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Part - III

These are just some of the risks that banks must manage, and clearly the list I have set forth is not exhaustive. In particular, banks in emerging market economies are subject to a unique set of risks as a result of the financing and investment cycles in their countries.

How do we try to manage these risks? Irrespective of the nature of risk, the best way for banks to protect themselves is to identify the risks, accurately measure and price it, and maintain appropriate levels of reserves and capital, in both good and bad times. However, this is often easier said than done, and more often than not, developing a holistic approach to assessing and managing the many facets of risks remains a challenging task for the financial sector.

What then are the optimal strategies to manage these risks? In managing credit risk, the key issue is to recognise the need to apply a consistent evaluation and rating scheme of all investment opportunities. This is essential in order for credit decisions to be made in a consistent manner. Prudential limits need to be laid down on various aspects of credit, viz., benchmark current debt/equity and profitability ratios, debt service coverage ratios, concentration limits for single/group borrower, maximum exposure limits to industry, etc. There should be provision of some flexibility to allow for very special features. There needs to be developed a comprehensive risk scoring system that serves as a single point indicator of diverse risk factors of counter-party.

As for managing interest rate risk, most commercial banks make a clear distinction between their trading activity and their balance sheet exposure. As regards trading book, Value-at-Risk (VaR) is presently the standard approach. The VaR method is employed to assess the potential loss that could crystallize on trading position or portfolio due to variations in market interest rate and prices. For balance sheet exposure to interest rate risk, banks rely on 'gap reporting system', identifying asymmetry in repricing of assets and liabilities commonly known as gap and putting in place a gap reporting system. This is often supplemented with balance sheet simulation models to investigate the effect of interest rate variation on reported earnings over a medium-time horizon.

Coming to foreign exchange risk, limits are key elements of risk management in foreign exchange trading, as they are for all trading business. As a general characterization, banks with active trading positions have tended to adopt the VaR approach to measure the risk associated with exposure. For banks, which could not develop VaR, some stress testing is required to be conducted to evaluate the potential loss associated with changes in the exchange rate. This is done for small movements in the exchange rates, as well as for historical maximum movements.

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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.