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Managing Operational Risks in Banking

Varun Hariharan

| Updated: Apr 21, 2020 | Category: CFO Service, Finance Business

Operational Risks in Banking

Risk management is a process in which the future risks of a business are identified. Once the risks are identified, the firm develops effective strategies to reduce or curb the risk. If this system is followed, a company can adequately handle the risks that come up. However, for an effective risk management system in place, the risks have to be categorized according to the potential damage caused to the business. By doing this, a proper system of risk management can be streamlined into the operations of a business. Risk Management is there in every business and organization. This system of risk management is also present in the Banking and Finance Companies. Without having an effective risk management system in place, banks and finance firms cannot make business decisions. In the Banking, Finance, and Insurance Sector (BFSI Sector), risk management is crucial for the development of the banking sector. Banks without proper risk management strategies could be prone to corporate governance issues, frauds, mismanagement, loan defaults. Hence operational Risks in Banking are crucial for the development of the banking sector. This will have a direct impact on the economic growth of the country.

Operational Risks in Banking – Risk management Process

For managing operational risks in banking, it is crucial to implement a proper risk management framework in place. This risk management framework would act as a guidance mechanism for the bank. By following this framework, the bank can assess compliance with risk management policies and guidelines. In the situation that a bank is non-compliant with the risk management strategy, then there can be scope for improvement or internal audit (screening). Through the internal audit process, a useful framework can be streamlined and complied. Operational Risks in banking can be effectually managed following the above process.

The procedure required to be followed in Managing Operational Risks in Banking is as follows:

  1. Risk Identification Mechanism– For a bank or financial institution, identifying various risks poses a big challenge. This is challenging because there are many changes in the economy. Because of constant fluctuations in the market, these would create significant risks in the banking sector. Apart from this, other challenges bring out various risks. These include- the development of technology, the use of mobile-based banking applications for carrying out transactions, the development of Artificial Intelligence (AI), IoT (Internet of things), and machine learning processes would increase the operational problems in the bank.  However, going by this, the management of banks should be more vigilant and adjust to the development of technologies. By carrying out the above processes, the bank can effectively manage operational risks in Banking.

However, the development of various technologies should be considered a benefit to the bank rather than a deterrent. With the use of technologies, banks could assess and predetermine multiple risks. For example- by using a loan software that has Artificial Intelligence enabled in it, the bank can understand the borrowing behaviour of specific borrowers and predetermine whether to provide the loan or not.

Similarly, like loan predictive software, which is used by various banks, other benefits can be availed by a bank using such technologies. Some of them are:

  • Understanding the market using predictive technologies;
  • Consumer behaviour analysis;
  • Technology not only helps the bank in becoming digital but also helps in increasing the amount of vigilance that is used in Banking Software;
  • It would help them to prioritize their banking and business goals faster thus saving excess time which is used in traditional banking processes; and
  • Use of these technologies also improves the overall corporate governance framework of the bank.

Therefore by using such technologies, operational risks in banking processes can be effectually managed.

2. Risk Analysis and Measurement- The next step in the risk management process of the bank is to measure the potential impact of the risk. Such can only be carried out by measuring the risk. By considering this option, a bank can understand how much threat is caused by the risk. They can effectively categorize the risk according to the potential danger they pose for the bank. These risks are measured based on the following basis:

  • High-level Risks
    • Market Risks
    • Lending Risks
    • Corporate Governance
    • Transparency
    • Frauds
  • Low- Level Risks
    • Changes in technology
    • Development of banking software on smartphones
    • Customer Satisfaction

The risks have to be measured and classified according to the potential threat they post.  Market-related risks can be dependent on various factors such as a change in GDP, amount of loans taken, consumer behaviour, changes in regulation. All the market risks can be classified as high-level risks. Classifying this as a higher risk category will help in managing operational risks in banking. The other form of risk also poses potential issues to the bank.

Corporate governance can be understood as having a proper framework and transparency between the shareholders, directors, and stakeholders. By ensuring that this framework is achieved in the bank, the amount of operational risks in banking can be handled. There has to be adequate transparency between the management and the public. Stakeholders are the primary sources of business of a bank. Hence a practical framework related to corporate governance is required for managing operational risks in the banking sector.

Lending Risks are the main issues what is faced by banks. Banks are hesitant to provide loans without proper security. On the other hand, there are excessive lending practices that are practiced by particular banks. Exorbitant interest rates are also charged on loans. Lending risks are one of the main priorities of a banking risk as the business of banking depends on lending. The Apex authority can monitor aggressive lending practices. Such a central body that regulates the banking sector in India is the Reserve Bank of India (RBI). The RBI has brought out specific mechanisms for handling the risks.  This was brought out in 2002, as the Guidance Note on Managing Operational Risks in a Banking Sector. The guidance note stressed on specific areas where operational risks in banking occur. Apart from the need of having senior management and board, they emphasized on the following:

  • Automation Processes Risks;
  • E-Commerce and other technologies risk;
  • Outsourcing Activities which are carried out by the financial sector; and
  • Acquisitions by banks.

While considering the factors, which create a threat to the bank, all the above factors have to be accessed and analyzed. If this is followed, then operational risks in the banking sector can be handled.

When it comes to handling low-level risks, though these risks are lower in the damage that can occur due to the risk, they still pose a potential risk to the banking processes. By dividing the above risks as high-level risk and low-level risks, the bank can prioritize the amount of time required to develop a proper strategy to effectively handle the risks.

Changes in technology have been a risk ever since 2010. With the advancement of digitization and the development of the tech bubble, start-ups have been productively collaborating with banks and financial institutions to develop products. One of the main risks posed by banks here is the reluctance of a bank to use the technologies that are produced by start-ups. However, from the front of a Non- Banking Financial Company (NBFC/ NBFCs), these technologies are adopted. These make the NBFCs more competitive to banks. Therefore for a framework to operate successfully, the bank has to make way to adopt new technologies. This would help in reducing the operational risks which are posed in the banking sector.

With the development of software’s on smart phones, banks have to tackle new risks. Some of these risks involve spreading awareness to existing banking customers regarding the use of the mobile-based application. This would be a challenging task for a bank, considering the population of India. Another risk that is prone to the advancement of software is the increase in the number of frauds that take place in a bank. These frauds can be divided into internal scams, external frauds, and third party frauds. All these frauds pose a significant threat and would pose as potential operational risks in banking. To tackle such operational risks in banking, there is the requirement of streamlining a proper system of firewalls; virus protection software’s in the application. This would significantly reduce the amount of operational risks in banking processes.

Therefore by effectually measuring the risks based on the potential damage caused, the bank can classify and categorize the risks and spend more time developing ideas to tackle these risks.

3. Development of Solutions- Once risks are identified and measured on the potential impact, solutions are developed to reduce or eradicate the risk. While certain risks are unavoidable, the effective way to handle them is to ensure that the damage caused by the risk is less. For example- consider the market-related risks in a bank. Developing effective risk mechanisms in place can reduce the amount of damage caused by the market risks. It cannot eliminate the risks that are formed due to the factors which affect market strategy.

Similarly, if there is a technological problem that poses as a risk in a bank, it can be solved by having proper support in technical processes.  By considering various solutions in the risk management process, the management can effectively reduce operational risks in banking. If there are risks related to fraud, then there has to be useful systems in place to reduce the number of frauds that occur in the banking process.

4. Implementation- Implementation is crucial for managing operational risks in banking. After solutions are developed, to understand the risks which affect the bank, effective implementation mechanisms are required. Without effective implementation and auditing, there will be no scope for improvement. Once a solution is implemented in the banking process, there can be space for understanding existing flaws in the solutions. Solutions can be effectively implemented after this process.

For example- for understanding the loan lending patterns and repayment patterns by consumers of a bank, many banks use predictive analysis software for understanding the repayment pattern. The use of AI and predictive analysis is a solution for banks for securing information on repayment. Through effective implementation, the operational risks in banking can be significantly reduced. However, operational risks in banking can be managed not only through the process of practical implementation.  They have to be screened and audited regularly.

5. Proper Monitoring- Monitoring processes helps reduce operational risks in the banking processes. Having a monitoring agency is required. This would ensure that the bank works according to the standards prescribed by the monitoring agency. Apart from this, the monitoring agency has the power to amend various rules from time to time. These rules have to be effectively followed by banks to reduce the operational risks in banking. Monitoring processes can be done through internal and external means. Internally the banks can be monitored by having executives who are independent in policy and decision making. Through internal monitoring policies, banks can achieve transparency. According to the Banking Regulation Act, 1949, banking companies are required to have independence at a senior level. This would ensure that proper corporate governance is maintained throughout the bank.

External monitoring processes can be conducted by an independent consultant performing the features such as the internal audit process for the bank. By using external audit processes in banking, the banks can ensure that there is independence as the relationship maintained by the external consultant would be related to the beneficiary and fiduciary. Professionalism will be preserved if this relationship subsists in the banking process.

Monitoring does not stop just by having an internal process or an external process.  Assessing the actual standards which are required to be provided by the banking industry to the current standards provided by the bank has to be measured. This is also known as the process of Quality Assessment. Quality Assessment practices are used by various banks to understand the practices followed by a bank. These practices are compared to the national or internationally accepted standards, which are followed by a banking system. One such quality assessment process is called a Collection Process Assessment. 

Collection Process Assessment is a procedure in which the actual standards of loan collection processes which are used by bank is compared to the standards which are determined by a central banking authority. By comparing the standards of loan collection processes with the actual standards, the bank can implement changes in the flaws of the loan collection processes. Using such systems in place will ensure that operational risks in a bank are reduced.

Therefore through proper channels of monitoring, operational risks in banking can be reduced. However, having a system to access the monitoring standards of the bank will ensure to improve the efficiency of the bank.

If a bank follows the following steps, it can ensure to reduce the amount of risks. However, these steps have to be implemented throughout the banking systems. This will ensure that there is transparency within all processes in a banking system.

Collapse of IL&FS- NBFC- Faulty Operational Risks in Banking

The Collapse of IL&FS (Infrastructure Leasing & Finance Services) was a shocking revelation to investors and stakeholders of IL&FS. Through proper risk analysis reports, it would found out that the directors of the committee had sanctioned various loans to borrowers. The internal risk mechanisms reported that the borrowers who had taken loans from IL&FS were not able to repay them. This is one of the High Level Risks, which was not considered by the financial institution. The loans which were sanctioned were based on the negative spread. The negative spread is viewed as a mechanism where the interest rates on the loans borrowed are lesser than the interest rates of the loans when paid.

The fall of this financial institution was also supported by a lack of transparent practices followed by the directors. They did not consider various factors before sanctioning loans. Most of the loans which were sanctioned were provided to borrowers who were under financial crisis. From the above case, it can be understood that there was no system of managing the operational risks in banking. Though IL&FS is an NBFC, still the operations of the NBFC would be similar to that of a banking process. Therefore by following the framework for risk management processes, banks can reduce the potential problems which are created as a result of the risk.

Conclusion for Managing Operational Risks in Banking

Before the development of technology and the increase in the number of risks posed to banks, there were no systems in place to monitor the operational framework of banking risks. With the development of regulation, technology, consumer preference, and markets, the management of banks has to ensure that there are effective mechanisms in place to manage the operational risks in banking. This can be achieved by following the procedure for risk management. Banks can understand the nature of the risk and the potential impact of the risk. Based on this, the risks can be divided. Finding effective solutions and implementation of the solutions is crucial in managing operational risks in the banking process. Through the above procedure, operational risks in banking can be reduced.

Varun Hariharan

Varun Hariharan has completed the Legal Practice Course from BPP Law School, Manchester. He has a Masters in Commercial and Corporate Law from the Queen Mary University of London and LLB Honours from Bangor University, UK. He specialises in law related to corporate, artificial intelligence and technology law.

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