Sources of Risk and Exposure

Sources of Risk:

There are a variety of situations that give rise to risk.

1. Decision/Indecision:

Taking or not taking a decision at the right time is generally the first cause of risk. Suppose a banker takes deposits and decides not to put money in statutory liquidity requirements, the bank would be called upon to pay penalties. Indecision in selling a Government security when the market is upswing is also a risk as it causes loss of revenue. The risk of revenue loss is on account of indecision.

2. Business Cycles/Seasonality:

There are certain exposures that are affected by seasonality or business cycles. Lending to sugar industry in India disregarding the fact that the production of sugar is restricted to six/seven months in a year, may give rise to risky situations.

3. Economic/Fiscal Changes:

The Government’s economic and taxation policies are sources of risk. The levying of import duty on certain capital goods can escalate the funding cost and bank finance requirement. While the borrower’s repay­ing capacity remains the same, such a situation enhances the exposure adding to the risk. The changes in Government policies can impact the cash inflow for the borrowing cus­tomer thereby limiting his repayment capacity.

4. Market Preferences:

Over the years, the consumer demands and preferences particularly from the youth segment, are changing substantially. The preference for a motorcycle over a scooter is an example. Lending to scooter dealers or manufacturers will have to be cautious due to this market trend.

5. Political Compulsions:

A Government may force the banks to lend in areas where the rewards may not be proportional.

6. Regulations:

The impact of change in regulations is similar to the changes in Government policies. In developed countries like the USA, there are certain anti- boycott laws prescribing restrictions. The anti-boycott laws specifically refer to boy­cotts involving one foreign Government against another foreign Government and participation of people in the US in those boycotts.

Indian banks operating in the USA do have to assess the regulatory risks. With the passing of USA Patriot Act, the processes for anti-money laundering have been strengthened. Compliance of a variety of regulations is also a source of risk.

7. Competition:

In order to remain competitive banks assume risks for enhancing the returns. In the quest to achieve better result there could be a tendency to assume risks highly unrelated to the return. The selection of the right counter party, lack of proper risk assessment, failure to appreciate the borrower rating, etc., all contribute in risk acceleration. Competition remains a major source of risk for banks as for all other sectors.

8. Technology:

Technology is both, a solution and a cause of risk. Deals worth millions are made in treasury operations through advanced technology supports. The process of maker-checker is scrupulously followed while entering into such deals. Still, machines can go wrong. The reflection of inaccurate values like dates, amounts, interest rates, etc., can cause a huge risk. It is a part of operational risk wherein technology itself becomes the source of risk.

9. Non-availability of Information:

Technology is an enabler for decision support for rational and data-based decision mak­ing. More often than not, in the absence of information support, banks do take decisions. The banks fix exposure limits per party or per industry. Exposures exceed these prudential limits in the absence of real time information, thereby multiplying the risk exposures.

In reality, the risk drivers are:

1. Changes in external environment, including regulatory as­pects,
2. Deficiencies in systems and procedures,
3. Errors, either intentional or otherwise,
4. Inadequate information and absence of required flows,
5. Unsuitable technology supports,
6. Communication gap or failure,
7. Lack of leadership, and 
8. Excessive and unreasonable incentives.

Indicators of Risk:

Risks very rarely occur as accidents. There are symptoms that indicate the possibility of risk. These indicators can be used to take pre-emptive actions. These actions may not eliminate the risks, but they would at least facilitate to minimize their impact.

1. Lack of supervision of lending/investment activities by designated officers.
2. Lack of specific lending or treasury policies or failure to enforce the existing policies.
3. Lack of code of conduct or failure to enforce existing code.
4. Dominant figure allowed to exerting influence without re­straint.
5. Lack of separation of duties.
6. Lack of accountability.
7. Lack of written policies and/or internal controls.
8. Circumvention of established policies and/or controls.
9. Lack of independent members of management and / or Board.
10. Entering into transactions where the institution lacks exper­tise.
11. Excessive growth through low quality loans.
12. Unwarranted concentrations.
13. Volatile sources of funding such as short-term deposits from out of area brokers.
14. Too much emphasis on earnings at the expense of safety and soundness.
15. Compromising credit policies.
16. High rate high risk investments.
17. Underwriting criteria allowing high risk loans.
18. Lack of documentation or poor documentation.
19. Lack of adequate credit analysis.
20. Failure to properly obtain and evaluate credit data, collat­eral, etc.
21. Failure to properly analyze and verify financial statement data.
22. Too much emphasis on character and collateral and not enough emphasis on credit.
23. Lack of proper mix in asset portfolio.
24. Unresolved exceptions or frequently recurring exceptions on exception reports.
25. Out of balance conditions.
26. Funds used for purposes other than the purpose recorded.
27. Lax policies on payment of checks against uncollected funds.
28. The institution is a defendant in a number of lawsuits alleging improper handling of transactions.