Friday, July 6, 2012

Complexities in Risk Management

Complexities rise in Risk Management

B. Yerram Raju*

The latest Financial Stability Report from the RBI confirms that the risks to financial stability have worsened although financial institutions are largely resilient to credit, market and liquidity risks. The 82nd Annual Report of BIS expressed more concerns: ‘Five years on from the outbreak of the financial crisis, and the global economy is still unbalanced, seemingly becoming more so as interacting weaknesses continue to amplify each other. The goals of balanced growth, balanced economic policies and a safe financial system still elude us. The Report points out that the financial sector, governments, and households and firms need to repair their balance sheets: "the financial sector needs to recognise losses and recapitalise; governments must put fiscal trajectories on a sustainable path; and households and firms need to deleverage. As things stand, each sector's burdens ... are worsening the position of the other two." It is the operational risks that continue to rise. Who would ever have imagined that Barclays or Stanchart would indulge in manipulating the LIBOR? Technology, the facilitator for speed and accuracy, started turning riskier than ever.

Markets rejoiced with the huge bailout packages for the Euro Zone. The earlier US Fed package and this package clearly throw up moral hazard to the front as the cascading effects on the rest of the global financial system seem to worsen. All along, risk management practices in emerging economies have been driven by regulation and intense supervision. The other side of risk, namely, the reward is forgotten. When does the coin turn to the other side and what the Banks need to consider and remedy? In the Indian context, these are briefly examined.

The conservative regulator, distancing from capital account convertibility, and non-introduction of derivatives saved the Indian financial system and economy from the contagion effect of global recession in 2008. But we could not stay far from it for long and throughout 2011and till now in 2012, the policy makers blame the global effects of Euro fall and job losses of US in the wake of continuing recession-effect for the ills of the Indian economy. "The financial sector is putting pressure on the government," the BIS Report adds. "Governments, with their deteriorating creditworthiness and need for fiscal consolidation, are hurting the ability of the other sectors to right themselves. And as households and firms work to reduce their debt levels, they hamper the recovery of governments and banks. All of these linkages are creating a variety of vicious cycles." There has been compression of credit in the first quarter despite rate corrections by the RBI.

A couple of decades back, when the reforms hit the financial sector, the NPAs were blamed on the government-sponsored programmes or directed credit portfolio. The fears of NPA have only multiplied ever since although banks have learnt the art of greening their balance sheets and giving net NPA position in the range of 3 to 0. Chairman of the biggest Bank, SBI, recently confirmed that 20 percent of the restructured debt would land in the NPA bracket . It is shocking to realize that it is not agriculture or SME sectors that take the giant share of this but the corporate credit. The quality of credit appraisals and due diligence is resting on technology instead of careful enquiry and analysis. Institutions have migrated to arm-chair lending. Playing to the gallery has become the name of the game. Due diligence of firms and their directors, expectations of financial flows are turning out faulty with billions of rupees getting unearthed in frauds and collusive part of banks being questioned in the process. ATM frauds are on the rise. Manipulations are maneuvering the systems.

Operational Risks:

The ground level staff is more tech-savvy than domain-knowledge driven. Recruitment is on machine to man ratio. Manpower planning in Banks does not seem to provide for continuous off-the desk training. The digital and on-line training has become system driven. Opportunity cost of training having gone up, institutions fall short of training and education expenditure. Training costs are treated as operational expenses by banks. If there is change in the accounting practices and such expenditure is treated as Investment Cost in the balance sheet of banks and it is in fact so, there is prospect for this portfolio of banks taking a positive turn. People and process risks need immediate attention as attrition is posing a problem. The Risk Managers may have to evolve a model where a person with more than 5 years of experience were to join another organization, the company engaging such person should pay to the company a part of the development cost of this resource. This can be a complex model but need working out if attrition were to be prevented in the long run.

Basel III concerns:

In this backdrop, if we look at the capital requirements, one keeps wondering whether capital availability of huge size would cover all the risks that are surfacing. Banks must reduce the NPAs not only when they surface but by preventing them for occurrence. Once they surface, they should quickly act on converting them into cash by taking recourse to factoring – not so popular with banks till now- and sale of collateralized assets to asset reconstruction companies like the ARCIL. The Government is the biggest owner of the financial system and should provide capital only after it is convinced that the options at their disposal are fully exhausted. Budgetary provisions for capital replenishment would mean putting deeper holes in the tax-payers’ pockets. The other best way is, reducing the share of government in Public sector banks while retaining its say on the affairs of management and governance. In fact, Narasimham Committee suggested in its very first report that the government should gradually reduce its share in the PSBs. Instead, we saw its increasing participation and interference. May be that the present Finance Minister in PM would revisit the reform agenda. It is not the size of the Bank but the quality of service and proximity that become crucial to financial inclusion agenda and therefore, the small and big banks, the public and private sector need to co-exist. The holding company concept with all checks and balances may become relevant for getting critical mass in shape in the financial sector. The less-attended cooperative sector needs also dedicated support for a clean-up and reform process.

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