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  1. 1. 1.1 INTRODUCTION TO BANKING INDUSTRYAt independence, saving and investment in India were low and only two-thirds of theeconomy was monetised. By the fifties, the banking system was concentrated primarily in theurban and metropolitan areas. After the establishment of the State Bank of India in 1955,there were distinct efforts on its part to expand rural branches, though there was no statutoryrequirement to this effect.The bank nationalization in July 1969 with its objective to ‘control the commanding heightsof the economy and to meet progressively the needs of development of the economy inconformity with national policy and objectives’ (Reserve Bank of India, 1983) served tointensify the social objective of ensuring that financial intermediaries fully met the creditdemands for productive purposes. Two significant aspects of nationalisation were (i) rapidbranch expansion and (ii) channeling of credit according to plan priorities. To meet the broadobjectives, banking facilities were made available in hitherto uncovered areas, so as to enablethem to not only mop up potential savings and meet the credit gaps in agriculture and small-scale industries, thereby helping to bring large areas of economic activities within theorganised banking system. Towards this end, the Lead Bank Scheme introduced in December1969 represented an important step towards implementation of the two-fold objective ofmobilisation of deposits on an extensive scale throughout the country and striving for plannedexpansion of banking facilities to bring about greater regional balance. As a consequence, theperceived need of the borrower gained primacy over commercial considerations in thebanking sector.In April 1980, six more private sector banks were nationalised, thus extending the domain ofpublic control over the banking system. Such control also resulted in several inefficienciescreeping into the banking system. Repression assumed the form of high and administeredinterest rate structure with a large measure of built-in crosssubsidisation (in the form ofminimum lending rates for commercial sector), high levels of preemptions of primary andsecondary reserve requirements, in the form of cash reserve ratio (CRR) and statutoryliquidity ratio (SLR).Also the retail lending to riskier areas of business on the ‘free’ portion of bank’s resourcesengendered ‘adverse selection’ of borrowers. With limited prospects of recovery, this raisedcosts and affected the quality of bank assets. Quantitative restrictions (branch licensing andrestrictions on new lines of business) and inflexible management structures severely 2
  2. 2. constrained the operational independence and functional autonomy of banks. The inflationaryexpectations and the inequitable tax structures exacerbated the strains on the exchequer, sinceresources for developmental purposes were not readily forthcoming. As the quality of assetportfolio of banks rapidly deteriorated, it was evident that the profitability of the bankingsystem was severely compromised and importantly, rather than acting as a conduit ofintermediation, the banking system was held hostage to the process of economic growthIn addition, the widespread market segmentation and the constraints on competitionexacerbated the already fragile situation. The market for short-term funds was reserved forbanks and the market for long-term funds was the exclusive domain of DevelopmentFinancial Institutions (DFIs). Direct access of corporate borrowers to lenders(disintermediation) was strictly controlled and non-bank financial companies (NBFCs) wereallowed to collect funds only for corporate.All these adverse developments coupled with the balance-of-payments crisis, which followedin the wake of the Gulf War of 1990 coupled with the erosion of public savings and theinability of the public sector to generate resources for investment rapidly brought forth theimperatives for Banking sector strengthening in India. Although these reforms were alsoprovoked by the globalization trends around the world. More importantly, the favorableexperience of liberalization in the 1980s created an intellectual climate for continuing in thesame direction. While the crisis of 1991 favored bolder reforms being ushered, the pace hadto be calibrated to what would be acceptable in a democracy.1.1.1 Effect of Reforms:The banking sector reforms in India, initiated since 1992 in the first phase has providednecessary platform to the banking sector to operate on the basis of operational flexibility andfunctional autonomy, thereby enhancing efficiency, productivity and profitability. Thereforms brought out structural changes in the financial sector, eased external constraints intheir working, introduced transparency in reporting procedures, restructuring andrecapitalization of banks and have increased the competitive element in the market. 3
  3. 3. Figure No. 1.1: Classifications of Banks Source: http://en.wikipedia.org/wiki/Banking_in_IndiaIndia has made significant progress in payment systems by introducing modern paymentmedia viz., smart/credit cards, electronic funds transfer, debit/credit clearing, e banking, etc.RBI would soon put in place Real Time Gross settlement System (RTGS) to facilitateefficient funds management and mitigating settlement risks.Indian banking has made significant progress in recent years. The prudential norms,accounting and disclosure standards and risk management practices, etc. are keeping pacewith global standards. The financial soundness and enduring supervisory practices as evidentin our level of compliance with the Basle Committees Core Principles for Effective BankingSupervision have made our banking system resilient to global shocks. The need for furtherrefinements in our regulatory and supervisory practices has been recognized and steps are 4
  4. 4. being taken by RBI to move towards the goal in a phased manner without destabilising thesystem. Success of the second phase of reforms will depend primarily on the organisationaleffectiveness of banks, for which the initiatives will have to come from banks themselves.Imaginative corporate planning combined with organisational restructuring is a necessarypre-requisite to achieve desired results. Banks need to address urgently the task oforganisational and financial restructuring for achieving greater efficiency.1.1.2 Future of Indian BankingThe future of Indian Banking represents a unique mixture of unlimited opportunities amidstinsurmountable challenges. On the one hand we see the scenario represented by the rapidprocess of globalisation presently taking shape bringing the community of nations in theworld together, transcending geographical boundaries, in the sphere of trade and commerce,and even employment opportunities of individuals. All these indicate newly emergingopportunities for Indian Banking. But on the darker side we see the accumulated morass,brought out by three decades of controlled and regimented management of the banks in thepast. It has siphoned profitability of the Government owned banks, accumulated bloated NPAand threatens Capital Adequacy of the Banks and their continued stability. Nationalisedbanks are heavily over-staffed. The recruitment, training, placement and promotion policiesof the banks leave much to be desired. In the nutshell the problem is how to shed the legaciesof the past and adapt to the demands of the new age.On the brighter side are the opportunities on account of -The advent of economic reforms, the deregulation and opening of the Indian economy to theglobal market, brings opportunities over a vast and unlimited market to business and industryin our country, which directly brings added opportunities to the banks.a) The advent of Reforms in the Financial & Banking Sectors (the first phase in the year1992 to 1995) and the second phase in 1998 heralds a new welcome development to reshapeand reorganize banking institutions to look forward to the future with competence andconfidence. The complete freeing of Nationalised Banks (the major segment) fromadministered policies and Government regulation in matters of day-to-day functioningheralds a new era of self-governance and a scope for exercise of self-initiative for thesebanks. There will be no more directed lending, pre-ordered interest rates, or investment 5
  5. 5. guidelines as per dictates of the Government or RBI. Banks are to be managed by themselves,as independent corporate organizations, and not as extensions of government departments.b) Acceptance of prudential norms with regards to Capital Adequacy, Income Recognitionand Provisioning are welcome measures of self regulation intended to fine-tune growth anddevelopment of the banks. It introduces a new transparency, and the balance sheets of banksnow convey both their strength and weakness. Capital Adequacy and provisioning norms areintended to provide stability to the Banks and protect them in times of crisis. These equallyinduce a measure of corporate accountability and responsibility for good management on thepart of the banks.c) Large scale switching to hi-tech banking by Indian Scheduled Commercial Banks (SCBs)through the application of Information Technology and computerisation of bankingoperations, will revolutionalise customer service. The age-old methods of ‘pen and ink’systems are over. Banks now will have more employees available for business developmentand customer service freed from the needs of bookkeeping and for casting or tallyingbalances, as it was earlier.d) All these welcome changes towards competitive and constructive banking could nothowever, deliver quick benefits on account insurmountable carried over problems of the pastthree decades. Since the 70s the SCBs of India functioned totally as captive capsule units cutoff from international banking and unable to participate in the structural transformations, thesweeping changes, and the new type of lending products emerging in the global bankingInstitutions. Our banks are over-staffed. The personnel lack training and knowledge resourcesrequired to compete with international players. The prevalence of corruption in publicservices of which PSBs are an integral part and the chaotic conditions in parts of the IndianIndustry have resulted in the accumulation of non-productive assets in an unprecedentedlevel. The future of Indian Banking is dependent on the success of its efforts as to how itshakes off these accumulated past legacies and carried forward ailments and how itregenerates itself to avail the new vistas of opportunities to be able to turn Indian Banking toInternational Standards.PSBs in India can solve their problems only if they assert a spirit of self-initiative and self-reliance through developing their in-house expertise. They have to imbibe the bankingphilosophy inherent in de-regulation. They are free to choose their respective paths and settheir independent goals and corporate mission. The first need is management up gradation. 6
  6. 6. We have learnt prudential norms of asset classification and provisioning. More importantnow, we must learn prudential norms of asset creation, of credit assessment and creditdelivery, of risk forecasting and de-risking strategies. The habit of looking to RBI andGovernment of India to step in and remove the barriers in the way of the Banks should begiven a go-bye. NPA and mismatch between assets and liabilities is a problem created by theBanks and they have to find the cause and the solution - how it was created and how theBanks are to overcome it. Powerful Institutions can be nurtured by strong and dynamicmanagement and not by corrupt and weak bureaucrats.Public sector ownership need not result in inefficiency and poor customer service. These arenot due to the ills of ownership, but due to failure to accept the correct "Mission" and "Goals"of management. On the other hand unlike several private sector units, Public sector units havespecific plus points. They do not evade taxes, and do not accumulate unassisted wealth orunaccounted money. They do not bribe controlling persons to get their way through. They donot indulge in predatory "take over" of weaker rival units. In fact a public unit nevercompetes unethically with its rival-units. It is in this context the subject of bettermanagement-efficiency and accountability is important. I have included discussion of suchsubjects like "Corporate Governance", Risk Analysis and Risk Management as part of thediscussions in this project.1.1.3 Opportunities and ChallengesThe bar for what it means to be a successful player in the sector has been raised. Fourchallenges must be addressed before success can be achieved. First, the market is seeingdiscontinuous growth driven by new products and services that include opportunities in creditcards, consumer finance and wealth management on the retail side, and in fee-based incomeand investment banking on the wholesale banking side. These require new skills in sales &marketing, credit and operations. Second, banks will no longer enjoy windfall treasury gainsthat the decade-long secular decline in interest rates provided. This will expose the weakerbanks. Third, with increased interest in India, competition from foreign banks will onlyintensify. Fourth, given the demographic shifts resulting from changes in age profile andhousehold income, consumers will increasingly demand enhanced institutional capabilitiesand service levels from banks. 7
  7. 7. 1.2 INTRODUCTION TO RISK ANALYSIS IN BANKSRisks manifest themselves in many ways and the risks in banking are a result of many diverseactivities, executed from many locations and by numerous people. As a financialintermediary, banks borrow funds and lend them as a part of their primary activity. Thisintermediation activity, of banks exposes them to a host of risks. The volatility in theoperating environment of banks will aggravate the effect of the various risks. The projectdiscusses the various risks that arise due to financial intermediation and by highlighting theneed for asset-liability management; it discusses the various Models for risk management.1.2.1 Risks in BankingToday’s banking is full of risks. So do not try hard to avoid it because is to stay in business isto stay with risk. What is required is to convert vulnerabilities and weaknesses into strengthsand threat as opportunities to build a sustainable development in banking sectorRisk is a concept that denotes the precise probability of specific eventualities. Technically,the notion of risk is independent from the notion of value and, as such, eventualities mayhave both beneficial and adverse consequences. However, in general usage the convention isto focus only on potential negative impact to some characteristic of value that may arise froma future event.Based on the origin and their nature, risks are classified into various categories. The mostprominent financial risks to which the banks are exposed to are:(a) Interest rate risk: Interest rate risk refers to the volatility in the market value ofstockholders’ equity attributable to changes in the level of interest rates and associatedchanges in balance sheet and off-balance sheet mix and volume. A bank that assumessubstantial risk will see its value of equity rise or fall sharply when interest rates changeunexpectedly. It is the risk that arises when the interest income/ market value of the bank issensitive to the interest rate fluctuations.(b) Foreign Exchange/Currency Risk: Risk that arises due to unanticipated changes inexchange rates and becomes relevant due to the presence of multi-currency assets and/orliabilities in the banks balance sheet. This risk is of two types: - 8
  8. 8. • Transaction Risk: - The transaction risk is observed when movements in price of a currency (transaction) move upward or downward, result in a loss on a particular transaction. Transaction risk also destabilizes the anticipated cash flow.(c)Translation risk: - in a situation of translation risk, the balance sheet of a bank, whenconverted in home currency, undergoes a drastic change, chiefly owing to exchange ratemovements and changes in the level of investments or borrowings in foreign currency, evenwithout having translation at a particular point of time.(d) Liquidity risk: Risk that arises due to the mismatch in the maturity patterns of the assetsand liabilities. This mismatch may lead to a situation where the bank is not in a position toimpart the required liquidity into its system - surplus/ deficit cash situation. In the case ofsurplus situation this risk arises due to the interest cost on the idle funds. Thus idle fundsdeployed at low rates contribute to negative returns.(e) Credit Risk: Risk that arises due to the possibility of a default/delay in the repaymentobligation by the borrowers of funds.(f) Contingency risk: Risk that arises due to the presence of off-balance sheet items such asguarantees, letters of credit, underwriting commitments etc.(g) Price risk: Price risk is a risk, which occurs due to changes in market price of assets,liabilities or derivative contracts. This results in strain on the profitability of bank(h) Operating risk: -The potential financial loss as a result of a breakdown in day-to-dayoperational processes. Operating risk is a result of failure of operating system in a bank dueto certain reasons like fraudulent activities, natural disaster, human error or omission orsabotage, etc.(i) Solvency risk: Solvency risk occurs when the bank is landed in a chronic situation of notable to meet its obligations. This type of risk gives the ultimate impression that the bank hasfailed.(j) Political risk: Introduction of service tax or increase in income tax, freezing the assets ofthe bank by the legal authority, etc. is termed as political risks. 9
  9. 9. (k)Human risk: Labour unrest, dispute among top executives, lack of motivation, inadequateskills, and en-mass resignation by competent executives, problems faced by banks afterimplementation of Voluntary Retirement Scheme (VRS), etc., lead to human risk.(l) Financial risk: Non-availability of liquid funds, strain on profitability due to low interestrate regime and adverse changes in exchange rates, etc., are reasons responsible for thefinancial risk.(m) Technology risk: Obsolescence, mismatches, breakdowns, adoption of latest technologyby competitors, etc., come under technology risk.(n)Legal risk: Legal changes, threat from customers etc., is called as legal risk.(o) Systematic risk: When the default of failure of one financial institution is spread as chainreaction to threaten the stability of financial system as a whole, the situation is expressed as asystematic risk.1.2.2 Currency RiskCurrency risk results from changes in exchange rates and originates in mismatches betweenthe values of assets and liabilities denominated in different currencies. When assessingcurrency risk, one must distinguish between the risk originating in political decisions, riskresulting from traditional banking operations, and the risk from trading operations.Origin and Components of Currency RiskCurrency risk results from changes in exchange rates between a banks domestic currency andother currencies. It originates from a mismatch, and may cause a bank to experience losses asa result of adverse exchange rate movements during a period in which it has an open on- oroff-balance-sheet position, either spot or forward, in an individual foreign currency. In recentyears, a market environment with freely floating exchange rates has practically become theglobal norm. This has opened the doors for speculative trading opportunities and increasedcurrency risk. The relaxation of exchange controls and the liberalization of cross bordercapital movements have fueled a tremendous growth in international financial markets. Thevolume and growth of global foreign exchange trading has far exceeded the growth ofinternational trade and capital flows, and has contributed to greater exchange rate volatilityand therefore currency risk. 10
  10. 10. Currency risk arises from a mismatch between the value of assets and that of capital andliabilities denominated in foreign currency (or vice versa), or because of a mismatch betweenforeign receivables and foreign payables that are expressed in domestic currency. Suchmismatches may exist between both principal and interest due. Currency risk is of a"speculative" nature and can therefore result in a gain or a loss, depending on the direction ofexchange rate shifts and whether a bank is net long or net short in the foreign currency. Forexample, in the case of a net long position in foreign currency, domestic currencydepreciation will result in a net gain for a bank and appreciation will produce a loss. Under anet short position, exchange rate movements will have the opposite effect.In principle, the fluctuations in the value of domestic currency that create currency risk resultfrom changes in foreign and domestic interest rates that are, in turn, brought about bydifferences in inflation. Fluctuations such as these are normally motivated by macroeconomicfactors and are manifested over relatively long periods of time, although currency marketsentiment can often accelerate recognition of the trend. Other macroeconomic aspects thataffect the domestic currency value are the volume and direction of a countrys trade andcapital flows. Short term factors, such as expected or unexpected political events, changedexpectations on the part of market participants, or speculation-based currency trading mayalso give rise to currency changes. All these factors can affect the supply and demand for acurrency and therefore the day-to-day movements of the exchange rate in currency markets.In practical terms, currency risk comprises the following:a) Transaction risk, or the price-based impact of exchange rate changes on foreignreceivables and foreign payables - i.e., the difference in price at which they are collected orpaid and the price at which they are recognized in local currency in the financial statementsof a bank or corporate entity.b) Economic or business risk related to the impact of exchange rate changes on a countryslong-term or a companys competitive position. For example, a depreciation of the localcurrency may cause a decline in imports and larger exports.c) Revaluation risk or translation risk, which arises when a banks foreign currency positionsare revalued in domestic currency or when a parent institution conducts financial reporting orperiodic consolidation of financial statements. 11
  11. 11. There are also other risks related to international aspects of foreign currency business that areincurred by banks conducting foreign exchange operations. One such risk is a form of creditrisk that relates to the default of the counterparty to a foreign exchange contract. In suchinstances, even a bank with balanced books may find itself inadvertently left with anuncovered exchange position. Another form of credit risk peculiar to exchange operations isthe time-zone-related settlement risk. This arises when an exchange contract involves twosettlements that take place at different times due to a time-zone difference, and thecounterparty or the payment agent defaults in the interim. The maturity mismatching offoreign currency positions can also result in interest rate risk between the currenciesconcerned, where a bank can suffer losses as a result of changes in interest rate differentialsand of concomitant changes in the forward exchange premiums, or discounts, if it has anymismatches with forward contracts or derivatives of a similar nature.1.2.3 Market RiskMarket risk is the risk that a bank may-experience loss due to unfavorable movements inmarket prices. Exposure to such risk may arise as a result of the bank taking deliberatespeculative positions (proprietary trading) or may ensue from the banks market-making(dealer) activities.Sources of market riskMarket risk results from changes in the prices of equity instruments, commodities, money,and currencies. Its major components are therefore equity position risk, commodities risk,interest rate risk, and currency risk. Each component of risk includes a general market riskaspect and a specific risk aspect that originates in the specific portfolio structure of a bank. Inaddition to standard instruments, market risk also applies to various derivatives instruments,such as options, equity derivatives, or currency and interest rate derivatives.a) Volatility: The price volatility of most assets held in stable liquidity investment andtrading portfolios is often significant. Volatility prevails even in mature markets, though it ismuch higher in new or illiquid markets. The presence of large institutional investors, such aspension funds, insurance companies, or investment funds, has also had an impact on thestructure of markets and on market risk. Institutional investors adjust their large-scale stableliquidity investment and trading portfolios through large-scale trades, and in markets withrising prices, large-scale purchases tend to push prices up. Conversely, markets with 12
  12. 12. downward trends become more skittish when large, institutional-size blocks are sold.Ultimately, this leads to a widening of the amplitude of price variances and therefore toincreased market risk.b) Proprietary trading versus stable liquidity investment portfolio management: Theincreasing exposure of banks to market risk is due to the trend of business diversificationfrom the traditional intermediation function toward market-making and proprietary tradingactivities, whereby banks set aside "risk capital" for deliberate risk taking activities. Theproprietary trading portfolio must be distinguished from the stable liquidity investmentportfolio. Proprietary trading is aimed at exploiting market opportunities with leveragedfunding (for example, through the use of repurchase agreements), whereas the stable liquidityinvestment portfolio is held and traded as a buffer/stable liquidity portfolio. As stated earlier,both proprietary trading and stable liquidity investment portfolios are subject to market risk.c) Value at risk: VAR is a modeling technique that typically measures a banks aggregatemarket risk exposure and, given a probability level, estimates the amount a bank would loseif it were to hold specific assets for a certain period of time.d) Inputs to a VAR-based model include data on the banks positions and on prices,volatility, and risk factors. The risks covered by the model should include all interest,currency, equity, and commodity and option positions inherent in the banks portfolio, forboth on- and off-balance-sheet positions. VAR-based models typically combine the potentialchange in the value of each position that would result from specific movements in underlyingrisk factors with the probability of such movements occurring. The changes in value areaggregated at the level of trading book segments and/or across all trading activities andmarkets. The VAR amount may be calculated using one of a number of methodologies.The measurement parameters include a holding period, a historical time horizon at which riskfactor prices are observed, and a confidence interval that allows for the prudent judgment ofthe level of protection. The observation period is chosen by the bank to capture marketconditions that are relevant to its risk management strategy.1.2.4 Interest Rate RiskInterest rate risk is the sensitivity of capital and income to changes in interest rates. Interestrate risk originates in mismatches in the repricing of assets and liabilities and from changes inthe slope and shape of the yield curve. Banks generally attempt to ensure that the repricing 13
  13. 13. structure of their balance sheet generates maximum benefits from expected interest ratemovements. This repricing structure may also be influenced by liquidity issues, particularly ifthe bank does not have access to interest rate derivatives to separate its liquidity and interestrate views. The goal of interest rate risk management is to maintain interest rate riskexposures within authorized levels.Sources of Interest Rate RiskAll financial institutions face interest rate risk. When interest rates fluctuate, a banksearnings and expenses change, as do the economic value of its assets, liabilities, and off-balance-sheet positions. The net effect of these changes is reflected in the banks overallincome and capital. The combination of a volatile interest rate environment, deregulation,and a growing array of on- and off-balance-sheet products has made the management ofinterest rate risk a growing challenge. At the same time, informed use of interest ratederivatives such as financial futures and interest rate swaps can help banks manage andreduce the interest rate exposure that is inherent in their business. Bank regulators andsupervisors therefore place great emphasis on the evaluation of bank interest rate riskmanagement - particularly so since the implementation of market-risk-based capital chargesas recommended by the Basel Committee.Broadly speaking, interest rate risk management comprises the various policies, actions, andtechniques that a bank can use to reduce the risk of diminution of its net equity as a result ofadverse changes in interest rates. This various aspects of interest rate risk and review thetechniques available to analyze and manage it. These include, in particular, repricing andsensitivity analyses.a) Repricing risk: Variations in interest rates expose a banks income and the underlyingvalue of its instruments to fluctuations. The most common type of interest rate risk arisesfrom timing differences in the maturity of fixed rates and the repricing of the floating rates ofbank assets, liabilities, and off-balance-sheet positions.b) Yield curve risk: Repricing mismatches also expose a bank to risk deriving from changesin the slope and shape of the yield curve. Yield curve risk materializes when yield curveshifts adversely affect a banks income or underlying economic value. For example, a banksposition may be hedged against parallel movements in the yield curve; for instance, a longposition in bonds with 10-year maturities may be hedged by a short position in five-year 14
  14. 14. notes from the same issuer. The value of the long maturity instrument can still decline sharplyif the yield curves increases, resulting in a loss for the bank.c) Basis risk: It is also described as spread risk, arises when assets and liabilities are pricedoff different yield curves and the spread between these curves shifts. When this yield curvespreads change, income and market values may be negatively affected. Such situations canoccur when an asset that is repriced monthly based on an index rate (such as U.S. treasurybills) is funded by a liability that also is repriced monthly, but based on a different index rate(such as LIBOR or swaps). Basis risk thus derives from unexpected change in the spreadbetween the two index rates.d) Assessing interest rate risk exposure: Since interest rate risk can have adverse effects onboth a banks earnings and its economic value, two separate but complementary approachesexist for assessing risk exposure. From the perspective of earnings, which is the traditionalapproach to interest rate risk assessment, the analysis focuses on the impact of interest ratechanges on a banks net interest income. As noninterest income has gained importance, sohave shifts in economic value (viewed as the present value of the banks net expected cashflows resulting from interest rate changes. In this sense, the economic value perspective alsoreflects the sensitivity of a banks net worth to fluctuations in interest rates, thereforeproviding a more comprehensive view of the potential long-term effects of interest ratechanges than the view provided by the earnings perspective. However, economic valueassessments are necessarily driven by myriad assumptions, and their precision thereforedepends on the accuracy and validity of those assumptions.1.2.5 Liquidity RiskLiquidity risk that arises due to the mismatch in the maturity patterns of the assets andliabilities. This mismatch may lead to a situation where the bank is not in a position to impartthe required liquidity into its system - surplus/ deficit cash situation. In the case of surplussituation this risk arises due to the interest cost on the idle funds. Thus idle funds deployed atlow rates contribute to negative returns.Bank liquidity management should comprise a risk management (decision making) structure,a liquidity management and funding strategy, asset of limits to liquidity risk exposures, and aset of procedures for liquidity planning under alternative scenarios, including crisis situations.The Need for Liquidity 15
  15. 15. Liquidity is necessary for banks to compensate for expected and unexpected balance sheetfluctuations and to provide funds for growth. It represents a banks ability to efficientlyaccommodate the redemption of deposits and other liabilities and to cover funding increasesin the loan and investment portfolio. A bank has adequate liquidity potential when it canobtain needed funds (by increasing liabilities, securitizing, or selling assets) promptly and at areasonable cost. The price of liquidity is a function of market conditions and the marketsperception of the inherent riskiness of the borrowing institution.Liquidity risk lies at the heart of confidence in the banking system, as commercial banks arehighly leveraged institutions with a ratio of assets to core (Tier 1) capital in the region of20:1. The importance of liquidity transcends the individual institution, because a liquidityshortfall at a single institution can have system wide repercussions. It is in the nature of abank to transform the term of its liabilities to different maturities on the asset side of thebalance sheet. Since the yield curve is typically upward sloping the maturity of assetsgenerally tends to be longer than that of liabilities. The actual inflow and outflow of funds donot necessarily reflect contractual maturities, and yet banks must be able to meet certaincommitments (such as deposits) whenever they come due. A bank may therefore experienceliquidity mismatches, making its liquidity policies and liquidity risk management key factorsin its business strategy.Liquidity risk analysis therefore addresses market liquidity rather than statutory liquidity. Theimplication of liquidity risk is that a bank may have insufficient funds on hand to meet itsobligations. (A banks net funding includes its maturing assets, existing liabilities, andstandby facilities with other institutions. It would sell its marketable assets in the stableliquidity investment portfolio to meet liquidity requirements only as a last resort.) Liquidityrisks are normally managed by a banks asset-liability management committee (ALCO),which must therefore have a thorough understanding of the interrelationship betweenliquidity and other market and credit risk exposures on the balance sheet.Understanding the context of liquidity risk analysis involves examining a banks approach tofunding and liquidity planning under alternative scenarios. As a result of the increasing depthof interbank (money) markets, a fundamental shift has taken place in the attitude that theauthorities have toward prudent liquidity management. Supervisory authorities now tend toconcentrate on the maturity structure of a banks assets and liabilities rather than solely on itsstatutory liquid asset requirements. They do this using maturity ladders for liabilities and 16
  16. 16. assets during specific periods (or time bands), a process that represents a move from thecalculation of contractual cash outflows to the calculation of expected liquidity flows.1.2.6 Credit RiskCredit risk that arises due to the possibility of a default/delay in the repayment obligation bythe borrowers of funds. Credit risk can be limited by reducing connected-party lending andlarge exposures to related parties.Components of Credit riskCredit or counterparty risk is defined as the chance that a debtor or financial instrument issuerwill not be able to pay interest or repay the principal according to the terms specified in acredit agreement - is an inherent part of banking. Credit risk means that payments may bedelayed or ultimately not paid at all, which can in turn cause cash flow problems and affect abanks liquidity. Despite innovation in the financial services sector, credit risk is still themajor single cause of bank failures. The reason is that more than 80 percent of a banksbalance sheet generally relates to this aspect of risk management. The three main types ofcredit (counterparty) risk are as follows:* Personal or consumer risk;* Corporate or company risk;* Sovereign or country risk.Because of the potentially dire effects of credit risk, it is important to perform acomprehensive evaluation of a banks capacity to assess, administer, supervise, enforce, andrecover loans, advances, guarantees, and other credit instruments. An overall credit riskmanagement review will include an evaluation of the credit risk management policies andpractices of a bank. This evaluation should also determine the adequacy of financialinformation received, from a borrower or the issuer of a financial instrument, which has beenused by a bank as the basis for investing in such financial instruments or the extension ofcredit; and the periodic assessment of its inherently changing risk. The credit riskmanagement function is primarily focused on the loan portfolio, although the principlesrelating to the determination of creditworthiness, apply equally to the assessment ofcounterparties who issue financial instrumenta) Credit portfolio managementb) Credit risk management policies 17
  17. 17. 1.2.7 Non Performing Assets:NPA’s are those assets for which interest is overdue for more than 180 days. In simple words,an asset (or a credit facility) becomes non-performing when it ceases to yield income. As aresult, banks do not recognize interest income on these assets unless it is actually received. Ifinterest amount is already credited on an accrual basis in the past years, it should be reversedin the current year’s account if such interest is still remaining uncollected.Once an asset falls under the NPA category, banks are required by the Reserve Bank of India(RBI) to make provision for the uncollected interest on these assets. For the purpose theyhave to classify their assets based on the strength and on collateral securities into:a) Standard assets: This is not a non-performing asset. It does not carry more than normalrisk attached to the business.b) Substandard assets: It is an asset, which has been classified as non-performing for aperiod of less than two years. In this case the current net worth of the borrower or the currentmarket value of the security is not enough to ensure recovery of the debt due to the bank. Theclassification of substandard assets should not be upgraded (to standard assets) merely as aresult of rescheduling of the payments. (Rescheduling indicates change in payment scheduleby the borrower or by the banker) There must be a satisfactory performance for two yearsafter such rescheduling.c) Doubtful assets: It is an asset, which has remained non-performing for a period exceedingtwo years.d) Loss assets: It is an asset identified by the bank, auditors or by the RBI inspection as aloss asset. It is an asset for which no security is available or there is considerable erosion inthe realizable value of the security. (If the realizable value of the security as assessed bybank, approved values or RBI is less than 10% of the outstanding, it is known as considerableerosion in the value of asset.) As a result even though there may be some salvage or recoveryvalue, its continuance as bankable asset is not warranted.After classifying assets into above categories, banks are required to make provision againstthese assets for the interest not collected by them. In terms of exact prudential regulations, theprovisioning norms are as under. 18
  18. 18. Table No. 1.1: Provisioning NormsAsset Classification Provision requirementsStandard assets 0.25%Substandard assets 10%Doubtful assets 20% - 50% of the secured portion depending on the age of NPA, and 100% of the unsecured portion.Loss assets It may be either written off or fully provided by the bank.The increasing levels of bad quality loans marred the prospects of nationalized banks in thepast few years. As a result banks shifted their focus from the industrial segment to thecorporate lending. This has curtailed the incremental NPAs to a certain extent.The norms are tightened even for financial institutions (FIs). They are worst affected by theNPA wave thanks to lending to the commodity and economy sensitive sectors, not to mentionthat loans to steel, chemicals and textile sector played a key role in dragging downperformance of FIs. So far they have been enjoying the privilege of recognizing a loan asNPA only if principal is overdue for more than 365 days and interest is outstanding for over180 days. With a view to bring greater transparency, the RBI has proposed to reduce the timelimit to 180 days (for principal). On the one hand imposition of stricter norms could lead to adifficult time for FIs permitting them an option of restructuring their loans could give themsome leeway.Apart from this scheme, the government has designed major policy reforms in order toenhance the efficiency of the banking system. It has decided to set up 7 more debt recoverytribunals (DRTs) in addition to the existing 22 and 5 appellate tribunals. It has also proposedto bring in legislation for facilitating foreclosure and enforcement of securities in case ofdefault.4.6.1 Evolution of NPAsIn the early Nineties PSBs were suffering from acute capital inadequacy and many of themwere depicting negative profitability. This is because the parameters set for their functioningwere deficient and they did not project the paramount need for these corporate goals. 19
  19. 19. a) Incorrect goal perception and identification led them to wrong destinationb) Since the 70s, the SCBs of India functioned totally as captive capsule units cut off frominternational banking and unable to participate in the structural transformations, the sweepingchanges, and the new type of lending products emerging in the global banking Institutions.c) The personnel lacked desired training and knowledge resources required to compete withinternational players. Such and other chaotic conditions in parts of the Indian Bankingindustry had resulted in the accumulation of assets, which were termed as non-productive inan unprecedented leveld) "Audit and Inspections" remained as functions under the control of the executiveofficers, which were not independent and were thus unable to correct the effect of seriousflaws in policies and directions of the higher ups.e) The quantum of credit extended by the PSBs increased by about 160 times in the threedecades after nationalization (from around Rs. 3000 crore in 1970 to Rs. 475113 Crore in2004). The Banks were not developed in terms of skills and expertise to regulate suchstupendous growth in the volume and manage the diverse risks that emerged in the process.f) The need for organizing an effective mechanism to gather and disseminate creditinformation amongst the commercial banks was never felt or implemented. The archaic lawsof secrecy of customers-information that was binding Bankers in India, disabled banks topublish names of defaulters for common knowledge of the other Banks in the system.g) Lack of effective corporate managementh) Credit management on the part of the lenders to the borrowers to secure their genuineand bonafide interests was not based on automatically calculated anticipated cash flows of theborrower concern, while recovery of installments of Term Loans was not out of profits andsurplus generated but through recourse to the corpus of working capital of the borrowingconcerns. This eventually led to the failure of the project financed leaving idle assets.i) Functional inefficiency was also caused due to over-staffing, manual processing of overexpanded operations and failure to computerize Banks in India, when elsewhere throughoutthe world the system was to switch over to computerization of operations. 20
  20. 20. 21
  21. 21. REVIEW OF LITERATUREReview of Literature is a body of text that aims to review the critical points of currentknowledge on a particular topic. Literature reviews are secondary sources, and as such, donot report any new or original experimental work. Its ultimate goal is to bring the reader up todate with current literature on a topic and forms the basis for another goal, such as futureresearch that may be needed in the area. Reviews covering some of the areas related to RiskAnalysis were mentioned below:Pyle (1997) report was based on, why risk management is needed. It outlines some oftheoretical underpinnings of contemporary bank risk management, with emphasis on marketrisk, credit risk, operational risk, and performance risk. The study was based on twoapproaches scenario analysis and value-at risk analysis. In scenario analysis, analysispostulates the changes in underlying determinant of the portfolio value and revalues theportfolio given those changes and value at risk analysis uses asset return distributions andpredicted return parameters to estimates potential portfolio losses. It had been found that, itis reasonable to require that banks have to produce and justify market risk measurementsystem and credit risk and to integrate them.Santomero (1997) studied the problems relating to banking industry which are most difficultto address, shortcomings of the current methodology used to analyze risk and the elementsthat are missing in the procedures of risk management. The study focused on three aspects i.e.risks that can be eliminated or avoided by simple business practices which involves actionsto reduce the chances of idiosyncratic losses from standard banking activity by eliminatingrisks that are superfluous to the institutions business purpose., risks that can be transferred toother participants which is done by construction of portfolios that benefit from 22
  22. 22. diversification across borrowers and that reduce the effects of any one loss experience andrisks that must be actively managed at the firm level, which is done by the implementation ofincentive-compatible contracts with the institutions management to require that employeesbe held accountable.McDonald and Guy (2000) examined the various elements of the Australian banks’ internalcredit risk rating systems, including the systems’ basic architecture, operating design andapplications. It focused on the assessment of the risk from the failure of a given counterpartyto meet debt servicing and other payment obligations on a timely basis and external resourceswhich exposes institutions to risks relating to the applicability, individual customer bases andlending practices. It had been concluded that by implementing data warehousing processesinstitutions can improving the length of a typical credit cycle and with small rated portfoliosinstitutions may not experience sufficient defaults for many years.Chakraborty (2005) studied that banking is full of risks. So do not try too hard to avoid riskbecause to stay in business is to stay with risk. What is required is to convert vulnerabilitiesand weaknesses into strengths and threats as opportunities to build a sustainable developmentin banking sector. It has been found that risk can be reduced by if risk management should beactively and continuously promoted throughout the organization and adequate competenceshould be developed through recruitment, training and development of employees to makethem efficiently handle the tools and techniques of modern risk management system.Willemse and Wolthuis (2005) investigated the resulting empirical situation of accepting arisk based solvency model as a legally valid method to determine minimum requiredsolvency margins. The relevance of this investigation was provided by the increasingapplication of risk based solvency models within credit institutions (Basel II) and insuranceundertakings (Solvency II). They also studied that what is the relation between the solvencynorm established by legislators and the actual capability of insurance undertakings to meettheir obligations and it had been concluded that the establishment of a solvency normprimarily orients towards the equitableness of risk of all insurance undertakings within thejurisdiction.Bandyopadhyay (2007) study would help the Indian Banks to mitigate risk in Agriculturallending. It took into account the characteristics of the agricultural sector, attributes ofagricultural loans and borrowers, and restrictions faced by commercial banks and it isconsistent with Basel II, including consideration given to forecasting accuracy and 23
  23. 23. applicability. Banks can use such credit rating tool in the loan processing, credit monitoring,loan pricing, management decision-making, and in calculating inputs like probability ofdefault, loss given default, default correlation and risk contribution etc. for portfolio creditrisk. This will enable the bank to diversify the risk and optimize the profit in the business.Tamimi and Mazrooei (2007) focused that all banks in the volatile environment had beenfacing a large number of risks such as credit risk, liquidity risk, foreign exchange risk, marketrisk and interest rate risk, among others--risks which may threaten a banks survival andsuccess. This study helped the financial institutions to maximize revenues and offer the mostvalue to shareholders by offering a variety of financial services, and especially byadministering risks. The study also focused on the three generic risk-mitigation strategies:eliminate or avoid risks by simple business practices; transfer risks to other participants; andactively manage risks at the bank level. The purpose of this research was to examine thedegree to which the UAE banks use risk management practices and techniques in dealingwith different types of risk. The secondary objective is to compare risk management practicesbetween the two sets of banks. He found that profit efficiency is sensitive to credit risk andinsolvency risk but not to liquidity risk or to the mix of loan products. The results alsoindicated that the importance of upgrading financial supervision and risk managementpractices as a precondition for successful financial liberalization. He also concluded that ifthe bank is a monopoly or banks are competing only in the loan market, deposit insurance hasno effect on risk taking. Banks in this situation tend to take risks, although extreme risktaking is avoided.Tchana (2008) reviewed the empirical literature of various banking regulations. This isfollowed by a proposal on the new directions for research of the link between bankingregulation and banking system stability. It had been found that there is a need to find a goodmeasure of banking stability in order to assess the importance of regulation on stability. It hastaken two main directions in respect of the stability measure which is used in the study. Theso called implicit-stability method uses an implicit measure of risk such as: the ratio of non-performing loan on the total asset, bank stock price volatility, and the ratio of risk-weightedassets to total assets; while the explicit-stability method uses the occurrence of a systemicbanking crisis in a given economy as the measure of instability. The measure of bankinginstability can be constructed using banking system indicators which are positively correlated 24
  24. 24. to banking crises, such as the growth of credit to the private sector, and the growth of banksdeposits.Hassan (2009) aimed to assess the degree to which Islamic banks in Brunei Darussalam userisk management practices (RMPs) and techniques in dealing with different types of risk.This study found that the three most important types of risk that the Islamic banks in BruneiDarussalam facing are foreign-exchange risk, followed by credit risk and then operating risk.It also found that the Islamic banks are somewhat reasonably efficient in managing riskwhere risk identification (RI) and risk assessment and analysis (RAA) are the mostinfluencing variables in RMPs. The results can be used as a valuable feedback forimprovement of RMPs in the Islamic banks in Brunei and will be of value to those peoplewho are interested in the Islamic banking systemThe perusal of literature revealed that there had been many researches regarding the study ofrisk analysis in which they stated the various kinds of risks faced by banks and how theymanaging the risks. It has been found that risk can be reduced by if risk management shouldbe actively and continuously promoted throughout the organization and adequate competenceshould be developed through recruitment, training and development of employees to makethem efficiently handle the tools and techniques of modern risk management system. 25
  25. 25. 26
  26. 26. NEED, SCOPE AND OBJECTIVES OF THE STUDY3.1 NEED OF THE STUDYThe need of the study aroused in order to fill the gap between the aspects which had alreadybeen covered by the previous works and what the objectives of this study will be. In theearlier studies little attention was directed at understanding the different types of risk faced bybanks. The rationale behind the study was to develop an understanding about the level ofNPAs and risk faced by banks.3.2 SCOPE OF THE STUDYThe scope of the present study extends to almost all the risks involved in banking sector. Inthe present study the perception of the bank managers towards the various risks involved inbanking and the techniques being used in order to minimize those risks was being studied.The scope of the study was limited to Private Banks viz. ICICI Bank, HDFC Bank, AXISBank, YES Bank and IDBI Bank of Ludhiana and Jalandhar City only.3.3 OBJECTIVES OF STUDYThe objectives of the study were as follows:1) To know the level of NPAs of the banks.2) To study the risks for which banks go for risk management techniques.3) To know the various risk model/ techniques use by banks. 27
  27. 27. 4) To study the perception of bankers regarding effectiveness of risk management techniques. 28
  28. 28. RESEARCH METHODOLOGYResearch Methodology is a way to systematically solve the research problem. The ResearchMethodology includes the various methods and techniques for conducting a Research.“Marketing Research is the systematic design, collection, analysis and reporting of data andfinding relevant solution to a specific marketing situation or problem”. D. Slesinger and M.Stephenson in the encyclopedia of Social Sciences define Research as “the manipulation ofthings, concepts or symbols for the purpose of generalizing to extend, correct or verifyknowledge, whether that knowledge aids in construction of theory or in the practice of anart”.Research is, thus, an original contribution to the existing stock of knowledge making for itsadvancement. The purpose of Research is to discover answers to the Questions through theapplication of scientific procedures. This project had a specified framework for collectingdata in an effective manner. Such framework was called “Research Design”. The researchprocess followed by this study consists of following steps:4.1 RESEARCH DESIGN:-The present study is a conclusion oriented descriptive study as this study was undertaken toget insight into the risks involved in banking sector and their effect on the level of NPAs.4.2 SAMPLE DESIGN: 29
  29. 29. Sampling can be defined as the section of some part of an aggregate or totality on the basis ofwhich judgement or an inference about aggregate or totality is made. The sampling designhelps in decision making in the following areas:- • Universe of the study-The universe comprises of two parts as theoretical universe and accessible universe • Theoretical universe- It includes all the banks throughout the universe. • Accessible universe- It includes all the private & public banks in India. • Sample size- Sample size is the number of elements to be included in a study. The sample size was 50 managers and assistant managers of banks. • Sample unit- Sampling unit is the basic unit containing the elements of the universe to be sampled. The sampling unit of the study was managers and assistant managers of banks. • Sampling Techniques- The sampling technique was Judgmental Sampling.4.3 METHODS OF DATA COLLECTIONInformation had been collected from both Primary and Secondary data. • Primary sources- Primary data are those, which are collected are fresh and for the first time and thus happen to be original in character. Primary data had been collected by conducting surveys through questionnaire, which include both open- ended and close-ended questions and personal and telephonic interview. • Secondary sources- Secondary data are those which have already been collected by someone else which already had been passed through the statistical process. Secondary data had been collected through magazines, websites, newspapers and journals.4.4 TOOLS OF ANALYSIS AND PRESENTATION:To analyze the data obtained with the help of questionnaire, following tools were used:Tables: - The data had been put in the form of tables so as to analyze it properly.Bar graphs, Column graphs and Pie charts: - Various forms of graphs had been used forthe purpose of presentation of the data like bar graphs, column graphs and pie charts etc.4.5 LIMITATIONS OF THE STUDYThe limitations of the study are:- 30
  30. 30.  There could be some errors in the observation procedure. Some hesitation on the part of managers to disclose all the details has also been a limitation. The explanations or the answers received from respondents may be erroneous on the pretext of their unwillingness to spare so much of time. 31
  31. 31. DATA ANALYSIS AND INTERPRETATIONThe data has been processed and analyzed by tabulation interpretation so that findingscommunicated well and would had been be easily understood.1: Well Defined and Documented Risk Management Policy: The purpose of this questionwas to know whether the banks have well defined and documented management policy. Theresults were as follows: Table No. 5.1 Well defined and Documented Risk Management Policy BANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE YES 20 10 10 5 5 50 100 NO 0 0 0 0 0 0 0 Figure No. 5.1 Well defined and Documented Risk Management Policy 32
  32. 32. Analysis and Interpretation:A well defined risk management policy is that, whereby the risks with the greatest loss andthe greatest probability of occurring are handled first, and risks with lower probability ofoccurrence and lower loss are handled in descending order. Thus all the banks in the surveyhad well defined & documented risk management policy.2. Operational Risk Management Policy: The purpose of this question was to knowwhether there is existence of operational risk management policy in the banks. The resultswere as follows: Table No 5.2: Operational Risk Management PolicyBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE YES 20 10 10 5 5 50 100 NO 0 0 0 0 0 0 0 Figure No 5.2: Operational Risk Management Policy 33
  33. 33. Analysis and Interpretation:From the above data it had been analyzed that 100% of the banks had Operational RiskManagement Policy.So it could be interperated that banks had documented operational risk managementcommittee in order to minimize the risk of loss resulting from inadequate or failed internalprocesses, people and systems. This Operational Risk framework includes identification,measurement, monitoring, reporting and control.3. Risk Based Internal Audit: The purpose of this question was to know whether the banksconduct risk based internal audit. The results were as follows: Table No 5.3: Risk Based Internal Audit BANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE YES 20 10 10 5 5 50 100 NO 0 0 0 0 0 0 0 Figure No 5.3: Risk Based Internal Audit 34
  34. 34. Analysis and Interpretation:From the above data it had been analyzed that 100% of the banks had Risk Based InternalAudit.So it could be interpretated that all the banks in the survey go for risk based internal auditbecause banks regulators and the bank management need an assurance in risk managementcompliance. Modern internal audit must add demonstrable value in the current competitivebanking environment4. Willingness to take Risks: The purpose of this question was to know whether the banksare willing to take risks. The options were given as very low, low, average, high and veryhigh. The results were as follows: Table No.5.4 Willingness to take RisksBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE Very 0 0 0 0 0 0 0 Low Low 4 2 3 4 3 16 32 Average 16 8 7 1 2 34 68 High 0 0 0 0 0 0 0 Very 0 0 0 0 0 0 0 High 35
  35. 35. Figure No 5.4: Willingness to take RisksAnalysis and Interpretation:The Research had shown that about 68 percent of banks were average risk takers. Thesebanks accept some exposure to riskier borrowers but ensure that such loans are well securedand monitor risk exposure closely to ensure that risk levels are acceptable. And about 32percent of banks were low risk taker.So it can be interpretated these banks follow conservative lending philosophy whichemphasizes borrower selection and tend to avoid or limit exposure to high risk borrowers andtypes of lending. Low risk taker banks even willing to sacrifice some amount of profitabilityto ensure consistent and superior credit performance.5. Strict Rules for Borrower Selection: The purpose of this question was to know whetherthe banks follow strict rules while selecting the borrowers so as to reduce the chances ofNPAs. The results were as follows: Table No.5.5: Strict Rules for Borrower SelectionBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE YES 20 10 10 5 5 50 100 NO 0 0 0 0 0 0 0 Figure No.5.5: Strict Rules for Borrower Selection 36
  36. 36. Analysis and Interpretation:From the above data it had been analyzed that 100% of the banks in the survey had strictrules for borrower’s selection because no bank wants non-performing assets in their balancesheet. But these rules vary from bank to bank according to their policy.6. NPA level of the banks: The purpose of this question was to know the level of NPA in thebanks. The options were given as high, average and low. The results were as follows: Table No. 5.6: Level of NPA of the BanksBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE High 0 0 0 0 0 0 0 Average 8 5 5 5 4 27 54 Low 12 5 5 0 1 23 46 Figure No. 5.6: Level of NPA of the Banks 37
  37. 37. Level of NPA of the Banks 0% 46% 54% High Average LowAnalysis and Interpretation:From the above data it had been analyzed that 54% of the banks in the survey had Averagelevel of NPA and 46% of the respondents had said that there is low level of NPAs in theirbanks.7. Adaptability of Banks: The purpose of this question was to know how the banks adapt tothe situation when things go robust. The options were given as uneasily, somewhat uneasily,somewhat easily and very easily. The results were as follows: Table No 5.7: Adaptability of BanksBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE Uneasily 6 3 4 3 3 20 40 Somewhat 11 6 5 2 2 25 50 Uneasily Somewhat 3 1 1 0 0 5 10 Easily Very 0 0 0 0 0 0 0 Easily Figure No 5.7: Adaptability of Banks 38
  38. 38. Analysis and Interpretation:From the above data it had been concluded that 50% of the respondents said that it wassomewhat uneasy to adapt, 40% of the respondents said that its uneasy to adapt and 10% ofthe respondents said that it is somewhat easy to adapt when things go robust but they had tochange their portfolio and strategies according to market conditions to save the customerfrom these fluctuations and provide maximum benefits.8. Risk Management Framework: The purpose of this question was to know for whichcategory the banks has developed a concrete risk management framework. The results wereas follows: Table No 5.8: Risk Management FrameworksBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE Market YES 20 10 10 5 5 50 100 Risk NO 0 0 0 0 0 0 0 Credit YES 20 10 10 5 5 50 100 Risk NO 0 0 0 0 0 0 0 Operational YES 20 10 10 5 5 50 100 Risk NO 0 0 0 0 0 0 0 Underwritin YES 18 8 8 3 3 40 80 g Risk NO 2 2 2 2 2 10 20 39
  39. 39. Figure No.5.8: Risk Management FrameworksAnalysis and Interpretation:From the above data it had been concluded that every bank had concrete risk managementframework for credit, market risk operational risk. But some banks do not have concrete riskmanagement frame work for underwriting risk, the number of such banks were very low.9: Risk Model(s)/Technique(s) used by Banks: The purpose of this question was to knowthe risk models/ techniques used by banks. The results were as follows: Table No 5.9: Risk Model/TechniquesBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE VAR YES 18 9 9 4 5 45 90 NO 2 1 1 1 0 5 10 Gap YES 18 8 8 4 4 43 86 Analysis NO 2 2 1 1 1 7 14 Forecasting YES 8 2 2 2 2 16 32 Technique NO 12 8 8 3 3 34 68 Scenario YES 0 2 0 0 0 2 4 Analysis NO 20 8 10 5 5 48 96 Figure No 5.9: Category of Risk Model/Techniques 40
  40. 40. Analysis and Interpretation:It had been found that banks mostly 45 and 43 of banks (resp.) used value at .risk and gapanalysis techniques and only 16 and 2 banks in the study use forecasting techniques andscenario techniques respectively.10. Effect of Credit Risk on Investment Portfolio by Banks: The purpose of this questionwas to know whether the banks monitor the effect of credit risk on Investment Portfolio. Theresults were as follows: Table No 5.10: Effect of Credit Risk on Investment Portfolio.BANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE YES 20 10 10 5 5 50 100 NO 0 0 0 0 0 0 0 Figure No 5.10: Effect on Credit Risk on Investment Portfolio. 41
  41. 41. Effect on Credit Risk on Investment Portfolio YES NO 0% 100%Analysis and Interpretation:From the above figure it had been examined that majority of the respondents i.e 100 % of therespondents monitor the credit risk in their investment portfolio because asset classificationand subsequent provisioning against possible losses impacts not only the value of the loanportfolio but also the true underlying value of a banks capital.11. Volatile Investments: The purpose of this question was to know the willingness of banksto take risks in banks. The results were as follows: Table No 5.11: Willingness of Banks to take Risks in Volatile InvestmentsBANKS HDFC ICICI AXIS YES IDBI TOTAL Percentage Bank Bank Bank Bank Bank (%) RESPONSE Strongly 5 2 3 3 3 16 32 Agree Agree 12 6 4 1 1 34 68 Somewhat 3 2 3 1 1 10 20 Agree Disagree 0 0 0 0 0 0 0 42
  42. 42. Strongly 0 0 0 0 0 0 0 Disagree Figure No 5.11: Willingness of Banks to take Risks in Volatile Investments Volatile Investments Strongly Agree Agree Somewhat Agree Disagree Strongly Disagree 0% 0% 20% 17% 63%Analysis and Interpretation:The survey had shown that 68% of banks were agreed that they are comfortable with volatileinvestments that experience large declines in value if there is potential for higher returns. And22% and 18% of banks were somewhat and strongly agreed that they are comfortable withvolatile investments. These volatile investment opportunities are mostly availed by thecustomers who are risk takers.12: Spread of Investment in Portfolio: The purpose of this question was to know the spreadof investment in portfolio on risk basis. The results were as follows: Table No 5.12: Spread of Investments in Portfolio on Risk BasisBanks HDFC ICICI AXIS YES IDBI Total %PortfoliosPortfolio 1 0 0 0 0 0 0 0Portfolio 2 0 0 0 0 0 0 0Portfolio 3 1 0 1 1 1 4 8Portfolio 4 7 4 3 3 4 21 42Portfolio 5 10 6 7 2 0 25 50Portfolio 6 0 0 0 0 0 0 0Portfolio 7 0 0 0 0 0 0 0 Figure No 5.12: Spread of Investments in Portfolio 43
  43. 43. 50 50 45 42 40 35 30 25 20 15 8 10 5 0 0 0 0 0 Portfolio Portfolio Portfolio Portfolio 1 3 5 7Analysis and Interpretation:From the above figure it had been examined that most of the bank manager believed thatportfolio 4 and portfolio 5 was in consonance with their banking portfolio. As theseportfolio’s are having suitable blend of high return & high risk, medium return & mediumrisk and low return & low risk. 44
  44. 44. 45
  45. 45. FINDINGS OF THE STUDYAfter analyzing various questionnaires which were filled by bank managers of various banks,the following were the findings of the study:  Delegation of greater autonomy in financial operations, increase in volume of cross border business, greater international financial linkages, wider range of products and services and the growing diversities and complexities of banking business have increased the risks faced by banks. Thus it had been found that every bank had well defined & documented risk management policy because they wanted to take calculated risk  It had been found that all the banks had documented operational risk management committee in order to minimize the risk of loss resulting from inadequate or failed internal processes, people and systems. This Operational Risk framework includes identification, measurement, monitoring, reporting and control.  It had been found that all the banks were having risk based internal audit because bank regulators and the bank management need an assurance in risk management compliance.  With the current financial environment, banks would encounter greater success in garnering low cost deposits and would thus be able to better manage their margins because of their average and low risk taking abilities. These banks follow conservative lending philosophy which emphasizes borrower selection and tend to avoid or limit exposure to high risk borrowers and types of lending. Thus risk tolerance of bank lies somewhere between average and low risk taking abilities.  All the banks have strict rules for borrower’s selection because no bank wants Non Performing Assets in their balance sheet. The measure of non-performing assets helps us to assess the efficiency in allocation of resources made by banks to productive sectors. But these rules are varies from bank to bank according to their policy.  It was not easy for the banks to adopt when things go robust but they have to change their portfolio and strategies according to market conditions. So that they can provide good returns to their customers up to maximum possible level irrespective of the market conditions 46
  46. 46.  All banks had concrete risk management framework for credit risk, market risk and operational. But some banks do not have concrete risk management frame work for underwriting risk. And the number of such banks was very low. Since banks portfolio was not linear in the market parameter. They had to measure its sensitivity or risk to small changes in each parameter. In order to measure these sensitivities or risks, banks mostly use value at risk, gap analysis and forecasting technique All the banks monitor the credit risk in their investment portfolio because asset classification and subsequent provisioning against possible losses impacts not only the value of the loan portfolio but also the true underlying value of a banks capital. Banks were even comfortable with volatile investments that experience large declines in value if there is potential for higher returns. But these volatile investment opportunities are mostly availed by the customers who are risk takers. 47
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  48. 48. 7.1 CONCLUSION OF THE STUDYIndian banking has made significant progress in recent years. The prudential norms,accounting and disclosure standards and risk management practices, etc. are keeping pacewith global standards.To conclude, it can be said that Indian banking industry is very well regulated. Every bankhas well defined & documented risk management policy because they want to take calculatedrisk. To minimize the risk of loss resulting from inadequate or failed internal processes,people and systems, or from external events, banks have documented operational riskcommittee. Risk management and risk mitigation techniques have therefore acquiredparamount importance in banking business. In order to provide assurance in risk managementcompliance, modern internal audit add demonstrable value in the current competitive bankingenvironment and the increasing expectations of regulators, governments and professionalbodies reflect the growing importance placed on the function. Banks have made stringentrules for borrowers selection so as to remove the fear of NPA’s and have well definedframework for analyzing not only credit risk but operational as well as market risk.But there is need to develop performance framework in order to comply with globalstandards. The advent of economic reforms, the deregulation and opening of the Indianeconomy to the global market, brings opportunities over a vast and unlimited market tobusiness and industry in our country, which directly brings added opportunities to the banks.Banks can solve their problems only if they assert a spirit of self-initiative and self-reliancethrough developing their in-house expertise. They have to imbibe the banking philosophyinherent in de-regulation. Today’s banking is full of risks. So do not try hard to avoid itbecause is to stay in business is to stay with risk. What is required is to convert vulnerabilitiesand weaknesses into strengths and threat as opportunities to build a sustainable developmentin banking sector. 49
  49. 49. 7.2 RECOMMENDATIONS OF THE STUDYThe recommendations of the study were as follows:- 1. Banks should develop risk concrete risk management framework for operational as well as underwriting risk. This will help to remove loss during transaction or internal process and fear of nonperforming assets. 2. Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. 3. Banks should give priority to calculation of all types of risk that would be an essential requirement in the banks as they would be in the process of calculating not only the Credit Risk, Market Risk and Operational Risks but also underwriting risk that the bank would be facing. 4. The various resolution strategies for recovery from NPAs should be made. 5. The capital to be set off for advances made by the bank would depend largely upon the fair and accurate calculation of these risks based internal audit. 50
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  51. 51. REFERENCESBandyopadhyay. (2007). Credit risk models for managing bank’s agricultural loan portfolio.Western Journal of Finance Research, 28(4), 955-973.Chakraborty. (2005). Risk management practices in banks. Journal of Chartered Accountant,27(7), 518-525.Hassan. (2009). Risk management practices of Islamic banks. Journal of Risk Finance, 10(1),23-27.Hassan and Mazrooei. (2007). Banks risk management: A comparison study of UAE nationaland foreign banks. Journal of Risk Finance, 8(4), 394- 409.McDonald and Eastwood. (2000). Credit risk rating at Australian banks. South Asian Journalof Management, 20(3), 85-91.Pyle. (1997). Bank risk management. Journal of American Finances, 99(5), 451-457.Santomero. (1997). Commercial bank risk management: An analysis of the process. CanadianJournal Administration Sciences, 69(6), 360-365.Tamimi and Mazrooei. (2007). A study of risks in banks. Journal of Administration Finance,38(5), 62-67.Tchana. (2008). Study of banking instability and risk indicators. Journal of Finance andManagement, 44(5), 44-58.Willemse and Wolthuis. (2005). Risk based solvency norms and their validity. Journal ofPediatric Psychology, 45(9), 82-86. 52
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  53. 53. QUESTIONNAIREDear Respondent,I Swati Seth, student of Apeejay Institute of Management,will be conducting a research on‘Risk Analysis in Banking Sector’. So, I request you to spare a few minutes from your busyschedule and fill this form. I assure you that the information provided by you will be keptconfidential.Demographic information:NAME: ____________________________________DESIGNATION: ____________________________________Please tick mark the appropriate options.1) Does your bank have a well-defined and documented risk management policy? Yes No.2) Do you have a documented operational risk management policy? Yes No3) Do you conduct risk based internal audit? Yes No4) How do you rate your institution on willingness to take risks? Very low risk Low risk Average risk High risk Very high taker. taker taker taker risk taker 1 2 3 4 55) Banks follows strict rules for borrower selection so as to remove the fear of NPA. Do you Strongly Agree Agree Somewhat Disagree Strongly Agree Disagree 1 2 3 4 56) What is the level of NPAs in your banks? High Average Low7) How easily does your bank adapt when things goes robust? Uneasily. Somewhat uneasily. Somewhat easily Very easily 1 2 3 4 54
  54. 54. 8) Please tick the category for which your bank has developed a concrete risk managementframework? Types of risk Yes NO Market Risk Credit Risk Operational Risk Underwriting Risk9) Please tick which risk model(s)/technique(s) does your bank use? Models/Techniques of risk Yes NO Scenario Analysis Value at risk Quantitative forecasting techniques Gap analysis10). Do you monitor the effect of credit risk on investment portfolio? Yes No11. Banks are comfortable with volatile investments that may frequently experience largedeclines in value if there is a potential for higher returns. Do you: Strongly Agree Somewhat Disagree Strongly Agree Agree Disagree 1 2 3 4 512. Most of the portfolios have a spread of investments - some of the investments may have high-expected returns but with high risk, some may have medium expected returns and medium risk, andsome may be low-risk/low-return.Which spread of investments do you find most appealing in order to minimize the portfolio risk. Spread of investments in Portfolio High Risk/Return Medium Risk/Return Low Risk/Return Portfolio 0% 0% 100% 1 Portfolio 0% 30% 70% 2 Portfolio 10% 40% 50% 3 Portfolio 30% 40% 30% 4 Portfolio 5 50% 40% 10% 55
  55. 55. Portfolio 70% 30% 0%6 Portfolio 100% 0% 0%7 56