“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

Page 1 of 28

“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.
Page 2 of 29

they point out that there is little evidence of any particular relationship between exchange-rate regimes and banking crises. is that they find Indian private banks have higher returns to assets in spite of lower spreads. using bivariate VAR systems. real estate and consumer prices are useful in explaining the profitability of Austrian banks. and the net NPA ratio. According to their empirical estimation results (which were achieved using a panel data of commercial and savings banks from 1985-1997). tries to understand how economic development affects bank loan quality. using a number of indicators: profitability ratio. They conclude that risk provisions increase in period of falling real GDP growth. suggesting that county economic activity does not have a relevant effect on bank performance. however. since systemic financial conditions help predict the soundness of the single intermediaries. Survey on the “Implementation of the Capital Adequacy Directive” by the Banking Federation of the European Union. They also find that some macro-economic variables such as interest rates. Arpa et al.. Shaffer (1998) shows that adverse selection has a persistent effect on the banks which are new entrants in a market. state-level data are significant. macro-economic policies leading to rapid lending growth and financial overheating generally set the stage for future problems. In particular. 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. capital adequacy ratio. 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. They find that none of the county-level coefficients is significant. the cycle (measured through the current and lagged-one-year GDP growth rates) has a Page 3 of 29 . confirming the pro-cyclical tendencies in bank behaviour. whereas falling inflation depresses them. Institutions in the U. 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. April 1998 (covering 17 countries) revealed that very few banks are using sophisticated models for managing their risks. Moreover. the role of the legal and regulatory framework is also uncertain.“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. Domestic interest-rate liberalization often accompanies these excessive lending activities. Most banks which use it at first place use it for internal risk management purposes only. rising real estate prices lead to higher provisions. (2001) study the effects of the business cycle on risk provisions and earnings of Austrian banks in the 1990s. Their findings confirm that unsustainable boom in domestic credit is a robust cause of financial distress. interest spread.S. What is of interest. 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. The conclusion is that Indian private banks outperform public sector banks. 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. and in Australia too for that matter were pursuing risk management not to comply with regulatory requirements but to enhance their own competitive positions. 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). He points out that. On the other hand. it may be interesting to predict the systemic financial conditions themselves. in contrast.

consistent with the hypothesis that cost-inefficient managers are also poor loan portfolio managers ('bad management'). 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. using single-equation OLS estimation for each. Berger and Deyoung (1997) address a little examined intersection between the problem loan literature and the bank efficiency literature. The most important finding pertains to the differences in the impact of foreign ownership between developed and developing countries. 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. In industrial countries. 199394 and 1994-95.S. mortgages have very low delinquency levels compared to consumer loans. and more a correlate of banking opportunities and the operating environment generally. The data set is at banklevel for 80 countries over the period 1988-95. consistent with the hypothesis that the extra costs of administering these loans reduces measured cost efficiency ('bad luck'). The current impact is much more important. is per capita GDP. The data also suggest that low levels of cost efficiency Granger-cause increases in nonperforming loans. The first finding bears out the better NPA performance by foreign banks in India by country of origin. to identify the leading indicators of financial distress. These results suggest that per capita GDP may be less a correlate of banking efficiency or superior banking technology. 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 investment in government securities.“Risk Management in Banks: The AHP way” negative and significant impact on problem loans. Households and firms have different levels of bad loans. the control variables include the (log of) total bank assets. the opposite is true. In the paper by Mario Quayliariello (1997). In developing countries foreign banks have greater interest margins and profits than domestic banks. Among households. the former is lower than the latter. commercial banks between 1985 and 1994. the interest spread (used as an efficiency indicator) and bank profitability. The data suggest that the intertemporal relationships between problem loans and cost efficiency ran in both directions for U. the relationship between bank loan quality and business cycle indicators is studied for Italy. The data suggest that high levels of nonperforming loans Granger-cause reductions in measured cost efficiency. credit loans or overdrafts. Among the macro variables reported by DKH that affect bank profitability positively although not net interest margins (the efficiency indicator). using two performance indicators separately regressed on a set of explanatory factors. On an average. Page 4 of 29 . The 1998 study by Demirgue-Kunt and Huizinga (DKH) is a cross-country study of variations in bank performance. They employ Granger-casualty techniques to test four hypotheses regarding the relationship among loan quality. 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 proportion of loans made to the priority sector. It is also shown that problem loans ratio differs by type of loan. therefore. 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. The Sarkar. cost efficiency. and bank capital. Private banks are divided into traded and non-traded categories. the proportion of semi-urban and rural branches and the proportion of non interest income to total income. for a total of 73 banks.

in one kind or the other. Risks that must be actively managed at the firm level Page 5 of 29 .“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. the hazards that exist in today's business climate are as diverse as the companies that face them. 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. On the basis of which. an abnormally high money growth and the decline in the terms-of-trade anticipate many of the banking crises. weakening of the export sector. from a management perspective. is inherent in every business. usually precede banking as well as currency crises. Risks pose new challenges to every company. monitoring and controlling risks • well laid out procedures. Data and Methodology The current study covers 3 banks and their names have been masked. 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. an attempt has been made to develop an AHP model for the same. capital strength. 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. Judgement sampling method has been used to collect the data. banks too face risks inherent to the company and the industry in which they exist. high real interest rates. Like any other business organization. Although some risks are inevitable. They also find that Credit expansions. they find that recessionary conditions such as economic activity decline. falling stock market. risk taking is essential to progress. nor should it absorb risk that can be efficiently transferred to other participants. It has been argued that risks facing all financial institutions can be segmented into three separable types. RBI circulars and bulletins. from social and political pressures to the vagaries of the weather. Regarding the influence of business cycle on the episode of financial instability and the possibility to identify macro-variables that act as early warning. Secondary data has been collected through published reports. Risks that can be eliminated or avoided by simple business practices. These are: Risks that can be transferred to other participants. 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. Primary data was collected with the help of questionnaires and series of interview schedules. it does not mean that attempting to recognize and manage them will harm opportunities for creativity. Furthermore. and failure is often a key part of learning. Objective of the Present Study Risk. Rather. 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. From employment practices to electronic commerce. The study required both primary and secondary data.

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

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

policy. handling of market risks. 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. the acquisition of meaningful data. It has laid stress on integrating this new discipline in the working systems of the Banks. The risk management structure followed at all banks is a combination of centralized and decentralized form. treasury functionality and culture of risk-rewards are bane of public sector banks. procedures and framework in place. Indeed. There are few banks which have articulated framework and risk quantification. assessment of credits. Whereas private sector banks and financial institutions are somewhat better in this context. Study of risk management system at banks under study Most of the banks do not have dedicated risk management team. The majority of banks associate operational risk with all business lines. market. The traditional lending practices. Since the year 1998 RBI has been giving serious attention towards evolving suitable and comprehensive models for Risk-management. although the mix of risks and their relative magnitude may vary considerably across businesses. 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. is providing a major stumbling block to the overall application of risk management approaches to operational risk. • In 1997. 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. to analyse the operational risk factors and loss events that cause fluctuations in the target. 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.“Risk Management in Banks: The AHP way” a function. After conducting the study it was found that the banks have lowest number of workforce assigned to this department. 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. But this department is a victim of ignorance in today’s scenario. 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. including infrastructure. There are various techniques of risk management to address the different types of risk. Within the Page 8 of 29 . ALM primarily aims at managing interest rate risk and liquidity risk. In view of this. 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. 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. Though risk department forms the heart of the organization because if it fails the bank will gasp for breath. cleared of market and credit factors. the risk management division in most of the banks was established in or after 1998 only. operational and strategic risks. All the details regarding the risk management framework is presented by the bank in a policy document called ICAAP. and was therefore taking risks that they did not see. Those banks have risk management department.

the bank faces a technology risk. 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”. Many banks have made rapid strides in this direction and achieved almost 100% branch computerisation. They achieve greater levels of computerization and coverage of business. if a major portion of their credit concentration loans are in Mumbai’s central suburban area. The private sector banks and the foreign banks have relatively fewer branches. This helps them in better asset liability management where the decisions should be based on timely accurate information. Apart from those risks mentioned under the Basel accord. Separate IT division exists in most of the banks to support Risk Management Department. The bank does not have sufficient skill set for driving risk management function. 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. on account of CBS. it would certainly affect their loan portfolio. The banks still depend heavily on manually prepared returns for its MIS. banks hardly pay attention to other categories of risks. 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 returns for other departments are prepared through different software and this causes difficulty in integration. anywhere” banking. Data collection is the biggest challenge faced. maximum stress is given to credit risk and other risks are still neglected. A pioneering effort of the bank in the use of IT is the implementation of Core Banking Solution (CBS) which facilitates “anytime. Complete IT based implementation of risk management system will take at least 1 or 2 more years. 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. The public sector banks have also made progress in the area of Page 9 of 29 . But on the other side. Also.“Risk Management in Banks: The AHP way” department. For example.

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

“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 . These banks have therefore had the opportunity to make more progress in the implementation of ALM.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. Each of these objectives would affect asset liability management. Management strategy depends on the corporate objective. Some of these may be conflicting. any rational asset liability management and pricing decisions would be difficult. had done so in a period ranging from 2 years to 3 months ahead of the issue of guidelines. • Possible fall in the Interest rates in Future and thus building up a better portfolio as of tomorrow • Investments give maximum contend. Page 11 of 29 . Unless the hierarchy of objectives is clear. All the banks under survey adopted ALM after the issue of guidelines. which adopted ALM before the issue of the guidelines. it is assumed that the asset liability management function must have plenty of support from the management. In fact. The objective can be deposit mobilization. The foreign banks had the advantage of guidance from their head offices abroad where ALM systems were already in place. For instance profitability may have to be sacrificed for branch expansion. 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. The banks under study have mentioned a definite objective in their ALM policy. Having taken the initiative to introduce ALM. The banks. long-term viability etc. branch expansion. the risks associated with banking operations has increased requiring 'strategic management'. 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. 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.

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

Opportunities for Banks from Basel II • Measuring. 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. organizing seminars and training. Periodic back testing and stress testing of the existing models to test their robustness in the changing environment and make suitable amendments. 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. 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. through ICAAP framework Handling interrelationship between businesses. Page 13 of 29 . Setting up of Data Warehouse to provide risk management solutions. Adopting RAROC framework and moving from regulatory capital to economic capital. motivation and support from senior management are essential to help ensure success of Basel II project. Credit risk. Asset and Liability Management. Linkage needs to be established between Funds Transfer Pricing. General issues • Guidance. Competitive pricing in niche areas. • • Challenges faced by banks 1. They use the maturity gap model. • 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. Market risk and Operational risk so that cost allocation can be done in a scientific manner. if required.“Risk Management in Banks: The AHP way” surveyed follow the classification of assets and liabilities recommended by the RBI. For Pillar III requirements.

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

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

however. The following graph shows the movement of NPAs. 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.“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. This increase in profitability can be attributed to efficient operations of banks along with good RBI supervision. Other evidences showing the CRAR levels. 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. the CRAR of nationalised banks at 12. UCO Bank and Dena Bank) have been taken for study. Narrow banking was recommended for these banks. the Operating Profit / Working Funds. The problem in the first three banks started in the 1996-97. Supervisory and regulatory actions were taken to arrest the deterioration of these banks and through a process of recapitalization. gross NPAs (in absolute terms) of nationalized banks and old private sector banks have continued to decline. 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. The bank’s internal management and controls contributed to the success. As at end-March 2008. Though the operating profits increased across all bank groups. Similarly. enough capital was also infused. The improvement was. operating profits of SCBs have increased over the years. Currently these banks are under control. A reason for this progress can be the stringent and conservative approach by RBI. the cases of four public sector banks (Indian Bank. Source: Basic Statistical Returns of Scheduled Commercial Banks in India • • • Bringing improvement in weak banks: Here. followed by SBI and associates. 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). which assure safe returns. Moreover. The following table shows the figures for the scheduled commercial banks. United Bank of India. Improvement in Capital Adequacy: The CRAR data of all the banks (private. when they began showing very poor performance in terms of profits. the increase was more pronounced in respect of new private sector and foreign banks. Supervision was also one of the qualifiers for the same.5 Page 16 of 29 . which were brought under control immediately. wherein all advances are stopped and the investments are limited to those in G-Securities. more pronounced in respect of new and old private sector banks.

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

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

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

“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 .

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

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

33 0.00 Table 2: Normalized matrix for Business Risk Page 23 of 29 .00 0. This rating would help in comparison with other banks in the industry and evaluate the areas of improvement if any.50 Liquidity Risk 4. both parties will need.33 Market Risk 3.00 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environmental Risk Operational Risk Group Risk Capital 1. Exhibits Exhibit 1: Arithmetic model Table 1: Pair wise comparison of Business Risk parameters Credit Risk 2. 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.50 0. not only on the part of RBI but by individual banks also.00 1. a lot of preparations for further strengthening the supervisory mechanism is required.50 0.00 0. etc. market intelligence etc. 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.20 2. Perhaps what is needed most is time. Another option for the regulator would be to refer to benchmark loss experiences. (later Banking Regulations Act.“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.00 0.00 5.00 1. RBI. as was the case with the original regulatory capital ratio set by the Basle Committee. keeping in view international best practices has already taken certain initiatives in this regard and there is a proposal to introduce shortly.20 0.25 Earnings 3.20 1. Consequently. necessary changes in the supervisory system have been made to meet with the new challenges emerging in the financial sector.00 0.50 0. Moreover.00 0.20 0.00 1.20 1. introduction of Securitization. In the wake of rapid changes in the financial sector such as emergence of Universal Banking.20 0.00 5. 1949) the scope of RBI supervision broadened over the years.33 Group Risk 5.00 5. and it is that there are more questions than answers around operational risk for both banks and regulators. 1949. alternatively. By critically examining all the aspects related to risk management. the only real touchstone for this is some sort of reference to current aggregate capital. World over the way financial markets are integrating day by day.50 0.00 5.00 1.00 Operational Risk 2.20 2.20 1.00 0. along with Risk Based Supervision. an AHP model was developed which gave the comprehensive risk rating of the bank.00 Business Strategy & Environmental Risk 5.20 1.00 5.00 2.00 5.00 2.00 3.00 2.50 0.00 2.00 0.20 0.00 5.00 1.20 3. rely on internal economic capital allocation. there was no separate comprehensive enactment for the banking sector.00 1.00 0. corporate governance.50 0.00 5. to enter into an open and technical discussion of the way forward.33 0.00 1.00 0.50 0.00 1.00 0. risk is continuously increasing. With the introduction of the Banking Companies Act. The regulator could. integration of various markets.00 0.00 5. 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. However.20 0. One thing is clear.00 5. the system of Consolidated Supervision too. in the immediate future.00 1.

303 0.114 0.030 Table 3: Pair wise comparison of Controls Risk parameters Internal Controls Internal Controls Management Organization Compliance 1.176 0.150 0.156 0.020 0.060 0.250 Compliance 0.058 Grou p Risk 0.034 0.222 Organization 0.50 1.100 0.013 0.214 Management 0.174 0.101 0.00 2.034 0.00 2.444 0.087 0.075 Credi t Risk 0.00 1.250 0.174 0.194 0.375 0.031 0.00 0.00 Compliance 2.087 0.“Risk Management in Banks: The AHP way” Business Strategy & Environment al Risk 0.111 0.202 0.083 0.202 0.00 1.259 0.030 0.101 0.444 0.00 1.122 0.50 Management 2.100 0.156 0.101 0.301 0.176 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 0.034 0.222 0.50 1.33 0.114 0.227 2 2 Exhibit 2: Geometric Model Page 24 of 29 .060 0.272 0.020 0.156 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environment al Risk Operational Risk Group Risk Capita l 0.058 Marke t Risk 0.176 0.214 0.114 0.064 Operation al Risk 0.156 0.087 0.227 0.156 0.00 Table 4: Normalized matrix for Controls Risk Internal Controls Internal Controls Management Organization Compliance 0.030 0.222 Average 0.00 0.129 0.031 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 0.050 Earning s 0.020 0.150 0.50 0.176 0.101 0.013 0.129 0.156 0.142 0.303 0.202 0.111 0.031 0.156 0.202 0.156 0.122 0.031 0.174 0.348 0.114 0.272 0.227 0.423 0.050 Liquidit y Risk 0.194 0.428 0.020 0.083 0.156 0.00 0.222 0.174 0.087 0.156 AVERAG E 0.034 0.00 Organization 3.423 0.125 0.156 0.348 0.156 0.

2 0.2 1 0.33 Grou p Risk 5 5 1.2 1 0.2 1 1.“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 0.5 0.33 0.86 1 0.29 1 Mean 10.5 Management 2 1 0.5 0.22 0.0289 0.5 1 Organization 3 2 1 2 Compliance 2 1 0.5 0.80 5 0.42 0.2273 0.2 0.1158 0.19 5 0.02 0.028 1 Table 2: Geometric Mean Transformation of Control Risk Internal Controls Internal Controls Management Organization Compliance 1 0.1813 0.29 0.53 Normalized 0.31 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 .2 2 0.2 0.18 0.1813 0.5 Liquidi ty Risk 4 3 2 2 1 Business Strategy & Environme ntal Risk 5 5 5 5 5 Operatio nal Risk 2 1 0.2 0.5 0.5 0.33 0.5 Earnin gs 3 2 1 1 0.25 Cred it Risk 2 1 0.78 1.11 0.87 5 0.39 1 Geometric Mean 1.2697 0.19 5 1.07 0.33 0.12 Table 3: Risk Rating of Bank A Weightages 0.2273 0.4231 0.22 1 Mean 1 4.1221 0.11 Geomet ric Mean 2.0778 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 0.87 Normaliz ed Priorities 0.2 0.1158 0.33 Mark et Risk 3 2 1 1 0.5 0.5 0.2 1 5 1 0.26 0.5 0.2 2 0.2 3 0.18 0.

16 3784.40 21.5 8 Earnin gs 1405.5 5 417.17 0.33 905.50 8. 33 588.33 8.86 2429.5 0.7 2 188.1 9 588.33 0.11 0.00 8.5 8 116. 50 915. 86 1728.33 0.6 7 183.0 0 151.67 36.00 1.02 0.3 4 Cred it Risk 905.2 0.00 3.33 12.00 8.5 4 3 2 2 1 2 1 0.46 2.50 Normalized Row sums/Priori ties 0.67 24.2 2 0.2 1 0.33 4.50 97.58 4.58 Liquid ity Risk 2158.2 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 8.67 36.2 0.00 57.2 1 5 1 0.33 3 2 1 1 0.5 8 27.19 97.00 1. 88 266.25 2 1 0.36 1405.00 5.00 57.36 233.19 588.88 266.5 0 3784.00 2.00 Mark et Risk 21.5 0 233.61 Operatio nal Risk 905.00 13.16 Cred it Risk 12.58 Earnin gs 21.33 8.00 2.5 0 905.5 0.50 3784.58 Operatio nal Risk 12.55 Business Strategy & Environme ntal Risk 5834.88 376.11 0.16 2429.18 0.9 4 7961.14 417.2 2 0.36 632.00 57.00 27.91 1013. 88 376.98 5.72 Grou p Risk 5834.“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 0.30 13.00 Gro up Risk 85.3 151.36 915.5 0.33 5 5 5 5 5 0. 16 632.2 0.33 5.02 Page 26 of 29 . 86 2429. 72 Mark et Risk 1405.98 1.14 97.5 0 915.2 3 0.7 3 Normalized Row sums/Priori ties 0.27 0.33 5.00 21. 19 97.11 0.5 8 266.40 8.00 1.30 3.30 13.17 0.2 0.19 632.33 644.19 376.18 0. 80 7961.27 0.58 0.0 0 588.67 24. 19 376.5 0.46 8.9 4 5658.19 417. 16 2429.47 8.16 632.00 5.2 1 0.07 0.00 151.0 0 1405.16 3784.91 183.50 8.19 588.5 0.00 57.02 0.2 0.58 Row sums 278.3 3 116.3 6 915. 80 2064.7 2 266.6 0.5 2064.5 0.00 5.3 3 8.47 8.33 588.50 36.1 9 417. 61 Row sums 19092. 83 0.6 3 12397.50 36.00 5.00 8.00 4.00 13.00 588.00 12.00 3.00 5.08 Capital Credit Risk Market Risk Earnings Liquidity Risk Business Strategy & Environme ntal Risk Operationa l Risk Group Risk 69.58 Liquidi ty Risk 34.5 3 2 1 1 0.11 0.86 1728.1 9 588.30 2.1 151.00 8. 55 12397.00 Business Strategy & Environme ntal Risk 85.33 4.5 8 69.3 3 79.02 1 Table 3: Another iteration Capit al 644.

33 1 Management 2 1 0.1144 0.“Risk Management in Banks: The AHP way” 9 6 0 3 69600.2743 0.50 4.2698 0.22 0.42 0.00 Row sums 33.0021 -0.00 2.22 Normalized Row sums/Priorities 0.66 77.1149 0.42 0.75 18.33 Compliance 120.22 0.0838 Page 27 of 29 Eigen Value 0.50 34.33 64.08 1251.50 Row sums 530.12 0.00 7.0001 Table 9: Business Risk profile comparison Capital Credit Risk Market Risk Earnings Liquidity Risk Geometric Mean 0.00 Table 8: Calculation of difference Difference between the priorities obtained from the two iterations -0.1764 0.1159 0. 05 1 Table 4: Calculation of difference Difference between the priorities obtained from the two iterations -0.12 0.33 64.0003 0.33 64.5 1 Table 6: Squaring the above matrix Internal Controls Internal Controls Management Organization Compliance 4.83 34.1144 0.0779 Arithmetic Mean 0.08 153.1149 0.0004 -0.50 4.5 1 Organization 3 2 1 2 Compliance 2 1 0.0004 0.50 120.22 1.0029 0.0813 Bank A 2 3 2 2 3 .05 284.75 64.0001 0.5 0.50 17.00 7.22 1 Table 7: Another iteration Internal Controls Internal Controls Management Organization Compliance 64.1159 0.16 4.66 9.00 2.00 Organization 14.1813 0.50 4.0021 Table 5: Pair-wise Comparison of Control Risk Components Internal Controls Management Organization Compliance Internal Controls 1 0.0005 -0.00 2.16 1.16 Management 7.50 Organization 224.83 120.50 Compliance 7.16 4.50 34.00 284.00 17.16 2.2722 0.75 64.0004 0.83 Normalized Row sums/Priorities 0.1781 0.0029 -0.75 Management 120.0029 0.72 34.

1222 0. The Influence of Macro-economic Developments on Austrian Banks: Implications For Banking Supervision. University of California Berkeley..0290 0. Klausner and L.“Risk Management in Banks: The AHP way” Business Strategy & Environmental Risk Operational Risk Group Risk 0.2270 Arithmetic Mean 0. and Bangar. Irwin Publishers. The Economics of Small Business Finance: The Roles of • Private Equity and Debt Markets in The Financial Growth Cycle. and the Liquidity Problem in Banking. Standardised Approach to Credit Risk.4231 0. Risk. Washington D. F.. R. Basel • Bessis. BIS Papers.1813 0. Illinois • BIS Publication (2001). D.C • Demirguc-Kunt. Altman Edward I. Securitization. Wiley • Coyle. John B. Global Professional Publishing. Center for Page 28 of 29 . A.(1998). 849-870 • Berger.1223 0.4231 0. 156. (2000). M. F. USA • Demirguc-Kunt. Political Economy Journal of India 7:1 and 2.0297 2 3 3 Table 9: Controls Risk profile comparison Internal Controls Management Organization Compliance Eigen Value 0. R. Supporting Document to the New Basel Capital Accord • BCBS (2001). A.1781 0.0297 0. & Narayan. (1993).1225 0.2270 0.2274 0.. (2000). Working Paper on the Regulatory Treatment of Operational Risk • _______(2000) Principles for Management of Credit Risk • _______(2000) Range of practice in Banks’ Internal Ratings Systems. Detragiache E. • Journal of Banking and Finance 21. Joel (2002).4236 0. and Udell. Risk Management in Banking.2272 Geometric mean 0.0307 0. Inside the Crisis: An Empirical Analysis of Banking Systems in Distress. Ittner A.D (1998): The Role and Performance of Private Sector Banks in India1991-92 to 1996-97. The New Basel Capital Accord • _______(2001). N.N. Journal of Banking and Finance.(2001).Wiley. The Second Consultative Document. Problem Loans and Cost efficiency in Commercial Banks. "Banking Crises in Emerging Markets: Presumptions and Evidence". The Next Great Financial Challenge.613-673 • Berger. and DeYoung.0290 0. n. A. Paul Managing Credit Risk. Asli and Huizinga. Credit Risk Management: Measuring Credit Risk. IMF Working Paper No. and Pauer F. 7-20 • Arpa M. G. and Udell. Harry (1998). P. Brian (2000).0307 0. N. 2nd edition • Berger. 22. (1997). 1.1764 0. Discussion Paper • _______(2001) Potential Modifications to the Committee’s Proposal • Caouette.2272 0. WPS 1900 • Eichengreen B. Giulini I. (1998). White editors. Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence. World Bank. A. pp. and Gupta. and Arteta C. • Structural Change in Banking.2274 Bank A 3 2 2 2 Table 10: Total risk rating of bank Total Business Risk Rating of Bank A Total Risk rating for Bank A 2 2 Total Control Risk Rating of Bank A 2 References • Ajit. G. in Haas School of Business.

accessed between 15th April 2009 and 10th June 2009 www.“Risk Management in Banks: The AHP way” • • • • • • • • • • • • • • • • • • International and Development Economic Research. Wiley. Discussion Paper Gambera M. "Simple Forecasts of Bank Loan Quality in the Business Cycle". (1999a) Saunders. 7. 359-392 www. for terminology on risk and risk management. Louis Review. in Federal Reserve Bank of St. Salas.com. "Are small Rural Vulnerable to Local Economic Downturns?”. for various reports. www.P.544. www. Chicago. for various reports.115 Elmer Funke Kupper (2000). March. for accessing various news articles and data. accessed between 15th April 2009 and 10th June 2009 Page 29 of 29 . accessed between 15th April 2009 and 10th June 2009 www. S. Credit Risk Measurement: New approaches to Value at Risk and other paradigms. pp. Louis. (2000). Risk Management in Banking.Bhaumik and N. Market Power and Risk Behaviour in Spanish Banks". Workign Papers. (1998). guidance notes.indiatimes. 16-23 RBI Guidance note on Credit risk Management (September 2001).in. Risk Management Systems in Banks (October 1999) RBI Master Circular. Risk: The new management imperative in finance. V. James T. and Yeager T. J. Anthony (1998). Economic and Political Weekly.. (March-April) Rajaraman. n. RBI Guidelines. Are Macro-economic Indicators Useful in Predicting Bank Loan Quality? Evidence from Italy Meyer A. (2001). Supervision and Regulation Department. (1999a). in Federal Reserve Bank of Chicago.org. circulars and other publications. 34: 3 and 4.rbi.org. I. Emerging Issues Series SandR-2000-3.economictimes.chicagofed. Prudential Norms on Capital Adequacy (August 2001).net.caalley.riskglossary. accessed between 15th April 2009 and 10th June 2009 www.Bhatia (1999) NPA Variations across Indian Commercial Banks: Some Findings. St. n. S.gov Mario Quagliariello. USA Shaffer.federalreserve. working papers and other publications.org Gleason. and Saurina.bis. accessed between 15th April 2009 and 10th June 2009 www. (2000).com. Bloomberg Press International Finance Discussion Papers.J. Journal of Financial Intermediation. Deregulation. The Winner's Curse in Banking.

Sign up to vote on this title
UsefulNot useful