Unit 8 Risk and Basic Risk Management Framework

What is risk? To understand it in financial terms, a business is done keeping in mind

certain expected cash flows. These cash flows represent money which will be
generated by doing that business. The money generated should cover all costs
incurred and estimated profits. Now lets say a business is expecting the following
net flows which will cover all its costs and give required profits for survival and
expansion:
Year
I
Expected
net 1000
flow
Actual net flow
1100
Variance
100

1.
2.
3.
4.

II
2000

III
3000

IV
4000

1900
(100)

3100
100

3500
(500)

As can be seen cash flows in Year I & III is more than expected but cash flow in
Year II & IV is lower than expected. Why cash flows are different from as projected?
Because of various uncertainties, these uncertainties can either be favourable or
unfavorable, only the unfavourable variance in cash flow is known as risk.
Few points need to be understood in this regard:
Risk is not bad.
Risk cannot be completely eliminated
Risk needs to be managed.
Higher the risk, higher the return and thus higher is the capital.
First to understand that risk is not bad. Risk also returns in higher reward and often
results in better and unique methods to do a business. Secondly risk cannot be
completely eliminated while doing a business, risk will always be there, it is for a firm
to decide its goal and risk appetite. Why risk needs to be managed? Reckless risk
taking can result into losses which cannot be afforded and business has to shut
down.
How
risk
and
capital
are
related?
Capital
represents that amount of fund in the business which is necessary to start and grow
the business and which is assumed to be in the business as long as the business is
run. Capital is necessary to absorb losses. If a business involves high risk, losses
could be high and thus capital needed would be high to cover those losses.
Basic Risk Management Framework:

As already explained earlier, risk cannot be eliminated altogether and thus it has to
be managed based upon the risk appetite of the firm. For this there must be a risk
management framework, the basic spirit of which is common to all organizations.
From now, onwards we will study risk management framework with respect to banks.
A risk management framework basically involves the following 6 steps:
1. Organization for risk management:
2. Risk Identification
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3.
4.
5.
6.

Risk measurement
Risk pricing
Risk Monitoring and control
Risk Mitigation.
1.Organization for Risk Management:
It must consist of

(i)
(ii)

(iii)
(iv)

Board of Directors: They have overall responsibility of management of risk. They

decide the risk management policy keeping in mind the corporate goal of the bank
Risk Management committee of board: A board level sub- committee, it sets
guidelines as to risk management and its reporting, set up prudential limits and their
review,ensure risk management process is robust and ensure proper manning of it
Senior Level executives: They implement the policy.
Risk management support group: Functionaries involved in analyzing, monitoring
and reporting.
2. Risk Identification:
This is most important function. It is to known what are the risks a bank will face in
doing business. They can emerge from products, processes, policies.
3. Risk Measurement:
Once you know what all risks will be there, it is important to know how much of it is
there. For example A Bank comes up with a product loan against property. What
risks can be identified? Since loan is only against security of property how will it be
repaid? From where the income to repay loan will come? For what purpose to give,
can we give for investing in stock market or buying properties? Whom to give?
Should it be given to businessmen or salaried people? How much value of property
should be given?All the above are the identified risks. Now question arises how
much is the risk. Can we measure that risk?
There are 3 methods to measure risks
(a)
Sensitivity :deviation of a target variable due to unit movement of a single
market parameter. For example, change in value of portfolio due to 1% change in
interest rate
(b)
Volatility: is common statistical measure of dispersion around the average of
any random variable. Volatility over a time horizon T is calculated as
(c)Downside potential which is measured by VaR ( Value at risk)
All the three parameters are discussed in details later in the unit.
4. Risk Pricing:
Once risk is identified and measured it should be priced accordingly.How to price it?
It is priced by adding risk premium on the interest charged to it. For example, lets
say based on measure of past data it is observed that AAA rated accounts have 1 %
probability of default and rate of interest charged to them is 10 % and AA rated
accounts have 4 % probability of default thus bank needs to charge higher rate of
interest on them lets say 12 %. This 2 % represent risk premium and method to
price the risk.
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Pricing takes into account the following 4 components:

(a)
Cost of fund
(b)
Operating expenses
(c)
Loss probability
(d)
Capital charge
For example, Bank A has taken a FD @ 10 % rate of interest for 3 years. This is cost
of fund. Now cost of staff, branch expenses work out to 1 %. Bank gives loan to AAA
rated borrower where probability of loss is 1 % and finally Bank has to keep capital
of 1 % as provisions Thus final rate at which loan can be given is 10+1+1+1=14 %.
(Please remember this is a very crude example for sake of simple understanding)
Risk Monitoring & Control:
Most important component of risk monitoring & control is Management Information
system ie MIS. Bank to continuously monitor that all the policy guidelines are
followed, powers are exercised as per delegation, stop loss limits etc are followed. A
separate and independent risk management department must be there which can
ensure proper assessing of risk and its monitoring and reporting.
Risk Mitigation:
Strategies to reduce risks are known as risk mitigation. Risk mitigation can be done
through various techniques like taking collateral, third party guarantee or can be
done through buying derivatives or portfolio diversification. Risk mitigation measures
reduce downside variability in net cash flow and also upside potential.

Unit -9 Risks in Banking Business

Unity
Banking business can be divided into three lines:
1. Banking book: Includes advances, deposits of the banks. They also represents
fixed assets of the banks and any borrowings made by them .The banking book is
exposed to credit risk, operational risk, liquidity risk and interest rate risk. They are
normally held till maturity and accrual system of accounting is applied.
2. Trading Book: These generally consists assets which are exposed to markets. For
e.g. Treasury Department of the Bank invests in various government bonds, stock,
foreign currency, corporate bonds. Trading book apart from credit, operational,
market and liquidity is also exposed to market risk. They are normally not held
until maturity and positions are liquidated in the market after holding it for a
period and mark to market system is followed.
3. Off Balance Sheet exposure: These are exposures which may convert into asset
or liability based upon the happening of a certain event. These do not appear in
Balance sheet but are shown as notes to Balance sheet. For example, Bank issues
guarantees on behalf of their customers, in case that guarantee is invoked by the
beneficiary, bank will have to immediately make payment to beneficiary then it will
become liability of the bank and reflect in Balance sheet. Can off balance sheet
exposures be asset too? Yes, suppose a Bank is involved in litigation and judgment
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comes in favor of Bank and Court directs the other party to pay some amount as
compensation to Bank then that will result as asset. Off valance sheet exposures
may convert into exposure of banking book or trading book depending upon the
nature of off balance sheet exposure.
Before we go any further and understand various risks faced by Bank, we need to
understand certain concepts which are related with valuation of assets and liabilities.
1. Mark to Market: Mark to market simply means that assets and liabilities should be
shown at their market value. Mark to market relates to trading book in banks. Why?
Banks hold government securities, bonds, stocks their prices changes daily,
Suppose a Bank holds a government bond valued at Rs 1000 on 01.01.2014, on
01.02.2014 it is valued at Rs 1200, now this Rs 200 is profit and must be recognized
as profit and bond must now be shown in books at Rs 1200.This procedure of
showing the securities at their market price is known as mark to market.
There are 6 types of investments hold by a bank (i) Government Securities (ii) Other
Approved Securities (iii) Shares (iv) Debentures and Bonds (v) Investments in
Subsidiaries/Joint Ventures (vi) Other Investments.
Now these securities can be held under three methods:
(a) Held Till Maturity (HTM): These comprise investments the Bank intends to hold till
maturity. Investments included in this category are carried at their acquisition cost.
(b) Held for Trading(HFT) :Investments acquired with the intention to trade within 90
days from the date of purchase are classified under this head.The individual scrip in
the category will be marked to market at quarterly or at more frequent intervals.
(c) Available for Sale (AFS) Investments which are not classified either as HTM or
HFT are classified as AFS. They are marked to market at monthly intervals.
Assets and liabilities in banking books are hold till maturity and thus always appear
at acquisition cost. For example Bank purchases computers for bank for Rs 1 crore.
These computers will appear at Rs 1 crore in the books of the company.
Risk in Banking
1.
Liquidity Risk: It arises because long term assets (loans) are financed by
short term liabilities (deposits). For eg a Bank has Rs 1 crore FD for 3 years. Now
Bank gives Rs 1 crore loan for 5 years. After 3 years bank has to repay this FD
amount but loan will be repaid only after 5 years, so how will bank pay back this
amount to depositor? This is known as liquidity risk.
They are of 3 types
(i)
Funding risk: Now suppose in the above example bank has given loan for 3
years only, but depositor withdraws the FD after 1 year then how to fund this is
known as funding risk
(ii)
Time risk: If loan repayment is not regular,ie cash inflows are not regular it is
known as time risk.
(iii) Call risk: If off balance sheet exposures or contingent liabilities crystalize it is
known as call risk. Lets say bank has issued bank guarantee of Rs 1 lakh on behalf

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of its customer. Guarantee is issued after obtaining a specific margin for a fee. Now
if the guarantee is invoked by the beneficiary bank will have to make payment of Rs
1 lakh, but how to have money for this Rs 1 lakh, this is known as call risk.
2.
Interest rate risk : If interest rates changes, banks income will change which
will affect profit, this is known as interest rate risk. They can be classified into
following 6 categories
(i)
Gap or mismatch risk: It arises because of difference in time, amount, etc of
assets and liabilities
(ii)
Basis risk. Suppose repo rate rate is reduced by 1 % now this will mean that
loan rates need to be reduced by lets say 0.5 % but banks may not be able to
reduce deposit rate by 0.5 %. This is called basis risk that same reduction or
increase in interest rate will affect price of deposits and advances differently.
(iii)
Yield curve risk: This is seen in case of investments in government securities,
bonds etc. They are of varying maturity period. For example 91 days T Bills, 182
days T bill, 364 days T Bill, prices of these securities change when interest rate
change, but same percentage change will not change prices of securities in similar
degree. For example, a 1 % increase in interest rate will cause prices of t bills to fall,
but the fall amount will be different for all the maturities. This is called yield curve
risk.
(iv)
Embedded option risk: Risk that embedded options may be used. For
example, a FD can be withdrawn before time.
(v)
Reinvestment risk: Let say Bank has taken FD of Rs 3 lakh at 10 % for 3 and
gives loan of Rs 3 lakh at 12 % for 3 years. Thus bank earns 2 % profit. But this
loan is repaid 1 lakh every year, here arises the problem the amount of Rs 1 lakh
which is repaid must again be re invested at 12 % if bank wants to maintain 2% profit
ratio.
(vi)
Net interest position risk: If bank has more advances then paying liabilities
(deposits) then reduction in interest rate would means net interest income of bank
decreases.
3.
Market Risk: Also known as price risk is, reduction in the value of securities
due to adverse price movement. For example bank hold share of Rs 100, and price
of the share falls to Rs 90, this is market or price risk.
4.
Credit Risk: The risk that counterparty will default on payment, due to refusal
or inability. It can be (a) Counter party risk or (b) country risk
5.
Operational Risk:Operational risk is the risk of loss resulting from inadequate
or failed internal processes, people and systems or from external events. Strategic
risk and reputation risk are not a part of operational risk It includes Fraud risk.
Communication risk. Competence risk. Model risk, Cultural risk, External events risk.
Legal risk, Regulatory risk, Compliance risk. System risk and so on.

Transaction Risk= is the risk arising from fraud, both internal and external,
failed business processes and the inability to maintain business continuity and
manage information.

Compliance Risk= risk of legal or regulatory sanction, financial loss or

reputation loss that a bank may suffer as a result of its failure to comply with any or
all of the applicable laws, regulations, codes of conduct and standards of good
practice. It is also called integrity risk

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Unit 10 Risk regulations in Banking Industry

From here we will study Basel, how Basel framework evolved, what were the pillars
prescribed, what risk were recognized, how it is applied in Indian context.
Why Banks are important? Ever heard of Too Big to Fail (TBTF)? TBTF became
popular after global meltdown crisis and failure of Banks like Lehman. It meant that
these institutions are so big and their survival so vital that they must not be allowed
to fail and must be protected at every cost. This is the importance of Banks in an
economy, failure of one bank can create failure of whole banking system because of
huge mutual lending and borrowings and commitments between Banks. Thus it is
very important to regulate the banking industry and ensure that banking system
remains robust and flourishing and is not engaged in reckless lending or taking
unwarranted or extraordinary risks.
Basel Committee on banking supervision (BCBS): on 26th June 1974 a number
of banks have released Deutschmarks( former currency of Germany) to Bank
Herstatt ( a German bank) in in Frankfurt in exchange for dollars which were to be
delivered in New York. However due to differences in time zone there was delay in
time payment. In the meantime German regulators liquidated Bank Herstatt. Result ?
Banks who had given Deutschmarks were faced with credit risk. Thus risk of
settlement that arises from time difference came to be known as Herstatt risk. This
prompted G-10 countries to for Basel Committee on banking supervision in 1974.
First Basel accord 1988:
The first Basel accord primarily focused on placing a framework for minimum capital
requirements to address credit risk. Once again we reiterate why capital is
important? In its simplest form, capital represents the portion of a banks assets
which have no associated contractual commitment for repayment. It is, therefore,
available as a cushion in case the value of the banks assets declines or its liabilities
rise. Thus when BCBS focused on credit risk, which means that money lent will not
be received back and loss would be suffered, it prescribed minimum capital
known as CRARwhich must be there to absorb these losses or shocks so that
Banks do not go bankrupt.
The accord provided for detailed definition of Tier I and Tier II capital. It also
classified Bank assets into 5 buckets. 0, 10 %, 20 % 50 % and 100 %
Category
Sovereigns
Banks
Public sector enterprises
Others
[

Risk weight assigned

0%
20%
50%
100

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What does this risk weight mean? Understand this, suppose a bank ABC Ltd in India
which has capital(Tier I + Tier II) of Rs 40 lakh and has given loans of Rs 100 lakh
to Government of India (GOI), Rs 200 lakh to State Bank of India and Rs 300 lakh to
Reliance company. What would be risk weighted assets (RWA) of ABC ltd ?
Exposure to
Amount
Risk weight
RWA
GOI
100
0
0
SBI
200
20
40
Reliance
300
100
300
Thus as we see from above example, RWA of Banks are 340, So CRAR of the bank
would be
Total Capital Funds
(RWA for Credit Risk)
=
40/340= 11.76 %. This was how initially CRAR was calculated with only capital
for credit risk being considered.

(i)
(ii)

1996 Amendment to include market risk.In 1996 amendments were made to 1988
basel accord and market risk was also recognized and methods to measure it were
prescribed. Salient features are given as below:
Banks to identify a trading book and hold capital for market risk under trading book
and organization wide foreign exchange exposures.
Capital charge to be measured based on 10-day 95 percent VaR metric. Market
requirements were equal to the greater of either the previous days VaR, or the
average VaR over the previous 6 days multiplied by 3.
Basel- II Accord- Need and Goals
Basel I accord understood the importance of viability and robust systems for
supervision of Banking Industry on a global basis and focused on maintaining
regulatory capital to absorb any business losses or shocks. However credit risk
assessment under Basel I was not risk sensitive enough.
How? There were fixed risk weight buckets; if exposure was to a corporate it
attracted uniform risk weight of 100%. For example Company A which is very strong
and has good fundamentals will also be given 100% risk weight and a Company B
which doesnt have very good net worth or business fundamentals will also be given
100 % risk weight.
[

So how it affected Banks?

Not all commercial loan recipients have the same amount of risk. A loan to a wellestablished company is far less risky than a loan to a start-up company. The effect of
this shortcoming in Basel Is risk-weighting methodology is that banks have an
incentive to engage in what is known as regulatory arbitrage.
Essentially, regulatory arbitrage describes a situation where, if a bank is presented
with two options, both of which receive the same regulatory treatment, but each of
which result in differing profit-making opportunities, the bank will choose the more

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lucrative option. In the commercial loan example above, from a regulatory

perspective, it doesnt matter whether the bank makes the loan to the start-up
company or the well-established company; in either case the bank will have to
include 100% of the loan in its risk-weighted assets. However, from a profit-making
perspective, the loan to the start-up company will be riskier, and therefore will
demand a higher interest rate.
Consequently, the bank will have an incentive to make the loan to the start-up
company. Given this situation, the bank will usually pursue the opportunity with
higher earning potential. However, as seen with the example of the start-up
company, pursuing greater profit usually means that the bank is taking on higher
risk. This again leads to a situation where the level of capital required under the
Basel I methodology is not sufficiently commensurate with the risk in the banks
assets.
Also Basel I did not recognize the role of credit risk mitigants such as credit
derivatives, securitizations, collaterals and guarantees in reducing credit risk. It also
did not take into account operation risks of the banks.
Thus After several years of negotiations and consultations, the BCBS released a set
of revisions to Basel I, entitled International Convergence of Capital Measurement
and Capital Standards: A Revised Framework, also known as Basel II on 26th June
2004 (exactly 30years after Herstatt Bank went into liquidation)
Structure of Basel II:
While Basel I was just focused on minimum capital requirement, basel II accord is
based on there pillars:
(i)
Minimum Capital Requirement
(ii)
Supervisory Review Process
(iii)
Market Discipline
In this unit we will concern ourselves with calculation of Minimum capital
requirement.
Pillar 1- Minimum Capital Requirement.
As we have seen above Basel accord 1988 prescribed minimum capital requirement
for credit risk. Subsequently in 1996, capital for market risk was also prescribed.
However Basel II accord also recognized operational risk and provided for
maintaining capital for it.
Before we proceed and understand how capital charge for all the three risks (i)
Credit (ii) Market & (iii) Operational risk is calculated, we need to first understand
what all forms part of capital funds:
Capital is divided into Tier I capital also known as Core capital and Tier II capital
Tier I Capital:
1.
Paid up equity capital, statutory reserves and other disclosed free reserves
2.
Capital Reserves arising out of sale proceeds of assets
3.
Innovative Perpetual Debt Instruments (IPDIs) which meet the regulatory
requirements advised by RBI for the purpose limited to maximum 15% of total Tier-1
capital as on 31st march of the previous financial year.

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4.
Perpetual non-cumulative preference shares (PNCPS), which meet the
regulatory requirements advised by RBI for the purpose subject to a limit such that
total of IPDIs and PNCPS doesnt exceed 40% of Tier I capital at any point of time.
Tier II Capital:
1.
Revaluation reserves at a discount of 55 %
2.
General provision on standard assets, floating provisions, provisions held for
country exposure, investment reserve accounts and excess provision subject to a
maximum of 1.25% of total RWA
3.
Upper Tier II capital which includes PNCPs, redeemable non-cumulative
preference shares (RNCPS) and redeemable cumulative preference shares (RCPS)
issued in accordance with the regulatory guidelines for the purpose.
4.
Subordinated dents issued and computed in accordance with the regulatory
guidelines for the purpose.
5.
IPDI and PNCPS held in the books in excess of prescribed limit and not
included for computing Tier I capital
The Tier II capital cannot be more than Tier I capital

Numericals & Case Studies - Calculation of Capital:

Case 1.

Bank of Indians had paid up capital of Rs 500 crore, Reserves of Rs

250 cr, , Revaluation reserve of Rs 100 cr, Perpetual non cumulativeprefence shares
(PNCPS) of Rs 50 cr and subordinated debts of Rs 200 cr. Calculate Tier I and Tier
II capital of Bank of Indians and total capital fund of the Bank.
Tier I capital of the Bank = Paid up capital + Reserves+PNCPS
= 500 + 250+ 50 = 800 cr
Tier II Capital =
Revaluation reserves at the discount of 55% +
Subordinated Debt
=
45* + 200 = 245 cr
*(Remember 55% of discount means, only 45% of revaluation reserve will be
considered)
Total Capital of Bank

= 800+245 = 1145 cr

Case 2.Lena Bank has paid up capital of800 crore and Free reserves of Rs 500 cr.
Bank during the yea sold one of its building recording profit of Rs 50 cr which were
capitalized. Bank also had general provision and contingency reserves of Rs 400 cr.
RWA for credit and operational risk for Bank were 7000 cr and RWA for market risk
was 2000 cr. Subordinate debt stood at 250 cr. Calculate Tier I, II and total capital of
Bank.
Tier I = Paid up capital+ Free reserve + capital reserve arising out of sale proceeds
of assets
= 800 + 500 + 50 = 1350 cr

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Tier II = Provisions for Contingency reserves + Subordinated Debt

= 112.50 + 250 = Rs 362.50
Total Capital funds = 1712.50 cr
Structure of Basel-II
Pillar 1 Minimum Capital Requirement
1. Capital for Credit Risk
(i) Standardised Approach (ii) Internal Ratings Based (IRB) Foundation Approach
(iii) Internal Ratings Based (IRB) Advanced Approach
2. Capital for Market Risk
(i) Standardised Approach (Maturity Method) (ii) Standardised Approach (Duration
Method) (iii) Internal Models Method
3. Capital for Operational Risk
(i) Basic Indicator Approach (ii) Standardised Approach (iii) Advanced Measurement
Approach
Pillar 2 - Supervisory Review Process
1. Evaluate risk assessment
2. Ensure soundness and integrity of banks' internal process to assess the
adequacy of capital
3. Ensure maintenance of minimum capital - with PCA for shortfall.
4.
Prescribe differential capital, where necessary - i.e., where the internal
processes are slack.
Pillar 3 - Market Discipline
1. Enhance disclosure
2. Core disclosures and supplementary disclosures
3. Timely - semi annual
Pillar 1 - Minimum Capital Requirement
Basel 1 Accord and the 1996 amendment thereto has defined capital requirement as
Capital = Min. Capital Ratio (8%) x (Credit Risk + Market Risk)
The Revised Capital Accord or Basel II defines the capital requirement as Capital =
Min. Capital Ratio (8%) x (Credit Risk + Market Risk + Operation Risk) It is to be
noted that there is no change In the definition of capital
In the minimum capital ratio, which remains 8%
In the calculation of market risk and it remains as per 1996 Amendment
The changes are in
Method of calculating risk in credit exposures& inclusion of operational risk
Capital Charge for Credit Risk:

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1) Standardised Approach: Banks are required to slot credit exposures into

supervisory and risk weight is accorded
The risk weights for sovereign, inter-bank, and corporate exposures are
differentiated based on external credit assessments.
[[
2. Internal Rating Based approach: IRB approach has two options Foundation IRB
and Advance IRB. In IRB approach bank s internal assessment of key risk
parameters serve as primary inputs to capital calculation. In IRB capital requirement
of each exposure is calculated. For eg Bank has given loans to 100 corporates with
AAA rating. If bank followed standardized approach all these 100 loans would be
assigned a specific risk weight of 20%. However, under IRB approach bank will
compute capital charge for each loan individually based on certain specified
parameters.
The IRB Approach computes the capital requirements of each exposure directly
before computing the risk-weighted assets. Capital charge computation is a function
of the following parameters:
1. Probability of default (PD):which measures the likelihood that the borrower will
default over a given time horizon
2. Loss given default (LDG) :which measures the proportion of the exposure that
will be lost if a default occurs
3. Exposure at default (EAD): which for loan commitment measures the amount of
the facility that is likely to be drawn in the event of a default.
4. Maturity (M): which measures the remaining economic maturity of the exposure.
Foundation IRB
Advanced IRB
PD: provided by bank, based on own PD: estimated by bank, based on own
estimates
estimates through historical records
LGD: Given by Supervisor
LGD: Provided by bank, based on own
estimates
EAD: Given by Supervisor
EAD: Provided by bank, based on own
estimates
M: Provided by bank, based on own M: Provided by bank, based on own
estimates
estimates
Risk weight: Function provided by the Risk weight: Function provided by the
committee
committee
Data Requirements: Historical data to Data Requirements: Historical data to
estimate PD ( 5 years )
estimate LGD ( 7 years ) and historical
exposure data to estimate EAD (7 years)
plus that for PD estimation

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Unit 11 Market Risk

Market risk means risk of reduction in the value of securities held in the portfolio due
to fall in the prices of securities. A bank in its trading books holds the following
financial instruments (i) Debt securities (ii) Equity (iii) Foreign Exchange
(iv)Commodities (v) Derivatives held for trading.
As has been explained earlier, the trading book of the bank is marked to market,
when portfolio is marked to market; there is risk of adverse price movement which
will result in decline in value of the portfolio.
For example a Bank has Rs 1, 00,000 in the form of Government bonds as on
01.01.2014. The government bonds are tradable just like shares and thus there
value changes daily. On 01.04.2014, value of these bonds reduces to Rs 90,000.
Thus bank has suffered loss of Rs 10,000 on account of decline in value. This is
called market risk.
Market risk can be categorized into (i) Interest rate risk (ii) equity price risk (iii)
foreign exchange risk (iv) commodity risk.
(i)
Interest rate risk: Interest rate and value of securities are inversely related.
As interest rate rise, bonds value fall and vice versa.
(ii)
Equity price risk : Stock prices may move on account of general market
factors or firm specific factor.
(iii)
Foreign exchange risk : Movement in the prices of currency creates, foreign
exchange risk
(iv)
Commodity risk: Trading of various commodities such as gold, silver,
cereals, and crude oil etc. is done. Banks take positions in these commodities. Any
adverse movement in the prices of commodities result in loss to the bank.
Market Risk Management(A) Framework Organisational Structure:
(I) Board of Directors: They have overall responsibility for management of risk. They
decide the risk management policy of bank and set limits for liquidty, interest rate,
foreign exchange and equity price risk.
(II) Risk Management committee: It is a board level sub committee. They ensure (i)
setting guidelines for market risk management and sub committee. (ii) ensure market
risk management conforms to overall risk policy of the bank. (iii) set up prudential
limits and its periodical review (iv) ensure robustness of measurement of risk models
(v) ensure proper manning.
(III) Asset liability Committee : ALCO is responsible for implementation of risk and
business policies. They ensure (i) product pricing for deposits and advances (ii)
maturity profile and mix of incremental assets and liabilities (iii) interest rate view of
bank (iv) funding policy(v)transfer pricing (vi) balance sheet management.

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(B) Risk identification: All products and transactions should be analyzed for risks
associated with them.
(C) Risk Measurement :Its based on (a) sensitivity (b) downside potential
a) Sensitivity: sensitivity captures change in market price due to unit movement of
a single market parameter. These parameters can be supply demand position,
interest rate, market liquidity, inflation, exchange rate etc. This measure suffers from
demerit that it doesnt take into consideration the combined effect of various
parameters. Sensitivity generally measures the change in the value of security due
to movement of interest rate and is generally measured by (i) basis point value (ii)
Duration
(i) Basis point value: This is the change in value of security due to 1 basis point
(0.01%) change in market yield.
Illustration 1. Federal Bank made investment in Govt. Securities worth Rs 4 crore.
Maturity period of bond is 5 years and face value is Rs 100 and coupon rate is 10.
Bond has market yield of 1 2 % and price of bond is 90. Now market yield increases
to 12.05 and price of bond changes to 89.50. Calculate (i) basis point value of
bond(ii) what will be change in the value of investment
(i) When yield changes by 0.05(5 basis point) % ie from 12 to 12.05 price changes
by 0.50 ie from 90 to 89.50 so basis point value of bond ie change in price for 1
basis point is is
= 0.50* 0.01 = 0. 10%
0.05
(ii) change in value of investment: Change per Rs 100 is 0.10 so change for Rs 4
crore will be will Rs 40,000
(ii) Duration :Duration (also known as Macaulay Duration) of a bond is a measure of
the time taken to recover the initial investment in present value terms. In simplest
form, duration refers to the payback period of a bond to break even, i.e., the time
taken for a bond to repay its own purchase price. Duration is expressed in number
of years.

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