Risk MGMT in Banks

Summer Training Project Report
ON
Risk Management in Banking Sector
Summer Training Project Report Submitted for Partial Fulfillment for the
Award of the Degree of
MASTER OF BUSINESS ADMINISTRATION

(MBA)
UNDER THE SUPERVISION OF
Prof. S.P Jain

SUBMITTED BY
Varun Sharma
0871913907
GITARATTAN INTERNATIONAL BUSINESS SCHOOL

(Affiliated to GURU GOBIND SINGH INDRAPRASTHA UNIVERSITY)
ROHINI, NEW DELHI 110085
(2007-09)
0871913907
ACKNOWLEDGEMENT
I express my heartiest gratitude to Mrs. ANITA KHANNA (CUSTOMER

RELATIONSHIP OFFICER - PNB) for giving me an opportunity to prepare a report on
the project assigned to me. I am also thankful to Prof. S.P Jain, faculty, Gitarattan
International Business School, Rohini. Under their guidance I undertook this project, for
extending the advice and direction that is required to carry on a study of this nature, and
for helping me with the intricate details of the project at every step. Without her support
and able guidance, it would have been very difficult to finish this work in the way I have
done it.
However, I accept the sole responsibility of any possible errors of omission.
Varun Sharma
Gitarattan International Business School
0871913907
TABLE OF CONTENTS
1. INTRODUCTION Objectives of the study

Scope of study
Limitations of study
5
6
6
2. DEFINITION OF RISK
What is Risk?
What is Risk Management? Dose it eliminate Risk?
Objectives of Risk Management functions
Risk in Banking
12
12
13
14
3. TOPOLOGY OF RISK EXPOSURE

Market Risk
Credit Risk
Operational Risk
19
25
36
4. AN IDEALIZED BANK OF THE FUTURE
48
5. STUDY OF OPERATIONAL RISK AT PUNJAB NATIONAL BANK

6. REFERENCES
49
54
0871913907
EXECUTIVE SUMMARY
This project at Punjab National Bank was undertaken during the period of 2 months
(JUNE 1st 08 to JULY 31st 08) as part of my summer training
As part of summer training, I was made to accompany Customer Relationship Officer to
observe Client Interaction, gauge the level of satisfaction by listening and solving
quarries of existing clients also helped in making new clients.
My Summer Training included the following
An in-depth induction through the Computer Based Training Module
Learning the basics of the various Baking Operations such as procedure of opening
new account (Savings, Current), printing and updating of passbook, procedure of
opening a F.D, deposits / withdrawals, issuing of ATM cards and internet banking
passwords etc.
Various Documents Necessary or Required at the Time of Opening of Account
Accompanying Customer Relationship Officer to observe client interaction.
Client Acquisition.
During the course of my training, I got valuable insights about the workings in a bank
branch, internet banking and client interface.
0871913907
OBJECTIVES
To study broad outline of management of credit, market and operational risks associated
with banking sector .
Though the risk management area is very wide and elaborated, still the project covers
whole subject in concise manner.
The study aims at learning the techniques involved to manage the various types of risks,
various methodologies undertaken. The application of the techniques involves us to gain
an insight into the following aspects:
An overview of the risks in general.
An insight of the various credit, market and operational risks attached to

the banking sector
The methodology related to the management of operational risk followed

at PNB.
Tools applied in for measurement and management of various types of

risks.
Having an insight into the practical aspects of the working of various

departments.
0871913907
SCOPE OF THE STUDY
The report seeks to present a comprehensive picture of the various risks inherent in the
bank. The risks can be broadly classified into three categories:
Credit risk
Market risk
Operational risk
Within each of these broad groups, an attempt has been made to cover as
comprehensively as possible, the various sub-groups
The computation of capital charge for market risk will also be taken practically as also
the assigning the ratings for individual borrowers. PNB is also under the key process of
testing and implementation of Reuters "KONDOR" software for its VaR calculations and
other aspects of market risk.
LIMITATION OF THE STUDY
1. The major limitation of this study shall be data availability as the data is proprietary
and not readily shared for dissemination.
0871913907
2. Due to the ongoing process of globalization and increasing competition, no one model
or method will suffice over a long period of time and constant up gradation will be
required. As such the project can be considered as an overview of the various risks
prevailing in Punjab National Bank and in the Banking Industry.
3. Each bank, in conforming to the RBI guidelines, may develop its own methods for
measuring and managing risk.
4. The concept of risk management implementation is relatively new and risk
management tools can prove to be costly.
5. Out of the various ways in which risks can be managed, none of the method is perfect
and may be very diverse even for the work in a similar situation for the future.
6. Due to ever changing environment , many risks are unexpected and the remedial
measures available are based on general experience from the past.
7. Selection of methods depends on the firms expectations as well as the risk appetite.
Also risks can only be minimized not completely erased.
0871913907
INTRODUCTION
The significant transformation of the banking industry in India is clearly evident
from the changes that have occurred in the financial markets, institutions and products.
While deregulation has opened up new vistas for banks to argument revenues, it has
entailed greater competition and consequently greater risks. Cross- border flows and
entry of new products, particularly derivative instruments, have impacted significantly on
the domestic banking sector forcing banks to adjust the product mix, as also to effect
rapid changes in their processes and operations in order to remain competitive to the
globalized environment. These developments have facilitated greater choice for
consumers, who have become more discerning and demanding compelling banks to offer
a broader range of products through diverse distribution channels. The traditional face of
banks as mere financial intermediaries has since altered and risk management has
emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The
benefits of globalization have been well documented and are being increasingly
recognized. Integration of domestic markets with international financial markets has been
facilitated by tremendous advancement in information and communications technology.
But, such an environment has also meant that a problem in one country can sometimes
adversely impact one or more countries instantaneously, even if they are fundamentally
strong.
There is a growing realisation that the ability of countries to conduct business
across national borders and the ability to cope with the possible downside risks would
0871913907
depend, interalia, on the soundness of the financial system. This has consequently meant
the adoption of a strong and transparent, prudential, regulatory, supervisory, technological
and institutional framework in the financial sector on par with international best
practices. All this necessitates a transformation: a transformation in the mindset, a
transformation in the business processes and finally, a transformation in knowledge
management. This process is not a one shot affair; it needs to be appropriately phased in
the least disruptive manner.
The banking and financial crises in recent years in emerging economies have
demonstrated that, when things go wrong with the financial system, they can result in a
severe economic downturn. Furthermore, banking crises often impose substantial costs on
the exchequer, the incidence of which is ultimately borne by the taxpayer. The World
Bank Annual Report (2002) has observed that the loss of US $1 trillion in banking crisis
in the 1980s and 1990s is equal to the total flow of official development assistance to
developing countries from 1950s to the present date. As a consequence, the focus of
financial market reform in many emerging economies has been towards increasing
efficiency while at the same time ensuring stability in financial markets.
From this perspective, financial sector reforms are essential in order to avoid such
costs. It is, therefore, not surprising that financial market reform is at the forefront of
public policy debate in recent years. The crucial role of sound financial markets in
promoting rapid economic growth and ensuring financial stability. Financial sector
reform, through the development of an efficient financial system, is thus perceived as a
key element in raising countries out of their 'low level equilibrium trap'. As the World
Bank Annual Report (2002) observes, a robust financial system is a precondition for a
sound investment climate, growth and the reduction of poverty .
Financial sector reforms were initiated in India a decade ago with a view to
improving efficiency in the process of financial intermediation, enhancing the
effectiveness in the conduct of monetary policy and creating conditions for integration of
0871913907
the domestic financial sector with the global system. The first phase of reforms was
guided by the recommendations of Narasimham Committee.
The approach was to ensure that the financial services industry operates on the
basis of operational flexibility and functional autonomy with a view to enhancing
efficiency, productivity and profitability'.
The second phase, guided by Narasimham Committee II, focused on

strengthening the foundations of the banking system and bringing about structural
improvements. Further intensive discussions are held on important issues related
to corporate governance, reform of the capital structure, (in the context of Basel II
norms), retail banking, risk management technology, and human resources
development, among others.
Since 1992, significant changes have been introduced in the Indian financial
system. These changes have infused an element of competition in the financial system,
marking the gradual end of financial repression characterized by price and non-price
controls in the process of financial intermediation. While financial markets have been
fairly developed, there still remains a large extent of segmentation of markets and nonlevel playing field among participants, which contribute to volatility in asset prices. This
volatility is exacerbated by the lack of liquidity in the secondary markets. The purpose of
this paper is to highlight the need for the regulator and market participants to recognize
the risks in the financial system, the products available to hedge risks and the
instruments, including derivatives that are required to be developed/introduced in the
Indian system.
The financial sector serves the economic function of intermediation by ensuring
efficient allocation of resources in the economy. Financial intermediation is enabled
through a four-pronged transformation mechanism consisting of liability-asset
transformation, size transformation, maturity transformation and risk transformation.
10
0871913907
Risk is inherent in the very act of transformation. However, prior to reform of

1991-92, banks were not exposed to diverse financial risks mainly because interest rates
were regulated, financial asset prices moved within a narrow band and the roles of
different categories of intermediaries were clearly defined. Credit risk was the major risk
for which banks adopted certain appraisal standards.
Several structural changes have taken place in the financial sector since 1992. The
operating environment has undergone a vast change bringing to fore the critical
importance of managing a whole range of financial risks. The key elements of this
transformation process have been
1. The deregulation of coupon rate on Government securities.
2. Substantial liberalization of bank deposit and lending rates.
3. A gradual trend towards disintermediation in the financial system in the wake of
increased access of corporates to capital markets.
4. Blurring of distinction between activities of financial institutions.
5. Greater integration among the various segments of financial markets and their
increased order of globalisation, diversification of ownership of public sector
banks.
6. Emergence of new private sector banks and other financial institutions, and,
7. The rapid advancement of technology in the financial system.
11
0871913907
DEFINITION OF RISK
What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means different
things to different people. For some it is "financial (exchange rate, interest-call money
rates), mergers of competitors globally to form more powerful entities and not leveraging
IT optimally" and for someone else "an event or commitment which has the potential to
generate commercial liability or damage to the brand image". Since risk is accepted in
business as a trade off between reward and threat, it does mean that taking risk bring forth
benefits as well. In other words it is necessary to accept risks, if the desire is to reap the
anticipated benefits.
Risk in its pragmatic definition, therefore, includes both threats that can
materialize and opportunities, which can be exploited. This definition of risk is very
pertinent today as the current business environment offers both challenges and
opportunities to organizations, and it is up to an organization to manage these to their
competitive advantage.
What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some future
event will cause harm. It provides strategies, techniques, and an approach to recognizing
and confronting any threat faced by an organization in fulfilling its mission. Risk
management may be as uncomplicated as asking and answering three basic questions:
12
0871913907
1. What can go wrong?

2. What will we do (both to prevent the harm from occurring and in the aftermath of
an "incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the organization to
bring their risks to manageable proportions while not severely affecting their income.
This balancing act between the risk levels and profits needs to be well-planned. Apart
from bringing the risks to manageable proportions, they should also ensure that one risk
does not get transformed into any other undesirable risk. This transformation takes place
due to the inter-linkage present among the various risks. The focal point in managing any
risk will be to understand the nature of the transaction in a way to unbundle the risks it is
exposed to.
Risk Management is a more mature subject in the western world. This is largely a
result of lessons from major corporate failures, most telling and visible being the Barings
collapse. In addition, regulatory requirements have been introduced, which expect
organizations to have effective risk management practices. In India, whilst risk
management is still in its infancy, there has been considerable debate on the need to
introduce comprehensive risk management practices.
Objectives of Risk Management Function
Two distinct viewpoints emerge
One which is about managing risks, maximizing profitability and creating

opportunity out of risks
And the other which is about minimising risks/loss and protecting corporate
assets.
The management of an organization needs to consciously decide on whether they
want their risk management function to 'manage' or 'mitigate' Risks.
13
0871913907
Managing risks essentially is about striking the right balance between risks and
controls and taking informed management decisions on opportunities and threats
facing an organization. Both situations, i.e. over or under controlling risks are
highly undesirable as the former means higher costs and the latter means possible
exposure to risk.
Mitigating or minimising risks, on the other hand, means mitigating all risks even
if the cost of minimising a risk may be excessive and outweighs the cost-benefit
analysis. Further, it may mean that the opportunities are not adequately exploited.
In the context of the risk management function, identification and management of
Risk is more prominent for the financial services sector and less so for consumer products
industry. What are the primary objectives of your risk management function? When
specifically asked in a survey conducted, 33% of respondents stated that their risk
management function is indeed expressly mandated to optimise risk.
Risks in Banking
Risks manifest themselves in many ways and the risks in banking are a result of
many diverse activities, executed from many locations and by numerous people. As a
financial intermediary, banks borrow funds and lend them as a part of their primary
activity. This intermediation activity, of banks exposes them to a host of risks. The
volatility in the operating environment of banks will aggravate the effect of the various
risks. The case discusses the various risks that arise due to financial intermediation and
by highlighting the need for asset-liability management; it discusses the Gap Model for
risk management.
Typology of Risk Exposure
Based on the origin and their nature, risks are classified into various categories.
The most prominent financial risks to which the banks are exposed to taking into
consideration practical issues including the limitations of models and theories, human
14
0871913907
factor, existence of frictions such as taxes and transaction cost and limitations on quality
and quantity of information, as well as the cost of acquiring this information, and more.
FINANCIAL RISKS
MARKET
RISK
LIQUIDITY
RISK
OPERATIONAL
RISK
CREDIT RISK
LEGAL &
REGULATORY RISK
FUNDING
LIQUIDITY RISK
TRANSACTION
RISK
ISSUE RISK
EQUITY RISK
HUMAN
FACTOR RISK
TRADING
LIQUIDITY RISK
PORTFOLIO
CONCENTRATION
ISSUER RISK
INEREST
RATE RISK
COUNTERPARTY
RISK
CURRENCY
RISK
COMMODITY
RISK
15
TRADING
RISK
GENERAL
MARKET RISK
0871913907
GAP RISK
SPECIFIC
RISK
1. MARKET RISK
Market risk is that risk that changes in financial market prices and rates will
reduce the value of the banks positions. Market risk for a fund is often measured relative
to a benchmark index or portfolio, is referred to as a risk of tracking error market risk
also includes basis risk, a term used in risk management industry to describe the chance
of a breakdown in the relationship between price of a product, on the one hand, and the
price of the instrument used to hedge that price exposure on the other. The market-Var
methodology attempts to capture multiple component of market such as directional risk,
convexity risk, volatility risk, basis risk, etc.
2. CREDIT RISK
Credit risk is that risk that a change in the credit quality of a counterparty will
affect the value of a banks position. Default, whereby a counterparty is unwilling or
unable to fulfill its contractual obligations, is the extreme case; however banks are also
exposed to the risk that the counterparty might downgraded by a rating agency.
Credit risk is only an issue when the position is an asset, i.e., when it exhibits a
positive replacement value. In that instance if the counterparty defaults, the bank either
loses all of the market value of the position or, more commonly, the part of the value that
it cannot recover following the credit event. However, the credit exposure induced by the
replacement values of derivative instruments are dynamic: they can be negative at one
point of time, and yet become positive at a later point in time after market conditions
have changed. Therefore the banks must examine not only the current exposure,
16
0871913907
measured by the current replacement value, but also the profile of future exposures up to
the termination of the deal.
3. LIQUIDITY RISK
Liquidity risk comprises both
Funding liquidity risk
Trading-related liquidity risk.

Funding liquidity risk relates to a financial institutions ability to raise the
necessary cash to roll over its debt, to meet the cash, margin, and collateral requirements
of counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding
liquidity risk is affected by various factors such as the maturities of the liabilities, the
extent of reliance of secured sources of funding, the terms of financing, and the breadth
of funding sources, including the ability to access public market such as commercial
paper market. Funding can also be achieved through cash or cash equivalents, buying
power , and available credit lines.
Trading-related liquidity risk, often simply called as liquidity risk, is the risk that
an institution will not be able to execute a transaction at the prevailing market price
because there is, temporarily, no appetite for the deal on the other side of the market. If
the transaction cannot be postponed its execution my lead to substantial losses on
position. This risk is generally very hard to quantify. It may reduce an institutions ability
to manage and hedge market risk as well as its capacity to satisfy any shortfall on the
funding side through asset liquidation.
4. OPERATIONAL RISK
It refers to potential losses resulting from inadequate systems, management
failure, faulty control, fraud and human error. Many of the recent large losses related to
derivatives are the direct consequences of operational failure. Derivative trading is more
prone to operational risk than cash transactions because derivatives are, by heir nature,
leveraged transactions. This means that a trader can make very large commitment on
17
0871913907
behalf of the bank, and generate huge exposure in to the future, using only small amount
of cash. Very tight controls are an absolute necessary if the bank is to avoid huge losses.
Operational risk includes fraud, for example when a trader or other employee
intentionally falsifies and misrepresents the risk incurred in a transaction. Technology
risk, and principally computer system risk also fall into the operational risk category.
5. LEGAL RISK
Legal risk arises for a whole of variety of reasons. For example, counterparty
might lack the legal or regulatory authority to engage in a transaction. Legal risks usually
only become apparent when counterparty, or an investor, lose money on a transaction and
decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk
is the potential impact of a change in tax law on the market value of a position.
6. HUMAN FACTOR RISK
Human factor risk is really a special form of operational risk. It relates to the
losses that may result from human errors such as pushing the wrong button on a
computer, inadvertently destroying files, or entering wrong value for the parameter input
of a model.
18
0871913907
MARKET RISK
What is Market Risk?
Market Risk may be defined as the possibility of loss to a bank caused by changes
in the market variables. The Bank for International Settlements (BIS) defines market risk
as the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected
by movements in equity and interest rate markets, currency exchange rates and
commodity prices". Thus, 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, foreign exchange and
equities, as well as the volatilities of those changes. Besides, it is equally concerned about
the bank's ability to meet its obligations as and when they fall due. In other words, it
should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on the
management of Liquidity Risk and Market Risk, further categorized into interest rate risk,
foreign exchange risk, commodity price risk and equity price risk. An effective market
risk management framework in a bank comprises risk identification, setting up of limits
and triggers, risk monitoring, models of analysis that value positions or measure market
risk, risk reporting, etc.
Types of market risk
Interest rate risk:
19
0871913907
Interest rate risk is the risk where changes in market interest rates might adversely
affect a bank's financial condition. The immediate impact of changes in interest rates is
on the Net Interest Income (NII). A long term impact of changing interest rates is on the
bank's networth since the economic value of a bank's assets, liabilities and off-balance
sheet positions get affected due to variation in market interest rates. The interest rate risk
when viewed from these two perspectives is known as 'earnings perspective' and
'economic value' perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from the
maturity and repricing mismatches and is measured both from the earnings and economic
value perspective.
Earnings perspective involves analyzing the impact of changes in interest
rates on accrual or reported earnings in the near term. This is measured by
measuring the changes in the Net Interest Income (NII) or Net Interest Margin
(NIM) i.e. the difference between the total interest income and the total interest
expense.
Economic Value perspective involves analyzing the changes of impact on
interest on the expected cash flows on assets minus the expected cash flows on
liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk
to networth arising from all repricing mismatches and other interest rate sensitive
positions. The economic value perspective identifies risk arising from long-term
interest rate gaps.
The management of Interest Rate Risk should be one of the critical components of
market risk management in banks. The regulatory restrictions in the past had greatly
reduced many of the risks in the banking system. Deregulation of interest rates has,
however, exposed them to the adverse impacts of interest rate risk. The Net Interest
Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of
interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing
20
0871913907
dates (floating assets or liabilities), expose bank's NII or NIM to variations. The earning
of assets and the cost of liabilities are now closely related to market interest rate volatility
Generally, the approach towards measurement and hedging of IRR varies with the
segmentation of the balance sheet. In a well functioning risk management system, banks
broadly position their balance sheet into Trading and Banking Books. While the assets
in the trading book are held primarily for generating profit on short-term differences in
prices/yields, the banking book comprises assets and liabilities, which are contracted
basically on account of relationship or for steady income and statutory obligations and
are generally held till maturity. Thus, while the price risk is the prime concern of banks in
trading book, the earnings or economic value changes are the main focus of banking
book.
Equity price risk:

The price risk associated with equities also has two components General market
risk refers to the sensitivity of an instrument / portfolio value to the change in the level
of broad stock market indices. Specific / Idiosyncratic risk refers to that portion of the
stocks price volatility that is determined by characteristics specific to the firm, such as its
line of business, the quality of its management, or a breakdown in its production process.
The general market risk cannot be eliminated through portfolio diversification while
specific risk can be diversified away.
Foreign exchange risk:

Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as
a result of adverse exchange rate movements during a period in which it has an open
position, either spot or forward, or a combination of the two, in an individual foreign
currency. The banks are also exposed to interest rate risk, which arises from the maturity
mismatching of foreign currency positions. Even in cases where spot and forward
positions in individual currencies are balanced, the maturity pattern of forward
21
0871913907
transactions may produce mismatches. As a result, banks may suffer losses as a result of
changes in premia/discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the counterparties or
settlement risk. While such type of risk crystallization does not cause principal loss,
banks may have to undertake fresh transactions in the cash/spot market for replacing the
failed transactions. Thus, banks may incur replacement cost, which depends upon the
currency rate movements. Banks also face another risk called time-zone risk or Herstatt
risk which arises out of time-lags in settlement of one currency in one center and the
settlement of another currency in another time-zone. The forex transactions with
counterparties from another country also trigger sovereign or country risk (dealt with in
details in the guidance note on credit risk).
The three important issues that need to be addressed in this regard are:
1. Nature and magnitude of exchange risk
2. Exchange managing or hedging for adopted be to strategy>
3. The tools of managing exchange risk
Commodity price risk:

The price of the commodities differs considerably from its interest rate risk
and foreign exchange risk, since most commodities are traded in the market in
which the concentration of supply can magnify price volatility. Moreover,
fluctuations in the depth of trading in the market (i.e., market liquidity) often
accompany and exacerbate high levels of price volatility. Therefore, commodity
prices generally have higher volatilities and larger price discontinuities.
Treatment of Market Risk in the Proposed Basel Capital Accord
22
0871913907
The Basle Committee on Banking Supervision (BCBS) had issued comprehensive

guidelines to provide an explicit capital cushion for the price risks to which banks are
exposed, particularly those arising from their trading activities. The banks have been
given flexibility to use in-house models based on VaR for measuring market risk as an
alternative to a standardized measurement framework suggested by Basle Committee.
The internal models should, however, comply with quantitative and qualitative criteria
prescribed by Basle Committee.
Reserve Bank of India has accepted the general framework suggested by the Basle
Committee. RBI has also initiated various steps in moving towards prescribing capital for
market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments
in Government and other approved securities, besides a risk weight each of 100% on the
open position limits in forex and gold. RBI has also prescribed detailed operating
guidelines for Asset-Liability Management System in banks. As the ability of banks to
identify and measure market risk improves, it would be necessary to assign explicit
capital charge for market risk. While the small banks operating predominantly in India
could adopt the standardized methodology, large banks and those banks operating in
international markets should develop expertise in evolving internal models for
measurement of market risk.
The Basle Committee on Banking Supervision proposes to develop capital charge
for interest rate risk in the banking book as well for banks where the interest rate risks are
significantly above average ('outliers'). The Committee is now exploring various
methodologies for identifying 'outliers' and how best to apply and calibrate a capital
charge for interest rate risk for banks. Once the Committee finalizes the modalities, it
may be necessary, at least for banks operating in the international markets to comply with
the explicit capital charge requirements for interest rate risk in the banking book. As the
valuation norms on banks' investment portfolio have already been put in place and
aligned with the international best practices, it is appropriate to adopt the Basel norms on
capital for market risk. In view of this, banks should study the Basel framework on
23
0871913907
capital for market risk as envisaged in Amendment to the Capital Accord to incorporate
market risks published in January 1996 by BCBS and prepare themselves to follow the
international practices in this regard at a suitable date to be announced by RBI.
The Proposed New Capital Adequacy Framework

The Basel Committee on Banking Supervision has released a Second Consultative
Document, which contains refined proposals for the three pillars of the New Accord Minimum Capital Requirements, Supervisory Review and Market Discipline. It may be
recalled that the Basel Committee had released in June 1999 the first Consultative Paper
on a New Capital Adequacy Framework for comments. However, the proposal to
provide explicit capital charge for market risk in the banking book which was included in
the Pillar I of the June 1999 Document has been shifted to Pillar II in the second
Consultative Paper issued in January 2001. The Committee has also provided a technical
paper on evaluation of interest rate risk management techniques. The Document has
defined the criteria for identifying outlier banks. According to the proposal, a bank may
be defined as an outlier whose economic value declined by more than 20% of the sum of
Tier 1 and Tier 2 capital as a result of a standardized interest rate shock (200 bps.)
The second Consultative Paper on the New Capital Adequacy framework issued
in January, 2001 has laid down 13 principles intended to be of general application for the
management of interest rate risk, independent of whether the positions are part of the
trading book or reflect banks' non-trading activities. They refer to an interest rate risk
management process, which includes the development of a business strategy, the
assumption of assets and liabilities in banking and trading activities, as well as a system
24
0871913907
of internal controls. In particular, they address the need for effective interest rate risk
measurement, monitoring and control functions within the interest rate risk management
process. The principles are intended to be of general application, based as they are on
practices currently used by many international banks, even though their specific
application will depend to some extent on the complexity and range of activities
undertaken by individual banks. Under the New Basel Capital Accord, they form
minimum standards expected of internationally active banks. The principles are given in
Annexure II.
CREDIT RISK
What is Credit Risk?
Credit risk is defined as the possibility of losses associated with diminution in the
credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from
outright default due to inability or unwillingness of a customer or counterparty to meet
commitments in relation to lending, trading, settlement and other financial transactions.
Alternatively, losses result from reduction in portfolio value arising from actual or
perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with
an individual, corporate, bank, financial institution or a sovereign. Credit risk may take
the following forms
In the case of direct lending: principal/and or interest amount may not be repaid;
In the case of guarantees or letters of credit: funds may not be forthcoming from
the constituents upon crystallization of the liability;
In the case of treasury operations: the payment or series of payments due from the
counter parties under the respective contracts may not be forthcoming or ceases;
In the case of securities trading businesses: funds/ securities settlement may not
be effected;
25
0871913907
In the case of cross-border exposure: the availability and free transfer of foreign
currency funds may either cease or the sovereign may impose restrictions.
Types of Credit Rating

Credit rating can be classified as:
2. External credit rating.
3. Internal credit rating
External credit rating:

A credit rating is not, in general, an investment recommendation concerning a
given security. In the words of S&P, A credit rating is S&P's opinion of the general
creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a
particular debt security or other financial obligation, based on relevant risk factors. In
Moody's words, a rating is, an opinion on the future ability and legal obligation of an
issuer to make timely payments of principal
and interest on a specific fixed-income
security.
Since S&P and Moody's are considered to have expertise in credit rating and are
regarded as unbiased evaluators, there ratings are widely accepted by market participants
and regulatory agencies. Financial institutions, when required to hold investment grade
bonds by their regulators use the rating of credit agencies such as S&P and Moody's to
determine which bonds are of investment grade.
The subject of credit rating might be a company issuing debt obligations. In the
case of such issuer credit ratings the rating is an opinion on the obligors
overall
capacity to meet its financial obligations. The opinion is not specific to any particular
liability of the company, nor does it consider merits of having guarantors for some of the
obligations. In the issuer credit rating categories are
a) Counterparty ratings
26
0871913907
b) Corporate credit ratings

c) Sovereign credit ratings
The rating process includes quantitative, qualitative, and legal analyses. The
quantitative analyses. The quantitative analysis is mainly financial analysis and is based
on the firms financial reports. The qualitative analysis is concerned with the quality of
management, and includes a through review of the firms
competitiveness within its
industry as well as the expected growth of the industry and its vulnerability to
technological changes, regulatory changes, and labor relations.
Internal credit rating:

A typical risk rating system (RRS) will assign both an obligor rating to each
borrower (or group of borrowers), and a facility rating to each available facility. A risk
rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should
offer a carefully designed, structured, and documented series of steps for the assessment
of each rating.
The following are the steps for assessment of rating:
a) Objectivity and Methodology:
The goal is to generate accurate and consistent risk rating, yet also to allow
professional judgment to significantly influence a rating where it is appropriate. The
expected loss is the product of an exposure (say, Rs. 100) and the probability of default
(say, 2%) of an obligor (or borrower) and the loss rate given default (say, 50%) in any
specific credit facility. In this example,
The expected loss = 100*.02*.50 = Rs. 1
A typical risk rating methodology (RRM)
a. Initial assign an obligor rating that identifies the expected probability of
default by that borrower (or group) in repaying its obligations in normal
course of business.
27
0871913907
b. The RRS then identifies the risk loss (principle/interest) by assigning an RR to

each individual credit facility granted to an obligor.
The obligor rating represents the probability of default by a borrower in repaying
its obligation in the normal course of business. The facility rating represents the expected
loss of principal and/ or interest on any business credit facility. It combines the likelihood
of default by a borrower and conditional severity of loss, should default occur, from the
credit facilities available to the borrower.
Risk Rating Continuum (Prototype Risk Rating System)

RISK
Sovereign
Low
Average
High
RR
Corresponding Probable
0
1
2
3
4
5
6
7
8
S&P or Moody's Rating

Not Applicable
AAA
AA
A
BBB+/BBB
BBBBB+/BB
BBB+/B
B-
10
11
12
CCC+/CCC
CCIn Default
Investment Grade
Below Investment
Grade
The steps in the RRS (nine, in our prototype system) typically start with a
financial assessment of the borrower (initial obligor rating), which sets a floor on the
obligor rating (OR). A series of further steps (four) arrive at the final obligor rating. Each
one of steps 2 to 5 may result in the downgrade of the initial rating attributed at step 1.
28
0871913907
These steps include analyzing the managerial capability of the borrower (step 2),
examining the borrowers absolute and relative position within the industry (step 3),
reviewing the quality of the financial information (step 4) and the country risk (step 5).
The process ensures that all credits are objectively rated using a consistent process to
arrive at the accurate rating.
Additional steps (four, in our example) are associated with arriving at a final facility
rating, which may be
above OR below the final obligor rating. These steps include
examining third-party support (step 6), factoring in the maturity of the transaction (step
7), reviewing how strongly the transaction is structured. (step 8), and assessing the
amount of collateral (step 9).
b) Measurement of Default Probability and Recovery Rates.
Credit rating systems can be compared to multivariate credit scoring systems to
evaluate their ability to predict bankruptcy rates and also to provide estimates of the
severity of losses. Altman and Saunders (1998) provide a detailed survey of credit risk
management approaches. They compare four methodologies for credit scoring:
1. The linear probability model
2. The logit model
3. The probit model
4. The discriminant analysis model
The logit model assumes that the default probability is logistically distributed, and
applies a few accounting variables to predict the default probability. The linear
probability model is based on a linear regression model, and makes use of a number of
accounting variables to try to predict the probability of default. The multiple discriminant
analysis (MDA), proposed and advocated by Aitman is based on finding a linear function
of both accounting and market based variables that best discriminates between two
groups: firms that actually defaulted and firms that did not default.
The linear models are based on empirical procedures. They are not found in
theory of the firm OR any theoretical stochastic processes for leveraged firms.
29
0871913907
Credit Risk Management

In this backdrop, it is imperative that banks have a robust credit risk management
system which is sensitive and responsive to these factors. The effective management of
credit risk is a critical component of comprehensive risk management and is essential for
the long term success of any banking organization. Credit risk management encompasses
identification, measurement, monitoring and control of the credit risk exposures.
Building Blocks of Credit Risk Management:
In a bank, an effective credit risk management framework would comprise of the
following distinct building blocks:
Policy and Strategy
Organizational Structure
Operations/ Systems
Policy and Strategy
The Board of Directors of each bank shall be responsible for approving and
periodically reviewing the credit risk strategy and significant credit risk policies.
Credit Risk Policy
1. Every bank should have a credit risk policy document approved by the Board. The
document should include risk identification, risk measurement, risk grading/
aggregation techniques, reporting and risk control/ mitigation techniques,
documentation, legal issues and management of problem loans.
2. Credit risk policies should also define target markets, risk acceptance criteria,
credit approval authority, credit origination/ maintenance procedures and
guidelines for portfolio management.
3. The credit risk policies approved by the Board should be communicated to
branches/controlling offices. All dealing officials should clearly understand the
30
0871913907
bank's approach for credit sanction and should be held accountable for complying
with established policies and procedures.
4. Senior management of a bank shall be responsible for implementing the credit
risk policy approved by the Board.</P< LI>
Credit Risk Strategy
1. Each bank should develop, with the approval of its Board, its own credit risk
strategy or plan that establishes the objectives guiding the bank's credit-granting
activities and adopt necessary policies/ procedures for conducting such activities.
This strategy should spell out clearly the organizations credit appetite and the
acceptable level of risk-reward trade-off for its activities.
2. The strategy would, therefore, include a statement of the bank's willingness to
grant loans based on the type of economic activity, geographical location,
currency, market, maturity and anticipated profitability. This would necessarily
translate into the identification of target markets and business sectors, preferred
levels of diversification and concentration, the cost of capital in granting credit
and the cost of bad debts.
3. The credit risk strategy should provide continuity in approach as also take into
account the cyclical aspects of the economy and the resulting shifts in the
composition/ quality of the overall credit portfolio. This strategy should be viable
in the long run and through various credit cycles.
4. Senior management of a bank shall be responsible for implementing the credit
risk strategy approved by the Board.
Organizational Structure
31
0871913907
Sound organizational structure is sine qua non for successful implementation of

an effective credit risk management system. The organizational structure for credit risk
management should have the following basic features:
1. The Board of Directors should have the overall responsibility for management of
risks. The Board should decide the risk management policy of the bank and set
limits for liquidity, interest rate, foreign exchange and equity price risks.
The Risk Management Committee will be a Board level Sub committee including
CEO and heads of Credit, Market and Operational Risk Management Committees. It will
devise the policy and strategy for integrated risk management containing various risk
exposures of the bank including the credit risk. For this purpose, this Committee should
effectively coordinate between the Credit Risk Management Committee (CRMC), the
Asset Liability Management Committee and other risk committees of the bank, if any. It
is imperative that the independence of this Committee is preserved. The Board should,
therefore, ensure that this is not compromised at any cost. In the event of the Board not
accepting any recommendation of this Committee, systems should be put in place to spell
out the rationale for such an action and should be properly documented. This document
should be made available to the internal and external auditors for their scrutiny and
comments. The credit risk strategy and policies adopted by the committee should be
effectively
Operations / Systems
Banks should have in place an appropriate credit administration, credit risk
measurement and monitoring processes. The credit administration process typically
involves the following phases:
1. Relationship management phase i.e. business development.
2. Transaction management phase covers risk assessment, loan pricing, structuring
the facilities, internal approvals, documentation, loan administration, on going
monitoring and risk measurement.
32
0871913907
3. Portfolio management phase entails monitoring of the portfolio at a macro level

and the management of problem loans
4. On the basis of the broad management framework stated above, the banks should
have the following credit risk measurement and monitoring procedures:
5. Banks should establish proactive credit risk management practices like annual /
half yearly industry studies and individual obligor reviews, periodic credit calls
that are documented, periodic visits of plant and business site, and at least
quarterly management reviews of troubled exposures/weak credits
Credit Risk Models
A credit risk model seeks to determine, directly or indirectly, the answer to the
following question: Given our past experience and our assumptions about the future,
what is the present value of a given loan or fixed income security? A credit risk model
would also seek to determine the (quantifiable) risk that the promised cash flows will not
be forthcoming. The techniques for measuring credit risk that have evolved over the last
twenty years are prompted by these questions and dynamic changes in the loan market.
The increasing importance of credit risk modeling should be seen as the
consequence of the following three factors:
1. Banks are becoming increasingly quantitative in their treatment of credit risk.
2. New markets are emerging in credit derivatives and the marketability of existing
loans is increasing through securitization/ loan sales market."
3. Regulators are concerned to improve the current system of bank capital
requirements especially as it relates to credit risk.
33
0871913907
Importance of Credit Risk Models
Credit Risk Models have assumed importance because they provide the decision
maker with insight or knowledge that would not otherwise be readily available or that
could be marshalled at prohibitive cost. In a marketplace where margins are fast
disappearing and the pressure to lower pricing is unrelenting, models give their users a
competitive edge. The credit risk models are intended to aid banks in quantifying,
aggregating and managing risk across geographical and product lines. The outputs of
these models also play increasingly important roles in banks' risk management and
performance measurement processes, customer profitability analysis, risk-based pricing,
active portfolio management and capital structure decisions. Credit risk modeling may
result in better internal risk management and may have the potential to be used in the
supervisory oversight of banking organizations.
RBI Guidelines on Credit Risk New Capital Accord: Implications for

Credit Risk Management
The Basel Committee on Banking Supervision had released in June 1999 the first
Consultative Paper on a New Capital Adequacy Framework with the intention of
replacing the current broad-brush 1988 Accord. The Basel Committee has released a
Second Consultative Document in January 2001, which contains refined proposals for the
three pillars of the New Accord - Minimum Capital Requirements, Supervisory Review
and Market Discipline.
The Committee proposes two approaches, for estimating regulatory capital. viz.,
1. Standardized and
2. Internal Rating Based (IRB)
Under the standardized approach, the Committee desires neither to produce a
net increase nor a net decrease, on an average, in minimum regulatory capital, even after
34
0871913907
accounting for operational risk. Under the Internal Rating Based (IRB) approach, the
Committee's ultimate goals are to ensure that the overall level of regulatory capital is
sufficient to address the underlying credit risks and also provides capital incentives
relative to the standardized approach, i.e., a reduction in the risk weighted assets of 2% to
3% (foundation IRB approach) and 90% of the capital requirement under foundation
approach for advanced IRB approach to encourage banks to adopt IRB approach for
providing capital.
The minimum capital adequacy ratio would continue to be 8% of the riskweighted assets, which cover capital requirements for market (trading book), credit and
operational risks. For credit risk, the range of options to estimate capital extends to
include a standardized, a foundation IRB and an advanced IRB approaches.
RBI Guidelines for Credit Risk Management Credit Rating Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations
associated with a simplistic and broad classification of loans/exposures into a "good" or a

"bad" category. The CRF deploys a number/ alphabet/ symbol as a primary summary
indicator of risks associated with a credit exposure. Such a rating framework is the basic
module for developing a credit risk management system and all advanced
models/approaches are based on this structure. In spite of the advancement in risk
management techniques, CRF is continued to be used to a great extent. These frameworks
have been primarily driven by a need to standardize and uniformly communicate the
"judgment" in credit selection procedures and are not a substitute to the vast lending
experience accumulated by the banks' professional staff.
Broadly, CRF can be used for the following purposes:
35
0871913907
1. Individual credit selection, wherein either a borrower or a particular exposure/

facility is rated on the CRF
2. Pricing (credit spread) and specific features of the loan facility. This would largely
constitute transaction-level analysis.
3. Portfolio-level analysis.
4. Surveillance, monitoring and internal MIS
Assessing the aggregate risk profile of bank/ lender. These would be relevant for
portfolio-level analysis. For instance, the spread of credit exposures across various CRF
categories, the mean and the standard deviation of losses occurring in each CRF category
and the overall migration of exposures would highlight the aggregated credit-risk for the
entire portfolio of the bank.
OPERATIONAL RISK
What is Operational Risk?
Operational risk is the risk associated with operating a
business. Operational risk covers such a wide area that it is useful to subdivide
operational risk into two components:
Operational failure risk.
Operational strategic risk.

Operational failure risk arises from the potential for failure in the course of
operating the business. A firm uses people, processes and technology to achieve the
business plans, and any one of these factors may experience a failure of some kind.
Accordingly, operational failure risk can be defined as the risk that there will be a failure
36
0871913907
of people, processes or technology within the business unit. A portion of failure may be
anticipated, and these risks should be built into the business plan. But it is unanticipated,
and therefore uncertain, failures that give rise to key operational risks. These failures can
be expected to occur periodically, although both their impact and their frequency may be
uncertain.
The impact or severity of a financial loss can be divided into two categories:
An expected amount
An unexpected amount.
The latter is itself subdivided into two classes: an amount classed as severe, and a
catastrophic amount. The firm should provide for the losses that arise from the expected
component of these failures by charging expected revenues with a sufficient amount of
reserves. In addition, the firm should set aside sufficient economic capital to cover the
unexpected component, or resort to insurance.
Operational strategic risk arises from environmental
factors, such as a
new
competitor that changes the business paradigram, a major political and regulatory regime
change, and earthquakes and other such factors that are outside the control of the firm. It
also arises from major new strategic initiatives, such as developing a new line of business
or re-engineering an existing business line. All business rely on people, processes and
technology outside their business unit, and the potential for failure exists there too, this
type of risk is referred to as external dependency risk.
Operational failure risk

Operational strategic risk
Operational
Risk
(Internal operational risk)
(External
operational risk)
The risk encountered in pursuit
of a particular strategy due to:
People
Process
Technology
The risk of choosing an

inappropriate strategy in
response to environmental
factor, such as
Gitarattan International
SchoolCategories
Figure: Business
Two Broad
Political
Taxation
Regulation
Government
of Operational
Risk
Societal
Competition, etc.
37
0871913907
The figure above summarizes the relationship between operational failure risk and
operational strategic risk. These two principal categories of risk are also sometimes
defined as internal and external operational risk.
Operational risk is often thought to be limited to losses that can occur in operating
or processing centers. This type of operational risk, sometimes referred as operations risk,
is an important component, but it by no means covers all of the operational risks facing
the firm. Our definition of operational risk as the risk associated with operating the
business means significant amounts of operational risk are also generated outside the
processing centers.
Risk begins to accumulate even before the design of the potential transaction gets
underway. It is present during negotiations with the client (regardless of whether the
negotiation is a lengthy structuring exercise or a routine electronic negotiation.) and
continues after the negotiation as the transaction is serviced.
A complete picture of operational risk can only be obtained if the banks activity
is analyzed from beginning to end. Several things have to be in place before a transaction
is negotiated, and each exposes the firm to operational risk. The activity carried on behalf
of the client by the staff can expose the institution to people risk. People risk are not
38
0871913907
only in the form of risk found early in a transaction. But they further rely on using
sophisticated financial models to price the transaction. This creates what is called as
Model risk which can arise because of wrong parameters like input to the model, or
because the model is used inappropriately and so on.
Once the transaction is negotiated and a ticket is written, errors can occur as the
transaction is recorded in various systems or reports. An error here may result in the
delayed settlement of the transaction, which in turn can give rise to fines and other
penalties. Further an error in market risk and credit risk report might lead to the
exposures generated by the deal being understated. In turn this can lead to the execution
of additional transactions that would otherwise not have been executed. These are
examples of what is often called as process risk
The system that records the transaction may not be capable of handling the
transaction or it may not have the capacity to handle such transactions. If any one of the
step is out-sourced, then external dependency risk also arises. However, each type of risk
can be captured either as people, processes, technology, or an external dependency risk,
and each can be analyzed in terms of capacity, capability or availability
Who Should Manage Operational Risk?
The responsibility for setting policies concerning operational risk remains with
the senior management, even though the development of those policies may be delegated,
and submitted to the board of directors for approval. Appropriate policies must be put in
place to limit the amount of operational risk
that is assumed by an institution. Senior
management needs to give authority to change the operational risk profile to those who
are the best able to take action. They must also ensure that a methodology for the timely
and effective monitoring of the risks that are incurred is in place. To avoid any conflict of
interest, no single group within the bank should be responsible for simultaneously setting
policies, taking action and monitoring risk.
Internal Audit
39
0871913907
Senior Management
Business Management
Risk Management
Legal
Insurance
Operations
Finance
Information
Technology
Policy Setting
The authority to take action generally rests with business management, which is
responsible for controlling the amount of operational risk taken within each business line.
The infrastructure and the governance groups share with business management the
responsibility for managing operational risk.
The responsibility for the development of a methodology for measuring and
monitoring operational risks resides most naturally with group risk management
functions. The risk management function also needs to ensure the proper operational risk/
reward analysis is performed in the review of existing businesses and before the
introduction of new initiatives and products. In this regard, the risk management function
works very closely with, but independent from, business management, infrastructure, and
other governance group
40
0871913907
Senior management needs to know whether the responsibilities it has delegated

are actually being tended to, and whether the resulting processes are effective. The
internal audit function within the bank is charged with this responsibility.
Key to Implementing Bank-wide Operational Risk Management:
The eight key elements are necessary to successfully implement a bank-wide
operational risk management framework. They involve setting policy and identifying risk
as an outgrowth of having designed a common language, constructing business process
maps, building a best measurement methodology, providing exposure management,
installing a timely reporting capability, performing risk analysis inclusive of stress
testing, and allocating economic capital as a function of operational risk.
EIGHT KEY ELEMENTS TO ACHIEVE BEST OPERATIONAL RISK

MANAGEMENT.
1. Policy
2.Risk Identification
8. Economic Capital
7. Risk Analysis
3. Business Process
Best Practice
6. Reporting
4. Measuring Methodology
5. Exposure Management
41
0871913907
1. Develop well-defined operational risk policies. This includes explicitly

articulating the desired standards for the risk measurement. One also needs to
establish clear guidelines for practices that may contribute to a reduction of
operational risk.
2. Establish a common language of risk identification. For e.g., the term people
risk includes a failure to deploy skilled staff. Technology risk would include
system failure, and so on.
3. Develop business process maps of each business. For e.g., one should create an
operational risk catalogue which categories and defines the various operational
risks arising from each organizational unit in terms of people, process, and
technology risk. This catalogue should be tool to help with operational risk
identification and assessment.
Types of Operational Failure Risk
1. People Risk
1. Incompetancy.
2. Fraud.
2. Process Risk
Model Risk
1. Model/ methodology error

2. Mark-to-model error.
TR
1. Execution error.
2. Product complexity.
3. Booking error.
OCR
4. Settlement error.
1. Exceeding limits.
2. Security risk.
3. Technology Risk
3.Volume risk.
1. System failure.
2. Programming error.
42
0871913907
3. Information risk.
4. Telecommunications failure.
4. Develop a comprehensible set of operational risk metrics. Operational risk

assessment is a complex process. It needs to be performed on a firm-wide basis at
regular intervals using standard metrics. In early days, business and infrastructure
groups performed their own assessment of operational risk. Today, selfassessment has been discredited. Sophisticated financial institutions are trying to
develop objective measures of operational risk that build significantly more
reliability into the quantification of operational risk.
5. Decide how to manage operational risk exposure and take appriate action to hedge
the risks. The bank should address the economic question of th cost-benefit of
insuring a given risk for those operational risks that can be insured.
6. Decide how to report exposure.
7. Develop tools for risk analysis, and procedures for when these tools should
deploped. For e.g., risk analysis is typically performed as part of a new product
process, periodic business reviews, and so on. Stress testing should be a standard
part of risk analysis process. The frequency of risk assessment should be a
function of the degree to which operational risks are expected to change over
time as businesses undertake new initiatives, or as business circumstances evolve.
This frequency might be reviewed as operational risk measurement is rolled out
across the bank a bank should update its risk assessment more frequently. Further
one should reassess whenever the operational risk profile changes significantly.
8. Develop techniques to translate the calculation of operational risk into a required
amount of economic capital. Tools and procedures should be developed to enable
businesses to make decisions about operational risk based on risk/reward analysis.
Four-Step Measurement Process For Operational Risk
Clear guiding principle for the operational risk measurement process should be set
to ensure that it provides an appropriate measure of operational risk across all business
43
0871913907
units throughout the bank. This problem of measuring operational risk can be best
achieved by means of a four-step operational risk process. The following are the four
steps involved in the process:
1. Input.
2. Risk assessment framework.
3. Review and validation.
4. Output.
1. Input:
The first step in the operational risk measurement process is to gather the
information needed to perform a complete assessment of all significant operational risks.
A key source of this information is often the finished product of other groups. For
example, a unit that supports the business group often publishes report or documents that
may provide an excellent starting point for the operational risk assessment.
Sources of Information in the Measurement Process of Operational Risk :The
Inputs (for Assessment)
Likelihood of Occurrence
Audit report
Regulatory report
Management report
Expert opinion
Business Recovery Plan
Business plans
Budget plans
Operations plans
Severity
Management interviews
Loss history
For example, if one is relying on audit documents as an indication of the degree of

control, then one needs to ask if the audit assessment is current and sufficient. Have there
been any significant changes made since the last audit assessment? Did the audit scope
include the area of operational risk that is of concern to the present risk assessment? As
one diligently works through available information, gaps often become apparent. These
44
0871913907
gaps in the information often need to be filled through discussion with the relevant
managers.
Typically, there are not sufficient reliable historical data available to confidently
project the likelihood or severity of operational losses. One often needs to rely on the
expertise of business management, until reliable data are compiled to offer an assessment
of the severity of the operational failure for each of the risks. The time frame employed
for all aspects of the assessment process is typically one year. The one-year time horizon
is usually selected to align with the business planning cycle of the bank.
2. Risk Assessment Framework

The input information gathered in the above step needs to be analyzed and
processed through the risk assessment framework. Risk assessment framework includes:
1. Risk categories:
The operational risk can be broken down into four headline risk categories like the
risk of unexpected loss due to operational failure in people, process and technology
deployed within the business
Internal dependencies should each be reviewed according to a set of factors. We
examine these 9nternal dependencies according to three key components of
capability, capacity and availability.
External dependencies can also be analyzed in terms of the specific type of external
interaction.
2. Connectivity and interdependencies
The headline risk categories cannot be viewed in isolation from one another. One
needs to examine the degree of interconnected risk exposures that cut across the
headline operational risk categories, in order to understand the full impact of risk.
3. Change, complexity, compliancy:
45
0871913907
One may view the sources that drive the headline risk categories as falling under the
broad categories of Change refers to such items as introducing new technology or
new products, a merger or acquisition, or moving from internal supply to outsourcing,
etc. Complexity refers to such items as complexity of products, process or
technology. Complacency refer to ineffective management of the business.
4. Net likelihood assessment
The likelihood that an operational failure might occur within the next year should be
assessed, net of risk mitigants such as insurance, for each identified risk exposure and
for each of the four headline risk categories. Since it is often unclear how to quantify
risk, this assessment can be rated along five point likelihood continuum from very
low, low, medium, high and very high.
5. Severity assessment
Severity describes the potential loss to the bank given that an operational risk failure
has occurred. It should be assessed for each identified risk exposure.
6. Combined likelihood and severity into the overall Operational Risk Assessment
Operational risk measures are constrained in that there is not usually a defensible way
to combine the individual likelihood of loss and severity assessments into overall
measure of operational risk within a business unit. To do so, the likelihood of loss
would need to be expressed in numerical terms. This cannot be accomplished without
statistically significant historical data on operational losses.
7. Defining Cause and Effect:
Loss data are easier to collect than data associated with the cause of loss. This
complicates the measurement of operational risk because each loss is likely to have
several causes. This relationship between these causes, and the relative importance of
each, can be difficult to assess in an objective fashion.
3. Review and validation:
Once the report is generated. First the centralised operational risk management
group (ORMG) reviews the assessment results with senior business unit management and
key officers, in order to finalize the proposed operational risk rating. Second, one may
46
0871913907
want an operational risk rating committee to review the assessment a validation process
similar to that followed by credit rating agencies. This takes the form of review of the
individual risk assessments by knowledgeable senior committee personnel to ensure that
the framework has been consistently applied across businesses, that there has been
sufficient scrutiny to remove any imperfections, and so on. The committee should have
representation from business management, audit, and functional areas, and be chaired by
risk management unit.
4. Output
The final assessment of operational risk will be formally reported to business
management, the centralised risk-adjusted return on capital (RAROC) group, and the
partners in corporate governance such as internal audit and compliance. The output of the
assessment process has two main uses:
1. The assessment provides better operational risk information to management for
use in improving risk management decisions.
2. The assessment improves the allocation of economic capital to better reflect the
extent of the operational riskier, being taken by a business unit.
3. The over all assessment of the likelihood of operational risk & severity of loss for
a business unit can be shown as:
Medium
Risk
Severity of Loss ($)
Low
Risk
Mgmt. Attention
High
Risk
Medium
Risk
Likelihood of Loss ($)

A business unit may address its operational risks in several ways. First, one can invest in
business unit. Second, one can avoid the risk by withdrawing from business activity.
Third, one can accept and manage risk through effective monitoring and control. Fourth,
47
0871913907
one can transfer risk to another party. Of course, not all-operational risks are insurable,
and in that case of those that are insurable the required premium may be prohibitive. The
strategy and eventually the decision should be based on cost benefit analysis.
An Idealized Bank Of The Future

The efficient bank of the future will be driven by a single analytical risk engine
that draws its data from a single logical data repository. This engine will power front-,
middle-, and back-office functions, and supply information about enterprise-wide risk.
The ability to control and manage risk will be finely tuned to meet specific business
objectives. For example, far fewer significantly large losses, beyond a clearly articulate
tolerance for loss, will be incurred and the return to risk profile will be vastly improved.
With the appropriate technology in place, financial trading across all asset classes
will move from the current vertical, product-oriented environment (e.g., swaps, foreign
exchange, equities, loans, etc.) to a horizontal, customer-oriented environment in which
complex combinations of asset types will be traded.
There will be less need for desks that specialize in single product lines. The focus
will shift to customer needs rather than instrument types. The management of limits will
be based on capital, set in such a manner so as to maximize the risk-adjusted return on
capital for the firm.
48
0871913907
The firms exposure will be known and disseminated in real time. Evaluating the
risk of a specific deal will take into account its effect on the firms total risk exposure,
rather than simply the exposure of the individual deal.
Banks that dominate this technology will gain a tremendous competitive
advantage. Their information technology and trading infrastructure will be cheaper than
todays by orders of magnitude. Conversely, banks that attempt to build this infrastructure
in-house will become trapped in a quagmire of large, expensive IT departments-and
poorly supported software.
The successful banks will require far fewer risk systems. Most of which will be
based on a combination of industry standard, reusable, robust risk software and highly
sophisticated proprietary analytics. More importantly, they will be free to focus on their
core business and offer products more directly suited to their customers desired return to
risk profiles.
Study of Operational Risk at Punjab National Bank
About Punjab National Bank
Established in 1895 at Lahore, undivided India, Punjab National Bank (PNB) has
the distinction of being the first Indian bank to have been started solely with Indian
capital.The bank was nationalised in July 1969 along with 13 other banks. From its
modest beginning, the bank has grown in size and stature to become a front-line banking
institution in India at present. It is a professionally managed bank with a successful track
record of over 110 years.
It has the largest branch network in India - 4525 Offices including 432 Extension
Counters spread throughout the country. With its presence virtually in all the important
centres of the country, Punjab National Bank offers a wide variety of banking services
which include corporate and personal banking, industrial finance, agricultural finance,
financing of trade and international banking. Among the clients of the Bank are Indian
conglomerates, medium and small industrial units, exporters, non-resident Indians and
49
0871913907
multinational companies. The large presence and vast resource base have helped the Bank
to build strong links with trade and industry.
Operational Risk
Punjab National Bank is exposed to many types of operational risk. Operational risk can
result from a variety of factors, including:
1. Failure to obtain proper internal authorizations,
2. Improperly documented transactions,
3. Failure of operational and information security procedures,
4. Computer systems,
5. Software or equipment,
6. Fraud,
7. Inadequate training and employee errors.
PNB attempts to mitigate operational risk by maintaining a comprehensive system of
internal controls, establishing systems and procedures to monitor transactions,
maintaining key backup procedures and undertaking regular contingency planning.
I. Operational Controls and Procedures in Branches
PNB has operating manuals detailing the procedures for the processing of various
banking transactions and the operation of the application software. Amendments to these
manuals are implemented through circulars sent to all offices.
When taking a deposit from a new customer, PNB requires the new customer to complete
a relationship form, which details the terms and conditions for providing various banking
services.
Photographs of customers are also obtained for PNBs records, and specimen signatures
are scanned and stored in the system for online verification. PNB enters into a
relationship with a customer only after the customer is properly introduced to PNB.
When time deposits become due for repayment, the deposit is paid to the depositor.
System generated reminders are sent to depositors before the due date for repayment.
50
0871913907
Where the depositor does not apply for repayment on the due date, the amount is
transferred to an overdue deposits account for follow up.
PNB has a scheme of delegation of financial powers that sets out the monetary limit for
each employee with respect to the processing of transactions in a customer's account.
Withdrawals from customer accounts are controlled by dual authorization. Senior officers
have delegated power to authorize larger withdrawals. PNBs operating system validates
the check number and balance before permitting withdrawals. PNBs banking software
has multiple security features to protect the integrity of applications and data.
PNB gives importance to computer security and has s a comprehensive information
technology security policy. Most of the information technology assets including critical
servers are hosted in centralized data centers, which are subject to appropriate physical
and logical access controls.
II. Operational Controls and Procedures for Internet Banking

In order to open an Internet banking account, the customer must provide PNB with
documentation to prove the customer's identity, including a copy of the customer's
passport, a photograph and specimen signature of the customer. After verification of the
same, PNB opens the Internet banking account and issues the customer a user ID and
password to access his account online.
III. Operational Controls and Procedures in Regional Processing Centers &
Central Processing Centers
To improve customer service at PNBs physical locations, PNB handles transaction
processing centrally by taking away such operations from branches. PNB has centralized
operations at regional processing centers located at 15 cities in the country. These
regional processing centers process clearing checks and inter-branch transactions, make
inter-city check collections, and engage in back office activities for account opening,
standing instructions and auto-renewal of deposits.
51
0871913907
PNB has centralized transaction processing on a nationwide basis for transactions like the
issue of ATM cards and PIN mailers, reconciliation of ATM transactions, monitoring of
ATM functioning, issue of passwords to Internet banking customers, depositing postdated cheques received from retail loan customers and credit card transaction processing.
Centralized processing has been extended to the issuance of personalized check books,
back office activities of non-resident Indian accounts, opening of new bank accounts for
customers who seek web broking services and recovery of service charges for accounts
for holding shares in book-entry form.
IV. Operational Controls and Procedures in Treasury
PNB has a high level of automation in trading operations. PNB uses technology to
monitor risk limits and exposures. PNBs front office, back office and accounting and
reconciliation functions are fully segregated in both the domestic treasury and foreign
exchange treasury. The respective middle offices use various risk monitoring tools such
as counterparty limits, position limits, exposure limits and individual dealer limits.
Procedures for reporting breaches in
limits are also in place.
PNBs front office treasury operation for rupee transactions consists of operations in
fixed income securities, equity securities and inter-bank money markets. PNBs dealers
analyze the market conditions and take views on price movements. Thereafter, they strike
deals in conformity with various limits relating to counterparties, securities and brokers.
The deals are then forwarded to the back office for settlement.
The inter-bank foreign exchange treasury operations are conducted through Reuters
dealing systems. Brokered deals are concluded through voice systems. Deals done
through Reuters systems are captured on a real time basis for processing. Deals carried
out through voice systems are input in the system by the dealers for processing. The
entire process from deal origination to settlement and accounting takes place via straight
through processing. The processing ensures adequate checks at critical stages. Trade
strategies are discussed frequently and decisions are taken based on market forecasts,
52
0871913907
information and liquidity considerations. Trading operations are conducted in conformity

with the code of conduct prescribed by internal and regulatory guidelines.
The Treasury Middle Office Group, monitors counterparty limits, evaluates the mark-tomarket impact on various positions taken by dealers and monitors market risk exposure
of the investment portfolio and adherence to various market risk limits set up by the Risk,
Compliance and Audit Group.
PNBs back office undertakes the settlement of funds and securities. The back office has
procedures and controls for minimizing operational risks, including procedures with
respect to deal confirmations with counterparties, verifying the authenticity of
counterparty checks and securities, ensuring receipt of contract notes from brokers,
monitoring receipt of interest and principal amounts on due dates, ensuring transfer of
title in the case of purchases of securities, reconciling actual security holdings with the
holdings pursuant to the records and reports any irregularity or shortcoming observed.
V. Audit
The Internal Audit Group undertakes a comprehensive audit of all business groups and
other functions, in accordance with a risk-based audit plan. This plan allocates audit
resources based on an assessment of the operational risks in the various businesses. The
Internal Audit group conceptualizes and implements improved systems of internal
controls, to minimize operational risk. The audit plan for every fiscal year is approved by
the Audit Committee of PNBs board of directors. The Internal Audit group also has a
dedicated team responsible for information technology security audits. Various
components of information technology from applications to databases, networks and
operating systems are covered under the annual audit plan.
53
0871913907
REFERENCES
Books:
Galai, Mark, Crouny , Risk Management, second edition.
Bhole L. M, Financial Institutions and Markets Structure, Growth and
Innovations, fourth edition.
Gleason T .James, Risk. The new Management Imperative in Finance,
fourth edition
Saunders Anthony, Credit Risk Management, second edition.
Schleiferr Bell, Risk Management, third edition.
54
0871913907
WEBSITES:
www.rbi.org
www.bis.com
www.iib.org
www.pnbindia.com
www.google.co.in
55

Risk MGMT in Banks

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Risk MGMT in Banks

Uploaded by

Copyright:

Available Formats

Summer Training Project Report

Risk Management in Banking Sector

MASTER OF BUSINESS ADMINISTRATION

Prof. S.P Jain

GITARATTAN INTERNATIONAL BUSINESS SCHOOL

Risk Management in Banking Sector

I express my heartiest gratitude to Mrs. ANITA KHANNA (CUSTOMER

However, I accept the sole responsibility of any possible errors of omission.

Gitarattan International Business School

Risk Management in Banking Sector

1. INTRODUCTION Objectives of the study

3. TOPOLOGY OF RISK EXPOSURE

4. AN IDEALIZED BANK OF THE FUTURE

5. STUDY OF OPERATIONAL RISK AT PUNJAB NATIONAL BANK

Gitarattan International Business School

Risk Management in Banking Sector

An in-depth induction through the Computer Based Training Module

Various Documents Necessary or Required at the Time of Opening of Account

Accompanying Customer Relationship Officer to observe client interaction.

Gitarattan International Business School

Risk Management in Banking Sector

An overview of the risks in general.

An insight of the various credit, market and operational risks attached to

The methodology related to the management of operational risk followed

Tools applied in for measurement and management of various types of

Having an insight into the practical aspects of the working of various

Gitarattan International Business School

Risk Management in Banking Sector

SCOPE OF THE STUDY

LIMITATION OF THE STUDY

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

The second phase, guided by Narasimham Committee II, focused on

Gitarattan International Business School

Risk Management in Banking Sector

Risk is inherent in the very act of transformation. However, prior to reform of

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

1. What can go wrong?

One which is about managing risks, maximizing profitability and creating

want their risk management function to 'manage' or 'mitigate' Risks.

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector

Funding liquidity risk

Trading-related liquidity risk.

Gitarattan International Business School

Risk Management in Banking Sector

Gitarattan International Business School

Risk Management in Banking Sector