While discussing the importance of risk management to the financial services industry, Mitali Kalita explains how it has brought sunshine to a gloomy economy

Chennai: Risks are an inevitable component of any financial organisation. The very existence of a financial institution is to take risks. Though there is no method to eliminate risks completely, regulations have been laid down from time to time to assist in minimising these risks. This is how the concept of risk management came into being.

Though the term gained momentum in recent times, the concept is not new to the financial industry. The process of identifying, measuring, reporting and controlling risks has been rooted in the industry since years. Risk management has helped organisations in identifying risks and in building up measures to minimise them.

A sound risk management practice has been identified as an essential ingredient for the progress of the financial services industry and has been accepted by the industry as a separate management function altogether.

Here we attempt to address the concept of risk management, review the reasons behind its popularity and explain its importance to the industry. We also try to unravel how the risk management concept has brought some sunshine to the gloomy economy, concluding with the steps that the financial services industry must adopt to improve risk management.

Sudden upsurge
Though banking institutions were involved in measuring risks, there was no quantitative practice to assess it, nor the technology and instruments to manage and distribute it. As a result, formal and systematic risk management was rather difficult until quite recently. The onus of crediting a loan would simply lie on the shoulder of a lending official, who would make this judgement on his own.

Quite often, the situation would follow a pattern - robust lending decisions during economic booms without worrying about risks undertaken, whereas exercising utmost caution in lending during economic downturns. As a result, there were no proper and quantitative methods to take care of decisions on bad loans.

Thus, the effect of wrongdoing by too much of risk-taking and reductions in credit availability on global financial markets and economies became too large to endure. At this hour, Basel II came to the rescue with the introduction of two critical risk management concepts - for example, the use of economic capital and enhancement of corporate governance. It has opened a whole plethora of risk management challenges for the financial services industry such as banks, non-banking institutions, customer rating agencies, and regulators among others.

The concept of risk management has gained a new momentum as all the financial services organisations are obligated to focus not only on market risk and credit risk but also on operational risk and meet the entire regulations laid down by Basel II by 2006.

Healthy business
The question that now arises is: How does the adoption of a sound risk management policy help in the growth of business? The answers are:

• It strengthens security and safety in the financial system
  
• It reduces fluctuations in credit availability, thereby putting a check on both credit extravaganza and credit crisis
  
• It saves time and effort spent in investigating lapses
  
• It reduces excessive build-up of unintended credit risks, and helps in building tighter lending standards during recessions
  
• It enhances risk culture, reduces volatility of all risks, lowers provision for bad debts, reduces operational losses, improves the institutions' external ratings, thereby ensuring access to capital markets and raising organisational efficiency
  
• Disclosures from the financial institutions will build up a transparent network between the regulators, rating agencies and the public, which in turn will enhance trust in the financial market
  
• It encourages a sound and comprehensive corporate governance practices

By staying up to date on the status of its clients, a bank can better evaluate the risk of its loans and make contingency plans in the event that some of the loans go into default.

The financial services industry was always involved in looking for means and ways to add new business at lower costs to add up huge revenues. There has been no change in the concept till today, but the only thing is that they have just changed their strategy of reaching those goals.

Managing tips
The industry faces the new challenge of changing its way of managing credit and operational risk due to the 2006 implementation deadline by big brother Basel II. Risk management will not remain the same, as the industry needs to re-look at its total management practice.

Some tips that might be helpful to them in adopting a sound risk management practice are:

• Implement a comprehensive risk framework across the institution
  
• Request new and timely information from customers, to perform internal rating assessments
  
• Stress more on the data related to the customer's financial statements and the current state of the industry, before lending money
  
• The move to STP may bring a significant reduction in operational risk
  
• Analyse operations, determine how to increase transparency and reporting of those operations, and decide how to manage operations better
  
• Incentives or largesse will boost employees to target the right customer and abide by a formal code of conduct, which will ensure reliable business processes by appropriate gathering and dissemination of risk-related information
  
• Though the Basel II deadline is set for 2006, get all the processes in place in advance, to comply with regulators' expectations
  
• Set up a formal approval process for pre-audit, identify key sensitive areas, and address the communication process with supervisory authorities

Huge opportunity
Reports say Basel II and therefore risk management will be areas of significant spending in the coming years. Research also indicates that it has opened up a huge outsourcing market in the financial services industry. Risk management obligations laid down by Basel II have sparked off the market of reporting and monitoring tools, as the industry would need to collate huge data for generating intelligence reports.

Thus, the IT outsourcing vendors will seem to reap the benefit in the coming years. The shift is almost visible with the opening up of the outsourcing market, due to the big firms shifting base to countries like India and China. The upsurge has created huge employment opportunities in the software sector with the projection that global IT spending on risk management technology will be at $18.8 billion in 2003 and reach $21 billion in 2006.

The risk management software solutions market is almost 9 per cent of the entire IT budget of the global financial industry, and it will open up a market of $10-20 billion every year globally for the next three years.

Software companies worldwide, especially in the top outsourcing destinations like India, have already started working on building domain expertise and deploying dedicated resources to develop consulting services and solutions, to help financial institutions in complying with risk management obligations.

Conclusion
The financial services industry has always been fast changing and new rules and regulations keep replacing one another. In the risk management sector, too, the industry has witnessed Basel I a few years ago, and is now busy preparing for Basel II for the next few years.

Hence we cannot conclude that with Basel II, the industry will be adopting the final step in risk management. As the complexity of the modern financial market increases, it will witness more measures and regulations in the future, too.