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A PROJECT SUBMITTED IN PART COMPLETION OF MASTERS OF MANAGEMENT STUDIES TO UNIVERSITY OF MUMBAI
BY NAYAN THARVAL
UNDER THE GUIDANCE OF PROF. SONALI TIPRE
THAKUR INSTITUTE OF MANAGEMENT STUDIES & RESEARCH KANDIALI (E), MUMBAI-400101 MMS (2005-2007)
THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH, MUMBAI
This is to certify that Mr. Nayan Tharval of TIMSR has successfully completed the project work titled Risk
Management In Banking in part completion for the degree of MMS prescribed by Mumbai University
This project is the record of authentic work carried out by him and References of work and relative sources of information have been given at the end of the project.
___________________ Signature of the Guide Prof. Sonali Tipre
_____________________ Signature of the Student Nayan Tharval
We believe that behind the ascend of each and every student lie not only the relentless urge to work hard but also the guidance and inspiration of their guide, co-guide and other helpful people. With a deep sense of gratitude I would like to thank each and every person who has contributed towards the successful completion of the project work. I owe a special thank to my project guide Prof. Sonali Tipre for providing me with the valuable insights in to the projects. She elucidated me the minute intricacies how the Banks carry out Risk Management and Measurement of various risks that they are exposed to. Sincere thanks to the workforce of TIMSR, for their kind and timely support & cooperation.
The past decade has seen dramatic losses in the banking industry.S. In response to this. interest rate positions taken. economic value added (EVA) and Value at Risk (VaR) to control and price their risks.Synopsis Market volatility. who plan to start using these concepts to calculate the minimum amount of capital that banks must hold. A large number of banks have implemented new performance measures such as risk adjusted return on capital (RAROC). corporate irregularities and anxious capital markets have shaken the banking industry and highlighted the perils of poor risk management. For competitive and regulatory reasons. Traditional risk systems can't capture the inter-relationships between various risk types across geographies. departments and lines of business. to determine the overall leverage for the bank as a whole. a number of large U. or derivative exposures that may or may not have been assumed to hedge balance sheet risk. thus. Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour. Since the late 1980s. 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. it is now necessary for all banks to have a sound risk-measurement framework 5 . The importance of these risk measurement tools has been greatly magnified by regulators. commercial banks have almost universally embarked upon an upgrading of their risk management and control systems. such as the Federal Reserve and Bank of England. 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.
iv. 6 . Explaining the basic concepts of Risk and Risk Management. Providing quick access to the whys and hows of risk management. Providing information bout how risk measurement is used in the management of risk and probability. iii. ii. including equations and examples that can be quickly applied to most risk measurement problems. Providing easy-to-understand information.This report aims at: i.
1 8.2 1.3 5.1 1.1 4.2 49-51 49 49-51 7 .5 6 7 7.2 Topic Part – I : Risks In Banking – An Introduction Introduction Defining Risk Defining Risk Management Risk Management framework Types Of Risks Risk Management Systems and Procedures Risk Measurement – An Introduction Economic Capital Risk Adjusted performance Part – II : Credit Risk Introduction to Credit Risk Meaning of Credit Risk Bifurcation of credit Risk Sources of credit Risk Need for Credit Risk Analysis Quantifying credit risk Types of Credit Structure Credit Risk and Basel Accords 1998 Basel Accord Basel 2 (New) accord Credit Risk Measurement EC Framework for Credit Risk Quantification Calculation of EL and UL for Single Facility/Loan Determining EL and UL due to default and Downgrades Calculation of EL and UL for Portfolio RAROC over one Year Part – III : Market Risk Introduction to Market risk Meaning of Market risk The Three Main Factors of Market Risk Page No.1 5.4 5.1 7.2 5. 9 9 9 9-10 11-13 14-16 17-19 17 18-19 5 5.3 2 3 4 4.5 21-27 21 21-22 23 23-25 25-27 28-34 35-39 35-36 37-39 40-47 40 41 42-44 45 46-47 9 9.4 8.1 9.Table of Content Chapter No 1 1.3 8.2 8.2 8 8.
1 11.2 13.2 12 12.10 10.1 13.2 13 13.1 10.1 12.3 Market Risk Management Board and Senior Management Oversight Organizational Structure for Market Risk Market Risk Monitoring And Control Risk Monitoring Risk Control Part – Part Iv Operational Risk Introduction To Operational Risk Meaning of Operational Risk Operational Risk Management Principles Operational Risk Management And Measurement Board And Senior Management’s Oversight Operational Risk Function Operational Risk Assessment and Quantification 52-57 52-53 54-57 58-69 58 58-59 61-62 61 61-62 63 63 64 64 8 .2 11 11.
Banks therefore try to ensure that their risk taking is informed and prudent. In general. 9 . The control of that gambling is the business of risk management. Banks run their business with two goals in mind: to generate profit and to stay in business.I Risk In Banking – An Overview Banks are said to be in the business of making money by providing services to customers and taking risks. but greater risk also increases the danger that the bank could lose badly and be forced out of business. if a bank takes more risk it can expect to make more money.Part .
measurement. Compliance / legal / regulatory and reputation risks.2 Defining Risk Management: Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. 11 . It involves identification. Risk management as commonly perceived does not mean minimizing risk.1 Defining Risk: Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size. Market. 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. A risk management framework encompasses the scope of risks to be managed. rather the goal of risk management is to optimize riskreward trade -off. Liquidity. volume etc. the process/systems and procedures to manage risk and the roles and responsibilities of individuals involved in risk management.Chapter 1 Introduction 1. Operational. Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. 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. 1. monitoring and controlling risks. it is believed that generally the banks face Credit. complexity business activities. 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. 1.3 Risk Management framework.
in addition to risk management functions for various risk categories may institute a setup that supervises overall risk management at the bank. reporting and control. 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. monitoring. 12 .An effective risk management framework includes: a) Clearly defined risk management policies and procedures covering risk identification. b) A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing it. There should be an explicit procedure regarding measures to be taken to address such deviations. Banks. policies and procedures for risk management and procedure to adopt changes. measurement. d) The framework should have a mechanism to ensure an ongoing review of systems. internal audit. The individuals responsible for review function (Risk review. 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. The structure should be such that ensures effective monitoring and control over risks being taken. Such a setup could be in the form of a separate department or bank’s Risk Management Committee (RMC) could perform such function. acceptance.
As 13 . Systematic risk/ Market Risk is the risk of asset value change associated with systematic factors. which is in fact a somewhat imprecise term. For e. and operational risk. Market risk. but cannot be diversified completely away.Chapter 2 Types of Risks Banks are exposed to the various kinds of risk. By its nature.g. whenever assets owned or claims issued can change in value as a result of broad economic factors. 1. Three Broad categories of Risks faced by banks are systematic or market risk. Bank operations Market risk Operational risk Credit risk Liquidity risk Forex risk Trading risk Traditional risk Interest rate risk Pre settlement settlement The risks associated with the provision of banking services differ by the type of service rendered. systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk. credit risk. In fact. It is sometimes referred to as market risk. this risk can be hedged. credit risk & operational risk.
some institutions with significant investments in one commodity such as oil. In such cases. For the banking sector. two are of greatest concern. the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. result from the systematic risk outlined above. in fact. Credit risk arises from non-performance by a borrower. Because of the bank's dependence on these systematic factors. This can affect the lender holding the loan contract. It may arise from either an inability or an unwillingness to perform in the precommitted contracted manner. credit risk is diversifiable. the 14 . The real risk from credit is the deviation of portfolio performance from its expected value.such. At the same time. In addition. Therefore. the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. through their lending activity or geographical franchise. international banks with large currency positions closely monitor their foreign exchange risk and try to manage. concern themselves with commodity price risk. This is particularly true for banks that lend in local markets and ones that take on highly illiquid assets. Accordingly. namely variations in the general level of interest rates and the relative value of currencies. most try to estimate the impact of these particular systematic risks on performance. as well as limit. Accordingly. This is because a portion of the default risk may. but difficult to eliminate completely. their exposure to it. most will track interest rate risk closely. 2. They measure and manage the firm's vulnerability to interest rate variation. Others with high single-industry concentrations may monitor specific industry concentration risk as well as the forces that affect the fortunes of the industry involved. however. systematic risk comes in many different forms. In a similar fashion. even though they can not do so perfectly. attempt to hedge against them and thus limit the sensitivity to variations in undiversifiable factors. as well as other lenders to the creditor.
Operational risk is associated with the problems of accurately processing. settling. and accurate estimates of loss are difficult to obtain. processing system failures and compliance with various regulations. 3. problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite 15 . and taking or making delivery on trades in exchange for cash.credit risk is not easily transferred. It also arises in record keeping. As such. individual operating costly.
Such internal reports need similar standardization 16 . (i) Standards and Reports The first of these risk management techniques involves two different conceptual activities. They are listed together because they are the sine qua non of any risk system. and rating agency evaluations are essential for investors to gauge asset quality and firm level risk. To see how each of these four parts of basic risk management techniques achieves these ends. and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives. the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. regulatory reports. standard setting and financial reporting. In general. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio. risk categorizations. these tools are established to measure exposure. Obviously outside audits. limit individual positions to acceptable levels. for better or worse.Chapter 3 Risk Management System and Procedure The management of the banking firm relies on a sequence of steps to implement a risk management system. and standards of review are all traditional tools of risk management and control.e. These reports have long been standardized. Underwriting standards. However. define procedures to manage these exposures. and the extent to which these risks must be mitigated or absorbed.. The standardization of financial reporting is the next ingredient. i. These can be seen as containing the following four parts: (i) Standards and reports (ii) Position limits or rules (iii) Investment guidelines or strategies (iv) Incentive contracts and compensation. we elaborate on each part of the process below.
17 . While such limits are costly to establish and administer. and therefore by the organization as a whole. The limits described above lead to passive risk avoidance and/or diversification. Here. lenders. Summary reports show limits as well as current exposure by business unit on a periodic basis. even for those investments that are eligible. This applies to traders. accurate and timely reporting is difficult. In general. the extent of desired asset-liability mismatching or exposure. and the need to hedge against systematic risk of a particular type. their imposition restricts the risk that can be assumed by any one individual. limits are imposed to cover exposures to counterparties. strategies are outlined in terms of concentrations and commitments to particular areas of the market. given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. In terms of the latter. Such guidelines lead to firm level hedging and asset-liability matching. In large organizations with thousands of positions maintained. and overall position concentrations relative to various types of risks.and much more frequent reporting intervals. guidelines offer firm level advice as to the appropriate level of active management. but even more essential. and portfolio managers. the domain of risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then. (iii) Investment Guidelines and Strategies Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. because managers generally operate within position limits and prescribed rules. each person who can commit capital will have a well-defined limit. credits. with daily or weekly reports substituting for the quarterly GAAP periodicity. and/or minimum standards for participation. (ii) Position Limits and Rules A second technique for internal control of active management is the use of position limits. Beyond this.
In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management's guidelines. (iv) Incentive Schemes To the extent that management can enter incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, then the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper internal control systems. Such tools which include position posting, risk analysis, the allocation of costs, and setting of required returns to various parts of the organization are not trivial. Notwithstanding the difficulty, well designed systems align the goals of managers with other stakeholders in a most desirable way.
Chapter 4 Risk Measurement – An Introduction
Until and unless risks are not assessed and measured it will not be possible to control risks. Further a true assessment of risk gives management a clear view of institution’s standing and helps in deciding future action plan. To adequately capture institutions risk exposure, risk measurement should represent aggregate exposure of institution both risk type and business line and encompass short run as well as long run impact on institution. To the maximum possible extent institutions should establish systems / models that quantify their risk profile, however, in some risk categories such as operational risk, quantification is quite difficult and complex. Wherever it is not possible to quantify risks, qualitative measures should be adopted to capture those risks. Economic Capital gives a common framework for quantifying the risk arising from many diverse sources. It also allows calculating the amount of equity capital that the bank should hold. RAROC has become industry standard way of measuring risk-adjusted probability. transactions. 4.1. Economic capital Economic capital is one of the most important risk metrics because it provides with a unifying framework to translate all the risks into a single metric. For market risks, daily value at risk is calculated and then translated into economic capital. For credit and operating risks economic capital is directly estimated from the probability distribution of losses. Economic capital is the net value the bank must have at the beginning of the year to ensure that there is only a small probability of defaulting within that year. The net value is the value of the assets minus the liabilities. The small probability is the probability that corresponds to the bank’s target credit rating. It allows comparing the probability of different
4.2 .Risk Adjusted Performance Economic capital is useful for identifying large risks and setting aside the required amount of capital to be held by the bank to ensure smooth functioning without defaulting. However, when deciding whether to carry out a transaction, the bank is not only concerned about the risk, it is also interested in probability relative to that risk. By measuring risk- adjusted performance (RAP), a bank can integrate risk measurement into the daily profitability management of the business. Traditionally, the banking industry relied on measurements that gave an incomplete picture and its relation to risk. The two most common measurements were Return on Assets (ROA) and Return on Equity (ROE). ROA is a profit divided by the rupee value of the portfolio. ROE is the profitability divided by either book capital or Regulatory capital. The book capital is the net value of the bank as measured by accounting methods. The regulatory capital is the minimum amount of capital that must be held by the bank according to regulators such as the Bank of England and the Federal Reserve. The return on assets takes no account of the risk of the assets. As an alternative, over the last decade the industry has developed two metrics for risk-adjusted performance that are based on Economic Capital: RAROC and SVA. RAROC is the risk-adjusted return on capital, and SVA is shareholder value added. 4.2.1. Risk – Adjusted Return on Capital (RAROC) RAROC is the expected net risk-adjusted profit (ENP) divided by the economic capital that is required to support the transaction.
RAROC = ENP EC
2.based measure of performance. It is simply the actual or expected probability minus the required probability to meet the hurdle rate.2.4. SVA = ENP – H x EC 21 . Shareholder Value Added (SVA) Shareholder value added (SVA) gives a dollar.
Part – II Credit Risk Burgeoning non-performing assets in the Indian banking system have brought to light the inefficiencies in the credit risk management practices of Indian banks. It is the time that Indian banks realize the importance of effective credit risk management practices in mitigating their losses and improving their bottom line. 22 .
or customer – specific factors. portfolio risk in turn determines the quantum of capital cushion required.Chapter 5 Introduction to Credit Risk 5. 23 . While risk decides the fate of overall portfolio. 5. industry. trading. 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 .2 Bifurcation of Credit Risk The study of credit risk can be bifurcated to facilitate better cognition of the concept. If the probability of loss is high. the credit risk involved is also high and vice-versa.1 Meaning of Credit Risk The Reserve Bank of India has defined Credit Risk as the possibility of the loss that stems from outright default due to inability or unwillingness of a customer or counter party to meet their commitments in relation to lending. settlement and other financial transactions. 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.
A creditor can diversify these risks by extending credit to a range of customers. Such risks are largely industryspecific and /or firm specific. The second type of credit risks is unsystematic risks and is controllable risks. 24 . Firm Credit Risk Portfolio Credit Risk Credit risk Systematic Risk Socio-political Risks Economic Risks Other Exogenous Risks Unsystematic Risk Business Risks Financial Risks External forces that affect all business and households in the country or economic system are called systematic risks and are considered as uncontrollable.Both firm credit risk and portfolio credit risk are impacted or triggered by systematic and unsystematic risks. They do not affect the entire economy or all business enterprises/households.
a default has not occurred.phase is highly challenging and so is providing credit during a recession period. Here.3. This risk is therefore typically treated as market risk 5. causing the value of the security to fall. Need for Credit Risk Analysis Much of importance has been attached to credit risk analysis. and financial institutions are no exceptions.5. just a change in market sentiment. a bond or a loan) and the credit quality of the security issuer falls. 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. especially by banks and other financial intermediaries with significant credit exposure. 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. Usually everyone is very confident during the heightened pace of economic activity. and then the market moves so that the customer owes money. as the result of over lending in the late 1980’s. but customer fails to pay. The main reasons are as follows: Prudence : It is the responsibility of the supplier of the credit to ensure that their actions are prudent. there is no credit event. the price for all BB-rated bonds may fall because the market is less wiling to take risks.4. Lending during the boom. In this case. The bank holds a debt security (e.g. but the increased possibility of a default makes the security less valuable. 25 . The bank holds a debt security and the market’s price for risk changes. For example.
the US economy went through massive job losses and sluggish growth and was almost on the verge of an economic slowdown. This can result in the lowering of the quality of the credit asset portfolio. many good credit-worthy customers. when collaterals offered comfort. With the increase in the competition. Increase in Competition: he banking business is witnessing more competition with the advent of the new generation banks and liberalization policies pursued by governments. technically your risk level should also reduce. the firms that are not able to fulfill this requirement approach financial intermediaries. 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 26 . Volatility of collateral/asset values: Gone are the days. So tighter credit risk analysis is necessary. as your returns become lower. a more vigilant approach by the lenders is necessary. especially the larger ones access and raise funds directly from public. Since credit rating is compulsory for raising debt from the public market. Hence. In 2002/2003. Given the fact that the incidence of bankruptcies during recession is high. including banks. Increase in bankruptcies: Recessionary phases are common in the economy. While it is no longer easy to insist on collateral security in view of the increasing competition in the market. In other words. the role of accurate credit analysis is very important Disintermediation: With the expansion of the secondary capital and debt markets. naturally pricing is under pressure. although the timing and causes may be different for different countries.
Quantifying Credit Risk Quantitative measurement has been adopted by banks to improve their processes for selecting and pricing credit transactions. Quantitative measurement has become even more important since it was adopted by the Basel Committee on Banking as the basis for getting regulatory capital.e. Exposure risk. In other words. Even a small credit facility turning bad will hurt business. NPA management is a major challenge for banks. 27 . unfortunately this is not true. Credit Risk Analysis helps in minimizing credit loss which is a best option rather than attempting to book 20. 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. Credit Risk analysis helps to keep check on NPA. credit assets that are on the verge of becoming credit losses. Credit Risk is a function of other risks or the combined outcome of other risk such as. Poor Asset Quality: Banks in India and abroad face the problem of non-performing assets (NPA). to ensure adequate returns to shareholders.may not quote even half the value of the credit extended during boom periods. Default risk. A bank’s credit risk has two distinct facets.5. especially for banks and other financial intermediaries operating in a highly competitive sector. However. they display high risk tendencies to become bad debts. and Recovery risk. i. “quality of Risk” and “quantity of risk”. The former refers to “severity of losses”. by both default probability and the recoveries that could affect in the event of default. The latter refers to the outstanding balance as on the date of default. 5. 25 or 50 times the business volumes.
overdrafts. Recovery Risk: The recoveries in case of losses are not predictable. but it triggers various types of actions such as renegotiation up to the obligation to repay all outstanding balances. missing a payment obligation. Guarantor’s Value: The net worth of the guarantors and.Default Risk: It is the probability of the event of default. i. third party guarantees.1. Exposure Risk: The uncertainty prevailing with future cash flows generates exposure risk. in turn. Although this cannot be measured directly. the amount at risk in future that can potentially be lost in case of default is uncertain. 5. if such collateral can be easily possessed and has significant value. Hence. project financing etc. A payment default doesn’t mean that the borrower will never pay. Legal Issues: Recovery risk depends upon the type of default. the economic value of collateral assets might be eroded and may even be less than the value of the outstanding debt. They depend upon the type of default. A payment default is declared when a scheduled payment is not made within 90 days from the due date. and legal issues. Why Measure Credit Risk? 28 . The outstanding balances at the time of default are not known in advance particularly under credit facilities like committed lines of credit. availability of collaterals.5.e. it can be observed from historical statistics or can be collected internally from rating agencies. breaking an agreement or economic default. Collateral’s Value: The existence of collateral minimizes credit risk. Sometimes. their ability to discharge liabilities upon invocation of guarantee may undergo changes affecting the ultimate realizable amount. Default Risk depends upon the credit standing of the borrower and is measured by the probability that default occurs during a given time period.
Supporting Origination Decisions: The most basic decision is whether to accept a new asset into the portfolio. Portfolio optimization.There are three main sets of decisions for which it is important to measure credit risk such as: Origination. and Capitalization 1. The origination decision can be framed in two possible ways: 29 .
To reduce the portfolio’s risk. the manager seeks to minimize the ratio of risk to return. Given the risk and a fixed price. Credit risk helps to set the provisions for expected losses over the next year. in case losses are unusually bad. the bank must raise more capital. 3. is the asset worth taking? This is the type of decision made when dealing with a large volume of retail customers. Quantifying credit risks with the help of appropriate credit-portfolio model helps the bank manager to identify risk concentrations in the given portfolio and allow the manager to try “what. liquid trading environment. the Supporting Capital Management: Quantification of credit risks reserves. 30 . or in negotiating rates and fees for a corporate loan 2. the manager must know where there are concentrations of risk and how the risk can be diversified. It is a more rigid approach where there is little opportunity to modify the price. If it is insufficient.if “analyses to test strategies for diversifying the portfolio. reduce the risk or expect to be downgraded. and therefore the decision becomes “yes/no” Given the risk. what price is required to make the asset worth buying? This approach is typically used in a flexible. and measurement also helps to ensure whether the total economic capital available is sufficient to maintain the bank’s target credit rating given the risks or not. Supporting Portfolio Optimization: In optimizing a portfolio.
from granting loans to trading derivatives.Chapter 6 Types of Credit Structure Credit risk can arise in many ways. An agreement between a bank and a customer that creates credit exposure is often called a credit structure or a credit facility Credit Exposure To 1. The amount of credit risk depends largely on the structure of the agreement between the bank and its customers.Credit Exposure To Large Corporations Personal Loans Commercial loans Commercial Lines Letter Of Credit & Gurantees Leases Credit derivatives Credit Exposures In Trading Operations Bonds Asset-backed securities Securities lending and repos Margin accounts Credit exposure for derivatives Credit Structure Credit cards Car Loans Leases and hirepurchase agreements Mortgages Home-equity lines of credit Retail Customers 31 .
6. For credit risk measurement. and should therefore set aside capital for each.e. the term or maturity and the scheduled amounts that are expected to be outstanding (i. the bank faces the possibility of loss on both the drawn and undrawn amounts. then in the event of default. including interest payments. There may also be a fee paid by the company at the initiation of the loan. With a line of credit. the pattern of disbursements and repayments is set on the day of closing deal. The company then draws on the line according to its needs and repays it when it wishes. then if there are any remaining assets. If it is secured. only a maximum amount is set in advance. it pays off the senior loans first. An unsecured loan is a general obligation of the company and in the case of default.When a company liquidates. the most important loan features are the collateral type. it pays off the subordinated loans. they have lower loss in the event of default. commercial loans have fixed structure for disbursements from the bank to the company and have a fixed schedule of repayments. The loan may also be classified as senior or Subordinated(also called junior). Letters of Credit: There are two primary types of letters of credit (LC): Trade LC and Backup LC. the level of seniority. Trade LC is tied to specific export 32 . For a line of credit (also known as revolver or a commitment).1 Credit Exposure to Large Corporations: Commercial Loans: Typically. the amount that the company owes the bank at any given time) Commercial Lines: In a standard loan. The loan may be secured (collateralized) or unsecured. the bank will just get its share of the residual value of the company. the bank will take legal possession of some specified asset and be able to sell this to reduce the loss. As senior loans always get paid before subordinated loans.
and n return. but it will also need to pay less to the first bank. This is used to lower the cost of the customer’s getting credit from the third party. this creates a short-term exposure to the local importer. having them buy the equipment. For the bank. and in return. In both the cases. In an equipment lease. In terms of credit risk. the bank will pay. this is equivalent to giving the customer a loan. a second bank agrees to make payments equal to all the payments they receive from a particular corporate loan. The changes in 33 . the customer makes rental payments. the bank will receive less money from the corporations. After sufficient payments. For the first bank. the bank ends up owing the equipment. the bank will receive less money and will therefore make a loss. the customer may keep the equipment. the calculation of the risk for credit derivatives can be based on the analysis that would be used for the underlying loan. if the importer fails to pay. and then try to reclaim the amount from the importer. and pledging the equipment as collateral to secure the loan. For the second bank. if the corporation defaults. Leases: Leases are form of collateralized loan. Credit Derivatives: In almost all cases. As a simple example. the equipment is given to the customer.transactions. consider a derivative in which one bank agrees to pay an initial amount. A backup letter of credit is a general form of guarantee or credit enhancement in which the bank agrees to make payments to a third party if the bank’s customer fails. if the customer stops making payments. but with different tax treatment in certain situations. He bank faces the full default risk from its customer and has the same risk as if it had given the customer a direct loan. A trade LC guarantees payment from a local importer to an overseas exporter. if the corporation defaults. because the third party now only faces the risk of a bank default.
The interest-rate is typically 10% to 15% above the floating prime rate. Credit Cards: Credit cards are again generally unsecured by collateral. The customer makes regular payments to cover the interest that would have been required to purchase the asset and to cover 34 . Leases are typically structured so that at the end of a finite period. The interest charges may be fixed at the time of origination. or may float according to the bank’s published prime rate. we would treat this credit derivative as if it were just a loan to the corporation. the asset will be returned to the bank. and they make no loss. which the bank may change at its discretion. to compensate for the very heavy default rates experienced on credit cards. Car Loans: Car loans are same as personal loans except that they are for a specific purpose and have the car as collateral. 6. Leases and Hire-Purchase Agreements: In a lease.payments therefore cancel each other out. and they have a lower probability of default because the customer is unwilling to lose the car. They tend to have a lower loss given default than personal loans because of the collateral. They are generally structured to have a fixed time for repayment. Through this agreement. In measuring the risk for the first bank. but they have no fixed time for repayment. the customer is allowed to use a physical asset (such as a car) that is owned by the bank. the economic risk of the loan has been transferred from the second bank to the first.2 Credit Exposure to Retail Customers: Personal Loans: Personal loans are typically unsecured and may be used by the customer for any purpose.
Home-Equity Lines of credit: A home-equity line of credit (HELOC) is like a credit card but secured by the customer’s house. so even if the property value drops by 10%. and the customer is certain to own the asset at the end of the agreement Leases and hire-purchase agreements are similar to car loans in that they are secured by the physical asset that has been purchased. This minimizes the probability of default. The customer typically has the option to buy the asset outright at the end of the lease for a prespecified lump sum. This ensures a low probability of default. Leases are structured such that the bank continues to own the physical asset legally until all lease payments have been made. In an asset-backed security. Asset. the payments from many uniform assets are bundled together to form a pool. Furthermore. Hire.backed securitization is used with retail assets.depreciation. the bank will still have a loss given default of 0. Mortgages: Mortgages use the customer’s home as collateral. such as credit cards and mortgages. This makes repossession easier and reduces the loss given default. This pool is then used to make payments to several sets of bonds.purchase agreements are similar to leases except that the payments include the full value of the asset.Backed Securities: Asset.3 Credit Exposures in Trading Operations Bonds: Bonds credit risk depends on the level of seniority and whether it is secured with collateral or not. banks generally ensure that the loan to value ratio is less than 90%. 6. The analysis of the 35 .
which is effectively an interest payment for the loan. the bank could make a credit loss if the counterparty defaults and the value of the security have risen to be higher than the amount of cash that the bank was expecting to pay to get the security back. 36 . both sec lending and repos are short-term collateralized loans. the bank receives cash. a security is sold by the bank with a guarantee from the bank to repurchase it at a fixed price and date. The calculation of the probability distribution depends on the risk of the individual assets and the correlation between them. The collateral is typically in the form of cash. plus a small additional amount. we calculate the probability distribution of the payments from the pool of underlying assets and use this to estimate the probability that the pool will sufficient to pay the bonds. less a small amount as a fee. the counterparty returns the security and the bank returns the cash. the counterparty gives collateral to the bank that is worth slightly more than the borrowed security. In sec lending. From credit-risk perspective. counterparty asks to borrow a security from the bank for a limited period of time. In this case. In a repo. At the end of the trade. Repos are very similar to securities lending except that they are used to gain funding. To minimize the credit risk. The security is typically a share or bond. At the time of sale. At the time of repurchase.credit risk of an asset-backed security is the same as the analysis of a portfolio of loans. In both the cases. the bank sends the cash to the counterparty. The expected exposure at default will be the average amount by which the value of the security can be expected to exceed the cash. Securities lending and Repurchase Agreements: Sec lending and repos agreements are common functions in bank’s trading operations.
If the securities lost more than 50% of their value before they are liquidated. Margin Accounts: A margin account is another form of collateralized loan. the bank will sell all or part of the shares. retail customers are allowed to borrow only up to half the value of the securities that own. and the customer failed to make up the difference. This is called rehypothecation. and then with the loan and his own funds. then after paying back the loan with interest. If the customer does not respond. Thus customer now has $20000 which he can use to buy securities worth $20000. consider a customer who has %10000 and takes a loan for $10000. a customer takes a loan from the bank. the bank will ask the customer for more cash to maintain the 50% ratio.000 and the customer sells these securities. It is also possible for the bank to pledge the security to another bank to get a loan. In a margin account. The security is then held by the bank as collateral against the loan. any residual value is given back to the customer. As an example. this is called a margin call. Typically. if the price falls by 10%. purchases a security. 37 . Margin accounts are used by customers who want to leverage their positions and increase their potential returns. the customer makes a 20% loss. conversely . the customer has a little less than $12.000. If the value of the securities falls. If the price rises by 10% to $22. the bank would suffer credit loss. The pledging of the security as collateral by the customer to the bank is called hypothecation. After paying off the. a nearly 20%gain.
hybrid capital instruments (such as mandatory convertible debt) and subordinated debt. 38 . such as the Bank of England and the Federal Reserve Board. To create more level playing field in competitive terms so that banks could no longer build business volume without adequate capital backing. It is a committee of national banking regulators.Chapter 7 Credit Risk and Basel Accords The Basel Committee on Banking Supervision was established in the mid – 1980s. Tier 2 capital comprises undisclosed reserves. 7. The purpose of the committee is to set common standards for banking regulations and to improve the stability of the international banking system. Also. the tier 1 capital should be at least 50% of the total capital. To ensure adequate level of capital in the international banking system. This low ratio was believed to allow the Japanese banks to make loans at unfairly low rates. The 1998 accord required that all banks should hold available capital equal to atleast 8% of their risk-weighted assets (RWA) . 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. asset revaluation reserves. 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. 2.1. Basel Accords helps the banks in managing credit risk and as well as other risks.The first accord has two basic principals: 1.
based on the risks.The portfolio approach is adopted to measure risk with assets classified into four buckets(0%. While central government/Central bank obligations carry nil (0%) risk.20%. depending upon counter parties. gives a unique perspective to the capital adequacy of a banking institution. If a bank has more counter parties having nil (or lower) risk.50%. it needs to hold less capital than a bank which has parties with 100% risk weight. This distinction. The summarized weight scale is given below: Risk Weight of On – B/S items Risk Weights Counter Parties Central Govt.and 100%). IBRD. those of the private business sector carry full risk (100%).Risk – Weighted Assets: Assets in the balance sheet of a bank have been differentiated. Central Bank 0% 20% 50% 100% exposure in National Currency OECD Govt/ Central Banks & x x X claims guaranteed by them MultiBanks Lateral in development Claims banks(ADB. etc ) OECD/ guaranteed by them Residential loans Private sector entities mortgage backed x x x 39 .
7. The supervisory review pillar requires regulators to ensure that the bank has effective risk management. the un-rated counter parties continue to 40 . In the standardized approach. 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 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%. 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. and requires the regulators to increase the required capital if they think that the risks are not being adequately measured.2. depending upon the rating assigned by ECAI. Basel 2 (New) Accord: The suggested form of new Accord was published in January 2001 to obtain comments from the banking industry. However. but broad intention is that risk weights should be set according to the credit rating of the customer. The new Accord retains the same concepts of EWA and Tier 1 and Tier 2 available capital. but it changes the method for calculating RWA. The final Accord will be effective from 2006 – 2007.
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). IRB foundation. Risk Weights for Government and Banks under the new standardized Approach Grade Governmen ts Banks AAA to AA0% 20% A+ to A20% 50% BBB+ to BBB50% 100% BB+ to B100% 100% Below B150% 150% Unrated 100% 100% Risk Weights for Corporate Exposures under the New Standardized Approach Grade Corporatio ns AAA to AA20% A+ to A50% BBB+ to BB100% Below BB150% Unrated 100% b) The Internal Rating Based Approach for Credit Risk: IRB allows banks to use their own internal estimates of risk to determine capital requirements. 41 . which the approval of their Supervisors (or Central Banks). Generally all AAA and AA rated companies require only 20% weight while credit exposures rated B and below require 150% weight. Exposure at Default (EAD) and a factor for maturity. IRB are of two types: i.receive 100% weight.
a bank estimates each borrower’s creditworthiness and the results are translated into estimates of a potential future loss amount. Under the IRB approach.risk customer Loss Given Default: It is estimated amount of loss expected if a credit facility defaults.000% for a zero risk customer to 100% for a very high. the main components are as follows: Probability of Default (PD) – Defined as the statistical percentage probability of a borrower defaulting within a oneyear time horizon. PD is directly linked to the Customer rating. The expected credit loss from an exposure is the main driver for determining the credit rating in IRB. The value depends on the collateral. This value does not take account of guarantees. where all inputs to risk weighted asset calculation – PD . subject to regulatory satisfaction iii. collateral or security. and EAD – estimated by the bank itself . IRB Advanced. LGD estimates are to be based upon historical recovery rates and stress tested for economic downturns. LGD. PD is based on the stand alone borrower risk rating or customer rating. LGD is dependent upon the collateral while EAD is the amount of credit extended. which from the basis of minimum capital requirements. 42 . calculated as a percentage of the exposure at the date of default. subject to strict methodological and disclosure standards. The PD can range from 0. among others Exposure at Default (EAD): Represents the expected level of usage of the facility when default occurs. The adoption of an IRB approach requires empirical data. if any and other factors that impact on the likely level of recovery.ii.
Economic Capital Framework for Credit Risk Quantification: EC captures the variance or the uncertainty of the losses around the average.1.Chapter 8 Credit Risk Measurement 8. EC quantifies the portfolio credit risk. the required economic Capital (EC) depends on the probability distribution of the losses. With its focus on uncertainty. The probability distribution for credit losses is sketched below: MPL EL P R O B A B I L I T y Credit Risk Measured as Economic Capital Worst Case loss Credit Loss EC = MPL – EL Where: MPL: Max Probable Loss EL : Expected Loss 44 . For the credit risk of lending operations.
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.0022 x $100 x 0.41 45 . and then EL is as follows: EL = 0. LGD is 30%.8. then P would be 22 basis points. the probability is represented as ‘P’ E: Exposure at Default S: Loss Given Default/ Severity (1 – P): In case there is no default.3 = $ 0. 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.066 (P) UL = (E) (S) 0.2.3 = $ 1.00222 x $ 100 x 0.
Consequently. 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. Determining Losses Due to Both Default and Downgrades When a company is downgraded. we require the probability of a grade change and the loss if such a change occurs.8. Looking down the third column. Rating At The Start Of The Year AAA AA A BBB BB B CCC Ratin g At The End Of the Year B CCC Defau lt To understand how to read this table.3. The probability of a grade change has been researched and published by the credit-rating agencies. it means that the rating agency believes that the probability of default has risen. let us use it to find the grade migration probabilities for a company that is rated Single A at the start of the year. 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. we see that the company 46 0 0 0 9 2 1 20 1 4 81 16 22 A BBB BB 40 8 3 AAA AA 9366 66 583 917 2 694 49 6 7 225 917 6 519 49 3 25 483 892 6 444 3 7 44 667 833 1 747 105 98 0 10 33 46 576 841 8 387 530 16 0 31 93 200 Defau lt 0 0 0 0 0 1074 0 6395 0 2194 10000 . To obtain the EL and UL for this risk. there is a fall in the value of the bond or a loan.
basis point chance of becoming AAA rated by the end of the year.45 (1 + 5% + 1.00 47 .free discount rate of 5% and the bond is still rated BBB. It has a 2. the value will be $88.52 $ .26 $ . Thus from external rating agencies we can get any company’s probability of moving to a different grade by the end of the year. 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%. Corporate Bond spreads – Table showing the probability (bps) of corporate bond migrating from one grade to another over the years. Looking down to the bottom of the column.71 $ 89.1.25% chance of being rated AA.45 Value BBB = $100________ = $ 88.0. 45 Loss $ . If it is assumed that the risk.0.has a 7.96 $ 89.19% chance of being downgraded to BBB.33%)2 Table Showing Change in Values for a BBB bond due to Credit Events: Rating AAA AA A BBB Value $ 89.1.84 $ . Associated with each grade is a discount rate relative to the risk-free rate.29 $ 88. we see that it has a 4basis points chance of falling into default.76% chance of remaining single – A and a 5. At the end of the year the bond will have 2 years to maturity. As an example. a 91.
328 0.053 $0.005 $0.BB B CCC Defaul t $ $ $ $ 85.90 79.71 81 $6.91 $ $ $ $ 2.53 Expected Loss (PG LG ) $(0.137 $1.015 $0.71 6.84 ) 8926 444 $2.537 48 .26 ) 483 $(0.003) $(0.058 $0.73 81.000) $(0.44 22 $26.121 $0.55 9.284 $0.001 $0. bps ) 3 $(1.051 $0.525 $1.040) $0.031 $0.203 Unexpected Loss (LG – EL )2 PG $ 0.53 The calculation of EL and UL for the same example of BBB bond is as follows Year End Rating AAA AA A BBB BB B CCC Default Total Probabili Loss ty (LG ) (PG .55 16 $9.91 61.44 26.52 ) 25 $(1.
6 0.4% 1.8 0.5 0.7 1.1 0.8.6 0.4.7 5.5 – offs %loss 0.2% terms.2% = $37. 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 In dollar Assets $Bn 231 236 243 245 250 269 284 309 333 352 386 Write $Bn 1.7 0.65 Bn 49 .7 2.1 1.3 2.2 11.3 2. The unexpected loss for the portfolio (ULP) is the standard deviation obtained from the sum of the variances for the individual loans.27 x 1.2 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. multiplied by the total size of the portfolio: UL PH = N E UL% PH = 11 x 285.5% 1.9 9.3 0. the UL for the portfolio is the UL as percentage.1 3.4 2.6 5.
the collateral is such that the LGD is 30% 2. plus any fees (F). The probability of default is 22 basis points i. 6. The Hurdle rate (H) of 25% 50 .22% 5. multiplied by the interest rate on the loan (rA) The interest to be paid on the debt is the amount of debt (D 0). RAROC = ENP EC Where for a loan. and minus expected loss. 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. the expected net profit ENP is the interest income on the loan. The average default correlation with the rest of the portfolio is 3% 3.5. The customer is being charged 6. The capital multiplier for the portfolio is 6 4. 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). 0. minus operating costs (OC). multiplied by the interest rate on the debt (rD). minus interest to be paid on debt.e. The interbank rate for one-year debt is 5 (rD). Example: A loan of $100 for 1 year to a company rated BBB with the following assumptions: 1.8.5% interest (rA) 7. The operating costs(OC) are $1 8.
46 51 .Solution: Calculation of risk characteristics of the loan EL = P x E x S = 0.24 EC = Economic multiplier x ULC = 6 x $0.0.22% x $100 x 30% = $0.22% 2 x $100 x 30% = $1.46 Calculation of RAROC RAROC = A0 rA + F – D0 rD – OC – EL = $100 x 6.22% .$1$0.41 x $ 1.066 UL = ULC = P – P2 x E x S = 3% 0.066 EC RAROC = 35% Calculation of SVA SVA = ENP – H x EC = 35% .46)x 5%.46 = $ 0.5% -($100-$1.14 $1.25% x $1.41 = $ 0.24 = $ 1.
52 . The measurement of trading risk is probably the most advanced of the three main types of risks faced by banks.Part – III Market Risk Banks are exposed to market risk via their trading activities and their balance sheets.
while a long term impact is on bank’s net worth since the economic value of bank’s assets.Chapter 9 Introduction to Market Risk 9. In this respect economic value is affected both by changes in future cash flows and discount rate used for determining present value. foreign exchange rates. Three Main factors of Market risk 1.1. the difference between the total interest income and the total interest expense. liabilities and offbalance sheet exposures are affected. Meaning of Market Risk: It is the risk that the value of on and off-balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates. 53 . Economic value of the bank can be viewed as the present value of future cash flows. funding and investment activities give rise to interest rate risk.2. Economic value perspective considers the potential longer-term impact of interest rates on an institution. credit spreads and/or commodity prices resulting in a loss to earnings and capital. The immediate impact of variation in interest rate is on bank’s net interest income. which are subject to interest rate adjustment within a specified period. b) Economic Value perspective: It reflects the impact of fluctuation in the interest rates on economic value of a financial institution. 9. equity prices. the focus of analysis is the impact of variation in interest rates on accrual or reported earnings. Interest rate risk: Interest rate risk arises when there is a mismatch between positions. This is a traditional approach to interest rate risk assessment and obtained by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i. Consequently there are two common perspectives for the assessment of interest rate risk a) Earning perspective: In earning perspective. The bank’s lending.e.
(4) interest-related options embedded in bank products (options risk). Even in cases where spot and forward positions in individual currencies are balanced. banks may incur replacement cost.Sources of interest rate risks: Interest rate risk occurs due to (1) Differences between the timing of rate changes and the timing of cash flows (re-pricing risk). It refers to the impact of adverse movement in currency exchange rates on the value of open foreign currency position. 2. the maturity pattern of forward transactions may produce mismatches. Thus. (3) Changing rate relationships across the range of maturities (yield curve risk). which depends upon the currency rate movements. The banks are also exposed to interest rate risk. 54 . which arises out of time lags in settlement of one currency in one center and the settlement of another currency in another time zone. (2) Changing rate relationships among different yield curves effecting bank activities (basis risk). In the foreign exchange business. As a result. While such type of risk crystallization does not cause principal loss. Banks also face another risk called time-zone risk. banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. which arises from the maturity mismatching of foreign currency positions. banks may suffer losses due to changes in discounts of the currencies concerned. banks also face the risk of default of the counter parties or settlement risk. The Forex transactions with counter parties situated outside Pakistan also involve sovereign or country risk. Foreign Exchange Risk: It is the current or prospective risk to earnings and capital arising from adverse movements in currency exchange rates.
Call risk:.g. 3. a request for the imp client 55 . non renewal of the wholesale funds 2.g.the need to compensate for the no receipt of the expected inflow of the funds e.3. e. a sudden surge in the borrowing under ATMs 4.the need to find new funds when contingent liability becomes due e. Funding risk: . when the borrower fails to meet his commitment. the need to undertake new transactions when desirable. Possible needs for the liquidity are manifold they can be classified into 4 broad categories 1. Time risk: .g. Liquidity risk Liquidity risk is potential outcome of the inability of the banks to generate cash to cope up with the decline in the deposits or increase in the assets.the need to replace the outflows of the funds. to the large extent it is an outcome of the mismatch in the maturity patterns of the assets & liabilities. e.g.
the concern for management of Market risk must start from the top management. The risk appetite in relation to market risk should be assessed keeping in view the capital of the institution as well as exposure to other risks. the institution should develop a strategy for market risk-taking in order to maximize returns while keeping exposure to market risk at or below the pre-determined level. expertise available to profit in specific markets and their ability to identify. b) Ensure that bank’s overall market risk exposure is maintained at prudent levels and consistent with the available capital. d) Ensure that the bank implements sound fundamental principles that facilitate the identification. The first element of risk strategy is to determine the level of market risk the institution is prepared to assume. While articulating market risk strategy the board needs to consider economic and market conditions. and the resulting effects on market risk. Finally the market risk strategy should be periodically reviewed and effectively communicated 56 . the board of directors has following responsibilities.Chapter 10 Market Risk Management 10. e) Ensure that adequate resources (technical as well as human) are devoted to market risk management. Likewise other risks. Effective board and senior management oversight of the bank’s overall market risk exposure is cornerstone of risk management process. monitor and control the market risk in those markets. measurement. Once the market risk appetite is determined. Board and senior Management Oversight. For its part. monitoring and control of market risk.1. the institution’s portfolio mix and diversification. a) Delineate banks overall risk tolerance in relation to market risk. c) Ensure that top management as well as individuals responsible for market risk management possess sound expertise and knowledge to accomplish the risk management function.
There should be a process to identify any shifts from the approved market risk strategy and target markets. determine if changes need to be made to the strategy. and to evaluate the resulting impact.to the relevant staff. Accordingly. delegation of approving authority for market risk control limit setting and limit Excesses. based on these results. senior management is responsible to: a) Develop and implement procedures that translate business policy and strategic direction set by BOD into operating standards that are well understood by bank’s personnel. and identify risk management issues. The Board of Directors should periodically review the financial results of the institution and. and control bank’s market risk. set out the risk management structure and scope of activities. managing. measure. b) Ensure adherence to the lines of authority and responsibility that board has established for measuring. c) Oversee the implementation and maintenance of Management Information System that identify. d) Establish effective internal controls to monitor and control market risk. senior management and other personnel responsible for managing market risk. The institutions should formulate market risk management polices which are approved by board. such as market risk control limits. 57 . The policy should clearly delineate the lines of authority and the responsibilities of the Board of Directors. While the board gives a strategic direction and goals. monitor. it is the responsibility of top management to transform those directions into procedural guidelines and policy document and ensure proper implementation of those policies. and reporting market risk.
reporting directly to senior management or BOD. d) The structure should be reinforced by a strong MIS for controlling. a) The structure should conform to the overall strategy and risk policy set by the BOD. however. Organizational Structure for Market Risk Management The organizational structure used to manage market risk vary depending upon the nature size and scope of business activities of the institution. Generally it could include heads of Credit. monitoring and reporting market risk. It will decide the policy and strategy for 58 . Besides the role of Board as discussed earlier a typical organization set up for Market Risk Management should include: The Risk Management Committee The Asset-Liability Management Committee (ALCO) The Middle Office. scope and complexity of business. c) The risk management function should be independent. and the approved limits. Risk Management Committee: It is generally a board level subcommittee constituted to supervise overall risk management functions of the bank. any structure does not absolve the directors of their fiduciary responsibilities of ensuring safety and soundness of institution. While the structure varies depending upon the size. products that they are allowed to trade. The structure of the committee may vary in banks depending upon the size and volume of the business.2. b) Those who take risk (front office) must know the organization’s risk profile. at a minimum it should take into account following aspect. including transactions between an institution and its affiliates. Market and operational risk Management Committees.10.
comprehensive and well-documented policies and procedural guidelines relating to risk management and the relevant staff fully understands those policies. measurement. To be effective ALCO should have members from each area of the bank that significantly influences liquidity risk. e) Ensuring robustness of financial models and the effectiveness of all systems used to calculate market risk. b) The committee also ensures that resources allocated for risk management are adequate given the size nature and volume of the business and the managers and staffs that take. including triggers or stop losses for traded and accrual portfolios. business mix and organizational complexity. The committee generally comprises of senior managers from treasury. The responsibilities of Risk Management Committee with regard to market risk management aspects include: a) Devise policies and guidelines for identification. monitoring and control for all major risk categories. f) The bank has robust Management information system relating to risk reporting. business heads generating and using the funds of the bank. In addition. is senior responsible for supervision / committee management of Market Risk (mainly interest rate and Liquidity risks). credit. Chief Financial Officer. monitor and control risk possess sufficient knowledge and expertise. The CEO or some senior person nominated by CEO should be head of the committee. the head of the Information system Department (if any) may be an invitee for building 59 . c) The bank has clear. and individuals from the departments having direct link with interest rate and liquidity risks. The size as well as composition of ALCO could depend on the size of each institution.integrated risk management containing various risk exposures of the bank including the market risk. d) Reviewing and approving market risk limits. Asset-Liability Committee: management level Popularly known as ALCO.
Rather. it will ensure that detailed analysis of assets and liabilities is carried out so as to assess the overall balance sheet structure and risk profile of the bank.up of MIS and related computerization. c) Articulate interest rate view of the bank and deciding on the future business strategy. ALCO should ensure that risk management is not confined to collection of data. The concept of middle office has recently been introduced so as to independently monitor measure and analyze risks inherent in treasury operations of banks. Basically the middle office performs risk review function of day-to-day activities. f) Evaluate market risk involved in launching of new products. Besides the unit also prepares report for the information of senior management as well as bank’s ALCO. Being a highly specialized function. d) Review and articulate funding policy. The ALCO should cover the entire balance sheet/business of the bank while carrying out the periodic analysis. b) Decide on required maturity profile and mix of incremental assets and liabilities. Major responsibilities of the committee include: a) To keep an eye on the structure /composition of bank’s assets and liabilities and decide about product pricing for deposits and advances. e) Decide the transfer pricing policy of the bank. which may vary from simple gap analysis to computerized VaR modeling. Middle Office staff may prepare forecasts (simulations) 60 . it should be staffed by people who have relevant expertise and knowledge. These same criteria will govern the reporting requirements demanded of the Middle Office. Middle Office: The risk management functions relating to treasury operations are mainly performed by middle office. The methodology of analysis and reporting may vary from bank to bank depending on their degree of sophistication and exposure to market risks.
61 . Segregation of duties should be evident in the middle office. Banks using VaR or modeling methodologies should ensure that its ALCO is aware of and understand the nature of the output. until normal Middle Office framework is established. In respect of banks without a formal Middle Office.showing the effects of various possible changes in market conditions related to risk exposures. which must report to ALCO independently of the treasury function. how it is derived. assumptions and variables used in generating the outcome and any shortcomings of the methodology employed. it should be ensured that risk control and analysis should rest with a department with clear reporting independence from Treasury or risk taking units.
a) Summaries of bank’s aggregate market risk exposure b) Reports demonstrating bank’s compliance with policies and limits c) Summaries of finding of risk reviews of market risk policies.2.Chapter 11 Market Risk Monitoring and Control 11. While the types of reports for board and senior management could vary depending upon overall market risk profile of the bank. Risk monitoring Risk monitoring processes are established to evaluate the performance of bank’s risk strategies/policies and procedures in achieving overall goals. Whether the monitoring function is performed by middle-office or it is a part of banks internal audit it is important that the monitoring function should be independent of units taking risk and report directly to the top management/board. at a minimum following reports should be prepared. Risk Control. Bank’s internal control structure ensures the effectiveness of process relating to market risk management. informative and timely to ensure dissemination of information to management to support compliance with board policy.1. The board on regular basis should review these reports. Persons responsible for risk monitoring and control procedures should be independent of the 62 . Further past forecast or risk estimates should be compared with actual results to identify any shortcomings in risk measurement techniques. Establishing and maintaining an effective system of controls including the enforcement of official lines of authority and appropriate segregation of duties. is one of the management’s most important responsibilities. Reporting of risk measures should be regular and should clearly compare current exposures to policy limits. procedures and the adequacy of risk measurement system including any findings of internal/external auditors or consultants. 11. Banks should have an information system that is accurate.
risk management systems and risk tolerance. a) The appropriateness of bank’s risk measurement system given the nature. In small banks. should be compatible with the institution’s strategies. 63 .functions they review. The audit or review should take into account. Based on these tolerances the senior management should establish appropriate risk limits. external auditors or consultants can perform the function. Key elements of internal control process include internal audit and review and an effective risk limit structure. scope and complexity of bank’s activities b) The accuracy or integrity of data being used in risk models. with changes in market Conditions or resources prompting a reassessment of limits. Risk limits: As stated earlier it is the board that has to determine bank’s overall risk appetite and exposure limit in relation to its market risk strategy. The limits should be approved and periodically reviewed by the Board of Directors and/or senior management. Risk limits for business units. This review function can be performed by a number of units in the organization including internal audit/control department or ALCO support staff. c) The reasonableness of scenarios and assumptions d) The validity of risk measurement calculations. Audit: Banks need to review and validate each step of market risk measurement process.
and so on. 64 . However. what is relatively new is the view of operational risk management as a comprehensive practice comparable to the management of credit and market risks in principle. it has always been important for banks to try to prevent fraud. and reduce errors in transactions processing.Part IV Operational Risk The management of specific operational risks is not a new practice. maintain the integrity of internal controls.
12. Meaning of Operational Risk: Operational risk is the risk of loss resulting from inadequate or failed internal processes. assessment. understand and have defined all categories of operational risk applicable to the institution. should address in their approach to operational risk management. regardless of their size or complexity. c) Board and executive management should recognize. technology failures.2. or other operational problems may result in unexpected losses or reputation problems.Chapter 12 Introduction to Operation Risk 12. people and system or from external events. Operational Risk Management Principles. Operational risk exists in all products and business activities. with defined roles and responsibilities for all aspects of operational risk management/monitoring and appropriate tools that support the identification. they should ensure that their operational risk management framework adequately covers all of these categories of 65 . fraud. Furthermore. system failures and inadequate procedures and controls. a) Ultimate accountability for operational risk management rests with the board.1. and the level of risk that the organization accepts. unforeseen catastrophes. is driven from the top down by those charged with overall responsibility for running the business. It is the risk of loss arising from the potential that inadequate information system. breaches in internal controls. There are 6 fundamental principles that all institutions. b) The board and executive management should ensure that there is an effective. control and reporting of key risks. together with the basis for managing those risks. Operational risk is associated with human error. This should incorporate a clearly defined organizational structure. integrated operational risk management framework.
66 . easy to implement. including those that do not readily lend themselves to measurement. monitoring and reporting of operational risks that are appropriate to the needs of the institution. assessment.operational risk. operate consistently over time and support an organizational view of operational risks and material failures. mitigation. d) Operational risk policies and procedures that clearly define the way in which all aspects of operational risk are managed should be documented and communicated. e) All business and support functions should be an integral part of the overall operational risk management framework in order to enable the institution to manage effectively the key operational risks facing the institution. f) Line management should establish processes for the identification. These operational risk management policies and procedures should be aligned to the overall business strategy and should support the continuous improvement of risk management.
the ultimate responsibility of operational risk management rests with the board of directors. The management should ensure that it is communicated and understood throughout in the institution.1 Board and senior management’s oversight Likewise other risks. to ensure it continue to reflect the environment within which the institution operates. Although the Board may delegate the management of this process. it must ensure that its requirements are being executed. Senior management should transform the strategic direction given by the board through operational risk management policy. It should be approved by the board and documented. b) The systems and procedures to institute effective operational risk management framework. 68 . The management also needs to place proper monitoring and control processes in order to have effective implementation of the policy. The policy should be regularly reviewed and updated. c) The structure of operational risk management function and the roles and responsibilities of individuals involved. Such a strategy should be based on the requirements and obligation to the stakeholders of the institution. will be evaluated for operational risk prior to going online. The board should establish tolerance level and set strategic direction in relation to operational risk. The policy should include: a) The strategy given by the board of the bank. Both the board and senior management should establish an organizational culture that places a high priority on effective operational risk management and adherence to sound operating controls. The policy should establish a process to ensure that any new or changed activity.Chapter 13 Operational Risk Management and Measurement 13. such as new products or systems conversions.
2. However the banks could systematically track and record frequency. While a number of techniques are evolving. operating risk remains the most difficult risk category to quantify. 13. monitors and handle incidents and prepare reports for management and BOD. Besides. Operational Risk Assessment and Quantification Banks should identify and assess the operational risk inherent in all material products. processes and systems are introduced or undertaken. it should also provide guidance relating to various risk management tools. activities. Such a functional set up would assist management to understand and effectively manage operational risk. The function would assess.3. monitor and report operational risks as a whole and ensure that the management of operational risk in the bank is carried out as per strategy and policy.13. Operational Risk Function A separate function independent of internal audit should be established for effective management of operational risks in the bank. processes and systems and its vulnerability to these risks. Such a data could provide control that risk. meaningful information for assessing the bank’s exposure to operational risk and developing a policy to mitigate / 69 . the operational risk inherent in them is subject to adequate assessment procedures. activities. severity and other information on individual loss events. Banks should also ensure that before new products. It would not be feasible at the moment to expect banks to develop such measures. To accomplish the task the function would help establish policies and standards and coordinate various risk management activities.
Bibliography Reference Books: 1. Credit Risk Models – By Amandio F C da Silva Websites: 1. Credit Risk Analysis . www.By Chris Marrison 2.htm 70 . The Fundamentals Of Risk Measurement . www.SAS Risk Management For Banking. htm 3.Risk Management – Banking Information.com 2. Federal reserve Bank Of Chicago.By Ciby Joseph 3. Google.