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  1. 1. i Summer Internship Project Report On RISK MANAGEMENT AND ITS FUNDAMENTAL ECONOMICS By SHRISHTI SHREE ECONOMICS HONORS BATCH 2012-2015 At LADY SHRI RAM COLLEGE FOR WOMEN DELHI UNIVERSITY NEW DELHI
  2. 2. ii DECLARATION RISK MANAGEMENT AND ITS FUNDAMENTAL ECONOMICS I declare (a) That the work presented for assessment in this Summer Internship Report is my own, that it has not previously been presented for another assessment and that my debts (for words, data, arguments and ideas) have been appropriately acknowledged (b) That the work conforms to the guidelines for presentation and style set out in the relevant documentation. Date: 30th June, 2013 Shrishti Shree 877 B.A. (Hons.) Economics
  3. 3. iii ACKNOWLEDGEMENT This Summer Internship offered me an exciting opportunity to gain insights on banking and its operations. I am thankful to Oriental Bank of Commerce to provide me with this valuable opportunity which has helped me to gain a holistic view of the banking Industry and the associated Bank’s risk management process. It is not possible to prepare a project report without the assistance & encouragement of other people. This one is certainly with no exception. I express my sincere thanks to my mentor, Mr.Vibhor Verma, Chief Manager, Risk management Department and Mr.Keshav Rao, Manager, Risk Management Department for guiding me right from the inception till the successful completion of the project. I sincerely acknowledge them for extending their valuable guidance, support for literature, critical reviews of project and the report and above all the moral support they had provided to me with all stages of this project. I would also like to thank, Mr.V.R. Iyer, General Manager, Risk Management Department, Mr. Ashutosh Chaudhary, Assistant General Manager, Risk Management Department and Mr. Tarundeep Singh, Manager, Risk Management Department, for their help and cooperation throughout my project. I am obliged, for the valuable information provided by him. I am grateful for his cooperation during the period of my assignment. At last but not least, gratitude goes to all of my friends and family who directly or indirectly helped me to complete this project report.
  4. 4. iv Contents 1. CHAPTER 1 ....................................................................................................... 1 ABSTRACT................................................................................................... 1 1.1 FUNDAMENTALS OF MONEY AND FOREIGN EXCHANGE MARKET ...................................................................................................... 2 1.1.1 MONEY ................................................................................................ 2 1.1.2MONEY SUPPLY ................................................................................. 2 1.1.3 TREASURY.......................................................................................... 3 1.1.4 MONEY SUPPLY IN THE INDIAN ECONOMY.............................. 4 1.1.5 MONEY DEMAND.............................................................................. 7 1.1.6 THE MONEY MARKET ..................................................................... 8 1.1.7 RELATIONSHIP BETWEEN MONEY MARKET AND MONEY SUPPLY ........................................................................................................ 9 1.2 FOREX (FOREIGN EXCHANGE MARKET)....................................... 9 1.3 EXCHANGE RATE .............................................................................. 11 1.4 TYPES OF EXCHANGE RATE........................................................... 11 1.5 EXCHANGE RATE SYSTEMS ........................................................... 12 1.6 DETERMINATION OF EXCHANGE RATE ...................................... 13 1.7 ROLE OF RBI IN AFFECTING FOREX/ EFFECT OF CHANGE IN DOMESTIC MONEY SUPPLY ................................................................. 18 1.8 RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT ..................................................................................................................... 19 1.9 ROLE OF RBI IN FOREIGN EXCHANGE MARKET ....................... 19 1.9.1 FERA AND EXCHANGE CONTROLS............................................ 21
  5. 5. v 1.9.2 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)............... 22 1.9.3 LINKING THE MONEY MARKET TO THE FOREIGN EXCHANGE MARKET ............................................................................. 22 1.10 RISKS ASSOCIATED WITH INCREASE IN MONEY SUPPLY.... 24 1.11 RISKS ASSOCIATED WITH DECREASE IN MONEY SUPPLY... 25 1.12 EFFECT OF INCREASE IN FOREIGN INVESTMENT ON FOREX ..................................................................................................................... 25 1.13 EFFECT OF DECREASE IN FOREIGN INVESTMENT ON FOREX ..................................................................................................................... 25 1.14 LIQUIDITY AND RBI........................................................................ 25 1.15 RISKS ASSOCIATED WITH MORE OF FII INFLOWS.................. 26 1.16 TOOLS TO CONTROL LIQUIDITY ................................................. 26 1.17 RISKS ASSOCIATED WITH LIQUIDITY........................................ 27 2. CHAPTER 2 ..................................................................................................... 28 ABSTRACT................................................................................................. 28 2.1 RISK MANAGEMENT AND ITS FUNDAMENTALS ...................... 29 2.11 TYPES OF RISKS ASSOCIATED WITH A BANK.......................... 41 2.11.1 CREDIT RISK .......................................................................... 41 2.11.2 MARKET RISK........................................................................ 45 2.11.3 LIQUIDITY RISK .................................................................... 47 2.11.4 OPERATIONAL RISK............................................................. 52 2.11.5 RESIDUAL RISKS................................................................... 54 2.12 RISKS ASSOCIATED WITH A COUNTRY..................................... 55 2.12.1 COUNTRY RISK...................................................................... 55
  6. 6. vi 3. CHAPTER 3 ..................................................................................................... 59 ABSTRACT................................................................................................. 59 3.1 INTEREST RATE OUTLOOK ............................................................. 60 3.2 INTEREST RATE ................................................................................. 60 3.3 VARIOUS TYPES OF INTEREST RATES ......................................... 60 3.4 TREND DETERMINANTS OF REAL INTEREST RATES ............... 60 3.5 SHORT RUN INFLUENCES................................................................ 61 3.6 LONG-RUN PARAMETERS ............................................................... 62 3.7 INTEREST RATES AND ITS COMPLICATIONS ............................. 63 3.8 INTEREST RATE AND SAVINGS ..................................................... 65 3.9 RBI AND ITS SUPERVISION OF INTEREST RATE........................ 65 3.9.1 THE REPO RATE .............................................................................. 66 3.9.2 THE CALL MONEY.......................................................................... 66 3.9.3 CASH RESERVE RATIO .................................................................. 66 3.9.4 REVERSE REPO RATE .................................................................... 67 3.9.5 REPO RATE ....................................................................................... 67 3.9.6 BANK RATE...................................................................................... 67 3.10 STATUTORY LIQUIDITY RATIO ................................................... 67 3.11 DETERMINATION OF RATE OF INTEREST AND ITS IMPACT 68 3.12 IMPACT OF INTEREST RATE ....................................................... 68 4. CHAPTER 4 ..................................................................................................... 70 ABSTRACT................................................................................................. 70 4.1 GROSS DOMESTIC PRODUCT (GDP) OF A COUNTRY................ 71
  7. 7. vii 4.2 DETERMING GDP ............................................................................... 71 4.2.1 PRODUCTION APPROACH............................................................. 72 4.2.2 INCOME APPROACH....................................................................... 73 4.2.3 EXPENDITURE APPROACH........................................................... 75 4.3 GDP Vs GNP ......................................................................................... 78 4.4 NOMINAL GDP AND ADJUSTMENTS TO GDP ............................. 79 4.5 CROSS BORDER COMPARISON AND PPP ..................................... 80 4.6 EXTERNALITIES................................................................................. 81 4.7 REAL GDP ............................................................................................ 83 4.8 GDP GROWTH RATE.......................................................................... 84 4.9 THE KNOW-HOW OF AN ECONOMY THROUGH GDP................ 84 4.10 HOW GDP AFFECTS US:.................................................................. 84 4.11 CREDIT CONTROL ........................................................................... 85 4.12 NEED FOR CREDIT CONTROL....................................................... 85 4.13 OBJECTIVES OF CREDIT CONTROL............................................. 86 4.14 METHODS OF CREDIT CONTROL................................................. 86 4.14.1 QUALITATIVE METHOD.............................................................. 86 4.14.2 QUANTITATIVE METHOD........................................................... 88 4.14.2.1 BANK RATE................................................................................. 89 4.15 THE LINKAGE BETWEEN GROWTH AND GDP.......................... 90 4.15.1 PRIMARY SECTOR ........................................................................ 93 4.15.2 SECONDARY SECTOR.................................................................. 95 4.15.3 TERTIARY SECTOR....................................................................... 98
  8. 8. viii 4.16 OVERHEATING ............................................................................... 102 CHAPTER 5 ....................................................................................................... 105 ABSTRACT............................................................................................... 105 5.1 SOME COMMONLY USED TERMS IN ECONOMICS .................. 107
  9. 9. 1 1. CHAPTER 1 ABSTRACT This chapter deals with the most important factor governing an economy the dynamics of money market, its demand, supply, and the resultant equilibrium. It starts with the basic definition of money, and defines the parameters that control the amount of money that control the amount of money supply in an economy by dividing the total money supply into two major broad categories:  Money with the financial institutions  Total money stock in the Indian economy It gives a brief explanation of the foreign exchange market, the exchange rate, its types, systems and its determination. It covers the various factors, political conditions, market psychology governing the foreign exchange market. It inculcates the demand for foreign exchange and the role of RBI in affecting the Foreign exchange market. It takes into account the various control measures by the RBI such as FEMA and FERA .The chapter also provides a linkage between the money market and foreign exchange market. It then explains the risks associated with an increase or decrease in the money supply. The chapter also signifies the importance of regulations in the foreign investment for a stable functioning of the foreign exchange market. At last, it gives a glimpse of liquidity and the associated risks attached to it in an economy.
  10. 10. 2 1.1 FUNDAMENTALS OF MONEY AND FOREIGN EXCHANGE MARKET 1.1.1 MONEY Money is an asset that is widely used and accepted as a means of payment. Different groups of assets may be classified as money. Currency and checking accounts form a useful definition of money, but bank deposits in the foreign exchange market are excluded from this definition. Money is very liquid: it can be easily and quickly used to pay for goods and services. Money, however, pays little or no rate of return. Suppose we can group assets into money (liquid assets) and all other assets (illiquid assets). All other assets are less liquid but pay a higher return. 1.1.2MONEY SUPPLY Central banks of a country determine the money supply. In India, this task is undertaken by the reserve bank of India. The Federal Reserve directly regulates the amount of currency in circulation. It indirectly controls the amount of checking deposits issued by private banks. Money supply in India Financial institutions Money stock in the Indian economy 1: POLICY RATES 2: CALL MONEY 3: MSF 4: OTHERS M1 M2 M3 M4
  11. 11. 3 1.1.3 TREASURY This takes into account various factors such as the reverse repo rate, repo rate, MSF, call money and several others which determine the Indian financial institutions in general. Marginal standing facility is the rate at which banks could borrow funds overnight from the Reserve Bank of India (RBI) against approved government securities. Banks can borrow funds through MSF during acute cash shortage (considerable shortfall of liquidity).This measure has been introduced by RBI to regulate short term asset liability. To provide greater liquidity cushion the Reserve Bank of India (RBI) introduced marginal standing facility or MSF. Call money is short term finance repayable on demand, with maturity period of one day to fifteen days, used for inter bank transactions. Commercial banks have to maintain a minimum cash balance known as cash reserve ratio. The Reserve Bank of India changes the cash ratio from time to time which in turn affects the amount of funds available to be given as loans by commercial banks. Call money is a method by which banks lend from each other to be able to maintain the cash reserve ratio. The interest rate paid on call money is known as call rate. It is a highly volatile rate that varies from day- to-day and sometimes even from hour-to-hour. There is an inverse relationship between call rates and other short-term money market instruments such as certificates of deposit and commercial paper. A rise in call money rates make other sources of finance such as commercial paper and certificates of deposit cheaper in comparison for banks raise funds from these sources. Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system. Scheduled banks are required to maintain with the RBI an average cash balance,
  12. 12. 4 the amount of which shall not be less than 4% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis. Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system. The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. 1.1.4 MONEY SUPPLY IN THE INDIAN ECONOMY Money supply at any instant of time is assumed to be constant. In economics, the money supply or money stock is the total amount of monetary assets available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits (depositors' easily accessed assets on the books of financial institutions). Money supply data are recorded and published, usually by the government or the central bank of the country (RBI in case of INDIA). Public and private sector analysts have long monitored changes in money supply because of its effects on the price level, inflation, the exchange rate and the business cycle. That relation between money and prices is historically associated with the quantity theory of money. There is strong empirical evidence of a direct relation between money-supply growth and long-term price inflation, at least for rapid increases in the amount of money in the economy.
  13. 13. 5 The nature of this causal chain is the subject of contention. Some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy. In addition, those economists seeing the central bank’s control over the money supply as feeble say that there are two weak links between the growth of the money supply and the inflation rate. First, in the aftermath of a recession, when many resources are underutilized, an increase in the money supply can cause a sustained increase in real production instead of inflation. Second, if the velocity of money, i.e., the ratio between nominal GDP and money supply, changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP. Money is used as a medium of exchange, a unit of account, and as a ready store of value. Its different functions are associated with different empirical measures of the money supply. There is no single "correct" measure of the money supply. Instead, there are several measures, classified along a spectrum or continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (currency, checkable deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.). This continuum corresponds to the way that different types of money are more or less controlled by monetary policy. Narrow measures include those more directly affected and controlled by monetary policy, whereas broader measures are less closely related to monetary-policy actions. It is a matter of perennial debate as to whether narrower or broader versions of the money supply have a more predictable link to nominal GDP. The different types of money are typically classified as "M"s. The "M"s usually range from M0 (narrowest) to M3 (broadest) but which "M"s are actually focused on in policy formulation depends on the country's central bank.
  14. 14. 6 The Reserve Bank of India defines the monetary aggregates as:- Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities. M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI). M2: M1 + Savings deposits with Post office savings banks. M3: M2+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits). M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).
  15. 15. 7 1.1.5 MONEY DEMAND Money demand is the amount of assets that people are willing to hold as money (instead of illiquid assets).Various factors influence money demand. The major ones are:- Expected returns/interest rate on money relative to the expected returns on other assets. Risk: the risk of holding money principally comes from unexpected inflation, thereby reducing the purchasing power of money overtime. But many other assets have this risk too, so this risk is not very important in money demand Liquidity: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought in transactions increases. The aggregate demand for money can be expressed by: Md = P x L(R, Y) Where: P is the price level Y is real national income R is a measure of interest rates L(R,Y) is the aggregate real money demand Alternatively: M/P = L(R, Y) Aggregate real money demand is a function of national income and interest rates.
  16. 16. 8 1.1.6 THE MONEY MARKET The money market uses the (aggregate) money demand and (aggregate) money supply. The condition for equilibrium in the money market is: Ms = Md .Alternatively, we can define equilibrium using the supply of real money and the demand for real money (by dividing both sides by the price level): Ms /P = L(R,Y) .This equilibrium condition will yield an equilibrium interest rate.
  17. 17. 9 1.1.7 RELATIONSHIP BETWEEN MONEY MARKET AND MONEY SUPPLY When there is an excess supply of money, there is an excess demand for interest bearing assets. People with an excess supply of money are willing to acquire interest bearing assets (by giving up their supply of money) at a lower interest rate. Potential money holders are more willing to hold additional quantities of money as the interest rate (the opportunity cost of holding money) falls. 1.2 FOREX (FOREIGN EXCHANGE MARKET) The foreign exchange market (FOREX, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial
  18. 18. 10 centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. EBS and REUTERS DEALING 3000 are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment by enabling currency conversion. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of the following characteristics:-  Its huge trading volume representing the largest asset class in the world leading to high liquidity;  Its geographical dispersion;  Its continuous operation: 24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday;  The variety of factors that affect exchange rate;  The low margins of relative profit compared with other markets of fixed income; and  The use of leverage to enhance profit and loss margins and with respect to account size. As such, it has been referred to as the market closest to the ideal of perfect competition, not withstanding currency intervention by central banks.
  19. 19. 11 1.3 EXCHANGE RATE Exchange rate refers to the rate at which a country’s currencies are exchanged for currencies of other country. In other words it is the price of one currency in terms of another currency. For E.g. If the value of 1 US dollar in Indian rupees is 45 then the exchange rate is 1 US $ = ` 45. Thus foreign exchange rate indicates the external value of a country’s currency. It also shows the purchasing power of a country’s currency in terms of currency of another country. Overall, we can say that the rate of exchange is nothing but the value or price of a country’s currency expressed in terms of a foreign currency. 1.4 TYPES OF EXCHANGE RATE The earliest exchange rate system was popularly known as Gold standard, this system existed during 1879-1934. In this exchange rate system the value of currencies of different countries was fixed in terms of gold. Hence under gold standard exchange rate system there could be only fixed exchange rates. After the end of World War II to 1971, another Fixed Exchange Rate System known as Bretton Woods System prevailed. After 1971, the exchange rate system was not purely flexible; hence it was called Managed Float System.
  20. 20. 12 1.5 EXCHANGE RATE SYSTEMS 1.5.1 Fixed Exchange Rate IMF was established with the object of stabilizing the rates of exchange between the member countries. Under its charter, every member country was required to fix and declare the par value of its currency in terms of gold or dollar and maintain it. The system of fixed exchange is known as pegged exchange rates. The Government determines the exchange rate by pegging operations (i.e. buying and selling foreign exchange at particular exchange rate).In pegging operation, Government fixes an official exchange rate and enforces it through Central Bank. An exchange stabilization fund may be set up in order to maintain the exchange rate by buying its currency when market exchange rate falls below specified exchange rate and vice versa. The major defect in this system was that if the market exchange rate falls consistently pegging operations will be very expensive as it will lead to heavy reduction in reserves. Under gold standard, rate of exchange varied within a small range of gold export point and gold import point. But gold standard was given up by all countries in 19'30s. Since the fixed exchange rates do not reflect true value of currencies, flexible exchange rates were adopted by countries. 1.5.2 Flexible Exchange Rate Flexible exchange rates are determined by forces of demand and supply in the foreign exchange market without the interference of Government. The relative positions of demand and supply depends on the deficit or surplus in the balance of payments of the country. The exchange rates are not rigidly fixed up but allowed to float with changing conditions. The relative value of currencies alters far more rapidly with automatic devaluation or revaluation. The free floating rate is allowed to seek its own level as no par of exchange is fixed. Since 1980s as many countries were in favour of the flexible exchange rates IMF was forced to adopt flexible exchange rates. 1.5.3 Managed Exchange Rate System I Managed Flexibility:-
  21. 21. 13 A system of managed flexibility came up to take the merits of fixed and flexible exchange rate and to overcome their demerits. This system is based on the par value concept under IMF guidelines. In managed flexibility of exchange rate system, the range of flexibility around fixed par values is determined by the country as per its economic need and the prevailing trend in international monetary system. This system of exchange rate requires the country to interfere in foreign exchange market from time to time in view of the emerging disequilibrium. 1.6 DETERMINATION OF EXCHANGE RATE The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):- 1. International parity conditions Relative purchasing power parity, interest rate parity, domestic fisher effect, international fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world. 2. Balance of payments model This model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows 3. Asset market model Views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the
  22. 22. 14 price that just balances the relative supplies of, and demand for, assets denominated in those currencies.” None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. Economic factors These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates)(c)Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the
  23. 23. 15 competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector. Political conditions Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
  24. 24. 16 Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways: Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The US DOLLAR has been traditional safe havens during times of political or economic uncertainty. Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer- term price trends that may rise from economic or political trends. "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought” To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short- term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
  25. 25. 17 Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns. The rate of exchange being a price of national currency in terms of another, is determined in foreign exchange market in accordance with general principle of the theory of value i.e., by the interaction of forces of demand and supply. Thus the rate of exchange in the foreign exchange market will be determined by interaction between demand for foreign exchange and supply of foreign exchange. 1.6.1 Demand for Foreign Exchange Foreign exchange is required by citizens or Government to make payments abroad. This results in demand for foreign exchange. These payments are recorded in payment side of BOP. The demand for foreign currency arises due to the following payments  Import of Goods Consumer as well as capital goods is imported from other countries. Foreign exchange is demanded by people who import these goods. Higher the value of Imports, higher is the demand for foreign currency.  Import of services Services rendered by other countries which include banking, insurance, transport, communication, educational services, etc. are required to be paid in foreign exchange.  Dividend. Interest and Profits In India, many foreign firms have invested in various sectors, which results in outflow of foreign exchange on account of dividend and profits. On other hand Government and Indian firms have also borrowed from foreign countries, which results in payment of Interest.
  26. 26. 18  Unilateral Payments Donations, gifts etc. are 'one sided payments without corresponding returns. Such payments create demand for foreign exchange.  Export of Capital Repayment of debt, purchase of assets in foreign countries etc. all requires foreign exchange. All the above categories of payments abroad result in aggregate demand for foreign exchange. The total demand for foreign currency is inversely related to foreign exchange rate. At a higher exchange rate, the demand for foreign currency may be low. 1.7 ROLE OF RBI IN AFFECTING FOREX/ EFFECT OF CHANGE IN DOMESTIC MONEY SUPPLY The Central Bank of the country holds large amount of foreign exchange. Hence the Central Bank can control the exchange rate by manipulating the magnitude of demand or supply in the FOREX market. For instance, the Central Bank resorts to large scale buying of foreign currency when there is an excess supply of foreign currency and vice versa. Monetary policies and actions by the RBI affect the equilibrium interest rate, changing the rupee/dollar exchange rate that clears the foreign exchange market. The RBI can affect the exchange rate by changing the Indian money supply and interest rate. An increase in the money supply would depreciate the value of money. Given at a given price and income, when the money supply increases, the rupee interest rate declines (as money market equilibrium is re-established) and rupee depreciates against the dollar (as foreign exchange market equilibrium is re-established).This is the effect of an increase in domestic money supply. A permanent increase in a country’s money supply causes a proportional long run depreciation of its currency. However, a large depreciation is encountered first and then a smaller subsequent appreciation.
  27. 27. 19 1.8 RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT In 1939, the Exchange Control Department of RBI was set up. In order to conserve the scarce foreign exchange reserves, the Foreign Exchange Regulation Act (FERA) was passed in 1993.India adopted fixed exchange rate of IMF up to 1971, whereby the Indian Rupee external par value was fixed. In 1973, FERA was amended and it came in force on January 1st , 1974. It gave wide powers to RBI to administer exchange control mechanism properly. In 1992, RBI introduced LERMS (Liberalized Exchange Rate Management System) Under LERMS a dual exchange rate was fixed. The 1993-94 Budget made Indian Rupee fully convertible on trade account. LERMS was withdrawn. Developing countries allowed market forces to determine the exchange rate. Under flexible exchange rate system, if demand for foreign currency is more than that of its supply, foreign currency appreciates and domestic currency depreciates and vice versa. To minimize the disadvantages of flexible exchange rate, most of the developing countries including India have adopted the concept of managed Flexible Exchange Rate (MFER).Under MFER, the Central bank intervenes to bring stability in exchange rate. RBI’s intervention involves purchase of foreign currency from market or release (sale) of foreign currency in the market, to bring stability in exchange rates. 1.9 ROLE OF RBI IN FOREIGN EXCHANGE MARKET The role of RBI in the foreign exchange market is revealed by the provisions of FERA (1973).  Administrative Authority The RBI is the administrative authority for exchange control in India. The RBI has been given powers to issue licenses to those who are involved in foreign exchange transactions.  Authorized Dealers
  28. 28. 20 The RBI has appointed a number of authorized dealers. They are permitted to carry out all transactions involving foreign exchange.  Issue of Directions The 'Exchange Control Manual' contains all directions and procedures given by RBI to authorized dealers from time to time.  Fixation of Exchange Rates The RBI has the responsibility of fixing the exchange value of home currency in terms of other currencies. This rate is known as official rate of exchange. All authorized dealers and money lenders are required to follow this rate strictly in all their foreign exchange transactions.  Foreign Investments Non-residents can make investments in India only after obtaining the necessary permission from Central Government or RBI. Great investment opportunities are provided to non-resident Indians.  Foreign Travel Indian residents can get foreign exchange released from RBI upto a specified amount for travelling abroad through proper application.  Import Trade The RBI regulates import trade. Imports are permitted only against proper licenses. The items of imports that can be imported freely are specified under Open General License.  Export Trade The RBI controls export trade. Export of gold and jewellery are allowed only with special permission from RBI.
  29. 29. 21  Gold, silver and currency notes In recent years, the limits fixed for bringing gold, silver, currency notes etc. has been relaxed considerably.  Submission of Returns All foreign exchange transactions made by authorized dealers must be reported to RBI. This enables the RBI to have a close watch on foreign exchange dealings in India. Thus, from above points we can say that RBI is the apex bank that intervenes, supervises, and controls the foreign exchange markets in order to create a stable and active exchange market 1.9.1 FERA AND EXCHANGE CONTROLS In 1939, under the Defense of India Rules (DIR), the Exchange Control was imposed. In 1973, FERA was amended. India has accepted a system of multilateral payments, i.e., the rupee should be freely convertible to currencies of all member countries of IMF. But the RBI adopted exchange controls under FERA, in order to conserve India's Foreign exchange reserves. Foreign exchange was rationed out strictly according to availability. Purchase and Sale of foreign securities by Indians were strictly controlled. All external payments had to be made through authorized dealers controlled by RBI. Exporters who acquired foreign exchange had to surrender their earnings to authorized dealer and get rupees in exchange. Imports were rigidly controlled and imports of unnecessary items were prohibited. The RBI as the apex bank supervised and controlled the foreign exchange market. The RBI decided the exchange rate of rupee in terms of pound sterling on a day to day basis. It would sell pound sterling against specific demand and would also buy US dollar, pound sterling, German mark and Japanese yen. In 1992, the Pound sterling was replaced by dollar as intervention currency. Hence, RBI would sell only dollar and continue to buy Dollar, Pound, Mark and Yen. In New Industrial Policy of 1991, the government announced major concessions to FERA companies.
  30. 30. 22 1.9.2 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA) The relaxation of FERA encouraged the inflow of foreign capital and the growth of Multi National Corporations (MNC's) in India. FERA was replaced by FEMA in 1999.Under FERA RBI's permission was necessary. Under FEMA, except for one section (that relates to foreign exchange) no other permission is required from RBI. The purpose of FEMA is to facilitate external trade and payments and promote orderly development and maintenance of foreign exchange market in India. FEMA has simplified the provisions of FERA. The two key aspects of FEMA are the relaxation of foreign exchange controls and move towards capital account convertibility. To facilitate foreign trade restrictions drawals of foreign exchange for current and capital account transactions have been removed. FEMA regulates both import and export trade methods of payment. If any person contravenes any provisions of FEMA, he shall be liable to a penalty up to twice the sum involved in such contravention. There would be no punishment by way of imprisonment. 1.9.3 LINKING THE MONEY MARKET TO THE FOREIGN EXCHANGE MARKET A change in the US money supply affects the Indian money market as well as foreign exchange market. An increase in the Indian money supply causes a depreciation of the rupee (appreciation of the dollar).On contrast, a decrease in the Indian money supply causes an appreciation of the rupee (a depreciation of the dollar). The increase in the US money supply reduces interest rates in the US, reducing the expected return on US deposits. This reduction in the expected return on US deposits leads to a depreciation of the dollar. However, a change in the in the US money supply does not change the Indian money market equilibrium. Basically, it can be judged by the perspective of demand and supply for foreign currencies. A currency having a greater demand will appreciate in comparison
  31. 31. 23 to its counterpart. It also represents to more inflows of foreign institutional investment since appreciation of a currency implies a healthy financial condition of the corresponding country, and hence more foreign investment both in terms of FDI and FIIs.
  32. 32. 24 EXTERNAL DETERMINANTS ( US money supply ) (Indian money supply ) (dollar interest rate ) (Indian interest rate ) 1.10 RISKS ASSOCIATED WITH INCREASE IN MONEY SUPPLY An increase in money supply will lead to more demand for goods and services. With better money holding capacity, the demand for several goods would rise simultaneously as there is too much money chasing a few goods. As a result of this, prices of goods would rise (demand is more and supply remains constant, so equilibrium prices of the goods will increase.). This increased prices leads to inflation. Also, this leads to uneven distribution of wealth. If continued for too long, it can even lead to hyperinflation with the native currency losing its value and purchasing power. This can UNITED STATES FEDERAL RESERVE SYSTEM RESERVE BANK OF INDIA U.S MONEY MARKET INDIAN MONEY MARKET FOREIGN EXCHANGE MARKET
  33. 33. 25 have serious repercussions on the economy. Due to this, the financial and political condition may get adversely affected, leading to country risk 1.11 RISKS ASSOCIATED WITH DECREASE IN MONEY SUPPLY With a decrease in the money supply people lose their money holding. The purchasing power of people decreases (due to less money holding), indicating a situation where there are more sellers and less buyers. As a result of which, liquidity risk arises. It leads to deflation that is a situation where the real value of goods decreases. 1.12 EFFECT OF INCREASE IN FOREIGN INVESTMENT ON FOREX With increase in FIIs and FDI, more of foreign currency enters the economy. In the domestic market there is more demand for the domestic currency. As a result of this, the domestic currency appreciates in the international exchange market (demand is more and supply is less of the domestic currency, assuming a fixed money supply). 1.13 EFFECT OF DECREASE IN FOREIGN INVESTMENT ON FOREX With decrease in FIIs and FDI, the demand for the domestic currency decreases. As a result of this the domestic currency depreciates in the international exchange market. 1.14 LIQUIDITY AND RBI A very basic definition of liquidity is 'the cash or money in a system'. Liquidity is measured in terms of the monetary base and the Reserve Bank of India (RBI) is the sole supplier of liquidity in the country. In general, the supply of monetary base by the central bank depends on the public's demand for currency and the banking system's need for reserves to settle or discharge payment obligations. The RBI monitors the liquidity situation on a daily basis and attempts to control and moderate liquidity conditions by varying the supply of bank reserves to meet its macroeconomic objectives of financial stability. The periodic liquidity assessment is done by the RBI based on the bank reserves position, and the expected inflows and outflows from both domestic operations and
  34. 34. 26 foreign flows. Depending on the liquidity forecast, the RBI decides on a course of action to be taken to either supplement or withdraw liquidity. These are some of the factors that influence liquidity conditions in the economy: 1.14.1 Domestic factors An increase in liquidity is required to cover inflation and GDP growth. Several instantaneous domestic factors also influence the liquidity in the system. Most commonly, quarterly or annual advance tax payments draw liquidity out of the system as a lot of liquid money gets locked with the government. On the other hand, any large payouts by the government or higher corporate sector spending can increase the liquidity in the system. 1.15 RISKS ASSOCIATED WITH MORE OF FII INFLOWS A strong economic performance and the relative under-performance in the developed countries attracted the attentions of many large global investors who were drawn towards investing here (FDI as well as portfolio investments).This results in healthy capital inflows. These capital inflows put a lot of pressure on the liquidity management here as uncontrolled capital flows can result in rising inflation, currency appreciation, loss of competitiveness and reduction in monetary control. 1.16 TOOLS TO CONTROL LIQUIDITY The RBI monitors the liquidity situation periodically and takes necessary steps to control the situation from time to time. The RBI uses various direct and indirect policies to control the short term and long-term liquidity position. These are various instruments used by the RBI to control liquidity:  Cash reserve ratio: The RBI uses the cash reserve ratio (CRR) as a tool to control the medium to long-term liquidity issues. An increase in the CRR results in an increase in the amount of money that banks have to maintain with the RBI
  35. 35. 27 as a percentage of their deposits. This reduces the overall liquid funds with the bank and hence reduces the overall liquidity.  Liquidity adjustment factor: The liquidity adjustment factor (LAF) was introduced a decade ago as a part of financial reforms. LAF helps in managing a short term liquidity situation resulting from the large and volatile capital flows (inflows as well as outflows).  Reverse repo rate: The RBI uses the reverse repo rate for short-term liquidity management and to smoothen interest rates in the call/money market. The repos also help in keeping the interest rates in a predictable range, as provided by the prevailing repo rate and reverse repo rate. In times of excess visible liquidity, the call rates hover around the reverse repo rate, whereas in times of tight liquidity, the call rate will hover around the repo rate. 1.17 RISKS ASSOCIATED WITH LIQUIDITY An uncontrolled and unmanaged liquidity situation can have a severe impact on the economy .It can lead to inflation, changes in rates of interest, large fluctuations in stock markets, and a unstable foreign exchange rates. Since the conditions in the global markets and foreign fund flows are quite volatile, the job of the RBI in controlling the liquidity condition has become more challenging.
  36. 36. 28 2. CHAPTER 2 ABSTRACT This chapter covers various angles and concepts in the field of risk management. It discusses the identification, assessment, and prioritization of risks followed by a coordinated approach. It enlightens us with the idea that how risk management tends to increase the efficiency in governing of the financial institutions thereby withstanding the market variations and achieving sustainability in terms of growth and well as in ensuring a stable financial environment. Thus the need for an efficient risk management framework is of paramount importance in order to factor in internal and external risks. Firstly, it revolves around the various aspects of risk management, its assessments, identification, characterization, and the vulnerability of critical assets to specific threats, risk reduction measures, prioritization of different risks and thereby adopting of an efficient and profitable strategy. It establishes the principles of risk management, the associated processes, the identification of risks based on several factors, the potential risk treatments and the avoidance measures It highlights the advantage of incorporating risk-prevention measures to the health of an economic institution. It gives an elaborate detail about various kinds of risks associated with a bank- credit risk, market risk, operational risk, liquidity risk and other residual risks by assessing the causes, impacts, factors associated to these risks and their limitations. Not only the chapter deals with risks at the micro-level of a bank but also widens itself to cover the various parameters and risks attached to a country. At last, it also gives a glimpse of various credit rating agencies and their ratings.
  37. 37. 29 2.1 RISK MANAGEMENT AND ITS FUNDAMENTALS Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risk management in Indian banks is a relatively newer practice, but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus the need for an efficient risk management framework is paramount in order to factor in internal and external risks. The financial sectors in various economies like that of India are undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. The 2007 recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. The various aspects of increasing global competition to Indian Banks by Foreign banks, increasing Deregulation, introduction of innovative products, and financial instruments as well as innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management. Indian banks have been making great advancements in terms of technology, quality, as well as stability such that they have started to expand and diversify at a rapid rate. However, such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. In banks and other financial institutions, risk plays a major part in the earnings of a bank. The higher the risk, the
  38. 38. 30 higher the return, hence, it is essential to maintain a parity between risk and return. Hence, management of financial risk incorporating set systematic and professional methods especially those defined by the Basel, an essential requirement of banks. The more risk averse a bank is, the safer is their Capital base. There are several kinds of risks associated with a bank ranging from credit risk, operational risk to several others. We’ll discuss each one of them in detail. Risks can come from uncertainty in financial markets, project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk. In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order. In practice the process of assessing overall risk can be Risk Management Mitigate the Risks In Times If Votality And Fluctuations Increase in Corporate Governance Of A Financial Institution
  39. 39. 31 difficult, and balancing resources used to mitigate between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process- engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. Again, ideal risk management minimizes spending (or manpower or other resources) and also minimizes the negative effects of risks. 2.2 Method For the most part, these methods consist of the following elements, performed, more or less, in the following order. 1) Identify, characterize threats 2) Assess the vulnerability of critical assets to specific threats 3) Determine the risk (i.e. the expected likelihood and consequences of specific types of attacks on specific assets) 4) Identify ways to reduce those risks 5) Risk reduction measures and prioritization of risks based on a strategy
  40. 40. 32 2.3 Principles of risk management The international standard organization (ISO) identifies the following principles of risk management Risk management should include the following components:  Create value– resources expended to mitigate risk should be less than the consequence of inaction  Be an integral part of organizational processes  Be part of decision making process  Explicitly address uncertainty and assumptions  Be systematic and structured  Be based on the best available information  Be tailorable  Take human factors into account  Be transparent and inclusive  Be dynamic, iterative and responsive to change  Be capable of continual improvement and enhancement  Be continually or periodically re-assessed 2.4 PROCESS The process of risk management consists of several steps as follows:  Establishing the context This involves: 1. Identification of risk in a selected domain of interest 2. Planning the remainder of the process 3. Mapping out the following:
  41. 41. 33  The social scope of risk management  The identity and objectives of stakeholders  The basis upon which risks will be evaluated, constraints. 4. Defining a framework for the activity and an agenda for identification 5. Developing an analysis of risks involved in the process 6. Mitigation or solution of risks using available technological, human and organizational resources.  Identification After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, 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 identify threats. For example: the threat of losing money, the threat of abuse of confidential information or the threat of human errors, accidents and casualties. The threats may exist with various entities, most important with shareholders, 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; confidential information may be
  42. 42. 34 stolen by employees even within a closed network; lightning striking an aircraft during takeoff may make all people on board immediate casualties. 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.  Scenario-based risk identification - in scenario based risk identification, 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 future studies for methodology used by Futurist.  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.  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.  Risk charting - This method combines the above approaches by listing resources at risk, threats to those resources, modifying factors which may increase or decrease the risk and consequences it is wished to avoid. Creating a matrix under these headings enables a variety of approaches. One can begin with resources and consider the
  43. 43. 35 threats they are exposed to and the consequences of each. Alternatively one can start with the threats and examine which resources they would affect, or one can begin with the consequences and determine which combination of threats and resources would be involved to bring them about. 2.5 ASSESSMENT Once risks have been identified, they must then be assessed as to their potential severity of impact (generally a negative impact, such as damage or 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 decisions in order to properly prioritize the implementation of 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 intangible 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: Rate (or probability) of occurrence multiplied by the impact of the event equals risk magnitude 2.5.1 Composite Risk Index The above formula can also be re-written in terms of a Composite Risk Index, as follows:
  44. 44. 36 Composite Risk Index = Impact of Risk event x Probability of Occurrence The impact of the risk event is commonly assessed on a scale of 1 to 5, where 1 and 5 represent the minimum and maximum possible impact of an occurrence of a risk (usually in terms of financial losses). However, the 1 to 5 scale can be arbitrary and need not be on a linear scale. The probability of occurrence is likewise commonly assessed on a scale from 1 to 5, where 1 represents a very low probability of the risk event actually occurring while 5 represents a very high probability of occurrence. The Composite Index thus can take values ranging (typically) from 1 through 25, and this range is usually arbitrarily divided into three sub-ranges. The overall risk assessment is then Low, Medium or high, depending on the sub-range containing the calculated value of the Composite Index. For instance, the three sub-ranges could be defined as 1 to 8, 9 to 16 and 17 to 25.Likewise; the impact of the risk is not easy to estimate since it is often difficult to estimate the potential loss in the event of risk occurrence. It is absolutely necessary to periodically re- assess risks and intensify/relax mitigation measures, or as necessary. Changes in procedures, technology, schedules, budgets, market conditions, political environment, or other factors typically require re-assessment of risks. 2.5.2 Potential risk treatments Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories  Avoidance (eliminate, withdraw from or not become involved)  Reduction (optimize – mitigate)  Sharing (transfer – outsource or insure)  Retention (accept and budget)
  45. 45. 37 2.6 RISK AVOIDANCE This 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 legal liability that comes with it. Another would be not flying in order not to take the risk that the airplane was 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 profits. Increasing risk regulation in hospitals has led to avoidance of treating higher risk conditions, in favour of patients presenting with lower risk. 2.6.1 Hazard prevention Hazard prevention refers to the prevention of risks in an emergency. The first and most effective stage of hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is otherwise impractical, the second stage is mitigation. 2.6.2 Risk reduction Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of the loss from occurring. Acknowledging that risks can be positive or negative, optimizing risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. 2.6.3 Risk sharing It is defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the measures to reduce a risk."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 up front, but instead losses are assessed to all members of the group.
  46. 46. 38 2.6.4 Risk retention It involves accepting the loss, or benefit of gain, from a risk 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 amounts of potential loss (risk) over the amount insured are retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much. 2.6.5 Create a risk management plan Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be approved by the appropriate level of management. For instance, 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 virus risks. 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 antivirus software. A good risk management plan should contain a schedule for control implementation and responsible persons for those actions. 2.6.6 Implementation Implementation follows 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 avoided without sacrificing the entity's goals, reduce others, and retain the rest.
  47. 47. 39 2.6.6.1 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. Risk analysis results and management plans should be updated periodically. There are two primary reasons for this: 1. To evaluate whether the previously selected security controls are still applicable and effective 2. To evaluate the possible risk level changes in the business environment. For example, information risks are a good example of rapidly changing business environment. 2.7 Limitations Prioritizing the risk management processes too highly could keep an organization from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete. It is also important to keep in mind the distinction between risk and uncertainty. Risk can be measured by their impacts and the probability of occurrence. 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. 2.8 Areas of Management As applied to corporate finance, risk management is the technique for measuring, monitoring and controlling the financial or operational risk on a firm's balance sheet.
  48. 48. 40 The Basel II framework breaks risks into market risk (price risk), credit risk and operational risk and also specifies methods for calculating capital requirements for each of these components. 2.9 Enterprise risk management In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question. Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, liquidity risk, market risk, and operational risk. 2.10 Positive Risk Management Positive Risk Management is an approach that recognizes the importance of the human factor and of individual differences in propensity for risk taking. It draws from the work of a number of academics and professionals who have expressed concerns about scientific rigor of the wider risk management debate, or who have made a contribution emphasizing the human dimension of risk. Firstly, it recognizes that any object or situation can be rendered hazardous by the involvement of someone with an inappropriate disposition towards risk; whether too risk taking or too risk averse. Secondly, it recognizes that risk is an inevitable and ever present element throughout life: from conception through to the point at the end of life when we finally lose our personal battle with life threatening risk. Thirdly, it recognizes that every individual has a particular orientation towards risk; while at one extreme people may by nature be timid, anxious and fearful, others will be adventurous, impulsive and almost oblivious to danger. These differences are evident in the way we drive our cars, in our diets, in our relationships, in our careers. Finally, Positive Risk Management recognizes that risk taking is essential to all enterprise, creativity, heroism, education, scientific advance – in fact to any activity
  49. 49. 41 and all the initiatives that have contributed to our evolutionary success and civilization. It is worth noting how many enjoyable activities involve fear and willingly embrace risk taking. This situation arises from the basic premises of traditional risk management and the practices associated with health and safety within the working environment. There is a basic logic to the idea that any accident must reflect some kind of oversight or situational predisposition that, if identified, can be rectified. But, largely due to an almost institutionalized neglect of the human factor, this situational focused paradigm has grown tendrils that reach into every corner of modern life and into situations where the unintended negative consequences threaten to outweigh the benefits Positive Risk Management views both risk taking and risk aversion as complementary and of equal value and importance within the appropriate context. As such, it is seen as complementary to the traditional risk management paradigm. It introduces a much needed balance to risk management practices and puts greater onus on management skills and decision making. It is the dynamic approach of the football manager who appreciates the offensive and defensive talents within the available pool of players. Every organization has roles better suited to risk takers and roles better suited to the risk averse. The task of management is to ensure that the right people are placed in each job. Positive Risk Management relies on the ability to identify individual differences in propensity for risk taking. 2.11 TYPES OF RISKS ASSOCIATED WITH A BANK 2.11.1 CREDIT RISK Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and
  50. 50. 42 increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example:  A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan  A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company  A business or consumer does not pay a trade invoice when due  A business does not pay an employee's earned wages when due  A business or government bond issuer does not make a payment on a coupon or principal payment when due  An insolvent insurance company does not pay a policy obligation  An insolvent bank won't return funds to a depositor  A government grants bankruptcy protection to an insolvent consumer or business To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt. 2.11.1.2 Types of credit risk Credit risk can be classified in the following way:  Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
  51. 51. 43  Concentration risk - The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.  Country risk - The risk of loss arising from sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk). 2.11.1.3 Assessing credit risk Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advice on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's, Fitch Ratings, and Dun and Bradstreet provide such information for a fee. Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property. Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above).
  52. 52. 44 2.11.1.4 Mitigating credit risk Lenders mitigate credit risk using several methods:  Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan- to-value ratio and estimate the effect on yield (credit spread).  Covenants: Lenders may write stipulations on the borrower, called covenants, into loan agreements:  Periodically report its financial condition  Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position  Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio  Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.  Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.  Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk,
  53. 53. 45 called concentration risk. Lenders reduce this risk by diversifying the borrower pool.  Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash. 2.11.2 MARKET RISK This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:  Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. It is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods.  Interest rate risk is the risk that interest rates or the implied volatility will change. Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has, depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond.  Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency.  Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. Commodity risk refers to the uncertainties of
  54. 54. 46 future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks: There are broadly three categories of agents who face the commodities risk:  Producers (farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk  Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.  Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion. 2.11.2.1 Measuring the potential loss amount due to market risk As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at Risk. The conventions of using Value at risk are well established and accepted in the short-term risk management practice. However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant. In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
  55. 55. 47 2.11.3 LIQUIDITY RISK This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk as given below:  Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:  Widening bid-offer spread  Making explicit liquidity reserves  Lengthening holding period for value at risk (VAR) calculations  Funding liquidity - Risk that liabilities:  Cannot be met when they fall due.  Can only be met at an uneconomic price.  Can be name-specific or systemic. 2.11.3.1 Causes of liquidity risk Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.
  56. 56. 48 Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell. Liquidity risk also tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:
  57. 57. 49  Construct multiple scenarios for market movements and defaults over a given period of time  Assess day-to-day cash flows under each scenario. Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented. Regulators are primarily concerned about systemic implications of liquidity risk. 2.11.3.2 Pricing of liquidity risk Risk-averse investors naturally require higher expected return as compensation for liquidity risk. The liquidity-adjusted pricing model therefore states that, the higher an asset’s market-liquidity risk, the higher its required return. Measures of Liquidity Risk Liquidity gap Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values. As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost. Liquidity risk elasticity Culp denotes the change of net of assets over funded liabilities that occur when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancial the LRE would be measured as a spread over commercial paper rates.
  58. 58. 50 Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads. Measures of Asset Liquidity Bid-offer spread The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid-price can be used. The smaller the ratio the more liquid the asset is. This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader. Market depth Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price. Immediacy Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost. Resilience Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.
  59. 59. 51 Managing Liquidity Risk Liquidity-adjusted value at risk Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level. Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions." Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty. Another important component of liquidity risk is refinancing risk. In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders. A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy, even when the borrower has a positive net worth.
  60. 60. 52 In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale of assets at a low price, including the borrower's own home and productive assets such as factories and plants. Most large corporations and banks face this risk to some degree, as they may constantly borrow and repay loans. Refinancing risk increases in periods of rising interest rates, when the borrower may not have sufficient income to afford the interest rate on a new loan Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits. In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis, when borrowing funds, such as inter-bank deposits, may be extremely difficult. Refinancing is also known as “rolling over” debt of various maturities, and so refinancing risk may be referred to as rollover risk 2.11.4 OPERATIONAL RISK An operational risk is defined as a risk incurred by an organization’s internal activities. Operational risk is the broad discipline focusing on the risks arising from the people, systems and processes through which a company operates. It can also include other classes of risk, such as fraud, legal risks, physical or environmental risks. A widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational risk management differs from other types of risk, because it is not used to generate profit (e.g. credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers). They all however manage operational risk to keep losses within
  61. 61. 53 their risk appetite - the amount of risk they are prepared to accept in pursuit of their objectives. What this means in practical terms is that organizations accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations. The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk Globalization and deregulation in financial markets, combined with increased sophistication in financial technology, have introduced more complexities into the activities of banks and therefore their risk profiles. These reasons underscore banks' and supervisors' growing focus upon the identification and measurement of operational risk. Events such as the September 11 terrorist attacks serve to highlight the fact that the scope of risk management extends beyond merely market and credit risk. The list of risks (and, more importantly, the scale of these risks) faced by banks today includes fraud, system failures, terrorism and employee compensation claims. These types of risk are generally classified under the term 'operational risk'. The identification and measurement of operational risk is a real and live issue for modern-day banks, particularly since the decision by the Basel Committee on Banking Supervision (BCBS) to introduce a capital charge for this risk as part of the new capital adequacy framework (Basel II). 2.11.4.1 Difficulties It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk because models exist which attempt to predict the potential impact of market movements, or changes in the cost of credit. It should be noted however that these models are only as good as the underlying assumptions, and a large part of the recent financial crisis arose because the valuations generated by these models for particular types of investments were based on incorrect assumptions.
  62. 62. 54 By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. Many now though collect data on operational losses - for example through system failure or fraud - and are using this data to model operational risk and to calculate a capital reserve against future operational losses. In addition to the Basel II requirement for banks, this is now a requirement for European insurance firms who are in the process of implementing Solvency II , the equivalent of Basel II for the banking sector. Methods of operational risk management Basel II and various Supervisory bodies of the countries have prescribed various soundness standards for Operational Risk Management for Banks and similar Financial Institutions. To complement these standards, Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk  Basic Indicator Approach - based on annual revenue of the Financial Institution  Standardized Approach - based on annual revenue of each of the broad business lines of the Financial Institution  Advanced Measurement Approaches - based on the internally developed risk measurement framework of the bank adhering to the standards prescribed (methods include IMA, LDA, Scenario-based, Scorecard etc.) The Operational Risk Management framework should include identification, measurement, monitoring, reporting, control and mitigation frameworks for Operational risk. 2.11.5 RESIDUAL RISKS These include other kinds of risks which also plays a vital role in the functioning of any bank.

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