1.

Background of the Study

Risk-taking is an inherent element of banking and, indeed, profits are in part the reward for
successful risk taking in business. On the other hand, excessive and poorly managed risk can
lead to losses and thus endanger the safety of a bank's depositors. Risks are considered warranted
when they are understandable, measurable, controllable and within a bank’s capacity to readily
withstand adverse results. Sound risk management systems enable managers of banks to take
risks knowingly, reduce risks where appropriate and strive to prepare for a future, which by its
nature cannot be predicted.

In recent years, following the global financial crisis, risk management issues have received
increasing attention of international supervisory bodies. While weak risk management has not
been seen as a specific trigger for the financial crisis, it has been identified along with weak
internal governance as an underlying factor. The risk management framework was often not
sufficiently integrated within institutions, there was not a uniform methodology and the holistic
view of all risks did not exist. Equally, where they existed, sound risk management practices
helped institutions to weather financial crisis significantly better than others. Following the
financial crisis, risk management in financial institutions moved from a compliance driven
function toward a top level comprehensive activity relevant at the highest levels of decision
making and strategy setting. While the extent of risk management function performed and
structure kept in place depend on the size and complexity of individual financial institutions, risk
management is most effective when basic principles and elements of risk management are
applied consistently throughout the financial institution.

Prior to 1988, there was no uniform international regulatory standard for setting bank capital
requirements. In 1988, the Basel Committee on Banking Supervision (BCBS) 1 developed the
Capital Accord, which is known as Basel I. It focused almost entirely on credit risk. It defined
capital and structure of risk weights for banks. The minimum capital requirement was fixed at
8% of risk weighted assets (RWA). Later the 1988 Capital Accord suffered from several
drawbacks as it exclusive focus on credit risk, it does not differentiate between sound and weak
banks using “one hat fit all” approach, it acquire broad brush structure. Hence, in order to
remedy the Basel Committee published a New Accord known as Basel II, on 2004. It is based
on three parameters, which the committee calls it as pillars. According to this, banks were
needed to develop and use better risk management techniques in monitoring and managing all
the three types of risks that a bank faces, viz. credit, market and operational risks - Market
Discipline. Again, the Basel Committee on Banking Supervision (BCBS) released a
comprehensive reform package entitled “Basel III in December 2010. It was introduced in
response to the financial crisis of 2008. A need was felt to further strengthen the system as banks
in the developed economies were under-capitalized, over-leveraged and had a greater reliance on
short-term funding. Basel III norms aim at making most banking activities such as their trading
book activities more capital-intensive.
Banks always faces different types of risks that may have a potentially negative effect on their
business. The major risk in banking business as commonly referred are Credit Risk, Market Risk,
operational Risk, Liquidity Risk, Business Risk, Reputational Risk and so on. The Basel
Committee on Banking Supervision defined Credit Risk, Market Risk and Operational Risk at
Basel Accord II under Pillar 1 at global level. These risks are common globally at banking
industry where the impacts of these risks are serious. At organizational level, overall risk
management is assigned to an independent Risk Management Committee or Executive
Committee of the top executives that reports directly to the Board of Directors. The purpose of
this top level committee is to empower one group with full responsibility of evaluating overall
risk faced by the bank and determining the level of risk which will be in the best interest of the
bank. At the same time the committee holds the line management more accountable for the risks
under their control and the performance of the bank in that area. The risk management is a
complex function and it requires specialized skills and expertise. Large banks and those
operating in international markets have developed internal risk management models to be able to
compete effectively with their competitors.

Risk management focuses on the identification of potential unanticipated events and on their
possible impact on the financial performance of the firm and at the limit on its survival. Risk
Management in its current form is different from what the banks used to practice earlier. Risk
environment has changed and according to the draft Basel II norms the focus is not only on
credit risk but more on the entire risk return equation. Under Basel II norms - Pillar 1 of the
specific NRB guidelines, the bank currently follows Simplified Standardized Approach for
Credit Risk, Basic Indicator Approach for Operational Risk and Net Open Position approach for
Market risk.