risks in the banking sector

8/8/2019 Risks in the Banking Sector

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Risks in the BankingRisks in the Banking

SectorSector

Deepak BhandariDeepak Bhandari



What is Risk?

Threats

AssetsVulnerabilities

=Risk Threat X Vulnerability X Cost of the Asset

Risk



Three major components of Risk

Vulnerability

►Opportunity for

a threat to be realized

►Gateways through which

threats can be manifested

►Can be exploited by an

,event a person or a

business process

Assets

► Tangible or intangible

item of significantb usiness

value

► Amount of damage that

the item will cause if

/destroyed affected is to be

desirably kept low

► Damage to these assets

may cause major business

disruption

►

Threat

►Source and the means

by which a particular attack

can be carried out

►Expose thevulnerabilities

of the organization

►Broadly classified as

► -Man made( )intentional

►Naturaldisaster

►Accidental

( )unintentional



Defining Risk

tial that a threat will be realized for a vulnerability

► Relativeimpact

level of exploited

vulnerability

on businesses

► Factor ofloss

► Can be financial or

reputational orboth

isk Types

►Financial

►Strategic

►Operational►Compliance

Uncertainty

hreat

Realized elativeImpact



Dealing with Risk Exposure: The 4Ts

Text

Terminate

Treat

Risk



Types of RisksKey considerations for management

What are our key risks?Are we focused on the risks that matter?

Who is accountable for the key risks?Are resources aligned to our risk profile?

Are we accepting an appropriate level of risk?Are we receiving a fair return on that risk?

Who is monitoring the significant risks?How are we improving key controls?

► l an nin g a nd r es ou rceallocation

► ajor initiatives► ,e rg ers a cqu is it io n a nd

divestures► arket dynamics► ommunication and investor

relations

► a le s a nd m ar ket in g

► upply chain►People► nformation Technology►Hazards► hysical assets►

►

►Governance► ode of conduct►Legal►Regulatory

►Market► iq ui dit y an d c re di t► ccounting and reporting►Tax► apital structure

Strategic

Operational

Financial

Compliance



Top Risks: 2010

: & ,ource Ernst Young Global Research 2010



Changing Risk Scenario postEconomic Downturn

• Dramatic loss of liquidity experiencedduring the financial crisis.

• Forward looking approach to risk critical

•

Developing a blended set of both risk-based and financial performanceindicators

– Taking into account both historical and

forward-looking factors• Improved risk management for

providing a holistic approach to riskacross the enterprise

– Risk forecasting and stress testing



ection 1

arket Risks



Market Risk• Defined as the possibility of loss to bank caused

by the changes in the market variables.• Risk that the value of on-/off-balance sheet

positions will be adversely affected bymovements in equity and interest rate markets,currency exchange rates and commodity

prices.• Risk to the bank’s earnings and capital due to

changes in the market level of interest rates orprices of securities, foreign exchange andequities, as well as the volatilities, of those

prices.• Types Of Market Risk

– Liquidity Risk

– Interest Rate Risk

– Forex Risk–



Liquidity Risk (1/2)

• Liquidity is the ability to efficiently accommodate

deposit as also reduction in liabilities and tofund the loan growth and possible funding of the off-balance sheet claims.

• Liquidity risk consists of Funding Risk, Time Risk& Call Risk.

• Funding Risk

– It is the need to replace net out flows due tounanticipated withdrawal/nonrenewal of deposit.

•

Time risk – It is the need to compensate for non receipt

of expected inflows of funds, i.e.performing assets turning intononperforming assets.

• Call risk



• The Asset Liability Management (ALM)

– It implies examination of all the assets andliabilities simultaneously on a continuousbasis with a view to ensuring a properbalance between funds mobilization and

their deployment with respect to their a)maturity profiles, b) cost, c) yield, d) riskexposure, etc

–

Liquidity Risk (2/2)



Interest Rate Risk• Changes in interest rate affect earnings, value of

assets, liability off-balance sheet items andcash flow.

• The types of Interest Rate Risk are :

– Gap/Mismatch risk:

– Basis Risk

– Embedded option Risk

– Yield curve risk

– Reprice risk

– Reinvestment risk

– Net interest position risk

• Different techniques such as a) the traditionalMaturity Gap Analysis to measure the interestrate sensitivity, b) Duration Gap Analysis to

measure interest rate sensitivity of capital, c)simulation and d) Value at Risk for



Forex Risk• Foreign exchange risk is the risk that a bank may

suffer loss as a result of adverse exchange ratemovement during a period in which it has anopen position, either spot or forward or both insame foreign currency.

•Currency Risk is the possibility that exchange rate

changes will alter the expected amount of principal and return of the lending orinvestment.

•

By setting appropriates limits-open position andgaps, stop-loss limits, Day Light as well asovernight limits for each currency, IndividualGap Limits and Aggregate Gap Limits ,the riskelement in foreign exchange risk can be

managed/monitored.



Country Risk• This is the risk that arises due to cross border

transactions that are growing dramatically inthe recent years owing to economicliberalization and globalization. It is thepossibility that a country will be unable toservice or repay debts to foreign lenders intime.

• It comprises of

–

Transfer Risk – Sovereign Risk

– Political Risk

– Cross border risk

–



Credit Risk (1/2)

• Credit Risk is the potential that a bankborrower/counter party fails to meetthe obligations on agreed terms

•

Credit risk is inherent to the business of lending funds to the operations linkedclosely to market risk variables

• The objective of credit riskmanagement is to minimize the riskand maximize bank’s risk adjustedrate of return by assuming andmaintaining credit exposure withinthe acceptable parameters

•



Credit risk consists of primarily two components:- – Quantity of risk

– Severity of loss

Credit risk is a combined outcome of :- – Default Risk

– Exposure Risk

The elements of Credit Risk is :- – Portfolio risk comprising Concentration Risk as well

as Intrinsic Risk – Transaction Risk comprising migration/down

gradation risk as well as Default Risk

Credit Risk (2/2)



Tools of Credit Risk Management

The instruments and tools, through whichcredit risk

management is carried out, are detailed

below:-►Exposure Ceilings

►Review/Renewal

►Risk Rating Model►Risk based scientific pricing

►Portfolio Management

►Loan Review Mechanism



Risk Rating Model

Credit Audit is conduced on site, i.e. at thebranch

that has appraised the advance and where

the mainoperative limits are made available

The model may consist of minimum of sixgrades forperforming and two grades for non-

performing assets



The need for the adoption of the credit risk-rating model is

on account of the following aspects► Disciplined way of looking at Credit Risk

► Reasonable estimation of the overall health status of anaccount captured under Portfolio approach

► Impact of a new loan asset on the portfolio can beassessed

► The co-relation or co-variance between different sectorsof portfolio measures the inter relationship betweenassets

► Concentration risks are measured in terms of additionalportfolio risk arising on account of increased exposure

to a borrower/group or co-related borrowers.

► Need for Relationship Manager to capture, monitor andcontrol the over all exposure to high value customers

► Active approach of credit portfolio management

► Pricing of credit risk on a scientific basis linking the loanprice to the risk involved therein



Exposure risk is the loss of amount outstanding at the time of default as reduced

by the recoverable amount.

The loss in case of default is D* X * (I-R) Where D is Default percentage, X is the Exposure Value and R is the recovery rate

Credit Risk is measured through :-

– Probability of Default (POD) and

– Loss Given Default (LGD)

Exposure at Default (EaD):-bank’s exposure to the borrower atthe time of default

ELGD:- The extent of provisioning required could be estimatedfrom the expected

Loss Given Default(ELGD)

ELGD = POD x LGD x EaD



ection 2

Operational Risks



Operational Risks

• Operational risk, though defined as any risk that is not categorizedas market or credit risk, is the risk of loss arising frominadequate or failed internal processes, people and systems orfrom external events.

•

•Banks live with the risks arising out of Human errors, Financial

fraud, Natural Disasters.

•

• Exponential growth in the use of technology and increase in globalfinancial inter linkages are the two primary changes thatcontributed to such risks.

•

• Operational risk events are associated with weak links in internalcontrol procedures.

•

• Operational risk involves breakdown in internal controls and

corporate governance leading to error, fraud, performancefailure, compromise on the interest of the bank resulting in



Operational RiskManagement

• In order to mitigate this, internal control and internal auditsystems are used as the primary means.

•

• Risk education for familiarizing the complex operations at alllevels of staff can also reduce operational risk.

•

• Putting in place proper corporate governance practices by itself would serve as an effective risk management tool.

•

• While measurement of operational risk and computing capitalcharges as envisaged in the Basel proposals are to be theultimate goals, what is to be done at present is startimplementing the Basel proposal in a phased manner andcarefully plan in that direction.

•

• The incentive for banks to move the measurement chain is not just



ection 3

egulatory Risks



Regulatory Risks

• Many Banks, having already gone for public issue, have agreater responsibility and accountability.

•

• As banks deal with public funds and money, they are

subject to various regulations.

•

• The very many regulators include Reserve Bank of India(RBI), Securities Exchange Board of India (SEBI),Department of Company Affairs (DCA), etc.

•

• More over, banks should ensure compliance of theapplicable provisions of The Banking Regulation Act, TheCompanies Act, etc.

•

• Thus all the banks run the risk of multi le re ulator -risk



Regulatory RiskManagement

Banks should learn the art of Banks should learn the art of playing their business activitiesplaying their business activitieswithin the regulatory controls.within the regulatory controls.



ection 4

nvironmental Risks



Environmental Risk

• With the economic liberalization andglobalization, more national andinternational players are operating

the financial markets, particularlyin the banking field.

• This provides the platform forenvironmental change and exposesthe bank to the environmental risk.

•



Environmental RiskManagement

Unless the banks improve theirUnless the banks improve theirdelivery channels, reach customers,delivery channels, reach customers,

innovate their products that areinnovate their products that areservice oriented, they are exposed toservice oriented, they are exposed tothe environmental risk resulting inthe environmental risk resulting in

loss in business share withloss in business share withconsequential profit.consequential profit.



ection 5

:ase Study ICICI Bank



ICICI Bank RiskManagement

• Primarily exposed to credit risk, marketrisk, liquidity risk, operational risk andlegal risk.

•

Central Risk, Compliance and AuditGroup is responsible for riskmanagement

• Risk, Compliance and Audit Group is

organized into six subgroups: – Credit Risk Management, Market Risk

Management, Analytics, Internal Audit,Retail Risk Management and Credit

Policies and Reserve Bank of IndiaIns ection



Reporting Hierarchy

redit Risk arket Risk Analytics nternal etail redit



Mgmt Mgmt Audit isk Mgmt Policies

Borrowercreditratings

&Developingimplementing

market risk

measurementMethodologies

Developmentof

proprietary

models for riskmeasurement

Comprehensive coverage of

operational

risk inherent in all areas of business

Approval of retail

policies

andprocedures

Formulation of credit

policies

and ensuringcompliance

Sectoral analysis and

review

Approval of all new products

Initiation ofsystems

audit ininformation

-technologyintensive

areas

Impact ofmacroeconomic

changes onthe

retail

portfolio

Coordinating Reserve Bank

of India

inspections

Creditportfolioanalysis

Monitoringmarket

risk exposures

Portfolioreview

and

monitoring



Credit Risk

• Structured and standardized credit approvalprocess involves:

–

Credit Risk Assessment Procedure forCorporate Loans

– Project Finance Procedures

– Corporate Finance Procedures

– Working Capital Finance Procedures

– Credit Monitoring Procedures for CorporateLoans

– Retail Loan Procedures

– Small Enterprises Loan Procedures

– Investment Banking Procedures



Market Risk

• Exposure to loss arising fromchanges in the value of a financialinstrument as a result of changes in

market variables such as interestrates, exchange rates and otherasset prices



Interest Rate Risk

• Asset-liability gap position:

•



Interest Rate Risk

• Impact of adverse changes in interest rate

•

•

•

•

•

• Based on the asset and liability position atyear-end fiscal 2003, the sensitivity modelshows that net interest income from thebanking book for fiscal 2004 would fall by

Rs. 174 million (US$ 4 million) if interestrates increased by 100 basis points during



Price Risk

• Rupee Fixed Income Trading Portfolio

•

•

•

•

•

• The sensitivity model shows that if interest rates increase by 100 basispoints during fiscal 2004, the value of the trading portfolio, would fall by Rs.

1.6 billion (US$ 34 million).



Exchange Rate Risk

• Use cross currency swaps, forwards,and options to hedge againstexchange risks arising out of foreigncurrency hedging transactions

• Trading activities in the foreign currencymarkets expose the bank to exchangerate risks. This risk is mitigated bysetting counterparty limits, stipulating

daily and cumulative stop-loss limits,and engaging in exception reporting.• In addition, foreign currency loans are

made on terms that are similar to

foreign currency borrowings



Liquidity Risk

• The goal of liquidity management is tobe able, even under adverseconditions, to meet all liability

repayments on time, to meetcontingent liabilities, and fund allinvestment opportunities.

• The bank funds operations principallyby accepting deposits from retail andcorporate depositors and throughpublic issuance of bonds.

• They also borrow in the short-term



Operational Risk (1/2)

• ICICI Bank is exposed to many typesof operational risk.

• They can result from a variety of

factors, including failure to obtainproper internal authorizations,improperly documentedtransactions, failure of operational

and information securityprocedures, computer systems,software or equipment, fraud,inadequate training and employeeerrors.



• ICICI Bank attempts to mitigateoperational risk by maintaining acomprehensive system of internalcontrols, establishing systems and

procedures to monitor transactions,maintaining key back–up proceduresand undertaking regular contingencyplanning. Eg:

–

Operational Controls and Procedures forInternet Banking – Operational Controls and Procedures in

Regional Processing Centers & CentralProcessing Centers

– Operational Controls and Procedures in

Operational Risk (2/2)



Legal Risk

• The uncertainty of the enforceability of the obligations of ICICI Bank’scustomers and counterparties,

including the foreclosure on collateral,creates legal risk.

• ICICI Bank seeks to minimize legal riskby using stringent legaldocumentation, employingprocedures designed to ensure thattransactions are properly authorized

and consulting internal and external



Thank You!Thank You!

risks in the banking sector

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