Evolution of Financial Risk Management

First of all we need to understand that what we actually meant by risk? Risk is defined as occurrence of unfavorable events. As risk is associated with uncertainty so risk management is done by various organizations specially banks to reduce this uncertainty in real time.

History of Risk management

The risk management is a concept that dates back thousands of years to when early visionaries tried to understand risk. The basic risk management principle can be traced back to ancient Roman and Greek markets. Also there is an evidence of future commodities trade in India around 2000 B.C. The first future contracts were used in Japan in 1600's which shows how much old is this concept of risk management. Whereas the history of modern risk management began in the grain trade in US during early 1800's. Before 1970s', there was a fairly stable exchange rates and inflation rates but all changed with the breaking of Bretton wood's system in 1971 which fixed the major value of relative exchange rate to US dollar. After 1970, when Organization of petroleum exporting countries (OPEC) restricted production of oil for increasing prices. So, study of risk management became the focus of attention. In 1990s', Enterprise risk management is introduced as new approach for the management of risk in business.

Creation Of Basel Committee

Two bank failures in 1974 became the reason for the creation of the Basel Committee. One of these failures has come to be known as the Herstatt Debacle, a banking crisis that was initiated in Germany, but proceeded to spread around the world. Afterwards Franklin National Bank ("FNB") in the U.S. also faced serious problems. This bank was the twentieth largest in the U.S. with deposits of close to $3 billion. It too "suffered very large foreign exchange losses and could not pay its quarterly dividend. The Herstatt Debacle and FNB's problems ultimately led to the creation of the Basel Committee.

Basel I & Basel II

Basel I addressed credit risk whereas Basel II came in to being in 1990s' for reducing market risk, foreign exchange risk and equity risk. Also one of the reasons of its formation is differences in national conditions and accounting rules. In 2002, Basel II accord formed that addressed operational risk which comes by virtue of operations. Also, Anti money laundering concept was introduced in it which was a very important doctrine and few countries are following it so that forgery and fraud can be controlled in financial institutions.

Introduction to Basel II framework

Basel I had some deficiencies in it, like it had no provision of capital allocation against operational risk and used "One fit size' approach for all asset types. So banks needed more precise risk management that can be applicable to foreign borrowers other than domestic borrowers. In June 2004, Basel Committee on Banking Supervision (BCBS) finalized the New Capital Adequacy framework commonly known as Basel II which was relatively more effective. Basel Committee on Banking Supervision (BCBS) finalized the New Capital Adequacy framework commonly known as Basel II in June 2004. The major objectives of Basel II was to establish a reliable link between risk and minimum regulatory capital, increasing market discipline for the development of minimum capital cushion to face adverse and uncertain time periods.

Emerging markets and Basel

Emerging market countries like China, India and Latin American countries made a significant contribution to the Basel Committee's Core Principles and have continued to contribute to Basel Committee activities. Also, The central banks from certain emerging markets such as China and India, joined the Bank for International Settlements in 1996. As emerging markets become more important in the international financial system, their involvement and influence in the Basel process will undoubtedly grow.