Risk Appreciation and Decision Making in Indian Financial Sector

One of the greatest risk takers in India’s modern history is Prime Minister Narendra Modi. Through his radical economic reforms, which threw away the conventional piecemeal approach, gave a tight slap to those slumbering under the shadows of economic slump and ‘policy paralysis’ and made inclusive economic growth a reality by forging ahead the financial inclusion through digital technological inclusion. This has set the ball rolling towards the growth of social inclusion. One of the notable aspects in his revolutionary approach is giving psychological boost to the poor and middle-class. “Risks” as such can be harnessed at the top but it becomes imperative that it encompasses the systems and gets institutionalised. Moreso, in the case of the financial services sector, specially banking and Insurance that are considered to be the “trustees” to manage the public funds. On the other hand, there are great expectations bestowed upon these trustees to generate sufficient returns for the money, which has been invested in them. Therefore, this calls for the banks and insurance companies to plunge into various risk cultures, risk appreciation, risk appetite statement and so forth.

In India, the practice of risk management has been prevailing for the last 25 years and at present when the economy is stabilising at around 7 per cent and GDPcredit ratio hovering around 60 per cent, there is a huge opportunity for India to grow. The spurt in digitalisation and its innovative technological developments have resulted in greater connectivity and collation of abundance of information for decision-making. In addition, the credit bureaus and credit agencies have facilitated the availability of all kinds of analysis around a company or in a corporate sector. But all is not rosy and the flip side is that, the financial sector is still grappling and it can be witnessed in day-to-day news coverage pertaining to insolvency, bankruptcy, large NPAs, low average corporate output etc. Therefore in the present era of ‘Volatility, Uncertainty, Complex and Ambiguity’ (VUCA) both international developments like Trump’s victory or domestic happenings like farmers’ loan waiver all have a lot of implications in the financial sector, particularly banking. In addition, the growth of new players like NBFCs. MFIs, wallet companies in relation to small banks and wholesale banking has created a complex scenario and an immediate need to trace out the opportunities, identify where the risks can be taken and assess the risk parameters and its management and more importantly imbibing the risk culture.

It is to be noted that ‘Risk’ comes from an Italian word “Risicare” which means to dare. Therefore it is all about the choice and the subsequent actions that we dare to take. It depends upon how we make those choices. Decision-making is an act of choosing between the two or more courses of actions and it also involves choosing between solutions and problems. Decisions can be made through either an intuitive or reasoned processes or a combination of the two. Praveen Kumar Gupta, MD, SBI, has aptly analysed risk appreciation and decision making by categorising them into three broad areas: i) increased risks ii) ability to identify and assess all the risk actions, and iii) various ways to manage risks.

One of the main reasons why risks are increasing in case of India is that, there are demanding stakeholders who want more dividends paid as a result of which there has to be more profit generation through risk. But it again calls for marketing different products to cater to the needs of the customer and also simultaneously complying with the regulations, which also involves risk. When organisations grow in size and numbers it becomes too large with too much interconnectedness, which indirectly pose risk to the entire industry if it fails, i.e., systemic risk. Each credit decision, customer doing a KYC, staff selection, introduction of any new product, all of these involve risk. To facilitate effective decision-making gathering of all the available data is important. But normally there is limited availability of data, however it is fast improving due to credit bureaus and websites.

There are various ways to mitigate risks and one of them is ‘risk acceptance’– accepting that risk will be taken to make money because without that risk banks cannot survive. ‘Risk avoidance’ on the contrary is to say no to whatever comes your way and you don’t take any decision. But then as bank, as an organisation, you will not be able to grow and you will not be able to generate enough returns for your shareholders. The third way to mitigate risk is the risk within the bank. Various kinds of limits are fixed saying that this risk is acceptable but only to that extent and beyond that I will not take the risk. The fourth and the most important risk mitigation technique used is ‘risk transference’, where you pass on the risk to a third party like insurance. In addition, there are hatching techniques like buying a derivative product to take you off the underlining risk. These are some of the things in which we manage the risk. In addition, ‘cyber security risk’ is becoming one of the major risks. Likewise, the strategic risk that can come out of underlining fundamental changes in your business model. ‘Reputation risk’ which earlier was not really considered as a risk but today all organisations consider that as a big risk. ‘Compliance risk’ and ‘conduct risk’ which are being considered crucial by most of the organisations deal with how your employees in the organisation behave and also how they perform. SBI recently recruited a person with designation ‘Chief Ethics Officer’ who takes care of the conduct within the organisation. Therefore, it is not adequate to take care of the traditional risk alone, but be able to take care of all the above risks and take informed decisions.

After SBI, Vijaya Bank is one of the well managed banks in terms of its numbers and its ROA (Return on Assets) shows considerable improvement. This is reflected in its share price, which has risen to Rs 97 from earlier Rs 37. BS Rama Rao, ED, Vijaya Bank states, “The role of risk management really depends upon the identification of the proper root causes and risk drivers so that policymaker will be able to decide and articulate risk profile of the bank.” RBI has stipulated prudential limit for various component of the capital namely common equity type in today’s context of raising of common equity capital is a challenge, which can only be addressed by improved bottomline and visibility in future earnings. Minimum liquidity requirement in the form of short-term liquidity coverage ratio called the LCR and long-term structure in the net stable funding ratio, NSF. The capital buffer can be used to observe the losses during the period of the financial and economic stress the customer cycle. Moreover, RBI has been adopting a consolidating approach of limiting the systematic risk originating from both the pro-cyclic as well as interconnected dimension. Accordingly, inter-sector ceilings are fixed to monitor sensitive sectors like steel, cement, textile, aviation, infra, power. The global crisis of 2008 stated that no financial institution can be resistant to all possible crisis and no quantitative model fully captures all the risk. This realisation has prompted the focus to shift on strengthening the risk governance. Risk governance has been brought to the centre stage and there are many initiatives underway to plug the gap and loopholes in the system.

In Insurance sector B N Narasimhan, GM, GIC, points out that Risk Management denotes, “pulling the resources of many to pay for the losses of the unfortunate few, so insurance companies take on the risk which is contract-based documentation and transfer the risk from the owner of the property to the insurance companies.” Insurance companies have got limited capacity provided by their balance sheet because of the compliance and regulations, as they have to maintain their solvency ratio at a particular level and cannot take on unlimited risk and all the types of risks. So they will have to choose the types of risks, which will suit the balance sheet and the liquidity norm set by the regulator keeping in mind the concept of reinsurance. But again seeing from the reinsurance perspective as far as the Indian scenario is concerned, though GIC is a monopolistic player because of the market share, in reality 50 per cent was actually taken on the balance sheets of the reinsurers spread across the globe. Moreover, new firms cover different types of risks like catastrophe, for example in places like Mumbai where there are accumulation of buildings risks.

In insurance and reinsurance parlance, the most fundamental thing is ‘pricing’ or ‘premium’. Specifically in direct market it is called reinsurance premium if it is a contract between an insurance company and a reinsurance company. The need to price the product adequately is crucial to run the business successfully otherwise the business will crumble. Who decides what is adequate, as there is no specific rule to it. Therefore, these norms are decided by corporate managers of the insurance companies and they will have to take a prudent risk based on quality data.

According to K Sanath Kumar, CMD, National Insurance Company, “In insurance sector there are two perspectives, one is the kind of risk which we insure and another is the risk to our organisation. So there are two very clear perspectives that we need to manage.” With regard to the second perspective, managing the risk inherent in the organisation, it is to be noted that one of the major risk is regulatory risk. Today the Insurance Regulatory and Development Authority of India (IRDAI) has brought out 30- odd regulations, guidelines etc, which mandates the need to work within those rules and regulations. All of these have to be assessed, managed, monitored and cannot be transferred. It has to be completely managed in-house. Moreover there are other risks such as public image risk, which is very important to safeguard against unwanted comments or negative news that can cause serious damage to an insurance company and therefore has to be managed. The external ecosystem, the interaction and interface also have to be managed. Most importantly, reaching out to the multiple customers at the same time, retaining and to continuously engage becomes important.

There are certain challenges, which still loom large in risk management arena and one of them is the ‘lack of penetration’ and lack of customers coming forward and buying the insurance product. This is because the penetration is quite low in other insurance schemes in comparison to ‘General Insurance’ and ‘Life Insurance’. There is also a widely prevalent notion of ‘lack of trust’ with regard to settlement of claims. This is because of the time-taking process and the end amount you get in the hand.

The way forward in streamlining and strengthening risk management for effective decision-making could be carried on by focusing some of the following pertinent areas: Praveen Gupta voices for accepted course of behaviour and the standardised code of conduct in every organisation, which is highlighted as second highest risks in the financial service sector as brought out by global survey in ‘Risk net”. In addition, Gupta also reiterated the need for quality data, which determines the pricing, which is crucial for risk management related dividends. Risk management therefore should involve identifying, assessing, prioritising, managing, reviewing, agreeing and updating. Applying risk management processes should help strategic decision makers take informed decisions about policy and service delivery options. In addition, to have better risk management system a holistic approach and the risk appreciation should be given top priority along with robust management information system and appropriate information technology platform. A uniform national risk strategy is a prerequisite, which should be implemented through the organisation. Presence of Chief Risk Officer at the head office and trained risk officers at every regional office is very important and should be given proper independence with necessary standing for inputs pertaining to critical decisions. Moreover, the risk culture is something beyond a board approved riskmanagement policy. An employee’s overenthusiasm or under-enthusiasm can create risk for the organisation. It highlights the need for a standardised code of conduct/SOPs with accepted behaviour within the organisation and penalties for defiant behaviour, which hampers an organisation’s image. Mass awareness programme to popularise various insurance schemes and its benefits should be taken on a war footing to penetrate and reach the unreached. It is important that every employee at the bank needs to know about risk management and how and why it is done. This can be done through staff training once in two months especially in rural areas to get an understanding about the various risk factors and also filter appropriate proposals for credit lending. As a next step moving the focus to branches – a form of decentralisation where the regional office has to go to the branch for the credit approval. Successful decision-making therefore requires an understanding of various risk aspects and making the best possible decision. As the present government’s policies and schemes towards digital economy favouring small and middle size entrepreneurships, the credit risk appraisal will have to balance between the confident entrepreneurial ability of the applicant vis-a-vis the discretion of bank manager taking into account the risk probabilities.