1.1 BACKGROUND OF THE STUDYRisk could simply be defined as a situation involving exposure to danger. In other words, according to NASDAQ, financial risk is the risk that the cash flow of an issuer will not be adequate to meet its financial obligation. It also refers to as the additional risk that a firm’s stakeholder bears when the firm uses debt and equity (NASDAQ, 2016). The etymology of the word “Risk” can be traced to the Latin word “Rescum” meaning Risk at sea or that which cuts (Raghavan, 2015).
“Risk is associated with uncertainty and reflected by way of charge on the fundamental basic i.e. in the case of business it is the capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of risk can have a ramifications and penetration for a range of other categories of risks” (Centre, 2017). The financial system and banking in particular are exposed to certain inherent risks which include: credit risk, interest rate risk, market risk, liquidity risk, market liquidity risk, operational risk, risk of fraud, reputation risk, legal risk, systematic risk and many more. Even though this work pays special consideration on measuring credit risk and liquidity spill over.
Failure to adequately manage these risks exposes banks not only to losses, but may also threaten their survival as business entities, thereby, endangering the stability of the financial system (RISKS AND RISK MANAGEMENT IN THE INDIAN BANKING, March 2014). Financial services organizations around the world face extraordinary challenges related to profitability, complexity and new regulations in an economic environment we refer to as one of “permanent volatility”. With return on equity below historic norms, many firms are undergoing fundamental restructuring of their business models while trying to deal with the impact of regulations such as Dodd- Frank, Base iii, and solvency ii, which can increase both capital requirement and compliance cost (Accenture consulting, 2018). These pressures may force some firms to exit particular lines of business or specific geographies. Many firms are also dealing with layers of complexity – a legacy from years of rapid growth – and with the consequences of under- investment in technology during the recent years of cost-cutting. In this challenging environment, the integration of risk and finance can be a source of competitive advantage for financial services firms (consulting, 2017). Risk Analysis and Risk Management has got much importance in banking today. The foremost among the challenges faced by banking sector today is the challenge of understanding and managing risk.
The very nature of banking business is having the threat of risk imbibed in it. The banks main role is to intermediation between those having resources and those requiring resources. Globalization has resulted in pressure on margins.
The lower the margin, the greater is the need for risk management. As a result, risk management has become a key are of focus. Additionally, due to the failure of many banks/financial institutions in recent past, it has attracted the attention of regulators (Centre, 2017).The banking sector has a pivotal role in the development of an economy; it is a key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilization so as to achieve maximum productivity (Set, 2016). In fact the foundation of any strong economy depends on how sound the banking sector is (KISHOR, 2014). Generally, banking is considered to be very risky business.
Financial institutions must take risk, but must do so consciously (carey, 2001). However, it should be noted that banks are fragile institutions which are built on costumers trust, brand, and reputation, above all dangerous leverage. In case something goes wrong, banks can collapse and failure of one bank is sufficient to send shock waves right through the economy (Rajadhyaksha, 2004).