability to
conduct its ongoing business or to take benefit of opportunities to enhance its business.
Regardless of the sophistication of the measures, banks often distinguish between expected and
unexpected losses.

Did u know? What are expected and unexpected losses?
Expected losses are those that the bank knows with reasonable certainty will occur (e.g.,
the expected default rate of corporate loan portfolio or credit card portfolio) and are
typically reserved for in some manner. Unexpected losses are those associated with
unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests,
Losses due to a sudden down turn in economy or falling interest rates). Banks rely on their
capital as a buffer to absorb such losses.
Risks are usually defined by the adverse impact on profitability of several distinct sources of
uncertainty. While the types and degree of risks an organization may be exposed to depend
upon a number of factors such as its size, complexity business activities, volume etc, it is believed
that generally the banks face Credit, Market, Liquidity, Operational, Compliance/legal/
regulatory and reputation risks.
Risk Management is a discipline at the core of every financial institution and encompasses all
the activities that affect its risk profile. The acceptance and management of financial risk is
inherent to the business of banking and banks’ roles as financial intermediaries. Risk management
as commonly perceived does not mean minimizing risk; rather the goal of risk management is
to optimize risk-reward trade-off. Notwithstanding the fact that banks are in the business of
taking risk, it should be recognized that an institution need not engage in business in a manner
that unnecessarily imposes risk upon it: nor it should absorb risk that can be transferred to other
participants. Rather it should accept those risks that are uniquely part of the array of bank’s
services.

A risk management framework encompasses the scope of risks to be managed, the process/
systems and procedures to manage risk and the roles and responsibilities of individuals involved
in risk management.

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