Risk Management in Banks

Chapter 1

 Introduction of Risk :

Risk management is a systematic approach to minimizing an organization's

exposure to risk. A risk management system includes various policies,
procedures and practices that work in unison to identify analyses, evaluate,
address and monitor risk. Risk management information is used along with
other corporate information, such as feasibility, to arrive at a risk
management decision. Transferring risk to another party, lessening the
negative affect of risk and avoiding risk altogether are considered risk
management strategies. Examples of risk management practices include
purchasing insurance, installing security systems, maintaining cash
reserves and diversification. Traditional risk management works to reduce
vulnerabilities that are associated with accidents, deaths and lawsuits, among
others. Financial risk management focuses on minimizing risks through the
use of financial tools and instruments including various trading techniques
and financial analysis. Many large corporations employ teams of risk
management personnel.

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 Risk Management in Banks

Chapter 2
 Introduction of risk management in bank:
Risk management in Indian banks is a relatively
newer practice, but has already shown to increase efficiency in governing of
these banks as such procedures tend to increase the corporate governance of
a financial institution. In times of volatility and fluctuations in the market,
financial institutions need to prove their mettle by withstanding the market
variations and achieve sustainability in terms of growth and well as have a
stable share value. Hence, an essential component of risk management
framework would be to mitigate all the risks and rewards of the products and
service offered by the bank. Thus the need for an efficient risk management
framework is paramount in order to factor in internal and external risks.

The financial sector in various economies like that of India is

undergoing a monumental change factoring into account world events such
as the on-going Banking Crisis across the globe. It has highlighted the need
for banks to incorporate the concept of Risk Management into their regular
procedures. The various aspects of increasing global competition to Indian
Banks by Foreign banks, increasing Deregulation, introduction of innovative
products, and financial instruments as well as innovation in delivery
channels have highlighted the need for Indian Banks to be prepared in terms
of risk management.

Indian Banks have been making great advancements in terms of progress in

terms of technology, quality, quantity as well as stability such that they have
started to expand and diversify at a rapid rate. However, such expansion

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brings these banks into the context of risk especially at the onset of
increasing Globalization and Liberalization. In banks and other financial
institution risk plays a major part in the earnings of a bank. Higher the risk,
higher is the return; hence, it is most essential to maintain parity between
risk and return. Hence, management of Financial risk incorporating a set
systematic and professional methods especially those defined by the Basel II
norms because an essential requirement of banks. The more risk averse a
bank is, the safer is their Capital base.

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Chapter 3

 Risk Management Framework for Indian Banks:

Banks must ensure that risk management is a custodian of overall

banking activities to mitigate the risks.

Risk management is relatively new and emerging practice as far as

Indian banks are concerned and has been proved that it’s a mirror of efficient
corporate governance of a financial institution. Globalization and significant
competition between foreign and domestic banks, survival and optimizing
returns are very crucial for banks and financial institutions. However,
selecting the efficient customer and providing innovative and value added
financial products and services are another paramount factors. In a volatile
and dynamic market place for achieving sustainable business growth and
shareholder’s value, it is essential to develop a link between risks and

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 Risk Management in Banks

rewards of all products and services of the bank. Hence, the banks should
have efficient risk management framework to mitigate all internal and
external risks.

The presence of accurate measures of bank-wide risk management practice

increase shareholder’s returns and allows the risk-taking behavior of bank to
be more closely aligned with strategic objectives. Bank-wide risk
management practice should aim to enhance the drivers of shareholder’s
value such as: -
 Growth
 Risk adjusted performance measurement
 Consistency of earnings and
 Quality and transparency of management

The important steps of the efficient framework of banking concern

should ensure all risks are identified, prioritized, quantified, controlled and
managed in order to achieve an optimal risk-reward profile. This entails
ideal and dedicated coordination of risk management across the bank’s
various business units. However, the approach to monitoring and enforcing
the adherence of business units within the bank may vary. The factors that
influence this decision are:

 The feasibility decisions of the business unit.

 The regulatory requirements in respect of the business unit.
 The cost of effective monitoring and controlling steps.

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Benefits of Bank-wide risk management

Risk management is a line function that needs to be addressed by

each individual cost center and business unit. However, a centralized bank-
wide risk management framework has certain advantages for the Bank. The
advantages are: -

 Improving capital efficiency by

1. Providing an objective basis for allocating resources

2. Reducing expenditures on immaterial risks and
3. Exploring natural hedges and portfolio effects

 Supporting informed decision making by

1. Uncovering areas of high potential adverse impact on drivers of share

value, and
2. Identifying and exploiting areas of risk-based advantage context.

 Building investor confidence by

1. Establishing a process to stabilize results by protecting them from

disturbances, and
2. Demonstrating proactive risk stewardship

 Define cost and profitability centers

1. Profitability and cost allocation on customer, product, services and

branch wide.

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 Risk Management in Banks

 Risk Management Framework

The important factors for how risks are managed in the bank and the
institution’s risk management philosophy and practice are as follows:

1. Organizational structure of the bank and the control arrangements that are
embedded in it, such as segregation of duties and ‘four eyes’ principle
2. Role of the board and board committees
3. Role of Management and management committees
4. Mandate of the board and management committees
5. Discussion of policies, procedures and limits; risk monitoring; and
internal controls for each risk
6. Role of the Risk Management function
7. Role of the compliance function
8. Role of Internal Audit
9. Pin pointed risk owner of each risk and reporting lines.
10.Risk monitoring reports, their frequency and distribution.

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Chapter 4
 Types of Financial risks
1) Credit risk

2) Interest rate risk

3) Market risk

4) Capital risk

5) Liquidity risk

 Credit risk:

Credit risk is the risk of counter party failure in performing repayment

obligation on due date is known as credit risk. Credit risk management is a
primary challenge for all the banks. The mismanagement of credit risk may
lead to failure of the banks itself.

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 Risk Management in Banks

Credit risk is managed by credit policy or loan policy of the bank. The
bank may take preventive measures or curative measures to avoid this risk.
Credit risk depends on external and internal factors (Sudden hike in steel
and cement prices affect the builder), stock market, foreign exchange rates
and interest rates, etc. The internal factors are bad loan policies, bad
appraisal of the borrowers and his credit worthiness, etc. The preventive
measures include checking the credit worthiness of the borrower, checking
type of security and the amount of security offered by the borrower. Curative
measures include selling the security offered by the borrower to recover the
amount of loan making the guarantor to pay the loan amount or extending
concessional measures to enable the borrower to repay the loan. Credit risk
is caused by market risk variable and thus the management of such risk
becomes a part of ALM.

 Market risks:

Market risk is the risk of adverse movement in the share price of the
bank. Management should have control over the market risk. Market risk is
relatively more now because of transparency in the market, frequency of
transactions and superior technology.

 Capital risk:

Banks require capital to protect themselves from various risks that

they undertake i.e. credit risk, liquidity risk, interest rate risk, adverse
movement of share prices, etc. Therefore it becomes important for the
banks to understand the relevance of capital adequacy and manage capital

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 Risk Management in Banks

risk. Banks can manage capital risk by bringing in more capital either
through promoters or IPO.

 Liquidity risk:

Banks need to maintain liquidity to meet deposit withdrawals and to

fund loan demand. There could be a mismatch in the maturity of assets and
liabilities leading to liquidity risk. The variability of loan demand and
variability of deposit determine banks liquidity needs.

Liquidity risk is potential inability of the banks to cope up with

declining deposits. Liquidity risk arises when the banks do not have
adequate cash when it is required. To manage liquidity risk banks need to
study customer withdrawal pattern and make provisions for the same.

For Example: There are heavy withdrawals on the first and the last day of
the week and even on the day before and after a public holiday.

Banks need to maintain liquid assets which can be converted into cash
quickly to meet customer requirements and thereby manage liquidity risk.

 Interest rate risk:

Till 1970’s regulatory restrictions on banks greatly reduced many risks

of the banks. The deposits were taken at a fixed mandatory rate and loans
were given at legally established rate. There were no changes in the interest
rates. Therefore, banks had to consider only credit risk and liquidity risk.

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In 1970, banks interest rates were deregulated which exposed the

banks to interest rate risk. Many banks failed because of poor management
of interest rate risk. However, today frequent changes in the interest rates
have become a common risk and almost all banks are able to cope up with
interest rate risk.
Interest rate risk is exposure of banks financial conditions to adverse
movements in interest rates. Accepting this risk is a normal part of banking
company, however, excessive interest rate risk can create significant threats
to the banks earnings. Changes in the interest rates affect the banks earnings
because of changes in NII. Interest rate risk refers to volatility in NII. An
effective risk management process that maintains interest rate risks in
controllable level is essential for safety and soundness of the banks. Most of
the banks have already identified interest rate risk as a drag on profitability
and have started assessing the magnitude of it.

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Chapter 5

 Risk Management Process:

The process of financial risk management is an on-going
one. Strategies need to be implemented a n d r e f i n e d a s t h e m a r k e t a n d
requirements change.
R e f i n e m e n t s m a y r e f l e c t c h a n g i n g expectations about market rates,
changes to the business environment, or changing international political
conditions, for example. In general, the process can be summarized as
follows:

• Identify and prioritize key financial risks.

• Determine an appropriate level of risk tolerance.
• Implement risk management strategy in accordance with policy.
• Measure, report, monitor, and refine as needed.

Risk management needs to be looked at as an

organizational approach, as management of risks independently cannot have
the desired effect over the long term. This is especially necessary as risks
result from various activities in the firm and the personnel responsible for
the activities do not always understand the risk attached to them. The steps
in risk management process are:

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1. Determining Objectives:-
Determination of objectives is the first step in the risk
management function. The objective may be to protect profits, or to develop
competitive advantages. The objectives of risk management need to be
decided upon by the management.

2. Identifying Risks:-
Every organization faces different risks, based on
its business, the economic, social and political factors, the features of the
industry it operates in – like the degree of competition, the strengths and
weakness of its competitors, availability of raw material, factors internal to
the company like the competence and outlook of the management, state of
industry relations, dependence on foreign markets for inputs, sales or
finances, capabilities of its staff and other innumerable factors.

3. Risk Evaluation:-
Once the risks are identified, they need to be evaluated for
ascertaining their significance. The significance of a particular risk depends
upon the size of the loss that it may result in, and the probability of the
occurrence of such loss. On the basis of these factors, the various risks
faced by the corporate need to be classified as critical risks, important
risks and not-so-important risks. Critical risks are those that may result in
bankruptcy of the firm. Important risks are those that may not result in
bankruptcy, but may cause severe financial distress.

4. Development of policy:-

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Based on the risk tolerance level of the firm, the risk management policy
needs to be developed. The time frame of the policy should be
comparatively long, so that the policy is relatively stable. A policy
generally takes the form of a declaration as to how much risk should be
covered.

5. Development of Strategy:-
Based on the policy, the firm then needs to develop the strategy to be
followed for managing risk. A strategy is essentially an action plan, which
specifies the nature of risk to be managed and the timing. It also
specifies the tools, techniques and instruments that can be used to manage
these risks. A strategy also deals with tax and legal problems. Another
important issue that needs to be specified by the strategy is whether
the company would try to make profits out of risk management
or would it stick to covering the existing risks.

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6. Implementation:-
Once the policy and the strategy are in place, they are to be implemented
for actually managing the risks. This is the operational part of risk
management. It includes finding the best deal in case of risk transfer,
providing for contingencies in case of risk retention, designing and
implementing risk control programs etc.

7. Review:-
The function of risk management needs to be reviewed periodically
depending on the costs involved. The factors that affect the risk management
decisions keep changing, thus necessitating the need to monitor the
effectiveness of the decisions taken previously.

Chapter 6

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 Importance of Risk management :

Risk management is a paramount consideration for the banking

industry, with higher proportions of banking executives (74 percent)
identifying it as a high priority than the overall survey average of 60 percent.
This focus on risk management has increased in the last two years – more
than in other industries – and banks plan a relatively high level of
investment to develop risk management capabilities.
Slightly higher percentages of banks and other financial services
companies, compared with other industries, report that their risk function has
become a source of competitive advantage. Across the survey, about half the
companies (49 percent) see their risk organization as a critical driver for
enabling long term profitable growth; another 42 percent believe their risk
management capabilities are “important” to growth.

Almost identical numbers (48 percent) see risk management as critical

to sustained future profitability, with another 45 percent believing it to be

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“important.” These are high percentages. Put another way, 91 percent and 93
percent of executives, respectively, believe that the risk management
function is important or critical to growth and profitability.
The Risk Director for an Asia Pacific bank states this importance
explicitly:
“Our risk organization and functions were established to support and enable
our organization to achieve strategic goals such as sustainable growth and
profitability, competitive advantages and capital management. Put simply,
we recognize risk as a part of the strategic agenda.”
The mind-set of risk management as a differentiator is also correlated with
risk mastery. Almost two-thirds of Masters across the global survey (64
percent) indicate that their risk management capabilities provide competitive
advantage to “a great extent,” compared with only 42 percent of the peer set.
These companies are also more likely to identify risk as a higher priority.

Chapter 7

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 MANAGEMENT OF RISKS:

An independent Risk Management department is functioning

for Effective risk management enterprise wide. Risk is managed through
following three Apex committees viz.
(i) Credit Risk Management Committee (CRMC)
(ii) Asset and Liability Management Committee (ALMC) and
(iii) Operational Risk Management Committee (ORMC)

These committees work within the overall guidelines and policies

approved by the Risk Management Committee of the Board. The Bank has
put in place various policies to manage the risk. To analyses the
risk enterprise wide and with the objective of integrating all the risks of the
Bank Integrated Risk Management Policy has also been put in place. The
important risk policies comprise of Credit Risk Policy, Asset and Liability
Management Policy, Operational Risk, Management Policy,
Business Continuity Planning, Whistle Blower Policy and Policy
on Corporate Governance.

Management of risks begins with identification and its quantification. It

is only after risks are identified and measured we may decide to accept the
risk or to accept the risk at a reduced level by undertaking steps to mitigate
the risk, either fully or partially. In addition pricing of the transaction should
be in accordance with the risk content of the transaction. Hence management
of risks may be sub-divided into following five processes:-

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α Risk Identification
α Risk measurement
α Risk pricing
α Risk monitoring and control
α Risk mitigation

Further, approach to manage risks at transaction level- i.e. at branch level

where business transactions are undertaken- and at aggregate level- i.e., sum

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total of all transactions undertaken at all the branches- differs. This is

because of risk diversification that take place at aggregate level.

Like in case of any other business, risks in banking business would

depend upon the variability of its net cash flow at the aggregate level.
Therefore, managing variability in aggregate cash flow is equally important
and portfolio risks also need to be managed. Therefore, risk management in
banking business is directed at transaction level and as well as at aggregate
level.

 RISK IDENTIFICATION:
Nearly all transaction undertaken would have one or more of the major risks
i.e.

 Liquidity risk
 Interest rate risk
 Market risk
 Credit risk &
 Operational risk.

Although all these risks are contracted at the transaction level, certain
risks such as liquidity risk and interest rate risk are managed at the aggregate
or portfolio level. Risks such as credit risk, operational risk and market risk
arising from individual transactions are taken cognizance of at transaction
level as well as at the portfolio level.

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Risk identification consist of identifying various risks associated with

the risk taking at the transaction level and examining its impact on the
portfolio and capital requirement. As we would see later risk content of a
transaction is also instrumental in pricing the exposure as risk adjusted
return is the key driving force in the management of banks.

 RISK MEASUREMENT:
Risk management relies on quantities measures of risk. The risk
measures seems to capture variations in earnings, market value, losses due to
default, etc.(referred to as target variables), arising out of uncertainties
associated with various risk elements. Quantitative measures of risks can be
classified into three categories:-
α Based on sensitivity
α Based on volatility
α Based on down side potential

 Sensitivity:
Sensitivity captures deviation of a target variable due to unit movement
of a single market parameter. Only those market parameters, which drive the
value of the target variable, are relevant for the purpose. For example,
change in market value due to1% change in interest rate would be a
sensitivity-based measure. Other examples of market parameters could be
exchange rates and stock prices. The interest rate gap is the sensitivity of the
interest rate margin of the banking book. Duration is the sensitivity of

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investment portfolio or trading book. Usually, market risk models use

sensitivities fairly widely. This measure suffers from couple of drawbacks.

First, it is only with reference to one market parameter and does not
consider impact of other parameters, which may also change simultaneously.
Secondly, sensitivities depend on prevailing conditions and change as
market environment changes.

 VOLATILITY:
It is possible combine sensitivity of target variables with the instability
of the underlying parameters. The volatility characterizes the stability or
instability of any random variable. It is the common statistical measure of
dispersion around the average of any random variable such as earnings,
mark-to-market values, market value, losses due to default, etc. volatility is
the standard deviation of the values of these variables. Standard deviation is
the square root of the variance of the random variable.

It is feasible to calculate historical volatility using any set of historical

data, whether or not they follow a normal distribution. Alternatively, implicit
volatility may also be computed using option prices, if quoted in the market
using Black and Scholes option pricing formula. Implicit volatility has an
advantage as it is forward looking since option price being quoted is also
forward looking. The calculation of historical mean and volatility requires
time series. Defining a time series requires defining the period of
observation and the frequency of observation.

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 RISK PRICING:
Risk in banking transactions impact banks in two ways. Firstly,
banks have to maintain necessary capital, at least as per regulatory
requirements. The capital required is not without costs. The cost of capital
arises from the need to pay investors in banks equity and internal generation
of capital necessary for business growth. Each banking transaction should be
able to generate necessary surplus to meet this costs. The pricing of
transaction must take that into account.

The actual costs incurred are cost of funds that has gone into the
transactions and costs incurred in giving the services, which are incurred by
way of maintaining the infrastructure, employees and other relevant
expenses. Pricing, therefore, should take into account the following:

• Cost of Deployable funds

• Operating Expenses
• Loss probabilities
• Capital charge

It should also be mention here that cost of funds should correspond to

the term for which it is deployed. This is because five year funds may have a
different cost than one year fund due to time value of money.

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 RISK MITIGATION:
Since risk arises from uncertainties’ associated with the risk elements,
risk reduction is achieved by adopting strategies that eliminate or reduce the
uncertainties’ associated with the risk elements. This is called ’RISK
MITIGATION’.

In banking we come across a variety of financial instruments and

number of techniques that can be used to mitigate risks. The techniques to
mitigate the different types of risk are different. For mitigating credit risk
banks have been using traditional techniques such as collateralizations by
first priority claims with cash or securities or landed properties, third party
guarantees etc. Banks may buy credit derivatives to offset various forms of
credit risk. For mitigating interest rate risk bank use interest rates swaps,
forward rate agreements or financial future. Similarly, for mitigating forex
risks banks use forex forward contract, forex options or futures and for
mitigating equity price risk, equity options.

Risk mitigation measures aim to reduce downside variability in net

cash flow but it also reduces upside potential simultaneously. In fact, risk
mitigation measures reduce the variability in net cash flow. In addition, risk
mitigation would involve counter party and it will always be associated with
counter party risk. It may also may be stated here that markets have

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 Risk Management in Banks

responded to the counter party risk bye establishing ‘Exchanges’ such as

stock exchange, commodity exchange, future and option exchanges.

Chapter 8
 MARKET RISK IN BANKS

INTRODUCTION

Much of the debate in recent year s concerning the management of

market risk within banks has focused on the appropriateness of so-called
Value-at-Risk (VaR) models. These models are designed to estimate, for a
given trading portfolio, the maximum amount that a bank could lose over a
specific time period with a given probability. In this way they provide a
summary measure of the risk exposure generated by a given portfolio. Draft
guidelines1 released by the Reserve Bank in August 1996 give banks the
option (subject to supervisory approval) of using VaR models to measure
market risk on traded instruments in determining appropriate regulatory
capital charges.

VaR models can be developed to varying degrees of complexity. The

simplest approach takes as its starting point estimates of the sensitivity of
each of the components of a portfolio to small price changes (for example, a
one basis point change in interest rates or a one per cent change in exchange
rates), then assumes that market price movements follow a particular
statistical distribution (usually the normal or log-normal distribution). This

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 Risk Management in Banks

simplifies the analysis by enabling a risk manager to use statistical theory to

draw inferences about potential losses with a given degree of statistical
confidence. For example on a given portfolio, it might be possible to show
that there is a 99 per cent probability that a loss over any one-week period
will not exceed, say, $1 million.

MANAGEMENT OF MARKET RISK

1.1 RISK IDENTIFICATION

All products and transaction should be analyzed for risks associated

with them. While various risks associated with a standardized product
stands analyzed, that in case of a non-standard product needs to be
analyzed. Therefore, approach to deal in standard and non – standard
products differs. We have seen under general approach to risk management;
guidance for risk taking at the transaction level comes from the corporate
level. It applies to the management of market risk also.
- Usually all standard products would have “product programmer” for each of
them. All risk taking units operate within an approved “product
programme”. Product program defines procedures, limits & control for all

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aspects of the products. The product programme also specifies market risk
measurement at an individual product level and at aggregate portfolio level.

- New products or non-standard products may operate under a “product

transaction memorandum” on a temporary basis while a full market risk
product programme is being prepared.

Product approved at corporate level shall provide for screening procedures.

Appropriate safe guards, product wise limit on exposure, and necessary
guidelines in risk taking. In fact, the guidelines help in standardizing risk
content in the business undertaken at the transaction level.

1.2 RISK MEASUREMENT:

Market risk management framework is heavily dependent upon

quantitative measures of risk. The market risk measures seek to capture
variation in market value arising out of uncertainties associated with
various risk elements. These provide an objective measure of market risk in
a transaction or of a portfolio. Market risk measures are based on
---- Sensitivity
---- Downside potential
- Sensitivity:

Supply-demand position, interest rate, market liquidity, inflation,

exchange rate, stock prices etc.., are the market parameters, which drive
market value .sensitivity is measured as change in market value due to unit
change in the variables.
- Basis point value (BPV)

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 Risk Management in Banks

This is the change in value due to 1 basis (0.01%) change in market

yield. This is used as a measure of risk. The higher the BPV is quite simple.
- Duration :

This is equivalent to time, on average, that the holder of the bond must
wait to receive the cash flows. In other words this represents cash flow
“centre of gravity”. It implies that if a five year 6% bond face value of Rs
100 with semi-annual interest has McCauley’s duration say 3.7 years, then
total cash flow to be received Rs 130 at the end of 3.7 years as a bullet
payment.
- Downside potential :

Risk materializes only when earnings deviate adversely. Downside

potential only captures possible losses ignoring profit potential. Downside
risk is the most comprehensive measures of risk as it integrates sensitivity
and volatility with the adverse effect of uncertainty. This is the measure that
is most relied upon by banking and financial service industry as also the
regulators.
1.3 RISK MONITORING AND CONTROL:

Risk monitoring & control calls for implementation of risk and

business policies simultaneously. It consist of setting market risk limits or
controlling market risk, based on economic measures of risk while ensuring
best risk adjusted return. Controlling market risk means keeping the
variation of the value of a given portfolio within given boundary values
through actions on limits which are upper bounds imposed on risks. This is
achieved through the following:
1. Policy guideline limiting roles & authority.

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 Risk Management in Banks

2. limits structure and approval process.

3. Defined policy for mark to market.
4. Limit monitoring and reporting.
5. Performance measurement and resource allocation
Role of risk measurement in controlling and monitoring involves setting up
of limits and triggers and monitoring them. Risk position should also be
reported to designated authority.

1.4 RISK MITIGATION :

Market risk arises due to volatility of financial instruments. The

volatility of financial instruments is instrumental for both profits and risk.
Risk mitigation in market risk i.e. reduction in market risk is achieved by
adopting strategies that eliminate or reduce the volatility of the portfolio.
However, there are couples of issues that are also associated with risk
mitigation measures.
- Risk mitigation measures aim to reduce downside variability in net cash
flow but it also reduces upside potential or profit potential simultaneously.

- In addition, risk mitigation strategies, which involve counter party will

always be associated with counterparty risk. Of course, where counterparty
is an established ‘exchange’, counterparty risk gets reduced very
substantially. In OTC deals, counterparty risk would depend upon the risk
level associated with party to the contract.

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Chapter 9
 Credit Risk in Banking

INTRODUCTION

Credit risk is easily understandable. We all know that credit

risk arise from the lending activities of the bank. It arises when a borrower
does not pay interest or installments as and when it falls due or in case where
a loan is repayable on demand, the borrower fails to make the payment as
and when demanded. This is the risk that arises from lending activities.
Credit risk in banks not only arises in course of direct lending when funds
are not repaid, it also arises in course of issuing guarantees or letter of credit
when funds will not be forth coming upon crystallization of the liability, or
in the course of transactions involving treasury products when series of
payment due from the counterparty cease or are not forthcoming, or in case
of trading of securities if settlement is not effected or in case of cross border
exposure where free transfer of currency is restricted or ceases.

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 DEFAULT RISK

Default risk is driven by the potential failure of a borrower to make

promised payments, either partly or wholly. In the event of default, a
fraction of the obligations will normally be paid. This is known as the
recovery rate.

- CREDIT SPREAD RISK OR DOWNGRADE RISK.

If a borrower does not default, there is still risk due to worsening in

credit quality. This result in the possible widening of the credit- spread.
This is credit spread risk. These may arise from a rating change.
Loans are not usually marked-to-market. Consequently, the only important
factor is whether or not the loan is in default today.
Default risk and downgrade risks. Risks associated with credit portfolio as
a whole is termed portfolio risks. Portfolio risk has two components-
 Systematic or intrinsic risk

 Concentration risk

1. Systematic or intrinsic risk

If a portfolio is fully diversified across geographies, industries,
borrowers, markets, etc., equitable, then the portfolio risk is reduced to a
minimum level.

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2. Concentration risk
If the portfolio is not diversified that is to say that it has higher
weight in respect of a borrower or geography or industry etc., the portfolio
gets concentration risk.

1.1 RISK MEASUREMENT:

Measurement of credit risk consist of
(a) Measurement of risk through credit rating/scoring;

(b) 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 the
unexpected loan losses i.e. the amount by which actual losses exceed the
expected loss (through standard deviation of losses or the difference
between expected loan losses and some selected target credit loss
quintiles).

1.2CREDIT RISK CONTROL AND MONITORING:

Risk taking through lending activities needs to be supported by a
very effective control and monitoring mechanism, firstly because this

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activity is widespread, and secondly, because of very high share of credit

risk in the total risk taking activity of a bank.
Consequently, credit risk control and monitoring is directed both at
transaction level and portfolio level.

1.3 CREDIT RISK MITIGATION:

Credit risk mitigation is an essential part of credit risk management. This

refers to the process through which credit risk is reduced or it is transferred
to a counter party. Strategies for risk reduction level differ from that sat
portfolio level.
At transaction level banks use a number of techniques to mitigate the credit
risks to which they are exposed, they are mostly traditional technique and
need no elaboration. They are, for examples, exposures collateralized by
first priority claims, either in whole or in part, with cash or securities, or an
exposure guaranteed by a third party. Recent techniques include buying a
credit derivative to offset credit risk at transaction level.
At portfolio level, assets securitization, credit derivatives, etc. are used to
mitigate risks in the portfolio. They are also used to achieve desired
diversification in the portfolio as also to develop a portfolio with desired
characteristic. It must be noted that while the use of CRM techniques
reduces or transfers credit risk, it simultaneously may increase other risk
such as legal, operational, liquidity and market risk. Therefore, it is
imperative that banks employ robust procedures and processes to control
these risks as well. In fact, advantage of risk mitigation must be weighed
against the risk acquired and its interaction with the bank’s overall risk
profile.

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Chapter 10
 INTEREST RATE RISK IN BANKS:

The risk that an investment's value will change due to a

change in the absolute level of interest rates, in the spread between two rates,
in the shape of the yield curve or in any other interest rate relationship. Such
changes usually affect securities inversely and can be reduced by
diversifying (investing in fixed-income securities with different durations) or
hedging (e.g. through an interest rate swap)

Exposure to loss resulting from a change in interest rates.

Hedging strategies are designed to minimize, possibly eliminate, interest-
rate risk. Interest rate risk affects the value of bonds more directly than
stocks, and it is a major risk to all bondholders. As interest rates rise, bond
prices fall and vice versa. The rationale is that as interest rates increase, the
opportunity cost of holding a bond decreases since investors are able to
realize greater yields by switching to other investments that reflect the
higher interest rate.
For example, a 5% bond is worth more if interest rates decrease since the
bondholder receives a fixed rate of return relative to the market, which is
offering a lower rate of return as a result of the decrease in rates.
Interest rate risk management is critical to the overall profitability of your
bank. Even if managing interest rate risk is not part of your day-to-day

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responsibilities, if you oversee and manage the process, you need a clear,
definitive understanding of the issues so your bank can stay profitable.

Historically, banks have offset the risk associated with funding

fixed rate loans with variable-rate assets, such as customer deposits, by
lengthening the duration of the bank's assets. To do this, a bank would
purchase fixed-rate government securities with maturities that correspond
with the expected maturities of the bank's fixed-rate loans. Assets acquired
to lengthen the duration of the bank's assets are commonly known as
"balancing assets." However, many banks have realized that the same goal is
achieved more efficiently by using derivatives to manage interest rate risk
Collars.

Another method to manage interest rate risk is the "costless" collar.

A collar consists of an interest rate cap and floor, usually based on the
London Inter-Bank Offered Rate (LIBOR). To enter into a collar, a bank
would simultaneously purchase an interest rate cap and sell an interest rate
floor in the derivatives market. An interest rate cap is a series of interest rate
call options set at the same exercise rate and that have expiration dates at
each point when the underlying liability (in this case, customer deposits) is
expected to reprise. On the other hand, an interest rate floor is a series of

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interest rate put options with the same exercise rate that have expiration
dates at each point when the underlying liability is expected to reprise. If
interest rates rise, the interest rate cap calls for the seller of the cap to pay the
bank the difference of LIBOR and the predetermined cap rate. If interest
rates fall, the interest rate floor calls for the bank to pay the buyer the
difference between the floor rate and LIBOR. Therefore, a bank knows its
future interest rate expense regardless of whether interest rates rise or fall.
The word costless means that the premium paid to purchase the interest rate
cap is roughly equal to the premium received on the floor, excluding
brokerage fees. By entering into a collar, a bank is in neither a short nor a
long interest rate position in the derivatives market. In a rising-interest-rate
environment, a bank that wants to offset only the interest rate risk associated
with rising interest rates could take a long position in the derivatives market
by purchasing only the interest rate cap. By having a negative interest rate
gap, a bank would naturally be in a short interest rate position.

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Chapter 11
 OPERATIONAL RISK IN BANKS:

The banking environment has dramatically changed in the recent

past. At times, the change was felt to be comforting; more so, when it threw
open new opportunities. Nevertheless, more often than not its accompanying
risks were quite threatening. One such all- pervasive risk that bank face is
operational risk. It is one of the oldest risks that all along has been managed
quite informally, but of late, has suddenly caught everyone’s attention for
reasons galore. The Basel committee, having identified operational risk as an
important risk faced by banks, proposed allocation of certain minimum
capital by banks to protect themselves from such losses. The Basel II
directives for allocating capital against operational risk have further
enhanced banks interest in the operational risk.

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 Risk Management in Banks

Operational risk is as old as banking. It even precedes market and credit

risks, and yet there is no universally accepted definition of it. Operational
risk is often defined by what it is not: Any risk that is not related to credit
market and liquidity risk is identified as operational risk. Different banks
perceive it in different ways as could be gauged from the following:
 Any risk that is not categorized as market or credit risk;
 Any risk of loss arising from various types of human or technical error;
 Risk associated with settlement or payment risk and business interruption
and legal risk;
 Risk of frauds by employees and outsiders; unauthorized transaction by
employees and errors relating to computer and telecommunication
systems.
 The potential exposure to missed opportunity or to unexpected financial
reputational or other damage resulting from the way in which an
organization operates and pursues its business objectives.

The Basel Committee on Banking Supervision defined operational risk as

“the risk of loss resulting from inadequate or failed internal processes,

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people and systems or from external events.” This definition had indeed
captured the whole horizon of operational risk except for the critical
“business-strategic risk.” This definition excludes strategic and reputational
risk, but includes legal risk.

Operational risk arises due to inadequate control systems,

operational problems and breaches in internal controls, fraud and unforeseen
catastrophes resulting in unexpected losses for the banks. Many of the
operational-risk related functions such as regulatory compliance, finance-
management, frauds, IT, legal and insurance are carried out by the staff and
thus human resources itself becomes a cause for operational risk. Financial
losses could also arise from external events such as fires and other disasters.
Operational risk is perceived to be highly capable of impacting business
lines that have high volume and high turnover coupled with low-margins.

 Operational Risk - Sources of Risk

Business
Processes
People

Business
Environment

Operational Constant
Risk Change
Business
Strategy
Control
Systems
ITS Systems

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1 MANAGEMENT OF OPERATIONAL RISK

1.1 RISK MONITORING & CONTROL PRATICES

Risk monitoring and control practices encompass the following:
 Collection of operational risk data (incident reporting framework)

 Regular monitoring and feedback mechanism in place for monitoring

any deterioration in operational risk profile.

 Collation of incident reporting data to assess frequency and

probability of occurrence of operational risk events.

 Monitoring and controlling of management of large exposures. The

modalities to be prescribed in the loan policy documents.

1.2 OPERATIONAL RISK MITIGATION

The mitigation of operational risk basically lies in the qualitative approach

in operational risk framework adopted and its implementation.
Insurance cover, where available, may provide mitigation of risk. Capital
allowance under insurance is available only where AMA has adopted
estimating capital for operational risk and is subject to certain conditions.
“Under the AMA, a bank will be allowed to recognize the risk mitigation
impact of insurance in the measures of operational risk used for regulatory
minimum capital requirements. The recognition of insurance mitigation will
be limited to 20% of the total operational risk capital charge calculated

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 Risk Management in Banks

under the AMA. A bank’s ability to take advantage of such risk mitigation
will depend on compliance with the few criteria”.

Chapter 12
 FOREIGN EXCHANGE RISK
Foreign Exchange Risk maybe defined as the risk that a bank may
suffer losses as a result of adverse exchange rate movements during a period
in which it has an open position, either spot or forward, or a combination of
the two, in an individual foreign currency.

The banks are also exposed to interest rate risk, which arises from the
maturity mismatching of foreign currency positions. Even in cases where
spot and forward positions in individual currencies are balanced, the
maturity pattern of forward transactions may produce mismatches. As a
result, banks may suffer losses as a result of changes in premia/discounts of
the currencies concerned.

In the forex business, banks also face the risk of default of the
counterparties or settlement risk. While such type of risk crystallisation
does not cause principal loss, banks may have to undertake fresh
transactions in the cash/spot market for replacing the failed transactions.
Thus, banks may incur replacement cost, which depends upon the currency
rate movements. Banks also face another risk called time-zone risk or
Herstatt risk which arises out of time-lags in settlement of one currency in
one centre and the settlement of another currency in another time-zone. The
forex transactions with counterparties from another country also trigger

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sovereign or country risk (dealt with in details in the guidance note on credit
risk).

The three important issues that need to be addressed in this regard are:

 Nature and magnitude of exchange risk

 The strategy to be adopted for hedging or managing exchange risk.
 The tools of managing exchange risk.

 Nature and Magnitude of Risk

The first aspect of management of foreign exchange risk is to

acknowledge that such risk does exist and that it must be managed to avoid
adverse financial consequences. Many banks refrain from active
management of their foreign exchange exposure because they feel that
financial forecasting is outside their field of expertise or because they find it
difficult to measure currency exposure precisely. However not recognising a

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risk would not make it go away. Nor is the inability to measure risk any
excuse for not managing it. Having recognized this fact the nature and
magnitude of such risk must now be identified.

The basic difficulty in measuring exposure comes from the fact that
available accounting information which provides the most reliable base to
calculate exposure (accounting or translation exposure) does not capture the
actual risk a bank faces, which depends on its future cash flows and their
associated risk profiles (economic exposure). Also there is the distinction
between the currency in which cash flows are denominated and the currency
that determines the size of the cash flows.

For example- A borrower selling jewellery in Europe may keep its records
in Rupees, invoice in Euros, and collect Euro cash flow, only to find that its
revenue stream behaves as if it were in U.S. dollars! This occurs because
Euro-prices for the exports might adjust to reflect world market prices which
could be determined in U.S. dollars.

For a bank, being a financial entity, it is relatively easier to gauge the

nature as well as the measure of forex risk simply because all financial
assets/liabilities are denominated in a currency. A bank’s future cash streams
are more predictable than those of a non-financial firm. Its net exposure, or
position, completely encapsulates the measure of its exposure to forex risk.

In order to manage forex risk some forex market relationships need to

be understood well. The first and most important of these is the covered
interest parity relationship. If there is free and unrestricted mobility of
capital, the interest differential between two currencies will equal the

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forward premium/discount for either of the currency. This relationship must

hold under the assumptions; otherwise arbitrage opportunities will arise to
restore the relationship. However, in the case of Rupee, since it is not totally
convertible, this relationship does not hold exactly. Although interest rate
differentials are the driving factor for the Dollar premium against the Rupee,
it also is a factor of forward demand / supply factors. This brings in typical
complications to forward hedging which must be taken into account.

From the above it can easily be determined that a currency with a

lower interest rate will be at a premium to a currency with a higher interest
rate. The other relationships in the forex market are not as deterministic as
the covered interest parity, but needs to be recognised to manage forex
exposure because they are the theoretical tools used for predicting exchange
rate movements, essential to any hedging strategy particularly to economic
risk as opposed to accounting risk. The most important of these is the
Purchasing Power Parity relationship which says exchange rate changes are
determined by inflation differentials. The Uncovered Interest Parity theory
says that the forward exchange rate is the best and unbiased predictor of
future spot rates under risk neutrality. These relationships have to be clearly
understood for any meaningful forex risk management process.

 Managing Foreign Exchange Risk

For a bank therefore the first major decision on forex risk

management is for the management to fix its open foreign exchange position
limits. Although typically this is a management decision, it could also be

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subject to regulatory capital and could also be required to be in tune with the
regulatory environment that prevails. These open position limits have two
aspects, the Daylight limit and the Overnight limit. The daylight limit
could typically be substantially higher for two reasons, (a) It is easier to
manage exchange risk when the market is open and the bank is actively
present in the market and (b) the bank needs a higher limit to accommodate
client flows during business hours. Overnight position, being subject to more
uncertainty and therefore being more risky should be much lower.

Having decided on the overall open position limits, the next step is to
allocate these limits among different operating centres of the bank (in the
case of banks which hold positions at multiple centres). Within a centre there
could be a further allocation among different dealers. It must however be
ensured that the bank has a system to monitor the overall open position limit
for the bank on a real time basis.

 Tools and Techniques for managing forex risk

There are various tools, often substitutes, available for hedging of

foreign exchange risk like over the counter forwards, futures, money market
instruments, options and the like. Most currency management instruments
enable the bank to take a long or a short position to hedge an opposite short
or long position. In equilibrium and in an efficient market the cost of all will
be the same, according to the fundamental relationships. The tools differ to
the extent that they hedge different risks. In particular, symmetric hedging
tools like futures cannot easily hedge contingent cash flows where risk is
non-linear: options may be better suited to the latter.

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 Risk Control Systems:

The management of the bank need to lay out clear and unambiguous
performance measurement criteria, accountability norms and financial limits
in its treasury operations. Management must specify in operational terms the
goals of exchange risk management. It must also clearly recognise the risks
of trading arising from open positions, credit risks, and operations risks. The
bank must also keep in place a system to independently evaluate through
marking to market the net positions taken. Marking to market should ideally
be based on objective market prices provided by an external agency. All
position limits should be made explicit and expressed in simple terms for
easy control.

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Chapter 13

 Current state of Risk management practices in

Indian banks:-

Most of the banks do not have dedicated risk management

team, policy, procedures and framework in place. Those banks have risk
management department, the risk manager’s role is restricted to prefect and
post fact analysis of customer’s credit and there is no segregation of credit,
market, operational and strategic risks. There are few banks have articulated
framework and risk quantification. However, the outputs are far formatting
the stressed or actual losses due to usage of un-compatible implications.

The traditional lending practices, assessment of credits, handling of

market risks, treasury functionality and culture of risk-rewards are hauls of
public sector banks.

The sheer size and wide coverage of banks is a big hurdle to

integrate and generate a cost effective real time operational data for mapping
the risks. Most of the financial institutions processes are encircled to
‘functional silos’ follows bureaucratic structure and yet to come up with a
transparent and appropriate corporate governance structure to achieve the
stated strategic good artivle

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Chapter 14
 Risk Management in Future

The bank of the future will be recognized around a new vision. To

succeed, it will have to be able to respond to opportunities as they present
themselves. And it will have to strive to improve the portfolio management
of its balance sheet and capital.
To manage conflicting objectives, it will need to determine a number
of policy variables such as a target risk-adjusted rate of returns (RAROC),
target regulatory return, target tier 1 ratio, target liquidity, and so on.

In turn, this will mean transforming the risk management function. Risk
management will need to encompass limit management, risk analysis,
RAROC, and active portfolio management of risk (APMR). These changes
in the risk management will be induced by:

1. Advances in technology
2. Introduction of more sophisticated regulatory measures
3. Rapidly accelerating market forces
4. Complex legal environment

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 Risk Management in Banks

Chapter 15
 CASE STUDY:
ICICI Bank-
Risk management is a key focus area at ICICI
Bank

Risk management is a key focus area at ICICI Bank and viewed as a

strategic tool for competitive advantage. In the Indian context ICICI Bank
has been doing pioneering work in this area since 1996, when a specialized
risk management group was set up within the Bank.

RCAG is a centralized group based at Mumbai with the

responsibility of enterprise wide risk management. RCAG is headed by a
senior executive of the rank of General Manager who reports to the
Executive Director (Corporate Centre). The philosophy at ICICI Bank is to
have a separate risk management group (independent of the business group)
whose mandate is to analyses, measure, and monitor and manage risks. Risk
management is done under the overall supervision of the Board of Directors
and sub committees of the Board - Risk Committee, Credit Committee and
Audit Committee.

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 Risk Management in Banks

 RCAG is comprised of six groups –

 Corporate Credit Risk,
 Retail Risk,
 Market Risk,
 Credit Policies &
 Compliance,
 Risk Analytics and
 Internal Audit

 Corporate Credit Risk Group carries out analysis of various industries

and does a credit rating of each borrower/ transaction in the portfolio.
The group has evolved risk analysis and rating methodologies suitable for
various industries/ products, including structured finance products. These
methodologies have been developed through a combination of rigorous
internal analysis and extensive interaction with domestic and
international rating agencies. Each analyst in the group tracks a few

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 Risk Management in Banks

industries and the prospects of the companies within that industry. Every
proposal has to be rated by the Credit Risk Group prior to sanction. The
Bank's portfolio is fully rated internally and risk based pricing
methodology for credit products has been implemented, which is a
significant achievement in the emerging markets context.

 The retail portfolio of the Bank comprises a wide range of products

including auto loans, housing loans, construction equipment, commercial
vehicles, two wheelers, credit cards etc. Retail Risk Group is responsible
for approving all product policies and monitoring the performance of the
retail portfolio. Approval of this group is mandatory before any product
policy is referred to the management. Analysis of the portfolio is done on
a regular basis across products, geographic locations etc.

 Market risk group analyses the interest rate risk, liquidity risk, foreign
exchange risk and commodity risk. Contemporary tools such as gap
analysis, duration, convexity and Value at Risk (VAR) are used to
manage market risks. This group also works on limit setting and
monitoring adherence to the limits.

 Credit Policies & Compliance Group is responsible for design and

review of all credit policies, ensuring regulatory compliance in all
activities of the Bank and coordinating the inspections of Reserve Bank
of India.
 Risk Analytics Group provides the quantitative analysis and modeling
support for risk management. This group is working on areas such as
analysis of default rates, loss rates; risk based pricing, economic capital

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 Risk Management in Banks

allocation and portfolio modeling. The group consists of analysts with a

strong academic background and work experience in quantitative
analysis.
 Internal Audit is responsible for managing Operational risk, which is an
area of significant importance in a large, growing organization with
multiple products such as ICICI Bank. With the growth of retail business
and introduction of technology based products, the challenges on this
group have increased. The Internal Audit Group has developed a
sophisticated methodology for conducting risk based audit, is equipped to
handle IS Audit and has obtained ISO 9001 certification.
ICICI bank is at the forefront of evolving and implementing risk
management concepts in the Indian context. There is a constant endeavor
towards further improvement and benchmarking with international best
practices. The bank focuses on providing training, learning opportunities
to facilitate the move towards implementation of global best practices in
risk management. The analysts from RCAG undergo training provided by
renowned experts within India as well as overseas. RCAG regularly
deputes analysts to specialized seminars and facilitates networking with
international risk management experts in rating agencies, banks etc.
The desired key attributes for analysts in RCAG are - strong conceptual
knowledge, ability to identify and analyze key issues, spot trends and
interlink ages between issues, take a logical, independent position under
pressure and communication skills.

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 Risk Management in Banks

Chapter 16
 Conclusion:
Risk is an opportunity as well as a threat and has different
meanings for different users. The banking industry is exposed to different
risks such as forex volatility risk, variable interest rate risk, market play risk,
operational risks, credit risk etc. which can adversely affect its profitability
and financial health.

Risk management has thus emerged as a new and challenging area

in banking. Basel II intended to improve safety and soundness of the
financial system by placing increased emphasis on bank's own internal
control and risk management process and models. The supervisory review
and market discipline. Indeed, to enable the calculation of capital
requirements under the new accord requires a bank to implement a
comprehensive risk management framework. Over a period of time, the risk
management improvements that are the intended result may be rewarded by
lower capital requirements.

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 Risk Management in Banks

However, these changes will also have wide-ranging effects on a

bank's information technology systems, process, people and business,
beyond and regulatory compliance, risk management and finance function.

Chapter 17

Recommendations:

 Banks should have a strong risk management solution because they are
the backbone of the economy.
 Banks should have a comprehensive risk scoring rating system that
serves as a single point indicator of diversed risk factor of a
borrower/counter party and for taking credit decisions in a consistent
manner.
 Deregulation increased competition between players unprepared by
their past experience thereby resulting in increasing risks of the system.
Therefore, they have to be regulated strongly.
 The risk rating system should be drawn up in a structured manner,
incorporating, financial analysis, projection and sensitivity, industrial
and management risks.

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 Risk Management in Banks

 Indian banks need to strengthen their risk management systems to better

deal with liquidity risks and those arising out of off-balance sheet and
derivatives deals.
 In the coming years, banks need to strengthen their risk management
framework in view of the domestic and international developments,
particularly in emerging areas of risks.

 Bibliography:

 Book
 Risk management by Indian institute of banking and finance-

Ajay Kumar, D.P. Chatterjee,

 Risk management -1 by Association of certified Treasury.

 Risk Management in Banks.
 Indian Financial Systems.

 Websites:

 www.rbi.org
 www.idbibank.com
 www.icicibank.com
 www.marketingteacher.com
 www.financial_edu.com

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 Risk Management in Banks

 Search Engines:
 Google
 Yahoo

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