Tag: risk management

How can risk management professionals switch between banking & insurance?, BFSI News, ET BFSI

Banking & Finance

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Life insurance and the banking sector are the two core sectors where customers keep money with the trust that their money is safe. Both the sectors protect the customer’s money. This article looks at both the assets and liabilities of the banking and insurance sector to find out the similarities and differences. The article also looks at the risks of both sectors to find whether there are opportunities for cross-pollination of people working from both sides.

In both sectors, customers place their money with the respective institutions such as banks and insurance companies. In the banking sector, deposited money creates liability to be returned upon withdrawal. Similarly, in the insurance sector, the premium received creates liability which is paid when a claim arises (death, maturity, and surrender). So, money placed by customers in both sectors creates liability.

Safer asset creation accords secured returns

On the other hand, the money collected by both institutions is invested to back the liabilities which create assets. Under the insurance sector, the money received in the form of a premium is used to purchase the assets like government securities, corporate bonds, equities, and other assets. These assets so purchased to match the amount and tenure of liabilities.

In the banking sector, the money deposited by customers is used to create assets in the form of Government securities, corporate bonds, and equities while other assets are created by giving loans. The bank charges a higher rate of interest from the loanee compared to the depositor to meet expenses and profit margin.

Both the institutions take credit risk by investing to back their liabilities. In the insurance sector, investments are highly regulated with a high percentage of investment in Government bonds and a relatively lower percentage in corporate bonds, and even lesser in equities, thereby having relatively lower credit risk from the point of the probability of default. On the other hand, in banks, most of the assets are created by giving loans to individuals and institutions subject to higher default risk, thereby they have high credit risk. The mechanism of the creation of credit risk under both institutions is similar.

Managing the risk of liquidity

Liquidity risk in the banking sector is a key risk from the customer’s deposit point of view, that is, customers to be paid on demand. Therefore, the banks in India are to maintain a certain Cash Reserve Ratio (CRR). The money kept under CRR may be used to pay when the demand arises from bank customers. The CRR is the ratio of cash required to keep as a reserve as a percentage of total deposits. This cash is either stored in the bank’s vault or deposited with the Reserve Bank of India (RBI) on which no interest payment is made. The current CRR is 4% of Net Demand and Time Liabilities (NDTL). This money cannot be used for investment and lending.

One of the applications of CRR is to control inflation as high CRR will reduce the amount available for lending in a form of loan thereby reducing banks’ liquidity leading to reduced circulation of money in the economy.

Similar to CRR, another tool used to manage the liquidity in the banking system is the Statutory Liquidity Ratio (SLR) is the minimum percentage of deposits (NDTL) that is to be invested in gold, cash, and other securities. These deposits are kept with banks and not with RBI. The current SLR is 18%.

Similar to CRR, SLR is also used to trap the circulation of money in the economy which can control inflation. Also, SLR is used to control the ability of the banks to lend; higher SLR would restrict bank’s ability to give loans.

The restrictions applied in the banking system in a form of CRR and SLR helps in managing the liquidity position of the banks to enable payment to depositors. Similarly, in the insurance sector, to enable the payment of claims, the regulator has prescribed a very strict investment norm with a high percentage of investment in government bonds for the security of money. Such investment in government bonds can be easily liquidated to help maintain liquidity in the insurance sector. Both the sectors use the same methodology of either cash flows or liquidity coverage ratio to assess the liquidity position along with stress tests to identify higher requirements of liquid cash.

In the banking sector, CRR and SLR act like a reserve to be used when required paying to customers on increase in withdrawals, similarly, in the insurance sector, insurance companies are to keep reserves to pay claims when arises. These reserves are calculated at prudential assumption based on guidelines given by the insurance regulator. Such reserves are to be invested based on the regulatory investment guidelines. The purpose of the reserve is to meet the customer’s claims when they arise. In both sectors, there are prudential norms to safeguard the money of the customers in meeting liabilities.

There is a similar inherent mechanism under both the banking and insurance sector to protect the customer’s money, managing the credit and liquidity risk. There can be opportunities for cross-pollination of skills between the two sectors. Actuaries are very strong on the liability side while banking folks are strong on the asset side, an amalgamation is possible.

The blog has been authored by Sonjai Kumar, Certified Risk Management Professional from IRM London

DISCLAIMER: The views expressed are solely of the author and ETBFSI.com does not necessarily subscribe to it. ETBFSI.com shall not be responsible for any damage caused to any person/organisation directly or indirectly.



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SBI official, BFSI News, ET BFSI

Banking & Finance

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Cyber security is critical for the success of digital banking and banks should create the infrastructure to win customers‘ trust for all such transactions, a senior SBI official said on Wednesday.

Digital banking or Figital is here to stay and is the future but it is equally important to safeguard the interests of all stakeholders, State Bank of India (SBI) Deputy Managing Director and Chief Digital Officer Ravindra Pandey said at a webinar.

“It is important to win the customers’ trust in any system. It is the objective of banks to create and win the customers’ trust, such that all transactions are routed through banks as is presently done by multiple payment apps,” Pandey was quoted as saying in a release issued by industry body PHD Chamber of Commerce & Industry.

The official said that fintech has bought about changes in the customer mindset and it is an era of techfins rather than fintech.

Digital banking has helped in enhancing customer relationship, engagement and satisfaction and reduced operating cost, processing cycle time, among others, he added.

Digital banking is thriving on artificial intelligence and technical algorithm models which help to find out the customer’s ability to pay and also the intention to pay along with credit ratings of the customer.

According to the official, conventional operating models have given way to new channels. There are three areas in fintech that needs to be intertwined to make it a success — payment and remittance; process improvement – compliance and risk management; and customer engagement –, he noted.

Sanjay Aggarwal, President of PHD Chamber of Commerce & Industry, said the banking industry is moving towards a more collaborative and open environment while focusing on data protection and minimising systemic risks.

Representatives from fintech companies, NBFCs and other financial sector also participated in the webinar.



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RBI unveils risk-based internal audit guidelines for select NBFCs, urban co-op banks, BFSI News, ET BFSI

Banking & Finance

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The Reserve Bank of India (RBI) on Wednesday unveiled the risk-based internal audit (RBIA) system for select non-bank lenders and urban co-operative banks, with a view to enhance the quality and effectiveness of their internal audit system. All the deposit-taking non-banking financial companies (NBFCs) and the ones with an asset size of over Rs 5,000 crore, and urban co-operatives banks (UCBs) with assets of over Rs 500 crore will have to migrate to the new system, the RBI said.

Currently, all the entities supervised by the RBI have their own approaches on internal audit, resulting in certain inconsistencies, risks and gaps in the system, the RBI said.

The NBFCs and UCBs face risks similar to the ones for scheduled commercial banks which require an alignment of processes, it added.

The central bank said the RBIA is an audit methodology that links an organisation’s overall risk management framework. It provides an assurance to the board of directors and the senior management on the quality and effectiveness of the organisation’s internal controls, risk management and governance-related systems and processes, it added.

The internal audit function is an integral part of sound corporate governance and is considered as the third line of defence, it said.

Historically, the internal audit system at NBFCs/UCBs has generally been concentrating on transaction testing, testing of accuracy and reliability of accounting records and financial reports, adherence to legal and regulatory requirements, which might not be sufficient in a changing scenario.

A shift to a framework which focuses on evaluation of the risk management systems and control procedures in various areas of operations, in addition to transaction testing, will help in anticipating areas of potential risks and mitigating such risks, the RBI said.

RBIA should undertake an independent risk assessment for the purpose of formulating a risk-based audit plan, which considers the inherent business risks emanating from an activity/location and the effectiveness of the control systems for monitoring such inherent risks, it said.

The entities have to implement the RBIA framework by March 31, 2022, and have been asked to constitute a committee of senior executives with the responsibility of formulating a suitable action plan.

The panel may address transitional and change management issues and should report progress periodically to the board and senior management, the central bank said.



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How a family can plan its finances holistically

Personal Finance

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The necessity of having a good plan to manage family money cannot be overstated. Having a holistic plan is necessary but not sufficient condition to preserve and grow wealth and achieve family goals. At best, it should act as a guard rail and guiding post for the next turn and not the entire journey.

Also read: How a senior citizen can generate more income amid low interest rates

A holistic plan is one which is prepared for most possible outcomes (internal and external) and considers both behavioural and analytical aspects of decision making.

Nassim Taleb puts it brilliantly: “If you want to figure out how a thing works, first figure out how it breaks.” If we study the reason for wealth destruction in families, mostly it is internal rather than external. Greed, hubris, imprudence create more harm to family wealth than war, inflation or recession.

Need for clarity

Primium non nocere – First, do no harm. The first step towards a holistic financial plan is having clarity on what is really needed for the family. Both the family and planner have to work hard to get their thinking clean and make it simple. A few goals such as children’s education and marriage, and retirement are common to every one’s life and should be part of the plan.

Also read: Things to keep in mind while exchanging your old gold jewellery

Other goals such as vacation, second home, starting a new business, early retirement etc are very personal and need to be really thought through. In essence, beyond some technicality, financial planning converges with life planning and becomes a sub-set of it. Amazon founder Jeff Bezos said: “Focus on what will not change in 10 years rather than thinking what will change.” This is a great piece of advice for anyone who is taking the first step to create a plan.

Risk and volatility

Another important aspect of holistic planning is the concept of uncertainty, risk and volatility. It applies greatly to financial planning. Investing in markets is dealing with a complex system where everything affects everything else and the systems are in perpetual motion. Also, global markets are linked with each other due to financial integration. All this make investing challenging.

Hence it is important for the family to know the following things. Volatility is an expression of risk and not risk by itself. Risk is something you can put a price on. Odds are known and one can budget for it. Uncertainty is hard to measure and cannot be budgeted or accounted for.

The important thing to note is that risk can be budgeted but uncertainty can only be embraced or hedged. To start with, a family should assess how much risk capacity the plan allows for and how much risk tolerance it has.

Also read: Your Taxes

For instance, if one of the goals is to buy a car in the next six months, the risk capacity permitted by the plan is the least. Also if the family is really uncomfortable seeing 5 per cent erosion of capital on a temporary basis, the risk tolerance is very less. There are a lot of tools available to help families/planners with psychometric testing to determine risk profile.

Investment framework

Once the financial objectives are defined and risk assessment is done for the family, the next step is to create an investment framework. In essence, an investment framework should help realign long-term capital to long-term assets, after budgeting for short-term liquidity requirements and contingencies. This is an important decision making node for the family/financial planner where they have to decide on asset class participation, allocation and its location.

Also read: How work from home can impact your tax outgo

Asset class Participation: Often it is asked as to why one should have diversification across asset classes. Quoting Warren Buffet, “Diversification is a price we pay for our ignorance.” Uncertainty cannot be budgeted for; it can only be hedged or embraced. Hence diversification across various asset classes helps a family to hedge future uncertainty and prepare the portfolio for various economic outcomes.

The important pillars of asset class participation are real estate, equity, gold and debt (not in any order). There are other asset classes such as private equity, art and passion investments. These asset classes should be evaluated if one has expertise of subject matter and time on hand. Also, most of these other investments have liquidity constraints and hence one should think very prudently before making them a core part of the investment allocation. An important objective of any plan is not to be asset rich and cash poor.

Asset Allocation: Deciding on the percentage of capital to be allocated to an asset class is a function of risk assessment done for the family. Analytically it is a very simple exercise but is the most difficult concept to execute in practice. Studies suggest if one does attribution analysis for investment gain from a diversified portfolio, 91 per cent of the gain can be attributed to asset allocation. Right execution of asset allocation is one of the cornerstones of any financial plan and its success.

One of the observations is that if any asset class does not give par return for 3 to 5 years, ownership in the portfolio goes down significantly or becomes zero. The recent example is having gold in a portfolio as a protection asset. Since gold didn’t perform well from 2011 to 2017, it had a negligible presence in most of the portfolios. A practical hack to this problem is to stay away from narrative and stories. The human mind is more susceptible to stories than facts. Most of the narratives and stories are post facto and after price performance.

Asset Location: Deciding on ownership of assets and how it is located is also very important. We believe one should be open minded and do the full spectrum of analysis on available opportunities. In each asset class there are multiple choices available to align investments with financial objectives. If the portfolio is in need of regular income, maybe bonds are a better option but if liquidity is required debt mutual funds will serve the purpose.

If one wants to build long-term annuity, options such as REIT and InvIT should be explored. Direct equity ownership can be explored if one is building a long-term intergenerational portfolio and has active involvement. The point to ponder is what choice will help you opt for simplicity over sophistication and still achieve your objective.

Maintenance matters

It is a fact that disproportionate energy goes in building something rather than maintaining it. Maintenance is underrated and building is overrated; hence, the key to success is maintenance. After the creation of a financial plan and investment framework, regular diligence (at least quarterly) with your advisor and rebalancing prudently is perpetual work-in-progress. It is very difficult to re-balance the portfolio in panic and mania. About 90 per cent of investors failed to re-balance portfolios in favour of equities in March 2020; reason: Fear.

Today it is equally difficult to re-balance to reduce allocation to Nasdaq if it has become overweight; reason: Greed. These are a few examples of how behavioural aspects impact portfolio outcome more strongly than external events. In times of crisis or euphoria only framework works; willpower gives up.

As in other aspects of life, the key to success lies in execution. There are some time-tested principles and learnings which can help execute plans better:

  • Have a long time preference – The only sustainable and real big edge that families have against big institutions is long-term investment horizon.
  • Distinguish between desirable and attainable. Most investment success also depends on initial conditions and hence this distinction will help family set realistic goals.
  • Do not underestimate liquidity. Having assets which provide liquidity during tough periods is a game changer.
  • Wu Wei is a philosophy of passive achievement. Often, in investing, a bias for inaction — rather than constant churning — helps.
  • Often decision making will happen between ignorance and knowledge, hence thinking probabilistically will be of immense value.

Holistic financial planning in essence is about finding your own equilibrium. This will protect the family from internal and external headwinds and help creating wealth in good times.

Lastly, festina lente — make haste slowly

The author is CEO and MD of TrustPlutus Wealth Managers (India)

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