8.1 Introduction

As we have discussed in the previous chapters, banks as financial intermediaries mobilise deposits from savers and lend out the funds generated to borrowers. The interest income earned on loans and investments over interest cost on deposits is the main source of a bank's profits. We also discussed how the banking business entails a variety of risks. The central aspect of the banking business is maximising risk-adjusted profits. In Chapter 7, we discussed how the policy authorities regulate banking activities to contain risks within reasonable limits and ensure that banks take necessary precautions to mitigate risks.

In this perspective, banks undertake risk management as part of their regular banking operations. Risk management practices adopted by banks serve mainly two purposes. First, they ensure a bank's compliance with regulatory prescriptions in letter and spirit. Second, in the interest of sustaining the banking business and maximising risk-adjusted returns in the long run, the bank undertakes related banking operations to maintain safety and soundness. Risk management within banks is not just a matter of obligation to comply with regulatory requirements, but it is also a necessity for their very survival and sustenance.

As part of the banking sector reforms commenced in India since the early 1990s, the banking regulatory apparatus witnessed a radical transformation. Implementation of international best practices related to capital adequacy norms, asset classification, provisioning and income recognition were the key components of such regulatory reforms. A related reform was the adoption of a risk management system for identifying, measuring and mitigating different types of banking risks. Details of these aspects are provided in Chapters 6 and 7 of this book.

It is pertinent to note that the risk management criteria or parameters within a bank cannot be below the standards prescribed by the RBI. Nevertheless, there are subtle differences as regards the regulatory prescriptions on a particular aspect vis-à-vis internal risk management practices across banks on several counts.