Risk Management in Banking

State Bank Academy, Gurgaon

RISK MANAGEMENT


BUSINESS IS INHERENTLY RISKY RISKS CANNOT BE AVOIDED COMPLETELY RISKS DEFY CONVENTIONAL THINKING IMPORTANCE OF RISKS CHANGES WITH TIME

FINANCIAL RISKS
 CREDIT

RISKS RISKS RISKS RISKS

 MARKET

 LIQUIDITY

 OPERATIONAL

Relevance of Credit Risk Management

Why Credit Risk Management?  Increase in bankruptcies  Decline in the average quality of loans  Higher concentration in loan portfolios  Capital market producing a Winners Curse effect  Changes in regulatory environment

What constitutes Credit Risk Management?

IDENTIFICATION QUANTIFICATION

POLICY/OBJECTIVES

MONITORING

IMPLEMENTATION

Objectives of CRM
Minimising losses  Remaining competitive despite various risks and stringent regulatory limits  Risk based pricing (for profit/capital optimisation)  Developing quality loan products  Developing sound lending policies and a rigorous appraisal system  Developing effective post sanction processes


What is Credit Risk?

Credit risk is the possibility of losses associated with changes in the credit profile of borrowers. The losses could take the form of default in the payment of principal or interest or both or non-payment of principal nonand/or interest when due or actual or perceived deterioration in the credit quality of portfolio (short of default).

Credit Risk
 All

credit assets have a profile of risks and returns  Credit risk can be a standalone risk (single loan) or the risk of a portfolio  The probability of non-payment is nonthe inherent risk in credit assets. The risks could be due to wilful default or nonnon-payment, financial distress/ bankruptcy, interest rate movements and possible pre-payment, changes prein credit spread etc.

Credit Risk
 If

the borrowers credit quality improves, there are no gains for the lending bank but the borrower can refinance his requirement at a lower price. If the borrowers credit quality declines, lending bank can revise the price upwards to recover a premium for the additional risk taken but the borrower may not agree to pay, particularly because he is now in a less comfortable position. All loan products have this characteristic of a limited upside and a large downside and are thus asymmetric.

Drivers of Credit Risk

 Default

Probability  Transition Probability  Credit Exposure  Loss Given Default  Time Horizon  Concentration

Default Probability
What is the probability that the borrower will default?  Define the event of default  Define the time horizon of default Default probability is the expected number of accounts in the portfolio or a particular rating grade that will fall in the default category within a specified time horizon

Transition Probability
Default is not an abrupt process  A firms credit worthiness and asset quality declines gradually. We may call this Credit Migration  Transition probability is the probability of credit quality of a firm improving or deteriorating over a specified time horizon  In the event of credit migration, the probability of future default increases  Changes in credit quality have implications in terms of changes in the credit spread


Financial Risk Parameters

 Financial

Ratios (Liquidity, leverage structure, profitability, interest cover, asset turnover)  Cash Flow adequacy  Maturity  Earnings protection  Financial flexibility  Accounting Quality  Quality of Financial Statements (auditors report, treatment of off-balance sheet offitems, exceptions reporting)

Industry Review
 Industry

rating (competitiveness, trade environment, cyclicality, regulatory framework, technology, financial performance and impact of macroeconomic environment) relative assessment (relative position within industry, relevant market share, customer base, cost structure, response to environmental change)

Business Analysis
 User

related  Product related  Price related  Market related  Promotional ventures  Availability of inputs  Manufacturing & Selling  Working Capital Management

Quality of Management
 Integrity  Track

Record  Experience/expertise/commitment/ competence  Financial conservatism  Attitude to risk  Succession planning  Structure & Systems  Payment record  Record of day-to-day operation of day-tothe account (s)

Transition Probability Matrix- An Example MatrixAAA AA+ AA A+ A BBB BB DEF

AAA AA+ AA A+ A BBB BB DEF

94.39 5.50 4.18 0.08 0.00 0.00 0.01 0.02 0.00

0.09

0.00

0.00 0.00 4.36

0.01 0.01 0.63 1.89

0.00 0.00 0.00 0.51 1.93

0.00 0.00 0.30 4.34 7.34

82.14 10.70 2.97 5.98 0.00 0.00 0.01 0.00 0.00 79.22 9.42 1.49 0.02 0.02 1.41 0.00

83.08 8.69 7.28 3.14 1.00 0.00

79.96 6.47 5.82 0.03 0.00

70.01 11.71 9.28 10.33 52.02 35.20 0.00 0.00 100.00

Credit Exposure
How much credit exposure does a bank have to a particular borrower at the time of default or credit migration?  Outstanding :that portion of the bank asset which has already been extended to the borrower. In case of default, the entire amount is exposed.  Commitment: the un-drawn portion of the loan. unThe borrower can draw from it whenever he faces financial distress  Covenants: terms and conditions/options which determine % of draw down under commitment (Usage Given default)


Loss Given Default

In the event of default, only a fraction of the risky debt can be recovered (recovery rate)  Recovery rate depends on industry, economic cycle, seniority of borrowing, value of collateral etc.  Recovery rate may also be sensitive to the borrowers credit rating  It is a calculated rate based on historical experience of the bank recovery in the event of default  LOSS GIVEN DEFAULT=1-RECOVERY RATE DEFAULT=1

Facility Expected Loss

The amount of income expected to be lost due to defaults and declining credit quality  Given that we can estimate a default profitability over a future time horizon and a loss given default; we can calculate how much we expect to lose  Expected loss (EL) = Default Probability * Loss Given Default * Credit Exposure  Expected losses can be managed with provisioning  EL is not a measure of risk


Portfolio Risk
 Standard

deviation and tail risk or extreme losses in loss distribution are two common measures of risk/unexpected loss. Both measures characterise the degree of dispersion in the distribution of losses  Portfolio risk is less than the sum of the standalone risks

Motivation for Active Credit Risk Management

Changing economics of traditional products (disintermediation, better capital mobility, lower returns and increased importance of risk)  New options e.g. syndicated lending  Higher exposure concentrations due to specialisation and maintenance of customer relationships  Taking advantage of the situation when capital adequacy requirements are disproportionately larger than the risk of the underlying assets


To recapitulate: Managing Standalone Credit Risk

Sound lending policy and loan appraisal systems  Credit risk rating and risk pricing based on expected loss and capital charge and proactive provisioning  Guarantees/collateral as risk mitigators  Proper documentation  Supervision, follow-up and monitoring of followadvances  Loan Review Mechanism


Managing Portfolio Credit Risk

Diversification and exposure settings based on group exposure, industry/sectorindustry/sectorwise exposure and geographic concentration  Asset diversification when the correlation is weak  Loan trading in the secondary market  Asset securitisation (collateralised loans/bond obligations  Credit derivatives e.g. credit swaps, credit spread options and credit linked notes


LIQUIDITY RISK
WHAT IS LIQUIDITY ?
LIQUIDITY REPRESENTS THE ABILITY OF A BANK TO TIMELY ACCOMMODATE DECREASE IN LIABILITIES FUND INCREASE IN ASSETS AT A REASONABLE COST

SOURCES OF LIQUIDITY
INCOMING DEPOSITS  CUSTOMER LOAN REPAYMENT  SALE OF BANK ASSETS  BORROWINGS  FLOAT FUNDS  REVENUES FROM SALE OF SERVICES


USES OF LIQUIDITY
    

DEPOSIT WITHDRAWALS DRAW-DOWN OF LOAN LIMITS FRESH LOANS REPAYMENT OF BANK BORROWINGS OTHER OPERATING EXPENSES

BANK LIQUIDITY PROBLEMS

A BANK FACES SIGNIFICANT LIQUIDITY PROBLEMS BECAUSE OF


THE NATURE OF ITS OPERATIONS

 MISMATCH IN TENORS OF DEPOSITS & LOANS

SENSITIVITY TO INTEREST RATE CHANGES

 EFFECT ON DEPOSITS & LOANS

LIQUIDITY RISK

THE RISK THAT A BANK MAY NOT BE ABLE TO MEET ITS MATURING COMMITMENTS OR MAY DO SO BY BORROWING PROBABLY AT EXCESSIVE COSTS

TYPES OF LIQUIDITY RISK

FUNDING RISK
NEED TO REPLACE NET OUTFLOWS DUE TO UNANTICIPATED WITHDRAWAL/NON-RENEWAL OF DEPOSITS

TIME RISK
NEED TO COMPENSATE FOR NON-RECEIPT OF EXPECTED INFLOWS OF FUNDS

CALL RISK
DUE TO CRYSTALLISATION OF CONTINGENT LIABILITIES & NEEDS OF NEW BUSINESS

SOURCES OF LIQUIDITY RISK

UNCERTAINTY OF: DEPOSITORS BEHAVIOUR DEMAND FOR CREDIT ENVIRONMENT IN THE FINANCIAL MARKET MAJOR NATIONAL/INTERNATIONAL DEVELOPMENTS

LIQUIDITY RISK MANAGEMENT



IDENTIFIED & MEASURED THROUGH MONTHLY (AS ON THE LAST REPORTING FRIDAY) GAP REPORTS.
 STRUCTURAL  LIQUIDITY

LIQUIDITY GAP ANALYSIS

RATIOS

DYNAMIC LIQUIDITY ESTIMATION

LIQUIDITY RISK MEASUREMENT STRUCTURAL LIQUIDITY GAP ANALYSIS



LIQUIDITY GAPS MEASURED USING STANDARD MATURITY BUCKETS RBI GUIDELINES ON CLASSIFICATION OF ASSETS, LIABILITIES & OFF- BALANCE SHEET ITEMS

A TYPICAL STRUCTURAL LIQUIDITY GAP ANALYSIS

(Rs. in Crores)
RESIDUAL MATURITY TOTAL OUTFLOW (A) 2188 565 1557 1544 2995 11023 4349 5870 30091 TOTAL INFLOW (B) 2481 978 4256 789 2980 7895 3361 7680 30420 GAP (C=B-A) 293 413 2699 -755 -15 -3128 -988 1810 329 GAP RATIO % (D=C/A) 13.39 73.09 173.35 -48.89 -0.05 -28.38 -22.72 30.83 1.09

1 TO 14 DAYS 15 TO 28 DAYS 29 DAYS TO 3 MONTHS OVER 3 MON. TO 6 MONTHS OVER 6 MON. TO 1 YEAR OVER 1 YEAR TO 3 YEARS OVER 3 YEARS TO 5 YEARS OVER 5 YEARS TOTAL

LIQUIDITY RISK - PRUDENTIAL LIMITS STRUCTURAL LIQUIDITY GAP ANALYSIS

RBI STIPULATION


MISMATCHES (NEGATIVE) IN 1-14 AND 15-28 DAYS NOT TO EXCEED 20% EACH OF THE CASH OUTFLOWS

INTERNAL POLICY STIPULATIONS



FUNDING OF LONG TERM ASSETS BY LONG TERM LIABILITIES MISMATCH RATIO IN OTHER TIME BUCKETS MAXIMUM CUMULATIVE OUTFLOWS TRACK COMMITMENTS GIVEN TO CORPORATES/ BANKS TO LIMIT OFF-BALANCE SHEET EXPOSURE

PRUDENTIAL LIMITS


CAP ON INTER-BANK BORROWINGS & CALL MONEY (RBI CLR. DATED 27-06.02) PURCHASED FUNDS VIS-A-VIS LIQUID ASSETS CORE DEPOSITS VIS--VIS CORE ASSETS (CRR/SLR& LOANS) DURATION OF LIABILITIES AND INVESTMENT PORTFOLIO WHOLE SALE / HIGH VALUE DEPOSITS SWAPPED FUNDS RATIO- EXTENT OF INDIAN RUPEES RAISED OUT OF FOREIGN CURRENCY SOURCES

INTEREST RATE RISK AND INVESTMENT MANAGEMENT

INTEREST RATE RISK

ADVERSE IMPACT ON THE EARNINGS OF A BANK (NET INTEREST INCOME) AND THE MARKET / ECONOMIC VALUE OF ITS ASSETS AND LIABILITIES DUE TO CHANGES IN INTEREST RATES

INTEREST RATE RISK TYPES

REPRICING RISK : DIFFERENT REPRICING DATES BASIS RISK : NON SYNCHRONOUS MOVEMENT OF RATES YIELD CURVE RISK : NON PARALLEL SHIFT IN YIELD CURVE OPTIONS RISK : EMBEDDED OPTIONALITIES IN PRODUCTS

INTEREST RATE RISK MEASUREMENT TECHNIQUES

INTEREST RATE SENSITIVE GAP ANALYSIS

RATE SENSITIVE GAPS MEASURED USING STANDARD MATURITY BUCKETS RATE SENSITIVITY BASED ON REPRICING OR REMAINING MATURITY OF ASSETS & LIABILITIES

ASSESSMENT OF IMPACT OF MISMATCHES ON NET INTEREST INCOME FOR EXPECTED SCENARIOS OF RATE CHANGES OVER ONE YEAR PERIOD

A TYPICAL INTEREST RATE SENSITIVITY ANALYSIS

(Rs. in Crores)
RESIDUAL MATURITY TOTAL LIABILITIES (A) 2188 565 1557 1544 2995 11023 4349 5870 30091 TOTAL ASSETS (B) 2481 978 4256 789 2980 7895 3361 7680 30420 GAP (C=B-A) (C=B293 413 2699 -755 -15 -3128 -988 1810 329

1 TO 28 DAYS 29 DAYS TO 3 MONTHS OVER 3 MON. TO 6 MONTHS OVER 6 MON. TO 1 YEAR OVER 1 YEAR TO 3 YEARS OVER 3 YEARS TO 5 YEARS OVER 5 YEARS NON SENSITIVE TOTAL

BASIS RISK


BASIS RISK OCCURS WHEN INTEREST RATES OF DIFFERENT ASSETS AND LIABILITIES MOVE IN DIFFERENT MAGNITUDES EVEN THOUGH THERE IS NO MISMATCH BETWEEN ASSETS AND LIABILITIES WITH RESPECT TO AMOUNTS AND REPRICING DATES, THERE WILL BE STILL SOME INTEREST RATE RISK DUE TO BASIS RISK

YIELD CURVE RISK

YIELD CURVE A LINE GRAPH PLOTTING THE YIELDS AT VARIOUS MATURITIES EVEN WHEN ASSETS AND LIABILITIES ARE PRICED BASED ON INTEREST RATES OF SAME KIND OF INSTRUMENT, INTEREST RATE RISK EXISTS ON ACCOUNT OF YIELD CURVE SHIFTS.

EMBEDDED OPTION RISK

PREPRE-PAYMENT OF LOANS IN CASE OF FALLING INTEREST RATES PREMATURE WITHDRAWAL OF DEPOSITS IN CASE OF RISING INTEREST RATES IN BOTH THE CASES BANKS ACTUAL NII IS LESS THAN THE ANTICIPATED NII

INTEREST RATE RISK PRUDENTIAL LIMITS



RBI HAS NOT PRESCRIBED ANY LIMITS BANKS ARE FREE TO PRESCRIBE THE PRUDENTIAL LIMITS DEVIATIONS TO BE REPORTED TO BOARD

MARKET RISK - INVESTMENT

CLASSIFICATION OF SECURITIES (B/S)
     

GOVERNMENT SECURITIES OTHER APPROVED SECURITIES SHARES DEBENTURES AND BONDS SUBSIDIARIES AND JOINT VENTURES OTHERS (CPs, MUTUAL FUND, UNITS ETC.)

CATEGORIES OF INVESTMENTS (PRUDENTIAL/ RISK MANAGEMENT ANGLE)

 HELD TO MATURITY

 HELD FOR TRADING  AVAILABLE FOR SALE

HELD TO MATURITY- NORMS MATURITY

INTENTION MAX. QUANTUM OF HTM ITEMS EXEMPTED FROM CEILING

RECAPITALISATION BONDS

PROFITS ON SALE TO CAPITAL RESERVES THROUGH P&L LOSS ON SALE TO P&L VALUATION - NOT MARKED TO MARKET

HTM-RISKS HTM-

PRICE RISK IF ACQUISITION COST IS ABOVE PAR RERE-INVESTMENT RISK

HELD FOR TRADING (HFT) INTENTION TRADING STRATEGIES RISK MANAGEMENT CAPABILITIES MANPOWER SKILLS CAPITAL POSITION

HELD FOR TRADING - NORMS



BASISBASIS- EXPECTED GAIN FROM MOVEMENT IN MARKET YIELDS TO BE SOLD WITHIN 90 DAYS PROFIT & LOSS ON SALE TO BE TAKEN TO P&L ACCOUNT FOR BOTH HFT AND AFS CATEGORIES VALUATION NORMS FOR HFT AND AFS MONTHLY/ QUARTERLY STIPULATIONS RECOGNITION OF APPRECIATION/ DEPRECIATION - DIFFERENCE IN TREATMENT BETWEEN AFS AND HFT

HFTHFT- RISKS MEASUREMENT & MANAGEMENT



PRICE RISK DURATION OF PORTFOLIO VAR TRADING POLICY

AVAILABLE FOR SALE (AFS)

RESIDUAL (WHATEVER IS NOT INCLUDED UNDER HTM AND HFT) SHOULD TAKE CARE OF REVENUES AND LIQUIDITY

INVESTMENT POLICY


BANKS TO FRAME POLICY TO ENSURE THAT INVESTMENTS OPERATIONS ARE CONDUCTED IN ACCORDANCE WITH SOUND AND ACCEPTABLE BUSINESS PRACTICES PRUDENTIAL LIMITS ON INVESTMENTS IN BONDS CAP ON UNRATED ISSUES AND PRIVATE PLACEMENTS SUBSUB-LIMITS FOR PSU BONDS, CORPORATE BONDS, GUARANTEED BONDS, ISSUER CEILINGS ETC. SAME DEGREE OF CREDIT RISK ANALYSIS AS IN THE CASE OF ANY LOAN PROPOSAL, NOT TO ENTIRELY RELY ON EXTERNAL AGENCIES MORE STRINGENT APPRAISAL FOR NON-BORROWER NONISSUERS

Why Operation Risk

 Deregulation  Globalisation

of financial services  Increased use of Information Technology  Mergers & Acquisitions  Increased outsourcing of activities  Sophisticated financial products

Examples of Operational Risk

Institution Activity
Barings Enron JP Morgan Chase, Citibank, Merrill Sumitomo Lehman Brothers LTCM London Stock Exchange Inadequate control of futures trading,poor segregation ofDuties Accounting standards deficiencies, governance weaknesses Enron SPVs Advances to Unauthorised copper trading, fraud and forgery Two minute delay in identifying, keying error Breakdown in understanding liquidity risk implications Computer system failure

Impact
1.4 bn pound loss $63.3 bn bankruptcy Loan Losses, 2.6 bn pound loss $6 m loss $3.6 bn bankruptcy Loss of Trading Day

Operational Risk

Historically, operational has taken a back seat to market and credit risk -it is not easy to quantify -it means different things to different people -in trading you are paid to assume market and credit risk but not operational risk However, operational risk can be large when not effectively measured or controlled

Operational Risk
 Basel

Committee Definition

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

Operational Risk
 Reserve

Bank of India Definition

Any risk which is not categorized 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.

Types of Operational Risks

People risk -Incompetence -Fraud  Process risk


Transaction risk
Execution error  Product complexity  Settlement error  Documentation/ contract risk


Types of Operational Risks

Operational control risk -Exceeding limits -Security risks -Volume risk  Technology risk -System risk -Programming error -Information risk -Telecommunication error  Risk from External Environment


Control of Operational Risk

 Overall

responsibility of control of Operational Risk vests with Board of Directors  Board Manages Operational Risk through IRMC/ORMC/Risk Management Dept  Major tool of managing Operational Risk is internal control systems

Control of Operational Risk

Book of Instructions  Circulars  Delegation of Financial Powers  Appropriate Reporting System  Policies of the Bank  Use of Information Technology  Self Assessment  Audit committees


Unless you are able to implement your controls & you have powers to penalise, the controls will be meaningless.

Mitigating Operational Risk

Basic objective of Operational Risk Management is to mitigate Operational Risk: Inspection & Audit Insurance Training Rewards

   

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