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Risk Management in Banks
A Project Report
Vikas Sharma Narsee Monjee Institute of Management Studies, Mumbai 2/17/2012
Market volatility, corporate irregularities and anxious capital markets have shaken the banking industry and highlighted the perils of poor risk management. The past decade has seen dramatic losses in the banking industry. Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour, interest rate positions taken, or derivative exposures that may or may not have been assumed to hedge balance sheet risk. In response to this, commercial banks have almost universally embarked upon an upgrading of their risk management and control systems. Traditional risk systems can't capture the inter-relationships between various risk types across geographies, departments and lines of business. Since the late 1980s, a number of large U.S. banks have invested heavily in systems designed to measure the risks associated with their different lines of business. Risk management in the banking sector is a key issue linked to financial system stability. The immediate purpose of such risk-measurement systems is to provide bank managements with a more reliable way to determine the amount of capital necessary to support each of their major activities and, thus, to determine the overall leverage for the bank as a whole. A large number of banks have implemented new performance measures such as risk adjusted return on capital (RAROC), economic value added (EVA) and Value at Risk (VaR) to control and price their risks. The importance of these risk measurement tools has been greatly magnified by regulators, such as the Federal Reserve and Bank of England, who plan to start using these concepts to calculate the minimum amount of capital that banks must hold. For competitive and regulatory reasons, it is now necessary for all banks to have a sound risk-measurement framework This report aims at: i. ii. iii. Explaining the basic concepts of Risk and Risk Management. Providing quick access to the whys and hows of risk management. Providing easy-to-understand information, including equations and examples that can be quickly applied to most risk measurement problems. iv. Providing information bout how risk measurement is used in the management of risk and probability
Table of Contents
Cover Page………………………………………………………………………..………….…….i Acknowledgement……………………………………….……………………….…..……..........ii Certificate…………………………………………………………...…………………………....iii Objective………………………………………………………………………………………….iv Executive Summary ……………………………………………………………………………..v Literature Review……………………………………………………………………………….1-4 Chapter 1: INTRODUCTION..............................................................................................1-11 1.1. Meaning of Risk and Risk Management 1.2. Risk Management Framework 1.3. Risk Management Components 1.4. Steps for implementing risk management in bank 1.5. Types of risks Chapter 2: CREDIT RISK MANAGEMENT.....................................................................12-23 2.1. Bifurcation of Credit Risk 2.2. Sources of Credit Risk 2.3. Need for Credit Risk Analysis 2.4. Quantifying Credit Risk 2.5. Measurement of Credit Risk Chapter 3: CREDIT RISK AND BASEL ACCORDS..........................................................24-28 3.1. 1998 Basel Accord 3.2. Basel 2 (New) Accord Chapter 4: MARKET RISK MANAGEMENT...................................................................29-43 4.1. Liquidity Risk 4.2. Interest Rate Risk 4.3. Market Risk: Standardized Approach Bibliography .........................................................................................................................44
I. “RISK MANAGEMENT IN COMMERCIAL BANKS” - (A CASE STUDY OF PUBLIC AND PRIVATE SECTOR BANKS), Indian Institute of Capital Markets 9th Capital Markets Conference Paper, By Prof. Rekha Arunkumar Objective: 1) Analysis of the trends in Non-Performing Assets of commercial banks in India. 2) Evaluation of the credit risk management practices in public sector banks vis-àvis private sector banks and suggest a broad outline for the same. Synopsis: Risk is the fundamental element that drives financial behavior. Without risk, the financial system would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain world. The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy. Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of public sector banks. NPAs are the primary indicators of credit risk. Capital Adequacy Ratio (CAR) is another measure of credit risk. The study also intends to throw some light on the two most significant developments impacting the fundamentals of credit risk management practices of banking industry – New Basel Capital Accord and Risk Based Supervision. II. “BANK CAPITAL REQUIREMENTS FOR MARKET RISK: THE INTERNAL MODELS APPROACH”; Economic Policy Review, Vol. 3, No. 4, December 1997 – By Darryll Hendricks (Havard University - Harvard Kennedy School) And Beverly Hirtle (Federal Reserve Bank Of New York) Objective: Understanding the importance of capital requirements of banks in managing market risk.
Narsee Monjee Institute of Management Studies, Mumbai | Vikas Sharma, MBE, 2010-12
MOHAMED HOUKARI AND JEAN-PAUL LAURENT Objective: To derive strategy to mitigate risk associated with Interest rate margin related to bank’s demand deposits at U. Libor rates had gradually increased by nearly 200 basis points. which aims at assessing the volatility of demand deposit’s interest rate margins rather than the volatility of their fair value. IV. MBE. a new kind of hedging strategy. For this. This paper offers an overview of the new requirements. Later on. This hedging strategy mainly works on the platform of Forward interest rates. the Interest Margin Hedge is designed. III. in US. Since the demand deposit's fair value is set as the discounted sum of future cash flows on demand deposits.Summary: The increases prominence of trading activities at many large banking companies has highlighted bank exposure to market risk-the risk of loss from adverse movements in financial market rates and prices. The paper talks about real example where during the year 2005. closely reproducing interest rate scenarios imposing problems for banks to estimate the future value due to the change in interest rates. Brazil’s stock market regulator alleged that between 15th April’09 and 22nd April’09. the information generated by the models should allow supervisors and market participants to compare risk exposures over time and across institutions. bank supervisors in the United States and abroad have developed a new set of capital requirements to ensure that banks have adequate capital resources to address market risk. Reason: Insider Trading (Credit Suisse purchased shares on the basis of price. its computation requires an assessment of future interest rate margins. Mumbai | Vikas Sharma. commercial banks. giving particular attention to their most innovative feature: a capital charge calculated for each bank using the output of that bank's internal risk measurement model. Source – JPMorgan Training and Development Knowledge Repository Fact: On 23rd April’09. The authors contend that the use of internal models should lead to regulatory capital charges that conform more closely to banks' true risk exposures. Credit Suisse made public announcement that it was acting as an advisor in Tema Participacoes SA’s sale to Companhia Energetica de Minas Gerais (another company). “HEDGING INTEREST RATE MARGINS ON DEMAND DEPOSITS” BY ALEXANDRE ADAM. In response. Synopsis: A worldwide study of the Bank for International Settlements shows that risk mitigation in interest rate margins has been a significant concern for banks for the last many years even before the subprime crisis. Credit Suisse purchased shares in the company “Tema Participacoes SA”.S. 2010-12 2 . In addition. CASE STUDY I – “CREDIT SUISSE GROUP”.sensitive confidential information) Narsee Monjee Institute of Management Studies.
CBI arrested the investment secretary of LIC’s Housing parent firm & the CEO of LICHF.153 to settle the allegations. VI. Reason: Bribe (LIC & LICHF Executives accepted bribes to facilitate the approval of large corporate loans for Money Matters’s clients without going through the normal approval process) Action/Impact: On 24th November’2010. Value: On 30th Nov’10.8 million (USD $5. the bank marketed and implemented fraudulent tax shelters to help its approx 2100 wealthy clients evade the payment of federal income taxes. 2010-12 3 . V. Source – JPMorgan Training and Development Knowledge Repository Fact: The Central Bureau of Investigation (CBI) claimed to have uncovered alleged bribes-for-loans scheme in which financial services firm “Money Matters Financial Services” were accused of bribing executives at major state-run financial institutions such as “LIC and LICHF”. Value: CBI has not disclosed full details but CEO of LICHF was alleged to have accepted INR 4. Narsee Monjee Institute of Management Studies. CASE STUDY III –“DEUTSCHE BANK GROUP”. Reason: Tax Non-Compliance/evasion Action/Impact: The bank paid civil penalty. Value: Deutsche Bank agreed to pay USD $553.4 million (USD $15. But bank said that the settlement would not materially reflect its 2010 results. MBE.3 million). Mumbai | Vikas Sharma. fees that it earned through shelter & tax revenue that was prevented because of the bank’s alleged misconduct. Brazil’s stock market regulator announced that it had fined the bank BRL 26. CASE STUDY II – “LIFE INSURANCE CORPORATION (LIC) OF INDIA (LIC HOUSING FINANCE LIMITED-LICHF)”.1 million) by trading shares based on alleged non-public information.7 billion (USD $102. The bank said it will appeal the fine.8 million) in bribes.663. Source – JPMorgan Training and Development Knowledge Repository Fact: From 1996 to 2002.Action/Impact: The regulator estimated that Credit Suisse gained around BRL 8.
emeraldinsight.papers.com/ JPMorgan Training and Development Knowledge Repository Narsee Monjee Institute of Management Studies.ebscohost.com/ http://xtra.com/ http://search.Literature Review References http://www. MBE.ssrn. 2010-12 4 . Mumbai | Vikas Sharma.
housing finance. The fact that contemporary bank risk management employs many of the important theoretical and methodological advances in our field is a source of collective pride. Measuring and quantifying risks is neither easy nor intuitive. Deregulation in the financial sector had widened the product range in the developed market. Risks originate in the forms: .They hold assets that are potentially subject to credit or default risk. 2010-12 5 . whereas Risk is that portion of uncertainty.Chapter 1: Introduction The financial sector especially the banking industry in most emerging economies including India is passing through a process of change. By developing a sound financial system the banking industry can bring stability within financial markets.There may be a mismatch in the maturity of assets and liabilities. this word has been derived from the Italian word “Risicare” which means “to dare”. . which is measurable. the Indian banking industry continued to respond to the emerging challenges of competition.Customer default or adverse movements of markets. any disruption or imbalance in its infrastructure will have significant impact on the entire economy. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. credit cards. It is often used in the same breath as “uncertainty” which is incorrect. 1. Meaning of Risk and Risk Management Defining Risk: “RISK”. risks and uncertainties.1. Then I shall provide some of the theoretical bases for bank risk management with an emphasis on market and credit risks. Simultaneously they have opened new areas of risks also. I shall begin with a discussion of what is risk management. As the financial activity has become a major economic activity in most economies. MBE. . My role in this study is to outline some of the theoretical underpinnings of contemporary bank risk management. Some of the new products introduced are Leverage Buy Out’s (LBOs). why risk management is needed. Mumbai | Vikas Sharma. Narsee Monjee Institute of Management Studies. derivatives and various off balance sheet items. Uncertainty refers to unknown. During the past decade.
2010-12 6 . Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Market. measurement. Greater the risk greater is the potential return and necessarily greater can be the loss. Compliance / legal / regulatory and reputation risks. It involves identification. and identifying those risks which are a hazard and avoid Narsee Monjee Institute of Management Studies. Then why do banks take this risk? The answer to this question lies in the fact that Risk is an integral part of any business environment. This is where the Art or Science of Risk Management comes into the picture. Mumbai | Vikas Sharma. MBE. Generally the banks face Credit. In risk as an opportunity there is a relation between risk and return. Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size. Risk management is about maximizing the probability of maximum returns and minimizing the probability of loss. This is what entices people or organizations to take the risk. Such constraints pose a risk as these could hinder a bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its business. do the business. volume etc. measured and hence an attempt to manage it can be made. Risk management as commonly perceived does not mean minimizing risk. Operational. Defining Risk Management: Risk can be expected. Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. monitoring and controlling risks. complexity business activities. Liquidity.Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. rather the goal of risk management is to optimize risk-reward trade -off. Risk has two distinct phases: Risk as an opportunity and risk as a hazard.
and Risk control. MBE. There should be an explicit procedure regarding measures to be taken to address such deviations. 2010-12 7 . in addition to risk management functions for various risk categories may institute a setup that supervises overall risk management at the bank. An effective risk management framework includes: a) Clearly defined risk management policies and procedures covering risk identification. measurement.3. Risk identification. compliance etc) should be independent from risk taking units and report directly to board or senior management who are also not involved in risk taking. Risk Management Components The process of risk management has three identifiable steps viz. policies and procedures for risk management and procedure to adopt changes. The framework should be comprehensive enough to capture all risks a bank is exposed to and have flexibility to accommodate any change in business activities. internal audit. reporting and control. Banks. b) A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing it. c) There should be an effective management information system that ensures flow of information from operational level to top management and a system to address any exceptions observed. monitoring. acceptance. Such a setup could be in the form of a separate department or bank’s Risk Management Committee (RMC) could perform such function.1.2. the process/systems and procedures to manage risk and the roles and responsibilities of individuals involved in risk management. 1. Risk measurement. The structure should be such that ensures effective monitoring and control over risks being taken. The individuals responsible for review function (Risk review. Mumbai | Vikas Sharma. Risk Management framework A risk management framework encompasses the scope of risks to be managed. d) The framework should have a mechanism to ensure an ongoing review of systems. (a) Risk Identification Narsee Monjee Institute of Management Studies.
This is the most difficult step in the risk management process and the methods.Risk identification means defining each of risks associated with a transaction or a type of bank product or service. Mumbai | Vikas Sharma. 2010-12 8 . structure. which is carried out to assess the current level of risk management processes. Steps for implementing Risk Management in Banks 1) Establishing a risk management long term vision and strategy Risk management implementation strategy is established depending on bank vision. positioning and resource commitments. liquidity risk. focus. MBE. The major alternatives available in risk control are: 1) Avoid the exposure 2) Reduce the impact by reducing frequency of severity 3) Avoid concentration in risky areas 4) Transfer the risk to another party 5) Employ risk management instruments to cover the risks 1. (c) Risk Control After identification and assessment of risk factors. technology and analytical sophistication at the bank. degree of sophistication and costs vary greatly. operational risk. interest rate risk. (b) Risk Measurement The second step in risk management process is the risk measurement or risk assessment. There are various types of risk which bank face such as credit risk. The potential loss is generally defined in terms of ‘Frequency’ and ‘Severity’. the next step involved is risk control.4. Risk assessment is the essemination of the size probability and timing of a potential loss under various scenarios. 2) Risk Identification The second step is identification of risks. Typically banks distinguish the following risk categories: Credit risk Narsee Monjee Institute of Management Studies. legal risk etc.
2010-12 9 . For example assuming that the current risks management score is 30 out of 100. Then it develops a score for the current level of bank risk practices that already exists. Narsee Monjee Institute of Management Studies. risk control and mitigation procedures for each activity line is to be provided.- Market risk Operational risk 3) Construction of risk management index and Sub indices Bank roll out a customized benchmark index based on its vision and risk management strategy. a. credit and operational risk in each line of activity is determined The process workflow organisation. Risk Based Supervision requirements b. For the gap in score of 70 roadmap is developed for achieving the milestones. the relative importance of market. Using risk strategy in the decision making process Capital allocation Provisioning Pricing of products Streamlining procedures and reducing operating costs By rolling out the action steps in phases the bank measure the progress of the implementation. 5) Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans. MBE. 6) Executing the key requirements: At an operational level checklist of key success factors and quantitative benchmark is generated. Basel II compliance c. 4) Defining Roadmap Based on the target risk management strategy/gap analysis bank develops unique work plans with quantifiable benefits for achieving sustainable competitive advantage. Mumbai | Vikas Sharma.
development of integrated risk reports and success measures and alignment of risk and business strategies. Forex Risks: It is the risk that a bank suffer loss due to adverse exchange rate movement during a period in which it has an open position either spot or forward both in same foreign currency. Strategic (Business) Risks: It is the risk in which entire lines of business is succumb to competition or obsolescence as strategic risks occurs when a bank is not ready or unable to compete in a newly developing line of business. which is concurrent with the risk of inadequate loss of key personnel or misplaced motivation among management personnel. foreign exchange equities as well as volatilities of prices. Regulatory Risks: It is the risk in which firm’s earnings value and cash flows is influenced adversely by unanticipated changes in regulation such as legal requirements and accounting rules. Types of Risks Credit Risks: Credit Risk is defined by the losses in to event of default of borrower to repay his obligations or in event of deterioration of the borrower’s credit quality. Mumbai | Vikas Sharma. 2010-12 10 . Operational Risks: It is the risk of loss resulting from failed or inadequate systems. Market Risks: Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities.5. people and processes or from external events.Models to be applied are tested and validated on a prototype basis. MBE. 1. (a) Liquidity Risks : Liquidity Risk consists of : Narsee Monjee Institute of Management Studies. evaluation scores on the benchmark levels specified helps to build up a risk process implementation score. Human Risks: It is risk. Legal Risks: It is the risk that makes transaction proves to be unenforceable in law or has been inadequately documented. Moreover. 7) Integrate Risks Management/Strategy into bank internal decision making process The objective is to integrate risk management into business decision making process which evolves risk culture through awareness and training.
condition to the movement in interest rates. Tata Consultancy Services (TCS). I – Flex Solutions and Infosys Technologies who have vast experience in risk modeling as these players identify the gap in the system and help the banks in devising a risk return model. Narsee Monjee Institute of Management Studies. - Funding liquidity risks: is defined as inability to obtain funds to meet cash flow obligations. NII = Gap * Change in Interest Rate Hence. Mumbai | Vikas Sharma. (Crisil). risk management focus on the identification of potential unanticipated events and on their possible impact on the financial performance of the firm and at the limit on its survival. Risk environment has changed and according to the draft Basel II norms the focus is more on the entire risk return equation. PricewaterhouseCoopers (PwC). Moreover. Risk Management in its current form is different from what the banks used to practice earlier.- Market liquidity risks : arises when a firm is unable to conclude a large transaction in a particular instrument anything near the current market prices. MBE. 2010-12 11 . (b) Interest Rate Risk: It is the potential negative impact on the Net Interest Income and refers to vulnerability of an institution’s financial. banks now a days seek services of Global Consultants like KPMG. The Credit Rating and Investment Services of India Ltd. Boston Consulting Group (BCG).
2010-12 12 . defined by the recoveries that could be made in the event of default. While risk decides the fate of overall portfolio. 2. Hence.1. trading. or customer – specific factors. which is outstanding loan balance as on the date of default and Quality of risk. industry. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. is called portfolio Credit Risk This bifurcation is important for the proper understanding and management of credit risk as the ultimate reasons for failure to pay can be traced to economic. Narsee Monjee Institute of Management Studies. settlement and other financial transactions. which is severity of loss. portfolio risk in turn determines the quantum of capital cushion required. MBE. losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relating to lending. In a banks portfolio. Overall Credit Risk Firm Credit risk Portfolio Credit Risk A single borrower/obligor exposure is generally known as Firm Credit Risk while the credit exposure to a group of similar borrowers .Chapter 2: Credit Risk Management Credit Risk is the possibility of default due to nonpayment or delayed payment. it is defined by the losses in the event of default of the borrower to repay his obligations or in the event of a deterioration of the borrower’s credit quality. It consists of two components – Quantity of risk. Bifurcation of Credit Risk The study of credit risk can be bifurcated to facilitate better cognition of the concept. Mumbai | Vikas Sharma. Both firm credit risk and portfolio credit risk are impacted or triggered by systematic and unsystematic risks.
Narsee Monjee Institute of Management Studies. The second type of credit risks is unsystematic risks and is controllable risks.Firm Credit Risk Portfolio Credit Risk Credit Risk Systematic Risk Unsystematic Risk Socio-political Risks Business Risk Economic Risks Other Exogenous Risks Business Risk External forces that affect all business and households in the country or economic system are called systematic risks and are considered as uncontrollable. Sources of Credit Risk Credit related losses can occur in the following ways: A customer fails to repay money that was lent by the bank A customer enters into a derivative contract with the bank in which the payments are based on market prices. A creditor can diversify these risks by extending credit to a range of customers. 2. but customer fails to pay. and then the market moves so that the customer owes money. They do not affect the entire economy or all business enterprises/households. 2010-12 13 .2. MBE. Such risks are largely industry-specific and /or firm specific. Mumbai | Vikas Sharma.
- The bank holds a debt security and the market’s price for risk changes. In 2002/2003. as the result of over lending in the late 1980’s. Usually everyone is very confident during the heightened pace of economic activity. Mumbai | Vikas Sharma. With the Narsee Monjee Institute of Management Studies. the role of accurate credit analysis is very important Disintermediation: With the expansion of the secondary capital and debt markets. Increase in bankruptcies: Recessionary phases are common in the economy. Hence.3. especially by banks and other financial intermediaries with significant credit exposure. the price for all BB-rated bonds may fall because the market is less wiling to take risks. just a change in market sentiment. This can result in the lowering of the quality of the credit asset portfolio. but the increased possibility of a default makes the security less valuable. Here. In this case. the US economy went through massive job losses and sluggish growth and was almost on the verge of an economic slowdown. 2010-12 14 . For example. Given the fact that the incidence of bankruptcies during recession is high. The main reasons are as follows: Prudence : It is the responsibility of the supplier of the credit to ensure that their actions are prudent.- The bank holds a debt security (e. a more vigilant approach by the lenders is necessary. there is no credit event. MBE. and financial institutions are no exceptions. a default has not occurred.g. a bond or a loan) and the credit quality of the security issuer falls. causing the value of the security to fall. This risk is therefore typically treated as market risk 2.phase is highly challenging and so is providing credit during a recession period. Need for Credit Risk Analysis Much of importance has been attached to credit risk analysis. especially the larger ones access and raise funds directly from public. the firms that are not able to fulfill this requirement approach financial intermediaries. Increase in Competition: he banking business is witnessing more competition with the advent of the new generation banks and liberalization policies pursued by governments. Since credit rating is compulsory for raising debt from the public market. including banks. because excessive credit will prove destructive to everyone involved as has been evidenced by the demise of many banks in Japan during the past decade. although the timing and causes may be different for different countries. many good credit-worthy customers. Lending during the boom.
i. While it is no longer easy to insist on collateral security in view of the increasing competition in the market. Default Risk: It is the probability of the event of default. In other words.e. MBE. Default risk. and Recovery risk.increase in the competition. they display high risk tendencies to become bad debts. High impact of Credit Losses: It is a common perception that a small percentage of bad debts is acceptable and won’t do much damage. unfortunately this is not true. especially for banks and other financial intermediaries operating in a highly competitive sector. naturally pricing is under pressure. “quality of Risk” and “quantity of risk”. Credit Risk analysis helps to keep check on NPA. as your returns become lower. NPA management is a major challenge for banks. Exposure risk. to ensure adequate returns to shareholders. Poor Asset Quality: Banks in India and abroad face the problem of non-performing assets (NPA). by both default probability and the recoveries that could affect in the event of default. 25 or 50 times the business volumes. Credit Risk is a function of other risks or the combined outcome of other risk such as. Credit Risk Analysis helps in minimizing credit loss which is a best option rather than attempting to book 20. Mumbai | Vikas Sharma. The former refers to “severity of losses”. 2010-12 15 . Even a small credit facility turning bad will hurt business. i. The latter refers to the outstanding balance as on the date of default. Volatility of collateral/asset values: Gone are the days. A bank’s credit risk has two distinct facets. credit assets that are on the verge of becoming credit losses. missing a payment obligation. Quantitative measurement has become even more important since it was adopted by the Basel Committee on Banking as the basis for getting regulatory capital. The land and houses that are as collateral security with the bank against the loan issued by the bank to customer may touch all time high during boom period but during recession it may not quote even half the value of the credit extended during boom periods. So tighter credit risk analysis is necessary. when collaterals offered comfort. 2. technically your risk level should also reduce.e. In other words. However. Quantifying Credit Risk Quantitative measurement has been adopted by banks to improve their processes for selecting and pricing credit transactions. A payment default is declared when a scheduled Narsee Monjee Institute of Management Studies.4. breaking an agreement or economic default.
5. the amount at risk in future that can potentially be lost in case of default is uncertain. A payment default doesn’t mean that the borrower will never pay. Mumbai | Vikas Sharma. Default Risk depends upon the credit standing of the borrower and is measured by the probability that default occurs during a given time period. and legal issues. Sometimes. the economic value of collateral assets might be eroded and may even be less than the value of the outstanding debt. the required economic Capital (EC) depends on the probability distribution of the losses. MBE. Economic Capital Framework for Credit Risk Quantification: EC captures the variance or the uncertainty of the losses around the average.payment is not made within 90 days from the due date. For the credit risk of lending operations. Hence. in turn. 2010-12 16 . Although this cannot be measured directly. With its focus on uncertainty. They depend upon the type of default. Recovery Risk: The recoveries in case of losses are not predictable. The probability distribution for credit losses is sketched below: Narsee Monjee Institute of Management Studies. The outstanding balances at the time of default are not known in advance particularly under credit facilities like committed lines of credit. project financing etc.1. Measurement of Credit Risk 2. overdrafts.5. Exposure Risk: The uncertainty prevailing with future cash flows generates exposure risk. if such collateral can be easily possessed and has significant value. but it triggers various types of actions such as renegotiation up to the obligation to repay all outstanding balances. Guarantor’s Value: The net worth of the guarantors and. Legal Issues: Recovery risk depends upon the type of default. it can be observed from historical statistics or can be collected internally from rating agencies. 2. third party guarantees. availability of collaterals. Collateral’s Value: The existence of collateral minimizes credit risk. their ability to discharge liabilities upon invocation of guarantee may undergo changes affecting the ultimate realizable amount. EC quantifies the portfolio credit risk.
5. the probability is represented as ‘P’ Narsee Monjee Institute of Management Studies.MPL EL P R O B Credit Risk Measured as Economic Capital A B I Worst Case loss L Credit Loss EC = MPL – EL Where: MPL: Max Probable Loss EL : Expected Loss 2.2. 2010-12 17 . Calculation of EL & UL for Singe Facility/ Single Loan Expected Loss (EL): Mean of losses Unexpected Loss (UL): Standard Deviation Formula for EL is as follows: EL = P (1 x E x S) + (1 – P) (0 x E x S) =PxExS Where: P: In case there is default. MBE. Mumbai | Vikas Sharma.
3 = $ 0. Determining Losses Due to Both Default and Downgrades When a company is downgraded. A promise by this downgraded company to make a future payment is no longer as valuable as it was because there is an increased probability that the company will not be able to fulfill its promise.3 = $ 1.00222 x $ 100 x 0.E: Exposure at Default S: Loss Given Default/ Severity (1 – P): In case there is no default. we require the probability of a grade change and the loss if such a change occurs. The probability of a grade change has been researched and published by the credit-rating agencies.0022 x $100 x 0. then P would be 22 basis points.5. 2010-12 18 . Mumbai | Vikas Sharma. To obtain the EL and UL for this risk.3.0022 – 0. it represented by ‘(1 – P)’ Formula for UL is as follows: UL = P – P2 x E x S Example: If we loaned $ 100 to a BBB rated company.066 (P) (E) (S) UL = 0. Narsee Monjee Institute of Management Studies. and then EL is as follows: EL = 0. LGD is 30%. it means that the rating agency believes that the probability of default has risen. Consequently. MBE.41 2. there is a fall in the value of the bond or a loan.
a 91. we see that the company has a 7. 2010-12 19 . It has a 2. Looking down to the bottom of the column. Thus from external rating agencies we can get any company’s probability of moving to a different grade by the end of the year.19% chance of being downgraded to BBB. MBE. Narsee Monjee Institute of Management Studies.25% chance of being rated AA. Rating At The Start Of The Year AAA Rating AAA At The End Of the Year B CCC 0 0 9 2 1 20 1 4 81 16 22 747 105 98 8418 387 530 1074 6395 2194 0 0 10000 AA A BBB BB 9366 583 40 8 3 AA 66 9172 694 49 6 A 7 225 9176 519 49 BBB 3 25 483 8926 444 BB 3 7 44 667 8331 B 0 10 33 46 576 CCC 16 0 31 93 200 Default 0 0 0 0 0 Default 0 To understand how to read this table.basis points chance of falling into default. let us use it to find the grade migration probabilities for a company that is rated Single A at the start of the year. Looking down the third column.Probability of Grade Migration (bps) – Table showing the probability of a company of one grade migrating to another grade before the end of the year.basis point chance of becoming AAA rated by the end of the year. Mumbai | Vikas Sharma. Associated with each grade is a discount rate relative to the risk-free rate.76% chance of remaining single – A and a 5. we see that it has a 4.
the value will be $88.free discount rate of 5% and the bond is still rated BBB. 2010-12 20 . Corporate Bond spreads – Table showing the probability (bps) of corporate bond migrating from one grade to another over the years.33%)2 Narsee Monjee Institute of Management Studies. MBE.45 Value BBB = $100________ = $ 88.As an example. If it is assumed that the risk. let us calculate the EL and UL for a BBB – rated bond with a single payment of $100 that is currently due in 3 years. Rating AAA AA A BBB BB B CCC 1yr 38 48 73 118 275 500 700 2yr 43 58 83 133 300 50 750 3yr 48 63 103 148 325 600 900 5yr 62 77 117 162 350 675 1000 7yr 72 92 137 182 375 725 1100 10yr 81 101 156 201 450 775 1250 30yr 92 112 165 220 575 950 1500 The loss given default (LGD) is assumed to be 30%.45 (1 + 5% + 1. At the end of the year the bond will have 2 years to maturity. Mumbai | Vikas Sharma.
00 $ 2.73 $ 81.040) $0.137 $1.52) $(1.Table Showing Change in Values for a BBB bond due to Credit Events: Rating AAA AA A BBB BB B CCC Default Value $ 89.525 $1.203 Unexpected Loss (LG – EL )2 PG $ 0.051 $0.0.031 $0.91 $ 61.121 $0.55 $9.26 $ .015 $0.058 $0.55 $ 9. Mumbai | Vikas Sharma.96 $ 89. MBE. 2010-12 21 .003) $(0.44 $26.053 $0.52 $ .71 $6.71 $ 6.29 $ 88.1.328 0.284 $0.0.44 $ 26.71 $ 89. bps ) 3 25 483 8926 444 81 16 22 Loss (LG ) $(1.91 Loss $ .53 The calculation of EL and UL for the same example of BBB bond is as follows: Year End Probability Rating AAA AA A BBB BB B CCC Default Total (PG .90 $ 79. 45 $ 85.005 $0.26) $(0.537 Narsee Monjee Institute of Management Studies.84 $ .001 $0.53 Expected Loss (PG LG ) $(0.000) $(0.1.84) $2.
6 0. MBE.7 1. 2010-12 22 .3 2.2. Calculation of EL and UL of the Portfolio The expected loss for the portfolio (ELP) is simply the sum of the expected losses for the individual loans within the portfolio.4 3. the UL for the portfolio is the UL as percentage. multiplied by the total size of the portfolio: Narsee Monjee Institute of Management Studies.7 5.6 5.9 9.7 2.2% In dollar terms.1 3.3 0.4.5 0.2 2.2 11.8 0.1 1.5% 1.1 0.5 %loss 0.7 0.4 2. Example of Historical Losses Used To Estimate the Unexpected Loss of the Portfolio Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 EL% PH UL% PH Assets $Bn 231 236 243 245 250 269 284 309 333 352 386 Write – offs $Bn 1. Mumbai | Vikas Sharma.3 2.6 0. The unexpected loss for the portfolio (ULP) is the standard deviation obtained from the sum of the variances for the individual loans.4% 1.5.
minus operating costs (OC). MBE. 2010-12 23 . plus any fees (F). the expected net profit ENP is the interest income on the loan. Narsee Monjee Institute of Management Studies. multiplied by the interest rate on the loan (rA) The interest to be paid on the debt is the amount of debt (D0). and minus expected loss. Thus Formula can be Re-written as: RAROC = A0 rA + F – D0 rD – OC – EL EC Here: The interest income on the loan asset is the initial loan amount (A0). Mumbai | Vikas Sharma.UL PH = N E UL% PH = 11 x 285.27 x 1.2% = $37. RAROC = ENP EC Where for a loan. minus interest to be paid on debt. multiplied by the interest rate on the debt (rD).5.5.65 Bn 2. RAROC Over One Year: RAROC is the expected net risk-adjusted profit (ENP) divided by the economic capital that is required to support the transaction.
and 100%). 1998 Basel Accord The 1998 accord was motivated largely by low amount of available capital kept by Japanese banks in relation to the risks in their lending portfolios. 2. The purpose of the committee is to set common standards for banking regulations and to improve the stability of the international banking system. The prescribed formula is given below: Tier1 + Tier 2 Capital Risk Weighted Assets Capital: While tier 1 capital consists of paid-up share capital and disclosed reserves. To create more level playing field in competitive terms so that banks could no longer build business volume without adequate capital backing.Chapter 3: Credit Risk and Basel Accords The Basel Committee on Banking Supervision was established in the mid – 1980s. 2010-12 24 . MBE. Risk – Weighted Assets: Assets in the balance sheet of a bank have been differentiated. It is a committee of national banking regulators.The first accord has two basic principals: 1. Tier 2 capital comprises undisclosed reserves.The portfolio approach is adopted to measure risk with assets classified into four buckets(0%. the tier 1 capital should be at least 50% of the total capital. 3. those of the private business sector carry full risk (100%).1.20%. This distinction. depending Narsee Monjee Institute of Management Studies. Basel Accords helps the banks in managing credit risk and as well as other risks. such as the Bank of England and the Federal Reserve Board. asset revaluation reserves. hybrid capital instruments (such as mandatory convertible debt) and subordinated debt. based on the risks. Mumbai | Vikas Sharma. Also. The 1998 accord required that all banks should hold available capital equal to atleast 8% of their risk-weighted assets (RWA) . To ensure adequate level of capital in the international banking system. While central government/Central bank obligations carry nil (0%) risk. This low ratio was believed to allow the Japanese banks to make loans at unfairly low rates.50%.
If a bank has more counter parties having nil (or lower) risk. IBRD.upon counter parties.Lateral development banks(ADB. Mumbai | Vikas Sharma. etc ) Banks in OECD/ Claims guaranteed by them Residential mortgage backed loans X Private sector entities X X X X X Narsee Monjee Institute of Management Studies. Central Bank exposure in National Currency OECD Govt/ Central Banks & claims guaranteed by them Multi. gives a unique perspective to the capital adequacy of a banking institution. 2010-12 25 . MBE. it needs to hold less capital than a bank which has parties with 100% risk weight. The summarized weight scale is given below: Risk Weight of On – B/S items Risk 0% 20% 50% 100% Weights Counter Parties Central Govt.
2. Generally all AAA and AA rated companies require only 20% weight while credit exposures rated B and below require 150% weight. The supervisory review pillar requires regulators to ensure that the bank has effective risk management. the credit rating must be made by an organization outside the bank such as External Credit Assessment Institutions (ECAI) The rated counter parties receive weights ranging from 20% to 150%. In the standardized approach. MBE. 2010-12 26 . However. Mumbai | Vikas Sharma. depending upon the rating assigned by ECAI. but broad intention is that risk weights should be set according to the credit rating of the customer. Minimum Capital Requirements: The new Accord allows banks to calculate their required regulatory capital using one of two approaches: a) The standardized Approach: The standardized approach is more complex than the 1998 Accord and has sections dealing with many specific cases. The new Accord has three pillars: i) Minimum requirement of Capital ii) Role of supervisory review process iii) Market discipline The measurement of minimum requirement of capital gives many formulas to replace the simple calculations of the 1998 Accord. The market discipline pillar requires banks to disclose large amounts of information so that depositors and investors can decide for themselves the risk of the bank and require commensurately high interest-rates and return on capital. but it changes the method for calculating RWA.3. Basel 2 (New) Accord The suggested form of new Accord was published in January 2001 to obtain comments from the banking industry. Narsee Monjee Institute of Management Studies. The final Accord will be effective from 2006 – 2007. and requires the regulators to increase the required capital if they think that the risks are not being adequately measured. The new Accord retains the same concepts of EWA and Tier 1 and Tier 2 available capital. the un-rated counter parties continue to receive 100% weight.
where all inputs to risk weighted asset calculation – PD . IRB foundation. which the approval of their Supervisors (or Central Banks). and EAD – estimated by the bank itself . Mumbai | Vikas Sharma. IRB Advanced. PD is directly linked to the Customer rating. The adoption of an IRB approach requires empirical data. subject to regulatory satisfaction iii.000% for a zero risk customer to 100% for a very highrisk customer Narsee Monjee Institute of Management Studies. The PD can range from 0. Exposure at Default (EAD) and a factor for maturity. LGD. the main components are as follows: Probability of Default (PD) – Defined as the statistical percentage probability of a borrower defaulting within a one-year time horizon. 2010-12 27 . where banks are required to provide their own internal estimates of Probability of Default (PD) and use predetermined regulatory inputs for Loss Given Default (LGD). MBE.A+ to A50% BBB+ to BB100% Below BB150% Unrated 100% Corporations 20% b) The Internal Rating Based Approach for Credit Risk: IRB allows banks to use their own internal estimates of risk to determine capital requirements. ii.Risk Weights for Government and Banks under the new standardized Approach Grade AAA AAGovernments 0% Banks 20% 20% 50% to A+ to ABBB+ BBB50% 100% 100% 100% 150% 150% 100% 100% to BB+ to BBelow BUnrated Risk Weights for Corporate Exposures under the New Standardized Approach Grade AAA to AA. IRB are of two types: i.
2010-12 28 . Under the IRB approach. among others Exposure at Default (EAD): Represents the expected level of usage of the facility when default occurs. MBE. LGD estimates are to be based upon historical recovery rates and stress tested for economic downturns. LGD is dependent upon the collateral while EAD is the amount of credit extended. calculated as a percentage of the exposure at the date of default. subject to strict methodological and disclosure standards. This value does not take account of guarantees. Narsee Monjee Institute of Management Studies.Loss Given Default: It is estimated amount of loss expected if a credit facility defaults. if any and other factors that impact on the likely level of recovery. collateral or security. Mumbai | Vikas Sharma. The expected credit loss from an exposure is the main driver for determining the credit rating in IRB. which from the basis of minimum capital requirements. PD is based on the stand alone borrower risk rating or customer rating. The value depends on the collateral. a bank estimates each borrower’s creditworthiness and the results are translated into estimates of a potential future loss amount.
The Middle Office apprises top management/ALCO/Treasury about adherence to risk parameters and aggregate total market risk exposures. interest rate market. Time Risk: need to compensate for non-receipt of expected inflows of funds i. MBE. The Asset Liability Management Committee (ALCO) functions as the top operational unit for managing the balance sheet within the risk parameters laid down by the board. Management of Market Risk is the major concern of top management.e performing assets turning into non-performing assets. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits. The Treasury Department is separated from middle office and is not involved in day to day work. reduction in liabilities. The liquidity risk in banks manifest in different dimension: 1. Narsee Monjee Institute of Management Studies. statisticians) to track the magnitude of market risk on a real time basis. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.Chapter 4 Market Risk Management Market Risk is defined as the possibility of loss to bank earnings and capital due to changes in the market variables. prudential risk limits. reporting and auditing systems. Mumbai | Vikas Sharma. Moreover. The board clearly articulates market risk management policies. The liquidity risk of banks arises from funding of longterm assets by short-term liabilities thereby making the liabilities subject to refinancing risk. procedures. 2. the banks set up an independent middle office (comprises of experts in market risk management. economists. currency exchange rate and commodity prices. bankers. 4.1 Liquidity Risk Liquidity planning is an important facet of risk management framework in banks. 2010-12 29 . It is the ability to efficiently accommodate deposit. to fund the loan growth and possible funding of the off balance sheet claims. It is the risk that the value of on/off balance sheet positions is adversely affected by movements in equity. review mechanisms. 3.
which entail a high level of risk. The key ratios adopted across the banking system are (See Annexure 3): (a) Core Deposits/Total Assets Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits. Mumbai | Vikas Sharma. 2010-12 30 .e whenever a bank depositors come to withdraw their money) and asset side reasons (which arises as a result of lending commitments). This is because investments are mainly government securities and other forms of relatively less risky instruments as compared to loans and advances. The two approaches used for managing the liquidity risk dimension are:(a) Fundamental Approach (b) Technical Approach Narsee Monjee Institute of Management Studies.Liquidity measurement is quite a difficult task and can be measured though stock or cash flow approaches. The liquidity ratios are the ideal indicator of liquidity of banks operating in developed markets as the ratios do not reveal the intrinsic liquidity profile of Indian banks. The cause and effect of liquidity risk is primarily linked to nature of assets and liabilities of a bank. 4.1 Strategies for Managing Liquidity Risk The risk arises because of two reasons .liability side reasons (i. MBE.1. (b) Volatile Liabilities/Total Assets Where volatile liabilities = Demand + Term deposits of other banks (c) Short term assets/Total Assets Where short term assets = Cash & Bank balance + Receivable + Bills Receivable + Short term/demand advances (d) Credit Deposit Ratio Credit Deposit Ratio = Loans & Advances/Total Deposits (e) Investments/Total Assets This ratio is highest for public sector banks reflecting the higher levels of conservatism in their policies. which are operating generally in an illiquid market.
government securities or instruments of other corporate as when the funds are put in the call market they are invested only for the short period where liquidity is ensured but have lower yield. Liquidity in the short run is linked to cash flows arising due to operational transactions. Thus if the technical approach is adopted to eliminate liquidity risk it is the cash flows position that needs to be tackled. CRR is to be maintained on an average daily basis during a reporting fortnight by all scheduled banks. Mumbai | Vikas Sharma.1 Fundamental Approach The fundamental approach involves two aspects: Asset management This approach aim at eliminating liquidity risk by holding near cash assets that can be turned into cash whenever required. Liability Management In this approach the bank does not maintain any surplus funds but tries to achieve it through by borrowing funds when the need arises. Likewise the sale of securities from the investment portfolio can enhance liquidity.As investing in the government securities generally offer higher yields with less risk involved. 2010-12 31 . This system provides maneuverability to banks to adjust their cash reserves on a daily basis depending upon intra fortnight variations in cash flows.1.1.1. MBE. For the computation of CRR to be maintained during the Narsee Monjee Institute of Management Studies. Below are the factors that affect its demand: Cash Reserve Ratio As per the RBI Act 1934.4. The risk perceived is low as participants are banks . The disadvantage is that since funds are raised from various sources and markets any rate fluctuations in a market enhance the cost of borrowing.1. Investment can be put in the call market. Call Money Market Call money is borrowings between banks for a period ranging from 1 to 14 days. 4.2 Technical Approach The technical approach focuses on the liquidity position of the bank in the short run.
5-6 % and deploy the proceeds to speculate on the rupee dollar moments in the forex market. demand for money in that market shoots up.fortnight. Third. attract deposits from small savers to fund the loan repayment. RBI have decided to reduce the requirements of a minimum of 85 percent of the CRR balance to 65 percent with effect from beginning May 6. it resorts to borrowing from the call market. As more banks resort to such borrowing. wanting to profit from any arbitrage opportunities between the forex and money markets. bank raised its short-term deposit rate to about Narsee Monjee Institute of Management Studies. This has resulted in smoother adjustment of liquidity between surplus and deficit units and enables better cash management by banks. these banks invariably profit from the cross-market deployment. borrow again in the call market at the higher rate and repay the earlier loan. 2010-12 32 . Mostly banks resort to the third alternative by hiking deposit rates. 1999 whereby banks have to maintain CRR on the net demand and time liabilities (NDTL) of the second preceding fortnight. In January 1999. MBE. sell dollars in the market and buy rupees to repay the loan. First. That placed them in a corner so far as meeting CRR requirement was concerned. When a bank falls short of its CRR requirement. banks are able to assess their liability positions and the corresponding reserve requirements. Mumbai | Vikas Sharma. With this. Liquidity requirements This arises from a liquidity mismatch. 2000.75% of the anticipated total demand and time liabilities. leading to high call rates. With a view to provide further flexibility to banks and enable them to choose an optimum strategy of holding reserve depending upon their intra-period cash flows. Speculation That is. This is what happened during the run-up to the credit policy in March 2000. a lagged reserve system has been introduced effective November. Banks borrow call money at say. Banks had invested their surplus cash in government securities. The CRR currently as on 31st march 2004 was 4.for instance. Given the general bias on rupee depreciation. which forces banks to borrow for the very short term. Second. If the call rates in the meanwhile shoot up the borrowing banks have three options.
In this way. In case of a repo. Arbitrage Banks have also started taking advantage of the arbitrage opportunity between the call money and the Government securities market. The RBI has banned banks from borrowing in call and trading in the forex market. The call money was ruling tight following advanced tax outflows from the market. which hold a large inventory of bonds and G. the overnight rates (or the call rates) seem to be very volatile largely due to an expectation of a fall in interest rate.5 %. use repo to amass additional Narsee Monjee Institute of Management Studies. MBE. these banks borrowed at 6%. In a reverse repo the buyer trades money for the securities agreeing to sell them later. with inter bank call rates hovering around 6 % and the current yield on Government securities ranging from 8. Mumbai | Vikas Sharma. The banks.5%.5 % .5% 9. which enables collateralized short term borrowing and lending through sale / purchase operation in debt instruments.3. The money put in the CRR is invested in government securities at the current yield of 8. In other words the inflow of cash from the transaction can be used to meet temporary liquidity requirement in the short-term money market at comparable cost.5% . In the money market this transaction is nothing but collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate. the buyers. A reverse repo is the same operation but seen from the other point of view.18% per annum.9. In order to maintain the cash reserve ratio requirements. 2010-12 33 . as it had to repay loans on calls and rates in that market which shot up to a high of 140%. the ‘forward clean price of the bonds’ is set in advance at a level which is different from the ‘spot clean price by’ adjusting the difference between repo interest and coupon earned on the security. Repo Market Repo is a money market instrument. Under a repo transaction a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. banks earn an arbitrage of around 2. In March 2003.Secs. It was forced to take this step. the borrowing banks in the money market had an opportunity to make money.5% over various maturities. Policy Variables Just before any policy announcement.
Hence whether transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. As for the likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate in stages to the earlier levels. The LAF operates though repo (for absorption of liquidity) reverse repo (for injection of liquidity) to set a corridor for money market interest rates. It was recommended by the Narasimhan Committee Report on the Banking Reforms and was announced in the Monetary and the Credit policy for the year 2000-2001. So also the liquidity support extended to all commercial banks (excluding RRBs) and Primary dealers though Additional Collateralized Lending Facility (ACLF) and finance/reverse repo under level II respectively will be withdrawn. When the reverse repurchase transaction matures the counter party returns the security to the entity concerned and receives its cash along with a profit spread. At present. The banks could Narsee Monjee Institute of Management Studies. MBE. The existing Fixed Rate Repo will be discontinued. Interim Liquidity Adjustment Facility (ILAF) RBI had introduced collateralized lending against government securities as Interim Liquidity Adjustment Facility (called Collateralized Lending Facility) to provide liquidity support to banks in replacement of the General Refinance. Mumbai | Vikas Sharma. the RBI regularly conducts only a three/four day fixed repo. Liquidity Adjustment Fund (LAF) The aim of the Liquidity Adjustment Facility (replacing Interim Liquidity Adjustment Facility) is to improve the operational flexibility and the effectiveness of the monetary policy. It is also appropriate as the financial markets move towards indirect instruments.funds. One factor that encourages an organisation to enter into reverse repo is that it earns some extra income on its otherwise idle cash. 2010-12 34 . Substitutability of the Call money market and the Repo market The rise in the call money rates often forces met borrowers in the money market such as private banks today to increasingly resort to repo (short for sale and purchase agreement) of Government securities for their financing requirements rather than borrowing from overnight call money market. Using the securities as collateral they borrow using repo.
The ILAF served its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of interest. The funds from this facility used by the banks for their day – to day mismatches in liquidity. collateralized-lending facilities. the focus of analysis is the impact of changes in interest rate on accrual or reported earnings. The ILAF was operated through a combination of repo. liability off balance sheet items and cash flow. Economic value perspective involves analyzing the expected cash in Narsee Monjee Institute of Management Studies. 2010-12 35 . Changes in interest rate affect earnings.borrow up to 25 basis points of the fortnightly average outstanding aggregate deposits in 1997-98 at the bank rate for a period of two weeks. Interest rate risk is particularly important for banks owing to high leverage and arises from maturity and repricing mismatches. an Interim Liquidity Adjustment Facility was introduced pending further up gradation in technology and legal/procedural changes to facilitate electronic transfer and settlement. Liabilities consist of deposits and bank borrowing classified into different time buckets. This is the traditional approach to interest rate risk assessment taken by many banks and is measured by measuring changes in Net Interest Income (NII) or Net Interest Margin (NIM). CLF and ACLF availed for periods beyond two weeks were subject to penal rate of 200 basis points for the next two weeks. Assets consist of loans and advances and investments. MBE. However during the period of availing the CLF or ACLF the banks continue to participate in the money market.2 Interest Rate Risk It is the potential negative impact on the Net Interest Income and refers to the vulnerability of an institution’s financial condition to the movement in interest rates. Mumbai | Vikas Sharma. It provided a ceiling and the Fixed Rate Repo were continued to provide a floor for the money market rates. export credit refinance. For purpose of monitoring liquidity risk RBI requires banks to disclose a statement on maturity pattern of their assets and liabilities classified in different time buckets. value of assets. In April 1999. 4. Investments in corporate and government debt are combined into one category and bucketed according to their time to maturity. An additional collateral (called Additional Collateralized Lending Facility) of similar amount was also made available to banks at 200 basis points over bank rate. From the Earning perspective.
Net Interest Position Risk: When banks have more earning assets than paying liabilities. It identifies risk arising from long-term interest rate gaps. maturity dates there by creating exposure to unexpected changes in the level of market interest rates. If interest rate goes up in future it would hurt banks. Embedded Option Risk: It is the option of pre-payment of loan and fore. iii. Basis Risk: It is the risk that the interest rate of different assets/liabilities and off balance items changes in different magnitude. Banks are faced with different types of interest rate risks: i. Reprice Risk: When assets are sold before maturities. administrative restrictions upon interest rates have been steadily eased. v. net interest position risk arises in case market interest rates adjust downwards RBI has initiated two approaches towards better measurement and management of interest rate risk and made the mandatory requirement that time to re-pricing or time to maturity to create Narsee Monjee Institute of Management Studies. large reserve requirement implies a policy of stretching out yield curve which innately involves forcing banks to increase the maturity of their assets. banks in India have relatively large fraction of assets held in government bonds and is partly driven by large reserve requirements. Gap/Mismatch Risk: It arises from holding assets/liabilities and off balance sheet items with different principal amounts. interest rates have fallen sharply in last four years. which have funded long maturity assets using short maturity liabilities.flows on assets minus expected cash out flow on liabilities plus the net cash flows on off balance sheet items. By International standards. iv. Reinvestment Risk: It’s the uncertainty in regard to interest rate at which the future cash flows could be reinvested. MBE. vi. In India from 1993 onwards. In India. Mumbai | Vikas Sharma. 2010-12 36 . This has given an unprecedented regime of enhanced interest rate volatility.closure of deposits before stated maturities. ii. Yield Curve Risk: It is the movement in yield curve and the impact of that on portfolio values and income. In particular. vii.
This statement is required to be reported to board of directors of bank and to RBI (not to public). The approach towards measurement and hedging interest rate risk varies with segmentation of banks balance sheet. liabilities and off balance sheet items. In addition RBI has created a requirement that banks have to build up Investment Fluctuation Reserve (IFR) using profits from sale of government securities in order to better cope with potential losses in future.2.pricing) and therefore reflects how Narsee Monjee Institute of Management Studies. It measures the relative sensitivity of the value of instruments to changing interest rates (the average term to re . Banks broadly bifurcate asset into trading book and banking book as trading book comprises of assets held for generating profits on short term differences in prices and banking book consists of assets/liabilities on account of relationship or steady income and are generally held till maturity by counter party. 4. 4.2 Duration Analysis Duration is the time weighted average maturity of the present value of the cash flows from assets. MBE. There are different techniques as: (a) traditional maturity gap analysis to measure interest rate sensitivity (b) Duration gap analysis to measure interest rate sensitivity of capital (c) simulation (d) value at risk for measurement of interest rate risk. Gap Analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off balance sheet positions). The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. Mumbai | Vikas Sharma. 2010-12 37 . The gap reports indicate whether the institution is in a position to benefit from rising interest rates by having the positive gap (RSA>RSL) or whether it is in a position to benefit from declining interest rate by the negative Gap (RSL >RSA). The positive gap indicates that it has more RSAs whereas the negative gap indicates that it has more RSLs.2.1 Gap Analysis The Gap or Mismatch risk can be measured by calculating gaps over different time intervals as at a given date.‘interest rate risk statement’ should classify assets and liabilities.
When the duration gap is negative (DL>DA) increase in market interest rate will decrease the market value of equity of the Bank. If the net duration is positive (DA>DL).2. Narsee Monjee Institute of Management Studies. the greater the chance of interest rate movements and hence unfavourable price changes. 2010-12 38 . This index represents the average term to maturity of the cash flows. the Duration method is used to measure the expected change in market value of equity (MVE) for a given change in market interest rate.3 Simulation Models Simulation model is a valuable to complement gap and duration analysis. net income and interest rate risk positions. The longer the term to maturity of an investment. It analyse interest rate risk in a dynamic context and evaluate interest rate risk arising from both current and future business and provides a way to evaluate the effects of strategies to increase earnings or reduce interest rate risks. Their forecasts are based on a number of assumptions including: Future levels and directional changes of interest rates The slope of yield curve and the relationship between the various indices that the institution uses to price credits and deposits Pricing strategies for assets and liabilities as they mature The growth volume and mix future business Simulation is used to measure interest rate risk by estimating what effect changes in interest rates. Mumbai | Vikas Sharma. 4. Simulation model is useful tool for strategic planning. Hence. it permits a member institution to effectively integrate risk management and control into planning process. Duration measure how price sensitive an asset/liability or off balance sheet item is to small changes in interest rates by using a single number to index the institution interest rate risk. a decrease in market interest rates will increase the market value of equity of the bank. business strategies and other factors will have on net interest income. The difference between duration of assets (DA) and liabilities (DL) is banks net duration. MBE.changes in interest rates affects the institutions economic value that is the present value of equity.
lock in periods etc. 4. The Historical period used for estimating the model.e the period over which the portfolio is considered to beheld constant. Interest rate risk. If the VaR with respect to interest rate risk of bank is desired. MBE.4.or 99. For any given bank portfolio one can calculate a loss distribution showing the probability of various amounts of loss. Foreign exchange risk. Narsee Monjee Institute of Management Studies. Portfolios cannot be adjusted instantaneously because of transaction costs. 3. 2. Commodities Risk and Risk from options. Mumbai | Vikas Sharma. The crucial input in the IRB approach is a VaR (value at risk) model. The three crucial concepts in a VaR are: The confidence coefficient (whether 95%.4 Value At Risk VaR is an alternative framework for risk measurement. Model the data generating process for zero coupon yield curve. at a 99 % level of significance on a one-year horizon then we would need to go through following steps: 1. Equity position risk. Market Risk: Standardized Approach Under the standardised approach five distinct sources of market risk are identified viz.3. Computethe 1th percentile of distribution of profit/loss seen in Nth realisation. The holding period i. Reprice assets and liabilities at each of these draws. A VaR estimate is an appropriate percentile of the bank portfolio loss distribution.99%. 4.9%). Market Risk IRB Approach Here. Simulate N draws from yield curve on a date one-year away. 2010-12 39 . banks are allowed to base market risk charges on their own on internal models but additionally a process called stress testing is to be included. This procedure is difficult to implement primarily because existing state of knowledge on data generating process for yield curve is weak.2.
Interest Rate Swaps After the Reserve Bank of India gave a green signal to banks to hedge themselves again interest Narsee Monjee Institute of Management Studies. This risk is considerably enhanced during a period when decline in the interest rates bottom out and begins to move in the opposite direction.The Basel Accord II proposes a confidence coefficient of 99% a holding period of 10 days and a historical period of observation of at least 1 year. In India. Interest Rate Futures and Swaps Interest Rate Risk is a very critical problem for banks and they use a number of derivative instruments to hedge against Interest Rate Risk. a capital requirement expressed as the higher of the following two factors Previous days VaR estimate (An average of the VaR of the preceding 60 business days)*m Here m is a multiplication factor set as m = 3+plus factor Where plus factor is related to the performance of the particular banks VaR model. this risk is further exacerbated since it is the Reserve Bank of India (RBI) --. The value ranges from 0 (exceptionally good performance) to 1(poor performance) Stress Testing is an important dimension of the IRB approach. Collars and Interest rate Swaps. Mumbai | Vikas Sharma. 2010-12 40 . Interest Rate Futures A bank whose asset portfolio has an average duration longer than the average duration of it liabilities has a positive duration gap. The VaR estimate is to be computed on a daily basis incorporating additional information becoming available on a daily basis. Interest Rate Caps. MBE. Each bank must meet on a daily basis. Some of the instruments used by banks are Interest Rate Futures.which still dictate the prevailing level of interest rates. Interest Rate Options. A rise in the market interest rate will cause the value of bank assets to decline faster than the liabilities reducing the banks net worth and vice versa.and not the market forces --. A financial futures contract is an agreement between a buyer and a seller reached at this point of time that calls for the delivery of a particular security in exchange for cash at some future date.
Rationale behind an Interest Rate Swap Interest Sensitive Gap = Rate Sensitive Assets – Rate Sensitive Liabilities Table No. Mumbai | Vikas Sharma. MBE. The principal amount is notional because there is no need to exchange actual amounts of principal. The interest is computed on a notional principal amount and the Narsee Monjee Institute of Management Studies. Swap participants can convert from fixed to floating or vice versa and more closely match the maturities of their assets and liabilities.5 Interest Rate Gap Positive Gap Negative Gap Interest Rate Increase Favorable Position Unfavorable Position Interest Rate Decrease Unfavorable Position Favorable Position Fixed – for. Swaps can transform cash flows through a bank to more closely match the pattern of cash flows desired by management. A notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.Floating Rate Swap A series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. There are many players in market---. the banks have used this as a major tool in interest rate risk management. Overnight Index Swaps (OIS) The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate is linked to an overnight /call money index. 2010-12 41 . An Interest Rate Swap (IRS) is defined as a contractual agreement entered into between two banks under which each agrees to make periodic payment to other for an agreed period of time based upon a notional amount of principal. An IRS is way to change an institution exposure interest rate fluctuation and also achieve lower borrowing cost. ICICI bank.HDFC bank.rate uncertainties through plain --vanilla interest rate swaps (IRSs) and forward rate agreements (FRAs) in the April 1999 monetary policy.
In this case the lower credit rated bank agrees to pay the higher-credit-rated bank fixed long term borrowing cost. The bank may alternatively purchase an interest rate cap from a third party (say from financial institutions) which promises to reimburse borrowers from any additional interest they owe their creditors beyond the cap. a borrower with a lower credit rating typically a smaller bank enters into an agreement to exchange interest payment with a borrower having a higher credit rating.term loan at a much lower interest cost than the low rated bank could otherwise obtain. At the same time the bank with the higher-credit-rating covers all or a portion of the lower rated banks short term floating loan rate. MBE. Interest Rate Hedging Devices Interest Rate Caps It protects its holder against rising market interest rates. Banks buy interest rate caps when conditions arise that could generate losses such as bank finds itself funding fixed rate assets with floating rate liabilities. Interest Rate Floors Banks can also lose earnings in periods of falling interest rates especially when rates on floating rate loan decline. borrower are assured that institutions lending them money cannot increase their loan rate above level of the cap. In return for paying an up front premium. typically a large nationalized bank. possesses longer term assets than liabilities or perhaps holds a large portfolio of bonds that will drop in value when interest rates rise. it is guaranteed some minimum rate of return. Quality Swap Under the terms of the agreement called a Quality Swap. thus converting a fixed long term interest rate into amore flexible and possibly cheaper short term interest rate. Mumbai | Vikas Sharma. the low credit-rated bank receives a long . In effect.swap settles on a net basis at maturity. Narsee Monjee Institute of Management Studies. A Bank can insist on establishing an interest rate floor under its loans so that no matter how far loan so that no matter how far loans rates tumble. 2010-12 42 . Swaps are often employed to deal with asset liability maturity mismatches. Thus the banks effective borrowing rate can float over time but can never increase the cap.
Mumbai | Vikas Sharma. Narsee Monjee Institute of Management Studies. The net premium paid for the collar can be positive or negative. MBE.Interest Rate Collars This instrument combines in one agreement a rate floor and rate cap. The collar purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor. 2010-12 43 . depending upon the outlook for interest rates and the risk aversion of the borrower and the lender at the time of the agreement. Banks can use collars to protect their earnings when interest rates appear to be unusually volatile.
MBE. 73 /21.com/ JPMorgan Training and Development Knowledge Repository Narsee Monjee Institute of Management Studies.com/ http://xtra.Bibliography RBI Guidelines for Implementation of the New Capital Adequacy Framework (Basel II) Prudential norms on Capital Adequacy and Market Discipline. Basel Committee on Banking Supervision.06.2001. “Working Paper on the Regulatory Treatment of Operational Risk”(September).BC. 2010 Study material. 2010-12 44 . Report: A Road map for Implementing an Integrated Risk Management System by Indian Banks by Mar 2005 (CRISIL) in IBA Bulletin (Jan 2004).papers.001/2009-10 DATED: February 10.com/ http://search. NCFM Debt Market Basel Committee on Banking Supervision.2001.ebscohost. “Sound Practices for the Management and Supervision of Operational Risk” (December).emeraldinsight. http://www.BP. Mumbai | Vikas Sharma.ssrn.No.New Capital Adequacy Framework (NCAF) DBOD.
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