A comprehensive presentation on the financial risks involved in businesses in general & specifically in banks. What is Risk? Generally - Danger, Hazard, Adverse impact, Fear of loss. Financially-Loss of earnings/capital May result in incapability of financial institution to meet business goals Basically there are 4 main risks: 1. Credit Risk 2. Market Risk 3. Liquidity Risk 4. Operational Risk

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MANAGING RISK IN
FINANCIAL SECTOR
By, Saad Khan & Mahrez Mohiuddin
Money & Banking

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What is Risk?
• Generally - Danger, Hazard, Adverse impact,
• Fear of loss
• Financially-Loss of earnings/capital
o May result in incapability of financial institution to meet
business goals
Money & Banking

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When it springs up?
• Arises when there is NO / LESS RETURN in
business
• Investors like Returns & dislike Risks.
• Therefore, people will invest in risky assets only
if they expect to receive higher returns.

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Loss
• Kinds of Losses
 Expected – Occur with reasonable certainty
o Expected default rate of corporate loan/credit card
portfolio
 Unexpected – associated with unforeseen events
o Falling interest rates being absorbed by banks,
using Capital as buffer

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How to increase returns?
• Banks must take
“Additional risks”
“Lower Risks
means
lower Returns”
Money & Banking

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.RISKS
Credit
Marketing
Liquidity
Operational
Strategic
Interest rate
Legal &
Reputation
Political
Compliance
Systematic
Country
Foreign
exchange
Default
Portfolio
Industry
Ownership
Audit

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Is there any global system to manage risks?
• BASEL II Accord
• Determines how much money banks must set aside for
dealing with emergencies
• Failure points –Credit, Market & Operational risks.

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Why we need strategies for Risk Management?
• Identify risks
• Assess impact
• Provide appropriate tools
• Developing methods for monitoring

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Risk Management
• Effective Risk management
i. Identifies threats
ii. Controls loss
iii. Safeguards against unauthorized use of funds
iv. Protects against injury
v. Takes appropriate actions
vi. Offers tools for financial loss

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Benefits of Risk Management
• Strategic planning
• Cost control
• Minimum losses & maximum opportunities
• Increase knowledge of understanding
• Well informed decision making
• Outside review
• Minimum disruptions
• Better utilization of resources
• Culture for continued improvement
• Quality organization
• Protect yourself, protect your organization

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FOUR MAJOR RISKS
TO WHICH FINANCIAL INSTITUTIONS CAN BE EXPOSED TO:
1. Credit Risk
2. Market Risk
3. Liquidity Risk
4. Operational Risk

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Credit Risk (contract)
• “The possibility of one of the parties, to the
contract not fulfilling its obligation.”
• Arises when the obligor is unwilling to, or its
ability to perform that obligation is impaired
resulting in loss to bank.
• Any default in lending, trading, settlement &
other financial transactions result in liquidity
problem to the bank.

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Components of Credit Risk
Management
1. Board & Senior management
o Duty-to approve bank’s credit risk strategy & policies to get
implementation
2. Organizational structure
o CRMC (Credit Risk Management Committee) under the
CR management dept implement policies, monitoring,
approving loan limits, delegating credit approving powers,
regulatory legal compliances, risk concentration etc.

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3. Systems & Procedures
• Credit organization
o Assessment of the borrower’s industry before
new or expansion of the credit
o Purpose, source of repayment, track record,
proposed conditions & covenants, collaterals,
financial position of borrower, appropriate
sanctioning authority & repute financial position.

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•Limit setting
oSize of the loan limits should be based on the credit
strength of the obligor, genuine requirement, economic
condition & institution risk tolerance, may be reviewed at
least annually.
•Credit administration
oComplete proper documentation, credit disbursement
after fulfillment of all formalities, its monitoring, timely
repayment, maintenance of file, collateral & security
documents.

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• Managing Credit risk
Credit risk rating framework – must incorporate first
Business Risk showing industry characteristics,
competitive positions & management.
Second-financial risk by showing financial position,
profitability, capital structure & cash flows of both
present and future.

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Internal Risk Rating
• Bank’s credit exposure.
• Facilitates bank in credit selection, price, tenure,
level of approving authority of loan & monitoring
provision for future loans.

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Architecture of Internal Rating System
• Point in time philosophy
• Through the cycle approach

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Operating design of rating system
• Exposures to rate
• Responsibility for grading
• Nature of rating review
• The rating process

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How to arrive at ratings?
• Borrower’s financial position
• Size
• Industry
• Position in industry
• Reliability of financial statement of borrower
• Quality of management
• Elements of transaction structure such as
covenants etc

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Rating review
• Revision & review of Risk Rating shall be done.

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Credit risk monitoring & control
• Policies are formed to relating to the:
• Roles and responsibilities for monitoring
• Assessment procedures
• Frequency of monitoring
• Examination of collaterals
• Covenants
• Frequency of sight visits
• Identification of any deterioration etc.
•

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Assessment of “Quality of Loan”
a. Financial position & Business conditions
b. Conduct of accounts
c. Loan covenants
d. Collateral valuation etc.

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RISK REVIEW

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Delegation of Authority
• Board of Directors should approve overall
lending authority to the senior management.
• Large banks – multiple credit approvers

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Managing problem credits
When loan is identified as a problem
oNegotiation & Follow up
oWorkout remedial strategies
oReview of collateral & security document
oStatus report & review

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MANAGING MARKET RISK
“The risk that an investment will not be as beneficial as
expected, due to fluctuations in rates/prices brought by
Market forces.”
On & off balance sheet position is adversely affected.

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Factors responsible for Market Risk
1. Interest rate risk
o Lending, funding, investment activities give rise to
it.
o Having effect on:
a. Net Interest Income (NII) or Net Interest Margin
(NIM)
b. Economic value perspective

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NIM Net Interest Margin
• Difference between the total interest income &
expense.
• Economic value perspective _ Present value of
Future cash flows

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2. Foreign exchange risk
• Impact of ADVERSE movement in currency
exchange rates on foreign currency position.
• Devaluation of Rupee with respect to $ will be
harmful for an Export company.

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3. Equity Price Risk
 Risk to earnings/capital resulting from adverse changes in
value of equity related portfolios.
DEFINITION of 'Portfolio'
• A grouping of financial assets such as stocks, bonds and cash equivalents.
• Portfolios are held directly by investors and/or managed by financial
professionals.
EQUITY - In finance, generally - ownership in any asset after all debts
associated with that asset are paid off.

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Value at risk (VAR)
• Observation of market rates
• Prices volatility & correlation
• By VAR Models & JP Morgan’s Risk metrics

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MANAGING LIQUIDITY RISK
“Liquid assets are not sufficient enough to meet the
requirements.”
Solution – funds from market (depends on liquidity in market &
institution, as well)
• Could result in bankruptcy of the institution

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Indicators
• Negative trend in any area
• Concentration in Assets / Liabilities
• Quality compromise
• Income reduction
• Large size of OBS

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Strategy
• Senior management & Board
• ALCO (Asset & Liability Committee)

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LRMM (Liquidity Ratio
Measurement & Monitoring)
• Contingency funding plans
• Use of CFP for emergencies
• CFP (cash flow projection)– estimates inflows &
outflows
• Seasonal / cyclical cash flows
• Funding requirement

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Ratios & Limits
• Cash flow ratios and limits
• Liability concentration ratios & limits
• OBS ratios

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MANAGING OPERATIONAL
RISK (MOR)
“Risk of loss due to improper management.”
CAUSES
•Unauthorized trading
•Fraud
•Error concealment

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Operational risk management
Principles (ORMP)
• Board shall be accountable
• Board and senior management should ensure effective
ORM framework, control and reporting of key risks
• They should recognize all define categories of risks
• Policies & procedures should be aligned to the business
strategy
• All business functions shall be part of ORM framework
• Line management should establish processes for
identification, assessment, monitoring & reporting risks.

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Operational Risk Management
steps
• Code of conduct
• Delegation of
authority
• Segregation of
duties
• Audit
• Planning
• Mandatory leave
• Staff
compensation
• Recruitment &
training
• Dealing with
customers
• Complaint
handling
• Record keeping

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Contingency planning
• An alternative plan when plan A fails to work
• Referred as plan B
• To be used in case of disasters / undesirable
situations.
“A plan devised to be used if the original plan fails
to materialize or having the desired impact.”

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CONCLUSION
“We need honesty & integrity of the leading
authorities.”

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SUGGESTIONS
oBasel – II
oHuman resource to be trained accordingly to demands of today
oAll the deficiencies pointed out by Audit shall be quickly rectified &
no concealed
oReward & punishment system may be adopted

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