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RiskManagementIn Banks

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Banks in the process of financial intermediation areconfronted with various kinds of financial and non-

financial risks viz., credit, interest rate, foreign exchangerate, liquidity, equity price, commodity price, legal,regulatory, reputational, operational, etc.

These risks are highly interdependent and events that

affect one area of risk can have ramifications for arange of other risk categories.

Internationally, a committee approach to riskmanagement is being adopted. While the Asset -

Liability Management Committee (ALCO) deal withdifferent types of market risk, the Credit PolicyCommittee (CPC) oversees the credit /counterparty riskand country risk.

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Hierarchy of Financial Risks

PortfolioConcentrationRisk

Transaction Risk

CounterpartyRisk

Issuer Risk

Trading Risk

Gap Risk

Equity Risk

Interest Rate Risk

Currency Risk

Commodity Risk

FinancialRisks

OperationalRisk

Market Risk

Credit Risk

Specific Risk

GeneralMarketRisk

Issue Risk

* From Chapter- 1, Risk Management by Crouhy, Galai and Mark

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Credit RiskCredit risk or default risk involves inability orunwillingness of a customer or counterparty to meetcommitments in relation to lending, trading,hedging, settlement and other financialtransactions.The Credit Risk is generally made up of transactionrisk or default risk and portfolio risk.

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The credit risk of a banks portfolio depends on both

external and internal factors.

The external factors are :the state of the economy,wide swings in commodity/equity prices, foreign exchange rates and interest rates,trade restrictions, economic sanctions, Government

policies, etc.The internal factors a r e :Deficiencies in loan policies/administration,absence of prudential credit concentration limits, inadequately defined lending limits for Loan

Officers/Credit Committees,deficiencies in appraisal of borrowers financial position,excessive dependence on collaterals and inadequaterisk pricing, absence of loan review mechanism and postsanction surveillance, etc.

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Instruments of Credit Risk

Management Credit Approving Authority:

The banks should evolve multi-tier credit approvingsystem where the loan proposals are approved byan Approval Grid or a Committee .

Prudential Limits:Maximum exposure limits to industry, sector, etc.should be set up.single/group borrower limits, which may be lowerthan the limits prescribed by Reserve Bank toprovide a filtering mechanism;

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Risk Rating: The risk rating system should be drawn up in astructured manner, incorporating, interalia , financialanalysis, projections and sensitivity, industrial andmanagement risks.The banks may use any number of financial ratiosand operational parameters and collaterals as alsoqualitative aspects of management and industrycharacteristics that have bearings on thecreditworthiness of borrowers. Banks can also weigh

the ratios on the basis of the years.Risk Pricing:

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Portfolio Management:Stipulate quantitative ceiling on aggregate

exposure in specified rating categories.

Evaluate the rating-wise distribution of borrowers invarious industry, business segments, etc.

Exposure to one industry/sector should beevaluated on the basis of overall rating distributionof borrowers in the sector/group.

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Market Risk Market risk takes the form of:

1) Liquidity Risk

2) Interest Rate Risk

3) Foreign Exchange Rate (Forex) Risk

4) Commodity Price Risk and

5) Equity Price Risk

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Management of Market RiskThe Asset-Liability Management Committee (ALCO) shouldfunction as the top operational unit for managing the balancesheet within the performance/risk parameters laid down by theBoard.

The banks should also set up an independent Middle Office totrack the magnitude of market risk on a real time basis. TheMiddle Office should comprise of experts in market risk

management, economists, statisticians and general bankers.

The Middle Office should also be separated from Treasury Deptand should not be involved in the day to day management ofTreasury.

The Middle Office should apprise the top management / ALCO /Treasury about adherence to prudential /risk parameters and alsoaggregate the total market risk exposures assumed by the bankat any point of time.

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Operational Risk

Operational risk is defined as any risk, which is notcategorized as market or credit risk, or the risk of lossarising from various types of human or technical error.

The most important type of operational risk involvesbreakdowns in internal controls and corporategovernance. Such breakdowns can lead to

financial loss through error, fraud, or failure toperform in a timely manner or cause the interest ofthe bank to be compromised.

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Management of OperationalRisk

Internal controls and the internal audit are used asthe primary means to mitigate operational risk.

Banks should have well defined policies onoperational risk management. The policy shouldaddress product review process, involvingbusiness, risk management and internal controlfunctions.One of the major tools for managing operational

risk is the well-established internal control system,which includes segregation of duties, clearmanagement reporting lines and adequateoperating procedures.