Risk Management in Banking

A PROJECT REPORT ON
RISK MANAGEMENT IN BANK
SUBMITTED TO
ALL INDIA MANAGEMENT ASSOCIATION-CENTRE FOR
MANAGEMENT EDUCATION
MANAGEMENT HOUSE, 14 INSTITUTIONAL AREA,

LODHI ROAD, NEW DELHI-110002
OCTOBER, 2010
BY
ABHIJEET KUMAR
REGISTRATION NO.
750621607
GUIDED BY
MR. RAKESH SINGH
SR. MANAGER – (ACCOUNT)
FOR THE PARTIAL FULFILLMENT OF

POST GRADUATION DIPLOMA IN MANAGEMENT
(FINANCE)
To
The Manager Evaluation

AIMA – CME
14, Institutional Area
Lodhi Road, New Delhi
Dear Sir,
I have sent the synopsis and it has been approved but I haven’t received the
copy of the approval synopsis, instead has collected the control number
from the Delhi Office. The synopsis control number is 8973 and dated 9th
April 2010.
Therefore, I am sending the project report along with a copy of the

synopsis with the expectation of earliest consideration from your side.
Thanking you
Abhijeet Kumar
Reg. No. 750621607
Date: 25 October, 2010
Project Report
RISK MANAGEMENT IN BANK
Submitted By
Abhijeet Kumar
Reg. No. 750621607
Date: 25 October 2010
DETAILS OF THE PROJECT
1. Name : Abhijeet Kumar
2. Reg. No. : 750621607
3. Name of the Course : PGDM
4. Address : 17/8, Indra Vikas Colony,
Mukherjee Nagar, New Delhi
5. Title of the project : Risk Management in Bank
6. Name of the project Supervisor : Rakesh Singh
Sr. Manager – (Account)
Date: 25 October 2010 Abhijeet Kumar

STUDENT’S DECLARATION
I hereby declare that the project report on “Risk Management in Bank” submitted to
All India Management Association Centre for Management Education, New Delhi
in partial fulfillment of the requirement for Post Graduate Diploma in Management
completed is my original work and not submitted for the award of any other Degree/
Diploma or other prizes.
Place: Delhi
Date: 25 October 2010

Abhijeet Kumar
CERTIFICATE
This is to certify that the dissertation titled “Risk Management in Bank” is a faithfully
bonafide work done by Mr. Abhijeet Kumar under my guidance and each completed as
a part of training done during 4th semester for the fulfillment of the requirement of Post
Graduate Diploma in Management (PGDM).
Rakesh Singh
Sr. Manager (Account)
ACKNOWLEDGEMENT
I have had considerable help and support in making this project report a reality.
I am thankful to ICICI Bank from where I got the relevant information regarding my
project. I am also thankful to Mr. Rakesh Singh, Sr. Manager (Account) who provides
us all the relevant information regarding my project. I would also like to thank my
friend and family member.
Thanks are also due to the staff of AIMA-CME Library and Information Centre.
In the end I am thankful to that almighty god who gave me inspiration to complete this
project.
Abhijeet Kumar
Reg. No. 750621607
PGDM
New Delhi
25 October, 2010
INDEX
Executive Summary 1
Chapter-1 2-5
• Introduction to risk management in banking 3
• Problem in study 4
• Objectives in study 4
• Research methodology 4
• Limitation 5
• Scope of the Study 5
Chapter-2 6-29
• Conceptual Framework of ALM 7
• Guidelines for Asset Liability Management (ALM)
System in Financial Institutions (FIS) 17
• Review of existing literature summary 28
Chapter-3 30-39
• History and Growth of the bank 20
• Risk Management at ICICI 37
Chapter-4 40-93
• Performance evaluation of bank 41
• Risk Management Guidelines for Commercial Banks 52
• Inter-Bank Exposure and Country Risk 68
• Foreign Exchange (FOREX) Risk 87
Conclusion & Recommendation 94
Bibliography 95
EXECUTIVE SUMMARY
In normal course Fis are expose to several major risk in the course of their
business- Generally classified as credit risk, market risk, operational risk- which
underlines the need of effective risk management system in Fis. The Fis needs
to address these risks in a structure manner by upgrading the quality of their
risk management and adopting more comprehensive ALM practices.
In order to give some giving to above lines we have made a project report on
ICICI bank. The project is divided into three phases in first phase we have
highlighted the introduction of risk management in banking sector, the problem
and objective of the project. Secondly we have also shown the research
methodology of the whole project.
Second phase consist of conceptual framework of risk management and ALM it

is also include some existing literature review on risk management. Third phase
consist of history and growth of the bank also its include the performance
evaluation of the bank.
1
CHAPTER – 1
2
INTRODUCTION TO RISK MANAGEMENT
Risk management is recognised in today’s business world as an integral part of

good management practice. In its broadest sense, it entails the systematic
application of management policies, procedures and practices to the tasks of
identifying, analysing, assessing, treating and monitoring risk.
The past decade has also heralded enormous developments in new financial
products. Mortgages and residential mortgages have given institutional and
individual investors powerful new tools with which to disperse risk both
domestically and internationally. Advances in complex financial products,
together with improvements in technology, have lowered the cost of and
expanded opportunities for hedging risk. With the raid growth in new tools,
quantifying risk and interpreting risk measurements have never been more
important.
These developments have enabled all companies to take a more proactive

view towards risk. Instead of only associating risk as a potential downside of
their operations, increasing numbers of firms are considering how risk can be
managed positively to enhance the firm’s value.
3
PROBLEM
Bank in the process of financial intermediation are confronted with various

kinds of financial and non financial risk viz,credit risk,liquidity risk,forex risk
etc.These risk are highly interdependent and event that affect one area of risk
can have ramification for a range of other risk categories so based on this
problem we are going to do our research that how commercial banks monitor
such risk and controll the overall level of risk.
OBJECTIVES
• To know the concept of risk management in banking.
• To know the guidelines setup by R.B.I for commercial banks
• To know whether the banks are following those guidelines or not.
• To know the banks performance.
RESEARCH METHODOLOGY
To get the conclusion from the undertaken project one should must go through
a proper methodology. Here in this project our methodology is based on two
source, primary and secondary source
Secondary source
Under secondary source we have data collected from outside the bank such as
internet, stock exchange ,ficci library.
4
SCOPE OF THE STUDY
Through effective and efficient asset-liability management, the banks can

increase their productivity and reduce cost-inefficiency.
If inefficient banking firms have a tendency to remain inefficient, it would be of

interest for the policy makers to investigate how these banks can remain
economically viable and not be driven out of the banking market and this can
be done through asset-liability management.
The asset-liability management plays a very important role in the banks and
has a very vital scope in these institutions.
5
CHAPTER – 2
6
CONCEPTUAL FRAMEWORK
An Overview
Historical Background
In the context of present day’s rapidly changing business environment, asset

liability management in the financial sector especially banking refers to a
holistic approach to risk management, concerning not only individual trading or
balance sheet positions but with overall balance sheet perspective. It requires
assessing all available avenues for managing risks through natural methods,
diversification, pricing, exposure control, and use of derivatives.
Risk can be categorized into credit and market risk. Historically, credit risk
constituted the major challenge to the banking sector. However, during the last
two decades market risk has gained prominence and especially after the Basle
Committee Accord of 1988, which was instrumental in framing broad guidelines
for determining the various risks associated with financial sector. Asset Liability
Management (ALM) encompasses the effects of market risk.
Concept of ALM
ALM has gradually gained currency in Indian conditions in the wake of the
financial sector reforms during the last decade with particular emphasis on
interest rate deregulation. The technique of managing both assets and liabilities
has come into being as a strategic response of banks to inflationary pressure,
volatility in interest rates and adverse business environments including the
recessionary trends in global economy, if any.
Simply put, asset-liability management is the management of total balance

sheet dynamics with regard to its size and quality. It involves,
a) Quantification of risk and
b) Conscious decision making with regard to asset-liability structure in order to

maximize interest earnings within the framework of perceived risk. The
7
profitable growth and at times survival of a financial institution depends on
effective ALM.
Scope and objectives of ALM
The primary objectives of ALM is not to eliminate risk ; but to manage it in such
a way that volatility of net interest income is minimized in the short term time
horizon and net economic value of the organization is protected in a long term
time horizon. In banking scenario, this would controlling the volatility of net
income, net interest margin, capital adequacy, and liquidity risk and finally
ensuring an acceptable balance between profitability, growth, and risk.
A sound ALM system should focus on
• Review of interest rate outlook
• Fixation of interest/product pricing on both assets and liabilities
• Examining loan portfolio
• Examining investment portfolio
• Measuring foreign exchange risk
• Managing liquidity risk
• Review of actual performance vis-à-vis projections in respect of net

profit, interest spread and other balance sheet ratios
• Budgeting and strategic planning
• Examine the profitability of new products
8
ALM-An Exercise for Risk Return Trade-Off
Risk is an inherent part of banking business and in simple words may be

defined as a profitability of loss or damage. Given the complexities of bank’s
balance sheets and rapidity of changes, chances of loss or risks are only
complex in nature but also varied in dimension. Broadly speaking, banks are
exposed to both categories of risk viz.credit risk and market risk. While credit
risk which is mainly on account of the counter party failure in performing the
repayment obligation on due date i.e. loan defaults are managed by the credit
policy of the bank, the market risk is related to the Asset Liability Management
process and is caused by changes in market variables, involving one or more
of the following:
• Interest rate risk
• Foreign exchange risk
• Commodity price risk
• Stock market risk
ALM as a process not only encompasses market risk but also involves liquidity
management, funding and capital planning, profitability growth and at times
management of certain credit risks which are caused by market risk variables
for e.g. in a highly volatile interest rate environment, loan defaults may increase
thereby deteriorating the credit quality.
Interest Rate Risk
The Basle Committee on Banking Supervision whose recommendations have

been accepted by the Banking Community throughout the world has called for
the Banks to have a comprehensive risk management process in place that
effectively identifies, measures, monitors and control interest rate risk exposure
and that is subject to appropriate board and senior management oversight
(source-www.bis.org; Amendment to the Capital Accord to Incorporate Market
Risks, January 1996).
9
Traditionally, interest rate risk means changes in the interest income due to
changes in the rate of interest. While this focus is not misplaced, it is definitely
incomplete in as much as it overlooks an important aspect-changes in interest
rate resulting in the value of assets/liabilities. Thus, interest rate risk may be
viewed from two different complementary perspectives- earning sensitivity to
rate fluctuations and price sensitivity of instruments/products to changes in
interest rate.
Changes in interest rates can affect banks with regard to changes in
a) Market value of assets/liabilities and off balance sheet (OBS) items;

ultimately having impact on the value of net worth.
b) Net interest income arising out of mismatch in the repricing terms of the
assets and liabilities;
c) Net income as a result of changes in interest income;
d) Net income margin owing to changes in interest income and sensitivity

of non-interest income to rate changes and
e) Capital-asset ratio due to changes in net margin.
The supervisory capital requirements established by Basle Committee from the

end of 1997 covers interest rate risks in the trading activities of banks.
Accordingly, interest
Rate risks in the trading activities of banks. Accordingly, interest rate risk
management process has been constituted to include development of business
strategy, the assumption of assets and liabilities in banking and trading
activities, as well as a system of internal controls. The focus has been on the
need for effective interest rate risk measurement, monitoring, and control
functions within the interest rate risk management process (Source- Principles
for management of interest rate risk by BIS).
10
According to the studies conducted by Basle Committee based on working
experience of Banks in more than 100 countries, the banks are normally
exposed to following forms of interest rate risk.
a) Repricing risk
b) Yield curve risk
c) Basis risk
d) Optionally
Repricing risk: arises from timing differences in the maturity (for fixed rate)
and repricing (for floating rate) of bank’s assets , liabilities and off balance
sheet (OBS) positions while such repricing mismatches are fundamental to the
business of banking , they can expose a bank’s income and underlying
economic value to unanticipated fluctuations as interest rate varies. For
instance, a bank that funded a long term fixed
rate loan with a short term deposit could face a decline in both the future
income arising from the position and its underlying value if the interest rate
increases. These declines arises because the cash flows on the loan are fixed
over its lifetime , while the interest paid on the funding is variable, and
increases after the short term deposits matures.
Yield Curve Risk: arises when unanticipated shifts of the yield curve have
adverse effects on a bank’s income or underlying economic value. For
example, the underlying economic value of a long position in 10 yr government
bonds hedged by a short position in 5yr government notes could decline
sharply if the yield curve steepens, even if the position is hedged against
parallel movements in the yield curve.
Basis Risk: arises from imperfect correlation in the adjustment of the rates
earned and paid on different instruments with otherwise similar repricing
characteristics. When interest rates changes, these differences can give rise to
unexpected changes in the cash flows and earnings spread between assets,
liabilities and OBS instruments of similar maturities or repricing frequencies for
example a strategy of funding one year loan that reprices monthly based on
11
one month LIBOR, exposes the institution to the risk that the spread between
the two index rates may change unexpectedly.
The concept of basis risk is applicable for any set of two different interest rates.
For example, basis risk between thee following the following rates can be
analyzed:
• Prime/LIBOR
• Treasury Bill/LIBOR
• Certificate of deposits/LIBOR
• LIBOR/Commercial Paper
• Prime/Certificate of Deposit
The reasons for basis risk depend on particula4r set of rates, for example,
Prime/LIBOR basis risks are as follows:
a) Prime is an administered rate while LIBOR is market rate. The LIBOR

changes everyday, but the prime changes infrequently.
b) In US context, prime is a rate applicable for loans in the US_LIBOR is

applicable for intermediated outside the US. Thus other things remaining
the same, costs of certain types of regulation (e.g. Deposit Insurance
Premium Change) may impact prime only and not LIBOR.
c) During a declining rate environment, Prime tends to lag changes in

LIBOR, leading to wider spread. In an increasing rate environment, there
is an urgency to increase Prime Rate, resulting in declining spread.
This kind of pricing is usual in products market also when costs are increasing,
prices go up quickly, when costs are declining, and prices go down slowly. The
rate of change is different in different environments.
Optionality: option provides the holder the right but not the obligations to buy,
sell or in some manner alter the cash flow of an instrument or financial contract.
Options, may be in the form of standard alone instruments such as exchange
traded options or embedded within an otherwise standard instrument like the
various type of bonds and notes with caller put provisions, loans which give
12
borrowers the right to repay balances and various type of non-maturity deposit
instruments which give depositors the right to withdraw funds at any time, often
without any penalties. If not adequately managed, the asymmetrical pay off
characteristic of options held both explicit and embedded are generally
exercised to the advantage of the holder and disadvantage of seller.
Effects of Interest Rate Risk:
Interest rate risk effects both on banks earning as well as its economic value.
Earnings, comprising of net interest income i.e., difference between total
interest income and total interest expense has been the focus of main attention
traditionally, and the impact of interest rate change on net interest income has
been accepted from time to time. However, in the emerging new scenario
increasing focus on fee-based income and other non-interest bearing income
and expenses have led to changes in the dimension of the game. The non-
interest income arising from many activities can also be highly sensitive to
market interest rates. In international arena, banks are providing the servicing
and loan-administration function for mortgage loan pools in return for a fee-
based on the volume of assets it administers. When interest rates fall, the
servicing bank may experience a decline in its fee income as the underlying
mortgages get prepared. In addition, even traditional sources of non-interest
income such as transaction processing fee are becoming more interest rate
sensitive. This increased sensitivity has led both bank management and
supervisors to take a broader view of potential effects of changes in market
interest rates on bank earnings and to factor these broader effects into their
estimated earnings under different interest rates environment.
The economic value, of a bank’s assets, liabilities, and OBS position can get
affected due to fluctuation in interest rates. The economic value of a bank can
be viewed as the present value of banks expected net cash, defined as the
expected cash flow on liabilities plus the expected net cash flows on OBS
positions. Since economic value considered the potential impacting interest
rate changes on the present value of all future cash flows, it provides a
comprehensive view of the potential long term effects of changes in interest
rates. Than is offered by the earlier earnings perspectives.
13
While the above two perspectives focus on the impact of changes in future
interest rates on a banks future performances, evaluation of impact past
interest rate changes may have on future performance is also of great
significance. In particular instruments that are not marked to market may
already contain embedded gains or losses due to past rate movements and
may ultimately affect bank earnings. For example, a long term fixed rate loan
entered into when interest rates were low and refunded more recently with
liabilities bearing a higher rate of interest will over its remaining, represent a
drain on banks resources
Foreign Exchange Risk:
It refers to potential impact of movement in foreign exchange rates. The risk

here is that the adverse fluctuations in exchange rates may result in a loss.
Foreign exchange risk arises when there are unhedged current mismatches in
an institution assets and liabilities. This risk persists until the open position is
covered by means of hedging transactions. The amount at risk is a function of
the magnitude of the potential exchange rate changes and the size and
duration of the foreign currency exposures. Indian banks normally do not
undertake currency exposure for funding operation (i.e. unhedged conversion
of resources in one currency for funding assets in another currency). Currency
position in Indian banks is concentrated in dealing rooms and these are
subjected to constant monitoring through separate daylight and overnight limits
and exception reporting.
Commodity Risk
It is a risk associated with trading in commodities. Commodity trading is not

practiced by Banks and Financial Institutions in India.
Stock Market Risk
Arises primarily because of movement of portfolio value, which may have an

overall impact on Banks financial position in adverse condition. The liquidation
of Barings and Daiwa Bank is related to the market related risk associated with
14
over exposure to stock market to influence their profitability and long term
viability.
In addition to market risk associated with Asset and Liability Management

process the two other important aspects which are also of importance while
discussing asset liability management include
a) Liquidity Risk Management

b) Capital risk and capital planning
Liquidity Risk
It is the potential inability to generate cash to cope with the decline in deposits
or increase in assets. Liquidity risk originates from mismatches in the maturity
patterns of assets and liabilities since banks deal with assets and liabilities with
varied maturity patterns and risk profile, they need to strike a trade-off between
been overtly liquid and relatively liquid. An effective measurement and
monitoring process assessing all of banks cash inflows against its outflow to
identify the potential for any net shortfalls going forward forms an essential
ingredient to overall liquidity risk management. This includes funding
requirements for off balance sheet commitments. As all banks are affected by
changes in the economic climate and market conditions, the monitoring of
economic and market trends is also a key to liquidity risk management.
Traditionally, banks have been relying on core deposits for their funding.
However, in today’s environment, banks have resorted to other means of
sources also for managing the liquidity on ongoing basis. Cash inflows arise
from such things as maturing assets, saleable non-maturing assets, access to
deposit liabilities, established credit lines that can be tapped and in developed
world through asset securitization also. These need to be matched against
cash flows stemming from liabilities and contingent liabilities falling due,
especially committed lines of credit that can be drawn down. A maturity ladder
is therefore a useful device to compare cash outflows and cash inflows both on
a day to day basis and over a period of time. The banks historical experience of
the patterns of flows and knowledge of market conventions can also guide a
bank’s decision on liquidity risk management especially in a difficult scenario.
15
Use of “what if” analysis situations can also help in building different liquidity
scenarios for practical applications. An effective system of internal control in
banks against liquidity risk will involve:-
• A strong control environment

• An adequate process for identifying and evaluating liquidity risk
• Establishment of policy and procedure for handling such risks
• An adequate information system
• Control review of adherence to established policies and procedures.
Capital Risk
Maintaining adequate capital on a continuous basis is the sine quo-non for

sound banking practice. In a business situation, banks require capital to
insulate themselves from the risks of business that they undertake. The capital
accord of 1988 calls for detailed guidelines for maintaining adequate capital by
banks to mitigate themselves from problems arising in business development
on account of inadequate capital structure.
16
GUIDELINES FOR ASSET LIABILITY MANAGEMENT (ALM)
SYSTEM IN FINANCIAL INSTITUTIONS (FIS)
In the normal course, FIs are exposed to credit and market risks in view of the
asset-liability transformation. With liberalisation in Indian financial markets over
the last few years and growing integration of domestic markets with external
markets, the risks, particularly the market risks, associated with FIs’ operations
have become complex and large, requiring strategic management. FIs are
operating in a fairly deregulated environment and are required to determine
interest rates on various products in their liabilities and assets portfolios, both in
domestic as well as foreign currencies, on a dynamic basis. Intense
competition for business involving both the assets and liabilities, together with
increasing volatility in the domestic interest rates as also in foreign exchange
rates, has brought pressure on the management of FIs to maintain a good
balance amongst spreads, profitability and long-term viability. These pressures
call for structured and comprehensive measures for institutionalising an
integrated risk management system and not just ad hoc action. The FIs are
exposed to several major risks in the course of their business – generically
classified as credit risk, market risk and operational risk – which underlines the
need for effective risk management systems in FIs. The FIs need to address
these risks in a structured manner by upgrading the quality of their risk
management and adopting more comprehensive ALM practices than has been
done hitherto.
The envisaged ALM system seeks to introduce a formalised framework for

management of market risks through measuring, monitoring and managing
liquidity, exchange rate and interest rate risks of a FI that need to be closely
integrated with the FIs’ business strategy. This note lays down broad
guidelines for FIs in respect of liquidity, exchange rate and interest rate risk
management systems which form part of the ALM function. The initial focus of
the ALM function would be to enforce the discipline of market risk management
viz. managing business after assessing the market risks involved. The objective
of a good risk management systems should be to evolve into a strategic tool for
effective management of FIs.
17
The ALM process rests on three pillars:
• ALM Information System
 Management Information System
 Information availability, accuracy, adequacy and expediency
• ALM Organisation
Structure and responsibilities
 Level of top management involvement
• ALM Process
 Risk parameters
 Risk identification
 Risk measurement
 Risk management
 Risk policies and tolerance levels.
ALM Information System
ALM has to be supported by a management philosophy which clearly specifies

the risk policies and tolerance limits. This framework needs to be built on
sound methodology with necessary supporting information system as the
central element of the entire ALM exercise is the availability of adequate
and accurate information with expedience. Thus, information is the key to the
ALM process. There are various methods prevalent world-wide for measuring
risks. These range from the simple Gap Statement to extremely sophisticated
and data intensive Risk Adjusted Profitability Measurement methods. The
present guidelines would require comparatively simpler information system for
generating liquidity gap and interest rate gap reports.
ALM Organisation
Successful implementation of the risk management process would require

strong commitment on the part of the senior management in the FI, to integrate
basic operations and strategic decision making with risk management. The
Board should have overall responsibility for management of market risks and
18
should decide the risk management policy of the FI and set limits for liquidity,
interest rate, exchange rate and equity price risks.
The ALCO is a decision-making unit, consisting of the FI's senior management

including CEO, responsible for integrated balance sheet management from
risk-return perspective including the strategic management of interest rate and
liquidity risks. While each FI will have to decide the role of its ALCO, its powers
and responsibilities as also the decisions to be taken by it, its responsibilities
would normally include:
• monitoring the market risk levels of the FI by ensuring adherence to the
various risk-limits set by the Board;
• articulating the current interest rate view and a view on future direction of
interest rate movements and base its decisions for future business strategy
on this view as also on other parameters considered relevant.
• deciding the business strategy of the FI, both - on the assets and liabilities
sides, consistent with the FI’s interest rate view, budget and pre-
determined risk management objectives. This would, in turn, include:
• determining the desired maturity profile and mix of the assets and liabilities
• product pricing for both - assets as well as liabilities side;
• deciding the funding strategy i.e. the source and mix of liabilities or sale of
assets; the proportion of fixed vs floating rate funds, wholesale vs retail
funds, money market vs capital market funding , domestic vs foreign
currency funding, etc.
• reviewing the results of and progress in implementation of the decisions

made in the previous meetings
The ALM Support Groups consisting of operating staff should be responsible

for analysing, monitoring and reporting the risk profiles to the ALCO. The staff
should also prepare forecasts (simulations) reflecting the impact of various
19
possible changes in market conditions on the balance sheet and recommend
the action needed to adhere to FI's internal limits.
Composition of ALCO
The size (number of members) of ALCO would depend on the size of each
institution, business mix and organisational complexity. To ensure commitment
of the Top Management and timely response to market dynamics, the
CEO/CMD/DMD or the ED should head the Committee. Though the
composition of ALCO could vary across the FIs as per their respective set up
and business profile, it would be useful to have the Chiefs of Investment,
Credit, Resources Management or Planning, Funds Management / Treasury
(forex and domestic), International Business and Economic Research as the
members of the Committee. In addition, the Head of the Technology Division
should also be an invitee for building up of MIS and related computerisation.
Some FIs may even have Sub-committees and Support Groups.
Committee of Directors
The Management Committee of the Board or any other Specific Committee

constituted by the Board should oversee the implementation of the ALM system
and review its functioning periodically.
ALM PROCESS
The scope of ALM function can be described as follows:

• Liquidity risk management
• Management of market risks
• Trading risk management
• Funding and capital planning
• Profit planning and growth projection
The guidelines contained in this note mainly address Liquidity and Interest Rate
risks.
20
21
Liquidity Risk Management
Measuring and managing liquidity needs are vital for effective operation of FIs.
By assuring a FI's ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation
developing. The importance of liquidity transcends individual institutions, as
liquidity shortfall in one institution can have repercussions on the entire
system. FIs’ management should measure not only the liquidity positions of FIs
on an ongoing basis but also examine how liquidity requirements are likely to
evolve under different assumptions. Experience shows that assets commonly
considered to be liquid, such as Government securities and other money
market instruments, could also become illiquid when the market and players
are unidirectional. Therefore liquidity has to be tracked through maturity or cash
flow mismatches. For measuring and managing net funding requirements, the
use of a maturity ladder and calculation of cumulative surplus or deficit of funds
at selected maturity dates is adopted as a standard tool. The format of the
Statement of Liquidity is furnished in Annexure I.
The Maturity Profile, as detailed in Appendix I, could be used for measuring

the future cash flows of FIs in different time buckets. The time buckets, may
be distributed as under:
i) 1 to 14 days
ii) 15 to 28 days
iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months
v) Over 6 months and upto 1 year
vi) Over 1 year and upto 3 years
vii) Over 3 years and upto 5 years
viii) Over 5 years and upto 7 years
ix) Over 7 years andupto 10 years
x) Over 10 years.
22
The investments are assumed as illiquid due to lack of depth in the secondary
market and are, therefore, generally shown, as per their residual maturity,
under respective time buckets. However, some of the FIs may be maintaining
securities in the ‘Trading Book’, which are kept distinct from other investments
made for retaining relationship with customers. Securities held in the 'Trading
Book’ should be subject to the following preconditions:
i)The composition and volume of the Trading Book should be clearly defined;
ii)Maximum maturity/duration of the trading portfolio should be restricted;
iii)The holding period of the trading securities should not exceed 90 days;
iv)Cut-loss limit(s) should be prescribed;
v) Product-wise defeasance periods (i.e. the time taken to liquidate the
‘position’
on the basis of liquidity in the secondary market) should be prescribed;
vi) Such securities should be marked-to-market on a daily/weekly basis and
the
revaluation gain/loss should be charged to the profit and loss account;
etc.
FIs which maintain such ‘Trading Books’ consisting of securities that comply
with the above standards, are permitted to show the trading securities under 1-
14 days, 15-28 days and 29-90 days buckets on the basis of the defeasance
periods. The Board/ALCO of the banks should approve the volume,
composition, maximum maturity/duration, holding/defeasance period, cut loss
limits, etc., of the ‘Trading Book’ . FIs, which are better equipped, will have the
option of evolving with the approval of the Board / ALCO, an integrated Value
at Risk (VaR) limit for their entire balance sheet including the “Banking Book”
and the “Trading Book”, for the rupee as well as foreign currency portfolio. A
copy of the approved policy note in this regard, should be forwarded to the
Department of Banking Supervision, FID, RBI.
Within each time bucket there could be mismatches depending on cash inflows
and outflows. While the mismatches upto one year would be relevant since
these provide early warning signals of impending liquidity problems, the main
focus should be on the short-term mismatches viz., 1-14 days and 15-28 days.
FIs however, are expected to monitor their cumulative mismatches (running
total) across all time buckets by establishing internal prudential limits with the
23
approval of the Board / ALCO. The negative gap during 1-14 days and 15-28
days time-buckets, in normal course, should not exceed 10 per cent and 15 per
cent respectively, of the cash outflows in each time bucket. If a FI in view of its
current asset-liability profile and the consequential structural mismatches needs
higher tolerance level, it could operate with higher limit sanctioned by its
Board / ALCO giving specific reasons on the need for such higher limit. The
discretion to allow a higher tolerance level is intended for a temporary period,
i.e. till March 31, 2001. While determining the tolerance levels, the FIs may
take into account all relevant factors based on their asset-liability base, nature
of business, future strategy, etc. The RBI is interested in ensuring that the
tolerance levels are determined keeping all necessary factors in view and
further refined with experience gained in Liquidity Management.
The Statement of Liquidity may be prepared by placing all cash inflows and
outflows in the maturity ladder according to the expected timing of cash flows.
A maturing liability will be a cash outflow while a maturing asset will be a cash
inflow. It would also be necessary to take into account the rupee inflows and
outflows on account of forex operations. Thus, the foreign currency resources
raised abroad but swapped into rupees and deployed in rupee assets, would be
reflected in the rupee liquidity statement. Some of the FIs have the practice of
disbursing rupee loans to their exporter clients but denominating such loans in
foreign currency in their books which are extinguished by the export proceeds.
Such foreign currency denominated loans too would be a part of rupee liquidity
statement since such loans are created out of rupee resources. As regards the
foreign currency loans granted out of foreign currency resources on a back-to-
back basis, a currency-wise liquidity statement for each of the foreign
currencies in which liabilities and assets have been created.
Currency Risk
Floating exchange rate arrangement has brought in its wake pronounced

volatility adding a new dimension to the risk profile of FIs’ balance sheets.
The increased capital flows across free economies following deregulation have
contributed to increase in the volume of transactions. Large cross border flows
24
together with the volatility has rendered the FIs' balance sheets vulnerable to
exchange rate movements.
Dealing in different currencies brings opportunities as also risks. If the liabilities

in one currency exceed the level of assets in the same currency, then the
currency mismatch can add value or erode value depending upon the currency
movements. Mismatched currency position, besides exposing the balance
sheet to movements in exchange rate, also exposes it to country risk and
settlement risk. FIs undertake operations in foreign exchange such as
borrowings and making loans in foreign currency, which exposes them to
currency or exchange rate risk. The simplest way to avoid currency risk is to
ensure that mismatches, if any, are reduced to zero or near zero. However,
irrespective of the strategies adopted, it may not be possible to eliminate
currency mismatches altogether.
At present, only five FIs (viz. EXIM Bank, ICICI, IDBI, IFCI and IIBI) have been
granted by RBI (ECD) restricted authorisation to deal in foreign exchange
under FERA 1973 while other FIs are not authorised to deal in foreign
exchange. The FIs are, therefore, unlike banks, are not subject to the full rigour
of the reporting requirements under Exchange Control regulations. Hence, the
MAP and SIR statements prescribed for banks vide AD (MA Series) circular no.
52 dated 27 December 1997 issued by RBI (ECD), are not applicable to FIs. In
order, however, to capture the liquidity and interest rate risk inherent in the
foreign currency portfolio of the FIs, it would be necessary to compile, on an
ongoing basis, currency-wise Statement of Liquidity and IRS Statement,
separately for each of the currencies in which the FIs have an exposure.
Interest Rate Risk (IRR)
Interest rate risk is the risk where changes in market interest rates might
adversely affect a FI's financial condition. The immediate impact of changes in
interest rates is on FI's earnings (i.e. reported profits) by changing its Net
Interest Income (NII). A long-term impact of changing interest rates is on FI's
Market Value of Equity (MVE) or Net Worth as the economic value of bank’s
25
assets, liabilities and off-balance sheet positions get affected due to variation in
market interest rates. The interest rate risk when viewed from these two
perspectives is known as ‘earnings perspective’ and ‘economic value’
perspective, respectively. The risk from the earnings perspective can be
measured as changes in the Net Interest Income (NII) or Net Interest Margin
(NIM). There are many analytical techniques for measurement and
management of Interest Rate Risk. In the context of poor MIS, slow pace of
computerisation in FIs, the traditional Gap analysis is considered to be a
suitable method to measure the Interest Rate Risk in the initial phase of the
ALM system. However, the FIs, which are better equipped, would have the
option of deploying
advanced IRR management techniques with the approval of their Board /
ALCO, in addition to the Gap Analysis prescribed under the guidelines. It is the
intention of RBI to move over to the modern techniques of Interest Rate Risk
measurement like Duration Gap Analysis, Simulation and Value at Risk over
time when FIs acquire sufficient expertise and sophistication in acquiring and
handling MIS.
The Gap or Mismatch risk can be measured by calculating Gaps over different
time intervals as at a given date. Gap analysis measures mismatches between
rate sensitive liabilities and rate sensitive assets (including off-balance sheet
positions). An asset or liability is normally classified as rate sensitive if:
i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the interval;
iii) it is contractually pre-payable or withdrawable before the stated maturities;
iv) It is dependent on the changes in the Bank Rate by RBI.
The Gap Report should be generated by grouping rate sensitive liabilities,

assets and off-balance sheet positions into time buckets according to residual
maturity or next re-pricing period, whichever is earlier. All investments,
advances, deposits, borrowings, purchased funds, etc. that mature/re-price
within a specified timeframe are interest rate sensitive. Similarly, any principal
repayment of loan is also rate sensitive if the FI expects to receive it within the
26
time horizon. This includes final principal repayment and interim instalments.
Certain assets and liabilities carry floating rates of interest that vary with a
reference rate and hence, these items get re-priced at pre-determined intervals.
Such assets and liabilities are rate sensitive at the time of re-pricing. While the
interest rates on term deposits and bonds are generally fixed during their
currency, the interest rates on advances could be re-priced any number of
occasions, on the pre-determined reset / re-pricing dates and the new rate
would normally correspond to the changes in PLR.
The interest rate gaps may be identified in the following time buckets:
i) 1-28 days
ii) 29 days and upto 3 months
iii) Over 3 months and upto 6 months
iv) Over 6 months and upto 1 year
v) Over 1 year and upto 3 years
vi) Over 3 years and upto 5 years
vii) Over 5 years and upto 7 years
viii) Over 7 years and upto 10 years
ix) Over 10 years
x) Non-sensitive
The various items of rate sensitive assets and liabilities and off-balance sheet
items may be classified into various time-buckets,
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate
Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that
it has more RSAs than RSLs whereas the negative Gap indicates that it has
more RSLs. The Gap reports indicate whether the institution is in a position to
benefit from rising interest rates by having a positive Gap (RSA > RSL) or
whether it is in a position to benefit from declining interest rates by a negative
Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest
rate sensitivity.
Each FI should set prudential limits on interest rate gaps in various time
buckets with the approval of the Board/ALCO. Such prudential limits should
have a relationship with the Total Assets, Earning Assets or Equity. In
27
addition to the interest rate gap limits, the FIs which are better equipped would
have the option of setting the prudential limits in terms of Earnings at Risk
(EaR) or Net Interest Margin (NIM) based on their views on interest rate
movements with the approval of the Board/ALCO.
The classification of various components of assets and liabilities into different

time buckets for preparation of Gap reports (Liquidity and Interest Rate
Sensitivity) as indicated in Appendices I & II is the benchmark. FIs which are
better equipped to reasonably estimate the behavioural pattern, embedded
options, rolls-in and rolls-out, etc of various components of assets and liabilities
on the basis of past data / empirical studies could classify them in the
appropriate time buckets, subject to approval from the ALCO / Board. A copy of
the note approved by the ALCO / Board may be sent to the Department of
Banking Supervision, Financial Institutions Division.
The impact of embedded options (i.e. the customers exercising their options for
premature closure of term deposits, premature encashment of bonds and pre-
payment of loans and advances) on the liquidity and interest rate risks profile of
FIs and the magnitude of embedded option risk during the periods of volatility in
market interest rates, is quite substantial. FIs should therefore evolve suitable
mechanism, supported by empirical studies and behavioural analysis, to
estimate the future behaviour of assets, liabilities and off-balance sheet items
to changes in market variables and estimate the impact of embedded options.
In the absence of adequate historical database, the entire amount payable
under the embedded options should be slotted as per the residual period to the
earliest exercise date.
A scientifically evolved internal transfer pricing model by assigning values on
the basis of current market rates to funds provided and funds used is an
important component for effective implementation of ALM System. The transfer
price mechanism can enhance the management of margin i.e. lending or credit
spread, the funding or liability spread and mismatch spread. It also helps
centralising interest rate risk at one place which facilitate effective control and
management of interest rate risk. A well defined transfer pricing system also
provide a rational framework for pricing of assets and liabilities.
28
REVIEW OF EXISTING LITERATURE SUMMARY
The article is remark from Wlliam J McDonough on risk management,
supervision and the new Basel Accord. According to the article in recent times
the are fail to develop the commitment to manage risk appropriately to avoid
this recent past requires a clear and consisted message, as well as transparent
pattern of behaviour. Also according to william the work of financial
supervision is moving away from a purely retrospective,rules based
approach.this is particularly in banking world.Banks supervisor in many
countries around the world are assessing the safety and soundness of banks
based les on the strength of the balance sheet today, and more on the strength
of controls that will safeguard bank financial health tomorrow but William J
believed that evaluating the strength of control is, in itself, not enough in deed
financial sector required innovation in the good and services offered. Also the
member of basel committee believes that public policy can best support the
enhancement of risk management by building incentives directly to their system
of supervision. According to William J the whole article based on how
supervisor have worked to embrace and encourage the developments, how
enhancement in banks risk management processes, driven by business
imperatives, have concurrently led supervisor to move to a more process-
oriented, risk focused approach to supervision. Secondly how provision in New
Basel Accord support further changes in there supervisory approach, and
promote further enhancement in risk management of market risk and thirdly
how those development will be coming together in there supervisory approach
going forward-particularly in terms of there supervisory expections for
management of market risk, credit risk and operational risk by large banking
organization.
29
Summary of article
The following article has been delivered by Dr Rakesh Mohan, Deputy

Governer of the Reserve Bank of India. The article highlight the need to work
toward reducing the real lending rates of banks. Also it focused on the need to
increase credit to SMEs as also look into aspects of creating an enabling
environment for long term financing. The article also state about the NPAs level
,the absolute amount of NPAs continues to be a major drag on the performance
of banks. The large volume of NPAs reflects both an overhang of past dues
and on-going problems of fresh accretion. Therefore reducing in NPA level and
appropriate risk management by banks would go a long way in improving
efficiency of banks and inculcating a sound credit culture
30
CHAPTER – 3
31
HISTORY AND GROWTH OF ICICI BANK
ICICI Bank Ltd. was formed in 1994 as a new private sector bank. Its initial
equity capital of Rs 150 crores was fully subscribed by ICICI, and as a result,
ICICI Bank became a wholly owned subsidiary of ICICI.
In May 1994, when ICICI obtained its commercial banking license to establish
ICICI Bank, the Reserve Bank of India (RBI) imposed a condition regarding
dilution of promoter’s holding in the bank. This condition required ICICI to
reduce its shareholding in ICICI Bank in stages, first to not more than 75% of its
equity share capital, and ultimately to not more than 40%. This took place in the
following ways:
Year Amount
(FY) Event Raised (Rs.) Holding of ICICI
IPO of 15 million equity shares
of Rs. 10 each at a price of
1998 Rs. 35 per share 52.5 crores 74.80%
ADR issue on NYSE for
2000 US$175 million 763.4 crores 62.20%
2001 Acquisition of Bank of Madura 236 crores 55.60%
(BOM): 2 equity shares in lieu
of every 1 share of BOM
Disinvestment of shares by
ICICI 19.39 crores 46.40%
Disinvestment of shares by 46%(on August
2002 ICICI 0.88 crores 2002)
During 2001, the senior managements of ICICI and ICICI Bank explored the
possibility amalgamation of ICICI with ICICI Bank. As a bank, ICICI would have
the ability to accept low-cost demand deposits and offer wider range on
products and services. In view of such benefits and RBI’s guidelines on
universal banking, ICICI explored various corporate restructuring alternatives
for its transformation into a universal bank. Subsequently, the shareholders of
both the institutions approved such amalgamation and the exchange ratio
32
determined was 1 fully paid-up equity share of ICICI Bank in lieu of 2 fully paid-
up equity shares of ICICI. As a result of such amalgamation, which was
approved by RBI on April 26, 2002, the paid-up capital increased to Rs. 613
crores. The scheme of amalgamation became effective on May 3, 2002.
RBI approved the merger subject to the following major conditions:
 Compliance with Reserve Requirements: ICICI Bank would comply with

the Cash Reserve Requirements (CRR) and Statutory Liquidity Reserve
(SLR) Requirements as applicable to banks on the net demand and time
liabilities of the bank, inclusive of the liabilities pertaining to ICICI from
the date of merger.
 Other Prudential Norms: ICICI Bank will continue to comply with all
prudential requirements and other instructions as applicable to banks
issued by RBI from time to time on the entire portfolio of assets and
liabilities of the bank after the merger.
 Priority Sector Lending: considering that the advances of ICICI were not
subject to the requirement applicable to banks in respect of priority
sector lending, ICICI Bank would after merger, maintain an additional
10% over and above the requirement of 40%, i.e., a total of 50% of the
net bank credit on the residual portion of the bank’s advances. This
additional 10% will apply until such time as the aggregate priority sector
advances reaches a level of 40% of the total net bank credit.
 Equity Exposure Ceiling of 5%: The investments of ICICI acquired by

way of project finance as on the date of merger would be kept outside
the exposure ceiling of 5% of advances towards exposure to equity and
equity-linked instruments for a period of 5 years. ICICI Bank should,
however, mark-to-market the above instruments and provide for any loss
in their value in the manner prescribed for investments.
33
Following the amalgamation, ICICI Bank has become the second largest
among all scheduled commercial banks (SCBs) in India, ranked on the basis of
their total assets, coming after the State Bank of India.
At end-FY2002, ICICI Bank had a network of 359 branches and 44 extension

counters in 251 centers across several India states. Nearly 51% (183
branches) of ICICI’s branches are in urban/metropolitan areas. The balance is
in rural/semi-urban areas. Till this time ICICI Bank had also installed 1,000
ATMs.
SUBSIDIARIES
At end-FY2001, ICICI Bank had no subsidiaries. Consequent to the merger,

ICICI’s subsidiary companies have become subsidiaries of ICICI Bank. At end-
FY2002, ICICI Bank had 11 subsidiaries. The major subsidiaries are described
below:
1. ICICI Securities and Finance Co. Ltd. - performs key merchant baking
activities including underwriting, placement of debt and equity, issue
management and corporate advisory services.
2. ICICI Brokerage Services Ltd. – engaged in security brokerage activities

on NSE and BSE.
3. ICICI Securities Holdings Inc. – incorporated in the US, this arm has
been set up to provide investment banking services to investors in the
US who wish to enter the Indian financial market and to investors in
India who wish to enter the financial markets in the US.
4. ICICI Securities Inc. – incorporated in the US, this subsidiary has been
set up to provide brokerage, research and investment banking services
to investors in the US who wish to enter the Indian financial markets.
5. ICICI Venture Funds Management Co. Ltd. – provides venture capital

funding to a wide spectrum of industrial sectors.
6. ICICI Prudential Life Insurance Co. Ltd. – carries out the business of Life
Insurance. This subsidiary has entered into an MoU with ICICI Bank for
34
distribution of its life insurance policies through the bank’s branch
network.
7. ICICI Lombard General Insurance Co. Ltd. – carries out the business of
general insurance.
8. ICICI Home Finance Co. Ltd. – provides finance for housing.
35
MANAGEMENT
The management team of ICICI Bank consists of the following individuals who
are very well qualified, possess rich experience and are competent
professionals from their field.
Name Designation
Mr. K.V. Kamath Managing Director & CEO
Mr. H.N. Sinor Joint Managing Director; In charge of domestic banking
Joint Managing Director; In charge of international
Ms. Lalita D. Gupte business
Ms. Kalpana Morparia Executive Director; In charge of legal department
Mr. S. Mukherji Executive Director; In charge project finance
Ms. Chanda D.
Kochhar Executive Director, In charge of retail banking
Dr. Nachiket Mor Executive Director, In charge of wholesale banking
BUSINESS & OPERATIONS
ICICI Bank’s asset base of Rs. 1,041 billion (at end FY2002) places it as the
second largest scheduled commercial bank in India – behind only State Bank of
India (SBI). ICICI Bank’s asset base is nearly 4.4 times larger than the second-
largest new private sector bank in India – HDFC Bank (assets of Rs. 238 billion
as end-FY2002).
ICICI Bank’s principal activities include corporate banking, retail banking and
treasury operations.
RELATIONSHIP WITH THE GOVERNMENT
The GoI has never directly held any shares of ICICI Bank. However, GoI’s
controlled institutions held a 20.8% stake in ICICI Bank at end August 2002.
These include the LIC (8.6%), the GIC and it’s subsidiaries (7.3%), UTI (3.3%),
and others (1.6%). Under the terms of the loan and guarantee facilities
provided by the GoI to ICICI that have been transferred to ICICI Bank, the GoI
36
is entitled to appoint and has appointed one representative to the BoD of ICICI
Bank. Comparison of key ratios is done on the basis of previous year and the
current year.
37
RISK MANAGEMENT AT ICICI
Risk is an inherent part of ICICI Bank’s business, and effective Risk
Compliance & Audit Group is critical to achieving financial soundness and
profitability. ICICI Bank has identified Risk Compliance & Audit Group as one of
the core competencies for the next millennium. The Risk Compliance & Audit
Group Group (RC & AG) at ICICI Bank benchmarks itself to international best
practices so as to optimise capital utilisation and maximise shareholder value.
With well defined policies and procedures in place, ICICI Bank identifies,
assesses, monitors and manages the principal risks:
• Credit risk (the possibility of loss due to changes in the quality of

counterparties)
• Market Risk (the possibility of loss due to changes in market prices and
rates of securities and their levels of volatility)
• Operational risk (the potential for loss arising from breakdowns in

policies and controls, human error, contracts, systems and facilities)
The ability to implement analytical and statistical models is the true test of a risk
methodology. In addition to three departments within the Risk Compliance &
Audit Group handling the above risks, an Analytics Unit develops quantitative
techniques and models for risk measurement.
CREDIT RISK MANAGEMENT
Credit risk, the most significant risk faced by ICICI Bank, is managed by the
Credit Risk Compliance & Audit Department (CRC & AD) which evaluates risk
at the transaction level as well as in the portfolio context. The industry analysts
of the department monitor all major sectors and evolve a sectoral outlook,
which is an important input to the portfolio planning process. The department
has done detailed studies on default patterns of loans and prediction of defaults
in the Indian context. Risk-based pricing of loans has been introduced.
The functions of this department include:
• Review of Credit Origination & Monitoring
• Credit rating of companies/structures
38
• Default risk & loan pricing
• Review of industry sectors
• Review of large exposures in industries/ corporate groups/

companies
• Ensure Monitoring and follow-up by building appropriate

systems such as CAS
• Design appropriate credit processes, operating policies & procedures
• Portfolio monitoring
• Methodology to measure portfolio risk
• Credit Risk Information System (CRIS)
• Focussed attention to structured financing deals
• Pricing, New Product Approval Policy, Monitoring
• Monitor adherence to credit policies of RBI
During the year, the department has been instrumental in reorienting the credit
processes, including delegation of powers and creation of suitable control
points in the credit delivery process with the objective of improving customer
response time and enhancing the effectiveness of the asset creation and
monitoring activities.
Availability of information on a real time basis is an important requisite for

sound risk management. To aid its interaction with the strategic business units,
and provide real time information on credit risk, the CRC & AD has
implemented a sophisticated information system, namely the Credit Risk
Information System. In addition, the CRC & AD has designed a web-based
system to render information on various aspects of the credit portfolio of ICICI
Bank.
MARKET RISK COMPLIANCE & AUDIT GROUP
ICICI Bank is exposed to all categories of Market Risk, viz.,
• Interest Rate Risk (risk due to changes in interest rates)
39
• Exchange Rate Risk (risk due to changes in exchange rates)
• Equity Risk (risk due to change in equity prices)
• Liquidity Risk (risk due to deterioration in market liquidity for tradable

instruments)
The Market Risk Compliance & Audit Department evaluates, tests and
approves market risk methodologies developed by the Treasury. It also
participates in the new product approval process on a firm-wide basis and
evaluates all new products from a market risk perspective
OPERATIONAL RISK MANAGEMENT
ICICI Bank, like all large banks, is exposed to many types of operational risks.
These include potential losses caused by events such as breakdown in
information, communication, transaction processing and settlement systems/
procedures.
The Audit Department, an integral part of the Risk Compliance & Audit Group,
focusses on the operational risks within the organisation. In recent times, there
has been a shift in the audit focus from transactions to controls. Some
examples of this paradigm shift are: Adherence to internal policies, procedures
and documented processes Risk Based Audit Plan Widening of Treasury
operations audit coverage Use of Computer Assisted Audit Techniques
(CAATs) Information Systems Audit Plans to develop/ buy software to capture
the workflow of the Audit Department
The Audit Department conceptualised and put into operation a Risk Based
Audit Plan during the year 1998-99. The Risk Based Audit Plan envisages
allocation of audit resources in accordance with the risk constituents of ICICI
Bank’s business.
40
CHAPTER – 4
41
PERFORMANCE OF ICICI BANK
1) Credit-Deposit (%): This ratio is compared as under:
We notice that in the year 1997 credit deposit ratio is 69.8% which fell to
21.37% in the year 1998. In 1999 it further drop to 11.22%. In 2000 it drop
to 1.03%. In the year 2001 it rose to 4.55%. In the year 2002 it rose to
70.83%.
2) Investment/Deposit (%): This ratio is compared as under:
We notice that in the year 1997 investment ratio is 33.64% it rose to 3.04%
in the year 1998. In the year 1999 again it rose to 7.96%. In the year 2000 it
rose to 1.02%. In the year 2001 it rose to 2.36%.In the year 2002 it rose to
42.93% which is a significant increase.
3) Cash /Deposit(%) : This ratio is compared as under:
We notice that in the year 1997 Cash /deposit ratio is 12.27% which fell to
0.69% in the year 1998. In the year 1999 it again fell to 2.66%. In the year
2000 it fell to 1.47%.In the year 2001 it again fell to 0.01%.In the year 2002
it fell to 1.24%.
4) Interest Expended/Interest Earned(%): this ratio is compared as under :
We notice that In the year 1997 interest earned(%) is 64.1% which rose
to7.78%.in the year 1998. again it rose to 6.33%. in the year 1999. in the
year 2000 it fell to 0.01%. in the year 2001 again it fell to 10.76%. in the
year 2002 it fell to 5%.
5) Other Income/Total Income(%) : this ratio is compared as under:
We notice that in the year 1997 percentage of other income/total income is

18.93% which rose to 5.75% in the year 1998. In the year 1999 it fell to
10.6%. In the year 2000 there is a significant increase of 4.47%. in the year
2001 it fell to 3.1%. in the year 2002 It rose to 6.5%.
6) Operating Expenses/Total Income(%) : This ratio is compared as under :
We notice that the percentage of operating expenses in the year 1997 is

17.98% which fell to 1.26% in the year 1998.In the year 1999 again it fell to
42
3.6%.In the year 2000 it rose to 0.59%.in the year 2001 it rose to 8.36%.in
the year 2002 it rose to 0.71%.
7) Interest Income/Total funds(%): this ratio is compared as under:
We notice that percentage of interest income in the year 1997 is 12.43%

which fell to 2.17% in the year 1998.In the year 1999 it rose to 0.34%.in the
year 2000 it fell to 1.65%.in the year 2001 it fell to 1.14%.in the year 2002 it
further fell to 4.33%.
8) Interest Expended/Total Funds(%) : this ratio is compared as under
1997:- 7.97%
1998:-0.59%(decrease)
1999: 0.91%(increase)
2000:1.29%(decrease)
9) Net interest income/Total funds(%) : This ratio is compared as under
1997 : 4.46%
1998 : 1.57%(decrease which take it to 2.89%)
1999 : 0.58%(decrease which take it to 2.31%)
2000 : 0.36%( decrease)
2001 : 0.59%(increase)
2002 : 1.58%(decrease)
10) Non interest income/total funds(%) : this ratio is compared as under
1997 :2.9%
1998:0.46%(increase)
2000: 0.3%(increase)
2001 :0.61%(decrease)
43
11. Operating expense/Total funds(%) : this ratio is compared as under :
1997 :2.76%
1998 :0.48%(decrease)
1999:0.66%(decrease further)
12.) Profit before provisions/total funds(%) : comparison of this I s done as

under:
1997 : 4.61%
1998 :0.64%(decrease)
13.) Net Profit/Total funds(%): comparison of this is given as under:
1997: 2.73%
1998 :0.75%(decrease)
2001:0.1%(decrease)
14.) RONW(%) : Comparison of this is done as under :
1997:23.7%
44
GAP ANALYSIS
Outflow 1-14 15-28 29-3 3-6 6-1 year 1-3 year 3-5 year Above 5 Total
days days months months
Deposits 315206 92177 481706 277906 579855 1289359 40318 14421 3090948
Borrowings 99649 149971 441520 322932 894286 1416256 395130 284823 4004567
Total 414855 242148 923226 600838 1474141 2705615 435448 299244 7095515
Inflow
Loans/adv. 82564 35692 255294 233150 371087 1322562 763733 1370069 4424151
Invest/Sect. 131998 68624 289018 267530 521877 736576 447461 1155706 3618790
Total 214562 104316 544312 500680 892964 2059138 121119 2525775 8052941
4
Mismatch -200293 -137832 -378914 -100158 -581177 -646477 775746 2226531 1603903
(B-A)
Gap report indicates that there is a mismatch in the maturity buckets of 1-14
days to 1-3 years. However this means RSL>RSA this shows the bank in a
position to benefit from declining interest rate by a negative gap.
45
ICICI BANK
FINANCIAL
OVERVIEW
2002-03 2001-03 2000-03 1999-03 1998-03 1997-03
Equity Paid Up 220.36 196.82 196.82 165 165 150

Networth 5855.9 1289.08 1149.51 308.33 266.75 181.88
Capital Employed 104109.92 19736.59 12072.63 6981.68 3279.43 1781.87
Gross Block 4494.29 589.67 315.14 261.57 218.97 110.58
Sales 2151.93 1242.13 852.87 544.05 259.7 182.68
PBIDT 1912.31 1100.57 823.64 536.41 271.67 178.86
PBDT 353.39 262.9 156.69 110.89 84.99 61.77
PBIT 1848.22 1063.82 798.85 518.88 257.2 170.62
PBT 289.3 226.15 131.9 93.36 70.52 53.53
PAT 258.3 161.1 105.3 63.36 50.22 40.13
CP 322.39 197.85 130.09 80.89 64.69 48.37
Revenue earnings 0 0 0 0 0 0
in forex
Revenue expenses 0 0 0 0 0 0
in forex
Book Value (Unit 265.74 65.5 58.4 18.69 16.17 12.13
Curr)
Market 2732.46 3255.4 5117.32 452.1 755.7 0
Capitalisation
CEPS (annualised) 14.43 9.82 6.47 4.78 3.82 3.22
(Unit Curr)
EPS (annualised) 11.52 7.96 5.21 3.72 2.95 2.68
(Unit Curr)
Dividend 20 20 15 12 10 10
(annualised%)
Payout (%) 17.36 28.14 24.13 32.26 33.4 37.38
Cash Flow From 2241.2 -394.02 1091.57 662.9 568.37 281.8
Operating Activities
Cash Flow From -23.68 -78.39 -56.03 -47.69 -105.9 -60.11
Investing Activities
Cash Flow From 131.4 -27.47 741.37 150.15 37.5 -11.73
Financing Activities
Rate of Growth (%)
Net Worth (%) 354.27 12.14 272.82 15.59 46.66 16.03
Capital Employed 427.5 63.48 72.92 112.89 84.04 53.97
(%)
Gross Block (%) 662.17 87.11 20.48 19.45 98.02 110.75
Sales (%) 73.25 45.64 56.76 109.49 42.16 57.31
PBIDT (%) 73.76 33.62 53.55 97.45 51.89 68.83
PBDT (%) 34.42 67.78 41.3 30.47 37.59 193.86
PBIT (%) 73.73 33.17 53.96 101.74 50.74 68.21
PBT (%) 27.92 71.46 41.28 32.39 31.74 224.23
PAT (%) 60.34 52.99 66.19 26.16 25.14 143.06
CP (%) 62.95 52.09 60.82 25.04 33.74 130.11
Revenue earnings 0 0 0 0 0 0
46
in forex (%)
Revenue expenses 0 0 0 0 0 0
in forex (%)
Market -16.06 -36.38 1031.9 -40.17 0 0
Capitalisation (%)
Key Ratios
Credit-Deposit(%) 111.56 40.73 36.18 37.21 48.43 69.8
Investment / 90.95 48.02 45.66 44.64 36.68 33.64
Deposit (%)
Cash / Deposit (%) 6.2 7.44 7.45 8.92 11.58 12.27
Interest Expended / 72.44 67.44 78.2 78.21 71.88 64.1
Interest Earned (%)
Other Income / 21.95 15.45 18.55 14.08 24.68 18.93
Total Income (%)
Operating 22.78 22.07 13.71 13.12 16.72 17.98
Expenses / Total
Income (%)
Interest Income / 3.48 7.81 8.95 10.6 10.26 12.43
Total Funds (%)
Interest Expended / 2.52 5.27 7 8.29 7.38 7.97
Total Funds (%)
Net Interest 0.96 2.54 1.95 2.31 2.89 4.46
Income / Total
Funds (%)
Non Interest 0.98 1.43 2.04 1.74 3.36 2.9
Income / Total
Funds (%)
Operating 1.01 2.04 1.51 1.62 2.28 2.76
Expenses / Total
Funds (%)
Profit before 0.92 1.93 2.48 2.43 3.97 4.61
Provisions / Total
Funds (%)
Net Profit / Total 0.42 1.01 1.11 1.23 1.98 2.73
funds (%)
RONW (%) 7.23 13.21 14.45 22.04 22.39 23.7
BS
200203 200103 200003 199903 199803 199703
CAPITAL AND
LIABILITIES
Capital + 220.36 196.82 196.82 165 165 150

Reserves and 5635.54 1092.26 952.69 143.33 101.75 31.88
Surplus +
Deposits + 32085.11 16378.21 9866.02 6072.94 2629.02 1347.6
Borrowings + 48681.21 1032.79 491.47 199.89 192.23 92.99
Other Liabilities & 17487.7 1036.51 565.63 400.52 191.43 159.4
Provisions +
TOTA 104109.92 19736.59 12072.63 6981.68 3279.43 1781.87

L
47
ASSETS
Cash & Balances 1774.47 1231.66 721.89 465.81 310.09 150.34

with RBI
Balances with 11011.88 2362.03 2693.27 1172.44 562.79 222.58
Banks & money at
Call & Short Notice
Investments + 35891.08 8186.86 4416.68 2861.23 1023.39 435.35
Advances + 47034.87 7031.46 3657.35 2110.12 1127.87 798
Fixed Assets + 4239.34 384.75 222.12 199.64 183.7 96.37
Other Assets + 4158.28 539.83 361.32 172.44 71.59 79.23
TOTAL 104109.92 19736.59 12072.63 6981.68 3279.43 1781.87
Contingent 39446.59 13848.01 9780.47 5013.97 2906.24 1495.76

Liabilities +
Bills for collection 1323.42 1229.8 761.44 438.46 218.19 123.01
PL
200203 (12) 200103 (12) 200003 (12) 199903 (12) 199803 (12) 199703 (12)
I. INCOME :
Interest Earned + 2151.93 1242.13 852.87 544.05 259.7 182.68
Other Income + 605.02 226.96 194.19 89.14 85.09 42.65
TOTAL 2756.95 1469.09 1047.06 633.19 344.79 225.33
II.
EXPENDITURE :
Interest expended 1558.92 837.67 666.95 425.52 186.68 117.09
+
Operating 628.09 324.28 143.54 83.08 57.65 40.51
Expenses +
Provisions & 311.64 146.04 131.27 61.23 50.24 27.6
Contingencies +
TOTAL 2498.65 1307.99 941.76 569.83 294.57 185.2
III. PROFIT/LOSS
Net Profit for the 258.3 161.1 105.3 63.36 50.22 40.13
year
Prior Year 0 0 0 0 0 0
Adjustments +
Profit brought 0.83 0.8 0.13 0.39 0.02 0.39
forward
TOTAL 259.13 161.9 105.43 63.75 50.24 40.52
IV.
APPROPRIATIONS
Transfer to 65 80 25 20 27 25.5
Statutory Reserves
Transfer to Other 126 32.5 52.82 21.84 5 0
Reserves +
Proposed Dividend / 48.57 48.57 27.47 21.78 17.85 15
Transfer to
Government +
Balance c/f to 19.56 0.83 0.14 0.13 0.39 0.02
Balance Sheet
48
TOTAL 259.13 161.9 105.43 63.75 50.24 40.52
Equity Dividend 44.07 44.07 24.75 19.8 16.23 15

Corporate Dividend 4.5 4.5 2.72 1.98 1.62 0
Tax
Equity Dividend (%) 20 20 15 12 10 10
Earning Per Share 11.52 7.96 5.21 3.72 2.95 2.68

(Rs.)(Unit Curr.)
Book Value(Unit 265.74 65.5 58.4 18.69 16.17 12.13
Curr.)
Extraordinary Items -0.03 -0.09 -0.1 -0.07 -0.03 -0.03
+
BS SCHEDULES
200203 200103 200003 199903 199803 199703
CAPITAL AND
LIABILITIES
Capital
Equity Authorised 300 300 300 300 300 300
Preference Capital 0 0 0 0 0 0
Authorised
Unclassified 0 0 0 0 0 0
Authorised
Equity Issued 220.36 196.82 196.82 165 165 150
Equity Subscribed 220.36 196.82 196.82 165 165 150
Equity Called Up 220.36 196.82 196.82 165 165 150
Less : Equity Calls 0 0 0 0 0 0
in Arrears
Equity Forfeited 0 0 0 0 0 0
Equity Suspense 392.67 23.54 0 0 0 0
Adjustments to 0 0 0 0 0 0
equity
Equity Paid Up 220.36 196.82 196.82 165 165 150
Preference Capital 0 0 0 0 0 0
Paid Up
Unclassified Shares 0 0 0 0 0 0
paid -up
TOTAL CAPITAL 220.36 196.82 196.82 165 165 150
Equity converted 0 0 0 0 0 0
during the year
GDRs Issued 0 0 0 0 0 0
During the Year
Bonus in Equity 0 0 0 0 0 0
Reserves and
Surplus
Contingency 0 0 0 0 0 0
Reserve
Other Statutory 249.43 184.43 103.86 78.86 58.86 31.86
Reserve
Capital Reserves 0 0 0 0 0 0
Capital Redemption 0 0 0 0 0 0
Reserve
Debt Redemption 0 0 0 0 0 0
49
Reserve
Debenture 10 0 0 0 0 0
Redemption
Reserve
Exchange 0 0 0 0 0 0
fluctuation Reserve
Amalgamation 0 0 0 0 0 0
Reserve
Share Premium 804.54 804.54 769.03 37.5 37.5 0
Revenue & other 4524.67 91.12 79.66 26.84 5 0
Reserves
Other Reserves 27.34 11.34 0 0 0 0
Profit & Loss A/c 19.56 0.83 0.14 0.13 0.39 0.02
TOTAL RESERVES 5635.54 1092.26 952.69 143.33 101.75 31.88
EXCLUDING
REVALUATION
RESERVE
Revaluation 0 0 0 0 0 0
Reserve
TOTAL RESERVES 5635.54 1092.26 952.69 143.33 101.75 31.88
AND SURPLUS
Deposits
Demand Deposits 2736.15 2621.86 1587.47 576.62 363.17 316.33
Saving Deposits 2497 1880.64 533.26 227.12 103.74 49.67
Term & Other 26851.96 11875.71 7745.29 5269.2 2162.11 981.6
Deposits
TOTAL DEPOSITS 32085.11 16378.21 9866.02 6072.94 2629.02 1347.6
Borrowings
Borrowings in India 140.89 301.24 218.67 148.48 0 0
- RBI
Borrowings in India 2687.6 397.8 192.18 41.77 29.29 80.04
-Other Banks
Borrowings in India 9265.09 333.75 80.62 9.64 162.94 12.95
-Other agencies
Borrowings outside 22709.97 0 0 0 0 0
India
Convertible 0 0 0 0 0 0
Debentures
Non Convertible 13744.47 0 0 0 0 0
Debentures
Partly Convertible 133.19 0 0 0 0 0
Debentures
Less : Debentures 0 0 0 0 0 0
Calls in arrears
TOTAL 48681.21 1032.79 491.47 199.89 192.23 92.99
BORROWINGS
Secured Borrowings 0 0 0 0 0 0
included above
Other Liabilities &

Provisions
Bills Payable 817.33 380.56 142.2 112.19 107.81 68.79
Inter Office 33.05 0 0 0 0 0
Adjustment (Net)
Interest Accrued 2289.51 55.65 33.52 23.49 17.56 5.67
Share Application 1280.12 23.54 0 0 0 0
50
Money
Unclaimed Dividend 0 0 0 0 0 0
Other Liabilities 13067.69 576.76 389.91 264.84 66.06 84.94
(Including
Provisions)
TOTAL OTHER 17487.7 1036.51 565.63 400.52 191.43 159.4
LIABILITIES AND
PROVISIONS
TOTAL 104109.92 19736.59 12072.63 6981.68 3279.43 1781.87
ASSETS
Cash & Balances 1774.47 1231.66 721.89 465.81 310.09 150.34

with RBI
Balances with Banks & 11011.88 2362.03 2693.27 1172.44 562.79 222.58
money at Call & Short
Notice
Investments
Quoted Government 22722.31 4070.44 2814.94 1527.36 704.67 313.36
Securities
Other Approved 70.46 41.49 0 0 0 0
Secutires
Shares 1908.65 125.12 160.95 138 47.03 10.47
Debentures & 6436.36 3070.08 1137.22 666.61 216.51 69.34
Bonds
Investment in 608.18 0 0 0 0 0
Subsidiaries
Units 0 0 0 0 0 0
Other Investments 4145.12 879.73 303.57 529.26 55.18 42.18
TOTAL 35891.08 8186.86 4416.68 2861.23 1023.39 435.35
INVESTMENTS
Market Value of 0 0 0 0 0 0
Quoted Investments
Advances
Bills Purchased & 2484.7 1087.04 701.3 454.96 140.92 76.4
Discounted
Cash Credits, 2402.51 4970.91 2577.67 1383.5 841.59 632.1
Overdraft & Loans
Repayable on
Demand
Term Loans 42147.66 973.51 378.38 271.66 145.36 89.5
TOTAL ADVANCES 47034.87 7031.46 3657.35 2110.12 1127.87 798
Fixed Assets
Premises 1443.17 203.09 144.74 130.21 106.62 28.82
Other Fixed Assets 3051.12 386.58 170.4 131.36 112.35 81.76
Gross Block 4494.29 589.67 315.14 261.57 218.97 110.58
Accumulated 254.95 204.92 93.02 61.93 35.27 14.21
Depreciation
Net Block 4239.34 384.75 222.12 199.64 183.7 96.37
Capital Work-in- 0 0 0 0 0 0
Progress
51
TOTAL FIXED 4239.34 384.75 222.12 199.64 183.7 96.37
ASSETS
52
RISK MANAGEMENT GUIDELINES FOR COMMERCIAL BANKS
Introduction
Banks in the process of financial intermediation are confronted with various

kinds of financial and non-financial risks viz., credit, interest rate, foreign
exchange rate, liquidity, equity price, commodity price, legal, regulatory,
reputational, operational, etc. These risks are highly interdependent and events
that affect one area of risk can have ramifications for a range of other risk
categories. Thus, top management of banks should attach considerable
importance to improve the ability to identify, measure, monitor and control the
overall level of risks undertaken.
The broad parameters of risk management function should encompass:

i) organizational structure;
ii) comprehensive risk measurement approach;
iii) risk management policies approved by the Board which should be
consistent with the broader business strategies, capital strength,
management expertise and overall willingness to assume risk;
iv) guidelines and other parameters used to govern risk taking including
detailed structure of prudential limits;
v) strong MIS for reporting, monitoring and controlling risks;
vi) well laid out procedures, effective control and comprehensive risk
reporting framework;
vii) separate risk management framework independent of operational
Departments and with clear delineation of levels of responsibility for
management of risk; and
viii) periodical review and evaluation.
RISK MANAGEMENT STRUCTURE
A major issue in establishing an appropriate risk management organisation

structure is choosing between a centralised and decentralised structure. The
global trend is towards centralising risk management with integrated treasury
management function to benefit from information on aggregate exposure,
53
natural netting of exposures, economies of scale and easier reporting to top
management. The primary responsibility of understanding the risks run by the
bank and ensuring that the risks are appropriately managed should clearly be
vested with the Board of Directors. The Board should set risk limits by
assessing the bank’s risk and risk-bearing capacity. At organisational level,
overall risk management should be assigned to an independent Risk
Management Committee or Executive Committee of the top Executives that
reports directly to the Board of Directors. The purpose of this top level
committee is to empower one group with full responsibility of evaluating overall
risks faced by the bank and determining the level of risks which will be in the
best interest of the bank. At the same time, the Committee should hold the line
management more accountable for the risks under their control, and the
performance of the bank in that area. The functions of Risk Management
Committee should essentially be to identify, monitor and measure the risk
profile of the bank. The Committee should also develop policies and
procedures, verify the models that are used for pricing complex products,
review the risk models as development takes place in the markets and also
identify new risks. The risk policies should clearly spell out the quantitative
prudential limits on various segments of banks’ operations. Internationally, the
trend is towards assigning risk limits in terms of portfolio standards or Credit at
Risk (credit risk) and Earnings at Risk and Value at Risk (market risk). The
Committee should design stress scenarios to measure the impact of unusual
market conditions and monitor variance between the actual volatility of portfolio
value and that predicted by the risk measures. The Committee should also
monitor compliance of various risk parameters by operating Departments.
A prerequisite for establishment of an effective risk management system is the
existence of a robust MIS, consistent in quality. The existing MIS, however,
requires substantial upgradation and strengthening of the data collection
machinery to ensure the integrity and reliability of data.
The risk management is a complex function and it requires specialised skills

and expertise. Banks have been moving towards the use of sophisticated
models for measuring and managing risks. Large banks and those operating in
international markets should develop internal risk management models to be
54
able to compete effectively with their competitors. As the domestic market
integrates with the international markets, the banks should have necessary
expertise and skill in managing various types of risks in a scientific manner. At
a more sophisticated level, the core staff at Head Offices should be trained in
risk modelling and analytical tools. It should, therefore, be the endeavour of all
banks to upgrade the skills of staff.
Given the diversity of balance sheet profile, it is difficult to adopt a uniform

framework for management of risks in India. The design of risk management
functions should be bank specific, dictated by the size, complexity of functions,
the level of technical expertise and the quality of MIS. The proposed guidelines
only provide broad parameters and each bank may evolve their own systems
compatible to their risk management architecture and expertise.
Internationally, a committee approach to risk management is being adopted.

While the Asset - Liability Management Committee (ALCO) deal with different
types of market risk, the Credit Policy Committee (CPC) oversees the credit
/counterparty risk and country risk. Thus, market and credit risks are managed
in a parallel two-track approach in banks. Banks could also set-up a single
Committee for integrated management of credit and market risks. Generally,
the policies and procedures for market risk are articulated in the ALM policies
and credit risk is addressed in Loan Policies and Procedures.
Currently, while market variables are held constant for quantifying credit risk,
credit variables are held constant in estimating market risk. The economic
crises in some of the countries have revealed a strong correlation between
unhedged market risk and credit risk. Forex exposures, assumed by
corporates who have no natural hedges, will increase the credit risk which
banks run vis-à-vis their counterparties. The volatility in the prices of collateral
also significantly affects the quality of the loan book. Thus, there is a need for
integration of the activities of both the ALCO and the CPC and consultation
process should be established to evaluate the impact of market and credit risks
on the financial strength of banks. Banks may also consider integrating market
risk elements into their credit risk assessment process.
55
CREDIT RISK
Lending involves a number of risks. In addition to the risks related to
creditworthiness of the counter party, the banks are also exposed to
interest rate, forex and country risks.
Credit risk or default risk involves inability or unwillingness of a customer or
counter party to meet commitments in relation to lending, trading, hedging,
settlement and other financial transactions. The Credit Risk is generally made
up of transaction risk or default risk and portfolio risk. The portfolio risk in turn
comprises intrinsic and concentration risk. The credit risk of a bank’s portfolio
depends on both external and internal factors. The external factors are the
state of the economy, wide swings in commodity/equity prices, foreign
exchange rates and interest rates, trade restrictions, economic sanctions,
Government policies, etc. The internal factors are deficiencies in loan
policies/administration, absence of prudential credit concentration limits,
inadequately defined lending limits for Loan Officers/Credit Committees,
deficiencies in appraisal of borrowers’ financial position, excessive dependence
on collateral’s and inadequate risk pricing, absence of loan review mechanism
and post sanction surveillance, etc.
Another variant of credit risk is counter party risk. The counter party risk arises
from non-performance of the trading partners. The non-performance may arise
from counter party’s refusal/inability to perform due to adverse price
movements or from external constraints that were not anticipated by the
principal. The counter party risk is generally viewed as a transient financial risk
associated with trading rather than standard credit risk.
The management of credit risk should receive the top management’s attention
and the process should encompass:
a) Measurement of risk through credit rating/scoring;
b) Quantifying the risk through estimating expected loan losses i.e. the amount
of loan losses that bank would experience over a chosen time horizon
(through tracking portfolio behaviour over 5 or more years) and unexpected
loan losses i.e. the amount by which actual losses exceed the expected loss
(through standard deviation of losses or the difference between expected
loan losses and some selected target credit loss quantile);
c) Risk pricing on a scientific basis; and
56
d) Controlling the risk through effective Loan Review Mechanism and portfolio
management.
The credit risk management process should be articulated in the bank’s Loan
Policy, duly approved by the Board. Each bank should constitute a high level
Credit Policy Committee, also called Credit Risk Management Committee or
Credit Control Committee etc. to deal with issues relating to credit policy and
procedures and to analyse, manage and control credit risk on a bank wide
basis. The Committee should be headed by the Chairman/CEO/ED, and should
comprise heads of Credit Department, Treasury, Credit Risk Management
Department (CRMD) and the Chief Economist. The Committee should, inter
alia, formulate clear policies on standards for presentation of credit proposals,
financial covenants, rating standards and benchmarks, delegation of credit
approving powers, prudential limits on large credit exposures, asset
concentrations, standards for loan collateral, portfolio management, loan review
mechanism, risk concentrations, risk monitoring and evaluation, pricing of
loans, provisioning, regulatory/legal compliance, etc. Concurrently, each bank
should also set up Credit Risk Management Department (CRMD), independent
of the Credit Administration Department. The CRMD should enforce and
monitor compliance of the risk parameters and prudential limits set by the CPC.
The CRMD should also lay down risk assessment systems, monitor quality of
loan portfolio, identify problems and correct deficiencies, develop MIS and
undertake loan review/audit. Large banks may consider separate set up for
loan review/audit. The CRMD should also be made accountable for protecting
the quality of the entire loan portfolio. The Department should undertake
portfolio evaluations and conduct comprehensive studies on the environment to
test the resilience of the loan portfolio.
Instruments of Credit Risk Management

Credit Risk Management encompasses a host of management techniques,
which help the banks in mitigating the adverse impacts of credit risk.
Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers.
The banks should also evolve multi-tier credit approving system where the loan
57
proposals are approved by an ‘Approval Grid’ or a ‘Committee’. The credit
facilities above a specified limit may be approved by the ‘Grid’ or ‘Committee’,
comprising at least 3 or 4 officers and invariably one officer should represent
the CRMD, who has no volume and profit targets. Banks can also consider
credit approving committees at various operating levels i.e. large branches
(where considered necessary), Regional Offices, Zonal Offices, Head Offices,
etc. Banks could consider delegating powers for sanction of higher limits to the
‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. The
spirit of the credit approving system may be that no credit proposals should be
approved or recommended to higher authorities, if majority members of the
‘Approval Grid’ or ‘Committee’ do not agree on the creditworthiness of the
borrower. In case of disagreement, the specific views of the dissenting
member/s should be recorded.
The banks should also evolve suitable framework for reporting and evaluating
the quality of credit decisions taken by various functional groups. The quality of
credit decisions should be evaluated within a reasonable time, say 3 – 6
months, through a well-defined Loan Review Mechanism.
Prudential Limits
In order to limit the magnitude of credit risk, prudential limits should be laid
down on various aspects of credit:
a) stipulate benchmark current/debt equity and profitability ratios, debt
service coverage ratio or other ratios, with flexibility for deviations. The
conditions subject to which deviations are permitted and the authority
therefor should also be clearly spelt out in the Loan Policy;
b) single/group borrower limits, which may be lower than the limits
prescribed by Reserve Bank to provide a filtering mechanism;
c) substantial exposure limit i.e. sum total of exposures assumed in respect
of those single borrowers enjoying credit facilities in excess of a threshold
limit, say 10% or 15% of capital funds. The substantial exposure limit
may be fixed at 600% or 800% of capital funds, depending upon the
degree of concentration risk the bank is exposed;
d) maximum exposure limits to industry, sector, etc. should be set up.
There must also be systems in place to evaluate the exposures at
58
reasonable intervals and the limits should be adjusted especially when a
particular sector or industry faces slowdown or other sector/industry
specific problems. The exposure limits to sensitive sectors, such as,
advances against equity shares, real estate, etc., which are subject to a
high degree of asset price volatility and to specific industries, which are
subject to frequent business cycles, may necessarily be restricted.
Similarly, high-risk industries, as perceived by the bank, should also be
placed under lower portfolio limit. Any excess exposure should be fully
backed by adequate collaterals or strategic considerations; and
e) banks may consider maturity profile of the loan book, keeping in view the
market risks inherent in the balance sheet, risk evaluation capability,
liquidity, etc.
Risk Rating
Banks should have a comprehensive risk scoring / rating system that serves as
a single point indicator of diverse risk factors of a counterparty and for taking
credit decisions in a consistent manner. To facilitate this, a substantial degree
of standardisation is required in ratings across borrowers. The risk rating
system should be designed to reveal the overall risk of lending, critical input for
setting pricing and non-price terms of loans as also present meaningful
information for review and management of loan portfolio. The risk rating, in
short, should reflect the underlying credit risk of the loan book. The rating
exercise should also facilitate the credit granting authorities some comfort in its
knowledge of loan quality at any moment of time.
The risk rating system should be drawn up in a structured manner,

incorporating, inter alia, financial analysis, projections and sensitivity, industrial
and management risks. The banks may use any number of financial ratios and
operational parameters and collaterals as also qualitative aspects of
management and industry characteristics that have bearings on the
creditworthiness of borrowers. Banks can also weigh the ratios on the basis of
the years to which they represent for giving importance to near term
developments. Within the rating framework, banks can also prescribe certain
level of standards or critical parameters, beyond which no proposals should be
59
entertained. Banks may also consider separate rating framework for large
corporate / small borrowers, traders, etc. that exhibit varying nature and degree
of risk. Forex exposures assumed by corporates who have no natural hedges
have significantly altered the risk profile of banks. Banks should, therefore,
factor the unhedged market risk exposures of borrowers also in the rating
framework. The overall score for risk is to be placed on a numerical scale
ranging between 1-6, 1-8, etc. on the basis of credit quality. For each
numerical category, a quantitative definition of the borrower, the loan’s
underlying quality, and an analytic representation of the underlying financials of
the borrower should be presented. Further, as a prudent risk management
policy, each bank should prescribe the minimum rating below which no
exposures would be undertaken. Any flexibility in the minimum standards and
conditions for relaxation and authority therefor should be clearly articulated in
the Loan Policy.
The credit risk assessment exercise should be repeated biannually (or even at
shorter intervals for low quality customers) and should be delinked invariably
from the regular renewal exercise. The updating of the credit ratings should be
undertaken normally at quarterly intervals or at least at half-yearly intervals, in
order to gauge the quality of the portfolio at periodic intervals. Variations in the
ratings of borrowers over time indicate changes in credit quality and expected
loan losses from the credit portfolio. Thus, if the rating system is to be
meaningful, the credit quality reports should signal changes in expected loan
losses. In order to ensure the consistency and accuracy of internal ratings, the
responsibility for setting or confirming such ratings should vest with the Loan
Review function and examined by an independent Loan Review Group. The
banks should undertake comprehensive study on migration (upward – lower to
higher and downward – higher to lower) of borrowers in the ratings to add
accuracy in expected loan loss calculations.
Risk Pricing
Risk-return pricing is a fundamental tenet of risk management. In a risk-return

setting, borrowers with weak financial position and hence placed in high credit
60
risk category should be priced high. Thus, banks should evolve scientific
systems to price the credit risk, which should have a bearing on the expected
probability of default. The pricing of loans normally should be linked to risk
rating or credit quality. The probability of default could be derived from the past
behaviour of the loan portfolio, which is the function of loan loss
provision/charge offs for the last five years or so. Banks should build historical
database on the portfolio quality and provisioning / charge off to equip
themselves to price the risk. But value of collateral, market forces, perceived
value of accounts, future business potential, portfolio/industry exposure and
strategic reasons may also play important role in pricing. Flexibility should also
be made for revising the price (risk premia) due to changes in rating / value of
collaterals over time. Large sized banks across the world have already put in
place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans,
which calls for data on portfolio behaviour and allocation of capital
commensurate with credit risk inherent in loan proposals. Under RAROC
framework, lender begins by charging an interest mark-up to cover the
expected loss – expected default rate of the rating category of the borrower.
The lender then allocates enough capital to the prospective loan to cover some
amount of unexpected loss- variability of default rates. Generally, international
banks allocate enough capital so that the expected loan loss reserve or
provision plus allocated capital covers 99% of the loan loss outcomes.
There is, however, a need for comparing the prices quoted by competitors for
borrowers perched on the same rating /quality. Thus, any attempt at price-
cutting for market share would result in mispricing of risk and ‘Adverse
Selection’.
Portfolio Management
The existing framework of tracking the Non Performing Loans around the
balance sheet date does not signal the quality of the entire Loan Book. Banks
should evolve proper systems for identification of credit weaknesses well in
advance. Most of international banks have adopted various portfolio
management techniques for gauging asset quality. The CRMD, set up at Head
Office should be assigned the responsibility of periodic monitoring of the
portfolio. The portfolio quality could be evaluated by tracking the migration
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(upward or downward) of borrowers from one rating scale to another. This
process would be meaningful only if the borrower-wise ratings are updated at
quarterly / half-yearly intervals. Data on movements within grading categories
provide a useful insight into the nature and composition of loan book.
The banks could also consider the following measures to maintain the portfolio
quality:
1) stipulate quantitative ceiling on aggregate exposure in specified rating
categories, i.e. certain percentage of total advances should be in the rating
category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5, etc.;
2) evaluate the rating-wise distribution of borrowers in various industry,
business segments, etc.;
3) exposure to one industry/sector should be evaluated on the basis of overall
rating distribution of borrowers in the sector/group. In this context, banks
should weigh the pros and cons of specialisation and concentration by
industry group. In cases where portfolio exposure to a single industry is
badly performing, the banks may increase the quality standards for that
specific industry;
4) target rating-wise volume of loans, probable defaults and provisioning
requirements as a prudent planning exercise. For any deviation/s from the
expected parameters, an exercise for restructuring of the portfolio should
immediately be undertaken and if necessary, the entry-level criteria could
be enhanced to insulate the portfolio from further deterioration;
5) undertake rapid portfolio reviews, stress tests and scenario analysis when
external environment undergoes rapid changes (e.g. volatility in the forex
market, economic sanctions, changes in the fiscal/monetary policies,
general slowdown of the economy, market risk events, extreme liquidity
conditions, etc.). The stress tests would reveal undetected areas of
potential credit risk exposure and linkages between different categories of
risk. In adverse circumstances, there may be substantial correlation of
various risks, especially credit and market risks. Stress testing can range
from relatively simple alterations in assumptions about one or more
financial, structural or economic variables to the use of highly sophisticated
models. The output of such portfolio-wide stress tests should be reviewed
by the Board and suitable changes may be made in prudential risk limits for
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protecting the quality. Stress tests could also include contingency plans,
detailing management responses to stressful situations.
6) introduce discriminatory time schedules for renewal of borrower limits.
Lower rated borrowers whose financials show signs of problems should be
subjected to renewal control twice/thrice an year.
Banks should evolve suitable framework for monitoring the market risks
especially forex risk exposure of corporates who have no natural hedges on a
regular basis. Banks should also appoint Portfolio Managers to watch the loan
portfolio’s degree of concentrations and exposure to counterparties. For
comprehensive evaluation of customer exposure, banks may consider
appointing Relationship Managers to ensure that overall exposure to a single
borrower is monitored, captured and controlled. The Relationship Managers
have to work in coordination with the Treasury and Forex Departments. The
Relationship Managers may service mainly high value loans so that a
substantial share of the loan portfolio, which can alter the risk profile, would be
under constant surveillance. Further, transactions with affiliated
companies/groups need to be aggregated and maintained close to real time.
The banks should also put in place formalised systems for identification of
accounts showing pronounced credit weaknesses well in advance and also
prepare internal guidelines for such an exercise and set time frame for deciding
courses of action.
Many of the international banks have adopted credit risk models for evaluation
of credit portfolio. The credit risk models offer banks framework for examining
credit risk exposures, across geographical locations and product lines in a
timely manner, centralising data and analysing marginal and absolute
contributions to risk. The models also provide estimates of credit risk
(unexpected loss) which reflect individual portfolio composition. The Altman’s Z
Score forecasts the probability of a company entering bankruptcy within a 12-
month period. The model combines five financial ratios using reported
accounting information and equity values to produce an objective measure of
borrower’s financial health. J. P. Morgan has developed a portfolio model
‘CreditMetrics’ for evaluating credit risk. The model basically focus on
estimating the volatility in the value of assets caused by variations in the quality
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of assets. The volatility is computed by tracking the probability that the
borrower might migrate from one rating category to another (downgrade or
upgrade). Thus, the value of loans can change over time, reflecting migration
of the borrowers to a different risk-rating grade. The model can be used for
promoting transparency in credit risk, establishing benchmark for credit risk
measurement and estimating economic capital for credit risk under RAROC
framework. Credit Suisse developed a statistical method for measuring and
accounting for credit risk which is known as CreditRisk+. The model is based
on actuarial calculation of expected default rates and unexpected losses from
default.
The banks may evaluate the utility of these models with suitable modifications
to Indian environment for fine-tuning the credit risk management. The success
of credit risk models impinges on time series data on historical loan loss rates
and other model variables, spanning multiple credit cycles. Banks may,
therefore, endeavour building adequate database for switching over to credit
risk modelling after a specified period of time.
Loan Review Mechanism (LRM)
LRM is an effective tool for constantly evaluating the quality of loan book and to
bring about qualitative improvements in credit administration. Banks should,
therefore, put in place proper Loan Review Mechanism for large value accounts
with responsibilities assigned in various areas such as, evaluating the
effectiveness of loan administration, maintaining the integrity of credit grading
process, assessing the loan loss provision, portfolio quality, etc. The
complexity and scope of LRM normally vary based on banks’ size, type of
operations and management practices. It may be independent of the CRMD or
even separate Department in large banks.
The main objectives of LRM could be:
• to identify promptly loans which develop credit weaknesses and initiate

timely corrective action;
• to evaluate portfolio quality and isolate potential problem areas;
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• to provide information for determining adequacy of loan loss provision;
• to assess the adequacy of and adherence to, loan policies and procedures,
and to monitor compliance with relevant laws and regulations; and
• to provide top management with information on credit administration,
including credit sanction process, risk evaluation and post-sanction follow-
up.
Accurate and timely credit grading is one of the basic components of an

effective LRM. Credit grading involves assessment of credit quality,
identification of problem loans, and assignment of risk ratings. A proper Credit
Grading System should support evaluating the portfolio quality and establishing
loan loss provisions. Given the importance and subjective nature of credit
rating, the credit ratings awarded by Credit Administration Department should
be subjected to review by Loan Review Officers who are independent of loan
administration.
Banks should formulate Loan Review Policy and it should be reviewed annually
by the Board. The Policy should, inter alia, address:
Qualification and Independence
The Loan Review Officers should have sound knowledge in credit appraisal,
lending practices and loan policies of the bank. They should also be well
versed in the relevant laws/regulations that affect lending activities. The
independence of Loan Review Officers should be ensured and the findings of
the reviews should also be reported directly to the Board or Committee of the
Board.
Frequency and Scope of Reviews
The Loan Reviews are designed to provide feedback on effectiveness of credit

sanction and to identify incipient deterioration in portfolio quality. Reviews of
high value loans should be undertaken usually within three months of
sanction/renewal or more frequently when factors indicate a potential for
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deterioration in the credit quality. The scope of the review should cover all
loans above a cut-off limit. In addition, banks should also target other accounts
that present elevated risk characteristics. At least 30-40% of the portfolio
should be subjected to LRM in a year to provide reasonable assurance that all
the major credit risks embedded in the balance sheet have been tracked.
Depth of Reviews
The loan reviews should focus on:

• Approval process;
• Accuracy and timeliness of credit ratings assigned by loan officers;
• Adherence to internal policies and procedures, and applicable laws /
regulations;
• Compliance with loan covenants;
• Post-sanction follow-up;
• Sufficiency of loan documentation;
• Portfolio quality; and
• Recommendations for improving portfolio quality
The findings of Reviews should be discussed with line Managers and the
corrective actions should be elicited for all deficiencies. Deficiencies that
remain unresolved should be reported to top management.
The Risk Management Group of the Basle Committee on Banking Supervision

has released a consultative paper on Principles for the Management of Credit
Risk. The Paper deals with various aspects relating to credit risk management.
The Paper is enclosed for information of banks.
Credit Risk and Investment Banking
Significant magnitude of credit risk, in addition to market risk, is inherent in

investment banking. The proposals for investments should also be subjected
to the same degree of credit risk analysis, as any loan proposals. The
proposals should be subjected to detailed appraisal and rating framework that
factors in financial and non-financial parameters of issuers, sensitivity to
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external developments, etc. The maximum exposure to a customer should be
bank-wide and include all exposures assumed by the Credit and Treasury
Departments. The coupon on non-sovereign papers should be commensurate
with their risk profile. The banks should exercise due caution, particularly in
investment proposals, which are not rated and should ensure comprehensive
risk evaluation. There should be greater interaction between Credit and
Treasury Departments and the portfolio analysis should also cover the total
exposures, including investments. The rating migration of the issuers and the
consequent diminution in the portfolio quality should also be tracked at periodic
intervals.
As a matter of prudence, banks should stipulate entry level minimum

ratings/quality standards, industry, maturity, duration, issuer-wise, etc. limits in
investment proposals as well to mitigate the adverse impacts of concentration
and the risk of liquidity.
Credit Risk in Off-balance Sheet Exposure

Banks should evolve adequate framework for managing their exposure in off-
balance sheet products like forex forward contracts, swaps, options, etc. as a
part of overall credit to individual customer relationship and subject to the same
credit appraisal, limits and monitoring procedures. Banks should classify their
off-balance sheet exposures into three broad categories - full risk (credit
substitutes) - standby letters of credit, money guarantees, etc, medium risk
(not direct credit substitutes, which do not support existing financial obligations)
- bid bonds, letters of credit, indemnities and warranties and low risk - reverse
repos, currency swaps, options, futures, etc.
The trading credit exposure to counter parties can be measured on static

(constant percentage of the notional principal over the life of the transaction)
and on a dynamic basis. The total exposures to the counter parties on a
dynamic basis should be the sum total of:
1) the current replacement cost (unrealized loss to the counter party); and
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2) the potential increase in replacement cost (estimated with the help of VaR
or other methods to capture future volatility’s in the value of the outstanding
contracts/ obligations).
The current and potential credit exposures may be measured on a daily basis
to evaluate the impact of potential changes in market conditions on the value of
counter party positions. The potential exposures also may be quantified by
subjecting the position to market movements involving normal and abnormal
movements in interest rates, foreign exchange rates, equity prices, liquidity
conditions, etc.
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INTER-BANK EXPOSURE AND COUNTRY RISK
A suitable framework should be evolved to provide a centralised overview on

the aggregate exposure on other banks. Bank-wise exposure limits could be
set on the basis of assessment of financial performance, operating efficiency,
management quality, past experience, etc. Like corporate clients, banks
should also be rated and placed in range of 1-5, 1-8, as the case may be, on
the basis of their credit quality. The limits so arrived at should be allocated to
various operating centres and followed up and half-yearly/annual reviews
undertaken at a single point. Regarding exposure on overseas banks, banks
can use the country ratings of international rating agencies and classify the
countries into low risk, moderate risk and high risk. Banks should endeavour for
developing an internal matrix that reckons the counter party and country risks.
The maximum exposure should be subjected to adherence of country and bank
exposure limits already in place. While the exposure should at least be
monitored on a weekly basis till the banks are equipped to monitor exposures
on a real time basis, all exposures to problem countries should be evaluated on
a real time basis.
Market Risk
Traditionally, credit risk management was the primary challenge for banks.
With progressive deregulation, market risk arising from adverse changes in
market variables, such as interest rate, foreign exchange rate, equity price and
commodity price has become relatively more important. Even a small change
in market variables causes substantial changes in income and economic value
of banks. Market risk takes the form of:
1) Liquidity Risk
2) Interest Rate Risk
3) Foreign Exchange Rate (Forex) Risk
4) Commodity Price Risk and
5) Equity Price Risk
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Market Risk Management
Management of market risk should be the major concern of top management of

banks. The Boards should clearly articulate market risk management policies,
procedures, prudential risk limits, review mechanisms and reporting and
auditing systems. The policies should address the bank’s exposure on a
consolidated basis and clearly articulate the risk measurement systems that
capture all material sources of market risk and assess the effects on the bank.
The operating prudential limits and the accountability of the line management
should also be clearly defined. The Asset-Liability Management Committee
(ALCO) should function as the top operational unit for managing the balance
sheet within the performance/risk parameters laid down by the Board. The
banks should also set up an independent Middle Office to track the magnitude
of market risk on a real time basis. The Middle Office should comprise of
experts in market risk management, economists, statisticians and general
bankers and may be functionally placed directly under the ALCO. The Middle
Office should also be separated from Treasury Department and should not be
involved in the day to day management of Treasury. The Middle Office should
apprise the top management / ALCO / Treasury about adherence to prudential /
risk parameters and also aggregate the total market risk exposures assumed
by the bank at any point of time.
Liquidity Risk
Liquidity Planning is an important facet of risk management framework in

banks. Liquidity is the ability to efficiently accommodate deposit and other
liability decreases, as well as, fund loan portfolio growth and the possible
funding of off-balance sheet claims. A bank has adequate liquidity when
sufficient funds can be raised, either by increasing liabilities or converting
assets, promptly and at a reasonable cost. It encompasses the potential sale
of liquid assets and borrowings from money, capital and forex markets. Thus,
liquidity should be considered as a defence mechanism from losses on fire sale
of assets.
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The liquidity risk of banks arises from funding of long-term assets by short-term
liabilities, thereby making the liabilities subject to rollover or refinancing risk.
The liquidity risk in banks manifest in different dimensions:
i) Funding Risk – need to replace net outflows due to unanticipated

withdrawal/non-renewal of deposits (wholesale and retail);
ii) Time Risk - need to compensate for non-receipt of expected inflows of

funds, i.e. performing assets turning into non-performing assets; and
iii) Call Risk - due to crystallisation of contingent liabilities and unable to

undertake profitable business opportunities when desirable.
The first step towards liquidity management is to put in place an effective

liquidity management policy, which, inter alia, should spell out the funding
strategies, liquidity planning under alternative scenarios, prudential limits,
liquidity reporting / reviewing, etc.
Liquidity measurement is quite a difficult task and can be measured through

stock or cash flow approaches. The key ratios, adopted across the banking
system are:
i) Loans to Total Assets
ii) Loans to Core Deposits
iii) Large Liabilities (minus) Temporary Investments to Earning Assets

(minus) Temporary Investments, where large liabilities represent
wholesale deposits which are market sensitive and temporary
Investments are those maturing within one year and those investments
which are held in the trading book and are readily sold in the market;
iv) Purchased Funds to Total Assets, where purchased funds include the
entire inter-bank and other money market borrowings, including
Certificate of Deposits and institutional deposits; and
v) Loan Losses/Net Loans.
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While the liquidity ratios are the ideal indicator of liquidity of banks operating in
developed financial markets, the ratios do not reveal the intrinsic liquidity profile
of Indian banks which are operating generally in an illiquid market.
Experiences show that assets commonly considered as liquid like Government
securities, other money market instruments, etc. have limited liquidity as the
market and players are unidirectional. Thus, analysis of liquidity involves
tracking of cash flow mismatches. For measuring and managing net funding
requirements, the use of maturity ladder and calculation of cumulative surplus
or deficit of funds at selected maturity dates is recommended as a standard
tool. The format prescribed by RBI in this regard under ALM System should be
adopted for measuring cash flow mismatches at different time bands. The cash
flows should be placed in different time bands based on future behaviour of
assets, liabilities and off-balance sheet items. In other words, banks should
have to analyze the behavioural maturity profile of various components of on /
off-balance sheet items on the basis of assumptions and trend analysis
supported by time series analysis. Banks should also undertake variance
analysis, at least, once in six months to validate the assumptions. The
assumptions should be fine-tuned over a period which facilitate near reality
predictions about future behaviour of on / off-balance sheet items. Apart from
the above cash flows, banks should also track the impact of prepayments of
loans, premature closure of deposits and exercise of options built in certain
instruments which offer put/call options after specified times. Thus, cash
outflows can be ranked by the date on which liabilities fall due, the earliest date
a liability holder could exercise an early repayment option or the earliest date
contingencies could be crystallised.
The difference between cash inflows and outflows in each time period, the
excess or deficit of funds, becomes a starting point for a measure of a bank’s
future liquidity surplus or deficit, at a series of points of time. The banks should
also consider putting in place certain prudential limits to avoid liquidity crisis:
1. Cap on inter-bank borrowings, especially call borrowings;
2. Purchased funds vis-à-vis liquid assets;
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3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity
Reserve Ratio and Loans;
4. Duration of liabilities and investment portfolio;
5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches

across all time bands;
6. Commitment Ratio – track the total commitments given to corporates/banks

and other financial institutions to limit the off-balance sheet exposure;
7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign
currency sources.
Banks should also evolve a system for monitoring high value deposits (other
than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities.
Further the cash flows arising out of contingent liabilities in normal situation and
the scope for an increase in cash flows during periods of stress should also be
estimated. It is quite possible that market crisis can trigger substantial increase
in the amount of draw downs from cash credit/overdraft accounts, contingent
liabilities like letters of credit, etc.
The liquidity profile of the banks could be analysed on a static basis, wherein
the assets and liabilities and off-balance sheet items are pegged on a particular
day and the behavioural pattern and the sensitivity of these items to changes in
market interest rates and environment are duly accounted for. The banks can
also estimate the liquidity profile on a dynamic way by giving due importance
to:
1) Seasonal pattern of deposits/loans;
2) Potential liquidity needs for meeting new loan demands, unavailed credit
limits, loan policy, potential deposit losses, investment obligations, statutory
obligations, etc.
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ALTERNATIVE SCENARIOS
The liquidity profile of banks depends on the market conditions, which influence
the cash flow behaviour. Thus, banks should evaluate liquidity profile under
different conditions, viz. normal situation, bank specific crisis and market crisis
scenario. The banks should establish benchmark for normal situation, cash
flow profile of on / off balance sheet items and manages net funding
requirements.
Estimating liquidity under bank specific crisis should provide a worst-case

benchmark. It should be assumed that the purchased funds could not be easily
rolled over; some of the core deposits could be prematurely closed; a
substantial share of assets have turned into non-performing and thus become
totally illiquid. These developments would lead to rating down grades and high
cost of liquidity. The banks should evolve contingency plans to overcome such
situations.
The market crisis scenario analyses cases of extreme tightening of liquidity

conditions arising out of monetary policy stance of Reserve Bank, general
perception about risk profile of the banking system, severe market disruptions,
failure of one or more of major players in the market, financial crisis, contagion,
etc. Under this scenario, the rollover of high value customer deposits and
purchased funds could extremely be difficult besides flight of volatile deposits /
liabilities. The banks could also sell their investment with huge discounts,
entailing severe capital loss.
Contingency Plan
Banks should prepare Contingency Plans to measure their ability to withstand
bank-specific or market crisis scenario. The blue-print for asset sales, market
access, capacity to restructure the maturity and composition of assets and
liabilities should be clearly documented and alternative options of funding in the
event of bank’s failure to raise liquidity from existing source/s could be clearly
articulated. Liquidity from the Reserve Bank, arising out of its refinance window
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and interim liquidity adjustment facility or as lender of last resort should not be
reckoned for contingency plans. Availability of back-up liquidity support in the
form of committed lines of credit, reciprocal arrangements, liquidity support
from other external sources, liquidity of assets, etc. should also be clearly
established.
Interest Rate Risk (IRR)
The management of Interest Rate Risk should be one of the critical

components of market risk management in banks. The regulatory restrictions in
the past had greatly reduced many of the risks in the banking system.
Deregulation of interest rates has, however, exposed them to the adverse
impacts of interest rate risk. The Net Interest Income (NII) or Net Interest
Margin (NIM) of banks is dependent on the movements of interest rates. Any
mismatches in the cash flows (fixed assets or liabilities) or repricing dates
(floating assets or liabilities), expose banks’ NII or NIM to variations. The
earning of assets and the cost of liabilities are now closely related to market
interest rate volatility.
Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market
Value of Equity (MVE), caused by unexpected changes in market interest rates.
Interest Rate Risk can take different forms:
Types of Interest Rate Risk
 Gap or Mismatch Risk:
A gap or mismatch risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or repricing
dates, thereby creating exposure to unexpected changes in the level of market
interest rates.
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 Basis Risk
Market interest rates of various instruments seldom change by the same

degree during a given period of time. The risk that the interest rate of different
assets, liabilities and off-balance sheet items may change in different
magnitude is termed as basis risk. The degree of basis risk is fairly high in
respect of banks that create composite assets out of composite liabilities. The
Loan book in India is funded out of a composite liability portfolio and is exposed
to a considerable degree of basis risk. The basis risk is quite visible in volatile
interest rate scenarios. When the variation in market interest rate causes the
NII to expand, the banks have experienced favourable basis shifts and if the
interest rate movement causes the NII to contract, the basis has moved against
the banks.
 Embedded Option Risk
Significant changes in market interest rates create another source of risk to

banks’ profitability by encouraging prepayment of cash credit/demand
loans/term loans and exercise of call/put options on bonds/debentures and/or
premature withdrawal of term deposits before their stated maturities. The
embedded option risk is becoming a reality in India and is experienced in
volatile situations. The faster and higher the magnitude of changes in interest
rate, the greater will be the embedded option risk to the banks’ NII. Thus,
banks should evolve scientific techniques to estimate the probable embedded
options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity)
to realistically estimate the risk profiles in their balance sheet. Banks should
also endeavour for stipulating appropriate penalties based on opportunity costs
to stem the exercise of options, which is always to the disadvantage of banks.
Yield Curve Risk
In a floating interest rate scenario, banks may price their assets and liabilities
based on different benchmarks, i.e. TBs yields, fixed deposit rates, call money
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rates, MIBOR, etc. In case the banks use two different instruments maturing at
different time horizon for pricing their assets and liabilities, any non-parallel
movements in yield curves would affect the NII. The movements in yield curve
are rather frequent when the economy moves through business cycles. Thus,
banks should evaluate the movement in yield curves and the impact of that on
the portfolio values and income.
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 price risk is
closely associated with the trading book, which is created for making profit out
of short-term movements in interest rates. Banks which have an active trading
book should, therefore, formulate policies to limit the portfolio size, holding
period, duration, defeasance period, stop loss limits, marking to market, etc.0
Reinvestment Risk
Uncertainty with regard to interest rate at which the future cash flows could be
reinvested is called reinvestment risk. Any mismatches in cash flows would
expose the banks to variations in NII as the market interest rates move in
different directions.
Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing
towards profitability of banks. When banks have more earning assets than
paying liabilities, interest rate risk arises when the market interest rates adjust
downwards. Thus, banks with positive net interest positions will experience a
reduction in NII as the market interest rate declines and increases when
interest rate rises. Thus, large float is a natural hedge against the variations in
interest rates.
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Measuring Interest Rate Risk
Before interest rate risk could be managed, they should be identified and
quantified. Unless the quantum of IRR inherent in the balance sheet is
identified, it is impossible to measure the degree of risks to which banks are
exposed. It is also equally impossible to develop effective risk management
strategies/hedging techniques without being able to understand the correct risk
position of banks. The IRR measurement system should address all material
sources of interest rate risk including gap or mismatch, basis, embedded
option, yield curve, price, reinvestment and net interest position risks
exposures. The IRR measurement system should also take into account the
specific characteristics of each individual interest rate sensitive position and
should capture in detail the full range of potential movements in interest rates.
There are different techniques for measurement of interest rate risk, ranging
from the traditional Maturity Gap Analysis (to measure the interest rate
sensitivity of earnings), Duration (to measure interest rate sensitivity of capital),
Simulation and Value at Risk. While these methods highlight different facets of
interest rate risk, many banks use them in combination, or use hybrid methods
that combine features of all the techniques.
Generally, the approach towards measurement and hedging of IRR varies with
the segmentation of the balance sheet. In a well functioning risk management
system, banks broadly position their balance sheet into Trading and Investment
or Banking Books. While the assets in the trading book are held primarily for
generating profit on short-term differences in prices/yields, the banking book
comprises assets and liabilities, which are contracted basically on account of
relationship or for steady income and statutory obligations and are generally
held till maturity. Thus, while the price risk is the prime concern of banks in
trading book, the earnings or economic value changes are the main focus of
banking book.
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Trading Book
The top management of banks should lay down policies with regard to volume,
maximum maturity, holding period, duration, stop loss, defeasance period,
rating standards, etc. for classifying securities in the trading book. While the
securities held in the trading book should ideally be marked to market on a
daily basis, the potential price risk to changes in market risk factors should be
estimated through internally developed Value at Risk (VaR) models. The VaR
method is employed to assess potential loss that could crystalise on trading
position or portfolio due to variations in market interest rates and prices, using a
given confidence level, usually 95% to 99%, within a defined period of time.
The VaR method should incorporate the market factors against which the
market value of the trading position is exposed. The top management should
put in place bank-wide VaR exposure limits to the trading portfolio (including
forex and gold positions, derivative products, etc.) which is then disaggregated
across different desks and departments. The loss making tolerance level
should also be stipulated to ensure that potential impact on earnings is
managed within acceptable limits. The potential loss in Present Value Basis
Points should be matched by the Middle Office on a daily basis vis-à-vis the
prudential limits set by the Board. The advantage of using VaR is that it is
comparable across products, desks and Departments and it can be validated
through ‘back testing’. However, VaR models require the use of extensive
historical data to estimate future volatility. VaR model also may not give good
results in extreme volatile conditions or outlier events and stress test has to be
employed to complement VaR. The stress tests provide management a view
on the potential impact of large size market movements and also attempt to
estimate the size of potential losses due to stress events, which occur in the
’tails’ of the loss distribution. Banks may also undertake scenario analysis with
specific possible stress situations (recently experienced in some countries) by
linking hypothetical, simultaneous and related changes in multiple risk factors
present in the trading portfolio to determine the impact of moves on the rest of
the portfolio. VaR models could also be modified to reflect liquidity risk
differences observed across assets over time. International banks are now
estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time
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horizons based on position size and relative turnover. In an environment where
VaR is difficult to estimate for lack of data, non-statistical concepts such as stop
loss and gross/net positions can be used.
Banking Book
The changes in market interest rates have earnings and economic value
impacts on the banks’ banking book. Thus, given the complexity and range of
balance sheet products, banks should have IRR measurement systems that
assess the effects of the rate changes on both earnings and economic value.
The variety of techniques ranges from simple maturity (fixed rate) and repricing
(floating rate) to static simulation, based on current on-and-off-balance sheet
positions, to highly sophisticated dynamic modelling techniques that
incorporate assumptions on behavioural pattern of assets, liabilities and off-
balance sheet items and can easily capture the full range of exposures against
basis risk, embedded option risk, yield curve risk, etc.
Maturity Gap Analysis

The simplest analytical techniques for calculation of IRR exposure begins with
maturity Gap analysis that distributes interest rate sensitive assets, liabilities
and off-balance sheet positions into a certain number of pre-defined time-bands
according to their maturity (fixed rate) or time remaining for their next repricing
(floating rate). Those assets and liabilities lacking definite repricing intervals
(savings bank, cash credit, overdraft, loans, export finance, refinance from RBI
etc.) or actual maturities vary from contractual maturities (embedded option in
bonds with put/call options, loans, cash credit/overdraft, time deposits, etc.) are
assigned time-bands according to the judgement, empirical studies and past
experiences of banks.
A number of time bands can be used while constructing a gap report.

Generally, most of the banks focus their attention on near-term periods, viz.
monthly, quarterly, half-yearly or one year. It is very difficult to take a view on
interest rate movements beyond a year. Banks with large exposures in the
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short-term should test the sensitivity of their assets and liabilities even at
shorter intervals like overnight, 1-7 days, 8-14 days, etc.
In order to evaluate the earnings exposure, interest Rate Sensitive Assets

(RSAs) in each time band are netted with the interest Rate Sensitive Liabilities
(RSLs) to produce a repricing ‘Gap’ for that time band. The positive Gap
indicates that banks have more RSAs than RSLs. A positive or asset sensitive
Gap means that an increase in market interest rates could cause an increase in
NII. Conversely, a negative or liability sensitive Gap implies that the banks’ NII
could decline as a result of increase in market interest rates. The negative gap
indicates that banks have more RSLs than RSAs. The Gap is used as a
measure of interest rate sensitivity. The Positive or Negative Gap is multiplied
by the assumed interest rate changes to derive the Earnings at Risk (EaR).
The EaR method facilitates to estimate how much the earnings might be
impacted by an adverse movement in interest rates. The changes in interest
rate could be estimated on the basis of past trends, forecasting of interest
rates, etc. The banks should fix EaR which could be based on last/current
year’s income and a trigger point at which the line management should adopt
on-or off-balance sheet hedging strategies may be clearly defined.
The Gap calculations can be augmented by information on the average coupon

on assets and liabilities in each time band and the same could be used to
calculate estimates of the level of NII from positions maturing or due for
repricing within a given time-band, which would then provide a scale to assess
the changes in income implied by the gap analysis.
The periodic gap analysis indicates the interest rate risk exposure of banks
over distinct maturities and suggests magnitude of portfolio changes necessary
to alter the risk profile. However, the Gap report quantifies only the time
difference between repricing dates of assets and liabilities but fails to measure
the impact of basis and embedded option risks. The Gap report also fails to
measure the entire impact of a change in interest rate (Gap report assumes
that all assets and liabilities are matured or repriced simultaneously) within a
given time-band and effect of changes in interest rates on the economic or
81
market value of assets, liabilities and off-balance sheet position. It also does
not take into account any differences in the timing of payments that might occur
as a result of changes in interest rate environment. Further, the assumption of
parallel shift in yield curves seldom happen in the financial market. The Gap
report also fails to capture variability in non-interest revenue and expenses, a
potentially important source of risk to current income.
In case banks could realistically estimate the magnitude of changes in market

interest rates of various assets and liabilities (basis risk) and their past
behavioural pattern (embedded option risk), they could standardise the gap by
multiplying the individual assets and liabilities by how much they will change for
a given change in interest rate. Thus, one or several assumptions of
standardised gap seem more consistent with real world than the simple gap
method. With the Adjusted Gap, banks could realistically estimate the EaR.
Duration Gap Analysis
Matching the duration of assets and liabilities, instead of matching the maturity
or repricing dates is the most effective way to protect the economic values of
banks from exposure to IRR than the simple gap model. Duration gap model
focuses on managing economic value of banks by recognising the change in
the market value of assets, liabilities and off-balance sheet (OBS) items. When
weighted assets and liabilities and OBS duration are matched, market interest
rate movements would have almost same impact on assets, liabilities and OBS,
thereby protecting the bank’s total equity or net worth. Duration is a measure
of the percentage change in the economic value of a position that will occur
given a small change in the level of interest rates.
Measuring the duration gap is more complex than the simple gap model. For
approximation of duration of assets and liabilities, the simple gap schedule can
be used by applying weights to each time-band. The weights are based on
estimates of the duration of assets and liabilities and OBS that fall into each
time band. The weighted duration of assets and liabilities and OBS provide a
rough estimation of the changes in banks’ economic value to a given change in
82
market interest rates. It is also possible to give different weights and interest
rates to assets, liabilities and OBS in different time buckets to capture
differences in coupons and maturities and volatilities in interest rates along the
yield curve.
In a more scientific way, banks can precisely estimate the economic value
changes to market interest rates by calculating the duration of each asset,
liability and OBS position and weigh each of them to arrive at the weighted
duration of assets, liabilities and OBS. Once the weighted duration of assets
and liabilities are estimated, the duration gap can be worked out with the help
of standard mathematical formulae. The Duration Gap measure can be used to
estimate the expected change in Market Value of Equity (MVE) for a given
change in market interest rate.
The difference between duration of assets (DA) and liabilities (DL) is bank’s net
duration. If the net duration is positive (DA>DL), a decrease in market interest
rates will increase the market value of equity of the bank. When the duration
gap is negative (DL> DA), the MVE increases when the interest rate increases
but decreases when the rate declines. Thus, the Duration Gap shows the
impact of the movements in market interest rates on the MVE through
influencing the market value of assets, liabilities and OBS.
The attraction of duration analysis is that it provides a comprehensive measure

of IRR for the total portfolio. The duration analysis also recognises the time
value of money. Duration measure is additive so that banks can match total
assets and liabilities rather than matching individual accounts. However,
Duration Gap analysis assumes parallel shifts in yield curve. For this reason, it
fails to recognise basis risk.
83
Simulation
Many of the international banks are now using balance sheet simulation models
to gauge the effect of market interest rate variations on reported
earnings/economic values over different time zones. Simulation technique
attempts to overcome the limitations of Gap and Duration approaches by
computer modelling the bank’s interest rate sensitivity. Such modelling
involves making assumptions about future path of interest rates, shape of
yield curve, changes in business activity, pricing and hedging strategies,
etc. The simulation involves detailed assessment of the potential effects
of changes in interest rate on earnings and economic value. The
simulation techniques involve detailed analysis of various components of
on-and off-balance sheet positions. Simulations can also incorporate
more varied and refined changes in the interest rate environment, ranging
from changes in the slope and shape of the yield curve and interest rate
scenario derived from Monte Carlo simulations.
The output of simulation can take a variety of forms, depending on users’ need.
Simulation can provide current and expected periodic gaps, duration gaps,
balance sheet and income statements, performance measures, budget and
financial reports. The simulation model provides an effective tool for
understanding the risk exposure under variety of interest rate/balance sheet
scenarios. This technique also plays an integral-planning role in evaluating the
effect of alternative business strategies on risk exposures.
The simulation can be carried out under static and dynamic environment.
While the current on and off-balance sheet positions are evaluated under static
environment, the dynamic simulation builds in more detailed assumptions about
the future course of interest rates and the unexpected changes in bank’s
business activity.
The usefulness of the simulation technique depends on the structure of the

model, validity of assumption, technology support and technical expertise of
banks.
84
The application of various techniques depends to a large extent on the quality
of data and the degree of automated system of operations. Thus, banks may
start with the gap or duration gap or simulation techniques on the basis of
availability of data, information technology and technical expertise. In any
case, as suggested by RBI in the guidelines on ALM System, banks should
start estimating the interest rate risk exposure with the help of Maturity Gap
approach. Once banks are comfortable with the Gap model, they can
progressively graduate into the sophisticated approaches.
Funds Transfer Pricing
The Transfer Pricing mechanism being followed by many banks does not
support good ALM Systems. Many international banks which have different
products and operate in various geographic markets have been using internal
Funds Transfer Pricing (FTP). FTP is an internal measurement designed to
assess the financial impact of uses and sources of funds and can be used to
evaluate the profitability. It can also be used to isolate returns for various risks
assumed in the intermediation process. FTP also helps correctly identify the
cost of opportunity value of funds. Although banks have adopted various FTP
frameworks and techniques, Matched Funds Pricing (MFP) is the most efficient
technique. Most of the international banks use MFP. The FTP envisages
assignment of specific assets and liabilities to various functional units (profit
centres) – lending, investment, deposit taking and funds management. Each
unit attracts sources and uses of funds. The lending, investment and deposit
taking profit centres sell their liabilities to and buys funds for financing their
assets from the funds management profit centre at appropriate transfer prices.
The transfer prices are fixed on the basis of a single curve (MIBOR or derived
cash curve, etc) so that asset-liability transactions of identical attributes are
assigned identical transfer prices. Transfer prices could, however, vary
according to maturity, purpose, terms and other attributes.
The FTP provides for allocation of margin (franchise and credit spreads) to
profit centres on original transfer rates and any residual spread (mismatch
85
spread) is credited to the funds management profit centre. This spread is the
result of accumulated mismatches. The margins of various profit centres are:
86
• Deposit profit centre:
Transfer Price (TP) on deposits - cost of deposits – deposit insurance-

overheads.
• Lending profit centre:
Loan yields + TP on deposits – TP on loan financing – cost of deposits –

deposit insurance - overheads – loan loss provisions.
• Investment profit centre:
Security yields + TP on deposits – TP on security financing – cost of

deposits – deposit insurance - overheads – provisions for depreciation in
investments and loan loss.
• Funds Management profit centre:
TP on funds lent – TP on funds borrowed – Statutory Reserves cost –

overheads.
For illustration, let us assume that a bank’s Deposit profit centre has raised
a 3 month deposit @ 6.5% p.a. and that the alternative funding cost i.e.
MIBOR for 3 months and one year @ 8% and 10.5% p.a., respectively. Let
us also assume that the bank’s Loan profit centre created a one year
loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of
bank is as under:
Profit Centres Total

Deposit Funds Loan
Interest Income 8.0 10.5 13.5 13.5
Interest Expenditure 6.5 8.0 10.5 6.5
Margin 1.5 2.5 3.0 7.0
Loan Loss Provision (expected) - - 1.0 1.0
Deposit Insurance 0.1 - - 0.1
87
Reserve Cost (CRR/ SLR) - 1.0 - 1.0
Overheads 0.6 0.5 0.6 1.7
NII 0.8 1.0 1.4 3.2
Under the FTP mechanism, the profit centres (other than funds management)
are precluded from assuming any funding mismatches and thereby exposing
them to market risk. The credit or counterparty and price risks are, however,
managed by these profit centres. The entire market risks, i.e interest rate,
liquidity and forex are assumed by the funds management profit centre.
The FTP allows lending and deposit raising profit centres determine their
expenses and price their products competitively. Lending profit centre which
knows the carrying cost of the loans needs to focus on to price only the spread
necessary to compensate the perceived credit risk and operating expenses.
Thus, FTP system could effectively be used as a way to centralise the bank’s
overall market risk at one place and would support an effective ALM modelling
system. FTP also could be used to enhance corporate communication; greater
line management control and solid base for rewarding line management.
88
FOREIGN EXCHANGE (FOREX) RISK
The risk inherent in running open foreign exchange positions have been
heightened in recent years by the pronounced volatility in forex rates, thereby
adding a new dimension to the risk profile of banks’ balance sheets.
Forex risk is 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. The banks are also exposed to 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 premia/discounts of the currencies
concerned.
In the forex business, banks also face the risk of default of the counter parties
or settlement risk. While such type of risk crystallisation does not cause
principal loss, banks may have to undertake fresh transactions in the cash/spot
market for replacing the failed transactions. Thus, banks may incur
replacement cost, which depends upon the currency rate movements. Banks
also face another risk called time-zone risk or Herstatt risk which arises out of
time-lags in settlement of one currency in one centre and the settlement of
another currency in another time-zone. The forex transactions with counter
parties from another country also trigger sovereign or country risk.
Forex Risk Management Measures
1. Set appropriate limits – open positions and gaps.

2. Clear-cut and well-defined division of responsibility between front, middle
and back offices.
The top management should also adopt the VaR approach to measure the risk
associated with exposures. Reserve Bank of India has recently introduced two
89
statements viz. Maturity and Position (MAP) and Interest Rate Sensitivity (SIR)
for measurement of forex risk exposures. Banks should use these statements
for periodical monitoring of forex risk exposures.
Capital for Market Risk
The Basle Committee on Banking Supervision (BCBS) had issued

comprehensive guidelines to provide an explicit capital cushion for the price
risks to which banks are exposed, particularly those arising from their trading
activities. The banks have been given flexibility to use in-house models based
on VaR for measuring market risk as an alternative to a standardised
measurement framework suggested by Basle Committee. The internal models
should, however, comply with quantitative and qualitative criteria prescribed by
Basle Committee.
Reserve Bank of India has accepted the general framework suggested by the
Basle Committee. RBI has also initiated various steps in moving towards
prescribing capital for market risk. As an initial step, a risk weight of 2.5% has
been prescribed for investments in Government and other approved securities,
besides a risk weight each of 100% on the open position limits in forex and
gold. RBI has also prescribed detailed operating guidelines for Asset-Liability
Management System in banks. As the ability of banks to identify and measure
market risk improves, it would be necessary to assign explicit capital charge for
market risk. In the meanwhile, banks are advised to study the Basle
Committee’s paper on ‘Overview of the Amendment to the Capital Accord to
Incorporate Market Risks’ – January 1996 (copy enclosed). While the small
banks operating predominantly in India could adopt the standardised
methodology, large banks and those banks operating in international markets
should develop expertise in evolving internal models for measurement of
market risk.
The Basle Committee on Banking Supervision proposes to develop capital

charge for interest rate risk in the banking book as well for banks where the
90
interest rate risks are significantly above average (‘outliers’). The Committee is
now exploring various methodologies for identifying ‘outliers’ and how best to
apply and calibrate a capital charge for interest rate risk for banks. Once the
Committee finalises the modalities, it may be necessary, at least for banks
operating in the international markets to comply with the explicit capital charge
requirements for interest rate risk in the banking book.
Operational Risk
Managing operational risk is becoming an important feature of sound risk

management practices in modern financial markets in the wake of phenomenal
increase in the volume of transactions, high degree of structural changes and
complex support systems. The most important type of operational risk involves
breakdowns in internal controls and corporate governance. Such breakdowns
can lead to financial loss through error, fraud, or failure to perform in a timely
manner or cause the interest of the bank to be compromised.
Generally, operational risk is defined as any risk, which is not categoried as

market or credit risk, or the risk of loss arising from various types of human or
technical error. It is also synonymous with settlement or payments risk and
business interruption, administrative and legal risks. Operational risk has some
form of link between credit and market risks. An operational problem with a
business transaction could trigger a credit or market risk.
Measurement
There is no uniformity of approach in measurement of operational risk in the

banking system. Besides, the existing methods are relatively simple and
experimental, although some of the international banks have made
considerable progress in developing more advanced techniques for allocating
capital with regard to operational risk.
91
Measuring operational risk requires both estimating the probability of an
operational loss event and the potential size of the loss. It relies on risk factor
that provides some indication of the likelihood of an operational loss event
occurring. The process of operational risk assessment needs to address the
likelihood (or frequency) of a particular operational risk occurring, the
magnitude (or severity) of the effect of the operational risk on business
objectives and the options available to manage and initiate actions to reduce/
mitigate operational risk. The set of risk factors that measure risk in each
business unit such as audit ratings, operational data such as volume, turnover
and complexity and data on quality of operations such as error rate or measure
of business risks such as revenue volatility, could be related to historical loss
experience. Banks can also use different analytical or judgmental techniques to
arrive at an overall operational risk level. Some of the international banks have
already developed operational risk rating matrix, similar to bond credit rating.
The operational risk assessment should be bank-wide basis and it should be
reviewed at regular intervals. Banks, over a period, should develop internal
systems to evaluate the risk profile and assign economic capital within the
RAROC framework.
Indian banks have so far not evolved any scientific methods for quantifying
operational risk. In the absence any sophisticated models, banks could evolve
simple benchmark based on an aggregate measure of business activity such
as gross revenue, fee income, operating costs, managed assets or total assets
adjusted for off-balance sheet exposures or a combination of these variables.
Risk Monitoring
The operational risk monitoring system focuses, inter alia, on operational

performance measures such as volume, turnover, settlement facts, delays and
errors. It could also be incumbent to monitor operational loss directly with an
analysis of each occurrence and description of the nature and causes of the
loss.
92
Control of Operational Risk
Internal controls and the internal audit are used as the primary means to
mitigate operational risk. Banks could also explore setting up operational risk
limits, based on the measures of operational risk. The contingent processing
capabilities could also be used as a means to limit the adverse impacts of
operational risk. Insurance is also an important mitigator of some forms of
operational risk. Risk education for familiarising the complex operations at all
levels of staff can also reduce operational risk.
Policies and Procedures
Banks should have well defined policies on operational risk management. The
policies and procedures should be based on common elements across
business lines or risks. The policy should address product review process,
involving business, risk management and internal control functions.
Internal Control
One of the major tools for managing operational risk is the well-established
internal control system, which includes segregation of duties, clear
management reporting lines and adequate operating procedures. Most of the
operational risk events are associated with weak links in internal control
systems or laxity in complying with the existing internal control procedures.
The ideal method of identifying problem spots is the technique of self-

assessment of internal control environment. The self-assessment could be
used to evaluate operational risk alongwith internal/external audit
reports/ratings or RBI inspection findings. Banks should endeavour for
detection of operational problem spots rather than their being pointed out by
supervisors/internal or external auditors.
93
Alongwith activating internal audit systems, the Audit Committees should play
greater role to ensure independent financial and internal control functions.
The Basle Committee on Banking Supervision proposes to develop an explicit
capital charge for operational risk.
Risk Aggregation and Capital Allocation
Most of internally active banks have developed internal processes and

techniques to assess and evaluate their own capital needs in the light of their
risk profiles and business plans. Such banks take into account both qualitative
and quantitative factors to assess economic capital. The Basle Committee now
recognises that capital adequacy in relation to economic risk is a necessary
condition for the long-term soundness of banks. Thus, in addition to complying
with the established minimum regulatory capital requirements, banks should
critically assess their internal capital adequacy and future capital needs on the
basis of risks assumed by individual lines of business, product, etc. As a part of
the process for evaluating internal capital adequacy, a bank should be able to
identify and evaluate its risks across all its activities to determine whether its
capital levels are appropriate.
Thus, at the bank’s Head Office level, aggregate risk exposure should receive
increased scrutiny. To do so, however, it requires the summation of the
different types of risks. Banks, across the world, use different ways to estimate
the aggregate risk exposures. The most commonly used approach is the Risk
Adjusted Return on Capital (RAROC). The RAROC is designed to allow all the
business streams of a financial institution to be evaluated on an equal footing.
Each type of risks is measured to determine both the expected and unexpected
losses using VaR or worst-case type analytical model. Key to RAROC is the
matching of revenues, costs and risks on transaction or portfolio basis over a
defined time period. This begins with a clear differentiation between expected
and unexpected losses. Expected losses are covered by reserves and
provisions and unexpected losses require capital allocation which is determined
on the principles of confidence levels, time horizon, diversification and
correlation. In this approach, risk is measured in terms of variability of income.
94
Under this framework, the frequency distribution of return, wherever possible is
estimated and the Standard Deviation (SD) of this distribution is also estimated.
Capital is thereafter allocated to activities as a function of this risk or volatility
measure. Then, the risky position is required to carry an expected rate of
return on allocated capital, which compensates the bank for the associated
incremental risk. By dimensioning all risks in terms of loss distribution and
allocating capital by the volatility of the new activity, risk is aggregated and
priced.
The second approach is similar to the RAROC, but depends less on capital
allocation and more on cash flows or variability in earnings. This is referred to
as EaR, when employed to analyse interest rate risk. Under this analytical
framework also frequency distribution of returns for any one type of risk can be
estimated from historical data. Extreme outcome can be estimated from the tail
of the distribution. Either a worst case scenario could be used or Standard
Deviation 1/2/2.69 could also be considered. Accordingly, each bank can
restrict the maximum potential loss to certain percentage of past/current
income or market value. Thereafter, rather than moving from volatility of value
through capital, this approach goes directly to current earnings implications
from a risky position. This approach, however, is based on cash flows and
ignores the value changes in assets and liabilities due to changes in market
interest rates. It also depends upon a subjectively specified range of the risky
environments to drive the worst case scenario.
Given the level of extant risk management practices, most of Indian banks may
not be in a position to adopt RAROC framework and allocate capital to various
businesses units on the basis of risk.
95
CONCLUSION & RECOMMENDATION
CONCLUSION
So on the basis of the data provided to us we can say that the banks are not
strictly following the ALM Guidelines.
RECOMMENDATION
• ALCO should keep a vigil on the working of the banks and ensure
that all the guidelines are met.
• RBI should show the banks as to how the banks can benefit by
following their guidelines.
• All the banks should provide complete information so that there is

more transparency.
96
BIBLIOGRAPHY
 Report: A Road map for Implementing an Integrated Risk Management

System by Indian Banks by Mar 2005 (CRISIL) in IBA Bulletin (Jan
2004).
 Reserve Bank of India, Report on Trend and progress of Banking in

India (various years).
 Annual Report of all bank (2004-05).
 IBA Bulletin (Mar 2003, Mar 2004).
 Websites of all banks studied.
97

Risk Management in Banking

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A PROJECT REPORT ON

RISK MANAGEMENT IN BANK

MANAGEMENT HOUSE, 14 INSTITUTIONAL AREA,

FOR THE PARTIAL FULFILLMENT OF

The Manager Evaluation

Therefore, I am sending the project report along with a copy of the

RISK MANAGEMENT IN BANK

1. Name : Abhijeet Kumar

2. Reg. No. : 750621607

3. Name of the Course : PGDM

4. Address : 17/8, Indra Vikas Colony,

Mukherjee Nagar, New Delhi

5. Title of the project : Risk Management in Bank

6. Name of the project Supervisor : Rakesh Singh

Sr. Manager – (Account)

Date: 25 October 2010 Abhijeet Kumar

Date: 25 October 2010

friend and family member.

Conclusion & Recommendation 94

Second phase consist of conceptual framework of risk management and ALM it

Risk management is recognised in today’s business world as an integral part of

These developments have enabled all companies to take a more proactive

Bank in the process of financial intermediation are confronted with various

• To know the concept of risk management in banking.

• To know the guidelines setup by R.B.I for commercial banks

• To know whether the banks are following those guidelines or not.

• To know the banks performance.

Through effective and efficient asset-liability management, the banks can

If inefficient banking firms have a tendency to remain inefficient, it would be of

In the context of present day’s rapidly changing business environment, asset

Simply put, asset-liability management is the management of total balance

a) Quantification of risk and

b) Conscious decision making with regard to asset-liability structure in order to

Scope and objectives of ALM

A sound ALM system should focus on

• Review of interest rate outlook

• Fixation of interest/product pricing on both assets and liabilities

• Examining loan portfolio

• Examining investment portfolio

• Measuring foreign exchange risk

• Managing liquidity risk

• Review of actual performance vis-à-vis projections in respect of net

• Budgeting and strategic planning

• Examine the profitability of new products

Risk is an inherent part of banking business and in simple words may be

• Interest rate risk

• Foreign exchange risk

• Commodity price risk

• Stock market risk

Interest Rate Risk

The Basle Committee on Banking Supervision whose recommendations have

Changes in interest rates can affect banks with regard to changes in

a) Market value of assets/liabilities and off balance sheet (OBS) items;

c) Net income as a result of changes in interest income;

d) Net income margin owing to changes in interest income and sensitivity

e) Capital-asset ratio due to changes in net margin.

The supervisory capital requirements established by Basle Committee from the

a) Prime is an administered rate while LIBOR is market rate. The LIBOR

b) In US context, prime is a rate applicable for loans in the US_LIBOR is

c) During a declining rate environment, Prime tends to lag changes in

Effects of Interest Rate Risk:

Foreign Exchange Risk:

It refers to potential impact of movement in foreign exchange rates. The risk