RESEARCH REPORT ON

Submitted in Partial Fulfillment of the Requirement for the award of degree of Masters in Business Administration- International Business

ON COMPARATIVE STUDY: “RISK MANAGEMENT IN BANKS”
Submitted To: by: Submitted

ACKNOWLEDGEMENT
I have taken considerable help and support in making this project report a reality. First and foremost, I would like to thank my respectable and learned guide Mr. Ashu Jain for whose untiring, persevering and unflinching help, this project would not have seen the light of day. It was he who initiated the development of the project and was thus instrumental in showing the right direction in the field of operation in practice. He provided encouragement and boost in the transformation of my inherent internal knowledge into a real work for external audience. He mustered internal support and sponsorship that I needed to make this a reality. through such a rough weather. The realization of this project marks the beginning of an ever - growing and valuable learning experience in my life. Throughout the period of this project every day was a new turning point in my career. It would be worthwhile here to mention the contributions made by people around me which lead to the successful completion of this project. I express my gratitude for all that I have learnt so far and continue learning with each passing day. Lastly, I would like to bestow my special regards and gratitude to the , a premier management institute of the country, for creating a knowledge building culture in me and vocal supporter for creating a strong marketing knowledge and corporate financial foundation. has always been a key discussion partner friend, a philosopher, and guide for me. I am thankful to him for seeing me

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PREFACE
Risk Management underscores the fact that the survival of an organisation depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity but to ensure that the risks are consciously taken with full knowledge, clear purpose and understanding so that it can be measured and mitigated. The present study is on Risk Management in Banks. The core of the study is to analyze various kinds of risk i.e credit, interest rate, liquidity and operational risk and how to measure and monitor these risk. The study undertakes sample of six banks, which includes both public and private sector. The entire dissertation has been divided into nine chapters. The first chapter contains discussion on the meaning and concept of risk, risk management, its functions, types of risk, RBI guidelines. Chapter Second contains the Research Methodology, which includes need, objective, significance of study. The Third chapter contains profiles of State Bank of India, ICICI BANK, CENTRAL BANK OF INDIA, HDFC BANK, ORIENTAL BANK OF COMMERCE AND IDBI BANK. In the forth, fifth and sixth chapter analyses of credit risk, market risk and operational risk is undertaken. Basel II norms and Risk Based Supervision Requirements are discussed in seventh chapter. Analysis of survey responses and profitability analysis, which is the central point of financial analysis, is included in eighth chapter. Chapter ninth presents the major findings of the study with some concluding remarks.

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..............................................CONTENTS Acknowledgement……………………………………………………….................ii Certificate………………………………………………......................................23-28 Chapter IV CREDIT RISK MANAGEMENT..……………..........iv Chapter I INTRODUCTION..1-13 (a) Introduction (b) Meaning of Risk and Risk Management (c) Risk management Structure (d) Risk management Components (e) Steps for implementing risk management in bank (f) Types of risks (g) RBI Guidelines on risk management Chapter II RESEARCH METHODOLOGY ..........................................…........................14-22 (a) Need of Study (b) (c) (d) (e) (f) (g) (h) Objective of Study Significance of Study Scope of Study Research Design Data Collection Techniques of Analysis Limitations of Study Chapter III BANKS PROFILE ..........29-40 a (a) Meaning of Credit Risk (b) Objectives of Credit Risk Management (c) Instruments of Credit Risk Management (d) Methods for Measuring Credit Risk (e) Strategies for Managing Credit Risk iv ..................iii Preface ……………………………………………………………...........

..........................61-67 (a) Definition of Operational Risk (b) Risk Mapping/Profiling (c) Measuring Operational Risk (d) Mitigating Operational Risk (e) Capital Budgeting for Operational Risk Chapter VII BASEL II COMPLIANCE.................................................................41-60 (c) Methods for measuring Liquidity Risk (d) Strategies for Managing Liquidity Risk (e) Meaning of Interest Rate Risk (f) Methods for measuring Interest Rate Risk (g) Strategies for managing Interest Rate Risk Chapter VI OPERATIONAL RISK MANAGEMENT................................................................................................................................................90-97 QUESTIONNAIRE....68-75 (a) Three pillar approach (b) Reservation about Basel II Risk Based Supervision Requirement (a) Background (b) Risk based supervision – a new approach (c) Features of RBS approach Chapter VIII ANALYSIS OF SURVEY RESPONSES........98-99 BIBLIOGRAPHY .....................100 v ..76-83 Chapter IX OBSERVATION AND SUGGESTIONS...........................................................Chapter V MARKET RISK (a) Meaning of Market Risk (b) Meaning of Liquidity Risk MANAGEMENT................................84-89 (a) Major Findings of Study (b) Suggestions ANNEXURES......................................

I INTRODUCTION 1 .CHAPTER .

2 . risks and uncertainties. By developing a sound financial system the banking industry can bring stability within financial markets. Risks originate in the forms of customer default. housing finance. any disruption or imbalance in its infrastructure will have significant impact on the entire economy. derivatives and various off balance sheet items. Therefore. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. Risk is an unplanned event with financial consequences resulting in loss or reduced earnings. Some of the new products introduced are LBOs. credit cards.The financial sector especially the banking industry in most emerging economies including India is passing through a process of change . Simultaneously they have opened new areas of risks also. Meaning of Risk and Risk Management The etymology of the word ‘Risk’ is traced to the Latin word ‘Rescum’ meaning Risk at sea or that which cuts. a risky proposition is one with potential profit or a looming loss. During the past decade. Our regulators have made some sincere attempts to bring prudential and supervisory norms conforming to international bank practices with an intention to strengthen the stability of the banking system.As the financial activity has become a major economic activity in most economies. funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. Deregulation in the financial sector had widened the product range in the developed market. It stems from uncertainty or unpredictability of the future. the Indian banking industry continued to respond to the emerging challenges of competition.

injury or other adverse circumstance. Exposure to the possibility of commercial loss apart of economic enterprise and the source of entrepreneurial profit.Source: James T Gleason.” 3 . Risk as Hazard: “Danger. (exposure to) the possibility of loss. In one of the publications Price Waterhouse Cooper has interpreted the word risk in two distinct senses. 2001 Risk is the potentiality of both expected and unexpected events which have an adverse impact on bank capital or earnings.

equity price. etc. 2. credit. to measure. the gap of which becomes thinner and thinner banks are exposed to severe competition and are compelled to encounter various types of financial and non-financial risks viz. measure. which should be 4 . foreign exchange rate. Till recently all the activities of banks are regulated and hence operational environment was not conducive to risk taking. Organizational structure. Better insight sharp intuition and longer experience were adequate to manage the limited risks. In the process of financial intermediation. operational. Risk management policies approved by the Board. but enables the banks to bring their risks to manageable proportions while not severely affecting their income. Comprehensive risk measurement approach. reputational. legal. liquidity. 3. banks have grown from being a financial intermediary into a risk intermediary at process. Risk is inherent in any walk of life in general and in financial sectors in particular.Risk as Opportunity: “The ordinary rate of profit always rises……with the risk” Hence. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Of late.” While non-performing assets are the legacy of the past in the present. to monitor and to manage uncertainty. top management of banks attach considerable importance to improve the ability to identify. Risk Management is an attempt to identify. commodity price. risk management system is the pro-active action in the present for the future. monitor and control the overall level of risks undertaken. It does not aim at risk elimination. regulatory. Managing risk is nothing but managing the change before the risk manages. The broad parameters of risk management function encompass: 1. interest rate. International Financial Risk Institute defines Risk Management as “The application of financial analysis and diverse financial instruments to control and typically the reduction of selected type of Risks. Thus.

Periodical review and evaluation. Well laid out procedures. framework independent of operational departments and with clear delineation of levels of responsibility for management of risk. 5. management expertise and overall willingness to assume risk. monitoring and controlling risks. Separate risk management. 4. capital strength. Strong MIS for reporting. 5 . Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits.consistent with the broader business strategies. 8. effective control and comprehensive risk reporting framework. 7. 6.

natural netting of exposures. the core staff at Head Offices is trained in risk modelling and analytical tools. Thus. At organisational level. The risk management is a complex function and it requires specialized skills and expertise. 6 . Internationally. market and credit risks are managed in a parallel two-track approach in banks. The global trend is towards centralising risk management with integrated treasury management function to benefit from information on aggregate exposure. Large banks and those operating in international markets have developed internal risk management models to be able to compete effectively with their competitors. The purpose of this top level committee is to empower one group with full responsibility of evaluating over all risk faced by the bank and determining the level of risk which will be in the best interest of the bank. Generally.Risk Management Structure: Establishing an appropriate risk management organisation structure is choosing between a centralised and decentralised structure. At a more sophisticated level. While the Asset-Liability Management Committee (ALCO) deal with different types of market risk. overall risk management is assigned to an independent Risk Management Committee or Executive Committee of the top executives that reports directly to the Board of Directors. the Credit Policy Committee (CPC) oversees the credit/counter party risk and country risk. the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures. The primary responsibility is of understanding the risks run by the bank and ensuring that the risks are appropriately managed and vested with the Board of Directors. At the same time the committee holds the line management more accountable for the risks under their control and the performance of the bank in that area. The Board sets risk limits by assessing the bank’s risk and risk-bearing capacity. economies of scale and easier reporting to top management. a committee approach to risk management is being adopted.

The potential loss is generally defined in terms of ‘Frequency’ and ‘Severity’.  Risk Control After identification and assessment of risk factors. The major alternatives available in risk control are: 1) Avoid the exposure 2) Reduce the impact by reducing frequency of severity 3) Avoid concentration in risky areas 4) Transfer the risk to another party 5) Employ risk management instruments to cover the risks 7 .Risk Management: Components The process of risk management has three identifiable steps viz. operational risk. This is the most difficult step in the risk management process and the methods. • Risk Measurement The second step in risk management process is the risk measurement or risk assessment. Risk identification. liquidity risk. and Risk control. the next step involved is risk control.  Risk Identification Risk identification means defining each of risks associated with a transaction or a type of bank product or service. interest rate risk. degree of sophistication and costs vary greatly. legal risk etc. There are various types of risk which bank face such as credit risk. Risk measurement. Risk assessment is the essemination of the size probability and timing of a potential loss under various scenarios.

technology and analytical sophistication at the bank. For example assuming that the current risks management score is 30 out of 100. structure. Basel II compliance 8 . Typically banks distinguish the following risk categories: Credit risk Market risk Operational risk 3) Construction of risk management index and Sub indices Bank roll out a customized benchmark index based on its vision and risk management strategy. 2) Risk Identification The second step is identification of risks. a. Then it develops a score for the current level of bank risk practices that already exists. Risk Based Supervision requirements b. For the gap in score of 70 roadmap is developed for achieving the milestones. focus. which is carried out to assess the current level of risk management processes.♦ Steps for implementing Risk Management in Banks 1) Establishing a risk management long term vision and strategy Risk management implementation strategy is established depending on bank vision. 4) Defining Roadmap Based on the target risk management strategy/gap analysis bank develops unique work plans with quantifiable benefits for achieving sustainable competitive advantage. positioning and resource commitments.

Using risk strategy in the decision making process Capital allocation     Provisioning Pricing of products Streamlining procedures and reducing operating costs By rolling out the action steps in phases the bank measure the progress of the implementation. 7) Integrate Risks Management/Strategy into bank internal decision making process The objective is to integrate risk management into business decision making process which evolves risk culture through awareness and strategies. risk control and mitigation procedures for each activity line is to be provided. training. evaluation scores on the benchmark levels specified helps to build up a risk process implementation score. the relative importance of market. Moreover. Models to be applied are tested and validated on a prototype basis. credit and operational risk in each line of activity is determined The process workflow organisation. 6) Executing the key requirements: At an operational level checklist of key success factors and quantitative benchmark is generated.c. 5) Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans. development of integrated risk reports and success measures and alignment of risk and business 9 .

 Regulatory Risks: It is the risk in which firm’s earnings value and cash flows is influenced adversely by unanticipated changes in regulation such as legal requirements and accounting rules. 10 .  Operational Risks: It is the risk of loss resulting from failed or inadequate systems.  Human Risks: It is risk. which is concurrent with the risk of inadequate loss of key personnel or misplaced motivation among management personnel.  Legal Risks: It is the risk that makes transaction proves to be unenforceable in law or has been inadequately documented. • Funding liquidity risks: is defined as inability to obtain funds to meet cash flow obligations. people and processes or from external events. foreign exchange equities as well as volatilities of prices.Types of Risks  Credit Risks: Credit Risk is defined by the losses in to event of default of borrower to repay his obligations or in event of deterioration of the borrower’s credit quality.  Market Risks: 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.  Liquidity Risks : Liquidity Risk consists of : • Market liquidity risks : arises when a firm is unable to conclude a large transaction in a particular instrument anything near the current market prices.  Strategic (Business) Risks: It is the risk in which entire lines of business is succumb to competition or obsolescence as strategic risks occurs when a bank is not ready or unable to compete in a newly developing line of business.

• Interest Rate Risk: It is the potential negative impact on the Net Interest Income and refers to vulnerability of an institution’s financial. Moreover. Risk environment has changed and according to the draft Basel II norms the focus is more on the entire risk return equation. condition to the movement in interest rates. (Crisil). PricewaterhouseCoopers (PwC). banks now a days seek services of Global Consultants like KPMG. • Country Risks: This is the risk that arises due to cross-border transactions owing to economic liberalization and globalization as it is the possibility that a country is unable to service or repay debts to foreign lenders in time. Boston Consulting Group (BCG). The Credit Rating and Investment Services of India Ltd. Risk Management in its current form is different from what the banks used to practice earlier. Tata Consultancy Services (TCS). 11 . risk management focus on the identification of potential unanticipated events and on their possible impact on the financial performance of the firm and at the limit on its survival. NII = Gap * Change in Interest Rate • Forex Risks: It is the risk that a bank suffer loss due to adverse exchange rate movement during a period in which it has an open position either spot or forward both in same foreign currency. Hence. I – Flex Solutions and Infosys Technologies who have vast experience in risk modelling as these players identify the gap in the system and help the banks in devising a risk return model.

12 Banks must equip themselves with an ability to identify. which are being implemented by banks through various committees. to measure. Losses RBI suggests that (a) provisions in due course.OPTIMIZING THE RISK RETURN EQUATION Profits DEGREE OF RISK RBI Guidelines on Risk Management RBI has issued guidelines from time to time. to monitor and to control the various risks with New Capital Adequacy .

(j) To enhance risk management function banks should move towards risk based supervision and risk focussed internal audit. (i) The limits to sensitive sectors like advances against equity shares. For measurement of market risk banks are advised to develop expertise in internal models (f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks operating in international markets. 13 . high-risk industries as perceived by the bank should be placed under lower portfolio limit. real estates which are subject to a high degree of asset price volatility as well as to specific industries which are subject to frequent business cycles should be restricted. One of the five specific areas is effective Risk Management Architecture to ensure adequate internal risk management practices. Similarly. (c) (d) (e) For managing credit risk.(b) For integrated management of risk there must be single risk management committee. portfolio approach must be adopted. Appropriate credit risk modelling in the future must be adopted. (h) Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based supervision. (g) Banks should upgrade credit risk management system to optimize use of capital.

II RESEARCH METHODOLOGY 14 .CHAPTER .

to measure. the need of the study arises so as to study the formulation and implementation of risk management in various banks.  Necessity of the banks to respond to the array of new and more complex risks caused by: . which raises the issue of how to identify the optimal strategies to curtail these risks.Globalization . Risk management is an attempt to identify.Rapidly increasing pace of change in technology . to monitor and to manage uncertainty.♦ Need of the Study The need of the study arises because of following factors:  Increasing liberalization. not much has been done on the practical implementation of this technique as assessing and managing risks still remains a challenging task for banks.Downsizing .  Increasing competition in the banking sector in India. payment of services have made risk management extremely critical and indispensable.  External pressures on senior management to increase profit and decrease costs. Hence.Mergers and acquisitions .Regulatory changes  The need forever increasing flexible financing.  Growing sophistication in banking operations. on-line electronic banking. derivative trading securities underwriting. deregulation and internationalization of banking sector in India. 15 . However.

which includes Liquidity risk and Interest rate risk .Operational risk 3. 6. It brings stability in earnings and increases efficiency in operations. To know the guidelines set up by RBI for banks. ♦ Significance of the Study Good risk management is good banking. To know various types of risks faced by banks.Market risk. To know about Basel II Accord and Risk Based Supervision Requirements. 4. The present study proposes to:  Enhance shareholders value with value creation value preservation capital optimization 16 . To analyse different types of risk such as . To study about the Risk Management approach adopted by six banks. To know how to measure and monitor various risks. 7. 5.Credit Risk . To know newer methodologies to quantify risk in light of newer businesses and challenges. which includes banks in both public as well as private sector.♦ Objectives of the Study The following objective have been fix for making thus study: 1. 2. And good banking is essential for profitable survival of institution. To know need for risk management.

Hence. overhead efficiency.  Improved Information Security. The present study evaluates key performance indicators of various banks in terms of credit deposit ratio. spread.  Integration of risk management within corporate governance framework. Scope of the Study Risk is intrinsic to banking business as the major risks confronting banks are credit risk. Gap analysis and maturity ladder. If Indian banks are to compete globally then they have to institute sound and robust risk management practices. While putting the risk management in place banks often find it difficult to collect reliable data.  Alleviate regulatory constraints and distortions thereof.  Improvement of portfolio identification and action plans. interest rate risk and operational risk of six banks (public and private sector). Enhance capital allocation. In real world risk management creates value. net interest margin. which will improve efficiency of banks. 17 .  An understanding of key business processes.  Corporate Reputation. liquidity risk and operational risk. it is an essential part of a financial institution as it involves stakeholders interest among others.  Instill confidence in the market place. The scope of this study involves analyzing and measuring major risks i. accurately measure.e credit risk. interest rate risk. Irrespective of the nature of the risk the best way for banks to protect themselves is to identify risk. price it and maintain appropriate levels of reserves and capital. The challenge is mainly in the area of operational risk where there is dearth of reliable historic data and not a great deal of clarity on the measurement of such risk. liquidity risk.

 State Bank of India  ICICI Bank  Central Bank of India  HDFC Bank  Oriental Bank of Commerce  IDBI Bank 18 . August 2005) which are shown in sequence from high profit banks to low profit banks. Following banks are included in the sample size (Business India.Data Collection The present study is based on both primary and secondary sources. Primary Research ‘Questionnaire’ has been prepared and sent to selected six banks to ascertain their degree of readiness for risk management on various parameters and information is collected through in depth interview of senior officers and employees of six banks. Secondary Sources Information has also been obtained through desk research such as (a) Annual reports of the banks (b) Indian Bank Association Bulletin (c) RBI Bulletin (d) Report on trends and progress of banking in India Sample Size The sample comprises of six banks both in public as well as private sector. The banks are selected on the basis of their net profit during the year.

It provides the empirical and logical basis for getting knowledge and drawing conclusions. It constitutes the framework for the collection. measurement and analysis of data. The research design in the study is of exploratory research. Various methods are utilized in order to gain the information and to interpret it in most rational and objective manner. Basel II Compliance and Risk Based Supervision Requirements 8. Introduction 2. 1.The study is divided into following chapters. Bank Profiles 4. Research Methodology 3. Credit Risk Management 5. 19 . Market Risk Management 6. In fact. Observations and Suggestions ♦ Research Design A research design is the arrangement of conditions for collection and analysis of data in a manner that aims to combine relevance to the research purpose with economy in procedure. Analysis of Survey Responses 9. Operational Risk Management 7. the research design is the conceptual structure within which research is conducted.

The following various accounting tools have been used. 20 . • Core Deposits/Total Assets Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits Volatile Liabilities/Total Assets Where Volatile liabilities = Demand + Term deposits of other banks • Short term Assets/Total Assets Where short term assets = Cash & Bank Balance + Receivable + Bills Receivable + short term /demand advances • Credit Deposit Ratio: Higher deposit ratio indicates poor liquidity position of a bank & vice versa. performance and profitability banks requires certain yardsticks .Techniques of Analysis The following techniques have been applied for analysis: -  Ratio Analysis To evaluate the financial condition. The ratio is calculated as follows: Loans and Advances/Total Deposits • Cost of Funds: Total Interest Expense/Interest bearing liabilities interest bearing liabilities = Deposits + Borrowings where • Net Interest Margin : Net Interest Income/Earning Assets where Net Interest Income = Total Interest Income – Total Interest Expenses Balances - Earning Assets = All Interest earning assets (Total Assets – Cash Fixed Assets .Other Asset) The impact of volatility on the short-term profits is measured by Net Interest Margin.

tax and Preference dividend /Equity Shareholders Funds. Overhead Efficiency = This is calculated as follows: Non-Interest Income/Non Interest Expense • Profit Margin = This is calculated as follows: Net Income/Total Revenue • Burden/Spread where Burden is the Net Non Interest Income and Spread is the Net Interest Expense  Gap Analysis  Maturity Ladder 21 . their investments. It is calculated as follows: Net profit after tax + Interest /Total assets • Return on Equity (ROE) = Shareholders are the real owner of the organisation. This is calculated as follows: Net profit after interest. so they are more interested in profitability and performance of an organisation.• Spread = Yield – Cost of funds where yield = Total Interest earned/ Earning Assets • Return on Average Assets (ROA) = This ratio is relationship between the net profit (after tax and interest) and the total assets of the bank. The paid up capital reserves of bank form an adequate percentage of assets of banks. • Capital Adequacy Ratio This ratio strengthens the capital base of bank. All these items are assigned weights according to prescribed risks and the ratio so computed is known as capital adequacy ratio. loans and advances.

In addition to other factor such as time that plays a very important role in every field of today’s life has also an important bearing on research work.Limitations of the Study However. The main limitations of the present study are as follows:   All data and information collected is true to some specific period of time. But the study at the disposal of a researcher on this level is limited. 22 . market and operational risks. The study hasn’t got the wider scope as only six banks are being considered for evaluating risk management.  It was difficult to have group discussions with experts due to their busy schedules. I have made every possible effort at my great extent level to show how selected sample of banks analyse the major risks i.e credit.

CHAPTER – III BANKS PROFILE 23 .

Moreover SBI has developed sensitive tools to hedge and minimize the risk arising out of movements in interest rates. an adjunct to risk based supervision has been introduced in the banks audit system on 1. A unique institution it was the first joint stock bank of British India sponsored by the government of Bengal/The Bank of Bombay (15th April. These three banks remained at the apex of modern banking in India till their amalgamation as the Imperial Bank of India on 27 January. The State Bank of India was thus born with a new sense of social purpose aided by the 480 offices comprising branches. 24 . (RFIA) Risk Focused Internal Audit. sub offices and three local head offices inherited from Imperial Bank. the State Bank of India (Subsidiary Banks) Act was passed in 1959 enabling the State Bank of India to take over eight former State associated banks as its subsidiaries. Later.4. 1806.Duly aligned with (RFIA) the Credit audit examines probability of default and suggests risk mitigation measures. 1921. The Bank’s aim is to reach global best standards in the area of risk management and to ensure that risk management processes are sufficiently robust and efficient. The Bank is using “Risk Manager” module (part of the ALM software) to strengthen the processes of risk management an operational risk management policy duly approved by central board of the bank is in place.The origin of the State Bank of India goes back to the first decade of the nineteenth century with the establishment of the Bank of Calcutta in Calcutta on 2nd June.03. More than a quarter of the resources of the Indian banking system thus passed under the direct control of the state. The Risk Management Committee of the board overseas the policy and strategy for integrated risk management relating to various risk exposures of the bank & Credit Risk Management Committee (CRMC) monitors banks domestic credit portfolio. 1955. 1955 and the State Bank of India was constituted on 1 July. 1840 and the Bank of Madras (1 July. The bank has an in built internal control system with well-defined responsibilities at each level. 1843) followed the Bank of Bengal.An act was accordingly passed in Parliament in May.Three years later the bank received its charter and was redesigned as the Bank of Bengal (2nd January 1809).

the compliance and audit group that are responsible for assessment. A comprehensive range of quantitative and modelling tools are developed by dedicated risk analytic team that supports the risk management function.Central Bank of India has business interests in diversified areas of banking and finance. It was established on Jan 5.ICICI Bank is among largest private sector banks in country. Central Bank of India has installed an enterprise wide ALM and risk management solution. Established in 1911. RBI Inspection and Anti. RMG is further organised into Credit Risk Management Group.Laundering Group and Internal Audit Group. Central Bank of India is a public sector bank of the government of India. new services. Its excellent performance is a result of its increase client focus and ability to structure financial solutions that meet client specific ends. management and mitigation of risk in ICICI bank. The risk management group. CAG is further organised into credit policies. 1955 to assist industrial enterprises in private sector. 25 . Risk is an integral part of the banking business and ICICI bank aim at delivery of superior shareholder value but an achieving an appropriate tradeoff between risk returns. The policies and procedures established for this purpose are continuously benchmarked with international best practices. Retail Risk Management group and Risk Analytics group. Market Risk Management group. These groups form a part of Corporate Center is completely independent of all business operations and is accountable to the Risk and Audit Committees of the Board of Directors. In line with the Basel II and RBI guidelines. new organisation structures and new business models have been the hallmarks of ICICI business strategy. New products.

Thereafter the bank registered phenomenal growth and noticeable improvement was observed under all performance parameters. Overall portfolio diversification and reviews also facilitate risk management in the bank.The Housing Development Finance Corporation Limited (HDFC) was amongst the first to receive an in –principle approval from Reserve Bank of India (RBI) to set up a bank in the private sector as part of RBI’s liberalisation of the Indian banking industry in 1994. HDFC Bank commenced its operations as a scheduled commercial bank in January. OBC has put in place an independent Risk Management System in the Bank and Risk Management Committee of the Board of Directors and top executives of the Bank oversees its implementation. India. 26 . The credit risk management policy for the Bank is framed and implemented which includes exposure limits for Single/Group Borrower.61 crores as deposits and Rs 152. On 15th April 1980. appropriate credit approval processes. Established in Lahore on 19th February 1943.the date when nationalization of the bank was announced the bank had 307 branches with Rs. 1994 in the name of HDFC Bank Limited with its registered office in Mumbai. the first Chairman of the bank. 1995.282. To implement the effective strategy in risk management HDFC Bank has distinct policies and processes in place for the wholesale and retail asset business. ongoing post disbursement monitoring and remedial management procedures. Oriental Bank of Commerce made a modest beginning under its founding father late Rai Bahudar Lal Sohan Lal. For wholesale credit exposures management of credit risk is done through target market definition. The bank was incorporated in August.69 crores as advances.

IDBI Bank successfully completed its public issue in February. (NSDL). which have revolutionized the Indian financial markets. OBC has strengthened the internal control system through simplification of documentation procedures and revision in the audit procedures. A few of such institutions built by IDBI are The National Stock Exchange (NSE). IDBI bank which began with an equity capital base of Rs 1000 million (Rs 800 million contributed by IDBI and Rs 200 million by SIDBI). The National Depository Services Ltd. There has also been considerable progress with regard to implementation of Risk Based Internal Audit in the Bank. The structural liquidity and interest rate sensitivity position of the bank is prepared and analyzed on fortnightly basis. updating operational manuals and implementation of related strategies and monitoring of their efficacy. as wholly owned subsidiary of RBI. 1999 which led to its paid up capital expanding to Rs 1400 million. The initiative has blossomed into a major success story. Thereafter in less than seven years the bank has attained a front ranking position in the Indian Banking Industry. The Bank has put in place Credit Risk Rating Models for rating of Large Corporate Borrowers and Retail Loans. However in February. Exposure to Capital Market. Stock Holding Corporation OF India (SHCIL) etc. 1964 under the Industrial Development Bank of India Act. 1976 it was delinked from the Reserve Bank and has emerged as an independent organization. It now serves as an apex financial institution. 1995. IDBI promoted IDBI bank to mark the formal array of the IDBI group into commercial banking. Industry-wise. 27 . The IDBI was established in July. commenced its first branch at Indore in November. IDBI is a strategic investor in a plethora of institutions. un-secured exposure and lays down thrust areas and restricted areas of lending. Intensive training is imparted to the field functionaries in respect of rating models.Sector-wise.

As bank rating and scoring models effectively manage the risk of individual/credit portfolio. The corporate credit rating system has developed significant degree of stability and is supplemented with an internally developed facility-rating model. VaR (Value at risk) technique is used by IDBI for measuring market risk on the balance sheet in respect of government securities and other traded portfolio.IDBI has deployed optimum resources in developing & implementing risk analytics to more finely assessing the quantum and severity of all types of risks such as credit. market and operational risk. which evaluates adequacy and effectiveness of internal controls for various business and operational activities within bank. 28 . It has centrally controlled & an independent Internal Audit Department that maintains a risk based focus.

IV CREDIT RISK MANAGEMENT 29 .CHAPTER .

which is severity of loss. trading. losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relating to lending. Interest rates (b) (c) Trade restrictions (d) Economic sanctions (e) Government policies ♦ Objectives of Credit Risk Management The credit risk management has different objectives at two levels namely Transaction level and Portfolio level. TABLE: 1 RISKS IN LENDING INTRINSIC RISKS (a) Deficiencies in Loan policies and procedures (b) Absence of prudential credit conc. defined by the recoveries that could be made in the event of default. State of economy Volatility in Equity markets. In a banks portfolio.limits (c) Inadequately defined lending limits (d) Deficiency in appraisal (e) Excessive dependence on collateral CONCENTRATION RISKS a. which is outstanding loan balance as on the date of default and Quality of risk. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The elements of credit risk in portfolio risk comprise of Intrinsic risk and Concentration risk. Commodity markets. FX markets. settlement and other financial transactions.Credit Risk is the possibility of default due to nonpayment or delayed payment. It consists of two components Quantity of risk. It is a combined outcome of Default risk and Portfolio Risk. 30 . it is defined by the losses in the event of default of the borrower to repay his obligations or in the event of a deterioration of the borrower’s credit quality. Hence.

The transaction level pursues value creation and the portfolio level pursues value preservation. Driving asset growth strategy. The management of credit risk receives the top management’s attention and the process encompasses: (a) Measurement of risk through credit rating or scoring. 31 . Maintaining an appropriate credit administration. group and product etc.  Ensuring adequate pricing formula to optimize risk return relationship.At Transaction level. Framing a sound credit approval process.   Ensuring adherence to regulatory guidelines. the objectives of credit risk management are:    Setting an appropriate credit risk environment. At Portfolio level the objectives of credit risk management are:  Development and monitoring of methodologies and norms to evaluate and mitigate risks arising from concentrating by industry.  Employing sophisticated tools/techniques to enable continuous risk evaluation on a scientific basis. (c) Risk pricing on a scientific basis. measurement and monitoring process. (b) Quantifying the risk through estimating expected loan losses and unexpected loan losses.

risk monitoring and evaluation. risk concentrations. duly approved by the Board. pricing of loans. and comprise of heads of Credit Department. each bank also set up Credit Risk Management Department (CRMD) independent of the Credit Administration Department that enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. rating standards and benchmarks. The Committee is headed by the Chairman/CEO/ED. Treasury. The Committee formulates clear policies on standards for presentation of credit proposals. prudential limits on large credit exposures. Each bank constitute a high level Credit Policy Committee. The credit risk management process is articulated in the bank’s Loan Policy. The other reason is the lurking fear of global recession. portfolio management. delegation of credit approving powers.(d) Controlling the risk through effective Loan review mechanism and portfolio management. In the global scenario. Concurrently. First. also called Credit Risk Management Committee to deal with issues relating to credit policy and procedures.tier credit approving system where an ‘Approval Grid’ or a ‘Committee’ approves loan proposals. provisioning. asset concentrations. Instruments of Credit Risk Management 1) Credit Approving Authority One of the instruments of credit risk management is multi. loan review mechanism. regulatory/legal compliance etc. the increased credit risk arises due to two reasons. The ‘Grid’ or ‘Committee’ comprises of at least 3 or 4 officers and invariably one officer is represented as CRMD. financial covenants. banks have been forced to lend to riskier clients because well-rated corporates have moved away from banks as they have access to low cost funds through disintermediation. Recession in the economy could lead to low industrial output which may lead to defaults by the industry under recession culminating into credit risk. Credit Risk Management Department (CRMD) and the Chief economist. For better rated/quality customers banks delegate powers 32 .

Threshold limit is fixed at a level lower than prudential exposure. business risk. machinery breakdown) which are market driven. Moreover. infrastructural changes) and unsystematic risk (such as labour strike.for sanction of higher limits to the ‘Grid’. Some of the risks rating methodologies are:  Altman’s Z score model involves forecasting the probability of a company entering bankruptcy. which is converted into simple 33 . Banks clearly defines rating threshold and reviews the rating periodically preferably at half yearly intervals. management risk and specify cutoff standards. Banks also consider maturity profile of the loan book. commitment and competence. fiscal policies of government. encompass industry risk. which is the sum total of the exposures beyond threshold limit and does not exceed 600% to 800% of the capital funds of the bank. track record. It separates defaulting borrower from non-defaulting borrower on the basis of certain financial ratios. financial risk. Management risk consists of integrity. The quality of credit decisions is evaluated. expertise. Business risk consists of systematic risk (such as changes in economic policies. 3) Risk Rating Banks set up comprehensive risk rating system on six to nine point scale which serves as a single point indicator of diverse risk factors of a counter party and for taking credit decisions in consistent manner. Assessment of financial risks involves of the financial strength of unit based on its performance and financial indicators like liquidity. Rating migration is mapped to estimate the expected loss. structure and systems. coverage and turnover. substantial exposure. there is separate rating framework for large corporates. Rating reflects underlying credit risk of loan book. 40% for a group with additional 10% for infrastructure undertaken by group. 2) Prudential Limits It is linked to capital funds . small borrowers and traders.say 15% for individual borrower entity.

current asset value. Across the world many banks have put in place RAROC (Risk Adjusted Return on Capital) framework for pricing of loans which calls for data on portfolio behaviour and allocation of capital that commensurate with credit risk inherent in loan proposals. business group and conducting rapid portfolio reviews. stress test.  KMV. It tracks rating migration which is the probability that borrower migrates from one risk rating to another risk rating. Banks link loan pricing to expected loss and high-risk category borrowers are priced high. 4) Risk Pricing Risk-return pricing is a fundamental tenet of risk management. It is based on actuarial rates and unexpected losses from defaults. The stress test reveals undetected areas of potential credit risk exposure and 34 . It calculates the asset value of a firm from the market value of its equity using an option pricing based approach that recognizes equity as a call option on the underlying asset of the firm. 5) Portfolio Management The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower.index.. Banks build historical database on the portfolio quality and provisioning to equip themselves to price the risk. distribution of borrowers in various industry.  Credit Risk +.  Credit Metrics focus on estimating the volatility of asset value caused by the variation in the quality of assets. a statistical method based on the insurance industry for measuring credit risk. through its Expected Default Frequency (EDF) methodology derives the actual probability of default for each obligator based on the functions of capital structure. sector or industry. To maintain portfolio quality banks adopt certain measures such as stipulate quantitative ceiling on aggregate exposures on specific rating categories.

compliance status. The figures obtained conform to the fact private sector banks make higher investments in sensitive sectors. Hence. pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. i. Moreover. 6) Loan Review Mechanism This is done independent of credit operations referred as Credit Audit covering review of sanction process. Regular. The level of credit risk that a bank is prepared to accept is what in turn determines the level of lending to each of these sectors. Credit Audit is conducted on site. Banks would not face any credit risk if all the financial claims held by them were paid in full on maturity and interest payments were made on their promised dates. banks lend to sensitive sectors such as capital market sector. It targets all loans above certain cut off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in balance sheet are tracked. The risk involved in this lending is what determines the credit risk faced by the bank. which distinguishes between default. real estate sector and the commodities sector. Interpretation The banks with higher credit risk makes larger provisions in their Profit and Loss Statements so as to cover credit risk. it is not required to visit borrower factory/office premises. Credit Risk arises because promised cash flows on the primary securities held by banks may or may not be paid in full. Mark to Market model evaluates credit portfolio in terms of market value and the risk the bank incurs if market value changes. the focus of credit audit is to be broadened from account level to overall portfolio level. Portfolio models such as default mode model. and non-default of borrower is assessed in terms of probability of occurrence to determine loss given default. However. This follows the concept of conservatism that needs to be exercised by banks while preparing the accounts. at the branch that has appraised the advance and where the main operative limits are made available.e. Public sector banks come out with figures outlining their exposures in three sensitive 35 .linkages between different categories of risk. proper and prompt reporting to top management should be ensured. review of risk rating.

93 crores but on the other hand IDBI exposure has been reduced to 16.e stock markets. Real Estate When it comes to exposure in real estate.55 crores (2003-2005). This is followed by the analysis of the same. Private Sector Banks Capital Market ICICI bank exposure in capital market has raised from 169. Real Estate In the analysis of the exposures of risk in real estate OBC tops the list with 1701.48 crores from 82.1) Lending to Sensitive Sectors Public Sector Banks Stock Markets None of the public sector bank except OBC (in 2004) has more than 1% of its total advance portfolio dedicated to capital market.27 crores to 248. In a recent RBI directive it has directed banks to tread cautiously on capital markets exposure. Commodities Sector In this sector SBI has not been contributing till the year 2004 but among other public sector bank OBC ranks the highest. (See Annexure 1. However it has given banks freedom to decide on the margin of the IPO financing. ICICI bank tops the league in the analyzed banks followed by IDBI bank.sectors i. 36 .69 crores. real estate and commodities sector.

Expected loss – Operating cost .8 2005 2004 2005 21.7 27. Credit Risk Measurement The risk measurement and quantification at the transaction level is of prime importance in CRM.2 21. The RAROC (Risk Adjusted Return on Capital) is pioneered by Bankers Trust (acquired by Deutsche Bank in 1998) and now virtually adopted by large banks.51 crores from year 2003-05.3 21.9 IDBI 2004 2005 2004 2005 18.5 ROE % 18. as it requires few statistical tools. An increasingly popular model to evaluate (and price) credit risk based on market data is the RAROC model. Hence it is defined as ratio of risk adjusted return to economic capital.1 2005 20.56 HDFC 2004 20.Taxes RAROC = ----------------------------------------------------------------------Loan (Asset) risk or capital at risk A loan is approved only if RAROC is sufficiently high relative to benchmark return on capital (ROE) for the FI. where ROE measures the return stockholders on their equity investment in the FI.65 20.2 Source: Annual Report of Banks 37 .4 OBC 2004 18.Commodities market ICICI bank ranks the highest contribution in absolute terms 380. 2 Table showing return on equity capital (%) Bank Year SBI ICICI CBI 2004 18. Table No. It is a risk adjusted profitability measurement and management framework for measuring risk adjusted financial performance and for providing consistent view of profitability across business.21 2005 20. Spread (Direct income earned on loan) + fees on loan (one year income on loan ) .

This approach ensures that a bank knows the quality of its exposures to strengthen its capital base according to risks it takes. RWA (Risk Weighted Assets) is determined as the counter parties are grouped into Sovereigns. Banks and Corporates. For Sovereigns.The Basel Committee has suggested the two alternative approaches for calculation of regulatory capital for credit risks.  The Standardised Approach Under this approach. the risk weights range from 0% to 100% and for banks and corporate the range is from 20% to 150%. Counterparty Credit assessment AAA to AAA + to A BBB + to BBB BB + to B <Bunrated Sovereigns Risk weights 0% 20% 50% 100% 150% 100% Counterparty Corporates Credit assessment Risk weights AAA to AA20% A + to A 50% BBB + to BBB 100% BB + to B 100% <B150% unrated 100% Other Banks Credit assessment Risk weights AAA to AA20% Counterparty 38 . it can take timely corrections. Instead of assigning a uniform risk weight to all borrowers differential risk weights are assigned on the basis of external risk assessments by the external credit rating agencies (ECRA). Its a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas.

LGD. LGD. project finance. 12. corporates. retail loans. Probability of Default: A borrower is in default when the obligations to pay principal and interest are not met. The banks internal model is expected to produce reliable estimates of PD. EaD RWC = Min. Finally the loss to the bank depends on the value of Exposure at Default. EAD. Loss given Default measures the extent of loss on a given exposure in the event of default.A + to A BBB + to BBB BB + to B <Bunrated 50% 50% 100% 150% 50% Source: The Journal of Indian Institute of Banking and Finance Oct-Dec 2004  Internal Ratings Based (IRB)Approach IRB Approach is more sophisticated as in respect of each exposure (sovereigns. equity investment) banks are asked to foresee the possibility of a shift in the asset quality over a period of time which can be done by working out probability of default (PD). These estimates must be based on at least 1-year data sampled over a minimum of 4 quarters. Risk components derived above are translated into risk weights called Risk Weight Function. It’s a fraction of total exposure whose exact value depends upon the extent of collateralisation and expressed as a percentage of exposure. the risk weight function gives the following risk weight for given PD. ({LGD/50}*BC. On this basis a loan is d eemed to be in default if it is classified as sub standard. other banks.5*LGD) 39 . the probability of loss in the event of default (LGD) and the exposure at default. For estimating the PD time horizon is important. For corporate exposures.

LGD is expressed as a whole number (i. 40 .e. a bank that has just made loans to some of its customers can sell these loans to other investors who take on the credit risks inherent in these loans. Similarly. A credit swap permits each institution to broaden the number of markets from which it collects loan revenue and loan principal thus reducing each bank dependence on one or narrow set of market areas.  Credit Options Credit Options guards against losses in the value of a credit asset or helps to off set higher borrowing cost that occur due to changes in credit ratings. ♦ Managing Credit Risks  Credit Derivatives The banks can make use of various credit derivative instruments to reduce the credit risk associated with its loan portfolio.Here. Each bank is granted the opportunity to further spread out the risk in its loan portfolio especially if the banks involved are located indifferent market areas.  Credit Swaps A Credit Swap is where two lenders agree to exchange portion of their customers loan repayments. For example removing a pool of loans from banks balance sheet reduces or disposes of the banks credit risk exposures from these loans. a 75% loss given default is written as 75) while BC is a benchmark risk weight for corporates prescribed by the supervisor based on statistical calibration and related to PD. Each calculated risk weight RWC is multiplied by the corresponding EAD and aggregating over all exposure categories yields an estimate of RWA for credit.

The securities are linked directly with the default risk of the tranche they securitize. the bank usually keep the ‘first loss piece’ on their own books which is equivalent to portfolio expected loss. The securitizing bank provides liquidity facilities to make securities attractive for investors. Furthermore. CHAPTER.V MARKET RISK MANAGEMENT 41 . Securitization of loans: In case of Securitization selected loans are transferred to a company set up. only the risk of unexpected rating deterioration is passed onto investors. Thus.

Liquidity Risk Liquidity planning is an important facet of risk management framework in banks. It is the risk that the value of on/off balance sheet positions is adversely affected by movements in equity. interest rate market. The Asset Liability Management Committee (ALCO) functions as the top operational unit for managing the balance sheet within the risk parameters laid down by the board. review mechanisms. It is the ability to efficiently accommodate deposit. the banks set up an independent middle office (comprises of experts in market risk management. Management of Market Risk is the major concern of top management. The Treasury Department is separated from middle office and is not involved in day to day work. bankers. economists. to fund the loan growth and possible funding of the off balance sheet claims. reporting and auditing systems. procedures.Market Risk is defined as the possibility of loss to bank earnings and capital due to changes in the market variables. The board clearly articulates market risk management policies. Moreover. The Middle Office apprises top management/ALCO/Treasury about adherence to risk parameters and aggregate total market risk exposures. prudential risk limits. reduction in liabilities. statisticians) to track the magnitude of market risk on a real time basis. The liquidity risk of 42 . currency exchange rate and commodity prices.

Liquidity measurement is quite a difficult task and can be measured though stock or cash flow approaches. 2.e performing assets turning into non-performing assets.128 %and 0. This exposes the private banks to higher 43 . This implies that the liquidity position of PSU banks is more stable which can be attributed to their larger customer /retail base. The key ratios adopted across the banking system are (See Annexure 3):  Core Deposits/Total Assets Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits For State Bank of India.181%. 3.870% for year 2004 while it is 0. But over the years the private sector also has been improving upon his ratio. IDBI and HDFC bank. The liquidity risk in banks manifest in different dimension: 1.  Volatile Liabilities/Total Assets Where volatile liabilities = Demand + Term deposits of other banks This ratio shows that the State Bank of India face less risk than the ICICI.883%. IDBI and HDFC bank as these banks rely more heavily on large deposits made by other banks with them. 0. This seems to show that PSU banks have a much more stable deposit base than private sector.065%. 0. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits. which are inherently unstable. Time Risk: need to compensate for non-receipt of expected inflows of funds i.banks arises from funding of long-term assets by short-term liabilities thereby making the liabilities subject to refinancing risk.189% for ICICI bank. 0. Central Bank of India and Oriental Bank of Commerce this ratio is 0.

which entail a high level of risk.levels of liquidity risks. which are operating generally in an illiquid market. Higher Deposit Ratio indicates poor liquidity position of the bank while lower figures indicates more comfortable liquidity positions. This ratio is essential for liquidity strategy of the bank. Analysis of liquidity involves tracking of cash flow mismatches.  Short term assets/Total Assets Where short term assets = Cash & Bank balance + Receivable + Bills Receivable + Short term/demand advances This ratio has shown steady over the period 2002-2003 to 2003-2004 for all categories of banks. For measuring and managing net funding requirements the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is 44 . This is because investments are mainly government securities and other forms of relatively less risky instruments as compared to loans and advances. The liquidity ratios are the ideal indicator of liquidity of banks operating in developed markets as the ratios do not reveal the intrinsic liquidity profile of Indian banks. A possible reason for this could be the fact that the management of each of them has a different emphasis regarding their lending policies. Investments/Total Assets This ratio is highest for public sector banks reflecting the higher levels of conservatism in their policies. Credit Deposit Ratio Credit Deposit Ratio = Loans & Advances/Total Deposits This is a popular measure of the liquidity position of banks. The percentage of short-term assets to total assets is minimum for private banks with a very large standard deviation among them.

The two approaches used for managing the liquidity risk dimension are:(a) Fundamental Approach (b) Technical Approach 45 . The assets and liabilities are classified in different maturity buckets: 1. 3.liability side reasons (i. 7.recommended as a standard tool. 1 to 14 days 15 to 28 days 29 days and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years The cash flows are placed indifferent time bands based on future behaviour of assets. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. 2. 4.e whenever a bank depositors come to withdraw their money) and asset side reasons (which arises as a result of lending commitments). 8. 5. The cause and effect of liquidity risk is primarily linked to nature of assets and liabilities of a bank. 6. The difference between cash inflows and outflows in each time period the excess of deficit of funds becomes the starting point for the measure of a banks future liquidity surplus or deficit at a series of points of time. liabilities and off –balance sheet items. Strategies for managing Liquidity risk The risk arises because of two reasons .

As investing in the government securities generally offer higher yields with less risk involved. The disadvantage is that since funds are raised from various sources and markets any rate fluctuations in a market enhance the cost of borrowing.Fundamental Approach The fundamental approach involves two aspects: Asset management This approach aim at eliminating liquidity risk by holding near cash assets that can be turned into cash whenever required. We have analyse the  Call Money Market  The Repo Market and  Liquidity Adjustment Facility (LAF) 46 . Investment can be put in the call market. Technical Approach The technical approach focuses on the liquidity position of the bank in the short run. The risk perceived is low as participants are banks . government securities or instruments of other corporate as when the funds are put in the call market they are invested only for the short period where liquidity is ensured but have lower yield. Liquidity in the short run is linked to cash flows arising due to operational transactions. Liability Management In this approach the bank does not maintain any surplus funds but tries to achieve it through by borrowing funds when the need arises. Likewise the sale of securities from the investment portfolio can enhance liquidity. Thus if the technical approach is adopted to eliminate liquidity risk it is the cash flows position that needs to be tackled.

Call Money Market
Call money is borrowings between banks for a period ranging from 1 to 14 days.

Factors that affect its demand:
Cash Reserve Ratio As per the RBI Act 1934, CRR is to be maintained on an average daily basis during a reporting fortnight by all scheduled banks. This system provides maneuverability to banks to adjust their cash reserves on a daily basis depending upon intra fortnight variations in cash flows. For the computation of CRR to be maintained during the fortnight, a lagged reserve system has been introduced effective November, 1999 whereby banks have to maintain CRR on the net demand and time liabilities (NDTL) of the second preceding fortnight. With this, banks are able to assess their liability positions and the corresponding reserve requirements. With a view to provide further flexibility to banks and enable them to choose an optimum strategy of holding reserve depending upon their intra-period cash flows, RBI have decided to reduce the requirements of a minimum of 85 percent of the CRR balance to 65 percent with effect from beginning May 6, 2000. This has resulted in smoother adjustment of liquidity between surplus and deficit units and enables better cash management by banks. The CRR currently as on 31st march 2004 was 4.75% of the anticipated total demand and time liabilities. When a bank falls short of its CRR requirement, it resorts to borrowing from the call market. As more banks resort to such borrowing, demand for money in that market shoots up, leading to high call rates. This is what happened during the run-up to the credit policy in March 2000. Banks had invested their surplus cash in government securities. That placed them in a corner so far as meeting CRR requirement was concerned.

Liquidity requirements:
This arises from a liquidity mismatch, which forces banks to borrow for the very short term.

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Speculation That is, wanting to profit from any arbitrage opportunities between the forex and money markets. Banks borrow call money at say, 5-6 % and deploy the proceeds to speculate on the rupee dollar moments in the forex market. Given the general bias on rupee depreciation, these banks invariably profit from the cross-market deployment. If the call rates in the meanwhile shoot up the borrowing banks have three options. First, borrow again in the call market at the higher rate and repay the earlier loan. Second, sell dollars in the market and buy rupees to repay the loan. Third, attract deposits from small savers to fund the loan repayment. Mostly banks resort to the third alternative by hiking deposit rates. In January 1999,for instance, bank raised its short-term deposit rate to about 18% per annum. It was forced to take this step, as it had to repay loans on calls and rates in that market which shot up to a high of 140%. The RBI has banned banks from borrowing in call and trading in the forex market. Arbitrage Banks have also started taking advantage of the arbitrage opportunity between the call money and the Government securities market. In March 2003, with inter bank call rates hovering around 6 % and the current yield on Government securities ranging from 8.5% - 9.5 %, the borrowing banks in the money market had an opportunity to make money. The call money was ruling tight following advanced tax outflows from the market. In order to maintain the cash reserve ratio requirements, these banks borrowed at 6%. The money put in the CRR is invested in government securities at the current yield of 8.5% - 9.5% over various maturities. In this way, banks earn an arbitrage of around 2.5 % - 3.5%. Policy Variables Just before any policy announcement, the overnight rates (or the call rates) seem to be very volatile largely due to an expectation of a fall in interest rate.

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Repo Market
Repo is a money market instrument, which enables collateralized short term borrowing and lending through sale / purchase operation in debt instruments. Under a repo transaction a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. In case of a repo, the ‘forward clean price of the bonds’ is set in advance at a level which is different from the ‘spot clean price by’ adjusting the difference between repo interest and coupon earned on the security. In the money market this transaction is nothing but collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate. In other words the inflow of cash from the transaction can be used to meet temporary liquidity requirement in the short-term money market at comparable cost. A reverse repo is the same operation but seen from the other point of view, the buyers, In a reverse repo the buyer trades money for the securities agreeing to sell them later. The banks, which hold a large inventory of bonds and G- Secs, use repo to amass additional funds. Using the securities as collateral they borrow using repo. Hence whether transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. When the reverse repurchase transaction matures the counter party returns the security to the entity concerned and receives its cash along with a profit spread. One factor that encourages an organisation to enter into reverse repo is that it earns some extra income on its otherwise idle cash. Substitutability of the Call money market and the Repo market The rise in the call money rates often forces met borrowers in the money market such as private banks today to increasingly resort to repo (short for sale and purchase agreement) of Government securities for their financing requirements rather than borrowing from overnight call money market. At present, the RBI regularly conducts only a three/four day fixed repo. As for the likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate in stages to the earlier levels.

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The ILAF was operated through a combination of repo. The existing Fixed Rate Repo will be discontinued. The LAF operates though repo (for absorption of liquidity) reverse repo (for injection of liquidity) to set a corridor for money market interest rates. an Interim Liquidity Adjustment Facility was introduced pending further up gradation in technology and legal/procedural changes to facilitate electronic transfer and settlement. So also the liquidity support extended to all commercial banks (excluding RRBs) and Primary dealers though Additional Collateralized Lending Facility (ACLF) and finance/reverse repo under level II respectively will be withdrawn. The ILAF served its purpose as a 50 . The funds from this facility used by the banks for their day – to day mismatches in liquidity. Liquidity Adjustment Fund (LAF) The aim of the Liquidity Adjustment Facility (replacing Interim Liquidity Adjustment Facility) is to improve the operational flexibility and the effectiveness of the monetary policy. An additional collateral (called Additional Collateralized Lending Facility) of similar amount was also made available to banks at 200 basis points over bank rate. It is also appropriate as the financial markets move towards indirect instruments. Interim Liquidity Adjustment Facility (ILAF) RBI had introduced collateralized lending against government securities as Interim Liquidity Adjustment Facility (called Collateralized Lending Facility) to provide liquidity support to banks in replacement of the General Refinance. It was recommended by the Narasimhan Committee Report on the Banking Reforms and was announced in the Monetary and the Credit policy for the year 2000-2001. In April 1999. collateralized-lending facilities. CLF and ACLF availed for periods beyond two weeks were subject to penal rate of 200 basis points for the next two weeks. export credit refinance. The banks could borrow up to 25 basis points of the fortnightly average outstanding aggregate deposits in 1997-98 at the bank rate for a period of two weeks. However during the period of availing the CLF or ACLF the banks continue to participate in the money market.

This is the traditional approach to interest rate risk assessment taken by many banks and is measured by measuring changes in Net Interest Income (NII) or Net Interest Margin (NIM). Assets consist of loans and advances and investments. interest rates have fallen sharply in last four years. ♦ Interest Rate Risk It is the potential negative impact on the Net Interest Income and refers to the vulnerability of an institution’s financial condition to the movement in interest rates. large reserve requirement implies a policy of 51 . In particular. which have funded long maturity assets using short maturity liabilities. Liabilities consist of deposits and bank borrowing classified into different time buckets. banks in India have relatively large fraction of assets held in government bonds and is partly driven by large reserve requirements. the focus of analysis is the impact of changes in interest rate on accrual or reported earnings. Changes in interest rate affect earnings. It provided a ceiling and the Fixed Rate Repo were continued to provide a floor for the money market rates. Interest rate risk is particularly important for banks owing to high leverage and arises from maturity and repricing mismatches. liability off balance sheet items and cash flow. If interest rate goes up in future it would hurt banks. From the Earning perspective. It identifies risk arising from long-term interest rate gaps. Investments in corporate and government debt are combined into one category and bucketed according to their time to maturity. administrative restrictions upon interest rates have been steadily eased. By International standards. This has given an unprecedented regime of enhanced interest rate volatility. In India from 1993 onwards. In India.transitional measure for providing reasonable access to liquid funds at set rates of interest. Economic value perspective involves analyzing the expected cash in flows on assets minus expected cash out flow on liabilities plus the net cash flows on off balance sheet items. value of assets. For purpose of monitoring liquidity risk RBI requires banks to disclose a statement on maturity pattern of their assets and liabilities classified in different time buckets.

(f) (g) Net Interest Position Risk: When banks have more earning assets than paying liabilities. net interest position risk arises in case market interest rates adjust downwards. maturity dates there by creating exposure to unexpected changes in the level of market interest rates. (d) Yield Curve Risk: It is the movement in yield curve and the impact of that on portfolio values and income. Banks are faced with different types of interest rate risks: (a) Gap/Mismatch Risk: It arises from holding assets/liabilities and off balance sheet items with different principal amounts. 52 . Reinvestment Risk: It’s the uncertainty in regard to interest rate at which the future cash flows could be reinvested. (b) Basis Risk: It is the risk that the interest rate of different assets/liabilities and off balance items changes in different magnitude.stretching out yield curve which innately involves forcing banks to increase the maturity of their assets. (e) Reprice Risk: When assets are sold before maturities. (c) Embedded Option Risk: It is the option of pre-payment of loan and foreclosure of deposits before stated maturities.

The approach towards measurement and hedging interest rate risk varies with segmentation of banks balance sheet. January 2005 RBI has initiated two approaches towards better measurement and management of interest rate risk and made the mandatory requirement that time to re-pricing or time to maturity to create ‘interest rate risk statement’ should classify assets and liabilities. Gap Analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off balance sheet positions). There are different techniques as (a) traditional maturity gap analysis to measure interest rate sensitivity (b) Duration gap analysis to measure interest rate sensitivity of capital (c) simulation (d) value at risk for measurement of interest rate risk. This statement is required to be reported to board of directors of bank and to RBI (not to public).S a eo B n in S c r in h r f a k g e to In r s R teR k te e t a is 1% 1 3 % PB S s P a Sc r riv te e to Bn ak 8% 6 F re nS c r o ig e to Bn ak S a o B n in S c rsinto l h re f a k g e to ta G-S cIn e tm n e vs et 1% 4 5 % P B S s P a S cto riv te e r Bn ak 8% 1 F re n S cto o ig e r Bn ak Source: IBA Bulletin. Banks broadly bifurcate asset into trading book and banking book as trading book comprises of assets held for generating profits on short term differences in prices and banking book consists of assets/liabilities on account of relationship or steady income and are generally held till maturity by counter party. Gap Analysis The Gap or Mismatch risk can be measured by calculating gaps over different time intervals as at a given date. 53 . In addition RBI has created a requirement that banks have to build up Investment Fluctuation Reserve (IFR) using profits from sale of government securities in order to better cope with potential losses in future.

years 7. 2. The gap reports indicate whether the institution is in a position to benefit from rising interest rates by having the positive gap (RSA>RSL) or whether it is in a position to benefit from declining interest rate by the negative Gap (RSL >RSA). The positive gap indicates that it has more RSAs whereas the negative gap indicates that it has more RSLs. therefore. months 4. years 6. year 5. 8. 3.sensitive The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. Table No.1 –2. The Gap can.4 Relationships in Gap Analysis GAP Positive Positive Negative Negative Zero Zero Change in Interest Rates Increase Decrease Increase Decrease Increase Decrease Change in Interest Income Increase Decrease Increase Decrease Increase Decrease > > < < = = Change in Interest Expense Increase Decrease Increase Decrease Increase Decrease Change in Net Interest Expense Increase Decrease Decrease Decrease None None 54 . be used as a measure of interest rate sensitivity. 1-28 days 29 days and upto 3 months 3 Over 3 months and upto 6 4 Over 6 months and upto 1 5 Over 1 year and upto 3 6 Over 3 years and upto 5 7 Over 5 years Non .The Gap may be identified in the following time buckets: (See Annexure 2.6) 1.

2 239193.2 1-3 yr.4 -1548 Bank SBI ICICI CBI RSA/RSL Bank 0.54 2825 -1338751. 55 .5 -5315.7 -53580 -7256. The difference between duration of assets (DA) and liabilities (DL) is banks net duration.75 -624.5 -793128.5 -24757.3 -762.01254 HDFC 0.2 -24070.1 -641906.4 521801. It measures the relative sensitivity of the value of instruments to changing interest rates (the average term to re . Hence.1 -3496.7 -28058. The longer the term to maturity of an investment.1-2.985092 0.9 -374.2 15077. liabilities and off balance sheet items.8 67133.5 6m-1 yr.3 14837.8 3061.01 -2626.8 -2149.4 -1843325 3-5yr -28058.3 2071. If the net duration is positive (DA>DL).3 8932. the greater the chance of interest rate movements and hence unfavourable price changes.95 1532.981659 Duration Analysis Duration is the time weighted average maturity of the present value of the cash flows from assets.6 Above 5yr 42953.789439 0.19 -56591.9 -374. This index represents the average term to maturity of the cash flows.5 4758892.634039 OBC 1.3 42953.98 16848.8 -2149.pricing) and therefore reflects how changes in interest rates affects the institutions economic value that is the present value of equity.973785 IDBI RSA/RSL 0.6 shows the calculation of GAP analysis in the sample banks Gap Analysis Bank SBI ICICI CBI OBC HDFC IDBI 1-14 days 15-28 days 29daysto 3 months 9967.4 -148959.7 -3837.246 -106772 -47987. When the duration gap is negative (DL>DA) increase in market interest rate will decrease the market value of equity of the Bank. the Duration method is used to measure the expected change in market value of equity (MVE) for a given change in market interest rate. a decrease in market interest rates will increase the market value of equity of the bank.6 Non rate sensitive -360853. -9191. Duration measure how price sensitive an asset/liability or off balance sheet item is to small changes in interest rates by using a single number to index the institution interest rate risk.464 -90529.5 35140.9 9967.72 25545. -127890 -112132.8 -3583 -739898.Annexure 2.77 19255.3 3 –6 mths -7256.4 -9191.5 -34777.

2. Value At Risk VaR is an alternative framework for risk measurement. Their forecasts are based on a number of assumptions including:  Future levels and directional changes of interest rates The slope of yield curve and the relationship between the various indices that the institution uses to price credits and deposits   Pricing strategies for assets and liabilities as they mature The growth volume and mix future business  Simulation is used to measure interest rate risk by estimating what effect changes in interest rates. each of these draws. 3. Simulation model is useful tool for strategic planning. it permits a member institution to effectively integrate risk management and control into planning process.Simulation Models Simulation model is a valuable to complement gap and duration analysis. If the VaR with respect to interest rate risk of bank is desired. at a 99 % level of significance on a one-year horizon then we would need to go through following steps: 1. process for zero coupon yield curve. net income and interest rate risk positions. curve on a date one-year away. business strategies and other factors will have on net interest income. It analyse interest rate risk in a dynamic context and evaluate interest rate risk arising from both current and future business and provides a way to evaluate the effects of strategies to increase earnings or reduce interest rate risks. 56 Reprice assets and liabilities at Simulate N draws from yield Model the data generating .

Market Risk IRB Approach Here. When interest rate fluctuate. A VaR estimate is an appropriate percentile of the bank portfolio loss distribution. Measurement of market risk Market Risk: Standardised Approach Under the standardised approach five distinct sources of market risk are identified viz. distribution of profit/loss seen in Nth realisation. Foreign exchange risk. In addition. This are then repriced under certain interest rate scenarios that are based on BIS norms and gives an estimate of impact of interest rate shock upon equity capital of bank. Commodities Risk and Risk from options. Interest rate risk.4. The three crucial concepts in a VaR are: 57 . Interpretation: In actual. Computethe 1th percentile of This procedure is difficult to implement primarily because existing state of knowledge on data generating process for yield curve is weak. stock market speculators utilise their understanding of exposure for each bank in forming share price. The crucial input in the IRB approach is a VaR (value at risk) model. For any given bank portfolio one can calculate a loss distribution showing the probability of various amounts of loss. banks are allowed to base market risk charges on their own on internal models but additionally a process called stress testing is to be included. banks measure interest rate risk using two different alternative methodologies: (a) Accounting disclosures by banks: here vectors of future cash flows that make up assets and liabilities are imputed. Equity position risk. interest rate risks of various banks are perceived by (b) stock market.

Interest Rate Caps. Collars and Interest rate Swaps. Portfolios cannot be adjusted instantaneously because of transaction costs. ♦ Managing Interest Rate Risk Interest Rate Risk is a very critical problem for banks and they use a number of derivative instruments to hedge against Interest Rate Risk. The holding period i. Interest Rate Options. Some of the instruments used by banks are Interest Rate Futures.or 99.and not the market forces --. lock in periods etc.99%. The Historical period used for estimating the model. The VaR estimate is to be computed on a daily basis incorporating additional information becoming available on a daily basis.   The Basel Accord II proposes a confidence coefficient of 99% a holding period of 10 days and a historical period of observation of at least 1 year. The value ranges from 0 (exceptionally good performance) to 1(poor performance) Stress Testing is an important dimension of the IRB approach. This risk is considerably enhanced during a period when decline in the interest rates bottom out and begins to move in the opposite direction. The confidence coefficient (whether 95%. Each bank must meet on a daily basis. a capital requirement expressed as the higher of the following two factors Previous days VaR estimate (An average of the VaR of the preceding 60 business days)*m Here m is a multiplication factor set as m = 3+plus factor Where plus factor is related to the performance of the particular banks VaR model. this risk is further exacerbated since it is the Reserve Bank of India (RBI) --.e the period over which the portfolio is considered to beheld constant. In India.9%).which still dictate the prevailing level of 58 .

A notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged. A rise in the market interest rate will cause the value of bank assets to decline faster than the liabilities reducing the banks net worth and vice versa. Swaps can transform cash flows through a bank to more closely match the pattern of cash flows desired by management. The principal amount is notional because there is no need to exchange actual amounts of principal. Interest Rate Swaps After the Reserve Bank of India gave a green signal to banks to hedge themselves again interest rate uncertainties through plain --vanilla interest rate swaps (IRSs) and forward rate agreements (FRAs) in the April 1999 monetary policy. There are many players in market---. An IRS is way to change an institution exposure interest rate fluctuation and also achieve lower borrowing cost.interest rates.HDFC bank. Rationale behind an Interest Rate Swap Interest Sensitive Gap = Rate Sensitive Assets – Rate Sensitive Liabilities 59 . Interest Rate Futures A bank whose asset portfolio has an average duration longer than the average duration of it liabilities has a positive duration gap. the banks have used this as a major tool in interest rate risk management. ICICI bank. A financial futures contract is an agreement between a buyer and a seller reached at this point of time that calls for the delivery of a particular security in exchange for cash at some future date. An Interest Rate Swap (IRS) is defined as a contractual agreement entered into between two banks under which each agrees to make periodic payment to other for an agreed period of time based upon a notional amount of principal.

At the same time the bank with the higher-credit-rating covers all or a portion of the lower rated banks short term floating loan rate.  Overnight Index Swaps (OIS) The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate is linked to an overnight /call money index. Swap participants can convert from fixed to floating or vice versa and more closely match the maturities of their assets and liabilities. In effect. the low credit-rated bank receives a long .Floating Rate Swap A series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest.Table No.term loan at a much lower interest cost than the low rated bank could otherwise obtain. In this case the lower credit rated bank agrees to pay the higher-credit-rated bank fixed long term borrowing cost. typically a large nationalized bank.5 Interest Rate Gap Positive Gap Negative Gap Interest Rate Increase Favorable Position Unfavorable Position Interest Rate Decrease Unfavorable Position Favorable Position Fixed – for. a borrower with a lower credit rating typically a smaller bank enters into an agreement to exchange interest payment with a borrower having a higher credit rating. The interest is computed on a notional principal amount and the swap settles on a net basis at maturity. 60 . Swaps are often employed to deal with asset liability maturity mismatches. Quality Swap Under the terms of the agreement called a Quality Swap. thus converting a fixed long term interest rate into amore flexible and possibly cheaper short term interest rate.

Interest Rate Hedging Devices
Interest Rate Caps It protects its holder against rising market interest rates. In return for paying an up front premium, borrower are assured that institutions lending them money cannot increase their loan rate above level of the cap. The bank may alternatively purchase an interest rate cap from a third party (say from financial institutions) which promises to reimburse borrowers from any additional interest they owe their creditors beyond the cap. Thus the banks effective borrowing rate can float over time but can never increase the cap. Banks buy interest rate caps when conditions arise that could generate losses such as bank finds itself funding fixed rate assets with floating rate liabilities, possesses longer term assets than liabilities or perhaps holds a large portfolio of bonds that will drop in value when interest rates rise.

Interest Rate Floors

Banks can also lose earnings in periods of falling interest rates especially when rates on floating rate loan decline. A Bank can insist on establishing an interest rate floor under its loans so that no matter how far loan so that no matter how far loans rates tumble, it is guaranteed some minimum rate of return. Interest Rate Collars This instrument combines in one agreement a rate floor and rate cap. The collar purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor. The net premium paid for the collar can be positive or negative, depending upon the outlook for interest rates and the risk aversion of the borrower and the lender at the time of the agreement. Banks can use collars to protect their earnings when interest rates appear to be unusually volatile.

61

CHAPTER – VI OPERATIONAL RISK MANAGEMENT

62

♦ Defining operational risks
Basel Committee on Banking Supervision (BCBS; September 2001) defines operational risk as the risk of monetary loss resulting from inadequate or failed internal processes, people, systems or from external events. It is an evolving and important risk factor faced by banks and banks need to hold capital to protect against losses from it. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on account of operational risk.

The key drivers of Operational Risk:
Regulatory pressure (Basel II), Increased awareness, Opportunity for performance improvement. Banks are however, still not entirely clear on how to implement the capital requirements for operational risk.

♦ Risk Mapping/Profiling
Risk Mapping is a process of breaking down the bank’s business into various functional lines and assessing the various risk elements involved in each of these lines. It involves listing out of the existing controls for identified risks. Both the risks listed and existing controls are graded as low, medium and high categories. It is a dynamic exercise and subject to continuous review based on experience gained from various loss events. The operational risk relates to failure of people, technical, legal and internal processes.

People Risk –
(a)

Internal/External Frauds Inadequate Staff Hiring Unsuitable Staff Loss of key personnel Insufficient training Insufficient succession 63

(b) (c) (d) (e) (f)

Process Risk – (a) (b) (c) (d) (e) Technical Risk – (a) (b) (c) (d) (e) (f) (g) Programming errors Incomplete/Inaccurate/Irrelevant MIS Network failure Telecommunication failure Inadequate system protection Lack of IT support services Inadequate back-up systems Transaction without proper authority Erroneous cash movements Limit Breaches Unlawful Access Incorrect recording/reporting of information 64 .

several approaches have been developed. Reputation and Other Risk – (a) Incomplete Documentation (b) Breaches of statutory Requirements (c) Failure to follow regulatory guidelines (d) Changes in business activities not incorporated (e) Group Risk ♦ Measuring operational risk A key component of risk management is measuring the size and scope of the firm’s risk exposures. such as terrorist attacks or major fraud. fire etc) (b) War/terrorism (c) Sabotage/crime (d) Collapse in market Legal. low impact”(HFLI) events such as minor accounting errors or bank teller mistakes. high impact”(LFHI) events. however. there is no clearly established. However. Instead. Once potential loss events and actual losses are defined. An example is the “matrix” approach in which losses are categorized according to the type of event and the business line in which the events have occurred. As yet. which summarize these data. Potential losses are categorized broadly arising from “high frequency. and “low frequency. a bank analyze in constructing databases for monitoring such losses and creating risk indicators. single way to measure operational risk. The bank hopes to identify which events have the most impact across the entire firm and which business practices are most susceptible to operational risk.External Risk – (a) Natural Disasters (flood. Data on losses arising from HFLI events are generally available from a bank’s internal auditing systems. LFHI events are uncommon and thus 65 .

several steps should be taken to mitigate such losses. these risks cannot be reduced to pure statistical analysis. or even avoiding specific transactions. good management information systems and contingency planning is necessary for effective operational risk management. For example. all the banks have introduced internet banking. Right levels of audit and control. Although quantitative analysis of operational risk is an important input to bank risk management systems. For example banks governing board of directors should recognize operational risk as a distinct area of concern and establish internal processes for periodically reviewing operational. such as scenario analysis will be an integral part of measuring a bank’s operational risks. purchasing insurance. Since.limit a single bank from having sufficient data for modelling purposes. but they can be mitigated with strong internal auditing procedures. to mitigate the operational risk 66 . such as employee fraud or product flaws are harder to identify and insure against. With respect to operational risk. Hence. banks should implement monitoring systems for operational risk exposures and losses for major business lines. a qualitative assessment. a bank needs to supplement its data with that from other firms. The first includes general corporate principles for developing and maintaining a banks operational risk management environment. To foster an effective risk management environment the strategy should be integral to a banks regular activities and should involve all levels of bank personnel. Banks are yet to get clarity on the issues that are to be included in operational risk but system vendors have identified that proper workflow and process automation can help in reducing and detecting errors. damages due to natural disaster can be insured against. either by hedging financial transactions. ♦ Mitigating operational risk In broad terms. The second category consists of general procedures for actual operational risk management. Policies and procedures for controlling or mitigating operational risk should be in place and enforced through regular internal auditing. For example. risk management is the process of mitigating the risks faced by the bank. For such events. The framework consists of two general categories. Losses due to internal reasons.

encryption. The ultimate goal of Basel proposal is to measure operational risk and computation of capital charges. TCS (Tata Consultancy Services) has developed a meta model to capture capital allocation for operational risk in terms of guidelines laid down by New Capital Accord. but after a period of review. ♦ Capital budgeting for operational risk Banks hold capital to absorb possible losses from their risk exposures. is a key component of bank risk management. BCBS proposed in 2001 that an explicit capital charge for operational risk be incorporated into the new Basel Capital Accord. and the process of capital budgeting for these exposures. Such approaches are based on bank’s internal calculations of the probabilities risk events occurring and the average losses from those events. including operational risk. two level passwords have been introduced. but what is to be done at present by all the surveyed banks is to start implementing the Basel proposal in phased manner and carefully plan in that direction. In parallel with industry developments. The use of these approaches will generally result in a reduction of the operational risk capital requirement. The committee initially proposed that the operational risk charge constitutes 20% of a bank’s overall regulatory capital requirement. 67 . the committee lowered the percentage to 12%. as is currently done for market risk capital requirements and is proposed for credit risk capital requirements. Basel Accord II offers tentative suggestions on the treatment of operational risk which are expected to be developed more fully in the coming months.in internet banking multi layer security like digital certification. the new Basel Accord have also set criteria for implementing more advanced approaches to operational risk. To encourage banks to improve their operational risk management systems.

activities.   Regulatory Authorities should review periodically about organisation approach to identify.  The Board of Directors should ensure that operational management framework of the organisation provides for effective &comprehensive internal audit. processes and systems operational risk contract should be identified and assessed.  Regular Monitoring System of operational risk profiles and material exposures to losses should be in place. Regulatory Authorities may ensure that appropriate mechanisms are put in place to allow them to remain apprised of position of operational risk management of the supervised organisations.  Policies.  In all material products. and control/mitigate operational risk.  Contingency and business continue plans should be evolved.  Adequate public disclosures to be made to enable market participants to assess organisations approach to operational risk. assess. 68 . monitor. processes and procedures to control/mitigate operational risk should be evolved.Basel Committee has identified following –10 principles for successful management of Operational Risk:  Board of Directors should be aware of major aspects of operational risk of the organisation as distinct risk category.  Senior management of the organisation should consistently implement approved operational management framework of the organisation.

CHAPTER VII BASEL II COMPLIANCE & RISK BASED SUPERVISION 69 .

There is also greater differentiation across risk categories. in order to remedy the Basel Committee published a New Accord in Dec 2001. which is expected to be implemented by most countries by 2006. regulatory control and market disclosure. market risk and operational risk. Hence.♦ BASEL II COMPLIANCE The 1988 Capital Accord suffered from several drawbacks as it exclusive focus on credit risk. The structure of New Accord – II consists of three pillars approach which are as follows: Pillar I Pillar II Pillar III Pillar Focus area Minimum capital requirement Supervisory review Market discipline Minimum Capital Requirement The major change in the first pillar is in measurement of risk weighting. The minimal ration of capital assigned to risk is calculated as follows: Total Capital (unchanged) Bank’s Capital Ratio (min 8%) = ---------------------------------------------------------(RBI prescribes 9 %) Credit risk + Market risk + Operational risk For Credit Risks three alternative approaches are suggested. The first is a standardised approach in which RWA (risk weighted assets) is determined except that the risk weights are no longer determined in asset once but are revised depending upon the ratings of the counter parties by external credit rating agencies (ECRA). In the second approach 70 . It allows banks certain latitude in determining their or own capital requirements based on internal models and focus on credit risk.Basel II focuses on achieving a high degree of bank-level management. it does not differentiate between sound and weak banks using “one hat fit all” approach. it acquire broad brush structure.

5 to make them comparable to the RWA.5{capital charges on account of operational risk}) To meet market risk special type of capital viz. Here capital charges are determined and then multiplied by 12. In Advanced internal rating based approach the range of risk weights are well diverse. The column chart shows the capital adequacy ratios of surveyed banks. standardised and internal measurement approach. For operational risk capital charges are computed directly and then multiplied by 12. Secondly a special type of capital (Tier3) is introduced for meeting market risk only.08(RWA +12. For meeting operational risk Accord II has specified three alternative approaches. For Market Risks also a similar twin track approach is followed. Tier III capital has been introduced in the New Accord which consist of short term subordinated debt but with a minimum original maturity of 2 years.5 to make it comparable to RWA. Capital adequacy in relation to economic risk is a necessary condition for the long-term 71 . Tier III capital cannot exceed 250% of the Tier I capital to meet market risk.basic indicator.5 * (Sum of capital charges due to market and operational risk) The numerator N consists of N = Tier I + Tier II + Tier III Subject to the proviso that Tier I + Tier II > 0.called the internal ratings based approach (IRB) banks rates the borrower and results are translated into estimates of a potential future loss amount which forms the basis of minimum capital requirement. Thus D (denominator of the capital adequacy ratio) is defined as D =RWA + 12.

9 11. The maintenance of capital adequacy is like aiming at a moving target as the composition of risk weighted assets gets changed every minute on account of fluctuation in a risk profile of bank.36 12.56 12. 100 risk weighted assets.4 10. SBI ICICI HDFC IDBI OBC CBI Capital Adequacy Ratio (%) 2003 14 11. 8 by way of capital for every Rs.8 9.47 2004 14.5 9.4 10.soundness of banks.2 10.3 Capital Adequacy Ratio (%) 16 14 12 10 8 6 4 2 0 SBI ICICI HDFC IDBI Banks OBC CBI 2003 2004 72 . Minimum capital adequacy ratio of 8 % implies holding of Rs.1 10.

73 .  Reservations about Basel II  One of the major critiques of the New Basel Accord pertains to the adoption of an internal rating based (IRB) system as the application of IRB is costly.Supervisory Review Process It entails allocation of supervisory resources and paying supervisory attention in accordance with risk profile of each bank. discriminates against smaller banks and exacerbate cyclical fluctuations. 3) Breakdown of risk exposures. In a recent paper the BIS has elaborated the recommendations of the Basel II concerning the nature of information to be disclosed: 1) Structure and components of bank capital. optimise utilisation of supervisory resources. Market Discipline The potential of market discipline to reinforce capital regulation depends on the disclosure of reliable and timely information with a view to enable banks counter parties to make well founded risk assessments. The process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on through evaluation of its risk.  Basel II involve shift in direct supervisory focus away to implementation issues and that banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet minimum standards. banks are encouraged to disclose ways in which they allocate capital among different activities. 2) The terms and main features of capital instruments. continuous monitoring and evaluation of the risk profiles of the supervised institution and construction of a risk matrix of each institution. Moreover. 4) Its capital ratio and other data related to its capital adequacy on a consolidated basis.

 Only those banks likely to benefit from IRB will adopt approach. The CAMELS (capital adequacy.  Asset size determines the length of inspection. 74 . It provides an opportunity to the regulator to monitor banks performance based on CAMELS/CALCS approach.  All areas of banks operations are covered.  Focus remains on transaction and asset valuation. liquidity. RISK BASED SUPERVISION REQUIREMENTS Background RBI Governor in assistance with PriceWaterHouse Coopers (PWC) an international consultant laid an overall plan for developing Risk Based Supervision.  Focus of follow up remains on rectification rather than prevention.  Fears of disintermediation have also been expressed. management. liquidity. systems & controls)/CALCS (capital adequacy. compliance with regulations and banking laws. tightening of exposure and enhancement in disclosure standards are all introduced by RBI to align the Indian banking system to International best practices. earnings. The major features of current supervisory are:  Annual Financial Inspection (AFI) of banks. asset quality. asset quality. other banks will hold on to the standardised approach. Current Supervisory Approach The current on site inspection driven approach of RBI is supplemented by off site monitoring and surveillance system (OSMOS) and supervisory follow up. compliance & systems) approach to supervisory risk assessments and ratings.

measures. In short term supervisory cycle remains at 12 months but it can be extended beyond 12 months for low risk banks. increased competition. 5) Enforcement process and Incentive framework: RBS ensures that the 75 . 1) 2) Supervisory Cycle: It varies according to risk profile of each bank.Risk Based Supervision (RBS) – A New Approach RBS looks at how well a bank (supervised) identifies. 4) Supervisory Organisation: It is the focal point for main conduit for information and communication between banks and RBI. controls and monitors risks. Focussed approach under RBS entails allocation of supervisory resources and paying attention in accordance with the risk profile of supervised (bank) which would further optimise utilisation of supervisory resources. the principle being higher the risk shorter will be the cycle of supervision. Risk profile document contains SWOT analysis. It not only tries to identify systemic risks caused by the economic environment in which banks operate but also management ability to deal with them. onsite findings.  Features of RBS Approach Risk Profiling of Banks: CAMELS rating is one of the core of risk profile compilation and the risk profiling of each bank draws upon a wide range of information such as market intelligence reports. 3) Supervisory Programme: It is prepared at the beginning of supervisory cycle. On site inspection is targeted to specific areas and a MAP (monitorable action plan) is drawn up for follow up to mitigate risks to supervisory objectives posed by individual banks. Monitorable action plan and banks progress to date. automation and market disclosure / transparency. globalisation. adhoc data from external and internal auditors. It involves assessing and monitoring the risk profile of banks on an on going basis in relation to business and exposures and prompt banks to develop systems rather than transactions. Sensitivity analysis. RBI decided to switch over to RBS due to autonomy of banks.

fix up supervisory cycle and supervisory tools. Moreover. catalogues. adopts Risk Focussed Internal Audit (RFIA). It works as a comprehensive guide to RBI for informed and focussed supervisory action in high-risk areas in banks. There should be well-defined standard of corporate governance. Moreover. Hence. RBI initiates banks to set up Risk Management Architecture. assesses and aggregate risks that bank are exposed to.banks with a better compliance record and a good risk management control system is entitled to an incentive package like longer supervisory cycle. 76 . The effectiveness of RBS depends on bank preparedness. strengthen MIS. RPTs is defined as a standardized and dynamic document that captures. banks that fails to show improvement in response to MAP is subject to frequent supervisory examination. well-documented policies and practices with clear demarcation of lines of responsibility and accountability. for effectiveness of RBS formation of separate Quality Assurance Team (QAT) should be there where members are not involved in preparation of Risk Profile Templates (RPTs).

CHAPTER VIII ANALYSIS OF SURVEY RESPONSES 77 .

there were no comments on this from other banks. OBC review loans after every three months or six months whereas Central Bank of India still follows 12-month cycle.  Documented Risk Management Policy All the private sector banks surveyed have 100% documented risk management policy i. group and industry  Frequency of Loan account review In this parameter ICICI. Among the PSU it’s only SBI and Central Bank of India. IDBI. As regular analysis of the loan portfolio feed into banks lending strategy.e it covers credit. all the six banks report that contingent liabilities fall within purview of their risk management processes. Oriental Bank of Commerce concentrates only on credit risks.  Compilation of Migration and Default Statistics Its only SBI which track probability of default and rating migration and same is in case of tracking loss given default. 78 .  Internal Credit Rating Models All the banks follow internal credit rating model. However. This high percentage among banks shows an adoption of scientific approach to credit risks in Indian Banking sector.  All the banks follow Integrated Risk Management Practices. which covers all the three aspects of risks. HDFC.There are certain parameters on which bank degree of readiness for risk management is ascertained. market and operational risk. Moreover.  On the matter of Exposure Limits all the banks surveyed define it in terms of counter party. SBI.

ICICI and IDBI bank are carrying out daily mark to market trading portfolio whereas Central Bank of India and HDFC bank didn’t comment on this. ICICI. HDFC periodically review their liquidity position under normal and stress scenarios whereas OBC.  Limits on Derivative transactions 79 . interest rate risk is also important in Indian banking system. OBC.  Periodic Review of Liquidity Position SBI. HDFC bank is also termed to be the best in industry in portfolio quality. Over 85 % of the corporate credit portfolio is now rated “A” and above in IDBI. HDFC banks carries out such analysis whereas in public sector banks this analysis is carried out only by SBI. IDBI does not review the liquidity position periodically. ICICI Banks calculate a daily Value at Risk (VaR) of trading portfolio where as rest of banks have fixed their own timeframe for moving to Value at Risk and Duration approach for measurement of interest rate risk. Evaluating Credit Risk at Portfolio level To have a comprehensive understanding of credit risk banks evaluate credit risk at portfolio level. SBI. ICICI.  Daily VaR (Value at Risk ) of Investment Portfolio IDBI.  NII (Net Interest Income) Sensitivity Analysis The surveyed banks are carrying out regular NII Sensitivity Analysis. The potential impact of upon equity capital of surveyed banks in system seems to be economically significant.  interest rate shocks Our result shows that in addition to credit risk.  Daily Mark-to-Market of Trading Portfolio In this area a substantial divergence of practices is found between private sector banks and public sector banks.IDBI. SBI.

The challenge is mainly in the area of operational risk where there is dearth of reliable historic data and not a great deal of clarity of the measurement of risk. OBC.r. ICICI. IDBI Bank stand out as banks. HDFC bank there is good agreement between the results from two approaches. HDFC.t interest rate risk. IDBI. IDBI. approaches i.  SBI. HDFC Bank and SBI seem to fairly hedged w. which have large exposures by both. 80 . ICICI banks maintain a certain level of investment fluctuation reserve to guard against any possible reversal of interest rate.  While putting the risk management in place HDFC.  ICICI Bank. Central bank of India finds difficult to collect reliable data.  It is striking to observe that three banks with best stock market liquidity SBI. SBI.This is one of the essential components of market risk control.  SBI.e accounting disclosures and stock market approach. CBI banks have placed limits on derivative transactions This is all due to strong monitoring and control system that derivative activity takes place in these banks. OBC. as it’s the area where structural focus is relatively nascent. ICICI banks have operational risk management system but rest of the surveyed banks did not have.  Among the six banks in our sample no bank proves to have significant ‘reverse exposures’ in the sense that they stand to earn profits in event of when interest rate goes up. as they didn’t comment on this. None of the banks surveyed follow this approach. Banks like Oriental Bank of Commerce and ICICI bank have sophisticated technologies.  OBC.  Banks following Score card approach Scorecard approach is followed for operational risk mitigation. ICICI. IDBI.

which aggregate risk parameters on live basis. ICICI. OBC for whom funds are not constraint thinks of developing in house software but they still go for outsourcing as the chief benefit of it is the speed of implementation and it temporarily reduce the load of the back office employees.  Capture of Risk data on regular basis Banks such as SBI. SBI. Moreover. Ltd. If bank has in house software then there is nothing like it in terms of delivery time since changes can be incorporated in an expeditious manner. OBC and ICICI bank conduct Risk Based Internal Audit as per RBI guidelines whereas central bank of India & HDFC Bank did not comment on this. 81 . OBC captures risk data on regular basis whereas other bank do not capture data on regular basis. Bank conducting Risk Based Internal Audit IDBI.  Information systems for live aggregation of risk parameters Only SBI and ICICI bank follow the presence of information system.  Bank on Inhouse/Outsource software for risk management All the three surveyed private banks go for readymade solutions since creating in house system proves to be expensive whereas established public sector banks like SBI. other banks did not comment on this. bank need to have a separate department of IT professionals working full time on product design and development. However.  State Bank of India is teaming with KPMG Consulting Pvt. But finally the decision regarding this rest on efficiency and accuracy in valuation and consequent risk analysis. (international consultant) for software solutions.

36 12.03 0.4 1.4 HDFC IDBI OBC CBI 2004 2005 2004 2005 2004 2005 2004 2005 0.1 3.3 3.4 Ratio (%) Net Interest Margin (%) 3.  Net Interest Margin = Net Interest Income/Earning Assets where Net Interest Income = Total Interest Income .9 1.89 1.36 1.1 20.86 1.Fixed Assets .4 21.65 20. The reason for this is the larger retail base that result in being able to raise capital in small lots.79 18. 6 Table showing key performance indicators determining the profitability of banks Key Performance (Financial) Indicators SBI 2004 2005 ROA (%) ROE (%) 0.02 0.Other Asset) This figure is critical component of the analysis of the risks faced by banks and other financial institutions. 4.9 2.8 11.8 3.47 3.05 18.Table No.Cash Balance .2 1. The impact of volatility on the short-term profits is measured by Net Interest Margin.79 Capital Adequacy 14.16 ICICI 2004 2005 1.1 10. 82 .21 9.91 1.56 10.75 3.5 21.8 20.5 10.8 11.9 9.09 3.5 0.03 14. IDBI and HDFC bank.Total Interest Expenses Earning Assets = All Interest earning assets (Total Assets . 3. It is at level of 3%.5 20. Only Central Bank of India is the bank among all the six banks.8 1.8 10.7 3.2 23.9 4.7% for SBI. 3.2 Some of the ratios used for analyzing the aspect of risk management are as follows:  Cost of Funds = Total Interest Expense / Interest bearing liabilities where Interest bearing liabilities = Deposit + Borrowings On analyzing this ratio we see that all the six banks have the lower cost of funds in year 2005 as compared to 2004.8%.3 21. 2.7%.5% for ICICI bank.5 11.7 27.3 22.7%. CBI and OBC bank in year 2005 while it is 1.

They do not differ significantly and the difference is in range of 1%.79%).which is able to stabilize short-term profits as net interest margin for year 2004 and 2005 is same (3. This is becoming a very critical component of the probability of a bank as the spreads are becoming thinner and thinner over the years as a result of increased competition.  Spread = Yield – Cost of Funds where Yield = Total Interest Earned/Earning Assets The level of spread at which each bank operates is different.  Profit Margin =Net Income/ Total Revenue The decreased profitability of private banks in 2005 as compared to 2004 is due to the increased competition in the industry as a whole. On having a closer look at the yield curves of the various subdivisions with in each sector on the basis of size we see that there is clear trend towards convergence over the period 2004-2005.  AssetUtilization = Total Revenue/Total Assets 83 .  Overhead Efficiency = Non Interest Income/Non Interest Expense This ratio gives us an idea of the ability of banks from the fee-based activities undertaken by them. This is a good method of improving their top line as this increased income can be generate without any significant additions to the fixed assets as well as without there being the need to raise additional deposits or borrowings from the market. This increased competition in the industry has resulted in lowering the spreads under which banks operate. The private banks have narrower spread as compared to the PSU bank. As the private banks have adopted a more aggressive strategy to gain market share and business.

This gives us an insight into the proportion of income coming from the fee based activities of banks as against those that are derived from the fund based activities. and CBI is around 10% over the two-year period whereas HDFC. This makes sense that asset utilization capability of the banks cannot be change rapidly over a short period of time. which is lower than that of the PSU banks. OBC.  Burden/Spread Burden is the Net Non Interest Income and Spread is the Net Interest expense. 84 .The asset utilization ratio for the public sector banks namely SBI. ICICI and IDBI bank asset utilization is of 8%. This in turn tells us the kind of areas where bank is focusing on a present and the pattern which they a likely to follow in the future.

CHAPTER – IX OBSERVATIONS AND SUGGESTIONS 85 .

 Degree of readiness for integrated risk management among banks differs widely.  Risk management is review and control exercise which requires independent functioning in maintaining reporting lines distinct from operating managers of corresponding departments but its not there within banks. proper organisational structure is an essential component of risk management effort. Observations initiate further refinements in the existing structure while suggestions provide better guidelines in the efficient working of the organisation. The challenge is mainly in the area of operational risk where there is dearth of reliable historic data and not a great deal of clarity on the measurement of risk. 86 . Hence. which have started the process of systematic capturing of risk data. A separate credit risk department distinct from credit function has been set up in all the surveyed banks. Implementing the necessary structure is the key task for all the banks surveyed. First part consists of major observations of study and second part comprises of its suggestions. This implies substantial progress from three years ago when risk management was new concept for all except the most advanced and sophisticated banks.  Risk Management System is not in line with organisation goals and objective. Degree of readiness also differs with regard to the risk elements covered. based on the responses to the questionnaire and the personal meetings with senior risk professionals in banks a few major findings of study are:  There is much greater awareness across the banking sector about the need for risk management and the various categories of risk which banks are exposed to.The present chapter is divided into two sections. As there are banks which have several years risk data and sophisticated risk models.  While putting the risk management in place banks surveyed often find it difficult to collect reliable data. there are also other banks. Hence.

 There is absence of binding time frame as for measuring and managing risk comprehensive and credible system is not placed by the specified date.  Procedural Audit reporting risk management is not done. datawarehousing and in sophisticated statistical models as aggregation and analysis of the vast amount of data is needed for successful risk management system.  Issues relating to internal audit system. It’s much longer before sufficient data aggregation could be carried out for the introduction of sophisticated quantitative approaches demanding sufficient internal measurements. Absence of standardised definition and measurement divergences lead delays in installing and integrating the components of an integrated risk management system.  Quarterly progress reports are not made in order to keep the track record for the progress of bank. Selection processes for vendors are long drawn and implementation gets delayed on account of time taken to freeze requirements and fine-tunes specifications.  Banks are facing significant challenge in rolling out IT networks. With increased awareness there has come about a need to ensure harmony of understanding and direction across banks.  Moreover each bank going for risk management implementation is faced with question of whether to outsource and if so how much and to whom.  Methodologies for measuring and assessing market risk and credit risks are inconsistent throughout the banking sector. loan review system and timeliness of internal ratings are not observed in most of the banks. 87 .  Regulatory and legal issues are not taken into account while setting up of risk management system. The banks on the software front could not entail investments in databases.

 Risk management solutions have been mainly used to calculate credit risk.  There is a lack of conceptual clarity in some of the fields of risk management. 88 . Training for supervisory cadres is not given in banks for understanding the critical issues raised under Basel II.  In the current interest rate environment.  In recent times much have been done in the area of credit risk management. That’s why they seek the services of global consultants like KPMG. TCS and many more.  Timeliness is recommended for progress of the components of risk management.  The risk management software solutions market is almost nine percent of the entire IT budget of the global financial industry. The following recommendations are worth mentioning:  Risk Management System should be in place to deal with current and potential risks.  Banks surveyed don’t have expertise in risk modelling.  Banks surveyed did not comply with Basel II norms and still follow rudimentary risk models. These consultants identify the gaps in system and help banks in devising risk return model. Price house water coopers. banks find more profitable to invest in government securities.  The system needs to be developed in line with organisation goals and objective. It’s in the area of operational risk that most firms will make fresh investments.  Selection processes of vendors for outsourcing the software solution are long drawn.

A technological application in the form of networking and data warehousing is indispensable. which will enhance the acceptability of adopting the risk management measures by the employees.  There should be an active participation of senior management and main line functional staff in setting up of risk management system.  Simple handbooks must be published on risk management demystifying the subject and making it accessible to the line managers who eventually need to implement and use it.  An efficient asset liability management system should be there which is an adequate tool to identify and mitigate market risks.  Monitoring and reviewing risk management process with dynamically changing global environment needs to be undertaken.  Measuring and disclosing various risks requires sound MIS.  Organisation of Seminars and workshops should be conducted for training of risk management professionals as its important not only in terms of concepts and methodologies but also to get across vital communication tools and techniques. 89 . risk based supervision. proper manpower planning. selection training and development and efficient compliance officer should be there in addressing risk management issues.  New system calls for skilled expertise sophisticated IT infrastructure and a comprehensive database. Quarterly progress reports should be made which is an effective way of keeping track of progress made by each bank.  Appropriate internal controls and audit.  Procedural Audit of all banks reporting risk management should be done.  Selection processes of vendors for outsourcing the software solution should not be long drawn.

 Banks should comply with Basel II norms There is no alternative to an efficient risk management system covering all aspects of risk for healthy growth of the organisation. 90 . Banks should place more emphasis on the cash flow based lending rather than traditional securities based lending.  With view to build up adequate reserves too guard against any possible reversal of interest rate banks should maintain a certain level of investment fluctuation reserve. The regulators must work closely with banks to ensure that banks take up the issue seriously.

ANNEXURE 91 .

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Does your bank evaluates credit risk at portfolio level? Yes ___ 8. Do you go for Internal Credit Rating Model? Yes ___ No___ 6. No____ Does your bank carry out NII (Net Interest Income) sensitivity analysis? 100 . Do you follow Risk Management in your bank? Yes ___ 2. Dated _______ No ___ What structure of Risk Management does your bank follows? Decentralized____ 3. What is the frequency of loan account review in your bank? 3 month ___ 6 month ___ 12 month___ 7. Does your bank goes for documented risk management policy? Centralized ___ Yes ___ No____ 4. Does your bank has independent credit risk management department? Yes ___ No___ 5.QUESTIONNAIRE Name of Bank ________ Name of Person ________ Designation ________ Regarding Risk Management 1.

Does your bank has documented operational risk management committee? Yes ___ No___ 13.Does your bank carry out Risk Focussed Internal Audit (RFIA)? Yes ___ No___ 21. No_____ Does your bank maintain certain level of investment fluctuation reserve to guard against any possible reversal of interest rate? Yes ___ No___ 11. Does your bank captures risk data on regular basis? Yes___ 22. Does your bank periodically review its liquidity position? Yes____ 10. Do you follow MIS in your bank? Yes ___ No___ No___ 23. Does your bank follow scorecard approach towards operational mitigation? Yes___ No___ risk 20.Do you feel that there is need to bring a cultural change in 101 . Does your bank outsource or develop in house software for risk management solutions? Yes ___ No___ 24. Does your bank comply with Basel II norms? Yes____ No___ 12.Yes____ No ____ 9.

IBA Bulletin (Mar 2002.organisations towards risk culture? Yes ___ No___ Signature_______ BIBLIOGRAPHY  Basel Committee on Banking Supervision. 2003-04).  Annual Report of all banks (2002-03.2001. Report on Trend and progress of Banking in India (various years). Websites of all banks studied. Mar 2003).   102 . “Sound Practices for the Management and Supervision of Operational Risk” (December).2001.  Basel Committee on Banking Supervision.  Reserve Bank of India. “Working Paper on the Regulatory Treatment of Operational Risk”(September).  Report: A Road map for Implementing an Integrated Risk Management System by Indian Banks by Mar 2005 (CRISIL) in IBA Bulletin (Jan 2004).

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