Introduction to Risk Management in Banks & NBFCs

Risk is at the centre stage of the banking business as Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit risk,  interest rate risk, foreign exchange rate risk, liquidity risk, market risk, operational risk,  etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Before understanding these risks, it is important to understand the business of banking.

Understanding Business of Banking

A bank can be defined in terms of 1) the economic functions it serves, 2) the service it offers its customers or 3) the legal basis for its existence. In the modern era, banks can be identified by the functions they perform in the economy and as such are involved in transferring from savers to borrowers ( financial Intermediation). Banks or NBFCs are highly regulated sectors in their respective jurisdictions. The common denominator of all banking activities remains accepting the deposit for lending. 

In India, Section 5 (b) in BANKING REGULATION ACT,1949 define Banking as `“Banking” means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise.

As per the above definition, the primary function of the banking company is to accept the deposits and do investments, grant loans, and advances. The secondary function includes the payment of funds, collection of bills, wealth management, certain consultancy services and various utility functions like offering lockers, safe custody of documents, merchant banking services etc.

Source of Funds with Banks

• Capital / Reserve 
• Borrowings from the Market
• Public deposits which are withdraw able on demand or otherwise
• Provisions and other liabilities

Main source of funding is public deposit & market borrowing which together constitutes  90 % of total funds available with banks.

Uses of Funds by Banks

• Cash and Balance with Banks
• Investment in Securities, Bonds, Forex & derivatives
• Loans & Advances
• Fixed and other assets

Main deployment of funds is in Investment and Loans & Advances. Both these components constitute about 90% of total assets.

Solvency and Liquidity in Banking 

Solvency and liquidity are important factors for the stability and resilience of banks. Being solvent, banks are in a position to absorb the expected or unexpected losses that occurred in the course of the normal business whereas being Liquid, banks are positioned well to meet their repayment obligations as well as fund the lucrative Investment or lending opportunities..

Bank’s  Deposits and its  Salient Features 

Broadly there are three categories of deposits offered in India:-

Banks having robust Risk management system in place segregate their deposit portfolio in the following two categories for better liquidity management:-

1. Demand and Term Deposits:- Current Account and Saving bank Deposits are demand deposits as these are payable on demand. To ascertain the maturity pattern of demand deposit portfolio banks follow behavioral analysis and distribute it in various time buckets. In the case of term deposits, banks follow residual maturity patterns and accordingly place in the various time buckets for better liquidity management.
2. Retail Deposits and Bulk deposits:- As per RBI extant guidelines, ‘Bulk Deposit’ means a Single Rupee term deposit of Rupees two crore and above for Scheduled Commercial Banks (excluding Regional Rural banks) and Small Finance Banks. Therefore, any single deposit up to Rs. 2 crores can be considered as Retail deposits. Retail term deposits provide a stable source of funding to banks whereas bulk deposits are highly interest sensitive and can create a liquid mismatch.

Loans & Advances Portfolio

One of the major functions of commercial banks is to grant loans and advances. The flow of the credit can be for productive purposes and consumption purposes so that desired growth of the economy can be achieved. The main facilities offered by the banks are as under:-

 Treasury  Functions

One of the important functions of the bank is Treasury Management. Treasury functions are centralized and it sets up banking operations, which refers to the integration of money market, securities market, and foreign exchange operations.

Traditionally, the Treasury Department is responsible for the overall management of funds of the bank. Depending upon the need, it borrows from the market to meet short-term and long-term fund requirements or invest in the market in case of the surplus position of the funds. It also manages the CRR and SLR requirements of the bank.

Main treasury functions are dealing in the Money market. Capital Markets, forex Markets, Derivative markets. They deal in T-bills, G-securities, corporate bonds, Forex transactions, Derivative transactions, participating in Open market operations, etc.

Due to economic reforms and deregulation of markets over a while, the scope of the Treasury has expanded considerably. Treasury has since evolved as a profit center, with its trading and investment activity. It, thus, plays an active role in Asset Liability Management.

Bank Balance Sheet 

Let us understand the balance sheet of a commercial bank as per format followed by them:-

Amount ( Rs. ‘in cr)

Off- Balance Sheet items

• Bills For Collections
• Claims against the bank not acknowledged as debts 
• Liability on account of outstanding forward exchange contracts 
• Liability on account of outstanding derivative contracts
• Guarantees given on behalf of constituents
• Acceptances, endorsements and other obligations 

Critical analysis of the data of above balance sheet reveal that:-

1. Main source of funding is Deposit for banks but in case of  NBFCs it is borrowing because all NBFCs are not allowed by RBI to take deposits. 90 % of the funds are mobilized from these sources
2. Main Avenue of deployment is Investment and Loans & advances. 90 % of funds are normally deployed in these portfolios.
3. Total exposure of the banks comprises On-Balance sheet and Off-Balance outstanding commitments  and not outstanding amounts.
4. In the business of banking, there is always a risk of  loss due to impaired loans and investment. To meet such losses banks should be adequately capitalized. 

Following Salient features can be inferred from Bank’s balance sheet :-

Banking Operations are:-

• Highly leveraged 
•  Deposits are the main source of funding Banking Operations 
• Main banking assets are:-
  • Investments in bonds & securities, &
  • loans & advances
• Banks are required to track the maturity pattern of their liabilities and assets to avoid liquidity risk
• Banks should keep a continuous track of the quality of their loans & Investment portfolio for better credit risk management
• Different maturity patterns of the Liability component and Asset components are giving rise to Asset Liability Mismatch.
• Off-Balance sheet items which are the source of Non-Interest Income in case of invocation are converted into the fund based. Therefore, banks try to hedge such contingent liabilities wherever possible.

Risk in Banking Business 

Risk is defined as danger that a certain unpredictable contingency can occur, which may lead to randomness in cash flow. Risk is prevalent in almost all types of banking activity but predominantly on the asset side.

Different types of risk arise within the framework of a bank’s operations, including credit risk, operational risk, market risk, Interest rate risk and liquidity risk. 

Major Risks in Banking

The article is based upon the lecture delivered by Mr Rajesh Mahajan, Ex GM (Risk Management), Bank of Baroda, in Banking Quest' online training "Program on Risk Management in Banks and NBFCs" on June 17, 2021.