LDM | Risk Management

Background

Risk management in banking is a relatively newer practice. Banks and financial institutions assume risks during the course of conducting business for the purpose of realizing returns on investments. Balance sheet of every bank or financial institution exposes it to different types of risk, all of which need to be managed in a coherent and institution-wide way and relative to each other. During the past decade, Nepalese banking industry continued to respond to the emerging challenges of competition, risks and uncertainties.

Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks is neither easy nor intuitive. In this context, Nepal Rastra Bank (NRB) have made some sincere attempts to bring prudential and supervisory norms conforming with international bank practices with an intention to strengthen the stability of the banking system.

Initiatives of NRB

Central banks around the world had started working towards strengthening prudential norms and enforcing transparency in financial reporting by financial institutions to avert any future international financial crisis.

To strengthen financial sector of Nepal, NRB started the financial reform process in early 1990s. NRB has taken a series of measures to realign its supervisory and regulatory standards almost on par with the international best practices. Accordingly, NRB had issued prudential regulations in the following area in the initial stage of reform:

Capital Adequacy Norms: Banks need to maintain minimum capital based on Risk-weighted Asset approach for the purpose of capital adequacy standards.

Exposure Norms: Banks are subject to limit on exposure to single borrower or group of borrowers on funded as well as Non-funded exposure. There will be capital charge for the exposure in excess of prescribed limit.

Asset Classification and Provisioning: Banks are required to classify their loan and non-banking assets and make provisions accordingly.

Income Recognition: Recognition of income on cash basis was mandatory with certain exceptions. However, now NFRS permits accrual basis of accounting.

Maintenance of Liquidity: Banks and Financial institutions are required to maintain 4% cash as liquidity.

Corporate Governance Norms: Banks and Financial institutions are required to follow stringent corporate governance norms such as norms for directors, formation of board sub-committees, appointment of CEO, code of conduct for employees, audit Committee, risk management committee, connected lending, etc.

Directives Specific to Risk Management

NRB has issued directives specific to Risk Management which requires banking sector to ensure effective management of various risks.

Liquidity Risk: Conduct Liquidity Gap Analysis and manage the risk.

Market Risk: Formulate robust policy, establish middle office at treasury department to ensure proper firewall, etc.

Interest Rate Risk: Conduct Maturity Gap Analysis and manage the risk.

Foreign Exchange Risk: Conduct Foreign Exchange Gap Analysis and manage the risk.

Credit Risk: Manage the risk through formulation and implementation of robust policies and processes, making appropriate provisions, complying exposure related norms, etc.

Operational Risk: Formulate robust HR Policies and procedures, ensure rotation of duties of employees, ensure robust internal checking system, ensure effective internal audit, formulate IT policy, formulate disaster recovery plan, etc.

Other Risks: Identify and manage reputational risk, strategic risk, AML/CFT risk.

Risk Management Guidelines

Nepal Rastra Bank had issued Risk Management Guidelines 2010 in July 2010 for the Banks and Financial Institutions which is recently replaced by Risk Management Guidelines 2018. This document is key for risk management in banking. It provides guidance to all financial institutions on minimum standards for risk management. Banks and Financial Institutions may, depending on its size and complexity, establish a more sophisticated framework than outlined in this document. The directive encourages banks and Financial Institutions to self-assess their risk profile and operational context. Also, Banks need to customize their risk management architecture and approach to attain organizational goals while meeting the minimum requirements standards set out in these Guidelines.

Model Risk Management in Banks

Banks may choose any risk management model commensurate with its risk appetite. But the model chosen should ensure safety as well as soundness of the bank’s financial position. Model Risk is the risk that theoretical models used in pricing, trading, hedging and estimating risk will turn out to produce misleading results. The model risk can have significant effect on financial performance of the bank. The loss arising out of the model inaccuracy and consequent model risk can be mitigated if the banks observe certain fundamental principles while making use of the model.

Risk Models have assumed importance in the area of Risk Management because they provide the decision-maker with insight or knowledge that would not otherwise be readily available. Such models aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play an increasingly important role in banks’ risk management and performance measurement process.