Why banks are special:
Banks are special because they create money-like liabilities, perform maturity transformation, and intermediate information and risk at scale, making risk management central to financial stability and growth. Their position within the safety net—interacting with deposit insurance, capital rules, and lender-of-last-resort facilities—heightens systemic importance and demands disciplined risk-taking and controls.
Functions banks perform
- Financial intermediation: pooling deposits and allocating credit to households and firms, lowering information and monitoring costs through relationship banking.
- Maturity and liquidity transformation: converting on-demand deposits into longer-term loans and securities, earning net interest margin while managing liquidity and interest-rate risk.
- Risk diversification: spreading exposures across borrowers, sectors, and instruments to reduce idiosyncratic risk relative to direct household lending.
- Payments and settlement: operating accounts and transaction rails that underpin commerce, making operational resilience a prudential priority.
Bank’s role in the economy
- Growth catalyst: efficient banking systems mobilize savings, reduce intermediation costs, and support investment and output.
- Shock absorber and amplifier: maturity transformation stabilizes credit in normal times but can amplify stress without sufficient capital, liquidity, and governance.
- Safety net nexus: banks sit within deposit insurance, resolution regimes, and lender-of-last-resort backstops that curb contagion and preserve confidence.
Bank reform in India
Bank reform in India has focused on strengthening public sector banks (PSBs), improving governance, enhancing technology and digital services, and addressing non-performing assets (NPAs). Key reforms include the Indradhanush framework for PSBs, the EASE (Enhanced Access & Service Excellence) program, the Financial Services Institutions Bureau, bank mergers, the Banking Regulation (Amendment) Act, 2020, and the Banking Laws (Amendment) Act, 2025. These efforts have led to improved asset quality, increased capital infusion, and a surge in digital transactions. To know more read:
REFORM OF THE BANKING SECTOR, PRESENT STATUS OF BANKING SYSTEM
Risk management imperatives
- Stability and solvency: rigorous identification, measurement, limits, and stress testing prevent liquidity squeezes and capital impairment.
- Capital allocation and returns: risk-adjusted performance directs scarce capital to the best risk-reward uses and constrains excess risk-taking.
- Reputation and trust: strong controls, compliance, and conduct programs protect the franchise value that anchors deposit funding and relationships.
Core risk categories in banks
- Financial risks: credit, market, interest-rate-in-the-banking-book, liquidity, and concentration risks directly impact earnings and capital.
- Non-financial risks: operational, compliance, cyber/IT, conduct/reputational, strategic/business model, model, and ESG/climate risks can trigger material financial and regulatory consequences.
Banking safety net and uniqueness
- Lender of last resort: central banks provide emergency liquidity to solvent but illiquid banks to prevent runs and systemic collapse.
- Complementary pillars: deposit insurance lowers run incentives, capital regulation reduces default probability, and resolution frameworks shape credible interventions.
- Policy trade-offs: backstops reduce systemic risk but introduce moral hazard, reinforcing governance, supervision, and credible loss-absorption needs.
What makes bank risk different?
- Opaqueness and asymmetry: bank assets are relationship-based and hard to value quickly, increasing reliance on confidence and supervision.
- Liquidity externalities: demandable deposits and payment obligations propagate shocks faster than in most nonfinancial firms.
- Interest-rate sensitivity: maturity mismatches expose banks to valuation swings and refinancing strains when rates shift abruptly, requiring active ALM and stress testing.
Best-practice risk management
- End-to-end framework: identify, assess, mitigate, monitor, and report risks, linking KRIs, limits, early warnings, and remediation to strategy and controls.
- Integrated governance: align three lines of defense with risk appetite, scenario analysis, model governance, and board oversight for coherent decisions.
- Continuous improvement: adapt to regulatory change and emerging risks using analytics, automation, independent challenge, and periodic assurance.
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