Various Risks associated with Banking Business
There are various kinds of risks associated with the banking such as credit risk, interest rate risk, foreign exchange rate risk, liquidity risk, equity price risk, commodity price risk, legal risk, regulatory risk, reputation risk, operational risk etc. They can be broadly converged into three categories viz. Credit Risk, Market Risk and Operational Risk. They have been briefly discussed below:
Credit risk is risk of loss arising from a borrower who does not make payments as promised. This event would be called “Default” and the person/ company/ entity would be called “Defaulter”. Due to this, credit risk is also known as “Default Risk”.
Market risk is the possible losses due to movement in the market prices. There are four standard market risk factors viz. stock prices, interest rates, foreign exchange rates, and commodity prices. Apart from there are associated market risks as follows:
- Equity risk, the risk that stock prices and/or the implied volatility will change.
- Interest rate risk, the risk that interest rates and/or the implied volatility will change.
- Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
- Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.
Operational Risk refers to the risk of loss from inadequate or failed internal processes, people, systems or external events including
- Incompetent management
- Improper planning
- Staff fraud
- Programming errors
- System Failure
- Increased competition
- Deficiency in loan documentations.
What are different approaches for risk assets calculation?
Banks have several approaches for risks assets calculations. They have been summarized in the below table:
Internal rating and external rating approaches
Standardized Approach / External Rating Approach
Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. The Banks have to follow it without any discretion to modify. The Reserve Bank of India has identified 4 external domestic agencies for this approach. They are CRISIL, ICRA, Care and Fitch.
Apart from this, there are international agencies such as Moody’s, Fitch, Standard and Poor’s etc.
Internal rating based Approach
This is basically an alternative to standardized approach. The Banks do the internal assessment of the Counterparties and exposures. Banks need RBI’s nod to do this.
Different credit rating agencies in India
The Credit rating market taken a definite shape in India after the SEBI made it mandatory for any debenture that has maturity of more than 18 months maturity. There are four domestic credit ratings in India for standardized approach for credit risk calculation. They have been discussed below:
CRISIL is India’s first credit rating agency, incorporated in 1987 and was promoted by the erstwhile ICICI Ltd, along with UTI and other financial institutions.
It commenced operations from 1988 onwards. In 1995, in partnership will National Stock Exchange, CRISIL developed CRISIL500 Equity Index. In 1996, it made a strategic alliance with the Standard & Poor’s (S&P) Ratings Group and in the following year Standard & Poor’s (S&P) Ratings Group acquired 9.68% shares in it.
In services Industry, the CRISIL in 1998 set up the Indian Index Services Ltd as a joint venture with the NSE and in 1999, it developed a Risk Assessment Model (RAM) which became a banking industry standard. S&P acquired the majority stake in the company in 2005 and so today CRISIL is a S&P company.
India’s second credit rating agency is ICRA (Investment Information and Credit Rating Agency) which was set up in 1991. It was promoted by Industrial Finance Corporation of India (IFCI), other leading financial/investment institutions, commercial banks and financial services companies as an independent and professional Investment Information and Credit Rating Agency. Today, ICRA and its subsidiaries together form the ICRA Group of Companies (Group ICRA). ICRA Limited is a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the National Stock Exchange.