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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.
Table of Contents
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
The procedure required to be followed in Managing Operational Risks in Banking is as follows:
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:
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:
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:
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
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.
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.
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.
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.
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.
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.
Also, Read: What is a Risk Assessment Model.
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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