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RISK DEFINED
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RISK MANAGEMENT IN BANKS
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TYPES OF RISKS
Risk is the potentiality that both the expected and unexpected events
may have as adverse impact on the bank’s capital or earnings. The expected
loss is to be borne by the borrower and hence is taken care of by adequately
pricing the products through risk premium and reserves created out of the
earnings. It is the amount expected to be lost due to changes in credit quality
resulting in default.
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Financial Risks
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It is essential that each bank develops its own credit risk strategy or
enunciates a plan that defines the objectives for the credit-granting function.
This strategy should spell out clearly the organisation's credit appetite and
the acceptable level of risk - reward trade-off at both the macro and the
micro levels.
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(a) Quantifying the risk through estimating expected loan losses i.e. the
amount of loan losses that bank would experience over a chosen time
horizon (through tracking portfolio behavior over 5 or more years)
and unexpected loss (through standard deviation of losses or the
difference between expected loan losses and some selected target
credit loss quantile);
(b) Risk pricing on a scientific basis; and
(c) Controlling the risk through effective Loan Review Mechanism and
portfolio management.
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The CRMD should also lay down risk assessment systems, monitor
quality of loan portfolio, identify problems and correct deficiencies, develop
MIS and undertake loan review/audit.
Large banks may consider separate set up for loan review/audit. The
CRMD should also be made accountable for protecting the quality of the
entire loan portfolio. The Department should undertake portfolio evaluations
and conduct comprehensive studies on the environment to test the resilience
of the loan portfolio.
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repaying the loan or not making the due payment in time. This uncertainty
of repayment by the borrower is also known as default risk.
Managing credit risk has been a problem for the banks for centuries.
As had been observed by JOHN MEDLIN, 1985 issue of US banker.
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1. PORTFOLIO MANAGEMENT.
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Market risk is the risk to the bank’s 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. Market Risk
management provides a comprehensive and dynamic framework for
measuring, monitoring and managing liquidity, interest rate, foreign
exchange and equity as well as commodity price risk of a bank that needs to
be closely integrated with the banks business strategy.
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Scenario analysis and stress testing is yet another tool used to asses
areas of potential problems in a given portfolio. Identification of future
changes in economic conditions like-
ECONOMIC / INDUSTRY OVERTURNS.
MARKET RISK EVENTS.
LIQUIDITY CONDITIONS.
Market risk arises out of the dynamics of market forces, which, for
the banking industry, may include interest rate fluctuations, maturity
mismatches, exchange rate fluctuations, market competition in terms of
services and products, changing customer preferences and requirements
resulting in product obsolescene, coupled with changes national and
international politico-economic scenario. These risks are like perils of the
sea, which can be caused by any change-taking place anywhere in the
national and international arena.
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products will divert the customers to other banks thereby reducing the
business and profits of the bank concerned.
ii. The macro-economic changes in the national and
international politico-economic scenario affect the risk element in different
business activities differently. This aspect has assumed greater importance
in the modern age, because of the increasing integration of global markets.
Since both these aspects are dynamic in nature, with change being the
only constant factor, market risks need to be monitored on a continuous
basis and appropriate strategies evolved to keep these risks within
manageable limits. Again, given that one can manage only what one can
measure, measurement of risks on a continuous basis deserves immediate
attention.
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effects on the bank. The operating prudential limits and the accountability of
the line management should also be clearly defined. The Asset-Liability
Management Committee (ALCO) should function as the top operational unit
for managing the balance sheet within the performance/risk parameters laid
down by the Board. The banks should also set up an independent Middle
Office to track the magnitude of market risk on a real time basis. The
Middle Office should comprise of experts in market risk management,
economists, statisticians and general bankers and may be functionally placed
directly under the ALCO. The Middle Office should also be separated from
Treasury Department and should not be involved in the day to day
management / ALCO / Treasury about adherence to prudential / risk
parameters and also aggregrate the total market risk exposures assumed by
the bank at any point of time.
1) Liquidity Risk
2) Interest Rate Risk
3) Commodity Price Risk and
4) Equity Price Risk
A concise definition of each of the above Market Risk factors and how
they are managed is described below:
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respect to their maturity: (a) profiles, (b) cost, (c) yield (d) risk exposures,
etc. It includes product pricing for deposits as well as advances, and the
desired maturity profile of assets and liabilities.
While the liquidity ratios are the ideal indicator of liquidity of banks
operating in developed financial markets, the ratios do not reveal the
intrinsic liquidity profile of Indian banks which are operating generally in an
illiquid market. Experiences show that assets commonly considered as
liquid like Government securities, other money market instruments, etc.
have limited liquidity as the market and players are unidirectional. Thus,
analysis of liquidity involves tracking of cash flow mismatches. For
measuring and managing net funding requirements, the use of maturity
ladder and calculation of cumulative surplus or deficit at selected maturity
dates is recommended as a standard tool.
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ALTERNATIVE SCENARIOS
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benchmark for normal situation; cash flow profile of on / off balance sheet
items and manages net funding requirements.
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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. Hence, the
objective of interest rate risk management is to maintain earnings, improve
the capability, ability to absorb potential loss and to ensure the adequacy of
the compensation received for the risk taken and effect risk return trade-off.
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earnings through fall in Net Interest Income (NII). Ultimately the impact of
the potential long-term effects of changes in interest rates is on the
underlying economic value of bank’s assets, liabilities and off-balance sheet
positions. The interest rate risk when viewed from these two perspective is
called as “Earning’s Perspective” and Economic Value Perspective”,
respectively.
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Price Risk:-
Price risk occurs when assets are sold before their stated maturities. In
the financial market, bond prices and yields are inversely related. The price
risk is closely associated with the trading book, which is created for making
profit out of short-term movements in interest rates. Banks which have an
active trading book should, therefore, formulate policies to limit the
portfolio size, holding period, duration, defeasance period, stop loss limits,
marking to market, etc.
Reinvestment Risk:-
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cash flows would expose the banks to variations in NII as the market interest
rates move in different directions.
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The positive Gap indicates that banks have more RSAs than RSLs. A
positive or assets sensitive Gap means that an increase in market interest
rates could cause an increase in NII.
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Measuring the duration Gap is more complex than the simple gap
model. The attraction of duration analysis is that it provides a
comprehensive measure of IRR for the total portfolio. The duration analysis
also recognizes the time value of money. Duration measure is addictive so
that banks can match total assets and liabilities rather than matching
individual accounts. However, Duration Gap analysis assumes parallel shifts
in yield curve. For this reason, it fails to recognize basis risk.
Equity Price Risk is the risk of loss in value of the bank’s equity
investments and/or equity derivative instruments arising out of change in
equity prices.
The risk of loss in value of commodity held / traded by the bank, arising out
of changes in prices, basis mismatch, forward price etc.
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Indeed, so significant has operational risk become that the bank for
International Settlement (BIS) has proposed that, as of 2006, banks should
be made to carry a Capital cushion against losses from this risk.
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The bank’s operational risks can be classified into following six exposure
classes :-
• People
• Process
• Management
• System
• Business and
• External
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To each of this exposure classes within each business line are attached
certain risk categories under which the bank can incur losses or potential
losses.
MEASUREMENT
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Indian Banks have so far not evolved any scientific methods for
quantifying operational risk. In the absence any sophisticated models, banks
could evolve simple benchmark based on an aggregate measure of business
activity such as gross revenue, fee income, operating costs, managed assets
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collateral also significantly affects the quality of the loan book. Thus, there
is a need for integration of the activities of both the ALCO and the CPC and
consultation process be established to evaluate the impact of market and
credit risks on the financial strength of banks. Banks may also consider
integrating market risk elements into their credit risk assessment process.
Why do organizations take risks? The apt answer would be-to make
some handsome gains. Banks, the world over, generally, it is said that “NO
RISK-NO GAIN”, but sometimes, taking risk becomes disastrous for the
organizations.
It is evident from above that if risk are not managed properly, even
the survival of the bank may become under threat, risk management has,
therefore, become an important area, which needs to be looked into with
great concern and care.
Individual banks risks create Systematic risk, i.e., the risk that the
whole banking system fails. Systematic risk results from the high
interrelations between banks through mutual lending and borrowing
commitments. The failure of single institution generates a risk of failure for
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all banks that have ongoing commitments with the defaulting bank.
Systematic Risk is a major challenge for the regulator.
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The major strength of cookie ratio is its simplicity, while of its major
drawbacks are :-
• There is no differentiation between the different risks in lending
activity. An 8% ratio applied for “AAA” rated large corporate exposure
and also for a small business with a lesser rating. That is, it was not risk
sensitive.
• In the CRAR computation, the capital charges are added. But,
summing arithmetically the capital charges of all transactions does not
capture diversification effects. By diversification we mean, that the
entire portfolio may not move unidirectional, but may compensate and
adjust in view of different co-relation among assets within the
exposure/portfolio. That is to say, there is an embedded diversification
in the 8% (CRAR), but the same ratio applies to all portfolios,
whatever their degree of diversification.
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capital adequacy, and risk exposure and assessment. The Risk Management
has come at the central stage in the new Basel Capital Accord.
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The main differences between the existing accord and the new one are
summarized below:-
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With the introduction of new products like plastic cards (credit, debit,
smart cards etc.) the risk of frauds have increased manifold. According to
estimation, in an active issuing Bank, card fraud is likely to claim the lion’s
share of fraud being experienced in general, and could well dominate
average operating losses as a whole. Worldwide, frauds occurred due to loss
or steal of plastic cards that cause the greatest losses. The second largest
source and fastest growing source of loss is use of counterfeit cards.
Emerging areas of E-commerce and internet banking are also a matter of
concern.
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Once the risks have been identified, the million dollar question is –
What to do about the Risks? The suitable answer to this question would be
to manage the risks in an efficient and effective manner so that the
organization incurs minimum loss.
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Case study
The Client
STATE BANK OF INDIA (SBI) is the largest bank in India with over 180
years of banking experience. Today, State Bank of India ranks among the
top 25 commercial banks in Asia with assets exceeding US$60 billion. SBI
operates worldwide through an extensive network of over 9000 offices
including 50 overseas offices in 48 countries. The Bank has won the
Technology Award 2005, from the ‘Banker’, London. Until recently, SBI
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UK operation has been using the Misys-Equation banking application for its
operations. This application runs on the IBM AS400 platform. Since 2001,
IIL Risk Management has provided various IT related services to the Bank.
The Problem
SBI, UK’s Treasury operations use the Reuters 3000 dealing system.
Dealers negotiate and confirm various deals every day involving money
market and forex trades. These deals were posted manually into the banking
application. Manual posting carried with it the risk of error prone entries,
missed out deals, lack of suitable and timely checks & verification and
inability to ascertain accurately counter party dealing limits. The Bank
required ‘straight through processing’ from Reuters dealing server to the
Misys-Equation platform to minimise operational risk. With an eye on
future proofing the investment in the system it also desired that the solution
be platform independent and therefore be based on ‘java’ programming and
be integrated with the Meridian middleware provided by Misys. In addition,
they required counter party limits and exposures to be displayed back to the
dealer on a separate screen by intelligently using the information from
dealer initiated Reuter conversations with the counter party. Investigation of
available products in the market place found that they contained many
functionalities already catered for by the Reuter system and were not cost
effective and used obsolete technologies.
The Solution
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IIL Risk Management (IIL) developed for the bank a unique and cost
effective solution to automate the entire process from capturing deals from
Reuter dealing 3000 server to posting into the core banking application.
All the above modules work closely with each other in terms of
connectivity, request and response along with reliable audit trails.
The Benefits
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CANARA Bank, one of the oldest public sector banks, has been improving
its performance under various parameters such as global deposits, advances,
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The bank has taken up a series of initiatives in the last couple of years
especially to improve the quality of its assets and also to contain fresh
accruals of non-performing assets (NPAs). These measures include inter-
face meetings with C ircle Offices and setting of targets, recovery meets for
compromise settlements and recovery camps at branches. All these
measures have resulted in a significant decline in the net NPA ratio from
7.52 per cent on March 31, 1998 to 7.09 per cent by the end of last fiscal
year.
With a progressive decline in the net NPAs ratio, the bank has aimed at
containing the level of net NPAs to below four per cent in the next few
years. Towards this, it has been embarking upon more and more innovative
measures, which would help it right f rom the stage of making credit
decisions to regularly monitoring them on an ongoing basis to effectively
avoid slippages.
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The Bank has computed capital charge for operational risk by adopting
Basic Indicator Approach as stipulated by RBI. The Bank has initiated steps
for strengthening internal operational loss data base through incident
reporting system by all branches/offices to capture loss/near miss
operational loss incidents. Risk Profile of the Bank is compiled on a
quarterly basis based on the risk templates provided by RBI, to analyze the
level and direction of various risks across the Bank.
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The Bank has computed capital charge for market risk on Available for
Sale (AFS) and Held for Trading (HFT) portfolios under Investments, by
adopting Standardized Modified Duration Approach. Integrated Mid
Office at Risk Management Wing monitors market risk through on line
connectivity with the domestic and forex treasury. Exposure limits, such as
stop loss limits on trading books, Dealer wise limits, limits on money
market operations, M-duration limits for AFS category,
Aggregate gap limit, Intra day and overnight limit for various currency
positions are fixed to act as risk mitigates and on line monitoring is being
done by Risk Management Wing. Various risk reports formats are
customized for effective market risk management.
Nostro A/c A banking term to describe an account one bank holds with a
bank in a foreign country, usually in the Currency of that foreign country.
Nostro Account is an Account Maintained by One bank with another
corresponding foreign bank in its Local Currency.
The Client
The Problem
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The Solution
IIL Risk Management provided a web based banking solution using the
customer's PC, a web server, a database server, a data transformer and a data
retriever using proven methodologies and protocols. The solution integrates
IBM AS/400, Microsoft web server, Microsoft SQL server, and the Internet
and Firewall technologies.
Credit risk, the most significant risk faced by ICICI Bank, is managed by the
Credit Risk Compliance & Audit Department (CRC & AD) which
evaluates risk at the transaction level as well as in the portfolio context. The
industry analysts of the department monitor all major sectors and evolve a
sectoral outlook, which is an important input to the portfolio planning
process. The department has done detailed studies on default patterns of
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During the year, the department has been instrumental in reorienting the
credit processes, including delegation of powers and creation of suitable
control points in the credit delivery process with the objective of improving
customer response time and enhancing the effectiveness of the asset creation
and monitoring activities.
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ICICI Bank, like all large banks, is exposed to many types of operational
risks. These include potential losses caused by events such as breakdown in
information, communication, transaction processing and settlement systems/
procedures.
The Audit Department, an integral part of the Risk Compliance & Audit
Group, focusses on the operational risks within the organisation. In recent
times, there has been a shift in the audit focus from transactions to
controls. Some examples of this paradigm shift are:
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The Audit Department conceptualized and put into operation a Risk Based
Audit Plan during the year 1998-99. The Risk Based Audit Plan envisages
allocation of audit resources in accordance with the risk constituents of
ICICI Bank’s business.
CONCLUSION
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