École Supérieure Libre des Science Commerciales Appliquées

Program: MIBA

Group: Eslsca 33

Dr. Khalil Abou Ras

Subject – Banking and Financial Institutions

Assignment: Risk Management.

Presented by: Ahmed Mohamed Atef Selim Beram.

CONTENTS

Preface

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INTRODUCTION

(a) Meaning of Risk and Risk Management

(b) Risk management Structure

(c) Risk management Components

(d) Steps for implementing risk management in bank

(e) RBI Guidelines on risk management

Types of risks

(a) Liquidity Risk (b) Market Risk

(c) Credit Risk

(d) Interest Rate Risk

(e) Reputation Risk

(f) Strategic Risk

(g) Operational Risk

BASEL II COMPLIANCE

(a) Three pillar approach

(b) Reservation about Basel II

Risk Based Supervision Requirement

(a) Background

(b) Risk based supervision – a new approach

(c) Features of RBS approach

Conclusion

PREFACE

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Risk Management underscores the fact that the survival of an organization depends heavily on its capabilities to

anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk

management is not to prohibit or prevent risk taking activity but to ensure that the risks are consciously taken with

full knowledge, clear purpose and understanding so that it can be measured and mitigated.

The present study is on Risk Management in Banks. The core of the study is to analyze various kinds of risk i.e

credit, interest rate, liquidity and operational risk and how to measure and monitor these risks.

The entire dissertation has been divided into nine chapters. The first chapter contains discussion on the meaning

and concept of risk, risk management, its functions, types of risk, RBI guidelines. Chapter second contains the

Research Methodology, which includes need, objective and significance of study.

Basel II norms and Risk Based Supervision Requirements are discussed in seventh chapter. Analysis of survey

responses and profitability analysis, which is the central point of financial analysis, is included in eighth chapter.

Chapter ninth presents the major findings of the study with some concluding remarks.

INTRODUCTION TO RISK MANAGEMENT

Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulate environment, banks could not afford to take risks. But of late, banks are exposed to same competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks.

Deregulation in the financial sector had widened the product range in the developed market. Some of the new products introduced are LBOs, credit cards, housing finance, derivatives and various off balance sheet items. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. Simultaneously they have opened new areas of risks also. During the past decade, the Indian banking industry continued to respond to the emerging challenges of competition, risks and uncertainties. Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. Our regulators have made some sincere attempts to bring prudential and supervisory norms conforming to international bank practices with an intention to strengthen the stability of the banking system.

RISK

The etymology of the word “Risk” can be traced to the Latin word “Rescum” meaning Risk at sea or that which cuts. Risk is an unplanned event with financial consequences resulting in loss or reduced earnings. It stems from uncertainty or unpredictability of the future. Therefore, a risky proposition is one with potential profit or a looming loss.

Risk is the potentiality of both expected and unexpected events which have an adverse impact on bank capital or earnings. In one of the publications Price Waterhouse Cooper has interpreted the word risk in two distinct senses.

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Risk as Hazard:

“Danger; (exposure to) the possibility of loss, injury or other adverse circumstance. Exposure to the possibility of

commercial loss apart of economic enterprise and the source of entrepreneurial profit.”

Risk as Opportunity:

“The ordinary rate of profit always rises……with the risk”

Hence, Risk Management is an attempt to identify, to measure, to monitor and to manage uncertainty. It does not

aim at risk elimination, but enables the banks to bring their risks to manageable proportions while not severely

affecting their income.

International Financial Risk Institute defines Risk Management as “The application of financial analysis and diverse

financial instruments to control and typically the reduction of selected type of Risks.” While non-performing assets

are the legacy of the past in the present, risk management system is the pro-active action in the present for the

future. Managing risk is nothing but managing the change before the risk manages.

Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of risk can have ramifications and penetrations for a range of other categories of risks. Foremost thing is to understand the risks run by the bank and to ensure that the risks are properly confronted, effectively controlled and rightly managed. Each transaction that the bank undertakes changes the risk profile of the bank. The extent of calculations that need to be performed to understand the impact

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of each such risk on the transactions of the bank makes it nearly impossible to continuously update the risk calculations. Hence, providing real time risk information is one of the key challenges of risk management exercise.Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to manage the limited risks. Business is the art of extracting money from other’s pocket, sans resorting to violence. But profiting in business without exposing to risk is like trying to live without being born.

Everyone knows that risk taking is failure prone as otherwise it would be treated as sure taking. Hence risk is inherent in any walk of life in general and in financial sectors in particular. Of late, banks have grown from being a financial intermediary into a risk intermediary at present. In the process of financial intermediation, the gap of which becomes thinner and thinner, banks are exposed to severe competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Business grows mainly by taking risk. Greater the risk, higher the profit and hence the business unit must strike a tradeoff between the two.

The essential functions of risk management are to identify measure and more importantly monitor the profile of the bank. While Non-Performing Assets are the legacy of the past in the present, Risk Management system is the pro-active action in the present for the future. Managing risk is nothing but managing the change before the risk manages. While new avenues for the bank has opened up they have brought with them new risks as well, which the banks will have to handle and overcome.

Risk is the probability that a hazard will turn into a disaster. Vulnerability and hazards are not dangerous, taken separately. But if they come together, they become a risk or, in other words, the probability that a disaster will happen.

Nevertheless, risks can be reduced or managed. If we are careful about how we treat the environment, and if we are aware of our weaknesses and vulnerabilities to existing hazards, then we can take measures to make sure that hazards do not turn into disasters.

"What is risk?" And what is a pragmatic definition of risk? Since risk is accepted in business as a tradeoff between reward and threat, it does mean that taking risk bring forth benefits as well. In other words it is necessary to accept risks, if the desire is to reap the anticipated benefits.

Risk in its pragmatic definition, therefore, includes both threats that can materialize and opportunities, which can be exploited. This definition of risk is very pertinent today as the current business environment offers both challenges and opportunities to organizations, and it is up to an organization to manage these to their competitive advantage.

RISK MANAGEMENT

“Risk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.”

Risk management is a discipline for dealing with the possibility that some future event will cause harm. It provides strategies, techniques, and an approach to recognizing and confronting any threat faced by an organization in fulfilling its mission. Risk management may be as uncomplicated as asking and answering three basic questions:

What can go wrong?What will we do (both to prevent the harm from occurring and in the aftermath of an "incident")? If something happens, how will we pay for it?

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RISK MANAGEMENT IN BANKS

Risk management does not aim at risk elimination, but enables the organization to bring their risks to manageable proportions while not severely affecting their income. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing the risks to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. This transformation takes place due to the inter-linkage present among the various risks. The focal point in managing any risk will be to understand the nature of the transaction in a way to unbundle the risks it is exposed to.

Risk Management is a more mature subject in the western world. This is largely a result of lessons from major corporate failures, most telling and visible being the Barings collapse. In addition, regulatory requirements have been introduced, which expect organizations to have effective risk management practices. In India, whilst risk management is still in its infancy, there has been considerable debate on the need to introduce comprehensive risk management practices.

BENEFITS OF RISK MANAGEMENT IN BANKS

Proper risk management allows a financial institution to prosper through taking and avoiding risks. Well run companies are now taking a closer interest in what its management is doing to mitigate risk exposure, allowing for a more efficient, effective and prudently run business.

Good risk management will greatly improve the transparency of how an organization operates, providing a roadmap to achieve strategic goals and objectives and reassurance over the management of risks. A risk based approach can make a company more flexible and responsive to market fluctuations, making it better able to satisfy the needs of its various stakeholders, in a constantly changing environment. Companies can also gain an advantage over competitors by identifying and adapting to circumstances faster than their rivals.

Increased risk awareness: With the advent of risk management in banks and in banking system, there is increased awareness on the several of types of risk, this has lead to the systematized pattern of working and thereby has created awareness among various people and management for the safe working of the banks. Also RBI has ensured that there is enough awareness of various risks and thereby banks take care of the risk prior to its happening.

Prioritization of business risks to those that matter: With the recognition of the various risk that are to be happening to the banks and with the increased awareness now banks can prioritize the risk to that of the other matters.

Fewer unexpected and unwelcome surprises: Due to increased use of risk management and its process there are few unexpected surprises, as banks are ready to face the financial and other hurdles that are on the way. Not only that because of risk management all contingent risk are reduced to a greater extent

A better focus internally on doing the right things well: Banks can now focus on the internal process and its betterment thereby increasing the efficiency of the banks and increasing the overall brand of the company. Risk management has lead to the increased efficiency and effectiveness of the banks due to prioritization of the process.

Reduced losses through process improvements developed by the business of banks: As there is increased efficiency in the process these results in better output and thereby reducing the losses that can take places due to process improvements of banks. This increases the utility of banks and its assets, as a result of these banks have reduced losses and better process in place.

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Providing a better basis for making key strategic decisions: Risk Management leads to estimation of the future and the various risks that can be on the way in future. This leads to proper knowledge of the future, thereby making the future bit more stable and predictable. This helps in making key strategic decisions and its better implementation for the further betterment.

Increasing the chance of change initiatives being achieved: Risk management in banks leads to various benefits as stated above, all of those benefits leads to increasing the chance of change initiatives being achieved at earlier stage thereby outperforming the set standards with better vision of the future.

Creating a greater likelihood of achieving business goals and objectives: Risk management leads to effective, efficient business, with vision and goals achieved in due to time, reducing the possible losses and streamlining the business of banks this leads to creating a greater likelihood of achieving business goals and objectives

Steps for implementing Risk Management in Banks

1) Establishing a risk management long term vision and strategy

Risk management implementation strategy is established depending on bank vision, focus, positioning and resource commitments.

2) Risk Identification

The second step is identification of risks, which is carried out to assess the current level of risk management

processes, structure, technology and analytical sophistication at the bank. Typically banks distinguish the following

risk categories:

- Credit risk

- Market risk

- Operational risk

3) Construction of risk management index and Sub indices

Bank roll out a customized benchmark index based on its vision and risk management strategy. Then it develops a

score for the current level of bank risk practices that already exists. For example assuming that the current risks

management score is 30 out of 100. For the gap in score of 70 roadmap is developed for achieving the milestones.

4) Defining Roadmap

Based on the target risk management strategy/gap analysis bank develops unique work plans with quantifiable

benefits for achieving sustainable competitive advantage.

a. Risk Based Supervision requirements

b. Basel II compliance

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c. Using risk strategy in the decision making process

Capital allocation

Provisioning

Pricing of products

Streamlining procedures and reducing operating costs

By rolling out the action steps in phases the bank measure the progress of the implementation.

5) Establish Risk measures and early warning indicators

Depending on the lines of business as reflected in bank balance sheet and business plans, the relative importance

of market, credit and operational risk in each line of activity is determined The process workflow organization, risk

control and mitigation procedures for each activity line is to be provided.

6) Executing the key requirements:

At an operational level checklist of key success factors and quantitative benchmark is generated. Models to be

applied are tested and validated on a prototype basis. Moreover, evaluation scores on the benchmark levels

specified helps to build up a risk process implementation score.

7) Integrate Risks Management/Strategy into bank internal decision making process

The objective is to integrate risk management into business decision making process which evolves risk culture

through awareness and training, development of integrated risk reports and success measures and alignment of

risk and business strategies.

Hence, risk management focus on the identification of potential unanticipated events and on their possible impact

on the financial performance of the firm and at the limit on its survival. Risk Management in its current form is

different from what the banks used to practice earlier. Risk environment has changed and according to the draft

Basel II norms the focus is more on the entire risk return equation.

Moreover, banks now a day’s seek services of Global Consultants like KPMG, PricewaterhouseCoopers (PwC), Tata

Consultancy Services (TCS), Boston Consulting Group (BCG), The Credit Rating and Investment Services of India Ltd.

(Crisil), I – Flex Solutions and Infosys Technologies who have vast experience in risk modeling as these players

identify the gap in the system and help the banks in devising a risk return model.

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RBI Guidelines on Risk Management

RBI has issued guidelines from time to time, which are being implemented by banks through various committees.

RBI suggests that

(a) Banks must equip themselves with an ability to identify, to measure, to monitor and to control the various

risks with New Capital Adequacy provisions in due course.

(b) For integrated management of risk there must be single risk management committee.

(c) For managing credit risk, portfolio approach must be adopted.

(d) Appropriate credit risk modeling in the future must be adopted.

(e) For measurement of market risk banks are advised to develop expertise in internal models

(f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks operating in international

markets.

(g) Banks should upgrade credit risk management system to optimize use of capital.

(h) Banks are advised by RBI to initiate action in five specific areas to prepare themselves for risk based

supervision. One of the five specific areas is effective Risk Management Architecture to ensure adequate

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DEGREE OF RISK

Profits

Losses

OPTIM

IZING

THE RISK RETU

RN

EQU

ATION

internal risk management practices.

(i) The limits to sensitive sectors like advances against equity shares, real estates which are subject to a high

degree of asset price volatility as well as to specific industries which are subject to frequent business cycles

should be restricted. Similarly, high-risk industries as perceived by the bank should be placed under lower

portfolio limit.

To enhance risk management function banks should move towards risk based supervision and risk focused internal audit.

Types of Risks:

Business activities entail a variety of risks. The banking industry has long viewed the problem of risk management as the need to control four of the above risks which make up most, if not all, of their risk exposure, viz., credit, interest rate, foreign exchange and liquidity risk For convenience, we distinguish between different categories of risk: market risk, credit risk, liquidity risk, etc. Although such categorization is convenient, it is only informal. Usage and definitions vary. Boundaries between categories are blurred. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss, so market risk and credit risk overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It cannot be divorced from the risks it compounds.

There are various types of risks that occur in the banks and affect its functioning. Some of these kinds of Risks are as follows:

1. Liquidity Risk

2. Market Risk

3. Credit Risk

4. Interest Rate Risk

5. Reputation Risk

6. Strategic Risk

7. Operational Risk

LIQUIDITY RISK

Liquidity risk is part and parcel for every banking institution. Unfortunately it isn‘t an isolated risk like credit or market risk, but a consequential risk. It is contingent on other factors like maturity mismatches or external events such as credit downgrades or market turmoil.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity Risk also arises from the long term funding of long term assets by the short term liabilities. The funding liquidity risk is defined as the inability to obtain funds to meet the cash flow obligations. The funding risk arises from the need to replace net outflow due to unanticipated withdrawal or non- renewal of deposits.

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Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Here, liquidity risk is compounding credit risk.

Liquidity planning is an important facet of risk management framework in banks. It is the ability to efficiently

accommodate deposit, reduction in liabilities, to fund the loan growth and possible funding of the off balance sheet

claims. The liquidity risk of banks arises from funding of long-term assets by short-term liabilities thereby making

the liabilities subject to refinancing risk.

The liquidity risk in banks manifest in different dimension:

1. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non renewal of deposits.

2. Time Risk: need to compensate for non-receipt of expected inflows of funds i.e performing assets turning into

non-performing assets.

3. Call Risk: due to crystallization of contingent liabilities and unable to undertake profitable business

opportunities when desirable.

Liquidity measurement is quite a difficult task and can be measured though stock or cash flow approaches . The key

ratios adopted across the banking system are:

Core Deposits/Total Assets

Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits

Volatile Liabilities/Total Assets

Where volatile liabilities = Demand + Term deposits of other banks

Short term assets/Total Assets

Where short term assets = Cash & Bank balance + Receivable + Bills Receivable + Short term/demand advances

Credit Deposit Ratio

Credit Deposit Ratio = Loans & Advances/Total Deposits

This is a popular measure of the liquidity position of banks. Higher Deposit Ratio indicates poor liquidity position of

the bank while lower figures indicate more comfortable liquidity positions.

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Investments/Total Assets

This ratio is highest for public sector banks reflecting the higher levels of conservatism in their policies. This is

because investments are mainly government securities and other forms of relatively less risky instruments as

compared to loans and advances, which entail a high level of risk.

The liquidity ratios are the ideal indicator of liquidity of banks operating in developed markets as the ratios do not

reveal the intrinsic liquidity profile of Indian banks, which are operating generally in an illiquid market. Analysis of

liquidity involves tracking of cash flow mismatches.

For measuring and managing net funding requirements the use of maturity ladder and calculation of cumulative

surplus or deficit of funds at selected maturity dates is recommended as a standard tool.

The assets and liabilities are classified in different maturity buckets:

1. 1 to 14 days

2. 15 to 28 days

3. 29 days and up to 3 months

4. Over 3 months and up to 6 months

5. Over 6 months and up to 1 year

6. Over 1 year and up to 3 years

7. Over 3 years and up to 5 years

8. Over 5 years

The cash flows are placed indifferent time bands based on future behavior of assets, liabilities and off –balance

sheet items. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. The difference

between cash inflows and outflows in each time period the excess of deficit of funds becomes the starting point for

the measure of a banks future liquidity surplus or deficit at a series of points of time.

Strategies for managing Liquidity risk

Business risk is managed with a long-term focus. Techniques include the careful development of business plans and appropriate management oversight. Book-value accounting is generally used, so the issue of day-to-day performance is not material. The focus is on achieving a good return on investment over an extended horizon.

The risk arises because of two reasons - liability side reasons (i.e whenever bank depositors come to withdraw their

money) and asset side reasons (which arise as a result of lending commitments). The cause and effect of liquidity

risk is primarily linked to nature of assets and liabilities of a bank.

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Liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk don't exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.

Most financial firms including banks use a variety of metrics to monitor the level of liquidity risk to which they are exposed. The basic approaches may be categorized into three types: the liquid assets approach, the cash flow approach, and a mixture of the two.

1. Liquid Assets Approach

Under the liquid assets approach, the firm maintains liquid instruments on its balance sheet that can be drawn upon when needed. As a variation on this approach, the firm may maintain a pool of unencumbered assets (usually government securities) that can be used to obtain secured funding through repurchase agreements and other secured facilities. (The relevant metrics in this approach are ratios.)

2. Cash Flow Matching Approach

Under the cash flow matching approach, the firm attempts to match cash outflows against contractual cash inflows across a variety of near-term maturity buckets.

3. Mixed Approach

The mixed approach combines elements of the cash flow matching approach and the liquid assets approach. The firm attempts to match cash outflows in each time bucket against a combination of contractual cash inflows plus inflows that can be generated through the sale of assets, repurchase agreement or other secured borrowing. Assets that are most liquid are typically counted in the earliest time buckets, while less liquid assets are counted in later time buckets.

Factors that affect its demand:

Cash Reserve Ratio

As per the RBI Act 1934, CRR is to be maintained on an average daily basis during a reporting fortnight by all

scheduled banks. This system provides maneuverability to banks to adjust their cash reserves on a daily basis

depending upon intra fortnight variations in cash flows. For the computation of CRR to be maintained during the

fortnight, a lagged reserve system has been introduced effective November, 1999 whereby banks have to maintain

CRR on the net demand and time liabilities (NDTL) of the second preceding fortnight. With this, banks are able to

assess their liability positions and the corresponding reserve requirements. With a view to provide further flexibility

to banks and enable them to choose an optimum strategy of holding reserve depending upon their intra-period

cash flows, RBI have decided to reduce the requirements of a minimum of 85 percent of the CRR balance to 65

percent with effect from beginning May 6, 2000. This has resulted in smoother adjustment of liquidity between

surplus and deficit units and enables better cash management by banks.

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The CRR currently as on 31st march 2004 was 4.75% of the anticipated total demand and time liabilities. When a

bank falls short of its CRR requirement, it resorts to borrowing from the call market. As more banks resort to such

borrowing, demand for money in that market shoots up, leading to high call rates. This is what happened during

the run-up to the credit policy in March 2000. Banks had invested their surplus cash in government securities. That

placed them in a corner so far as meeting CRR requirement was concerned.

Liquidity requirements:

This arises from a liquidity mismatch, which forces banks to borrow for the very short term.

Speculation

That is, wanting to profit from any arbitrage opportunities between the forex and money markets. Banks borrow

call money at say, 5-6 % and deploy the proceeds to speculate on the rupee dollar moments in the forex market.

Given the general bias on rupee depreciation, these banks invariably profit from the cross-market deployment.

If the call rates in the meanwhile shoot up the borrowing banks have three options. First, borrow again in the call

market at the higher rate and repay the earlier loan. Second, sell dollars in the market and buy rupees to repay the

loan. Third, attract deposits from small savers to fund the loan repayment. Mostly banks resort to the third

alternative by hiking deposit rates. In January 1999, for instance, bank raised its short-term deposit rate to about

18% per annum. It was forced to take this step, as it had to repay loans on calls and rates in that market which shot

up to a high of 140%. The RBI has banned banks from borrowing in call and trading in the forex market.

Arbitrage

Banks have also started taking advantage of the arbitrage opportunity between the call money and the

Government securities market. In March 2003, with inter bank call rates hovering around 6 % and the current yield

on Government securities ranging from 8.5% - 9.5 %, the borrowing banks in the money market had an opportunity

to make money. The call money was ruling tight following advanced tax outflows from the market. In order to

maintain the cash reserve ratio requirements, these banks borrowed at 6%. The money put in the CRR is invested in

government securities at the current yield of 8.5% - 9.5% over various maturities. In this way, banks earn an

arbitrage of around 2.5 % - 3.5%.

Policy Variables

Just before any policy announcement, the overnight rates (or the call rates) seem to be very volatile largely due to

an expectation of a fall in interest rate.

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Repo Market

Repo is a money market instrument, which enables collateralized short term borrowing and lending through sale /

purchase operation in debt instruments. Under a repo transaction a holder of securities sells them to an investor

with an agreement to repurchase at a predetermined date and rate. In case of a repo, the ‘forward clean price of

the bonds’ is set in advance at a level which is different from the ‘spot clean price by’ adjusting the difference

between repo interest and coupon earned on the security. In the money market this transaction is nothing but

collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost

of the transaction is the repo rate. In other words the inflow of cash from the transaction can be used to meet

temporary liquidity requirement in the short-term money market at comparable cost.

A reverse repo is the same operation but seen from the other point of view, the buyers, in a reverse repo the buyer

trades money for the securities agreeing to sell them later. The banks, which hold a large inventory of bonds and G-

Secs, use repo to amass additional funds. Using the securities as collateral they borrow using repo. Hence whether

transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction.

When the reverse repurchase transaction matures the counter party returns the security to the entity concerned

and receives its cash along with a profit spread. One factor that encourages an organization to enter into reverse

repo is that it earns some extra income on its otherwise idle cash.

Substitutability of the Call money market and the Repo market

The rise in the call money rates often forces met borrowers in the money market such as private banks today to increasingly resort to repo (short for sale and purchase agreement) of Government securities for their financing requirements rather than borrowing from overnight call money market.

At present, the RBI regularly conducts only a three/four day fixed repo. As for the likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate in stages to the earlier levels.

Liquidity Adjustment Fund (LAF)

The aim of the Liquidity Adjustment Facility (replacing Interim Liquidity Adjustment Facility) is to improve the operational flexibility and the effectiveness of the monetary policy. It is also appropriate as the financial markets move towards indirect instruments. It was recommended by the Narasimhan Committee Report on the Banking Reforms and was announced in the Monetary and the Credit policy for the year 2000-2001. The LAF operates though repo (for absorption of liquidity) reverse repo (for injection of liquidity) to set a corridor for money market interest rates. The existing Fixed Rate Repo will be discontinued. So also the liquidity support extended to all commercial banks (excluding RRBs) and Primary dealers though Additional Collateralized Lending Facility (ACLF) and finance/reverse repo under level II respectively will be withdrawn.

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Interim Liquidity Adjustment Facility (ILAF)

RBI had introduced collateralized lending against government securities as Interim Liquidity Adjustment Facility (called Collateralized Lending Facility) to provide liquidity support to banks in replacement of the General Refinance. The banks could

Borrow up to 25 basis points of the fortnightly average outstanding aggregate deposits in 1997-98 at the bank rate

for a period of two weeks. Additional collateral (called Additional Collateralized Lending Facility) of similar amount

was also made available to banks at 200 basis points over bank rate. CLF and ACLF availed for periods beyond two

weeks were subject to penal rate of 200 basis points for the next two weeks. However during the period of availing

the CLF or ACLF the banks continue to participate in the money market. The funds from this facility used by the

banks for their day – to day mismatches in liquidity. In April 1999, an Interim Liquidity Adjustment Facility was

introduced pending further up gradation in technology and legal/procedural changes to facilitate electronic

transfer and settlement. The ILAF was operated through a combination of repo, export credit refinance,

collateralized-lending facilities. The ILAF served its purpose as a transitional measure for providing reasonable

access to liquid funds at set rates of interest. It provided a ceiling and the Fixed Rate Repo were continued to

provide a floor for the money market rates.

For purpose of monitoring liquidity risk RBI requires banks to disclose a statement on maturity pattern of their assets and liabilities classified in different time buckets. Liabilities consist of deposits and bank borrowing classified into different time buckets. Assets consist of loans and advances and investments. Investments in corporate and government debt are combined into one category and bucketed according to their time to maturity.

Liquidity risk comprises of:

1. Funding liquidity risk 2. Trading-related liquidity risk.

1. Funding liquidity risk: Funding liquidity risk relates to a financial institution’s ability to raise the necessary cash to roll over its debt, to meet the cash, margin, and collateral requirements of counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding liquidity risk is affected by various factors such as the maturities of the liabilities, the extent of reliance of secured sources of funding, the terms of financing, and the breadth of funding sources, including the ability to access public market such as commercial paper market. Funding can also be achieved through cash or cash equivalents, “buying power,” and available credit lines.

2. Trading-related liquidity risk: Trading-related liquidity risk, often simply called as liquidity risk, is the risk that an institution will not be able to execute a transaction at the prevailing market price because there is, temporarily, no appetite for the deal on the other side of the market. If the transaction cannot be postponed its execution my lead to substantial losses on position. This risk is generally very hard to quantify. It may reduce an institution’s ability to manage and hedge market risk as well as its capacity to satisfy any shortfall on the funding side through asset liquidation.

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MARKET RISK

Market risk consumes about nearly 25% of the risk capital in the bank. It is rightly said that “to win without risk is to triumph without glory”.

The Bank for International Settlements (BIS) defines market risk as “the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices". Thus, Market Risk is the risk to the bank's earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes.

Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on the management of Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc.

It is a risk of adverse deviation of the mark to market value of trading portfolio due to the market movements during the period required to liquidate the transactions. It is also referred to as Price Risk. It occurs when the assets are sold before their stated maturities. Price Risk is closely associated to the trading book, which is created for making profit out of short term movements in the interest rates.

Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a variety of risk metrics —duration and convexity, the Greeks, beta, etc.—to assess their exposures. These allow them to identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage market risk by applying risk limits to traders' or portfolio managers' activities. Increasingly, value-at-risk is being used to define and monitor these limits. Some organizations also apply stress testing to their portfolios

Management of Market Risk is the major concern of top management. The board clearly articulates market risk management policies, procedures, and prudential risk limits, review mechanisms, reporting and auditing systems. The Asset Liability Management Committee (ALCO) functions as the top operational unit for managing the balance sheet within the risk parameters laid down by the board. Moreover, the banks set up an independent middle office (comprises of experts in market risk management, economists, bankers, statisticians) to track the magnitude of market risk on a real time basis. The Treasury Department is separated from middle office and is not involved in day to day work. The Middle Office appraises top management/ALCO/Treasury about adherence to risk parameters and aggregate total market risk exposures.

Benefits of Market Risk

The effective measurement of market risk benefits the banks in the following ways:

1. Efficient allocation of the capital to exploit the different risks or rewards pattern.

2. Better product pricing.

3. There is reduced earnings volatility.

4. There is increase in the shareholders value

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Managing the Market Risk in the Banks:

The measurement of risk has changed over time. It has evolved from the simple indicators, such as Face value/ Notional amount for an individual security to the latest methodologies of computing VaR. the quest for better and more accurate measure of market risk is ongoing; each new market turmoil reveals the limitations of even the most sophisticated measure of market risk. There are various methods of measuring the market risks:

1. The Notional Amount Approach: Until recently, trading desks in major banks were allocated economic capital by reference to notional amount.

The notional approach measures risk as the notional, or nominal, amount of a security, or the sum of the notional values of the holdings for a portfolio.

This method is flawed since it does not:

Differentiate between short and long positions.

Reflect price volatility and correlation between prices.

Moreover, in the case of derivative positions in the over the counter market, there are often very large discrepancies between true amount of market exposure, which is often small, and the notional amount which may be huge. For example, two call options on the same underlying instrument with the same notional value and same maturity, with one option being in the money and the other one out-of-the-money, have very different market values and risk exposures.

1. Value At Risk (VaR): Value at risk can be defined as the worst loss that might be expected from holding a security or portfolio over a given period of time (say a single day, 10 days for the purpose of regulatory capital reporting), given a specified level of probability (known as the “confidence level”)

Value at risk is a measure of market risk, which measures the maximum loss in the market value of the portfolio with a given confidence. VaR is denominated in the units of currency or as a percentage of the portfolio holdings.

For example, if we say that a position has a daily VaR of Rs. 10 million at the 99% confidence level, we mean that the realized daily losses from the position will, on average, be higher than Rs. 10 million on only one day every 100 trading days (i.e., two to three days each year).VaR offers probability statement about the potential change in the value of a portfolio resulting from a change in the market factors, over a specified period of time.

For e.g. a set of portfolio having current value of say Rs.100000 can be described to have a daily value at risk of Rs.5000 at 99% confidence level, which means there is 1/100th chance of loss exceeding Rs.5000 considering there are no shifts in the underlying factors.

It is thus a probability of the occurrence and hence it is a statistical measure of the risk exposure.

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CREDIT RISK

Credit risk is the oldest and biggest risk that a bank, by virtue of its very nature of business, inherits. This has, however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market-driven economy. Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of public sector banks.

Bank optimizes utilization of deposits by deploying funds for developmental activities and productive purposes through credit creation process. Deposit mobilization & Credit deployment constitute the core of banking activities and substantial portion of expenditure and income are associated with them. In the case of deposits, baring few stray instances of operational risks linked to the system and human failure culminating in fraud, forgeries & loss, there may not be anything very alarming. But credit portfolio is the real dynamic activity that requires close monitoring and continuous management.

Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country.

Credit risk may take various forms, such as:

In the case of direct lending, that funds will not be repaid; In the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon

crystallization of the liability under the contract; In the case of treasury products, that the payment or series of payments due from the counterparty under the

respective contracts is not forthcoming or ceases; In the case of securities trading businesses, that settlement will not be effected; In the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases.

COMPONENTS OF CREDIT RISK MANAGEMENT

Credit risk management framework broadly categorized into following main components. a) Board and senior Management’s Oversight b) Organizational structure c) Systems and procedures for identification, acceptance, measurement, monitoring and control risks.

Board and Senior Management’s Oversight

It is the overall responsibility of bank’s Board to approve bank’s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank’s overall business strategy. To keep it current, the overall strategy has to be reviewed by the board, preferably annually.

The responsibilities of the Board with regard to credit risk management include: 1. Delineate bank’s overall risk tolerance in relation to credit risk. 2. Ensure that bank’s overall credit risk exposure is maintained at prudent levels and consistent with the available

capital

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3. Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function

4. Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk.

5. Ensure that appropriate plans and procedures for credit risk management are in place.

The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get those approved from board. Such policies and procedures shall provide guidance to the staff on various types of lending including corporate, SME, consumer, agriculture, etc.

At minimum the policy should include;1. Detailed and formalized credit evaluation/ appraisal process. 2. Credit approval authority at various hierarchy levels including authority for approving exceptions. 3. Risk identification, measurement, monitoring and control 4. Risk acceptance criteria 5. Credit origination and credit administration and loan documentation procedures 6. Roles and responsibilities of units/staff involved in origination and management of credit

Organizational Structure

To maintain bank’s overall credit risk exposure within the parameters set by the board of directors, the importance of a sound risk management structure is second to none. While the banks may choose different structures, it is important that such structure should be commensurate with institution’s size, complexity and diversification of its activities. It must facilitate effective management oversight and proper execution of credit risk management and control processes.

Each bank, depending upon its size, should constitute a Credit Risk Management Committee (CRMC), ideally comprising of head of credit risk management Department, credit department and treasury. This committee reporting to bank’s risk management committee should be empowered to oversee credit risk taking activities and overall credit risk management function.

Functions of CRMD: To follow a holistic approach in management of risks inherent in banks portfolio and Ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee. The department also ensures that business lines comply with risk parameters and Prudential limits established by the Board or CRMC. Establish systems and procedures relating to risk identification, Management Information System, monitoring

of loan / investment portfolio quality and early warning. The department would work out remedial measure when deficiencies/problems are identified.

Systems and Procedures Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing credits. Credits should be extended within the target markets and lending strategy of the institution. Before

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allowing a credit facility, the bank must make an assessment of risk profile of the customer/transaction. This may include:

Credit assessment of the borrower’s industry, and macro economic factors. The purpose of credit and source of repayment. The track record / repayment history of borrower. Assess/evaluate the repayment capacity of the borrower. The Proposed terms and conditions and covenants. Adequacy and enforceability of collaterals. Approval from appropriate authority

Limit setting An important element of credit risk management is to establish exposure limits for single obligors and group of connected obligors. Institutions are expected to develop their own limit structure while remaining within the exposure limits set by RBI. The size of the limits should be based on the credit strength of the obligor, genuine requirement of credit, economic conditions and the institution’s risk tolerance. Appropriate limits should be set for respective products and activities. Institutions may establish limits for a specific industry, economic sector or geographic regions to avoid concentration risk.

Credit limits should be reviewed regularly at least annually or more frequently if obligor’s credit quality deteriorates. All requests of increase in credit limits should be substantiated.

Credit Administration:

Credit administration unit performs following functions:

1. Documentation It is the responsibility of credit administration to ensure completeness of documentation (loan agreements, guarantees, transfer of title of collaterals etc) in accordance with approved terms and conditions. Outstanding documents should be tracked and followed up to ensure execution and receipt.

2. Credit Disbursement The credit administration function should ensure that the loan application has proper approval before entering facility limits into computer systems. Disbursement should be effected only after completion of covenants, and receipt of collateral holdings. In case of exceptions necessary approval should be obtained from competent authorities.

3. Risk Rating Model Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.

4. Credit monitoring After the loan is approved and draw down allowed, the loan should be continuously watched over. These include keeping track of borrowers’ compliance with credit terms, identifying early signs of irregularity, conducting periodic valuation of collateral and monitoring timely repayments.

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5. Loan Repayment The obligors should be communicated ahead of time as and when the principal/markup installment becomes due. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. Proper records and updates should also be made after receipt.

6. Maintenance of Credit Files Institutions should devise procedural guidelines and standards for maintenance of credit files. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment performance.

7. Collateral and Security Documents Institutions should ensure that all security documents are kept in a fireproof safe under dual control. Registers for documents should be maintained to keep track of their movement.

Procedures should also be established to track and review relevant insurance coverage for certain facilities/collateral. Physical checks on security documents should be conducted on a regular basis.

8. Measuring Credit Risk The measurement of credit risk is of vital importance in credit risk management. A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio are evolving. To start with, banks should establish a credit risk rating framework across all type of credit activities. Among other things, the rating framework may, incorporate: Business Risk

1. Industry Characteristics 2. Competitive Position (e.g. marketing/technological edge) 3. Management

Financial Risk 1. Financial condition 2. Profitability 3. Capital Structure 4. Present and future Cash flows

Types of Credit Rating Credit rating can be classified as: 1. External credit rating. 2. Internal credit rating

External Credit Rating: A credit rating is not, in general, an investment recommendation concerning a given security. In the words of S&P,” A credit rating is S&P's opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors.” In Moody's words, a rating is, “an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed-income security.”

Since S&P and Moody's are considered to have expertise in credit rating and are regarded as unbiased evaluators, there ratings are widely accepted by market participants and regulatory agencies. Financial institutions, when

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required to hold investment grade bonds by their regulators use the rating of credit agencies such as S&P and Moody's to determine which bonds are of investment grade.

The rating process includes quantitative, qualitative, and legal analyses, quantitative analyses. The quantitative analysis is mainly financial analysis and is based on the firm’s financial reports. The qualitative analysis is concerned with the quality of management, and includes a through review of the firm’s competitiveness within its industry as well as the expected growth of the industry and its vulnerability to technological changes, regulatory changes, and labor relations.

Internal Credit Rating:

A typical risk rating system (RRS) will assign both an obligor rating to each borrower (or group of borrowers), and a facility rating to each available facility. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should offer a carefully designed, structured, and documented series of steps for the assessment of each rating.

Risk Rating Models Short term ratings Risk weights

CARE CRISIL FITCH ICRA

PR1++ P1++ F1++ A1++ 20%

PR11 P11 F11 A11 30%

PR22 P22 F22 A22 50%

PR33 P33 F33 A33 100%

PR4/PR55 P4/P55 B/C/DD AR/A55 150%

UNRATEDD UNRATEDD UNRATEDD UNRATEDD 100%

Under the New Basel II Accord, assessment of Credit Risk can be carried out in any of the three approaches viz. 1. Standardized Approach 2. Foundation Internal Rating Based Approach and 3. Advanced Internal Rating Based Approach.

1. Standardized Approach Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B- . Similarly, exposure on public sector entities, multilateral development banks, other banks, securities firms and corporate also may have risk weights from 20 percent to 150 percent.

Exposure on retail portfolio may carry risk weight of 75 percent. While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets, India has prescribed 9 percent. Under Basel II exposure on a corporate with ‘AAA’ rating will have a risk weight of only 20 percent. This implies that for Rs. 100 crore exposure on a ‘AAA’ rated corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%) compared to the earlier requirement of Rs. 9 crore. However, claims on a corporate with below BB- rating will carry a risk weight of 150 percent and the capital requirement will be Rs.13.50 crore (100 x 150% x 9%). Thus, a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital.

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Under this approach, RWA (Risk Weighted Assets) is determined as the counter parties are grouped into Sovereigns, Banks and Corporate. Instead of assigning a uniform risk weight to all borrowers differential risk weights are assigned on the basis of external risk assessments by the external credit rating agencies (ECRA). For Sovereigns, the risk weights range from 0% to 100% and for banks and corporate the range is from 20% to 150%. This approach ensures that a bank knows the quality of its exposures to strengthen its capital base according to risks it takes. It’s a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas, it can take timely corrections.

Counterparty Sovereigns

Credit assessment Risk weights

AAA to AA- 0%

A + to A - 20%

BBB + to BBB - 50%

BB + to B - 100%

< B - 150%

unrated 100%

Counterparty Other Banks

Credit assessment Risk weights

AAA to AA- 20%

A + to A - 50%

BBB + to BBB - 50%

BB + to B - 100%

< B - 150%

unrated 50%

Source: The Journal of Indian Institute of Banking and Finance Oct-Dec 2004

2. Internal Ratings Based (IRB) Approach: Foundation and Advanced Approach. Banks, which have developed reliable Management Information System (MIS) and have received the approval of the central bank, can use the IRB approach to measure credit risk on their own. The bank should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and effective maturity (M) to make use of IRB approach.

IRB Approach is more sophisticated as in respect of each exposure (sovereigns, corporate, other banks, retail loans,

project finance, equity investment) banks are asked to foresee the possibility of a shift in the asset quality over a

period of time which can be done by working out probability of default (PD), the probability of loss in the event of

default (LGD) and the exposure at default.

Probability of Default: A borrower is in default when the obligations to pay principal and interest are not met. On

this basis a loan is deemed to be in default if it is classified as sub standard. For estimating the PD time horizon is

important. Loss given Default measures the extent of loss on a given exposure in the event of default. It’s a fraction

Counterparty Corporate

Credit assessment Risk weights

AAA to AA- 20%

A + to A - 50%

BBB + to BBB - 100%

BB + to B - 100%

< B - 150%

unrated 100%

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of total exposure whose exact value depends upon the extent of collateralization and expressed as a percentage of

exposure. Finally the loss to the bank depends on the value of Exposure at Default. The banks internal model is

expected to produce reliable estimates of PD, LGD and EAD. These estimates must be based on at least 1-year data

sampled over a minimum of 4 quarters. Risk components derived above are translated into risk weights called Risk

Weight Function.

For corporate exposures, the risk weight function gives the following risk weight for given PD, LGD, EaD

RWC = Min. ({LGD/50}*BC; 12.5*LGD)

Here, LGD is expressed as a whole number (i.e. a 75% loss given default is written as 75) while BC is a benchmark

risk weight for corporate prescribed by the supervisor based on statistical calibration and related to PD. Each

calculated risk weight RWC is multiplied by the corresponding EAD and aggregating over all exposure categories

yields an estimate of RWA for credit.

Example of Union Bank of India:-

In UBI, a business receiving Credit Rating above level 6 are not considered good from point of investment and thus are avoided.

Rating Score Revised w.e.f. 01.04.09

Working capital Term loan

CR-1 >90 BPLR BPLR+ 0.25%

CR-2 86-90 BPLR+ 0.25% BPLR+ 0.75%

CR-3 81-85 BPLR+ 0.75% BPLR+ 1.25%

CR-4 76-80 BPLR+ 1.00% BPLR+ 1.75%

CR-5 71-75 BPLR+ 1.25% BPLR+ 2.25%

CR-6 61-70 BPLR+ 1.75% BPLR+ 2.75%

CR-7 51-60 BPLR+ 3.50% BPLR+ 3.50%

CR-8 50 & below BPLR+ 3.50% BPLR+ 3.50%

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Managing Credit Risks

Credit Derivatives

The banks can make use of various credit derivative instruments to reduce the credit risk associated with its loan

portfolio. For example removing a pool of loans from banks balance sheet reduces or disposes of the banks credit

risk exposures from these loans. Similarly, a bank that has just made loans to some of its customers can sell these

loans to other investors who take on the credit risks inherent in these loans.

Credit Swaps

A Credit Swap is where two lenders agree to exchange portion of their customer’s loan repayments. Each bank is

granted the opportunity to further spread out the risk in its loan portfolio especially if the banks involved are located

indifferent market areas. A credit swap permits each institution to broaden the number of markets from which it

collects loan revenue and loan principal thus reducing each bank dependence on one or narrow set of market areas.

Credit Options

Credit Options guards against losses in the value of a credit asset or helps to off set higher borrowing cost that occur

due to changes in credit ratings.

Securitization of loans: In case of Securitization selected loans are transferred to a company set up. The securities are linked directly with

the default risk of the tranche they securitize. The securitizing bank provides liquidity facilities to make securities

attractive for investors. Furthermore, the banks usually keep the ‘first loss piece’ on their own books which is

equivalent to portfolio expected loss. Thus, only the risk of unexpected rating deterioration is passed onto investors.

INTEREST RATE RISK

“Interest rate risk arises when there is a mismatch between positions, which are subject to interest rate adjustment within a specified period. The bank’s lending, funding and investment activities give rise to interest rate risk. The immediate impact of variation in interest rate is on bank’s net interest income, while a long term impact is on bank’s net worth since the economic value of bank’s assets, liabilities and off-balance sheet exposures are affected.”

Consequently there are two common perspectives for the assessment of interest rate risk 1. Earning perspective: In earning perspective, the focus of analysis is the impact of variation in interest rates on accrual or reported earnings. This is a traditional approach to interest rate risk assessment and obtained by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense.

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2. Economic Value perspective: Economic Value perspective involves analyzing the expected cash inflows on assets minus expected cash out flows on liabilities plus the net cash flows on off-balance sheet items. The economic value perspective identifies risk arising from long-term interest rate gaps. Objective of Interest Rate Risk Management 1. To maintain earnings 2. Improve the capability, 3. Ability to absorb potential loss 4. To ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off.

In order to manage interest rate risk, banks should begin evaluating the vulnerability of their portfolios to the risk of fluctuations in market interest rates. . One such measure is Duration of market value of a bank asset or liabilities to a percentage change in the market interest rate. The difference between the average duration for bank assets and the average duration for bank liabilities is known as the duration gap which assesses the bank’s exposure to interest rate risk. The Asset Liability Committee (ALCO) of a bank uses the information contained in the duration gap analysis to guide and frame strategies. By reducing the size of the duration gap, banks can minimize the interest rate risk

SOURCES OF INTEREST RATE RISKS: Interest rate risk occurs due to, 1. Differences between the timing of rate changes and the timing of cash flows(re-pricing risk); 2. Changing rate relationships among different yield curves effecting bank activities(basis risk); 3. changing rate relationships across the range of maturities (yield curve risk); 4. Interest-related options embedded in bank products (options risk).

Types of Interest Rate Risks

1. Gap/Mismatch risk: It arises from holding assets and liabilities and off balance sheet items with different principal amounts, maturity dates & re-pricing dates thereby creating exposure to unexpected changes in the level of market interest rates.

2. Basis Risk: It is the risk that the Interest rat of different Assets/liabilities and off balance items may change in different magnitude. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities.

3. Embedded option Risk: Option of pre-payment of loan and Fore- closure of deposits before their stated maturities constitute embedded option risk.

4. Yield curve risk: Movement in yield curve and the impact of that on portfolio values and income.

5. Re-price risk: When assets are sold before maturities.

6. Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested.

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7. Net interest position risk: When banks have more earning assets than paying liabilities, net interest position risk arises in case market interest rates adjust downwards. There are different techniques such a a) The traditional Maturity Gap Analysis to measure the interest rate sensitivity, b) Duration Gap Analysis to measure interest rate sensitivity of capital, c) Simulation and d) Value at Risk for measurement of interest rate risk.

Source: IBA Bulletin, January 2005

RBI has initiated two approaches towards better measurement and management of interest rate risk and made the

mandatory requirement that time to re-pricing or time to maturity to create ‘interest rate risk statement’ should classify

assets and liabilities. This statement is required to be reported to board of directors of bank and to RBI (not to public). In

addition RBI has created a requirement that banks have to build up Investment Fluctuation Reserve (IFR) using profits

from sale of government securities in order to better cope with potential losses in future.

Interest Rate Risk Management While rising interest rates make banks vulnerable to treasury losses, banks in India have a number of lines of defense. First, banks have, in recent years, realized substantial profits from their holdings of government securities, thanks to the soft interest rate environment. Banks are required to follow conservative accounting practices in respect of unrealized capital gains on their investment portfolio and have constituted latent reserves. Moreover, banks in India have been encouraged to build up investment fluctuation reserves as a cushion against interest rate risk. Finally, banks can adjust their behavior to offset treasury losses by adequately managing their asset-liability mismatch.

Banks manage interest rate risk through a number of measures. Banks could (i) reduce the duration of their assets by selling long-dated government securities; (ii) Reduce their holdings of government securities and increase their loan books by building on the recent high growth in consumer credit and infrastructure; (iii) Increase the contribution of fee-based income to operating income.

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REPUTATION RISK

Reputation risk is arising from negative public opinion. This risk may be exposed the financial loss or a decline in a customer based or decline in the reputation of business. “Reputation risk is the risk to earning or capital arising from negative public opinion of the bank”. Negative public opinion can arise from poor service, failure to serve the credit needs of their communities or for other reasons. This affects the institution’s ability to establish new relationships or services or continue servicing existing relationships.

The Bank manages reputation risk with the aim to bring potential losses down, preserve and maintain the Bank’s reputation among customers, counteragents, shareholders, participants of the financial market, state governmental authorities, local self-government, the Bank unions (association), self-governed organizations, in which the Bank participates.

Aggregate Level of Reputation Risk Indicators: The following indicators should be used when assessing the aggregate level of reputation.

Low

1. Management anticipates and responds well to changes of a market or regulatory nature that impact its reputation in the marketplace. 2. Management fosters a sound culture that is well supported throughout the organization and has proven very effective over time. 3. The Bank effectively self-policies risks. 4. Internal control and audit are fully effective 5. Franchise value is only minimally exposed by reputation risk. Exposure from reputation risk is expected to remain low in the foreseeable future. 6. Losses from fiduciary activities are low relative to the number of accounts, the volume of assets under Management, and the number of affected transactions. The Bank does not regularly experience litigation or customer complaints.7. Management has a clear awareness of privacy issues and uses customer information responsibly.

Moderate

1. Management adequately responds to changes of a market or regulatory nature that impact the institution’s reputation in the marketplace.

2. Administration procedures and processes are satisfactory. Management has a good record of correcting problems. Any deficiencies in management information systems are minor.

3. The Bank adequately self-policies risks. 4. Internal control and audit are generally effective. 5. The exposure of franchise value from reputation risk is controlled. Exposure is not expected to increase in the

foreseeable future. 6. The Bank has avoided conflicts of interest and other legal or control breaches. The level of litigation, losses, and

customer complaints are manageable and commensurate with the volume of business conducted. 7. Management understands privacy issues and generally uses customer information responsibly.

High

1. Management does not anticipate or take timely or appropriate actions in response to changes of a market or regulatory nature. 2. Weaknesses may be observed in one or more critical operational, administrative, or investment activities. Management information at various levels exhibits significant weaknesses. 3. The institution’s performance in self-policing risk is insufficient.

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4. Internal control or audits are not effective in reducing exposure. Management has either not initiated, or has a poor record of, corrective action to address problems. 5. Franchise value is substantially exposed by reputation risk shown in significant litigation, large dollar losses, or a high volume of customer complaints. The potential exposure is increased by the number of accounts, the volume of assets under Management, or the number of affected transactions. Exposure is expected to continue in the foreseeable future. 6. Poor administration, conflicts of interest, and other legal or control breaches may be evident. 7. Management is not aware and/or concerned with privacy issues and may use customer information irresponsibly.

The Bank manages reputation risks by

The system of marginal values (limits);

The system of authorities and decision-making;

The system of reputation risk monitoring;

The system of minimization and control

STRATEGIC RISK

Strategic risk is a risk arising from adverse business decisions, improper implementation of decisions of lack of responsiveness to industry change. “Strategic risk is the risk to earnings or capital arising from making bad business decisions that adversely affect the value of the bank.”

Strategic risk is the risk of losses of the credit organization as a result of mistakes made (imperfections) in taking decisions. Strategic risk is the risk associated with the financial institution’s future business plans and strategies. This risk category includes plans for entering new business lines, expanding existing services through mergers and acquisitions, and enhancing infrastructure (e.g., physical plant and equipment and information technology and networking). The Bank uses the following methods of strategic risk management:

Business planning;

Financial planning;

Market analysis;

Readjustment of plans.

OPERATIONAL RISK

Operational risk is faced by all organizations in one way or the other. The exposure to Operational risk depends upon the complexity of the Organization. Operational risk would arise due to deviations from normal and planned functioning of systems, procedures, technology and human failures of omission and commission. This not only affects the revenue of the organization but also cost it in terms of opportunities loss that would be otherwise feasible. Basel Committee has defined 'Operational Risk' as follows

“The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events".

Need For Operational Risk Management

The criticality of operational risk in the functioning of banks has to be viewed in the context of changes that has taken place in the banking industry. Since late nineties in India, there has been a remarkable change in the functioning of

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banks. Driven by deregulation and need to become globally competitive, the banks have made tremendous technological advances, brought in a plethora of new financial products, and are catering to a very large volume of customers on several platforms.

The time tested systems and procedures in traditional banking were developed over several decades. In the process of perfecting the systems and procedures banks may have faced operational losses but as the changes were only few and far between, systems had time to stabilize. For e.g. the computerization of banks which took place slowly in Indian banking industry. In the present context of fast changing environment and work practices, the time required to stabilize systems and procedures is not enough. So, as banks respond to the needs of competition, systems and procedures and human adaptation of the changes create operational risks inherent in the banking business. Accordingly, this risk needs to be factored in and taken into account in the banking business. Therefore, proper management of operational risks is an imperative. If operational risks are managed well, the rewards are available by way of lesser risk capital and cost reductions in operations. Both have a favorable impact on competitive edge. Basic motivation for management of operational risk stems from it.

Types Operational Risk

Operational risk arises from almost all the activities undertaken and consequently it is everywhere in an Organization. Impact of various forms of operational risk on the organization may vary in degree i.e., some risks may have more potential of causing damages while some may have less potential, some may occur more frequently while some may occur less frequently. As the activities of an organization changes in response to market and competition, new and until then unknown factors may add to operational risks.

Operational risks vary in their components. Some are high occurrence low value risks, while some are low occurrence high value risks. Operational risks in the Organization continuously change especially when an Organization is undergoing changes.

Basel II suggested classification of operational risks based on the 'Causes' and 'Effects'. That is classifications based on causes that are responsible for operational risks or classifications based on effects of risks were suggested. Classifications based on 'Causes' and 'Effects' are listed below.

1. CAUSE BASED

People oriented causes: negligence, incompetence, insufficient training, integrity, key man. Process oriented (Transaction based) causes: business volume fluctuation, organizational complexity, product

complexity, and major changes. Process oriented (Operational control based) causes: inadequate segregation of duties, lack of management

supervision, inadequate procedures. Technology oriented causes: poor technology and telecom, obsolete applications, lack of automation, information

system complexity, poor design, development and testing. External causes: natural disasters, operational failures of a third party, deteriorated social or political context.

EFFECT BASED Legal liability Regulatory, compliance and taxation penalties Loss or damage to assets Restitution Loss of recourse Write downs

However, the Third Consultative Paper recommended for event based classification. They are listed below.

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EVENT BASED

Internal Fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or

company policy, excluding diversity/ discrimination events, which involves at least one internal party.

External Fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party.

Employment practices and workplace safety Losses arising from acts inconsistent with employment, health or safety laws or agreements from payment of personal injury claims, or from diversity/ discrimination events.

Clients, products and business practices Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product.

Damage to physical assets Losses arising from loss or damage to physical assets from natural disasters or other events.

Business disruption and system failures

Losses arising from disruption of business or system failures

Execution, delivery and process management Losses from failed transaction processing or process management, from relations with trade counterparties and vendors

OPERATIONAL RISK MANAGEMENT (ORM) PRACTICES

Basel II document provides guidelines for operational risk management practices. These are called 'Sound Practices for the Management of Operational Risks'. Out of 10 first 7 are relevant at the organization level. Out of remaining three, two are relevant to regulators/supervisors and one related to disclosure requirements have not been reproduced.

Principle 1

Board of directors' should be aware of the major aspects of bank's operational risk as a distinct risk category that should be managed, and it should approve and periodically review the bank's ORM (Operational Risk Management) framework. The framework should provide a firm wide definition of operational risk and lay down the principles of how operational risk is to be identified, assessed, monitored, and controlled/ mitigated.

Principle 2

The Board of Directors should ensure that the ORM framework is subject to effective and comprehensive internal audit by operationally independent and competent staff. The internal audit function should not be directly responsible for operational risk management.

Principle 3

Senior management should have responsibility for implementing ORM framework approved by board of directors. The framework should be consistently implemented throughout the whole banking organization, and all levels of staff should understand their responsibilities with respect to ORM. Senior management should also have responsibility for developing policies, processes and procedures for managing operational risk in all of the bank's material products, processes and systems.

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Principle 4

Banks should identify and assess OR inherent in all material products, activities, processes and systems. Banks should also ensure that before new products, activities, processes and systems are introduced or undertaken, the operational risk inherent in them is subject to adequate assessment procedures.

Principle 5

Banks should implement a process to regularly monitor operational risk profiles and material exposures to losses. There should be regular reporting of pertinent information to senior management and the board of directors that supports the proactive management of operational risk.

Principle 6

Banks should have Policies, processes and procedures to control/mitigate material operational risks. Banks should periodically review their risk limitation and control strategies and should adjust their operational risk profile accordingly using appropriate strategies, in light of their overall risk appetite and profile.

Principle 7

Banks should have in place contingency and business continuity plans to ensure their ability to operate on an ongoing basis and limit losses in the event of severe business disruption.

Principle 8

Banking supervisors should require that all banks, regardless of size, have an effective framework in place to identify, assess, monitor and control or mitigate material operational risks as part of an overall approach to risk management.

Principle 9

Supervisors should conduct, directly or indirectly, regular independent evaluation of a bank’s policies, procedures and practices related to operational risks. Supervisors should ensure that there are appropriate reporting mechanisms in place which allow them to remain apprised of developments at banks.

Principle 10

Banks should make sufficient public disclosure to allow market participants to assess their approach to operational risk management

Operational Risk Management Practices should be based on a well laid out policy duly approved at the board level that describes the processes involved in controlling operational risks. It should meet the standards set in terms of the principles mentioned above. In addition, well laid down procedures in dealing with various products and activities should be in place. The policies and procedures should also be communicated across the Organization.

The Policy should cover

Operational risk management structure Role and responsibilities Operational risk management processes Operational risk assessment/measurement methodologies

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Operational Risk Quantification

The measurement of this risk is most difficult. This is because behavioral pattern of operational risk does not the statistically normal distribution pattern and that makes it difficult to estimate the probability of an event resulting in losses. Basel II has recognized this and has provided options in the measurement of operational risk for this purpose. 1. The Basic Indicator Approach 2. The Standardized Approach 3. Advanced Measurement Approaches (AMA) Of these, basic indicator approach and Standardized approach are based on income generated. The advance measurement approach is based on operational loss measurement.

1. The Basic Indicator Approach

Banks using the Basic Indicator Approach must hold capital for operational risk. Equal to the average over the previous three years of a fixed percentage (15%) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.

Gross income is defined as net interest income plus net non interest income, gross of any provisions (e.g. for unpaid interest) , gross of operating expenses, including fees paid to outsourcing service providers, exclude realized profits/ losses from the sale of securities in the banking book; and exclude extraordinary or irregular items as well as income derived from insurance.

2. The Standardized Approach In the Standardized Approach, banks' activities are divided into eight business lines: commercial banking, Corporate finance, trading and sales, retail banking, payment and settlement, agency services, asset management, and retail brokerage.

Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line (Beta Factors).

Business Lines Beta Factors

corporate finance 18%

Trading and sales 18%

Retail banking 12%

Commercial banking 15%

Payment and settlement 18%

Agency services 15%

Asset management 12%

Retail brokerage 12%

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3. Advanced Measurement Approaches (AMA) Under the AMA, the regulatory capital requirement will equal the risk measure generated by the bank's internal

operational risk measurement system using the quantitative and qualitative criteria for the AMA discussed below. Use of the AMA is subject to supervisory approval.

A Generic Measurement Approach

The first step in measurement approach is operation profiling. The steps involved OP Profiling is:

Identification and quantification of operational risks in terms of its components Prioritization of operational risks and identification of risk concentrations hot spots resulting in lower exposure. Formulation of bank's strategy for operational risk management and risk based audit

Estimated level of operational risk depends on

Estimated probability of occurrence Estimated potential financial impact Estimated impact of internal controls

Estimated Probability of Occurrence

This will be based on historical frequency of occurrence and estimated likelihood of future occurrence. Probability is mapped on a scale of 5 say where

1. Implies negligible risk 2. Implies low risk 3. Implies medium risk 4. Implies high risk 5. Implies very high risk

Estimated Potential Financial impact

This will be based on severity of historical impact and estimated severity of impact from unforeseen events. Probability is mapped on a scale of 5 as mentioned above.

Estimated Impact of Internal Controls

This will be based on historical effectiveness of internal controls and estimated impact of internal controls on risks. This is estimated as fraction in relation to total control, which is valued at 100%.

Estimated level of operational risk = Estimated probability of occurrence x Estimated potential financial impact x Estimated impact of internal controls

In case of a hypothetical example where Probability of occurrence = 2 (Medium)

Potential financial impact = 4 (very high) impact of internal controls = 50% Estimated level of operational risk = [( 2 x 4 x (1 0.501 ^ 0.5 = 2.0 or 'Low'

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BASEL II COMPLIANCE & RISK BASED SUPERVISION

BASEL II COMPLIANCE

The 1988 Capital Accord suffered from several drawbacks as it exclusive focus on credit risk, it does not

differentiate between sound and weak banks using “one hat fit all” approach, it acquire broad brush structure.

Hence, in order to remedy the Basel Committee published a New Accord in Dec 2001, which is expected to be

implemented by most countries by 2006.Basel II focuses on achieving a high degree of bank-level management,

regulatory control and market disclosure.

The structure of New Accord – II consists of three pillars approaches which are as follows:

Pillar Focus area

I Pillar Minimum capital requirement

II Pillar Supervisory review

III Pillar Market discipline

Minimum Capital Requirement

The major change in the first pillar is in measurement of risk weighting. It allows banks certain latitude in

determining their or own capital requirements based on internal models and focus on credit risk, market risk and

operational risk.

The minimal ration of capital assigned to risk is calculated as follows:

Total Capital (unchanged)Bank’s Capital Ratio (min 8%) = ----------------------------------------------------------

(RBI prescribes 9 %) Credit risk + Market risk + Operational risk

For Credit Risks three alternative approaches are suggested. The first is a standardized approach in which RWA

(risk weighted assets) is determined except that the risk weights are no longer determined in asset once but are

revised depending upon the ratings of the counter parties by external credit rating agencies (ECRA). There is also

greater differentiation across risk categories. In the second approach called the internal ratings based approach

(IRB) banks rates the borrower and results are translated into estimates of a potential future loss amount which

forms the basis of minimum capital requirement. In Advanced internal rating based approach the range of risk

weights are well diverse.

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For Market Risks also a similar twin track approach is followed. Here capital charges are determined and then

multiplied by 12.5 to make them comparable to the RWA. Secondly a special type of capital (Tier3) is introduced for

meeting market risk only.

For meeting operational risk Accord II has specified three alternative approaches- basic indicator, standardized and

internal measurement approach. For operational risk capital charges are computed directly and then multiplied by

12.5 to make it comparable to RWA.

Thus D (denominator of the capital adequacy ratio) is defined as

D =RWA + 12.5 * (Sum of capital charges due to market and operational risk)

The numerator N consists of

N = Tier I + Tier II + Tier III

Subject to the proviso that

Tier I + Tier II > 0.08(RWA +12.5{capital charges on account of operational risk})

To meet market risk special type of capital viz. Tier III capital has been introduced in the New Accord which consists

of short term subordinated debt but with a minimum original maturity of 2 years. Tier III capital cannot exceed

250% of the Tier I capital to meet market risk.

Supervisory Review Process

It entails allocation of supervisory resources and paying supervisory attention in accordance with risk profile of

each bank, optimizes utilization of supervisory resources, continuous monitoring and evaluation of the risk profiles

of the supervised institution and construction of a risk matrix of each institution. The process requires supervisors

to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on

through evaluation of its risk.

Market Discipline

The potential of market discipline to reinforce capital regulation depends on the disclosure of reliable and timely

information with a view to enable banks counter parties to make well founded risk assessments. Moreover, banks

are encouraged to disclose ways in which they allocate capital among different activities. In a recent paper the BIS

has elaborated the recommendations of the Basel II concerning the nature of information to be disclosed:

1) Structure and components of bank capital.37

2) The terms and main features of capital instruments.

3) Breakdown of risk exposures.

4) Its capital ratio and other data related to its capital adequacy on a consolidated basis.

Reservations about Basel II

One of the major critiques of the New Basel Accord pertains to the adoption of an internal rating based (IRB)

system as the application of IRB is costly, discriminates against smaller banks and exacerbates cyclical

fluctuations.

Basel II involve shift in direct supervisory focus away to implementation issues and that banks and the

supervisors would be required to invest large resources in upgrading their technology and human resources to

meet minimum standards.

Only those banks likely to benefit from IRB will adopt approach, other banks will hold on to the standardized

approach.

Fears of disintermediation have also been expressed.

RISK BASED SUPERVISION REQUIREMENTS

Background

RBI Governor in assistance with PriceWaterHouse Coopers (PWC) an international consultant laid an overall plan

for developing Risk Based Supervision. The CAMELS (capital adequacy, asset quality, management, earnings,

liquidity, systems & controls)/CALCS (capital adequacy, asset quality, liquidity, compliance & systems) approach to

supervisory risk assessments and ratings, tightening of exposure and enhancement in disclosure standards are all

introduced by RBI to align the Indian banking system to International best practices.

Current Supervisory Approach

The current on site inspection driven approach of RBI is supplemented by off site monitoring and surveillance

system (OSMOS) and supervisory follow up. It provides an opportunity to the regulator to monitor banks

performance based on CAMELS/CALCS approach.

The major features of current supervisory are:

Annual Financial Inspection (AFI) of banks.

Asset size determines the length of inspection.

All areas of banks operations are covered.38

Focus remains on transaction and asset valuation, compliance with regulations and banking laws.

Focus of follow up remains on rectification rather than prevention.

Risk Based Supervision (RBS) – A New Approach

RBS looks at how well a bank (supervised) identifies, measures, controls and monitors risks. It not only tries to

identify systemic risks caused by the economic environment in which banks operate but also management ability to

deal with them.

Focused approach under RBS entails allocation of supervisory resources and paying attention in accordance with

the risk profile of supervised (bank) which would further optimize utilization of supervisory resources. It involves

assessing and monitoring the risk profile of banks on an on going basis in relation to business and exposures and

prompt banks to develop systems rather than transactions.

RBI decided to switch over to RBS due to autonomy of banks, increased competition, globalization, automation and

market disclosure / transparency.

Features of RBS Approach

1) Risk Profiling of Banks: CAMELS rating is one of the core of risk profile compilation and the risk profiling of each bank draws upon a wide range of information such as market intelligence reports, onsite findings, adhoc data from external and internal auditors. Risk profile document contains SWOT analysis, Sensitivity analysis, Monitor able action plan and banks progress to date.

2) Supervisory Cycle: It varies according to risk profile of each bank, the principle being higher the risk shorter will

be the cycle of supervision. In short term supervisory cycle remains at 12 months but it can be extended

beyond 12 months for low risk banks.

3) Supervisory Program: It is prepared at the beginning of supervisory cycle. On site inspection is targeted to

specific areas and a MAP (monitorable action plan) is drawn up for follow up to mitigate risks to supervisory

objectives posed by individual banks.

4) Supervisory Organization: It is the focal point for main conduit for information and communication between

banks and RBI.

5) Enforcement process and Incentive framework: RBS ensures that the banks with a better compliance record

and a good risk management control system is entitled to an incentive package like longer supervisory cycle.

Moreover, banks that fails to show improvement in response to MAP is subject to frequent supervisory

examination.

The effectiveness of RBS depends on bank preparedness. Hence, RBI initiates banks to set up Risk Management Architecture,

adopts Risk Focused Internal Audit (RFIA), strengthen MIS. There should be well-defined standard of corporate governance, 39

well-documented policies and practices with clear demarcation of lines of responsibility and accountability. Moreover, for

effectiveness of RBS formation of separate Quality Assurance Team (QAT) should be there where members are not involved in

preparation of Risk Profile Templates (RPTs). RPTs is defined as a standardized and dynamic document that captures,

catalogues, assesses and aggregate risks that bank are exposed to. It works as a comprehensive guide to RBI for informed and

focused supervisory action in high-risk areas in banks, fix up supervisory cycle and supervisory tools.

CONCLUSION

In the today’s fierce competitive world, each sector in the industry is undergoing revolution every now and then. Banking Sector is no exception to it. But with it comes great uncertainty of events making banks vulnerable in the market. Thus for all banks risk management becomes necessary to stay in the competition. Risk management allows banks to access the actual as well as potential dangers. The banks have become more conscious about risk management as negligence may not only cost bank losing its profit but also it may wipe out the presence of the bank. Although some risks cannot be avoided but they can be managed properly so as to cause less damage, whereas others can be avoided completely.

Risk management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity, but to ensure that the risks are consciously taken with full knowledge, clear purpose and understanding so that it can be measured and mitigated. It also prevents an institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position. Functions of risk management should actually be bank specific dictated by the size and quality of balance sheet, complexity of functions, technical/ professional manpower and the status of MIS in place in that bank.

There may not be one-size-fits-all risk management module for all the banks to be made applicable uniformly. Balancing risk and return is not an easy task as risk is subjective and not quantifiable whereas return is objective and measurable. If there exist a way of converting the subjectivity of the risk into a number then the balancing exercise would be meaningful and much easier. Banking is nothing but financial inter-mediation between the financial savers on the one hand and the funds seeking business entrepreneurs on the other hand.

As such, in the process of providing financial services, commercial banks assume various kinds of risks both financial and non-financial. Therefore, banking practices, which continue to be deep routed in the philosophy of securities, based lending and investment policies, need to change the approach and mindset, rather radically, to manage and mitigate the perceived risks, so as to ultimately improve the quality of the asset portfolio.

As in the international practice, a committee approach may be adopted to manage various risks. Risk Management Committee, Credit Policy Committee, Asset Liability Committee, etc are such committees that handle the risk management aspects. While a centralized department may be made responsible for monitoring risk, risk control should actually take place at the functional departments as it is generally fragmented across Credit, Funds, and Investment and Operational areas. Integration of systems that includes both transactions processing as well as risk systems is critical for implementation. In a scenario where majority of profits are derived from trade in the market, one can no longer afford to avoid measuring risk and managing its implications thereof. Crossing the chasm will involve systematic changes coupled with the characteristic uncertainty and also the pain it brings and it may be worth the effort. The engine of the change is obviously the evolution of the market economy abetted by unimaginable advances in technology, communication, transmission of related uncontainable flow of information, capital and commerce throughout the world. Like a powerful river, the market economy is widening and breaking down barriers.

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Government’s role is not to block that flow, but to accommodate it and yet keep it sufficiently under control so that it does not overflow its banks and drown us with the associated risks and undesirable side effects.

To the extent the bank can take risk more consciously, anticipates adverse changes and hedges accordingly, it becomes a source of competitive advantage, as it can offer its products at a better price than its competitors. What can be measured can mitigation is more important than capital allocation against inadequate risk management system. Basel proposal provides proper starting point for forward-looking banks to start building process and systems attuned to risk management practice. Given the data-intensive nature of risk management process, Indian Banks have a long way to go before they comprehend and implement Basel II norms, in to-to.

The effectiveness of risk measurement in banks depends on efficient Management Information System, computerization and net working of the branch activities. The data warehousing solution should effectively interface with the transaction systems like core banking solution and risk systems to collate data. An objective and reliable data base has to be built up for which bank has to analyze its own past performance data relating to loan defaults, trading losses, operational losses etc., and come out with bench marks so as to prepare themselves for the future risk management activities. Any risk management model is as good as the data input. With the onslaught of globalization and liberalization from the last decade of the 20th Century in the Indian financial sectors in general and banking in particular, managing Transformation would be the biggest challenge, as transformation and change are the only certainties of the future.

BIBLIOGRAPHY

Basel Committee on Banking Supervision.2001. “Working Paper on the Regulatory Treatment of Operational

Risk” (September).

Basel Committee on Banking Supervision.2001. “Sound Practices for the Management and Supervision of

Operational Risk” (December).

Report: A Road map for Implementing an Integrated Risk Management System by Indian Banks by Mar 2005

(CRISIL) in IBA Bulletin (Jan 2004).

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