École Supérieure Libre des Commerciales Appliquées

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CONTENTS

Program: MIBA Group: Eslsca 33 Dr. Khalil Abou Ras Subject – Banking and Financial Institutions Assignment: Risk Management. Presented by: Ahmed Mohamed Atef Selim Beram.
Preface
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INTRODUCTION (a) Meaning of Risk and Risk Management (b) Risk management Structure (c) Risk management Components (d) Steps for implementing risk management in bank (e) RBI Guidelines on risk management Types of risks a (a) Liquidity Risk (b) Market Risk (c) Credit Risk (d) Interest Rate Risk (e) Reputation Risk (f) Strategic Risk (g) Operational Risk BASEL II COMPLIANCE (a) Three pillar approach (b) Reservation about Basel II Risk Based Supervision Requirement (a) Background (b) Risk based supervision – a new approach (c) Features of RBS approach Conclusion

PREFACE
Risk Management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the
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change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity but to ensure that the risks are consciously taken with full knowledge, clear purpose and understanding so that it can be measured and mitigated. The present study is on Risk Management in Banks. The core of the study is to analyze various kinds of risk i.e credit, interest rate, liquidity and operational risk and how to measure and monitor these risks. The entire dissertation has been divided into nine chapters. The first chapter contains discussion on the meaning and concept of risk, risk management, its functions, types of risk, RBI guidelines. Chapter second contains the Research Methodology, which includes need, objective and significance of study. Basel II norms and Risk Based Supervision Requirements are discussed in seventh chapter. Analysis of survey responses and profitability analysis, which is the central point of financial analysis, is included in eighth chapter. Chapter ninth presents the major findings of the study with some concluding remarks.

INTRODUCTION TO RISK MANAGEMENT
Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulate environment, banks could not afford to take risks. But of late, banks are exposed to same competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Deregulation in the financial sector had widened the product range in the developed market. Some of the new products introduced are LBOs, credit cards, housing finance, derivatives and various off balance sheet items. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. Simultaneously they have opened new areas of risks also. During the past decade, the Indian banking industry continued to respond to the emerging challenges of competition, risks and uncertainties. Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. Our regulators have made some sincere attempts to bring prudential and supervisory norms conforming to international bank practices with an intention to strengthen the stability of the banking system. RISK The etymology of the word “Risk” can be traced to the Latin word “Rescum” meaning Risk at sea or that which cuts. Risk is an unplanned event with financial consequences resulting in loss or reduced earnings. It stems from uncertainty or unpredictability of the future. Therefore, a risky proposition is one with potential profit or a looming loss. Risk is the potentiality of both expected and unexpected events which have an adverse impact on bank capital or earnings. In one of the publications Price Waterhouse Cooper has interpreted the word risk in two distinct senses.
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Risk as Hazard: “Danger; (exposure to) the possibility of loss, injury or other adverse circumstance. Exposure to the possibility of commercial loss apart of economic enterprise and the source of entrepreneurial profit.” Risk as Opportunity: “The ordinary rate of profit always rises……with the risk” Hence, Risk Management is an attempt to identify, to measure, to monitor and to manage uncertainty. It does not aim at risk elimination, but enables the banks to bring their risks to manageable proportions while not severely affecting their income. International Financial Risk Institute defines Risk Management as “The application of financial analysis and diverse financial instruments to control and typically the reduction of selected type of Risks.” While non-performing assets are the legacy of the past in the present, risk management system is the pro-active action in the present for the future. Managing risk is nothing but managing the change before the risk manages. Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of
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Risk in its pragmatic definition. then we can take measures to make sure that hazards do not turn into disasters. Business is the art of extracting money from other’s pocket. But profiting in business without exposing to risk is like trying to live without being born. sharp intuition and longer experience were adequate to manage the limited risks. The essential functions of risk management are to identify measure and more importantly monitor the profile of the bank. therefore. While Non-Performing Assets are the legacy of the past in the present. Hence. Vulnerability and hazards are not dangerous. The extent of calculations that need to be performed to understand the impact of each such risk on the transactions of the bank makes it nearly impossible to continuously update the risk calculations. the probability that a disaster will happen. Each transaction that the bank undertakes changes the risk profile of the bank. higher the profit and hence the business unit must strike a tradeoff between the two. Everyone knows that risk taking is failure prone as otherwise it would be treated as sure taking. Better insight. includes both threats that can materialize and opportunities. Managing risk is nothing but managing the change before the risk manages. it does mean that taking risk bring forth benefits as well. and if we are aware of our weaknesses and vulnerabilities to existing hazards. Risks and uncertainties form an integral part of banking which by nature entails taking risks. in other words. Nevertheless.” 5 . if the desire is to reap the anticipated benefits. "What is risk?" And what is a pragmatic definition of risk? Since risk is accepted in business as a tradeoff between reward and threat. and it is up to an organization to manage these to their competitive advantage. banks have grown from being a financial intermediary into a risk intermediary at present. Greater the risk. taken separately.risk can have ramifications and penetrations for a range of other categories of risks. Of late. the gap of which becomes thinner and thinner. which the banks will have to handle and overcome. Business grows mainly by taking risk. sans resorting to violence. effectively controlled and rightly managed. Hence risk is inherent in any walk of life in general and in financial sectors in particular. banks are exposed to severe competition and hence are compelled to encounter various types of financial and non-financial risks. But if they come together. RISK MANAGEMENT “Risk Management is the process of measuring or assessing the actual or potential dangers of a particular situation. In the process of financial intermediation. which can be exploited. If we are careful about how we treat the environment. they become a risk or. While new avenues for the bank has opened up they have brought with them new risks as well. Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Foremost thing is to understand the risks run by the bank and to ensure that the risks are properly confronted. Risk Management system is the pro-active action in the present for the future. providing real time risk information is one of the key challenges of risk management exercise. risks can be reduced or managed. In other words it is necessary to accept risks. Risk is the probability that a hazard will turn into a disaster. This definition of risk is very pertinent today as the current business environment offers both challenges and opportunities to organizations.

providing a roadmap to achieve strategic goals and objectives and reassurance over the management of risks. regulatory requirements have been introduced. there is increased awareness on the several of types of risk.Risk management is a discipline for dealing with the possibility that some future event will cause harm. how will we pay for it? RISK MANAGEMENT IN BANKS Risk management does not aim at risk elimination. BENEFITS OF RISK MANAGEMENT IN BANKS Proper risk management allows a financial institution to prosper through taking and avoiding risks. which expect organizations to have effective risk management practices. It provides strategies. most telling and visible being the Barings collapse. and an approach to recognizing and confronting any threat faced by an organization in fulfilling its mission. techniques. In India. This balancing act between the risk levels and profits needs to be well-planned. this has lead to the systematized pattern of working and thereby has created awareness among various people and management for the safe working of the banks. This is largely a result of lessons from major corporate failures. there has been considerable debate on the need to introduce comprehensive risk management practices. they should also ensure that one risk does not get transformed into any other undesirable risk. Companies can also gain an advantage over competitors by identifying and adapting to circumstances faster than their rivals. as banks are ready to 6 • • . Risk Management is a more mature subject in the western world. In addition. allowing for a more efficient. Also RBI has ensured that there is enough awareness of various risks and thereby banks take care of the risk prior to its happening. in a constantly changing environment. effective and prudently run business. making it better able to satisfy the needs of its various stakeholders. The focal point in managing any risk will be to understand the nature of the transaction in a way to unbundle the risks it is exposed to. Well run companies are now taking a closer interest in what its management is doing to mitigate risk exposure. Fewer unexpected and unwelcome surprises: Due to increased use of risk management and its process there are few unexpected surprises. A risk based approach can make a company more flexible and responsive to market fluctuations. Risk management may be as uncomplicated as asking and answering three basic questions: What can go wrong? What will we do (both to prevent the harm from occurring and in the aftermath of an "incident")? If something happens. Good risk management will greatly improve the transparency of how an organization operates. but enables the organization to bring their risks to manageable proportions while not severely affecting their income. This transformation takes place due to the inter-linkage present among the various risks. • Increased risk awareness: With the advent of risk management in banks and in banking system. Apart from bringing the risks to manageable proportions. Prioritization of business risks to those that matter: With the recognition of the various risk that are to be happening to the banks and with the increased awareness now banks can prioritize the risk to that of the other matters. whilst risk management is still in its infancy.

This increases the utility of banks and its assets. positioning and resource commitments. Typically banks distinguish the following risk categories: Credit risk Market risk Operational risk 3) Construction of risk management index and Sub indices 7 . efficient business. Reduced losses through process improvements developed by the business of banks: As there is increased efficiency in the process these results in better output and thereby reducing the losses that can take places due to process improvements of banks. Increasing the chance of change initiatives being achieved: Risk management in banks leads to various benefits as stated above. which is carried out to assess the current level of risk management processes. with vision and goals achieved in due to time. Not only that because of risk management all contingent risk are reduced to a greater extent • A better focus internally on doing the right things well: Banks can now focus on the internal process and its betterment thereby increasing the efficiency of the banks and increasing the overall brand of the company. focus. technology and analytical sophistication at the bank. all of those benefits leads to increasing the chance of change initiatives being achieved at earlier stage thereby outperforming the set standards with better vision of the future. reducing the possible losses and streamlining the business of banks this leads to creating a greater likelihood of achieving business goals and objectives • • • • ♦ Steps for implementing Risk Management in Banks 1) Establishing a risk management long term vision and strategy Risk management implementation strategy is established depending on bank vision. Providing a better basis for making key strategic decisions: Risk Management leads to estimation of the future and the various risks that can be on the way in future.face the financial and other hurdles that are on the way. thereby making the future bit more stable and predictable. 2) Risk Identification The second step is identification of risks. structure. as a result of these banks have reduced losses and better process in place. This leads to proper knowledge of the future. Risk management has lead to the increased efficiency and effectiveness of the banks due to prioritization of the process. Creating a greater likelihood of achieving business goals and objectives: Risk management leads to effective. This helps in making key strategic decisions and its better implementation for the further betterment.

Models to be applied are tested and validated on a prototype basis. evaluation scores on the benchmark levels specified helps to build up a risk process implementation score.Bank roll out a customized benchmark index based on its vision and risk management strategy. Using risk strategy in the decision making process Capital allocation     Provisioning Pricing of products Streamlining procedures and reducing operating costs By rolling out the action steps in phases the bank measure the progress of the implementation. a. 5) Establish Risk measures and early warning indicators Depending on the lines of business as reflected in bank balance sheet and business plans. 6) Executing the key requirements: At an operational level checklist of key success factors and quantitative benchmark is generated. 7) Integrate Risks Management/Strategy into bank internal decision making process The objective is to integrate risk management into business decision making process which 8 . Basel II compliance c. For the gap in score of 70 roadmap is developed for achieving the milestones. the relative importance of market. Moreover. Then it develops a score for the current level of bank risk practices that already exists. credit and operational risk in each line of activity is determined The process workflow organization. Risk Based Supervision requirements b. 4) Defining Roadmap Based on the target risk management strategy/gap analysis bank develops unique work plans with quantifiable benefits for achieving sustainable competitive advantage. risk control and mitigation procedures for each activity line is to be provided. For example assuming that the current risks management score is 30 out of 100.

Tata Consultancy Services (TCS). 9 Losses Profit s . risk management focus on the identification of potential unanticipated events and on their possible impact on the financial performance of the firm and at the limit on its survival. development of integrated risk reports and success measures and alignment of risk and business strategies.evolves risk culture through awareness and training. Boston Consulting Group (BCG). PricewaterhouseCoopers (PwC). banks now a day’s seek services of Global Consultants like KPMG. (Crisil). which are being implemented by banks through various committees. Risk Management in its current form is different from what the banks used to practice earlier. Moreover. I – Flex Solutions and Infosys Technologies who have vast experience in risk modeling as these players identify the gap in the system and help the banks in devising a risk return model. Hence. The Credit Rating and Investment Services of India Ltd. Risk environment has changed and according to the draft Basel II norms the focus is more on the entire risk return equation. OPTIMIZING THE RISK RETURN EQUATION DEGREE OF RISK RBI Guidelines on Risk Management RBI has issued guidelines from time to time.

It cannot be divorced from the risks it compounds. The banking industry has long viewed the problem of risk management as the need to control four of the above risks which make up most. etc. One of the five specific areas is effective Risk Management Architecture to ensure adequate internal risk management practices. There are various types of risks that occur in the banks and affect its functioning. to measure. if not all. portfolio approach must be adopted. so market risk and credit risk overlap. foreign exchange and liquidity risk For convenience. Boundaries between categories are blurred. to monitor and to control the various risks with New Capital Adequacy provisions in due course. interest rate. To enhance risk management function banks should move towards risk based supervision and risk focused internal audit. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss. (g) (h) Banks should upgrade credit risk management system to optimize use of capital. Similarly. Appropriate credit risk modeling in the future must be adopted. (b) (c) (d) For integrated management of risk there must be single risk management committee. Types of Risks: Business activities entail a variety of risks. Market Risk 10 . it is only informal. credit.RBI suggests that (a) Banks must equip themselves with an ability to identify. Usage and definitions vary. credit risk. For measurement of market risk banks are advised to develop expertise in internal models (e) (f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks operating in international markets. of their risk exposure. such as market risk and credit risk.. real estates which are subject to a high degree of asset price volatility as well as to specific industries which are subject to frequent business cycles should be restricted. we distinguish between different categories of risk: market risk. Some of these kinds of Risks are as follows: 1. liquidity risk. Liquidity risk compounds other risks. Although such categorization is convenient. Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based supervision. (i) The limits to sensitive sectors like advances against equity shares. For managing credit risk. high-risk industries as perceived by the bank should be placed under lower portfolio limit. viz. Liquidity Risk 2.

If the counterparty that owes it a payment defaults. The funding liquidity risk is defined as the inability to obtain funds to meet the cash flow obligations.e performing assets turning into non-performing assets. its limited ability to liquidate that position at short notice will compound its market risk. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable. reduction in liabilities. liquidity risk is compounding credit risk. It is contingent on other factors like maturity mismatches or external events such as credit downgrades or market turmoil.renewal of deposits. the firm will have to raise cash from other sources to make its payment. or some other event causes counterparties to avoid trading with or lending to the institution. If a trading organization has a position in an illiquid asset. The liquidity risk in banks manifest in different dimension: 1. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity planning is an important facet of risk management framework in banks. but a consequential risk. 11 . it experiences sudden unexpected cash outflows. Liquidity risk tends to compound other risks. An institution might lose liquidity if its credit rating falls. Time Risk: need to compensate for non-receipt of expected inflows of funds i. Strategic Risk 7. It is the ability to efficiently accommodate deposit. Unfortunately it isn‘t an isolated risk like credit or market risk. Credit Risk 4. 2. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits. The funding risk arises from the need to replace net outflow due to unanticipated withdrawal or non. Reputation Risk 6. Interest Rate Risk 5.3. Liquidity risk is financial risk due to uncertain liquidity. Operational Risk LIQUIDITY RISK Liquidity risk is part and parcel for every banking institution. 3. to fund the loan growth and possible funding of the off balance sheet claims. Suppose a firm has offsetting cash flows with two different counterparties on a given day. Here. Liquidity Risk also arises from the long term funding of long term assets by the short term liabilities. The liquidity risk of banks arises from funding of long-term assets by short-term liabilities thereby making the liabilities subject to refinancing risk.

For measuring and managing net funding requirements the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The key ratios adopted across the banking system are:  Core Deposits/Total Assets Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits  Volatile Liabilities/Total Assets Where volatile liabilities = Demand + Term deposits of other banks  Short term assets/Total Assets Where short term assets = Cash & Bank balance + Receivable + Bills Receivable + Short term/demand advances Credit Deposit Ratio Credit Deposit Ratio = Loans & Advances/Total Deposits This is a popular measure of the liquidity position of banks. Higher Deposit Ratio indicates poor liquidity position of the bank while lower figures indicate more comfortable liquidity positions. Investments/Total Assets This ratio is highest for public sector banks reflecting the higher levels of conservatism in their policies.Liquidity measurement is quite a difficult task and can be measured though stock or cash flow approaches. Analysis of liquidity involves tracking of cash flow mismatches. which are operating generally in an illiquid market. 1 to 14 days 15 to 28 days 12 . This is because investments are mainly government securities and other forms of relatively less risky instruments as compared to loans and advances. The liquidity ratios are the ideal indicator of liquidity of banks operating in developed markets as the ratios do not reveal the intrinsic liquidity profile of Indian banks. which entail a high level of risk. 2. The assets and liabilities are classified in different maturity buckets: 1.

A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Book-value accounting is generally used. Such an analysis can be supplemented with stress testing. Most financial firms including banks use a variety of metrics to monitor the level of liquidity risk to which they are exposed. the firm maintains liquid instruments on its balance sheet that can be drawn upon when needed.e whenever bank depositors come to withdraw their money) and asset side reasons (which arise as a result of lending commitments).liability side reasons (i.) 13 . the firm may maintain a pool of unencumbered assets (usually government securities) that can be used to obtain secured funding through repurchase agreements and other secured facilities. 7. credit and other risks. so the issue of day-to-day performance is not material. comprehensive metrics of liquidity risk don't exist. Because of its tendency to compound other risks. Liquidity risk has to be managed in addition to market. liabilities and off –balance sheet items. Liquid Assets Approach Under the liquid assets approach. 1. In all but the most simple of circumstances. Any day that has a sizeable negative net cash flow is of concern. it is difficult or impossible to isolate liquidity risk. 29 days and up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years 8. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. 5. Strategies for managing Liquidity risk Business risk is managed with a long-term focus. 4.3. The basic approaches may be categorized into three types: the liquid assets approach. Techniques include the careful development of business plans and appropriate management oversight. The cash flows are placed indifferent time bands based on future behavior of assets. The risk arises because of two reasons . The difference between cash inflows and outflows in each time period the excess of deficit of funds becomes the starting point for the measure of a banks future liquidity surplus or deficit at a series of points of time. Certain techniques of asset-liability management can be applied to assessing liquidity risk. and a mixture of the two. The focus is on achieving a good return on investment over an extended horizon. the cash flow approach. (The relevant metrics in this approach are ratios. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. The cause and effect of liquidity risk is primarily linked to nature of assets and liabilities of a bank. As a variation on this approach. 6.

while less liquid assets are counted in later time buckets. RBI have decided to reduce the requirements of a minimum of 85 percent of the CRR balance to 65 percent with effect from beginning May 6. Liquidity requirements: This arises from a liquidity mismatch. a lagged reserve system has been introduced effective November. With a view to provide further flexibility to banks and enable them to choose an optimum strategy of holding reserve depending upon their intra-period cash flows. The CRR currently as on 31st march 2004 was 4. Speculation 14 . Assets that are most liquid are typically counted in the earliest time buckets. With this. This is what happened during the run-up to the credit policy in March 2000. Factors that affect its demand: Cash Reserve Ratio As per the RBI Act 1934.75% of the anticipated total demand and time liabilities. 3. leading to high call rates. As more banks resort to such borrowing. This system provides maneuverability to banks to adjust their cash reserves on a daily basis depending upon intra fortnight variations in cash flows. CRR is to be maintained on an average daily basis during a reporting fortnight by all scheduled banks. demand for money in that market shoots up. This has resulted in smoother adjustment of liquidity between surplus and deficit units and enables better cash management by banks. When a bank falls short of its CRR requirement. it resorts to borrowing from the call market. the firm attempts to match cash outflows against contractual cash inflows across a variety of near-term maturity buckets. which forces banks to borrow for the very short term. 2000. banks are able to assess their liability positions and the corresponding reserve requirements. For the computation of CRR to be maintained during the fortnight. That placed them in a corner so far as meeting CRR requirement was concerned.2. Banks had invested their surplus cash in government securities. 1999 whereby banks have to maintain CRR on the net demand and time liabilities (NDTL) of the second preceding fortnight. repurchase agreement or other secured borrowing. Mixed Approach The mixed approach combines elements of the cash flow matching approach and the liquid assets approach. Cash Flow Matching Approach Under the cash flow matching approach. The firm attempts to match cash outflows in each time bucket against a combination of contractual cash inflows plus inflows that can be generated through the sale of assets.

Third. The call money was ruling tight following advanced tax outflows from the market. In this way. these banks borrowed at 6%. for instance. Arbitrage Banks have also started taking advantage of the arbitrage opportunity between the call money and the Government securities market. In January 1999. the ‘forward clean price of the bonds’ is set in advance at a level which is different from the ‘spot clean price by’ adjusting the difference between repo interest and coupon earned on the security. 15 . Second. borrow again in the call market at the higher rate and repay the earlier loan. 5-6 % and deploy the proceeds to speculate on the rupee dollar moments in the forex market.5% .5% .9. attract deposits from small savers to fund the loan repayment. In March 2003. The RBI has banned banks from borrowing in call and trading in the forex market. Banks borrow call money at say.That is. with inter bank call rates hovering around 6 % and the current yield on Government securities ranging from 8. It was forced to take this step. Repo Market Repo is a money market instrument. The money put in the CRR is invested in government securities at the current yield of 8. the borrowing banks in the money market had an opportunity to make money. Policy Variables Just before any policy announcement. In case of a repo.3. wanting to profit from any arbitrage opportunities between the forex and money markets. as it had to repay loans on calls and rates in that market which shot up to a high of 140%. the overnight rates (or the call rates) seem to be very volatile largely due to an expectation of a fall in interest rate. First. If the call rates in the meanwhile shoot up the borrowing banks have three options.5 %. Given the general bias on rupee depreciation.5%. which enables collateralized short term borrowing and lending through sale / purchase operation in debt instruments. Mostly banks resort to the third alternative by hiking deposit rates.5% over various maturities. banks earn an arbitrage of around 2.9. these banks invariably profit from the cross-market deployment. In the money market this transaction is nothing but collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate. Under a repo transaction a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. sell dollars in the market and buy rupees to repay the loan. In order to maintain the cash reserve ratio requirements.5 % . bank raised its short-term deposit rate to about 18% per annum.

The banks. It is also appropriate as the financial markets move towards indirect instruments. The banks could Borrow up to 25 basis points of the fortnightly average outstanding aggregate deposits in 16 . in a reverse repo the buyer trades money for the securities agreeing to sell them later. Hence whether transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction.Secs. It was recommended by the Narasimhan Committee Report on the Banking Reforms and was announced in the Monetary and the Credit policy for the year 2000-2001. The LAF operates though repo (for absorption of liquidity) reverse repo (for injection of liquidity) to set a corridor for money market interest rates. A reverse repo is the same operation but seen from the other point of view.  Liquidity Adjustment Fund (LAF) The aim of the Liquidity Adjustment Facility (replacing Interim Liquidity Adjustment Facility) is to improve the operational flexibility and the effectiveness of the monetary policy. the buyers. The existing Fixed Rate Repo will be discontinued.  Interim Liquidity Adjustment Facility (ILAF) RBI had introduced collateralized lending against government securities as Interim Liquidity Adjustment Facility (called Collateralized Lending Facility) to provide liquidity support to banks in replacement of the General Refinance. When the reverse repurchase transaction matures the counter party returns the security to the entity concerned and receives its cash along with a profit spread. One factor that encourages an organization to enter into reverse repo is that it earns some extra income on its otherwise idle cash. At present. which hold a large inventory of bonds and G. Using the securities as collateral they borrow using repo. As for the likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate in stages to the earlier levels. So also the liquidity support extended to all commercial banks (excluding RRBs) and Primary dealers though Additional Collateralized Lending Facility (ACLF) and finance/reverse repo under level II respectively will be withdrawn. Substitutability of the Call money market and the Repo market The rise in the call money rates often forces met borrowers in the money market such as private banks today to increasingly resort to repo (short for sale and purchase agreement) of Government securities for their financing requirements rather than borrowing from overnight call money market. use repo to amass additional funds. the RBI regularly conducts only a three/four day fixed repo.In other words the inflow of cash from the transaction can be used to meet temporary liquidity requirement in the short-term money market at comparable cost.

” and available credit lines. the extent of reliance of secured sources of funding. This risk is generally very hard to quantify. often simply called as liquidity risk. “buying power. Trading-related liquidity risk. including the ability to access public market such as commercial paper market. temporarily. However during the period of availing the CLF or ACLF the banks continue to participate in the money market. For purpose of monitoring liquidity risk RBI requires banks to disclose a statement on maturity pattern of their assets and liabilities classified in different time buckets. export credit refinance. Additional collateral (called Additional Collateralized Lending Facility) of similar amount was also made available to banks at 200 basis points over bank rate. The ILAF served its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of interest. Liquidity risk comprises of: 1. 1. It may reduce an institution’s ability to manage and hedge market risk as well as its capacity to satisfy any shortfall on the funding side through asset liquidation. Investments in corporate and government debt are combined into one category and bucketed according to their time to maturity. It provided a ceiling and the Fixed Rate Repo were continued to provide a floor for the money market rates. the terms of financing. collateralizedlending facilities. Assets consist of loans and advances and investments. margin. If the transaction cannot be postponed its execution my lead to substantial losses on position. and the breadth of funding sources. Funding can also be achieved through cash or cash equivalents. The funds from this facility used by the banks for their day – to day mismatches in liquidity.1997-98 at the bank rate for a period of two weeks. no appetite for the deal on the other side of the market. In April 1999. MARKET RISK 17 . 2. Liabilities consist of deposits and bank borrowing classified into different time buckets. an Interim Liquidity Adjustment Facility was introduced pending further up gradation in technology and legal/procedural changes to facilitate electronic transfer and settlement. Funding liquidity risk is affected by various factors such as the maturities of the liabilities. CLF and ACLF availed for periods beyond two weeks were subject to penal rate of 200 basis points for the next two weeks. to meet the cash. Trading-related liquidity risk: Trading-related liquidity risk. is the risk that an institution will not be able to execute a transaction at the prevailing market price because there is. The ILAF was operated through a combination of repo. Funding liquidity risk: Funding liquidity risk relates to a financial institution’s ability to raise the necessary cash to roll over its debt. Funding liquidity risk 2. and (in the case of funds) to satisfy capital withdrawals. and collateral requirements of counterparties.

etc. Price Risk is closely associated to the trading book. An effective market risk management framework in a bank comprises risk identification. Market Risk is the risk to the bank's earnings and capital due to changes in the market level of interest rates or prices of securities. 2. The Middle Office appraises top management/ALCO/Treasury about adherence to risk parameters and aggregate total market risk exposures.—to assess their exposures. Thus. foreign exchange and equities. commodity price risk and equity price risk. In other words. which is created for making profit out of short term movements in the interest rates. risk monitoring. the banks set up an independent middle office (comprises of experts in market risk management. focus on the management of Liquidity Risk and Market Risk. On a tactical level. value-at-risk is being used to define and monitor these limits. beta. further categorized into interest rate risk. It is a risk of adverse deviation of the mark to market value of trading portfolio due to the market movements during the period required to liquidate the transactions. Better product pricing. It is rightly said that “to win without risk is to triumph without glory”. Some organizations also apply stress testing to their portfolios Management of Market Risk is the major concern of top management.Market risk consumes about nearly 25% of the risk capital in the bank. It occurs when the assets are sold before their stated maturities. the Greeks. procedures. and prudential risk limits. The Treasury Department is separated from middle office and is not involved in day to day work. it should be ensured that the bank is not exposed to Liquidity Risk. etc. 3. models of analysis that value positions or measure market risk. it is equally concerned about the bank's ability to meet its obligations as and when they fall due. traders and portfolio managers employ a variety of risk metrics —duration and convexity. Thus. Benefits of Market Risk The effective measurement of market risk benefits the banks in the following ways: 1. reporting and auditing systems. 18 . Market risk is managed with a short-term focus. setting up of limits and triggers. On a more strategic level. Moreover. Increasingly. economists. The Bank for International Settlements (BIS) defines market risk as “the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by movements in equity and interest rate markets. Besides. currency exchange rates and commodity prices". Efficient allocation of the capital to exploit the different risks or rewards pattern. review mechanisms. It is also referred to as Price Risk. foreign exchange risk. The board clearly articulates market risk management policies. There is reduced earnings volatility. organizations manage market risk by applying risk limits to traders' or portfolio managers' activities. Long-term losses are avoided by avoiding losses from one day to the next. risk reporting. as well as the volatilities of those changes. The Asset Liability Management Committee (ALCO) functions as the top operational unit for managing the balance sheet within the risk parameters laid down by the board. statisticians) to track the magnitude of market risk on a real time basis. These allow them to identify and reduce any exposures they might consider excessive. bankers.

Reflect price volatility and correlation between prices. For example. It is thus a probability of the occurrence and hence it is a statistical measure of the risk exposure.100000 can be described to have a daily value at risk of Rs. 10 million at the 99% confidence level. have very different market values and risk exposures. Moreover. which means there is 1/100th chance of loss exceeding Rs. For e. given a specified level of probability (known as the “confidence level”) Value at risk is a measure of market risk. a set of portfolio having current value of say Rs. Value At Risk (VaR): Value at risk can be defined as the worst loss that might be expected from holding a security or portfolio over a given period of time (say a single day. if we say that a position has a daily VaR of Rs. with one option being in the money and the other one out-of-the-money. the quest for better and more accurate measure of market risk is ongoing. The notional approach measures risk as the notional. which measures the maximum loss in the market value of the portfolio with a given confidence. 10 days for the purpose of regulatory capital reporting). two to three days each year). It has evolved from the simple indicators. we mean that the realized daily losses from the position will. or the sum of the notional values of the holdings for a portfolio.5000 at 99% confidence level. There is increase in the shareholders value Managing the Market Risk in the Banks: The measurement of risk has changed over time. which is often small. there are often very large discrepancies between true amount of market exposure. The Notional Amount Approach: Until recently.5000 considering there are no shifts in the underlying factors.. amount of a security.g.e. VaR is denominated in the units of currency or as a percentage of the portfolio holdings. For example.4.VaR offers probability statement about the potential change in the value of a portfolio resulting from a change in the market factors. There are various methods of measuring the market risks: 1. on average. or nominal. be higher than Rs. 19 . 10 million on only one day every 100 trading days (i. 1. This method is flawed since it does not: • • Differentiate between short and long positions. each new market turmoil reveals the limitations of even the most sophisticated measure of market risk. in the case of derivative positions in the over the counter market. such as Face value/ Notional amount for an individual security to the latest methodologies of computing VaR. and the notional amount which may be huge. over a specified period of time. trading desks in major banks were allocated economic capital by reference to notional amount. two call options on the same underlying instrument with the same notional value and same maturity.

arises from the banks' dealings with or lending to a corporate. Credit risk may take various forms. But credit portfolio is the real dynamic activity that requires close monitoring and continuous management. that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases. Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of public sector banks. In the case of guarantees or letters of credit. however. that funds will not be repaid. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. that the availability and free transfer of currency is restricted or ceases. that funds will not be forthcoming from the customer upon crystallization of the liability under the contract. individual. In the case of treasury products. 1 Board and Senior Management’s Oversight 20 . financial institution or a country.CREDIT RISK Credit risk is the oldest and biggest risk that a bank. Deposit mobilization & Credit deployment constitute the core of banking activities and substantial portion of expenditure and income are associated with them. acceptance. Bank optimizes utilization of deposits by deploying funds for developmental activities and productive purposes through credit creation process. measurement. In the case of cross-border exposure. This has. a) Board and senior Management’s Oversight b) Organizational structure c) Systems and procedures for identification. another bank. there may not be anything very alarming. therefore. by virtue of its very nature of business. inherits. that settlement will not be effected. In the case of securities trading businesses. monitoring and control risks. COMPONENTS OF CREDIT RISK MANAGEMENT Credit risk management framework broadly categorized into following main components. Foremost among them is the wind of economic liberalization that is blowing across the globe. Credit risk. forgeries & loss. In the case of deposits. India is no exception to this swing towards market-driven economy. acquired a greater significance in the recent past for various reasons. baring few stray instances of operational risks linked to the system and human failure culminating in fraud. such as: • • • • • In the case of direct lending.

Risk identification. etc. complexity and diversification of its activities. depending upon its size. measurement. It must facilitate effective management oversight and proper execution of credit risk management and control processes. Ensure that the bank implements sound fundamental principles that facilitate the identification. consumer. The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get those approved from board. Detailed and formalized credit evaluation/ appraisal process. The responsibilities of the Board with regard to credit risk management include: 1. To keep it current. Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function 4. 3. Functions of CRMD: • To follow a holistic approach in management of risks inherent in banks portfolio and 21 . Such policies and procedures shall provide guidance to the staff on various types of lending including corporate. Credit approval authority at various hierarchy levels including authority for approving exceptions. 5. it is important that such structure should be commensurate with institution’s size. Risk acceptance criteria 5.It is the overall responsibility of bank’s Board to approve bank’s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank’s overall business strategy. Credit origination and credit administration and loan documentation procedures 6. preferably annually. Delineate bank’s overall risk tolerance in relation to credit risk. measurement. monitoring and control 4. the overall strategy has to be reviewed by the board. the importance of a sound risk management structure is second to none. should constitute a Credit Risk Management Committee (CRMC). 2. monitoring and control of credit risk. credit department and treasury. At minimum the policy should include. ideally comprising of head of credit risk management Department. SME. This committee reporting to bank’s risk management committee should be empowered to oversee credit risk taking activities and overall credit risk management function. While the banks may choose different structures. 1. 2. Ensure that bank’s overall credit risk exposure is maintained at prudent levels and consistent with the available capital 3. agriculture. Each bank. Ensure that appropriate plans and procedures for credit risk management are in place. Roles and responsibilities of units/staff involved in origination and management of credit Organizational Structure To maintain bank’s overall credit risk exposure within the parameters set by the board of directors.

Systems and Procedures Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing credits. The size of the limits should be based on the credit strength of the obligor.• • • • Ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee. the bank must make an assessment of risk profile of the customer/transaction. transfer of title of collaterals etc) in accordance with approved terms and conditions. Institutions may establish limits for a specific industry. Institutions are expected to develop their own limit structure while remaining within the exposure limits set by RBI. economic sector or geographic regions to avoid concentration risk. Disbursement should be 22 . Appropriate limits should be set for respective products and activities. genuine requirement of credit.  The purpose of credit and source of repayment.  Adequacy and enforceability of collaterals. Credit Administration: Credit administration unit performs following functions: 1.  The Proposed terms and conditions and covenants.  Approval from appropriate authority Limit setting An important element of credit risk management is to establish exposure limits for single obligors and group of connected obligors. Credit limits should be reviewed regularly at least annually or more frequently if obligor’s credit quality deteriorates. Credit Disbursement The credit administration function should ensure that the loan application has proper approval before entering facility limits into computer systems. and macro economic factors. monitoring of loan / investment portfolio quality and early warning. economic conditions and the institution’s risk tolerance. guarantees. Management Information System. 2. Outstanding documents should be tracked and followed up to ensure execution and receipt. The department also ensures that business lines comply with risk parameters and Prudential limits established by the Board or CRMC.  The track record / repayment history of borrower. The department would work out remedial measure when deficiencies/problems are identified. Establish systems and procedures relating to risk identification.  Assess/evaluate the repayment capacity of the borrower. Credits should be extended within the target markets and lending strategy of the institution. All requests of increase in credit limits should be substantiated. Documentation It is the responsibility of credit administration to ensure completeness of documentation (loan agreements. Before allowing a credit facility. This may include:  Credit assessment of the borrower’s industry.

A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio are evolving. To start with. Among other things. Procedures should also be established to track and review relevant insurance coverage for certain facilities/collateral. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. identifying early signs of irregularity. banks should establish a credit risk rating framework across all type of credit activities. Competitive Position (e.effected only after completion of covenants. Risk Rating Model Set up comprehensive risk scoring system on a six to nine point scale. 5. and receipt of collateral holdings. 7. Financial condition 2. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. incorporate:  Business Risk 1.Measuring Credit Risk The measurement of credit risk is of vital importance in credit risk management. In case of exceptions necessary approval should be obtained from competent authorities. conducting periodic valuation of collateral and monitoring timely repayments. Profitability 3. Maintenance of Credit Files Institutions should devise procedural guidelines and standards for maintenance of credit files. 6. Physical checks on security documents should be conducted on a regular basis. Credit monitoring After the loan is approved and draw down allowed. Proper records and updates should also be made after receipt. the loan should be continuously watched over. These include keeping track of borrowers’ compliance with credit terms. the rating framework may. 3. marketing/technological edge) 3. Loan Repayment The obligors should be communicated ahead of time as and when the principal/markup installment becomes due.Collateral and Security Documents Institutions should ensure that all security documents are kept in a fireproof safe under dual control. Present and future Cash flows Types of Credit Rating 23 . 8. Registers for documents should be maintained to keep track of their movement. Management  Financial Risk 1. 4. Industry Characteristics 2. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment performance. Rating migration is to be mapped to estimate the expected loss.g. Capital Structure 4.

quantitative analyses. qualitative. an investment recommendation concerning a given security. and legal analyses. 1. In the words of S&P. Financial institutions. Internal Credit Rating: A typical risk rating system (RRS) will assign both an obligor rating to each borrower (or group of borrowers). and labor relations. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should offer a carefully designed. “an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed-income security. and includes a through review of the firm’s competitiveness within its industry as well as the expected growth of the industry and its vulnerability to technological changes. there ratings are widely accepted by market participants and regulatory agencies.Credit rating can be classified as: 1.” In Moody's words. structured. regulatory changes. and documented series of steps for the assessment of each rating. Risk Rating Models Short term ratings CARE PR1++ PR11 PR22 PR33 PR4/PR55 UNRATEDD CRISIL P1++ P11 P22 P33 P4/P55 UNRATEDD FITCH F1++ F11 F22 F33 B/C/DD UNRATEDD ICRA A1++ A11 A22 A33 AR/A55 UNRATEDD 20% 30% 50% 100% 150% 100% Risk weights Under the New Basel II Accord. Standardized Approach 24 . when required to hold investment grade bonds by their regulators use the rating of credit agencies such as S&P and Moody's to determine which bonds are of investment grade. and a facility rating to each available facility.” Since S&P and Moody's are considered to have expertise in credit rating and are regarded as unbiased evaluators. Standardized Approach 2. based on relevant risk factors. The rating process includes quantitative. Advanced Internal Rating Based Approach. The qualitative analysis is concerned with the quality of management. or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation. a rating is. in general. 1. Foundation Internal Rating Based Approach and 3. Internal credit rating External Credit Rating: A credit rating is not. The quantitative analysis is mainly financial analysis and is based on the firm’s financial reports. assessment of Credit Risk can be carried out in any of the three approaches viz.” A credit rating is S&P's opinion of the general creditworthiness of an obligor. 2. External credit rating.

Similarly. Thus. This implies that for Rs.Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. claims on a corporate with below BB. Instead of assigning a uniform risk weight to all borrowers differential risk weights are assigned on the basis of external risk assessments by the external credit rating agencies (ECRA).13. exposure on public sector entities. Under this approach.rating will carry a risk weight of 150 percent and the capital requirement will be Rs.. RWA (Risk Weighted Assets) is determined as the counter parties are grouped into Sovereigns.50 crore (100 x 150% x 9%). it can take timely corrections. Banks and Corporate. securities firms and corporate also may have risk weights from 20 percent to 150 percent. Under Basel II exposure on a corporate with ‘AAA’ rating will have a risk weight of only 20 percent. This approach ensures that a bank knows the quality of its exposures to strengthen its capital base according to risks it takes. For Sovereigns. While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets. a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital. 9 crore. However. multilateral development banks. India has prescribed 9 percent.1. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B. other banks. the risk weights range from 0% to 100% and for banks and corporate the range is from 20% to 150%. 100 crore exposure on a ‘AAA’ rated corporate the capital adequacy will be only Rs. Exposure on retail portfolio may carry risk weight of 75 percent. Counterparty Sovereigns Credit assessment Risk weights AAA to AA0% A + to A BBB + to BBB BB + to B <Bunrated 20% 50% 100% 150% 100% 25 . It’s a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas.8 crore (100 x 20% x 9%) compared to the earlier requirement of Rs.

The bank should have reliable data on Probability of Default (PD). equity investment) banks are asked to foresee the possibility of a shift in the asset quality over a period of time which can be done by working out probability of default (PD). retail loans. On this basis a loan is deemed to be in default if it is classified as sub standard. Finally the loss to the bank depends on the value of Exposure at Default. Internal Ratings Based (IRB) Approach: Foundation and Advanced Approach. For estimating the PD time horizon is important. corporate. the risk weight function gives the following risk weight for given 26 . can use the IRB approach to measure credit risk on their own. Loss Given Default (LGD). which have developed reliable Management Information System (MIS) and have received the approval of the central bank. LGD and EAD. For corporate exposures. other banks. Risk components derived above are translated into risk weights called Risk Weight Function.Counterparty Corporate Credit assessment Risk weights AAA to AA20% A + to A 50% BBB + to BBB 100% BB + to B 100% <B150% unrated 100% Counterparty Credit assessment AAA to AAA + to A BBB + to BBB BB + to B <Bunrated Other Banks Risk weights 20% 50% 50% 100% 150% 50% Source: The Journal of Indian Institute of Banking and Finance Oct-Dec 2004 2. project finance. These estimates must be based on at least 1-year data sampled over a minimum of 4 quarters. The banks internal model is expected to produce reliable estimates of PD. IRB Approach is more sophisticated as in respect of each exposure (sovereigns. the probability of loss in the event of default (LGD) and the exposure at default. Loss given Default measures the extent of loss on a given exposure in the event of default. Banks. Probability of Default: A borrower is in default when the obligations to pay principal and interest are not met. It’s a fraction of total exposure whose exact value depends upon the extent of collateralization and expressed as a percentage of exposure. Exposure at Default (EAD) and effective maturity (M) to make use of IRB approach.

50% BPLR+ 0.00% BPLR+ 1.50% BPLR+ 3. LGD.75% BPLR+ 1.50% BPLR+ 3. Example of Union Bank of India:In UBI.25% BPLR+ 1.25% BPLR+ 0. 01.25% BPLR+ 1.e.75% BPLR+ 2.50% Managing Credit Risks  Credit Derivatives The banks can make use of various credit derivative instruments to reduce the credit risk associated with its loan portfolio.25% BPLR+ 0.75% BPLR+ 3.04. Each calculated risk weight RWC is multiplied by the corresponding EAD and aggregating over all exposure categories yields an estimate of RWA for credit. ({LGD/50}*BC. a business receiving Credit Rating above level 6 are not considered good from point of investment and thus are avoided.e.25% BPLR+ 2.09 Term loan BPLR BPLR+ 0. a 75% loss given default is written as 75) while BC is a benchmark risk weight for corporate prescribed by the supervisor based on statistical calibration and related to PD.PD.5*LGD) Here. EaD RWC = Min. LGD is expressed as a whole number (i. Rating Working capital CR-1 CR-2 CR-3 CR-4 CR-5 CR-6 CR-7 CR-8 >90 86-90 81-85 76-80 71-75 61-70 51-60 50 & below Score Revised w.75% BPLR+ 1.f. 12. For example removing a pool of loans from banks balance 27 .75% BPLR+ 3.

 Credit Options Credit Options guards against losses in the value of a credit asset or helps to off set higher borrowing cost that occur due to changes in credit ratings. only the risk of unexpected rating deterioration is passed onto investors. 28 . Earning perspective: In earning perspective. which are subject to interest rate adjustment within a specified period.e. The bank’s lending. while a long term impact is on bank’s net worth since the economic value of bank’s assets. a bank that has just made loans to some of its customers can sell these loans to other investors who take on the credit risks inherent in these loans. Thus. Each bank is granted the opportunity to further spread out the risk in its loan portfolio especially if the banks involved are located indifferent market areas.  Credit Swaps A Credit Swap is where two lenders agree to exchange portion of their customer’s loan repayments.  Securitization of loans: In case of Securitization selected loans are transferred to a company set up. funding and investment activities give rise to interest rate risk. the difference between the total interest income and the total interest expense. This is a traditional approach to interest rate risk assessment and obtained by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i. The securitizing bank provides liquidity facilities to make securities attractive for investors.” Consequently there are two common perspectives for the assessment of interest rate risk 1. Economic Value perspective: Economic Value perspective involves analyzing the expected cash inflows on assets minus expected cash out flows on liabilities plus the net cash flows on off-balance sheet items. liabilities and off-balance sheet exposures are affected. the focus of analysis is the impact of variation in interest rates on accrual or reported earnings. 2. A credit swap permits each institution to broaden the number of markets from which it collects loan revenue and loan principal thus reducing each bank dependence on one or narrow set of market areas. The securities are linked directly with the default risk of the tranche they securitize. the banks usually keep the ‘first loss piece’ on their own books which is equivalent to portfolio expected loss. Furthermore. The economic value perspective identifies risk arising from long-term interest rate gaps. Similarly. The immediate impact of variation in interest rate is on bank’s net interest income.sheet reduces or disposes of the banks credit risk exposures from these loans. INTEREST RATE RISK “Interest rate risk arises when there is a mismatch between positions.

The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. Changing rate relationships among different yield curves effecting bank activities(basis risk). banks can minimize the interest rate risk SOURCES OF INTEREST RATE RISKS: Interest rate risk occurs due to. 3. One such measure is Duration of market value of a bank asset or liabilities to a percentage change in the market interest rate. By reducing the size of the duration gap. 2. Basis Risk: It is the risk that the Interest rat of different Assets/liabilities and off balance items may change in different magnitude. To ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off. 1. Net interest position risk: 29 . Re-price risk: When assets are sold before maturities. . Embedded option Risk: Option of pre-payment of loan and Fore. 3. 6. The Asset Liability Committee (ALCO) of a bank uses the information contained in the duration gap analysis to guide and frame strategies. changing rate relationships across the range of maturities (yield curve risk). Types of Interest Rate Risks 1. Differences between the timing of rate changes and the timing of cash flows(re-pricing risk). To maintain earnings 2. 7. 4. 4. banks should begin evaluating the vulnerability of their portfolios to the risk of fluctuations in market interest rates. The difference between the average duration for bank assets and the average duration for bank liabilities is known as the duration gap which assesses the bank’s exposure to interest rate risk. In order to manage interest rate risk. 5. Yield curve risk: Movement in yield curve and the impact of that on portfolio values and income. Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested. 2.Objective of Interest Rate Risk Management 1. 3. Ability to absorb potential loss 4. Gap/Mismatch risk: It arises from holding assets and liabilities and off balance sheet items with different principal amounts.closure of deposits before their stated maturities constitute embedded option risk. maturity dates & re-pricing dates thereby creating exposure to unexpected changes in the level of market interest rates. Improve the capability. Interest-related options embedded in bank products (options risk).

Interest Rate Risk Management While rising interest rates make banks vulnerable to treasury losses. realized substantial profits from their holdings of government securities. banks have. Banks manage interest rate risk through a number of measures. Moreover. Banks are required to follow conservative accounting practices in respect of unrealized capital gains on their investment portfolio and have constituted latent reserves. Finally. 30 . This statement is required to be reported to board of directors of bank and to RBI (not to public). There are different techniques such a a) The traditional Maturity Gap Analysis to measure the interest rate sensitivity. banks can adjust their behavior to offset treasury losses by adequately managing their asset-liability mismatch. thanks to the soft interest rate environment. January 2005 RBI has initiated two approaches towards better measurement and management of interest rate risk and made the mandatory requirement that time to re-pricing or time to maturity to create ‘interest rate risk statement’ should classify assets and liabilities. banks in India have been encouraged to build up investment fluctuation reserves as a cushion against interest rate risk. b) Duration Gap Analysis to measure interest rate sensitivity of capital. in recent years. Banks could (i) reduce the duration of their assets by selling long-dated government securities. (iii) Increase the contribution of fee-based income to operating income. banks in India have a number of lines of defense. First. (ii) Reduce their holdings of government securities and increase their loan books by building on the recent high growth in consumer credit and infrastructure.When banks have more earning assets than paying liabilities. net interest position risk arises in case market interest rates adjust downwards. c) Simulation and d) Value at Risk for measurement of interest rate risk. S a eo B n in S c r in h r f a k g e to In r s R t R k te e t ae is 1% 1 3 % PB Ss P a Sc r riv te e to Bn ak 8% 6 F re nS c r o ig e to Bn ak S are o B h f ankin S g ecto in total rs G-S In tm t ec ves en 1% 4 5 % P B S s P a S cto riv te e r Bn ak 8% 1 F re n S cto o ig e r Bn ak Source: IBA Bulletin. In addition RBI has created a requirement that banks have to build up Investment Fluctuation Reserve (IFR) using profits from sale of government securities in order to better cope with potential losses in future.

Management fosters a sound culture that is well supported throughout the organization and has proven very effective over time. local self-government. The Bank manages reputation risk with the aim to bring potential losses down. Any deficiencies in management information systems are minor. 7. The Bank adequately self-policies risks. Management has a good record of correcting problems. Management understands privacy issues and generally uses customer information responsibly.  High 1. 3. Exposure from reputation risk is expected to remain low in the foreseeable future. participants of the financial market. 4. Internal control and audit are generally effective. Exposure is not expected to increase in the foreseeable future. Administration procedures and processes are satisfactory. 4. and the number of affected transactions. 3. Losses from fiduciary activities are low relative to the number of accounts. 5. 2. the Bank unions (association). preserve and maintain the Bank’s reputation among customers. This risk may be exposed the financial loss or a decline in a customer based or decline in the reputation of business. The exposure of franchise value from reputation risk is controlled. 6. The Bank does not regularly experience litigation or customer complaints. Management does not anticipate or take timely or appropriate actions in response to changes of a market or regulatory nature. This affects the institution’s ability to establish new relationships or services or continue servicing existing relationships. Aggregate Level of Reputation Risk Indicators: The following indicators should be used when assessing the aggregate level of reputation.  Moderate 1. Management anticipates and responds well to changes of a market or regulatory nature that impact its reputation in the marketplace. Internal control and audit are fully effective 5. in which the Bank participates. Management has a clear awareness of privacy issues and uses customer information responsibly. and customer complaints are manageable and commensurate with the volume of business conducted. counteragents. 6. The Bank effectively self-policies risks. Franchise value is only minimally exposed by reputation risk. the volume of assets under Management. “Reputation risk is the risk to earning or capital arising from negative public opinion of the bank”. state governmental authorities. 7. 2. The Bank has avoided conflicts of interest and other legal or control breaches. shareholders. 31 . failure to serve the credit needs of their communities or for other reasons.  Low 1.REPUTATION RISK Reputation risk is arising from negative public opinion. losses. The level of litigation. self-governed organizations. Negative public opinion can arise from poor service. Management adequately responds to changes of a market or regulatory nature that impact the institution’s reputation in the marketplace.

Management is not aware and/or concerned with privacy issues and may use customer information irresponsibly. and other legal or control breaches may be evident. OPERATIONAL RISK Operational risk is faced by all organizations in one way or the other. The Bank uses the following methods of strategic risk management:  Business planning. or the number of affected transactions. large dollar losses.  Financial planning. 4. 5.. conflicts of interest. procedures. administrative. The exposure to Operational risk depends upon the complexity of the Organization.  The system of authorities and decision-making. and enhancing infrastructure (e. Weaknesses may be observed in one or more critical operational. or a high volume of customer complaints.  Market analysis. Management information at various levels exhibits significant weaknesses. “Strategic risk is the risk to earnings or capital arising from making bad business decisions that adversely affect the value of the bank. or investment activities. Strategic risk is the risk associated with the financial institution’s future business plans and strategies. This risk category includes plans for entering new business lines. improper implementation of decisions of lack of responsiveness to industry change. Management has either not initiated.” Strategic risk is the risk of losses of the credit organization as a result of mistakes made (imperfections) in taking decisions. The Bank manages reputation risks by  The system of marginal values (limits).2. Internal control or audits are not effective in reducing exposure. 7. Operational risk would arise due to deviations from normal and planned functioning of systems. Poor administration. or has a poor record of. The institution’s performance in self-policing risk is insufficient.  Readjustment of plans. corrective action to address problems. Franchise value is substantially exposed by reputation risk shown in significant litigation.  The system of minimization and control STRATEGIC RISK Strategic risk is a risk arising from adverse business decisions. This not only affects the revenue of the organization but also cost it in terms of opportunities loss that would be otherwise feasible. The potential exposure is increased by the number of accounts.g. 6. Basel Committee has defined 'Operational Risk' as follows 32 . Exposure is expected to continue in the foreseeable future. physical plant and equipment and information technology and networking). 3.  The system of reputation risk monitoring. technology and human failures of omission and commission. expanding existing services through mergers and acquisitions. the volume of assets under Management.

 External causes: natural disasters. key man. Since late nineties in India. or from external events". For e. Impact of various forms of operational risk on the organization may vary in degree i. Classifications based on 'Causes' and 'Effects' are listed below. insufficient training. 1. Need For Operational Risk Management The criticality of operational risk in the functioning of banks has to be viewed in the context of changes that has taken place in the banking industry. Operational risks in the Organization continuously change especially when an Organization is undergoing changes. the computerization of banks which took place slowly in Indian banking industry. new and until then unknown factors may add to operational risks. In the present context of fast changing environment and work practices.. If operational risks are managed well. the time required to stabilize systems and procedures is not enough. Both have a favorable impact on competitive edge. operational failures of a third party.g. some risks may have more potential of causing damages while some may have less potential. Driven by deregulation and need to become globally competitive. organizational complexity. Types Operational Risk Operational risk arises from almost all the activities undertaken and consequently it is everywhere in an Organization. lack of management supervision. deteriorated social or political context. That is classifications based on causes that are responsible for operational risks or classifications based on effects of risks were suggested. CAUSE BASED  People oriented causes: negligence. As the activities of an organization changes in response to market and competition. Therefore. Some are high occurrence low value risks. So.  Technology oriented causes: poor technology and telecom. poor design. integrity.  Process oriented (Transaction based) causes: business volume fluctuation. this risk needs to be factored in and taken into account in the banking business. the banks have made tremendous technological advances. In the process of perfecting the systems and procedures banks may have faced operational losses but as the changes were only few and far between. systems had time to stabilize. brought in a plethora of new financial products. obsolete applications. proper management of operational risks is an imperative. Basic motivation for management of operational risk stems from it. people and systems. incompetence. and are catering to a very large volume of customers on several platforms.“The risk of loss resulting from inadequate or failed internal processes. there has been a remarkable change in the functioning of banks. information system complexity. The time tested systems and procedures in traditional banking were developed over several decades. 33 . inadequate procedures. systems and procedures and human adaptation of the changes create operational risks inherent in the banking business. while some are low occurrence high value risks. the rewards are available by way of lesser risk capital and cost reductions in operations. lack of automation. Accordingly. and major changes. Basel II suggested classification of operational risks based on the 'Causes' and 'Effects'. as banks respond to the needs of competition. development and testing. product complexity.  Process oriented (Operational control based) causes: inadequate segregation of duties. Operational risks vary in their components. some may occur more frequently while some may occur less frequently.e.

Out of 10 first 7 are relevant at the organization level. which involves at least one internal party. health or safety laws or agreements from payment of personal injury claims. from relations with trade counterparties and vendors OPERATIONAL RISK MANAGEMENT (ORM) PRACTICES Basel II document provides guidelines for operational risk management practices. or from diversity/ discrimination events.  Clients. misappropriate property or circumvent the law. Principle 1 Board of directors' should be aware of the major aspects of bank's operational risk as a distinct risk category that should be managed.  External Fraud Losses due to acts of a type intended to defraud. compliance and taxation penalties  Loss or damage to assets  Restitution  Loss of recourse  Write downs However. They are listed below. or from the nature or design of a product. Out of remaining three. misappropriate property or circumvent regulations. delivery and process management Losses from failed transaction processing or process management. two are relevant to regulators/supervisors and one related to disclosure requirements have not been reproduced.  Damage to physical assets Losses arising from loss or damage to physical assets from natural disasters or other events. by a third party. EVENT BASED  Internal Fraud Losses due to acts of a type intended to defraud. products and business practices Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements). and it should approve and periodically review the bank's 34 .  Employment practices and workplace safety Losses arising from acts inconsistent with employment. the Third Consultative Paper recommended for event based classification. These are called 'Sound Practices for the Management of Operational Risks'. excluding diversity/ discrimination events.EFFECT BASED  Legal liability  Regulatory. the law or company policy.  Business disruption and system failures Losses arising from disruption of business or system failures  Execution.

directly or indirectly.ORM (Operational Risk Management) framework. Principle 4 Banks should identify and assess OR inherent in all material products. Principle 7 Banks should have in place contingency and business continuity plans to ensure their ability to operate on an ongoing basis and limit losses in the event of severe business disruption. The framework should provide a firm wide definition of operational risk and lay down the principles of how operational risk is to be identified. in light of their overall risk appetite and profile. procedures and practices related to operational risks. processes and procedures for managing operational risk in all of the bank's material products. Principle 8 Banking supervisors should require that all banks. Principle 2 The Board of Directors should ensure that the ORM framework is subject to effective and comprehensive internal audit by operationally independent and competent staff. Principle 3 Senior management should have responsibility for implementing ORM framework approved by board of directors. regular independent evaluation of a bank’s policies. Principle 9 Supervisors should conduct. processes and procedures to control/mitigate material operational risks. Banks should periodically review their risk limitation and control strategies and should adjust their operational risk profile accordingly using appropriate strategies. Supervisors should ensure that there are appropriate reporting mechanisms in place which allow them to remain apprised of developments at banks. 35 . regardless of size. processes and systems. monitor and control or mitigate material operational risks as part of an overall approach to risk management. and controlled/ mitigated. There should be regular reporting of pertinent information to senior management and the board of directors that supports the proactive management of operational risk. assessed. The internal audit function should not be directly responsible for operational risk management. Senior management should also have responsibility for developing policies. processes and systems. Banks should also ensure that before new products. processes and systems are introduced or undertaken. Principle 6 Banks should have Policies. the operational risk inherent in them is subject to adequate assessment procedures. assess. activities. Principle 5 Banks should implement a process to regularly monitor operational risk profiles and material exposures to losses. monitored. and all levels of staff should understand their responsibilities with respect to ORM. have an effective framework in place to identify. activities. The framework should be consistently implemented throughout the whole banking organization.

The Standardized Approach 3. asset management. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. Basel II has recognized this and has provided options in the measurement of operational risk for this purpose. including fees paid to outsourcing service providers. Equal to the average over the previous three years of a fixed percentage (15%) of positive annual gross income. payment and settlement. The advance measurement approach is based on operational loss measurement. This is because behavioral pattern of operational risk does not the statistically normal distribution pattern and that makes it difficult to estimate the probability of an event resulting in losses. for unpaid interest) . The Basic Indicator Approach 2. and retail brokerage. 2. 36 .g. banks' activities are divided into eight business lines: commercial banking. Corporate finance.Principle 10 Banks should make sufficient public disclosure to allow market participants to assess their approach to operational risk management Operational Risk Management Practices should be based on a well laid out policy duly approved at the board level that describes the processes involved in controlling operational risks. In addition. 1. and exclude extraordinary or irregular items as well as income derived from insurance. It should meet the standards set in terms of the principles mentioned above. The Standardized Approach In the Standardized Approach. Gross income is defined as net interest income plus net non interest income. The policies and procedures should also be communicated across the Organization. exclude realized profits/ losses from the sale of securities in the banking book. well laid down procedures in dealing with various products and activities should be in place. The Policy should cover  Operational risk management structure  Role and responsibilities  Operational risk management processes  Operational risk assessment/measurement methodologies Operational Risk Quantification The measurement of this risk is most difficult. 1. Advanced Measurement Approaches (AMA) Of these. gross of any provisions (e. retail banking. agency services. The Basic Indicator Approach Banks using the Basic Indicator Approach must hold capital for operational risk. trading and sales. gross of operating expenses. basic indicator approach and Standardized approach are based on income generated.

Use of the AMA is subject to supervisory approval.Within each business line. Implies low risk 37 . The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line (Beta Factors). The steps involved OP Profiling is:  Identification and quantification of operational risks in terms of its components  Prioritization of operational risks and identification of risk concentrations hot spots resulting in lower exposure. Advanced Measurement Approaches (AMA) Under the AMA. Business Lines corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset management Retail brokerage Beta Factors 18% 18% 12% 15% 18% 15% 12% 12% 3. gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. A Generic Measurement Approach The first step in measurement approach is operation profiling. Implies negligible risk 2. Probability is mapped on a scale of 5 say where 1.  Formulation of bank's strategy for operational risk management and risk based audit Estimated level of operational risk depends on  Estimated probability of occurrence  Estimated potential financial impact  Estimated impact of internal controls Estimated Probability of Occurrence This will be based on historical frequency of occurrence and estimated likelihood of future occurrence. the regulatory capital requirement will equal the risk measure generated by the bank's internal operational risk measurement system using the quantitative and qualitative criteria for the AMA discussed below.

it acquire broad brush structure.Basel II focuses on achieving a high degree of bank-level management.501 ^ 0. Implies very high risk Estimated Potential Financial impact This will be based on severity of historical impact and estimated severity of impact from unforeseen events. It allows banks 38 . regulatory control and market disclosure. which is valued at 100%. which is expected to be implemented by most countries by 2006. Estimated level of operational risk = Estimated probability of occurrence x Estimated potential financial impact x Estimated impact of internal controls In case of a hypothetical example where Probability of occurrence = 2 (Medium) Potential financial impact = 4 (very high) impact of internal controls = 50% Estimated level of operational risk = [( 2 x 4 x (1 0. Hence. it does not differentiate between sound and weak banks using “one hat fit all” approach. Implies medium risk 4.3. The structure of New Accord – II consists of three pillars approaches which are as follows: Pillar I Pillar II Pillar III Pillar Focus area Minimum capital requirement Supervisory review Market discipline Minimum Capital Requirement The major change in the first pillar is in measurement of risk weighting. This is estimated as fraction in relation to total control. in order to remedy the Basel Committee published a New Accord in Dec 2001. Estimated Impact of Internal Controls This will be based on historical effectiveness of internal controls and estimated impact of internal controls on risks. Probability is mapped on a scale of 5 as mentioned above.5 = 2.0 or 'Low' BASEL II COMPLIANCE & RISK BASED SUPERVISION ♦ BASEL II COMPLIANCE The 1988 Capital Accord suffered from several drawbacks as it exclusive focus on credit risk. Implies high risk 5.

There is also greater differentiation across risk categories. Thus D (denominator of the capital adequacy ratio) is defined as D =RWA + 12.certain latitude in determining their or own capital requirements based on internal models and focus on credit risk.basic indicator. Secondly a special type of capital (Tier3) is introduced for meeting market risk only. The first is a standardized approach in which RWA (risk weighted assets) is determined except that the risk weights are no longer determined in asset once but are revised depending upon the ratings of the counter parties by external credit rating agencies (ECRA). standardized and internal measurement approach. For meeting operational risk Accord II has specified three alternative approaches. In Advanced internal rating based approach the range of risk weights are well diverse.08(RWA +12. For operational risk capital charges are computed directly and then multiplied by 12. The minimal ration of capital assigned to risk is calculated as follows: Total Capital (unchanged) Bank’s Capital Ratio (min 8%) = ---------------------------------------------------------(RBI prescribes 9 %) Credit risk + Market risk + Operational risk For Credit Risks three alternative approaches are suggested.5 to make them comparable to the RWA.5{capital charges on account of operational risk}) 39 . Here capital charges are determined and then multiplied by 12. In the second approach called the internal ratings based approach (IRB) banks rates the borrower and results are translated into estimates of a potential future loss amount which forms the basis of minimum capital requirement.5 to make it comparable to RWA.5 * (Sum of capital charges due to market and operational risk) The numerator N consists of N = Tier I + Tier II + Tier III Subject to the proviso that Tier I + Tier II > 0. For Market Risks also a similar twin track approach is followed. market risk and operational risk.

 Reservations about Basel II  One of the major critiques of the New Basel Accord pertains to the adoption of an internal rating based (IRB) system as the application of IRB is costly.To meet market risk special type of capital viz. other banks will hold on to the standardized approach. 4) Its capital ratio and other data related to its capital adequacy on a consolidated basis.  Fears of disintermediation have also been expressed. 40 .  Basel II involve shift in direct supervisory focus away to implementation issues and that banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet minimum standards. In a recent paper the BIS has elaborated the recommendations of the Basel II concerning the nature of information to be disclosed: 1) Structure and components of bank capital. 3) Breakdown of risk exposures. 2) The terms and main features of capital instruments. Moreover. banks are encouraged to disclose ways in which they allocate capital among different activities. The process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on through evaluation of its risk. optimizes utilization of supervisory resources. Tier III capital has been introduced in the New Accord which consists of short term subordinated debt but with a minimum original maturity of 2 years. Market Discipline The potential of market discipline to reinforce capital regulation depends on the disclosure of reliable and timely information with a view to enable banks counter parties to make well founded risk assessments. Tier III capital cannot exceed 250% of the Tier I capital to meet market risk. Supervisory Review Process It entails allocation of supervisory resources and paying supervisory attention in accordance with risk profile of each bank. discriminates against smaller banks and exacerbates cyclical fluctuations. continuous monitoring and evaluation of the risk profiles of the supervised institution and construction of a risk matrix of each institution.  Only those banks likely to benefit from IRB will adopt approach.

automation and market disclosure / transparency.  Focus remains on transaction and asset valuation. 41 . The major features of current supervisory are:  Annual Financial Inspection (AFI) of banks.  Asset size determines the length of inspection. measures. Current Supervisory Approach The current on site inspection driven approach of RBI is supplemented by off site monitoring and surveillance system (OSMOS) and supervisory follow up. Focused approach under RBS entails allocation of supervisory resources and paying attention in accordance with the risk profile of supervised (bank) which would further optimize utilization of supervisory resources.RISK BASED SUPERVISION REQUIREMENTS Background RBI Governor in assistance with PriceWaterHouse Coopers (PWC) an international consultant laid an overall plan for developing Risk Based Supervision. The CAMELS (capital adequacy. increased competition. It provides an opportunity to the regulator to monitor banks performance based on CAMELS/CALCS approach. liquidity. systems & controls)/CALCS (capital adequacy. liquidity. Risk Based Supervision (RBS) – A New Approach RBS looks at how well a bank (supervised) identifies. controls and monitors risks. management. compliance with regulations and banking laws. asset quality. earnings. RBI decided to switch over to RBS due to autonomy of banks. tightening of exposure and enhancement in disclosure standards are all introduced by RBI to align the Indian banking system to International best practices. globalization. asset quality.  Focus of follow up remains on rectification rather than prevention.  All areas of banks operations are covered. compliance & systems) approach to supervisory risk assessments and ratings. It involves assessing and monitoring the risk profile of banks on an on going basis in relation to business and exposures and prompt banks to develop systems rather than transactions. It not only tries to identify systemic risks caused by the economic environment in which banks operate but also management ability to deal with them.

1) Risk Profiling of Banks: CAMELS rating is one of the core of risk profile compilation and 2) Supervisory Cycle: It varies according to risk profile of each bank. But with it comes great uncertainty of events making banks vulnerable in the market. Thus for all banks risk management becomes necessary to stay in the competition. strengthen MIS. It works as a comprehensive guide to RBI for informed and focused supervisory action in high-risk areas in banks. CONCLUSION In the today’s fierce competitive world. 42 . There should be well-defined standard of corporate governance. Risk profile document contains SWOT analysis. 3) Supervisory Program: It is prepared at the beginning of supervisory cycle. Risk management allows banks to access the actual as well as potential dangers. catalogues. Banking Sector is no exception to it. RPTs is defined as a standardized and dynamic document that captures. Although some risks cannot be avoided but they can be managed properly so as to cause less damage. RBI initiates banks to set up Risk Management Architecture. The banks have become more conscious about risk management as negligence may not only cost bank losing its profit but also it may wipe out the presence of the bank. assesses and aggregate risks that bank are exposed to. Features of RBS Approach the risk profiling of each bank draws upon a wide range of information such as market intelligence reports. 4) Supervisory Organization: It is the focal point for main conduit for information and communication between banks and RBI. Hence. Sensitivity analysis. On site inspection is targeted to specific areas and a MAP (monitorable action plan) is drawn up for follow up to mitigate risks to supervisory objectives posed by individual banks. the principle being higher the risk shorter will be the cycle of supervision. 5) Enforcement process and Incentive framework: RBS ensures that the banks with a better compliance record and a good risk management control system is entitled to an incentive package like longer supervisory cycle. Moreover. Monitor able action plan and banks progress to date. fix up supervisory cycle and supervisory tools. well-documented policies and practices with clear demarcation of lines of responsibility and accountability. adhoc data from external and internal auditors. banks that fails to show improvement in response to MAP is subject to frequent supervisory examination. whereas others can be avoided completely. adopts Risk Focused Internal Audit (RFIA). Moreover. The effectiveness of RBS depends on bank preparedness. onsite findings. each sector in the industry is undergoing revolution every now and then. In short term supervisory cycle remains at 12 months but it can be extended beyond 12 months for low risk banks. for effectiveness of RBS formation of separate Quality Assurance Team (QAT) should be there where members are not involved in preparation of Risk Profile Templates (RPTs).

If there exist a way of converting the subjectivity of the risk into a number then the balancing exercise would be meaningful and much easier. in to-to. the market economy is widening and breaking down barriers. Risk Management Committee. but to ensure that the risks are consciously taken with full knowledge. so as to ultimately improve the quality of the asset portfolio. risk control should actually take place at the functional departments as it is generally fragmented across Credit. in the process of providing financial services. commercial banks assume various kinds of risks both financial and non-financial. Functions of risk management should actually be bank specific dictated by the size and quality of balance sheet. What can be measured can mitigation is more important than capital allocation against inadequate risk management system. As such.Risk management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. Balancing risk and return is not an easy task as risk is subjective and not quantifiable whereas return is objective and measurable. Government’s role is not to block that flow. which continue to be deep routed in the philosophy of securities. clear purpose and understanding so that it can be measured and mitigated. communication. As in the international practice. Therefore. Banking is nothing but financial inter-mediation between the financial savers on the one hand and the funds seeking business entrepreneurs on the other hand. To the extent the bank can take risk more consciously. rather radically. The engine of the change is obviously the evolution of the market economy abetted by unimaginable advances in technology. a committee approach may be adopted to manage various risks. The objective of risk management is not to prohibit or prevent risk taking activity. Like a powerful river. Funds. Asset Liability Committee. to manage and mitigate the perceived risks. need to change the approach and mindset. but to accommodate it and yet keep it sufficiently under control so that it does not overflow its banks and drown us with the associated risks and undesirable side effects. based lending and investment policies. it becomes a source of competitive advantage. transmission of related uncontainable flow of information. etc are such committees that handle the risk management aspects. capital and commerce throughout the world. and Investment and Operational areas. Integration of systems that includes both transactions processing as well as risk systems is critical for implementation. 43 . There may not be one-size-fits-all risk management module for all the banks to be made applicable uniformly. It also prevents an institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position. banking practices. Credit Policy Committee. In a scenario where majority of profits are derived from trade in the market. one can no longer afford to avoid measuring risk and managing its implications thereof. Crossing the chasm will involve systematic changes coupled with the characteristic uncertainty and also the pain it brings and it may be worth the effort. anticipates adverse changes and hedges accordingly. Indian Banks have a long way to go before they comprehend and implement Basel II norms. technical/ professional manpower and the status of MIS in place in that bank. Given the data-intensive nature of risk management process. While a centralized department may be made responsible for monitoring risk. as it can offer its products at a better price than its competitors. complexity of functions. Basel proposal provides proper starting point for forward-looking banks to start building process and systems attuned to risk management practice.

as transformation and change are the only certainties of the future. With the onslaught of globalization and liberalization from the last decade of the 20th Century in the Indian financial sectors in general and banking in particular. An objective and reliable data base has to be built up for which bank has to analyze its own past performance data relating to loan defaults..2001. managing Transformation would be the biggest challenge.2001. The data warehousing solution should effectively interface with the transaction systems like core banking solution and risk systems to collate data. computerization and net working of the branch activities. BIBLIOGRAPHY  Basel Committee on Banking Supervision. “Working Paper on the Regulatory Treatment of Operational Risk” (September).  Basel Committee on Banking Supervision. and come out with bench marks so as to prepare themselves for the future risk management activities. trading losses.  Report: A Road map for Implementing an Integrated Risk Management System by Indian Banks by Mar 2005 (CRISIL) in IBA Bulletin (Jan 2004). “Sound Practices for the Management and Supervision of Operational Risk” (December). 44 . operational losses etc.The effectiveness of risk measurement in banks depends on efficient Management Information System. Any risk management model is as good as the data input.

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