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Part - II

As you may be aware, the credit risk depends on both internal and external factors. The external factors are the state of the economy, swings in commodity prices and equity prices, foreign exchange rates and interest rates, etc. The internal factors are deficiencies in loan policies and administration of loan portfolio which would cover weaknesses in the area of prudential credit concentration limits, appraisal of borrowers' financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc. Such risks may extend beyond the conventional credit products such as loans and letters of credit and appear in more complicated, less conventional forms, such as credit derivatives or tranches of securitised assets.

The second category of risk that has gained prominence is interest rate risk. Interest rate risk arises because banks fix and refix interest rates on their resources and on the assets in which they are deployed at different times. Changes in interest rates can significantly impact the net interest income, depending on the extent of mismatch between the times when the interest rates on asset and liability are reset. Any such mismatches in cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities) expose banks' net interest margin to variations.

A third important category of risk pertains to foreign exchange risk. The risk inherent in running open foreign exchange positions have become pronounced in recent years owing to the wide variation in exchange rates. Such risks arise owing to adverse exchange rate movements, which may affect a bank's open position, either spot or forward, or a combination of the two, in any individual foreign currency.

The final major category of financial risk is liquidity risk. The liquidity risk arises from funding of long-term assets by short-term liabilities or resources, thereby making the liabilities subject to rollover or refinancing risk. Those banks that fund their domestic assets with foreign currency deposits with them may be particularly susceptible to liquidity risk when sharp fluctuations in exchange rates and market turbulence make it difficult to retain sources of financing.

Beyond the four basic financial risks, banks have a host of other concerns. Some of them, like operating risk, are a natural outgrowth of their business. Banks employ standard risk avoidance techniques to mitigate them. In other cases, for instance, where counter-party risk is seen as significant, it is evaluated using standard credit risk procedures. Likewise, most bankers would view legal risks as arising from their credit decisions or, more likely, from absence of proper procedure while finalizing a financial contract. It does not require very sophisticated tools to cover such risk.

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* This is the keynote address delivered by Shri. Jagdish Capoor, Deputy Governor, Reserve Bank of India, at One Day Seminar on Risk Management in Financial System at a Mumbai-based Management Institute.