Presentation by S P Dhal, Faculty

Member, SPBT College

Risk Management in Banks

Live Interactive Learning Session [16-04-2007]

[Module B]

What is Risk?

• Risk is the probability that the realized return would be different from the anticipated/expected return on investment.

• Risk is a measure of likelihood of a bad financial outcome.

• All other things being equal risk will be avoided.• All other things are however not equal and that a

reduction in risk is accompanied by a reduction in expected return.

What is Risk?

The uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or un-favourable. The un-favaourable impact is ‘RISK’ of the business.

Anatomy of Bank Risk

Non-Financial Risk Financial Risk

Business Risk

Strategic Risk

Delivery (of Financial Services) Risk

Balance Sheet Risk

Operational Risk

Legal Risk Reputational Risk

Balance Sheet Risk

Credit Risk

Concentration Risk

Intrinsic Risk

Market Risk

Interest Rate Risk

Liquidity Risk

Currency Risk

Commodity Risk

Interest Rate Risk

Price Risk Reinvestment Risk

Yield Curve Risk

Basis Risk

Gap Risk

Risk in Traditional Sense Systematic Risks

Affects all Industry/ All securitiesNon-controllableNon-diversifiable

Unsystematic RisksAffects specific Industry/ Specific SecuritiesControllableDiversifiable

Risk in Banking Business

Banking business is broadly grouped under following major heads from Risk Management point of view:

1. The Banking Book

2. The Trading Book

3. Off-Balance-sheet Exposures

The Banking Book

All assets & liabilities in ‘banking book’ have following characteristics:

1. They are normally held until maturity

2. Accrual system of accounting is applied

Since assets & liabilities are held till maturity, their mismatch may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as ‘Liquidity Risk’.

The Banking BookDue to change in interest rates, assets and liabilities are subjected to interest rate risk on their maturities/re-pricing.

Further, the assets side of the banking book generates credit risk arising from defaults in payment of interest and or installments by the borrowers.

In addition to all these risk, banking book also suffers from ‘Operational Risk’.

The Trading Book

The trading book includes all the assets that are held with intention of trading that are marketable. They are normally held for a short duration and positions are liquidated in the market. Trading Book assets include investment held under ‘Held for Trading’ category.

They are subjected to Market Risk and are marked to market.

Off-Balance-Sheet Exposure

• Off-balance sheet exposure is contingent in nature- Guarantees, LCs, Committed or back up credit lines etc.

• A contingent exposure may become a fund-based exposure in Banking book or Trading book. It is known as Call Risk

• Therefore, Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, credit or default risk and operational risk

RISKS IN BANKING

• Risk is inherent in Banking• Banking is not avoiding risks but managing

it• Risks in banking can be of Broadly 3 types:

– Credit Risk– Market Risk– Operational Risk

ALM addresses to Market Risks

Risk Management in Banks & Basel Accord –I, 1988

In 1988, Basel Committee on Banking Supervision, published a framework for a minimal capital requirement for credit exposure. The bank books were classified into 5 buckets i.e. grouped under 5 categories according to credit risk weights of zero, ten, twenty, fifty and one hundred percent.Assets required to be classified into one of these risk buckets based on the parameter of counter party.Banks required to hold capital equal to 8% of the risk-weighted value of assets. In India, the minimum capital requirement is 9% as decided by RBI.

1996 Amendment to include Market Risk

In 1996, BCBS published an amendment to provide an explicit capital cushion for ‘Market Risk’ to which banks are exposed.

Market Risk is the risk of adverse deviations of the marked-to-market value of the assets due to market movements as a result of change in interest rates, market price or exchange rate.

Basel II Accord- Need & Goals

Linking of risks with capital in terms of Basel Accord I needed a revision for the following reasons:- Credit assessment under Basel I is not risk sensitive enough. ‘One Suit fit all’ approach was applied to all types of entities with uniform 100% risk weightage.- Risk arising out of operation were ignored though it has potential of affecting the bank’s survival.

Basel Accord II

The Basel II Accord is based on three pillars:

• Minimum Capital Requirement

• Supervisory review process &

• Market discipline

Minimum Capital

Requirement

Three Basic PillarsThree Basic Pillars

Supervisory Review Process

Supervisory Review Process

Market Discipline

Requirements

Market Discipline

Requirements

The New Basel Capital Accord

StandardizedStandardized

Internal RatingsInternal Ratings

Credit Risk ModelsCredit Risk Models

Credit MitigationCredit Mitigation

Market RiskMarket Risk

Credit RiskCredit Risk

Other RisksOther Risks

RisksRisksTrading BookTrading Book

Banking BookBanking Book

OperationalOperational

OtherOther

Minimum Capital RequirementPillar One

1. Minimum Capital Requirements- Credit Risk (Pillar One)

• Standardized approach (External Ratings)

• Internal ratings-based approach• Foundation approach

• Advanced approach

• Credit risk modeling(Sophisticated banks in the future)

Minimum Capital

Requirement

Evolutionary Structure of the Accord

Credit Risk Modeling ?

Standardized Approach

Foundation IRB Approach

Advanced IRB Approach

Increased level of sophistication

Standardized Approach

• Provides Greater Risk Differentiation than 1988• Risk Weights based on external ratings• Five categories [0%, 20%, 50%, 100%, 150%]

• The loans considered past due be risk weighted at

150 percent unless a threshold amount of specific

provision has already been set aside by the bank

against the loan• Special treatment for ‘Retail’ & ‘SME’ sectors

The New Basel Capital Accord

Option 222

Assessment

ClaimAAA to

AA-

A+ to A- BBB+ to

BBB-

BB+ to

BB- (B-)

Below BB-

(B-)

Un-rated

Sovereigns 0% 20% 50% 100% 150% 100%

20% 50% 50% 100% 150%

100%Banks

Option 111 20% 50%

3

100%

3

100%

3

150%

50%33

Corporates 20% 50%(100%)

100% 100% 150% 100%

11 Risk weighting based on risk weighting of sovereign in which the bank is incorporated.22 Risk weighting based on the assessment of the individual bank.

33 Claims on banks of a short original maturity, for example less than six months, would receive a weighting that is one category more favourable than the usual risk weight on the bank’s claims

.

Standardized Approach:New Risk Weights (January 2001)

The New Basel Capital AccordCapital for Credit Risk- Internal Rating Based Approach:

•Three elements:

– Risk Components [PD, LGD, EAD]

– Risk Weight conversion function

– Minimum requirements for the management of policy

and processes

– Emphasis on full compliance

–EL (Expected Loss) = PDxLGDxEADDefinitions;PD = Probability of default

LGD = Loss given default

EAD = Exposure at default

Note: BIS is Proposing 75% for unused commitments

EL = Expected Loss

Standardized Approach verses IRB Approach

0

1.6

8

16

PER CENT

AA

A

AA

A+ A-

BB

B

BB

+

BB

- B

CC

C

RATING

New standardized model Internal rating system & Credit VaR

12

1 2 3 4 4.5 5 5.5 6 76.5

S & P :

The New Basel Capital Accord

Market Risk:

(a) Standardised Method

(i) Maturity Method

(ii) Duration Method

(b) Internal Models Method

What is Operational Risk?

• Earlier stood for non-financial risks

• Current Basel II definition is “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”

Basel II definitionCont…

– Includes both internal and external event risk

– Legal risk is also included, but reputational risk not included

– Direct losses are included, but indirect losses (opportunity costs) are not

Examples of OR Loss Events

* Based on Basel Committee’s OR loss event classification

Types of OR* Examples

Internal Fraud• Unauthorized transaction resulting in monetary loss

• Embezzlement of funds

External Fraud• Branch robbery

• Hacking damage (systems security)

Employment Practices & Workplace Safety

• Employee discrimination issues

• Inadequate employee health or safety rules

Clients, Products & Business Practices

• Money laundering

• Lender liability from disclosure violations or aggressive sales

Damage to Physical Assets• Natural disasters, e.g. earthquakes

• Terrorist activities

Business Disruption and System Failures

• Utility outage (e.g. blackout)

Execution, Delivery & Process Management

• Data entry error

• Incomplete or missing legal documents

• Disputes with vendors/outsourcing

The New Basel Capital Accord

Capital Charge for Operational Risk-

As in credit, three alternate approaches are prescribed:

- Basic Indicator Approach

- Standardised Approach

- Advanced Measurement Approach

1). Basic Indicator Approach(Capital Charge for Operational Risk)

To begin with, RBI has advised bank to follow Basic Indicator Approach in India which is 15% of the average Gross Income over three year.

KBIA = [ ∑ (GI*) ] / n,

Where

KBIA = the capital charge under the Basic Indicator Approach.

GI = annual gross income, where positive, over the previous three years

= 15% set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator.

n = number of the previous three years for which gross income is

positive

Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM investments.

2). Standardized Approach (the betas)Capital = b*gross income, by business line

• Standardized / Alternative Standardized– Bank’s activities divided (‘mapped’) into 8 business lines– Capital charge is sum of specified % (‘beta’) of each business

line’s average annual gross income over previous 3 years*– Beta varies by business line (12%-18% range)– General criteria required to qualify for its use

• Active involvement of Board and senior management in OR management framework

• Existence of OR management function, reporting and systems• Systematic tracking of OR data (including losses) by business line• OR processes and systems subject to validation and regular

independent review by internal and external parties

Advantages/ DisadvantagesStrength:

• SimplicityLimitations:

– Blunt charge, not risk-sensitive:• One size fits all

• Risk does not increase linearly with gross income

– Fails to capture effect of bank’s management of operational risk

• No incorporation of qualitative factors

• No incentive for banks to invest in op risk infrastructure

– Capital = firm specific calculation, statistically based methodology

– Intended to overcome the lack of risk sensitivity in the simpler approaches by setting regulatory capital based on the bank’s internal risk measurement models

– These models use the bank’s own metrics to measure operational risk, internal loss data, external loss experience, scenario analysis, and risk mitigation techniques to set capital commensurate with the operational risk posed by the bank’s activities

3) Advanced Measurement Approach (AMA)(Capital Charge for Operational Risk)

ADVANTAGE

COMPARING OPERATIONALRISK WITH MARKET RISK AND CREDIT RISK

Market Risk Credit Risk Operational Risk

Quantifiable exposure

Yes Yes Difficult1

Exposure measure

Position; Risk sensitivity

Money lent; Potential exposure

Difficult – no ready position equivalent available1

Portfolio completeness

Known Known Unknown

Context dependency

Low Medium High

Data frequency High Medium Low

Risk assessment

VAR; Stress testing; Economic risk capital

Rating models; Loss models; Economic risk

capital

No industry consensus; top-down scenarios may be useful

Accuracy Good Reasonable Low

TestingAdequate data for

backtesting

Backtesting difficult to perform over short

term

Results very difficult to test over any time horizon

Usage issues

Instability of underlying price

volatility; Correlation instability in stressed

markets

Many issues: correlations, ratings through time, data

lumpy

Results could be misleading; distraction effect; false reliance;

lack of cause and effect; redundant systems

SummaryMarket risk models

well established and proven tools

Using models considered reasonable – but should be used

with care

Models appear flawed

New Basel Accord II: supervisory review process-

• Defines the role of supervisors with regard to capital adequacy

Pillar II

New Basel Accord II: Market Discipline

• Disclosure requirements that allow market participants to assess key information about a bank’s risk profile and level of capitalisation.

Pillar-III

Value at Risk

VaR is defined as the predicted worst-case loss at a specific confidence level over a certain period of time assuming normal trading conditions.

That means, we can incur loss a maximum of Rs. X (the VaR) over the next one week (time period) and, may expect with 99% confidence level (i,.e. it would be so 99 times out of 100).

Value at Risk

There are three main approaches to calculating VaR:

1. The Correlation Method, also known as Variance/Covariance Matrix Method

2. Historical Simulation Method

3. Monte Carlo Simulation

Comparison of various VaR Modules

Methodology Description Applications

Variance/ Covariance

(Parametric)

Estimates VaR with equation that specifies parameters such as Volatility, Correlation, Delta and Gama

Accurate for traditional assets and linear derivatives, but less accurate for non-linear Derivatives

Monte Carlo Simulation Estimates VaR by simulating random scenarios and revaluing positions in the portfolio

Appropriate for all types of instruments, linear and non-linear

Historical Simulation Estimates VaR by reliving history; takes actual historical rates and revalues positions for each change in the market

Advantages of VaR

• It captures an important aspect of risk in a single number

• It is easy to understand

• It asks the simple question: “How bad can things get?”

Back Testing

• Is a process where model based VaR is compared with the actual performance of the portfolio. This is carried out for evaluating a new model or to assess the accuracy of the existing model

Stress Testing

Stress Testing essentially seeks to determine possible changes in the market value of a portfolio that could arise due to non-normal movement in one or more market parameters.

Stress Testing covers many different techniques. Some of important ones are:

1. Simple Sensitivity Test

2. Scenario Analysis

3. Maximum Loss

4. Extreme Value Theory

Risk Monitoring & Control

• Risk Monitoring and Control calls for implementation of risk and business policies simultaneously. This is achieved through the following:

1. Policy guidelines limiting roles and authority2. Limits structure and approval process3. System and procedures to unbundle products and

transactions to capture all risks4. Guidelines on portfolio size and mix5. Defined policy for market to market6. Limit monitoring and reporting7. Performance Measurement and Resource

allocation

Few Practice Questions

 

(a) The daily return on the company portfolio follows a normal distribution so that a one-week VaR could be computed.

(b) The one week VaR at the 99% confidence level is $5M.

(c) With probability 95%, the company will not experience a loss greater than $95M in one week.

(d) With probability 5%, the company will loose $1M or more in one week.

Q. A Bank reports a one-week VaR of $1M at the 95% confidence level. Which of the following statements is most likely to be true?

Answer: (d)

Q. Reserve Bank of India has advised Banks to build up an Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of their investments in the categories “Held for Trading” (HFT) and “Available for Sale” (AFS). The specification is to take care of following Risk.

(a). Interest Rate Risk

(b). Operational Risk

(c). Credit Risk

(d). None of above Answer: (a)

Q. “Netting” is a method of aggregating two or more obligations to achieving a reduced net obligation. The benefits accrues from “Netting” is:

(a). Reduced Credit Risk

(b). Liquidity Risk

(c). Systemic Risk

(d) All of the above

Answer: (d)

Q. How is the risk of so-called catastrophic losses dealt with?

(a). Through RAROC models. (b). Through VaR, preferably delta-

gamma approach.(c). By proper Disaster Recovery Plan

& Business Continuity Plan in place.

(d). By mitigation, with reserves in capital.

Answer: (c)

Q. Money market funds are generally considered to have ______ interest rate risk,and______ default risk.

(a). low; low

(b). low; high

(c). high; low

(d). high; high

Answer: (a)

Q. The June 1999 Basle Committee on Banking Supervision issued proposals for reform of its 1988 Capital Accord (the Basle II Proposals). These proposals contained MAINLY:

I. Settlement risk management

II. Capital requirements III. Supervisory review IV. The handling of hedge funds V. Contingency plans VI. Market discipline

(a). I, III and VI (b). II, IV and V (c). I, IV and V (d). II, III and VI

Answer: (d)

Q. If the default probability for an “A”-rated company over a three year period is 0.30%, then the most likely probability of default for the same company over a six year period is:

(a). 0.30%

(b). Between 0.30% and 0.60%

(c). 0.60%

(d). Greater than 0.60%

Answer: (d)

Q. Which of the following procedures is essential in validating the VaR estimates.

(a) Back Testing

(b) Scenario Analysis

(c) Stress Testing

(d) Once approved by regulators no further validation is required.

Answer: (a)

Q. Loans are securitized to:

(a) Reduce credit concentrations.

(b) Reduce regulatory capital.

(c) Provide access to loan products for investors.

(d) All of the above.

Answer: (d)

Q. If the volatility per annum is 25% and the number of trading days per annum is 252, find the volatility per day.

a) 1.58%b) 15.8%c) 158%d) 0.10

Ans: (a).

Q. When the costs/yields of liabilities/assets are linked to a floating rate and there is no simultaneous movement in interest rates, it leads to:

a) Real Interest Rate Riskb) Reinvestment Riskc) Volatility Risk

d)  Basis Risk

Ans. (d)

Q. Quite a few models were developed in the last few years to measure credit risk exposure. Which of the models below is based on an actuarial approach?

a) CreditMetricsb) CreditRisk+ c) KMVd) Credit Portfolio View

Ans. (b)

Q.   What is the Internal Models Approach?

(a). A method of calculating regulatory capital using a firm’s own internal market risk model and data.

(b). Using standardized models from the regulatory to calculate capital.

(c). Making forecasts on credit ratings using inside information.

(d). Using the Regulator’s own propriety risk model to calculate capital requirements.

Ans. (a)

THANK YOU