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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.....................................iv Chapter I INTRODUCTION....................................iii Preface ……………………………………………………………..............…....CONTENTS Acknowledgement………………………………………………………................23-28 Chapter IV CREDIT RISK MANAGEMENT.................................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 ..................……………................ii Certificate………………………………………………......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 ........................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 ................

...........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..............98-99 BIBLIOGRAPHY ....................................................................................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..............................................90-97 QUESTIONNAIRE....84-89 (a) Major Findings of Study (b) Suggestions ANNEXURES..........................................................................................100 v .........................................................Chapter V MARKET RISK (a) Meaning of Market Risk (b) Meaning of Liquidity Risk MANAGEMENT.......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.................................................................76-83 Chapter IX OBSERVATION AND SUGGESTIONS.....................

I INTRODUCTION 1 .CHAPTER .

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

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. 2001 Risk is the potentiality of both expected and unexpected events which have an adverse impact on bank capital or earnings. (exposure to) the possibility of loss. In one of the publications Price Waterhouse Cooper has interpreted the word risk in two distinct senses. injury or other adverse circumstance.

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

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

a committee approach to risk management is being adopted. the Credit Policy Committee (CPC) oversees the credit/counter party risk and country risk.Risk Management Structure: Establishing an appropriate risk management organisation structure is choosing between a centralised and decentralised structure. the core staff at Head Offices is trained in risk modelling and analytical tools. While the Asset-Liability Management Committee (ALCO) deal with different types of market risk. The Board sets risk limits by assessing the bank’s risk and risk-bearing capacity. 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. 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. At a more sophisticated level. Large banks and those operating in international markets have developed internal risk management models to be able to compete effectively with their competitors. Thus. Generally. 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. At organisational level. economies of scale and easier reporting to top management. The global trend is towards centralising risk management with integrated treasury management function to benefit from information on aggregate exposure. 6 . market and credit risks are managed in a parallel two-track approach in banks. The risk management is a complex function and it requires specialized skills and expertise. Internationally. 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. the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures. natural netting of exposures.

degree of sophistication and costs vary greatly.Risk Management: Components The process of risk management has three identifiable steps viz. 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 Measurement The second step in risk management process is the risk measurement or risk assessment. Risk identification.  Risk Control After identification and assessment of risk factors. liquidity risk. The potential loss is generally defined in terms of ‘Frequency’ and ‘Severity’.  Risk Identification Risk identification means defining each of risks associated with a transaction or a type of bank product or service. legal risk etc. and Risk control. interest rate risk. operational risk. This is the most difficult step in the risk management process and the methods. There are various types of risk which bank face such as credit risk. the next step involved is risk control. Risk measurement. Risk assessment is the essemination of the size probability and timing of a potential loss under various scenarios.

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. a. focus. For example assuming that the current risks management score is 30 out of 100. 2) Risk Identification The second step is identification of risks. Basel II compliance 8 .♦ 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. 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. structure. positioning and resource commitments. For the gap in score of 70 roadmap is developed for achieving the milestones. Then it develops a score for the current level of bank risk practices that already exists. technology and analytical sophistication at the bank. Risk Based Supervision requirements b. which is carried out to assess the current level of risk management processes.

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. the relative importance of market. credit and operational risk in each line of activity is determined The process workflow organisation. training.c. development of integrated risk reports and success measures and alignment of risk and business 9 . Moreover. 5) Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans. Models to be applied are tested and validated on a prototype basis. 6) Executing the key requirements: At an operational level checklist of key success factors and quantitative benchmark is generated. risk control and mitigation procedures for each activity line is to be provided. evaluation scores on the benchmark levels specified helps to build up a risk process implementation score. 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.

• Funding liquidity risks: is defined as inability to obtain funds to meet cash flow obligations. which is concurrent with the risk of inadequate loss of key personnel or misplaced motivation among management personnel. people and processes or from external events.  Legal Risks: It is the risk that makes transaction proves to be unenforceable in law or has been inadequately documented.  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.  Operational Risks: It is the risk of loss resulting from failed or inadequate systems.  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.  Human Risks: It is risk. 10 .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.  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. foreign exchange equities as well as volatilities of prices.

• 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). 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. condition to the movement in interest rates. Moreover. The Credit Rating and Investment Services of India Ltd. Risk environment has changed and according to the draft Basel II norms the focus is more on the entire risk return equation. 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. Tata Consultancy Services (TCS). banks now a days seek services of Global Consultants like KPMG. Hence. 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.• Interest Rate Risk: It is the potential negative impact on the Net Interest Income and refers to vulnerability of an institution’s financial. Risk Management in its current form is different from what the banks used to practice earlier. 11 . PricewaterhouseCoopers (PwC). (Crisil).

to measure. to monitor and to control the various risks with New Capital Adequacy . which are being implemented by banks through various committees. 12 Banks must equip themselves with an ability to identify. 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.

(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.(b) For integrated management of risk there must be single risk management committee. Appropriate credit risk modelling in the future must be adopted. portfolio approach must be adopted. (h) Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based supervision. 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. Similarly. (g) Banks should upgrade credit risk management system to optimize use of capital. (j) To enhance risk management function banks should move towards risk based supervision and risk focussed internal audit. One of the five specific areas is effective Risk Management Architecture to ensure adequate internal risk management practices. (c) (d) (e) For managing credit risk. 13 .

II RESEARCH METHODOLOGY 14 .CHAPTER .

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

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

If Indian banks are to compete globally then they have to institute sound and robust risk management practices. liquidity risk and operational risk. Enhance capital allocation.  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. While putting the risk management in place banks often find it difficult to collect reliable data. net interest margin. liquidity risk. The present study evaluates key performance indicators of various banks in terms of credit deposit ratio.  Instill confidence in the market place.  Improved Information Security. which will improve efficiency of banks. The scope of this study involves analyzing and measuring major risks i. overhead efficiency. 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. 17 . interest rate risk. Irrespective of the nature of the risk the best way for banks to protect themselves is to identify risk. Gap analysis and maturity ladder. accurately measure. interest rate risk and operational risk of six banks (public and private sector).  An understanding of key business processes. it is an essential part of a financial institution as it involves stakeholders interest among others.e credit risk. In real world risk management creates value. Hence.  Corporate Reputation.  Alleviate regulatory constraints and distortions thereof. price it and maintain appropriate levels of reserves and capital.  Improvement of portfolio identification and action plans. spread.

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. August 2005) which are shown in sequence from high profit banks to low profit banks.  State Bank of India  ICICI Bank  Central Bank of India  HDFC Bank  Oriental Bank of Commerce  IDBI Bank 18 . 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.Data Collection The present study is based on both primary and secondary sources. Following banks are included in the sample size (Business India.

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

Techniques of Analysis The following techniques have been applied for analysis: -  Ratio Analysis To evaluate the financial condition.The following various accounting tools have been used. • 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. 20 . 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. performance and profitability banks requires certain yardsticks .

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 . It is calculated as follows: Net profit after tax + Interest /Total assets • Return on Equity (ROE) = Shareholders are the real owner of the 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. All these items are assigned weights according to prescribed risks and the ratio so computed is known as capital adequacy ratio. so they are more interested in profitability and performance of an organisation. This is calculated as follows: Net profit after interest. their investments. loans and advances. • Capital Adequacy Ratio This ratio strengthens the capital base of bank. tax and Preference dividend /Equity Shareholders Funds. The paid up capital reserves of bank form an adequate percentage of assets of banks.

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

CHAPTER – III BANKS PROFILE 23 .

24 .Duly aligned with (RFIA) the Credit audit examines probability of default and suggests risk mitigation measures. 1955 and the State Bank of India was constituted on 1 July.4. The State Bank of India was thus born with a new sense of social purpose aided by the 480 offices comprising branches. 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. Later. 1840 and the Bank of Madras (1 July. 1921.Three years later the bank received its charter and was redesigned as the Bank of Bengal (2nd January 1809). 1806. 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.03. 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. 1955. an adjunct to risk based supervision has been introduced in the banks audit system on 1. More than a quarter of the resources of the Indian banking system thus passed under the direct control of the state. sub offices and three local head offices inherited from Imperial Bank. The bank has an in built internal control system with well-defined responsibilities at each level. Moreover SBI has developed sensitive tools to hedge and minimize the risk arising out of movements in interest rates. 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 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. 1843) followed the Bank of Bengal. 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. These three banks remained at the apex of modern banking in India till their amalgamation as the Imperial Bank of India on 27 January.An act was accordingly passed in Parliament in May. (RFIA) Risk Focused Internal Audit.

25 . management and mitigation of risk in ICICI bank. RBI Inspection and Anti.ICICI Bank is among largest private sector banks in country. CAG is further organised into credit policies. Established in 1911.Central Bank of India has business interests in diversified areas of banking and finance. Its excellent performance is a result of its increase client focus and ability to structure financial solutions that meet client specific ends. Central Bank of India has installed an enterprise wide ALM and risk management solution. RMG is further organised into Credit Risk Management Group. the compliance and audit group that are responsible for assessment. 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. new organisation structures and new business models have been the hallmarks of ICICI business strategy. new services. 1955 to assist industrial enterprises in private sector. Central Bank of India is a public sector bank of the government of India. New products. In line with the Basel II and RBI guidelines. Retail Risk Management group and Risk Analytics group. The risk management group. Market Risk Management group. A comprehensive range of quantitative and modelling tools are developed by dedicated risk analytic team that supports the risk management function.Laundering Group and Internal Audit 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. It was established on Jan 5.

Overall portfolio diversification and reviews also facilitate risk management in the bank.the date when nationalization of the bank was announced the bank had 307 branches with Rs. 26 . 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. HDFC Bank commenced its operations as a scheduled commercial bank in January. Thereafter the bank registered phenomenal growth and noticeable improvement was observed under all performance parameters.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. Established in Lahore on 19th February 1943.69 crores as advances. The bank was incorporated in August. To implement the effective strategy in risk management HDFC Bank has distinct policies and processes in place for the wholesale and retail asset business. appropriate credit approval processes. the first Chairman of the bank. ongoing post disbursement monitoring and remedial management procedures. On 15th April 1980. 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. India.282. 1994 in the name of HDFC Bank Limited with its registered office in Mumbai. 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. 1995.

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

market and operational risk. 28 . As bank rating and scoring models effectively manage the risk of individual/credit portfolio. which evaluates adequacy and effectiveness of internal controls for various business and operational activities within bank. It has centrally controlled & an independent Internal Audit Department that maintains a risk based focus.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. 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.

CHAPTER .IV CREDIT RISK MANAGEMENT 29 .

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

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

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

Moreover. machinery breakdown) which are market driven. Banks also consider maturity profile of the loan book. which is converted into simple 33 . encompass industry risk. management risk and specify cutoff standards. Rating migration is mapped to estimate the expected loss. commitment and competence. fiscal policies of government. Assessment of financial risks involves of the financial strength of unit based on its performance and financial indicators like liquidity. structure and systems. substantial exposure. 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. track record. Management risk consists of integrity. coverage and turnover. The quality of credit decisions is evaluated.say 15% for individual borrower entity. Business risk consists of systematic risk (such as changes in economic policies. Some of the risks rating methodologies are:  Altman’s Z score model involves forecasting the probability of a company entering bankruptcy. 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 . Threshold limit is fixed at a level lower than prudential exposure. Banks clearly defines rating threshold and reviews the rating periodically preferably at half yearly intervals. small borrowers and traders.for sanction of higher limits to the ‘Grid’. 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. financial risk. expertise. It separates defaulting borrower from non-defaulting borrower on the basis of certain financial ratios. business risk. infrastructural changes) and unsystematic risk (such as labour strike. there is separate rating framework for large corporates.

sector or industry. To maintain portfolio quality banks adopt certain measures such as stipulate quantitative ceiling on aggregate exposures on specific rating categories.  Credit Risk +. distribution of borrowers in various industry. Banks link loan pricing to expected loss and high-risk category borrowers are priced high.index. 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. stress test. It is based on actuarial rates and unexpected losses from defaults. 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.  KMV. The stress test reveals undetected areas of potential credit risk exposure and 34 .  Credit Metrics focus on estimating the volatility of asset value caused by the variation in the quality of assets. business group and conducting rapid portfolio reviews. through its Expected Default Frequency (EDF) methodology derives the actual probability of default for each obligator based on the functions of capital structure.. 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. a statistical method based on the insurance industry for measuring credit risk. current asset value. Banks build historical database on the portfolio quality and provisioning to equip themselves to price the risk. It tracks rating migration which is the probability that borrower migrates from one risk rating to another risk rating. 4) Risk Pricing Risk-return pricing is a fundamental tenet of risk management.

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

This is followed by the analysis of the same. 36 .55 crores (2003-2005).sectors i. real estate and commodities sector.93 crores but on the other hand IDBI exposure has been reduced to 16.27 crores to 248. Real Estate In the analysis of the exposures of risk in real estate OBC tops the list with 1701. In a recent RBI directive it has directed banks to tread cautiously on capital markets exposure. Private Sector Banks Capital Market ICICI bank exposure in capital market has raised from 169.e stock markets.69 crores.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. ICICI bank tops the league in the analyzed banks followed by IDBI bank. However it has given banks freedom to decide on the margin of the IPO financing. (See Annexure 1. Real Estate When it comes to exposure in real estate.48 crores from 82. Commodities Sector In this sector SBI has not been contributing till the year 2004 but among other public sector bank OBC ranks the highest.

3 21. 2 Table showing return on equity capital (%) Bank Year SBI ICICI CBI 2004 18.8 2005 2004 2005 21.2 Source: Annual Report of Banks 37 .21 2005 20.4 OBC 2004 18. where ROE measures the return stockholders on their equity investment in the FI.2 21.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.9 IDBI 2004 2005 2004 2005 18. 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. as it requires few statistical tools.Expected loss – Operating cost .65 20.56 HDFC 2004 20. Table No. Hence it is defined as ratio of risk adjusted return to economic capital. Spread (Direct income earned on loan) + fees on loan (one year income on loan ) .Commodities market ICICI bank ranks the highest contribution in absolute terms 380.1 2005 20. 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.5 ROE % 18. An increasingly popular model to evaluate (and price) credit risk based on market data is the RAROC model.51 crores from year 2003-05. Credit Risk Measurement The risk measurement and quantification at the transaction level is of prime importance in CRM.7 27.

The Basel Committee has suggested the two alternative approaches for calculation of regulatory capital for credit risks. Its a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas.  The Standardised Approach Under this approach. Banks and Corporates. the risk weights range from 0% to 100% and for banks and corporate the range is from 20% to 150%. RWA (Risk Weighted Assets) is determined as the counter parties are grouped into Sovereigns. 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). it can take timely corrections. This approach ensures that a bank knows the quality of its exposures to strengthen its capital base according to risks it takes. 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 . For Sovereigns.

12.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. Probability of Default: A borrower is in default when the obligations to pay principal and interest are not met. LGD.5*LGD) 39 . For estimating the PD time horizon is important. other banks. Risk components derived above are translated into risk weights called Risk Weight Function. Finally the loss to the bank depends on the value of Exposure at Default. EAD. EaD RWC = Min. the risk weight function gives the following risk weight for given PD. On this basis a loan is d eemed to be in default if it is classified as sub standard. project finance. For corporate exposures. 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). the probability of loss in the event of default (LGD) and the exposure at default. It’s a fraction of total exposure whose exact value depends upon the extent of collateralisation and expressed as a percentage of exposure. ({LGD/50}*BC. corporates. LGD. The banks internal model is expected to produce reliable estimates of PD. retail loans. Loss given Default measures the extent of loss on a given exposure in the event of default. These estimates must be based on at least 1-year data sampled over a minimum of 4 quarters.

 Credit Swaps A Credit Swap is where two lenders agree to exchange portion of their customers loan repayments. 40 .  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. 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.Here. LGD is expressed as a whole number (i. Similarly. For example removing a pool of loans from banks balance sheet reduces or disposes of the banks credit risk exposures from these loans. 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. ♦ 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. Each calculated risk weight RWC is multiplied by the corresponding EAD and aggregating over all exposure categories yields an estimate of RWA for credit.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. 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.

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

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

Central Bank of India and Oriental Bank of Commerce this ratio is 0.banks arises from funding of long-term assets by short-term liabilities thereby making the liabilities subject to refinancing risk. 3. 0. IDBI and HDFC bank as these banks rely more heavily on large deposits made by other banks with them. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits. 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. This seems to show that PSU banks have a much more stable deposit base than private sector. Liquidity measurement is quite a difficult task and can be measured though stock or cash flow approaches.128 %and 0. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable. 0. which are inherently unstable.e performing assets turning into non-performing assets.189% for ICICI bank. The liquidity risk in banks manifest in different dimension: 1.181%. 0.870% for year 2004 while it is 0. Time Risk: need to compensate for non-receipt of expected inflows of funds i.065%.  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. 2. But over the years the private sector also has been improving upon his ratio. This implies that the liquidity position of PSU banks is more stable which can be attributed to their larger customer /retail base. IDBI and HDFC bank.883%. This exposes the private banks to higher 43 .

This ratio is essential for liquidity strategy of the bank. The percentage of short-term assets to total assets is minimum for private banks with a very large standard deviation among them. Investments/Total Assets This ratio is highest for public sector banks reflecting the higher levels of conservatism in their policies. 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 . which entail a high level of risk. 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.levels of liquidity risks. Analysis of liquidity involves tracking of cash flow mismatches. which are operating generally in an illiquid market. A possible reason for this could be the fact that the management of each of them has a different emphasis regarding their lending policies. Higher Deposit Ratio indicates poor liquidity position of the bank while lower figures indicates more comfortable liquidity positions.  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. Credit Deposit Ratio Credit Deposit Ratio = Loans & Advances/Total Deposits This is a popular measure of the liquidity position of banks. This is because investments are mainly government securities and other forms of relatively less risky instruments as compared to loans and advances.

liability side reasons (i. The two approaches used for managing the liquidity risk dimension are:(a) Fundamental Approach (b) Technical Approach 45 . The cause and effect of liquidity risk is primarily linked to nature of assets and liabilities of a bank. 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. 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. liabilities and off –balance sheet items. 3.e whenever a bank depositors come to withdraw their money) and asset side reasons (which arises as a result of lending commitments). 4. 2. 5. 8. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. Strategies for managing Liquidity risk The risk arises because of two reasons . The assets and liabilities are classified in different maturity buckets: 1.recommended as a standard tool. 6. 7.

Liquidity in the short run is linked to cash flows arising due to operational transactions. 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. We have analyse the  Call Money Market  The Repo Market and  Liquidity Adjustment Facility (LAF) 46 . 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. Thus if the technical approach is adopted to eliminate liquidity risk it is the cash flows position that needs to be tackled.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. Likewise the sale of securities from the investment portfolio can enhance liquidity.As investing in the government securities generally offer higher yields with less risk involved. Investment can be put in the call market. The risk perceived is low as participants are banks . The disadvantage is that since funds are raised from various sources and markets any rate fluctuations in a market enhance the cost of borrowing. Technical Approach The technical approach focuses on the liquidity position of the bank in the short run.

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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It is also appropriate as the financial markets move towards indirect instruments. 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. The ILAF was operated through a combination of repo. In April 1999. The funds from this facility used by the banks for their day – to day mismatches in liquidity. collateralized-lending facilities. An additional collateral (called Additional Collateralized Lending Facility) of similar amount was also made available to banks at 200 basis points over bank rate. The ILAF served its purpose as a 50 . an Interim Liquidity Adjustment Facility was introduced pending further up gradation in technology and legal/procedural changes to facilitate electronic transfer and settlement. export credit refinance. CLF and ACLF availed for periods beyond two weeks were subject to penal rate of 200 basis points for the next two weeks. 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. However during the period of availing the CLF or ACLF the banks continue to participate in the money market. 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. 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. 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. 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.

This has given an unprecedented regime of enhanced interest rate volatility. Liabilities consist of deposits and bank borrowing classified into different time buckets. liability off balance sheet items and cash flow. It provided a ceiling and the Fixed Rate Repo were continued to provide a floor for the money market rates. Assets consist of loans and advances and investments. administrative restrictions upon interest rates have been steadily eased. value of assets. Changes in interest rate affect earnings. Investments in corporate and government debt are combined into one category and bucketed according to their time to maturity. 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. the focus of analysis is the impact of changes in interest rate on accrual or reported earnings. 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. large reserve requirement implies a policy of 51 .transitional measure for providing reasonable access to liquid funds at set rates of interest. From the Earning perspective. If interest rate goes up in future it would hurt banks. By International standards. banks in India have relatively large fraction of assets held in government bonds and is partly driven by large reserve requirements. ♦ 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. It identifies risk arising from long-term interest rate gaps. which have funded long maturity assets using short maturity liabilities. interest rates have fallen sharply in last four years. Interest rate risk is particularly important for banks owing to high leverage and arises from maturity and repricing mismatches. In particular. In India from 1993 onwards. 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). In India.

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

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. 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. This statement is required to be reported to board of directors of bank and to RBI (not to public). The approach towards measurement and hedging interest rate risk varies with segmentation of banks balance sheet. 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. 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 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. Gap Analysis The Gap or Mismatch risk can be measured by calculating gaps over different time intervals as at a given date.

years 6. 8. Table No.6) 1. months 4.4 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 . 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 .sensitive The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. 2. 3. be used as a measure of interest rate sensitivity. years 7.The Gap may be identified in the following time buckets: (See Annexure 2.1 –2. The Gap can. The positive gap indicates that it has more RSAs whereas the negative gap indicates that it has more RSLs. therefore. 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). year 5.

4 521801.8 3061.5 6m-1 yr.634039 OBC 1.9 -374.5 4758892.4 -1843325 3-5yr -28058.5 -793128.72 25545. 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.75 -624.2 -24070.8 -2149.6 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 -1548 Bank SBI ICICI CBI RSA/RSL Bank 0.19 -56591.1 -3496. 55 .2 15077.98 16848.4 -9191.8 67133. a decrease in market interest rates will increase the market value of equity of the bank.6 Above 5yr 42953.981659 Duration Analysis Duration is the time weighted average maturity of the present value of the cash flows from assets.2 239193.9 -374.5 -24757.9 9967.8 -3583 -739898. liabilities and off balance sheet items.7 -3837.973785 IDBI RSA/RSL 0.5 -5315.pricing) and therefore reflects how changes in interest rates affects the institutions economic value that is the present value of equity.01254 HDFC 0.3 14837.7 -28058. The difference between duration of assets (DA) and liabilities (DL) is banks net duration.7 -53580 -7256.1-2.4 -148959.3 -762.3 42953. -127890 -112132. The longer the term to maturity of an investment.6 Non rate sensitive -360853.5 35140.3 8932.01 -2626.54 2825 -1338751.985092 0.5 -34777.3 3 –6 mths -7256. the greater the chance of interest rate movements and hence unfavourable price changes. If the net duration is positive (DA>DL).Annexure 2. It measures the relative sensitivity of the value of instruments to changing interest rates (the average term to re . This index represents the average term to maturity of the cash flows.246 -106772 -47987.95 1532.1 -641906.789439 0.8 -2149. the Duration method is used to measure the expected change in market value of equity (MVE) for a given change in market interest rate. When the duration gap is negative (DL>DA) increase in market interest rate will decrease the market value of equity of the Bank.464 -90529.2 1-3 yr.3 2071. Hence. -9191.77 19255.

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. business strategies and other factors will have on net interest income. 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. 56 Reprice assets and liabilities at Simulate N draws from yield Model the data generating .Simulation Models Simulation model is a valuable to complement gap and duration analysis. Value At Risk VaR is an alternative framework for risk measurement. Simulation model is useful tool for strategic planning. 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. 3. If the VaR with respect to interest rate risk of bank is desired. curve on a date one-year away. 2. each of these draws. it permits a member institution to effectively integrate risk management and control into planning process. net income and interest rate risk positions.

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. In addition. Commodities Risk and Risk from options. interest rate risks of various banks are perceived by (b) stock market. distribution of profit/loss seen in Nth realisation. Measurement of market risk Market Risk: Standardised Approach Under the standardised approach five distinct sources of market risk are identified viz. Equity position risk. 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. Interpretation: In actual. Market Risk IRB Approach Here. When interest rate fluctuate. 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. The three crucial concepts in a VaR are: 57 . A VaR estimate is an appropriate percentile of the bank portfolio loss distribution. The crucial input in the IRB approach is a VaR (value at risk) model.4. 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. Interest rate risk. For any given bank portfolio one can calculate a loss distribution showing the probability of various amounts of loss. Foreign exchange risk. stock market speculators utilise their understanding of exposure for each bank in forming share price.

Collars and Interest rate Swaps.and not the market forces --. this risk is further exacerbated since it is the Reserve Bank of India (RBI) --. The holding period i. 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. Interest Rate Options.   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.99%. ♦ 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.e the period over which the portfolio is considered to beheld constant. lock in periods etc. 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 Historical period used for estimating the model. Some of the instruments used by banks are Interest Rate Futures. The confidence coefficient (whether 95%.9%).which still dictate the prevailing level of 58 . Portfolios cannot be adjusted instantaneously because of transaction costs. The value ranges from 0 (exceptionally good performance) to 1(poor performance) Stress Testing is an important dimension of the IRB approach. Interest Rate Caps. The VaR estimate is to be computed on a daily basis incorporating additional information becoming available on a daily basis.or 99. Each bank must meet on a daily basis. In India.

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. 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. Swaps can transform cash flows through a bank to more closely match the pattern of cash flows desired by management. There are many players in market---.HDFC bank. 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. ICICI bank. An IRS is way to change an institution exposure interest rate fluctuation and also achieve lower borrowing cost. 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. 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. Rationale behind an Interest Rate Swap Interest Sensitive Gap = Rate Sensitive Assets – Rate Sensitive Liabilities 59 .interest rates. The principal amount is notional because there is no need to exchange actual amounts of principal. A notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.

Swap participants can convert from fixed to floating or vice versa and more closely match the maturities of their assets and liabilities. In effect. 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.5 Interest Rate Gap Positive Gap Negative Gap Interest Rate Increase Favorable Position Unfavorable Position Interest Rate Decrease Unfavorable Position Favorable Position Fixed – for. thus converting a fixed long term interest rate into amore flexible and possibly cheaper short term interest rate. Quality Swap Under the terms of the agreement called a Quality Swap. typically a large nationalized bank. 60 . Swaps are often employed to deal with asset liability maturity mismatches.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.  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.Table No.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. the low credit-rated bank receives a long . 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.

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.

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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 .

such as terrorist attacks or major fraud. and “low frequency. Once potential loss events and actual losses are defined. 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. fire etc) (b) War/terrorism (c) Sabotage/crime (d) Collapse in market Legal.External Risk – (a) Natural Disasters (flood. single way to measure operational risk. Instead. However. there is no clearly established. 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. which summarize these data. high impact”(LFHI) events. Potential losses are categorized broadly arising from “high frequency. a bank analyze in constructing databases for monitoring such losses and creating risk indicators. several approaches have been developed. Data on losses arising from HFLI events are generally available from a bank’s internal auditing systems. 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. however. low impact”(HFLI) events such as minor accounting errors or bank teller mistakes. LFHI events are uncommon and thus 65 . As yet.

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

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

 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. assess.  Adequate public disclosures to be made to enable market participants to assess organisations approach to operational risk.  Policies. monitor.  Contingency and business continue plans 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.  In all material products.   Regulatory Authorities should review periodically about organisation approach to identify. processes and procedures to control/mitigate operational risk should be evolved. 68 . and control/mitigate operational risk. activities.  Senior management of the organisation should consistently implement approved operational management framework of the organisation.  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.

CHAPTER VII BASEL II COMPLIANCE & RISK BASED SUPERVISION 69 .

There is also greater differentiation across risk categories. market risk and operational risk.Basel II focuses on achieving a high degree of bank-level management. 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. 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. which is expected to be implemented by most countries by 2006. it does not differentiate between sound and weak banks using “one hat fit all” approach. Hence. in order to remedy the Basel Committee published a New Accord in Dec 2001.♦ 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. regulatory control and market disclosure. it acquire broad brush structure. 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).

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. The column chart shows the capital adequacy ratios of surveyed banks. Here capital charges are determined and then multiplied by 12. Tier III capital cannot exceed 250% of the Tier I capital to meet market risk.5 to make them comparable to the RWA. Capital adequacy in relation to economic risk is a necessary condition for the long-term 71 .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. For operational risk capital charges are computed directly and then multiplied by 12.basic indicator. Secondly a special type of capital (Tier3) is introduced for meeting market risk only. Thus D (denominator of the capital adequacy ratio) is defined as D =RWA + 12. standardised and internal measurement approach.08(RWA +12.5{capital charges on account of operational risk}) To meet market risk special type of capital viz.5 to make it comparable to RWA. In Advanced internal rating based approach the range of risk weights are well diverse. 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. For meeting operational risk Accord II has specified three alternative approaches. For Market Risks also a similar twin track approach is followed.

5 9. Minimum capital adequacy ratio of 8 % implies holding of Rs. 100 risk weighted assets.2 10.4 10.soundness of banks.3 Capital Adequacy Ratio (%) 16 14 12 10 8 6 4 2 0 SBI ICICI HDFC IDBI Banks OBC CBI 2003 2004 72 .36 12.9 11.47 2004 14. 8 by way of capital for every Rs. 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.1 10.4 10.8 9. SBI ICICI HDFC IDBI OBC CBI Capital Adequacy Ratio (%) 2003 14 11.56 12.

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. continuous monitoring and evaluation of the risk profiles of the supervised institution and construction of a risk matrix of each institution. 2) The terms and main features of capital instruments. discriminates against smaller banks and exacerbate cyclical fluctuations.Supervisory Review Process It entails allocation of supervisory resources and paying supervisory attention in accordance with risk profile of each bank. 3) Breakdown of risk exposures. banks are encouraged to disclose ways in which they allocate capital among different activities. 73 .  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. 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.  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. 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. Moreover. 4) Its capital ratio and other data related to its capital adequacy on a consolidated basis.

 Asset size determines the length of inspection. earnings.  Focus remains on transaction and asset valuation.  Fears of disintermediation have also been expressed. compliance with regulations and banking laws. 74 . other banks will hold on to the standardised approach. liquidity. asset quality. 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. systems & controls)/CALCS (capital adequacy. liquidity.  Focus of follow up remains on rectification rather than prevention. management. compliance & systems) approach to supervisory risk assessments and ratings. The CAMELS (capital adequacy.  All areas of banks operations are covered. It provides an opportunity to the regulator to monitor banks performance based on CAMELS/CALCS approach. 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. asset quality. The major features of current supervisory are:  Annual Financial Inspection (AFI) of banks. tightening of exposure and enhancement in disclosure standards are all introduced by RBI to align the Indian banking system to International best practices. Only those banks likely to benefit from IRB will adopt approach.

automation and market disclosure / transparency. 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. the principle being higher the risk shorter will be the cycle of supervision. 4) Supervisory Organisation: It is the focal point for main conduit for information and communication between banks and RBI. controls and monitors risks. Sensitivity analysis. 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. 1) 2) Supervisory Cycle: It varies according to risk profile of each bank. Monitorable action plan and banks progress to date. In short term supervisory cycle remains at 12 months but it can be extended beyond 12 months for low risk banks. 5) Enforcement process and Incentive framework: RBS ensures that the 75 . onsite findings.Risk Based Supervision (RBS) – A New Approach RBS looks at how well a bank (supervised) identifies. increased competition. globalisation. 3) Supervisory Programme: It is prepared at the beginning of supervisory cycle. adhoc data from external and internal auditors. 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. RBI decided to switch over to RBS due to autonomy of banks.  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. measures. 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.

Moreover. assesses and aggregate risks that bank are exposed to. strengthen MIS. adopts Risk Focussed Internal Audit (RFIA). Hence.banks with a better compliance record and a good risk management control system is entitled to an incentive package like longer supervisory cycle. Moreover. RBI initiates banks to set up Risk Management Architecture. catalogues. well-documented policies and practices with clear demarcation of lines of responsibility and accountability. The effectiveness of RBS depends on bank preparedness. 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). fix up supervisory cycle and supervisory tools. There should be well-defined standard of corporate governance. banks that fails to show improvement in response to MAP is subject to frequent supervisory examination. 76 . It works as a comprehensive guide to RBI for informed and focussed supervisory action in high-risk areas in banks. RPTs is defined as a standardized and dynamic document that captures.

CHAPTER VIII ANALYSIS OF SURVEY RESPONSES 77 .

HDFC. IDBI. 78 . 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. Oriental Bank of Commerce concentrates only on credit risks.There are certain parameters on which bank degree of readiness for risk management is ascertained. all the six banks report that contingent liabilities fall within purview of their risk management processes. group and industry  Frequency of Loan account review In this parameter ICICI. Among the PSU it’s only SBI and Central Bank of India.  All the banks follow Integrated Risk Management Practices.e it covers credit.  On the matter of Exposure Limits all the banks surveyed define it in terms of counter party.  Internal Credit Rating Models All the banks follow internal credit rating model. Moreover.  Documented Risk Management Policy All the private sector banks surveyed have 100% documented risk management policy i.  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. This high percentage among banks shows an adoption of scientific approach to credit risks in Indian Banking sector. However. SBI. market and operational risk. which covers all the three aspects of risks. As regular analysis of the loan portfolio feed into banks lending strategy.

 Evaluating Credit Risk at Portfolio level To have a comprehensive understanding of credit risk banks evaluate credit risk at portfolio level. 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. HDFC bank is also termed to be the best in industry in portfolio quality.  Periodic Review of Liquidity Position SBI.  Daily VaR (Value at Risk ) of Investment Portfolio IDBI. IDBI does not review the liquidity position periodically. ICICI. 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. 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.IDBI. Over 85 % of the corporate credit portfolio is now rated “A” and above in IDBI. SBI.  Limits on Derivative transactions 79 . SBI. interest rate risk is also important in Indian banking system. HDFC banks carries out such analysis whereas in public sector banks this analysis is carried out only by SBI.  NII (Net Interest Income) Sensitivity Analysis The surveyed banks are carrying out regular NII Sensitivity Analysis. OBC. ICICI. HDFC periodically review their liquidity position under normal and stress scenarios whereas OBC.  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.

ICICI. HDFC Bank and SBI seem to fairly hedged w.e accounting disclosures and stock market approach. which have large exposures by both. Central bank of India finds difficult to collect reliable data. IDBI. approaches i.  While putting the risk management in place HDFC.  OBC.  SBI. None of the banks surveyed follow this approach. Banks like Oriental Bank of Commerce and ICICI bank have sophisticated technologies. as it’s the area where structural focus is relatively nascent. ICICI.  ICICI Bank. 80 .  Banks following Score card approach Scorecard approach is followed for operational risk mitigation. HDFC. IDBI. SBI. 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. IDBI Bank stand out as banks. HDFC bank there is good agreement between the results from two approaches. as they didn’t comment on this.  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. 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. ICICI banks maintain a certain level of investment fluctuation reserve to guard against any possible reversal of interest rate.r.This is one of the essential components of market risk control. OBC. ICICI banks have operational risk management system but rest of the surveyed banks did not have. OBC.t interest rate risk.  It is striking to observe that three banks with best stock market liquidity SBI.

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. OBC captures risk data on regular basis whereas other bank do not capture data on regular basis. which aggregate risk parameters on live basis.  State Bank of India is teaming with KPMG Consulting Pvt. ICICI. 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.  Capture of Risk data on regular basis Banks such as SBI. other banks did not comment on this. (international consultant) for software solutions. bank need to have a separate department of IT professionals working full time on product design and development. 81 . 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. SBI.  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. Moreover. 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. Ltd. But finally the decision regarding this rest on efficiency and accuracy in valuation and consequent risk analysis. However.

9 9.03 14.79 18.9 2.1 10.5 20.4 HDFC IDBI OBC CBI 2004 2005 2004 2005 2004 2005 2004 2005 0.7%.5% for ICICI bank.8 10.86 1.4 Ratio (%) Net Interest Margin (%) 3.79 Capital Adequacy 14.1 3.  Net Interest Margin = Net Interest Income/Earning Assets where Net Interest Income = Total Interest Income . 82 . 3.36 1.3 21.56 10.3 3.5 10.Cash Balance .02 0.8%.36 12. 3.8 1.2 23.7 3.75 3.9 4.8 11.5 11.Table No. The reason for this is the larger retail base that result in being able to raise capital in small lots.7 27.91 1.09 3. CBI and OBC bank in year 2005 while it is 1.89 1.1 20.8 3. IDBI and HDFC bank.05 18.7% for SBI.3 22. It is at level of 3%.65 20.4 21. The impact of volatility on the short-term profits is measured by Net Interest Margin. 2.Total Interest Expenses Earning Assets = All Interest earning assets (Total Assets .21 9.16 ICICI 2004 2005 1.4 1.7%. 6 Table showing key performance indicators determining the profitability of banks Key Performance (Financial) Indicators SBI 2004 2005 ROA (%) ROE (%) 0.8 11.47 3.Other Asset) This figure is critical component of the analysis of the risks faced by banks and other financial institutions.Fixed Assets .5 21.8 20.2 1.9 1.2 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. 4.5 0.03 0. Only Central Bank of India is the bank among all the six banks.

79%). They do not differ significantly and the difference is in range of 1%.which is able to stabilize short-term profits as net interest margin for year 2004 and 2005 is same (3.  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 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. The private banks have narrower spread as compared to the PSU bank.  AssetUtilization = Total Revenue/Total Assets 83 .  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. This increased competition in the industry has resulted in lowering the spreads under which banks operate. 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. As the private banks have adopted a more aggressive strategy to gain market share and business. 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.  Spread = Yield – Cost of Funds where Yield = Total Interest Earned/Earning Assets The level of spread at which each bank operates is different.

ICICI and IDBI bank asset utilization is of 8%. and CBI is around 10% over the two-year period whereas HDFC.  Burden/Spread Burden is the Net Non Interest Income and Spread is the Net Interest expense.The asset utilization ratio for the public sector banks namely SBI. 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. 84 . which is lower than that of the PSU banks. OBC. This makes sense that asset utilization capability of the banks cannot be change rapidly over a short period of time. 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 .

This implies substantial progress from three years ago when risk management was new concept for all except the most advanced and sophisticated banks. Observations initiate further refinements in the existing structure while suggestions provide better guidelines in the efficient working of the organisation. 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. 86 . 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. 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.  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. 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. Hence.The present chapter is divided into two sections. Hence. there are also other 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. proper organisational structure is an essential component of risk management effort. which have started the process of systematic capturing of risk data. First part consists of major observations of study and second part comprises of its suggestions.

 Regulatory and legal issues are not taken into account while setting up of risk management system.  Issues relating to internal audit system.  Procedural Audit reporting risk management is not done. 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. 87 .  Moreover each bank going for risk management implementation is faced with question of whether to outsource and if so how much and to whom.  Quarterly progress reports are not made in order to keep the track record for the progress of bank.  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.  There is absence of binding time frame as for measuring and managing risk comprehensive and credible system is not placed by the specified date. The banks on the software front could not entail investments in databases. It’s much longer before sufficient data aggregation could be carried out for the introduction of sophisticated quantitative approaches demanding sufficient internal measurements. datawarehousing and in sophisticated statistical models as aggregation and analysis of the vast amount of data is needed for successful risk management system. Absence of standardised definition and measurement divergences lead delays in installing and integrating the components of an integrated risk management system.

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

 Procedural Audit of all banks reporting risk management should be done. which will enhance the acceptability of adopting the risk management measures by the employees.  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. selection training and development and efficient compliance officer should be there in addressing risk management issues.  Measuring and disclosing various risks requires sound MIS. Quarterly progress reports should be made which is an effective way of keeping track of progress made by each bank.  New system calls for skilled expertise sophisticated IT infrastructure and a comprehensive database. risk based supervision.  Selection processes of vendors for outsourcing the software solution should not be long drawn.  An efficient asset liability management system should be there which is an adequate tool to identify and mitigate market risks.  There should be an active participation of senior management and main line functional staff in setting up of risk management system. 89 .  Appropriate internal controls and audit.  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.  Monitoring and reviewing risk management process with dynamically changing global environment needs to be undertaken. proper manpower planning. A technological application in the form of networking and data warehousing is indispensable.

 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.  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. 90 . Banks should place more emphasis on the cash flow based lending rather than traditional securities based lending.

ANNEXURE 91 .

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

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 carry out Risk Focussed Internal Audit (RFIA)? Yes ___ No___ 21. Does your bank has documented operational risk management committee? Yes ___ No___ 13. Does your bank outsource or develop in house software for risk management solutions? Yes ___ No___ 24. Do you follow MIS in your bank? Yes ___ No___ No___ 23. Does your bank periodically review its liquidity position? Yes____ 10.Yes____ No ____ 9.Do you feel that there is need to bring a cultural change in 101 . Does your bank comply with Basel II norms? Yes____ No___ 12. Does your bank follow scorecard approach towards operational mitigation? Yes___ No___ risk 20.

organisations towards risk culture? Yes ___ No___ Signature_______ BIBLIOGRAPHY  Basel Committee on Banking Supervision.2001.  Annual Report of all banks (2002-03.  Basel Committee on Banking Supervision. “Working Paper on the Regulatory Treatment of Operational Risk”(September).   102 .2001.  Reserve Bank of India. Report on Trend and progress of Banking in India (various years). 2003-04). IBA Bulletin (Mar 2002.  Report: A Road map for Implementing an Integrated Risk Management System by Indian Banks by Mar 2005 (CRISIL) in IBA Bulletin (Jan 2004). “Sound Practices for the Management and Supervision of Operational Risk” (December). Mar 2003). Websites of all banks studied.

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