The document discusses the concept of risk, defining it as uncertainty leading to adverse outcomes, particularly in financial contexts. It outlines various types of risks such as credit risk, liquidity risk, interest rate risk, and operational risk, as well as strategies for risk identification, measurement, pricing, monitoring, and mitigation. Additionally, it highlights lessons from historical failures in risk management, emphasizing the need for separation of trading activities and back-office operations and the importance of understanding complex financial instruments.

2. What is risk???
• Risk is defined as uncertainty resulting in adverse outcomes-adverse in
relation to a planned objective or expectations.
• Financial risks are uncertainties resulting in adverse variations or
fluctuations of profitability or outright losses.

3. • UNCERTAINTIES IMPACT THE NET CASHFLOW OF ANY BUSINESS OR
INVESTMENT
• THE UNCERTAINTY COULD BE EITHER FAVOURABLE OR UNFAVOURABLE
• THE POSSIBLE UNFAVOURABLE IMPACT IS CALLED RISK ASSOCIATED
WITH BUSINESS OR INVESTMENT

4. What is risk???
• THE RISK COULD BE EITHER LOWER OR HIGHER.LOWER RISK IMPLIES LOWER
VARIATIONS OR FLUCTUATIONS IN NET CASHFLOWS- HIGHER RISK IMPLIES
HIGHER VARIATIONS OR FLUCTUATIONS IN NET CASHFLOWS
• ZERO RISK IMPLIES NO VARIATIONS- BY IMPLICATION IT ALSO MEANS LOWER
RETURNS AS COMPARED TO OTHER ‗RISKY‘ OPPORTUNITIES AVAILABLE IN
THE MARKET.
• TO ASSUME ZERO/ LOW / HIGH RISK DEPENDS ON THE RISK APPETITE OF THE
BUSINESS OR THE INVESTOR.

5. Risk Identification
IN ESSENCE RISK IDENTIFICATION CONSISTS IN IDENTIFYING VARIOUS
RISKS ASSOCIATED WITH THE RISK- TAKING AT THE TRANSACTION LEVEL
AND EXAMINING ITS IMPACT ON THE OVERALL PORTFOLIO AND ON
CAPITAL REQUIREMENT. THE RISK CONTENT IS ALSO TAKEN IN TO
ACCOUNT WHILE PRICING A PARTICULAR PRODUCT
/INSTRUMENT/EXPOSURE.

6. Risk Identification
• EXAMPLE:
• FOR EXAMPLE, A BANK HAS GIVEN A LOAN OF 1 CRORE FOR 5 YEARS
IN ACCORDANCE WITH ITS LENDING POLICY AT 1% OVER THE BASE
LENDING RATE (BLR) WHICH IS SAY 9% PA.
• THE LOAN IS TO BE REPAID BY THE BORROWER IN EQUAL QUARTERLY
INSTALMENT WITH A ONE YEAR MORATORIUM (MEANING
REPAYMENT HOLIDAY).

7. Risk Identification
• THE BANK IS FUNDING THE LOAN BY RAISING A DEPOSIT OF 3 YEARS
FOR THE SAME AMOUNT AT 7% PA—NOW WHAT ARE THE RISKS
ASSOCIATED WITH THIS TRANSACTION? WE WILL IGNORE SLR/CRR
REQUIREMENTS FOR THE SAKE OF SIMPLIFICATION

8. Risk Identification
• THE TENOR OF THE LOAN IS 5 YEARS WHICH IS LONGER THAN THE TENOR
OF THE DEPOSIT WHICH IS 3 YEARS. AND THE END OF 3 YEARS THE
DEPOSIT BECOMES DUE AND PAYABLE WHEREAS THE LOAN IS STILL
OUTSTANDING (REMEMBER, THE LOAN IS ONLY PARTIALLY REPAID BY
THE BORROWER) TO THE EXTENT OF ONLY 50%.
• THEREFORE,AT THE END OF 3 YEARS THE BANK FACES THE FUNDING RISK
/ LIQUIDITY RISK/DEFAULT RISK-INCASE THERE IS A DEFAULT BY THE
BORROWER

9. Risk Identification
• THE INTEREST ON THE LOAN IS LINKED TO THE BLR OF THE BANK
WHEREAS THE DEPOSIT CARRIES A FIXED RATE OF 7% PA THROUGHOUT
ITS TENOR. IF THE BLR IS REDUCED SAY FROM 9% TO 8% DURING THE
SECOND YEAR OF THE LOAN AND FROM 8% TO 7.5% IN THE THIRD YEAR
OF THE LOAN, A BASIS RISK WOULD ARISE. THE SPREAD GETS REDUCED
TO 2% AND 1.5% IN THE SECOND AND THIRD YEAR RESPECTIVELY.

10. Continued
• AFTER 3 YEARS, WHEN THE QUESTION OF FUNDING THE LOAN ARISES,
THE DEPOSIT RATE MAY NOT REMAIN THE SAME. THE TRANSACTION
NOW FACES THE GAP OR MISMATCH RISK AT THE END OF 3 YEARS.
• FURTHER AS THE LOAN GETS REPAID, THE REPAYMENT PROCEEDS
WILL HAVE TO BE DEPLOYED IN TO SOME OTHER INVESTMENT
AVENUE. THE RATE AT WHICH THIS WILL BE DONE WILL NOT BE ON
PAR WITH THE RATE BEING CHARGED ON THE LOAN AMOUNT. HERE
THE BANK FACES THE REINVESTMENT RISK .

11. • IT IS ALSO POSSIBLE THAT THE LOAN IS PREPAID AND THE DEPOSIT IS
WITHDRAWN PREMATURELY GIVING A NEW DIMENSION TO THE RISK
VALLED THE EMBEDDED OPTION RISK.
• THUS WE SEE A PLETHORA OF RISKS ASSOCIATED WITH A SINGLE
TRANSACTION NAMELY, CREDIT RISK (DEFAULT RISK)/ FUNDING
RISK/BASIS RISK/GAP OR MISMATCH RISK/EMBEDDED OPTION RISK.
• WHAT WE DISCUSSED ABOVE IS AN EXAMPLE RISK IDENTIFICATION

12. Risk Measurement
• RISK MEASUREMENT:
• RISK MEASUREMENT IS AN IMPORTANT ASPECT OF RISK MANAGEMENT. IT
QUANTIFIES THE AMOUNT OF RISK. RISK MEASUREMENT SEEKS TO
CAPTURE VARIATIONS IN EARNINGS, MARKET VALUE,LOSSES DUE TO
DEFAULT ETC.
• QUANTITATIVE MEASUREMENT OF RISK CAN BE CLASSIFIED IN TO THREE
CATEGORIES:
• MEASUREMENT BASED ON SENSITIVITY
• MEASUREMENT BASED ON VOLATILITY
• MEASUREMENT BASED ON DOWNSIDE POTENTIAL

13. Risk Measurement
• SENSITIVITY: CAPTURES THE DEVIATION OF A TARGET VARIABLE IN
RESPONSE TO A UNIT MOVEMENT OF A SINGLE PARAMETER. HERE
THE TARGET VARIABLE COULD BE BOND PRICES ( in case of a portfolio
of bonds) AND THE PARAMETER COULD BE THE INTEREST RATE. THAT
IS TO SAY WHAT WOULD BE THE DOWNWARD MOVEMENT IN THE
PRICE OF A COUPON -BEARING BOND (TARGET VARIABLE) FOR A 1%
UPWARD MOVEMENT IN THE INTEREST RATES (PARAMETER).
.

14. Risk Measurement
• VOLATILITY: CHARACTERISES THE STABILITY OR INSTABILITY OF A
RANDOM VARIABLE.THIS IS A STATISTICAL MEASURE OF DISPERSION.
HIGHER THE VOLATILITY- HIGHER THE RISK.
• DOWNSIDE POTENTIAL: IT IS THE MOST COMPREHENSIVE MEASURE
OF RISK AS IT INTEGRATES SENSITIVITY & VOLATILITY WITH THE
ADVERSE EFFECT OF UNCERTAINTY. THIS IS THE MEASURE THAT IS
MOST RELIED UPON BY THE BANKING AND FINANCIAL SERVICES
INDUSTRY AND ALSO THE REGULATOR. THE VALUE AT RISK ( VaR) IS A
DOWNSIDE RISK MEASURE.

15. Risk Pricing
• RISK IN BANKING TRANSACTIONS IMPACTS BANKS PRIMARILY IN
TWO WAYS:
• NEED TO MAINTAIN CAPITAL AS PER REGULATORY REQUIREMENTS
• THE BANK NEEDS TO PAY THE INVESTORS WHO HAVE INVESTED IN
BANK‘S CAPITAL (BOTH DEBT AND EQUITY) THROUGH SERVICING OF
DEBT AND PAYMENT OF DIVIDEND AND TO GENERATE INTERNAL
SURPLUS TO FUND BUSINESS GROWTH.

16. Risk Pricing
• THEREFORE ADEQUATE CAPITALIZATION IS REQUIRED WHICH COMES
AT A COST.
• NEXT, IN ANY LENDING ACTIVITY THERE IS ALWAYS THE
PROBABILITY OF LOSS. IF THE PROBABILITY OF LOSS IS TWO
PERCENT FOR A PORTFOLIO OF LOANS AND ADVANCES THEN THE
RISK PREMIUM GOES UP BY 2%

17. Risk Pricing
• THEREFORE WHILE PRICING THE RISK THE FOLLOWING FACTORS
SHOULD BE TAKEN IN TO ACCOUNT:
• COST OF FUNDS RAISED
• OPERATING EXPENSES-INFRASTRUCTURE COST AND COST OF
EMPLOYEES

18. Risk Pricing
• LOSS PROBABILITY (RISK PREMIUM)
• CAPITAL CHARGE –CAPITAL SET ASIDE FOR LOANS /ADVANCES AND
OTHER ASSETS AND INVESTMENTS BASED ON THEIR RISKINESS.
HIGER THE RISK- HIGHER THE AMOUNT OF CAPITAL THAT SHOULD BE
SET ASIDE.

19. RISK MONITORING AND
CONTROL
• IN ORDER TO ACHIEVE THE OBJECTIVE OF RISK MONITORING AND
CONTROL THE FOLLOWING ARE PUT IN PLACE:
• PROPERLY STRUCTURED RISK MANAGEMENT ORGANIZATION
• A COMPREHENSIVE APPROACH TO RISK MANAGEMENT

20. RISK MONITORING AND
CONTROL
• RISK MANAGEMENT POLICIES THAT ARE CONSISTENT WITH BUSINESS
STRATEGIES AND THE RISK APPETITE.
• PROPER INTERNAL GUIDELINES ON PRUDENTIAL LIMITS/EXPOSURE
LIMITS/DISCRETIONARY POWERS.

21. Risk Mitigation
• RISK MITIGATION OR RISK REDUCTION IS ACHIEVED BY ADOPTING
STRATEGIES THAT EITHER REDUCE OR COMPLETELY ELIMINATE THE
UNCERTAINTIES ASSOCIATED WITH VARIOUS RISK FACTORS.

22. Risk Mitigation
• RISK MITIGATION AIMS AT REDUCING THE DOWNSIDE VARIATIONS IN NET
CASHFLOWS BUT SIMULTANEOUSLY PUTS A CAP ON UPSIDE POTENTIAL.RISK
MITIGATION CAN ALSO BE ACHIEVED BY DIVERSIFICATION ,
COLLATERALIZATION OF RISK BY OBTAINING MARGIN MONEY AND OTHER
SECURITIES,BUYING INSURANCE,USING DERIVATIVE INSTRUMENTS, NETTING
OF EXPOSURES AND OTHER IMMUNIZATION STRATEGIES.

23. Risk Mitigation
• FROM THE RISK MANAGEMENT POINT OF VIEW BANKING BUSINESS
LINES MAY BE GROUPED IN TO THE FOLLOWING HEADS:
• THE BANKING BOOK
• THE TRADING BOOK &
• OFF-BALANCE SHEET EXPOSURE

24. Risk Mitigation
• ALL ASSETS AND LIABILITIES IN THE BANKING BOOK ARE HELD TILL
MATURITY AND ACCRUAL SYSTEM OF ACCOUNTING IS FOLLOWED.
THE BANKING BOOK IS GENERALLY EXPOSED TO LIQUIDITY RISK,
INTEREST RATE RISK, DEFAULT RISK AND OPERATIONAL RISK

25. Risk Mitigation
• THE ITEMS IN THE TRADING BOOK ARE NORMALLY HELD FOR
TRADING PURPOSES AND TO PROFIT FROM THE SHORT-TERM PRICE
MOVEMENTS. THESE ITEMS ARE LIQUIDATED WHEN MARKET
CONDITIONS ARE FAVOURABLE. THE DIFFERENCE BETWEEN THE
BOOK VALUE AND THE PRICE REALISED IS THE PROFIT OR LOSS. THE
TRADING BOOK IS MAINLY EXPOSED TO MARKET RISK, MARKET
LIQUIDITY RISK,DEFAULT OR CREDIT RISK & OPERATIONAL RISK.

26. Risk Mitigation
• OFF-BALANCE SHEET (OBS) EXPOSURES MAY BECOME FUND-BASED
ON CERTAIN CONTINGENCIES-THAT UPON THE HAPPENING OF
CERTAIN EVENTS. OBS EXPOSURES MAY HAVE LIQ RISK / INT RATE
RISK/MKT RISK/DEFAULT RISK/ OP.RISK.

27. • LIQUIDITY RISK: LIQ RISK IS DEFINED AS THE INABILITY TO OBTAIN
FUNDS TO MEET CASHFLOW OBLIGATIONS AS AND WHEN SUCH
OBLIGATIONS ARISE AT AREASONABLE COST. THIS MAY HAPPEN
WHEN LONG TERM ASSETS ARE FUNDED OUT OF SHORT TERM
LIABILITIES MAKING THE LIABILITIES SUBJECT TO ROLL OVER OR
REFINANCING RISK. AT THE OTHER EXTREME BANKS MAY FAIL TO
FUND THE LIQUIDITY GAPRESULTING IN DEFAULT WITH ITS SERIOUS
CONSEQUENCES.

28. • THE LIQ RISK MAY BE OF THE FOLLOWING TYPES:
• FUNDING RISK- ON ACCOUNT OF UNEXPECTED WITHDRAWAL OR
NON-RENEWAL OF DEPOSITS.(the deposits may be withdrawn by the depositor
due to certain emergencies or unexpected need for funds)

29. • TIME RISK- NEED TO ARRANGE FOR FUNDS ON ACCOUNT OF NON RECEIPT OF
EXPECTED CASH INFLOWS OF FUNDS –FOR EXAMPLE FAILURE ON THE PART OF
THE BORROWER TO REPAY LOAN INSTALMENT.
• CALL RISK: ARISES DUE TO CRYSTALLIZATION OF CONTINGENT LIABILITIES-
FOR EXAMPLE WHEN A GUARANTEE IS INVOKED FOR NON-PERFORMANCE BY
A CUSTOMER ON WHOSE BEHALF THE GTEE HAS BEEN ISSUED BY THE BANK.

30. Types of risk
• INT RATE RISK: (IRR) ARISES ON A/C OF EXPOSURE OF BANK‘S REVENUE
TO ADVERSE MOVEMENTS IN INTEREST RATES. IRR IMPACTS NET INT
INCOME / NET INT MARGIN OF THE BANK.
• GAP RISK or MISMATCH RISK: ARISES FROM HOLDING ASSETS AND
LIABILITIES AND OBS ITEMS WITH DIFF PRINCIPAL AMOUNTS, MATURITY
DATES OR REPRICING DATES THEREBY CREATING EXPOSURE TO
UNEXPECTED CHANGES IN THE LEVEL OF MARKET INT RATES.

31. • BASIS RISK: WHERE THE INT RATES ON DIFF ASSETS AND LIABILITIES
MAY CHANGE BY DIFFERENT MAGNITUDE . FOR EXAMPLE IN AN
RISING INT RATE SCENARIO THE INT RATES ON ASSETS MAY CHANGE
BY A DIFFERENT MAGNITUDE AS COMPARED TO INT RATES ON
LIABILITIES CREATING VARIATIONS IN NET INT INCOME. BASIS RISK
BECOMES EXTREMELY PROMINENT WHERE A COMPOSITE ASSET
PORTFOLIO IS CREATED OUT OF A COMPOSITE LIABILITY PORTFOLIO.

32. • MARKET RISK: RISK ON A/C OF ADVERSE DEVIATION OF THE ―MTM‖
VALUE OF THE TRADING PORTFOLIO. MKT RISK RESULTS FROM
ADVERSE MOVEMENT IN INT RATES, EXCHANGE RATES, AND PRICES
OF COMMODITIES. MARKET RISK IS ALSO KNOWN AS PRICE RISK.
• RISK MANAGEMENT THEREFORE IS A FASCINATING AS WELL AS
IMPORTANT FACET OF MODERN DAY FINANCIAL MANAGEMENT.

33. Lessons from failures in Risk Management:
BARINGS BANK CASE:
Barings was a highly respected British Bank. The Bank collapsed in the year 1995 as a result of huge
losses caused by a trader in the Bank‘s Singapore office. Nick Leeson their star trader had posted
strong performances in the past and the bank had placed absolute faith in him. Emboldened by this,
the trader took huge positions in the Nikkie Index Derivatives (Futures and Options) in the Tokyo
Stock Exchange. Strangely enough he was also managing the back office operations (which is
totally against risk management principles- the back office functions should not be in the hands of
the front office trader). While front office must solely engage in trading activities, it is the back
office that is in charge of confirmation of trades, accounting, settlement and reconciliation. When
his bets on Nikkie Index Derivatives failed miserably, the bank ran in to huge losses on account of
margin calls ( it may be noted that all trades in futures and options are subject to margin calls).
Main Lessons to be learnt:
• The first principle of risk management- separation of trading and back office activities was not
followed at all. This allowed Leeson to hide the mark to market losses successfully and hoodwink
his superiors.
• Even though the trader may be extremely successful and has a good track record, his activities must
always be subject to scrutiny by his superiors- in this case this did not happen.

34. Procter and Gamble Case:
P& G is a huge multinational company and is in the business of fast
moving consumer goods (FMCG) that is soaps, toiletries, detergents
, over the counter medicines etc. P&G suffered huge losses –over
100 million dollars in 1994 by entering in to complex derivative
contracts. The company sued the bank ‗Bankers Trust‘ claiming that
the full implications of the derivative contracts were not explained
to the company. The matter was finally settled out of court. In this
case the derivative contracts were not hedging mechanisms but
speculative positions that went wrong.
Lesson to be learnt:
Never enter in to any complex derivative structure unless it is fully
understood and the entire transaction is transparent.

35. • Avoid complex derivative products. Go for simple hedging
strategies. Understand the product and its financial implications.
• Never try to predict the market nobody can ‗correctly‘ predict the
financial markets – one can only have a view on the markets. Be
ready to change your views based on the facts available on the
ground.
• The markets are more efficient than all of us put together and the
unexpected can happen.
• Do not borrow short-term to take long-term positions in the market.
• For corporates, their main business is manufacturing/services –
depending upon the industry they are in. Their profits should come
from their core activities and not from currency or derivatives
trading.
• The top management and the Board should always be kept abreast of
any deviations from the laid down policies and procedures.