Risk management


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Risk management

  1. 1. RISK MANAGEMENT RISK MANAGEMENT INTRODUCTON RISK MANAGEMENT IN BANK Indian Banking Industry is going through a transformation process in its transitional journey from the era of protected economy to the tough world of market economy. Banks are expanding their operations, entering new market and trading in new asset types. The changes in financial system, product and structures have created new opportunities along with new risks. Risk Management has become an internal part of financial activity of Bank and other market participants. These risks can’t be ignored and either has to be managed by market participants as part of Asset Liability Management or hedge. Under these circumstances, creating an environment that promotes risk management assumes critical importance. This requires addressing certain policy and institutional issues in developing in India. First and foremost a well-developed market, repo market constitutes an important prerequisite for the promotion of risk management practice among market participants. Regulatory gaps and overlaps in debt markets need to be sorted out quickly to facilitate the repeal of the 1969 notification which will go a long way in aiding the process of Asset Liability Management for Banks. Indian conditions are suitable for introduction of credit default swap in India. It offers advantages of hedging credit risk without impairing the relationship with the borrower. Forward rate agreements and interest rate swaps enable users to lock into spreads. The RBI has already permitted interest rate swaps. A major reason for lack of term money market is the absence of T.Y.BBI1
  2. 2. RISK MANAGEMENT the practice of Asset Liability Management system among bank for identifying mismatches in carious time periods. The recent RBI guidelines to lend on a term and also offer two-way quotes in the market. The advisory group on banking supervision constituted by RBI recommended greater orientation of banks management. OECD principles of corporate governance recognized the risk management as area of increasing importance for Board, which is related to corporate strategy. DEFINATION “Life is inherently risky. There is only one big risk you should avoid at all costs and that is the risk or doing nothing” Denis Waitely Risks associated with financial institutions are becoming more and more diverse and complicated due to changes taking place in the operating environment. In response, and in recognition of the fact that risk cannot be entirely avoided. “It is the process for identifying the risk the business faces, evaluating them according to the likely hood of their occurring and the damage. They would ensure deciding whether to wear, avoid, control or ensure against then, allocating responsibility for dealing with them ensuring that the process actual works and reporting material problems as early a possible to the right level”. The operation of bank inevitably means facing risk of many kinds risk. Risk is inherent in bank but it is far from routine, nor is it one- dimensional. All round the globe, market risks, technical risk, operational T.Y.BBI2
  3. 3. RISK MANAGEMENT risk, political risk, legal risks, and change rapidly and continually. A recent survey in USA revealed that the directors are not focusing enough on risk management. Most of the bank did not have a formal enterprise wide risk management process. However, directors are not expected to understand ever-small aspect of the management process orb monitor every transaction. Nevertheless, they have the responsibility to oversee the risk management function and internal control system of the bank. There can be no one size-fit all risk management system due to diversity in the size of balance sheet and risk appetite among banks. Each bank must design and develop its own system to suit its specific needs depending upon the size and complexity of business, risk philosophy, market perception and level of capital. Objectives of Risk Management The very basic objective of risk management system is to put in place and operate a systematic process to give a reasonable degree of assurance to the top management that the ultimate corporate goals that are vigorously pursued by it would be achieved in the most efficient manner. In this way, all the risk that come in the way of institution achieving the goals it has to set for itself would managed properly by the risk management system. In the absence of such a system, no institution can exist in the long run without being able to fulfill the objective for which it was set up. T.Y.BBI3
  4. 4. RISK MANAGEMENT DIFFERENT TYPES OF RISK 1. Financial Risk: The risk of loss from holding positions that is subject to change in value with changing market conditions. This risk includes all changing, in market conditions, such as prices, volatility, liquidity, and credit risk, the ability and willingness of counterparties to honor their contractual obligations. Lloyd’s of London provided re-insurance without protracted and significant losses for 300 years. The equity holders in these enterprises started to think they were purchasing annuities rather than placing their considerable assets at risk. With a history of profits without significant loss that spans centuries, such a belief is understandable. Lloyd’s accumulated $8.6 billion in losses in the three years from 1988 through 1990. The equity holders achieved a better understanding of the financial risk they were incurring. I. Credit risk Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. RBI has been extremely sensitive to the credit risk it faces on the investment of foreign currency assets and gold in the international markets. Investments in bonds/treasury bills, which represent debt obligations of Triple-A rated sovereigns and supranational entities do not give rise to any substantial credit risk. Placement of deposit with BIS and other central banks like Bank of England is also considered credit risk- free. However, placement of deposits with commercial banks as also T.Y.BBI4
  5. 5. RISK MANAGEMENT transactions in foreign exchange and bonds/treasury bills with commercial banks/investment banks and other securities firms give rise to credit risk. Stringent credit criteria are, therefore, applied for selection of counterparties. Credit exposure vis-à-vis sanctioned limit in respect of approved counterparties is monitored on line. The basic objective of an on-going tracking exercise is to identify any institution (which is on the RBI’s approved list) whose credit quality is under potential threat and to prune down the credit limits or de-list it altogether, if considered necessary. A quarterly review exercise is also carried in respect of counterparties for possible inclusion/deletion. II. Trading credit Risk This is the risk of loss from the failure of a trading counterparty to perform its trading obligations as agreed. The largest exposures for this risk typically occur between major global trading counterparties e.g. liquidity providers in several markets. Unlike traditional lending, these exposures change values with changing market conditions (prices, volatility). Note, however, the largest risk of loss is linked but not directly proportional to the largest exposures. Credit risk combines exposure with default and recoveries. Thus a lower exposure can have a higher risk if the default probability is much higher. T.Y.BBI5
  6. 6. RISK MANAGEMENT II. Commercial credit Risk This is the risk of loss form providing credit to corporate counterparties. Extensions of credit can take the form of direct loans and contingencies or guarantees. 2. Market Risk: This is the risk that positions can lose value due to changing market conditions including prices, volatility, and market liquidity. It also includes basis risk for hedge positions. Market risk, along with credit risk are the two major components of financial risk. Market risk, which consists primarily of price risk and volatility risk, occurs within the major market sectors. I. Commodity market Risk This is the risk of loss from having positions in any of the commodity markets. There are certainly tremendous variety of them, ranging from agricultural markets, which include various grains, meats, produce, and wood products to minerals and metals. More recently, the energy market has undergone an expansion as electricity has deregulated and become a commodity whose price fluctuates. II. Currency market Risk This is the risk of loss from having positions in any of the currency markets. The risk can be from outright positions. It can also reside on the balance sheet or in the income flows of a company. Many Thai companies were carrying currency risk on their balance sheets with assets in Thai baht and liabilities/ loans in U.S. dollars. In the summer of 1997, they were bankrupted overnight by a 20% reduction in their dollar T.Y.BBI6
  7. 7. RISK MANAGEMENT liabilities. Other firms suffer large fluctuations in income when earnings denominated in foreign currencies must be converted and reported in dollars III. Interest Rate Risk The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The focus of the investment strategy revolves around the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a view to minimizing losses arising out of adverse interest rate movements, if any. This approach is warranted as reserves are viewed as a market stabilizing force in an uncertain environment IV. Market Liquidity Risk: This is the risk of loss from being unable to buy or sell positions easily, at a low transaction cost. The speed and ease with which a buyer or seller can convert assets into cash and vice versa varies with each class of assets in the market. Gold, for example, is much more liquid than real estate. In addition, liquidity fluctuates over time. During August and September 1998, some of the most liquid markets, such as the U.S. government bond market and the swap markets became considerably less liquid. In the early 1990’s a steep spike in interest rates caused large losses in many trenches of mortgaged- backed securities (MBS). The market for these instruments froze because no one was interested in bidding for them, even at huge discounts to their remaining fair market T.Y.BBI7
  8. 8. RISK MANAGEMENT value. That liquidity freeze helped keep MBS prices depressed for a long time. V. Equity market Risk: This is the risk of loss from holding positions in the equity markets. This is investor risk and almost everyone is familiar with it. Like the other markets it contains price, volatility, and liquidity. 3. Operational risk and control system Internally, there is a total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. There is a separate set up responsible for risk measurement and monitoring, performance evaluation and concurrent audit. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the RBI for this purpose and statutory audit of accounts by external auditors, there is a system of appointing a special external auditor to audit dealing room transactions. The main objective of the special audit is to see that risk management systems and internal control guidelines are adhered to. T.Y.BBI8
  9. 9. RISK MANAGEMENT There exists a comprehensive reporting mechanism covering all significant areas of activity/operations relating to reserve management. These are being provided to the senior management periodically, viz., on daily, weekly, monthly, quarterly, half-yearly and yearly intervals, depending on the type and sensitivity of information. 4. Settlement Risk: This is the risk of loss from failure of a trading counterparty to perform as obligated during the settlement process. Most settlement processes for financial transactions have established safeguards to greatly reduce this risk. For Ex. Most equity and debt purchases settle through clearing houses that hold delivers until payment is received. Other financial products frequently settle on a net difference basis. In most swaps, just the difference between the fixed and floating leg is transmitted. Daily settlement amounts between the biggest traders i.e. liquidity provider, especially when they do not occur on a net basis, are very large. The failure of a major financial institution to honor its side of these trades of these trades could cause significant loss and serious market disruption. In 1974, a small bank in Germany, Bank Herstatt, which had $60 million in FX, trades settling the next day closed its doors. The three days of increasing payment system gridlock that followed served as a waked- up call to the industry and its regulators. T.Y.BBI9
  10. 10. RISK MANAGEMENT 5. Asset liability Risk: This is the risk that current obligations cannot be met with current assets. This is a fundamental risk in all organizations, which must maintain liquidity, or they become insolvent. In financial institutions, this risk is quite significant because many liabilities can be accelerated if the market perceives a weakness. Markets and regulators have demanded that financial institutions maintain a high level of capital to protect the fund providers and a high level of reserves to safeguard against “runs”. Most of the risk arises as a result of mismatch of assets and liability. If the assets of a bank exactly matched its liability of identical maturity, interest rate conditions and currency risk could have been avoided. However in practice it’s near impossible to have such a perfectly matched balance sheet. A banker, therefore, has to keep different types of risk within acceptable limits. It requires the ability to forecast future changes in the environment and formulate suitable action plans to protect the bet worth of the organization form the impact of these risks. It is by no means an easy task. If he is proving wrong in his judgment the whole process of risk management may go haywire. Few would disagree with the statement that “being a banker is like being a country hound dog. If you stand still you get kicked. If you run, they throw rocks at you”. 2. Basis Risk (Hedged Positions): This is the risk of loss from hedging market exposures with instruments whose changes in value do not exactly offset value changes in the position being hedged. The mismatch could be in terms of maturity, the underlying instrument e.g. short a government bond to hedge a long corporate bond position, or some other characteristic. These T.Y.BBI10
  11. 11. RISK MANAGEMENT “small” differences can sometimes cause the combined position to be much more risky than thought. On May 1, 1997, L.P.Morgan lost $20 to $40 million due to basis risk on one trade. The trader sold a yen/dollar option, and bought the same option from counterparty. Both the bought and sold option carried the same “knock-out” feature. The change rate is canceled if the dollar/yen exchange rate is greater than 127.3. This looks like one of those perfect hedges, rumored to occur only in Japanese gardens. The problem was mismatch in maturity. The sold option expired six hours before the bought option. The exchange rate was below 127.3 yen when the sold leg matured but moved above that barrier by the time the bought leg matured. The hedge, the bought leg, was knocked out by the shift in dollar yen rates, leaving J.P. Morgan with an unhedged loss. Ironically, if the deals had not contained the “knock-out” feature, Morgan would have made money on the basis risk timing it was holding. 3. PRESETTLEMENT RISK: This is the risk of loss from failure of a trading counterparty to perfume as obligated, but before the trade actually settles. If counterparty to a deal that matures in six years, defaults after three years, the other counterparty may have to go into the marketplace and “replace” the defaulted deal. This potential replacement cost is based on the market prices and other factors, like applicable netting agreements and collaterals, at the time of the default. T.Y.BBI11
  12. 12. RISK MANAGEMENT 4. Commercial Credit Risk: This is the risk of loss form providing credit to corporate counterparties. Extensions of credit can take the form of direct loans and contingencies or guarantees. 5. Loan Risk: This is the risk of loss from loaning money and having the borrower fail to repay, either due to default or because they are not willing to repay. Most analysis in commercial lending considers how the borrower will repay. 6. Guarantee Risk: This is the risk or loss from providing guarantees or letters of credit. These are from of contingent credit exposure (e.g. the exposure is contingent on other events occurring). 7. Portfolio Exposure: A measure of the possible loss that could occur with each given counterparty and with groups of counterparties, for ex. Industries, countries, and economics regions. When traditional credit products, such as, loans, leases, letters of credits and guarantee are transacted the exposure is known as static. Capturing credit exposure for the corporate counterparties that typically use these traditional credit products is fairly straightforward and consideration quickly shifts to “default risk” for them. When the portfolio contains a significant proportion of derivative trades, exposure might undergo large shifts with changes I market T.Y.BBI12
  13. 13. RISK MANAGEMENT conditions. Therefore, measuring portfolio exposure to the d4ealer or banks where derivative trades predominate, is a much more difficult the sum deal by deal exposures, due to portfolio effects, close out netting agreements and margin or collateral agreement. 8. Portfolio Defaults: A measure of the rate at which exposure convert in to losses due to default. Default consideration occurs on both a granular level, “counterparty by counterparty” and at various portfolio levels. At the granular level, the credit managers rate the counterparty ability to repay loans. At the portfolio levels, credit managers consider how defaults might correlate. 9. Portfolio Recovery: A measure of how much credit risk is ameliorated by loan recoveries, which reduce the loss when counterparty defaults. Loans can contain features and structures that create higher recovery rates, significantly reducing credit risk. The two-loan structure considerations that most directly impact recovery rates are seniority where the loan is situated within the borrowing firm’s internal capital structure and security what collateral secures the loan. 10. Global Portfolio Risk: This is the risk of loss from all financial risks, including the combination of credit and market risks. There are fundamental factors, like economic conditions, which create a link between them. Market and credit risks are not independent from each other, yet most financial firm’s measures and manage them separately. T.Y.BBI13
  14. 14. RISK MANAGEMENT 11. New Products and Risks With the introduction of new products like plastic cards, credit, debit, smart card, etc. The risk of fraud has increased manifold. According to estimation in an active issuing bank card, fraud is likely to claim the lion’s share of fraud being experienced in general and could well dominate average operating losses as a whole worldwide frauds occurred due to loss or steal of plastic cards that cause the greatest losses. The second largest sources and the fastest growing source of loss is use of counterfeit card. Emerging areas of E-commerce and Internet banking are also a matter of concern. T.Y.BBI14
  15. 15. RISK MANAGEMENT RISK MANAGEMENT PROCESS 1) IDENTIFICATION. 2) MEASUREMENT. 3) CONTROL. 4) MONITORING.  Risk can be defined as the potential that events expected or anticipated may have adverse impact on banks capital or earnings. Therefore proper identification of existing risk and risk that may arise from new business is crucial to the risk management process.  Accurate and timely measurement of risk enables a bank to quantify the risk for controlling and monitoring risk level. T.Y.BBI15 IDENTIFY CONTROL MEASURE MONITOR Process
  16. 16. RISK MANAGEMENT  It is administered by establishment and communication of limits for risk taking units through policies standards and procedures. There should be a let out system to authorize accretion in controlling the risk.  It is affected through risk reporting to ensure timely review of risk positions and acceptations. Monitoring report should be concise, frequent, timely and reasonably accurate. The purpose of monitoring is to present right information to the right people. With respect to risk management, the Bank places great importance on implementing the following processes. When commencing new businesses or handling new products, the Bank also ascertains legal compliance as well as the application of an adequate risk management system. T.Y.BBI16
  17. 17. RISK MANAGEMENT 1. Risk Identification: it is crucial that all the have to be identified first. The methodology normally followed is risk matrix approach which appears as under Risk Matrix ( Indicative) Products Credit Risk Interest Rate Risk Market Risk Liquidity Risk Operational Risk Loans & Advances Yes Yes No Yes Yes Investments Yes Yes Yes Yes Yes Cash Managemen t & Payment Services No No No No Yes Deposits No Yes No Yes Yes The matrix above has been prepared main products. The matrix can be detailed to go down to individual product level risks for better identification of the risks present. 2. Risk Measurement: the step is the most crucial step of all. Having identified the risks, tools for measurement of each one of the risks need to be put in place to measure each one of the risks quantitatively. The most challenging task is the selection of an appropriate tool or measures for quantification of risk. The measures of quantification range from very simple to highly complex. What is important is to use an appropriate quantification method or tool suitable for the blank. T.Y.BBI17
  18. 18. RISK MANAGEMENT 3. Risk Control & Monitoring: It deals with setting up of limits to each one of the risks and monitoring to ensure that the actual exposure to each one of the risks defined is within the limits prescribed in the risk management policy. Any violation of limits needs to be thoroughly investigated to ascertain the reason for violation and to avoid such violation in future. The traditional control based risk management ends with the above-mentioned steps. The modern risk management, which strives to align risk management with overall corporate objectives and strategies, involves to addition steps in the form of allocation and risk adjusted performance measurement. T.Y.BBI18
  19. 19. RISK MANAGEMENT Steps in the risk management process Identification and assessment A first step in the process of managing risk is to identify potential risks. The risks must then be assessed as to their potential severity of loss and to the probability of occurrence. Risks are about events that, when triggered, will cause problems. Hence, risk identification can start with the source of problems, or with the problem itself. • Source analysis Risk sources may be internal or external to the system that is the target of risk management. Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport. • Problem analysis Risks are related to identified threats. For example: the threat of losing money, the threat of abuse of privacy information or the threat of accidents and casualties. The threats may exist with various entities, most important with shareholder, customers and legislative bodies such as the government. When either source or problem is known, the events that a source may trigger or the events that can lead to a problem can be investigated. For example: stakeholders withdrawing during a project may endanger funding of the project; privacy information may be stolen by employees T.Y.BBI19
  20. 20. RISK MANAGEMENT even within a closed network; lightning striking a Boeing 747 during takeoff may make all people onboard immediate causalities. The chosen method of identifying risks may depend on culture, industry practice and compliance. The identification methods are formed by templates or the development of templates for identifying source, problem or event. Common risk identification methods are: • Objectives-based Risk Identification Organizations and project teams have objectives. Any event that may endanger achieving an objective partly or completely is identified as risk. Objective-based risk identification is at the basis of COSO's • Scenario-based Risk Identification In scenario analysis different scenarios are created. The scenarios may be the alternative ways to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle. Any event that triggers an undesired scenario alternative is identified as risk - see Futures Studies for methodology used by Futurists. • Taxonomy-based Risk Identification The taxonomy in taxonomy-based risk identification is a breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The answers to the questions reveal risks. T.Y.BBI20
  21. 21. RISK MANAGEMENT • Common-risk Checking In several industries lists with known risks are available. Each risk in the list can be checked for application to a particular situation. An example of known risks in the software industry is the Common Vulnerability and Exposures list found at http://cve.mitre.org. Assessment Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation on the risk management plan. The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical information is not available on all kinds of past incidents. Furthermore, evaluating the severity of the consequences (impact) is often quite difficult for immaterial assets. Asset valuation is another question that needs to be addressed. Thus, best educated opinions and available statistics are the primary sources of information. Nevertheless, risk assessment should produce such information for the management of the organization that the primary risks are easy to understand and that the risk management decisions may be prioritized. Thus, there have been several theories and attempts to quantify risks. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is: T.Y.BBI21
  22. 22. RISK MANAGEMENT Rate of occurrence multiplied by the impact of the event equals risk Later research has shown that the financial benefits of risk management are not so much dependent on the formulae used. The most significant factor in risk management seems to be that 1.) Risk assessment is performed frequently and 2.) it is done using as simple methods as possible. In business it is imperative to be able to present the findings of risk assessments in financial terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial terms. The Courtney formula was accepted as the official risk analysis method for the US governmental agencies. The formula proposes calculation of ALE (Annualized Loss Expectancy) and compares the expected loss value to the security control implementation costs (cost-benefit analysis). T.Y.BBI22
  23. 23. RISK MANAGEMENT Possible actions available Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories: Avoidance Reduction Retention Transfer Ideal use of these strategies may not be possible. Some of them may involve trade offs that are not acceptable to the organization or person making the risk management decisions. Risk avoidance Includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the liability that comes with it. Another would be not flying in order to not take the risk that the planes were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning the profits. Risk reduction Involves methods that reduce the severity of the loss. Examples include sprinklers designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not T.Y.BBI23
  24. 24. RISK MANAGEMENT be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibited by the strategy. Modern software development methodologies reduce risk by developing and delivering software incrementally. Early methodologies suffered from the fact that they only delivered software in the final phase of development; any problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing in increments, software projects can limit effort wasted to a single increment. A current trend in software development, spearheaded by the Extreme Programming community, is to reduce the size of increments to the smallest size possible, sometimes as little as one week is allocated to an increment. Risk retention Involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amount of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or T.Y.BBI24
  25. 25. RISK MANAGEMENT if the cost to insure for greater coverage amounts were so great it would hinder the goals of the organization too much Risk transfer Means causing another party to accept the risk, typically by contract Insurance is one type of risk transfer. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group, involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group. Create the plan Decide on the combination of methods to be used for each risk. Each risk management decision should be recorded and approved by the appropriate level of management. For example, a risk concerning the image of the organization should have top management decision behind it whereas IT management would have the authority to decide on computer variousrisk. The risk management plan should propose applicable and effective security controls for managing the risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and implementing anti virus software. A good risk management plan should T.Y.BBI25
  26. 26. RISK MANAGEMENT contain a schedule for control implementation and responsible persons for those actions. The risk management concept is old but is still not very effectively measured Implementation Follow all of the planned methods for mitigating the effect of the risks. Purchase insurance policies for the risks that have been decided to be transferred to an insurer, avoid all risks that can be without sacrificing the entity's goals, reduce others, and retain the rest. Review and evaluation of the plan Initial risk management plans will never be perfect. Practice, experience, and actual loss results, will necessitate changes in the plan and contribute information to allow possible different decisions to be made in dealing with the risks being faced. Limitations If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur, but if the risk is unlikely enough to occur, it may be better to simply retain the risk, and deal with the result if the loss does in fact occur. Prioritizing too highly the Risk management processes itself could potentially keep an organization from ever completing a project or even T.Y.BBI26
  27. 27. RISK MANAGEMENT getting started. This is especially true if other work is suspended until the risk management process is considered complete.  SYSTEM RISK MANAGEMENT Computer systems have become indispensable in banking operations, which are not only growing more diverse and sophisticated, but are encompassing large increases in transaction volumes. Accordingly, safety measures to avoid system risks are extremely crucial for providing customers with high-quality services. From January 2004, the Bank transitioned its core computer system to a new system with the most advanced functions at the NTT Data Banking Center for Regional Banks. This center has established solid safety measures that include the adoption of a mutual backup system using its two centers in eastern and western Japan. The Bank takes all possible measures against system risks through utilization of a program that specifies detailed responses in case of system failure and internal rules for preventing computer crimes and malfunctions. The Bank also employs external audits of its system risk management. By undergoing strict checking of our system risk management by an independent institution, we are further ensuring that our risk management is maintained at the highest level while increasing the sophistication of our system risk management. T.Y.BBI27
  28. 28. RISK MANAGEMENT  REPUTATION RISK MANAGEMENT The Bank institutes measures to control and minimize reputation risk. These include formulating reputation risk management regulations that specify means for reducing and preventing reputation risk, as well as measures to be taken should such problems arise.  INFORMATION SECURITY RISK MANAGEMENT Recent advances in IT have led to a rapid increase in and diversification of information-processing environments and objectives, including the use of the Bank's internal LAN and connection to the Internet. Therefore, strengthening the management system to maintain information security against system threats such as information leakage, unauthorized changes and destruction of information is becoming extremely crucial. To respond to these circumstances, the Bank formulated an Information Security Policy as a basic policy on safety measures concerning the protection of information assets (information and information systems). The Bank has also formulated Information Security Standards as its specific safety standards for information security. In addition, in February 2005, the Bank formulated new Regulations on the Handling of Personal Information and established a Privacy Policy (a statement on protection of personal information), while seeking to further reinforce its systems for adequately protecting personal T.Y.BBI28
  29. 29. RISK MANAGEMENT information in line with the enactment of the Personal Information Protection Act as of April 1, 2005.  CONTINGENCY PLAN The Bank has formulated its Contingency Plan that outlines specific procedures for responding to an array of unforeseen circumstances including crimes, natural disasters such as fires or earthquakes, computer system malfunctions, financial crises, information security risks, and market and other risks. We strengthen our response structure by carrying out drills based on this plan and review this plan on a regular basis. T.Y.BBI29
  30. 30. RISK MANAGEMENT ASSET LIABILITY MANAGEMENT In the regulated economy he interest spread is primarily a function of central banks of the country because banks accept deposits of regulated rate and lend at regulated rates and earn the stipulated rates. In a globalize environment intense competition for business and increasing fluctuations in both domestic interest rates as well as foreign exchange rates put pressure on the management of banks to maintain spreads profitability and long term viability without increasing market risk. There are two major types of risks that commercial banks are exposed to in the course of their operation i.e. credit risk and market risk. Banking business itself is a credit risk. Market risk arising out of fluctuations in interest rates, foreign exchange rate, equity price risk and commodity price risk is virtually not existent in such a regime where market rates and prices are stable for relatively long periods of time. Banks are exposed to market risk in market driven and liberalized environment. Therefore, banks have to manage not only credit risk but also market risk. They require a managerial approach to control the viability of market risk. Thus, Asset Liability Management is a strategic response of banks to inflationary pressures, volatility in interest rate and severe recessionary trends in the global economy. The commercial banks in India began to face tremendous problems of Assets and liability mismatch leading to deregulation of interest rate and free play of market forces, entry of new player, emergence of new instrument and new products at competitive rates and enhancement of risks. The banks witnessed the vulnerability of mismatch during 1995-96. The banks which funded term assets bank in T.Y.BBI30
  31. 31. RISK MANAGEMENT such a way as to maximize its net income minimize the market risk. This is to be done by analyzing the current market risk profile of the banks and its impact on the future risk profile. The manager has to choose the best course of action depending the risk performance of the management. A. ASSET MANAGEMENT 1. CASH MANAGEMENT: Cash management is a dynamic function that need to be dealt with effectively at various levels. Cash balances are the idle assets of the bank, hence cash should be kept at a bare minimum level. The banks need to manage their cash balances in order to meet their customer requirements of their demand deposits. 2. RESERVES AND INVESTMENT MANAGEMENT: Reserve requirement constitute the first charge on any banks funds and the balance can be used for advances and other income generating assets. The reduction in statutory liquidity ration helps the banks to invest more resources in profitable avenues. The banks should plan their requirements properly. 3. CREDIT MANAGEMENT: A major portion of banks income is derived from returns on advances and credit expansion. Managing credit is a critical function of any banks. Effective credit management is necessary to ensure that the advances remain performing and the income is maximized. T.Y.BBI31
  32. 32. RISK MANAGEMENT 4. MANAGEMENT OF OTHER ASSETS: The banks have to invest in other assets in order to generate more income and not to keep idle assets. It can invest in real estate, government security, money market etc. However the creation of other assets should generate additional income to the bank. B. LIABILITY MANAGEMENT: 1. OWNED FUNDS: The banks owned funds are capital and reserve and surplus. Capital is raised by offering equity to the public. It can also be achieved through increasing reserves. Capital adequacy has to be maintained by the banks. It is considered as a financial barometer for the stability and soundness of a bank. 2. DEPOSITS: A major source of asset creation of a bank is mobilization of deposits. It has become a challenging task for banks in these days. Banks collect funds through different types of deposits having different maturities. There are some demand deposits also. The banks have to see that these deposits are rapid on time. 3. BORROWING: Whenever there is a shortage of funds, banks can borrow from RBI, financial institutions, and markets. It is also a major source of raising T.Y.BBI32
  33. 33. RISK MANAGEMENT funds. However, the banks have to consider the rate of interest, maturity and other statutory requirement, while borrowing from outside. 4. FLOATING FUNDS: The banks have floating funds with them in the form of bills payables, draft payables. These funds are available for short and temporary period. These funds have no costs. However, proper management of these funds requires network of branches, speed in delivery of services and technological advancement. T.Y.BBI33
  34. 34. RISK MANAGEMENT C. PROCESS OF ASSET LIABILITY MANAGEMENT: Asset liability management is a strategic approach to measure, monitor and manage the market risk of a bank. The process of ALM involves the following stages: 1) MEASUREMENT OF RISK: The first step in ALM is to decide or measure the risk. The appropriateness or risk measurement parameters depending upon the degree of volatility in the operation environment, availability of supporting data and expertise with in the bank and the expected market and business developments. Generally, the net interest income and market value of portfolio equity are the two major parameters which banks employ to measure their balance sheet risk. The short term as well as long term balance sheet risks can be measured with the help of these parameters. There are various methods used to measure interest risk, the T.Y.BBI ASSET LIABILITY MISMATCH POSSIBILITY IN A BANK ASSET-LIABILITY MANAGEMENT CLASSIFICATION OF ASSET LIABILITY ASSET L 34
  35. 35. RISK MANAGEMENT important methods are gap method, Duration method, Simulation method and value of risk method. Gap analysis is the important technique used to analyze interest rate risk. It measures the difference between a banks asset and liability and off balance sheet positions which will be reprised or will mature within a pre- determined period. This technique measures the difference between the absolute value of rate sensitive and rate sensitive liability over a gap period. It ignores the time when the assets and liability would need to be reprised. The rate sensitivity gap can be mathematically expressed as follows: RSA RSG = ------ RSL RSG=Rate Sensitive Gap. RSL=Rate Sensitive Asset. RSL=Rate Sensitive Liability. A ratio of 1 indicates perfect match of rate sensitive assets to liability. If spread is positive at the beginning of the period, this perfect match protects the same even in the wake of subsequent change in interest rates. If the ratio is greater than one, higher income is produced with increase in interest rate. Similarly, a ratio of less than one produces higher losses with fall in interest rates. However, a major drawback of Gap analysis is that it ignores the timing of re- pricing of assets and liability rarely takes place at the same time. T.Y.BBI35
  36. 36. RISK MANAGEMENT Duration method attempts to assess the effects of interest rate changes on the market value of the assets and liability of the banks. The duration of the asset and liability is computed as the weighted average maturity of the resultant cash flow, the weight being the present value of the cash flow. Duration is the less than the maturity for coupon bond. Greater the duration gap, higher is the interest rate risk exposer of the asset liability picture under different scenarios, ascribing probability to them and choosing the most optimal model. This method is most dynamic but its utility is depends upon the accuracy of forecast. The value of risk method is an attempt work out depreciation and appreciation in the value of asset and liability due to change in interest rate with a view to indicate the trend in economic value of portfolio. For evaluating the opportunity cost benefits carrying of market items of balance sheet such as loan, deposits etc, in a longer time frame, impact of interest rate changes on the value of such assets or liabilities under different interest rate scenarios will have to be calculated. It is also useful to compute the net worth of the bank at particular point of time which will be helpful in ascertaining long-term risk implications of the decisions which have already been taken or are to be taken. 2) ENHANCEMENT OF LONG-TERM PROFITABILITY: The next step of ALM is identification of favorably priced assets or liability and off balance sheet item so as to enhance long term profitability for a given level of risk. The branch manager should resist the temptation of accession to easily found high priced liabilities. Every effort should be made to find out low priced liabilities. The management has to build up core business and create assets and liability for the bank. The thrust of the management should be on client market and not on a T.Y.BBI36
  37. 37. RISK MANAGEMENT financial market. Mismatch are usually built in client market as assets and liability are created sequentially but not simultaneously and the same are managed in financial markets. 3) MANAGEMENT OF RISK: The third stage in the ALM is effective management of market risk. The directors should formulate overall investment policy liquidity policy and the policy regarding financing. It should also determine the acceptable level of risk in term of the parameters chosen. The bank should undertaken strategic planning exercise for it asset-liability. It involves management of CRR and SLR for the Banks as whole formulating schemes having refinance facilities to have better leverage in managing the assets and liability and as a spin off earning better profit. The management should also focus on product and services, that are made available to branches with have special advantage. The policies and strategies of the bank need to be reviewed from time to time keeping in view the banks liquidity exercise and development in the business. The banks should set up an assets and liability Management committee giving it the responsibility of deciding on business and risk management strategy. The committee should consist of banks senior management with chief management with chief executive management as its head for drawing up strategic plan. The committee should periodically review the plans in terms of market funds, interest rate movement, deposits growth and financing need of the bank. The ALM committee has to address crucial issues like product pricing of deposits and loans, the derived maturity profile of incremental assets and liability, extend of exposure in long dated government security and impact of the long business deals on the banks risk profile. The ALM committee should T.Y.BBI37
  38. 38. RISK MANAGEMENT review the results and progress in implementation of the decisions. It should also articulate the current interest rate review of bank and base its decisions for the future business strategy in this regard. The bank can also constitute sub-committees to handle certain important activity and for its better planning and implementation. Strategic management of investment calls for periodic review of investment portfolio. Strategic liability management involves satisfying liquidity constraints, balancing source of funds, taking advantage of relative interest rates on different money market instruments. Strategic planning exercise should also be done at the branch level. At this level assets and liability of the branch should be bifurcated into core and non- core assets and liability. Reasonable estimate on assets and liability under core and non-core category can be made by scanning through the individual deposit accounts and advance accounts. Management core deposits with core advances could be attempted by identifying some of their lending schemes like term loan, housing loan, consumer credit loan, vehicle loan etc. Other assets like cash or bank balances which do both earn ant remuneration could be managed in such a way sending frequent cash remittances to currency chest and bank balances by sending TTs to the credit of central office account. T.Y.BBI38
  39. 39. RISK MANAGEMENT D. UTILITY OF ASSET LAIBILITY MANAGEMENT: The ALM program plans crucial role in ensuring adequate liquidity in the bank by assessing liquidity needs of the bank managing simultaneously assets and liability of the bank. Thus, the utility of ALM for banks lies in its effectiveness to enable the management to achieve the banks basic objective of maximizing income while controlling its risk exposure and maintaining reasonable amount of liquidity in an environment of competitiveness and discontinuity ALM allows a bank to plan for risks well ahead of the time they can prove damaging to price is loans and deposits in a competitive manner and to structure its products in such a way as to attain optimum level of income with acceptable risk. It also facilities its earnings by imparting stability to its interest margins. E. PRE-REQUISITES TO THE EFFECTIVENESS OF ASSETS AND LIABILITY MANAGEMENT: Asset and liability management as an approach of managing assets- liability can help in achieving the desired result if the following conditions are fulfilled: • ALM requires deduction to acting on the basis of the contemplated future, a determination to plan regularly and systematically as an integral part of management. T.Y.BBI39
  40. 40. RISK MANAGEMENT • The ALM presupposes the team approach in decision making and action. • Visualization of the banks vision and its articulation in terms of purpose and mission is the hallmark of ALM • The top management should evolve system to provide to all levels of management a thorough understanding and awareness of risk and all its parameters. • Technological and infrastructure support system in the bank would be an important prerequisite to implement the system effectively. • The bank must develop human resource and craft a well thought out strategy for developing skills and competencies of its functionaries for risk definition, risk quantification and risk analysis. T.Y.BBI40
  41. 41. RISK MANAGEMENT From Risk Management to Value Management The subject of finance suggests that the ultimate objective of any commercially oriented enterprise is ‘shareholder wealth maximization’. This means that all the decisions should be towards maximizing the market the value of equity shares traded in the market in the long run. Accounting measures of performance evaluation such as Net Profit Margin, Return on Assets, Return on Equity, Earnings per Share, etc. are at best useless as they are only return measures. They do not consider the actual risk taken to earn the return earned. The measures of shareholder wealth maximization, broadly called as SWM measures, consider both the return and risk in its framework and are superior to the accounting measures in a number of ways. The following description explains the relationship between the expected return, actual return and addition to shareholder wealth in a given time period: • AR > ER: Addition to existing wealth of shareholders • AR < ER: Destruction of existing wealth of shareholders • AR = ER: Maintenance of existing wealth of shareholders Where AR = Actual rate of return on shareholders’ capitals ER = Expected Rate of Return on shareholders’ capitals T.Y.BBI41
  42. 42. RISK MANAGEMENT As it can be seen, wealth maximization takes place only when the actual return is higher than the expected return. Actual return for this purpose is an economic measure, not an accounting measure. The term ‘expected return’ denotes the rate of return expected by the shareholders for the level of risk they are exposed to in their investment. There are a number of approaches to estimating the expected return such as Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), etc. There has been a shift gradually from accounting based measures to SWM measures in many industries. Banking is not an exception to this. The most popular SWM measure in the banking industry is Risk Adjusted Return On Capital (RAROC) and its variants. RAROC has its numerator the return earned and capital allocated in its denominator. Given the importance of SWM measures, the traditional control oriented risk management system should have pave the way for value based risk management system. In order to achieve this, the two steps need to be added to the existing list of steps in risk management: 1. Capital Allocation: Under this step, activities of a blank would be broken down to various major businesses, retail banking, corporate banking, government business, proprietary trading, etc. Each one can be viewed as a Strategic Business Unit (SBU) with targets of return performance. Each one of the SBUs is allocated a portion of the bank’s equity capital. The allocation of capital is based on the contribution of each SBU to various risk of the bank. Higher the contribution of an SBU to the risk of the bank, higher will be the capital allocated. 2. Risk-adjusted Performance Measurement: Having allocated capital to each SBU commensurate with its contribution to the overall T.Y.BBI42
  43. 43. RISK MANAGEMENT risk of the bank, a target return on the capital allocated needs to be set. The question of whether the target returns to be achieved by each SBU dependent upon risk contribution is the most contentious issue occupying the attention of the risk management community. Integration of Risks Leading to EWRM System: Each one of the risk is interrelated to the other. It has been observed that one type of risk can transfer itself into some other type, if not managed properly thereby causing losses to the bank. For example, it has been generally observed that when interest rate go up in the economy, the credit risk also increases as increase in the interest rates on loan increases the burden of the borrower to pay. Similarly, the market risk and liquidity risk are highly interrelated. It has been witnessed that when the markets crash, the liquidity of the traded securities in the market dries up drastically. The recent example in the Indian market highlighting the interrelationship between operational risk and market risk (of adverse price change) was the fall in the market value of ONGC stocks when wrong allotments were made due to error in the software used by the registrar of the issue. When risk are interrelated strongly, managing each one of them under a ‘silo’ approach can leads to losing the focus on interrelationship as each one the risk management function would be concentrating only on a particular risk. To prevent this leakage, RBI has suggested that the banks should move towards an integrated risk management system in which the mentioned interrelationships are analyzed prior to ascertaining the impact of risk. The current risk management practices under the ‘silo’ approach do not pave the way for T.Y.BBI43
  44. 44. RISK MANAGEMENT identifying the tool. This means that there is a need for a thorough overhauling of the entire risk management system rather than merely making cosmetic changes to the existing system. Technology and Risk Management Technology can be very effectively employed in measurement and management of various risks in banks. ‘Liquidity risk’ can be controlled by proper deployment of technology for centralized operations with networking of branches, payment system reforms, implementation of technology-oriented schemes like electronic clearing services, electronic fund transfer, real-time gross settlement systems, centralized fund management systems, public debt office negotiated dealing system etc. measures which can mitigate ‘credit risk’ include analysis of industry data, software-based preventive monitoring system for borrower accounts, straight through processing, implementation of know your customer guidelines of RBI etc. ‘Product/Services risk’ can be controlled by proper customer relationship management, implementing data warehousing and data mining, proper market analysis, emphasis on proper deployment of delivery channels. Technology has a major role in deployment of product and services. T.Y.BBI44
  45. 45. RISK MANAGEMENT Minimum Capital Requirement Three Basic PillarsThree Basic Pillars Supervisory Review Process Supervisory Review Process Market Discipline Requirements Market Discipline Requirements The NewBaselCapital Accord T.Y.BBI45
  46. 46. RISK MANAGEMENT Banking Risks & Capital Accords The extent of risk taken by a bank and the amount of capital required to be maintained by the bank for such risk-taken is all about capital adequacy standards. Prior to the implementation of the Basel’s first capital accord in the beginning of the 1990s, there was no relationship between capital and risk taking. Banking businesses, being one of the highly levered businesses, is the significantly prone to stocks. Moreover, banking business is the business of public confidence. If public confidence erodes, it becomes difficult for a bank to be in business. Basel Committee, with a view to protecting banks from vulnerabilities and to maintain financial stability, recommended a minimum capital to risk- weighted assets ratio, thereby limiting the risk exposure to availability of capital. Initially the capital accord recognized only credit risk. Subsequently, the market risks also brought under the capital accord. Recently in the Basel Accord-2, sweeping changes have been suggested for the computation of capital adequacy as Basel Accord-1 miserably failed to achieve its objectives of promoting safety and soundness of the financial system. Apart from credit and market risks, the operational risk would also require minimum capital to be maintained under Basel Accord-II. T.Y.BBI46
  47. 47. RISK MANAGEMENT To achieve these objectives, Basel Committee proposed a three-pillared framework as under: Pillar 1: Minimum Capital Requirements: Under this, in the current accord, a minimum capital has been prescribed to be maintained. To arrive at the capital for various types of risks, a number of approaches, widely classified as standardized approach, have been prescribed. The critical issues in the internal approach in which the banks are free to develop their own approach to measures risks, validating the internal approach and ensuring consistency across banks. Pillar 2: Supervisory Review Process: This puts responsibility on the bank supervisor to ensure that bank follow rigorous processes, measure their risk exposures correctly and maintain capital in accordance with risk exposure. The recent initiatives of the RBI in the introduction of Risk Based Supervision and Risk Based internal Audit are in conformity with this pillar. Pillar 3: Market Discipline: This aims to strengthen the safety and soundness of the banking system through better disclosure of risk exposure and capital maintained. This is expected to help the market participants to better assess the position of banks. T.Y.BBI47
  48. 48. RISK MANAGEMENT Why Basel II? The essence of Basel II is to manage the risk profitably and align the risks undertaken/assumed by the bank to the economic capital of the bank. The new accord is designed to introduce safety and soundness into the banking system. Banks need to measure risk, diversify exposures and manage risks in an optimum manner that fetches them adequate compensation, improves bottom-line in the short-term and helps them to maximize the stakeholders value in the long-run. Banks have been compelled to review and overhaul the Risk Managements is also emerging as an important business differentiator in the face of rapid economic growth that is being witnessed in the global economy and is capable of ensuring orderliness in the global financial scenario if implemented properly. The keystone of Basel initiative is to achieve this objective and to ensure that banks are not strapped for capital to cover the risks they assume. Basel II framework provides a methodology for transforming banks into vibrant and stable entities in the globally competitive and dynamic financial markets. It points towards RAPM (Risk Adjusted Performance Management) methodology and RAROC (Risk Adjusted Return on Capital). All the three pillars are intended to be equal in importance. The first pillar echoes Basel I in terms of minimum prescriptive levels of regulatory capital, across credit and market risks, but also introduces operational risk charges for the first time. With increasing transactional complexities, multiplicity of technology platforms and T.Y.BBI48
  49. 49. RISK MANAGEMENT various product innovations, banks face a number of operational risks which could affect their market reputation. Pillar II is actually the next sieve for any of the risks not captured under Pillar I with a Supervisory Review Process (SRP) designed for this. Pillar III brings into play the importance of market driven disclosures to peers and other stakeholders. As the saying goes, it is a “Risk Determined Code of Conduct”, signifying among others, the status of the bank in terms of adoption of sophisticated risk management practices. T.Y.BBI49
  50. 50. RISK MANAGEMENT Basel-II A Need for Existence The Indian Scenario A feature, which is unique to our Indian financial system, is the diversity of its composition . We have the dominance of government ownership coupled with significant private shareholding in the public sector banks, which in turn continue to have a dominate share in the total banking system. These public sector banks, especially the new ones are continuously trying to be at par with international standards and norms. We also have cooperative banks whose numbers are large. There are Regional Rural Banks with links to their parent commercial banks. The foreign banks operate profitably and have uniform regulatory standards. Now banking has become a one-stop shop of varied financial services. In this scenario, Reserve Bank of India has been setting prudential norms in convergence to international standard. India has to aim for global standards across the banking sector in order to manage risk. This is the guiding principle in Basel-II Accord. In the annual policy statement in May this year, the RBI announced that Indian banks should come out with a framework by the end of December 2006 for migrating their standards of supervision, accountability and best practice guidelines in line with the provision of the Basel-II Accord. Moreover, the framework adopted by the banks must be adaptable to changes in business size, market dynamics, and introduction of newer products in future. T.Y.BBI50
  51. 51. RISK MANAGEMENT To ensure that Indian banks must: • Make an in-depth analysis of the option available under Basel-II. • Adopt ‘standardized approach ‘for credit risk. • Adopt ‘basic indicator approach’ for operational risk. • Review the progress at quarterly intervals. • Install comprehensive and rigorous system to assess borrower’s risk. T.Y.BBI51
  52. 52. RISK MANAGEMENT Issue in implementing Basel II by the Indian banking Industry “Implementation OF Basel II is no longer a possibility, it is a certainty. Thus, the Indian banking industry has to gear up towards it and ensure that it is implemented well in time-or else the cost of being left behind will be too large to bear” The draft Basel II Accord has finally been accepted and is applicable to all banks in member countries from January 1, 2007, and India is no exception. In fact, India’s association with the Basel Committee on Banking Supervision dates back to 1997 when it was among the 16 non- member countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India (RBI) became a member of the Core Principle Liaison Group in 1998 and subsequently became a member of the Core Principle Working Group on capital. Within the CPWG, RBI had the privilege of leading a group of 6 major non G-10 supervisors who presented a proposal on a simplified approach for Base II to the committee. The main addition or improvement fund in Basel II over Basel I is that it recognizes both credit and operational risks apart from market risk as the primary sources of risks and directs banks to allocate adequate amount of capital for these types of risks. RBI’s approach to implementing the prudential norms has been one of gradual convergence with international best practices with appropriate adaptations. RBI wants T.Y.BBI52
  53. 53. RISK MANAGEMENT to achieve this in a phased manner through a consultative process evolved within the country. RBI, in its annual policy statement in May 2004, had announced that banks in India should examine, in depth, the option available under Basel II and draw a road map by the end of December 2004 for migration to Basel II by December 2006, and review the progress made thereof at quarterly intervals. Further, the RBI will be closely monitoring the progress made by the banks in this direction. Hence, all banks in India, to begin with, will be directed to adopt the Standardized Approach for Credit Risk and the Basic Indicator Approach for Operational Risk. After adequate skills are developed, both in banks as well as at the supervisory levels, some banks may be allowed to migrate to the Integrated Risk Based (IRB) approach. The regulatory initiatives taken by RBI towards implementing Basel II include: • Ensuring that banks have a suitable risk management framework oriented towards their requirements as dictated by the size and complexity of their business, risk philosophy, market perceptions and expected level of capital. The framework adopted by the banks has to be one that can be adoptable to changes, if required. • Introduction of Risks Based Supervision (RBS) in 23 banks on pilot basis. T.Y.BBI53
  54. 54. RISK MANAGEMENT • Encouraging banks to formalize their Capital Adequacy Assessment Program (CAAP) in alignment with their business plan and performance budgeting systems. • Enhancing the area of disclosure, so as to have greater transparency, of the financial position and the risk profit of the banks. The areas of greater disclosure include capital ratios, profitability ratios, non-performing loans, provision for non- performing loans, etc. • Improvement the level of corporate governance standards in banks. • Building capacity for ensuring the regulator’s ability to identify and permit eligible banks for IRB/Advanced Measurement approach. T.Y.BBI54
  55. 55. RISK MANAGEMENT RBI Initiatives RBI has initiatives concepts like: • Risk-Based Supervision (RBS) in 23 banks on pilot basis. • Encouraging banks to formulate Capital Adequacy Assessment Program. • Improving corporate governance in banks. • RTGS System: Many Indian banks (11to be precise) are going in for Real Time Gross Settlement (RTGS) system, e.g., ING Vysya Bank. This system will allow the clients to transfer funds instantaneously across RTGS-enabled Banks in India, thus putting their funds to better use because of a quicker realization as compared to current instrument based fund transfers. Also the bank can manage intraday liquidity effectives. Nevertheless, there are many challenges that Indian banks faces by virtue of its culture diversity and lack of infrastructure. T.Y.BBI55
  56. 56. RISK MANAGEMENT Requirement for an Effective Risk Management System The Basel Committee on Banking Supervision has set out the requirement for an effective risk management system as under: • Well-informed board of directors and oversight of board • Capable management • Adequate risk management policies and processes • High quality MIS for risk management and • Appropriate staffing of the risk management function The job of the board is to establish bank’s strategic direction and define risk tolerances for various type of risk. The risk management policies and standards need to be approved by the board. The senior management of the board is responsible for implementation, integrity and maintenance of the risk management system. T.Y.BBI56
  57. 57. RISK MANAGEMENT Challenges The Indian financial system, the banking system in particular, is vastly diverse. There is a simultaneous existence of the huge government ownership along with significant private shareholders in public sector banks, which have a huge presence in total banking system. Apart from the public sector banks there are the relatively new private sector banks- most of which are multinationals. There are also many Co-operative Banks and the Regional Rural Banks and branches of foreign banks (these branches are, by and large, hugely profitable operations for the present banks). The process of providing financial services is also changing rapidly from traditional banking to a one-stop shop of varied financial services, and the old institutional demarcations are increasingly getting blurred. To implement Basel II norms in India, the following challenges are envisaged: • Implementation of Basel II Accord, especially the IRB approach, will be a major challenge as banks will have to substantially upgrade their information system, risk management systems as well as technical skills of the staff. T.Y.BBI57
  58. 58. RISK MANAGEMENT • In terms of operational risk, the banks will have to prioritize risk control among different business lines. Given the complexities and data requirements, may banks will be compelled to use the standardized Approach, which means that the capital charge for operational risk will only be an add-on to the overall capital. • The issue of credit rating has to be streamlined. Though there are a few players in the credit rating arena in India, the credit rating methodology used by these agencies need to be strengthened and applied universally. Also, encouraging the ratings of issuers could turn out to be a challenge. • Basel II allows the supervisor to prescribe higher minimum capital levels for banks for, amongst other things, interest rate in the banking book and concentration of risk exposures. RBI has already initiated action to identify these issues in banks. But given the huge magnitude of this task in the Indian context, the task is, at a very last, daunting. • Issues of cross-border capital have to be sorted out-this will particularly affect foreign banks (currently foreign banks are statutorily required to be maintain local capital). Note that this list of challenges is not exhaustive, but in all likelihood refers to the major challenges that would need to be addressed in the process of implementation of Basel II. T.Y.BBI58
  59. 59. RISK MANAGEMENT Impact RBI in various documents has pointed out that Basel II will involve a shift from direct supervisory focus to implementation issues, and that banks and supervisors will be required to invest large resources in upgrading technology and human resources to meet the minimum standards. Assuming that banks and supervisors can switch over to the Basel II norms without a problem, Indian banks, especially the public sector banks, will become more efficient and globally competitive. Implementation of Basel II will, in general, lead to decrease in the required capital with respect to operational risks. However, in India, several factors may raise the required capital even for credit risks (one example to this effect could be the use of real estate as collateral for loans attracting a 150% risk weight on non-performing loans). On the contrary, a 75% risk weight on retail lending to SMEs and a 35% risk weight on home loans might lead to some reduction in the capital requirements. As per Basel II, the bulk of the borrowers in the Indian market fall in the speculative grade-this might cause a dramatic rise in the debt costs and heightened cyclicality of bank credit. Augmenting the capital requirements of the banks could have adverse impact on the credit portfolios of the banking sectors. Another issue could be the introduction of the Economic Capital Based (ECB) models to help banks in capital budgeting, deal pricing and performance management in a “risk adjusted” framework. Though this T.Y.BBI59
  60. 60. RISK MANAGEMENT will be a useful tool, it would require banks and supervisors to understand the two elements of economic capital assessment; namely: • Calculation of aggregate economic capital across all sources of risk. • Allocation of capital to individual business units or profit centers on a risk-efficient basis. These are some of the major impacts that are going to be felt by all the banks including the RBI in implementing Basel II. However, there is no doubt that a successful implementation of Basel II will ensure that the banks would benefit from the economic capital framework. IT will further provide the banks with a platform to develop models for managing their business efficiently and complete with the more sophisticated players. It will also help banks learn to use their capital in the most efficient manner, which will definitely be the key to survival in a global, unconstrained and ruthless environment in the financial service sector. T.Y.BBI60
  61. 61. RISK MANAGEMENT Improved Risk Management (RM) Process Basel II is normally seen largely as a compliance driven issue and only a small number of banks have fully exploited business efficiency and integrity. In fact, Base II affords a good opportunity to undertake a through review of RM processes and consolidated them. While implementing to comply, we can implement to gain. We can implement for reduced overall cost, increased RAROC and improved decision- making process. It also helps build a transparent corporate accountability and enables management of risk in accordance with the risk appetite enabling economic capital saving, a precursor to development of integrated risk management capability across the bank. It creates an increased level of transparency around disclosure of risk. Hence, banks need to use the opportunity to implement effective RM system to achieve competitive efficiency. As Basel II helps banks differentiate customers by risk, advantages and disadvantages are likely to accrue for bank customers. Those with possible advantage: • Prime customer • Well-rated entities. T.Y.BBI61
  62. 62. RISK MANAGEMENT • Small and medium- sized business. • High-quality liquidity portfolios. • Collateralized and hedged exposures • Low credit and operational loss exposures. • Strong risk management processes. Those with possible disadvantages: • Higher credit risk individuals. • Uncollateralized credit. • Specialized lending (in some cases). • High historical credit and operational loss experience. • Weak risk management processes. T.Y.BBI62
  63. 63. RISK MANAGEMENT Challenges Ahead Infrastructure In a recent survey conducted by the Federation of Indian Cambers of Commerce and Industry (FICCI), 55% of the respondents’ claims that Indian banks lack adequate preparedness to be able to confirm to the Basel-II provision by 2006. Whereas, 50% of public sector banks have expressed their preparedness in meeting these guidelines, only 25% of the old and new private sector and foreign banks are likely to be ready to meet them by 2006. According to the survey, concerns of the Indian banks in implementing these norms are: • 51.6% said due to low levels of computerization, • 87% said due to absence of robust internal credit rating mechanism, • 80.6% said due to lack a strong management information system, T.Y.BBI63
  64. 64. RISK MANAGEMENT • And 58% said due to the lack of sufficient training and education to reach the levels to conform to the provision of Basel-II. Effect on Indian Banks State Bank of India, Bank of Baroda, and Bank of India Vivek Srivastava, senior bank analyst at Fitch Ratings, Mumbai, is more skeptical. Collecting the necessary data is going to take sometime, he says. So far, the RBI has told only the internationally active banks that they to be ready to comply with Basel-II from the outset. And, there are only about three banks that fall into this category, even loosely defined: The State Bank of India, Bank of Baroda, and Bank of India (all public sector banks). These banks will probably adopt the standardized approach to credit risk management he says. In addition, some of the progressive new generation of private sector banks, which have the most advanced technology platforms because they entered the business late, will also want to apply the new Accord from the outset. HDFC Bank This is confirmed by Paresh Sukthankar, head of credit and market risk, at HDFC Bank, one of the largest of the new generation of private sector (it is eight years old). Fully automated and growing at an annual compound rate of 20-25%, HDFC Bank has had a grading model in a place to rate its corporate portfolio for some time. Sukthankar says he is T.Y.BBI64
  65. 65. RISK MANAGEMENT still waiting for final guidelines from the RBI, buts expects that banks will initially be required to adopt the standardized approach for credit risk, with amore advanced approach being introduced a year or two later. “We will be at the forefront in implementing the new guidelines as they are rolled out by the central bank,” he says. ABN AMRO ABN AMRO has decided to adopt the A-IRB approach, under the new accord, for calculating the minimum capital required against its credit risk, reveals Jan Sijbrand in the interview with GRR. But the bank has not yet decided whether it would adopt the AMA approach for operational risk. If it does not, this could raise difficulties over its regulation in the US. Adopting the A-IRB means that the bank will attract “seriously lower” capital charge on its mortgage retail business-its main strength in the US mid-west – than its local competitors, who will face the higher capital charges associated with Basel-I. IDBI Bank IDBI bank has chosen to go by the advanced management approach for operational risk. CITIGROUP Citigroup will be on the advanced approach for all risk types. It planes to run parallels of Base-II from 2006 onwards and go live from 2007. This will give it a strategic edge by reaping advantages through the “learning curve” throughout 2006. From data collection and implementation T.Y.BBI65
  66. 66. RISK MANAGEMENT standpoint, it will be more challenging for Citigroup, given over 50% of Citigroup’s exposures reside outside of the US. Citigroup will be the most complex Basel-II implementation in the world. CONCLUSION Today RBI states that due to diversity and varying size of Balance Sheet it is not necessary to adopt risk management. I assume that banks can evolve their own system competable with their type and size of operation as well as risk perception and with the Implementation of technology-oriented schemes like electronic fund transfer, real-time gross settlement systems, centralized fund management systems public debt office negotiated dealing system etc. T.Y.BBI66
  67. 67. RISK MANAGEMENT BIBLOGRAPHY WEBSITES 1. www.google.com 2. www.yahoo.com 3. g.kakkar@yahoo.com BOOKS PROFFESSIONAL BANKER T.Y.BBI67