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Risk Management in Banks
Chapter 1
Introduction of Risk :
Risk managementis 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. xamples of risk management practices include
purchasing insurance, installing security systems, maintaining cash
reservesand diversification. Traditional risk management works to reduce
vulnerabilities that are associated with accidents, deaths and lawsuits, among
others. !inancial risk management focuses on minimizing risks through the
use of financial tools and instruments including various trading techni"ues
and financial analysis. #any large corporations employ teams of risk
management personnel.
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Chapter 2
Introduction of risk management in bank:
Risk managementin Indian banksis 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. %n 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. &ence, 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 %ndia is
undergoing a monumental change factoring into account world events such
as the ongoing (anking )risis across the globe. %t has highlighted the needfor banks to incorporate the concept of Risk #anagement into their regular
procedures. The various aspects of increasing global competition to %ndian
(anksby !oreign banks, increasing *eregulation, introduction of innovative
products, and financial instruments as well as innovation in delivery
channels have highlighted the need for %ndian (anksto be prepared in terms
of risk management.
%ndian (ankshave been making great advancements in terms of progress in
terms of technology, "uality, "uantity as well as stability such that they have
started to expand and diversify at a rapid rate. &owever, such expansion
+
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brings these banks into the context of risk especially at the onset of
increasing lobalization and -iberalization. %n banks and other financial
institution risk plays a maor part in the earnings of a bank. &igher the risk,
higher is the return/ hence, it is most essential to maintain parity between
risk and return. &ence, management of !inancial riskincorporating a set
systematic and professional methods especially those defined by the (asel %%
norms because an essential re"uirement of banks. The more risk averse a
bank is, the safer is their )apital base.
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Chapter 3
Risk Management Framework for Indian Banks:
(anks 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
%ndian banks are concerned and has been proved that it1s a mirror of efficient
corporate governance of a financial institution. lobalization and significant
competition between foreign and domestic banks, survival and optimizing
returns are very crucial for banks and financial institutions. &owever,
selecting the efficient customer and providing innovative and value addedfinancial products and services are another paramount factors. %n a volatile
and dynamic market place for achieving sustainable business growth and
shareholder1s value, it is essential to develop a link between risks and
rewards of all products and services of the bank. &ence, the banks should
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have efficient risk management framework to mitigate all internal and
external risks.
The presence of accurate measures of bankwide risk management practice
increase shareholder1s returns and allows the risktaking behavior of bank to
be more closely aligned with strategic obectives. (ankwide risk
management practice should aim to enhance the drivers of shareholder1s
value such as3
rowth
Risk adusted performance measurement
)onsistency of earnings and
4uality and transparency of management
The important steps of the efficient framework of banking concern
should ensure all risks are identified, prioritized, "uantified, controlled and
managed in order to achieve an optimal riskreward profile. This entails
ideal and dedicated coordination of risk management across the bank1s
various business units. &owever, the approach to monitoring and enforcing
the adherence of business units within the bank may vary. The factors that
influence this decision are3
The feasibility decisions of the business unit.
The regulatory re"uirements in respect of the business unit.
The cost of effective monitoring and controlling steps.
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(enefits of (ankwide risk management
Risk management is a line function that needs to be addressed by
each individual cost center and business unit. &owever, a centralized bank
wide risk management framework has certain advantages for the (ank. The
advantages are3
%mproving capital efficiency by
$. 6roviding an obective basis for allocating resources
+. Reducing expenditures on immaterial risks and
0. xploring natural hedges and portfolio effects
7upporting informed decision making by
$. 8ncovering areas of high potential adverse impact on drivers of share
value, and
+. %dentifying and exploiting areas of riskbased advantage context.
(uilding investor confidence by
$. stablishing a process to stabilize results by protecting them from
disturbances, and
+. *emonstrating proactive risk stewardship
*efine cost and profitability centers
$. 6rofitability and cost allocation on customer, product, services and
branch wide.
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Risk Management Framework
The important factors for how risks are managed in the bank and the
institution1s risk management philosophy and practice are as follows3
$. :rganizational structure of the bank and the control arrangements that are
embedded in it, such as segregation of duties and ;four eyes1 principle
+. Role of the board and board committees
0. Role of #anagement and management committees
2. #andate of the board and management committees
5. *iscussion of policies, procedures and limits/ risk monitoring/ and
internal controls for each risk
9. Role of the Risk #anagement function
. 6in pointed risk owner of each risk and reporting lines.
$?.Risk monitoring reports, their fre"uency and distribution.
Chapter 4
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!pes of Financia" risks
$@ )redit risk
+@ %nterest rate risk
0@ #arket risk
2@ )apital risk
5@ -i"uidity risk
Credit risk:
)redit risk is the risk of counter party failure in performing repayment
obligation on due date is known as credit risk. )redit risk management is a
primary challenge for all the banks. The mismanagement of credit risk may
lead to failure of the banks itself.
)redit 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.
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)redit risk depends on external and internal factors 7udden 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. )urative
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. )redit risk
is caused by market risk variable and thus the management of such risk
becomes a part of A-#.
Market risks:
#arket risk is the risk of adverse movement in the share price of the
bank. #anagement should have control over the market risk. #arket risk is
relatively more now because of transparency in the market, fre"uency of
transactions and superior technology.
Capita" risk:
(anks re"uire capital to protect themselves from various risks that
they undertake i.e. credit risk, li"uidity risk, interest rate risk, adverse
movement of share prices, etc. Therefore it becomes important for the
banks to understand the relevance of capital ade"uacy and manage capital
risk. (anks can manage capital risk by bringing in more capital either
through promoters or %6:.
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#i$uidit! risk3
(anks need to maintain li"uidity to meet deposit withdrawals and tofund loan demand. There could be a mismatch in the maturity of assets and
liabilities leading to li"uidity risk. The variability of loan demand and
variability of deposit determine banks li"uidity needs.
-i"uidity risk is potential inability of the banks to cope up with
declining deposits. -i"uidity risk arises when the banks do not have
ade"uate cash when it is re"uired. To manage li"uidity risk banks need tostudy customer withdrawal pattern and make provisions for the same.
For %&"e3 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.
(anks need to maintain li"uid assets which can be converted into cash
"uickly to meet customer re"uirements and thereby manage li"uidity risk.
Interest rate risk3
Till $>
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%n $>
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Risk Management (rocess:
The process of financial risk management is an ongoing
one. 7trategies need to be implemented and ref ined as the market and
re"ui rements change.
Refinements may reflect changing expectations about market rates,
changes to the business environment, or changing international political
conditions, for example. %n general, the process can be summarized as
follows3
C %dentify and prioritize key financial risks.
C *etermine an appropriate level of risk tolerance.
C %mplement risk management strategy in accordance with policy.
C #easure, report, monitor, and refine as needed.
Risk management needs to be looked at as anorganizational approach, as management of risks independently cannot have
the desired effect over the long term. This is especially necessary asrisks
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 are3
1) *etermining +b,ecti-es:.
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*etermination of obectives is the first step in the risk
management function. The obective may be to protect profits, or to develop
competitive advantages. The obectives of risk management need to be
decided upon by the management.
2) Identif!ing Risks :.
very organization faces different risks, based on
its business, the economic, social and political factors, the features of the
industry it operates in D 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 %-a"uation:.
:nce 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. :n the basis of these factors, the various risks
faced by the corporate need to be classified as critical risks, important
risks and notsoimportant risks. )ritical risks are those that may result in
bankruptcy of the firm. %mportant risks are those that may not result in
bankruptcy, but may cause severe financial distress.
4) *e-e"opment of po"ic!:.
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(ased 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.
') *e-e"opment of /trateg!:.
(ased 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. %t also
specifies the tools, techni"ues 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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Importance of Risk management :
Risk management is a paramount consideration for the banking
industry, with higher proportions of banking executives percent@ see their risk organization as a critical driver for
enabling long term profitable growth/ another 2+ percent believe their risk
management capabilities are EimportantF to growth.
Almost identical numbers 2= percent@ see risk management as critical
to sustained future profitability, with another 25 percent believing it to be
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Eimportant.F These are high percentages. 6ut another way, >$ percent and >0
percent of executives, respectively, believe that the risk management
function is important or critical to growth and profitability.
The Risk *irector for an Asia 6acific bank states this importance
explicitly3
E:ur 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. 6ut simply,
we recognize risk as a part of the strategic agenda.F
The mindset of risk management as a differentiator is also correlated with
risk mastery. Almost twothirds of #asters across the global survey 92
percent@ indicate that their risk management capabilities provide competitive
advantage to Ea great extent,F compared with only 2+ percent of the peer set.
These companies are also more likely to identify risk as a higher priority.
Chapter
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M%M% +F RI/5/:
An independent Risk #anagement department is functioning
for ffective risk management enterprise wide. Risk is managed through
following three Apex committees viz.(i) )redit Risk #anagement )ommittee )R#)@(ii) Asset and -iability #anagement )ommittee A-#)@ and(iii) :perational Risk #anagement )ommittee :R#)@
These committees work within the overall guidelines and policies
approved by the Risk #anagement )ommittee of the (oard. The (ank has
put in place various policies to manage the risk. To analyses the
risk enterprise wide and with the obective of integrating all the risks of the
(ank %ntegrated Risk #anagement 6olicy has also been put in place. The
important risk policies comprise of )redit Risk 6olicy, Asset and -iability
#anagement 6olicy, :perational Risk, #anagement 6olicy,
(usiness )ontinuity 6lanning, Ghistle (lower 6olicy and 6olicy
on )orporate overnance.
#anagement of risks begins with identification and its "uantification. %t
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. %n addition pricing of the transaction should
be in accordance with the risk content of the transaction. &ence management
of risks may be subdivided into following five processes3
$=
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H Risk %dentification
H Risk measurement
H Risk pricing
H Risk monitoring and control
H Risk mitigation
!urther, 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.
-ike 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 e"ually 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.
RI/5 I*%IFICI+:
Bearly all transaction undertaken would have one or more of the maor risks
i.e.
-i"uidity risk
%nterest rate risk
#arket risk
)redit risk I
:perational risk.
Although all these risks are contracted at the transaction level, certainrisks such as li"uidity 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 re"uirement. As we would see later risk content of a
transaction is also instrumental in pricing the exposure as risk adusted
return is the key driving force in the management of banks.
RI/5 M%/6R%M%:
Risk management relies on "uantities 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. 4uantitative measures of risks can be
classified into three categories3
H (ased on sensitivity
H (ased on volatility
H (ased on down side potential
/ensiti-it!:
7ensitivity captures deviation of a target variable due to unit movement
of a single market parameter. :nly those market parameters, which drive the
value of the target variable, are relevant for the purpose. !or example,
change in market value due to$J change in interest rate would be asensitivitybased measure. :ther 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. *uration is the sensitivity of
+$
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investment portfolio or trading book. 8sually, market risk models use
sensitivities fairly widely. This measure suffers from couple of drawbacks.
!irst, it is only with reference to one market parameter and does not
consider impact of other parameters, which may also change simultaneously.
7econdly, sensitivities depend on prevailing conditions and change as
market environment changes.
7+#I#I8:
%t 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. %t is the common statistical measure of
dispersion around the average of any random variable such as earnings,
marktomarket values, market value, losses due to default, etc. volatility is
the standard deviation of the values of these variables. 7tandard deviation isthe s"uare root of the variance of the random variable.
%t 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 "uoted in the market
using (lack and 7choles option pricing formula. %mplicit volatility has an
advantage as it is forward looking since option price being "uoted is also
forward looking. The calculation of historical mean and volatility re"uires
time series. *efining a time series re"uires defining the period of
observation and the fre"uency of observation.
++
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RI/5 (RICI:
Risk in banking transactions impact banks in two ways. !irstly,
banks have to maintain necessary capital, at least as per regulatory
re"uirements. The capital re"uired is not without costs. The cost of capital
arises from the need to pay investors in banks e"uity and internal generation
of capital necessary for business growth. ach 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. 6ricing, therefore, should take into account the following3
C )ost of *eployable funds
C :perating xpenses
C -oss probabilities
C )apital charge
%t 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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RI/5 MIII+:
7ince risk arises from uncertainties1 associated with the risk elements,
risk reduction is achieved by adopting strategies that eliminate or reduce the
uncertainties1 associated with the risk elements. This is called 1R%7K
#%T%AT%:B1.
%n banking we come across a variety of financial instruments and
number of techni"ues that can be used to mitigate risks. The techni"ues to
mitigate the different types of risk are different. !or mitigating credit risk
banks have been using traditional techni"ues such as collateralizations by
first priority claims with cash or securities or landed properties, third party
guarantees etc. (anks may buy credit derivatives to offset various forms of
credit risk. !or mitigating interest rate risk bank use interest rates swaps,
forward rate agreements or financial future. 7imilarly, for mitigating forex
risks banks use forex forward contract, forex options or futures and for
mitigating e"uity price risk, e"uity options.
Risk mitigation measures aim to reduce downside variability in netcash flow but it also reduces upside potential simultaneously. %n fact, risk
mitigation measures reduce the variability in net cash flow. %n addition, risk
mitigation would involve counter party and it will always be associated with
counter party risk. %t may also may be stated here that markets have
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responded to the counter party risk bye establishing ;xchanges1 such as
stock exchange, commodity exchange, future and option exchanges.
Chapter 9
MR5% RI/5 I B5/
IR+*6CI+
#uch of the debate in recent year s concerning the management of
market risk within banks has focused on the appropriateness of socalled
LalueatRisk LaR@ 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. %n this way they provide a
summary measure of the risk exposure generated by a given portfolio. *raft
guidelines$ released by the Reserve (ank in August $>>9 give banks the
option subect to supervisory approval@ of using LaR models to measure
market risk on traded instruments in determining appropriate regulatory
capital charges.
LaR 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
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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.
- Bew products or nonstandard products may operate under a Eproduct
transaction memorandumF on a temporary basis while a full market risk
product programme is being prepared.
6roduct approved at corporate level shall provide for screening procedures.
Appropriate safe guards, product wise limit on exposure, and necessary
guidelines in risk taking. %n fact, the guidelines help in standardizing risk
content in the business undertaken at the transaction level.
1)2 RI/5 M%/6R%M%:
#arket risk management framework is heavily dependent upon
"uantitative 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 obective measure of market risk ina transaction or of a portfolio. #arket risk measures are based on
7ensitivity
*ownside potential
- /ensiti-it!:
7upplydemand position, interest rate, market li"uidity, 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 -a"ue B(7;
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This is the change in value due to $ basis ?.?$J@ change in market
yield. This is used as a measure of risk. The higher the (6L is "uite simple.
- *uration :
This is e"uivalent to time, on average, that the holder of the bond must
wait to receive the cash flows. %n other words this represents cash flow
Ecentre of gravityF. %t implies that if a five year 9J bond face value of Rs
$?? with semiannual interest has #c)auley1s duration say 0.< years, then
total cash flow to be received Rs $0? at the end of 0.< years as a bullet
payment.
- *ownside potentia" :
Risk materializes only when earnings deviate adversely. *ownside
potential only captures possible losses ignoring profit potential. *ownside
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 RI/5 M+I+RI * C+R+#:
Risk monitoring I control calls for implementation of risk and
business policies simultaneously. %t consist of setting market risk limits or
controlling market risk, based on economic measures of risk while ensuring
best risk adusted return. )ontrolling market risk means keeping thevariation 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 following3
$. 6olicy guideline limiting roles I authority.
+=
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+. limits structure and approval process.
0. *efined policy for mark to market.
2. -imit monitoring and reporting.
5. 6erformance 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 RI/5 MIII+ :
#arket 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.
&owever, 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.
- %n addition, risk mitigation strategies, which involve counter party will
always be associated with counterparty risk. :f course, where counterparty
is an established ;exchange1, counterparty risk gets reduced very
substantially. %n :T) deals, counterparty risk would depend upon the risk
level associated with party to the contract.
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Chapter
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1 M%M% +F +(%RI+# RI/5
1)1 RI/5 M+I+RI ? C+R+# (RIC%/
Risk monitoring and control practices encompass the following3
)ollection of operational risk data incident reporting framework@
Regular monitoring and feedback mechanism in place for monitoring
any deterioration in operational risk profile.
)ollation of incident reporting data to assess fre"uency and
probability of occurrence of operational risk events.
#onitoring and controlling of management of large exposures. The
modalities to be prescribed in the loan policy documents.
2?
:perationalRisk
(usiness6rocesses
6eople
)onstant)hange
)ontrol7ystems
%T7 7ystems
(usiness7trategy
(usinessnvironment
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1)2 +(%RI+# RI/5 MIII+
The mitigation of operational risk basically lies in the "ualitative approach
in operational risk framework adopted and its implementation.
%nsurance cover, where available, may provide mitigation of risk. )apital
allowance under insurance is available only where A#A has adopted
estimating capital for operational risk and is subect to certain conditions.
E8nder the A#A, a bank will be allowed to recognize the risk mitigation
impact of insurance in the measures of operational risk used for regulatory
minimum capital re"uirements. The recognition of insurance mitigation will
be limited to +?J of the total operational risk capital charge calculated
under the A#A. A bank1s ability to take advantage of such risk mitigation
will depend on compliance with the few criteriaF.
Chapter 12
F+R%I %@CA% RI/5
Foreign %&changeRisk 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 positioneither 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. ven in cases wherespot 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 premiaNdiscounts of
the currencies concerned.
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%n the forex business, banks also face the risk of default of the
counterparties or settlement risk. Ghile such type of risk crystallisation
does not cause principal loss, banks may have to undertake fresh
transactions in the cashNspot market for replacing the failed transactions.
Thus, banks may incur replacement cost, which depends upon the currency
rate movements. (anks also face another risk called timezone risk or
&erstatt risk which arises out of timelags in settlement of one currency in
one centre and the settlement of another currency in another timezone. The
forex transactions with counterparties from another country also trigger
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 are3
Bature and magnitude of exchange risk
The strategy to be adopted for hedging or managing exchange risk.
The tools of managing exchange risk.
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ature 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 conse"uences. #any 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. &owever not recognising a
risk would not make it go away. Bor is the inability to measure risk any
excuse for not managing it. &aving 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 tocalculate 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
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Risk Management in Banks
between the currency in which cash flows are denominatedand the currency
that determinesthe size of the cash flows.
For e&"e.A borrower selling ewellery in urope may keep its records
in Rupees, invoice in uros, and collect uro cash flow, only to find that its
revenue stream behaves as if it were in 8.7. dollarsP This occurs because
uroprices for the exports might adust to reflect world market prices which
could be determined in 8.7. dollars.
!or 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 financialassetsNliabilities are denominated in a currency. A bank1s future cash streams
are more predictable than those of a nonfinancial firm. %ts net exposure, or
position, completely encapsulates the measure of its exposure to forex risk.
%n 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. %f there is free and unrestricted mobility of
capital, the interest differential between two currencies will e"ual the
forward premiumNdiscount for either of the currency. This relationship must
hold under the assumptions/ otherwise arbitrage opportunities will arise to
restore the relationship. &owever, 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 *ollar premium against the Rupee,it also is a factor of forward demand N supply factors. This brings in typical
complications to forward hedging which must be taken into account.
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!rom 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
6urchasing 6ower 6arity relationship which says exchange rate changes are
determined by inflation differentials. The 8ncovered %nterest 6arity 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 %&change Risk
!or a bank therefore the first maor 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
subect to regulatory capital and could also be re"uired to be in tune with the
regulatory environment that prevails. These open position limits have two
aspects, the *a!"ight "imit and the +-ernight "imit. The daylight limit
could typically be substantially higher for two reasons, a@ %t 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
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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. #arking to market should ideally
be based on obective market prices provided by an external agency. All
position limits should be made explicit and expressed in simple terms for
easy control.
Chapter 13
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Current state of Risk management practices in
Indian banks:.
#ost of the banks do not have dedicated risk management
team, policy, procedures and framework in place. Those banks have risk
management department, the risk manager1s role is restricted to prefect and
post fact analysis of customer1s credit and there is no segregation of credit,
market, operational and strategic risks. There are few banks have articulated
framework and risk "uantification. &owever, the outputs are far formatting
the stressed or actual losses due to usage of uncompatible implications.
The traditional lending practices, assessment of credits, handling of
market risks, treasury functionality and culture of riskrewards 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 mappingthe risks. #ost of the financial institutions processes are encircled to
;functional silos1 follows bureaucratic structure and yet to come up with a
transparent and appropriate corporate governance structure to achieve the
stated strategic good artivle
Chapter 14
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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 obectives, it will need to determine a number
of policy variables such as a target riskadusted rate of returns RAR:)@,
target regulatory return, target tier $ ratio, target li"uidity, and so on.
%n turn, this will mean transforming the risk management function. Risk
management will need to encompass limit management, risk analysis,
RAR:), and active portfolio management of risk A6#R@. These changes
in the risk management will be induced by3
$. Advances in technology
+. %ntroduction of more sophisticated regulatory measures0. Rapidly accelerating market forces
2. )omplex legal environment
Chapter 1'
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C/% /6*8:
ICICI Bank-
Risk management is a key focus area at ICICI Bank
Risk management is a key focus area at %)%)% (ank and viewed as a
strategic tool for competitive advantage. %n the %ndian context %)%)% (ank
has been doing pioneering work in this area since $>>9, when a specialized
risk management group was set up within the (ank.
R)A is a centralized group based at #umbai with theresponsibility of enterprise wide risk management. R)A is headed by a
senior executive of the rank of eneral #anager who reports to the
xecutive *irector )orporate )entre@. The philosophy at %)%)% (ank 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 (oard of *irectors
and sub committees of the (oard Risk )ommittee, )redit )ommittee and
Audit )ommittee.
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RC is comprised of si& groups
Corporate Credit Risk
Retai" Risk
Market Risk
Credit (o"icies ?
Comp"iance
Risk na"!tics and
Interna" udit
Corporate Credit Riskroup carries out analysis of various industries
and does a credit rating of each borrowerN transaction in the portfolio.
The group has evolved risk analysis and rating methodologies suitable for
various industriesN 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. ach analyst in the group tracks a few
industries and the prospects of the companies within that industry. very
proposal has to be rated by the )redit Risk roup prior to sanction. The
(ank's portfolio is fully rated internally and risk based pricing
methodology for credit products has been implemented, which is asignificant achievement in the emerging markets context.
The retai" portfo"ioof the (ank comprises a wide range of products
including auto loans, housing loans, construction e"uipment, commercial
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vehicles, two wheelers, credit cards etc. Retail Risk roup 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 riskgroup analyses the interest rate risk, li"uidity risk, foreign
exchange risk and commodity risk. )ontemporary tools such as gap
analysis, duration, convexity and Lalue at Risk LAR@ are used to
manage market risks. This group also works on limit setting andmonitoring adherence to the limits.
Credit (o"icies ? Comp"ianceroup is responsible for design and
review of all credit policies, ensuring regulatory compliance in all
activities of the (ank and coordinating the inspections of Reserve (ank
of %ndia.
Risk na"!ticsroup provides the "uantitative 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
allocation and portfolio modeling. The group consists of analysts with a
strong academic background and work experience in "uantitative
analysis.
Interna" uditis responsible for managing :perational risk, which is an
area of significant importance in a large, growing organization with
multiple products such as %)%)% (ank. Gith the growth of retail business
and introduction of technology based products, the challenges on this
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group have increased. The %nternal Audit roup has developed a
sophisticated methodology for conducting risk based audit, is e"uipped to
handle %7 Audit and has obtained %7: >??$ certification.
%)%)% bank is at the forefront of evolving and implementing risk
management concepts in the %ndian 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 R)A undergo training provided by
renowned experts within %ndia as well as overseas. R)A 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 R)A 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 10
Conc"usion: 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. (asel %% 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. %ndeed, to enable the calculation of capital
re"uirements under the new accord re"uires a bank to implement a
comprehensive risk management framework. :ver a period of time, the risk
management improvements that are the intended result may be rewarded by
lower capital re"uirements.
&owever, these changes will also have wideranging effects on a
bank's information technology systems, process, people and business,
beyond and regulatory compliance, risk management and finance function.
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Chapter 1
Recommendations:
(anks should have a strong risk management solution because they are
the backbone of the economy.
(anks should have a comprehensive risk scoring rating system that
serves as a single point indicator of diversed risk factor of a
borrowerNcounter party and for taking credit decisions in a consistentmanner.
*eregulation 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, proection and sensitivity, industrial
and management risks.
%ndian banks need to strengthen their risk management systems to better
deal with li"uidity risks and those arising out of offbalance sheet and
derivatives deals.
%n 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.
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Risk Management in Banks
Bib"iograph!:
Book
Risk management by %ndian institute of banking and finance
Aay Kumar, *.6. )hatteree,
Risk management $ by Association of certified Treasury.
Risk #anagement in (anks.
%ndian !inancial 7ystems.
=ebsites:
www.rbi.org
www.idbibank.com
www.icicibank.com
www.marketingteacher.com
www.financialQedu.com
/earch %ngines:
59
http://www.rbi.org/http://www.idbibank.com/http://www.marketingteacher.com/http://www.rbi.org/http://www.idbibank.com/http://www.marketingteacher.com/ -
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