A PROJECT REPORT ON
RISK MANAGEMENT IN BANK
ALL INDIA MANAGEMENT ASSOCIATION-CENTRE FOR MANAGEMENT EDUCATION
MANAGEMENT HOUSE, 14 INSTITUTIONAL AREA, LODHI ROAD, NEW DELHI-110002 OCTOBER, 2010
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
RISK MANAGEMENT IN BANK
Reg. No. 750621607
Date: 25 October 2010
New Delhi 5.DETAILS OF THE PROJECT
1. No. 6. Manager – (Account)
Name of the project Supervisor :
Date: 25 October 2010
. 4. Name of the Course Address : : : : Abhijeet Kumar 750621607 PGDM 17/8. Name Reg. 2. Title of the project : Risk Management in Bank Rakesh Singh Sr. Mukherjee Nagar. 3. Indra Vikas Colony.
Place: Delhi Date: 25 October 2010 Abhijeet Kumar
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.
This is to certify that the dissertation titled “Risk Management in Bank” is a faithfully bonafide work done by Mr.
Rakesh Singh Sr. 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). Manager (Account)
Abhijeet Kumar Reg. 2010
. Manager (Account) who provides us all the relevant information regarding my project. No. I am also thankful to Mr. Thanks are also due to the staff of AIMA-CME Library and Information Centre. I am thankful to ICICI Bank from where I got the relevant information regarding my project. I would also like to thank my friend and family member. Sr. In the end I am thankful to that almighty god who gave me inspiration to complete this project. 750621607 PGDM New Delhi 25 October.ACKNOWLEDGEMENT
I have had considerable help and support in making this project report a reality. Rakesh Singh.
Executive Summary Chapter-1 • Introduction to risk management in banking • Problem in study • Objectives in study • Research methodology • Limitation • Scope of the Study Chapter-2 6-29 • Conceptual Framework of ALM
1 2-5 3 4 4 4 5 5
7 17 28 30-39 20 37
Guidelines for Asset Liability Management (ALM) System in Financial Institutions (FIS)
• Review of existing literature summary Chapter-3 • History and Growth of the bank • Risk Management at ICICI Chapter-4 40-93 • Performance evaluation of bank • Risk Management Guidelines for Commercial Banks • Inter-Bank Exposure and Country Risk • Foreign Exchange (FOREX) Risk Conclusion & Recommendation Bibliography
41 52 68 87 94 95
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 normal course Fis are expose to several major risk in the course of their business.which underlines the need of effective risk management system in Fis. The project is divided into three phases in first phase we have highlighted the introduction of risk management in banking sector. In order to give some giving to above lines we have made a project report on ICICI bank. Second phase consist of conceptual framework of risk management and ALM it is also include some existing literature review on risk management. market risk. Third phase consist of history and growth of the bank also its include the performance evaluation of the bank. operational risk.Generally classified as credit risk. the problem and objective of the project. Secondly we have also shown the research methodology of the whole project.
CHAPTER – 1
procedures and practices to the tasks of identifying. Mortgages and residential mortgages have given institutional and individual investors powerful new tools with which to disperse risk both domestically and internationally. increasing numbers of firms are considering how risk can be managed positively to enhance the firm’s value. together with improvements in technology.
. Instead of only associating risk as a potential downside of their operations. it entails the systematic application of management policies. These developments have enabled all companies to take a more proactive view towards risk. In its broadest sense. analysing. The past decade has also heralded enormous developments in new financial products. assessing. With the raid growth in new tools. treating and monitoring risk. Advances in complex financial products. have lowered the cost of and expanded opportunities for hedging risk.INTRODUCTION TO RISK MANAGEMENT
Risk management is recognised in today’s business world as an integral part of good management practice. quantifying risk and interpreting risk measurements have never been more important.
forex risk etc. Here in this project our methodology is based on two source. primary and secondary source
Under secondary source we have data collected from outside the bank such as internet.ficci library.credit risk. To know the banks performance.B. To know the guidelines setup by R.
To get the conclusion from the undertaken project one should must go through a proper methodology.liquidity risk.I for commercial banks To know whether the banks are following those guidelines or not.
.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.
• • • • To know the concept of risk management in banking. stock exchange .PROBLEM
Bank in the process of financial intermediation are confronted with various kinds of financial and non financial risk viz.
The asset-liability management plays a very important role in the banks and has a very vital scope in these institutions. 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.
.SCOPE OF THE STUDY
Through effective and efficient asset-liability management. If inefficient banking firms have a tendency to remain inefficient. the banks can increase their productivity and reduce cost-inefficiency.
CHAPTER – 2
asset-liability management is the management of total balance sheet dynamics with regard to its size and quality. Simply put. concerning not only individual trading or balance sheet positions but with overall balance sheet perspective. exposure control. volatility in interest rates and adverse business environments including the recessionary trends in global economy. 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. It requires assessing all available avenues for managing risks through natural methods. It involves. The technique of managing both assets and liabilities has come into being as a strategic response of banks to inflationary pressure. during the last two decades market risk has gained prominence and especially after the Basle Committee Accord of 1988. The
. Historically. pricing.CONCEPTUAL FRAMEWORK
An Overview Historical Background In the context of present day’s rapidly changing business environment. if any. asset liability management in the financial sector especially banking refers to a holistic approach to risk management. Asset Liability Management (ALM) encompasses the effects of market risk. credit risk constituted the major challenge to the banking sector. Risk can be categorized into credit and market risk. which was instrumental in framing broad guidelines for determining the various risks associated with financial sector. and use of derivatives. 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. diversification. However.
profitable growth and at times survival of a financial institution depends on effective ALM. 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. interest spread and other balance sheet ratios • • Budgeting and strategic planning Examine the profitability of new products
. growth. 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. this would controlling the volatility of net income. and liquidity risk and finally ensuring an acceptable balance between profitability. net interest margin. In banking scenario. Scope and objectives of ALM The primary objectives of ALM is not to eliminate risk . and risk. capital adequacy.
loan defaults are managed by the credit policy of the bank. Broadly speaking.org.e. Given the complexities of bank’s balance sheets and rapidity of changes. banks are exposed to both categories of risk viz. funding and capital planning. Amendment to the Capital Accord to Incorporate Market Risks. profitability growth and at times management of certain credit risks which are caused by market risk variables for e. loan defaults may increase thereby deteriorating the credit quality. the market risk is related to the Asset Liability Management process and is caused by changes in market variables. in a highly volatile interest rate environment.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.credit risk and market risk. 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. While credit risk which is mainly on account of the counter party failure in performing the repayment obligation on due date i.bis.
.g. 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. January 1996). chances of loss or risks are only complex in nature but also varied in dimension. monitors and control interest rate risk exposure and that is subject to appropriate board and senior management oversight (source-www.
interest rate risk means changes in the interest income due to changes in the rate of interest. as well as a system of internal controls. Thus. Accordingly. b) Net interest income arising out of mismatch in the repricing terms of the assets and liabilities.Principles for management of interest rate risk by BIS).
. 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. The supervisory capital requirements established by Basle Committee from the end of 1997 covers interest rate risks in the trading activities of banks. c) Net income as a result of changes in interest income.Traditionally.earning sensitivity to rate fluctuations and price sensitivity of instruments/products to changes in interest rate. interest Rate risks in the trading activities of banks. 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 focus has been on the need for effective interest rate risk measurement. it is definitely incomplete in as much as it overlooks an important aspect-changes in interest rate resulting in the value of assets/liabilities. Changes in interest rates can affect banks with regard to changes in a) Market value of assets/liabilities and off balance sheet (OBS) items. monitoring. ultimately having impact on the value of net worth. interest rate risk may be viewed from two different complementary perspectives. Accordingly. While this focus is not misplaced. and control functions within the interest rate risk management process (Source.
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. When interest rates changes.According to the studies conducted by Basle Committee based on working experience of Banks in more than 100 countries. For instance. the banks are normally exposed to following forms of interest rate risk. Basis Risk: arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. they can expose a bank’s income and underlying economic value to unanticipated fluctuations as interest rate varies. Yield Curve Risk: arises when unanticipated shifts of the yield curve have adverse effects on a bank’s income or underlying economic value. while the interest paid on the funding is variable. 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. liabilities and off balance sheet (OBS) positions while such repricing mismatches are fundamental to the business of banking . even if the position is hedged against parallel movements in the yield curve. these differences can give rise to unexpected changes in the cash flows and earnings spread between assets. For example. These declines arises because the cash flows on the loan are fixed over its lifetime . a) b) c) d) Repricing risk Yield curve risk Basis risk Optionally
Repricing risk: arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank’s assets . and increases after the short term deposits matures. liabilities and OBS instruments of similar maturities or repricing frequencies for example a strategy of funding one year loan that reprices monthly based on
The LIBOR changes everyday. This kind of pricing is usual in products market also when costs are increasing. Prime tends to lag changes in LIBOR. exposes the institution to the risk that the spread between the two index rates may change unexpectedly. prices go up quickly. Deposit Insurance Premium Change) may impact prime only and not LIBOR. resulting in declining spread. Options. leading to wider spread. The concept of basis risk is applicable for any set of two different interest rates. for example.g. Optionality: option provides the holder the right but not the obligations to buy. The rate of change is different in different environments. there is an urgency to increase Prime Rate. b) In US context. Thus other things remaining the same. when costs are declining.one month LIBOR. c) During a declining rate environment. but the prime changes infrequently. In an increasing rate environment. 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. sell or in some manner alter the cash flow of an instrument or financial contract. 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. costs of certain types of regulation (e. Prime/LIBOR basis risks are as follows: a) Prime is an administered rate while LIBOR is market rate. prime is a rate applicable for loans in the US_LIBOR is applicable for intermediated outside the US. loans which give
. For example. and prices go down slowly.
the servicing bank may experience a decline in its fee income as the underlying mortgages get prepared. comprising of net interest income i.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. it provides a comprehensive view of the potential long term effects of changes in interest rates. banks are providing the servicing and loan-administration function for mortgage loan pools in return for a feebased on the volume of assets it administers.
. The economic value of a bank can be viewed as the present value of banks expected net cash. Since economic value considered the potential impacting interest rate changes on the present value of all future cash flows. defined as the expected cash flow on liabilities plus the expected net cash flows on OBS positions.e. However. liabilities. and OBS position can get affected due to fluctuation in interest rates. The economic value. In international arena. Effects of Interest Rate Risk: Interest rate risk effects both on banks earning as well as its economic value. If not adequately managed. The noninterest income arising from many activities can also be highly sensitive to market interest rates. 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. In addition. When interest rates fall. often without any penalties. 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. 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. and the impact of interest rate change on net interest income has been accepted from time to time. difference between total interest income and total interest expense has been the focus of main attention traditionally. of a bank’s assets. Than is offered by the earlier earnings perspectives.. Earnings.
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. Commodity trading is not practiced by Banks and Financial Institutions in India. Indian banks normally do not undertake currency exposure for funding operation (i. Stock Market Risk Arises primarily because of movement of portfolio value. 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. 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. 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. 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
. unhedged conversion of resources in one currency for funding assets in another currency).e. evaluation of impact past interest rate changes may have on future performance is also of great significance. Commodity Risk It is a risk associated with trading in commodities. represent a drain on banks resources Foreign Exchange Risk: It refers to potential impact of movement in foreign exchange rates. 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.While the above two perspectives focus on the impact of changes in future interest rates on a banks future performances. The risk here is that the adverse fluctuations in exchange rates may result in a loss. For example.
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. established credit lines that can be tapped and in developed world through asset securitization also. the monitoring of economic and market trends is also a key to liquidity risk management. These need to be matched against cash flows stemming from liabilities and contingent liabilities falling due. Cash inflows arise from such things as maturing assets. As all banks are affected by changes in the economic climate and market conditions. 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.
. especially committed lines of credit that can be drawn down. 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.over exposure to stock market to influence their profitability and long term viability. banks have been relying on core deposits for their funding. However. 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. they need to strike a trade-off between been overtly liquid and relatively liquid. banks have resorted to other means of sources also for managing the liquidity on ongoing basis. access to deposit liabilities. in today’s environment. This includes funding requirements for off balance sheet commitments. 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. saleable non-maturing assets. Traditionally.
Use of “what if” analysis situations can also help in building different liquidity scenarios for practical applications. In a business situation.
. 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. 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. banks require capital to insulate themselves from the risks of business that they undertake.
FIs are operating in a fairly deregulated environment and are required to determine interest rates on various products in their liabilities and assets portfolios. has brought pressure on the management of FIs to maintain a good balance amongst spreads. particularly the market risks. This note lays down broad guidelines for FIs in respect of liquidity. FIs are exposed to credit and market risks in view of the asset-liability transformation. monitoring and managing liquidity. The objective of a good risk management systems should be to evolve into a strategic tool for effective management of FIs. market risk and operational risk – which underlines the need for effective risk management systems in FIs. These pressures call for structured and comprehensive measures for institutionalising an integrated risk management system and not just ad hoc action. profitability and long-term viability. together with increasing volatility in the domestic interest rates as also in foreign exchange rates. Intense competition for business involving both the assets and liabilities.GUIDELINES FOR ASSET LIABILITY MANAGEMENT (ALM) SYSTEM IN FINANCIAL INSTITUTIONS (FIS)
In the normal course. associated with FIs’ operations have become complex and large. exchange rate and interest rate risk management systems which form part of the ALM function. the risks. The FIs are exposed to several major risks in the course of their business – generically classified as credit risk. on a dynamic basis. exchange rate and interest rate risks of a FI that need to be closely integrated with the FIs’ business strategy. requiring strategic management. 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. managing business after assessing the market risks involved. both in domestic as well as foreign currencies. The initial focus of the ALM function would be to enforce the discipline of market risk management viz. With liberalisation in Indian financial markets over the last few years and growing integration of domestic markets with external markets. The envisaged ALM system seeks to introduce a formalised framework for management of market risks through measuring.
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
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 predetermined 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 currency funding, etc. vs capital market funding , domestic vs foreign
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
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.
The format of the Statement of Liquidity is furnished in Annexure I. The importance of liquidity transcends individual institutions. could be used for measuring the future cash flows of FIs in different time buckets. 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. For measuring and managing net funding requirements. such as Government securities and other money market instruments.Liquidity Risk Management Measuring and managing liquidity needs are vital for effective operation of FIs. 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. Therefore liquidity has to be tracked through maturity or cash flow mismatches. liquidity management can reduce the probability of an adverse situation developing. could also become illiquid when the market and players are unidirectional. as liquidity shortfall in one institution can have repercussions on the entire system. as detailed in Appendix I.
. By assuring a FI's ability to meet its liabilities as they become due. The Maturity Profile. The time buckets. Experience shows that assets commonly considered to be liquid. 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.
cut loss limits. FIs.. FID. the time taken to liquidate the ‘position’ on the basis of liquidity in the secondary market) should be prescribed. FIs however. under respective time buckets. While the mismatches upto one year would be relevant since these provide early warning signals of impending liquidity problems. 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. will have the option of evolving with the approval of the Board / ALCO. composition. the main focus should be on the short-term mismatches viz. RBI. an integrated Value at Risk (VaR) limit for their entire balance sheet including the “Banking Book” and the “Trading Book”. However. generally shown. which are kept distinct from other investments made for retaining relationship with customers. holding/defeasance period. maximum maturity/duration. The Board/ALCO of the banks should approve the volume. iii)The holding period of the trading securities should not exceed 90 days. are permitted to show the trading securities under 114 days. for the rupee as well as foreign currency portfolio. 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. some of the FIs may be maintaining securities in the ‘Trading Book’. which are better equipped. A copy of the approved policy note in this regard. ii)Maximum maturity/duration of the trading portfolio should be restricted.
FIs which maintain such ‘Trading Books’ consisting of securities that comply with the above standards. 15-28 days and 29-90 days buckets on the basis of the defeasance periods. of the ‘Trading Book’ .e.. iv)Cut-loss limit(s) should be prescribed. should be forwarded to the Department of Banking Supervision. v) vi) Product-wise defeasance periods (i.The investments are assumed as illiquid due to lack of depth in the secondary market and are. 1-14 days and 15-28 days. as per their residual maturity. etc. are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the
. Within each time bucket there could be mismatches depending on cash inflows and outflows. therefore.
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. As regards the foreign currency loans granted out of foreign currency resources on a back-toback basis. 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. 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. It would also be necessary to take into account the rupee inflows and outflows on account of forex operations. would be reflected in the rupee liquidity statement. future strategy. If a FI in view of its current asset-liability profile and the consequential structural mismatches needs higher tolerance level. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. Thus. etc. of the cash outflows in each time bucket.e. The negative gap during 1-14 days and 15-28 days time-buckets. nature of business. in normal course. till March 31. the FIs may take into account all relevant factors based on their asset-liability base. 2001.approval of the Board / ALCO. 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. should not exceed 10 per cent and 15 per cent respectively. Such foreign currency denominated loans too would be a part of rupee liquidity statement since such loans are created out of rupee resources. While determining the tolerance levels. a currency-wise liquidity statement for each of the foreign currencies in which liabilities and assets have been created. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. i. the foreign currency resources raised abroad but swapped into rupees and deployed in rupee assets. Large cross border flows
. 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.
then the currency mismatch can add value or erode value depending upon the currency movements. besides exposing the balance sheet to movements in exchange rate. to capture the liquidity and interest rate risk inherent in the foreign currency portfolio of the FIs. FIs undertake operations in foreign exchange such as borrowings and making loans in foreign currency. separately for each of the currencies in which the FIs have an exposure. if any. the MAP and SIR statements prescribed for banks vide AD (MA Series) circular no. Dealing in different currencies brings opportunities as also risks. it would be necessary to compile. ICICI. IDBI. are reduced to zero or near zero. however. reported profits) by changing its Net Interest Income (NII). The FIs are. on an ongoing basis. Hence.together with the volatility has rendered the FIs' balance sheets vulnerable to exchange rate movements. If the liabilities in one currency exceed the level of assets in the same currency.e. However. it may not be possible to eliminate currency mismatches altogether. Interest Rate Risk (IRR) Interest rate risk is the risk where changes in market interest rates might
adversely affect a FI's financial condition. 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
. The immediate impact of changes in interest rates is on FI's earnings (i. are not subject to the full rigour of the reporting requirements under Exchange Control regulations. 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. 52 dated 27 December 1997 issued by RBI (ECD). also exposes it to country risk and settlement risk. unlike banks. which exposes them to currency or exchange rate risk. are not applicable to FIs. irrespective of the strategies adopted. EXIM Bank. Mismatched currency position. therefore. In order. currency-wise Statement of Liquidity and IRS Statement. The simplest way to avoid currency risk is to ensure that mismatches. only five FIs (viz. At present.
The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date.assets. the FIs. deposits. In the context of poor MIS. iii) it is contractually pre-payable or withdrawable before the stated maturities. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). The Gap Report should be generated by grouping rate sensitive liabilities. 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. Simulation and Value at Risk over time when FIs acquire sufficient expertise and sophistication in acquiring and handling MIS. any principal repayment of loan is also rate sensitive if the FI expects to receive it within the
. However. assets and off-balance sheet positions into time buckets according to residual maturity or next re-pricing period. purchased funds. iv) It is dependent on the changes in the Bank Rate by RBI. 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. 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. An asset or liability is normally classified as rate sensitive if: i) within the time interval under consideration. there is a cash flow. that mature/re-price within a specified timeframe are interest rate sensitive. whichever is earlier. Similarly. borrowings. etc. All investments. ii) the interest rate resets/reprices contractually during the interval. respectively. advances. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis. which are better equipped. The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective. liabilities and off-balance sheet positions get affected due to variation in market interest rates.
Earning Assets or Equity. the interest rates on advances could be re-priced any number of occasions.time horizon. Such prudential limits should have a relationship with the Total Assets. 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) viii) Over 5 years and upto 7 years 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. be used as a measure of interest rate sensitivity. The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. 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). these items get re-priced at pre-determined intervals. This includes final principal repayment and interim instalments. The Gap can. on the pre-determined reset / re-pricing dates and the new rate would normally correspond to the changes in PLR. Certain assets and liabilities carry floating rates of interest that vary with a reference rate and hence. therefore. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. While the interest rates on term deposits and bonds are generally fixed during their currency. Such assets and liabilities are rate sensitive at the time of re-pricing. In
. Each FI should set prudential limits on interest rate gaps in various time
buckets with the approval of the Board/ALCO.
A well defined transfer pricing system also provide a rational framework for pricing of assets and liabilities. supported by empirical studies and behavioural analysis. liabilities and off-balance sheet items to changes in market variables and estimate the impact of embedded options.
. 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. the customers exercising their options for premature closure of term deposits. premature encashment of bonds and prepayment 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. 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 entire amount payable under the embedded options should be slotted as per the residual period to the earliest exercise date. Financial Institutions Division. In the absence of adequate historical database. lending or credit spread. The transfer price mechanism can enhance the management of margin i. FIs which are better equipped to reasonably estimate the behavioural pattern. embedded options. subject to approval from the ALCO / Board.e. the funding or liability spread and mismatch spread. etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets. 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. rolls-in and rolls-out. It also helps centralising interest rate risk at one place which facilitate effective control and management of interest rate risk. The impact of embedded options (i.e. FIs should therefore evolve suitable mechanism. to estimate the future behaviour of assets.addition to the interest rate gap limits. is quite substantial. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision.
REVIEW OF EXISTING LITERATURE SUMMARY
The article is remark from Wlliam J McDonough on risk management. Also according supervision is to william the work of financial moving away from a purely retrospective. how enhancement in banks risk management processes. risk focused approach to supervision. credit risk and operational risk by large banking organization.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.this is particularly in banking world. According to William J the whole article based on how supervisor have worked to embrace and encourage the developments. 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. 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.
. as well as transparent pattern of behaviour. in itself. 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. 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. driven by business imperatives.rules based
approach. not enough in deed financial sector required innovation in the good and services offered. supervision and the new Basel Accord. have concurrently led supervisor to move to a more processoriented.
The article highlight the need to work toward reducing the real lending rates of banks. Deputy Governer of the Reserve Bank of India.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.Summary of article
The following article has been delivered by Dr Rakesh Mohan. The article also state about the NPAs level . 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
. 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.
CHAPTER – 3
Its initial equity capital of Rs 150 crores was fully subscribed by ICICI. ICICI explored various corporate restructuring alternatives for its transformation into a universal bank. As a bank. This condition required ICICI to reduce its shareholding in ICICI Bank in stages.20% 55. and as a result. first to not more than 75% of its equity share capital. the senior managements of ICICI and ICICI Bank explored the possibility amalgamation of ICICI with ICICI Bank.80% Amount Raised (Rs. 35 per share ADR issue on NYSE for 763. This took place in the following ways: Year (FY) Event IPO of 15 million equity shares of Rs.) Holding of ICICI
During 2001. In May 1994.60% 2000 US$175 million 2001 Acquisition of Bank of Madura (BOM): 2 equity shares in lieu of every 1 share of BOM Disinvestment of shares by ICICI Disinvestment of shares by 2002 ICICI 0. Subsequently. ICICI Bank became a wholly owned subsidiary of ICICI.88 crores 19. In view of such benefits and RBI’s guidelines on universal banking. and ultimately to not more than 40%. the shareholders of both the institutions approved such amalgamation and the exchange ratio
.39 crores 46. when ICICI obtained its commercial banking license to establish ICICI Bank.5 crores 74.40% 46%(on August 2002) 52. ICICI would have the ability to accept low-cost demand deposits and offer wider range on products and services. was formed in 1994 as a new private sector bank. the Reserve Bank of India (RBI) imposed a condition regarding dilution of promoter’s holding in the bank. 10 each at a price of 1998 Rs.HISTORY AND GROWTH OF ICICI BANK
ICICI Bank Ltd.4 crores 236 crores 62.
2002. ICICI Bank would after merger. inclusive of the liabilities pertaining to ICICI from the date of merger.
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. ICICI Bank should.
. 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.determined was 1 fully paid-up equity share of ICICI Bank in lieu of 2 fully paidup equity shares of ICICI. maintain an additional 10% over and above the requirement of 40%. As a result of such amalgamation. mark-to-market the above instruments and provide for any loss in their value in the manner prescribed for investments. 2002. i. which was approved by RBI on April 26.e. Priority Sector Lending: considering that the advances of ICICI were not subject to the requirement applicable to banks in respect of priority sector lending.. the paid-up capital increased to Rs. 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. however. a total of 50% of the net bank credit on the residual portion of the bank’s advances. 613 crores. The scheme of amalgamation became effective on May 3.
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. Ltd. ICICI Bank has become the second largest among all scheduled commercial banks (SCBs) in India. 5. – incorporated in the US. Nearly 51% (183 branches) of ICICI’s branches are in urban/metropolitan areas. 3. ICICI Securities Holdings Inc. ICICI Bank had no subsidiaries. 6. – incorporated in the US. Till this time ICICI Bank had also installed 1. ICICI Prudential Life Insurance Co. coming after the State Bank of India. . 4.
At end-FY2001. Ltd. At endFY2002. – engaged in security brokerage activities on NSE and BSE. ICICI’s subsidiary companies have become subsidiaries of ICICI Bank. placement of debt and equity.Following the amalgamation. – provides venture capital funding to a wide spectrum of industrial sectors. The balance is in rural/semi-urban areas. The major subsidiaries are described below:
1. ranked on the basis of their total assets. 2. ICICI Bank had 11 subsidiaries. this subsidiary has been set up to provide brokerage. Ltd.performs key merchant baking activities including underwriting. This subsidiary has entered into an MoU with ICICI Bank for
. ICICI Venture Funds Management Co. Consequent to the merger. ICICI Securities and Finance Co. ICICI Bank had a network of 359 branches and 44 extension counters in 251 centers across several India states. – carries out the business of Life Insurance. ICICI Securities Inc. research and investment banking services to investors in the US who wish to enter the Indian financial markets.000 ATMs. ICICI Brokerage Services Ltd. issue management and corporate advisory services. At end-FY2002.
7.distribution of its life insurance policies through the bank’s branch network.
. Ltd. Ltd. – provides finance for housing. ICICI Home Finance Co. 8. ICICI Lombard General Insurance Co. – carries out the business of general insurance.
ICICI Bank’s asset base is nearly 4. In charge of international business Executive Director. Kalpana Morparia Mr. Nachiket Mor Executive Director. the GIC and it’s subsidiaries (7.
RELATIONSHIP WITH THE GOVERNMENT
The GoI has never directly held any shares of ICICI Bank. In charge of wholesale banking Designation Managing Director & CEO Joint Managing Director. 1. In charge of legal department Executive Director. Kochhar Dr. GoI’s controlled institutions held a 20.4 times larger than the secondlargest new private sector bank in India – HDFC Bank (assets of Rs.N. Sinor Ms. and others (1.041 billion (at end FY2002) places it as the second largest scheduled commercial bank in India – behind only State Bank of India (SBI). 238 billion as end-FY2002). Kamath Mr. the GoI
. K. In charge project finance
BUSINESS & OPERATIONS
ICICI Bank’s asset base of Rs. Gupte Ms.3%). retail banking and treasury operations. UTI (3.V. Under the terms of the loan and guarantee facilities provided by the GoI to ICICI that have been transferred to ICICI Bank. Lalita D. Mukherji Ms. These include the LIC (8. H. possess rich experience and are competent professionals from their field.8% stake in ICICI Bank at end August 2002.MANAGEMENT
The management team of ICICI Bank consists of the following individuals who are very well qualified. S.6%). In charge of retail banking Executive Director. In charge of domestic banking Joint Managing Director.3%).6%). ICICI Bank’s principal activities include corporate banking. Chanda D. Name Mr. However.
. Comparison of key ratios is done on the basis of previous year and the current year.is entitled to appoint and has appointed one representative to the BoD of ICICI Bank.
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. 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.RISK MANAGEMENT AT ICICI
Risk is an inherent part of ICICI Bank’s business. the most significant risk faced by ICICI Bank. The industry analysts of the department monitor all major sectors and evolve a sectoral outlook. contracts. ICICI Bank has identified Risk Compliance & Audit Group as one of the core competencies for the next millennium. which is an important input to the portfolio planning process. assesses. ICICI Bank identifies. The department has done detailed studies on default patterns of loans and prediction of defaults in the Indian context. an Analytics Unit develops quantitative techniques and models for risk measurement.
CREDIT RISK MANAGEMENT
Credit risk. With well defined policies and procedures in place. systems and facilities)
The ability to implement analytical and statistical models is the true test of a risk methodology. Risk-based pricing of loans has been introduced. In addition to three departments within the Risk Compliance & Audit Group handling the above risks. and effective Risk Compliance & Audit Group is critical to achieving financial soundness and profitability. human error. 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. The functions of this department include:
Review of Credit Origination & Monitoring • Credit rating of companies/structures
operating policies & procedures Portfolio monitoring • • Methodology to measure portfolio risk Credit Risk Information System (CRIS)
Focussed attention to structured financing deals • Pricing. MARKET RISK COMPLIANCE & AUDIT GROUP ICICI Bank is exposed to all categories of Market Risk. and provide real time information on credit risk. Availability of information on a real time basis is an important requisite for sound risk management. • Interest Rate Risk (risk due to changes in interest rates)
.. the department has been instrumental in reorienting the credit processes. the CRC & AD has designed a web-based system to render information on various aspects of the credit portfolio of ICICI Bank. To aid its interaction with the strategic business units. In addition. Monitoring
Monitor adherence to credit policies of RBI
During the year. namely the Credit Risk Information System. the CRC & AD has implemented a sophisticated information system. New Product Approval Policy.• • •
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. viz. 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.
an integral part of the Risk Compliance & Audit Group. there has been a shift in the audit focus from transactions to controls. is exposed to many types of operational risks. communication. These include potential losses caused by events such as breakdown in information. focusses on the operational risks within the organisation. Some examples of this paradigm shift are: Adherence to internal policies. tests and approves market risk methodologies developed by the Treasury. transaction processing and settlement systems/ procedures.• • •
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. In recent times.
. like all large banks. 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. 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. The Audit Department.
CHAPTER – 4
04% in the year 1998.37% in the year 1998. 3) Cash /Deposit(%) : This ratio is compared as under: We notice that in the year 1997 Cash /deposit ratio is 12.76%.78%. In the year 2000 it rose to 1.93% which is a significant increase.36%.24%.In the year 2001 it again fell to 0. In the year 2002 it rose to 70.22%.In the year 1999 again it fell to
.In the year 2002 it rose to 42. In the year 2000 there is a significant increase of 4.69% in the year 1998.1% which rose to7. in the year 2001 again it fell to 10.1%.96%. In the year 1999 it again fell to 2. 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. In the year 2001 it rose to 2. 2) Investment/Deposit (%): This ratio is compared as under: We notice that in the year 1997 investment ratio is 33.01%. in the year 2000 it fell to 0.27% which fell to 0. In the year 2000 it fell to 1. 4) Interest Expended/Interest Earned(%): this ratio is compared as under : We notice that In the year 1997 interest earned(%) is 64.26% in the year 1998. In the year 1999 it fell to 10. in the year 2002 It rose to 6.64% it rose to 3.In the year 2002 it fell to 1. In the year 1999 again it rose to 7.5%.47%. in the year 2002 it fell to 5%. again it rose to 6. in the year 2001 it fell to 3.98% which fell to 1.83%.02%.6%. in the year 1999.66%. In 1999 it further drop to 11.55%.03%.in the year 1998. 6) Operating Expenses/Total Income(%) : This ratio is compared as under : We notice that the percentage of operating expenses in the year 1997 is 17.47%.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. In 2000 it drop to 1.8% which fell to 21.33%.01%.93% which rose to 5.75% in the year 1998. In the year 2001 it rose to 4.
3%(increase) 2001 :0.71%.46% 1998 : 1.In the year 1999 it rose to 0.29%(decrease) 2001:1.14%.58%(decrease) 10) Non interest income/total funds(%) : this ratio is compared as under 1997 :2.89%) 1999 : 0.in the year 2001 it rose to 8.31%) 2000 : 0.61%(decrease) 2002:0. 8) Interest Expended/Total Funds(%) : this ratio is compared as under 1997:.57%(decrease which take it to 2.43% which fell to 2.59%(decrease) 1999: 0.36%( decrease) 2001 : 0.62%(decrease) 2000: 0.59%(increase) 2002 : 1.In the year 2000 it rose to 0.7.45%(decrease)
.36%.in the year 2000 it fell to 1.in the year 2002 it further fell to 4.3.33%.46%(increase) 1999:1.6%.59%.in the year 2001 it fell to 1. 7) Interest Income/Total funds(%): this ratio is compared as under: We notice that percentage of interest income in the year 1997 is 12.9% 1998:0.73%(decrease) 2002:2.17% in the year 1998.58%(decrease which take it to 2.97% 1998:-0.65%.in the year 2002 it rose to 0.34%.91%(increase) 2000:1.75%(decrease) 9) Net interest income/Total funds(%) : This ratio is compared as under 1997 : 4.
66%(decrease further) 2000:0.31%(decrease) 1999:0.11%(decrease) 2001:0.76% 1998 :0.03%(decrease) 12.73% 1998 :0.11%(increase) 2001:0.53%(increase) 2002:1.12%(decrease) 2001:0.75%(decrease) 2000:0.48%(decrease) 1999:0.) Net Profit/Total funds(%): comparison of this is given as under: 1997: 2.59%(decrease) 14. Operating expense/Total funds(%) : this ratio is compared as under : 1997 :2.54%(decrease) 2000:0.) RONW(%) : Comparison of this is done as under : 1997:23.75%(decrease) 1999:0.7% 1998:1.55%(decrease) 2002:1.61% 1998 :0.11.35%(decrease)
.01%(decrease) 13.64%(decrease) 1999:1.) Profit before provisions/total funds(%) : comparison of this I s done as under: 1997 : 4.1%(decrease) 2002:0.
Outflow 1-14 days 15-28 days 29-3 months 3-6 months 6-1 year 1-3 year 3-5 year Above 5 Total
Deposits Borrowings Total Inflow Loans/adv. However this means RSL>RSA this shows the bank in a position to benefit from declining interest rate by a negative gap. Total
315206 99649 414855
92177 149971 242148
481706 441520 923226
277906 322932 600838
579855 894286 1474141
1289359 1416256 2705615
40318 395130 435448
14421 284823 299244
3090948 4004567 7095515
82564 131998 214562
35692 68624 104316
255294 289018 544312
233150 267530 500680
371087 521877 892964
1322562 736576 2059138
763733 447461 121119 4 775746
1370069 1155706 2525775
4424151 3618790 8052941
Gap report indicates that there is a mismatch in the maturity buckets of 1-14 days to 1-3 years.
354.26 662.82 7.33 6981.16 25.64 156.89 37.89 0 0 18.97 259.47 101.59 112.59 589.4 568.4 9.67 84.21 224.37 0 0 12.76 34.34 62.85 0 0 65.92 60.89 19.9 105.83 193.13 1091.17 73.58 182.74 0
16.46 14.22 289.21 15 24.49 97.64 33.ICICI BANK
FINANCIAL OVERVIEW 2002-03 Equity Paid Up Networth Capital Employed Gross Block Sales PBIDT PBDT PBIT PBT PAT CP Revenue earnings in forex Revenue expenses in forex Book Value (Unit Curr) Market Capitalisation CEPS (annualised) (Unit Curr) EPS (annualised) (Unit Curr) Dividend (annualised%) Payout (%) Cash Flow From Operating Activities Cash Flow From Investing Activities Cash Flow From Financing Activities Rate of Growth (%) Net Worth (%) Capital Employed (%) Gross Block (%) Sales (%) PBIDT (%) PBDT (%) PBIT (%) PBT (%) PAT (%) CP (%) Revenue earnings 220.11 0
.99 257.27 427.52 50.82 0
15.9 1063.89 518.87 110.02 -78.39 -27.05 536.68 261.06 130.73 27.36 80.4 2001-03 196.69 150.69 0 0 16.28 66.88 93.53 40.3 258.13 1100.92 4494.51 12072.62 53.17 71.16 51.39 26.95 0
12.14 852.72 12 32.57 -56.4 5117.11 45.31 353.74 31.7 3.42 73.46 52.1 197.82 2.62 67.82 1149.43 218.55 41.96 20 28.57 544.04 98.3 322.85 131.22 64.82 72.13 48.9 104109.43 11.63 315.25 73.39 1848.74 2732.14 33.86 61.36 63.15 1998-03 165 266.09 0 0 58.99 52.8 -60.2 70.48 56.97 110.5 1997-03 150 181.68 131.77 170.23 143.82 226.15 161.74 25.37 -105.09 0
272.3 130.14 63.48 87.59 50.17 755.96 41.03 53.36 2241.13 0 3.45 30.9 37.29 2151.41 110.11 -11.9 -47.1 4.52 20 17.68 178.78 3.2 -23.87 823.74 32.75 57.47 5.69 798.39 0 0 265.02 42.95 10 33.69 452.66 84.45 109.38 281.31 68.82 1289.5 3255.92 20.88 1781.57 262.86 68.68 10 37.76 53.93 1912.32 6.67 1242.03 741.78 33.08 19736.19 60.37 1999-03 165 308.7 271.75 3279.04 0
46.47 2000-03 196.5 662.3 53.36 5855.14 -394.
21 44.71 8.95 6.72 10.02 192.62 2.63
111.21 14.28 3.29 2.02 7.82 952.97 4.75 2629.58 71.51
196.04 1.2 72.in forex (%) Revenue expenses in forex (%) Market Capitalisation (%) Key Ratios Credit-Deposit(%) Investment / Deposit (%) Cash / Deposit (%) Interest Expended / Interest Earned (%) Other Income / Total Income (%) Operating Expenses / Total Income (%) Interest Income / Total Funds (%) Interest Expended / Total Funds (%) Net Interest Income / Total Funds (%) Non Interest Income / Total Funds (%) Operating Expenses / Total Funds (%) Profit before Provisions / Total Funds (%) Net Profit / Total funds (%) RONW (%) BS
12072.43 1.98 12.1 18.45 78.43
36.64 12.23 191.52 0.27 2.9
0 -40.66 7.26 16378.36 5635.48 2.95 22.12 10.98 22.04 1.43 36.79 1036.89 3.47 565.81 5.76 4.8 33.44 67.11 14.39
69.43 2.88 1347.73 23.92
19736.44 21.82 1092.01 0.63
165 143.96 0.73 48.21 17487.07 7.93 1.9 2.4
104109.88 24.61 2.23 22.6 92.27 64.43
150 31.26 7.93 17.68 11.48 1.54 1.54 32085.08 13.42 7.98 1.23
40.55 13.92 0.33 6072.2 18.74 1.97 1.64 8.95 7 1.95 2.68
3279.36 2.01 13.43 7.52
200203 CAPITAL AND LIABILITIES Capital + Reserves and Surplus + Deposits + Borrowings + Other Liabilities & Provisions + TOTA L 220.92 78.45
37.69 9866.78 3.45 22.38 2.56 90.99 159.11 48681.94 199.6 8.04
48.18 45.44 15.46 2.51 2.02 491.31 1.7
09 562.95 143.83
.44 2861.8 721.27 941.39 40.68 5013.68 42.22 0 0.34 222.78 0.52
65 126 48.35 798 96.06 199903 (12) 199803 (12) 199703 (12) 544.54 131.13 0 0.8 161.08 47034.01
1558.87 183.47 761.05 89.81 1172.2
666.47 0.82 27.75
50.08 61.83 19736.34 4158. APPROPRIATIONS Transfer to Statutory Reserves Transfer to Other Reserves + Proposed Dividend / Transfer to Government + Balance c/f to Balance Sheet 2151. EXPENDITURE : Interest expended + Operating Expenses + Provisions & Contingencies + TOTAL III.86 7031.13
161. PROFIT/LOSS Net Profit for the year Prior Year Adjustments + Profit brought forward TOTAL IV. INCOME : Interest Earned + Other Income + TOTAL II.79 182.65 225.46 384.12 361.7 85.52 83.ASSETS Cash & Balances with RBI Balances with Banks & money at Call & Short Notice Investments + Advances + Fixed Assets + Other Assets + TOTAL Contingent Liabilities + Bills for collection PL 200203 (12) I.19 259.24 218.47 11011.02 2756.83
186.39 1127.44 465.36 0 0.46 310.12 199.1 0 0.59 3279.64 172.37 79.13 226.42 1231.96 1469.23 569.59 1323.65
837.79 1023.27 4416.97 438.95 200103 (12) 1242.14
20 21.66 2362.13 105.68 57.28 146.28 104109.7 71.09 344.19 1047.02 50.5 0 15 0.33 1774.83 259.51 27.88 35891.89 2693.09 40.76 123.43
63.5 48.59 13848.87 4239.44 6981.24 294.68 3657.9
105.09 200003 (12) 852.3 0 0.84 21.75 539.93 605.92 39446.03 8186.6 185.39 63.23 1781.13
27 5 17.67 324.32 12072.43 2906.87 194.64 2498.63 9780.35 222.65 50.76
425.58 435.92 628.57 19.01 1229.04 1307.19 150.09 311.57 0.23 2110.39
25.3 0 0.
82 0 0 196.86 0 0 0
0 31.82 196.82 0 0 0 0 196.07 4.36 220.36 0 0 220.43 0 0 0
200203 CAPITAL AND LIABILITIES Capital Equity Authorised Preference Capital Authorised Unclassified Authorised Equity Issued Equity Subscribed Equity Called Up Less : Equity Calls in Arrears Equity Forfeited Equity Suspense Adjustments to equity Equity Paid Up Preference Capital Paid Up Unclassified Shares paid -up TOTAL CAPITAL Equity converted during the year GDRs Issued During the Year Bonus in Equity Reserves and Surplus Contingency Reserve Other Statutory Reserve Capital Reserves Capital Redemption Reserve Debt Redemption
300 0 0 220.54 0 196.75 19.1
63.36 0 0 0
300 0 0 196.68 12.8 1.86 0 0 0
.98 12 3.95 16.36 0 0 392.) Extraordinary Items + BS SCHEDULES
50.17 -0.13 44.82 0 0 23.13 -0.82 0 0 0
300 0 0 196.5 20 7.5 -0.86 0 0 0
0 58.43 0 0 0
0 184.82 0 0 196.03
40.24 16.69 -0.4 -0.52 265.86 0 0 0
0 78.52 15 0 10 2.96 65.82 0 0 0
300 0 0 165 165 165 0 0 0 0 165 0 0 165 0 0 0
300 0 0 165 165 165 0 0 0 0 165 0 0 165 0 0 0
300 0 0 150 150 150 0 0 0 0 150 0 0 150 0 0 0
0 249.) Book Value(Unit Curr.82 196.82 196.36 220.23 1.75 2.21 58.09
105.72 15 5.67 0 220.9 44.74 -0.43 24.5 20 11.72 18.)(Unit Curr.07 4.TOTAL Equity Dividend Corporate Dividend Tax Equity Dividend (%) Earning Per Share (Rs.62 10 2.82 196.
5 5 0 0.2 6072.54
817.64 11875.77 9.75
0 31.47 533.09 22709.54
0 1092.33 49.17 103.14 952.88
140.15 2497 26851.71 16378.49 0
107.03 79.2 0 33.13 143.RBI Borrowings in India -Other Banks Borrowings in India -Other agencies Borrowings outside India Convertible Debentures Non Convertible Debentures Partly Convertible Debentures Less : Debentures Calls in arrears TOTAL BORROWINGS Secured Borrowings included above Other Liabilities & Provisions Bills Payable Inter Office Adjustment (Net) Interest Accrued Share Application
2621.86 1880.62 227.75
0 0 0 0 0 0 0.84 0 0.74 2162.47 0
148.97 0 13744.24 397.02
316.29 9866.11 2629.64 0 0 0 0 0 199.51 1280.67 981.52 0
0 143.62 0 0 0 0 0 491.21
1587.56 5635.04 12.33
0 101.89 0
363.54 91.79 0
218.6 9265.34 0.26
0 0 0 769.6 1347.81 0 17.54 4524.05 2289.8 333.88
Revaluation Reserve TOTAL RESERVES AND SURPLUS Deposits Demand Deposits Saving Deposits Term & Other Deposits TOTAL DEPOSITS Borrowings Borrowings in India .02 31.83 1092.26 7745.19 0 48681.67 192.21 0
301.65 23.47 133.89 2687.12
0 80.12 5269.26
0 952.66 0 0.39 101.54
0 0 0 804.95 0 0 0 0 0 92.12 11.67 27.56 0
68.29 162.19 0 23.75 0 0 0 0 0 1032.79 0 5.5 26.69
0 0 0 37.48 41.Reserve Debenture Redemption Reserve Exchange fluctuation Reserve Amalgamation Reserve Share Premium Revenue & other Reserves Other Reserves Profit & Loss A/c
TOTAL RESERVES EXCLUDING REVALUATION RESERVE
10 0 0 804.34 19.67 0
0 0 0 37.56 0 55.33 33.94 0 0 0 0 0 192.96 32085.02
62 112.08 0 0 879.63
0 389.12 0
150.04 4970.67 204.79
222.4 632.44 41.5 798
973.12 3070.66 47034.66 2110. Overdraft & Loans Repayable on Demand Term Loans TOTAL ADVANCES Fixed Assets Premises Other Fixed Assets Gross Block Accumulated Depreciation Net Block Capital Work-inProgress
ASSETS Cash & Balances with RBI
Balances with Banks & money at Call & Short Notice
1774.12 4494.61 0 0 529.47
1231.27 183.08 0
0 66.18 1023.37 0
.Money Unclaimed Dividend Other Liabilities (Including Provisions) TOTAL OTHER LIABILITIES AND PROVISIONS TOTAL
378.06 191.34 0
203.18 435.18 0 4145.7 2402.86 0
2814.96 1383.65 6436.75 0
562.94 0 160.84 400.43
0 84.14 93.12
145.21 96.36 0 10.51
89.03 216.36 0 138 666.94 159.67 0 47.36 261.34
271.76 1036.95 4239.97 35.46 1908.7 0
Investments Quoted Government Securities Other Approved Secutires Shares Debentures & Bonds Investment in Subsidiaries Units Other Investments TOTAL INVESTMENTS Market Value of Quoted Investments Advances Bills Purchased & Discounted Cash Credits.58 14.22 0 0 303.57 61.88
0 264.31 70.51 0 0 55.4
104109.92 841.57 4416.12 35891.74 170.26 2861.92
12072.29 254.58 589.35 218.38 3657.02 222.68
3279.69 17487.36 608.91 565.34 0 0 42.3 2577.17 3051.95 1137.23 0
704.82 81.92 384.93 199.39 0
454.21 131.51 7031.76 110.81
0 576.73 8186.35 0
96.TOTAL FIXED ASSETS
and viii) periodical review and evaluation. commodity price. monitor and control the overall level of risks undertaken. top management of banks should attach considerable importance to improve the ability to identify. measure. legal. Thus.
. monitoring and controlling risks. comprehensive risk measurement approach. capital strength. etc. effective control and comprehensive risk reporting framework. strong MIS for reporting. The global trend is towards centralising risk management with integrated treasury management function to benefit from information on aggregate exposure.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. separate risk management framework independent of operational Departments and with clear delineation of levels of responsibility for management of risk. iv) v) vi) vii) guidelines and other parameters used to govern risk taking including detailed structure of prudential limits. interest rate.
RISK MANAGEMENT STRUCTURE
A major issue in establishing an appropriate risk management organisation structure is choosing between a centralised and decentralised structure. management expertise and overall willingness to assume risk.. regulatory. liquidity. equity price. The broad parameters of risk management function should encompass: i) ii) iii) organizational structure. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. well laid out procedures. operational. risk management policies approved by the Board which should be consistent with the broader business strategies. credit. reputational. foreign exchange rate.
A prerequisite for establishment of an effective risk management system is the existence of a robust MIS.natural netting of exposures. Internationally. 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. verify the models that are used for pricing complex products. Banks have been moving towards the use of sophisticated models for measuring and managing risks. The Board should set risk limits by assessing the bank’s risk and risk-bearing capacity. The risk management is a complex function and it requires specialised skills and expertise. 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. The Committee should also monitor compliance of various risk parameters by operating Departments. At organisational level. The existing MIS. requires substantial upgradation and strengthening of the data collection machinery to ensure the integrity and reliability of data. 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. At the same time. monitor and measure the risk The Committee should also develop policies and procedures. The functions of Risk Management Committee should essentially be to identify. The risk policies should clearly spell out the quantitative prudential limits on various segments of banks’ operations. however. economies of scale and easier reporting to top management. consistent in quality. Large banks and those operating in international markets should develop internal risk management models to be
. profile of the bank. the Committee should hold the line management more accountable for the risks under their control. 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. and the performance of the bank in that area. 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). review the risk models as development takes place in the markets and also identify new risks.
assumed by corporates who have no natural hedges. Thus. the level of technical expertise and the quality of MIS. market and credit risks are managed in a parallel two-track approach in banks. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise. Banks could also set-up a single Committee for integrated management of credit and market risks. the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. it is difficult to adopt a uniform framework for management of risks in India. a committee approach to risk management is being adopted. While the Asset . The volatility in the prices of collateral also significantly affects the quality of the loan book. Forex exposures. 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. Banks may also consider integrating market risk elements into their credit risk assessment process. 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. the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures. be the endeavour of all banks to upgrade the skills of staff. therefore.Liability Management Committee (ALCO) deal with different types of market risk. complexity of functions. As the domestic market integrates with the international markets. dictated by the size. At a more sophisticated level. The design of risk management functions should be bank specific. the core staff at Head Offices should be trained in risk modelling and analytical tools. will increase the credit risk which banks run vis-à-vis their counterparties. while market variables are held constant for quantifying credit risk. It should. Currently. the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk. Generally.
. Given the diversity of balance sheet profile.able to compete effectively with their competitors. Internationally.
trade restrictions. In addition to the risks related to creditworthiness of the counter party. The counter party risk arises from non-performance of the trading partners. The internal factors are deficiencies in loan policies/administration. inadequately defined lending limits for Loan Officers/Credit Committees. etc. excessive dependence on collateral’s and inadequate risk pricing. and
. deficiencies in appraisal of borrowers’ financial position. c) Risk pricing on a scientific basis.e. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The counter party risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.CREDIT RISK Lending involves a number of risks. foreign exchange rates and interest rates. Another variant of credit risk is counter party risk. economic sanctions. The external factors are the state of the economy. the banks are also exposed to interest rate. 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. trading. Credit risk or default risk involves inability or unwillingness of a customer or counter party to meet commitments in relation to lending. wide swings in commodity/equity prices. hedging. forex and country risks. 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. The credit risk of a bank’s portfolio depends on both external and internal factors. 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). Government policies. etc. absence of loan review mechanism and post sanction surveillance. settlement and other financial transactions. The portfolio risk in turn comprises intrinsic and concentration risk.e. b) Quantifying the risk through estimating expected loan losses i. absence of prudential credit concentration limits. 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.
Concurrently.d) Controlling the risk through effective Loan Review Mechanism and portfolio management. inter alia. regulatory/legal compliance. Treasury. each bank should also set up Credit Risk Management Department (CRMD). manage and control credit risk on a bank wide basis. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. identify problems and correct deficiencies. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. test the resilience of the loan portfolio. risk monitoring and evaluation. prudential limits on large credit exposures. Instruments of Credit Risk Management Credit Risk Management encompasses a host of management techniques. The CRMD should also lay down risk assessment systems. provisioning. etc. also called Credit Risk Management Committee or Credit Control Committee etc. Each bank should constitute a high level Credit Policy Committee. The banks should also evolve multi-tier credit approving system where the loan
The Department should undertake
portfolio evaluations and conduct comprehensive studies on the environment to
. Credit Risk Management Department (CRMD) and the Chief Economist. independent of the Credit Administration Department. monitor quality of loan portfolio. standards for loan collateral. The credit risk management process should be articulated in the bank’s Loan Policy. The Committee should. and should comprise heads of Credit Department. Credit Approving Authority Each bank should have a carefully formulated scheme of delegation of powers. Large banks may consider separate set up for loan review/audit. portfolio management. asset concentrations. The Committee should be headed by the Chairman/CEO/ED. loan review mechanism. rating standards and benchmarks. risk concentrations. which help the banks in mitigating the adverse impacts of credit risk. pricing of loans. delegation of credit approving powers. financial covenants. duly approved by the Board. to deal with issues relating to credit policy and procedures and to analyse. develop MIS and undertake loan review/audit. formulate clear policies on standards for presentation of credit proposals.
should be set up. Banks can also consider credit approving committees at various operating levels i.
maximum exposure limits to industry. debt service coverage ratio or other ratios. which may be lower than the limits prescribed by Reserve Bank to provide a filtering mechanism. large branches (where considered necessary). etc. who has no volume and profit targets. The conditions subject to which deviations are permitted and the authority therefor should also be clearly spelt out in the Loan Policy. Banks could consider delegating powers for sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. b)
single/group borrower limits. prudential limits should be laid down on various aspects of credit: a) stipulate benchmark current/debt equity and profitability ratios. depending upon the degree of concentration risk the bank is exposed. The quality of credit decisions should be evaluated within a reasonable time.
There must also be systems in place to evaluate the exposures at
. The substantial exposure limit may be fixed at 600% or 800% of capital funds. substantial exposure limit i. say 3 – 6 months. In case of disagreement.e. The credit facilities above a specified limit may be approved by the ‘Grid’ or ‘Committee’. Head Offices. Prudential Limits In order to limit the magnitude of credit risk. sum total of exposures assumed in respect of those single borrowers enjoying credit facilities in excess of a threshold limit. etc. if majority members of the ‘Approval Grid’ or ‘Committee’ do not agree on the creditworthiness of the borrower. the specific views of the dissenting member/s should be recorded. say 10% or 15% of capital funds.
sector. Regional Offices.e. The banks should also evolve suitable framework for reporting and evaluating the quality of credit decisions taken by various functional groups.proposals are approved by an ‘Approval Grid’ or a ‘Committee’. comprising at least 3 or 4 officers and invariably one officer should represent the CRMD. The spirit of the credit approving system may be that no credit proposals should be approved or recommended to higher authorities. with flexibility for deviations. Zonal Offices. through a well-defined Loan Review Mechanism.
beyond which no proposals should be
. financial analysis. The risk rating system should be designed to reveal the overall risk of lending. which are subject to frequent business cycles. should also be placed under lower portfolio limit. keeping in view the market risks inherent in the balance sheet. which are subject to a high degree of asset price volatility and to specific industries. a substantial degree of standardisation is required in ratings across borrowers. such as. Similarly. and e) banks may consider maturity profile of the loan book. The risk rating system should be drawn up in a structured manner. incorporating. Any excess exposure should be fully backed by adequate collaterals or strategic considerations. etc.reasonable intervals and the limits should be adjusted especially when a particular sector or industry faces slowdown or other sector/industry specific problems. liquidity. Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. projections and sensitivity. 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. advances against equity shares. The risk rating. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time. To facilitate this. etc. industrial and management risks. 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. inter alia. high-risk industries. The exposure limits to sensitive sectors. Within the rating framework. may necessarily be restricted. risk evaluation capability. critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio. in short. banks can also prescribe certain level of standards or critical parameters. as perceived by the bank.. should reflect the underlying credit risk of the loan book. real estate.
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
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 pricecutting 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
(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
J. across geographical locations and product lines in a timely manner. would be under constant surveillance. centralising data and analysing marginal and absolute contributions to risk. The model combines five financial ratios using reported accounting information and equity values to produce an objective measure of borrower’s financial health. The model basically focus on estimating the volatility in the value of assets caused by variations in the quality
. Lower rated borrowers whose financials show signs of problems should be subjected to renewal control twice/thrice an year.protecting the quality. The credit risk models offer banks framework for examining credit risk exposures. detailing management responses to stressful situations. The Relationship Managers have to work in coordination with the Treasury and Forex Departments. banks may consider appointing Relationship Managers to ensure that overall exposure to a single borrower is monitored. 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. For comprehensive evaluation of customer exposure. The Altman’s Z Score forecasts the probability of a company entering bankruptcy within a 12month period. P. Many of the international banks have adopted credit risk models for evaluation of credit portfolio. Further. captured and controlled. Stress tests could also include contingency plans. Morgan has developed a portfolio model ‘CreditMetrics’ for evaluating credit risk. Banks should also appoint Portfolio Managers to watch the loan portfolio’s degree of concentrations and exposure to counterparties. The models also provide estimates of credit risk (unexpected loss) which reflect individual portfolio composition. transactions with affiliated companies/groups need to be aggregated and maintained close to real time. 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. 6) introduce discriminatory time schedules for renewal of borrower limits. which can alter the risk profile. The Relationship Managers may service mainly high value loans so that a substantial share of the loan portfolio.
The complexity and scope of LRM normally vary based on banks’ size. The model can be used for promoting transparency in credit risk. The success of credit risk models impinges on time series data on historical loan loss rates and other model variables.
. Credit Suisse developed a statistical method for measuring and accounting for credit risk which is known as CreditRisk+.
The volatility is computed by tracking the probability that the
borrower might migrate from one rating category to another (downgrade or upgrade). therefore. risk modelling after a specified period of time. The main objectives of LRM could be: • • to identify promptly loans which develop credit weaknesses and initiate timely corrective action. It may be independent of the CRMD or even separate Department in large banks. assessing the loan loss provision. type of operations and management practices. spanning multiple credit cycles. endeavour building adequate database for switching over to credit
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 may. the value of loans can change over time. portfolio quality. Banks should. The banks may evaluate the utility of these models with suitable modifications to Indian environment for fine-tuning the credit risk management. evaluating the effectiveness of loan administration. Thus. to evaluate portfolio quality and isolate potential problem areas. put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as. The model is based on actuarial calculation of expected default rates and unexpected losses from default. reflecting migration of the borrowers to a different risk-rating grade. establishing benchmark for credit risk measurement and estimating economic capital for credit risk under RAROC framework. therefore. maintaining the integrity of credit grading process.of assets. etc.
inter alia. Given the importance and subjective nature of credit rating. lending practices and loan policies of the bank. loan policies and procedures. and assignment of risk ratings.
Accurate and timely credit grading is one of the basic components of an effective LRM. 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. address: Qualification and Independence The Loan Review Officers should have sound knowledge in credit appraisal.• • •
to provide information for determining adequacy of loan loss provision. The Policy should. Reviews of high value loans should be undertaken usually within three months of sanction/renewal or more frequently when factors indicate a potential for
. risk evaluation and post-sanction followup. Banks should formulate Loan Review Policy and it should be reviewed annually by the Board. the credit ratings awarded by Credit Administration Department should be subjected to review by Loan Review Officers who are independent of loan administration. identification of problem loans. Credit grading involves assessment of credit quality. and to provide top management with information on credit administration. and to monitor compliance with relevant laws and regulations. to assess the adequacy of and adherence to.
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. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions. including credit sanction process. They should also be well The versed in the relevant laws/regulations that affect lending activities.
The Risk Management Group of the Basle Committee on Banking Supervision has released a consultative paper on Principles for the Management of Credit Risk. in addition to market risk. The proposals for investments should also be subjected to the same degree of credit risk analysis. The Paper deals with various aspects relating to credit risk management. Post-sanction follow-up. as any loan proposals. banks should also target other accounts that present elevated risk characteristics. remain unresolved should be reported to top management. sensitivity to
. is inherent in investment banking. Sufficiency of loan documentation. Depth of Reviews The loan reviews should focus on: • • • • • • • • Approval process. Accuracy and timeliness of credit ratings assigned by loan officers. The scope of the review should cover all loans above a cut-off limit. Compliance with loan covenants. 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. 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. Portfolio quality. The proposals should be subjected to detailed appraisal and rating framework that factors in financial and non-financial parameters of issuers. and applicable laws / regulations.deterioration in the credit quality. Credit Risk and Investment Banking Significant magnitude of credit risk. The Paper is enclosed for information of banks. Adherence to internal policies and procedures. In addition.
currency swaps. banks should stipulate entry level minimum ratings/quality standards. swaps.
Credit Risk in Off-balance Sheet Exposure Banks should evolve adequate framework for managing their exposure in offbalance sheet products like forex forward contracts.reverse repos. As a matter of prudence. letters of credit. particularly in investment proposals. duration.full risk (credit substitutes) . options. There should be greater interaction between Credit and Treasury Departments and the portfolio analysis should also cover the total exposures. issuer-wise. limits in investment proposals as well to mitigate the adverse impacts of concentration and the risk of liquidity. etc. which are not rated and should ensure comprehensive risk evaluation. etc. and
. including investments. medium risk (not direct credit substitutes. etc. which do not support existing financial obligations) . etc.external developments. The banks should exercise due caution. etc. money guarantees. maturity. options. 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.bid bonds. The coupon on non-sovereign papers should be commensurate with their risk profile. 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). The maximum exposure to a customer should be bank-wide and include all exposures assumed by the Credit and Treasury Departments. Banks should classify their off-balance sheet exposures into three broad categories . indemnities and warranties and low risk . industry. limits and monitoring procedures. futures. The rating migration of the issuers and the consequent diminution in the portfolio quality should also be tracked at periodic intervals.standby letters of credit. as a part of overall credit to individual customer relationship and subject to the same credit appraisal.
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. equity prices.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). etc. liquidity conditions. foreign exchange rates.
. The potential exposures also may be quantified by subjecting the position to market movements involving normal and abnormal movements in interest rates.
moderate risk and high risk. foreign exchange rate. 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. operating efficiency. credit risk management was the primary challenge for banks. banks should also be rated and placed in range of 1-5. Even a small change in market variables causes substantial changes in income and economic value of banks. past experience. management quality. equity price and commodity price has become relatively more important. on the basis of their credit quality. etc. 1-8. such as interest rate. Banks should endeavour for developing an internal matrix that reckons the counter party and country risks.
Market Risk Traditionally. banks can use the country ratings of international rating agencies and classify the countries into low risk. all exposures to problem countries should be evaluated on a real time basis. Like corporate clients. Regarding exposure on overseas banks. market risk arising from adverse changes in market variables. Bank-wise exposure limits could be set on the basis of assessment of financial performance.INTER-BANK EXPOSURE AND COUNTRY RISK
A suitable framework should be evolved to provide a centralised overview on the aggregate exposure on other banks. The maximum exposure should be subjected to adherence of country and bank exposure limits already in place. as the case may be. With progressive deregulation. 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. 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
Liquidity is the ability to efficiently accommodate deposit and other liability decreases.Market Risk Management
Management of market risk should be the major concern of top management of banks. liquidity should be considered as a defence mechanism from losses on fire sale of assets. review mechanisms and reporting and auditing systems. either by increasing liabilities or converting assets. capital and forex markets. as well as. fund loan portfolio growth and the possible funding of off-balance sheet claims.
. procedures. promptly and at a reasonable cost. 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. statisticians and general bankers and may be functionally placed directly under the ALCO. 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. economists. 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. Thus. The operating prudential limits and the accountability of the line management should also be clearly defined. A bank has adequate liquidity when sufficient funds can be raised. The Boards should clearly articulate market risk management policies.
Liquidity Risk Liquidity Planning is an important facet of risk management framework in banks. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. 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. It encompasses the potential sale of liquid assets and borrowings from money. prudential risk limits.
etc. adopted across the banking system are:
i) ii) iii)
Loans to Total Assets Loans to Core Deposits Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments.due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable. performing assets turning into non-performing assets.
Time Risk .The liquidity risk of banks arises from funding of long-term assets by short-term liabilities. which. i. thereby making the liabilities subject to rollover or refinancing risk. prudential limits. The liquidity risk in banks manifest in different dimensions:
Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail).
. including Certificate of Deposits and institutional deposits. inter alia. liquidity reporting / reviewing. and
Loan Losses/Net Loans. 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.need to compensate for non-receipt of expected inflows of funds.e. where purchased funds include the entire inter-bank and other money market borrowings. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. should spell out the funding strategies.
The first step towards liquidity management is to put in place an effective liquidity management policy. The key ratios. liquidity planning under alternative scenarios. and
Call Risk .
Purchased Funds to Total Assets.
have limited liquidity as the market and players are unidirectional. 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. etc.
. the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. the excess or deficit of funds. Experiences show that assets commonly considered as liquid like Government securities. other money market instruments. For measuring and managing net funding requirements. especially call borrowings. Cap on inter-bank borrowings. The cash flows should be placed in different time bands based on future behaviour of assets. liabilities and off-balance sheet items. Apart from the above cash flows. at a series of points of time. Banks should also undertake variance The analysis. banks should also track the impact of prepayments of loans.
assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on / off-balance sheet items. Purchased funds vis-à-vis liquid assets. becomes a starting point for a measure of a bank’s future liquidity surplus or deficit. the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. once in six months to validate the assumptions. 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. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1. 2. Thus. at least. In other words. Thus. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. cash outflows can be ranked by the date on which liabilities fall due. analysis of liquidity involves tracking of cash flow mismatches.While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets.
unavailed credit limits. investment obligations. statutory obligations. The liquidity profile of the banks could be analysed on a static basis. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts.e.1 crore or more to track the volatile liabilities.
. contingent liabilities like letters of credit. 4. 7. Liquidity Reserve Ratio and Loans.3. 5.
Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs. etc. Banks should fix cumulative mismatches across all time bands. potential deposit losses. etc. Core deposits vis-à-vis Core Assets i. 6. 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. loan policy. Swapped Funds Ratio. Cash Reserve Ratio. extent of Indian Rupees raised out of foreign currency sources. 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. 2) Potential liquidity needs for meeting new loan demands. Commitment Ratio – track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure.e. i. Duration of liabilities and investment portfolio. Maximum Cumulative Outflows. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: 1) Seasonal pattern of deposits/loans.
severe market disruptions. entailing severe capital loss. some of the core deposits could be prematurely closed. It should be assumed that the purchased funds could not be easily rolled over. contagion. banks should evaluate liquidity profile under different conditions. which influence the cash flow behaviour. viz.
Estimating liquidity under bank specific crisis should provide a worst-case benchmark. bank specific crisis and market crisis scenario. failure of one or more of major players in the market. general perception about risk profile of the banking system.ALTERNATIVE SCENARIOS
The liquidity profile of banks depends on the market conditions. market access. financial crisis. normal situation. The banks should establish benchmark for normal situation. cash flow profile of on / off balance sheet items and manages net funding requirements. the rollover of high value customer deposits and purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. Under this scenario. etc. The banks could also sell their investment with huge discounts. 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. The banks should evolve contingency plans to overcome such situations. a substantial share of assets have turned into non-performing and thus become totally illiquid. The blue-print for asset sales. Thus. These developments would lead to rating down grades and high cost of liquidity. Liquidity from the Reserve Bank. arising out of its refinance window
. Contingency Plan Banks should prepare Contingency Plans to measure their ability to withstand bank-specific or market crisis scenario. The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank.
liquidity of assets. expose banks’ NII or NIM to variations.and interim liquidity adjustment facility or as lender of last resort should not be reckoned for contingency plans. Deregulation of interest rates has. liquidity support from other external sources. however. thereby creating exposure to unexpected changes in the level of market interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities). should also be clearly established. maturity dates or repricing dates. Availability of back-up liquidity support in the form of committed lines of credit. reciprocal arrangements. interest rate volatility.
. 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 offbalance sheet items with different principal amounts. The earning of assets and the cost of liabilities are now closely related to market
Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE). 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. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system.
Interest Rate Risk (IRR) The management of Interest Rate Risk should be one of the critical components of market risk management in banks. caused by unexpected changes in market interest rates. etc.
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 basis has moved against the banks. which is always to the disadvantage of banks. banks may price their assets and liabilities based on different benchmarks.e.
Yield Curve Risk In a floating interest rate scenario. the banks have experienced favourable basis shifts and if the interest rate movement causes the NII to contract. fixed deposit rates. liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. The embedded option risk is becoming a reality in India and is experienced in volatile situations. TBs yields. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. When the variation in market interest rate causes the NII to expand.
Market interest rates of various instruments seldom change by the same degree during a given period of time. The faster and higher the magnitude of changes in interest rate. 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. Thus. The risk that the interest rate of different assets. The Loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. Banks should also endeavour for stipulating appropriate penalties based on opportunity costs to stem the exercise of options. The basis risk is quite visible in volatile interest rate scenarios. i. call money
. the greater will be the embedded option risk to the banks’ NII.
banks with positive net interest positions will experience a reduction in NII as the market interest rate declines and increases when interest rate rises. Price Risk Price risk occurs when assets are sold before their stated maturities. any non-parallel movements in yield curves would affect the NII. etc. duration. marking to market. therefore. which is created for making profit out of short-term movements in interest rates. bond prices and yields are inversely related. Banks which have an active trading book should.rates.0
Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. holding period. defeasance period. In the financial market. The movements in yield curve are rather frequent when the economy moves through business cycles. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities. formulate policies to limit the portfolio size. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions. Thus.
. banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. Thus. etc. When banks have more earning assets than paying liabilities. The price risk is closely associated with the trading book. interest rate risk arises when the market interest rates adjust downwards. Net Interest Position Risk The size of nonpaying liabilities is one of the significant factors contributing towards profitability of banks. MIBOR. stop loss limits. Thus. large float is a natural hedge against the variations in interest rates.
Generally. yield curve. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields. the earnings or economic value changes are the main focus of banking book.
. they should be identified and quantified. While these methods highlight different facets of interest rate risk. reinvestment and net interest position risks exposures. price. while the price risk is the prime concern of banks in trading book. Duration (to measure interest rate sensitivity of capital). 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.Measuring Interest Rate Risk Before interest rate risk could be managed. the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. it is impossible to measure the degree of risks to which banks are exposed. basis. Simulation and Value at Risk. ranging from the traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings). which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Unless the quantum of IRR inherent in the balance sheet is identified. In a well functioning risk management system. Thus. or use hybrid methods that combine features of all the techniques. The IRR measurement system should address all material sources of interest rate risk including gap or mismatch. the banking book comprises assets and liabilities. banks broadly position their balance sheet into Trading and Investment or Banking Books. many banks use them in combination. It is also equally impossible to develop effective risk management strategies/hedging techniques without being able to understand the correct risk position of banks. embedded option.
While the securities held in the trading book should ideally be marked to market on a daily basis. The advantage of using VaR is that it is comparable across products. etc. usually 95% to 99%. However. maximum maturity. holding period. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical. 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 potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models.) which is then disaggregated across different desks and departments. 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 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. derivative products. using a given confidence level. within a defined period of time. duration. which occur in the ’tails’ of the loss distribution. defeasance period. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions.Trading Book The top management of banks should lay down policies with regard to volume. rating standards. 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. stop loss. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time
. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. 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. etc. VaR models require the use of extensive historical data to estimate future volatility. desks and Departments and it can be validated through ‘back testing’. for classifying securities in the trading book.
etc. to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets. Thus.
A number of time bands can be used while constructing a gap report. overdraft. loans. banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. Those assets and liabilities lacking definite repricing intervals (savings bank. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) to static simulation.horizons based on position size and relative turnover. etc. Maturity Gap Analysis The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets. embedded option risk. It is very difficult to take a view on interest rate movements beyond a year. half-yearly or one year. monthly. quarterly. cash credit.) are assigned time-bands according to the judgement. based on current on-and-off-balance sheet positions. refinance from RBI etc. export finance. cash credit/overdraft. yield curve risk. time deposits. given the complexity and range of balance sheet products. loans. empirical studies and past experiences of banks. Banks with large exposures in the
. liabilities and offbalance sheet items and can easily capture the full range of exposures against basis risk. Generally.) or actual maturities vary from contractual maturities (embedded option in bonds with put/call options. 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. 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). viz. In an environment where VaR is difficult to estimate for lack of data. most of the banks focus their attention on near-term periods.
Conversely. The changes in interest rate could be estimated on the basis of past trends. In order to evaluate the earnings exposure. The positive Gap indicates that banks have more RSAs than RSLs. 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. forecasting of interest rates. etc. The negative gap indicates that banks have more RSLs than RSAs.short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight. 8-14 days. The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. A positive or asset sensitive Gap means that an increase in market interest rates could cause an increase in NII. 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 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
. 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. which would then provide a scale to assess the changes in income implied by the gap analysis. a negative or liability sensitive Gap implies that the banks’ NII could decline as a result of increase in market interest rates. 1-7 days. The Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings at Risk (EaR). The Gap is used as a measure of interest rate sensitivity. 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. However. etc. 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.
When weighted assets and liabilities and OBS duration are matched. banks could realistically estimate the EaR. the simple gap schedule can be used by applying weights to each time-band. Thus. Duration Gap Analysis Matching the duration of assets and liabilities. Duration gap model focuses on managing economic value of banks by recognising the change in the market value of assets. liabilities and OBS. liabilities and off-balance sheet position. the assumption of parallel shift in yield curves seldom happen in the financial market. 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
. The weights are based on estimates of the duration of assets and liabilities and OBS that fall into each time band. liabilities and off-balance sheet (OBS) items. 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). a potentially important source of risk to current income.market value of assets. The Gap report also fails to capture variability in non-interest revenue and expenses. 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. Measuring the duration gap is more complex than the simple gap model. 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. 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. With the Adjusted Gap. 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. For approximation of duration of assets and liabilities. Further. market interest rate movements would have almost same impact on assets. one or several assumptions of standardised gap seem more consistent with real world than the simple gap method.
It is also possible to give different weights and interest rates to assets. Once the weighted duration of assets and liabilities are estimated. liability and OBS position and weigh each of them to arrive at the weighted duration of assets. Duration measure is additive so that banks can match total assets and liabilities rather than matching individual accounts. 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 duration analysis also recognises the time value of money. When the duration gap is negative (DL> DA). For this reason. banks can precisely estimate the economic value changes to market interest rates by calculating the duration of each asset. liabilities and OBS in different time buckets to capture differences in coupons and maturities and volatilities in interest rates along the yield curve. the duration gap can be worked out with the help of standard mathematical formulae. In a more scientific way. The difference between duration of assets (DA) and liabilities (DL) is bank’s net duration.market interest rates. liabilities and OBS. The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. the MVE increases when the interest rate increases but decreases when the rate declines. Thus. it fails to recognise basis risk.
. liabilities and OBS. However. If the net duration is positive (DA>DL). a decrease in market interest rates will increase the market value of equity of the bank. the Duration Gap shows the impact of the movements in market interest rates on the MVE through influencing the market value of assets. Duration Gap analysis assumes parallel shifts in yield curve.
The usefulness of the simulation technique depends on the structure of the model. the dynamic simulation builds in more detailed assumptions about the future course of interest rates and the unexpected changes in bank’s business activity. duration gaps. Simulation can provide current and expected periodic gaps. changes in business activity. on-and off-balance sheet positions. While the current on and off-balance sheet positions are evaluated under static environment.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. shape of yield curve. The simulation can be carried out under static and dynamic environment. etc. ranging from changes in the slope and shape of the yield curve and interest rate scenario derived from Monte Carlo simulations. validity of assumption. budget and financial reports. pricing and hedging strategies. This technique also plays an integral-planning role in evaluating the effect of alternative business strategies on risk exposures. technology support and technical expertise of banks. The simulation model provides an effective tool for understanding the risk exposure under variety of interest rate/balance sheet scenarios. Simulation technique attempts to overcome the limitations of Gap and Duration approaches by computer modelling the bank’s interest rate sensitivity. performance measures. depending on users’ need. balance sheet and income statements. The simulation techniques involve detailed analysis of various components of Simulations can also incorporate more varied and refined changes in the interest rate environment. Such modelling involves making assumptions about future path of interest rates. The output of simulation can take a variety of forms.
. The simulation involves detailed assessment of the potential effects of changes in interest rate on earnings and economic value.
however. The FTP envisages assignment of specific assets and liabilities to various functional units (profit centres) – lending. Each unit attracts sources and uses of funds. Matched Funds Pricing (MFP) is the most efficient technique. investment. vary according to maturity. Thus. as suggested by RBI in the guidelines on ALM System. etc) so that asset-liability transactions of identical attributes are assigned identical transfer prices. Most of the international banks use MFP. FTP also helps correctly identify the cost of opportunity value of funds. The lending. In any case.The application of various techniques depends to a large extent on the quality of data and the degree of automated system of operations. 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
. 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. It can also be used to isolate returns for various risks assumed in the intermediation process. Although banks have adopted various FTP frameworks and techniques. banks may start with the gap or duration gap or simulation techniques on the basis of availability of data. deposit taking and funds management. Once banks are comfortable with the Gap model. 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. The transfer prices are fixed on the basis of a single curve (MIBOR or derived cash curve. purpose. information technology and technical expertise. Transfer prices could. they can progressively graduate into the sophisticated approaches. banks should start estimating the interest rate risk exposure with the help of Maturity Gap approach. Funds Transfer Pricing The Transfer Pricing mechanism being followed by many banks does not support good ALM Systems.
spread) is credited to the funds management profit centre. This spread is the result of accumulated mismatches. The margins of various profit centres are:
The franchise (liability).0 0.a. credit and mismatch spreads of bank is as under: Profit Centres Deposit Funds 8.5 7.
Lending profit centre: Loan yields + TP on deposits – TP on loan financing – cost of deposits – deposit insurance .5 6. For illustration.e.0 1.overheads – provisions for depreciation in investments and loan loss. and that the alternative funding cost i.1 Total Loan 13.5 6.overheads – loan loss provisions.0 1.5 2.•
Deposit profit centre: Transfer Price (TP) on deposits .
Funds Management profit centre: TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads.5% p.
Investment profit centre: Security yields + TP on deposits – TP on security financing – cost of deposits – deposit insurance .5 3.cost of deposits – deposit insuranceoverheads.a.5 8.a.. Let us also assume that the bank’s Loan profit centre created a one year loan @ 13.5 10.5% p.5% p. MIBOR for 3 months and one year @ 8% and 10.0 13.5 0.0 1. respectively.0 10.1
Interest Income Interest Expenditure Margin Loan Loss Provision (expected) Deposit Insurance
. let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @ 6.
The credit or counterparty and price risks are.0 0.6 1. managed by these profit centres.0 1. liquidity and forex are assumed by the funds management profit centre.8
1. Thus. The entire market risks. 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. The FTP allows lending and deposit raising profit centres determine their expenses and price their products competitively. the profit centres (other than funds management) are precluded from assuming any funding mismatches and thereby exposing them to market risk.4
1. greater line management control and solid base for rewarding line management. i.6 0. however.2
Under the FTP mechanism.Reserve Cost (CRR/ SLR) Overheads
0.e interest rate.5 1.7 3. FTP also could be used to enhance corporate communication. 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.0
As a result. banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions.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. Reserve Bank of India has recently introduced two
. middle and back offices. banks also face the risk of default of the counter parties or settlement risk. 2. thereby adding a new dimension to the risk profile of banks’ balance sheets. banks may suffer losses as a result of changes in premia/discounts of the currencies concerned. which arises from the maturity mismatching of foreign currency positions. Set appropriate limits – open positions and gaps. Clear-cut and well-defined division of responsibility between front. While such type of risk crystallisation does not cause Thus. 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. or a combination of the two. banks may incur principal loss. replacement cost. the maturity pattern of forward transactions may produce mismatches. Even in cases where spot and forward positions in individual currencies are balanced. The banks are also exposed to interest rate risk. The forex transactions with counter parties from another country also trigger sovereign or country risk. which depends upon the currency rate movements. Forex Risk Management Measures 1. in an individual foreign currency. 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. In the forex business. either spot or forward. The top management should also adopt the VaR approach to measure the risk associated with exposures.
Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of forex risk exposures.5% has been prescribed for investments in Government and other approved securities. comply with quantitative and qualitative criteria prescribed by Basle Committee. As an initial step. As the ability of banks to identify and measure market risk improves. Reserve Bank of India has accepted the general framework suggested by the Basle Committee. however. While the small banks operating predominantly in India could adopt the standardised methodology. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. particularly those arising from their trading activities. 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
. a risk weight of 2. In the meanwhile. besides a risk weight each of 100% on the open position limits in forex and gold.
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. 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. 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). Banks should use these statements for periodical monitoring of forex risk exposures. it would be necessary to assign explicit capital charge for market risk. The internal models should.statements viz. RBI has also initiated various steps in moving towards prescribing capital for market risk.
interest rate risks are significantly above average (‘outliers’). or the risk of loss arising from various types of human or technical error. Operational risk has some form of link between credit and market risks.
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. fraud.
Measurement There is no uniformity of approach in measurement of operational risk in the banking system. Once the Committee finalises the modalities. It is also synonymous with settlement or payments risk and business interruption. the existing methods are relatively simple and experimental. which is not categoried as market or credit risk.
Generally. 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 is defined as any risk. The most important type of operational risk involves breakdowns in internal controls and corporate governance. administrative and legal risks. Such breakdowns can lead to financial loss through error. high degree of structural changes and complex support systems. 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. or failure to perform in a timely manner or cause the interest of the bank to be compromised. although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk. Besides. it may be necessary. An operational problem with a business transaction could trigger a credit or market risk.
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. turnover. managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables. delays and errors. should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framework. 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. turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility. Indian banks have so far not evolved any scientific methods for quantifying operational risk. banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue. inter alia. operational data such as volume. operating costs. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. could be related to historical loss experience.
Risk Monitoring The operational risk monitoring system focuses. The set of risk factors that measure risk in each business unit such as audit ratings. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring. Banks. similar to bond credit rating.Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. Some of the international banks have already developed operational risk rating matrix.
. fee income. on operational performance measures such as volume. In the absence any sophisticated models. over a period. settlement facts. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals.
Banks should endeavour for
detection of operational problem spots rather than their being pointed out by
. The policy should address product review process. supervisors/internal or external auditors. The policies and procedures should be based on common elements across business lines or risks. Banks could also explore setting up operational risk limits. Policies and Procedures
Banks should have well defined policies on operational risk management.Control of Operational Risk Internal controls and the internal audit are used as the primary means to mitigate operational risk.
One of the major tools for managing operational risk is the well-established internal control system.
The ideal method of identifying problem spots is the technique of selfassessment of internal control environment. The self-assessment could be used to evaluate operational risk alongwith internal/external audit reports/ratings or RBI inspection findings. risk management and internal control functions. 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 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. which includes segregation of duties. involving business. clear management reporting lines and adequate operating procedures. based on the measures of operational risk. Risk education for familiarising the complex operations at all levels of staff can also reduce operational risk.
This begins with a clear differentiation between expected and unexpected losses. Key to RAROC is the matching of revenues. The RAROC is designed to allow all the business streams of a financial institution to be evaluated on an equal footing. product. at the bank’s Head Office level. diversification and correlation. Banks. Thus. As a part of the process for evaluating internal capital adequacy.
. time horizon. risk is measured in terms of variability of income. 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. The most commonly used approach is the Risk Adjusted Return on Capital (RAROC). Each type of risks is measured to determine both the expected and unexpected losses using VaR or worst-case type analytical model. it requires the summation of the different types of risks. Thus. The Basle Committee on Banking Supervision proposes to develop an explicit capital charge for operational risk. etc. across the world. To do so. in addition to complying with the established minimum regulatory capital requirements. the Audit Committees should play greater role to ensure independent financial and internal control functions. however. Such banks take into account both qualitative and quantitative factors to assess economic capital. aggregate risk exposure should receive increased scrutiny. In this approach. a bank should be able to identify and evaluate its risks across all its activities to determine whether its capital levels are appropriate.Alongwith activating internal audit systems. costs and risks on transaction or portfolio basis over a defined time period. The Basle Committee now recognises that capital adequacy in relation to economic risk is a necessary condition for the long-term soundness of banks. use different ways to estimate the aggregate risk exposures. Expected losses are covered by reserves and provisions and unexpected losses require capital allocation which is determined on the principles of confidence levels. banks should critically assess their internal capital adequacy and future capital needs on the basis of risks assumed by individual lines of business.
the frequency distribution of return. Capital is thereafter allocated to activities as a function of this risk or volatility measure. rather than moving from volatility of value through capital. the risky position is required to carry an expected rate of return on allocated capital. is based on cash flows and ignores the value changes in assets and liabilities due to changes in market interest rates. Accordingly. when employed to analyse interest rate risk. This is referred to as EaR. risk is aggregated and priced. It also depends upon a subjectively specified range of the risky environments to drive the worst case scenario. Either a worst case scenario could be used or Standard Deviation 1/2/2. This approach. however. each bank can restrict the maximum potential loss to certain percentage of past/current income or market value. but depends less on capital allocation and more on cash flows or variability in earnings.Under this framework. Then. Extreme outcome can be estimated from the tail of the distribution. The second approach is similar to the RAROC. Thereafter. wherever possible is estimated and the Standard Deviation (SD) of this distribution is also estimated. Given the level of extant risk management practices. By dimensioning all risks in terms of loss distribution and allocating capital by the volatility of the new activity.
. Under this analytical framework also frequency distribution of returns for any one type of risk can be estimated from historical data.69 could also be considered. 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. which compensates the bank for the associated incremental risk. this approach goes directly to current earnings implications from a risky position.
• 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
• ALCO should keep a vigil on the working of the banks and ensure
that all the guidelines are met.
.CONCLUSION & RECOMMENDATION
So on the basis of the data provided to us we can say that the banks are not strictly following the ALM Guidelines.
Websites of all banks studied.
Annual Report of all bank (2004-05).
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). Mar 2004). IBA Bulletin (Mar 2003.