Risks in the Banking Sector

Deepak Bhandari

What is Risk?
Threats

Vulnerabilities

Risk

Assets

Risk= Threat X Vulnerability X Cost of the Asset

Three major components of Risk
Vulnerability ►Opportunity for a threat to be realized ►Gateways through which threats can be manifested ►Can be exploited by an event, a person or a business process Threat ►Source and the means by which a particular attack can be carried out ►Expose the vulnerabilities of the organization ►Broadly classified as ►Man-made (intentional) ►Natural disaster ►Accidental (unintentional ) Assets ►Tangible or intangible item of significant business value ►Amount of damage that the item will cause if destroyed/affected is to be desirably kept low ►Damage to these assets may cause major business disruption

Defining Risk
Uncertai nty ►Factor of loss ►Can be financial or reputational or both

Risk Types ►Financial ►Strategic Threat ►Operational Realized ►Compliance ntial that a threat will be realized for a vulnerability

Relative Impact ►Relative impact level of exploited vulnerability on businesses

Dealing with Risk Exposure: The 4Ts
Terminate

Transfer

Text

Ris k

Tolerate

Treat

Types of Risks
Key considerations for management
►Planning

Strategic

and resource What are our key risks? allocation Are we focused on the risks that matter? ►Major initiatives ►Mergers , acquisition and divestures ►Market dynamics ►Communication and investor relations

Operation al

►Sales and marketing ►Supply chain ►People ►Information Technology ►Hazards ►Physical assets ► ► ►Market ►Liquidity and credit ►Accounting and reporting ►Tax ►Capital structure

Who is accountable for the key risks? Are resources aligned to our risk profile?

 

Are we accepting an appropriate level of risk? Are we receiving a fair return on that risk?

Financial

 

Complianc e

►Governance ►Code of conduct ►Legal ►Regulatory

Who is monitoring the significant risks? How are we improving key controls?

Top Risks: 2010

Source : Ernst & Young Global Research , 2010

Changing Risk Scenario post Economic Downturn
• Dramatic loss of liquidity experienced during the financial crisis. • Forward looking approach to risk critical • Developing a blended set of both riskbased and financial performance indicators
– Taking into account both historical and forward-looking factors

• Improved risk management for providing a holistic approach to risk across the enterprise
– Risk forecasting and stress testing

Section 1

Market Risks

Market Risk
• Defined as the possibility of loss to bank caused by the changes in the market variables. • Risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. • Risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. • Types Of Market Risk – Liquidity Risk – Interest Rate Risk – Forex Risk

Liquidity Risk (1/2)
• Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. • Liquidity risk consists of Funding Risk, Time Risk & Call Risk. • Funding Risk – It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit. • Time risk – It is the need to compensate for non receipt of expected inflows of funds, i.e. performing assets turning into nonperforming assets. • Call risk

Liquidity Risk (2/2)
• The Asset Liability Management (ALM) – It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their a) maturity profiles, b) cost, c) yield, d) risk exposure, etc

Interest Rate Risk
• Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and cash flow. • The types of Interest Rate Risk are : – Gap/Mismatch risk: – Basis Risk – Embedded option Risk – Yield curve risk – Reprice risk – Reinvestment risk – Net interest position risk • Different techniques such as a) the traditional Maturity Gap Analysis to measure the interest rate sensitivity, b) Duration Gap Analysis to measure interest rate sensitivity of capital, c) simulation and d) Value at Risk for

Forex Risk
• Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. • Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment. • By setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits ,the risk element in foreign exchange risk can be managed/monitored.

Country Risk
• This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time.

• It comprises of – Transfer Risk – Sovereign Risk – Political Risk – Cross border risk

Credit Risk (1/2)
• Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms • Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables • The objective of credit risk management is to minimize the risk and maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters

Credit risk consists of primarily two components:– Quantity of risk – Severity of loss

Credit Risk (2/2)

Credit risk is a combined outcome of :– Default Risk – Exposure Risk

The elements of Credit Risk is :– Portfolio risk comprising Concentration Risk as well as Intrinsic Risk – Transaction Risk comprising migration/down gradation risk as well as Default Risk

Tools of Credit Risk Management

The instruments and tools, through which credit risk management is carried out, are detailed below:►Exposure Ceilings ►Review/Renewal ►Risk Rating Model ►Risk based scientific pricing ►Portfolio Management ►Loan Review Mechanism

Risk Rating Model
Credit Audit is conduced on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available
 

The model may consist of minimum of six grades for performing and two grades for nonperforming assets

The need for the adoption of the credit riskrating model is on account of the following aspects

► Disciplined way of looking at Credit Risk ► Reasonable estimation of the overall health status of an account captured under Portfolio approach ► Impact of a new loan asset on the portfolio can be assessed ► The co-relation or co-variance between different sectors of portfolio measures the inter relationship between assets ► Concentration risks are measured in terms of additional portfolio risk arising on account of increased exposure to a borrower/group or co-related borrowers. ► Need for Relationship Manager to capture, monitor and control the over all exposure to high value customers ► Active approach of credit portfolio management ► Pricing of credit risk on a scientific basis linking the loan price to the risk involved therein

Exposure risk is the loss of amount outstanding at the time of default as reduced by the recoverable amount.
  

The loss in case of default is D* X * (I-R)
 

Where D is Default percentage, X is the Exposure Value and R is the recovery rate

 

Credit Risk is measured through :– Probability of Default (POD) and – Loss Given Default (LGD) Exposure at Default (EaD):-bank’s exposure to the borrower at the time of default

 

ELGD:- The extent of provisioning required could be estimated from the expected Loss Given Default(ELGD)  ELGD = POD x LGD x EaD

Section 2

Operational Risks

Operational Risks
• Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. Banks live with the risks arising out of Human errors, Financial fraud, Natural Disasters. Exponential growth in the use of technology and increase in global financial inter linkages are the two primary changes that contributed to such risks. Operational risk events are associated with weak links in internal control procedures. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in

• • • •

• • • •

Operational Risk Management
• In order to mitigate this, internal control and internal audit systems are used as the primary means.


• Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk.


• Putting in place proper corporate governance practices by itself would serve as an effective risk management tool.


• While measurement of operational risk and computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is start implementing the Basel proposal in a phased manner and carefully plan in that direction.


• The incentive for banks to move the measurement chain is not just

Section 3

Regulatory Risks

Regulatory Risks
• Many Banks, having already gone for public issue, have a greater responsibility and accountability.


• As banks deal with public funds and money, they are subject to various regulations.


• The very many regulators include Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI), Department of Company Affairs (DCA), etc.


• More over, banks should ensure compliance of the applicable provisions of The Banking Regulation Act, The Companies Act, etc.


• Thus all the banks run the risk of multiple regulatory-risk

Regulatory Risk Management
  

Banks should learn the art of playing their business activities within the regulatory controls.

Section 4

Environmental Risks

Environmental Risk
• With the economic liberalization and globalization, more national and international players are operating the financial markets, particularly in the banking field.
 

• This provides the platform for environmental change and exposes the bank to the environmental risk. •

Environmental Risk Management
 

Unless the banks improve their delivery channels, reach customers, innovate their products that are service oriented, they are exposed to the environmental risk resulting in loss in business share with consequential profit.

Section 5

Case Study : ICICI Bank

ICICI Bank Risk Management
• Primarily exposed to credit risk, market risk, liquidity risk, operational risk and legal risk. • Central Risk, Compliance and Audit Group is responsible for risk management • Risk, Compliance and Audit Group is organized into six subgroups:
– Credit Risk Management, Market Risk Management, Analytics, Internal Audit, Retail Risk Management and Credit Policies and Reserve Bank of India Inspection

Reporting Hierarchy

Credit Risk Market Risk Mgmt Mgmt Borrower credit ratings Developing & implementing market risk measurement Methodologies

Analytics

Internal Audit Comprehensive coverage of operational risk inherent in all areas of business

Retail Risk Mgmt Approval of retail policies and procedures

Credit Policies Formulation of credit policies and ensuring compliance

Development of proprietary models for risk measurement

Sectoral analysis and review

Approval of all new products

Initiation of systems audit in information technologyintensive areas

Impact of macro economic changes on the retail portfolio

Coordinating Reserve Bank of India inspections

Credit portfolio analysis

Monitoring market risk exposures

Portfolio review and monitoring

Credit Risk
• Structured and standardized credit approval process involves:

– Credit Risk Assessment Procedure for Corporate Loans – Project Finance Procedures – Corporate Finance Procedures – Working Capital Finance Procedures – Credit Monitoring Procedures for Corporate Loans – Retail Loan Procedures – Small Enterprises Loan Procedures – Investment Banking Procedures

Market Risk
• Exposure to loss arising from changes in the value of a financial instrument as a result of changes in market variables such as interest rates, exchange rates and other asset prices

Interest Rate Risk
• Asset-liability gap position: •

Interest Rate Risk
• Impact of adverse changes in interest rate

• • • • •
• Based on the asset and liability position at year-end fiscal 2003, the sensitivity model shows that net interest income from the banking book for fiscal 2004 would fall by Rs. 174 million (US$ 4 million) if interest rates increased by 100 basis points during

Price Risk
• Rupee Fixed Income Trading Portfolio

• • • • •
• The sensitivity model shows that if interest rates increase by 100 basis points during fiscal 2004, the value of the trading portfolio, would fall by Rs. 1.6 billion (US$ 34 million).

Exchange Rate Risk
• Use cross currency swaps, forwards, and options to hedge against exchange risks arising out of foreign currency hedging transactions • Trading activities in the foreign currency markets expose the bank to exchange rate risks. This risk is mitigated by setting counterparty limits, stipulating daily and cumulative stop-loss limits, and engaging in exception reporting. • In addition, foreign currency loans are made on terms that are similar to foreign currency borrowings

Liquidity Risk
• The goal of liquidity management is to be able, even under adverse conditions, to meet all liability repayments on time, to meet contingent liabilities, and fund all investment opportunities. • The bank funds operations principally by accepting deposits from retail and corporate depositors and through public issuance of bonds. • They also borrow in the short-term

Operational Risk (1/2)
• ICICI Bank is exposed to many types of operational risk. • They can result from a variety of factors, including failure to obtain proper internal authorizations, improperly documented transactions, failure of operational and information security procedures, computer systems, software or equipment, fraud, inadequate training and employee errors.

Operational Risk (2/2)
• ICICI Bank attempts to mitigate operational risk by maintaining a comprehensive system of internal controls, establishing systems and procedures to monitor transactions, maintaining key back–up procedures and undertaking regular contingency planning. Eg:
– Operational Controls and Procedures for Internet Banking – Operational Controls and Procedures in Regional Processing Centers & Central Processing Centers – Operational Controls and Procedures in

Legal Risk
• The uncertainty of the enforceability of the obligations of ICICI Bank’s customers and counterparties, including the foreclosure on collateral, creates legal risk. • ICICI Bank seeks to minimize legal risk by using stringent legal documentation, employing procedures designed to ensure that transactions are properly authorized and consulting internal and external

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