In order to ensure growth in future, it is crucial to have proper risk management practices to curb increase in distressed assets.
Abhishek SinhaThere were two brothers. Both were reckless and borrowed more than they could pay. Both got married to professionals who augmented their respective family incomes. The elder bride was wise and succeeded in bringing fiscal discipline in family matters. On the contrary, the
younger bride joined the bandwagon and kept borrowing more than her family could pay.
Hence, the financial position of the first family improved, while the financial position of the second family deteriorated till, they became bankrupt.
This story has two lessons for us. Every time a family, a company or a bank grows, it leads to increased revenue, and more assets. However, the increase in revenue and assets does not always translate to higher profits.
that have become one have to strategize a growth path together. The entity then must believe in the growth path and stick to it. For banks, the growth drivers would depend on the quality of assets. Assets for banks are generally the loans that corporates and individuals take.
Additionally, the bank might also invest money in government securities. In order to ensure growth in future and ensuring that the company keeps earning the profit it is of prima facie importance that there are proper risk management practices to curb increase in distressed assets.
Now before addressing risk management in banks it is imperative to first understand the nature of business that banks conduct. A general belief among theoreticians and academicians is that banking business is more opaque than other businesses. In other words, most of the time the risk management failures that cripple the functioning of banks are low frequency high value transactions and trades that have escaped the vigilant eyes of the risk manager.
It is almost impossible for the top management to ensure the quality of assets of each bank if the managers of the branch falter and look at asset growth rather than quality of assets.To illustrate this better, I would like to talk about two categories of lending institutions in India. They are international banks, and NBFCs. International banks such as Standard Chartered Bank boast of a rich risk management culture. This was evident when the banks were the first to increase provisioning in 2016. This led to better lending practices and the
subsequent year saw increase in profitability of the Indian operations.
On the other hand, NBFCs took to “evergreening of loans” to ‘hide” risk. This led to increase in overall risk position which finally snowballed into defaults. This is not a one-off incident; it is often seen aggressive lending leading to higher profits in the short run and annihilation in the long run.
Global Trust Bank is the case in the point. In 2004, one of the fastest growing private retail banks went bust and the government had to then merge the bank with Oriental Bank of Commerce to save the interest of the depositors and customers of the bank.A vital issue now with number of banks decreasing substantially is an overall increase in the concentration of risk in the financial system. If any banks fail from here, there will be a greater impact on the system. This bring us to the central issue that the consolidating banks
face in terms of risk management.
The size of the banks has amplified and hence it can be safely assumed that there is a probability that banks may evidence an increasing opaqueness in the overall system. This logically leads to conceding that there is a need to have a robust risk management framework.The government has taken the first step in this direction by announcing that each bank would have to have a Chief Risk Officer. However, there are
certain critical issues that needs to be addressed first.
The risk management of a bank does not depend on the Chief Risk Officer. It depends on the risk culture that the organisation has. Hence, the involvement of the Board of Directors and Managing Directors of Banks in creating an organisation wide risk management culture become pertinent.Secondly, having the same definition of risk in each department and using
the best risk management practices that exist globally should be targeted. It has been generally observed that when there is a recession or a crisis looming, banks seem to tighten their risk management practices.
However, in the good times the same practices are ignored.
Risk management generally propagates stress testing and highlights the importance of contagion effect, which could be blamed for the subprime crisis. In simpler terms, the correlation between risks which are seemingly unrelated leads to a magnified systemic risk.
Thus, the board of directors and top management should then make sure that they have given enough autonomy to the Chief Risk Officer to create an environment where the organisation understands risks and takes manageable and predetermined risk only.
I would like to conclude by saying that consolidation of banks is indeed a good decision provided banks are able to streamline operations to realise synergies and create enterprise wide risk management culture. Appointing a Chief Risk Officer is a good beginning and should lead to sustainable growth.(The author is is a trained equity analyst having worked with companies such as B&K Securities and Systematix Corporate. He is a certified FRM from GARP. He is at present gainfully employed at VJIM, Hyderabad as a finance faculty and is also a corporate trainer and consultant)Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.