Risk Measurement Techniques used by Local Commercial Banks in Pakistan

Abstract

The banking risks have been known as a total of credit and market risks for a long time. The banking sector has come across the operational risk by the occurrence of financial crises in recent years. Operational risk may simply be defined as all risks other than credit and market risks, banks incur in their operations. The aim of this research is to present factors resulting market risk and examine various market risk measurement models and compare the level of efficiency of the underlying models in terms of capital requirement. Furthermore, each model is applied on a bank operating currently in the banking sector. The results support that the use of advanced risk measurement models reduces the capital needs of the bank under examination. In order to manage risks effectively, banks are first required to find out their risk profiles and pinpoint which of their operations lead risks. After identifying and classifying the risk factors, banks need to measure their risks adequately and allocate sufficient amount of risk based capital. Basel Committee defines three different approaches for measurement of operational risk; namely, basic indicator approach, standardized approach and advanced measurement approach. This study initially discloses the factors causing risk in banks, and then demonstrates the application of various risk measurement approaches on a bank operating in the Pakistani banking sector, and finally compares the effects of the application of each model on the underlying Pakistani bank’s risk based capital requirement. In order to quantify operational risk, operational risk factors first need to be categorized. Capital adequacy standards of banks known as Basel II classifies the risk factors resulting risks in banks as human, system, processes and external factors.