risk analysis

1.1 INTRODUCTION TO BANKING INDUSTRY

At independence, saving and investment in India were low and only two-thirds of the

economy was monetised. By the fifties, the banking system was concentrated primarily in the

urban and metropolitan areas. After the establishment of the State Bank of India in 1955,

there were distinct efforts on its part to expand rural branches, though there was no statutory

requirement to this effect.

The bank nationalization in July 1969 with its objective to ‘control the commanding heights

of the economy and to meet progressively the needs of development of the economy in

conformity with national policy and objectives’ (Reserve Bank of India, 1983) served to

intensify the social objective of ensuring that financial intermediaries fully met the credit

demands for productive purposes. Two significant aspects of nationalisation were (i) rapid

branch expansion and (ii) channeling of credit according to plan priorities. To meet the broad

objectives, banking facilities were made available in hitherto uncovered areas, so as to enable

them to not only mop up potential savings and meet the credit gaps in agriculture and small-

scale industries, thereby helping to bring large areas of economic activities within the

organised banking system. Towards this end, the Lead Bank Scheme introduced in December

1969 represented an important step towards implementation of the two-fold objective of

mobilisation of deposits on an extensive scale throughout the country and striving for planned

expansion of banking facilities to bring about greater regional balance. As a consequence, the

perceived need of the borrower gained primacy over commercial considerations in the

banking sector.

In April 1980, six more private sector banks were nationalised, thus extending the domain of

public control over the banking system. Such control also resulted in several inefficiencies

creeping into the banking system. Repression assumed the form of high and administered

interest rate structure with a large measure of built-in crosssubsidisation (in the form of

minimum lending rates for commercial sector), high levels of preemptions of primary and

secondary reserve requirements, in the form of cash reserve ratio (CRR) and statutory

liquidity ratio (SLR).

Also the retail lending to riskier areas of business on the ‘free’ portion of bank’s resources

engendered ‘adverse selection’ of borrowers. With limited prospects of recovery, this raised

costs and affected the quality of bank assets. Quantitative restrictions (branch licensing and

restrictions on new lines of business) and inflexible management structures severely

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constrained the operational independence and functional autonomy of banks. The inflationary

expectations and the inequitable tax structures exacerbated the strains on the exchequer, since

resources for developmental purposes were not readily forthcoming. As the quality of asset

portfolio of banks rapidly deteriorated, it was evident that the profitability of the banking

system was severely compromised and importantly, rather than acting as a conduit of

intermediation, the banking system was held hostage to the process of economic growth

In addition, the widespread market segmentation and the constraints on competition

exacerbated the already fragile situation. The market for short-term funds was reserved for

banks and the market for long-term funds was the exclusive domain of Development

Financial Institutions (DFIs). Direct access of corporate borrowers to lenders

(disintermediation) was strictly controlled and non-bank financial companies (NBFCs) were

allowed to collect funds only for corporate.

All these adverse developments coupled with the balance-of-payments crisis, which followed

in the wake of the Gulf War of 1990 coupled with the erosion of public savings and the

inability of the public sector to generate resources for investment rapidly brought forth the

imperatives for Banking sector strengthening in India. Although these reforms were also

provoked by the globalization trends around the world. More importantly, the favorable

experience of liberalization in the 1980s created an intellectual climate for continuing in the

same direction. While the crisis of 1991 favored bolder reforms being ushered, the pace had

to be calibrated to what would be acceptable in a democracy.

1.1.1 Effect of Reforms:

The banking sector reforms in India, initiated since 1992 in the first phase has provided

necessary platform to the banking sector to operate on the basis of operational flexibility and

functional autonomy, thereby enhancing efficiency, productivity and profitability. The

reforms brought out structural changes in the financial sector, eased external constraints in

their working, introduced transparency in reporting procedures, restructuring and

recapitalization of banks and have increased the competitive element in the market.

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Figure No. 1.1: Classifications of Banks

Source: http://en.wikipedia.org/wiki/Banking_in_India

India has made significant progress in payment systems by introducing modern payment

media viz., smart/credit cards, electronic funds transfer, debit/credit clearing, e banking, etc.

RBI would soon put in place Real Time Gross settlement System (RTGS) to facilitate

efficient funds management and mitigating settlement risks.

Indian banking has made significant progress in recent years. The prudential norms,

accounting and disclosure standards and risk management practices, etc. are keeping pace

with global standards. The financial soundness and enduring supervisory practices as evident

in our level of compliance with the Basle Committee's Core Principles for Effective Banking

Supervision have made our banking system resilient to global shocks. The need for further

refinements in our regulatory and supervisory practices has been recognized and steps are

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being taken by RBI to move towards the goal in a phased manner without destabilising the

system. Success of the second phase of reforms will depend primarily on the organisational

effectiveness of banks, for which the initiatives will have to come from banks themselves.

Imaginative corporate planning combined with organisational restructuring is a necessary

pre-requisite to achieve desired results. Banks need to address urgently the task of

organisational and financial restructuring for achieving greater efficiency.

1.1.2 Future of Indian Banking

The future of Indian Banking represents a unique mixture of unlimited opportunities amidst

insurmountable challenges. On the one hand we see the scenario represented by the rapid

process of globalisation presently taking shape bringing the community of nations in the

world together, transcending geographical boundaries, in the sphere of trade and commerce,

and even employment opportunities of individuals. All these indicate newly emerging

opportunities for Indian Banking. But on the darker side we see the accumulated morass,

brought out by three decades of controlled and regimented management of the banks in the

past. It has siphoned profitability of the Government owned banks, accumulated bloated NPA

and threatens Capital Adequacy of the Banks and their continued stability. Nationalised

banks are heavily over-staffed. The recruitment, training, placement and promotion policies

of the banks leave much to be desired. In the nutshell the problem is how to shed the legacies

of the past and adapt to the demands of the new age.

On the brighter side are the opportunities on account of -

The advent of economic reforms, the deregulation and opening of the Indian economy to the

global market, brings opportunities over a vast and unlimited market to business and industry

in our country, which directly brings added opportunities to the banks.

a) The advent of Reforms in the Financial & Banking Sectors (the first phase in the year

1992 to 1995) and the second phase in 1998 heralds a new welcome development to reshape

and reorganize banking institutions to look forward to the future with competence and

confidence. The complete freeing of Nationalised Banks (the major segment) from

administered policies and Government regulation in matters of day-to-day functioning

heralds a new era of self-governance and a scope for exercise of self-initiative for these

banks. There will be no more directed lending, pre-ordered interest rates, or investment

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guidelines as per dictates of the Government or RBI. Banks are to be managed by themselves,

as independent corporate organizations, and not as extensions of government departments.

b) Acceptance of prudential norms with regards to Capital Adequacy, Income Recognition

and Provisioning are welcome measures of self regulation intended to fine-tune growth and

development of the banks. It introduces a new transparency, and the balance sheets of banks

now convey both their strength and weakness. Capital Adequacy and provisioning norms are

intended to provide stability to the Banks and protect them in times of crisis. These equally

induce a measure of corporate accountability and responsibility for good management on the

part of the banks.

c) Large scale switching to hi-tech banking by Indian Scheduled Commercial Banks (SCBs)

through the application of Information Technology and computerisation of banking

operations, will revolutionalise customer service. The age-old methods of ‘pen and ink’

systems are over. Banks now will have more employees available for business development

and customer service freed from the needs of bookkeeping and for casting or tallying

balances, as it was earlier.

d) All these welcome changes towards competitive and constructive banking could not

however, deliver quick benefits on account insurmountable carried over problems of the past

three decades. Since the 70s the SCBs of India functioned totally as captive capsule units cut

off from international banking and unable to participate in the structural transformations, the

sweeping changes, and the new type of lending products emerging in the global banking

Institutions. Our banks are over-staffed. The personnel lack training and knowledge resources

required to compete with international players. The prevalence of corruption in public

services of which PSBs are an integral part and the chaotic conditions in parts of the Indian

Industry have resulted in the accumulation of non-productive assets in an unprecedented

level. The future of Indian Banking is dependent on the success of its efforts as to how it

shakes off these accumulated past legacies and carried forward ailments and how it

regenerates itself to avail the new vistas of opportunities to be able to turn Indian Banking to

International Standards.

PSBs in India can solve their problems only if they assert a spirit of self-initiative and self-

reliance through developing their in-house expertise. They have to imbibe the banking

philosophy inherent in de-regulation. They are free to choose their respective paths and set

their independent goals and corporate mission. The first need is management up gradation.

We have learnt prudential norms of asset classification and provisioning. More important

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now, we must learn prudential norms of asset creation, of credit assessment and credit

delivery, of risk forecasting and de-risking strategies. The habit of looking to RBI and

Government of India to step in and remove the barriers in the way of the Banks should be

given a go-bye. NPA and mismatch between assets and liabilities is a problem created by the

Banks and they have to find the cause and the solution - how it was created and how the

Banks are to overcome it. Powerful Institutions can be nurtured by strong and dynamic

management and not by corrupt and weak bureaucrats.

Public sector ownership need not result in inefficiency and poor customer service. These are

not due to the ills of ownership, but due to failure to accept the correct "Mission" and "Goals"

of management. On the other hand unlike several private sector units, Public sector units have

specific plus points. They do not evade taxes, and do not accumulate unassisted wealth or

unaccounted money. They do not bribe controlling persons to get their way through. They do

not indulge in predatory "take over" of weaker rival units. In fact a public unit never

competes unethically with its rival-units. It is in this context the subject of better

management-efficiency and accountability is important. I have included discussion of such

subjects like "Corporate Governance", Risk Analysis and Risk Management as part of the

discussions in this project.

1.1.3 Opportunities and Challenges

The bar for what it means to be a successful player in the sector has been raised. Four

challenges must be addressed before success can be achieved. First, the market is seeing

discontinuous growth driven by new products and services that include opportunities in credit

cards, consumer finance and wealth management on the retail side, and in fee-based income

and investment banking on the wholesale banking side. These require new skills in sales &

marketing, credit and operations. Second, banks will no longer enjoy windfall treasury gains

that the decade-long secular decline in interest rates provided. This will expose the weaker

banks. Third, with increased interest in India, competition from foreign banks will only

intensify. Fourth, given the demographic shifts resulting from changes in age profile and

household income, consumers will increasingly demand enhanced institutional capabilities

and service levels from banks.

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1.2 INTRODUCTION TO RISK ANALYSIS IN BANKS

Risks manifest themselves in many ways and the risks in banking are a result of many diverse

activities, executed from many locations and by numerous people. As a financial

intermediary, banks borrow funds and lend them as a part of their primary activity. This

intermediation activity, of banks exposes them to a host of risks. The volatility in the

operating environment of banks will aggravate the effect of the various risks. The project

discusses the various risks that arise due to financial intermediation and by highlighting the

need for asset-liability management; it discusses the various Models for risk management.

1.2.1 Risks in Banking

Today’s banking is full of risks. So do not try hard to avoid it because is to stay in business is

to stay with risk. What is required is to convert vulnerabilities and weaknesses into strengths

and threat as opportunities to build a sustainable development in banking sector

Risk is a concept that denotes the precise probability of specific eventualities. Technically,

the notion of risk is independent from the notion of value and, as such, eventualities may

have both beneficial and adverse consequences. However, in general usage the convention is

to focus only on potential negative impact to some characteristic of value that may arise from

a future event.

Based on the origin and their nature, risks are classified into various categories. The most

prominent financial risks to which the banks are exposed to are:

(a) Interest rate risk: Interest rate risk refers to the volatility in the market value of

stockholders’ equity attributable to changes in the level of interest rates and associated

changes in balance sheet and off-balance sheet mix and volume. A bank that assumes

substantial risk will see its value of equity rise or fall sharply when interest rates change

unexpectedly. It is the risk that arises when the interest income/ market value of the bank is

sensitive to the interest rate fluctuations.

(b) Foreign Exchange/Currency Risk: Risk that arises due to unanticipated changes in

exchange rates and becomes relevant due to the presence of multi-currency assets and/or

liabilities in the bank's balance sheet. This risk is of two types: -

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http://en.wikipedia.org/wiki/Event_(probability_theory)

http://en.wikipedia.org/wiki/Value_(economics)

http://en.wikipedia.org/wiki/Concept

Transaction Risk: - The transaction risk is observed when movements in price of a

currency (transaction) move upward or downward, result in a loss on a particular

transaction. Transaction risk also destabilizes the anticipated cash flow.

(c)Translation risk: - in a situation of translation risk, the balance sheet of a bank, when

converted in home currency, undergoes a drastic change, chiefly owing to exchange rate

movements and changes in the level of investments or borrowings in foreign currency, even

without having translation at a particular point of time.

(d) Liquidity risk: Risk that arises due to the mismatch in the maturity patterns of the assets

and liabilities. This mismatch may lead to a situation where the bank is not in a position to

impart the required liquidity into its system - surplus/ deficit cash situation. In the case of

surplus situation this risk arises due to the interest cost on the idle funds. Thus idle funds

deployed at low rates contribute to negative returns.

(e) Credit Risk: Risk that arises due to the possibility of a default/delay in the repayment

obligation by the borrowers of funds.

(f) Contingency risk: Risk that arises due to the presence of off-balance sheet items such as

guarantees, letters of credit, underwriting commitments etc.

(g) Price risk: Price risk is a risk, which occurs due to changes in market price of assets,

liabilities or derivative contracts. This results in strain on the profitability of bank

(h) Operating risk: -The potential financial loss as a result of a breakdown in day-to-day

operational processes. Operating risk is a result of failure of operating system in a bank due

to certain reasons like fraudulent activities, natural disaster, human error or omission or

sabotage, etc.

(i) Solvency risk: Solvency risk occurs when the bank is landed in a chronic situation of not

able to meet its obligations. This type of risk gives the ultimate impression that the bank has

failed.

(j) Political risk: Introduction of service tax or increase in income tax, freezing the assets of

the bank by the legal authority, etc. is termed as political risks.

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(k)Human risk: Labour unrest, dispute among top executives, lack of motivation, inadequate

skills, and en-mass resignation by competent executives, problems faced by banks after

implementation of Voluntary Retirement Scheme (VRS), etc., lead to human risk.

(l) Financial risk: Non-availability of liquid funds, strain on profitability due to low interest

rate regime and adverse changes in exchange rates, etc., are reasons responsible for the

financial risk.

(m) Technology risk: Obsolescence, mismatches, breakdowns, adoption of latest technology

by competitors, etc., come under technology risk.

(n)Legal risk: Legal changes, threat from customers etc., is called as legal risk.

(o) Systematic risk: When the default of failure of one financial institution is spread as chain

reaction to threaten the stability of financial system as a whole, the situation is expressed as a

systematic risk.

1.2.2 Currency Risk

Currency risk results from changes in exchange rates and originates in mismatches between

the values of assets and liabilities denominated in different currencies. When assessing

currency risk, one must distinguish between the risk originating in political decisions, risk

resulting from traditional banking operations, and the risk from trading operations.

Origin and Components of Currency Risk

Currency risk results from changes in exchange rates between a bank's domestic currency and

other currencies. It originates from a mismatch, and may cause a bank to experience losses as

a result of adverse exchange rate movements during a period in which it has an open on- or

off-balance-sheet position, either spot or forward, in an individual foreign currency. In recent

years, a market environment with freely floating exchange rates has practically become the

global norm. This has opened the doors for speculative trading opportunities and increased

currency risk. The relaxation of exchange controls and the liberalization of cross border

capital movements have fueled a tremendous growth in international financial markets. The

volume and growth of global foreign exchange trading has far exceeded the growth of

international trade and capital flows, and has contributed to greater exchange rate volatility

and therefore currency risk.

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Currency risk arises from a mismatch between the value of assets and that of capital and

liabilities denominated in foreign currency (or vice versa), or because of a mismatch between

foreign receivables and foreign payables that are expressed in domestic currency. Such

mismatches may exist between both principal and interest due. Currency risk is of a

"speculative" nature and can therefore result in a gain or a loss, depending on the direction of

exchange rate shifts and whether a bank is net long or net short in the foreign currency. For

example, in the case of a net long position in foreign currency, domestic currency

depreciation will result in a net gain for a bank and appreciation will produce a loss. Under a

net short position, exchange rate movements will have the opposite effect.

In principle, the fluctuations in the value of domestic currency that create currency risk result

from changes in foreign and domestic interest rates that are, in turn, brought about by

differences in inflation. Fluctuations such as these are normally motivated by macroeconomic

factors and are manifested over relatively long periods of time, although currency market

sentiment can often accelerate recognition of the trend. Other macroeconomic aspects that

affect the domestic currency value are the volume and direction of a country's trade and

capital flows. Short term factors, such as expected or unexpected political events, changed

expectations on the part of market participants, or speculation-based currency trading may

also give rise to currency changes. All these factors can affect the supply and demand for a

currency and therefore the day-to-day movements of the exchange rate in currency markets.

In practical terms, currency risk comprises the following:

a) Transaction risk, or the price-based impact of exchange rate changes on foreign

receivables and foreign payables - i.e., the difference in price at which they are collected or

paid and the price at which they are recognized in local currency in the financial statements

of a bank or corporate entity.

b) Economic or business risk related to the impact of exchange rate changes on a country's

long-term or a company's competitive position. For example, a depreciation of the local

currency may cause a decline in imports and larger exports.

c) Revaluation risk or translation risk, which arises when a bank's foreign currency positions

are revalued in domestic currency or when a parent institution conducts financial reporting or

periodic consolidation of financial statements.

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There are also other risks related to international aspects of foreign currency business that are

incurred by banks conducting foreign exchange operations. One such risk is a form of credit

risk that relates to the default of the counterparty to a foreign exchange contract. In such

instances, even a bank with balanced books may find itself inadvertently left with an

uncovered exchange position. Another form of credit risk peculiar to exchange operations is

the time-zone-related settlement risk. This arises when an exchange contract involves two

settlements that take place at different times due to a time-zone difference, and the

counterparty or the payment agent defaults in the interim. The maturity mismatching of

foreign currency positions can also result in interest rate risk between the currencies

concerned, where a bank can suffer losses as a result of changes in interest rate differentials

and of concomitant changes in the forward exchange premiums, or discounts, if it has any

mismatches with forward contracts or derivatives of a similar nature.

1.2.3 Market Risk

Market risk is the risk that a bank may-experience loss due to unfavorable movements in

market prices. Exposure to such risk may arise as a result of the bank taking deliberate

speculative positions (proprietary trading) or may ensue from the bank's market-making

(dealer) activities.

Sources of market risk

Market risk results from changes in the prices of equity instruments, commodities, money,

and currencies. Its major components are therefore equity position risk, commodities risk,

interest rate risk, and currency risk. Each component of risk includes a general market risk

aspect and a specific risk aspect that originates in the specific portfolio structure of a bank. In

addition to standard instruments, market risk also applies to various derivatives instruments,

such as options, equity derivatives, or currency and interest rate derivatives.

a) Volatility: The price volatility of most assets held in stable liquidity investment and

trading portfolios is often significant. Volatility prevails even in mature markets, though it is

much higher in new or illiquid markets. The presence of large institutional investors, such as

pension funds, insurance companies, or investment funds, has also had an impact on the

structure of markets and on market risk. Institutional investors adjust their large-scale stable

liquidity investment and trading portfolios through large-scale trades, and in markets with

rising prices, large-scale purchases tend to push prices up. Conversely, markets with

downward trends become more skittish when large, institutional-size blocks are sold.

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Ultimately, this leads to a widening of the amplitude of price variances and therefore to

increased market risk.

b) Proprietary trading versus stable liquidity investment portfolio management: The

increasing exposure of banks to market risk is due to the trend of business diversification

from the traditional intermediation function toward market-making and proprietary trading

activities, whereby banks set aside "risk capital" for deliberate risk taking activities. The

proprietary trading portfolio must be distinguished from the stable liquidity investment

portfolio. Proprietary trading is aimed at exploiting market opportunities with leveraged

funding (for example, through the use of repurchase agreements), whereas the stable liquidity

investment portfolio is held and traded as a buffer/stable liquidity portfolio. As stated earlier,

both proprietary trading and stable liquidity investment portfolios are subject to market risk.

c) Value at risk: VAR is a modeling technique that typically measures a bank's aggregate

market risk exposure and, given a probability level, estimates the amount a bank would lose

if it were to hold specific assets for a certain period of time.

d) Inputs to a VAR-based model include data on the bank's positions and on prices,

volatility, and risk factors. The risks covered by the model should include all interest,

currency, equity, and commodity and option positions inherent in the bank's portfolio, for

both on- and off-balance-sheet positions. VAR-based models typically combine the potential

change in the value of each position that would result from specific movements in underlying

risk factors with the probability of such movements occurring. The changes in value are

aggregated at the level of trading book segments and/or across all trading activities and

markets. The VAR amount may be calculated using one of a number of methodologies.

The measurement parameters include a holding period, a historical time horizon at which risk

factor prices are observed, and a confidence interval that allows for the prudent judgment of

the level of protection. The observation period is chosen by the bank to capture market

conditions that are relevant to its risk management strategy.

1.2.4 Interest Rate Risk

Interest rate risk is the sensitivity of capital and income to changes in interest rates. Interest

rate risk originates in mismatches in the repricing of assets and liabilities and from changes in

the slope and shape of the yield curve. Banks generally attempt to ensure that the repricing

structure of their balance sheet generates maximum benefits from expected interest rate

movements. This repricing structure may also be influenced by liquidity issues, particularly if

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the bank does not have access to interest rate derivatives to separate its liquidity and interest

rate views. The goal of interest rate risk management is to maintain interest rate risk

exposures within authorized levels.

Sources of Interest Rate Risk

All financial institutions face interest rate risk. When interest rates fluctuate, a bank's

earnings and expenses change, as do the economic value of its assets, liabilities, and off-

balance-sheet positions. The net effect of these changes is reflected in the bank's overall

income and capital. The combination of a volatile interest rate environment, deregulation,

and a growing array of on- and off-balance-sheet products has made the management of

interest rate risk a growing challenge. At the same time, informed use of interest rate

derivatives such as financial futures and interest rate swaps can help banks manage and

reduce the interest rate exposure that is inherent in their business. Bank regulators and

supervisors therefore place great emphasis on the evaluation of bank interest rate risk

management - particularly so since the implementation of market-risk-based capital charges

as recommended by the Basel Committee.

Broadly speaking, interest rate risk management comprises the various policies, actions, and

techniques that a bank can use to reduce the risk of diminution of its net equity as a result of

adverse changes in interest rates. This various aspects of interest rate risk and review the

techniques available to analyze and manage it. These include, in particular, repricing and

sensitivity analyses.

a) Repricing risk: Variations in interest rates expose a bank's income and the underlying

value of its instruments to fluctuations. The most common type of interest rate risk arises

from timing differences in the maturity of fixed rates and the repricing of the floating rates of

bank assets, liabilities, and off-balance-sheet positions.

b) Yield curve risk: Repricing mismatches also expose a bank to risk deriving from changes

in the slope and shape of the yield curve. Yield curve risk materializes when yield curve

shifts adversely affect a bank's income or underlying economic value. For example, a bank's

position may be hedged against parallel movements in the yield curve; for instance, a long

position in bonds with 10-year maturities may be hedged by a short position in five-year

notes from the same issuer. The value of the long maturity instrument can still decline sharply

if the yield curves increases, resulting in a loss for the bank.

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c) Basis risk: It is also described as spread risk, arises when assets and liabilities are priced

off different yield curves and the spread between these curves shifts. When this yield curve

spreads change, income and market values may be negatively affected. Such situations can

occur when an asset that is repriced monthly based on an index rate (such as U.S. treasury

bills) is funded by a liability that also is repriced monthly, but based on a different index rate

(such as LIBOR or swaps). Basis risk thus derives from unexpected change in the spread

between the two index rates.

d) Assessing interest rate risk exposure: Since interest rate risk can have adverse effects on

both a bank's earnings and its economic value, two separate but complementary approaches

exist for assessing risk exposure. From the perspective of earnings, which is the traditional

approach to interest rate risk assessment, the analysis focuses on the impact of interest rate

changes on a bank's net interest income. As noninterest income has gained importance, so

have shifts in economic value (viewed as the present value of the bank's net expected cash

flows resulting from interest rate changes. In this sense, the economic value perspective also

reflects the sensitivity of a bank's net worth to fluctuations in interest rates, therefore

providing a more comprehensive view of the potential long-term effects of interest rate

changes than the view provided by the earnings perspective. However, economic value

assessments are necessarily driven by myriad assumptions, and their precision therefore

depends on the accuracy and validity of those assumptions.

1.2.5 Liquidity Risk

Liquidity risk that arises due to the mismatch in the maturity patterns of the assets and

liabilities. This mismatch may lead to a situation where the bank is not in a position to impart

the required liquidity into its system - surplus/ deficit cash situation. In the case of surplus

situation this risk arises due to the interest cost on the idle funds. Thus idle funds deployed at

low rates contribute to negative returns.

Bank liquidity management should comprise a risk management (decision making) structure,

a liquidity management and funding strategy, asset of limits to liquidity risk exposures, and a

set of procedures for liquidity planning under alternative scenarios, including crisis situations.

The Need for Liquidity

Liquidity is necessary for banks to compensate for expected and unexpected balance sheet

fluctuations and to provide funds for growth. It represents a bank's ability to efficiently

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accommodate the redemption of deposits and other liabilities and to cover funding increases

in the loan and investment portfolio. A bank has adequate liquidity potential when it can

obtain needed funds (by increasing liabilities, securitizing, or selling assets) promptly and at a

reasonable cost. The price of liquidity is a function of market conditions and the market's

perception of the inherent riskiness of the borrowing institution.

Liquidity risk lies at the heart of confidence in the banking system, as commercial banks are

highly leveraged institutions with a ratio of assets to core (Tier 1) capital in the region of

20:1. The importance of liquidity transcends the individual institution, because a liquidity

shortfall at a single institution can have system wide repercussions. It is in the nature of a

bank to transform the term of its liabilities to different maturities on the asset side of the

balance sheet. Since the yield curve is typically upward sloping the maturity of assets

generally tends to be longer than that of liabilities. The actual inflow and outflow of funds do

not necessarily reflect contractual maturities, and yet banks must be able to meet certain

commitments (such as deposits) whenever they come due. A bank may therefore experience

liquidity mismatches, making its liquidity policies and liquidity risk management key factors

in its business strategy.

Liquidity risk analysis therefore addresses market liquidity rather than statutory liquidity. The

implication of liquidity risk is that a bank may have insufficient funds on hand to meet its

obligations. (A bank's net funding includes its maturing assets, existing liabilities, and

standby facilities with other institutions. It would sell its marketable assets in the stable

liquidity investment portfolio to meet liquidity requirements only as a last resort.) Liquidity

risks are normally managed by a bank's asset-liability management committee (ALCO),

which must therefore have a thorough understanding of the interrelationship between

liquidity and other market and credit risk exposures on the balance sheet.

Understanding the context of liquidity risk analysis involves examining a bank's approach to

funding and liquidity planning under alternative scenarios. As a result of the increasing depth

of interbank (money) markets, a fundamental shift has taken place in the attitude that the

authorities have toward prudent liquidity management. Supervisory authorities now tend to

concentrate on the maturity structure of a bank's assets and liabilities rather than solely on its

statutory liquid asset requirements. They do this using maturity ladders for liabilities and

assets during specific periods (or time bands), a process that represents a move from the

calculation of contractual cash outflows to the calculation of expected liquidity flows.

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1.2.6 Credit Risk

Credit risk that arises due to the possibility of a default/delay in the repayment obligation by

the borrowers of funds. Credit risk can be limited by reducing connected-party lending and

large exposures to related parties.

Components of Credit risk

Credit or counterparty risk is defined as the chance that a debtor or financial instrument issuer

will not be able to pay interest or repay the principal according to the terms specified in a

credit agreement - is an inherent part of banking. Credit risk means that payments may be

delayed or ultimately not paid at all, which can in turn cause cash flow problems and affect a

bank's liquidity. Despite innovation in the financial services sector, credit risk is still the

major single cause of bank failures. The reason is that more than 80 percent of a bank's

balance sheet generally relates to this aspect of risk management. The three main types of

credit (counterparty) risk are as follows:

* Personal or consumer risk;

* Corporate or company risk;

* Sovereign or country risk.

Because of the potentially dire effects of credit risk, it is important to perform a

comprehensive evaluation of a bank's capacity to assess, administer, supervise, enforce, and

recover loans, advances, guarantees, and other credit instruments. An overall credit risk

management review will include an evaluation of the credit risk management policies and

practices of a bank. This evaluation should also determine the adequacy of financial

information received, from a borrower or the issuer of a financial instrument, which has been

used by a bank as the basis for investing in such financial instruments or the extension of

credit; and the periodic assessment of its inherently changing risk. The credit risk

management function is primarily focused on the loan portfolio, although the principles

relating to the determination of creditworthiness, apply equally to the assessment of

counterparties who issue financial instrument

a) Credit portfolio management

b) Credit risk management policies

1.2.7 Non Performing Assets:

17

NPA’s are those assets for which interest is overdue for more than 180 days. In simple words,

an asset (or a credit facility) becomes non-performing when it ceases to yield income. As a

result, banks do not recognize interest income on these assets unless it is actually received. If

interest amount is already credited on an accrual basis in the past years, it should be reversed

in the current year’s account if such interest is still remaining uncollected.

Once an asset falls under the NPA category, banks are required by the Reserve Bank of India

(RBI) to make provision for the uncollected interest on these assets. For the purpose they

have to classify their assets based on the strength and on collateral securities into:

a) Standard assets: This is not a non-performing asset. It does not carry more than normal

risk attached to the business.

b) Substandard assets: It is an asset, which has been classified as non-performing for a

period of less than two years. In this case the current net worth of the borrower or the current

market value of the security is not enough to ensure recovery of the debt due to the bank. The

classification of substandard assets should not be upgraded (to standard assets) merely as a

result of rescheduling of the payments. (Rescheduling indicates change in payment schedule

by the borrower or by the banker) There must be a satisfactory performance for two years

after such rescheduling.

c) Doubtful assets: It is an asset, which has remained non-performing for a period exceeding

two years.

d) Loss assets: It is an asset identified by the bank, auditors or by the RBI inspection as a

loss asset. It is an asset for which no security is available or there is considerable erosion in

the realizable value of the security. (If the realizable value of the security as assessed by

bank, approved values or RBI is less than 10% of the outstanding, it is known as considerable

erosion in the value of asset.) As a result even though there may be some salvage or recovery

value, its continuance as bankable asset is not warranted.

After classifying assets into above categories, banks are required to make provision against

these assets for the interest not collected by them. In terms of exact prudential regulations, the

provisioning norms are as under.

Table No. 1.1: Provisioning Norms

Asset Classification Provision requirements

18

Standard assets 0.25%

Substandard assets 10%

Doubtful assets 20% - 50% of the secured portion depending on the

age of NPA, and 100% of the unsecured portion.

Loss assets It may be either written off or fully provided by the bank.

The increasing levels of bad quality loans marred the prospects of nationalized banks in the

past few years. As a result banks shifted their focus from the industrial segment to the

corporate lending. This has curtailed the incremental NPAs to a certain extent.

The norms are tightened even for financial institutions (FIs). They are worst affected by the

NPA wave thanks to lending to the commodity and economy sensitive sectors, not to mention

that loans to steel, chemicals and textile sector played a key role in dragging down

performance of FIs. So far they have been enjoying the privilege of recognizing a loan as

NPA only if principal is overdue for more than 365 days and interest is outstanding for over

180 days. With a view to bring greater transparency, the RBI has proposed to reduce the time

limit to 180 days (for principal). On the one hand imposition of stricter norms could lead to a

difficult time for FIs permitting them an option of restructuring their loans could give them

some leeway.

Apart from this scheme, the government has designed major policy reforms in order to

enhance the efficiency of the banking system. It has decided to set up 7 more debt recovery

tribunals (DRTs) in addition to the existing 22 and 5 appellate tribunals. It has also proposed

to bring in legislation for facilitating foreclosure and enforcement of securities in case of

default.

4.6.1 Evolution of NPAs

In the early Nineties PSBs were suffering from acute capital inadequacy and many of them

were depicting negative profitability. This is because the parameters set for their functioning

were deficient and they did not project the paramount need for these corporate goals.

a) Incorrect goal perception and identification led them to wrong destination

19

b) Since the 70s, the SCBs of India functioned totally as captive capsule units cut off from

international banking and unable to participate in the structural transformations, the sweeping

changes, and the new type of lending products emerging in the global banking Institutions.

c) The personnel lacked desired training and knowledge resources required to compete with

international players. Such and other chaotic conditions in parts of the Indian Banking

industry had resulted in the accumulation of assets, which were termed as non-productive in

an unprecedented level

d) "Audit and Inspections" remained as functions under the control of the executive

officers, which were not independent and were thus unable to correct the effect of serious

flaws in policies and directions of the higher ups.

e) The quantum of credit extended by the PSBs increased by about 160 times in the three

decades after nationalization (from around Rs. 3000 crore in 1970 to Rs. 475113 Crore in

2004). The Banks were not developed in terms of skills and expertise to regulate such

stupendous growth in the volume and manage the diverse risks that emerged in the process.

f) The need for organizing an effective mechanism to gather and disseminate credit

information amongst the commercial banks was never felt or implemented. The archaic laws

of secrecy of customers-information that was binding Bankers in India, disabled banks to

publish names of defaulters for common knowledge of the other Banks in the system.

g) Lack of effective corporate management

h) Credit management on the part of the lenders to the borrowers to secure their genuine

and bonafide interests was not based on automatically calculated anticipated cash flows of the

borrower concern, while recovery of installments of Term Loans was not out of profits and

surplus generated but through recourse to the corpus of working capital of the borrowing

concerns. This eventually led to the failure of the project financed leaving idle assets.

i) Functional inefficiency was also caused due to over-staffing, manual processing of over

expanded operations and failure to computerize Banks in India, when elsewhere throughout

the world the system was to switch over to computerization of operations.

20

REVIEW OF LITERATURE

Review of Literature is a body of text that aims to review the critical points of current

knowledge on a particular topic. Literature reviews are secondary sources, and as such, do

not report any new or original experimental work. Its ultimate goal is to bring the reader up to

date with current literature on a topic and forms the basis for another goal, such as future

research that may be needed in the area. Reviews covering some of the areas related to Risk

Analysis were mentioned below:

Pyle (1997) report was based on, why risk management is needed. It outlines some of

theoretical underpinnings of contemporary bank risk management, with emphasis on market

risk, credit risk, operational risk, and performance risk. The study was based on two

approaches scenario analysis and value-at risk analysis. In scenario analysis, analysis

postulates the changes in underlying determinant of the portfolio value and revalues the

portfolio given those changes and value at risk analysis uses asset return distributions and

predicted return parameters to estimates potential portfolio losses. It had been found that, it

is reasonable to require that banks have to produce and justify market risk measurement

system and credit risk and to integrate them.

Santomero (1997) studied the problems relating to banking industry which are most difficult

to address, shortcomings of the current methodology used to analyze risk and the elements

that are missing in the procedures of risk management. The study focused on three aspects i.e.

risks that can be eliminated or avoided by simple business practices which involves actions

to reduce the chances of idiosyncratic losses from standard banking activity by eliminating

risks that are superfluous to the institution's business purpose., risks that can be transferred to

other participants which is done by construction of portfolios that benefit from

diversification across borrowers and that reduce the effects of any one loss experience and

risks that must be actively managed at the firm level, which is done by the implementation of

22

http://en.wikipedia.org/wiki/Secondary_source

http://en.wikipedia.org/wiki/Knowledge

incentive-compatible contracts with the institution's management to require that employees

be held accountable.

McDonald and Guy (2000) examined the various elements of the Australian banks’ internal

credit risk rating systems, including the systems’ basic architecture, operating design and

applications. It focused on the assessment of the risk from the failure of a given counterparty

to meet debt servicing and other payment obligations on a timely basis and external resources

which exposes institutions to risks relating to the applicability, individual customer bases and

lending practices. It had been concluded that by implementing data warehousing processes

institutions can improving the length of a typical credit cycle and with small rated portfolios

institutions may not experience sufficient defaults for many years.

Chakraborty (2005) studied that banking is full of risks. So do not try too hard to avoid risk

because to stay in business is to stay with risk. What is required is to convert vulnerabilities

and weaknesses into strengths and threats as opportunities to build a sustainable development

in banking sector. It has been found that risk can be reduced by if risk management should be

actively and continuously promoted throughout the organization and adequate competence

should be developed through recruitment, training and development of employees to make

them efficiently handle the tools and techniques of modern risk management system.

Willemse and Wolthuis (2005) investigated the resulting empirical situation of accepting a

risk based solvency model as a legally valid method to determine minimum required

solvency margins. The relevance of this investigation was provided by the increasing

application of risk based solvency models within credit institutions (Basel II) and insurance

undertakings (Solvency II). They also studied that what is the relation between the solvency

norm established by legislators and the actual capability of insurance undertakings to meet

their obligations and it had been concluded that the establishment of a solvency norm

primarily orients towards the equitableness of risk of all insurance undertakings within the

jurisdiction.

Bandyopadhyay (2007) study would help the Indian Banks to mitigate risk in Agricultural

lending. It took into account the characteristics of the agricultural sector, attributes of

agricultural loans and borrowers, and restrictions faced by commercial banks and it is

consistent with Basel II, including consideration given to forecasting accuracy and

applicability. Banks can use such credit rating tool in the loan processing, credit monitoring,

loan pricing, management decision-making, and in calculating inputs like probability of

23

default, loss given default, default correlation and risk contribution etc. for portfolio credit

risk. This will enable the bank to diversify the risk and optimize the profit in the business.

Tamimi and Mazrooei (2007) focused that all banks in the volatile environment had been

facing a large number of risks such as credit risk, liquidity risk, foreign exchange risk, market

risk and interest rate risk, among others--risks which may threaten a bank's survival and

success. This study helped the financial institutions to maximize revenues and offer the most

value to shareholders by offering a variety of financial services, and especially by

administering risks. The study also focused on the three generic risk-mitigation strategies:

eliminate or avoid risks by simple business practices; transfer risks to other participants; and

actively manage risks at the bank level. The purpose of this research was to examine the

degree to which the UAE banks use risk management practices and techniques in dealing

with different types of risk. The secondary objective is to compare risk management practices

between the two sets of banks. He found that profit efficiency is sensitive to credit risk and

insolvency risk but not to liquidity risk or to the mix of loan products. The results also

indicated that the importance of upgrading financial supervision and risk management

practices as a precondition for successful financial liberalization. He also concluded that if

the bank is a monopoly or banks are competing only in the loan market, deposit insurance has

no effect on risk taking. Banks in this situation tend to take risks, although extreme risk

taking is avoided.

Tchana (2008) reviewed the empirical literature of various banking regulations. This is

followed by a proposal on the new directions for research of the link between banking

regulation and banking system stability. It had been found that there is a need to find a good

measure of banking stability in order to assess the importance of regulation on stability. It has

taken two main directions in respect of the stability measure which is used in the study. The

so called implicit-stability method uses an implicit measure of risk such as: the ratio of non-

performing loan on the total asset, bank stock price volatility, and the ratio of risk-weighted

assets to total assets; while the explicit-stability method uses the occurrence of a systemic

banking crisis in a given economy as the measure of instability. The measure of banking

instability can be constructed using banking system indicators which are positively correlated

to banking crises, such as the growth of credit to the private sector, and the growth of banks

deposits.

24

Hassan (2009) aimed to assess the degree to which Islamic banks in Brunei Darussalam use

risk management practices (RMPs) and techniques in dealing with different types of risk.

This study found that the three most important types of risk that the Islamic banks in Brunei

Darussalam facing are foreign-exchange risk, followed by credit risk and then operating risk.

It also found that the Islamic banks are somewhat reasonably efficient in managing risk

where risk identification (RI) and risk assessment and analysis (RAA) are the most

influencing variables in RMPs. The results can be used as a valuable feedback for

improvement of RMPs in the Islamic banks in Brunei and will be of value to those people

who are interested in the Islamic banking system

The perusal of literature revealed that there had been many researches regarding the study of

risk analysis in which they stated the various kinds of risks faced by banks and how they

managing the risks. It has been found that risk can be reduced by if risk management should

be actively and continuously promoted throughout the organization and adequate competence

should be developed through recruitment, training and development of employees to make

them efficiently handle the tools and techniques of modern risk management system.

25

NEED, SCOPE AND OBJECTIVES OF THE STUDY

3.1 NEED OF THE STUDY

The need of the study aroused in order to fill the gap between the aspects which had already

been covered by the previous works and what the objectives of this study will be. In the

earlier studies little attention was directed at understanding the different types of risk faced by

banks. The rationale behind the study was to develop an understanding about the level of

NPAs and risk faced by banks.

3.2 SCOPE OF THE STUDY

The scope of the present study extends to almost all the risks involved in banking sector. In

the present study the perception of the bank managers towards the various risks involved in

banking and the techniques being used in order to minimize those risks was being studied.

The scope of the study was limited to Private Banks viz. ICICI Bank, HDFC Bank, AXIS

Bank, YES Bank and IDBI Bank of Ludhiana and Jalandhar City only.

3.3 OBJECTIVES OF STUDY

The objectives of the study were as follows:

1) To know the level of NPAs of the banks.

2) To study the risks for which banks go for risk management techniques.

3) To know the various risk model/ techniques use by banks.

4) To study the perception of bankers regarding effectiveness of risk management

techniques.

27

RESEARCH METHODOLOGY

Research Methodology is a way to systematically solve the research problem. The Research

Methodology includes the various methods and techniques for conducting a Research.

“Marketing Research is the systematic design, collection, analysis and reporting of data and

finding relevant solution to a specific marketing situation or problem”. D. Slesinger and M.

Stephenson in the encyclopedia of Social Sciences define Research as “the manipulation of

things, concepts or symbols for the purpose of generalizing to extend, correct or verify

knowledge, whether that knowledge aids in construction of theory or in the practice of an

art”.

Research is, thus, an original contribution to the existing stock of knowledge making for its

advancement. The purpose of Research is to discover answers to the Questions through the

application of scientific procedures. This project had a specified framework for collecting

data in an effective manner. Such framework was called “Research Design”. The research

process followed by this study consists of following steps:

4.1 RESEARCH DESIGN:-

The present study is a conclusion oriented descriptive study as this study was undertaken to

get insight into the risks involved in banking sector and their effect on the level of NPAs.

4.2 SAMPLE DESIGN:

Sampling can be defined as the section of some part of an aggregate or totality on the basis of

which judgement or an inference about aggregate or totality is made. The sampling design

helps in decision making in the following areas:-

Universe of the study-The universe comprises of two parts as theoretical universe

and accessible universe

29

Theoretical universe- It includes all the banks throughout the universe.

Accessible universe- It includes all the private & public banks in India.

Sample size- Sample size is the number of elements to be included in a study. The

sample size was 50 managers and assistant managers of banks.

Sample unit- Sampling unit is the basic unit containing the elements of the universe

to be sampled. The sampling unit of the study was managers and assistant managers

of banks.

Sampling Techniques- The sampling technique was Judgmental Sampling.

4.3 METHODS OF DATA COLLECTION

Information had been collected from both Primary and Secondary data.

Primary sources- Primary data are those, which are collected are fresh and for the

first time and thus happen to be original in character. Primary data had been collected

by conducting surveys through questionnaire, which include both open- ended and

close-ended questions and personal and telephonic interview.

Secondary sources- Secondary data are those which have already been collected by

someone else which already had been passed through the statistical process.

Secondary data had been collected through magazines, websites, newspapers and

journals.

4.4 TOOLS OF ANALYSIS AND PRESENTATION:

To analyze the data obtained with the help of questionnaire, following tools were used:

Tables: - The data had been put in the form of tables so as to analyze it properly.

Bar graphs, Column graphs and Pie charts: - Various forms of graphs had been used for

the purpose of presentation of the data like bar graphs, column graphs and pie charts etc.

4.5 LIMITATIONS OF THE STUDY

The limitations of the study are:-

There could be some errors in the observation procedure.

Some hesitation on the part of managers to disclose all the details has also been a

limitation.

The explanations or the answers received from respondents may be erroneous on the

pretext of their unwillingness to spare so much of time.

30

DATA ANALYSIS AND INTERPRETATION

The data has been processed and analyzed by tabulation interpretation so that findings

communicated well and would had been be easily understood.

1: Well Defined and Documented Risk Management Policy: The purpose of this question

was to know whether the banks have well defined and documented management policy. The

results were as follows:

Table No. 5.1 Well defined and Documented Risk Management PolicyBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank

TOTAL Percentage (%)

RE

SP

ON

SE YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Figure No. 5.1 Well defined and Documented Risk Management Policy

32

Analysis and Interpretation:

A well defined risk management policy is that, whereby the risks with the greatest loss and

the greatest probability of occurring are handled first, and risks with lower probability of

occurrence and lower loss are handled in descending order. Thus all the banks in the survey

had well defined & documented risk management policy.

2. Operational Risk Management Policy: The purpose of this question was to know

whether there is existence of operational risk management policy in the banks. The results

were as follows:

Table No 5.2: Operational Risk Management PolicyBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Figure No 5.2: Operational Risk Management Policy


From the above data it had been analyzed that 100% of the banks had Operational Risk

Management Policy.

33

http://en.wikipedia.org/wiki/Probability

So it could be interperated that banks had documented operational risk management

committee in order to minimize the risk of loss resulting from inadequate or failed internal

processes, people and systems. This Operational Risk framework includes identification,

measurement, monitoring, reporting and control.

3. Risk Based Internal Audit: The purpose of this question was to know whether the banks

conduct risk based internal audit. The results were as follows:

Table No 5.3: Risk Based Internal Audit

BANKS HDFC Bank

ICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Figure No 5.3: Risk Based Internal Audit


From the above data it had been analyzed that 100% of the banks had Risk Based Internal

Audit.

34

So it could be interpretated that all the banks in the survey go for risk based internal audit

because banks regulators and the bank management need an assurance in risk management

compliance. Modern internal audit must add demonstrable value in the current competitive

banking environment

4. Willingness to take Risks: The purpose of this question was to know whether the banks

are willing to take risks. The options were given as very low, low, average, high and very

high. The results were as follows:

Table No.5.4 Willingness to take RisksBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

Very Low

0 0 0 0 0 0 0

Low 4 2 3 4 3 16 32

Average 16 8 7 1 2 34 68

High 0 0 0 0 0 0 0

Very High

0 0 0 0 0 0 0

Figure No 5.4: Willingness to take Risks


The Research had shown that about 68 percent of banks were average risk takers. These

banks accept some exposure to riskier borrowers but ensure that such loans are well secured

35

and monitor risk exposure closely to ensure that risk levels are acceptable. And about 32

percent of banks were low risk taker.

So it can be interpretated these banks follow conservative lending philosophy which

emphasizes borrower selection and tend to avoid or limit exposure to high risk borrowers and

types of lending. Low risk taker banks even willing to sacrifice some amount of profitability

to ensure consistent and superior credit performance.

5. Strict Rules for Borrower Selection: The purpose of this question was to know whether

the banks follow strict rules while selecting the borrowers so as to reduce the chances of

NPAs. The results were as follows:

Table No.5.5: Strict Rules for Borrower SelectionBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Figure No.5.5: Strict Rules for Borrower Selection


From the above data it had been analyzed that 100% of the banks in the survey had strict

rules for borrower’s selection because no bank wants non-performing assets in their balance

sheet. But these rules vary from bank to bank according to their policy.

36

6. NPA level of the banks: The purpose of this question was to know the level of NPA in the

banks. The options were given as high, average and low. The results were as follows:

Table No. 5.6: Level of NPA of the BanksBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE High 0 0 0 0 0 0 0

Average 8 5 5 5 4 27 54

Low 12 5 5 0 1 23 46

Figure No. 5.6: Level of NPA of the Banks


From the above data it had been analyzed that 54% of the banks in the survey had Average

level of NPA and 46% of the respondents had said that there is low level of NPAs in their

banks.

37

7. Adaptability of Banks: The purpose of this question was to know how the banks adapt to

the situation when things go robust. The options were given as uneasily, somewhat uneasily,

somewhat easily and very easily. The results were as follows:

Table No 5.7: Adaptability of BanksBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

Uneasily 6 3 4 3 3 20 40

SomewhatUneasily

11 6 5 2 2 25 50

SomewhatEasily

3 1 1 0 0 5 10

Very Easily

0 0 0 0 0 0 0

Figure No 5.7: Adaptability of Banks


From the above data it had been concluded that 50% of the respondents said that it was

somewhat uneasy to adapt, 40% of the respondents said that its uneasy to adapt and 10% of

the respondents said that it is somewhat easy to adapt when things go robust but they had to

38

change their portfolio and strategies according to market conditions to save the customer

from these fluctuations and provide maximum benefits.

8. Risk Management Framework: The purpose of this question was to know for which

category the banks has developed a concrete risk management framework. The results were

as follows:

Table No 5.8: Risk Management FrameworksBANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

Market Risk

YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0CreditRisk

YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0OperationalRisk

YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Underwriting Risk

YES 18 8 8 3 3 40 80NO 2 2 2 2 2 10 20

Figure No.5.8: Risk Management Frameworks


39

From the above data it had been concluded that every bank had concrete risk management

framework for credit, market risk operational risk. But some banks do not have concrete risk

management frame work for underwriting risk, the number of such banks were very low.

9: Risk Model(s)/Technique(s) used by Banks: The purpose of this question was to know

the risk models/ techniques used by banks. The results were as follows:

Table No 5.9: Risk Model/Techniques

BANKS HDFC Bank

ICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

VAR YES 18 9 9 4 5 45 90

NO 2 1 1 1 0 5 10Gap Analysis

YES 18 8 8 4 4 43 86

NO 2 2 1 1 1 7 14

Forecasting Technique

YES 8 2 2 2 2 16 32

NO 12 8 8 3 3 34 68

Scenario Analysis

YES 0 2 0 0 0 2 4NO 20 8 10 5 5 48 96

Figure No 5.9: Category of Risk Model/Techniques

Analysis and Interpretation:It had been found that banks mostly 45 and 43 of banks (resp.) used value at .risk and gap

analysis techniques and only 16 and 2 banks in the study use forecasting techniques and

scenario techniques respectively.

40

10. Effect of Credit Risk on Investment Portfolio by Banks: The purpose of this question

was to know whether the banks monitor the effect of credit risk on Investment Portfolio. The

results were as follows:

Table No 5.10: Effect of Credit Risk on Investment Portfolio.BANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE YES 20 10 10 5 5 50 100

NO 0 0 0 0 0 0 0

Figure No 5.10: Effect on Credit Risk on Investment Portfolio.


From the above figure it had been examined that majority of the respondents i.e 100 % of the

respondents monitor the credit risk in their investment portfolio because asset classification

and subsequent provisioning against possible losses impacts not only the value of the loan

portfolio but also the true underlying value of a bank's capital.

41

11. Volatile Investments: The purpose of this question was to know the willingness of banks

to take risks in banks. The results were as follows:

Table No 5.11: Willingness of Banks to take Risks in Volatile Investments BANKS HDFC

BankICICI Bank

AXIS Bank

YES Bank

IDBI Bank


RE

SP

ON

SE

Strongly Agree

5 2 3 3 3 16 32

Agree 12 6 4 1 1 34 68

Somewhat Agree

3 2 3 1 1 10 20

Disagree 0 0 0 0 0 0 0

Strongly Disagree

0 0 0 0 0 0 0

Figure No 5.11: Willingness of Banks to take Risks in Volatile Investments


The survey had shown that 68% of banks were agreed that they are comfortable with volatile

investments that experience large declines in value if there is potential for higher returns. And

22% and 18% of banks were somewhat and strongly agreed that they are comfortable with

volatile investments. These volatile investment opportunities are mostly availed by the

customers who are risk takers.

42

12: Spread of Investment in Portfolio: The purpose of this question was to know the spread

of investment in portfolio on risk basis. The results were as follows:

Table No 5.12: Spread of Investments in Portfolio on Risk BasisBanksPortfolios

HDFC ICICI AXIS YES IDBI Total %

Portfolio 1 0 0 0 0 0 0 0Portfolio 2 0 0 0 0 0 0 0Portfolio 3 1 0 1 1 1 4 8Portfolio 4 7 4 3 3 4 21 42Portfolio 5 10 6 7 2 0 25 50Portfolio 6 0 0 0 0 0 0 0Portfolio 7 0 0 0 0 0 0 0

Figure No 5.12: Spread of Investments in Portfolio

43


From the above figure it had been examined that most of the bank manager believed that

portfolio 4 and portfolio 5 was in consonance with their banking portfolio. As these

portfolio’s are having suitable blend of high return & high risk, medium return & medium

risk and low return & low risk.

44

FINDINGS OF THE STUDY

After analyzing various questionnaires which were filled by bank managers of various banks,

the following were the findings of the study:

Delegation of greater autonomy in financial operations, increase in volume of cross

border business, greater international financial linkages, wider range of products and

services and the growing diversities and complexities of banking business have

increased the risks faced by banks. Thus it had been found that every bank had well

defined & documented risk management policy because they wanted to take

calculated risk

It had been found that all the banks had documented operational risk management

committee in order to minimize the risk of loss resulting from inadequate or failed

internal processes, people and systems. This Operational Risk framework includes

identification, measurement, monitoring, reporting and control.

It had been found that all the banks were having risk based internal audit because

bank regulators and the bank management need an assurance in risk management

compliance.

With the current financial environment, banks would encounter greater success in

garnering low cost deposits and would thus be able to better manage their margins

because of their average and low risk taking abilities. These banks follow

conservative lending philosophy which emphasizes borrower selection and tend to

avoid or limit exposure to high risk borrowers and types of lending. Thus risk

tolerance of bank lies somewhere between average and low risk taking abilities.

45

All the banks have strict rules for borrower’s selection because no bank wants Non

Performing Assets in their balance sheet. The measure of non-performing assets

helps us to assess the efficiency in allocation of resources made by banks to

productive sectors. But these rules are varies from bank to bank according to their

policy.

It was not easy for the banks to adopt when things go robust but they have to change

their portfolio and strategies according to market conditions. So that they can provide

good returns to their customers up to maximum possible level irrespective of the

market conditions

All banks had concrete risk management framework for credit risk, market risk and

operational. But some banks do not have concrete risk management frame work for

underwriting risk. And the number of such banks was very low.

Since banks portfolio was not linear in the market parameter. They had to measure its

sensitivity or risk to small changes in each parameter. In order to measure these

sensitivities or risks, banks mostly use value at risk, gap analysis and forecasting

technique

All the banks monitor the credit risk in their investment portfolio because asset

classification and subsequent provisioning against possible losses impacts not only

the value of the loan portfolio but also the true underlying value of a bank's capital.

Banks were even comfortable with volatile investments that experience large

declines in value if there is potential for higher returns. But these volatile investment

opportunities are mostly availed by the customers who are risk takers.

46

7.1 CONCLUSION OF THE STUDY

Indian banking has made significant progress in recent years. The prudential norms,

accounting and disclosure standards and risk management practices, etc. are keeping pace

with global standards.

To conclude, it can be said that Indian banking industry is very well regulated. Every bank

has well defined & documented risk management policy because they want to take calculated

risk. To minimize the risk of loss resulting from inadequate or failed internal processes,

people and systems, or from external events, banks have documented operational risk

committee. Risk management and risk mitigation techniques have therefore acquired

paramount importance in banking business. In order to provide assurance in risk management

compliance, modern internal audit add demonstrable value in the current competitive banking

environment and the increasing expectations of regulators, governments and professional

bodies reflect the growing importance placed on the function. Banks have made stringent

rules for borrowers selection so as to remove the fear of NPA’s and have well defined

framework for analyzing not only credit risk but operational as well as market risk.

But there is need to develop performance framework in order to comply with global

standards. The advent of economic reforms, the deregulation and opening of the Indian

economy to the global market, brings opportunities over a vast and unlimited market to

business and industry in our country, which directly brings added opportunities to the banks.

Banks can solve their problems only if they assert a spirit of self-initiative and self-reliance

through developing their in-house expertise. They have to imbibe the banking philosophy

inherent in de-regulation. Today’s banking is full of risks. So do not try hard to avoid it

because is to stay in business is to stay with risk. What is required is to convert vulnerabilities

48

and weaknesses into strengths and threat as opportunities to build a sustainable development

in banking sector.

7.2 RECOMMENDATIONS OF THE STUDY

The recommendations of the study were as follows:-

1. Banks should develop risk concrete risk management framework for operational as

well as underwriting risk. This will help to remove loss during transaction or internal

process and fear of nonperforming assets.

2. Risk management activities will be more pronounced in future banking because of

liberalization, deregulation and global integration of financial markets. This would be

adding depth and dimension to the banking risks.

3. Banks should give priority to calculation of all types of risk that would be an essential

requirement in the banks as they would be in the process of calculating not only the

Credit Risk, Market Risk and Operational Risks but also underwriting risk that the

bank would be facing.

4. The various resolution strategies for recovery from NPAs should be made.

5. The capital to be set off for advances made by the bank would depend largely upon

the fair and accurate calculation of these risks based internal audit.

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REFERENCES

Bandyopadhyay. (2007). Credit risk models for managing bank’s agricultural loan portfolio.

Western Journal of Finance Research, 28(4), 955-973.

Chakraborty. (2005). Risk management practices in banks. Journal of Chartered Accountant,

27(7), 518-525.

Hassan. (2009). Risk management practices of Islamic banks. Journal of Risk Finance, 10(1),

23-27.

Hassan and Mazrooei. (2007). Banks' risk management: A comparison study of UAE national

and foreign banks. Journal of Risk Finance, 8(4), 394- 409.

McDonald and Eastwood. (2000). Credit risk rating at Australian banks. South Asian Journal of

Management, 20(3), 85-91.

Pyle. (1997). Bank risk management. Journal of American Finances, 99(5), 451-457.

Santomero. (1997). Commercial bank risk management: An analysis of the process. Canadian

Journal Administration Sciences, 69(6), 360-365.

Tamimi and Mazrooei. (2007). A study of risks in banks. Journal of Administration Finance,

38(5), 62-67.

Tchana. (2008). Study of banking instability and risk indicators. Journal of Finance and

Management, 44(5), 44-58.

Willemse and Wolthuis. (2005). Risk based solvency norms and their validity. Journal of

Pediatric Psychology, 45(9), 82-86.

51

http://www.emeraldinsight.com/1526-5943.htm

QUESTIONNAIRE

Dear Respondent,

I Swati Seth, student of Apeejay Institute of Management,will be conducting a research on

‘Risk Analysis in Banking Sector’. So, I request you to spare a few minutes from your busy

schedule and fill this form. I assure you that the information provided by you will be kept

confidential.

Demographic information:

NAME: ____________________________________

DESIGNATION: ____________________________________

Please tick mark the appropriate options.

1) Does your bank have a well-defined and documented risk management policy? Yes No.

2) Do you have a documented operational risk management policy? Yes No

3) Do you conduct risk based internal audit? Yes No

4) How do you rate your institution on willingness to take risks?

Very low risk taker.

Low risk taker

Average risk taker

High risk taker

Very high risk taker

1 2 3 4 5

5) Banks follows strict rules for borrower selection so as to remove the fear of NPA. Do you

Strongly Agree Agree Somewhat Agree

Disagree Strongly Disagree

53

1 2 3 4 5

6) What is the level of NPAs in your banks?

High Average Low

7) How easily does your bank adapt when things goes robust?

Uneasily. Somewhat uneasily. Somewhat easily Very easily 1 2 3 4

8) Please tick the category for which your bank has developed a concrete risk management framework?

Types of risk Yes NO

Market Risk

Credit Risk

Operational Risk

Underwriting Risk

9) Please tick which risk model(s)/technique(s) does your bank use?

Models/Techniques of risk Yes NO

Scenario AnalysisValue at riskQuantitative forecasting techniquesGap analysis

10). Do you monitor the effect of credit risk on investment portfolio? Yes No

11. Banks are comfortable with volatile investments that may frequently experience large declines in value if there is a potential for higher returns. Do you:

Strongly Agree

Agree Somewhat Agree

Disagree Strongly Disagree

1 2 3 4 5

12. Most of the portfolios have a spread of investments - some of the investments may have high-expected returns but with high risk, some may have medium expected returns and medium risk, and some may be low-risk/low-return. Which spread of investments do you find most appealing in order to minimize the portfolio risk.

54

Spread of investments in Portfolio

High Risk/Return Medium Risk/Return Low Risk/Return Portfolio 1 0% 0% 100%

Portfolio 2 0% 30% 70%

Portfolio 3 10% 40% 50%

Portfolio 4 30% 40% 30%

Portfolio 5 50% 40% 10%

Portfolio 6 70% 30% 0% Portfolio 7 100% 0% 0%

55

risk analysis

Economy & Finance