Banks are essentially known for transferring financial resources from net savers to net borrowers. The banking sector plays a dominant role in the complex financial system of a country by providing liquidity and payment services to the real sector. It institutionalizes savings by accepting deposits from the public and using them to make credit available to households, government, businesses, and others. This intermediation is basically achieved through four transformation mechanisms: Liability-asset transformation, size transformation, maturity transformation, and risk transformation. It is in this context that banks are exposed to various embedded risks: market risk, credit risk, and operational risk. Secondly, banks being highly leveraged, these inherent risks have enough potential to inflict catastrophic losses unless they are managed effectively. Hence Merton Miller, the Nobel Laureate said: "Banking is 19th century disaster-prone industry."
And, at the same time, as the empirical studies of Levine (1997) suggest, the economic growth of a country is positively related to the stage of financial development, in terms of the size of the financial markets relative to GDP, by facilitating better risk-sharing and mitigating informational problems. But the recent advances in computation and communication technology, and the emergence of assorted products, accompanied by liberalization and globalization of financial markets, have all cumulatively increased the exposure of banks to varied risks. This have resulted in the need for effective risk management across the financial architecture. For, failure of one bank can pull down a country's very financial system. |
