CHAPTER I

INTRODUCTION

1.1 Background of the Study

Prabhu banks limited are established with the goal of maximizing shareholder wealth, which is
influenced by both risk and return. In monetary business sectors, as well as in numerous business
exercises to accomplish higher pace of return by and large, one frequently needs to expect higher
gamble (Prowse, 1997). Risk management is a specialty of prabhu banks limited. During the
time spent offering monetary types of assistance, they accept different sorts of monetary dangers.
The risks associated with various business activities vary in their nature and frequency. That is,
certain risks have particular characteristics that specifically impact banking industry operations
(Meshack & Mwaura, 2016).

Banks face numerous and diverse forms of risk on a daily basis. Banks have a long association
with risk the board; for instance, while making credits pondering over risk issues. Thus, banks
experience various kinds of hazard. Banks face a variety of risks, some of which are listed
below. Market risk, liquidity hazard, and dissolvability risk. Also, the risks associated with
banking services vary depending on the service. According to Bessis (2011), banks encounter
numerous risks in their operations, and effective management and understanding of these risks
are crucial for profitability and determining the required capital reserves. Key risks faced by
banks include credit risk, market risk, and operational risk. Credit risk refers to the potential loss
of principal or financial reward due to a borrower's failure to repay a loan or fulfill contractual
obligations. As per Kimi (2007), market risk involves potential losses resulting from fluctuations
in the value of market risk factors. The management of financial funds, from cash to credit, is a
part of the banking industry's work system.

According to Santika et al. (2022), the primary function of banking is to accumulate and
distribute public funds with the goal of enhancing equity in development outcomes and
supporting the implementation of national development. In order to improve public finances,
banking is also one of the foundations for economic expansion and national stability. Every
business is interested in the cost of holding risk. During this time, there are questions and

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concerns about the stocks' operations in every way. According to Hussain et al. (2012), during
that exceptional time period, a lot of businesses faced extremely difficult circumstances, and
Pakistan in particular experiences more of these unstable times.

As per Henri (2004), monetary execution is the assurance of functional, hierarchical and worker
viability in light of foreordained targets, guidelines and measures occasionally. Execution
estimation is applied by the organization to do enhancements to its functional exercises so it can
rival different organizations. The monetary exhibition of organization is a proportion of the
organization benefit or misfortunes in a specific timeframe. Company as a whole over time; it
can be used to compare companies in the same industry that are similar to one another and to
compare industries or sectors as a whole (Pandey, 2008). Operating income, profit before interest
and taxes, and net asset value are all components of financial performance. Utilizing profitability
measures, businesses regularly monitor their profitability levels to gauge their financial
performance. Hazard can likewise mean a sort of spontaneous occasions whose monetary
outcomes prompts decreased income or misfortune (Holzer and Millo, 2005). Due to the
unpredictability or uncertainty of the trading activity, any activity or operation that yields profits
or losses may be considered a risky proposition. In less difficult words, the gamble is
characterized as vulnerability to a result.

According to Perminova et al. (2008), despite the fact that the terms uncertainty and risk are
frequently used interchangeably, there is a distinction between the two. In business, uncertainty
occurs when a decision-maker is aware of the anticipated outcomes of a particular action.
Naturally, uncertainties that can be measured are risks. No matter what the reality in the field of
money, the board and foundation of dangers have consistently been a first expectation of the
money obviously inside hierarchical development and actually take a look at limit; non-monetary
gamble specialists have been despondently for the larger part division inconspicuous (Akhtar et
al., 2011). According to Ramasesh & Browning (2014), operational risk differs from all other
types of risk because it negotiates internally using very well-organized means rather than
supervising unfamiliar environments. Nonfinancial risk is distinct from other types of
banks' associated economic risks in terms of both its amount and management. The different
normal universe of nonfinancial gamble either from inside/outside mediation to business

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association pursuits makes requesting efficient and sound estimations with requirements (Jobst,
2007). Since banking is one of the world's riskiest businesses, risk control has become the most
important aspect of any organization in recent years. For the administration of such sorts of
dangers, associations should have efficient and able gamble the board labor force, on the grounds
that compelling gamble the executives don’t occur consequently (Noordegraaf, 2011).

The banking industry has been made more susceptible to operational risk as a result of
globalization and new technology (Bloom & Galloway, 1999). It would appear that the industry's
risk management capabilities have not kept up with these changes. The event along with
numerous others spurred banks to adopt a more proactive strategy to functional gamble the
board. Sabato (2010) battles that a deep-seated conviction that banks were excessively huge to
fall flat is one reason that prompted the disappointment of monetary establishments in 2008.
Another issue was the absence of obviously characterized technique that could be utilized for
risk allotment. According to Hess (2011), one of the main reasons why financial institutions
failed in 2008 and continue to fail today is a lack of an effective operational risk management
strategy.

According to Schwartz-Gârliste (2013), operational risk management's significance has increased

sufficiently to draw the global banking community's attention. Along these lines, consistent and
advance exploration on functional gamble in monetary organizations has been recognized as one
of the manners in which that can be utilized to guarantee cognizance and productive monetary
administration, which in future can be utilized to keep away from the difficulties saw during the
extraordinary monetary emergency. Bank risks are complex and not as straightforward as many
people believe. Kaplan and Garrick (2006) noticed that since chances are undeniable, it is urgent
for people to go up against when given risk circumstances with capricious results. It is important
to note that early research demonstrates a significant distinction between risk and uncertainty.
According to Hamberg (2002), risks are situations in which the probability of the outcome is
known, whereas uncertainties are situations in which the expectation is unknown. According
to Kaplan and Garrick (2006), risk typically entails some damage or loss as well as uncertainty.

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Operation risk associated with individuals, frameworks, cycles and outside occasions is one of
the extraordinary difficulties for banks everywhere. During the most recent few years, the
financial area has refined and limited broad misfortunes because of functional gamble. In order
to avoid such crises, the organization must maintain a competent operational risk management
workforce in order to overcome operational risk (Kneevi, 2013). Even though operational risk is
relatively new to the banking industry, it is now a significant component of any risk department.
An organization successfully manages its risk through effective operational risk management.
Even though operational risks are not new, they have recently received a lot of attention in new
contexts. Operational risk is characterized as the weakness of big business as a result of doing it
in an ill-advised or deficient kind, and may result from outer elements (Waters, 2011). The risks
of a loss arising from a faulty or inadequate internal process, system, person, or event are known
as operational risks. The definition contains legitimate dangers and bars notoriety and vital
dangers (Aloqab et al., 2019). Processes, people, the system, and external events are the four
causes of operational risks in a financial institution, according to BCBS (2004).

According to Cummins et al. (2007), Barings Bank's $1.3 billion losses are one of the most
significant and perfect examples of operational risk in a financial institution. Nick Leeson, a
single individual, was responsible for the loss. He took an illegal speculative position, which
caused the bank to keep losing money until it went bankrupt in 1975. The vast field of study that
focuses on the growing risks posed by a company's personnel, systems, and procedures is known
as operational risk. It can likewise incorporate different Classifications of chance, like lawful
gamble, extortion, physical or natural dangers (Ice et al., 2000). It emerges from a great many
exercises like demonstrations of fakes, mistakes, carelessness, infringement, occasions of
innovative disappointments, process inadequacies, frameworks imperfections, activities of
psychological militants and defacing, catastrophic events, similar to floods, quakes, and so forth,
(Hussain et al., 2016). Nystrom and Skoglund (2002) battles that functional dangers are not
special for monetary foundations and these days, there is a rising worldwide need to oversee
functional dangers. Financial institutions worldwide are developing risk management
systems, with most striving to enhance risk management and reallocation efficiency. Nystrom
emphasizes that a fundamental aspect of operational risk management (ORM) in a financial
institution is identifying the risks the organization is likely to face in its operations. One method

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of mitigating these risks is by setting aside capital for unforeseen and potential losses. He above
discussion highlights the importance of studies focusing on the factors influencing operational
risk management practices in prabhu bank limited. Indeed, few studies have examined
operational risk management in prabhu bank limited in Nepal. Therefore, this study focuses on
examining the determinants of operational risk management practices in prabhu bank limited in
Nepal.

1.2 Statement of the Problem

Financial institutions are not the only ones that face operational risks. However, technological
advancements, the evolution of global financial views, and the emergence of globalization and
deregulation of financial institutions necessitated that financial institutions pay greater attention
to operational risks (Merton & Bodie, 1995). Scientist fights that functional dangers are the result
of individuals in control, the monetary framework set up, the monetary cycle applied or other
outer occasions that can influence a monetary foundation. The kind of dangers starting from
individuals in control can come from the executives and human asset disappointment (Schuler
and Jackson, 1987). When looking at how the process works, breaking the stable operation or not
following the steps exactly can cause a breakdown. Framework chance can incorporate
specialized disappointments and other inward issues. Ultimately, outer occasions can incorporate
defacement, robbery and market disappointments (White, 1995).

Dardac and Chiriac (2010) say that financial disasters in government agencies and non- banking
institutions highlight the need for risk management. Unknown risks within banks have resulted in
significant bank failures. According to Baloi & Price (2003), banks typically operate in
environments where risk fluctuates frequently. As a result, an effective risk management
procedure that is categorized according to risk type is required to address specific risk factors.
The allocation of accountability and responsibility to address each risk factor will be guaranteed
by providing a concise description of all of them. There are still no such descriptions for
operational risk because it appears that operational risk encompasses all risk factors that cannot
be addressed by credit, market, or liquidity risk types. This might prompt the circumstance
where functional gamble turns into an unloading ground for risk factors and may bring about
basic center being disregarded (Hwang et al., 2013).

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According to Knezevic (2013), operational risks hold a special place among the numerous
financial risks that are inherent to the banking industry. The fact that operational risks follow
banking transactions from beginning to end and are highly interconnected with other risks
contributes to their uniqueness in the banking industry. Despite receiving little attention,
operational risks remain one of the challenges facing the modern banking industry. Most banks
are worried about the gamble emerging from credit. ORM is centered around the rapidly
controllable and countable gamble and their sources. The key inquiry that bank chiefs ought to
pose to themselves is, the way best they can deal with functional dangers later on and how best
they can remember them adequately early. Where upgrading the inner models of functional
gamble the executives stay a urgent errand to bank directors (Hoffman, 2002). The most
significant issue facing banks is operational risk; they are more likely to encounter and endure
the greatest financial crisis. The current fund announcement offers loans to bank deposits as well
as lending for those deposits. Banks and successful businesses alike are increasingly exposed to
the specific capacity, preparation, and efficient performance of operational risk because it is the
most dangerous threat and challenge for banks (Giesecke, 2004). This examination pushed on
significant reasons for bank disappointment because of the quick development of functional
gamble in bank (Njanike, 2009). Taking a gander at the gamble of showcasing and chance of
loaning inside its focal company, bank's prosperity wretchedness and they can't test, screen and
deal with the preliminaries in the tried way.

According to Smithson and Simkins (2005), banks have tried to feature risk the executives
procedures that might turn out to be progressively critical, past the risk of monetary profits.
Throughout the long term, monetary foundations have confronted different difficulties for
various reasons, however the primary drivers of banking issues are to a great extent connected
with expanding measures for obligation loan specialists and concurring with counter-parties.
The risk related with a unintegrated portfolio incorporates lacking fulfillment, energy, and
combination inside business or different conditions. These elements can prompt poor functional
situating inside banks. Generally speaking, this chance is perceived as it is one of the most solid
and impending risks emerging from numerous monetary threats that banks face (Sackett and
Shaffer, 2006).

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Monetary gamble costly through an efficient and viable administration of obligation risk doesn't
uphold the compelling administration of monetary organizations (Banks) simply the capacity and
efficiency of their own enterprises (Psillaki et al., 2010). It is impossible to overstate the
significance of operational risk management, which will make it easier to identify prohibited
activities, reduce potential risk exposure, and ultimately reduce operational losses (Habib et al.
2014). Regardless of the developing writing regarding the matter of functional gamble the
executives in created economies, there is a striking absence of writing in Economies of non-
industrial nations like Nepal, a couple of studies had inspected determinants of hazard the board
research.

Operational risk management, being one of the more current areas of the board concern,
frequently is by all accounts treated as a trump card. This postures difficulties in the
acknowledgment and the executives of functional gamble and its related elements. In order to
provide a comprehensive description of this risk category and distinguish it from other risks in
the context of prabhu bank limited, this study is necessary to ascertain the current state,
conceptual issues, and underlying factors of operational risk management. Furthermore, the
concentrate fundamentally examines the functional dangers looked by business banks and the
techniques they have taken on to deal with these risks. This study primarily deals with the
following research questions:
 What are the determinants of operational risks management practices in prabhu bank
limited in Nepal ?
 Is there any significant relationship between independent variables (capital adequacy
ratio, gearing ratio, liquid assets and non- performing loan ratio) and dependent variable
(Operational efficiency) ?
 Is there any effect of dependent variable (Operational efficiency) with independent
variables (capital adequacy ratio, gearing ratio, liquid assets and non- performing loan
ratio) ?

1.3 Objectives of the Study

The major objective of the study is to analyze the determinants of operational risk management
practices in commercial banks in Nepal. The specific objectives are as follows:

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  To examine the determinants of operational risks management practices and financial
performance in prabhu bank limited in Nepal.
 To examine the relationship between independent variables (capital adequacy ratio,
gearing ratio, liquid assets and non- performing loan ratio) and dependent variable
(Operational efficiency) ?
 To analyze the effect of dependent variable (Operational efficiency) with independent
variables (capital adequacy ratio, gearing ratio, liquid assets and non- performing loan
ratio).

1.4 Rationale of the Study

The objective of managing operational risks is to ensure the smooth functioning of the bank's
daily operations. The findings of this study will be significant for the following reasons: they will
provide senior bank managers with guidance on management strategies and the identification of
operational risks within the banking industry. Employees of prabhu banks who are involved in
operational risk management on a daily basis will be able to draw conclusions from the study and
identify areas for improvement.

Prabhu bank limited in Nepal face different functional dangers originating from interior cycles,
individuals, frameworks, and outside occasions. Research in this space distinguishes these
dangers and foster procedures to alleviate them, consequently protecting the monetary solidness
of the banks. Compliance with Nepal's regulatory requirements imposed by the central bank or
other regulatory bodies requires an understanding of operational risks. Research can help ensure
compliance by shedding light on the specific regulations that apply to Nepalese banks. By
enhancing the knowledge and abilities of bank staff, risk managers, and regulators, research in
operational risk management can contribute to capacity building within Nepalese banks.

As a result, the banking industry's resilience is enhanced by giving them the ability to anticipate
and manage operational risks. Implementing effective operational risk management procedures
boosts investor confidence in Nepalese banks, which in turn encourages investment and
economic expansion. Examination can give experiences into the gamble the executives structures
and practices embraced by banks, accordingly supporting financial backer trust. Research

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contributes to the long-term viability of Prabhu banks by promoting efficient operational risk
management. Manageable financial practices upgrade strength to shocks, support monetary turn
of events, and cultivate trust among partners, establishing the groundwork for proceeded with
development and soundness in the financial area. One bank's operational failures can have
systemic effects on the stability of the financial system as a whole. Examination can assist with
recognizing interconnectedness and virus gambles inside the financial area, empowering
policymakers to go to preplanned lengths to diminish fundamental gamble.

1.5 Limitations of the Study

As in other research, this research can have its own limitations and they are listed below:
 Due to the merger and acquisition process during the study period and unavailability of
data, some banks are excluded from the study.
 This study used operational risk management variables such as capital adequacy ratio,
gearing ratio, liquid assets, non-performing loan and loan to deposit ratio but other
internal and external variables are excluded which can be most significant factors to
determine operational risk management.
 There are other different models to analyze the collected data but only regression model
is used to analyze the panel data to examine the factors determining operational risk
management.
 This study assumes that every bank operates in the same market. Therefore, the analysis
is not based on bank's market segmentation or group of banks (whether it is government,
foreign or private banks).