Chapter 08 risk management in banks

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Chapter 08 risk management in banks

  1. 1. CREDIT RISK AND RISK MANAGEMENT IN BANKS
  2. 2. CREDIT RISK <ul><li>Inherent in banking . </li></ul><ul><li>Risks that banks take must be- reasonable, controlled, within their financial resources and competence </li></ul><ul><li>Covers- all risks related to a borrower not fulfilling his obligations on time </li></ul><ul><li>Magnitude of risk dependant on - likelihood of default by counter party, potential value of outstanding contracts, legally enforceable netting arrangements allowing offsetting contracts, collateral security </li></ul>
  3. 3. 6C`S OF CREDIT <ul><li>Character (borrower's personal character – honesty, willingness and commitment to pay debts) </li></ul><ul><li>Capacity </li></ul><ul><li>Capital (financial condition) </li></ul><ul><li>Condition (economic) </li></ul><ul><li>Compliance </li></ul>
  4. 4. OBTSTACLES IN CREDIT RISK MANAGEMENT <ul><li>Governmental control </li></ul><ul><li>Asymmetric and unreliable Information </li></ul><ul><li>Legal framework </li></ul><ul><li>Political pressures </li></ul><ul><li>Production difficulties </li></ul><ul><li>Financial restrictions </li></ul><ul><li>Market disruptions </li></ul><ul><li>Delays in production </li></ul><ul><li>Instability in business environment </li></ul>
  5. 5. CREDIT RISK MANAGEMENT - OVERVIEW <ul><li>Origin – Client request, Prospect discovery, Outside referral </li></ul><ul><li>Evaluation – Purpose, Business, Management </li></ul><ul><li>Negotiation – Tenor, Repayment, Covenants, Security </li></ul><ul><li>Approval </li></ul><ul><li>Documentation – Legal drafting, Collateral </li></ul><ul><li>Disbursement </li></ul><ul><li>A dministration – Repayment, Unforeseen events, Compliance of terms and conditions </li></ul><ul><li>Reviews – early recognition, Recovery Strategy </li></ul><ul><li>Repayment </li></ul>
  6. 6. METHODS - REDUCTION OF CREDIT RISKS <ul><li>Raising credit standards to reject </li></ul><ul><li>Obtain collateral and Guarantees </li></ul><ul><li>Ensure compliance with loan agreement </li></ul><ul><li>Transfer credit risk by selling standardized loans </li></ul><ul><li>Transfer risk of changing interest by Hedging, financial futures, options </li></ul><ul><li>Opt for loan syndication </li></ul>
  7. 7. CREDIT DERIVATIVES <ul><li>Unbundling of credit risk - Off-balance sheet financial instruments that permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset </li></ul><ul><li>It is a bilateral contract between a protection buyer (Lending bank) and a protection seller (Credit Risk Buyer or Guarantor ) </li></ul><ul><li>Upon happening of credit event – Protection Seller will make contingent payment (difference between full face value and current resale value of a particular bank loan) </li></ul><ul><li>Condition that trigger payout – payment default, insolvency, rating downgrading [ 8 different types of credit events stipulated by International Swaps and Derivatives Association] </li></ul><ul><li>Protection buyer will pay - periodic fee to protection seller </li></ul>
  8. 8. CREDIT RISK IN INDIA AND SARFAESI ACT 2002 <ul><li>Credit Risk : The risk of non-payment of principal and/or interest to investors can be at two levels: </li></ul><ul><ul><li>SPV; and </li></ul></ul><ul><ul><li>underlying assets. </li></ul></ul><ul><li>SPV is normally structured to have no other activity apart from the asset pool sold by the originator </li></ul><ul><li>Credit risk principally lies with the underlying asset pool. </li></ul><ul><li>A careful analysis of the underlying credit quality of the Obligors and the correlation between the obligors needs to be carried out to ascertain the probability of default of the asset pool. </li></ul><ul><li>A well diversified asset portfolio can significantly reduce the simultaneous occurrence of default </li></ul>
  9. 9. PROCESS OF SECURITIZATION ANCILLARY SERVICE PROVIDERS OBLIGOR (Borrower) SPV ORIGINATOR (Banker) CREDIT RATING OF SECURITIES CREDIT RATING AGENCY BANKER INVESTORS (QIBs) ISSUE OF SECURITIES SALE OF ASSETS
  10. 10. RISKS IN COMMERCIAL BANKING Management Risk Business Operations Systemic Risk EDP Risk Market Operations, ALM Operation Risk Liquidity Risk Lending Operations Foreign Exchange Risk Interest Rate Risk Management & Internal Controls Credit Risk
  11. 11. CROSS BORDER MONEY FLOWS AND REGULATIONS <ul><li>Growth of cross-border money flows highlighted lack of efficient banking supervision on an international level </li></ul><ul><li>National banking supervisory authorities regulate domestic banks and domestic activities of international banks </li></ul><ul><li>Failure of some US Banks prompted G10 central bank Governors to set up Basel Committee on Banking Supervision </li></ul><ul><li>Committee issued Basel Capital Accord, credit risk measurement framework for internationally active banks, became a globally accepted standard (Basel I) </li></ul><ul><li>Revised by Basel II- to achieve a better transparent measurement of various risks incurred by internationally active banks, limiting possibility of contagion in case of a crisis </li></ul>
  12. 12. BASEL ACCORD AND BASEL II NORMS <ul><li>Basel accord - regulations for banks set by Basel Committee, to protect interest of depositors in a Bank. </li></ul><ul><li>Basel- I accord was accountable for two risks viz, Credit Risk and Market Risk </li></ul><ul><li>Basel II uses a &quot;three pillars&quot; concept – </li></ul><ul><li>(1) minimum capital requirements </li></ul><ul><li>(2) supervisory review and </li></ul><ul><li>(3) market discipline – to promote greater stability in the financial system </li></ul><ul><li>The Basel I accord dealt with only parts of each of these pillars </li></ul>
  13. 13. <ul><li>Asset-Liability Management [ALM] models enable institutions to </li></ul><ul><ul><li>measure and monitor risk, and </li></ul></ul><ul><ul><li>provide suitable strategies for their management </li></ul></ul><ul><li>Even in the absence of a formal ALM program, understanding of these concepts is of value to an institution as it provides a truer picture of risk/ reward trade-off in which institution is engaged </li></ul><ul><li>The various aspects of B/S management deal with planning as well as direction and control of levels, changes and mixes of assets, liabilities, and capital </li></ul>ASSET LIABILITY MANAGEMENT
  14. 14. ALM STRUCTURE GENERAL ASSET, LIABILITY & CAPITAL MANAGEMENT SPECIFIIC LIBILITY MANGEMENT ASSET MANAGEMENT FINANCIAL BALANCE SHEET MANAGEMENT INCOME & EXPENDITURE MANAGEMENT
  15. 15. <ul><li>ALM process </li></ul><ul><li>Liquidity Risk Management – process to measure liquidity positions of bank on an ongoing basis and also to examine how liquidity requirements are likely to evolve under crisis scenarios - assuring bank's ability to meet its liabilities as they become due </li></ul><ul><li>Currency Risk - banks are free to set gap limits with RBI's approval by adopting Value at Risk (VaR) approach to measure risk associated with forward exposures. </li></ul><ul><li>Gap - difference between Rate Sensitive Assets and Rate Sensitive Liabilities for each time bucket. </li></ul><ul><li>Interest Rate Risk - risk where changes in market interest rates might adversely affect a bank's financial condition </li></ul><ul><li>Risk from earnings perspective can be measured as changes in Net Interest Income (NII) or Net Interest Margin (NIM ) </li></ul>
  16. 16. CAPITAL ADEQUACY RATIO <ul><li>Objectives : to strengthen soundness and stability of banking system; Standardised Approach for credit risk and Basic Indicator Approach for operational risk </li></ul><ul><li>Effective date of migration – 31 st March 2009. </li></ul><ul><li>Capital Adequacy Ratio (CAR or CRAR) : ratio of </li></ul><ul><li>Eligible total capital funds Credit Risk RWA + Market Risk RWA + Operational Risk RWA </li></ul><ul><li>Capital Fund has two tiers – </li></ul><ul><ul><li>Tier I capital - PUC, Free Reserves </li></ul></ul><ul><ul><li>Tier II capital - Revaluation Reserves and other non free reserves </li></ul></ul><ul><li>Reckoning of Tier 2 capital – reckoned as capital funds up to a maximum of 100 % of Tier 1 capital, after making necessary deductions/ adjustments </li></ul><ul><li>Minimum requirements of capital fund - 9 % on an ongoing basis </li></ul>
  17. 17. Capital Adequacy Ratio (Contd.) <ul><li>Risk Weighted Assets – </li></ul><ul><ul><li>Fund Based : cash, loans, investments and other assets. </li></ul></ul><ul><ul><li>Non Fund Based -The credit risk exposure attached to off-balance sheet items </li></ul></ul><ul><li>Risk factors considered by RBI </li></ul><ul><ul><li>effectiveness of bank’s risk management systems in identifying, assessing / measuring, monitoring and managing various risks including interest rate risk, liquidity risk, concentration risk and residual risk </li></ul></ul>
  18. 18. INTEREST RATE RISK <ul><li>Determinant of banks` profitability - difference between interest income and interest expense (called Net Interest Income) </li></ul><ul><li>Why Risk - mismatch of Assets and Liabilities gives rise to interest rate risk ;may arise due to higher borrowing charges and preferences of its constituents </li></ul><ul><li>Objective of Risk Management – to insulate Net Interest Income </li></ul><ul><li>Methods of risk analysis – by Maturity; Funding Gap Analysis, duration analysis and value at risk </li></ul><ul><li>Risk Management Tool – transacting in derivative instruments provide flexibility to banks; Forward Rage Agreements; Interest Rate Swap </li></ul>

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