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“Risk Management in Urban Co-operative Banks”
Reserve Bank of India, Mumbai
In partial fulfillment of
POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT (2005-2007)
Shashank P Pai PGDBM 534 Finance
Sydenham Institute of Management Studies Research and Entrepreneurship Education
Emergence of risk management in the financial sector especially in the banks following the aggressive push given to de-regulation and liberalization of Indian banks provides a challenging field of knowledge involving almost every aspect of a bank. For a novice Post Graduate student like me, this project was an incredible learning experience. I, therefore, thank Reserve Bank of India, Mumbai for giving me the valuable opportunity of working on this immensely interesting project. It would have been very difficult for me to do justice and complete this project in all respects in the limited time at my disposal, without the stimulating guidance and invaluable suggestions I received from my project guide, Mr. Sathyan David, General Manager, UBD. I would take this opportunity to express my earnest gratitude to Mr. Vishwanathan Chief General Manager, UBD who not only encouraged me to put in my best in the project but also gave me the full benefit of his vast knowledge by giving me right directions for preparing this Report. I also thank Mr. Vivek Mandlik, Senior Investment and Tresury manager, And Mrs. Bina Dixit for giving me the opportunity to undertake my study at Shamrao Vitthal Bank. I also acknowledge my debt to Mr Jagdish Pai from Risk Management Department Saraswat Bank for sharing with me their vast repertoire of knowledge and experience in the field of Risk Management and providing me with all the necessary guidance and help I also wish to acknowledge the help and support provided to me by Mr Shinde and many others of the Central office, UBD without which the completion of the project would have not been possible. 2
July 29th 2006
Shashank Padmanabh Pai
The following Project Report titled “Risk Management in Urban Co-operative Banks” has been prepared as a part of the Summer Training Programme undergone at Reserve Bank of India as well as other leading Urban Co-operative Banks. It is an academic exercise carried out based on the reading material provided by the institutions mentioned above as also individual study. The views expressed and the observations recorded in the Report are of the author and not of the organizations where the study has been undertaken.
Reserve Bank of India. Mr.Certificate This is to certify that Mr Shashank Padmanabh Pai. RBI 4 . Sathyan David GM. 2006. PGDBM 2005-07 students from Sydenham Institute of Management Studies and Research & Enterpreneurship Education. Mumbai from May 2 2. The title of his project is ‘Risk Management in Urban Co-operative Banks’. Mumbai has undergone summer training under my guidance at the Department of Banking Supervision. 2006 to July 22. UBD.
Increased competition from both domestic and foreign players puts pressure on the margins and reduces the cushion for absorbing the losses even as the potential for business losses increases due to higher market volatility. Many new players have entered market. they tend to reduce the arbitrage opportunities as market imperfections are eliminated. Just a few years ago market set up for banks were not as complex as it is today. By definition. The sheer movements of major macroeconomic parameters over the past few years have been breathtaking. Deregulation and Internationalization Within a fairly short span of time. by and large roles of all financial intermediaries were well defined and banks had a stable and well known set of customers and counterparties to deal with. the competitive framework also undergoes a change. financial assets moved within a narrow band. It can be exemplified saying – forex and exchange market. These players enter across different financial market segments and became more dynamic with more deregulation. It also brings in its own influences. This volatility in the financial sector results in not only from domestic deregulation but is also an inevitable product of opening up of the economy. inter linkages between them begin to develop and become more pronounced. The regulations were felt necessary 5 . Interest rates were regulated. was largely under regulatory provision from the Reserve Bank of India and the Government of India. till 1985.Executive Summary Economic reforms and liberalization gave a new dimension to the playing field in financial markets especially banks. In a liberalizing environment. the canvas has changed drastically. too. foreign exchange rate was pegged. in fact in many ways the rules of the game. The Process of Liberalization The Indian banking industry.
Post Liberalization – an experience The experience of Indian banks in the post liberalization era had been of mixed feelings. freeing of interest rates. The private sector banks have shown relatively better results as compared to the public sector banks and co-operative banks. The Growth in investment had been uptrend as banks found it safe to invest in government securities than to lend money to borrowers. the banking system had to move from deregulated environment to a more gradual liberalized environment. the equity of banks has increased. 6 . Simultaneously. more vigorously. more so towards the neglected sector. Low Level of Technology and Poor Customer Service. It continues even today. the process of liberalization was initially introduced in 1985. which had its effect on the Indian economy too. In Indian. more on an experimental basis and from 1991. and prudential norms for classification of assets. The gradual integration in the world economy prompted Indian economy to become a part of it. However. convertibility of rupee to foreign currency etc. The regulations in the initial stage did give a thrust to expand the banking activities to every nook and corner of the country. The focus here was to open up the banking sector to more competition. there were significant changes in the global scenario. deposit and credit growth has been slow and sluggish. Low Profitability. It had to accept the world standards of accounting. transparencies in balance sheets.to direct the scarce savings uniformly for all sectors of the economy. The Indian banking system being the backbone of the economy could not remain far behind. transparencies in performance. Along with it were negative indicators too like high level of Non-Performing Assets. Throughout the world. diversifying of banking activities. There were positive sides of such directed bank lending. both in developed as well as the developing countries. Due to the importance given to capital adequacy norms.
In fact. By definition. Under Operational Risk: the business strategy risk. financial infrastructure and systemic risk. Capital Adequacy. macro policy risk. where financial markets are connected to each other. In the world of advanced technology and economic liberalization. Liquidity Risk. a good risk management system is important to stay competitive. in this era of fast economic growth. Banking Risk Spectrum Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks as mentioned below: Under Financial Risks: Balance Sheet Structure. Internal System. Operational Risk. Income Statement Structure and Profitability. Under Event Risk: the political risk and other exogenous risks. Market Risk and Currency Risk. Technology Risk. Credit Risk. on which they can capitalize. Effective RMS will enable to accurately assess the acceptable level of risks. However. Risk management is important for banks in a globalization era. Interest Rate Risk. Under Banking Risk: the legal risk. 7 . Mismanagement & Fraud and Reputation Risk. what is needed is better management of funds available and various risks to which the banks are exposed. “Risk” is the potential that events expected or unanticipated may have an adverse impact on a financial institution’s capital or earnings. banks would be one of the biggest beneficiaries. prepare adequate level of capital as a buffer against loss and appropriately incorporate risk into price setting.
The Basle committee has proposed a revised Capital Adequacy framework in June 1999. The Basle Capital Accord is primarily targeted towards internationally active banks. The three pillars are critically interdependent and the success of the new framework hinges on ensuring the proper functioning of all three of them. Hence. this regulatory framework for measuring capital adequacy has come under severe criticism for various reasons such as inadequate differentiation of credit risk. in order to 8 .A formalized universal approach to credit risk was from set out in the BIS Accord 1988. Banks were required by their regulators to set aside a flat fixed percentage of their riskweighted assets as regulatory capital. it is an attempt to narrow the gap between regulatory and economic capital. The ultimate goal of the New Capital Accord is to ensure that the regulatory capital requirement is sufficient to address the underlying risks of banks. etc. (b) supervisory review process to ensure that bank’s capital is aligned to its actual risk profile and (c) market discipline to enhance the role of other market participants in ensuring that appropriate capital is held by prescribing greater disclosure. ignoring diversification benefits. The revised framework lays more emphasis on bank’s internal risk management systems. envisaged to remove shortcomings of the 1988 Accord and remove deficiencies in its risk-weighting model. driven by increasing sophistication of risk management techniques in banks. The new framework uses three-pillar approach consisting of (a) minimum capital requirements. However. Reserve Bank of India has issued various guidelines to Indian banks in line with the committee’s proposal for the purpose of effective Risk Management. Banks will require regulatory capital changes for “Operational Risk” and “Market Risk”. The bank lacked adequate operational controls. The Operational risk was the cause of various well-publicized financial disasters such as collapse of Barings bank in 1995. However. Improving standards of risk management will enable the banking sector to prosper in future.
Topic Page no. No.sustain them in the increasingly competitive environment INDEX Sr. 1 2 Introduction The Essence of Urban Co-operative Banks 3 4 Risk and risk management concepts Risk Management System in Banks (Introduction) 5 6 7 8 Credit Risk Market Risk Operational Risk Case Study 9 .
Citigroup's expanded scope is by no means unique. it is typical of the bank and non-bank consolidation that has taken place. Let us understand in brief the above 4 factors.Technological Changes M . CITICORP (1970-84) Risk Management has assumed greater significance in the past decade or so for the following key environmental factors that has changed in the financial services industry and has required the industry to improve both its monitoring and its management of risk exposures: I . pure and simple.Increased Competition T . but their combined influence has clearly altered the management challenges. Rather. that is the business of banking.Industry Consolidation I . Its major national credit card operation was its most significant departure from traditional banking lines. starting with Consolidation: Twenty years ago. Today. thirteen financial holding companies hold more than $100 10 . In contrast. America's largest bank was Citicorp. today's Citigroup has $1 trillion in assets and is a highly diversified financial services provider operating not only throughout the United States but also internationally.” Walter Wriston – Chairman and CEO. with assets of around $120 billion. Though Citicorp had a major international banking presence. not the only ones affecting the industry.INTRODUCTION “The fact is that bankers are in the business of managing risk. its domestic banking operation was contained largely in the State of New York.Management These factors are of course.
credit review and administration. virtually every financial product offered by the banking industry is also offered--either identically or by a close substitute--outside the regulated financial services industry. and asset funding. Let me touch on several ways that technology has changed the banking industry.billion in assets. technology has helped institutions monitor and manage risk by hedging exposure to credit risk and interest rate risk or by selling certain assets in secondary markets. Thirdly. The motivation for this goal is obvious. such as the availability of labor or the tax environment. the financial services industry remains highly competitive. The stock market has accorded a price-earnings premium to financial institutions that consistently outperform their competitors. but they also face competition from non-bank financial service providers. and the largest organizations of them now have nationwide presence and offer a broad array of financial products. Not only do banks face intraindustry competition. technology has allowed organizations to separate the various business functions. technological advances from the past decade have allowed real-time access to credit information and public records. Despite the consolidation that has taken place. This ability to mine data allows providers of financial products to identify target markets with minimal geographic restraint. First. The fourth environmental factor is the virtually unanimous corporate goal of maximizing shareholder value by the management. Let's move on to competition. As of all of you know. Secondly. However. This premium translates into highly receptive capital markets and enhanced compensation to employees through stock options and provides the institution with a strong currency with which to pursue mergers or acquisitions. there are more than 6. and to locate each of these functions based on separate criteria.000 separate banking organizations in United States. 11 . such as product marketing.
Post Barings episode. asset classification and income recognition have pride of place in the glossaries of financial sector. This volatility has manifested itself as increased risk and the failure to manage this risk has seen several institutions collapse across the globe. there has been increased financial volatility in the financial markets worldwide. Enhanced competition has brought increased pressure on interest-rate spreads and. The consolidation that has created these giant institutions has also created many new riskmanagement challenges. 12 . regulatory initiatives and the thrust on profitability. which was triggered by the breakdown of the fixed exchange rate system in the 1970s and fuelled further by the introduction of new financial products.Thus far we have understood only the positive aspects of each of these environmental factors. Sophisticated technology can at times be its own risk as a system failure or software error can have extremely negative consequences. when combined with the continual pressure for earnings performance. can encourage either imprudent risk-taking or a push for aggressive accounting treatment. Instead of merely addressing the credit quality issues. but each also has potential negatives. With the globalization of economies world-over. the quantum leap in technological capabilities that blurred financial boundaries. the concepts like capital adequacy. Over the past few decades. financial sector in general and banks in particular are laying emphasis on overall risk profile. the focus of supervisory concern has shifted from Asset Quality to Risk Management.
Foreign Exchange Risk . whereas such prescriptions had not been made for the domestic operations.Solvency Risk 13 . In the last decade. In part. Contingency Risk 2. the operational risks. and.Equity Prices Risk. deregulation of interest rates and the higher levels of technology absorption in the industry.Interest Rate Risk .Liquidity Risk .Capital Risks . liquidity. banking in India has undergone significant transformation due to the increased market orientation of the banks. control and monitoring i. The arising of new risks and the heightened awareness of existing ones has accompanied this transformation. ALM.Commodities Prices Risk . . Market Risk . market) has not traditionally been a component of the risk recognition and control systems. the focus in the areas of risks and controls in Indian banking has been on the elements of management oversight. The business risks faced by Indian banks today can be classified as follows: Financial Intermediation Risk A] Financial Risks: Credit Risk 1.e. limit setting etc. This contextual focus is evident from the fact that the measures generally associated with assessment and control of the financial risks viz.Historically. this has been due to the fact that only operational and credit risks were the key concerns of the banks since they were not exposed to market risks till recently. Risk assessment of financial nature (credit. the increased competition brought out by the entry of new banks in the private sector. have been implemented in 1986 itself for the overseas branches of Indian Banks which operate in such market driven environment.
Banks are however yet to put in place comprehensive Risk Management Systems as indicated in the Basle Core Principles and have essentially been reacting to regulatory and reporting requirements in their risk management efforts. Legal Risks 4. and which will put in place internal reporting systems required for the management of the risks. Reputation Risk Over a period of time.B] Non-Financial Risks: 1. In an environment where the risk-reward tradeoff can have immediate and systemic implications. ALM guidelines have also been drawn up which are already been advised to banks. These systems must be proactive enough to constantly scan the external environment in the search of emerging market risks and simultaneously be reactive and firmly entrenched in systems and procedures to be able to carry out a continuous self-assessment and trigger corrective action. These systems must also recognize that their purpose is not to contain or remove risk but to assist the organization in exploiting potential business opportunity in a manner so as to enhance shareholders value without endangering the assets of the firm. having risk management systems in place is no longer a matter of choice. Operational Risk 2. 14 . The focus of supervision has also shifted towards a risk-based approach. requiring banks to provide for capital against credit risk in line with the BIS capital accord. With interest rate risks becoming a reality only in the last couple of years following the deregulation of administered rates. banks have been advised to set up ALM committees to manage interest rate and liquidity risks. regulations have been introduced by apex bank and regulator Reserve Bank of India. Systemic Risk 3.
regulation and policies. (iii) Senior management should be responsible for ensuring that there are adequate policies and procedure for conducting various businesses. adequate systems for measuring risk. dictated by the size. capital strength. management expertise and overall willingness to take risk. the level of technical expertise and the quality of MIS. monitoring and reporting risks. This responsibility includes ensuring that there are clear delineation of lines of responsibility for managing risk. and compliance with relevant laws. Given the diversity of balance sheet profile. (i) The main components of a sound risk management focus are: competitive risk measurement approach. complexity of functions. (ii) The risk appetite of a bank is decided by its Board of Directors who should approve all significant policies relating to the management of risks. These policies have to be consistent with the broader business strategies. and a strong management information system for controlling. (vi) A sound internal control system should promote effective operations. throughout the bank. guidelines and other parameters used to govern risk taking. reliable financial and regulatory reporting. Internal auditors have to evaluate the independence and overall effectiveness of the bank’s risk management functions. a detailed structure of limits. The guidelines outlined by Reserve Bank of India in 15 . appropriately structured limits on risk taking. The design of risk management functions should be bank specific. it is difficult to adopt a uniform framework for management of risks in India.The broad parameters of risk management function are as under. effective internal controls and a comprehensive risk reporting framework (iv) (v) The risk management function should be an independent function Management should ensure that the various components of the institution’s risk management process are regularly reviewed and evaluated.
October 1999. only provides broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise. The Broad objective of this paper is to analyze the risk management system followed in urban cooperative Banks vis-à-vis RBI guidelines. 16 .
The guiding principles of voluntary and open membership. voluntarily associate and come together on the basis of equality for the promotion of their economic interests.The Essence of Urban Co-operative Banks Definition of co-operation The word co-operation has been defined in different ways by economists. In India first urban co-operative bank was started by Mr Vitthal Laxman Kavthekar in 1889. According to co-operative planning Committee appointed by the Government of India in 1945 known as Saraiya Committee the definition of co-operation is: “Cooperation is a form of organization in which persons the bonds of moral solidarity between them. Thus urban co-operative banks are more than 100 years old. lawmakers and others. equal economic participation and concern for the community were the basis. Those who come together have a common economic aim which they cannot achieve by individual isolated action because of the weakness of economic position of a large majority of them. This element of individual weakness can be overcome by pooling their resources by making self help effective through mutual aid and by strengthening”. 17 . What is an Urban Co-operative Bank? The urban co-operative banks were first started in Germany in 1888 and in Italy in 1898.
The long term rural co-operative structure has two tiers. The co-operative banking structure in India comprises urban co-operative banks and rural co-operative credit institutions. short term and long term. primary co-operative. Till end of March 2005 the number of UCBs was 1872 and till end of March 2004 the count of rural co-operative credit institutions was 1. commonly referred to as urban co-operative banks (UCBs). viz. State co-operative agriculture and rural development banks (SCARDBs) at the state level and primary co-operative and rural development banks (PCARDBs) at the taluka/tehsil level. The smaller States and union territories have a two tier structure with the StCBs directly meeting the credit requirements of PACS. The century old co-operative banking structure is viewed as an important instrument of banking access to the rural masses and thus a vehicle for democratization of Indian financial System. The rural co-operative credit structure has traditionally been bifurcated into two parallel wings viz.Out of short term StCBs had 31 CCBs had 365 and PACS had 1. In long term SCARDBs had 20 and PCARDBs had 768 institutions respectively.919 with short term having a majority share of 1.131 institutions and long term having 788. Short term co-operative and credit institutions have a federal three tier structure consisting of a large number of primary agricultural credit societies (PACS) at the grassroot level. 18 .05.Co-operative Banks in India have come a long way since the enactment of the agricultural Credit Co-operative Societies Act 1904. Co-operative Banks mobilize deposits and purvey agricultural and rural credit with a wider outreach.735 institutions respectively. particularly subsidy based programmes for the poor. They have also been an important instrument for various development schemes. However some states have a unitary structure with the State level banks operating through their own branches: three States have a mixed structure incorporating both unitary and federal systems. central co-operative banks (CCBs) at the district level and State co-operative banks (StCBs) at the state/apex level. Urban co-operative banks consist of single tier viz.06.06.
19 . The co-operative banks are owned by the customers or the users.How do Urban Cooperative Banks differ from others? Unlike commercial banks which are promoted by institutions or the government and are in the nature of a joint stock company. co-operative banks are promoted by a group of individuals to fulfill their needs. Thus to borrow funds from a cooperative bank one has to be a shareholder of the bank. Various state governments have placed limitations on maximum share holding by an individual to ensure that no single individual or group obtains control of the bank. The shareholders in turn elect a managing committee which runs the bank.
The basic idea of establishing the co-operative bank is still relevant but they have to change their working style and adopt modern means of ICT. retail and petty traders transport operators and other weaker sections of the society. UCBs mobilize savings from the middle and lower income groups and purvey credit to small sections of the society. Still a large number of people in the urban. The first Co-operative society known as Rochdale Pioneer was formed by 28 flannel weavers in England in 1843 to protect themselves against the organized sector. Hence it would be useful to discuss in brief the basic philosophy behind establishing the cooperative institutions. The co-operatives can play a very significant role in the traditional areas like small borrowers. Primary urban co-operative banks play an important role in meeting the growing credit needs of urban and semi-urban areas.Objectives of the co-operative banks The co-operative system world over has emerged with a distinct objective namely to safeguard the interests of its members and to provide financial assistance to those who are unable to get financial help from other institutions. But the ultimate aim of co-operatives was the protection of poor sections of the society by pooling the available sources with them to help their members by providing financial assistance to face the competition from the organized sector. Risk and Risk Management 20 . The movement later spread on to the other fields of economic activities. Early history of cooperative movement through out the world shows that cooperative organizations began with consumers cooperatives. semiurban and villages are unable to receive the benefits. Today there are over 2000 primary urban cooperative banks with a deposit of over Rs 60000 crores. They have not benefited from the new developments to a desired extent.
The possibility of suffering harm or loss. we cannot attach a probe to a device and measure risk. Many in the organizations still view risk as a scientific or engineering tool but not as an essential metric. are all risks bad. is risk a natural metric. requiring a degree of intellect that may. perhaps. 'risk' raises many questions viz. irrelevant to many in organizations. Secondly. An extension of this analogy further reveals that risk is not something to be faced but a set of opportunities open to choice. to anyone trying to understand risk there appears to be no frame of reference within which it could be understood. to quantify it. A chance of loss and the degree of probability of such loss. It is not hard to understand the reasons behind it. risk is an abstract parameter. 21 . Peril A dangerous element or factor. Definition of Risk The word 'risk' is derived from an Italian word "risicare" which means 'to dare'. The danger or probability of loss. Any of them could be the reasons why risk-related discussions even today sound theoretical if not philosophical and for most of the part. Interestingly. hazard. in what units is risk measured. than answers about its nature. yet so eluding. Thirdly. no one precise definition of risk that captures its entire spectra but a plethora of opinions: Possibility of loss or injury. It means risk is more 'a choice' than 'a fate'. Fourthly.Risk analysis and management is just as common to our everyday existence as the very concept of self-preservation. be unique to human beings. Firstly. organizations are no exception to these paradoxes. There is however. can risk be measured directly. A factor. element or course involving uncertain danger. It is very much a part of human psyche. danger. can risk be added and subtracted..
2. Risk is just the chance of losing money. if everyone valued every risk in precisely the same way. It arises as a deviation between what happens and what was expected to happen. not solely assigned to finance department. not increased regulation or aversion of employing financial instruments that can reduce risk if used properly. Risk Retention – One can retain the risks on to their own books. how people view hazards will greatly influence their perception of associated risk. risk is defined as the degree of variability of possible outcomes for a particular event. Risk Management is not an ivory tower for arcane specialists. Risk Reduction – Risk reduction through safety measures. In financial parlance. 4. Risk Avoidance – Avoiding taking risks. 3. Therefore. Risks can be dealt in any one or the combination of following ways: 1. In statistical terms. In a way this is a good thing for. Risk is a chance of gaining less money than normally expected. risk is always associated with loss that is expected to be incurred or less profit to be incurred due to the happening or non-happening of certain events or activities. Risk Transfer – By way of Insurance or Hedging. many risk opportunities would be passed by. Risk Management must be senior management strategic responsibility. Increased disclosure of risk assessments and responses is the best course of action. 22 . Survey on Corporate risk management published by the Economist makes the following observations: Risk Management must be regarded as a core skill by every firm.
goals and risk tolerance. reflective of organizations risk characteristics. It is based on separation of responsibilities principle. Along with financial performance of an institution equal importance is given to risk management practices. There is a mistaken belief that risk management is window dressing for regulators. Ultimately how exposures and risks are managed depends upon the organizational culture. New technologies. not just the narrowly defined financial ones. Over focus on one type of risk or another simply perpetuates the outmoded fragmented approach to the management of risk.The primary message of this survey is that the firms need to understand all the main risks to which their future cash flows are exposed. Risk Management is neither an added layer of bureaucracy nor an impediment to quick execution and superior customer service. Risk Management Concept Risk Management is the continuous process of identifying and capitalizing on appropriate opportunities while avoiding inappropriate exposures in such a way to maximize the value of the enterprise. Risk Management is the primary duty of line managers. executed from many locations by numerous people. Exposures in the aggregate result from diverse activities. generating of risk profile and the process. Identifying exposure . It is fundamentally a managerial process. new products and size and speed of financial transactions have added impetus to the risk management issues. Risk Management is critical to the conduct of safe and sound banking activities. The aforesaid clearly brings out the need to have proper understanding of framework for risk management including the concept.its worthiness or otherwise. The Risk Management procedures need to address the following issues: 23 . is the greatest challenge in the risk management.
. The second component is risk measurement. asset/liability analysis is considered as a measure for estimating impact of changes in interest rates on portfolio value. Soundness of implicit and explicit assumptions . degree of sophistication and costs involved.both qualitative and quantitative in the risk management system. This is a difficult component due to variety of available methods. Ability to manage risk inherent in lending. What is required is anticipating and preventing risk at the source and the continuous monitoring of risk controls and ineffective processes which are the primary source of risk. Consistency of policies/guidelines with lending/trading activities. A fully integrated risk management system that effectively identifies and controls all major types of risks including those from new products and changing environment would facilitate long-term growth and stability. Hence. Risk Identification. Risk Identification. risk management needs to address to the process issue. Various interest rate scenarios 24 . As such. as a starting point consists of naming and defining each risk associated with a type of transaction or a product or a service. and. trading and other transactions. Risk Management encompasses three activities viz. Risk Measurement and Risk Control. Managerial capacity to identify and accommodate new risks. practically everyone throughout the organization is concerned with identifying and managing risk. For example. Appropriateness of MIS and communication network vis-à-vis level of business activity. Risk is a multidimensional concept and risk management is a continuous activity. It is the estimation of size. When the transactions are many and the chain of communication is long a formal risk identification system is necessary. managements experience level and overall financial strength. probability and timing of potential loss under various scenarios.
while the qualitative requirements include aspects. reduction (specification and adherence to limit) and risk retention. and. elimination or avoidance (staying out of risky business). helps to define each person's role. The quantitative requirements provide a level of consistency necessary for a capital standard. reporting mechanism and the like. The other aspect of risk control is risk-mitigating activity. They are: 25 . Having proper policies/procedures. each organization has to address to certain pre-requisites. The available options could be risk transfer (insurance or hedging). For a sound risk management system to meet these quantitative and qualitative criteria. while the second is risk-mitigating activity. The goal of each such policy is to keep the outcome within risk tolerance ranges. The first relates to policy administrative control. limit to which he can take risk. e) Conducting independent review of risk management process by internal auditors. which may take the shape of a) Having risk control unit independent of the operating unit b) Implementing a regular program for validation c) Laying down procedures for periodic stress testing to evaluate the impact of unusual transactions d) Adopting internal policies/procedures/controls which are documented.could be developed for appreciation of risk involved. Risk control has two sub-categories. Uniformity of language is useful while defining each risk precisely from department to department. Prerequisites of Effective Risk Management Systems in Banks Establishment of a sound risk management system presupposes specification of and adherence to certain qualitative and quantitative criteria.
They should receive in meaningful terms reports identifying the size and significance of risks. Senior Management is responsible for implementing strategies that limit risks associated with each strategy and ensures compliance with laws and regulations. Board needs to approve overall business strategies/ policies including managing and undertaking risks. 4. Board therefore needs to have a clear understanding of the types of risks. the institution is exposed to. Appropriate Risk Measurement and Reporting Systems. delineating accountability and lines of authority creating and communicating awareness of internal controls as also ethical standards are all tasks of senior management.1. Adequate Risk Management Policies and Limits 3. devising control mechanisms and risk monitoring systems. It may be useful to have briefing from outside experts so that the board is capable to guide its institution on the level of acceptable risk. This would also facilitate that the senior management implements the procedures and controls necessary to comply with adopted policies. Adequate Risk Management Policies and Limits 26 . and. Comprehensive Internal Control System Active Board and Senior Management Oversight Boards of Directors have the ultimate responsibility to determine the level of risks undertaken by the organization. Ensuring capability of senior management to conduct the risk management task is also the board’s responsibility. Active Board and Senior Management Oversight 2. Adopting policies.
Comprehensive Internal Control System 27 . identification. measurement. MIS for example will include daily financials including profit/loss details. These policies and procedures provide risk management framework based on management experience level.e. The purpose is to ultimately ensure that policies and procedures address to material risks areas and that they are modifies to respond to the changes in activities.There can be nothing like proto-type policies or procedures for risk management. managerial capacity and ability to undertake risks are some of the determinants while documenting policies and procedures.. The size of operations. operational performance and risk exposures. objectives and overall financial strength of the banking organization. sophistication. The policies and procedures are tailored according to the types of risks that arise from the activities of the organization. Delineating accountability and lines of authority across the organizational activities and review of activities new to the bank are also facilitated through such policies. business conditions and environment. They provide detailed guidelines on implementation and prescribe limits designed to protect the organization from excessive and imprudent risks. Monitoring and Management Information Systems Risk management related activity i. Such MIS provides reports on financial condition. and monitoring/ control need to be supported by a proper Management Information System (MIS). goals. etc. level of technology. The core of these policies is to address to the material areas of risk and their necessary modification to respond to significant changes to bank activities or business environment. more detailed activity reports across the whole organization may be necessary. Complexity and diversity of institutions financial transactions would dictate sophistication of MIS. Whenever trading activities are on a larger scale. a watch list of troubled loans. Line Managers can expect to obtain more detailed feedback on day-to-day operating activities.
A properly placed internal control system aims at: • • • Promoting effective operations and reliable reporting Safeguarding assets. failure to implement/ maintain separation of duties can result in serious financial and reputation losses. RISK MANAGEMENT SYSTEMS IN BANKS 28 . The internal controls primarily check the policies/procedures in terms of their adequacy and effectiveness. The prescription for proper policies and procedures do equally hold good for internal controls. who would report directly to the top management.Internal control structure is critical for safety and soundness of any organization. As the instances of Daiwa/ Barings have proved. Ensuring regulatory/ policy compliance Effective internal controls need to be looked into by internal auditors. and.
operational. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. commodity price. top management of banks should attach considerable importance to improve the ability to identify measure. consistent with the broader business strategies. capital strength. credit. vi) Well laid out procedures. effective control and comprehensive risk reporting framework. v) Strong MIS for reporting. iv) Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits. management expertise and overall Risk Management Structure 29 . monitoring and controlling risks. foreign exchange rate. monitor and control the overall level of risks undertaken. Thus. liquidity. legal. regulatory. The broad parameters of risk management function should encompass: i) Organizational structure. and viii) Periodical review and evaluation. etc.Introduction Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz.. iii) Risk management policies approved by the Board which should be willingness to assume risk. interest rate. equity price. ii) Comprehensive risk measurement approach. vii) Separate risk management framework independent of operational Departments and with clear delineation of levels of responsibility for management of risk. reputation.
verify the models that are used for pricing complex products. and the performance of the bank in that area. the trend is towards assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk). the Committee should hold the line management more accountable for the risks under their control. At the same time. review the risk models as development takes place in the markets and also identify new risks.A major issue in establishing an appropriate risk management organization structure is choosing between a centralized and decentralized structure. monitor and measure the risk profile of the bank. overall risk management should be assigned to an independent Risk Management Committee or Executive Committee of the top Executives that reports directly to the Board of Directors. economies of scale and easier reporting to top management. The Board should set risk limits by assessing the bank’s risk and risk-bearing capacity. The existing MIS. Internationally. The Committee should also monitor compliance of various risk parameters by operating Departments. however. The risk policies should clearly spell out the quantitative prudential limits on various segments of banks’ operations. A prerequisite for establishment of an effective risk management system is the existence of a robust MIS. The global trend is towards centralizing risk management with integrated treasury management function to benefit from information on aggregate exposure. The Committee should also develop policies and procedures. requires substantial 30 . At organizational level. The functions of Risk Management Committee should essentially be to identify. natural netting of exposures. The purpose of this top level committee is to empower one group with full responsibility of evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. The Committee should design stress scenarios to measure the impact of unusual market conditions and monitor variance between the actual volatility of portfolio value and that predicted by the risk measures. consistent in quality. The primary responsibility of understanding the risks run by the bank and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors.
Generally. be the endeavor of all banks to upgrade the skills of staff. While the Asset . It should. the level of technical expertise and the quality of MIS. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise. it is difficult to adopt a uniform framework for management of risks in India.up gradation and strengthening of the data collection machinery to ensure the integrity and reliability of data. The risk management is a complex function and it requires specialized skills and expertise. Banks could also set-up a single Committee for integrated management of credit and market risks. complexity of functions. As the domestic market integrates with the international markets. dictated by the size. Given the diversity of balance sheet profile. the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk. the core staff at Head Offices should be trained in risk modeling and analytical tools. Large banks and those operating in international markets should develop internal risk management models to be able to compete effectively with their competitors. market and credit risks are managed in a parallel two-track approach in banks. the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. At a more sophisticated level. 31 . The design of risk management functions should be bank specific. Thus.Liability Management Committee (ALCO) deal with different types of market risk. a committee approach to risk management is being adopted. Banks have been moving towards the use of sophisticated models for measuring and managing risks. the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures. Internationally. therefore.
assumed by corporates who have no natural hedges. The volatility in the prices of collateral also significantly affects the quality of the loan book. Thus. there is a need for integration of the activities of both the ALCO and the CPC and consultation process should be established to evaluate the impact of market and credit risks on the financial strength of banks. while market variables are held constant for quantifying credit risk.Currently. credit variables are held constant in estimating market risk. The economic crises in some of the countries have revealed a strong correlation between unhedged market risk and credit risk. Banks may also consider integrating market risk elements into their credit risk assessment process. 32 . will increase the credit risk which banks run vis-à-vis their counterparties. Forex exposures.
excessive dependence on collaterals and inadequate risk pricing. hedging. absence of prudential credit concentration limits. Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending. Another variant of credit risk is counterparty risk. Government policies. inadequately defined lending limits for Loan Officers/Credit Committees. settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk. wide swings in commodity/equity prices. etc. etc.Credit Risk General Lending involves a number of risks. The counterparty risk arises from nonperformance of the trading partners. deficiencies in appraisal of borrowers’ financial position. The portfolio risk in turn comprises intrinsic and concentration risk. absence of loan review mechanism and post sanction surveillance. The internal factors are deficiencies in loan policies/administration. The management of credit risk should receive the top management’s attention and the process should encompass: 33 . The non-performance may arise from counterparty’s refusal/inability to perform due to adverse price movements or from external constraints that were not anticipated by the principal. The credit risk of a bank’s portfolio depends on both external and internal factors. foreign exchange rates and interest rates. economic sanctions. forex and country risks. trade restrictions. trading. In addition to the risks related to creditworthiness of the counterparty. the banks are also exposed to interest rate. The external factors are the state of the economy.
The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The Committee should be headed by the Chairman/CEO/ED. the amount by which actual losses exceed the expected loss (through standard deviation of losses or the difference between expected loan losses and some selected target credit loss quantity). The credit risk management process should be articulated in the bank’s Loan Policy. rating standards and benchmarks. risk monitoring and evaluation. delegation of credit approving powers. also called Credit Risk Management Committee or Credit Control Committee etc. asset concentrations. risk concentrations. identify problems and correct deficiencies.a) b) Measurement of risk through credit rating/scoring. formulate clear policies on standards for presentation of credit proposals. The Department should undertake portfolio 34 . provisioning. and should comprise heads of Credit Department. portfolio management.e. prudential limits on large credit exposures. pricing of loans. independent of the Credit Administration Department. financial covenants. Credit Risk Management Department (CRMD) and the Chief Economist. Each bank should constitute a high level Credit Policy Committee. Treasury. manage and control credit risk on a bank wide basis. regulatory/legal compliance.e. standards for loan collateral. and Controlling the risk through effective Loan Review Mechanism and portfolio management. to deal with issues relating to credit policy and procedures and to analyze. inter alia. c) d) Risk pricing on a scientific basis. each bank should also set up Credit Risk Management Department (CRMD). The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The CRMD should also lay down risk assessment systems. Quantifying the risk through estimating expected loan losses i. Concurrently. the amount of loan losses that bank would experience over a chosen time horizon (through tracking portfolio behavior over 5 or more years) and unexpected loan losses i. Large banks may consider separate set up for loan review/audit. loan review mechanism. The Committee should. develop MIS and undertake loan review/audit. duly approved by the Board. monitor quality of loan portfolio. etc.
Regional Offices. through a well-defined Loan Review Mechanism. The banks should also evolve suitable framework for reporting and evaluating the quality of credit decisions taken by various functional groups. the specific views of the dissenting member/s should be recorded. if majority members of the ‘Approval Grid’ or ‘Committee’ do not agree on the creditworthiness of the borrower.e. Banks could consider delegating powers for sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. The credit facilities above a specified limit may be approved by the ‘Grid’ or ‘Committee’. The quality of credit decisions should be evaluated within a reasonable time. In case of disagreement. who has no volume and profit targets. Credit Approving Authority Each bank should have a carefully formulated scheme of delegation of powers. Head Offices. The banks should also evolve multi-tier credit approving system where the loan proposals are approved by an ‘Approval Grid’ or a ‘Committee’. etc. Banks can also consider credit approving committees at various operating levels i. Zonal Offices. which help the banks in mitigating the adverse impacts of credit risk. comprising at least 3 or 4 officers and invariably one officer should represent the CRMD. 35 .evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. say 3 – 6 months. large branches (where considered necessary). Instruments of Credit Risk Management Credit Risk Management encompasses a host of management techniques. The spirit of the credit approving system may be that no credit proposals should be approved or recommended to higher authorities.
d) Maximum exposure limits to industry. a substantial degree of standardization is required in 36 . risk evaluation capability. The conditions subject to which deviations are permitted and the authority therefore should also be clearly spelt out in the Loan Policy. The exposure limits to sensitive sectors. keeping in view the market risks inherent in the balance sheet. depending upon the degree of concentration risk the bank is exposed. etc. advances against equity shares.e. sector. which are subject to frequent business cycles. debt service coverage ratio or other ratios. should also be placed under lower portfolio limit. To facilitate this. b) Single /group borrower limits. etc. should be set up..Prudential Limits In order to limit the magnitude of credit risk. may necessarily be restricted. Similarly. There must also be systems in place to evaluate the exposures at reasonable intervals and the limits should be adjusted especially when a particular sector or industry faces slowdown or other sector/industry specific problems. which may be lower than the limits prescribed by Reserve Bank to provide a filtering mechanism. sum total of exposures assumed in respect of those single borrowers enjoying credit facilities in excess of a threshold limit. say 10% or 15% of capital funds. such as. which are subject to a high degree of asset price volatility and to specific industries. as perceived by the bank. high-risk industries. prudential limits should be laid down on various aspects of credit: a) Stipulate benchmark current/debt equity and profitability ratios. liquidity. with flexibility for deviations. Risk Rating Banks should have a comprehensive risk scoring / rating system that serves as a single point indicator of diverse risk factors of counterparty and for taking credit decisions in a consistent manner. and e) Banks may consider maturity profile of the loan book. real estate. c) Substantial exposure limit i. etc. The substantial exposure limit may be fixed at 600% or 800% of capital funds. Any excess exposure should be fully backed by adequate collaterals or strategic considerations.
1-8. and an analytic representation of the underlying financials of the borrower should be presented. Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. beyond which no proposals should be entertained. a quantitative definition of the borrower. projections and sensitivity. The risk rating system should be designed to reveal the overall risk of lending. therefore. traders. Within the rating framework. inter alia. financial analysis. For each numerical category. critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio. The overall score for risk is to be placed on a numerical scale ranging between 1-6. industrial and management risks. etc. banks can also prescribe certain level of standards or critical parameters. should reflect the underlying credit risk of the loan book. factor the unhedged market risk exposures of borrowers also in the rating framework. that exhibit varying nature and degree of risk. Banks should. Forex exposures assumed by corporates who have no natural hedges have significantly altered the risk profile of banks. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time. each bank should prescribe the minimum rating below which no exposures would be undertaken. The risk rating. The updating of the credit ratings should be undertaken normally at 37 . as a prudent risk management policy. The banks may use any number of financial ratios and operational parameters and collaterals as also qualitative aspects of management and industry characteristics that have bearings on the creditworthiness of borrowers. on the basis of credit quality. The risk rating system should be drawn up in a structured manner. The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for low quality customers) and should be delinked invariably from the regular renewal exercise. Any flexibility in the minimum standards and conditions for relaxation and authority therefore should be clearly articulated in the Loan Policy. Banks may also consider separate rating framework for large corporate / small borrowers. the loan’s underlying quality.ratings across borrowers. in short. etc. Further. incorporating.
Thus. Banks should build historical database on the portfolio quality and provisioning / charge off to equip themselves to price the risk. if the rating system is to be meaningful. banks should evolve scientific systems to price the credit risk. Thus. The pricing of loans normally should be linked to risk rating or credit quality. perceived value of accounts. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- 38 . lender begins by charging an interest mark-up to cover the expected loss – expected default rate of the rating category of the borrower. which calls for data on portfolio behavior and allocation of capital commensurate with credit risk inherent in loan proposals.quarterly intervals or at least at half-yearly intervals. the credit quality reports should signal changes in expected loan losses. But value of collateral. Under RAROC framework. Flexibility should also be made for revising the price (risk premia) due to changes in rating / value of collaterals over time. In a risk-return setting. the responsibility for setting or confirming such ratings should vest with the Loan Review function and examined by an independent Loan Review Group. in order to gauge the quality of the portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate changes in credit quality and expected loan losses from the credit portfolio. The probability of default could be derived from the past behavior of the loan portfolio. Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans. The banks should undertake comprehensive study on migration (upward – lower to higher and downward – higher to lower) of borrowers in the ratings to add accuracy in expected loan loss calculations. market forces. In order to ensure the consistency and accuracy of internal ratings. borrowers with weak financial position and hence placed in high credit risk category should be priced high. which is the function of loan loss provision/charge offs for the last five years or so. future business potential. portfolio/industry exposure and strategic reasons may also play important role in pricing. which should have a bearing on the expected probability of default. Risk Pricing Risk-return pricing is a fundamental tenet of risk management.
Portfolio Management The existing framework of tracking the Non Performing Loans around the balance sheet date does not signal the quality of the entire Loan Book. banks should weigh the pros and cons of specialization and concentration by industry group.variability of default rates. international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital cover 99% of the loan loss outcomes. 3) Exposure to one industry/sector should be evaluated on the basis of overall rating distribution of borrowers in the sector/group. The portfolio quality could be evaluated by tracking the migration (upward or downward) of borrowers from one rating scale to another. In cases where portfolio 39 . Thus. This process would be meaningful only if the borrower-wise ratings are updated at quarterly / half-yearly intervals. 2) Evaluate the rating-wise distribution of borrowers in various industry. In this context. The banks could also consider the following measures to maintain the portfolio quality: 1) Stipulate quantitative ceiling on aggregate exposure in specified rating categories.. There is. Most of international banks have adopted various portfolio management techniques for gauging asset quality. set up at Head Office should be assigned the responsibility of periodic monitoring of the portfolio. etc. business segments.e. The CRMD. a need for comparing the prices quoted by competitors for borrowers perched on the same rating /quality. Data on movements within grading categories provide a useful insight into the nature and composition of loan book. certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3. Generally. however. any attempt at price-cutting for market share would result in mispricing of risk and ‘Adverse Selection’. i. etc. 2 to 4 or 4 to 5. Banks should evolve proper systems for identification of credit weaknesses well in advance.
structural or economic variables to the use of highly sophisticated models. especially credit and market risks. the banks may increase the quality standards for that specific industry. economic sanctions. an exercise for restructuring of the portfolio should immediately be undertaken and if necessary. market risk events. there may be substantial correlation of various risks.exposure to a single industry is badly performing. Lower rated borrowers whose financials show signs of problems should be subjected to renewal control twice/thrice a year. For any deviation/s from the expected parameters. probable defaults and provisioning requirements as a prudent planning exercise. changes in the fiscal/monetary policies. The output of such portfolio-wide stress tests should be reviewed by the Board and suitable changes may be made in prudential risk limits for protecting the quality. 4) Target rating-wise volume of loans. the entry-level criteria could be enhanced to insulate the portfolio from further deterioration. etc. The Relationship Managers may service mainly high value loans so that a substantial share of the loan 40 . detailing management responses to stressful situations. 5) Undertake rapid portfolio reviews. Stress testing can range from relatively simple alterations in assumptions about one or more financial. For comprehensive evaluation of customer exposure. banks may consider appointing Relationship Managers to ensure that overall exposure to a single borrower is monitored.g. stress tests and scenario analysis when external environment undergoes rapid changes (e. The Relationship Managers have to work in coordination with the Treasury and Forex Departments. captured and controlled. 6) Introduce discriminatory time schedules for renewal of borrower limits. Banks should evolve suitable framework for monitoring the market risks especially forex risk exposure of corporates who have no natural hedges on a regular basis. volatility in the forex market. general slowdown of the economy. The stress tests would reveal undetected areas of potential credit risk exposure and linkages between different categories of risk. Banks should also appoint Portfolio Managers to watch the loan portfolio’s degree of concentrations and exposure to counterparties. extreme liquidity conditions. In adverse circumstances. Stress tests could also include contingency plans.).
transactions with affiliated companies/groups need to be aggregated and maintained close to real time.portfolio. Further. The banks may evaluate the utility of these models with suitable modifications to Indian environment for fine-tuning the credit risk management. Thus. therefore. establishing benchmark for credit risk measurement and estimating economic capital for credit risk under RAROC framework. Many of the international banks have adopted credit risk models for evaluation of credit portfolio. which can alter the risk profile. across geographical locations and product lines in a timely manner. Banks may. The model is based on actuarial calculation of expected default rates and unexpected losses from default. The model can be used for promoting transparency in credit risk. The model basically focuses on estimating the volatility in the value of assets caused by variations in the quality of assets. Credit Suisse developed a statistical method for measuring and accounting for credit risk which is known as CreditRisk+. The credit risk models offer banks framework for examining credit risk exposures. P. The model combines five financial ratios using reported accounting information and equity values to produce an objective measure of borrower’s financial health. The Altman’s Z score forecasts the probability of a company entering bankruptcy within a 12-month period. reflecting migration of the borrowers to a different risk-rating grade. endeavor building 41 . would be under constant surveillance. The models also provide estimates of credit risk (unexpected loss) which reflect individual portfolio composition. The volatility is computed by tracking the probability that the borrower might migrate from one rating category to another (downgrade or upgrade). spanning multiple credit cycles. the value of loans can change over time. Morgan has developed a portfolio model ‘CreditMetrics’ for evaluating credit risk. J. The banks should also put in place formalized systems for identification of accounts showing pronounced credit weaknesses well in advance and also prepare internal guidelines for such an exercise and set time frame for deciding courses of action. The success of credit risk models impinges on time series data on historical loan loss rates and other model variables. centralizing data and analyzing marginal and absolute contributions to risk.
assessing the loan loss provision. to evaluate portfolio quality and isolate potential problem areas. loan policies and procedures. Accurate and timely credit grading is one of the basic components of an effective LRM. Banks should. and assignment of risk ratings. Given the importance and subjective nature of credit rating. to provide information for determining adequacy of loan loss provision to assess the adequacy of and adherence to. put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions. risk evaluation and post-sanction follow-up. It may be independent of the CRMD or even separate Department in large banks. and to provide top management with information on credit administration. type of operations and management practices. The complexity and scope of LRM normally vary based on banks’ size. etc. maintaining the integrity of credit grading process. portfolio quality. including credit sanction process.adequate database for switching over to credit risk modeling after a specified period of time. and to monitor compliance with relevant laws and regulations. 42 . identification of problem loans. evaluating the effectiveness of loan administration. Loan Review Mechanism (LRM) LRM is an effective tool for constantly evaluating the quality of loan book and to bring about qualitative improvements in credit administration. Credit grading involves assessment of credit quality. The main objectives of LRM could be: • • • • • to identify promptly loans which develop credit weaknesses and initiate timely corrective action. therefore. the credit ratings awarded by Credit Administration Department should be subjected to review by Loan Review Officers who are independent of loan administration.
In addition. They should also be well versed in the relevant laws/regulations that affect lending activities. Reviews of high value loans should be undertaken usually within three months of sanction/renewal or more frequently when factors indicate a potential for deterioration in the credit quality. Adherence to internal policies and procedures. and applicable laws / regulations. Post-sanction follow-up. . directly to the Board or Committee of the Board.2. At least 30-40% of the portfolio should be subjected to LRM in a year to provide reasonable assurance that all the major credit risks embedded in the balance sheet have been tracked. lending practices and loan policies of the bank. address: • Qualification and Independence The Loan Review Officers should have sound knowledge in credit appraisal.7 Banks should formulate Loan Review Policy and it should be reviewed annually by the Board. • Depth of Reviews The loan reviews should focus on: • • • • Approval process.3. The Policy should. 43 Compliance with loan covenants. • Frequency and Scope of Reviews The independence of Loan Review Officers should be ensured and the findings of the reviews should also be reported The Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to identityncipient deterioration in portfolio quality. Accuracy and timeliness of credit ratings assigned by loan officers. The scope of the review should cover all loans above a cut-off limit. banks should also target other accounts that present elevated risk characteristics. inter alia.
The proposals should be subjected to detail appraisal and rating framework that factors in financial and non-financial parameters of issuers. sensitivity to external developments. etc. The Risk Management Group of the Basle Committee on Banking Supervision has released a consultative paper on Principles for the Management of Credit Risk.• • • Sufficiency of loan documentation. Portfolio quality. The banks should exercise due caution. Deficiencies that remain unresolved should be reported to top management. The Paper deals with various aspects relating to credit risk management. including investments. particularly in investment proposals. The coupon on non-sovereign papers should be commensurate with their risk profile. and Recommendations for improving portfolio quality The findings of Reviews should be discussed with line Managers and the corrective actions should be elicited for all deficiencies. enclosed for information of banks. There should be greater interaction between Credit and Treasury Departments and the portfolio analysis should also cover the total exposures. The Paper is 44 . as any loan proposals. The maximum exposure to a customer should be bank-wide and include all exposures assumed by the Credit and Treasury Departments. The rating migration of the issuers and the consequent diminution in the portfolio quality should also be tracked at periodic intervals. The proposals for investments should also be subjected to the same degree of credit risk analysis. Credit Risk and Investment Banking Significant magnitude of credit risk. in addition to market risk. which are not rated and should ensure comprehensive risk evaluation. is inherent in investment banking.
etc. futures. options. The total exposures to the counterparties on a dynamic basis should be the sum total of: 1) The current replacement cost (unrealized loss to the counterparty).As a matter of prudence. options. limits and monitoring procedures. currency swaps. The trading credit exposure to counterparties can be measured on static (constant percentage of the notional principal over the life of the transaction) and on a dynamic basis. etc. etc. limits in investment proposals as well to mitigate the adverse impacts of concentration and the risk of illiquidity. Banks should classify their off-balance sheet exposures into three broad categories . which do not support existing financial obligations) .bid bonds. letters of credit.full risk (credit substitutes) . as a part of overall credit to individual customer relationship and subject to the same credit appraisal. duration. indemnities and warranties and low risk .standby letters of credit. and 2) The potential increase in replacement cost (estimated with the help of VaR or other methods to capture future volatilities in the value of the outstanding contracts/ obligations). 45 . etc. equity prices. issuer-wise. medium risk (not direct credit substitutes. maturity. money guarantees. foreign exchange rates. The current and potential credit exposures may be measured on a daily basis to evaluate the impact of potential changes in market conditions on the value of counterparty positions.reverse repos. swaps. industry. etc. liquidity conditions. banks should stipulate entry level minimum ratings/quality standards. Credit Risk in Off-balance Sheet Exposure Banks should evolve adequate framework for managing their exposure in off-balance sheet products like forex forward contracts. The potential exposures also may be quantified by subjecting the position to market movements involving normal and abnormal movements in interest rates.
etc. as the case may be. The maximum exposure should be subjected to adherence of country and bank exposure limits already in place. on the basis of their credit quality. moderate risk and high risk.Inter-bank Exposure and Country Risk A suitable framework should be evolved to provide a centralized overview on the aggregate exposure on other banks. Bank-wise exposure limits could be set on the basis of assessment of financial performance. 1-8. banks can use the country ratings of international rating agencies and classify the countries into low risk. all exposures to problem countries should be evaluated on a real time basis. Regarding exposure on overseas banks. past experience. management quality. Banks should endeavor for developing an internal matrix that reckons the counterparty and country risks. The limits so arrived at should be allocated to various operating centres and followed up and half-yearly/annual reviews undertaken at a single point. Like corporate clients. banks should also be rated and placed in range of 1-5. While the exposure should at least be monitored on a weekly basis till the banks are equipped to monitor exposures on a real time basis. 46 . operating efficiency.
such as interest rate. review mechanisms and reporting and auditing systems. equity price and commodity price has become relatively more important. economists. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. The Middle Office should apprise the top management / ALCO / Treasury about adherence to prudential / 47 . With progressive deregulation. foreign exchange rate. prudential risk limits. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank.Market Risk Traditionally. procedures. Even a small change in market variables causes substantial changes in income and economic value of banks. statisticians and general bankers and may be functionally placed directly under the ALCO. market risk arising from adverse changes in market variables. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The Boards should clearly articulate market risk management policies. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. Market risk takes the form of: 1) Liquidity Risk 2) Interest Rate Risk 3) Foreign Exchange Rate (Forex) Risk 4) Commodity Price Risk and 5) Equity Price Risk Market Risk Management Management of market risk should be the major concern of top management of banks. The Middle Office should comprise of experts in market risk management. The operating prudential limits and the accountability of the line management should also be clearly defined. credit risk management was the primary challenge for banks.
prudential limits. A bank has adequate liquidity when sufficient funds can be raised. Liquidity Risk Liquidity Planning is an important facet of risk management framework in banks. either by increasing liabilities or converting assets. inter alia. fund loan portfolio growth and the possible funding of off-balance sheet claims. 48 . The liquidity risk in banks manifest in different dimensions: i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/nonrenewal of deposits (wholesale and retail).need to compensate for non-receipt of expected inflows of funds. liquidity reporting / reviewing. etc. Thus. i. Liquidity is the ability to efficiently accommodate deposit and other liability decreases.due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable. ii) Time Risk . The liquidity risk of banks arises from funding of long-term assets by short-term liabilities.risk parameters and also aggregate the total market risk exposures assumed by the bank at any point of time. and iii) Call Risk . as well as. The first step towards liquidity management is to put in place an effective liquidity management policy. should spell out the funding strategies. capital and forex markets. which. promptly and at a reasonable cost. liquidity should be considered as a defense mechanism from losses on fire sale of assets. thereby making the liabilities subject to rollover or refinancing risk. It encompasses the potential sale of liquid assets and borrowings from money.e. liquidity planning under alternative scenarios. performing assets turning into non-performing assets.
at least. premature closure of deposits 49 . banks should also track the impact of prepayments of loans. including Certificate of Deposits and institutional deposits. The cash flows should be placed in different time bands based on future behavior of assets. etc.Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. adopted across the banking system are: i) Loans to Total Assets ii) Loans to Core Deposits iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments. The assumptions should be fine-tuned over a period which facilitate near reality predictions about future behavior of on / off-balance sheet items. the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. liabilities and off-balance sheet items. iv) Purchased Funds to Total Assets. The key ratios. have limited liquidity as the market and players are unidirectional. Thus. the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets. banks should have to analyze the behavioral maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. where large liabilities represent wholesale deposits which are market sensitive and temporary Investments are those maturing within one year and those investments which are held in the trading book and are readily sold in the market. where purchased funds include the entire interbank and other money market borrowings. In other words. once in six months to validate the assumptions. Experiences show that assets commonly considered as liquid like Government securities. and v) Loan Losses/Net Loans. For measuring and managing net funding requirements. other money market instruments. Apart from the above cash flows. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. analysis of liquidity involves tracking of cash flow mismatches. Banks should also undertake variance analysis.
contingent liabilities like letters of credit. Banks should also evolve a system for monitoring high value deposits (other than interbank deposits) say Rs.e. Liquidity Reserve Ratio and Loans. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts. The difference between cash inflows and outflows in each time period. i. Maximum Cumulative Outflows. Cash Reserve Ratio. 2. 7. Commitment Ratio – track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure. Further the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. cash outflows can be ranked by the date on which liabilities fall due.1 crore or more to track the volatile liabilities. especially call borrowings. 5. on inter-bank borrowings. Core deposits vis-à-vis Core Assets i. 4. Duration of liabilities and investment portfolio. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1.and exercise of options built in certain instruments which offer put/call options after specified times. 6. the excess or deficit of funds becomes a starting point for a measure of a bank’s future liquidity surplus or deficit. at a series of points of time. 3. 50 . Purchased funds vis-à-vis liquid assets. etc. Banks should fix cumulative mismatches across all time bands. Thus. Swapped Funds Ratio. extent of Indian Rupees raised out of foreign currency sources. the earliest date A liability holder could exercise an early repayment option or the earliest date contingencies could be crystallized.e.
It should be assumed that the purchased funds could not be easily rolled over. which influence the cash flow behavior. wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioral pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. statutory obligations. etc. unavailed credit limits. the rollover of high value customer deposits and purchased funds could extremely be difficult besides 51 . The banks should establish benchmark for normal situation. some of the core deposits could be prematurely closed. These developments would lead to rating down grades and high cost of liquidity. potential deposit losses. failure of one or more of major players in the market. The banks should evolve contingency plans to overcome such situations. viz. Estimating liquidity under bank specific crisis should provide a worst-case benchmark. Under this scenario. etc. The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank. severe market disruptions. bank specific crisis and market crisis scenario. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: 1) 2) Seasonal pattern of deposits/loans. banks should evaluate liquidity profile under different conditions. Potential liquidity needs for meeting new loan demands. financial crisis. normal situation. general perception about risk profile of the banking system. loan policy. a substantial share of assets have turned into non-performing and thus become totally illiquid.The liquidity profile of the banks could be analyzed on a static basis. contagion. Alternative Scenarios The liquidity profile of banks depends on the market conditions. Thus. cash flow profile of on / off balance sheet items and manages net funding requirements. investment obligations.
should also be clearly established. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities).flight of volatile deposits / liabilities. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. however. caused by unexpected changes in market interest rates. arising out of its refinance window and interim liquidity adjustment facility or as lender of last resort should not be reckoned for contingency plans. market access. Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE). Contingency Plan Banks should prepare Contingency Plans to measure their ability to withstand bankspecific or market crisis scenario. expose banks’ NII or NIM to variations. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. capacity to restructure the maturity and composition of assets and liabilities should be clearly documented and alternative options of funding in the event of bank’s failure to raise liquidity from existing source/s could be clearly articulated. Liquidity from the Reserve Bank. Interest Rate Risk can take different forms: 52 . liquidity support from other external sources. exposed them to the adverse impacts of interest rate risk. The blue-print for asset sales. etc. liquidity of assets. Interest Rate Risk (IRR) The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The banks could also sell their investment with huge discounts. reciprocal arrangements. Availability of back-up liquidity support in the form of committed lines of credit. Deregulation of interest rates has. entailing severe capital loss.
the greater will be the embedded option risk to the banks’ NII. The embedded option risk is becoming a reality in India and is experienced in volatile situations.Types of Interest Rate Risk Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts. The basis risk is quite visible in volatile interest rate scenarios. 53 . The faster and higher the magnitude of changes in interest rate. When the variation in market interest rate causes the NII to expand. the basis has moved against the banks. thereby creating exposure to unexpected changes in the level of market interest rates. Embedded Option Risk Significant changes in market interest rates create another source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The Loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. maturity dates or repricing dates. The risk that the interest rate of different assets. the banks have experienced favorable basis shifts and if the interest rate movement causes the NII to contract. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. Basis Risk Market interest rates of various instruments seldom change by the same degree during a given period of time.
call money rates. In the financial market. banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to realistically estimate the risk profiles in their balance sheet. MIBOR.Thus. defeasance period. Thus. which is always to the disadvantage of banks. which is created for making profit out of short-term movements in interest rates. The movements in yield curve are rather frequent when the economy moves through business cycles. Banks which have an active trading book should. formulate policies to limit the portfolio size. stop loss limits. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions. Price Risk Price risk occurs when assets are sold before their stated maturities. holding period. etc. TBs yields. bond prices and yields are inversely related. The price risk is closely associated with the trading book. any non-parallel movements in yield curves would affect the NII. marking to market. banks may price their assets and liabilities based on different benchmarks. 54 . Yield Curve Risk In a floating interest rate scenario. banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. fixed deposit rates.e. Banks should also endeavour for stipulating appropriate penalties based on opportunity costs to stem the exercise of options. i. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities. therefore. duration. etc. Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk.
Measuring Interest Rate Risk Before interest rate risk could be managed. ranging from the traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings). embedded option. large float is a natural hedge against the variations in interest rates. it is impossible to measure the degree of risks to which banks are exposed.Net Interest Position Risk The size of nonpaying liabilities is one of the significant factors contributing towards profitability of banks. yield curve. Duration (to measure interest rate sensitivity of capital). While these methods highlight different facets of interest rate risk. Thus. It is also equally impossible to develop effective risk management strategies/hedging techniques without being able to understand the correct risk position of banks. Generally. they should be identified and quantified. the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. Thus. basis. or use hybrid methods that combine features of all the techniques. banks with positive net interest positions will experience a reduction in NII as the market interest rate declines and increases when interest rate rises. Simulation and Value at Risk. many banks use them in combination. The IRR measurement system should address all material sources of interest rate risk including gap or mismatch. There are different techniques for measurement of interest rate risk. reinvestment and net interest position risks exposures. interest rate risk arises when the market interest rates adjust downwards. banks 55 . Unless the quantum of IRR inherent in the balance sheet is identified. price. In a well functioning risk management system. The IRR measurement system should also take into account the specific characteristics of each individual interest rate sensitive position and should capture in detail the full range of potential movements in interest rates. When banks have more earning assets than paying liabilities.
desks and Departments and it can be validated through ‘back testing’. defeasance period. for classifying securities in the trading book. derivative products. holding period. which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. The advantage of using VaR is that it is comparable across products. However. etc. While the securities held in the trading book should ideally be marked to market on a daily basis. the earnings or economic value changes are the main focus of banking book. using a given confidence level. Thus. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. VaR models require the use of extensive historical data to estimate future volatility. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis visà-vis the prudential limits set by the Board.broadly position their balance sheet into Trading and Investment or Banking Books. The stress tests provide management a view on the potential impact of large size market movements and 56 . stop loss. usually 95% to 99%. the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. the banking book comprises assets and liabilities. The VaR method is employed to assess potential loss that could crystallize on trading position or portfolio due to variations in market interest rates and prices. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields. Trading Book The top management of banks should lay down policies with regard to volume. rating standards. while the price risk is the prime concern of banks in trading book. within a defined period of time. etc. duration. The top management should put in place bankwide VaR exposure limits to the trading portfolio (including forex and gold positions.) which is then disaggregated across different desks and departments. maximum maturity. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR.
VaR models could also be modified to reflect liquidity risk differences observed across assets over time. In an environment where VaR is difficult to estimate for lack of data.) or actual maturities vary from contractual 57 . loans. which occur in the ’tails’ of the loss distribution. Maturity Gap Analysis The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets. given the complexity and range of balance sheet products. cash credit. based on current onand-off-balance sheet positions. yield curve risk. export finance. refinance from RBI etc. banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) to static simulation. embedded option risk. liabilities and off-balance sheet positions into a certain number of pre-defined time-bands according to their maturity (fixed rate) or time remaining for their next repricing (floating rate). International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. simultaneous and related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio.also attempt to estimate the size of potential losses due to stress events. to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets. non-statistical concepts such as stop loss and gross/net positions can be used. Those assets and liabilities lacking definite repricing intervals (savings bank. Thus. Banking Book The changes in market interest rates have earnings and economic value impacts on the banks’ banking book. liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk. overdraft. etc.
1-7 days. The changes in interest rate could be estimated on the basis of past trends. It is very difficult to take a view on interest rate movements beyond a year. The Gap calculations can be augmented by information on the average coupon on assets and liabilities in each time band and the same could be used to calculate estimates of the level of NII from positions maturing or due for repricing within a given time-band. Banks with large exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight. empirical studies and past experiences of banks. The Gap is used as a measure of interest rate sensitivity. loans. The positive Gap indicates that banks have more RSAs than RSLs.) are assigned time-bands according to the judgment. a negative or liability sensitive Gap implies that the banks’ NII could decline as a result of increase in market interest rates. monthly. Conversely. quarterly. A positive or asset sensitive Gap means that an increase in market interest rates could cause an increase in NII. Generally. which would then provide a scale to assess the changes in income implied by the gap analysis. etc. The negative gap indicates that banks have more RSLs than RSAs. forecasting of interest rates. The Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings at Risk (EaR). 8-14 days. interest Rate Sensitive Assets (RSAs) in each time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a repricing ‘Gap’ for that time band. A number of time bands can be used while constructing a gap report.maturities (embedded option in bonds with put/call options. viz. 58 . etc. cash credit/overdraft. The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. The banks should fix EaR which could be based on last/current year’s income and a trigger point at which the line management should adopt on-or off-balance sheet hedging strategies may be clearly defined. half-yearly or one year. time deposits. In order to evaluate the earnings exposure. most of the banks focus their attention on near-term periods. etc.
Further. Duration Gap Analysis Matching the duration of assets and liabilities. the assumption of parallel shift in yield curves seldom happen in the financial market. the Gap report quantifies only the time difference between repricing dates of assets and liabilities but fails to measure the impact of basis and embedded option risks. one or several assumptions of standardized gap seem more consistent with real world than the simple gap method. The Gap report also fails to measure the entire impact of a change in interest rate (Gap report assumes that all assets and liabilities are matured or repriced simultaneously) within a given time-band and effect of changes in interest rates on the economic or market value of assets.The periodic gap analysis indicates the interest rate risk exposure of banks over distinct maturities and suggests magnitude of portfolio changes necessary to alter the risk profile. banks could realistically estimate the EaR. In case banks could realistically estimate the magnitude of changes in market interest rates of various assets and liabilities (basis risk) and their past behavioral pattern (embedded option risk). Duration gap model focuses on managing economic value of banks by recognising the change in the market value of assets. market interest rate movements would have almost same 59 . When weighted assets and liabilities and OBS duration are matched. With the Adjusted Gap. Thus. The Gap report also fails to capture variability in non-interest revenue and expenses. a potentially important source of risk to current income. liabilities and off-balance sheet position. liabilities and off-balance sheet (OBS) items. instead of matching the maturity or repricing dates is the most effective way to protect the economic values of banks from exposure to IRR than the simple gap model. It also does not take into account any differences in the timing of payments that might occur as a result of changes in interest rate environment. However. they could standardize the gap by multiplying the individual assets and liabilities by how much they will change for a given change in interest rate.
If the net duration is positive (DA>DL). thereby protecting the bank’s total equity or net worth. liability and OBS position and weigh each of them to arrive at the weighted duration of assets. the MVE increases when the interest rate increases but decreases when the rate declines. The Duration Gap measure can be used to estimate the expected change in Market Value of Equity (MVE) for a given change in market interest rate. the simple gap schedule can be used by applying weights to each time-band. The difference between duration of assets (DA) and liabilities (DL) is bank’s net duration. The weighted duration of assets and liabilities and OBS provide a rough estimation of the changes in banks’ economic value to a given change in market interest rates. liabilities and OBS.impact on assets. liabilities and OBS in different time buckets to capture differences in coupons and maturities and volatilities in interest rates along the yield curve. a decrease in market interest rates will increase the market value of equity of the bank. The weights are based on estimates of the duration of assets and liabilities and OBS that fall into each time band. It is also possible to give different weights and interest rates to assets. Duration is a measure of the percentage change in the economic value of a position that will occur given a small change in the level of interest rates. the duration gap can be worked out with the help of standard mathematical formulae. Measuring the duration gap is more complex than the simple gap model. banks can precisely estimate the economic value changes to market interest rates by calculating the duration of each asset. liabilities and OBS. When the duration gap is negative (DL> DA). For approximation of duration of assets and liabilities. 60 . the Duration Gap shows the impact of the movements in market interest rates on the MVE through influencing the market value of assets. Thus. liabilities and OBS. In a more scientific way. Once the weighted duration of assets and liabilities are estimated.
The simulation model provides an effective tool for understanding the risk exposure under variety of interest rate/balance sheet scenarios. duration gaps. it fails to recognize basis risk. This technique also plays an integral-planning role in evaluating the effect of alternative business strategies on risk exposures. For this reason. Duration Gap analysis assumes parallel shifts in yield curve. performance measures. Such modeling involves making assumptions about future path of interest rates. balance sheet and income statements. ranging from changes in the slope and shape of the yield curve and interest rate scenario derived from Monte Carlo simulations. However. The simulation involves detailed assessment of the potential effects of changes in interest rate on earnings and economic value. etc. budget and financial reports. Simulation technique attempts to overcome the limitations of Gap and Duration approaches by computer modeling the bank’s interest rate sensitivity.The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. changes in business activity. The duration analysis also recognizes the time value of money. depending on users’ need. shape of yield curve. Duration measure is additive so that banks can match total assets and liabilities rather than matching individual accounts. pricing and hedging strategies. The simulation techniques involve detailed analysis of various components of on-and off-balance sheet positions. Simulations can also incorporate more varied and refined changes in the interest rate environment. Simulation can provide current and expected periodic gaps. Simulation Many of the international banks are now using balance sheet simulation models to gauge the effect of market interest rate variations on reported earnings/economic values over different time zones. 61 . The output of simulation can take a variety of forms.
banks may start with the gap or duration gap or simulation techniques on the basis of availability of data. they can progressively graduate into the sophisticated approaches. In any case. The lending. While the current on and off-balance sheet positions are evaluated under static environment. the dynamic simulation builds in more detailed assumptions about the future course of interest rates and the unexpected changes in bank’s business activity. It can also be used to isolate returns for various risks assumed in the intermediation process. Once banks are comfortable with the Gap model. technology support and technical expertise of banks. deposit taking and funds management. Although banks have adopted various FTP frameworks and techniques. Each unit attracts sources and uses of funds. FTP is an internal measurement designed to assess the financial impact of uses and sources of funds and can be used to evaluate the profitability. validity of assumption. Most of the international banks use MFP. investment.The simulation can be carried out under static and dynamic environment. Many international banks which have different products and operate in various geographic markets have been using internal Funds Transfer Pricing (FTP). Thus. FTP also helps correctly identify the cost of opportunity value of funds. banks should start estimating the interest rate risk exposure with the help of Maturity Gap approach. information technology and technical expertise. investment and deposit taking profit centers sell their liabilities to and buys funds for financing their assets from the funds management profit centre at 62 . as suggested by RBI in the guidelines on ALM System. The usefulness of the simulation technique depends on the structure of the model. The application of various techniques depends to a large extent on the quality of data and the degree of automated system of operations. Funds Transfer Pricing The Transfer Pricing mechanism being followed by many banks does not support good ALM Systems. Matched Funds Pricing (MFP) is the most efficient technique. The FTP envisages assignment of specific assets and liabilities to various functional units (profit centers) – lending.
appropriate transfer prices. The transfer prices are fixed on the basis of a single curve (MIBOR or derived cash curve, etc) so that asset-liability transactions of identical attributes are assigned identical transfer prices. Transfer prices could, however, vary according to maturity, purpose, terms and other attributes. The FTP provides for allocation of margin (franchise and credit spreads) to profit centers on original transfer rates and any residual spread (mismatch spread) is credited to the funds management profit centre. This spread is the result of accumulated mismatches. The margins of various profit centers are: • Deposit profit centre:
Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads. • Lending profit centre:
Loan yields + TP on deposits – TP on loan financing – cost of deposits – deposit insurance - overheads – loan loss provisions. • Investment profit centre:
Security yields + TP on deposits – TP on security financing – cost of deposits – deposit insurance - overheads – provisions for depreciation in investments and loan loss. • Funds Management profit centre:
TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads. For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and 10.5% p.a., respectively. Let us also assume that the bank’s Loan 63
profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as under: Profit Centres -------------------------------------Deposit Funds Loan 8.0 10.5 13.5 6.5 8.0 10.5 1.5 2.5 3.0 1.0 0.1 1.0 0.6 0.5 0.6 0.8 1.0 1.4 Total ----------13.5 6.5 7.0 1.0 0.1 1.0 1.7 3.2
Interest Income Interest Expenditure Margin Loan Loss Provision (expected) Deposit Insurance Reserve Cost (CRR/ SLR) Overheads NII
Under the FTP mechanism, the profit centers (other than funds management) are precluded from assuming any funding mismatches and thereby exposing them to market risk. The credit or counterparty and price risks are, however, managed by these profit centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the funds management profit centre. The FTP allows lending and deposit raising profit centers determine their expenses and price their products competitively. Lending profit centre which knows the carrying cost of the loans needs to focus on to price only the spread necessary to compensate the perceived credit risk and operating expenses. Thus, FTP system could effectively be used as a way to centralize the bank’s overall market risk at one place and would support an effective ALM modeling system. FTP also could be used to enhance corporate communication; greater line management control and solid base for rewarding line management.
Foreign Exchange (Forex) Risk
The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks’ balance sheets. Forex risk is 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 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 centre and the settlement of another currency in another time-zone. The forex transactions with counterparties from another country also trigger sovereign or country risk. Forex Risk Management Measures 1. 2. Set appropriate limits – open positions and gaps. Clear-cut and well-defined division of responsibility between front, middle and
back offices. The top management should also adopt the VaR approach to measure the risk associated with exposures. Reserve Bank of India has recently introduced two statements viz.
however. Reserve Bank of India has accepted the general framework suggested by the Basle Committee. it would be necessary to assign explicit capital charge for 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’). RBI has also initiated various steps in moving towards prescribing capital for market risk. particularly those arising from their trading activities. comply with quantitative and qualitative criteria prescribed by Basle Committee. besides a risk weight each of 100% on the open position limits in forex and gold. 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. As an initial step. banks are advised to study the Basle Committee’s paper on ‘Overview of the Amendment to the Capital Accord to Incorporate Market Risks’ – January 1996 (copy enclosed). Capital for Market Risk 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. Banks should use these statements for periodical monitoring of forex risk exposures. 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.Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of forex risk exposures. The Committee is now exploring various 66 . As the ability of banks to identify and measure market risk improves. In the meanwhile. The internal models should. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks.5% has been prescribed for investments in Government and other approved securities. a risk weight of 2.
it may be necessary. Operational Risk 67 . Once the Committee finalizes the modalities. 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.methodologies for identifying ‘outliers’ and how best to apply and calibrate a capital charge for interest rate risk for banks.
or failure to perform in a timely manner or cause the interest of the bank to be compromised. which is not categoried as market or credit risk. The most important type of operational risk involves breakdowns in internal controls and corporate governance. Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. Operational risk has some form of link between credit and market risks. high degree of structural changes and complex support systems. Such breakdowns can lead to financial loss through error. The set of risk factors that measure risk in each business unit such as audit ratings.Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the volume of transactions. or the risk of loss arising from various types of human or technical error. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring. An operational problem with a business transaction could trigger a credit or market risk. Measurement There is no uniformity of approach in measurement of operational risk in the banking system. administrative and legal risks. Generally. turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue 68 . fraud. operational data such as volume. operational risk is defined as any risk. the magnitude (or severity) of the effect of the operational risk on business objectives and the options available to manage and initiate actions to reduce/ mitigate operational risk. although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. the existing methods are relatively simple and experimental. Besides. It is also synonymous with settlement or payments risk and business interruption.
operating costs. should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framework. similar to bond credit rating. The contingent processing capabilities could also be used as a means to limit the adverse impacts of operational risk. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue. Insurance is also an important mitigator of some forms of operational risk. It could also be incumbent to monitor operational loss directly with an analysis of each occurrence and description of the nature and causes of the loss. could be related to historical loss experience. over a period. In the absence any sophisticated models. Policies and Procedures 69 . settlement facts. Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. fee income. Banks could also explore setting up operational risk limits. Some of the international banks have already developed operational risk rating matrix. managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables. delays and errors. Risk Monitoring The operational risk monitoring system focuses. inter alia.volatility. turnover. Indian banks have so far not evolved any scientific methods for quantifying operational risk. Banks. based on the measures of operational risk. on operational performance measures such as volume. Control of Operational Risk Internal controls and the internal audit are used as the primary means to mitigate operational risk. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals.
The self-assessment could be used to evaluate operational risk along with internal/external audit reports/ratings or RBI inspection findings. The policies and procedures should be based on common elements across business lines or risks. Risk Aggregation and Capital Allocation Most of internally active banks have developed internal processes and techniques to assess and evaluate their own capital needs in the light of their risk profiles and business 70 . The policy should address product review process. Banks should endeavor for detection of operational problem spots rather than their being pointed out by supervisors/internal or external auditors. the Audit Committees should play greater role to ensure independent financial and internal control functions. risk management and internal control functions. clear management reporting lines and adequate operating procedures.Banks should have well defined policies on operational risk management. Along with activating internal audit systems. Internal Control One of the major tools for managing operational risk is the well-established internal control system. which includes segregation of duties. Most of the operational risk events are associated with weak links in internal control systems or laxity in complying with the existing internal control procedures. The ideal method of identifying problem spots is the technique of self-assessment of internal control environment. The Basle Committee on Banking Supervision proposes to develop an explicit capital charge for operational risk. involving business.
time horizon. etc. Under this framework. As a part of the process for evaluating internal capital adequacy. Thus. The RAROC is designed to allow all the business streams of a financial institution to be evaluated on an equal footing. Such banks take into account both qualitative and quantitative factors to assess economic capital. banks should critically assess their internal capital adequacy and future capital needs on the basis of risks assumed by individual lines of business. costs and risks on transaction or portfolio basis over a defined time period. In this approach. diversification and correlation. Capital is thereafter allocated to activities as a function of this risk or volatility measure. 71 . use different ways to estimate the aggregate risk exposures. aggregate risk exposure should receive increased scrutiny. risk is measured in terms of variability of income. Banks. Then. it requires the summation of the different types of risks. By dimensioning all risks in terms of loss distribution and allocating capital by the volatility of the new activity. wherever possible is estimated and the Standard Deviation (SD) of this distribution is also estimated. Each type of risks is measured to determine both the expected and unexpected losses using VaR or worst-case type analytical model. product. across the world. Expected losses are covered by reserves and provisions and unexpected losses require capital allocation which is determined on the principles of confidence levels. Thus.plans. To do so. a bank should be able to identify and evaluate its risks across all its activities to determine whether its capital levels are appropriate. the risky position is required to carry an expected rate of return on allocated capital. risk is aggregated and priced. This begins with a clear differentiation between expected and unexpected losses. Key to RAROC is the matching of revenues. in addition to complying with the established minimum regulatory capital requirements. which compensates the bank for the associated incremental risk. The Basle Committee now recognizes that capital adequacy in relation to economic risk is a necessary condition for the long-term soundness of banks. the frequency distribution of return. at the bank’s Head Office level. however. The most commonly used approach is the Risk Adjusted Return on Capital (RAROC).
It also depends upon a subjectively specified range of the risky environments to drive the worst case scenario.The second approach is similar to the RAROC. This is referred to as EaR. This approach. each bank can restrict the maximum potential loss to certain percentage of past/current income or market value. Given the level of extant risk management practices. when employed to analyze interest rate risk. rather than moving from volatility of value through capital. this approach goes directly to current earnings implications from a risky position. Extreme outcome can be estimated from the tail of the distribution. Either a worst case scenario could be used or Standard Deviation 1/2/2. Risk Management in Saraswat Bank 72 . however. most of Indian banks may not be in a position to adopt RAROC framework and allocate capital to various businesses units on the basis of risk. Under this analytical framework also frequency distribution of returns for any one type of risk can be estimated from historical data. However. Thereafter.69 could also be considered. is based on cash flows and ignores the value changes in assets and liabilities due to changes in market interest rates. banks operating in international markets should develop suitable methodologies for estimating economic capital. at least. Accordingly. but depends less on capital allocation and more on cash flows or variability in earnings.
maintain the highest service levels and comply with all of the regulatory requirements. risk management is identifying. offer a wide spectrum of products. managing and mitigating risks emanating from different business activities. lending. Procedure Of risk Management in the Bank Ownership • • Head of risk management department shall be responsible for implementing the policy in the bank The owner shall co-ordinate the tasks with the Business Head and treasury head for implementing the policy in a cohesive manner.The mission of the bank has been “To emerge as one of the premier and most preferred banks in the country by adopting highest standard of professionalism and excellence in all areas of working”. • Market risks means risks which may cause loss to the bank due to the market forces 73 . According to Mr Pai of the Risk Management department. measuring. hedging. settlement and other financial transactions. We therefore strive sincerely to adopt best practices. market risk and operational risk. Credit risk means the ability or willful default on the part of customer/counter party to honor due commitments in relation to trading. Risk management of the Bank has remained active in its efforts to contain various types of risks namely credit risk. Some Definitions • • Risk means probability of loss pecuniary or otherwise which may damage the reputation of the bank or otherwise affect its fundamentals.
• Mismatch means the difference in the interest sensitive assets and liabilities in the given time bucket and or in the cash inflow and cash outflow in the given time bucket. 74 . liquidity risk. interest sensitivity and dynamic liquidity on a monthly basis Owner shall analyze the mismatches vis-à-vis past trend and suggest ways and means of managing it for safeguarding bank’s interest. Credit Risk • • • Owner shall manage credit risk inherent in the loan as well as investment portfolio of the bank Owner shall evolve mechanism to measure the credit risk in quantifiable terms using appropriate internal rating model and or any other techniques Owner shall continuously review and monitor the credit as well as investment portfolio to ensure that the measured risk is mitgated Market Risk • • • • Treasury Head shall manage market risk associated with investment portfolio in particular and all other portfolios in general He shall ensure that the investments are consistent with the bank’s investment policy In it’s endeavor to mange market risk bank shall manage associated risks such as interest rate risk. In managing these risks bank shall use tools such as gap analysis/mismatch as suggested RBI Asset liability Statement • • Owner shall draw the statement of structural liquidity. foreign exchange rate risk.
• • Owner shall ensure that the norms/limits suggested by RBI in regard to mismatches are adhered to Owner shall calculate mismatch in interest sensitive assets and liabilities and suggest steps to be taken by the bank to maintain Net interest income Operational Risk • Vigilance officer of the bank as well Audit department shall ensure that KYC policy as well as the deposit policy is adhered o while managing the deposit portfolio of the bank • Owner shall ensure that IT related policies are complied by the banks IT Subsidiary Saraswat Infotech Limited while delivering core banking solutions and other systems in banks. The respective heads shall ensure compliance to statutory requirements as prescribed by the Law and or RBI. Review • Owner shall review the policy at periodic intervals depending on the exigencies and not later than once in a year The guidelines followed by the bank in respect of the asset-liability management are on the basis of those given by the Reserve Bank of India which is as follows 75 . • • Vigilance officer shall be guided in minimizing the frauds being committed by the officials of the bank. Central Registrar and or any other governing body.
Asset Liability Management Introduction to ALM Considering their structure. adequacy and expediency • ALM Organization ⇒ Structure and responsibilities ⇒ Level of top management involvement • ALM Process ⇒ Risk parameters ⇒ Risk identification 76 . among other functions. The objective of good bank management is to provide strategic tools for effective risk management systems. ALM. The initial focus of the ALM function would be to enforce the risk management discipline viz. balance sheet profile and skill levels of personnel of UCBs. also provides a dynamic framework for measuring. These Guidelines lay down broad framework for measuring liquidity. interest rates and forex risks. The ALM process rests on three pillars: • ALM Information Systems ⇒ Management Information Systems (MIS) ⇒ Information availability. managing business after assessing the risks involved. UCBs need to address the market risk in a systematic manner by adopting necessary sector–specific ALM practices than has been done hitherto. monitoring and managing liquidity. RBI found it necessary to provide technical support for putting in place an effective ALM framework. accuracy. interest rate and foreign exchange (forex) risks. It involves assessment of various types of risks and altering balance sheet (assets and liabilities) items in a dynamic manner to manage risks.
recognized that varied business and customer profiles of UCBs do not make the adoption of a uniform ALM System for all banks feasible. However. Information is the key to the ALM process. There are various methods prevalent world-wide for measuring risks. adequate and accurate manner information. the introduction of the essential information system for ALM has to be addressed urgently. The existing systems will be the biggest challenge in many UCBs do not generate scale information in the manner required for ALM. prudential limits and auditing. As commercial banks have already been prescribed with ALM system and are in the process of adopting capital adequacy for market risk. This framework needs to be built on sound methodology with necessary information system as back up. The problem of ALM data needs to be addressed by following an ABC approach i. However. Considering the customer profile and inadequate support system for collecting information required for ALM which analyses various components of assets and liabilities on the basis of residual maturity (remaining term to maturity) and behavioral pattern.e. reporting and review. These range from easy-to-comprehend and simple ‘Gap analysis’ to extremely sophisticated and data intensive `Simulation’ methods. an efficient information system for initiating ALM 77 . it will take some time for UCBs some time to get the requisite information. it is imminent for UCBs to put in process. ALM Information Systems ALM has to be supported by a management philosophy which clearly specifies the risk policies and procedures and prudential limits. the central element for the entire ALM exercise is the availability of timely. however. Thus. Collecting accurate data in a timely before the UCBs taking full computerization.⇒ Risk measurement ⇒ Risk management ⇒ Risk policies and procedures. It is.
Unlike in the case of commercial banks that have large network of branches. The spread of computerization will also help UCBs in accessing data at a faster pace. set prudential limits. investment portfolio and money market operations. in view of the centralized nature of functions. monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank’s internal limits. ALM Organization Successful implementation of the risk management process would require strong commitment on the part of their boards and senior management. auditing.analyzing the behavior of asset and liability products in the sample branches accounting for significant business (at least 60-70% of the total business) and then making rational assumptions about the way in which assets and liabilities would behave in other branches. reporting and review mechanism in respect of liquidity. The Asset . The ALM Support Groups consisting of operating staff should be responsible for analyzing. Further. it would be much easier to collect reliable data. interest rate and forex risks. The board should have overall responsibility for management of risks and should decide the risk management policy and procedures.Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the policies and limits set by the Board as well as for deciding the business strategy (on the assets and liabilities sides) in line with the bank’s business and risk management objectives. 78 . The data and assumptions can then be refined over time as UCBs gain experience of conducting business within an ALM environment. in respect of foreign exchange [at present there are only 2 Authorized Dealers (ADs)]. UCBs are better placed in view of their compact area of operation and two-tier hierarchical structure to have greater access to the data.
Credit. inter alia. Towards this end. for instance. etc. 79 . includes pricing of both deposits and advances. wholesale vs. The Chiefs of Investment/ Treasury including forex. In addition. The business issues that an ALCO considers. long term deposits etc. short term vs. retail deposits. the Head of the Information Technology Division. its responsibility would be to decide on source and mix of liabilities or sale of assets. the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. if a separate division exists should also be an invitee for building up of Management Information System (MIS) and related IT network. To ensure commitment of the Top Management and timely response to market dynamics. the CEO or the Secretary should head the Committee. Composition of ALCO The size (number of members) of ALCO would depend on the size of each UCB.The ALCO is a decision making unit responsible for balance sheet planning from riskreturn perspective including the strategic management of liquidity. The ALCOs future business strategy decisions should be based on the banks views on current interest rates. desired maturity profile and mix of the incremental assets and liabilities. In respect of the funding policy. it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs. floating rate funds. etc can be members of the Committee. interest rate and forex risks. Individual UCBs will have to decide the frequency for holding their ALCO meetings. In addition to monitoring the risk levels of the bank. UCBs may at their discretion even have Sub-committees and Support Groups. level of business and organizational structure. Planning. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board.
The format of the Statement of Structural Liquidity under static scenario without reckoning future business growth is given in Annexure I. loans to total assets. credit deposit ratio. UCBs should measure not only the liquidity positions on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions/scenarios. at selected maturity bands. analysis of liquidity involves tracking of cash flow mismatches (flow approach). the ratios do not reveal the real liquidity profile of Indian banks including UCBs. liquidity management can reduce the probability of an adverse situation developing. The maturity ladder is generally used as a standard tool for measuring the liquidity profile under the flow approach. The stock approach uses certain liquidity ratios viz. While the liquidity ratios are the ideal indicators of liquidity of banks operating in developed financial markets. 80 . By assuring an UCBs ability to meet its liabilities as they become due. Thus. have limited liquidity when the market and players move in one direction. which are operating generally in an illiquid market. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches.ALM Process The scope of ALM function can be described as follows: •Liquidity risk management •Interest rate risk management •Trading (Price) risk management •Funding and capital planning •Profit planning and business projection Liquidity Risk Management Measuring and managing liquidity needs are vital for effective operation of UCBs. other money market instruments. etc. The importance of liquidity problem of an UCB need not necessarily confine to itself but its impact may be felt on other UCBs/banks as well. Experience shows that assets commonly considered as liquid like Government securities. etc. loans to core deposits.
if a security bought at Rs.00. some of the UCBs may be maintaining few securities in the trading book. corresponding to the residual maturity.The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of UCBs in different time bands. iii)The holding period not exceeding 90 days. However. which are kept distinct from other investments made for complying with the Statutory Reserve requirements and for retaining relationship with customers. Illustrating. 98 and the board of management fixed the maximum loss which may be incurred on this particular transaction at not more than Rs. given the Statutory Reserve cycle of 14 days may be distributed as under: i) 1 to 14 days ii) 15 to 28 days iii) 29 days and upto 3 months iv) Over 3 months and upto 6 months v) Over 6 months and upto 1 year vi) Over 1 year and upto 3 years vii) Over 3 years and upto 5 years viii) Over 5 years The investments in SLR securities and other investments are generally assumed as illiquid due to lack of depth in the secondary market and are therefore required to be shown under respective residual maturity bands. The time bands.2. ii)Maximum maturity/duration of the portfolio is restricted. 100 is quoted in the market on a given day at Rs. the cut loss limit is placed 81 . iv)Cut-loss limit prescribed. Securities held in the trading book are subject to certain preconditions such as: i)The composition and volume are clearly defined. (The level up to which loss could be ascribed by liquidating an asset.
however. holding/defeasance period.2. The Statement of Structural Liquidity (Annexure I) may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. etc. etc. 1-14 and 15-28 days time bands. The mismatches (negative gap between cash inflows and outflows) during 1-14 and 15-28 days time bands in normal course should not exceed 20% of the cash outflows in each time band. The ALCO of the UCBs should approve the volume. time taken to liquidate the position on the basis of liquidity in the secondary market is prescribed. The defeasance period is dynamic and in volatile environments. The cut loss limit varies from security to security based on bank’s loss / risk bearing capacity). UCBs. Within each time band there could be mismatches depending on cash inflows and outflows. A maturing liability will be a cash outflow while a maturing asset will be a cash 82 . are expected to monitor their cumulative mismatches (running total) across all time bands by establishing internal prudential limits with the approval of the Board. the main focus should be on the short-term mismatches viz.. If an UCB in view of its current asset-liability profile and the consequential structural mismatches needs higher tolerance level. such period also undergoes changes on account of product-specific or general market conditions.00 for this particular security. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems. of the trading book. composition. v)Marking to market on a weekly basis and the revaluation gain/loss absorbed in the profit and loss account. 15-28 days and 29-90 days time bands on the basis of the defeasance periods. UCBs which maintain such trading books and complying with the above requirements are permitted to show the trading securities under 1-14 days.e. it could operate with higher limit sanctioned by RBI for a limited period. cut loss. Defeasance periods (product-wise) i.at Rs.
the UCBs may take into account all relevant factors based on their asset-liability base. nature of business. UCBs may estimate their short-term liquidity profiles on the basis of business projections and other commitments for planning purposes. etc. Although UCBs predominantly confined to domestic operations. In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days. Large cross border flows together with the volatility has rendered the banks’ balance sheets vulnerable to exchange rate movements. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. While determining the probable cash inflows / outflows. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Currency Risk Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks’ balance sheets. ADs have been setting up overnight limits and selectively undertaking active day time trading. Managing currency risk is one more dimension of ALM. It would also be necessary for UCBs with AD licenses to take into account the rupee inflows and outflows on account of their forex operations. future strategy. Following the introduction of “Guidelines for Internal Control over Foreign Exchange Business” in 1981. While determining the tolerance levels. in view of few UCBs being ADs in foreign exchange.inflow. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978. maturity mismatches (gaps) are also subject to control. Following the recommendations of Expert Group on Foreign 83 . it is necessary to address forex risk also.liability profiles. An indicative format (Annexure III) for estimating Short-term Dynamic Liquidity is enclosed. UCBs have to make a number of assumptions according to their asset .
liabilities and off-balance sheet positions get affected due to variation in market rates. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. A long-term impact of changing interest rates is on bank’s Market Value of Equity (MVE) or Net Worth as the marked to market value of bank’s assets. For monitoring such risks banks should follow the instructions contained in Circular A. Thus the open position limits together with the gap limits form the risk management approach to forex operations. 1997 issued by the Exchange Control Department. respectively. the traditional `Gap Analysis’ is considered as a suitable method to measure the Interest Rate Risk in the first place. There are many analytical tools for measurement and management of Interest Rate Risk.D (M. The risk from the earnings perspective can be measured as changes in the NII or Net Interest Margin (NIM).52 dated December 27. the ADs are also free to set gap limits with RBI’s approval but are required to adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Series) No.Exchange Markets in India (Sodhani Committee). A. the calculation of exchange position has been redefined and banks have been given the discretion to set up overnight limits linked to maintenance of capital to Risk-Weighted Assets Ratio of 9% of open position limit. The immediate impact of changes in interest rates is on bank’s profits by changing its spread [Net Interest Income (NII)]. The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective. Presently. 84 . In the context of poor MIS. Interest Rate Risk (IRR) The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest Rate Risk. slow pace of computerization and the absence of total deregulation. The changes in interest rates affect banks in a larger way.
Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). for instance. borrowings. All investments. etc.e. While the interest rates on term deposits are fixed during their currency. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. term loan accounts before maturity.) in cases where interest rates are administered. etc. and The Gap Report should be generated by grouping rate sensitive liabilities. DRI advances. that mature/reprice within a specified timeframe are interest rate sensitive. any repayment of loan installment is also rate sensitive if the bank expects to receive it within the time horizon. deposits. An asset or liability is normally classified as rate sensitive if: i) within the time interval under consideration. This includes final principal payment and periodical installments. For instance. charges made in the interest on CC accounts. whichever is earlier. there is a cash flow . Refinance. assets and offbalance sheet positions into time bands according to residual maturity or next repricing period. advances. The difficult task in Gap analysis is determining rate sensitivity. the advance portfolio of the banking system is basically floating. Minimum Lending Rate(MLR). interest rates on Savings Bank Deposits. The Gaps may be identified in the following time bands: i) Upto 3 months ii) Over 3 months and upto 6 months iii) Over 6 months and upto 1 year iv) Over 1 year and upto 3 years 85 . Similarly. Certain assets and liabilities receive/pay rates that vary with a reference rate.The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. iii) RBI changes the interest rates (i. CRR balance. repayment of installments of term loans etc ii) The interest rate resets/reprices contractually during the interval. The interest rates on advances could be repriced any number of occasions.
v) Over 3 years and upto 5 years vi) Over 5 years vii) Non-sensitive The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified as explained in Appendix - II and the sensitive assets and liabilities is given in Annexure II. The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time band. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity. Each bank should set prudential limits on individual Gaps with the approval of the Reporting Format for interest rate
Board. The prudential limits should have a bearing on the Total Assets, Earning Assets or Equity. The banks may also work out Earnings at Risk (EaR) i.e. 20–30% of the last years NII or Net Interest Margin (NIM) based on their views on interest rate movements. When the UCBs gain sufficient experience in operating ALM system, RBI introduce capital adequacy for market risk in due course. Behavioral Patterns The classification of various components of assets and liabilities into different time bands for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. Banks which are better equipped to reasonably estimate the behavioral pattern of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time bands, subject to approval from the ALCO. may
SWOT analysis In order to better understand the cooperative banks and the environment in which they function (taking into consideration Fund management, Risk management, Asset and Liability management), a SWOT analysis has been undertaken. STRENGTHS: • • • • • • Cooperative banks have less number of branches and that to in a small area. Thus it is easier for them to control and regulate their overall operation. These banks have limited and known customer base, which give them more potential to control credit risk These banks are free from market risk arising due to fluctuations in the market These banks are free from risk arising out of Para-banking activities. As these banks are localized they are able to maintain a personal touch with depositors and borrowers. These banks can avail of cheaper labor and thus can maintain low costs.
WEAKNESS: • • • These banks suffer from dual accountability to both the regulators (RBI) ant the state government. These banks suffer from lack of corporate governance. The BOD as well as the staff members lacks professional banking knowledge and expertise. These banks have very limited avenues for expanding and diversifying loan as well as investment portfolios.
These banks are unable to raise additional capital by making public issue of capital. Reluctance of state government to give up control over cooperative banks and political involvement in the management of banks further worsens the state of these banks.
• • •
Lack of internal control systems makes these banks vulnerable to fraud and scams. The cooperative spirit no more exists in these banks. The distance between the members and the cooperatives has widened. Smaller size and lesser profit make it difficult for the banks to adopt latest MIS systems and other technologies.
OPPORTUNITIES • • • These banks have the opportunity to tap local resources fir mobilizing deposits and granting advances. They can provide better customized services thus leading to longer relationships and customer satisfaction. As these banks are area specific, it will be easier for them to consolidate information necessary for putting in place ALM systems. THREATS • These banks face serious threats form then private banks and foreign banks, which use advanced techniques and technologies for risks and fund management. As public sector banks have also joined the competition, cooperative banks face threats form these banks too.
Cooperative banks suffer from threats of frauds, scams and misinterpretations as well as from lack of professionalism.
Therefore. Risk management and Assets liability management in UCBs. • Many a time. Since UCBs are primarily credit institutions meant to be run on commercial lines. interest fixation on deposits and advances. the responsibility for their supervision devolves on the Reserve Bank. while the banking operations pertaining to branch licensing. and the survey results of UCBs as well as a detailed theoretical study of UCBs. the Government has not provided such support. • An important contributory factor for this positive feature is the fact that these banks have maintained close proximity with their borrowers. This duality of control needs to be done away with and 89 . brings out the high need for introducing Funds Management. therefore. audit and investments are under the jurisdiction of the RBI. expansion of areas of operations. constitution of management. The Government has provided a big budgetary support to commercial banks and RRBs to cleanse their balance sheet. UCBs would. An indiscriminate branch expansion would perhaps erode this vital strength. But in case of cooperative banking institutions. • One of the problem areas in the supervision of UCBs is the duality in control by the State Government and the Reserve Bank. are controlled by the State Governments under the provisions of the respective State Cooperative Societies Act.Recommendations and Suggestions The comparison of practices of different commercial banks. the Government should also provide such support to them. the managerial aspects of these banks relating to registration. the populist policies of the Government such as loan waivers have done a great harm to the cooperative agricultural credit and banking institutions. do well to keep this in mind while planning their expansion in terms of branches. Since cooperative credit and banking institutions constitute a very important segment of financial sector particularly in the context of effective flow of credit to the agriculture and priority sectors. administration and recruitment.
Funds management and Assets and liability management to training centers and colleges. RBI can distribute a detailed list of institutes where such training is given to all UCBs. • There are serious doubts over the accuracy and credibility of the data sent by the UCBs to RBI. 1984. there is often a serious delay in the submission of these returns by individual banks. PCBs have to improve their statistical reporting system and bridge the wide gap in data availability as compared to that of commercial banks. or CFAs. • Training for bank executives is very necessary for any system to run smoothly.well versed in prudent financial practices. Unfortunately. It is only when an on-site inspection is carried out that exact financial position of a particular UCB can be determined. Banks can also go for professional executives 90 . the on-site inspections are carried out at a very low frequency. sometimes even 2 to 3 years for a bank. There is a dire need to increase the frequency of on-site inspections to at least 6 months. CAs. In house training can also prove to be useful. • Banks should be asked to employ professional MBAs. In particular. This will require amendment of the MultiState Cooperative Societies Act. State Cooperative Societies Act. Banks should be asked to send their employees for regular training in Risk management. • One issue of serious concern regarding UCBs is the delay/ non-submission of returns within the stipulated time frame. and the Banking Regulation Act. However.RBI needs to be given the full control. In this context. Non-availability of adequate and timely data would no doubt have serious effect on timely policy action. PCBs are required to submit two types of returns (statutory returns and control returns) to the Reserve Bank with a view to exercise adequate supervision over them.
the banks should be asked to give more information through their published balance sheets. This would support competition in the cooperative sector and motivate banks to increase their profitability and improve their functioning. • RBI should undertake ratings of cooperative banks or should appoint an agency to do so and make their ratings public. Cash flow statements. NPA and provision disclosures. are some of the items that the banks can be made to disclosed annually. • In order to increase transparency in operations. • Strict penalties should be levied for inaccurate reporting or misreporting by UCBs to RBI. Attempts should be made to make such norms compulsory. Maturity profiles of assets and liabilities.having experience in Commercial Banking Sector. 91 . • Sharing of defaulters’ list amongst the UCBs would help them to contain risk to some extent. etc.
a central bank perspective which is supposed to exercise control. It was interesting to look at the banking world from two different angles. This has greatly enhanced my understanding of the basic principles of banking. • I interacted with many people during tenure of my project. • It was an enriching experience to work with highly knowledgeable people with excellent people skills and banking experience running in decades. • The project helped me apply theoretical inputs to practical situations.Personal Learning’s • The most significant value-addition was a good exposure to the banking sector. This helped me to improve my soft skills. which are demanding more autonomy. 92 . and co-operative banks.
banknetindia.indiainfoline.erisk. Magazines • • • • Banking Finance Professional Banker Analyst Vision B.in www. Vasant and Vinay Joshi 93 .com www.com Value at Risk – Phillipe Jorion Managing Indian Banks – The Challenges Ahead. Books • • • D.bankersindia.com www. Internet • • • • • • www.com www.com www.google.org.rbi. RBI Publications • • • • Master Circulars Trend and Progress Reports Notifications Draft Vision document on UCBs C.Bibliography A.
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