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INTRODUCTION
RISK DEFINED
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TYPES OF RISKS
Risk is the potentiality that both the expected and unexpected events
may have as adverse impact on the bank’s capital or earnings. The expected
loss is to be borne by the borrower and hence is taken care of by adequately
pricing the products through risk premium and reserves created out of the
earnings. It is the amount expected to be lost due to changes in credit quality
resulting in default.
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Thus, the expected losses are covered by reserves and provisions and the
unexpected losses require capital allocation. Hence, the need for sufficient
Capital Adequacy Ratio is felt. Each type of risk is
measured to determine both the expected and unexpected losses using VaR
(Value at Risk) or worst-case type analytical model.
Financial Risks
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external and internal factors. The external factors are the state of the
economy, rates and interest rates, trade restrictions, economic sanctions,
(a) 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 behavior over 5 or more years)
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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.
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Managing credit risk has been a problem for the banks for centuries.
As had been observed by JOHN MEDLIN, 1985 issue of US banker.
The instruments and tools, through which credit risk management are
carried out, are detailed below:
1. Portfolio management.
2. Loan review mechanism.
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1. PORTFOLIO MANAGEMENT.
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Market risk is the risk to the bank’s earnings and capital due to
changes in the market level of interest rates or prices of securities, foreign
exchange and equities, as well as the volatilities of those prices. Market Risk
management provides a comprehensive and dynamic framework for
measuring, monitoring and managing liquidity, interest rate, foreign
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exchange and equity as well as commodity price risk of a bank that needs to
be closely integrated with the banks business strategy.
Scenario analysis and stress testing is yet another tool used to asses
areas of potential problems in a given portfolio. Identification of future
changes in economic conditions like-
ECONOMIC / INDUSTRY OVERTURNS.
MARKET RISK EVENTS.
LIQUIDITY CONDITIONS.
Market risk arises out of the dynamics of market forces, which, for
the banking industry, may include interest rate fluctuations, maturity
mismatches, exchange rate fluctuations, market competition in terms of
services and products, changing customer preferences and requirements
resulting in product obsolescene, coupled with changes national and
international politico-economic scenario. These risks are like perils of the
sea, which can be caused by any change-taking place anywhere in the
national and international arena.
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Since both these aspects are dynamic in nature, with change being the
only constant factor, market risks need to be monitored on a continuous
basis and appropriate strategies evolved to keep these risks within
manageable limits. Again, given that one can manage only what one can
measure, measurement of risks on a continuous basis deserves immediate
attention.
Market risk can be defined as the risk of losses in on and off balance
sheet positions arising from adverse movement of market variables.
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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 / ALCO / Treasury about adherence to prudential / risk
parameters and also aggregrate the total market risk exposures assumed by
the bank at any point of time.
1) Liquidity Risk
2) Interest Rate Risk
3) Commodity Price Risk and
4) Equity Price Risk
A concise definition of each of the above Market Risk factors and how
they are managed is described below:
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Efforts are also being made by some banks to track the impact
of repayment of loans and premature closure of deposits to
estimate realistically the cash flow profile.
Banks are closely monitoring the mismatches in the category of
1-14 days and 15-28 days time bands and tolerance levels on
mismatches are being fixed for various maturities, depending
on asset-liability profile, stand deposit base nature of cash
flows, etc.
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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 at selected maturity
dates is recommended as a standard tool.
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ALTERNATIVE SCENARIOS
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Interest Rate Risk is the potential negative impact on the Net Interest
Income and it refers to the vulnerability of an institutions financial condition
to the movement in interest rates. Changes in interest rate affect earnings,
value of assets, liability, off-balance sheet items and cash flow. Hence, the
objective of interest rate risk management is to maintain earnings, improve
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the capability, ability to absorb potential loss and to ensure the adequacy of
the compensation received for the risk taken and effect risk return trade-off.
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 bank’s 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 is the potential negative impact on the Net Interest
Income and it refers to the vulnerability of an institutio’s financial condition
to the movement in interest rates. Changes in interest rate affect earnings,
value of assets, liabities, off-balance sheet items and cash flow. Hence, the
objective of interest rate risk management is to maintain earnings, improve
the capability, ability to absorb potential loss and to ensure the adequacy of
the compensation received for the risk taken and effect risk return trade-off.
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Price Risk:-
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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.
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.
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The positive Gap indicates that banks have more RSAs than RSLs. A
positive or assets sensitive Gap means that an increase in market interest
rates could cause an increase in NII.
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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.
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Measuring the duration Gap is more complex than the simple gap
model. The attraction of duration analysis is that it provides a
comprehensive measure of IRR for the total portfolio. The duration analysis
also recognizes the time value of money. Duration measure is addictive 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 recognize basis risk.
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Equity Price Risk is the risk of loss in value of the bank’s equity
investments and/or equity derivative instruments arising out of change in
equity prices.
The risk of loss in value of commodity held/traded by the bank, arising out
of changes in prices, basis mismatch, forward price etc.
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Indeed, so significant has operational risk become that the bank for
International Settlement (BIS) has proposed that, as of 2006, banks should
be made to carry a Capital cushion against losses from this risk.
The bank’s operational risks can be classified into following six exposure
classes
• People
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• Process
• Management
• System
• Business and
• External
To each of this exposure classes within each business line are attached
certain risk categories under which the bank can incur losses or potential
losses.
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MEASUREMENT
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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.
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Why do organizations take risks? The apt answer would be-to make
some handsome gains. Banks, the world over, generally, it is said that “NO
RISK-NO GAIN”, but sometimes, taking risk becomes disastrous for the
organizations.
It is evident from above that if risk are not managed properly, even
the survival of the bank may become under threat, risk management has,
therefore, become an important area, which needs to be looked into with
great concern and care.
Individual banks risks create Systematic risk, i.e., the risk that the
whole banking system fails. Systematic risk results from the high
interrelations between banks through mutual lending and borrowing
commitments. The failure of single institution generates a risk of failure for
all banks that have ongoing commitments with the defaulting bank.
Systematic Risk is a major challenge for the regulator.
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minimum values, say Capital Adequacy Ratio, certain caps are placed viz.,
Single Borrowers etc., so as to limit the risks.
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The major strength of cookie ratio is its simplicity, while of its major
drawbacks are :-
• There is no differentiation between the different risks in lending
activity. An 8% ratio applied for “AAA” rated large corporate exposure
and also for a small business with a lesser rating. That is, it was not risk
sensitive.
• In the CRAR computation, the capital charges are added. But,
summing arithmetically the capital charges of all transactions does not
capture diversification effects. By diversification we mean, that the
entire portfolio may not move unidirectional, but may compensate and
adjust in view of different co-relation among assets within the
exposure/portfolio. That is to say, there is an embedded diversification
in the 8% (CRAR), but the same ratio applies to all portfolios,
whatever their degree of diversification.
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The main differences between the existing accord and the new one are
summarized below:-
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With the introduction of new products like plastic cards (credit, debit,
smart cards etc.) the risk of frauds have increased manifold. According to
estimation, in an active issuing Bank, card fraud is likely to claim the lion’s
share of fraud being experienced in general, and could well dominate
average operating losses as a whole. Worldwide, frauds occurred due to loss
or steal of plastic cards that cause the greatest losses. The second largest
source and fastest growing source of loss is use of counterfeit cards.
Emerging areas of E-commerce and internet banking are also a matter of
concern.
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Once the risks have been identified, the million dollar question is –
What to do about the Risks? The suitable answer to this question would be
to manage the risks in an efficient and effective manner so that the
organization incurs minimum loss.
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The Client
STATE BANK OF INDIA (SBI) is the largest bank in India with over 180
years of banking experience. Today, State Bank of India ranks among the
top 25 commercial banks in Asia with assets exceeding US$60 billion. SBI
operates worldwide through an extensive network of over 9000 offices
including 50 overseas offices in 48 countries. The Bank has won the
Technology Award 2005, from the ‘Banker’, London. Until recently, SBI
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UK operation has been using the Misys-Equation banking application for its
operations. This application runs on the IBM AS400 platform. Since 2001,
IIL Risk Management has provided various IT related services to the Bank.
The Problem
SBI, UK’s Treasury operations use the Reuters 3000 dealing system.
Dealers negotiate and confirm various deals every day involving money
market and forex trades. These deals were posted manually into the banking
application. Manual posting carried with it the risk of error prone entries,
missed out deals, lack of suitable and timely checks & verification and
inability to ascertain accurately counter party dealing limits. The Bank
required ‘straight through processing’ from Reuters dealing server to the
Misys-Equation platform to minimise operational risk. With an eye on
future proofing the investment in the system it also desired that the solution
be platform independent and therefore be based on ‘java’ programming and
be integrated with the Meridian middleware provided by Misys. In addition,
they required counter party limits and exposures to be displayed back to the
dealer on a separate screen by intelligently using the information from
dealer initiated Reuter conversations with the counter party. Investigation of
available products in the market place found that they contained many
functionalities already catered for by the Reuter system and were not cost
effective and used obsolete technologies.
The Solution
IIL Risk Management (IIL) developed for the bank a unique and cost
effective solution to automate the entire process from capturing deals from
Reuter dealing 3000 server to posting into the core banking application.
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All the above modules work closely with each other in terms of
connectivity, request and response along with reliable audit trails.
The Benefits
The implemented solution reduced SBI, UK Treasury Department’s
workload considerably virtually eliminating the need for human
intervention. Operational efficiency was greatly improved. Timely display
of counter party dealing limits at both Group and Individual level and actual
exposures enabled the dealers to know the exact ‘position’ at any given
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time. This was an important technology based support for the Bank’s efforts
to minimise operational risk from manual interventions.
Case Study
Bank of Baroda, London, United Kingdom
The Client
BANK OF BARODA has significant International presence with a network
of 57 Offices in 19 countries including 38 branches of the bank and 17
branches of its seven subsidiaries besides 2 representative offices in
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Malaysia and China and a network of more than 2700 branches in India. In
the U.K, since the 1990’s the bank has been using the Misys-Equation
core banking application to support its activities at its London Main Office
and other branches. This application runs on the IBM AS400 Operating
platform. IIL Risk Management has been providing various IT related
services to the bank.
The Problem
Bank of Baroda U.K conducts it's clearing through Natwest/Royal Bank of
Scotland. The bank (main office and branches) receives all clearing
information such as cheques, giro credits and direct debits from Natwest on
a daily basis as printed statements along with the related instruments. The
process involves classifying each payment and posting the resultant
transactions into Misys Equation core banking product manually. Checks
have to be made in respect of stopped cheque, blocked account, inactive
account, closed account and incorrect accounts. Moreover, the account
numbers held at Natwest do not exactly match with that in the Misys-
Equation database. Manual entries were error prone requiring additional
verification. This process therefore, called for considerable effort and use of
human resources contributed to operational risk.
The Solution
IIL Risk Management has provided a solution to automate the entire process
end to end with the necessary validations at every level of the data pass
through. The objective being the reduction of manual effort to a minimum
and improvement in the accuracy of posted transactions and operational
efficiency.
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exchanged between banks and their customers. Both Microsoft and IBM
technologies are used with suitable data transfer methodology to IBM
AS/400.
IBM AS/400 operations menu guides the user to process the transferred
data, categorising the transactions as 'OK' to post and 'Exceptions' based on
established business validation rules and to tally the credit/Debit totals with
those from Natwest. The automatic mapping function enables correction of
incorrect account numbers. All the Branches including the Main Office have
access to menu options to view and correct the exceptions. A specially
written automatic posting program handles the posting of accounting entries
into Misys-Equation.
The Benefits
Implementation of the automated clearing system increased the speed of
processing, drastically reduced manual errors, eliminated delays in posting
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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
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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.
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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:
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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.
CONCLUSION
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