Previous

Part - VI

Secondly, the evaluation of credit rating continues to be an imprecise process. Over time, one should expect that the banking industry's rating procedures should be compatible with rating systems elsewhere in the capital market and have the same degree of objectivity.

A third area where improvements seem warranted is the analysis of ex-post outcomes from lending. Credit losses are, currently not precisely related to credit rating. They need to be more closely tracked by the banking industry than they currently are. In short, credit pricing, credit rating and expected losses ought to be demonstrably linked.

Fourthly, interest rate risk approaches include both the trading systems and balance sheet risk analysis. On trading systems, there has been considerable improvement. The VaR methodology has converted a rather subjective hand-on process of risk control to a more quantitative one. However, several questions still remain unanswered. The first of these is that the whole approach of VaR is dependent upon estimated distribution of returns. These are the key inputs to the risk measure, but the true ex-ante distribution is unknown. Estimates are obtained from either historical data or Monte Carlo simulation, but in either case, the estimated distribution is not unique. This problem in risk management will need to be examined by the banking industry.

Finally, as banks move more towards off-balance sheet activities, the implied risk of agency activities must be better integrated into overall risk management and strategic decision-making. Currently, they are ignored when bank risk management is considered or are at a fairly primitive stage. If reasonable exposure estimates are to be obtained, and the true costs of risk absorption are to be factored in the operations, much more needs to be done including building up of a strong Management Information System (MIS) backed up by a sound database.

To conclude, risk management systems have attracted considerable attention in the financial sector. Considerably more work needs to be done. The current state of risk management is merely a beginning. Many questions still remain unanswered, many questions have been answered only superficially and for certain others, we have no complete and comprehensive answers. It is here that the management science professionals have a clear role to play in this important task.

Concluded.

* 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.