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5
Asian Journal
of Research in
Banking
and
Finance Asian Journal of Research in Banking and Finance Vol. 5, No. 11, November 2015, pp. 47-58.
ISSN 2249-7323
47
www.aijsh.org
Asian Research Consortium
Risk Management in Indian Banks: An Evaluation through Z Risk Index
Suksham R.Aneja*; Dr. Bhisham Kapoor**; Dr. (Mrs) Anurag Pahuja***
*Research Scholar,
Mewar University,
India.
**Associate Professor,
M.M.H. College,
Ghaziabad, India.
***Associate Professor,
IMS,
Ghaziabad, India.
DOI NUMBER: 10.5958/2249-7323.2015.00133.9
Abstract
Nothing is constant but risk in today’s dynamic environment. Banking is the business of risks and all banks are exposed to a variety of risks viz. a viz. credit risk, liquidity risk, foreign exchange risk, market risk and interest rate risk. It is very important to handle these risks in a pre-emptive, proficient and cohesive manner to maintain sound financial health of a bank. The purpose of this empirical study is to make an assessment as to how far Indian banks have been successful in achieving their objectives of minimizing the negative effects that risks can put on the financial results and capital of a bank. The need of the hour is an efficient risk management system comprising risk identification, measurement and control. An effort has been made to assess the financial health of the commercial banks in India by analyzing their riskiness and the probability of being insolvent. The insolvency risk for 73 Indian banks (26 public sector banks, 20 private sector banks and 27 selected foreign banks) using Z-Index along with the probabilistic prediction of their book value bankruptcy over a period of nine years i.e. from 2005-06 to 2013-14 has been analyzed and a comparative analysis among public, private and foreign banks to examine the probability of their book value bankruptcy has been made.
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Keywords: Risk Management, Z Risk Index, Insolvency Risk, Indian Banks, Public sector banks, Pvt. sector banks. ________________________________________________________________________________
Introduction
Sound banking system is an important indicator of an economically strong nation, and Indian banking has evolved through several distinct phases since independence. In order to make the banks economically viable and financially strong, Government of India in consultation with RBI have been taking, a series of major reformative measures such as interest rate deregulation, introduction of prudential norms relating to income recognition, provisioning, capital adequacy, emergence of new private sector banks, opening up of branches of foreign banks in India, increasing use of technology, continuing mergers and acquisitions, modernizing backroom operation and emphasis on customer satisfaction etc. Due to ever evolving financial institutions in this dynamic environment, banks are confronted with various types of risks like credit risk, liquidity risk, market risk, interest rate risk, etc., which are correlated and need to be handled in a proactive, efficient and integrated manner so as to maintain, sound financial health. Indian banking sector has seen many positive developments in the past by the policy makers and financial sector regulatory authorities to bring an improvement in the regulation of the sector. Gone are the days when typical bank’s business involved only accepting deposits and disbursement of advances. Today's technology driven world provides International financial markets a showcase of opportunities to banks for designing new instruments, products, and services in the financial world. Such innovations like derivative products and securitization along with “off-balance-sheet” financial instruments expose banks to major risks. These risks are not only correlated but contagious as well as evidenced by the financial crisis which started from one country but affected almost the whole world. Banks have flourished from being a financial intermediary into a risk intermediary due to changes in the economic and regulatory scenarios banks operate in. This process of financial intermediation exposes banks to severe competition and hence compels them to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. With each transaction that the bank undertakes the risk profile of the bank evolves in new dimensions which needs to be tapped.
Risk management is a forward looking process, which involves decision making on an on-going basis. The Basel Committee on Banking Supervision (BCBS) defines financial risk management as “a sequence of four processes: the identification of events into one or more broad categories of market, likewise, credit, operational and other risks (and then into specific sub-categories); the assessment of risks using data and a risk model; the monitoring and reporting of the risk assessments on a timely basis and control of these risks by senior management.
The purpose of implementing risk management in a bank is not to turn all professionals into risk modellers rather it is to cultivate minimum understanding of risk models and techniques so as to build up Risk oversight in them. Risk oversight entails awareness among bank professionals, supervisors and standard setters, of risks rooted in the balance sheets and off balance sheets of the banks. Risk oversight implies knowledge of risks, ability to anticipate adverse events and whenever risks drift away the boundaries of permissible limits as per banks’ policies, risk manager knows the
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right time of enforcing risk controls and systems. In today’s IT world it is feasible theoretically as well possible to build such risk processes, techniques and models through which Risk oversight and risk controlling can be implemented. In this study an attempt has been made to measure Z risk index score of Indian banks from 2006-2014 to analyse the effects of improvement in risk management practices i.e. to understand whether better risk management practices are leading to less risk. Section II presents the review of existing literature relating to risk management and Z Risk Index particularly. Section III describes the research methodology adopted in this study. While section IV is dedicated for analysing and interpreting the empirical observations, findings and concluding remarks are depicted in section V.
Section II: Literature Review
This section covers important studies conducted in the field of risk management in India and abroad, so as to give a better understanding of the concept and its appliocability in banking industry.
The study by Cebenoyan & Strahan (2001) tried to test whether banks that were better able to trade credit risks in the loan sales market experienced significant benefits. For this purpose the researchers executed a series of cross-sectional, reduced form regressions to establish relationship of capital structure, investments in risky loans, profits and risk to control variables with usage of loan sales market by banks to foster risk management. Such relationship was clearly visible in the research. However, on general level, the buy-sell banks appeared no safer and, perhaps, somewhat riskier; but when compared to their peers, banks with similar operating and financial ratios, the buy-sell banks exhibitted significantly lower risk. The study concluded that the benefits of advances in risk management in banking will likely be greater credit availability rather than reduced risk in the banking system.
Bichsel & Blum, 2001 investigated the relationship between changes in risk and changes in accounting market data for risk and both accounting and market data for capital over the period between 1990 and 1999, a positive correlation was found between changes in capital and changes in risk, i.e., higher levels of capital were associated with higher levels of risk. Using monthly data covering a period of 10 years between 1990 and 1999 for a sample of 18 publicly traded Swiss banks; the authors examined the relationship between the leverage ratio and the risk of banks. A positive correlation was found between changes in capital and risk. Despite the positive correlation between risk and capital, no significant relationship was found between the default probability and the capital ratio.
Naïmy, 2005 gauged the overall performance of the Lebanese Banks in terms of profitability and risks for the period 1993 to 2002. He used Du Pont equation to measure profitability and risk index suggested by Hannam and Hanweck (1988) to measure risk of Lebanese commercial banks so as to evaluate the performance of this sector in terms of profitability and risks for the period 1993 through 2002. Despite a healthy banking management and relatively strong capitalization along with rigorous control, the growth rate of the banking economic activity encountered a slowdown since the beginning of the year 2000. Solvency and profitability of banks were threatened by unexpected movements in interest rates or any political or regional shock. This study analyzed the general performance of the Lebanese banking system and found that it was highly correlated with
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the economic situation of the country which was suffering from severe structural imbalances, an increasing deficit, and a permanent deficit in the balance of trade.
Rahman et al., 2009 tried to investigate the impact of lending structure on the insolvency risk exposure. For this a comparative analysis of insolvency risk behaviour between the Islamic and conventional banks was made. The findings of this study was that the real estate lending was positively related to the conventional banks’ risk, but inversely related to Islamic banks’ risk exposure. A linear model was conducted using the generalised least squares (GLS) estimation to test the risk behaviour of lending structure. Based on unbalanced panel data, three models were analysed; namely, pooled effect (also known as none effect model), fixed effect, and random effect model with an objective of examining the effect of lending structure on the insolvency risk exposure of Islamic and conventional banks in Malaysia.
Sinha, Taneja and Gothi (2009) suggested that the framework developed by Hannan and Hanweck (1988) was also relevant in the Indian context. The study explored a direct relationship between risk and return indicating that increasing one will subsequently increase the other and vice versa. Findings of this paper suggested that the most significant achievement of the financial sector reforms had been the marked improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as also greater attention to risk management and this improvement was visible in the form of increasing Z-statistic values obtained over years.
Coote, 2004 extended the economic framework used by Bichsel and Blum (2002) in examining the relationship between bank capital and default risk. This paper provided an important variation of the Bichsel and Blum (2002) study, which found a positive relationship between bank capital and risk taking for Swiss banks based on data between 1990 and 2002 through an economic and empirical framework. An option-based default metric was computed for Jamaican banks based on Merton (1974) model for tracking the default experience for Jamaican banks over the period of 1996 to 2004. However, the study did not uncover a significant relationship between either bank capital and asset risk or bank capital and the likelihood of default. Additionally, contrary to previous research, it was found that a higher volatility in equity prices was associated with a lower default probability.
Research gaps were identified in the light of the recent financial crisis in the US, India and European countries which refocused attention on the financial health of commercial banks and efforts have been made to measure the bankruptcy risk of Indian banks (public, private and foreign sector) for a period of nine years (2005-06 to 2012-14) using a popular risk measure in the banking and financial stability related literature called Z risk index that reflects a bank’s probability of insolvency.
Section III: Objectives and Research Methodology
Primary objective of this study is to analyse whether regulatory risk management guidelines provided at national and international levels have genuinely brought a decrease in the risk faced by banks.
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The specific objectives of the study include the following:
1. To measure Z Risk index for public, private and selected foreign banks operating in India during the period of 2006-2014.
2. To draw out a cross-sectional as well as longitudinal comparison of the probability of insolvency amongst public, private and selected foreign banks operating in India on the basis of data pertaining to the selected period.
In order to capture the overall risk of a bank, the standard deviation of ROA (return on assets) is a good measure of the variability of ROA which provides a comprehensive measure that reflects not only credit risk but also interest rate risk, liquidity risk and any other risk that is realized in bank earnings (Sinha, et al., 2009,). To proceed with such analysis, Z risk index has been used as an indicator which is a comprehensive measure of bank insolvency risk exposure.
Z Risk Index
The Z risk index as a measure of insolvency risk was suggested by Hannan and Hanweck (1988) which was subsequently used by Liang & Savage (1990), Eisenbeis & Kwast (1991), Sinvey & Nash (1993), Naimy (2005), Rahman, Ibrahim, Kameel & Meera (2009) and Sinha et al. (2010). The Z statistic takes into consideration banks’ return on assets, volatility of return and the capital base. In spite of its simplicity, it is widely used as it can be calculated using only accounting information and thus applicable for both listed and unlisted financial institutions (Strobel, 2011). Hannan and Hanweck’s probability of bankruptcy is based on the probability of return on assets being negative and larger than the capital-asset ratio. Z risk index is a function of the normal profit margin of the bank, the variation in that profit margin, and the equity capital available to absorb that variation. In effect, the Z risk index measures the strength of the ROA capacity divided by the number of standard deviations indicating how much ROA could be decreased without impacting the capital base i.e. before the book equity capital of the bank would be exhausted. The Z risk index attempts to capture the likelihood of a bank's earnings in a given year becoming low enough to exhaust the bank's capital base and, thus, the likelihood of the bank becoming insolvent.The relationship between the Z-ratio and the probability of bankruptcy is an inverse one, with higher Z-ratios indicating a lower probability of bankruptcy.
Specifically, Z is defined as:
Where:
Return on Assets (ROA) = Net Income / Average of Total Assets.
Capital-to-Asset Ratio (CTA) = Equity/ Total Assets.
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As applied in studies conducted by Sinha, et al (2010) and Krishna Murari (2012), in the present study instead of Total Assets, Risk weighted assets have been used which is Capital Adequacy Ratio (CAR).
Higher values of Z imply lower insolvency risk because higher values of Z indicates higher levels of equity and earnings as compared to a potential shock to the earnings denoted by variability in return on assets of a bank. Thus, even if banks have wider access to funds invested in risky loan portfolios they can maintain a low risk of insolvency as long as they are adequately capitalized.
Probabilistic Interpretation of Bankruptcy
Probability of book value insolvency (P) has been computed by applying the following formula:
P = 1/ [2Z2]
Where the multiplication by (1/2) reflects the fact that bankruptcy occurs only in the left tail of the distribution. The relation of P to Z is inverse, with higher Z risk index indicating low probability of bankruptcy and vice versa. One-period probability of insolvency could be calculated as a function of the Z risk index while assuming that the potential ROAs of the business are normally distributed. However, empirical studies (Sinha, et al, 2009) suggested that ROAs are not normally distributed, but instead are “fat-tailed,” causing actual probability of insolvency to be higher. Reason behind this might be that one-period probability may understate the true probability of insolvency as it measures the risk of a single-period loss which might be so big that it wipes out equity. In practice, insolvency often occurs after a sequence of smaller losses occurring over several periods, indicating that serial correlation between negative shocks may exist.
Section IV: Data Analysis and Results
Measuring the Z Risk Index for Indian Banks
The present study is based on the observations of 73 Indian commercial banks, comprising of 27 Public Sector Banks (PSB), 20 Private Sector Banks (PrSB) and 27 Foreign Banks (FB). In this study only those foreign banks have been considered which were operating in India during the whole period of study i.e. from 2005-06 to 2012-14. The required secondary data was collected from Performance Highlights of various banks as published by Indian Banking Association, (Indian Banking Association) for a period of 9 years from 2005-06 to 2013-14.
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Table 1 Z Risk Index and Probability of Insolvency of Indian Banks on the
basis of financial results of banks from 2005-06 to 2013-14
Banks ROAµ CARµ ROAϭ Z P
Nationalised Banks (20) 0.00853 0.12570 0.00378 35.47592 0.00040 SBI Group (6) 0.00928 0.12655 0.00213 63.86803 0.00012 Public Sector Banks (26) 0.00861 0.12589 0.00347 38.75170 0.00033
Old Pvt. Banks(13) 0.01038 0.14813 0.00573 27.65114 0.00065 New Pvt. Banks(7) 0.01210 0.15154 0.00770 21.26416 0.00111 Private Sector Banks (20) 0.01098 0.14932 0.00652 24.59397 0.00083
Foreign Banks (27)* 0.02296 0.34019 0.06354 5.715399 0.015307
Note: * Those foreign banks have been considered which were operational in India during the whole period of 2006-2014.
The Table 1 shows the Z-index and probability of bankruptcy (P) of PSB (Public Sector Banks), PrSB (Private Sector Banks) and FB (Foreign Banks) during the period of 2005-06 to 2013-14. It is evident from the table that average ROA of PSB (0.00861) is less than ROA of PrSB (0.01098). However, ROA of Foreign banks (0.02296) is considerably higher. In case of CAR (Capital Adequacy Ratio), significant higher value is observed for FB (0.34019) as compared to PrSB (0.14932) and PSB (0.12589). But Z-statistic of FB (5.715399) is much lower than that of other two bank groups i.e. PrSB (24.59397) and PSB (38.75170). This difference is due to the variability of ROA as measured by the standard deviation. While standard deviation of ROA is only 0.00347 in the case of PSB, it is a very high of 0.06354 for FB. It is also high in the case of PrSB (0.00652) as compared to PSB. This significant difference in the variability of ROA leads to lower Z-statistic despite higher ROA and CARof FB and PrSB. Thus, the observed Z risk index indicates that the public sector banks are safer as compared to private sector banks and foreign banks.
The probability of bankruptcy, as shown in the table, also depicts the same. It can be mentioned here that the findings of the present study support the findings of Sinha, et al (2010) and Krishna Murari (2012). Among the public sector banks, average performance of State Bank of India (SBI) group is better than the nationalized banks in terms of maintaining sound financial health as indicated by Z risk index which for state bank group is found to be 63.86803, whereas it is 35.47592 for nationalized banks during the study period. By maintaining almost same capital base and same average (ROAµ), SBG could improve its Z risk index by lowering variability of ROA being 0.00213 which is quite less than 0.00378 i.e. standard deviation of ROA of nationalised banks. Among the private sector banks, though the probability of book value insolvency is lower for old private sector banks (0.00065) than the new private sector banks (0.00111), but it is considerably higher than the state bank group. The reason is same higher standard deviation of ROA denoting higher risk. Both new and old private sector banks could not maintain a steady return on assets over the years leading to higher standard deviation of ROA causing higher probability of insolvency.
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Table 2: Top Ten Banks with Highest Z-Index
SNo Name of the Bank ROAMEA
N
CTAMEA
N
ROAS.D
.
Z P
1. The Federal Bank Ltd. (Old PrSB)
0.013256
0.168267
0.001022
177.547246
0.000016
2. Shinhan Bank (FB) 0.018867
0.553189
0.003225
177.386898
0.000016
3. City Union Bank Ltd. (Old PrSB) 0.015611
0.130833
0.000910
160.878321
0.000019
4. State Bank of India (SBI) 0.008678
0.130133
0.001253
110.802933
0.000041
5. IDBI Ltd. (PSB) 0.006478
0.130644
0.001292
106.126015
0.000044
6. State Bank of Bikaner & Jaipur (SBG)
0.008800
0.127344
0.001377
98.834605
0.000051
7. Syndicate Bank (Old PrSB) 0.008300
0.122189
0.001321
98.781546
0.000051
8. State Bank of Patiala (SBG) 0.007622
0.125044
0.001487
89.202024
0.000063
9. State Bank of Hyderabad (SBG) 0.010300
0.128533
0.001575
88.159255
0.000064
10. YES Bank (New PrSB) 0.016400
0.164333
0.002071
87.258876
0.000066
Table 2 depicts the top 10 banks out of the selected 73 banks with respect to Z risk index. It is revealed through this table that The Federal Bank Ltd. seized first position with a very high Z-index of 177.547246. Out of the top ten banks, four banks are Private Sector Banks, including one New Private Sector banks and three old generation Private Sector Banks. On the other hand, State Bank of India and three other banks from State Bank Group have made up to the list of top ten banks. One Public Sector bank and one Foreign Bank are also in the list. In the similar study of (Murari, 2012) none of New private sector banks had been able to enter the list due to lower Z-index as compared to other banks but now with better risk management practices YES bank has joined the list. It signifies that some of the Banks have played exceptionally thriving in acting as financial intermediary and supervising sound financial health, while others could not.
One more thing is clear from Table 2 that very high Z-index of The Federal Bank Ltd. is due to lower variability of return (ROAS.D.). The average ROA of City Union Bank Ltd. (0. 0.015611) is greater than that of The Federal Bank Ltd. (0. 013256), but the SD of ROA of the former bank depicting risk is higher than the later. Similarly, in comparison to State Bank of Patiala (PSB) and Syndicate Bank (PrSB), YES Bank, State Bank of Hyderabad (SBG) have much higher ROA as well as CAR but still they rank lower in respect of Z-risk index due to higher Standard deviation of ROA.
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Table 3. Year-wise Z Risk Index and Probability of Insolvency of Indian
Banks
Year
(31
March)
Public Sector Banks Private Sector Banks Foreign Banks
Z P Z P Z P
2006 35.372803 0.000400 14.6778 0.002321 19.47233 0.001319 2007 53.653943 0.000174 30.05948 0.000553 21.66058 0.001066 2008 46.441750 0.000232 39.43146 0.000322 23.16467 0.000932 2009 44.474481 0.000253 25.24266 0.000785 14.89392 0.002254 2010 45.259118 0.000244 23.23071 0.000926 16.49538 0.001838 2011 50.831415 0.000194 33.17275 0.000454 27.17599 0.000677 2012 53.902062 0.000172 34.72208 0.000415 20.36242 0.001206 2013 56.447113 0.000157 29.90912 0.000559 15.97925 0.001958 2014 31.94555 0.00049 17.91747 0.001557 13.55922 0.00272
Year-wise Z risk index and probabilistic interpretation of book value insolvency for Indian banks, as shown above in Table 3, reveals that Indian banks have shown a fluctuating trend during the period of study in terms of financial stability. In case of PSB, Z risk index increased from35.372803 in 2005-06 to 56.447113 in 2012-13 and again reduced to31.94555. Indeed, during the tough time for the world with respect to financial crisis, the Z risk index for Indian PSB has been almost consistent and went little down. In the case of PrSB, though Z risk index increased from 14.6778 in 2005-06 to 17.91747in 2013-14, a fluctuating trend is seen over the years. For instance, the highest Z-statistic is found in the year 2007-08(39.43146), but in the immediately succeeding year, it came down to 25.24266 which showed the impact of the US subprime crisis. The probabilityof insolvency for PrSB has been fluctuating within the limits during the period of study. In thecase of FB, it increased from 19.47233 in 2005-06 to 23.16467 in 2008-09 with an increasing trend, but it came down to 13.55922 in the last year of the study period after recording an increase during medieval years. In the last year of study 2013-14 again risks have increased and probability of insolvency has reduced. This change might be because of Indian economic crisis in 2013 which India had been facing persistently resulting in high current account deficits for many years which. There has been increasing reliance on external capital flows in the form of debt and equity to finance this deficit with short-term debt and fickle equity flows for several years. Besides many corporates carry fair amounts of unhedged foreign exchange liabilities. Overall, a declining probability trend for insolvency is observed for the PSB and PrSB during the study period as shown in the Table 3. Foreign banks operating in India showed a little worrisome trend with respect to the probability of book value insolvency which may be attributed to the small operational coverage in India. A positive trend is found for all the bank groups in recent years indicating a good sign for Indian commercial banks except foreign banks and however in the last year health of India’s banking system showed a slowing economic growth and rapid currency depreciation depicting higher risk.
Section V: Conclusion
Risk manager’s job is to adopt such policies and practices which minimizes risk for a given return. Variation in the returns is a critical factor in judging the performance of risk management
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department of the banks. To check such performance of risk management of banks Z risk index has been used. As observed from the data analysis of present study insolvency risk of the public sector banks is less as compared to private and foreign banks. Average performance of state bank group is showing better performance as compared to the nationalized banks in terms of maintaining sound financial health depicted by Z risk index. Except last year 2013-14 and years of US subprime crisis, overall financial health seems to be strong for Indian banks as measured by Z risk index which is showing overall an upward trend for all the bank groups. Financial health of banks can be improved by reducing the variability of ROA which represents the risk. However different results were noted for foreign banks’ financial performance which may be due to the fraction of business they are doing in India as compared to their home country.
Scope for Future Resaerch
The study suggests that in order to improve their financial health, Indian banks need to reduce the non-performing loans to a very negligible level and maintain a steady ROA and that's where effective risk management has to come in action. However insolvency risk is becoming a matter of serious concern for Indian banks as last financial year has seen a combination of growth weakening, lower market confidence, more NPAs and further reductions in asset quality challenging their resilience. Though at micro level, the risk and its management in banking industry has been gauged in the paper, further studies can focus on various macro parameters along with micro factors to have a holistic coverage.
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