“Risk Management in Banks: The AHP way”

By: Diksha Arora PG Candidate, Class of PGDM-2010 BIMTECH, India Abstract Risk is inherent in every walk of life. Banks are, by definition, in the business of taking and managing risk. The paper deals with the study of Risks associated with commercial banks like risk revolving on capital, credit risk, market risk, liquidity risk, earnings risk, business strategy risk, environmental risk, operational risk, group risk, internal control risk, organizational risk, management risk and compliance risk. In the global scenario, the degree to which the models have been incorporated into the Risk Management and economic capital allocation process varies greatly between banks. Through this paper an attempt was made to construct an optimal model using Analytical Hierarchy Programming to find the risk rating of a bank. This model will bring uniformity and help in assessing performance of a bank vis-a-vis another which also forms a part of RBI supervision. Introduction The etymology of the word "Risk" can be traced to the Latin word "Rescum" meaning Risk at Sea or that which cuts. Risk is inherent in every walk of life. Banks are, by definition, in the business of taking and managing risk. With growing competition and fast changes in the operating environment impacting the business potentials, banks are compelled to encounter various kinds of financial and non-financial risks. Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. The various risks that a bank is bound to confront is divided into two categories namely business risks and control risks. Business risk involves the risks arising out of the operations of the bank, the business it is into and the way it conducts its operations. It consists of 8 types of risks namely capital, credit, market, earnings, liquidity, business strategy and environmental, operational and group risk. Control risk measures the risk arising out of any lapses in the control mechanism such as the organizational structure and the management and the internal controls that exist in the bank. Controls risk further consists of internal controls, management, organizational and compliance risk. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken. The three main categories of risks which have a mention in the capital accord are: Credit Risk, Market Risk and Operational Risk. Credit risk, a major source of loss, is the risk that customers fail to comply with their obligations to service debt. Major credit risk components are exposure, likelihood of default, or of a deterioration of credit standing, and the recoveries under default. Modelling default probability directly with credit risk models remains a major challenge, not addressed until recent years. Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. Market risk management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank's business strategy. Operational risk involves breakdown in internal controls, personnel and corporate governance leading to error, fraud, and performance failure, compromise on the interest of the bank resulting in financial

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“Risk Management in Banks: The AHP way”

loss. Putting in place proper corporate governance practices by itself would serve as an effective risk management tool. The practical difficulties lie in agreeing on a common classification of events and on the data gathering process. Risk management in banking designates the entire set of risk management processes and models allowing banks to implement risk-based policies and practices. They cover all techniques and management tools required for measuring, monitoring and controlling risks. The spectrum of models and processes extends to all risks: credit risk, market risk, interest rate risk, liquidity risk and operational risk, to mention only major areas. For centuries bankers as well as their regulators have assessed and managed risk intuitively, without the benefit of a formal and generally accepted framework or common terminology. No longer is it sufficient to understand just the primary risks associated with a product or service. They have to constantly monitor and review their approach to credit, the main earning asset in the balance sheet. Regulators make the development of risk-based practices a major priority for the banking industry, because they focus on ‘systematic risk’, the risk of the entire banking industry made up of financial institutions whose fates are intertwined by the density of relationships within the financial system. Banking failures have been numerous in the past, both in India and internationally. Banking failures make risk material and convey the impression that the industry is never far away from major problems. Regulators have been very active in promoting pre-emptive policies for avoiding individual bank failures and for helping the industry absorb the shock of failures when they happen. To achieve these results, regulators have totally renovated the regulatory framework. They are promoting and enforcing new guidelines for measuring and controlling the risks of individual players. From the banks point of view risk based practices are so important, because banks being ‘risk machines’, they take risks, they transform them, and they embed them in banking products and services. Banks take risk-based decisions under an ex-ante perspective and they do risk monitoring under an ex-post perspective, once the decisions are made. There are powerful; motives to implement risk based practices to provide a balanced view of risk and return from a management point of view; to develop competitive advantages, to comply with increasingly stringent regulations. It is easy to lend and obtain attractive revenues from risky borrower. The price to pay is a risk that is higher than the prudent bank’s risk. The prudent bank limits risk and therefore both future losses and expected revenues by restricting business volume and screening out risky borrowers. It might avoid losses but it might suffer from lower market share and lower revenues. However, after a while, the risk-taker might end with an ex-post performance lower than the prudent bank due to higher losses materializing. Risks remain intangible and invisible until they materialize into losses. Simple solutions simply do not really help to capture risks. All these factors led to the commencement of this study. Literature review Shashi Bhattarai and Shivjee Roy Yadav (2009) review application of Analytic Hierarchy Process (AHP) in the finance sector with specific reference to banking. Their paper also describes feedback from bankers’ community in Nepal on utility of AHP as a decision support tool in the situation of global financial crisis. The relationship between problem loans and the economic cycle is also analysed by Salas and Saurina (2002). Using panel data, they report that the business cycle (proxied by the current and lagged growth of GDP) has a negative and significant impact on bad loans. They also find that credit risk was significantly influenced by individual bank level variables, after controlling for macro-economic conditions.
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The conclusion is that Indian private banks outperform public sector banks. the role of the legal and regulatory framework is also uncertain. Institutions in the U. is that they find Indian private banks have higher returns to assets in spite of lower spreads. According to their empirical estimation results (which were achieved using a panel data of commercial and savings banks from 1985-1997). capital adequacy ratio. interest spread. using bivariate VAR systems. In particular. Salas and Saurina (1999b) have modelled the problem loans ratio of Spanish banks in order to gauge the impact of loan growth policy on bad loans. and in Australia too for that matter were pursuing risk management not to comply with regulatory requirements but to enhance their own competitive positions. Eichengreen and Arteta (2000) carefully analyse the robustness of the empirical results on banking crises using a sample of 75 emerging markets in the period 1975-1997 and considering a huge range of explanatory variables mentioned in previous works. Their findings confirm that unsustainable boom in domestic credit is a robust cause of financial distress. rising real estate prices lead to higher provisions. whereas falling inflation depresses them. Survey on the “Implementation of the Capital Adequacy Directive” by the Banking Federation of the European Union. They conclude that risk provisions increase in period of falling real GDP growth. Ajit and Bangar (1998) present a tabulation of the performance of private sector banks vis-à-vis public sector banks over the period 1991-1997. They find that none of the county-level coefficients is significant. (2001) study the effects of the business cycle on risk provisions and earnings of Austrian banks in the 1990s. using a number of indicators: profitability ratio. What is of interest. Meyer and Yeager (2001) employ a set of county macro-economic variables to test if rural bank performance is affected by the local economic framework. Gambera (2000). tries to understand how economic development affects bank loan quality. On the other hand.. they point out that there is little evidence of any particular relationship between exchange-rate regimes and banking crises.“Risk Management in Banks: The AHP way” In 2001 Boston Consulting Group study confirmed the general impression that North American banks have a clear lead on most of their European and Asian competitors. state-level data are significant. Arpa et al. April 1998 (covering 17 countries) revealed that very few banks are using sophisticated models for managing their risks. and the net NPA ratio. it may be interesting to predict the systemic financial conditions themselves. suggesting that county economic activity does not have a relevant effect on bank performance. the cycle (measured through the current and lagged-one-year GDP growth rates) has a Page 3 of 29 . Most banks which use it at first place use it for internal risk management purposes only. macro-economic policies leading to rapid lending growth and financial overheating generally set the stage for future problems. Shaffer (1998) shows that adverse selection has a persistent effect on the banks which are new entrants in a market. he uses the ratio of delinquencies to total loans and the ratio of non-performing loans to total loans as alternative dependent variables and he estimates a bivariate system for each series of macro-economic variables. He points out that. confirming the pro-cyclical tendencies in bank behaviour. Moreover. They also find that some macro-economic variables such as interest rates. They fit an OLS model when the return on assets and the net loan losses are the dependent variables and a to bit specification for the nonperforming loans. however. Domestic interest-rate liberalization often accompanies these excessive lending activities.S. in contrast. since systemic financial conditions help predict the soundness of the single intermediaries. real estate and consumer prices are useful in explaining the profitability of Austrian banks.

The data suggest that the intertemporal relationships between problem loans and cost efficiency ran in both directions for U. It is also shown that problem loans ratio differs by type of loan. The most important finding pertains to the differences in the impact of foreign ownership between developed and developing countries. the proportion of semi-urban and rural branches and the proportion of non interest income to total income. The first finding bears out the better NPA performance by foreign banks in India by country of origin. using single-equation OLS estimation for each. In developing countries foreign banks have greater interest margins and profits than domestic banks. the opposite is true. using two performance indicators separately regressed on a set of explanatory factors. mortgages have very low delinquency levels compared to consumer loans. for a total of 73 banks.“Risk Management in Banks: The AHP way” negative and significant impact on problem loans. credit loans or overdrafts. They employ Granger-casualty techniques to test four hypotheses regarding the relationship among loan quality. therefore. consistent with the hypothesis that cost-inefficient managers are also poor loan portfolio managers ('bad management'). is per capita GDP. The Sarkar. Private banks are divided into traded and non-traded categories. The data set is at banklevel for 80 countries over the period 1988-95.S. Demirguc-Kunt and Detragiache (1998) estimate a logit model of banking crises over the period 1980-1994 in order to understand the features of the economic environment in the periods preceding a banking crisis and. the relationship between bank loan quality and business cycle indicators is studied for Italy. The study focuses exclusively on an examination of the prediction from the property rights literature about the superiority of private ownership in terms of performance. In the paper by Mario Quayliariello (1997). The current impact is much more important. The 1998 study by Demirgue-Kunt and Huizinga (DKH) is a cross-country study of variations in bank performance. 199394 and 1994-95. cost efficiency. consistent with the hypothesis that the extra costs of administering these loans reduces measured cost efficiency ('bad luck'). Households and firms have different levels of bad loans. and bank capital. The data also suggest that low levels of cost efficiency Granger-cause increases in nonperforming loans. commercial banks between 1985 and 1994. the proportion of investment in government securities. to identify the leading indicators of financial distress. The data suggest that high levels of nonperforming loans Granger-cause reductions in measured cost efficiency. These results suggest that per capita GDP may be less a correlate of banking efficiency or superior banking technology. Page 4 of 29 . Among the macro variables reported by DKH that affect bank profitability positively although not net interest margins (the efficiency indicator). the interest spread (used as an efficiency indicator) and bank profitability. A distributed lag model (which is estimated using ordinary least squares) and bivariate Granger-causality tests are used in order to evaluate the importance of macroeconomic factors in predicting the quality of bank loans measured by the ratio of non-performing loans to total loans. The main target of the research is to understand the contribution that macro-data can offer in capturing the evolution of credit quality and to select a reasonably manageable set of indicators which can act as early warning signals of the banking system fragility. the proportion of loans made to the priority sector. the former is lower than the latter. Among households. In industrial countries. the control variables include the (log of) total bank assets. On an average. and more a correlate of banking opportunities and the operating environment generally. Sarkar and Bhaumik (1998) cross-bank study for India regresses two profitability and four efficiency measures (one of which is the net interest margin) on pooled data for two years. Berger and Deyoung (1997) address a little examined intersection between the problem loan literature and the bank efficiency literature.

capital strength. weakening of the export sector. Risks that must be actively managed at the firm level Page 5 of 29 . RBI circulars and bulletins. Judgement sampling method has been used to collect the data. is inherent in every business. it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. They also find that Credit expansions. an attempt has been made to develop an AHP model for the same. high real interest rates. Rather. nor should it absorb risk that can be efficiently transferred to other participants. Like any other business organization. Objective of the Present Study Risk. usually precede banking as well as currency crises. Risks that can be eliminated or avoided by simple business practices. banks too face risks inherent to the company and the industry in which they exist. Secondary data has been collected through published reports. Data and Methodology The current study covers 3 banks and their names have been masked. Furthermore. It has been argued that risks facing all financial institutions can be segmented into three separable types. the hazards that exist in today's business climate are as diverse as the companies that face them. risk taking is essential to progress. Although some risks are inevitable. from social and political pressures to the vagaries of the weather. in one kind or the other. Primary data was collected with the help of questionnaires and series of interview schedules. from a management perspective. Analysis and Findings Risk management: According to the RBI circular issued on risk management by the RBI the broad parameters of risk management function should encompass: • organizational structure • comprehensive risk measurement approach • risk management policies approved by the Board which should be consistent with the broader business strategies. they find that recessionary conditions such as economic activity decline. The study required both primary and secondary data. Regarding the influence of business cycle on the episode of financial instability and the possibility to identify macro-variables that act as early warning. monitoring and controlling risks • well laid out procedures. and failure is often a key part of learning. These are: Risks that can be transferred to other participants. Risks pose new challenges to every company. On the basis of which. From employment practices to electronic commerce.“Risk Management in Banks: The AHP way” Kaminsky and Reinhart (1996) in their well-known paper on twin-crises study about 25 episodes of banking crises and 71 balance of payments crises in the period 1970-1995. it does not mean that attempting to recognize and manage them will harm opportunities for creativity. effective control and comprehensive risk reporting framework • separate risk management framework independent of operational Departments and with clear delineation of levels of responsibility for management of risk • Periodical review and evaluation The banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it. management expertise and overall willingness to assume risk • guidelines and other parameters used to govern risk taking including detailed structure of prudential limits • strong MIS for reporting. falling stock market. This paper has been undertaken with the objective to critically examine the current risk management practices as directed by RBI and supervision process undertaken by RBI. an abnormally high money growth and the decline in the terms-of-trade anticipate many of the banking crises.

a small German bank. and maintain appropriate levels of reserves and capital. The domains to which they are applied are credit approval. Iridium. if not all. accurately measure and price it. neural networks. Irrespective of the nature of risk. While they recognize counterparty and legal risks. • In 1974. but because the US markets were still open. had a string of losses in forex dealings. KMV model for measuring default risk. Herstatt had not yet been required to deliver $620 million for its side of the trades. The outputs of these models also play increasingly important roles in banks' risk management and performance measurement processes. It went bankrupt at the end of a trading day in Germany. At the time that it went bankrupt. manage proactively.“Risk Management in Banks: The AHP way” The management of the banking firm relies on a sequence of steps to implement a risk management system. of their risk exposure. Drivers of effective credit risk management: These are effective credit risk management as a valueenhancing activity. CreditMetrics. assess. it had already received $620 million worth of forex payments from its US trading counter parties. this is often easier said than done. in both good and bad times. CreditRisk+ and Logit & probit models. Credit risk management: Credit risk management enables banks to identify.. but could not repay due to unexpected low earnings. and more often than not. The credit risk models are intended to aid banks in quantifying. interest rate. credit. it stopped all payments. Accordingly. efficient use of economic and regulatory capital. Bankhaus Herstatt. the satellite telecom company. and US banks lost virtually all of the $620 million. active portfolio management and capital structure decisions. These can be seen as containing the following four parts: Figure: Steps for implementation of risk management systems The banking industry has long viewed the problem of risk management as the need to control four of the given risks which make up most. Some examples of credit risk are: • In August of 1999. aggregating and managing risk across geographical and product lines. consolidating credit lines. The commonly used techniques are econometric technique. developing a holistic approach to assessing and managing the many facets of risks remains a challenging task for the financial sector. the study of bank risk management processes is essentially an investigation of how they manage all these risks. viz. The various models covering these techniques and domain are Altman's Z-score model (1968). and optimise their credit risk at an individual level or at an entity level or at the level of a country.5 billion that it had borrowed to launch the satellites. customer profitability analysis. credit rating determination and risk pricing. foreign exchange and liquidity risk. it was the end of the trading day in Germany. the best way for banks to protect themselves is to identify the risks. defaulted on two syndicated loans of $1. Because. However. optimisation models. Page 6 of 29 . they view them as less central to their concerns. rule based and hybrid systems. risk-based pricing.

• Private Banks and foreign banks have made the most progress. Some of them had a head start in ALM.64 points. most of the interest rates have been deregulated. equity prices. Market risk management: Market risk is defined as the uncertainty in the future values of the Group’s on and off balance sheet financial items. exchange rates and the liquidity position of the bank. 1997 the BSE SENSEX had lost 302. an exercise of informal discussion and unstructured questionnaire was conducted at the banks under study. being an emerging market. • Banks have also made an attempt to integrate ALM and management of other risks to facilitate integrated risk management.“Risk Management in Banks: The AHP way” ensuring that the bank has a safe level of capital. • All of the banks have set up ALM function and established the requisite organizational framework consisting of the ALCO and the support groups. pricing loans to earn attractive risk-adjusted profits. The drivers of market risk are equity and commodities prices. They have not made the progress that could possibly have been made considering that their problems are not of the magnitude of some other banks.g. In Indian market. Duration analysis. Some examples of market risk exposure are: • On March 31. The ALM process allows an institution to take on positions. Few highlights are given as: • The banks have been making progress in the area of Asset Liability Management. 1998 the BSE SENSEX fell a whopping 224 points and undoubtedly this day is the Black Monday in the history of Indian stock exchanges. with a few exceptions free to determine the interest rates on deposits and advances. • Banks are complaint with the regulatory requirements of the RBI regarding the preparation of statements. Asset liability management: ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates. They have also laid out policies and maintain records as required by the guidelines. scope and functions of these bodies are in accordance with the guidelines. resulting from movements in factors such as interest rates. liquidity and inefficiency are the major concerns in the forex. government securities are sold in auctions and banks are also. the more critical the ALM function within the enterprise. All these factors contribute to the market risk of the bank. • In October 5. and foreign exchange rates. one of the biggest losses in a single day. their volatilities and correlations. applying economic capital’s trio of core decision making criteria. which are otherwise deemed too large without such Page 7 of 29 . To analyze the market risk management techniques. interest rates. Hence the ALM function is not simply about risk protection. Value-at-Risk (VAR). In recent years in India. use of derivatives to reshape credit profile and technology. Market risk can be measured and managed through the use of Maturity gap analysis. which has been attained in banks abroad. The more leveraged an institution is. Stress Testing and the Greeks. effect on stock markets during Indo-Pak tension and the recent Government change). debt and stock markets. But they are still far from achieving the level. Convexity. Many of them have also achieved 100% coverage of business by ALM. foreign exchange rates. The composition. It should also be about enhancing the net worth of the institution through opportunistic positioning of the balance sheet. Panic and knee jerk reactions are also common (e. Market risk can be classified into directional and non-directional risks.

Those banks have risk management department. Though risk department forms the heart of the organization because if it fails the bank will gasp for breath. Most of the financial institutions processes are encircled to ‘functional silos’ follows bureaucratic structure and yet to come up with a transparent and appropriate corporate governance structure to achieve the stated strategic objectives. including infrastructure. It has laid stress on integrating this new discipline in the working systems of the Banks. In view of this. • In 1997. operational and strategic risks. But this department is a victim of ignorance in today’s scenario. The risk management structure followed at all banks is a combination of centralized and decentralized form. All the details regarding the risk management framework is presented by the bank in a policy document called ICAAP. cleared of market and credit factors. Some examples of operational risk are: • A US government bond trader at the New York branch of a Japanese bank was able to switch securities out of customers’ accounts to cover credit losses which mounted to over $1 billion in 10years. Indeed. After conducting the study it was found that the banks have lowest number of workforce assigned to this department. the acquisition of meaningful data. handling of market risks. ALM primarily aims at managing interest rate risk and liquidity risk. the risk manager’s role is restricted to pre fact and post fact analysis of customer’s credit and there is no segregation of credit. The majority of banks associate operational risk with all business lines. treasury functionality and culture of risk-rewards are bane of public sector banks. The major conclusions as listed below have been arrived on the basis of the documents supplied and informal discussion held with the officials of the bank. although the mix of risks and their relative magnitude may vary considerably across businesses. Whereas private sector banks and financial institutions are somewhat better in this context. There are various techniques of risk management to address the different types of risk. The sheer size and wide coverage of banks is a big hurdle to integrate and generate a cost effective real time operational data for mapping the risks. There are few banks which have articulated framework and risk quantification. policy. to analyse the operational risk factors and loss events that cause fluctuations in the target. is providing a major stumbling block to the overall application of risk management approaches to operational risk. Study of risk management system at banks under study Most of the banks do not have dedicated risk management team. market. Operational risk management techniques come in two basic varieties —bottom –up or top down approaches take aggregate targets such as net income or net asset value. The traditional lending practices. Since the year 1998 RBI has been giving serious attention towards evolving suitable and comprehensive models for Risk-management. assessment of credits. the risk management division in most of the banks was established in or after 1998 only.“Risk Management in Banks: The AHP way” a function. Within the Page 8 of 29 . and was therefore taking risks that they did not see. Nat West lost $127 million and had to greatly reduce its trading operations because its options traders had been using the wrong data for implied volatility in their pricing models. Operational risk management: Many banks have defined operational risk as any risk not categorised as market or credit risk and some have defined it as the risk of loss arising from various types of human or technical error. procedures and framework in place.

This helps them in better asset liability management where the decisions should be based on timely accurate information. if a major portion of their credit concentration loans are in Mumbai’s central suburban area. maximum stress is given to credit risk and other risks are still neglected. Data collection is the biggest challenge faced. Complete IT based implementation of risk management system will take at least 1 or 2 more years. They achieve greater levels of computerization and coverage of business. Many banks have made rapid strides in this direction and achieved almost 100% branch computerisation. The bank does not have sufficient skill set for driving risk management function. The banks still depend heavily on manually prepared returns for its MIS. Apart from those risks mentioned under the Basel accord. But on the other side. The public sector banks have also made progress in the area of Page 9 of 29 . it would certainly affect their loan portfolio. Some of the risks not addressed by most of the banks are: • Interest rate risk in the banking book • • • • • • Settlement risk Reputational risk Strategic risk Legal and compliance risk Risk of under estimation of credit risk under the standardized approach Model risk • Residual risk of securitization The bank can also be exposed to a different category of risk apart from the financial risks called the environmental risk. Separate IT division exists in most of the banks to support Risk Management Department. on account of maintaining a separate “risk management function” include following: • Improvement in productivity • Enabling risk adjusted performance • Improved assessment of product profitability • Use of risk sensitive approach in business processes • Better pricing of products and consumer segments • Developing skills for risk transfer products • Competitive advantage • Fraud reduction/deduction • Better understanding and scrutiny of all functionalities of the bank. The private sector banks and the foreign banks have relatively fewer branches. The benefits in the next two years. If some calamity or unforeseen event happens in that area like extensive rainfall incident that took place in 2006-07. anywhere” banking. For example. banks have always looked at technology as a key facilitator to provide better customer service and ensured that its ‘IT strategy’ follows the ‘Business strategy’ so as to arrive at “Best Fit”.“Risk Management in Banks: The AHP way” department. the bank faces a technology risk. on account of CBS. banks hardly pay attention to other categories of risks. The returns for other departments are prepared through different software and this causes difficulty in integration. A pioneering effort of the bank in the use of IT is the implementation of Core Banking Solution (CBS) which facilitates “anytime. Also.

Unlike US based banks the approaches used in Indian banks are less advanced and more conservative in nature due to stringent RBI guidelines. Banks make use of a diversified media for advertisements which helps them to reach out to the masses more effectively and efficiently. Strategies adapted by banks to overcome risks include: • Integrative growth • Intensive growth • Downsizing older business Page 10 of 29 . Attention has been drawn towards liquidity risk management which has emerged to be one of the most crucial risk management forms. Banks do not feel any risk fatigue. At Indian banks securitization occurs at a very low level. But on the other hand banks do not carry the exercise of forensic audit also. service control and they satisfy customer complaints to achieve customer satisfaction. All the banks use all the tools like feedback. The threats Exposed to the Banks consists of: • Competition • Less of customers • Volatility in the market share • Attention • Threat of new entrants It is seen that competition is exposed to all the banks equally and is the most important threat that they are exposed to. the number of branches covered is still low. the competitive advantage of banks can range from Human Resource base to its marketing abilities. Further. Basel II compliance efforts have led to improvement in their risk management system. For a large scale bank number of corporate clients is more. The bank is now able to measure residual risks. while coverage of business is high. Sooner or later the banks expect Basel III that will include liquidity risk under pillar 1. With Basel-II compliance the bank was able to articulate the need for external ratings and data integrity. Also. Therefore there has not been a drastic impact of the subprime crisis on the Indian banking industry. In fact high degree of realisation exists where it is believed that a control from a number of regulatory bodies has protected the system from the failures like that of subprime crisis.“Risk Management in Banks: The AHP way” computerization but have not achieved complete coverage of business. The main challenges faced by the operational risk management department are: • Quantification of operational risk • • • Reporting of the near miss events. Less stress on operational risk by the top management Less available manpower in operational risk management department The customer profile of all banks consists mainly of individuals and Corporate. The top revenue earners of all banks are Corporate. It may therefore mean that the public sector banks will take more time to achieve complete coverage of business by computerization as the number of branches to be covered will be high whereas the percentage of business covered will be lower.

These banks have therefore had the opportunity to make more progress in the implementation of ALM. long-term viability etc. all the public sector banks introduced ALM in compliance with the guidelines and therefore have had less time compared to the others to evolve their systems. any rational asset liability management and pricing decisions would be difficult.Performing Assets • High Costs of Servicing • Greater Political Interference • Stricter Formalities to be compiled with • Falling demand & the Pressure on the Banks The reason as why targets set for loans have not reached by banks includes: • Projects Placed were not Feasible or Risky in the Respective Category • Inadequate Security Provided by the Borrowers • Large No. Management strategy depends on the corporate objective. All the banks under survey adopted ALM after the issue of guidelines. branch expansion. The foreign banks had the advantage of guidance from their head offices abroad where ALM systems were already in place. Some of these may be conflicting. The banks. • Possible fall in the Interest rates in Future and thus building up a better portfolio as of tomorrow • Investments give maximum contend. Unless the hierarchy of objectives is clear. Each of these objectives would affect asset liability management. For instance profitability may have to be sacrificed for branch expansion. The objective can be deposit mobilization. it is assumed that the asset liability management function must have plenty of support from the management. of Borrowers Whose Credit Worthiness is not Satisfactory • Fear of NPA's Opinion of Banks for the Trend towards Investments in government securities include: • Large Availability of Government Securities in the Market. The banks under study have mentioned a definite objective in their ALM policy. In fact. which adopted ALM before the issue of the guidelines. Page 11 of 29 . Having taken the initiative to introduce ALM. the risks associated with banking operations has increased requiring 'strategic management'. had done so in a period ranging from 2 years to 3 months ahead of the issue of guidelines.“Risk Management in Banks: The AHP way” • Diversification Banks have given following as reasons for high incidence of NPAs • Improper Loan Appraisal System by Banks • Poor Risk Management Techniques as a Contribution to NPA's • Lack of Strong Legal Framework to initiate action • Incorrect Evaluation of the Credit Worthiness of the borrower • Poor Loan Monitoring • Poor Recovery Mechanisms Analysing the reasons that has led to loans becoming unpopular with the banking industry: • High Incidences of Non . as Risk is reduced very much as compared to that of loans and Advances • There is at least an amount of satisfaction that some Income may be leaped with least or no risk at all • Regulating requirement: SLR In the note attached with the guidelines it is mentioned that with liberalization.

It is probably the main factor in the ALM. the banks have ensured that the ALM function has large coverage extending over their many operational areas. Now the banks approach this problem through behavioural analysis. All the banks under study had this principle in place. The banks while adhering to this composition have also included other departments' representatives. even when in the form of loans. All of the banks surveyed have an ALCO in conformity with the guidelines. Until the banks are able to achieve daily data collection. International Banking and Economic Research can be members of the ALCO. The ALM in most banks has this scope. knowledge of the details of the ALM process and requirements in their own bank is lacking. Management of other risks. Profit planning and growth projection and Trading RM. Decisions will continue to be made on stale data and the bank's management will not be able to adapt quickly to changes in the external environment. This is a large and significant proportion of the assets and liabilities. RBI had asked banks to achieve 100% coverage of assets and liabilities by April 1st 2002. Some banks have opted to train all of their officers in this field. All of the banks have conducted training programmes on ALM. One of the banks has also adopted a system where other departments are invited based on the agenda of the meeting. would not result in much accuracy. Interest rate RM. As on March 31. 2008. Since all of these activities have come under the purview of ALM. The guidelines state that that the heads of Credit. the ALM function will not be very effective. ALCO support groups are also in existence in almost all the banks surveyed whereas the composition of the support groups varies. But while such training as has been imparted would raise the awareness among the staff about what ALM is. Some of these banks consist of those using the ABC approach. Profit planning and growth projection found place in none of the bank’s policy. This type of software would require far more frequent data collection than exists currently. The majority of the banks have opted for specific software for ALM. The head of IT should be included in the committee. Such software can greatly assist in scenario analysis and simulation as well as generation of statements. Given the difficulty in forecasting.“Risk Management in Banks: The AHP way” Stress testing framework based on scenario and simulation techniques which is based on historical data to ensure plausibility is applied at few banks but not all. Not all banks have clearly defined policies for management of other risks apart from those under pillar 1. The RBI guidelines state that the ALCO should be headed by the CEO/Managing Director of the bank. the coverage while compliant with RBI guidelines. Investment. On the liabilities side the principal items with no fixed maturity are the current and savings bank accounts. It would also necessitate the building of a database. On the assets side this includes practically all of the working capital finance. This is to ensure top management support to the ALM function. All of the banks Page 12 of 29 . Certain banks do not have a trading book and therefore do not have trading risk management. Raising the level of such awareness would help in better data collection at the branch level and especially help those banks where full computerisation has not been achieved. It is the process of capturing the assets and liabilities as per the buckets given by RBI. the asset liability management function assumes greater importance. Information requirements: The banks are trying to upgrade the frequency of the data collection. Funding and capital planning. for the scheduled banks together current account and savings bank deposits formed about 28% of external liabilities: again the bulk of the loans and advances (40% of assets) was probably working capital finance. Fund Management/ Treasury. Indian banks have a very significant proportion of assets and liabilities with no fixed maturity. Some of the banks have achieved this target. Many have been internally developed and conducted. By involving various departments in the ALCO. Much of this contractually repayable on demand but in practice it is subject to more or less automatic rollovers. The guidelines outline the possible scope of ALM in banks which include Liquidity RM.

motivation and support from senior management are essential to help ensure success of Basel II project. if required. Setting up of Data Warehouse to provide risk management solutions. Page 13 of 29 . Opportunities for Banks from Basel II • Measuring. through ICAAP framework Handling interrelationship between businesses. Linkage needs to be established between Funds Transfer Pricing. Managing and Monitoring Risk in a scientific manner • Align risk appetite and business strategy • Risk Based Pricing • Effective Portfolio Management • Optimum utilization of Capital • Enhance shareholders’ value by generating risk adjusted return on capital Benefits of moving to advanced approaches • Relief in Capital Charge • Risk based Pricing – focus on identified business areas. organizing seminars and training. They use the maturity gap model. Periodic back testing and stress testing of the existing models to test their robustness in the changing environment and make suitable amendments. banks should disclose information that are easily understood by the market players and gradually move to disclosure of information requiring advanced concepts and complex analysis. For Pillar III requirements. Integrating risk management with operational decision making process by conducting periodic use tests. Putting in place a comprehensive plan of action to capture risks not captured under Pillar I.“Risk Management in Banks: The AHP way” surveyed follow the classification of assets and liabilities recommended by the RBI. Market risk and Operational risk so that cost allocation can be done in a scientific manner. • • Challenges faced by banks 1. Asset and Liability Management. Credit risk. General issues • Guidance. Competitive pricing in niche areas. • Image/Prestige • International recognition/benefits in dealing with Foreign banks • Risk Control Action Points for Effective Implementation • Grooming and Retaining Talent • • • • • • Percolating risk culture across the organization through frequent communications. Adopting RAROC framework and moving from regulatory capital to economic capital.

It is a systems based inspection approach. 4. • Rigorous legal and regulatory framework and less developed secondary market for bonds/ loans etc is a major impediment in development of credit derivative markets. • Banks to customize and tailor make the risk products Legal& Regulatory infrastructure • Steps required for adoption of internationally accepted accounting standards. • Sophisticated risk management techniques require human resources with appropriate skill sets and training. which may create difficulties in mapping and compliance with disclosure criterion if they want to be accredited by RBI. Derivatives& mitigation products • Credit derivative products yet to be introduced in India. The focus of RBS is on the assessment of inherent risks in the business undertaken by a bank and efficacy of the systems to identify measure. • Legal systems will require changes for speedier and effective liquidation of collaterals • The laws governing supervisory confidentiality and bank secrecy would require modifications to permit disclosure envisaged under pillar III. consistent. Embedding good risk mgmt practices into day to day business will be difficult. Evolution of developed market for credit derivative is required to mange credit risk effectively and to get full benefit of risk mitigation. enterprise wide integrated data warehouse pose challenge. • The models under advanced approaches require lot of historical data. • Lack of data driven culture: Historical issues in getting reliable data. corporate governance etc needs to be addressed. MIS and IT • 100% internal IT development is costly • System integration. monitor and control the risks.“Risk Management in Banks: The AHP way” • 2. 3. collection of data is a formidable task. 5. RBI prepares a customized supervisory program. • Operational autonomy. This has been put into practice in various countries. • Banks are awaiting detailed guidelines from the regulator involving regulatory discretion under IRB approach. of data points in LGD. dedicated software for risk assessment. Risk based supervision: The Basel Committee on Banking Supervision has advocated a risk-based supervision of banks as stability of the financial system has become the central challenge to bank regulators and supervisors throughout the world. data-backed decisionmaking has not been very prevalent. only data that was necessary to ease operational processes was captured. • In India banks/ FI’s are having stake in rating agencies that may impact their independence. In pursuance of that risk profile. realistic and prudent rules for asset valuation and loan loss provisions reflecting realistic repayment expectations. Credit rating agencies • Limited no of agencies and insignificant level of penetration • At present default rates are disclosed by CRISIL only and other agencies are yet to declare. structured. This is a robust and sophisticated supervision with adoption of the CAMELS/CALCS approach essentially based on risk profiling of banks. EAD and high impact low frequency events in operational risk may give distorted results. Good risk management involves a high degree of cultural changes. • Short data history and lesser no. Page 14 of 29 .

If actions and timetable set out in the MAP is not met. Compliance and Systems. on-site findings. off-site surveillance and monitoring (OSMOS) data. The objective of prudential regulation and supervision is a banking system that is safe and sound. prudential returns and market intelligence reports. inter face dialogue with the auditors etc. would use a range of tools to prepare the risk profile of each bank including CAMELS rating. CALCS: (Applicable to Indian operations of banks incorporated outside India) Capital Adequacy. sanctions applied. Effectiveness of RBI supervision: For the purpose of study. Supervised entity • it will enhance the bank’s own capability for risk management and risk control • it will provide a built-in incentive of lesser supervisory intervention for the good performer 3. Depositor • The increased attention to risk factors both by the supervisor and the bank itself will reduce the risk of insolvency and provide for greater comfort for deposit protection. Earnings. Asset Quality. Liquidity. • It is to minimise impact of crisis situation in the financial system. • Construction of a Risk Matrix for each institution. the supervised entities and the depositor as shown below: 1. Liquidity and Systems & Controls. impact of supervision on bank’s performance has been assessed in terms of a few parameters Page 15 of 29 . information from other domestic and overseas supervisors. to mitigate risks to supervisory objectives posed by individual banks would be drawn up for follow-up. • The approach is expected to optimize utilisation of supervisory resources. RBI would consider issuing further directions to the defaulting banks and even impose sanctions and penalties. RBS. A monitorable action plan (MAP). Safety and soundness are difficult to define because there are no limits to how safe or sound a bank can be. Asset Quality. • Facilitates implementation of new capital adequacy frame work Benefits of RBS: The RBS holds out a package of benefits of the supervisor. run out of capital or run out of both. • Continuous monitoring & evaluation of risk profile of the supervised institutions. which cause more supervisory concern 2. structured meetings with bank executives at all various levels. Management. ad-hoc data from external and internal auditors.“Risk Management in Banks: The AHP way” CAMELS: (Applicable to all domestic banks) Capital Adequacy. RBI is already using MAPs to set out the improvements required in the areas identified during the current on-site and off-site supervisory process. Supervisor • Deeper understanding of the risks associated with the banks and • Facilitate optimum use of scarce supervisory resources and direct supervisory attention to those banks and those areas within the banks. Banks may fail due to any of the following reasons: run out of liquidity. Objectives of risk based supervision: • RBI follows a carrot and stick system for implementation of Risk Management and Supervisory controls in Banks.

Narrow banking was recommended for these banks. public and foreign) provided in the Reports on Trend and Progress of banking in India of the last few years show that there is a considerable improvement in the capital adequacy of the banks. The improvement was. Reflecting the buoyant growth in noninterest income on the one hand and a relatively subdued growth in operating expenses on the other. problems cropped up in Dena Bank in 2000. Improvement in Capital Adequacy: The CRAR data of all the banks (private. Moreover. Other evidences showing the CRAR levels.5 Page 16 of 29 . The following graph shows the movement of NPAs. the cases of four public sector banks (Indian Bank. The following table shows the figures for the scheduled commercial banks. This increase in profitability can be attributed to efficient operations of banks along with good RBI supervision. however. which were brought under control immediately. which assure safe returns. the increase was more pronounced in respect of new private sector and foreign banks. gross NPAs (in absolute terms) of nationalized banks and old private sector banks have continued to decline. Supervision was also one of the qualifiers for the same. operating profits of SCBs have increased over the years. wherein all advances are stopped and the investments are limited to those in G-Securities. The bank’s internal management and controls contributed to the success. As at end-March 2008. enough capital was also infused. the Operating Profit / Working Funds. followed by SBI and associates.“Risk Management in Banks: The AHP way” Level of NPAs: The trend of improvement in the asset quality of banks continued during the period of study. A reason for this progress can be the stringent and conservative approach by RBI. Source: Basic Statistical Returns of Scheduled Commercial Banks in India • • • Bringing improvement in weak banks: Here. Profitability of Banks: To judge the effect of profitability of banks Net Profit / Loss as a percentage of Total Assets has been taken for study. more pronounced in respect of new and old private sector banks. UCO Bank and Dena Bank) have been taken for study. when they began showing very poor performance in terms of profits. The problem in the first three banks started in the 1996-97. United Bank of India. Similarly. Though the operating profits increased across all bank groups. the CRAR of nationalised banks at 12. Currently these banks are under control. Supervisory and regulatory actions were taken to arrest the deterioration of these banks and through a process of recapitalization. Net NPAs / Net Advances and Return on Assets of the three banks indicate a gradual improvement in the overall health of the three banks (though the improvement in the case of Indian Bank is marginal).

Higher the rating of the prospect. But there are times when banks also fail to perform. it is also desired that bank should also be assigned a rating so that it comes to the rescue of the borrowers. exposure to one risk may lead to another risk.0 per cent). Besides this. the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach Major finding: Devising a model for calculation of bank’s rating based on its risk management practices Models exist for assigning credit rating to borrowers. and the forward-looking banks placed their MIS for the collection of data required for the calculation of Probability of Default (PD). Quarterly visits are being made to the weak banks and also the new banks. RBI is also practicing the same but it does not publish the ratings of these banks. Inter-branch / Inter-bank reconciliation and balancing of books. wherein RBI has taken up special in-house monitoring of certain areas of weakness in the banks. the emphasis laid down by the supervisors on the computerization of the various branches has been successful as a number of branches of both public and private sector banks have been computerized. Also the personnel skills. This helps the bank to identify potential borrowers by determining their credit worthiness. The quantum of outstanding entries has been brought down drastically. This has not only helped the shareholders. while that of all other groups was above the industry level. but now. Page 17 of 29 . The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years. This would be adding depth and dimension to the banking risks. Potential customers find it difficult to determine in which bank they should deposit their money or take loan from. The supervisory process has acquired a certain level of robustness and sophistication with the adoption of the CAMELS / CALCS approach to supervisory risk assessments and rating. but has also helped in keeping the management under a kind of check. Risk management scenario in the future Risk management activities will be more pronounced in future banking because of liberalization. they are also being inspected every year. but now they are inspected annually. viz. Similarly. Earlier the private and foreign banks were inspected once in two years. • Improvement in Inspection and Supervision Method: There has been an improvement in the periodicity of the inspections. higher is his worthiness and lesser are the chances of loss to the bank. The standardized approach was to be implemented by 31st March 2007. thus reducing the fraud prone areas. efficient & integrated manner will be the strength of the successful banks. deregulation and global integration of financial markets.“Risk Management in Banks: The AHP way” per cent was below the industry average (13. more and more information is being brought out to the public. Hence. Hence banks extend loans to the higher rated borrowers. Disclosure Norms: With stricter disclosure norms. the public sector banks were inspected once in four years (besides the Annual Financial Reviews). It assigns the ratings to all the banks under its jurisdiction but keeps it for the discussion with the top management. Presently most Indian banks do not possess the data required for the calculation of their LGDs. • Internal Control and Management: A strong internal control mechanism has been developed in the banks. Exposure at Default (EAD) and Loss Given Default (LGD). As the risks are correlated. therefore management of risks in a proactive. who are now in a better position to assess the performance of the banks. But this model caters to the need of the bank so that chances of loss are minimized.

in this section. In this problem. Here. AHP has been done in three ways in the given section. the rating model suggested henceforth. geometric mean transformation and Eigen value transformation. For this purpose a model has been proposed using which a bank will be assigned such a rating. AHP has been used. Capital risk is the most crucial type of risk faced by banks. The same solution for each verifies the integrity of the model proposed. is purely based on a bank’s risk management framework. 2. Least important/ crucial risks are business and group risk. the criterion/goals are: In case of business risk category (after driving conclusion from above mentioned analysis) 1. It is a multicriteria decision problem. Credit and operational risk are at second level and are equally important. an attempt has been made to give the various banks a rating which would help to determine healthiness of the bank. This software will enable the regulator to just enter the rating of individual risks and the final risk rating of the bank would be generated. Banks have to manage all the risks. Further a C++ program has been developed to make it more user friendly. It can be depicted as: Figure: Hierarchy of business risk In the case of controls risk category: (after driving conclusion from above mentioned analysis) Page 18 of 29 . This rating would describe how successful a bank is as compared to its peer banks. These criterions should be met and suffice to one solution.“Risk Management in Banks: The AHP way” Here. The three methods used under AHP are arithmetic mean transformation method. Two possible ways of solving it are: analytical hierarchy process (AHP) and goal programming. Next most crucial risk faced after capital credit and operational risk is market risk. Due to the limited scope of the study. Earnings risk is also equally important as market risk. So a comparison of all risks has been made to come to a set of criterions. But some risks are important than the others. Liquidity risk is the next most important risk 5. Risk management practices by banks cover almost all the perspectives as they have to manage the risk associated with their each and every business line. 4. Banking industry faces two kinds of risks as shown namely business risk and controls risk. 3. The solution should be true representative of all the criterions. The multiple criterions faced in this problem are with regards to various risks faced by banks.

Internal controls risk the most crucial risk faced. 2. 2.“Risk Management in Banks: The AHP way” 1. 5 . Page 19 of 29 . Here. The step by step procedure is explained as under.S. 2 . 4 . 3. It can be depicted as: Figure: Hierarchy of controls risk Use the coding of risks as: 1 . Step1.e. First = Read L. Management and compliance risk are the next most important risks.First is moderately more important than second. Column cell Arithmetic mean transformation method For this purpose a two phase procedure is followed. 3 .First is slightly more important than second.First is strongly more important than second.H. i.H.e. In the second phase after using statistical tools on the results of the first phase. In the first phase.Both are equally important. Row cell Second = Read R. and 6 deal with in the controls risk category. mapping of risks is done wherein all the risks are compared with each other.S. i. Risk associated with organization is the least important of all. Step 4. and 3 deals with this in business risk category.First is very strongly more important than second. 5. weighted average of individual ratings of risks associated with banks is done.

“Risk Management in Banks: The AHP way” Figure: Flowchart for arithmetic model Geometric Model: Figure: Flowchart for geometric model Eigen model Page 20 of 29 .

They should be more indicative. Suggestions by banks to RBI: Some suggestions were given by the bank officials through the mode of an informal discussion. the Reserve Bank has issued broad guidelines for risk management systems in banks. RBI has modified the CRAR from 8% to 9%. This makes capital a limiting factor. The terms used in the guidelines issued are directly picked from the documents in Basel or those finding implementation in foreign countries. The document requirement for complying by the guidelines of RBI and Basel are highly centered according to international banks. • • RBI guidelines are broader in nature. Hence there is a need to revise the framework of guidelines with an Indian perspective so that the fatigue of writing so many documents can be done away with. The terms should be explained more correctly to all the banks.“Risk Management in Banks: The AHP way” Figure: Flowchart for Eigen value model Mathematically all these models are shown in Exhibits. They are: • Banks are of the opinion that it would ease the processes if regulator comes up with industry wise correlation. there is an increasing trend towards centralizing risk management with integrated treasury management to benefit from information synergies on aggregate exposure. • • Conclusion Worldwide. This has placed the primary Page 21 of 29 . Keeping all this in view. Hence it restricts the natural growth of the bank. as well as scale economies and easier reporting to top management. Hence the regulator should reconsider this. Some scenarios are not at all relevant to Indian markets.

The growth of OTC derivatives markets has facilitated a variety of hedging strategies. the evolution of ALM in commercial banks will be a slow process.“Risk Management in Banks: The AHP way” responsibility of laying down risk parameters and establishing the risk management and control system on the Board of Directors of the bank. standards for collaterals. A more scientific & Quantitative approach is the need of the hour. in view of the diversity and varying size of balance sheet items as between banks. be oriented towards the bank's own requirement dictated by the size and complexity of business. This is not least because regulators. Today. which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. banks may critically evaluate their existing risk management system in the light of the guidelines issued by the Reserve Bank and should identify the gaps in the existing risk management practices and the policies and strategies for complying with the guidelines. When considering operational risk. Thus it can be safely said that Asset Liability Management will continue to grow in future and an efficient ALM technique will go a long way in managing volume. However. implement and monitor. Traditional tools of credit risk management include loan policies. mix. which will determine the interest spread charged over PLR. An intensified interest by the latter in everyday operational losses is likely to reduce the possibility of large losses. market perception and the existing level of capital. in line with some banks. Operational risk management: The best defense against operational risk is to have effective systems and controls. Credit risk management can be viewed at two levels—at the level of an individual asset or exposure and at the portfolio level. maturity. it is likely these questions will become even more pertinent. have to work at both individual and portfolio levels. The banks’ progress in Asset Liability Management will depend on the initiatives of their management rather than on RBI supervision. improve general risk awareness in a company and the regulator will feel that the interests of the consumer are being better safeguarded. rate sensitivity. Credit risk management: Risk management has assumed increased importance of regulatory compliance point of view. has been adequately focused upon. Banks assign internal ratings to borrowers. There is a strong common interest here between the regulator and a bank’s senior management. Given the existing hurdles. But it is also Page 22 of 29 . standards for presentation of credit proposals. Corporations have adopted techniques of ALM to address interest-rate exposures. limits on asset concentrations and independent loan review mechanisms. stipulation of financial covenants. These ratings are also used for monitoring of loans. A significant development has been securitization. While doing so. being an important component of risk. Thus. The challenge for the banks therefore is to put in place the necessary infrastructure that can help them derive the utmost benefit from ALM. liquidity risk and foreign exchange risk. Credit risk management tools. the scope of ALM activities has widened. a focus on remedy rather than advance warning or prevention. it might neither be possible nor necessary to adopt a uniform risks management system. Market risk management: Asset Liability Management as a risk management technique is gaining in popularity as banks are beginning to recognize the need for proper risk management. risk philosophy. Monitoring of non-performing loans has. however. and what level of capital can reasonably be required? In future. prudential limits on credit exposures to companies and groups. it is to be recognized that. credit and operational risk. therefore. how can they best be controlled. are carving out capital to be held specifically against market. therefore. multi-tier credit approving systems. These need to be appropriate to the risks and as easy as possible to understand. ALM has evolved since the early 1980's. Credit risk. ALM departments are addressing (non-trading) foreign exchange risks as well as other risks. delegation of loan approving powers. Techniques of ALM have also evolved. quality and liquidity of the assets and liabilities so as to earn a sufficient and acceptable return on the portfolio. The design of risk management framework should. the regulator faces a similar dilemma to the bank: where are the main risks.

00 0.20 1.25 Earnings 3.00 5.00 1.00 1.00 5.00 0.50 0.00 5. the only real touchstone for this is some sort of reference to current aggregate capital. Consequently. In the wake of rapid changes in the financial sector such as emergence of Universal Banking.20 1.50 0.20 0.00 5.00 2.00 0.00 1.00 Business Strategy & Environmental Risk 5.50 0. the system of Consolidated Supervision too.00 2.20 3. rely on internal economic capital allocation.50 0.00 0.33 0.00 1. etc.00 0.20 0.50 Liquidity Risk 4.20 1. 1949. an AHP model was developed which gave the comprehensive risk rating of the bank.00 0. corporate governance. With the introduction of the Banking Companies Act.33 Group Risk 5.00 0. and it is that there are more questions than answers around operational risk for both banks and regulators.50 0.20 2.20 2. Supervision process: Before 1950s regulation and supervision by RBI was not that stringent as the banking activity was limited to collection of deposits and issue of loans.00 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Risk Operational Risk Group Risk Capital 1.00 5. integration of various markets. both parties will need. in the immediate future.00 0.00 5.00 5. necessary changes in the supervisory system have been made to meet with the new challenges emerging in the financial sector. there was no separate comprehensive enactment for the banking sector. market intelligence etc. along with Risk Based Supervision.00 2.33 0. alternatively.33 Market Risk 3.00 5.20 0.00 0. not only on the part of RBI but by individual banks also. Moreover.00 1.00 1. Exhibits Exhibit 1: Arithmetic model Table 1: Pair wise comparison of Business Risk parameters Credit Risk 2.00 1. However.00 5. World over the way financial markets are integrating day by day.20 0. RBI.50 0. introduction of Securitization. keeping in view international best practices has already taken certain initiatives in this regard and there is a proposal to introduce shortly.00 3.00 1. The problem here is that the data are often not obtainable – availability differs from country to country and business to business – and may not be suitable for operational risk throughout the bank. Another option for the regulator would be to refer to benchmark loss experiences.20 1. By critically examining all the aspects related to risk management. The impact on bank’s key ratios due to banking supervision reveals good results and walking on the same continuum few issues can be stressed upon like technology upgradation.“Risk Management in Banks: The AHP way” because regulators have come to think that operational risk may not be significantly correlated with either of the other two types of risk categories.20 0.00 Table 2: Normalized matrix for Business Risk Page 23 of 29 . as was the case with the original regulatory capital ratio set by the Basle Committee. a lot of preparations for further strengthening the supervisory mechanism is required. risk is continuously increasing.50 0.00 Operational Risk 2.00 0. to enter into an open and technical discussion of the way forward. Perhaps what is needed most is time.00 1.00 2. One thing is clear. 1949) the scope of RBI supervision broadened over the years. The regulator could. This rating would help in comparison with other banks in the industry and evaluate the areas of improvement if any.00 0.00 5. (later Banking Regulations Act.

00 2.111 0.031 0.156 0.150 0.101 0.031 0.122 0.33 0.156 0.214 0.100 0.030 0.020 0.423 0.125 0.101 0.101 0.013 0.087 0.222 Organization 0.250 Compliance 0.00 0.00 1.031 0.083 0.030 0.129 0.“Risk Management in Banks: The AHP way” Business Strategy & Environment al Risk 0.050 Earning s 0.176 0.087 0.00 2.114 0.150 0.194 0.227 Table 5: Risk profile rating of a bank: Business Risk Risk Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Risk Operational Risk Group Risk Total Business Risk Rating of a Bank Rating 2 3 2 2 3 2 3 3 Weightage 0.156 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environment al Risk Operational Risk Group Risk Capita l 0.156 0.030 2 Table 6: Risk profile rating of a bank: Controls Risk Risk Internal Controls Management Organization Compliance Total Control Risk Rating of a Bank Total Risk Rating for a Bank Rating 3 2 2 2 Weightage 0.060 0.129 0.174 0.013 0.301 0.031 0.111 0.122 0.176 0.156 0.087 0.075 Credi t Risk 0.202 0.176 0.348 0.034 0.00 1.00 Organization 3.250 0.174 0.194 0.020 0.272 0.222 Average 0.00 0.174 0.058 Grou p Risk 0.156 AVERAG E 0.020 0.114 0.50 1.423 0.156 0.303 0.348 0.50 1.087 0.222 0.156 0.227 0.156 0.101 0.156 0.202 0.222 0.227 0.259 0.034 0.064 Operation al Risk 0.034 0.114 0.050 Liquidit y Risk 0.303 0.00 Table 4: Normalized matrix for Controls Risk Internal Controls Internal Controls Management Organization Compliance 0.083 0.444 0.227 2 2 Exhibit 2: Geometric Model Page 24 of 29 .00 Compliance 2.020 0.202 0.50 0.272 0.176 0.142 0.50 Management 2.428 0.375 0.214 Management 0.00 1.034 0.114 0.030 Table 3: Pair wise comparison of Controls Risk parameters Internal Controls Internal Controls Management Organization Compliance 1.444 0.100 0.156 0.058 Marke t Risk 0.174 0.156 0.060 0.202 0.00 0.

028 1 Table 2: Geometric Mean Transformation of Control Risk Internal Controls Internal Controls Management Organization Compliance 1 0.39 1 Geometric Mean 1.22 1 Mean 1 4.2 0.33 0.2 2 0.42 0.5 0.“Risk Management in Banks: The AHP way” Table 1: Geometric Mean Transformation of Business Risk Capit al Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environme ntal Risk Operational Risk Group Risk 1 0.18 0.80 5 0.33 0.1813 0.1158 0.5 0.5 0.2697 0.19 5 1.5 Liquidi ty Risk 4 3 2 2 1 Business Strategy & Environme ntal Risk 5 5 5 5 5 Operatio nal Risk 2 1 0.5 0.0289 0.22 0.33 Mark et Risk 3 2 1 1 0.2 1 5 1 0.1221 0.2 3 0.5 Earnin gs 3 2 1 1 0.29 1 Mean 10.33 Grou p Risk 5 5 1.4231 0.5 0.33 0.11 0.29 0.12 Table 3: Risk Rating of Bank A Weightages 0.5 0.0778 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Risk Operational Risk Group Risk Ratings 2 3 2 2 3 Internal Controls Management Organization Compliance Ratings 3 2 2 2 Weightages 0.25 Cred it Risk 2 1 0.86 1 0.5 1 Organization 3 2 1 2 Compliance 2 1 0.26 0.31 0.2 0.0289 Total Business Risk Rating Total Risk rating 2 3 3 2 2 Total Control Risk Rating 2 Exhibit 3: Eigen Value Model Table 1: Pair-wise Comparison of Control Risk Components Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Operational Risk Group Risk Page 25 of 29 .07 0.2 0.2 1 1.78 1.87 5 0.18 0.1813 0.11 Geomet ric Mean 2.2 1 0.5 0.2 2 0.2273 0.19 5 0.5 0.2 1 0.1158 0.5 Management 2 1 0.2 0.02 0.2 0.87 Normaliz ed Priorities 0.2273 0.53 Normalized 0.

67 24.40 21.33 644.00 21.33 5.27 0.2 1 0.02 1 Table 3: Another iteration Capit al 644.7 3 Normalized Row sums/Priori ties 0.2 0.98 1.07 0.58 0.50 97.2 0.00 151.17 0.5 0.88 376.00 2.5 0.5 0 3784.2 2 0.5 0 915.00 Mark et Risk 21.00 3.58 Earnin gs 21.5 3 2 1 1 0.00 57.02 0.50 8.33 5.9 4 5658.00 8.58 4. 16 2429.19 588.“Risk Management in Banks: The AHP way” Risk 5 5 5 5 5 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Risk Operational Risk Group Risk 1 0.5 0 905. 50 915.14 417. 86 1728.6 0.5 0.00 12.00 5. 83 0.18 0.5 8 266.1 9 588.36 1405.2 0.00 Business Strategy & Environme ntal Risk 85. 55 12397.16 Cred it Risk 12.36 632.72 Grou p Risk 5834.67 36.50 Normalized Row sums/Priori ties 0.19 588.00 5.5 8 69.0 0 588. 19 97.5 0.3 4 Cred it Risk 905. 80 7961.55 Business Strategy & Environme ntal Risk 5834.3 3 116.00 57.50 8. 19 376. 16 632. 88 266. 16 3784.11 0.58 Row sums 278.86 2429.33 4.3 6 915.33 0.16 3784.7 2 266.08 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environme ntal Risk Operationa l Risk Group Risk 69.3 151.00 1.02 Page 26 of 29 .17 0.58 Operatio nal Risk 12.16 2429.33 8.2 1 5 1 0.36 233.00 5.50 3784.2 1 5 1 Table 2: Squaring the above matrix Capit al Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environme ntal Risk Operationa l Risk Group Risk 8.00 1.5 0.46 2.11 0.91 183.00 8.33 5 5 5 5 5 0.50 36.14 97.36 915.1 9 417.0 0 1405.11 0.5 4 3 2 2 1 2 1 0.46 8.91 1013. 88 376. 72 Mark et Risk 1405.3 3 8.33 8.25 2 1 0.00 Gro up Risk 85.16 632.33 588.2 1 0. 86 2429.30 13.27 0.2 3 0.00 57.47 8.02 0.5 0 233.1 151.00 1. 33 588.00 8.98 5.00 3.19 97.19 376.2 2 0.67 36.67 24.1 9 588.5 0.3 3 79.50 36.00 4.6 3 12397.58 Liquidi ty Risk 34.19 632.33 905.58 Liquid ity Risk 2158.00 27.30 2.33 12.33 4.5 5 417.47 8.9 4 7961.86 1728. 61 Row sums 19092.33 0. 80 2064.11 0.00 57.5 8 116.2 0.18 0.6 7 183.7 2 188.88 266.30 3.00 588.5 8 27.00 8.19 417.30 13.5 8 Earnin gs 1405.5 2064.0 0 151.61 Operatio nal Risk 905.40 8.00 5.00 2.00 5.33 3 2 1 1 0.00 13.00 13.2 0.

50 Row sums 530.00 284.5 1 Organization 3 2 1 2 Compliance 2 1 0.16 4.22 0.83 120.0004 0.05 284.66 77.00 7.1159 0. 05 1 Table 4: Calculation of difference Difference between the priorities obtained from the two iterations -0.00 Table 8: Calculation of difference Difference between the priorities obtained from the two iterations -0.00 Row sums 33.0813 Bank A 2 3 2 2 3 .33 64.2743 0.16 2.50 34.66 9.22 1.0004 0.0001 0.5 1 Table 6: Squaring the above matrix Internal Controls Internal Controls Management Organization Compliance 4.0029 -0.75 Management 120.1149 0.22 1 Table 7: Another iteration Internal Controls Internal Controls Management Organization Compliance 64.00 Organization 14.00 17.33 64.72 34.16 4.22 0.12 0.1144 0.“Risk Management in Banks: The AHP way” 9 6 0 3 69600.16 Management 7.75 64.00 2.08 153.0021 Table 5: Pair-wise Comparison of Control Risk Components Internal Controls Management Organization Compliance Internal Controls 1 0.0003 0.0004 -0.0021 -0.33 Compliance 120.42 0.1813 0.08 1251.5 0.0029 0.1144 0.83 34.50 4.1149 0.50 Compliance 7.33 64.50 4.1781 0.16 1.50 34.50 Organization 224.0001 Table 9: Business Risk profile comparison Capital Credit Risk Market Risk Earnings Liquidity Risk Geometric Mean 0.0838 Page 27 of 29 Eigen Value 0.12 0.00 2.42 0.2722 0.00 2.00 7.2698 0.75 18.1764 0.50 17.33 1 Management 2 1 0.22 Normalized Row sums/Priorities 0.1159 0.0029 0.0779 Arithmetic Mean 0.50 4.75 64.83 Normalized Row sums/Priorities 0.0005 -0.50 120.

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