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Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken.
“Risk is the possibility of loss or damage”. “Risk is the measure of profitability and severity of adverse effects”. “Risk is the potential for realization of unwanted negative consequences of an event”. In any transaction, when there is a possibility of loss or peril, it may be termed as a risky transaction. As discussed above, risk are inherent in financial intermediation and cannot be eliminated. However, they cannot only be managed and controlled but even be turned into opportunities.
RISK MANAGEMENT IN BANKS
THE BROAD PARAMETERS OF RISK MANAGEMENT FUNCTION SHOULD ENCOMPASS
(i) (ii) (iii)
Organizational structure; Comprehensive risk measurement approach; Risk management policies approved by the Board which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk;
(iv) (v) (vi)
Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits; Strong MIS for reporting, monitoring and controlling risks; Well laid out procedures, effective control and comprehensive risk reporting framework;
(vii) Separate risk management framework independent of operational Departments and with clear delineation of levels of responsibilities for management of risk; and (viii) Periodical review and evaluation.
RISK MANAGEMENT IN BANKS
THE PROCESS OF RISK MANAGEMENT INVOLVES THE FOLLOWING
• Recognition and understanding, • Measurement and • Monitoring and control. For effective risk management, a comprehensive risk management policy has to be formulated incorporating a detailed structure of limits and guidelines to be followed, and a strong management information system built up for continuous monitoring and reporting of risk exposures. Risk management is a process, by which an organization, say a bank, identifies, measures, monitors and controls its risk exposures. Risk management is a continuous process and not a one time activity. Diagrammatically risk management process can be presented as under.
Appropriate processes facilitate explicit and clear risk-taking decisions. Expected return compensates for the risk taken and Capital allocation is consistent with risk exposures.RISK MANAGEMENT IN BANKS By this process. Risks are within the tolerances established by the board of directors. Risk taking decisions are consistent with strategic business objectives. 4 . the bank ensures that: There is a common understanding of risks across the organizations.
RISK MANAGEMENT IN BANKS TYPES OF RISKS As per the RESERVE BANK OF INDIA guidelines issued in October 1999. Further. In August 2001. a guidance note on Market Risk Management was also circulated to all the banks and this was followed by a discussion paper on Country Risk released in May 2002. a discussion paper on move towards Risk based Supervision was published. In the article. the unexpected loss on account of the individual exposure and the whole portfolio in entirety is to be borne by the bank itself and hence is to be taken care of by the capital. MARKET RISK AND OPERATIONAL RISK. Recently in March 2002. It is the amount expected to be lost due to changes in credit quality resulting in default. Whereas. The expected loss is to be borne by the borrower and hence is taken care of by adequately pricing the products through risk premium and reserves created out of the earnings. 5 . there are three major types of risks encountered by the banks and these CREDIT RISK. Risk is the potentiality that both the expected and unexpected events may have as adverse impact on the bank’s capital or earnings. in September 2001 a guidance note on Credit Risk Management was sent to all the banks. we will see what are the components of these three major risks.
Hence. the need for sufficient Capital Adequacy Ratio is felt. the expected losses are covered by reserves and provisions and the unexpected losses require capital allocation. Types of Financial Risks Financial Risks Market Risk Risk Credit Risk Operational 6 .RISK MANAGEMENT IN BANKS Thus. Each type of risk is measured to determine both the expected and unexpected losses using VaR (Value at Risk) or worst-case type analytical model.
are to a great extent centralized. forex and country risks. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. control etc. settlement and other financial transactions. The objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.RISK MANAGEMENT IN BANKS [I] CREDIT RISKS:In course of banks lending involves a number of risks. This is to say that credit risk taking activity is spread across the length and breadth of the network of branches. The credit risk of a banks portfolio depends on both 7 . hedging. Proper a sufficient care has to be taken for appropriate management of credit risk. as lending is a decentralized function. Unlike market risks. The portfolio risk in turn comprises intrinsic and concentration risk. Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending. monitoring. where the measurement. trading. Credit risks management is a decentralized function or activity. the banks are also exposed to interest rate. In addition to the risks related to creditworthiness of the counterparty.
deficiencies in appraisal of borrowers financial position. absence of prudential credit concentration limits. The external factors are the state of the economy. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk. economic sanctions. wide swings in commodity/equity prices. The counterparty risk arises from non-performance of the trading partners. The nonperformance may arise from counterparty’s refusal/inability to perform due to adverse price movements or from external constraints that were not anticipated by the principal. trade restrictions.RISK MANAGEMENT IN BANKS external and internal factors. the amount of loan losses that bank would experience over a chosen time horizon (through tracking portfolio behavior over 5 or more years) 8 . economic sanctions. The internal factors are deficiencies in loan policies/administration. trade restrictions. foreign exchange rates and interest rates. etc. excessive dependence on collaterals and inadequate risk pricing. Government policies.e. Another variant of credit risk is counterparty risk. etc. rates and interest rates. The management of credit risk should receive the top management’s attention and the process should encompass: Measurement of risk through credit rating/scoring:(a) Quantifying the risk through estimating expected loan losses i. inadequately defined lending limits for Loan Officers/Credit Committees. absence of loan review mechanism and post sanction surveillance.
regulatory/legal compliance. pricing of loans. portfolio management. prudential limits on large credit exposures. formulate clear policies on standards for presentation of credit proposals. etc. rating standards and benchmarks. provisioning. risk concentrations. asset concentrations. duly approved by the Board. inter alia. standards for loan collateral. (b) Risk pricing on a scientific basis. Each bank should constitute a high level Credit Policy Committee. also called Credit Risk Management Committee or Credit Control Committee etc. financial covenants. risk monitoring and evaluation. 9 . The credit risk management process should be articulated in the bank’s Loan Policy. The Committee should be headed by the Chairman/CEO/ED. delegation of credit approving powers. to deal with issues relating to credit policy and procedures and to analyze. Credit Risk Management Department (CRMD) and the Chief Economist. Treasury.RISK MANAGEMENT IN BANKS and unexpected loss (through standard deviation of losses or the difference between expected loan losses and some selected target credit loss quantile). manage and control credit risk on a bank wide basis. The Committee should. and (c) Controlling the risk through effective Loan Review Mechanism and portfolio management. and should comprise heads of Credit Department. loan review mechanism.
each bank should also set up Credit Risk Management Department Department.RISK MANAGEMENT IN BANKS Concurrently. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. identify problems and correct deficiencies. Ratio of non performing advances to total advances. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. develop MIS and undertake loan review/audit. independent of the Credit Administration Some of the commonly used methods to measure credit risk are: a. CREDIT RISK may be defined as the risk of default on the part of the borrower. 10 . This uncertainty of repayment by the borrower is also known as default risk. Large banks may consider separate set up for loan review/audit. (CRMD). monitor quality of loan portfolio. The CRMD should also lay down risk assessment systems. The lender always faces the risk of the counter party not repaying the loan or not making the due payment in time.
inter alia. e. provides for standards. through which credit risk management are carried out. d. 1985 issue of US banker. “Balancing the risk equation is one of the most difficult aspects of banking. The credit policy of the banks generally prescribes the criteria on which the bank extends credit and. The instruments and tools. Ratio of loan losses to bad debt reserves. 11 . c. Ratio of bad debt provision to total income. Ratio of loan loss provisions to impaired credit. etc. 2. Managing credit risk has been a problem for the banks for centuries. Over the tears.RISK MANAGEMENT IN BANKS b. If you don’t lend liberally you get criticized”. Loan review mechanism. TOOLS OF CREDIT RISK MANAGEMENT. bankers have developed various methods for containing credit risk. you get into trouble. If you lend too liberally. Ratio of loan losses to capital and reserves. As had been observed by JOHN MEDLIN. Portfolio management. are detailed below: 1.
RISK MANAGEMENT IN BANKS 1. 12 . The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. distribution of borrowers in various industries. Initiative steps to preserve the desired the portfolio quality and integrate portfolio reviews with credit decision making process. PORTFOLIO MANAGEMENT. business group rapid portfolio reviews. Credit portfolio management emanated from the potential adverse impact of concentration of exposures and the necessity to optimize the benefit associated with diversification. Stipulate quantitative ceiling on aggregate exposure on specific rating Categories. There should be a proper and regular on-going system for identification of credit weakness well in advance.
foreign exchange rate. foreign exchange and equities. credit risk management was the primary challenge for banks. With progressive deregulation. equity price and commodity price has become relatively more important.RISK MANAGEMENT IN BANKS [II] MARKET RISK:Traditionally. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities. currency exchange rates and commodity prices. as well as the volatilities of those prices. MARKET RISK may be defined as the possibility of loss to a bank caused by the changes in the market variables. Even a small change in market variables causes substantial changes in income and economic value of banks. monitoring and managing liquidity. interest rate. market risk arising adverse changes in market variables. Market Risk management provides a comprehensive and dynamic framework for measuring. It is the risk that the value of on/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets. foreign 13 . such as interest rate.
out-put of the test should be reviewed periodically. These risks are like perils of the sea. for the banking industry. market competition in terms of services and products. exchange rate fluctuations. Market risk arises out of the dynamics of market forces. changing customer preferences and requirements resulting in product obsolescene.RISK MANAGEMENT IN BANKS exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the banks business strategy. Scenario analysis and stress testing is yet another tool used to asses areas of potential problems in a given portfolio. coupled with changes national and international politico-economic scenario. which can be caused by any change-taking place anywhere in the national and international arena. MARKET RISK EVENTS. That could have unfavorable effect on banks portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keeps changing from time to time. Market risks affect banks in two ways: 14 . which. may include interest rate fluctuations. LIQUIDITY CONDITIONS. maturity mismatches. Identification of future changes in economic conditions like- ECONOMIC / INDUSTRY OVERTURNS.
Again. The Boards should clearly articulate market risk management policies. Hence banks have to fine-tune/modify their products to make them customer friendly. The customer requirements are changing because of the changing economics scenario. measurement of risks on a continuous basis deserves immediate attention. This aspect has assumed greater importance in the modern age. prudential risk limits. with change being the only constant factor. procedures. Market risk can be defined as the risk of losses in on and off balance sheet positions arising from adverse movement of market variables. otherwise the obsolescene of products will divert the customers to other banks thereby reducing the business and profits of the bank concerned. because of the increasing integration of global markets. given that one can manage only what one can measure. ii. Market Risk Management Management of market risk should be the major concern of top management of banks. Since both these aspects are dynamic in nature. market risks need to be monitored on a continuous basis and appropriate strategies evolved to keep these risks within manageable limits. review mechanisms 15 . The macro-economic changes in the national and international polotico-economic scenario affect the risk element in different business activities differently.RISK MANAGEMENT IN BANKS i.
RISK MANAGEMENT IN BANKS and reporting and auditing systems. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregrate the total market risk exposures assumed by the bank at any point of time. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. 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 comprise of experts in market risk management. The operating prudential limits and the accountability of the line management should also be clearly defined. MARKET RISK TAKES THE FORM OF:1) Liquidity Risk 2) Interest Rate Risk 3) Commodity Price Risk and 4) Equity Price Risk A concise definition of each of the above Market Risk factors and how they are managed is described below: 16 . economists.
RISK MANAGEMENT IN BANKS
LIQUIDITY RISK/MATURITY GAP RISK:Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompass the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defence mechanism from losses on fire sale of assets. Liquidity risk is the potential inability of a bank to meet its payment obligations in a timely and cost effective manner. It arises when the bank is unable to generate cash to cope with a decline in deposits/liabilities or increase in assets. The cash flows are placed in different time buckets based on future behavior of assets, liabilities and 0ff-balance sheet items. LIQUIDITY may be defined as the ability to meet commitments and/or undertake new transactions. The most obvious form of liquidity risk is the inability to honour desired withdrawals and commitments, that is, the risk of cash shortages when it is needed which arises due to maturity mismatch.
RISK MANAGEMENT IN BANKS
BANKING can also be described as a business of maturity transformation. Usually banks, lend for a longer period than for which they borrow. Therefore, they generally have a mismatched balance sheet in so far as their short-term liabilities are greater than short-term assets and long-term assets are greater than long term liabilities. i. Liquidity risk is measured by preparing a maturity profile of
assets and liabilities, which enables the management to form a judgement on liquidity mismatch. As the basic problem for a bank is to ascertain whether it will be able to meet maturing obligations on the date they fall due, it must prepare a projected cash-flow statement and estimate the probability of facing any liquidity crisis. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are: the other methods of measuring liquidity risk are:_ To manage liquidity risk, banks should keep the maturity profile of liabilities compatible with those of assets. The behavioral maturity profile of various components of on/off balance sheet items is being analysed and variance analysis is been undertaken regularly.
RISK MANAGEMENT IN BANKS
Efforts are also being made by some banks to track the impact of repayment of loans and premature closure of deposits to estimate realistically the cash flow profile. Banks are closely monitoring the mismatches in the category of 1-14 days and 15-28 days time bands and tolerance levels on mismatches are being fixed for various maturities, depending on asset-liability profile, stand deposit base nature of cash flows, etc. Liquidity Risk means, the bank is not in a position to make its repayments, withdrawal, and other commitments in time. For EXAMPLE two Canadian banks, Northland Bank and Continental Bank of Canada suffered a run on deposits because of a credit crisis at Canadian commercial bank.
Liquidity risk consists of FUNDING RISK, TIME RISK, and CALL RISK.
The liquidity risk in banks manifest in different dimensions: Funding Risk – It is the need to replace net outflows due to unanticipated withdrawals/non-renewal of deposits (wholesale and retail)
20 . Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile. and the desired maturity profile of assets and liabilities. etc. liquidity planning under alternative scenarios. The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. performing assets turning into non-performing assets. which. It includes product pricing for deposits as well as advances. Bank should track the impact of pre-payment of loans and premature closure of deposits so as to realistically estimate the cash flow profile.e. prudential limits. should spell out the funding strategies. etc. (b) cost. liquidity reporting/reviewing. (d) risk exposures. nature of cash flow etc. The first step towards liquidity management is to put in place an effective liquidity management policy.RISK MANAGEMENT IN BANKS Time Risk – It is the need to compensate for non-receipt of expected inflows of funds. and Call Risk – It happens due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable. deposit mix. i. (c) yield. inter alia. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their maturity: (a) profiles.
balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. at least. the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallized. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements. etc. the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. cash outflows can be ranked by the date on which liabilities fall due. banks should have to analyze the behavioural maturity profile of various components of on / off. 21 . In other words. Thus. once in six months to validate the assumptions. the use of maturity ladder and calculation of cumulative surplus or deficit at selected maturity dates is recommended as a standard tool. Experiences show that assets commonly considered as liquid like Government securities. have limited liquidity as the market and players are unidirectional. Banks should also undertake variance analysis.RISK MANAGEMENT IN BANKS While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets. other money market instruments. Thus. The cash flows should be placed in different time bands based on future behavior of assets. liabilities and off-balance sheet items. The assumptions should be fine-tuned over a period which facilitates near reality predictions about future behaviour of on/off-balance sheet items.
e. Cash Reserve Ratio. Maximum Cumulative outflows. Commitment Ratio – track the total commitments given to corporate/banks and other financial institutions to limit the off-balance sheet exposures. Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs. It is quite possible that market crisis can trigger substantial increase in the amount of draw from cash credit/overdraft accounts. extent of Indian Rupees raised out of foreign currency sources. 7. Liquidity reserve Ratio and Loans. 5. 22 . Purchased funds vis-à-vis liquid assets. Core deposits vis-à-vis Core Assets i. etc. the excess or deficit of funds becomes a staring point for a measure of a bank’s future liquidity surplus or deficit. i.RISK MANAGEMENT IN BANKS The difference between cash inflows and outflows in each time period. contingent liabilities like letters of credit. at a series of points of time.1 crore or more to track the volatile liabilities. Duration of liabilities and investment portfolio. 4. Cap on inter-bank borrowings. 6. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1. especially call borrowings.e. Banks should fix cumulative mismatches across all time bands. 2. 3. Swapped Funds Ratio. Further the cash flows arising out of contingent liabilities in normal situation and the scope for a n increase in cash flows during periods of stress should also e estimated.
general perception about risk profile of the banking system. Estimating liquidity under bank specific crisis should provide a worst-case benchmark. viz. severe market disruptions. The banks could also sell their investment with huge discounts. contagion. some of the core deposits could be prematurely closed. banks should evaluate liquidity profile under different conditions. cash flow profile of on / off balance sheet items and manages net funding requirements. bank specific crisis and market crisis scenario. financial crisis. These developments would lead to rating down grades and high cost of liquidity. which influence the cash flow behaviour. the rollover of high value customer deposits and purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. etc. 23 . Thus. It should be assumed that the purchased funds could not be easily rolled over. a substantial share of assets have turned into non-performing and thus become totally illiquid. normal situation. The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank. Under this scenario. The banks should evolve contingency plans to overcome such situations.RISK MANAGEMENT IN BANKS ALTERNATIVE SCENARIOS The liquidity profile of banks depends on the market conditions. entailing severe capital loss. The banks should establish benchmark for normal situation. failure of one or more of major players in the market.
Hence. the objective of interest rate risk management is to maintain earnings. value of assets. exposed them to the adverse impacts of interest rate risk.RISK MANAGEMENT IN BANKS INTEREST RATE RISK (IRR) The management of Interest Rate Risk should be one of the critical components of market risk management in banks. Changes in interest rate affect earnings. off-balance sheet items and cash flow. however. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. improve 24 . Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. liability. Deregulation of interest rates has.
Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities). ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off. Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institutio’s financial condition to the movement in interest rates. Hence.RISK MANAGEMENT IN BANKS the capability. ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off. Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective. improve the capability. expose bank’s NII or NIM to variations. off-balance sheet items and cash flow. 25 . The earning of assets and the cost of liabilities are now closely related to market interest rate volatility. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Changes in interest rate affect earnings. the objective of interest rate risk management is to maintain earnings. liabities. value of assets.
RISK MANAGEMENT IN BANKS Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. which might adversely affect the bank’s financial condition. The immediate impact of change in interest rates is on the bank’s earnings through fall in Net Interest Income (NII). Ultimately the impact of the potential long-term effects of changes in interest rates is on the underlying economic value of bank’s assets. The interest rate risk when viewed from these two perspective is called as “Earning’s Perspective” and Economic Value Perspective”. 26 . The economic value perspective identifies risk arising from long-term inteerst rate gaps. respectively. Economic Value perspective involves analyzing the expected cash inflows on assets minus expected cash outflows on liabilities plus the net cash flows or off-balance sheet items. In simple terms. This is measured by measuring the changes in the NET INTEREST INCOME (NII) equivalent to the difference between total interest income and total interest expense. high proportion of fixed income assets would mean that any increase in interest rate will not result in higher interest income (due to fixed nature of interest rate) and likewise reduction interest rate will not decrease interest income. Low proportion of fixed assets will have the opposite effect. liabilities and off-balance sheet positions. In detail Interest Rate Risk is the risk due to changes in market interest rates.
However it will continue to get interest rate at the old rate from the bond. for classifying securities in the trading book. earning assets or equity have been set up. If the market interest rate arises by 1%. DURATION. Interest rate will be explained with the help of examples:For instances.. MINIMUM MATURITY. it will have to reduce interest rate on cash credit by 1% as cash credit is repriced quarterly. a bank has accepted long-term deposits @ 13% and deployed in cash credit @ 17%. Prudential limits on gaps with a bearing on total assets. The statement of interest rate sensitivity is being prepared by banks. the bank will have to renew the deposits after 90 days at a higher rate. RATING STANDARDS. If the market interest rate falls by 1%. Thus. The various types of interest rate risks are identified as follows:- Price Risk:- 27 . the net interest income will go down by 1%. etc. However. In this case too. the net interest income of the bank will go down by 1%. HOLDING PERIOD.RISK MANAGEMENT IN BANKS Banks have laid down policies with regard to VOLUME. STOP LOSS. Or suppose a bank has 90 days deposit @ 9% deployed in one year bond @ 12%. it will not be able to reduce interest on term deposits.
therefore. formulate policies to limit the portfolio size. Reinvestment Risk:Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. which is created for making profit out of short-term movements in interest rates. In the financial market. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions. export finance. 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). holding period. stop loss limits.) or actual maturities vary 28 . cash credit.RISK MANAGEMENT IN BANKS Price risk occurs when assets are sold before their stated maturities. etc. defeasance period. overdraft. Those assets and liabilities lacking definite repricing intervals (savings bank. duration. loans. marking to market. MATURITY GAP ANALYSIS The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets. bond prices and yields are inversely related. Banks which have an active trading book should. The price risk is closely associated with the trading book. refinance from RBI etc.
a negative or liability sensitive Gap implies that the banks NII could decline as a result of increase in market interest rates. 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. It is very difficult to take a view on interest rate movements beyond a year.RISK MANAGEMENT IN BANKS from contractual maturities (embedded option in bonds with put/call options. 29 . viz. Banks with large exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight. Gap is the difference between a bank’s assets and liabilities maturing or subject to repricing over a designated period of time. 1-7 days. 8-1 4 days etc. The negative gap indicates that banks have more RSLs than RSAs. etc. time deposits.) are assigned timebands according to the judgement. cash credit/overdraft. The positive Gap indicates that banks have more RSAs than RSLs. half-yearly or one year. Conversely. empirical studies and past experience of banks. Generally. monthly. A positive or assets sensitive Gap means that an increase in market interest rates could cause an increase in NII. In order to evaluate the earnings exposure. loans. quarterly. A number of time bands can be used while constructing a gap report. most of the banks focus their attention on near-term periods.
With the Adjusted Gap. The changes in interest could be estimated on the basis of past trends. In case banks could realistically estimate the magnitude of changes in market interest rates of various assets and liabilities (basic risk) and their past behavioural pattern (embedded option risk). one or several assumptions of standardized gap seem more consistent with real world than the simple gap method. banks could realistically estimate the EaR. The Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. which would then provide a scale to assess the changes in income implied by the gap analysis.RISK MANAGEMENT IN BANKS 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. they could standardize the gap by multiplying the individual assets and liabilities by how much they will change for a given change in interest rate. 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. Thus. forecasting of interest rates. etc. 30 .
For this reason. It is expressed in time periods. Duration Gap analysis assumes parallel shifts in yield curve. EQUITY PRICE RISK:- 31 . the duration would be equal to maturity. Duration measure is addictive so that banks can match total assets and liabilities rather than matching individual accounts. that is. corrective action may be taken to create a duration match.RISK MANAGEMENT IN BANKS DURATION GAP ANALYSIS Duration is a measure of change in the value of the portfolio due to change in interest rates. if necessary. Duration of high coupon bond is always shorter than duration of low coupon bonds because of larger cash inflow from higher interest payments. Duration of an asset or a liability is computed by calculating the weighted average value of all the cash-flows that it will produce with each cash-flow weighted by the time at which it occurs. However. With zero coupon bonds. the duration gap can be calculated. Measuring the duration Gap is more complex than the simple gap model. By calculating the duration of the entire asset and liability portfolio. The duration analysis also recognizes the time value of money. The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. it fails to recognize basis risk. the mismatch in asset and liability duration and.
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.” Generally. forward price etc. [III] OPERATIONAL RISK:“Operational Risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes. arising out of changes in prices. operational risk is defined as any risk. An operational problem with a business transaction could trigger a credit or market risk. COMMODITY PRICE RISK:The risk of loss in value of commodity held/traded by the bank. people and system or from external events. which is not categorized as market or credit risk. It is also synonymous with settlement or payments risk and business interruption. administrative and legal risks. basis mismatch.RISK MANAGEMENT IN BANKS Equity Price Risk is the risk of loss in value of the bank’s equity investments and/or equity derivative instruments arising out of change in equity prices. 32 .
There is no uniformity of approach in measurement of Operational Risk in the banking system at present The bank’s operational risks can be classified into following six exposure classes • People 33 . as of 2006. The ultimate objective of operational risk management is to enhance the shareholder’s value by being ready for risk based capital allocation. Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the volume of transactions. high degree of structural changes and complex support systems. fraud. The most important type of operational risk involves breakdowns in internal controls and corporate governance. banks should be made to carry a Capital cushion against losses from this risk.RISK MANAGEMENT IN BANKS Indeed. Such breakdowns can lead to financial loss through error. or failure to perform in a timely manner or cause the interest of the bank to be compromised. The objectives of Operational Risk Management is to reduce the expected operational losses that focuses on systematic removal of operational risk sources and uses a set of key risk indicators to measure and control risk on continuous basis. so significant has operational risk become that the bank for International Settlement (BIS) has proposed that.
Bank collected information at first instance for a 5 year period and is being updated on a six monthly basis June and December. Bank may suitably at a latter date move to appropriate models for measuring and managing Operational Risk also after receipt of RBIs Guidance Note. 34 .. • • • • • Corporate finance Retail banking Commercial banking Payment and Settlement and Trading and Sales (Treasury operations) also To each of this exposure classes within each business line are attached certain risk categories under which the bank can incur losses or potential losses. These date help in qualifying the overall potential / actual loss on account of Operational Risk and initiate measure for plugging these risk areas.RISK MANAGEMENT IN BANKS • • • • • Process Management System Business and External Bank has also identified 5 business lines viz….
similar to bond credit rating. operational data such as volume. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. Banks. the existing methods are relatively simple and experimental.RISK MANAGEMENT IN BANKS MEASUREMENT There is no uniformity of approach in measurement of operational risk in the banking system. Besides. 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. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk. could be related to historical loss experience. should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framnework…. 35 . over a period. Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss.. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring. turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility. The set of risk factors that measure risk in each business unit such as audit ratings. Some of the international banks have already developed operational risk rating matrix.
Banks have been making vigorous in following these guidelines. operating costs. RISK MANAGEMENT STRUCTURE A major issue in establishing an appropriate risk management organization structure is choosing between a centralized and decentralized 36 . In the absence any sophisticated models. It is now argued that many of these failures were due to the fact that the risks were not identified and managed properly. At present. banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue. RISK MANAGEMENT IN BANKS The history of banking is full of major and minor failures. fee income. The reserve bank of India has issued elaborate guidelines on asset liability management and risk management to banks in India. Hence. 20% charge on the Capital Funds is earmarked for operational risk.RISK MANAGEMENT IN BANKS Indian Banks have so far not evolved any scientific methods for quantifying operational risk. scientific measurement of operational risk has not been evolved. managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables.
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 organizational level. The Board should set risk limits by assessing the bank’s risk and risk-bearing capacity.RISK MANAGEMENT IN BANKS structure. 37 . The global trend is towards centralizing risk management with integrated treasury management function to benefit from information on aggregate exposure. 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. natural netting of exposures. The Committee should also develop policies and procedures. verify the models that are used for pricing complex products. the trend is towards assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk). The function of Risk Management Committee should essentially be to identify. review the risk models a development takes place in the markets and also identify new risks. 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. economies of scale and easier reporting to top management. Internationally. monitor and measure the risk profile of the bank.
38 . dictated by the size. At a more sophisticated level. it is difficult to adopt a uniform framework for management of risks in India. therefore. however. consistent in quality.RISK MANAGEMENT IN BANKS A prerequisite for establishment of an effective risk management system is the existence of a robust MIS. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise. the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. the level of technical expertise and the quality of MIS. requires substantial up gradation and strengthening of the data collection machinery to ensure the integrity and reliability of data. As the domestic market integrates with the international markets. It should. The risk management is a complex function and it requires specialized skills and expertise. be the endeavor of all banks to upgrade the skills of staffs. The existing MIS. The design of risk management functions should be bank specific. the core staff at Head Offices should be trained in risk modeling and analytical tools. Given the diversity of balance sheet profile. Banks have been moving towards the use of sophisticated models for measuring and managing risks. Large banks and those operating in international markets should develop internal risk management models to be able to compete effectively with their competitors. complexity of functions.
Banks could also set up a single Committee for integrated management of credit and market risks. assumed by corporate whi have no natural hedges.RISK MANAGEMENT IN BANKS Internationally. Currently. Generally. RISK IS A SERIOUS BUSINESS 39 . Thus. the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and procedures. The economic crises in some of the countries have revealed a strong correlation between unhedged market risk and credit. While the Asset-Liability Management Committee (ALCO) deals with different types of market risk. The volatility in the prices of collateral also significantly affects the quality of the loan book. a committee approach to risk management is being adopted. the Credit Policy Committee (CPC) oversees the credit/counterparty risk and country risk. while market variables are held constant for qualifying credit risk. Banks may also consider integrating market risk elements into their credit risk assessment process. will increase the credit risk which banks run vis-à-vis their counterparties. Forex exposures. credit variables are held constant in estimating market risk. there is a need for integration of the activities of both the ALCO and the CPC and consultation process be established to evaluate the impact of market and credit risks on the financial strength of banks.
but sometimes. Systematic risk results from the high interrelations between banks through mutual lending and borrowing commitments. i. risk management has. therefore. which needs to be looked into with great concern and care. Banks. the world over. the risk that the whole banking system fails. It is evident from above that if risk are not managed properly. it is said that “NO RISK-NO GAIN”. generally. REGULATORY ISSUES AND CAPITAL ADEQUACY Individual banks risks create Systematic risk.. have been in force for a long time. For instance. A number of rules. aimed at limiting risks in a simple manner.RISK MANAGEMENT IN BANKS Why do organizations take risks? The apt answer would be-to make some handsome gains. become an important area. even the survival of the bank may become under threat. Systematic Risk is a major challenge for the regulator. certain ratios are subject to 40 . taking risk becomes disastrous for the organizations. The failure of single institution generates a risk of failure for all banks that have ongoing commitments with the defaulting bank.e.
Guidelines are defined by a group of regulators in Basel at the bank for International Settlements (BIS). creditors in the event of insolvency and lquidation. regulators focus on pre-emptive (in-anticipation) actions limiting the risk of failure. The main enforcement of such regulations is Capital Adequacy.RISK MANAGEMENT IN BANKS minimum values. so as to limit the risks. The process attempts to reach a consensus on the feasibility of implementing new guidelines by interacting with the industry. Single Borrowers etc. However. 41 .. certain caps are placed viz. Capital Adequacy requirements are primarily to meet the following objectives:• • To ensure survival of the institution to protect it against the risk of insolvency. • To protect depositors. Basel guidelines are subject to some implementation variations from one country to another according to the view of local supervisors (RBI in case of our country).. To absorb unanticipated losses with enough margin to inspire stakeholders confidence and enable the institution to continue as a going concern. Switzerland (hence the name Basel Accord). say Capital Adequacy Ratio. That is by enforcing a capital level in a level in a line with risks. bondholders.
summing arithmetically the capital charges of all transactions does not capture diversification effects. But. it was not risk sensitive. focused on Credit Risk. • In the CRAR computation. The proposed New Basel Accord is the of consultative documents that describe recommended rules for enhancing credit risk measures. there is an embedded diversification in the 8% (CRAR). An 8% ratio applied for “AAA” rated large corporate exposure and also for a small business with a lesser rating. extending the scope of capital requirements to operational risk.RISK MANAGEMENT IN BANKS The first Accord (1998) known as Basel I. whatever their degree of diversification. but the same ratio applies to all portfolios. with the famous Cookie Ratio. but may compensate and adjust in view of different co-relation among assets within the exposure/portfolio. while of its major drawbacks are :• There is no differentiation between the different risks in lending activity. that the entire portfolio may not move unidirectional. The New Accord is under finalization. The proposed New Basel Accord to be known as Basel II considerably enhances the previous credit risk regulations. providing various 42 . The Cookie Ratio sets up the minimum required capital as a fixed percentage of assets weighted according to their nature. By diversification we mean. The major strength of cookie ratio is its simplicity. the capital charges are added. The scope of regulations extended progressively later. That is to say. That is. The extension to market risk was in 1996 by way of an amendment.
and (iii) to promote safety and soundness in banks and financial systems. and risk exposure and assessment. including an incentive to maintain a strong capital base as a cushion against potential future losses arising from risk exposures. (ii) to have the supervisory review process. the Foundation and Advanced approaches and provides remedies for several critical issues/draw backs of the existing system. As New Basel Capital Accord is based around three complementary elements viz… (i) to reinforce minimum capital standards. 43 . The New Basel Accord appears to be a major step forward. The Risk Management has come at the central stage in the new Basel Capital Accord. Pillar 3 – Market Discipline. The Basel Committee is already working on the scope of application of the Accord. The accord is likely to also extend the scope of capital requirements to Operational Risk. capital and capital adequacy.RISK MANAGEMENT IN BANKS enhancements to the existing accord and detailing the supervision and market discipline. 3. Pillar 1 – Minimum Capital Requirements. On the quantitative side of risk measurements. the accord offers a choice between the Standardised. The new sets of ratios are called the Mc Donough Ratios. Weighs are based on credit risk components allowing a much improved differentiate of risks. 2. sound and efficient manner. Pillar 2 – Supervisory Review Process. The new accord comprises of 3 pillars:1. Market Discipline imposes strong incentives to banks to conduct their business in safe.
In consultation with the supervisory authorities of a few non G-10 countries including India. The Basel Committee on Banking Supervision (popularly known as BCBS) is a committee of banking supervisory authorities of G-10 countries and has been developing standards and establishment of a framework for bank supervision towards strengthening financial stability throughout the world. Banker’s for International Settlement (BIS) meet at Basel situated at Switzerland to address the common issues concerning bankers all over the world.RISK MANAGEMENT IN BANKS BASEL’S NEW CAPITAL ACCORD. core principles for effective banking supervision 44 .
One size fits all 45 . Flexibility. The main differences between the existing accord and the new one are summarized below:- Existing Accord 1. Focus on single measure. supervisory Review and market discipline.RISK MANAGEMENT IN BANKS in the form of minimum requirements to strengthen current supervisory regime. were mooted. 2. More emphasis on bank’s own Internal methodology. it provides spectrum of approaches for the measurement of credit. As an improvement on the above. Incentive Management. the New Capital Accord was published in 2001. New Accord 1. menu of approaches. The 1998 Capital Accord essentially provided only one option measuring the appropriate capital in relation to the risk-weighted assets of the financial institution. for better risk 2. It focused on the total amount of bank capital so as to reduce the risk of bank solvency at the potential cost of bank’s failure for the depositors. market and operational risks to determine the capital required. to be implemented by the financial year 2003-04.
Supervisory 46 Pillar 3: Market Discipline. 3. Sets minimum Acceptable Capital level. Pillar 1: Minimum Capital Requirements. Enhanced Pillar 2: Superviory Review of Capital Adequacy. More risk sensitivity The structure of the New Accord – II consist of three pillar approach as given below:- PILLAR First Pillar Second Pillar Third Pillar FOCUS AREA Minimum Capital Requirements Supervisory Review Process Market Discipline BASEL’S NEW CAPITAL ACCORD.RISK MANAGEMENT IN BANKS 3. Improved disclosure of capital structure. risk profile. Improved . Banks must assess solvency Vs. Broad brush structure.
Regulators will intervene at an early stage if capital levels detediorate. frauds occurred due to loss or steal of plastic cards that cause the greatest losses. 1. smart cards etc. disclosure of risk profile Improved disclosure of capital adequacy. 47 . and could well dominate average operating losses as a whole. Ratios are Unchanged. According to estimation. NEW PRODUCTS AND RISK. Market risk Framework.) the risk of frauds have increased manifold. debit. The second largest source and fastest growing source of loss is use of counterfeit cards. Improved disclosure of risk measurement & management practices. Worldwide. in an active issuing Bank. With the introduction of new products like plastic cards (credit. Mitigation Explicit Treatment of Operational risk. card fraud is likely to claim the lion’s share of fraud being experienced in general. Public ratings 2. Emerging areas of E-commerce and internet banking are also a matter of concern. Bank should hold in excess of minimum level of capital. review of banks Calculation & Capital strategies.RISK MANAGEMENT IN BANKS Approach for Credit risk. Internal ratings 3.
counterbalance and neutralize the risk to a certain degree. accept the risk and retain it on an economically justifiable basis. • If suitable. 48 . try to avoid it. will help in taking timely decisions for avoidance of risks. For risky business areas. if put in place in the right perspective. in itself. is a very risky option. and it is unavoidable. This. Try to execute some effective actions as to reduce or eliminate the loss likely to be incurred due to happening of the particular risky incident. the million dollar question is – What to do about the Risks? The suitable answer to this question would be to manage the risks in an efficient and effective manner so that the organization incurs minimum loss. • • • Try to diversify within a portfolio of risks with a view to shortening the loss.e. hedge the risk artificially i. introduction of prudent exposure norms. The resource available to banks could be:• • • If the risk is at prospective stage.RISK MANAGEMENT IN BANKS WHAT TO DO ABOUT RISK? Once the risks have been identified. Sound risks management procedures and information systems. by use of derivative instruments. may help in minimizing the loss. in advances. If the risk is likely to occur.
Put in place the comprehensive internal control and audit systems with a view to controlling risks. SBI operates worldwide through an extensive network of over 9000 offices including 50 overseas offices in 48 countries. from the ‘Banker’. will help in minimizing the losses. which does not result in getting rid of risks. SBI 49 . London.RISK MANAGEMENT IN BANKS • • • Monitor various categories of risks on continuous basis and report to appropriate authority so that risks can be overcome in future. Liquidate the risk by transfer without resources to other party. The Bank has won the Technology Award 2005. Until recently. United Kingdom study The Client STATE BANK OF INDIA (SBI) is the largest bank in India with over 180 years of banking experience. London. Today. State case Bank of India. The effective Risk Management Process in Bank’s. State Bank of India ranks among the top 25 commercial banks in Asia with assets exceeding US$60 billion.
Manual posting carried with it the risk of error prone entries. they required counter party limits and exposures to be displayed back to the dealer on a separate screen by intelligently using the information from dealer initiated Reuter conversations with the counter party. The Bank required ‘straight through processing’ from Reuters dealing server to the Misys-Equation platform to minimise operational risk. 50 . Investigation of available products in the market place found that they contained many functionalities already catered for by the Reuter system and were not cost effective and used obsolete technologies. missed out deals. In addition. With an eye on future proofing the investment in the system it also desired that the solution be platform independent and therefore be based on ‘java’ programming and be integrated with the Meridian middleware provided by Misys. This application runs on the IBM AS400 platform. IIL Risk Management has provided various IT related services to the Bank. These deals were posted manually into the banking application. Dealers negotiate and confirm various deals every day involving money market and forex trades. Since 2001. The Problem SBI. lack of suitable and timely checks & verification and inability to ascertain accurately counter party dealing limits. UK’s Treasury operations use the Reuters 3000 dealing system.RISK MANAGEMENT IN BANKS UK operation has been using the Misys-Equation banking application for its operations. The Solution IIL Risk Management (IIL) developed for the bank a unique and cost effective solution to automate the entire process from capturing deals from Reuter dealing 3000 server to posting into the core banking application.
• Secure and user-friendly interface to monitor flow of deal data. Misys Meridian middleware and The process can be IBM categorised as AS/400. • Deal data processing with data validation and writing to database. Equation. correct any • Intelligent use of Reuters Current Interest Feed (CIF) to retrieve counterparty dealing limits and actual exposures from the Equation banking system and displaying the same back to the dealers. follows: • Electronic capture of deals via Reuter Ticket Output Feed (TOF). Timely display of counter party dealing limits at both Group and Individual level and actual exposures enabled the dealers to know the exact ‘position’ at any given 51 . All the above modules work closely with each other in terms of connectivity. Operational efficiency was greatly improved. Access database. • Deal data mapping.RISK MANAGEMENT IN BANKS The solution integrates various technologies such as Microsoft Windows 2000 server. formatting and posting to Misys Equation using Meridian exceptions and Middleware/IBM review status of posting MQ into Misys Series. IBM MQ series. UK Treasury Department’s workload considerably virtually eliminating the need for human intervention. The Benefits The implemented solution reduced SBI. request and response along with reliable audit trails.
United Kingdom The Client BANK OF BARODA has significant International presence with a network of 57 Offices in 19 countries including 38 branches of the bank and 17 branches of its seven subsidiaries besides 2 representative offices in 52 .RISK MANAGEMENT IN BANKS time. London. This was an important technology based support for the Bank’s efforts to minimise operational risk from manual interventions. Case Study Bank of Baroda.
The process involves classifying each payment and posting the resultant transactions into Misys Equation core banking product manually. giro credits and direct debits from Natwest on a daily basis as printed statements along with the related instruments. The Problem Bank of Baroda U.K. since the 1990â€™s the bank has been using the Misys-Equation core banking application to support its activities at its London Main Office and other branches. blocked account. 53 . In the U.RISK MANAGEMENT IN BANKS Malaysia and China and a network of more than 2700 branches in India. The Solution IIL Risk Management has provided a solution to automate the entire process end to end with the necessary validations at every level of the data pass through. closed account and incorrect accounts. called for considerable effort and use of human resources contributed to operational risk. IIL Risk Management has been providing various IT related services to the bank. The objective being the reduction of manual effort to a minimum and improvement in the accuracy of posted transactions and operational efficiency. Manual entries were error prone requiring additional verification. This process therefore. the account numbers held at Natwest do not exactly match with that in the MisysEquation database. The bank (main office and branches) receives all clearing information such as cheques. inactive account. This application runs on the IBM AS400 Operating platform.K conducts it's clearing through Natwest/Royal Bank of Scotland. Checks have to be made in respect of stopped cheque. Moreover.
An MS Windows based front-end provides a user-friendly interface to process downloaded data from Natwest. carry out necessary checks to ensure data integrity and to transfer the data to AS/400. Both Microsoft and IBM technologies are used with suitable data transfer methodology to IBM AS/400.RISK MANAGEMENT IN BANKS The implemented solution integrates with electronic receipt of Agency Credit Clearing data from Natwest based on APACS (Association of Payment Clearing Services) standards 27 and 29. drastically reduced manual errors. The automatic mapping function enables correction of incorrect account numbers. The Benefits Implementation of the automated clearing system increased the speed of processing. which define the specification of files exchanged between banks and their customers. All the Branches including the Main Office have access to menu options to view and correct the exceptions. categorising the transactions as 'OK' to post and 'Exceptions' based on established business validation rules and to tally the credit/Debit totals with those from Natwest. IBM AS/400 operations menu guides the user to process the transferred data. A specially written automatic posting program handles the posting of accounting entries into Misys-Equation. eliminated delays in posting 54 .
which is an important input to the portfolio planning process. The solution is centrally managed from the Head Office and use of the AS/400 platform on which the banking application runs. The department has done detailed studies on default patterns of 55 . the most significant risk faced by ICICI Bank. The industry analysts of the department monitor all major sectors and evolve a sectoral outlook. allows branches to handle their part of the data effectively while not worrying about uploading and managing their branch specific clearing data Credit Risk Management of ICICI Credit risk.RISK MANAGEMENT IN BANKS customer accounting entries and kept up-to-date individual customer accounts. 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 IN BANKS loans and prediction of defaults in the Indian context. the department has been instrumental in reorienting the credit processes. Monitoring Monitor adherence to credit policies of RBI During the year. New Product Approval Policy. operating policies & procedures Portfolio monitoring Methodology to measure portfolio risk Credit Risk Information System (CRIS) Focussed attention to structured financing deals Pricing. The functions of this department include: Review of Credit Origination & Monitoring Credit rating of companies/structures 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. 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. Risk-based pricing of loans has been introduced. 56 .
communication. In recent times. These include potential losses caused by events such as breakdown in information. and provide real time information on credit risk.RISK MANAGEMENT IN BANKS Availability of information on a real time basis is an important requisite for sound risk management. procedures and documented processes Risk Based Audit Plan Widening of Treasury operations audit coverage Use of Computer Assisted Audit Techniques (CAATs) Information Systems Audit 57 . Operational Risk Management of ICICI ICICI Bank. transaction processing and settlement systems/ procedures. the CRC & AD has implemented a sophisticated information system. there has been a shift in the audit focus from transactions to controls. an integral part of the Risk Compliance & Audit Group. like all large banks. In addition. namely the Credit Risk Information System. is exposed to many types of operational risks. Some examples of this paradigm shift are: Adherence to internal policies. the CRC & AD has designed a web-based system to render information on various aspects of the credit portfolio of ICICI Bank. focusses on the operational risks within the organisation. The Audit Department. To aid its interaction with the strategic business units.
CONCLUSION 58 .RISK MANAGEMENT IN BANKS 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.
are such committee that handles the risk management aspects.. technical/professional manpower and the status of MIS in place in that bank. An objective and reliable data base has to be built up for which bank has to analyse its own past performance data relating to loan defaults. Functions of risk management should actually be bank specific dictated by the size and quality of balance sheet. A large project involves certain risks.. There may not be one-size-fits-all risk management module for all the banks to be made applicable uniformity. trading losses.RISK MANAGEMENT IN BANKS The objective of risk management is not to prohibit or prevent risk taking. but to ensure that the risks are consciously taken with full knowledge. and come out with bench . As in the international practice. The effectiveness of risk management depends on efficient Management Information System. a committee approach may be adopted to manage various risks.marks so as to prepare themselves for the future risk management activities. The Risk Management helps banks in preventing problems even before they occur. the Board of Directors and Senior 59 . The Risk Management is an emerging area that aims to address the problem of identifying and managing the risks associated with the banking industry. The purpose of managing risk is to prevent an institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position. etc. Credit Policy Committee. and that is true of banking projects. In managing the risks. Risk Management Committee. Asset Liability Management Committee. computerization and net working of the branch activities. operational losses. complexity of functions. clear purpose and understanding so that it can be measured and mitigated. etc.
If he is proved wrong in his judgment. you get kicked. they throw rocks at you”. the process of risk management may go haywire. which integrates:• • • Prudent risk limits. 60 . The keen interest taken by the Reserve Bank of India in this context needs to be appreciated and supported at all levels. Continuous risk monitoring and frequent reporting is said to be efficient one. If the Assets of a bank exactly matched its liabilities of identical maturity. in practice it is near impossible to have such a perfectly matched balance sheet. Sound risk management procedures and information systems. to keep different types of risk within acceptable limits. interest rate risk. If you run. The Risk Management System. It is by no means an easy task.RISK MANAGEMENT IN BANKS Management will have to play an effective role by formulating clear and comprehensive policies. Few would disagree with the statement that “being a banker is like being a country hound dog. and currency risk could have been avoided. then liquidity risk. and currency. However. Most of the risks arise as a result of mismatch of assets and liabilities. It requires the ability to forecast future changes in the environment and formulate suitable action plans to protect the net worth of the organization from the impact of these risks. If you stand still. interest rate conditions. A banker therefore has.
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