CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING
SESSION 10 & 11

MODULE 3

Risk management – An overview

28 & 29 September 2021

COMMERCIAL BANKING : RISK MANAGEMENT OVERVIEW

SESSION PLAN
(a)Different types of risks
(b) Credit Risk
(c) Market Risk
(d) Operational Risk
(e) Q&A

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING
• RISK – the possibility of something “bad” happening.

• In financial terms, Risk may be defined as the probability that

- an assets’ value will be less than its expected / planned value, or

- actual income received is less than the expected / planned income.

- Risk also includes possibility of loss due to theft, fraud, natural hazards, government action, market
movements ….in fact, any thing that causes a financial loss.

• Risk is not used to refer to gains/profits. I do not risk winning a lottery: I risk not winning the
lottery and thereby losing the amount I paid to participate in the lottery.

• Theoretically, Risk is measurable and insurable. Uncertainty is a risk that is not measurable or
insurable.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

RISK MANAGEMENT PROCESS

- Risk Identification – Examine the business model, identify assets/incomes/processes that are important
and have risk events associated with them

- Risk Assessment or Measurement - Expected Loss = Probability of Occurrence of risk event X “Exposure”
– (amount of money that may be lost)

- Risk Mitigation -

- Risk mitigation strategies aim to reduce expected loss from occurrence of the risk event

- Risk avoidance

- Risk reduction

- Risk transfer

- Risk retention / acceptance

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW : BASIC BUSINESS MODEL DIAGRAM :

MAPPING TO BS & P&L A/C
PROVIDERS CUSTOMERS
P & L- P&L
OF GOODS FOR GOODS
EXPENSES INCOMES
& SERVICES & SERVICES
B/S - G&S INCOMES
EXPENSES G&S RECEIVED
B/S –
LIABILITIES RECD.
PAID GIVEN ASSETS
DEPOSITS
CAPITAL LOANS
CAPITAL LOANS
CAPITAL
PROFITS
BANK INTT. RECD. (BORROWERS)
DEPOSITS (D&T) DEPOSITS
(DEPOSITORS) INTT. PAID EMPLOYEES INVESTMENTS -
INVESTMENTS
B/S – (SECURITIES -
BORROWINGS BORROWINGS FIXED INV. INCOME
ASSETS ASSETS GOVT. CORP .)
(LENDERS) INTT. PAID

BANK’S PROFIT =
NET INTEREST INCOME (INTT.RECD-INTT PAID) PLUS OTHER INCOME LESS EXPENSES LESS PROVISION FOR BAD LOANS

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

Common RISKs faced by Banks:

• CREDIT RISK – Risk that a loan is not repaid. Risk that a counter-party fails to perform his part of a trade.

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open position” – “long” or “short”

• LIQUIDITY RISK – Asset side – An asset cannot be sold or can only be sold at a loss due to lack of liquidity in
the market, or maturing asset cannot be replaced at same price – re-investment risk, CALL Risk

• Liability side – A liability cannot be met when it falls due, or can be re-financed only at a loss, PUT risk

• OPERATIONAL RISK – Risk of loss from operations e.g. mistakes, errors and negligence, theft and burglary,
dacoity, frauds (internal and external), regulatory/government actions, natural hazards – fire, flood,
earthquakes, war, riots and Civil commotion, Settlement Risk

• OTHER RISKS - Legal Risk, Reputational risk, IT Risk, Model Risk, Compliance Risk, Concentration Risk,
Country/Sovereign Risk,, competition risk, inflation risk, RECESSION/Taxation/Govt. Policy risk, etc.

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COMMERCIAL BANKING

Credit Risk – Definition

Credit risk is the possibility of a loss resulting from a COUNTER-PARTY’S failure to meet its contractual
obligations – i.e. DEFAULT
• a Borrower may not pay the owed principal and interest – Lender is facing Credit Risk
• A Seller may not deliver goods for which he has received advance payment – Buyer is facing Credit Risk
• A Buyer may not pay for goods he has received in advance – Seller is facing Credit Risk (CR)
• A Counter Party (CP) may not settle his part of a trade – forex, security, derivatives etc. - Party is facing CR

A default may result in the Party whose CP has defaulted to face :

- interruption of cash flow for the party i.e. credit-risk taker due to non - repayment of principal and/or intt.
- Party may have to incur expenses on recovery, which may be only partial recovery
- Party may haver to un-wind at some cost, any back to back transactions he may have entered into.
- For banks, default by its borrowers leads to deterioration in NPA ratios, RoA, Profitability ratios – and in
worst case scenarios, even liquidity pressure. It may also invite corrective actions by Regulators.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

Credit Risk – Formula

Credit Risk = Expected Credit Loss = EAD x PD x LGD expressed as a percentage of EAD.

Exposure at default (EAD) is the total value a bank is exposed to i.e. total amount that can be lost when a CP
defaults.

Normally, EAD is equal to :

(i) The loan amount in case of lending or investment amount in case of investment in debt securities.

(ii) The trade amount in Non-DVP trades, or the un-winding cost in case of DVP trades.

(iii) Exposure to a CCP may also be subject to credit risk on the CCP, calculated by complex formulae.

Probability of Default (PD) is the likelihood over a specified period (usually one year), that a CP will default .

Loss given default (LGD) is the amount of money a bank or other financial institution may lose, when a CP
defaults. LGD is expressed as a percentage of EAD.

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COMMERCIAL BANKING
Relation between Credit Risk and loan Pricing

Expected Credit Loss = EAD x PD x LGD expressed as a % of EAD

Let us say EAD = Rs. 1,000, PD = 5%, and LGD = 25%, for a pool of similar loans, say Auto loans.

Expected Loss from this Loan poon due to credit default = 1,000 x 5% x 25% = 12.5 = 1.25% of EAD 1,000.

If bank’s funding costs (including opex) is 6% p.a., a bank has to charge at least 7.25% (6% + 1.25%) p.a. to
break even. Otherwise, the interest income from this pool will fall short of the default losses and there will be
aggregate loss on this portfolio.

1.25% is called the CREDIT RISK PREMIUM.

• Note that, In some contexts, the (credit) risk-free rate (e.g. G-Sec Rate) is taken as base instead of funding
costs, on which the credit Risk Premium is applied.

• Also note that all calculations are for a pool of loans, not for individual loans.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW :

Relation between Credit Risk and loan Pricing
POOL SIZE FUNDING DEFAULT LGD 25% TOTAL COST LOAN PRICE INTT NET PROFIT/
COST @ 6% PD=5% (INTT). TOTAL (LOSS)
INCL. OPEX INCOME
A B C D= E= F G= H=
25% OF C B+D AXF G–E

1,000 60 50 12.5 72.5 7.00% 70.0 (-2.5)

1,000 60 50 12.5 72.5 7.25% 72.5 0

1,000 60 50 12.5 72.5 8.00% 80.0 7.5

CETERIUS PARIBUS,
- PROFITS ARE INVERSELY PROPORTIONAL TO PD AND LGD, AND DIRECTLY PROPORTIONAL TO LOAN INTT.
- PRICING OF LOAN SHOULD TAKE INTO ACCOUNT PD AND LGD – I.E. “CREDIT RISK”, OTHERWISE THE LOAN POOL MAY
BE IN OVERALL LOSS.

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COMMERCIAL BANKING

Credit - Risk Management Strategies

Given that the Expected Credit Loss = EAD x PD x LGD, we can minimise Credit Risk by -

Minimising EAD –Laws, RBI regulations, Bank’s Loan policy, LE norms, Concentration risk, Loan Appraisal

(acceptability of borrower and purpose of loan, assessment of loan requirement - need based finance)

Minimising PD – Loan Appraisal (stipulation of Terms and conditions), Loan Disbursement, and Post - disbursal

monitoring of loan

Minimising LGD – Loan Appraisal(Security & Collateral, Guarantees including CDS, other terms and conditions),

Efficacy / selection of Enforcement mechanisms, NPA Management (Next session)

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – From “Open Positions” in Equity, interest bearing assets, currency, commodity etc.

• A Position may be “Long” or “Short” or “Square”. Position refers to a Quantity.

• “Long” or “Over-bought” Position means a positive Quantity of the asset is held – I hold the asset.

• A Long position appears on the Asset side of my BS.

• “Short” or “Over-sold” position means a negative Quantity of the asset is held – I have to deliver the asset.

• A short position will appear on the Liability side of my BS.

• A Position arises by Purchase or Sale, or a Net Purchase or Net Sale.

• Starting from a Zero position,

• If Purchases are More than Sales, a Long or Over-bought position arises.

• If Sales are more than Purchases, a Short or Over-sold position arises.

• If Sales are equal to Purchases, a Square position arises.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

Today I borrowed Rs 1,000. I bought 100 units of Item Q @ Rs 10 per unit and sold it today itself @ Rs 12 per unit.

EoD P&L
Purchases Amount Sales Amount
To Purchase 100 Q 1,000 By Sales 100 Q 1,200
To P& L 200
Total 1,200 1,200

Item Q Could be an Equity Share, NCD, Foreign Currency, Commodity, Derivative, etc.

Transactions completed / squared off on the same day are called “Intra-day trades”.

Positions appearing temporarily in the course of the day are called “Intra-day” Positions.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

Today I borrowed Rs 1,000. I bought 100 units of Item Q @ Rs 10 per unit and sold it today itself @ Rs 12 per unit.
EoD P&L
Purchases Amount Sales Amount
To Purchase 100 Q 1,000 By Sales 100 Q 1,200
To P& L 200
Total 1,200 1,200

EoD BS

Liabilities Amount Assets Amount

Realised Profit 200 Cash 200

Total 200 200

Purchases 100 Q = Sales 100 Q = “Square” position.

The borrowed amount purchase cost of Rs 1,000 has been repaid, and profit Rs 200 is realised / locked in.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

I bought Item 100 Q @ Rs 10 per unit and sold 50 of it today at Rs 12 per unit.
Purchases Amount Sales Amount
To Purchases 100 Q @10 1,000 By Sales 50 Q @ 12 600
To P& L 100 Closing Stock 50 Q @10 500
Total 1,100 1,100
Liabilities Amount Assets Amount
Accumulated Profit 100 Cash 100
Creditors for Purchases 500 Closing Stock 50 Q @ 10 500
Total 600 600
• Position = Purchases – Sales = (100 Q – 50 Q) = 50 Q = “Over-bought” in Q or “Long” in Q.

• Cost Value of this Position = 50 Q X 10 = Rs 500.

• Market Value of this position = 50 Q x 12 = Rs 600

• Unrealised profit in this position = MV of Position – Cost of Position = Rs 600 – 500 = Rs 100.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”

• POSITION = Quantity x Price.

• Position arises from Sales – Purchases OR Liabilities – Assets

Long Position Position Closing Price Market Value Cost Value of MTM Day’s change in
day qty Of Q per Unit of position Position @ 10 Profit/Loss MTM
A B C D=BXC E = B X 10 F=D-E G = F(d) – F(d-1)
D0 50 12 600 500 +100 0
D1 50 9 450 500 -50 -150
D2 50 14 700 500 +200 +250
D3 50 10 500 500 0 -200

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”

• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 10 F=D-E G = F(d) – F(d-1)
D0 50 12 600 500 100 0
D1 50 9 450 500 -50 -150
D2 50 14 700 500 200 +250
D3 50 10 500 500 0 -200
• B/S D-0 Liabilities Amount Assets Amount
Realised Profit 100 Cash 100
Creditors for Purchases 500 Closing Stock Position 50 500
Q @ 10
Total 600 600

COMMERCIAL BANKING - RISK MANAGEMENT

OVERVIEW
• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”
• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 10 F=D-E G = F(d) – F(d-1)
D0 50 12 600 500 100 0
D1 50 9 450 500 -50 -150
D2 50 14 700 500 200 +250

• B/S D-1 D3 50 10 500 500 0 -200

Liabilities Amount Assets Amount
Realised Profit 100 Cash 100
MTM Loss due to market movement - 50
Creditors for Purchases 500 Closing Stock Position 50 Q @ 9 450
Total 550 550
Closing Long position has to be valued at Cost of MV whichever is lower.
Hence unrealized MTM losses are provided for, but MTM unrealized gains are ignored for P&L/BS purposes.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”
• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 10 F=D-E G = F(d) – F(d-1)
D0 50 12 600 500 100 0
D1 50 9 450 500 -50 -150
D2 50 14 700 500 200 +250
D3 50 10 500 500 0 -200

Liabilities Amount Assets Amount

• B/S D-2
Realised Profit 100 Cash 100
Creditors for Purchases 500 Closing Stock Position 50 500
Q @ 10 (@ Cost)
Total 600 600
MTM UNREALISED GAIN 200 MV of Closing Stock 700
NOT TO BE RECKONED Position 50 Q @ 14

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

I bought Item 100 Q @ Rs 10 per unit and sold Rs 150 Q at Rs 12 per unit.
EoD P&L
Purchases Amount Sales Amount
To Purchase 100 Q @ 10 1,000 By Sales 150 Q @ 12 1,800
To Delivery Obligation 50 Q @12 600

To P& L 200

Total 1,800 1,800

I paid off Rs 1000 I borrowed rom the Rs 1800 sales proceeds.
EoD BS

Liabilities Amount Assets Amount

To Delivery Obligation 50 Q @12 600 Cash 800

Realised Profit 200
Total 800 800

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

I bought Item 100 Q @ Rs 10 per unit and sold 150 of it today at Rs 12 per unit.
EoD P&L
Purchases Amount Sales Amount
To Purchase 100 Q @ 10 1,000 By Sales 150 Q @ 12 1,800
To Delivery Obligation 50 Q @12 600
To P& L 200
Total 1,800 1,800

EoD BS
Liabilities Amount Assets Amount
To Delivery Obligation 50 Q @12 600 Cash 800
Accumulated Profit 200
Total 800 800

Position = Purchases – Sales = (100 Q – 150 Q) = (- 50 Q) = “Over-sold” in Q or “Short” in Q.

• Cost Value of this Position = -50 Q X 12 = - 600. Market Value of this position = 50 Q x 12 = Rs 600
• Unrealised profit in this position = MV of Position – Cost of Position = Rs 600 - Rs 600 = 0.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”

• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 12 F=D-E G = F(d) – F(d-1)
D0 -50 12 - 600 - 600 0 0
D1 -50 9 - 450 - 600 + 150 -150
D2 -50 14 - 700 - 600 - 100 +250
D3 -50 10 - 500 - 600 + 100 -200

EoD BS - D1

Liabilities Amount Assets Amount

To Delivery Obligation 50 Q @12 600 Cash 800

Accumulated Profit 200
Total 800 800

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”
• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 12 F=D-E G = F(d) – F(d-1)
D0 -50 12 - 600 - 600 0 0
D1 -50 9 - 450 - 600 + 150 -150
D2 -50 14 - 700 - 600 - 100 +250
D3 -50 10 - 500 - 600 + 100 -200

EoD BS – D2

Liabilities Amount Assets Amount

To Delivery Obligation 50 Q @12 600 Cash 800

Realised Profit 200
Total 800 800
Un-realised profit not to be reckoned +150

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”
• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 12 F=D-E G = F(d) – F(d-1)
D0 -50 12 - 600 - 600 0 0
D1 -50 9 - 450 - 600 + 150 -150
D2 -50 14 - 700 - 600 - 100 +250
D3 -50 10 - 500 - 600 + 100 -200

EoD BS – D3

Liabilities Amount Assets Amount

To Delivery Obligation 50 Q @14 700 Cash 800

Realised Profit 200
Un-realised MTM loss to be reckoned -100
Total 800 800

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

• MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open positions” – “long” or “short”
• POSITION = Quantity x Price. Position arises from Sales – Purchases OR Liabilities – Assets
Long Position Position qty Closing Price Market Value Cost Value of MTM Day’s change in
day of position Position Profit/Loss MTM
A B C D=BXC E = B X 12 F=D-E G = F(d) – F(d-1)
D0 -50 12 - 600 - 600 0 0
D1 -50 9 - 450 - 600 + 150 -150
D2 -50 14 - 700 - 600 - 100 +250
D3 -50 10 - 500 - 600 + 100 -200

• Closing Short position has to be valued at Cost of MV whichever is higher.

• Hence unrealized MTM losses are provided for, but MTM unrealized gains are ignored for P&L/BS
purposes.
• As per accounting Standards, MTM Losses have to be provided and MTM Profits ignored.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – From “Open Positions” in Equity, interest bearing assets, currency,
commodity etc.

MARKET RISK DRIVERS / FACTORS FOR EACH CLASS OF UNDERLYING ASSET/LIABILITY

• Equity – Share prices

• Fixed Income securities – Interest Rates : Bond value is inversely related to Interest rate

• Currency – Forex Rates

• Commodity – Commodity Prices

• Derivatives – Volatility

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management

1. Open Position Method – Nominal Amount Approach

- Size of the open position is the risk measure.

- Absolute limits are fixed on the open position in each class of asset, depending on risk perception

- Trading Limit for G-sec may be fixed at Rs 1 Crore while equity may be fived at Rs 10 Lac

Advantages :

- Very easy to calculate and implement

Disadvantages

- Ignores correlation amongst portfolio components, leading to under/over estimating portfolio risk

- Provides no measure of likely loss amount

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management
2. Sensitivity based methods :
- Calculate the change in Portfolio Market Value for unit change in risk parameter of underlying asset
- For example, MV of a Fixed Income security or portfolio may fall by Rs 1 Crore for a 1% across the
board rise in Interest rates.
- BPV (Basis Point Value) and Duration are two common measures of sensitivity.
- Limits may be set on maximum BPV or Duration for each trader.
Advantages :
- Easy to calculate and implement, easy to understand
Disadvantages
- Knowledge of BPV is only one part, we need to know how much the Interest rate will move.
- BPV method assumes parallel movement of yield curve
- Difficult to implement for other classes of securities like Equity/Commodities.
- Ignores correlation amongst portfolio components, leading to under/over estimating portfolio risk
- Provides no measure of likely loss amount

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management

3. Value at Risk (VAR) Method

VAR expresses the ‘maximum’ amount a bank might lose, within a certain period, to a certain level of
probability, as a result of changes in interest rates (value of fixed income securities), exchange rates, equity
and commodity prices.

To interpret VAR, we need to know the probability and period over which it is being computed.

The VaR approach aims to answer the following question:

‘What is the maximum amount a portfolio may lose, over the next x days, with p% probability, under
normal Trading Conditions?’

Portfolio may be a portfolio of securities, currencies, or even loans – in fact, any thing that has a value
expressible in monetary terms, which can be measured periodically.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method

D0 D1 D2 D3 D1
+3 Assumptions

+2 • Portfolio Value (PV) changes by Re. 1 only per day, either up or down.
+1 • Up or down are having equal chance of occurring.
+1 +1 • PV change is the Portfolio Return (positive or negative)
0
-1
PV
+1
0
-1 -1
-1
-2
-3

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method

D0 D1 D2 D3 PV RETURN D1 D2 D3 D4 D5 % Cumulative %
+3 +5 1 3% 3%
+2 +4 1
+1 +3 1 5 16% 19%
+1 +1
+2 1 4
0
+1 1 3 10 31% 50%
-1
0 2 6
PV
-1 1 3 10 31% 81%
+1
-2 1 4
0
-3 1 5 16% 97%
-1 -1
-1 -4 1

-2 -5 1 3% 100%
-3 TOTAL 2 4 8 16 32 100%

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV RETURN D1 D2 D3 D4 D5 D5% Cum.%

‘What is the maximum amount this portfolio may

+5 1 3% 3%
lose, over the next 5 days, with 97% probability,
+4 1
+3 1 5 16% 19% under normal Trading Conditions?’

+2 1 4
+1 1 3 10 31% 50% The maximum amount this portfolio may lose over

0 2 6 the next 5 days with 97% probability (confidence) is

-1 1 3 10 31% 81% Rs. 3.
-2 1 4
-3 1 5 16% 97% In technical terms,
-4 1 For this portfolio, the 5 day VAR at 97% Confidence
-5 1 3% 100% level is Rs. 3.
TOTAL 2 4 8 16 32 100%
Say PV=Rs. 100 on Day 0, No trades thereafter.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV D1 D2 D3 D4 D5 D5% Cum.% What is the maximum amount this portfolio may lose,
RETURN
over the next 5 days, with 81% probability, under
+5 1 3% 3%
normal Trading Conditions?’
+4 1
+3 1 5 16% 19%
+2 1 4 The maximum amount this portfolio may lose over the

+1 1 3 10 31% 50% next 5 days with 81% probability is Rs. 1.

0 2 6
-1 1 3 10 31% 81% In technical terms,

-2 1 4 For this portfolio, the 5 day VAR at 81% “Confidence

-3 1 5 16% 97% level” (probability) is Rs. 1.
-4 1
-5 1 3% 100%
TOTAL 2 4 8 16 32 100%
Say PV=Rs. 100 on Day 0, No trades thereafter.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV D1 D2 D3 D4 D5 D5% Cum.% What is the maximum amount this portfolio may
RETURN
lose, over the next 5 days, with 100% probability,
+5 1 3% 3%
under normal Trading Conditions?’
+4 1
+3 1 5 16% 19%
+2 1 4 The maximum amount this portfolio may lose over

+1 1 3 10 31% 50% the next 5 days with 100% probability (Confidence

0 2 6 level) is Rs. 5.
-1 1 3 10 31% 81%
-2 1 4 In technical terms,
-3 1 5 16% 97% For this portfolio, the 5 day VAR at 100%
-4 1 “Confidence level” (probability) is Rs. 5.
-5 1 3% 100%
TOTAL 2 4 8 16 32 100%
Say PV=Rs. 100 on Day 0, No trades thereafter.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV D1 D2 D3 D4 D4% Cum.
1. The 4 day VAR at 94% “Confidence level” (probability) is Rs. 2.
CHNGE %
- Under normal Trading Conditions, there is a 94% Chance that over the
+5 0% next 4 days, the maximum value the portfolio may lose is Rs. 2.
+4 1 6% 6%
+3 1 1. The 4 day VAR at 100 “Confidence level” (probability) is Rs. 4.

+2 1 4 25% 31% 2. Under normal Trading Conditions, there is 100% chance that over

+1 1 3 the next 4 days, the maximum value the portfolio may lose is Rs. 4.

0 2 6 38% 69%
-1 1 3
-2 1 4 25% 94%
-3 1
-4 1 6% 100%
-5 0%
TOTAL 2 4 8 16
Say PV=Rs. 100 on Day 0, No trades thereafter.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method

DAYS CONFIDENCE LEVEL VAR

4 94% 2

4 100% 4

5 97% 3

5 81% 1

5 100% 5
1. VaR is α (Days) : Greater the number of days, More is VaR

2. VaR is α (Confidence Level) : Greater he confidence level, greater the VaR.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV RETURNS D5% Cum.%
Q1. How to Calculate VaR for N number of days? (N is determined by Policy or
+5 3% 3%
Regulations)
+4
STEP 1 : Calculate the Nth day distribution of the Portfolio returns (Col. 1 and 2)
+3 16% 19%
STEP 2 : Decide confidence interval and read off the VaR in Col. 1
+2
+1 31% 50%
For example, 5 Day VAR @ 97% confidence interval is Rs. 3
0
For example, 5 Day VaR @ 100% confidence interval is Rs. 5
-1 31% 81%
-2
-3 16% 97%
-4
-5 3% 100%
TOTAL 100%

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV RETURNS D5% Cum.% Q2. We have 5 day VaR. How to calculate 4 day VaR? 10 day VAR? (at the same
+5 3% 3% confidence levels)

+4 FORMULA: An approximate answer is given by the following formula:

+3 16% 19% N day VaR = n day VaR x SQRT (N/n), where N IS THE NUMBER OF DAYS FOR WHICH
VAR IS REQUIRED TO BE CALCULATED, and n I the number of days for which VaR is
+2 already available.
+1 31% 50%
5 day VaR at 100% confidence level is Rs 5.
0 Therefore, 4 day VaR at 100% confidence level would be approximately
-1 31% 81% 5 x SQRT (4/5)
= 5 X 0.894
-2 = 4.47
-3 16% 97% ≈ 4 (this compares with the actual VaR of 4 as arrived at in a previous slide.
Therefore, 10 day VaR at 100% confidence level would be
-4 5 x SQRT (10/5)
-5 3% 100% = 5 X 1.414
= 7.07
TOTAL 100% Students may like to extend the Model studied in the previous slides to 10 days and
N day VaR = n day VaR x SQRT (N/n) arrive at actual VaR for 10 days @100% confidence and compare the same to the
formula result. Check if the accuracy improves at lower levels of confidence, say 97%.

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV D 5 % Cum.
Conditional VaR = Average of negative outcomes beyond calculated VaR.
RETUR %
NS In our example, e.g. 5 day VaR at 81% confidence was Rs. 1. i.e. “Under normal Trading Conditions,
+5 3% 3% there is a 81% Chance that over the next 5 days, the maximum value the portfolio may lose is Rs. 1.”
+4 This implies that there is a 19% chance that over the next five days, the portfolio may lose more
+3 16% 19% than Rs. 1. However, How much more may be lost is not given by the absolute VaR measure of Rs. 1.
+2 In our model, the next adverse outcome after loss of Rs. 1 was loss of Rs 3 (16% chance) and loss of
+1 31% 50% Rs. 5. (3% Chance).
0 So in our example, VaR is Rs 1 and Conditional VaR can be said to be
-1 31% 81% (Rs. 3 + Rs 5)/2 = Rs. 4.
-2 It can be calculated weighted by probability also –
-3 16% 97% {(3 x 16) + (5 x 3)} / 19 = {48 + 15} / 19 = 63 / 19 = Rs. 3.32
-4 Hence, while 5 day VaR of the portfolio at 81% confidence level is Rs 1., Conditional VaR is Rs. 4 or
-5 3% 100% Rs. 3.32 (weighted).
TOTAL 100% (CVaR is somewhat like LGD for Credit Risk.) This concept is not yet being used in India.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : 3. Value at Risk (VAR) Method
PV RETURNS D5% Cum.%
Approaches to calculate the Nth day distribution of the Portfolio returns:
+5 3% 3%
- Variance-CoVariance approach : Estimate by Statistical Methods the Mean and SD
+4
of the N-day portfolio returns. Tabulate the expected values of returns (Col 1 & 2).
+3 16% 19%
Simple approach, but requires assumption of normal distribution of returns.
+2
+1 31% 50%
- Historical Simulation – Revalue the current portfolio based on the observed risk
0
parameters for past say, 500 days. Calculate and tabulate the returns (Col 1 & 2).
-1 31% 81%
Computationally demanding, but requires no assumptions regarding Var/CoVar or
-2
distribution of returns. May be stale, esp. in periods of rapid change in economy.
-3 16% 97%
-4
- Monte Carlo Simulation – Revalue Portfolio based on several sets of randomly
-5 3% 100%
generated risk parameters, based on certain rules/judgements. Tabulate the
TOTAL 100%
expected values of the N-day returns (Col 1 and 2).
N day VaR = n day VaR x SQRT N/n)

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management : VaR

Back-testing – Comparing the Model based VaR with actual VaR: Very important to investigate reasons for Model failure
and take action if predictions are not true. Regulatory requirement. BASEL Committee recommendations.

Stress testing – Estimating portfolio losses in stress scenarios or “Abnormal” Trading conditions e.g. interest rates move by
1% across the board, or USD/INR rates move by +/- 5%, Equity Index moves by +/- 10%, etc.

4 common methods are Simple Sensitivity Analysis, Scenario Analysis, Maximum Loss Approach, Extreme Value theory
(attaches a probability to Stress test results)

(Students are advised to look up above methods in textbooks/web-resources for further study/understanding)

Stress testing complements the VaR approach.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management

Strategies to Mitigate Market Risk

- Open Position Limits

- BPV limits
- VaR limits
- Stress limits
- Portfolio Diversification*
- Hedging*
- Derivatives*
- *- More on this, in later modules

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COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

MARKET RISK – Measurement and Management

Strategies to Mitigate Market Risk

• Note that we have not talked about Reward at all.
• The most effective market risk mitigation technique is to avoid it altogether by having a
zero position. But this position does not yield any return.
• Risk / return balance has to be struck.
• But there are pundits who say -
“Manage the risks - the returns will take care of themselves”.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

Some Common RISKs faced by Banks:
• ✓ CREDIT RISK – Risk that a loan is not repaid. Risk that a counter-party fails to perform his part of a trade.

• ✓ MARKET RISK - Equity, interest rate, currency risk, commodity – from “Open position” – “long” or “short”

• OPERATIONAL RISK – Risk of loss from operations e.g. mistakes, errors and negligence, theft and burglary,
dacoity, frauds (internal and external), regulatory/government actions, natural hazards – fire, flood,
earthquakes, war, riots and Civil commotion, Settlement Risk

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW :

OPERATIONAL RISK : Examples

RISK EVENT EXAMPLES

TYPEEXAMPLES
Internal fraud Intentional misreporting of positions, employee theft, and insider trading on an employee’s own
account
External fraud Robbery, forgery, kite-flying, and damage from computer hacking.
Employment Workers’ compensation claims, violation of employee health and safety rules, organised labour
practices and activities, discrimination claims and general liability.
workplace safety
Clients, products & Fiduciary breaches, misuse of confidential customer information, improper trading activities on the
business practices bank’s account, money laundering, and sale of unauthorised products
Damage to Terrorism, vandalism, earthquakes, fires and floods.
physical assets
Business Hardware and software failures, telecommunication problems and utility outages
disruption and
system failures
Execution, delivery Data entry errors, INCOMPATIBLE SOFTWARE, collateral management failures, incomplete legal
and process documentation, unapproved access given to client accounts, non-client counterparty mis-
management performance and vendor disputes.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW OPERATIONAL RISK

:MITIGATION STRATEGIES
RISK EVENT TYPETYPE PREVENTIVE DETECTIVE AMELIORATIVE

Internal fraud KYE, 4 EYES, ACCESS
CONTROL, ZERO-
TOLERANCE POLICY,
DETERRENT PUNISHMENT,
TRAINING
MIS ANALYSIS, AUDITS, FIDELITY INSURANCE, FIR –
RECONCILIATION, VACATION POLICY, POLICE INVESTIFATION,
SCRUTINY OF ACCOUNTS, LEGAL RECOVERY
COMPLAINT PROCESSING, WHISTLE- MECHANISMS
BLOWER POLICY

External fraud ACCESS CONTROL, DUE- MIS ANALYSIS, AUDITS, FIR – POLICE
DILIGENCE ON COUNTER- RECONCILIATION, COMPLAINT INVESTIGATION, LEGAL
PARTIES, TRAINING PROCESSING RECOVERY MECHANISMS

Employment practices TRAINING FOR AWARENESS REGULAR INSPECTION OF FACILITIES QUICK REPAIRS,
and workplace safety OF CURRENT GUIDELINES/ AND MONITORING, COMPLIANCE INSURANCE,
DEVELOPMENTS, AUDITS, COMPENSATION PAYMENT
COMPLAINT MANAGEMENT TO AFFECTED,

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW OPERATIONAL RISK

:MITIGATION STRATEGIES
RISK EVENT TYPETYPE PREVENTIVE DETECTIVE AMELIORATIVE

Business disruption REDUNDANCY IN SYSTEMS, UPS, REPORTING EFFECTIVE HELP-DESKS,

and system failures ALTERNATE COMM. CHANNELS, CHANNELS, HELP- WELL DRILLED BUSINESS
MIRROR SITES, BCP SITES. LINE, TRAINING CONTINUITY PLAN,
INSURANCE, RETRIEVABLE
/ SECURE BACK-UPS,
Execution, delivery SOP, TRAINING, AUTO- COMPLIANCE AND PENALTY CLAUSE
and process VALIDATION SOFTWARE, LEGAL AUDITS, ENFORCEMENT CONTRACT
management MAKER-CHECKER-AUTHORISER, RECONCILIATION, ENFORCEMENT, E
VENDOR KYV/DUE DILIGENCE,
CONTRACT MGT., (INCL. SLA
AND PENALTY CLAUSES),
ACCESS CONTROL

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

BASEL III STANDARDS AS IMPLEMENTED BY RBI – CURRRENT STATUS -
OPERATIONAL RISK : The Basic Indicator Approach (BIA)
Under the Basic Indicator Approach, banks must maintain
KBIA = [ ∑ (GI1…n x α )] / n I.E.
Where: KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years,
Gross Income = “Net interest income” plus “net non-interest income” (certain adjustments are
prescribed)
n = number of the previous three years for which gross income is positive
α = 15 per cent, which is set by the BCBS
Then multiply capital charge by 12.5 to arrive at notional RWA for Operational Risk.
Our Generic risk formula is “Expected Loss = Probability of Occurrence of risk event X Exposure”
The BI approach implies that “Exposure” for the purpose of operational risk is calculated as 15% of average
Annual Gross Income over previous three years, and probability of occurrence of risk event is assumed to
be the same as for Credit and Market risk exposures. We shall be covering Capital Adequacy requirements
in detail in subsequent sessions.

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CB SESSIONS 10 & 11 28 & 29 SEPT 2021

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

OPERATIONAL RISK : RBI GUIDELINES

“GUIDANCE NOTE ON MANAGEMENT OF OPERATIONAL RISK”

https://m.rbi.org.in/upload/notification/pdfs/66813.pdf

All students to download and go through the above document.

COMMERCIAL BANKING - RISK MANAGEMENT OVERVIEW

IN CASE OF ANY DOUBTS/QUERIES

PLEASE CONTACT

shridhar58@gmail.com

WhatsApp: 9818547778

GUEST FACULTY: SHRIDHAR S 25