CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING
SESSION 12 & 13

MODULE 3

Risk management – An overview

5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

SESSION 12 & 13 PLAN :

1. Liquidity risk

2. Interest Rate risk

3. Gap Analysis – Funding Gap

4. Gap Analysis – Interest Rate Sensitivity Gap

5. Concept of Capital Adequacy

Q&A

GUEST FACULTY: SHRIDHAR S 1

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

1. Liquidity risk
• Liability side – A liability cannot be met when it falls due.
• Asset side – An asset cannot be sold due to lack of liquidity in the market.

In tight Liquidity conditions, neither will a depositor/lender be willing to roll-over the liability, neither there
will there new depositors/lenders, nor will here be purchasers for the assets. Thus it is a self-reinforcing Risk.

2. Interest Rate (Re-pricing) risk

• Asset side – A maturing / re-pricing asset cannot be re-invested at the same or higher rate than it was
yielding. Other things remaining equal, this will reduce NIM. (Re-investment Risk)
• Liability side – A maturing / re-pricing liability cannot be re-financed/re-priced at the same or lower
rate than was being paid. Other things remaining equal, this will reduce NIM. (Re-financing Risk)

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

CAUTION NOTE

THE TERM “INTEREST RATE RISK” IS ALSO USED TO REFER TO MARKET RISK
IN FIXED INCOME SECURITIES, AS THE MARKET VALUE OF A FIXED INCOME
SECURITY IS INVERSELY PROPORTIONAL TO THE INTEREST RATE. A CHANGE
IN INTEREST RATE THEREFORE CHANGES THE VALUE OF THE SECURITY IN THE
OPPOSITE DIRECTION.

WE ARE NOT DISCUSSING THIS TYPE OF INTEREST RATE RISK HERE.

GUEST FACULTY: SHRIDHAR S 2

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

Example of Liquidity Risk
Asset side Liquidity Risk
• Bank is holding 10 Year Bonds of XYZ Town Municipality worth Rs. 1,000 Cr.
• These Bonds were Rated AAA at the time of issue.
• But now they have been downgraded to B.
• Bank needed to raise money to repay depositors, and tried to sell the Bonds, but now nobody is willing to
buy them.
• (The Sub-prime Crisis is an example of Liquidity risk materialising)
Liability side Liquidity Risk
• Bank A has a bulk deposit of Rs 10,000 Cr which is falling due tomorrow.
• However, the bank has no new in-flow of bulk deposits or maturing loan/security of like amount for next 15
days. It has no surplus security available for Repo/sale.
• Money is available in the Call Money Market, but the Call money rates have gone to 20% p.a.

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

Example of INTEREST RATE OR RE-PRICING RISK
Asset side Interest rate (re-pricing) Risk – Re-investment risk
• Bank is holding 10 Year Bonds of XYZ Town Municipality worth Rs. 1,000 Cr, yielding interest of 10% p.a.
(Interest Income for bank from investment this bond = Rs. 100 Cr p.a.)
• These Bonds are rated AAA and are maturing on 30-09-2021.
• But on 30-9-2021, the yield on 10 year bonds of AAA rating is only 8% p.a. (Interest Income of bank from
investment in this bond Rs. 80 Cr p.a.)
• Hence bank’s interest income will decline by Rs 100 Cr – Rs 80 Cr = 20 Crore p.a. (i.e. NIM declines)
Liability side Liquidity Risk – Re-financing Risk
• Bank A has a 1 year bulk deposit of Rs 1,000 Cr which is falling due on 30-09-2021.
• The bank was paying interest of 5% p.a. on this deposit. (Interest Expenditure for bank on this deposit = Rs.
50 Cr p.a.)
• But on 30-09-21, bank can get such 1 year bulk deposit of Rs 1,000 Cr only if it pays 7% Interest on it.
(Interest Expenditure for bank on this deposit = Rs. 70 Cr p.a.)
• Hence bank’s interest expenditure will increase by Rs 70 Cr – Rs 50 Cr = 20 Crore p.a. (i.e. NIM declines)

GUEST FACULTY: SHRIDHAR S 3

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

Asset side Interest Rate Risk – Re-investment Risk – Another Example
Starting Position:
Liabilities Amount Interest rate Intt. Paid Assets Amount Interest Interest
Rate Received
Capital 100 NA 0 Loans 750 12% 90
Deposits 900 8% 72 Cash 250 0% 0
Total 1,000 72 Total 1,000 90
NET INTT MARGIN = INTT. RECEIVED – INTEREST PAID = 90 - 72 = 18

The Loans have all fallen due and got repaid or became due for re-pricing. New Loans can be given or existing
Loans can be repriced only at 10% p.a. New Position:
Liabilities Amount Interest rate Intt. Paid Assets Amount Interest Interest
Rate Received
Capital 100 NA 0 Loans 750 10% 75
Deposits 900 8% 72 Cash 250 0% 0
Total 1,000 72 Total 1,000 75
NET INTT MARGIN = INTT. RECEIVED – INTEREST PAID = 75 - 72 =3 NIM DECLINED FROM 18 TO 3.

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

Liability side Interest Rate Risk – Re-finance Risk – Another Example
Starting Position:
Liabilities Amount Interest rate Intt. Paid Assets Amount Interest Interest
Rate Received
Capital 100 NA 0 Loans 750 12% 90
Deposits 900 8% 72 Cash 250 0% 0
Total 1,000 72 Total 1,000 90
NET INTT MARGIN = INTT. RECEIVED – INTEREST PAID = 90-72 = 18

The Deposits have all fallen due and had to be repaid. But now, new deposits can be raised only at 10% p.a.
New Position:
Liabilities Amount Interest rate Intt. Paid Assets Amount Interest Interest
Rate Received
Capital 100 NA 0 Loans 750 12% 90
Deposits 900 10% 90 Cash 250 0% 0
Total 1,000 90 Total 1,000 90
NET INTT MARGIN = INTT. RECEIVED – INTEREST PAID = 90 - 90 =0 NIM DECLINED FROM 18 TO 0.

GUEST FACULTY: SHRIDHAR S 4

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

GAP ANALYSIS : MEASURING LIQUIDITY RISK, OR FUNDING GAP

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

BANK BS : FUNDING GAP
LIABILITY AMT ASSET AMT

Capital 6 Cash, RBI, banks 7

Deposits – CASA 37 Investments 26

Deposits – FD 45 Loans & Advances 59

Borrowings 8 Fixed Assets 1

Other Liab. and
4 Other assets 7
provisions
Total Liabilities 100 Total Assets 100
10

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CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW BANK BS : Assets and Liabilities – Maturity
pattern/ladder
6-12
TOTAL 0 to 7 to 30 1 to 3 3 to 6 12+ TOTAL 0 to 7 7 to 30 1 to 3 3 to 6 6-12 12+
LIABILITY m ASSET
AMT 7 d d m m m AMT d d m m m m
Cash, RBI,
Capital 6 0 0 0 0 0 6 7 7 0 0 0 0 0
banks
Deposits – Investm--
37 37 0 0 0 0 0 26 1 1 1 12 10 1
CA SA ents
Deposits – Loans &
45 1 2 2 10 10 20 59 2 1 1 10 20 25
FD Advances
Fixed
Borrowings 8 2 2 1 2 1 0 1 0 0 0 0 0 1
Assets
Other Liab.
Other
& 4 0 0 0 0 0 4 7 0 0 0 0 0 7
assets
provisions
Total Total
Liabilities
100 40 4 3 12 11 30 100 10 2 2 22 30 34
Assets

The Assets and Liabilities are distributed in various Time Buckets according to the date of their RESIDUAL CONTRACTUAL*
(OR BEHAVIOURAL) maturity.
* PUT/CALL option date is taken as maturity date for assets/liabilities with put or call options respectively. 11

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW BANK BS : Assets and Liabilities – Maturity
pattern/ladder
LIABILITY TOTAL AMT 0 to 7 d 7 to 30 d 1 to 3m 3 to 6 m 6-12m 12+m
Total Assets 100 10 2 2 22 30 34
Total Liabilities 100 40 4 3 12 11 30
FUNDING GAP 0 -30 -2 -1 +10 +19 +4
CUM. FUNDING GAP -30 -32 -33 -23 -4 0
Suppose above table is as per contractual / behavioral maturity. To meet the GAP in the 0 to 7 days bucket,
bank has to raise cash.
One way to do this is by selling loans/investments. Say bank sells loan/investments of Rs 30 due in 2 years. It
will immediately get cash of 30, which will appear in 0 to 7 days bucket. Assets Maturing beyond 12 months
will decline by 30. (Bank risks making a loss in the sale of the assets). Position will be:
Total Assets 100 40 2 2 22 30 4
Total Liabilities 100 40 4 3 12 11 30
FUNDING GAP 0 0 -2 -1 +10 +19 -26
CUM. FUNDING GAP 0 -2 -3 +7 +26 12 0

GUEST FACULTY: SHRIDHAR S 6

CB Sessions 12 & 13 5 & 6 October 2021

LIABILITY TOTAL AMT 0 to 7 d 7 to 30 d 1 to 3m 3 to 6 m 6-12m 12+m

Total Assets 100 10 2 2 22 30 34
Total Liabilities 100 40 4 3 12 11 30
FUNDING GAP 0 -30 -2 -1 +10 +19 +4
CUM. FUNDING GAP -30 -32 -33 -23 -4 0
Suppose above table is as per contractual / behavioral maturity.
To meet the GAP in the 0 to 7 days bucket, bank has to raise cash.
It can do this by raising liability – deposit or borrowing. Say bank issues a 3 month CD for Rs. 40. It will get cash
Rs. 40 which will appear in 0 to 7 days bucket. Newly issued CD will appear in Liabilities maturing in 1 to 3
months. (Bank risks having to pay a higher interest on the CD than the liability it is paying off). After issue of
CD, position will be:
Total Assets 140 50 2 2 22 30 34
Total Liabilities 140 40 4 43 12 11 30
FUNDING GAP 0 +10 -2 -41 +10 +19 +4
CUM. FUNDING GAP +10 +8 -33 -23 -4 0
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COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

GAP ANALYSIS : MEASURING INTEREST RATE RISK OR

INTEREST RATE SENSITIVITY GAP

GUEST FACULTY: SHRIDHAR S 7

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW : BANK BS

LIABILITY AMT ASSET AMT

Capital 6 Cash, RBI, banks 7

Deposits – CASA 37 Investments 26

Deposits – FD 45 59
Loans & Advances
Borrowings 8 Fixed Assets 1
Other Liab. and
4 Other assets 7
provisions
Total Liabilities 100 Total Assets 100
15

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

BANK BS : INTEREST RATE SENSITIVE Assets and Liabilities

LIABILITY AMT IRSL ASSET AMT IRSA

Capital 6 0 Cash, RBI, banks 7 0

Deposits – CA SA 37 0 Investments 26 25

Deposits – FD 45 45 Loans & Advances 59 50

Borrowings 8 8 Fixed Assets 1 0

Other Liab. and

4 0 Other assets 7 0
provisions

Total Liabilities 100 53 Total Assets 100 75

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GUEST FACULTY: SHRIDHAR S 8

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

BANK BS : INTEREST RATE SENSITIVE Assets and Liabilities

IRSL ASSET IRSA

Deposits – FD 45 Investments 25

Borrowings 8 Loans & Advances 50

Total IRS Liabilities 53 Total IRS Assets 75

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COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW BANK BS : INTEREST RATE SENSITIVE Assets and
Liabilities
REPRICIN MORE MORE
3 TO 6 6 TO 12 UPTO 3 3 TO 6 6 TO 12
IRSL G UPTO 3 THAN 1 ASSET IRSA THAN 1
MO MO MO MO MO
MO YR YR
Deposit Investment
s – FD
45 5 10 10 20
s
25 1 2 12 10

Borrowi Loans &

ngs
8 5 2 1 0
Advances
50 4 10 20 16

Total
IRS Total IRS
Liabilit
53 10 12 11 20
Assets
75 5 12 32 26
ies
The IRS assets and IRS liabilities are distributed in Total IRS
various Time Buckets according to the date of their Liabilities 53 10 12 11 20
maturity or date of their re-pricing.
IRS GAP is arrived at by subtracting IRS Liabilities IRS GAP 22 -5 0 21 6
from IRS Assets for each maturity bucket and
CUM.GAP -5 -5 16 22
cumulative also. 18

GUEST FACULTY: SHRIDHAR S 9

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW BANK BS : INTEREST RATE SENSITIVE Assets and
Liabilities
MORE
UPTO 3 3 TO 6 6 TO 12 INTT. RATES INTT. RATES GO
ITEM TOTAL THAN 1 ITEM
MO MO MO GO UP DOWN
YR
A. Total IRS +VE IRS GAP NIM GOES
75 5 12 32 26 NIM GOES UP
Assets (IRSA>IRSL) DOWN
B. Total IRS -VE IRS GAP
Liabilities
53 10 12 11 20 NIM GOES DOWN NIM GOES UP
(IRSA<IRSL)
C = A-B
22 -5 0 21 6
IRS GAP 1. A Bank may hedge (maintain IRS GAP as close to
IMPACT ON zero as possible) or take position based on its
NIM FOR 10% Interest rate view. (If Rates expected to rise,
= Δ INTT.
p.a. RISE IN
XC -0.5 0 +2.1 +0.6 maintain +ve GAP, and if rates expected to Fall,
INTT at
repricing date
maintain –ve GAP.)
IMPACT ON 2. Tools include product-mix of Floating and Fixed rate
NIM FOR 10% = Δ INTT. loans, sale / purchase of loans, Deposit interest
p.a. FALL IN XC +0.5 0 -2.1 -0.6 policy, Borrowing policy, Derivatives (IRS) etc.
INTT at 3. This is static GAP Analysis. Dynamic GAP analysis is
reprising date preferred. Duration GAP (DA-DL) analysis is even
ASSUMPTION: INTEREST RATE CHANGES BY 10% ON BOTH more preferred. (Please look up these terms in
DEPOSITS AND ADVANCES, FOR ALL MATURITIES IN THAT BUCKET. text-books/web resources for your information
19
and further understanding).

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

BANK BS : INTEREST RATE SENSITIVE Assets and Liabilities

GAP ANALYSIS
Advantages
1. Simple to Calculate, easy to understand
2. Gives early warning of impending Liquidity or Profitability crises
3. Indicates options to correct the Gap / exploit the Gap by pin-pointing
exact cause – drilling down possible to discover ultimate cause

Dis-advantages
1. Based on Static data, not realistic in a dynamic situation
2. Differs from Liquidity risk management approach prescribed by
BASEL/RBI.

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GUEST FACULTY: SHRIDHAR S 10

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : BASIC BUSINESS MODEL DIAGRAM : MAPPING TO RISKS

BANK’S PROFIT = PROVIDERS CUSTOMERS Operational Credit
NET INTEREST INCOME (INTT.RECD -INTT OF GOODS FOR GOODS Risk Risk
PAID) PLUS OTHER INCOME LESS EXPENSES & SERVICES & SERVICES
LESS PROVISION FOR BAD LOANS
G&S OTHER
EXPENSES G&S INCOMES
PAID RECD.
GIVEN

DEPOSITS
CAPITAL
CAPITAL LOANS LOANS
CAPITAL
PROFITS
BANK INTT. RECD. (BORROWERS)
DEPOSITS (D&T) DEPOSITS
(DEPOSITORS) INTT. PAID EMPLOYEES INVESTMENTS -
INVESTMENTS
(SECURITIES -
BORROWINGS BORROWINGS INV. INCOME
GOVT., CORP .)
(LENDERS) INTT. PAID Interest
rate(Repricing) Risk MARKET
RISK

Liquidity Risk

COMMERCIAL BANKING : RISK MANAGEMENT - OVERVIEW

CONCEPT OF CAPITAL ADEQUACY

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GUEST FACULTY: SHRIDHAR S 11

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING : Capital : Serves as safety net or cushion for depositors

Liabilities Amount Assets Amount
Capital 100 Loans 750
Deposits 900 Cash 250
Total 1,000 Total 1,000
Capital to Loans Ratio (100/750) 13%
Let us say 50 Rs. of Loans turned bad, incurring a loss of Rs.
Liabilities Amt Assets Amount
Unimpaired Capital 50 Good or Realisable Loans 700
Provision for Bad Loans 50 Bad Loans or NPA 50
Deposits 900 Cash 250
Total 1000 Total 1,000
Unimpaired Capital to Realisable Loans Ratio (50/700) 7% NPA % = 50/750 = 7%

If we liquidate the bank at this stage, the Assets will fetch Rs. 950. The Depositors can be paid full Rs 900 against their
full claim of Rs 900. The Shareholders lose 50% of their Investment in the bank.
Thus the amount of Capital has been sufficient to “absorb” the loss of Rs. 50, leaving no loss to be borne by the
depositors or keeping the Depositor’s money “safe”. CAPITAL WAS “ADEQUATE”.

COMMERCIAL BANKING : Capital : Serves as safety net or cushion for depositors

Liabilities 1 Amount 1 Amount
Capital 100 Loans 750
Deposits 900 Cash 250
Total 1,000 Total 1,000
Capital to Loans Ratio (100/750) 13 %
Let us say 150 Rs. of Loans turned bad, incurring a loss of Rs. 150

Liabilities Amount Assets Amount

Capital -50 Good or Realisable Loans 600
Provision for Bad Loans 150 Bad Loans or NPA 150
Deposits 900 Cash 250
Total 1,000 Total 1,000
Unimpaired Capital to Realisable Loan Ratio (-50/700) -ve NPA % = 150/750 = 20 %
If we liquidate the bank at this stage, the Assets will fetch Rs. 850. The Depositors can be paid only Rs 850 against their full claim of
Rs 900. The Shareholders lose 100% of their Investment in the bank. Thus the Capital has been able to “absorb” a loss of only Rs.
100, leaving remaining loss of Rs. 50 to be “absorbed” by the Depositors. CAPITAL WAS “INADEQUATE”.

GUEST FACULTY: SHRIDHAR S 12

CB Sessions 12 & 13 5 & 6 October 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

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