risk management final
TRANSCRIPT
-
7/31/2019 Risk Management Final
1/47
-
7/31/2019 Risk Management Final
2/47
INDEX
Topic Page no.
Introduction 1-3
Basel II-An Integrated Risk Management
System 4-9
What Is Risk?
Banking risk
Liquidity risk
Interest rate risk
Market risk
Credit risk
Operational risk
Legal risk
10-16
Market Risk 17-19
Credit risk 20-21
Operational risk 22-23
Risk Management Process 24-26
Risk regulation 26-27
Strategic role of risk management 28
Why do banks manage risk 29-30
Risk Measurement/Management 31-36
Findings from the survey 37
Bibliography/Webliography
-
7/31/2019 Risk Management Final
3/47
To whomsoever it may concern
This is to certify that work entitled A PROJECT REPORT ON Role Of
Risk Management In Banking Sector is a piece of work done by
NAMITA DUBEY under my guidance and supervision for the partial
fulfilment of diploma of PGDM in Dr. Gaur Hari Singhania Institute of
Management & Research, Kanpur.
To the best of my knowledge and belief the report embodies the work of the
candidate herself and has duly been completed. Simultaneously the report fulfilsthe requirement of the rules and regulations relating to the final research report
of the institute and I am assured that the project is up to the standard both in
respect to contents and language being referred to the examiner.
Date: 15/01/10 Prof. V.K.Murti
Faculty Guide
-
7/31/2019 Risk Management Final
4/47
ACKNOWLEDGEMENT
I would like to express my gratitude to all those who gave me the possibility to complete this
project. I would like to thank my college authorities and my Head of the Organization, Prof.
Prithvi Yadav first for providing me the opportunity to work on the research project i.e. Role
of Risk Management in Banking Sector. I want to thanks my project guide Prof.
V.K.Murtifor giving me permission to commence this project in the first instance, to do thenecessary work.
I want to thank all other finance teachers and my friends for all their help, support and valuable
hints.
Especially, I would like to give my special thanks to my parents, their love and blessing
enabled me to complete this work.
NAMITA DUBEY
-
7/31/2019 Risk Management Final
5/47
PREFACE
This project is undertaken for the partial fulfilment of PGDM course from Dr. Gaur Hari
Singhania Institute of Management and Research, Kanpur (Batch XIV 2008-2010)
Risk is the word which in common terms defined as the deviation from what we achieve and
what we plan. There is uncertainties related to in the future and this is so banks also and
therefore they are required to manage the risk. This project Role of Risk Management in
banking sector aims at providing the understanding of different types of risk faced by banks
and how they manage those. It also aims to analyse if they have any risk management system
what role it play and how it manages and up to what extent. Understanding Basel II As an
Integrated Risk Management solution. Understanding different risk faced by banking sector
also understand how to eliminate them Risk analysis (credit risk, market risk, operational risk
and others).Financial crisis lead the economy of whole world in a down turn which risk was the
main cause for that.
-
7/31/2019 Risk Management Final
6/47
ABBREVIATIONS
ACM Asset Creation Multiple
AMA Advanced Management Approach
BCBS Basel Committee of Banking Supervision
BIS Bankers for International Settlement
BPV Basic Point Value
CFO Chief financial officer
EAD Exposure At Default
ECAI External Credit Assessment Institution
EM Effective Maturity
EVA Economic Value Added
ERM Enterprise risk management
IRB Internal Rating Based
KYE Know Your Employee
LGD Loss Given Default
MIS Management Information System
NBFCs Non-banking Financial Companies
PD Probability of Default
RRS Risk Rating System
-
7/31/2019 Risk Management Final
7/47
RRM Risk Rating Methodology
RAROC Risk Adjusted Return on Capital
S&P Standards And Poors
SVM Shareholder Value Maximization
VaR Value at Risk
List of tables and figures
s.no Tables/figure
-
7/31/2019 Risk Management Final
8/47
Figure 1 Basel II
Figure 2 Financial risks
Table 1 Changing Pattern of Off-balance Sheet
Exposure of Different Banks In India
Figure 3 Credit risk
Chart 1 Transaction Relevant By Credit Conversion
Factor
INTRODUCTION
Financial sector reforms were initiated as part of overall economic reforms in the country and
wide ranging reforms covering industry, trade, taxation, external sector, banking and financial
-
7/31/2019 Risk Management Final
9/47
markets have been carried out since mid 1991. A decade of economic and financial sector
reforms has strengthened the fundamentals of the Indian economy and transformed the
operating environment for banks and financial institutions in the country. The sustained and
gradual pace of reforms has helped avoid any crisis and has actually fuelled growth. As pointed
out in the RBI Annual Report 2001-02, GDP growth in the 10 years after reforms i.e. 1992-93
to 2001-02 averaged 6.0 against 5.8% recorded during 1980-81 to 1989-90 in the pre-reform
period.
The most significant achievement of the financial sector reforms has been the marked
improvement in the financial health of commercial banks in terms of capital adequacy,
profitability and asset quality as also greater attention to risk management. Further,
deregulation has opened up new opportunities for banks to increase revenues by diversifying
into investment banking, insurance, credit cards, depository services, mortgage financing,
securitisation, etc. At the same time, liberalisation has brought greater competition among
banks, both domestic and foreign, as well as competition from mutual funds, NBFCs, post
office, etc. Post-WTO, competition will only get intensified, as large global players emerge on
the scene. Increasing competition is squeezing profitability and forcing banks to work
efficiently on shrinking spreads. Positive fallout of competition is the greater choice available
to consumers, and the increased level of sophistication and technology in banks. As banks
benchmark themselves against global standards, there has been a marked increase in
disclosures and transparency in bank balance sheets as also greater focus on corporate
governance.
The waves of globalisation are sweeping across the world, and have thrown up several
opportunities accompanied by concomitant risks. Integration of domestic market with
international financial markets has been facilitated by tremendous advancement in information
and communications technology. There is a growing realisation that the ability of countries to
conduct business across national borders and the ability to cope with the possible downside
risks would depend, inter alia, on the soundness of the financial system. This has necessitated
convergence of prudential norms with international best practices as well consistent refinement
of the technological and institutional framework in the financial sector through a non-disruptive
and consultative process.
-
7/31/2019 Risk Management Final
10/47
The Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S. Tarapore)
observed that under a full capital account convertibility regime, the banking system would be
exposed to greater market volatility, and this necessitated enhancing the risk management
capabilities in the banking system in view of liquidity risk, interest rate risk, currency risk,
counter-party risk and country risk that arise from international capital flows. The potential
dangers associated with the proliferation of derivative instruments credit derivatives and
interest rate derivatives also need to be recognised in the regulatory and supervisory system.
The issues relating to cross-border supervision of financial intermediaries in the context of
greater capital flows are just emerging and need to be addressed.
Therefore the need for a regulation was understood and so basel1 and 2 accords wereimplemented. Basel I is the round of deliberations by central bankers from around the world,
and in 1988, the Basel Committee (BCBS) in Basel,Switzerland, published a set of minimal
capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced
by law in the Group of Ten (G-10) countries in 1992.
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were
classified and grouped in five categories according to credit risk, carrying risk weights of zero
(for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent(this category has, as an example, most corporate debt). Banks with international presence are
required to hold capital equal to 8 % of the risk-weighted assets.
Implementiaon of Basel II
The Reserve Bank and the commercial banks have been preparing to implement Basel II, and it
has been decided to allow banks some more time in adhering to new norms. As against the
deadline of March 31, 2007 for compliance with Basel II, it was decided in October 2006 that
foreign banks operating in India and Indian banks having presence outside India would migrate
to the standardised approach for credit risk and the basic indicator approach for operational risk
under Basel II with effect from March 31, 2008, while all other scheduled commercial banks
are required to migrate to Basel II by March 31, 2009. It is widely acknowledged that
implementation of Basel II poses significant challenge to both banks and the regulators. Basel
II implementation may also be seen as a compliance challenge. But at the same time, it offers
two major opportunities to banks, viz., refinement of risk management systems; and
http://en.wikipedia.org/wiki/Central_bankinghttp://en.wikipedia.org/wiki/1988http://en.wikipedia.org/wiki/Basel_Committee_on_Banking_Supervisionhttp://en.wikipedia.org/wiki/Baselhttp://en.wikipedia.org/wiki/Switzerlandhttp://en.wikipedia.org/wiki/Group_of_Ten_(economic_1962)http://en.wikipedia.org/wiki/1992http://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Sovereign_debthttp://en.wikipedia.org/wiki/Central_bankinghttp://en.wikipedia.org/wiki/1988http://en.wikipedia.org/wiki/Basel_Committee_on_Banking_Supervisionhttp://en.wikipedia.org/wiki/Baselhttp://en.wikipedia.org/wiki/Switzerlandhttp://en.wikipedia.org/wiki/Group_of_Ten_(economic_1962)http://en.wikipedia.org/wiki/1992http://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Sovereign_debt -
7/31/2019 Risk Management Final
11/47
improvement in capital efficiency. The transition from Basel I to Basel II essentially involves a
move from capital adequacy to capital efficiency. This transition in how capital is used and
how much capital is needed will become a significant factor in return-inequity strategy for
years to come. The reliance on the market to assess the riskiness of banks would lead to
increased focus on transparency and market disclosure, critical information describing the risk
profile, capital structure and capital adequacy. Besides making banks more accountable and
responsive to better-informed investors, these processes enable banks to strike the right balance
between 10 risks and rewards and to improve the access to markets. Improvements in market
discipline also call for greater coordination between banks and regulators.
Understanding Basel II As an Integrated Risk Management Solution.
Basel II has made a more comprehensive approach to manage risks for the banking system. It
captures the risk on a consolidated basis for internationally active banks. Banking, Securities
-
7/31/2019 Risk Management Final
12/47
and other financial subsidiaries are consolidated to reckon capital requirements. The framework
encompasses all the entities in a banking group. It tries to ensure that the capital recognized in
capital adequacy measures provides adequate protection to depositors. The framework of Basel
II is as follows:
Figure 1.
Basel II adopts a three pillar approach to risk management.
Under Pillar 1 minimum capital requirements are stipulated for credit risk, market risk
and operational risk.
Pillar 2 deals with supervisory review process by the central bank.
Pillar 3 underlines the need for market discipline and disclosures required there under.
Pillar 1 stipulates the following options for assigning capital to meet credit risk:
1. Standardized Approach
2. Internal Rating Based (IRB) Approach
3. Advanced IRB Approach.
Standardized Approach.
BASEL II
- Minimum Capital
Requirements
-Calculation of three
types of risk:
Market
Credit
Operational
-Supervisory review
process
Adequate
capital
Sound
supervisory
review
process
Improvement
of risk
management
techniques
-Market discipline
Disclosure of
risks and risk
practices
Pillar 1 Pillar 2
BASEL II
- Minimum Capital
Requirements
-Calculation of three
types of risk:
Market
Credit
Operational
-Supervisory review
process
Adequate capital
Sound supervisory
review process
Improvement of risk
management
techniques
-Market discipline
Disclosure of risks
and risk practices
Pillar 1 Pillar 2
Pillar 3
Pillar 1 Pillar 2
Pillar 3
-
7/31/2019 Risk Management Final
13/47
Banks may use external credit ratings by institutions recognized for the purpose by the
central bank for determining the risk weight. Exposure on sovereigns and their central banks
could vary from zero percent to 150 percent depending on credit assessment from AAA to
below B- . Similarly, exposure on public sector entities, multilateral development banks, other
banks, securities firms and corporate also may have risk weights from 20 percent to 150
percent. Exposure on retail portfolio may carry risk weight of 75 percent. While Basel II
stipulates minimum capital requirement of 8 percent on risk weighted assets, India has
prescribed 9 percent. Under Basel II exposure on a corporate with AAA rating will have a
risk weight of only 20 percent. This implies that for Rs. 100 crore exposure on a AAA rated
corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%) compared to the
earlier requirement of Rs. 9 crore. However, claims on a corporate with below BB- rating will
carry a risk weight of 150 percent and the capital requirement will be Rs.13.50 crore (100 x
150% x 9%). Thus, a bank with a credit portfolio with superior rating may be able to save
capital while banks having lower rated credit exposure will have to mobilize more capital. Risk
weights can go beyond 150 percent in respect of exposures with low rating. For example,
securitization tranches with rating between BB+ and BB- may carry risk weight of 350 percent.
In order to adopt standardized approach, banks will have to encourage their corporate
customers to go in for obligor rating and get them rated. The central bank has to accredit
External Credit Assessment Institutions (ECAI) who satisfies defined criteria of objectivity,
independence, international access, transparency, disclosure, resources and credibility.
Internal Ratings Based (IRB) Approach: Foundation and Advanced Approach.
Banks, which have developed reliable Management Information System (MIS) and have
received the approval of the central bank, can use the IRB approach to measure credit risk on
their own. The bank should have reliable data on Probability of Default (PD), Loss Given
Default (LGD), Exposure at Default (EAD) and effective maturity (M) to make use of IRB
approach. Minimum requirements to adopt the IRB approach are:
1. Banks overall Credit Risk management practices must be consistent with the sound
practice guidelines issued by the Basel committee and the National Supervisor.
2. Rating dimensions to include both Borrower Rating and Facility Rating and has to
be applied to all asset classes.
-
7/31/2019 Risk Management Final
14/47
3. The Rating Structure adopted need to have minimum 7 grades of performing
borrowers and a minimum 1 Grade of non-performing borrowers and Enough
grades to avoid undue concentrations of borrowers in particular grades.
4. Criteria of Rating Systems to be documented and have the ability to differentiate
risk, predictive and discriminatory power.
5. Assessment Horizon for PD estimation to be 1 year
6. Use of models to be coupled with the use of human judgment and oversight.
7. Rating Assignment and Rating Confirmation to be independent.
8. The PD to be a long run average over an entire economic cycle (at least 5 years)
9. Banks should have confidence in the robustness of PD estimates and the underlying
statistical analysis.
10. Data collection and IT systems to improve the predictive power of rating systems
and PD estimates.
11. Validation of internal Rating systems/ Models by the Supervisor.
12. Streamlining use of credit risk mitigates and ensuring legal certainty of executed
documents.
Under foundation approach banks provide more of their own estimates of PD and rely on
supervisory estimates for other risk components. In the case of advanced approach banks
provide more of their own estimate of PD, LGD, EAD and M, subject to meeting minimum
stipulated standards.
Market Risk:
A banks investment portfolio is impacted by the fluctuation in prices of securities.
Even in respect of sovereign exposure there will be change in market price because of interest
rate movements. When the prices of securities are marked to market, a bank may incur loss if
the prices have declined. Change in interest rates, foreign exchange rates and prices of equity,
corporate debt instruments and commodities may involve market risk for the bank. Mismatches
in interest rates on assets and liabilities may also entail risk for the bank. The investment
portfolio has to be divided into the trading book and the banking book. While the trading book
has to be valued on a daily basis on mark to market basis, for the banking book, there should be
frequent assessment of shock absorption capacity of the portfolio to interest rate movements.
Operational Risk:
-
7/31/2019 Risk Management Final
15/47
A bank also encounters risks other than on account of default by a third party or adverse
market rate movements. These risks can be attributed to failed internal systems, processes,
people and external events. Mistakes committed because of weak internal systems may lead to
losses. Frauds may be committed on the bank by some customers, outsiders and even by
employees. If a proper KYC system is not in place, a bank may be exposed to loss of money
and reputation in a punitive action by the regulators. To minimize operational risks Know your
Employee (KYE) principles are also to be observed before employees are entrusted with
sensitive assignments.
Pillar 1:- Envisages that banks assess credit risk, market risk and operational risk and provide
for adequate capital to cover the risks.
Pillar 2:- Supervisory Review Process.
Compliance of requirements under Pillar 1 and providing adequate capital alone may not be
enough to prevent bank failures and to protect the interests of depositors. Therefore, under
Pillar 2 which deals with key principles of supervisory review, risk management guidance and
supervisory transparency and accountability with respect to banking risks, including guidance
relating to the treatment of interest rate risk in the banking book, credit risk (stress testing,
definition of default, residual risk and credit concentration risk), operational risk, enhanced
cross border communication and co-operation and securitization, supervisors are expected to
evaluate how well banks are assessing their capital needs relative to their risks and to intervene
where appropriate. This interaction is intended to foster an active dialogue between banks and
supervisors so that when deficiencies are identified, prompt and decisive action can be taken to
reduce risk or restore capital. Supervisors may focus more intensely on banks with risk profiles
or operational experience, which warrants such attention. There are the following four main
areas to be treated under Pillar 2:
1. Risks considered under Pillar 1 that are not fully captured by Pillar 1 process (e.g
credit concentration risk);
2. Those factors not taken into account by Pillar 1 process (e.g. interest rate risk in the
banking book, business and strategic risk).
3. Factors external to the bank (e.g. business cycle effects).
4. Assessment of compliance with minimum standards and disclosure requirements of
the more advanced methods under Pillar 1.
-
7/31/2019 Risk Management Final
16/47
Supervisors have to ensure that these requirements are being met both as qualifying criteria and
on a continuing basis.
The four key principles of supervisory review are:
Principle 1: Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.
The five main features of a rigorous process are as follows:
1. Board and senior management oversight;
2. Sound capital assessment;
3. Comprehensive assessment of risks;
4. Monitoring and reporting; and
5. Internal control review.
Principle 2: Supervisors should review and evaluate banks internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance with
regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not
satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital
ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required to support the risk characteristics of a particular
bank and should require rapid remedial action if capital is not maintained or restored.
Reserve Bank of India has implemented the risk-based supervision and has made a good
beginning in implementation of the guidelines under Pillar 2. Internal inspections of banks in
India are also tuned more towards risk-based audit.
Pillar 3:- Market Discipline.
Disclosure requirements are stipulated for banks to encourage market discipline. This will help
the market participants to assess the information on capital, risk exposures, risk assessment
processes and capital adequacy of the bank. Such disclosures are more important in the case of
banks, which are permitted to rely on internal methodologies giving them more discretion in
assessing capital requirements. Market discipline supplements regulation as sharing of
-
7/31/2019 Risk Management Final
17/47
information facilitates assessment of the bank by others including investors, analysts,
customers, other banks and rating agencies. It also leads to good corporate governance.
Supervisors can stipulate the minimum disclosures to be made by banks. Banks can also have
Board approved policies on disclosure. A transparent organization may create more confidence
in the investors, customers and counter parties with whom the bank has dealings. It would also
be easier for such banks to attract more capital.
All the requirements under the three Pillars of Basel II can be met only if banks have a robust
and reliable MIS. Technology therefore plays a crucial role in implementation of Basel II.
Beyond Core Banking which facilitates networking of branches to put through customer
transactions with ease and speed, technology should be able to play a supportive role in
enabling banks to access and use data in a meaningful manner so that the demands of Basel II
can be met in a cost effective manner. Reliance on internal methodologies will save cost and
provide greater discretion to banks to make assessment of capital requirements. Capital is a
very scarce resource and it needs to be put to optimum use. As per present norms, tier II capital
can be only 100 percent of Tier I capital. The stipulation of minimum Government holding of
51 percent poses challenges for public sector banks in raising tier I capital. India may have to
find a solution to this issue by asking for acceptance of new instruments as tier I capital. In the
context of the very robust growth in credit, which supports a buoyant economy, more capital
becomes indispensable for the Indian banking system. And compliance of Basel II norms will
help Indian banks adopt best international practices, enable them to have a larger global
presence and attract capital even from abroad.
Definition of Risk
What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means different things to
different people. For some it is "financial (exchange rate, interest-call money rates), mergers of
-
7/31/2019 Risk Management Final
18/47
competitors globally to form more powerful entities and not leveraging IT optimally" and for
someone else "an event or commitment which has the potential to generate commercial liability
or damage to the brand image". Since risk is accepted in business as a trade off between reward
and threat, it does mean that taking risk bring forth benefits as well. In other words it is
necessary to accept risks, if the desire is to reap the anticipated benefits.
Risk in its pragmatic definition, therefore, includes both threats that can materialize and
opportunities, which can be exploited. This definition of risk is very pertinent today as the
current business environment offers both challenges and opportunities to organizations, and it
is up to an organization to manage these to their competitive advantage.
What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some future event will
cause harm. It provides strategies, techniques, and an approach to recognizing and confronting
any threat faced by an organization in fulfilling its mission. Risk management may be as
uncomplicated as asking and answering three basic questions:
1. What can go wrong?
2. What will we do (both to prevent the harm from occurring and in the aftermath of an
"incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the organization to bring their
risks to manageable proportions while not severely affecting their income. This balancing act
between the risk levels and profits needs to be well-planned. Apart from bringing the risks to
manageable proportions, they should also ensure that one risk does not get transformed into any
other undesirable risk. This transformation takes place due to the inter-linkage present among
the various risks. The focal point in managing any risk will be to understand the nature of the
transaction in a way to unbundle the risks it is exposed to.
Risk Management is a more mature subject in the western world. This is largely a result of
lessons from major corporate failures, most telling and visible being the Barings collapse. In
addition, regulatory requirements have been introduced, which expect organizations to have
effective risk management practices. In India, whilst risk management is still in its infancy,
-
7/31/2019 Risk Management Final
19/47
there has been considerable debate on the need to introduce comprehensive risk management
practices.
Objectives of Risk Management FunctionTwo distinct viewpoints emerge
One which is about managing risks, maximizing profitability and creating opportunity
out of risks
And the other which is about minimising risks/loss and protecting corporate assets.
The management of an organization needs to consciously decide on whether they want their
risk management function to 'manage' or 'mitigate' Risks.
Managing risks essentially is about striking the right balance between risks and controls
and taking informed management decisions on opportunities and threats facing an
organization. Both situations, i.e. over or under controlling risks are highly undesirable
as the former means higher costs and the latter means possible exposure to risk.
Mitigating or minimising risks, on the other hand, means mitigating all risks even if the
cost of minimising a risk may be excessive and outweighs the cost-benefit analysis.
Further, it may mean that the opportunities are not adequately exploited.
In the context of the risk management function, identification and management of Risk
is more prominent for the financial services sector and less so for consumer products industry.
What are the primary objectives of your risk management function? When specifically asked in
a survey conducted, 33% of respondents stated that their risk management function is indeed
expressly mandated to optimise risk.
Risks in Banking
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 case discusses the various risks that
arise due to financial intermediation and by highlighting the need for asset-liability
management; it discusses the Gap Model for risk management.
Typology of Risk Exposure
-
7/31/2019 Risk Management Final
20/47
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 taking into consideration practical
issues including the limitations of models and theories, human factor, existence of frictions
such as taxes and transaction cost and limitations on quality and quantity of information, as
well as the cost of acquiring this information, and more.
Figure 2
TRANSACTIO
N RISK
PORTFOLIO
CONCENTRATIO
N
ISSUE RISK ISSUER RISK COUNTERPARTYRISK
EQUITY RISKINEREST
RATE RISK
CURRENCY
RISK
COMMODITY
RISK
TRADINGRISK
GAP RISK
GENERAL
MARKET RISK
SPECIFIC
RISK
FUNDINGLIQUIDITYRISK
TRADINGLIQUIDITY RISK
FINANCIAL RISKS
MARKET
RISK
LIQUIDITY
RISK
OPERATIONA
L RISK
HUMAN
FACTOR RISK
CREDIT RISK
LEGAL &
REGULATORY
RISK
-
7/31/2019 Risk Management Final
21/47
Banking risk
Liquidity risk
The liquidity risk of banks arises from funding of long-term assets by short term liabilities,
herby making the subject to rollover of refinancing risk. Funding liquidity risk is denied
as the inability to obtain funds to meet cash flow obligations. The liquidity risk in banks
manifest in different dimensions:
Funding risk: this arises from the need to replace net outflow due to unanticipated withdrawal
of deposits (wholesale and retail).
Time risk: this arises from the need to compensate for non-receipt of expected in flows of funds
i.e. performing assets turning into non performing assets.
Call risk: this arises due to crystallisation of continent liabilities. This may also arise when a
bank may not be bale to undertake profitable business opportunities when it arises
-
7/31/2019 Risk Management Final
22/47
Interest rate risk
Interest rate risk is the exposure of banks financial condition to adverse movements in interest
rates. Interest rate risk refers to potential impact on net interest income or net interest rate
margin or market value of equity, caused by unexpected changes in market interest rates.
IRR can be viewed in two ways: its impact on the earnings of the banks or its impact on the
economic value of the banks assets, liabilities OBS positions.
Gap and mismatch risk
Yield covers risk
Basis risk
Embedded option risk
Reinvestment risk
Net interest position risk
Market risk
Market risk is the risk of adverse deviation of the mark to market value of the trading
portfolios, due to market movements, during the period required to liquidate the transactions.
Market risk is also referred to as price risk.
Price risk occurs when assets are sold before their stated maturities. In the financial market,
bond prices and yields are inversely related.
The term market risk applies to (i) that the part of IRR which affects the price of interest rate
instruments (ii) pricing risk for all other portfolios that are held in the trading book of the bank
(iii) foreign currency risk.
Forex risk
Market liquidity risk
Credit risk
-
7/31/2019 Risk Management Final
23/47
Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail to
meet its obligation in accordance with agreed terms. For most banks, loans are the largest and
most obvious source of credit risk.
Default Risk
Credit Spread Risk
Systematic or Intrinsic Risk
Concentration Risk
Operational risks
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people
and system or from external events. Strategic risk and reputation risk are not a part of
operational risk.
It includes fraud risk, cultural risk, communication risk, documentation risk, competence risk,
model risk, external events risk, legal risk, regulatory risk, compliance risk, system risk.
Recently legal risk has been taken as a separate as perShyamala Gopinath, Deputy Governor
in his articleChanging Dynamics of Legal Risks in Financial Sector
Legal risk
Legal risk arises for a whole of variety of reasons. For example, counterparty might lack the
legal or regulatory authority to engage in a transaction. Legal risks usually only become
apparent when counterparty, or an investor, lose money on a transaction and decided to sue the
bank to avoid meeting its obligations. Another aspect of regulatory risk is the potential impact
of a change in tax law on the market value of a position.
In general there are three main risk faced by banks they are:
1. Market risk
2. Credit risk
3. Operational risk
Transaction Level
Risk
Portfolio Risk
-
7/31/2019 Risk Management Final
24/47
We will understand them in detail
MARKET RISK
Market Risk may be defined as the possibility of loss to bank caused by the changes in the
market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely
affected by movements in equity and interest rate markets, currency exchange rates and
commodity prices.
Market risk is the risk to the banks earnings and capital due to changes in the market level of
interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of
those prices. Market Risk Management provides a comprehensive and dynamic frame work for
-
7/31/2019 Risk Management Final
25/47
measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as
well as commodity price risk of a bank that needs to be closely integrated with the banks
business strategy.
Market can also be defined as Risk which is common to an entire class of assets or liabilities.
The value of investments may decline over a given time period simply because of economic
changes or other events that impact large portions of the market. Asset allocation and
diversification can protect against market risk because different portions of the market tend to
underperform at different times, also called systematic risk.
Market risk in banks
Banks also have several activities and undertake transaction that result in market exposure,
therefore they are not immune to this risk they also face it. All such transaction is reflected in
the grading book of the bank.
1. A trading book consists of banks proprietary positions in financial instrument
covering
Debt securities
Equity
Foreign exchange
Commodities
Derivatives held by trading
2. They also include position in the financial instrument arising form mismatched
principal broking and market making or positions taken in order to hedge otherelements of the trading books.
A banks trading book exposure has the following risks, which arise due to adverse changes in
the market variables such as interest rates, currency exchange rate ,commodity prices, market
liquidity and their volatilities and therefore these impact on banks earning nad capital
adequacy.
The main types of market risk faced by banks are:
-
7/31/2019 Risk Management Final
26/47
1. Foreign exchange risk:
Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a
result of adverse exchange rate movements during a period in which it has an open position,
either spot or forward, or a combination of the two, in an individual foreign currency, in forex
risk banks are exposed to other risk as well like:
Interest rate risk- Which arises from the maturity mismatching of foreign currency
positions. Even in cases where spot and forward positions in individual currencies are
balanced, the maturity pattern of forward transactions may produce mismatches. As a
result, banks may suffer losses as a result of changes in premium/discounts of the
currencies concerned. Counter party risk or settlement risk.
The three important issues that need to be addressed in this regard are:
1. Nature and magnitude of exchange risk
2. Exchange managing or hedging for adopted be to strategy>
3. The tools of managing exchange risk
2. Liquidation risk
Liquidation involves asset and market liquidity risk.
Liquidation risk arises from the lack of trading liquidity and result in
Adverse change in market prices
Inability of positions at the fair market price
Liquidation of position cause large price change
Inability to liquidate position at any price
Asset liquidation risk refers to a situation where a specific asset faces lack of trading liquidity.
Market liquidation risk refers to a situation when there is a general liquidity crunch in the
market and it reflects trading liquidity adversely.
Table1:-Changing Pattern of Off-balance Sheet Exposure of Different Banks In India
-
7/31/2019 Risk Management Final
27/47
Group of banks 2001-02 2002-03 2003-04 2004-05 2005-06
Public sector banks 3293 4066 4864 6840 8422
New private sector banks 870 1660 3536 4980 7901
Old private sector banks 243 301 329 600 630
Foreign banks 4460 5630 8904 15906 25541
Scheduled commercial 8866 11657 17633 28326 42494
CREDIT RISK
Credit risk arises from the lending activities of banks. It arises when the borrower does
not pay the interest and/or instalments as and when it falls due or in case where a loan is
payable on demand, the borrower fails to make payment as and when demanded.
Credit risk is defined as the possibility of losses associated with diminution in the credit
quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default
due to inability or unwillingness of a customer or counterparty to meet commitments in relation
to lending, trading, settlement and other financial transactions. Alternatively, losses result from
reduction in portfolio value arising from actual or perceived deterioration in credit quality.
Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial
institution or a sovereign.
-
7/31/2019 Risk Management Final
28/47
Credit risk may take the following forms
In the case of direct lending: principal/and or interest amount may not be repaid;
In the case of guarantees or letters of credit: funds may not be forthcoming from the
constituents upon crystallization of the liability;
In the case of treasury operations: the payment or series of payments due from the
counter parties under the respective contracts may not be forthcoming or ceases;
In the case of securities trading businesses: funds/ securities settlement may not be
effected;
In the case of cross-border exposure: the availability and free transfer of foreign
currency funds may either cease or the sovereign may impose restrictions.
Credit risk can be divided into: Figure 3
Default Risk
Default risk is driven by the potential failure of a borrower to make a promised payment, either
partly or wholly. In the event of default, a fraction of the obligation will normally be paid. This
is known as the recovery rate.
Credit Spread
If a borrower does not default, there is still risk due to worsening in credit quality. This result in
the possible widening of the credit spread. This is credit spread risk. This may arise from a
rating change (i.e. an upgrade or a down grade).It will usually be firm specific.
Chart 1:- Transaction Relevant By Credit Conversion Factor
S.No Off Balance Sheet Instrument Credit Conversion Factor (CCF)
Portfolio RiskTransaction
Risk
Credit risk
Default Risk
r
Credit Spread
Risk
Concentration
risk
Systematic
Risk
-
7/31/2019 Risk Management Final
29/47
1 Direct credit substitutes, in general guarantees of
indebtedness including stand by LC, financial
guarantees, acceptances and endorsement.
100
2 Certain transaction related contingent items such asperformance bonds, bid bonds, warranties and
indemnities.
50
3 Short term self-liquidating trade letters of credit
arising from the movement of goods i.e. documentary
credits collateralised by the underlying shipments for
both issuing and confirming banks.
20
4 Sale and repurchase agreement and asset sales with
recourse, where credit risk remains with bank
100
5 Other commitments i.e. formal standby facilities and
credit lines with an original maturity-(a)up to 1 year
20
6 Other commitments i.e. formal standby facilities and
credit lines with an original maturity-(b)over 1 year
100
OPERATIONAL RISK
Operational risk is one of the areas of risk that is faced by all organisations. More complex the
organisation is more exposed it would be to operational risk. Organisational risk would arise
due to the deviation from the normal and the planned functioning of systems, procedures,
technology and human failures of omission and commission.
Basel committee has defined Operational risk as follows, the risk of loss resulting frominadequate or failed internal processes, people and systems, or from external events. Nature of
organisational risk may be listed as:
Operational risk exists everywhere in the organisation.
Operational risks vary in their components. Some are high occurrence low value risks,
while some are low occurrence high value risks.
-
7/31/2019 Risk Management Final
30/47
Operational risks in the organisation continuously change especially when an
organisation is undergoing changes.
The performance of the banks have to be viewed in the context of growing number of
operational loss events and the consequential banking disasters such as Barclays Bank and
Allied Irish Bank. The four fundament principles, which underpin the entire gamut of
operational risk, can be summarised as:
Accept no unnecessary risk
Make risk decisions at appropriate level.
Accept risk after careful cost benefit analysis
Dovetail the operational risk management into business planning.
The second consultative paper of Basel II suggested classification of operational risks based on
the cause and effects .That is classification based on causes that are responsible for operational
risk or classifications based on the effects of risk were suggested.
Cause-Based
People oriented causes-negligence, incompetence, Insufficient training
Process oriented causes-business volume fluctuation, organisational complexity,
product complexity
Technology oriented causes-poor technology and telecom, obsolete application, lack of
automation
External causes-natural disaster, operational failures of third party
Effect Based
Legal liability
Regulatory, compliance and taxation policies
-
7/31/2019 Risk Management Final
31/47
Loss or damage to assets
Restitution
Loss of recourse
Write downs
MANAGEMENT OF RISK
Management of risk begins with the identification and its quantification. It is only after the risk
is identified and measured it may be decided to accept the risk or to accept the risk at a reduced
level, by undertaking steps to mitigate the risk, either full or partial. Therefore the management
of risk may sub-divide into following five processes:-
Risk Identification
Risk Management
Based on Sensitivity
Based on Volatility
Based on Downside potential
-
7/31/2019 Risk Management Final
32/47
Risk Pricing
Risk Monitoring and control
Risk adjusted return on capital
Risk Mitigation
RISK MANAGEMENT PROCESS
The process of financial risk management is an ongoing one. Strategies need to be implemented
and refined as the market and requirements change. Refinements may reflect changing
expectations about market rates, changes to the business environment, or changing international
political conditions, for example. In general, the process can be summarized as follows: Identify and prioritize key financial risks.
Determine an appropriate level of risk tolerance.
Implement risk management strategy in accordance with policy.
Measure, report, monitor, and refine as needed.
Risk management needs to be looked at as an organizational approach, as management of risks
independently cannot have the desired effect over the long term. This is especially necessary as
risks result from various activities in the firm and the personnel responsible for the activities donot always understand the risk attached to them. The steps in risk management process are:
a) Determining objectives
Determination of objectives is the first step in the risk management function. The objective
may be to protect profits, or to develop competitive advantage. The objective of risk
management needs to be decided upon by the management. So that the risk manager may fulfilhis responsibilities in accordance with the set objectives.
b) Identifying Risks
Every organization faces different risks, based on its business, the economic, social and
political factors, the features of the industry it operates in like the degree of competition, the
strengths and weakness of its competitors, availability of raw material, factors internal to the
company like the competence and outlook of the management, state of industry relations,
-
7/31/2019 Risk Management Final
33/47
dependence on foreign markets for inputs, sales or finances, capabilities of its staff and other
innumerable factors.
c) Risk Evaluation
Once the risks are identified, they need to be evaluated for ascertaining their significance. The
significance of a particular risk depends upon the size of the loss that it may result in, and the
probability of the occurrence of such loss. On the basis of these factors, the various risks faced
by the corporate need to be classified as critical risks, important risks and not-so-important
risks. Critical risks are those that may result in bankruptcy of the firm. Important risks are those
that may not result in bankruptcy, but may cause severe financial distress.
d) Development of policy
Based on the risk tolerance level of the firm, the risk management policy needs to bedeveloped. 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) Development of strategy
Based on the policy, the firm then needs to develop the strategy to be followed for managing
risk. A strategy is essentially an action plan, which specifies the nature of risk to be managed
and the timing. It also specifies the tools, techniques and instruments that can be used to
manage these risks. A strategy also deals with tax and legal problems. Another important issue
that needs to be specified by the strategy is whether the company would try to make profits out
of risk management or would it stick to covering the existing risks.
f) Implementation
Once the policy and the strategy are in place, they are to be implemented for actuallymanaging the risks. This is the operational part of risk management. It includes finding the best
deal in case of risk transfer, providing for contingencies in case of risk retention, designing and
implementing risk control programs etc.
g) Review
-
7/31/2019 Risk Management Final
34/47
The function of risk management needs to be reviewed periodically, depending on the costs
involved. The factors that affect the risk management decisions keep changing, thus
necessitating the need to monitor the effectiveness of the decisions taken previously.
Risk regulation in banking industry
Banking and financial services are regulated because they are the back bone of the economy.
Regulations have decisive impact on risk management. Regulation seek to improve the safety
of the banking industry, ensure a level playing field, promote sound business and supervisory
practices, control and monitor Systematic Risk and protect the interest of depositors.Bankers
for International Settlement (BIS) meet at Basel situated at Switzerland to address the common
issues concerning bankers all over the world. The Basel Committee on Banking Supervision
(BCBS) is a committee of banking supervisory authorities of G-10 countries and has been
developing standards and establishment of a framework for bank supervision towards
strengthening financial stability throughout the world. In consultation with the supervisory
authorities of a few non-G-10 countries including India, core principles for effective banking
supervision in the form of minimum requirements to strengthen current supervisory regime.
In banks asset creation is an event happening subsequent to the capital formation and depositmobilization. Therefore, the preposition should be for a given capital how much asset can be
created? Hence, in ideal situation and taking a radical view, stipulation of Asset Creation
Multiple (ACM), in lieu of capital adequacy ratio, would be more appropriate and rational.
That is to say, instead of Minimum Capital Adequacy Ratio of 8 percent (implying holding of
Rs 8 by way of capital for every Rs 100 risk weighted assets), stipulation of Maximum Asset
Creation Multiple of 12.5 times (implying for maximum Asset Creation Multiple of 12.5 time
for the given capital of Rs 8) would be more meaningful. However as the assets have been
already created when the norms were introduced, capital adequacy ratio is adopted instead of
asset creation multiple. At least in respect of the new banks (starting from zero), Asset Creation
Multiple (ACM) may be examined/thought of for strict implementation. The main differences
between the existing accord and the new one are summarized below:-
Existing Accord New Accord
Focus on single risk More emphasis on banks measure own
internal methodology supervisory Review and
-
7/31/2019 Risk Management Final
35/47
market discipline.
One size fits all Flexibility, menu of
approaches, incentive for better
risk management
Broad brush structure More risk sensitivity.
The structure of the New Accord II consists of three pillars approach as given below.
Pillar Focus area
I Pillar Minimum Capital Requirement
II Pillar Supervisory review process
III Pillar Market Discipline
Strategic Role of Risk Management in Banks
Risk management seeks to provide an assurance to the top management that the core objective
would be achieved to desired degree of assurance. The higher the risk taken and the greater the
level of assurance required for achieving core objective, the higher the sophistication of risk
management system that a bank must aim for. The core enterprise objective that is sought to
assured by risk management for profit-oriented business is well known but often misinterpreted
concept of shareholder value maximization (SVM). In the event of losses, shareholders accept
it first before others by providing much needed protection to other capital providers such as
debt and deposit holders in a bank. In return for providing capital the shareholders expect the
return commensurate with the risks that they are exposed to . while the ultimate test of SVM is
addition to market capitalization, difficulties associated with using it in practice has lead to a
number of proxies to economic value Added (EVA), risk adjusted return on capital(RAROC),
and its variants.
Why Do Banks Manage These Risks At All?
Why banking firms manage risk. According to standard economic theory, managers of value
maximizing firms ought to maximize expected profit without regard to the variability around its
expected value. However, there is now a growing literature on the reasons for active risk
management including the work of Stulz (1984), Smith, Smithson and Wolford (1990), and
-
7/31/2019 Risk Management Final
36/47
Froot, Sharfstein and Stein (1993) to name but a few of the more notable contributions. In fact,
the recent review of risk management reported in Santomero (1995) lists dozens of
contributions to the area and at least four distinct rationales offered for active risk management.
These include managerial selfinterest, the non-linearity of the tax structure, the costs of
financial distress and the existence of capital market imperfections. Any one of these justifies
the firms' concern over return variability, as the above-cited authors demonstrate.
How Are These Risks Managed?
In light of the above, what are the necessary procedures that must be in place to carry out
adequate risk management? In essence, what techniques are employed to both limit and manage
the different types of risk, and how are they implemented in each area of risk control? It is to
these questions that we now turn. After reviewing the procedures employed by leading firms,
an approach emerges from an examination of large-scale risk management systems. The
management of the banking firm relies on a sequence of steps to implement a risk management
system. These can be seen as containing the following four parts:
(i) Standards and reports,
(ii) Position limits or rules,
(iii) Investment guidelines or strategies,
(iv) Incentive contracts and compensation.
In general, these tools are established to measure exposure, define procedures to manage these
exposures, limit individual positions to acceptable levels, and encourage decision makers to
manage risk in a manner that is consistent with the firm's goals and objectives. To see how each
of these four parts of basic risk management techniques achieves these ends, we elaborate on
each part of the process below. In Section IV we illustrate how these techniques are applied to
manage each of the specific risks facing the banking community.
Standards and Reports
The first of these risk management techniques involves two different conceptual activities, i.e.,
standard setting and financial reporting. They are listed together because they are thesine qua
non of any risk system. Underwriting standards, risk categorizations, and standards of review
are all traditional tools of risk management and control. Consistent evaluation and rating of
exposures of various types are essential to understand the risks in the portfolio, and the extent
to which these risks must be mitigated or absorbed. The standardization of financial reporting is
the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations
-
7/31/2019 Risk Management Final
37/47
are essential for investors to gauge asset quality and firm level risk. These reports have long
been standardized, for better or worse. However, the need here goes beyond public reports and
audited statements to the need for management information on asset quality and risk posture.
Such internal reports need similar standardization and much more frequent reporting intervals,
with daily or weekly reports substituting for the quarterly GAAP periodicity.
Position Limits and Rules
A second technique for internal control of active management is the use of position limits,
and/or minimum standards for participation. In terms of the latter, the domain of risk taking is
restricted to only those assets or counterparties that pass some prespecified quality standard.
Then, even for those investments that are eligible, limits are imposed to cover exposures to
counterparties, credits, and overall position concentrations relative to various types of risks.
While such limits are costly to establish and administer, their imposition restricts the risk that
can be assumed by any one individual, and therefore by the organization as a whole. In general,
each person who can commit capital will have a well-defined limit. This applies to traders,
lenders, and portfolio managers. Summary reports show limits as well as current exposure by
business unit on a periodic basis. In large organizations with thousands of positions maintained,
accurate and timely reporting is difficult, but even more essential.
Investment Guidelines and Strategies
Investment guidelines and recommended positions for the immediate future are the third
technique commonly in use. Here, strategies are outlined in terms of concentrations and
commitments to particular areas of the market, the extent of desired asset-liability mismatching
or exposure, and the need to hedge against systematic risk of a particular type.
The limits described above lead to passive risk avoidance and/or diversification, because
managers generally operate within position limits and prescribed rules. Beyond this, guidelines
offer firm level advice as to the appropriate level of active management, given the state of the
market and the willingness of senior management to absorb the risks implied by the aggregate
portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition,
securitization and even derivative activity are rapidly growing techniques of position
management open to participants looking to reduce their exposure to be in line with
management's guidelines.
Incentive Schemes
-
7/31/2019 Risk Management Final
38/47
To the extent that management can enter incentive compatible contracts with line managers and
make compensation related to the risks borne by these individuals, then the need for elaborate
and costly controls is lessened. However, such incentive contracts require accurate position
valuation and proper internal control systems. Such tools which include position posting, risk
analysis, the allocation of costs, and setting Jensen and Meckling (1976), and Santomero
(1984) for discussions of the shortcomings in simple linear risk sharing incentive contracts for
assuring incentive compatibility between principals and agents. of required returns to various
parts of the organization are not trivial. Notwithstanding the difficulty, well designed systems
align the goals of managers with other stakeholders in a most desirable way. In fact, most
financial debacles can be traced to the absence of incentive compatibility, as the cases of the
deposit insurance and maverick traders so clearly illustrate.
RISK MANAGEMENT
MARKET RISK MANAGEMENT
After identification of major type of risk faced by banks. The next step for the risk management
process is the quantification or measurement of risk. Measurement of market risk (interest rate
risk) may be done by:
a) The Interest Sensitive Gap Analysis:-is the most popular analytical tool used by
banks managements to hedge the balance sheet from the interest rate risk. While the
Traditional Gap Analysis seeks to manage risk arising from the mismatch in prising of
-
7/31/2019 Risk Management Final
39/47
the assets and liabilities, a more redefined method is known as Standardised Gap
Analysis attempts to address basis risk also. Traditional gap analysis involves an
analysis and management of the banks positions in interest sensitive assets, liabilities
and off-balance sheet items with reference to existing interest sensitivity exposure of
the banks on a particular day. Gap analysis is the analysis between the interest rate
sensitive assets and interest rate sensitive liabilities.
b) Duration Analysis:-the concept of the duration is helpful to come out of the market
risk which either appreciates the bonds value or vice versa. Duration of a coupon
bearing bond is the weighted average maturity of its cash flow streams in present value
terms. It can be described as the maturity of an equivalent zero coupons bound.
Duration is calculated using the following formula:
Duration =
c) Simulation Analysis:-In simulation method a financial model of the institution is first
developed incorporating interrelationship of the assets, liabilities, prices,costs ,
volume ,mix and other business related variables.
d) Value at Risk: - Value at Risk or VaR is a recent innovation. The value at risk is based
on some elementary statistical concepts. Quantifying risk obviously means finding out
in numbers the likely loss a position would make in the market. value at risk may be
commuted using three major methods :
The Parametric or The Delta Normal Method
The Historical Simulation Method
The Monte Carlo Method.
e) Basic point value-this is the change value due basis point (0.01%) change in market
yield. This is used to measure the risk. The higher the BPV of a bond, higher is the risk
associated with the bond. Computation of BPV is quite simple.
PV (C1)*1+PV (C2)*2-----------+P V
V
-
7/31/2019 Risk Management Final
40/47
CREDT RISK MEASUREMENT
Measurement of credit risk consist of
a) Measurement of risk through credit rating/scoring.
Credit rating can be classified as:
External credit rating: - A credit rating is, in general, an investment recommendation
concerning a given security, in the words of Standards and Poors(S&P). A credit rating
is a creditworthiness of an obligor, or the creditworthiness of an obligor with respect to
a particular debt security or other financial obligation, based on relevant risk factors.
In Moody's words, a rating is, an opinion on the future ability and legal obligation of
an issuer to make timely payments of principal and interest on a specific fixed-income
security.
Financial institutions, when required to hold investment grade bonds by their
regulators use the rating of credit agencies such as S&P and Moody's to determine
which bonds are of investment grade.
The subject of credit rating might be a company issuing debt obligations. In the
case of such issuer credit ratings the rating is an opinion on the obligors overall
capacity to meet its financial obligations. The opinion is not specific to any particularliability of the company, nor does it consider merits of having guarantors for some of
the obligations. In the issuer credit rating categories are
a) Counterparty ratings
b) Corporate credit ratings
c) Sovereign credit ratings
Claims on sovereigns and their central banks will be risk weighted as follows:
Credit
Assessment
AAA to
AA-
A+
to A-
BBB+ to
BBB-
BB+
to B-
Below B- Unrated
Risk Weight 0% 20% 50% 100% 150% 100%
Internal credit rating: - A typical risk rating system (RRS) will assign both an obligor
rating to each borrower (or group of borrowers), and a facility rating to each available
facility. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A
robust RRS should offer a carefully designed, structured, and documented series ofsteps for the assessment of each rating.
-
7/31/2019 Risk Management Final
41/47
The following are the steps for assessment of rating:
a) Objectivity and Methodology:
The goal is to generate accurate and consistent risk rating, yet also to allow
professional judgment to significantly influence a rating where it is appropriate. The
expected loss is the product of an exposure (say, Rs. 100) and the probability of default
(say, 2%) of an obligor (or borrower) and the loss rate given default (say, 50%) in any
specific credit facility. In this example,
The expected loss = 100*.02*.50 = Rs. 1
A typical risk rating methodology (RRM)
a. Initial assign an obligor rating that identifies the expected probability of
default by that borrower (or group) in repaying its obligations in normal
course of business.
b. The RRS then identifies the risk loss (principle/interest) by assigning an
RR to each individual credit facility granted to an obligor.
The obligor rating represents the probability of default by a borrower in
repaying its obligation in the normal course of business. The facility rating represents
the expected loss of principal and/ or interest on any business credit facility. It
combines the likelihood of default by a borrower and conditional severity of loss,
should default occur, from the credit facilities available to the borrower.
b) Quantifying the risk through estimating expected loans losses.
OPERATIONAL RISK MEASUREMENT
Three methods for calculating operational risk capital charges in a continuum of increasing
sophistication and risk sensitivity:
a) The Basic Indicator Approach:-Banks using the Basic Indicator Approach must hold
capital for operational risk equal to the average over the previous three years of a fixed
percentage (denoted alpha) of annual gross income. Figures for any year in which
annual gross income is negative or zero should be excluded from both the numerator
and denominator when calculating the average. The charge may be expressed as
follows:
KBIA = [(GI1n x )]/n
-
7/31/2019 Risk Management Final
42/47
-
7/31/2019 Risk Management Final
43/47
-
7/31/2019 Risk Management Final
44/47
adjusted rate of return and, ultimately, the economic value added of each business unit.
The economic value added of each business unit, defined in detail below, is simply the
units adjusted net income less a capital charge (the amount of equity capital allocated
to the unit times the required return on equity). The objective in this case is to measure
a business units contribution to shareholder value and, thus, to provide a basis for
effective capital budgeting and incentive compensation at the business-unit level.
RAROC and Financial Theory
Allocating equity capital on the basis of the risk of individual business units seems pointless in
the classical theoretical paradigm of frictionless capital markets (one with perfect
information and without taxes, bankruptcy costs or conflicts between managers and
shareholders). If markets operated in this manner, the pricing of specific risks would be the
same for all banks and would not depend on the characteristics of an individual banks
portfolio.
RESEARCH METHODOLOGY
Problem Definition- risk is something which cannot be defined clearly every organisation
needs to minimise the risk up to some extent and for which system, tools, techniques and rules
are adopted by them. Bank is an organisation which face many risk and therefore its important
to know what role does the risk management system plays in mitigating it.
-
7/31/2019 Risk Management Final
45/47
Objective of Study-
The objective of the study is to understand the role of risk management in banks.
1) Basel II understanding it as an Integrated Risk Management Solution.
2) Understanding different risk faced by banking sector also understand how to
eliminate them
3) Risk analysis (credit risk, market risk, operational risk and others).
4) Role of risk management strategic role.
Research Design: - Descriptive Research
Source of Information:-Secondary Data
Analysis is based on the understanding from various researches, articles and papers.
Scope of the Study: - The study will analyze the risk factor which tells about the basis on
which banks provide loans to the customers as well as other risks, viz. market risk, operational
risk, liquidity risk etc. These are covered under the BASEL II accord which is a set of
interesting ideas, and crafts a new framework of banking regulation based on genuine
understanding of risk.
Limitations of study:-
It tells about the risk but the only shortcoming is the lack of terms related to the riskreduction.
Very stipulated time is allotted for the research.
Many banks may not be able to manage the risk.
Many of the banks may not be implementing the risk measurement/management toolsin the research
FINDINGS
As per the delottie risk management survey:-
Risk management is not fully integrated throughout many institutions: 49 percent of the
institutions surveyed had completely or substantially incorporated responsibilities for
-
7/31/2019 Risk Management Final
46/47
risk management into performance goals and compensation decisions for senior
management.
Overall responsibility for oversight and governance of risks rested with the board of
directors at 77 percent of the institutions participating, and 63 percent of these had aformal, approved statement of risk appetite.
Seventy-three percent of the institutions surveyed had a Chief Risk Officer (CRO) or
equivalent position. As an indicator of the roles importance, the CRO reported to the
board of directors and/or the CEO at roughly three quarters of these institutions.
Only 36 percent of the institutions had an enterprise risk management (ERM) program,
although another 23 percent were in the process of creating one. Among institutions
with $100 billion or more in assets, 58 percent had an ERM program already in place.
The institutions that had ERM programs found them to be valuable: 85 percent of the
executives reported that the total value (both quantifiable and non-quantifiable) derived
from their ERM programs exceeded costs.
Institutions have made substantial progress towards complying with Basel II. For many
areas, more than half of the institutions subject to Basel II reported they had already
complied or that little work remained, a far higher number than in our previous global
risk management surveys. These responses are clearly influenced by the fact that Basel
II has different timeframes for implementation in different countries, with multiple
approaches available in many jurisdictions.
BIBLIOGRAPHY/WEBLIOGRAPHY
Risk Management
-
7/31/2019 Risk Management Final
47/47
Conference papers 2007
Bank risk management
www.rbi.org
http://www.rbi.org/http://www.rbi.org/