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INTRODUCTION The financial sector especially the banking industry in most emerging economies including India is passing through

a process of change .As the financial activity has become a major economic activity in most economies, any disruption or imbalance in its infrastructure will have significant impact on the entire economy. By developing a sound financial system the banking industry can bring stability within financial markets. Deregulation in the financial sector had widened the product range in the developed market. Some of the new products introduced are LBOs, credit cards, housing finance, derivatives and various off balance sheet items. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. Simultaneously they have opened new areas of risks also. During the past decade, the Indian banking industry continued to respond to the emerging challenges of competition, risks and uncertainties. Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. Our regulators have made some sincere attempts to bring prudential and supervisory norms conforming to international bank practices with an intention to strengthen the stability of the banking system. Risk management Risk management is the identification, assessment, and prioritization of risks (defined in ISO 31000 as the effect of uncertainty on objectives, whether positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety.

The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk. Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk, whether the confidence in estimates and decisions seem to increase.

DEFINING RISK The word RISK is derived from the Italian word Risicare meaning to dare. There is no universally acceptable definition of risk. Prof. John Geiger has defined it as an expression of the danger that the effective future outcome will deviate from the expected or planned outcome in a negative way. The Basel Committee has defined risk as the probability of the unexpected happening the probability of suffering a loss. The four letters comprising of the word RISK define its features.

R = Rare (unexpected) I = Incident (outcome) S = Selection (identification) K = Knocking (measuring, monitoring, controlling) The broad parameters of risk management function encompass: 1. Organizational structure. 2. Comprehensive risk measurement approach. 3. Risk management policies approved by the Board, which should be consistent with the

broader business strategies, capital strength, management expertise and overall willingness to assume risk. 4. Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits. 5. Strong MIS for reporting, monitoring and controlling risks.

6. Well laid out procedures, effective control and comprehensive risk reporting framework. 7. Separate risk management, framework independent of operational departments and with clear delineation of levels of responsibility for management of risk. 8. Periodical review and evaluation. Risk Management: Components The process of risk management has three identifiable steps viz. Risk identification, Risk measurement, and Risk control. Risk Identification

Risk identification means defining each of risks associated with a transaction or a type of bank product or service. There are various types of risk which bank face such as credit risk, liquidity risk, interest rate risk, operational risk, legal risk etc.

Risk Measurement

The second step in risk management process is the risk measurement or risk assessment. Risk assessment is the essemination of the size probability and timing of a potential loss under various scenarios. This is the most difficult step in the risk management process and the methods, degree of sophistication and costs vary greatly. The potential loss is generally defined in terms of Frequency and Severity. Risk Control

After identification and assessment of risk factors, the next step involved is risk control. The major alternatives available in risk control are: 1) Avoid the exposure 2) Reduce the impact by reducing frequency of severity 3) Avoid concentration in risky areas 4) Transfer the risk to another party 5) Employ risk management instruments to cover the risks

Steps for implementing Risk Management in Banks 1) Establishing a risk management long term vision and strategy Risk management implementation strategy is established depending on bank vision, focus, positioning and resource commitments. 2) Risk Identification The second step is identification of risks, which is carried out to assess the current level of risk management processes, structure, technology and analytical sophistication at the bank. Typically banks distinguish the following risk categories: Credit risk Market risk Operational risk

3) Construction of risk management index and Sub indices Bank roll out a customized benchmark index based on its vision and risk management strategy. Then it develops a score for the current level of bank risk practices that already exists. For example assuming that the current risks management score is 30 out of 100. For the gap in score of 70 roadmap is developed for achieving the milestones. 4) Defining Roadmap Based on the target risk management strategy/gap analysis bank develops unique work plans with quantifiable benefits for achieving sustainable competitive advantage. a. Risk Based Supervision requirements b. Basel II compliance c. Using risk strategy in the decision making process Capital allocation Provisioning

Pricing of products Streamlining procedures and reducing operating costs By rolling out the action steps in phases the bank measure the progress of the implementation.

5) Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans, the relative importance of market, credit and operational risk in each line of activity is determined The process workflow organisation, risk control and mitigation procedures for each activity line is to be provided. 6) Executing the key requirements: At an operational level checklist of key success factors and quantitative benchmark is generated. Models to be applied are tested and validated on a prototype basis. Moreover, evaluation scores on the benchmark levels specified helps to build up a risk process implementation score. 7) Integrate Risks Management/Strategy into bank internal decision making process The objective is to integrate risk management into business decision making process which evolves risk culture through awareness and training, development of integrated risk reports and success measures and alignment of risk and business strategies. RBI Guidelines on Risk Management RBI has issued guidelines from time to time, which are being implemented by banks through various committees. RBI suggests that (a) Banks must equip themselves with an ability to identify, to measure, to monitor and to control the various risks with New Capital Adequacy provisions in due course. (b) (c) (d) (e) For integrated management of risk there must be single risk management committee. For managing credit risk, portfolio approach must be adopted. Appropriate credit risk modelling in the future must be adopted. For measurement of market risk banks are advised to develop expertise in internal

models (f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks operating in international markets. (g) (h) Banks should upgrade credit risk management system to optimize use of capital. Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based supervision. One of the five specific areas is effective Risk Management Architecture to ensure adequate internal risk management practices. (i) The limits to sensitive sectors like advances against equity shares, real estates which are subject to a high degree of asset price volatility as well as to specific industries which are subject to frequent business cycles should be restricted. Similarly, high-risk industries as perceived by the bank should be placed under lower portfolio limit. (j) To enhance risk management function banks should move towards risk based supervision and risk focussed internal audit. Types of Risks There are three main categories of risks Credit Risk Market Risk & Operational Risk

Credit Risk: Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank.

These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and

maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.

Market Risk: Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Whereas market risk is further divided as following: Liquidity risk Interest rate risk Forex risk Country risk Liquidity risk : Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behavior of assets, liabilities and off-balance sheet items.

Interest rate risk: Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and cash flow.

Forex risk: Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches.

Country risk: This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time.

Operational Risk: Always banks live with the risks arising out of human error, financial fraud and natural disasters. The happenings such as WTC tragedy has highlighted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter-linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. Operational risk events are associated with weak links in internal control procedures. The key to management of operational risk lies in the banks ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss.

OTHER TYPES OF RISKS INVOLVE

REGULATORY RISK: When owned funds alone are managed by an entity, it is natural that very few regulators operate and supervise them. However, as banks accept deposit from public obviously better governance is expected of them. This entails multiplicity of regulatory controls. Many Banks, having already gone for public issue, have a greater responsibility and accountability. As banks deal with public funds and money, they are subject to various regulations. The very many regulators include Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI), Department of Company Affairs (DCA), etc. Moreover, banks should ensure compliance of the applicable provisions of The Banking Regulation Act, The Companies

Act, etc. Thus all the banks run the risk of multiple regulatory-risks which inhibits free growth of business as focus on compliance of too many regulations leave little energy and time for developing new business. Banks should learn the art of playing their business activities within the regulatory controls.

ENVIRONMENTAL RISK: As the years roll by and technological advancement takes place, expectation of the customers change and enlarge. With the economic liberalization and globalization, more national and international players are operating the financial markets, particularly in the banking field. This provides the platform for environmental change and exposes the bank to the environmental risk. Thus, unless the banks improve their delivery channels, reach customers, innovate their products that are service oriented; they are exposed to the environmental risk resulting in loss in business share with consequential profit.

Market Risk Market risk is the risk that the financial instrument's value will fluctuate as a result from market price changes, regardless of whether these changes are caused by factors typical for individual instruments or their issuer (counterparty), or by factors pertaining to all the instruments traded on the market 1. The four most common factors connected with market risk are interest rates, currency exchange rates, costs of investments in trade portfolio (regardless of the instruments' character debt or capital), prices of exchange commodities and other market variables related to the bank's activity. The market risk pertaining to both individual financial instruments and portfolio instruments can be a function of one, several or all these factors, and in many cases it can be very complicated. Ingeneral, market risk can be defined as a risk arising from market movements of prices,interest rates and currency exchange rates.The policy for market risk control and management should be subordinated to several main aims:

via independent identification, assessment and understanding of business market risks;

in line with the best international practices and to set minimum standards for

market risks control;

Risks as a base for reasonable decision-making; To establish a structure that will help the bank to realize the connection between the business strategy and the operations on one hand, and between the purposes of risk control and monitoring, on the other. The admissible threshold of market risk is the amount of potential unexpected loss which the bank is willing to assume because of unexpected and unfavorable changes in the market variables. The admissible threshold of market risk should not exceed the losses which the bank can assume without disturbing its financial stability. The bank's ability to overcome losses caused by market risk depends on its capital and reserves, on the potential losses originating from other non-market risks and on the regulatory capital required for maintaining the business activity. Risk monitoring is the fundament for effective management process. That is the reason why the banking institutions should have adequate internal reporting systems reflecting their exposure to market risk. Sufficiently detailed regular reports should be submitted to the top management and to the various management levels.
Liquidity Risk Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defence mechanism from losses on fire sale of assets.

The liquidity risk in banks manifest in different dimension: 1. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits. 2. Time Risk: need to compensate for non-receipt of expected inflows of funds i.e performing assets turning into non-performing assets.

3. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

. TYPES OF MARKET RISK

1. Interest rate risk Interest rate risk is the probability that variations in the interest rates will have a negative influence on the quality of a given financial instrument or portfolio, as well as on the institution's condition as a whole. Assuming of that risk is a normal aspect of the bank's activity and can be an important source of profit and share value. However, excess interest rate risk can significantly jeopardize the bank's incomes and capital base. Variations in the interest rates influence the bank's incomes and change its net interest revenues and the level of other interest-sensitive earnings and operative costs. Interest rate variations also affect the basic value of the bank's assets, liabilities and off-balance instruments, because the present value of the future cash flows (and in some cases the cash flows themselves) alters when interest rates change. Interest rates variations can also influence the level of credit risk and the ability to retain the attracted resources. That is why the effective interest risk management that keeps risk in reasonable limits is of vital importance for bank stability.

1.1.Sources of interest rate risk

Repricing risk Banks in their capacity as financial brokers face interest rate risk every day. The most common and debated form of interest rate risk originates from the time differences of maturity (for fixed rate), and changes in the interest rates (for floating rate) of the bank's assets, liabilities and off-balance items2. Although these discrepancies are fundamental for the bank's activity, they can expose the bank's income and basic economic value to unexpected fluctuations when interest rates vary. For example, a bank which finances a longterm credit with a fixed interest rate with a short-term deposit can experience a decrease in the future revenues and in its basic value if the interest rates rise. This decrease happens because the cash flows are fixed for the credit period while the interests paid on the

funding are variable and the interest rates' increase takes place after the short-term deposit matures (respectively, the interest-related costs increase).

Yield curve risk The repricing discrepancies can also expose the bank to changes of the yield curve tilt and shape. The yield curve risk arises when unexpected changes of the yield curve have an adverse effect on the bank's returns or basic economic value. The yield curve risk results from a change in the percentage ratios of identical instruments with different maturities. For example, the 30-year government bond' profitability can change by 200 basic points, while the profitability of a 3-year government promissory note can change by only 50 basic points for the same time period (one basic point is defined as one hundredth of a percent, i.e. 100 basic points are equal to 1%). Or, the basic economic value of a long position in 10-year government bonds, which is hedged with a short position in 5-year government promissory notes, can abruptly drop if the yield curve steepens even if the position is hedged against parallel changes of the yield curve.

Basic risk The basic risk is a result from a weak correlation adjustment of the interest rates which are received and paid on various instruments otherwise having the same repricing characteristics. When the interest rates change, that absence of correlation can cause unexpected alterations in the cash flow and the spread between assets, liabilities and off-balance instruments with similar maturities. For example, three-month interest rates are paid on three-month inter-bank deposits, three-month Euro-dollar deposits and three-month treasury bills. However, these three-month rates do not from ideal ratios among each other and their profitability margins can change over time. As a result, three-month treasury bills financed by three-month Euro-dollar deposits represent an improperly balanced or hedged position which can cost the bank a lot when interest rates change.

Option risk (risk of client's right of choice) An additional source of interest rate risk with increasing significance is the risk arising from options imbedded in many bank's assets, liabilities and off-balance portfolios. Formally,

these options provide their holder with the right, but not the obligation to buy, sell or change in a certain way the cash flow of a given instrument or financial contract. Instruments with imbedded options include various types of bonds and promissory notes with call or put option, credits which provide the borrowers with the right to premature repayment, as well as various types of undated deposit instruments which entitle the depositors to withdrawing their money at any time, often without any penalties. This type of risk can have an adverse impact on the profit or economic value of the bank's own capital via a decrease in the assets' profitability, increase in the attracted funds' price or decrease in the expected cash flow's net present value. For example, if a client repays their credit earlier during a period of decreasing interest rates, the bank will not receive the initially expected cash flow. And thus it will have to reinvest the sum at a lower interest rate.

1. Methods for interest rate risk measurement

Banks use different methods for the calculation of interest rate risk, but none is appropriate for all banks simultaneously. Regardless of the diversity, all methods require solid accounting information which is the basis for adequate information necessary for monitoring and timely reporting of exposures to interest rate risk.The three most frequently used methods for interest rate risk measurement are the discrepancyanalysis, the simulation method and the duration method. The application ofeach individual method depends on the bank's size, the complexity of its activity organizationand the level of interest rate risk.

1.1. Discrepancy analysis (GAP analysis)

The discrepancy analysis is the most frequently used method for interest rate risk assessment. Discrepancy is the difference between interest sensitive assets and interest sensitive liabilities (including off-balance items) over a particular period of time. The discrepancy analysis includes both assets and liabilities with fixed and with floating interest

rate. Under the discrepancy analysis the bank's assets and liabilities are grouped in different time periods depending on their maturity (in case of fixed interest rate) or on the timeremaining until the next change of their prices (in case of floating interest rate). The allocationof interest sensitive assets and liabilities to different revaluation periods allows forshowing the discrepancy for each of those periods. The time periods vary for each bank;the discrepancy schedule can include the following categories: 1 day, 2 days 1 month, 1- 3 months, 3 - 6 months, 6 months 1 year, 1 2 years, 2 5 years, and over 5 years.

A bank has a positive discrepancy when the sum of the assets being revaluated over a particular period is bigger than the sum of the liabilities being revaluated for the same period. A bank has a negative discrepancy if more liabilities than assets are being revaluated. The discrepancy is a normal phenomenon and it cannot be avoided or fully eliminated. The discrepancy affects the profit and is equal to the difference between the assets being revaluated (the liabilities) and the off-setting liabilities (assets). If a bank has a negative discrepancy and interest rates rise, the net interest income will decrease as more liabilities than assets will be revaluated at higher interest rates. But, if interest rates drop, the bank's net interest income will improve. On the other hand, if the bank has a positive discrepancy and the interest rates increase, the net interest income will improve as more assets than liabilities will be revaluated at higher interest rates. If the bank has a positive discrepancy and the interest rates drop, revenues will decrease. The bank's position in relation to interest rates sensitivity can be measured in several ways. One of the used methods is the ratio between the interest sensitive assets and the interest sensitive liabilities. A ratio of interest sensitive assets to interest sensitive liabilities equal to 1 shows a balanced position; a ratio bigger than 1 shows a position sensitive to assets, and a ratio smaller than 1 shows a position sensitive to liabilities. In principal, the discrepancy analysis shows a periodical and cumulative discrepancy. Regardless of that whether at a particular moment the bank has a position sensitive to assets or to liabilities,that position should always be in line with the management's forecasts about the interest rates movements, and should never be speculative. The most frequently used discrepancy coefficient is the following: Interest sensitive assets Interest sensitive liabilities Profitable assets Interest sensitive assets - Interest sensitive liabilities Profitable assets

In some cases, the total assets indicator can be used instead of profitable assets, but that can lead to underestimating the interest rate risk.The discrepancy shows the risk to which interest income is exposed.

1.2. Duration analysis One of the discrepancy analysis' limitations is its inability to show the portfolio value or its change as a consequence from interest rates' change. For tackling with this problem, another analytical method for measuring risk in portfolios of interest sensitive securities has been developed. The duration is a measure for the percentage deviation of the economic value of an individual position which will occur at a small change of the interest rates. It shows the time and amount of cash flows which are received before the instrument's contractuallyagreed maturity. On principle, the longer the maturity period and the period for the next change in the instrument's price is, or the smaller the payments received prior to maturity are (for example, coupon payments), the longer the duration is. The longer duration means that a certain change in interest rates levels will have a greater impact on the economic value.

2. Value at Risk (VaR) The Value at Risk model (VAR) is the most common measurement method used by the banks to generalize their market risk exposures. The bank applies the Value at Risk (VAR) models for measuring the trade and the bank portfolios' market risk and for the potential losses assessment via an appropriate analytical method supported by empirical circumstances and documented analysis. This method is applied consistently and with a higher level of conservativeness when the available data is limited. All instruments that are valuated at market prices are exposed to market risk. These financial instruments are reported in the bank's financial condition report at fair value on the basis of market prices quotes, and the effect from changes in the market conditions is recognised as profit or loss in the comprehensive income statement. The VaR method is defined as the estimated maximum loss amount from a given instrument or portfolio which can be expected over a particular time interval and a specified

level of probability. The level of probability at which that value will not be exceeded, should be determined in advance6, and in practice it is usually set between 95% and 99% (one-sided confidence interval). The shortest period is one day and it is used in banks, while the longest one is usually one year and is used by investment funds. The standard practice has determined this period to be 10 days (a 10-day equivalent period of holding). Changes in the current portfolio's value are calculated on the basis of possible changes in the risk parameters during the following working day.

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