You are on page 1of 66

RISK MANAGEMENT

Risk Management is
the
process of measuring or
assessing the actual or
potential
dangers
of
a
particular situation.

RISK MANAGEMENT
Types of Risk
Operational
Market
Credit

OPERATIONAL RISK
The risk of loss resulting from
inadequate or failed internal
processes,
people
and
systems, or from external
events. This includes legal
risk but excludes strategic &
reputational risk.
4

RISK
MANAGEMENT
OPERATIONAL
RISK
1. Internal Fraud.
Unauthorized Activity.
Transactions not reported.
Transaction type unauthorized.
Mismarking of position.
Theft and Fraud.
Fraud/credit fraud/worthless deposits.
Theft/extortion/embezzlement/robbery.
Misappropriation of assets.
Account take-over/impersonation.
Bribes/kickbacks.
Money laundering.

Willful blindness.
5

OPERATIONAL RISK
2.External Fraud.
Theft and Fraud.
Theft / Robbery.
Forgery.
Check kiting.
Elder financial abuse.
Systems Security.
Hacking damage.
Theft of information (with monetary loss).
6

OPERATIONAL RISK
3.Employment Practices and Workplace Safety :
Employee Relations.
Compensation, benefit, termination issues.
Organized labor issues.
Safe Environment.
General liability
Employee health and safety rules.
Workers compensation.
Diversity and Discrimination.
All discrimination types.
Harassment.
Equal Employment Opportunity (EEO).
7

OPERATIONAL RISK
4.Clients, Products and Business Practices :
Suitability, Disclosure and Fiduciary.

Fiduciary breaches/guideline violations.


Suitability/disclosure issues.
Retail consumer disclosure violations.
Breach of privacy/Lender liability.
Inadequate product offerings.
Misuse of confidential information.
Improper Business or Market Practices .
Improper trade /market practice.
Market manipulation.
Insider trading (on firms account).
Unlicensed activity/Money laundering.
8

OPERATIONAL RISK
4.Clients,

Products and Business Practices

(CONTINUED).
Selection, Sponsorship and Exposure.
Failure to investigate client as per guidelines.
Exceeding client exposure limits.
Advisory Activities.
Disputes over performance or advisory
activities.

OPERATIONAL RISK
5. Damage to Physical Assets :
Disasters and Other Events.
Natural disaster losses.
Human losses from external sources
(terrorism, vandalism).
6.Business Disruption and System Failures
Systems.
Hardware.
Software.
Telecommunications.
Utility outage/disruptions.
10

OPERATIONAL RISK
7. Execution, Delivery and Process Management.
Transaction Capture, Execution and Maintenance.
Miscommunication/Delivery Failure
Data entry, maintenance or loading errors.
Missed deadline or responsibility.
Accounting error
Record retention.
Documentation maintenance.
Collateral management failure.
Reference data maintenance.
contd.
11

OPERATIONAL RISK
Monitoring and Reporting.
Failed mandatory reporting obligations.
Inaccurate external loss (loss incurred).
Customer Intake and Documentation.
Unapproved access given to accounts.
Incorrect client records (loss incurred).
Negligent loss or damage of client assets.
Trade Counterparties.
Non-client counterparty misperformance.
Vendors and Suppliers.
Outsourcing.
Vendor disputes.
12

OPERATIONAL RISK
STEPS TO BE TAKEN BY BANKS :
To minimize operational risk & strengthen internal
control, the objective of the Bank is to develop an
appropriate
policy,
procedures,
strategy,
framework, and risk culture by adopting best
practices to achieve the goal set by the Bank.
To find out the extent of Banks Operational Risk
exposure and to allocate capital for operational
risk.

13

OPERATIONAL RISK
The New Capital Adequacy Framework outlines
three methods for calculating operational risk
capital charges for increasing sophistication
and risk sensitivity:
(i) the Basic Indicator Approach (BIA) - Under
this Approach, banks must hold capital for
operational risk equal to the average over the
previous three years of a fixed percentage
(presently 15% by BCBS) of positive annual gross
income (Net interest + Net non-interest income).
14

OPERATIONAL RISK
(ii) The Standardised Approach (TSA) : Banking
activities have been mapped into 8 business
lines: (on average gross income of last 3 yrs)
1.Corporate finance
2. Trading & Sales
3. Retail Banking
4. Commercial Banking
5. Asset Management
6. Retail brokerage
7. Agency service
8. Payment settlement . ( w.e.f. 30.09.2010)
15

OPERATIONAL RISK
(iii) Advanced Measurement Approaches (AMA)
Basel II - Banks can use this approach only
subject to approval from their local regulators :
Its board of directors and senior management, are
actively involved in the oversight of the
operational risk management framework;
It has an operational risk management system
that is conceptually sound and is implemented
with integrity; and
It has sufficient resources for use of approach in
major business lines, control & audit areas.
(Implemented by 31.03.2014)
16

OPERATIONAL RISK
Operational Risk Checklist :

17

Employee training.
Close management vigil.
Segregation of duties.
Employee background checks.
Procedures and process.
Purchase of insurance.
Exit from certain businesses.
Capitalization of risks.

MARKET RISK
Market risk is, risk of losses in onbalance sheet and off balance-sheet
positions arising from movements in
market prices. The market risk
positions subject to capital charge
requirement are :

18

MARKET RISK

19

(i)

The risks pertaining to interest rate


related instruments and equities in
the trading book

(ii)

Foreign
exchange risk
(including
open position in
precious metals) throughout the
bank (both banking
and trading*
books). [*Investment/securities]

MARKET RISK
RBI GUIDELINES :
Banks are required to manage the
market risks in their books on an
ongoing basis and ensure that the
capital requirements for market risks
are being maintained on a continuous
basis, i.e. at the close of each
business day.
20

MARKET RISK
MEASURES :
1. Prudential gap limits are fixed and reviewed
periodically for the liquidity and interest rate
risk of the banks books.
2. The ALM solution would encompass the
Global operations of the bank.
3. Behavioral studies shall continue to be done
for assessing and apportioning volatile and
non-volatile portion of various non-maturity
products of both assets and liabilities.
21

MARKET RISK

22

4.Minimum capital requirement be calculated


separately for (i) Specific Risk - charge for each
security to protect against an adverse movement in
the price of an individual security (Capital charge
for Capital Market Investments will be higher of
11.25% and Security Receipts 13.5% or 125% &
150% of Risk Wieght)
(ii)General Market Risk - charge towards interest
rate risk in the portfolio, where long and short
positions (which is not allowed in India except in
derivatives) in different securities or instruments
can be offset.(Starting 2.5% extra for HFT(Held for
Trading)/AFS(Available for sale) not now.

MARKET RISK
5. The banks Foreign Exchange Risk position in
each currency should be calculated by
summing : net spot position, net forward position,
Guarantees, Net future income/ expenses
(capital charge for foreign exchange risk and gold
open position presently is 9 per cent).
6.Duration gap analysis (measure the percentage
change in the economic value of a position)
continue to be carried out at Monthly (since April
2012 earlier Qtly) intervals to assess the interest
rate risk of both banking book and trading book.
23

MARKET RISK
7. Foreign Exchange risk be regularly monitored and
managed through exposure limits i.e. Day Light
Limit, Overnight Limit, Stop Loss limits, Inter Bank
Exposure Limits etc.
8. Maturity Position and Interest Sensitivity of Forex
Open positions are assessed on monthly basis and
put up to ALCO.
9. Bank may enter into Interest Rate Swaps (IRS) &
Forward Rate Agreement (FRA) selectively with the
objective of hedging actual balance sheet
exposures and to meet the requirements of
corporate clients.
24

MARKET RISK
10.VaR (Value-at-risk) a measure of the worst
expected loss over a given time interval under
normal market conditions at a given confidence
level shall be computed on the trading book of the
Investment Portfolio on daily basis
11.Earnings at risk (EAR) measure the quantity by
which net income might change in the event of an
adverse change in interest rates.
VAR looks at the change in the entire value over
the forecast horizon, EAR looks at potential
changes in cash flows or earnings.
25

MARKET RISK
12.RBI said : Banks should identify their major
sources of risk and carry out stress tests
appropriate to them, may be run daily or weekly,
monthly or at quarterly intervals. This stress testing
would also form a part of preparedness for Pillar 2
of the Basel II framework.
It is another modern risk management practice
which has found wide acceptability in Indian
Banking System, for determining the required
buffer size of capital is an important risk
management issue for banks
26

CREDIT RISK
Credit Risk is defined as the possibility of
losses associated with diminution in the credit
quality of borrowers or counter-parties. In a
banks portfolio, losses stem from:
1. Outright default due to inability or unwillingness
of a customer or counter-party to meet
commitments in relation to lending, trading,
settlement and other financial transactions.
2. Reduction in portfolio value arising from actual
or perceived deterioration in credit quality.
27

CREDIT RISK
Credit risk incorporates following three risks: Counterparty Risk: Risk to each party of a contract that
other party (or parties) will not live up to their obligations
under the contract. In most financial contracts,
counterparty risk is default risk i.e. failure to make
payments because of bankruptcy. To reduce the potential
of counterparty risk, margin is taken in the accounts.
Credit Spread Risk: It arises due to changes in the
credit quality of the obligor between a rating horizon.
Example - If credit quality of a borrower deteriorates after
last rating but before next rating becomes due, in that
case bank is not compensated for taking additional risk if
loan price is not revised. However, if the borrowers
credit quality improves between a rating horizon, it is
beneficial for the bank.
28

CREDIT RISK
Concentration Risk: Refers to additional portfolio risk by
increased exposure to one obligor or groups of correlated
obligors (e.g., by industry, by location, etc.). It includes:
Significant exposures to an individual counterparty or
group of related counterparties;
Credit exposures to counterparties in the same economic
sector or geographic region;
Credit exposures to counterparties whose financial
performance is dependent on the same activity or
commodity; and
Indirect credit exposures arising from a banks Credit Risk
Mitigation (CRM) activities (e.g. exposure to a single
collateral type or to credit protection provided by a single
counterparty).
29

CREDIT RISK MANAGEMENT


Credit risk management enables banks to identify,
assess, manage proactively, and optimise their credit
risk at the level of individual borrower as well as for
Bank as a whole.
The quality of the credit risk management function is
one of the key drivers of the level of shareholders
return. Industry analysis has demonstrated that the
average shareholder return of the best credit
performance US banks during 1989 1997 was 56%
higher than their peers.***
*** (Source: Guidance note on Credit Risk Management by RBI, dated
20.09.2001)
30

Expected Loss
The Expected Loss (in absolute terms)
EL = PD * EAD * LGD
If expressed in percentage terms of the EAD
EL = PD * LGD.
The bank should incorporate an expected loss rate in the
estimation of the total spread to be charged on the loan.
Expected Loss is the banks cost of doing business.
Expected loss is not a measure of risk as it is anticipated.
Probability of Default (PD)
Loss given Default (LGD)
Exposure at Default (EAD)

Unexpected Loss (UL):


Regardless of how prudent a bank is in managing
its day-to-day business activities, there are market
conditions that can cause uncertainty in the
amount of loss in portfolio value.
This uncertainty, or more appropriately the
volatility of loss, is the unexpected loss.
Unexpected losses are triggered by the
occurrence of higher default rates as a result of
unexpected credit migrations.
Mathematically, Unexpected Loss is the standard
deviation of the change in the asset value at the
end of the horizon. This implies that unexpected
loss is the estimated volatility of potential loss in
portfolio value around the expected loss.

Credit Management Vs Credit Risk Management


Credit Management

Credit Risk Management

It involves selecting and It involves identifying and


identifying
the
borrower/ analyzing risk in a credit
counter-party.
transaction.
It revolves around examining It revolves around measuring,
three Ps of borrowers:
managing and controlling credit
People, Purpose & Protection risk in the context of an
organization's credit philosophy
and credit appetite.
It is predominantly based on It is data driven, scientific and is
accounting information and more objective in nature.
Judgment and is subjective in
nature.
33

Tools for Credit Risk Assessment


The credit risk rating system and credit scoring
system provides a common language and uniform
framework across bank for assessing credit risk. The
system enables the bank to evaluate and track risk on
individual borrowers on a continuing basis.
Risk Rating models are mostly based on the
financials of the borrowers whereas credit scoring
models are based on the personal attributes of an
individual.

34

Advantages of Credit Rating or Credit Scoring


Credit Selection/Rejection
Evaluation of borrower in totality and of any particular
exposure /facility
Transaction level analysis and credit pricing & tenure.
Activity wise/Sector wise portfolio study keeping in
view the macro-level position.
Fixing outer limits for taking up/maintaining an
exposure arising out of risk rating.
Monitoring exposure already in the books and
deciding exit strategies in appropriate cases.

35

Advantages of Credit Rating (Contd)


Allocation of risk capital for credit sanctions.
Avoiding over concentration of exposure in specific risk
grades, which may not be major concern at a particular
point of time, but may in the future pose problems if the
concentration continues.
Clarity and consistency, together with transparency in
rating a particular borrower/exposure, enabling a proper
control mechanism to check risks associated in the
exposure.

36

Credit Risk Rating System


In order to create and stabilize robust credit risk management
system, bank has been continuously monitoring the ratings and
their migration. To provide a standard definition and benchmarks
under the credit risk rating system, seven rating grades for
performing loans have been specified.
To ensure the quality and consistency of credit risk ratings, vetting
of the rating is also done.
The credit risk rating of a borrower becomes due for updation
after the expiry of 12 months from the month of previous rating.
Thus fresh rating in the accounts is conducted annually.
Out of the seven rating grades, B and above are treated as
Investment Grade. The average annual default rates in these
rating grades is under 2%
37

38

Approaches to Credit Risk Management under


Basel II
INCREASED
SOPHISTICATION

Banks use internal


estimations of PD,
loss given
default
(LGD) and exposure at
default
(EAD)
to
calculate risk weights
for exposure classes
Banks use internal estimations
of probability of default (PD) to
calculate risk weights for
exposure classes. Other risk
components are standardized.

ADVANCED
INTERNAL RATING
BASED
APPROACH
FOUNDATION
INTERNAL
RATING BASED
APPROACH

STANDARDISE Risk weights are assigned in slabs


according to the asset class or are based
D
on assessment by external credit
APPROACH assessment institutions
REDUCED CAPITAL
REQUIREMENT
39

BASEL-II: IRB APPROACH


Two Approaches
IRB Foundation Approach
IRB Advanced Approach
Banks estimated potential future loss Main elements
Risk Component
Risk Weight
Minimum Requirement

40

BASEL-II: IRB APPROACH (Contd.)


Risk Component
Probability of Default (PD)
Loss given Default (LGD)
Exposure at Default (EAD)
Maturity (M)
Risk Weights: Dependent on PD, LGD, and effective maturity (M).
Minimum Requirements:
Credit Rating System for all categories.
Track record of using internal ratings for min. 3 yrs.
Risk quantification i.e. EAD and LGD covering one economic cycle.
Validation of internal estimates.
Stress testing process for assessment of capital adequacy.
Disclosure requirements.
41

Risk Components
Probability of Default (PD)
Probability of default measures the likelihood that the
borrower will default over a given time-horizon i.e. What is
the likelihood that the counterparty will default on its
obligation either over the life of the obligation or over some
specified horizon, such as a year?
Calculated for a one-year horizon, this may be called the
expected default frequency.

42

Risk Components
Loss Given Default (LGD)
Loss Given Default is the credit loss incurred if an obligor
of the bank defaults.
LGD = 1 Recovery Rate
where, Recovery = Present Value of { Cash flows
received from borrower after the date of default - Costs
incurred by the bank on recovery }
Recovery rate = Recovery (as
Exposure on the date of default

43

calculated

above)/

Risk Components
Exposure at Default (EAD)
EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK

44

Risk Components
Maturity (M)
It measures the remaining economic maturity of the
exposure.
Determines framework for comparing different exposures.

45

Internal Rating Based (IRB) approaches


IRB Foundation Approach
Under the foundation approach, banks, which comply with
certain minimum requirements viz. comprehensive credit rating
system with capability to quantify Probability of Default (PD)
could assign preferential risk weights, with the data on Loss
Given Default (LGD) and Exposure at Default (EAD) provided by
the national supervisors.

Internal Rating Based (IRB) approaches


IRB Advanced Approach
Banks need to estimate all three risk inputs i.e PD,EAD, &
LGD internally.
This will help the bank to calculate the expected and
unexpected loss. Based on unexpected loss, capital is
allocated.
46

Expected Loss (EL)


Expected Loss is the banks cost of doing business.
Expected Loss has to be provided for.
The Expected Loss (in currency amounts)
EL = PD * EAD * LGD
If expressed as a percentage figure of the EAD
EL = PD * LGD.
The bank should also proactively incorporate an
expected loss rate in the estimation of the total spread
to be charged on the loan.
Expected loss is not a measure of risk as it is
anticipated.
47

Unexpected Loss (UL)


Regardless of how prudent a bank is in managing its
day-to-day business activities, there are market
conditions that can cause uncertainty in the amount of
loss in portfolio value.
This uncertainty, or more appropriately the volatility of
loss, is the unexpected loss. Unexpected losses are
triggered by the occurrence of higher default rates as a
result of unexpected credit migrations.

48

BASEL-II: IRB APPROACH (Contd.)


IRB Foundation Approach
Banks need to provide own assessment of PD whereas
estimates of EAD and LGD will be provided by supervisor.

IRB Advanced Approach


Banks need to estimate all three risk inputs i.e PD,EAD, &
LGD internally.

49

Foundation IRB Vs Advanced IRB Approach


Foundation IRB Approach

Advanced IRB Approach

Values for Loss Given Default


(LGD) and exposure at default
(EAD) are provided by the
regulatory authority.

Values for Loss Given Default


(LGD) and exposure at default
(EAD) are determined by each
bank through internal modeling
with a data of 5-7 years.

Assessment of values of credit


mitigants is done by the regulatory
authority.

Banks may assess the value of


its credit mitigants.

For retail exposure, there is no


Advanced IRB is applicable to
foundation IRB (only advanced IRB retail exposure also.
where besides PD, the bank
concerned will have to estimate
LGD & EAD.)
50

Implementing Foundation IRB approach in PNB

All eligible credit exposures beyond a threshold limit are


individually risk rated through internal credit risk rating
models.
Default Rates for large corporate model generated for last
six years. The default rates are satisfactory and
comparable with international standards.
Migration of ratings analysed since last five years.

51

51

Implementing Advanced IRB approach


Gaps in the existing systems for adoption of advanced IRB
approach are being identified.
Data collection for estimation of LGD started and model is
being prepared for computation of the same.
Data requirements as well as application tools for Risk
Management finalized and shall be implemented alongwith
the data warehouse project.
Establishment of Enterprise wide Data Warehouse and
application tools for Credit Risk, Operational Risk, Market
Risk, ALM and FTP (Fund Transfer Price) are under
process.

52

53

Benefits and drivers of Credit Risk Management


Helps in establishing a system for measuring, monitoring
and managing risk scientifically.
Introduction of rating framework for improved selection of
clients according to their risk profile
Improved pricing of products
Reduces Concentration risk
Optimized allocation of economic capital
Supports portfolio optimization (Minimising ratio of risk to
return)
Assuming that we have capital of Rs. 13.50 with a option of
lending to BB rated assets or AAA rated assets
54

The position works out as under:


Particulars
Maximum Exposure

BB

AAA

100

750

11.00

73.10

Cost of Funds (assumed) 4.5%

4.50

33.75

Cost of Operations (Estimated)

1.00

2.00

Risk Premium (assuming 1% EL for BB and 0.1% for AAA)

1.00

0.75

Capital Charge @10%

1.35

1.35

Total Cost

7.85

37.10

Return on Capital

3.15

36.00

Total Interest Income @11% for BB & 9.75% for AAA


Cost:

It can be inferred from the above that lending to AAA assets at 9.75%
would be more remunerative vis--vis lending to BB at 11%.
Our natural choice for selection of borrowers would shift from BB &
upwards under Basel I to AAA & downwards under Basel II (SA).
In case sufficient number of AAA assets are not available at lease our
order of preference would be AA, A and then BB.

Inherent Risk in Different Activities

Manufacturing

Trading

Unlimited Up Side

Limited Up Side

Unlimited Down Side

Limited Down Side

Lending

Very Limited Up Side


Unlimited Down Side

What is Credit Risk Rating?


Credit risk rating is a rating assigned to borrowers, based
on detailed analysis of their ability and willingness to repay
the debt taken from the bank.
Credit risk ratings help a bank to assign a probability of
default for borrower according to its risk category.
The probability of default increases in an exponential
manner as the credit risk rating deteriorates.

BENEFITS OF CREDIT RISK ASSESSMENT


Credit Risk Rating Mechanism means Measurement of
Risk and Quantification of the same through Credit
Rating.
It is an important tool for taking credit decisions,
i.e. whether to lend to a Borrower or not.
Assessing Banks Risk Bearing Capacity.
Quantification of Estimated Loan Loss.
Better Provisioning
Risk based Pricing (ROI) of Loans.
Product Mix (switching one facility to another).
Level (Authority) of decision Making.
Frequency of Renewal / Monitoring.

Unexpected Loss (UL):


Regardless of how prudent a bank is in managing
its day-to-day business activities, there are market
conditions that can cause uncertainty in the
amount of loss in portfolio value.
This uncertainty, or more appropriately the
volatility of loss, is the unexpected loss.
Unexpected losses are triggered by the
occurrence of higher default rates as a result of
unexpected credit migrations.
Mathematically, Unexpected Loss is the standard
deviation of the change in the asset value at the
end of the horizon. This implies that unexpected
loss is the estimated volatility of potential loss in
portfolio value around the expected loss.

GENERAL GUIDELINES
Latest Audited Financial Statements only (not more
than 1 Yr old).
Each parameter to be evaluated and no parameter
should be left un-assessed.
Careful analysis & evaluation of each parameter.
Subjective parameters need qualitative evaluation
and continuous updating knowledge about the
business & industry.
To improve information base about management
and conduct of the accounts - through regular visit
of the industry, interaction valuable insight
beyond financial data.

GENERAL GUIDELINES Contd


Information about borrower to be collected from all possible
sources.
Data used to assign rating should be annualized and
comparable.
Financials of the Co. should be made comparable with
peers in case of change in accounting policies, merger, demerger, acquisition, sell-off etc.
For multi-divisional Co. more than one activity/ product/
industry Business parameters to be evaluated separately
for each of 3 major activities.
The complete rating sheet, justification, financial ratios (if
computed manually) and other relevant information must be
sent to vetting authority for each rating.

GENERAL GUIDELINES Contd


Record of rating exercise & history of ratings should be
kept on record for further reference, uses, audit etc.
Final/ approved rating to be informed to the original rating
office after vetting by competent authority.
The credit risk rating along with date of approval & date of
B/sheet to be mentioned in all references made to
competent authority for taking credit decisions.
Other guidelines mentioned in manuals of individual credit
rating models to be followed strictly.
Maintaining utmost secrecy of the rating mechanism and
to prevent its misuse.

Basel I
Rating

AAA
BB

Exposure

ROI

RISK
WEIGHT

Capital
Charge

100
100

9%
11%

100%
100%

9
9

Both the above assets are investment grade.


As a prudent banker our natural choice is for BB asset vis--vis AAA asset
because BB is more remunerative.

Basel II (Standardised Approach)


Rating

Exposure

ROI

RISK
WEIGHT

Capital
Charge

AAA

100

9%

20%

1.8

BB

100

11%

150%

13.5

Risk weights under Standardised Approach are more Risk Sensitive.


Because of the risk weights are more risk sensitive, we can do 7.5 times more
business for AAA assets vis--vis BB assets, which will be more
remunerative.

Results :
It can be inferred from the above that lending
to AAA assets at 9% would be more
remunerative vis--vis lending to BB at 11%.
Our natural choice for selection of borrowers
would shift from BB & upwards under Basel I
to AAA & downwards under Basel II (SA).
In case sufficient number of AAA assets are
not available at lease our order of preference
would be AA, A and then BB.