Risk Management in Banks-Chapter1

7/31/2019 Risk Management in Banks-Chapter1

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Risk Management at Central Bank of India

Government R. C. College of Commerce and Management 1

Risk Management in Banks

Introduction:

isks are usually defined by the adverse impact on profitability of several

distinct sources of uncertainty. While the types and degree of risks an

organization may be exposed to depend upon a number of factors such as its

size, complexity business activities, volume etc, it is believed that generally the

banks face Credit, Market, Liquidity, Operational, Compliance / legal /

regulatory and reputation risks. Before overarching these risk categories, given

below are some basics about risk management and some guiding principles to

manage risks in banking organization.

Risk management in Indian banks is a relatively newer practice, but has already

shown to increase efficiency in governing of these banks as such procedures

tend to increase the corporate governance of a financial institution. In times of

volatility and fluctuations in the market, financial institutions need to prove

their mettle by withstanding the market variations and achieve sustainability in

terms of growth and well as have a stable share value. Hence, an essential

component of risk management framework would be to mitigate all the risks

and rewards of the products and service offered by the bank. Thus the need for

an efficient risk management framework is paramount in order to factor in

internal and external risks.

The financial sector in various economies like that of India is undergoing amonumental change factoring into account world events such as the ongoing

Banking Crisis across the globe. The 2007present recession in the United

States has highlighted the need for banks to incorporate the concept of Risk

Management into their regular procedures. The various aspects of increasing

global competition to Indian Banks by Foreign banks, increasing Deregulation,

introduction of innovative products, and financial instruments as well as

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innovation in delivery channels have highlighted the need for Indian Banks to

be prepared in terms of risk management.

Indian Banks have been making great advancements in terms of progress in

terms of technology, quality, quantity as well as stability such that they have

started to expand and diversify at a rapid rate. However, such expansion brings

these banks into the context of risk especially at the onset of increasing

Globalization and Liberalization. In banks and other financial institution risk

plays a major part in the earnings of a bank. Higher the risk, higher is the return,

hence, it is most essential to maintain a parity between risk and return. Hence,

management of Financial risk incorporating a set systematic and professional

methods especially those defined by the Basel II norms because an essential

requirement of banks. The more risk averse a bank is, the safer is their Capital

base.

Risk Management is a discipline at the core of every financial institution and

encompasses all the activities that affect its risk profile. It involves

identification, measurement, monitoring and controlling risks to ensure that

The individuals who take or manage risks clearly understand it. The organizations Risk exposure is within the limits established by

Board of Directors.

Risk taking Decisions are in line with the business strategy and objectivesset by BOD.

The expected payoffs compensate for the risks taken Risk taking decisions are explicit and clear. Sufficient capital as a buffer is available to take risk


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In every financial institution, risk management activities broadly take place

simultaneously at following different hierarchy levels.

Strategic level: It encompasses risk management functions performed bysenior management and BOD. For instance definition of risks,

ascertaining institutions risk appetite, formulating strategy and policies

for managing risks and establish adequate systems and controls to ensure

that overall risk remain within acceptable level and the reward

compensate for the risk taken.

Macro Level: It encompasses risk management within a business area oracross business lines. Generally the risk management activities performed

by middle management or units devoted to risk reviews fall into this

category.

Micro Level: It involves On-the-line risk management where risks areactually created. This is the risk management activities performed by

individuals who take risk on organizations behalf such as front office

and loan origination functions. The risk management in those areas is

confined to following operational procedures and guidelines set by

management.

Various Steps Involved in Risk Management:

1. IdentificationAfter establishing the context, the next step in the process of managing riskis to

identify potential risks. Risks are about events that, when triggered, cause

problems. Hence, risk identification can start with the source of problems, or

with the problem itself.
http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Risk


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Source analysis Risk sources may be internal or external to the systemthat is the target of risk management. Examples of risk sources are:

stakeholders of a project, employees of a company or the weather over anairport.

Problem analysis Risks are related to identified threats. For example: thethreat of losing money, the threat of abuse of privacy information or the

threat of accidents and casualties. The threats may exist with various

entities, most important with shareholders, customers and legislative

bodies such as the government.

2. AssessmentOnce risks have been identified, they must then be assessed as to their potential

severity of loss and to the probability of occurrence. These quantities can be

either simple to measure, in the case of the value of a lost building, or

impossible to know for sure in the case of the probability of an unlikely event

occurring. Therefore, in the assessment process it is critical to make the best

educated guesses possible in order to properly prioritize the implementation of

the risk management plan. After identifying and assessing the risk the bank

shall consider any of the following risk methods:

Risk Avoidance- This can be done by means of elimination of risk. i.e.,not to undertake or undergo those risks.

Risk Reduction- This can be done by reducing the risk of loss. It can bedone either by creating enough security for the particular risk.

Risk Retention- This can be done through that, they shall retain the riskwhich is of small in nature or where the risk level is very less.

Risk Transfer- This can be done through that, the bank shall transfer therisk to other party by taking insurance or entering into third party

contract.
http://en.wikipedia.org/wiki/Risk_management_planhttp://en.wikipedia.org/wiki/Risk_management_plan


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Benefits of Risk Management:

Brings order and system to the process of risk quantification Enables the assigning of value to estimated risk of loss, e.g. VAR Flags extreme risky situations for necessary immediate action by

management

Improves risk awareness when it is actively courted by the company Results in increased valuation and reduced cost of capital More objective performance appraisal based on risk-adjusted capital

employed

Types of Risk:

The term Risk and the types associated to it would refer to mean financial risk

or uncertainty of financial loss. The Reserve Bank of India guidelines issued in

Oct. 1999 has identified and categorized the majority of risk into three major

categories assumed to be encountered by banks. These belong to the clusters:

Credit Risk Market Risk Operational Risk

The type of risks can be fundamentally subdivided in primarily of two types, i.e.

Financial and Non-Financial Risk. Financial risks would involve all those

aspects which deal mainly with financial aspects of the bank. These can be

further subdivided into Credit Risk and Market Risk. Both Credit and Market

Risk may be further subdivided.

Non-Financial risks would entail all the risk faced by the bank in its regular

workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk,

and Legal Risk.


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The following chart in nutshell shows the various risks that the banks shall get

into.

Chart 1.1- Types of Risk.


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Credit Risk Management:

hile financial institutions have faced difficulties over the years for a

multitude of reasons, the major cause of serious banking problems

continues to be directly related to lax credit standards for borrowers and

counterparties, poor portfolio risk management, or a lack of attention to changes

in economic or other circumstances that can lead to a deterioration in the credit

standing of a bank's counterparties. Credit risk is most simply defined as the

potential that a bank borrower or counterparty will fail to meet its obligations in

accordance with agreed terms. The goal of credit risk management is to

maximise a bank's risk-adjusted rate of return by maintaining credit risk

exposure within acceptable parameters. Banks need to manage the credit risk

inherent in the entire portfolio as well as the risk in individual credits or

transactions. Banks should also consider the relationships between credit risk

and other risks. The effective management of credit risk is a critical component

of a comprehensive approach to risk management and essential to the long-term

success of any banking organisation.

Credit risk is an investor's risk of loss arising from a borrower who does not

make payments as promised. Such an event is called a default. Investor losses

include lost principal and interest, decreased cash flow, and increased collection

costs, which arise in a number of circumstances:

A consumer does not make a payment due on a mortgage loan, creditcard, line of credit, or other loan.

A company is unable to repay amounts secured by a fixed or floatingcharge over the assets of the company.

A business or consumer does not pay a trade invoice when due. A business does not pay an employee's earned wages when due.

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A business or government bond issuer does not make a payment on acoupon or principal payment when due.

An insolvent insurance company does not pay a policy obligation. An insolvent bank won't return funds to a depositor. A government grants bankruptcy protection to an insolvent consumer or

business.

The Credit Risk is generally made up of transaction risk or default risk and

portfolio risk. The portfolio risk in turn comprises intrinsic and concentration

risk. The credit risk of a banks portfolio depends on both external and internal

factors. The external factors are the state of the economy, rates and interest

rates, trade restrictions, economic sanctions, wide swings in commodity/equity

prices, foreign exchange rates and interest rates, trade restrictions, economic

sanctions, Government policies, etc. The internal factors are deficiencies in loan

policies/administration, absence of prudential credit concentration limits,

inadequately defined lending limits for Loan Officers/Credit Committees,

deficiencies in appraisal of borrowers financial position, excessive dependence

on collaterals and inadequate risk pricing, absence of loan review mechanism

and post sanction surveillance, etc.

Another variant of credit risk is counterparty risk. The counterparty risk arisesfrom non-performance of the trading partners. The non-performance may arise

from counterpartys refusal/inability to perform due to adverse price movements

or from external constraints that were not anticipated by the principal. The

counterparty risk is generally viewed as a transient financial risk associated with

trading rather than standard credit risk.


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The bank aims at minimizing this risk that could arise from individual

borrowers or the entire portfolio. The former can be addressed by having well-

developed systems to appraise the borrowers; the latter, on the other hand, canbe minimized by avoiding concentration of credit exposure with a few

borrowers who have similar risk profiles. Credit risk management becomes

even more relevant in the light of the changes that have been brought about in

the economic environment, including increasing competition and thinning

spreads on both the sides of Balance sheet

Determinants of Credit Risk

Factors determining credit risk of a banks portfolio can be divided into external

and internal factors. The banks do not have control on external factors. These

include factors across a wide spectrum ranging from the state of the economy to

the correlation among different segments of industry. The risk arising out of

external factors can be mitigated via diversification of the credit portfolio across

industries especially in light of any expectations of adverse developments in the

existing portfolio.

Given that the banks have very little control over such external factors, the bank

can minimize the credit risk that it faces mainly by managing the internal

factors.

These include the internal policies and processes of the bank like Loan policies,

appraisal processes, monitoring systems etc. These internal factors can be taken

care of, partly, via effective rating and monitoring systems, entry level criteria

etc. These processes would enable improvement in the quality of credit

decisions.


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This would effectively improve the quality (and hence profitability) of the

portfolio. While monitoring systems are useful tool at post-sanction stage, rating

systems act as important aid at the pre-sanction stage.

The discussion of the credit risk management function is primarily focused on

the loan portfolio, although the principles relating to the determination of

creditworthiness, apply equally to the assessment of counter parties who issue

financial instruments. Following are the important themes under credit risk

management;

Credit portfolio management Lending function and operations Credit portfolio quality review Nonperforming loan portfolio Credit risk management policies Policies to limit or reduce credit risk Asset classification Loan loss provisioning policy

Introduction to Credit Risk Management Tools

The Bank has developed tools for better credit risk management. These focus on

the areas of rating of corporate (pre-sanctioning of Loans) and monitoring of

Loans (post-sanctioning). The focus of this manual is to familiarise the user

with the credit rating tool.


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Credit Rating:

Credit rating is the process of assigning a letter rating to borrowers indicating

the creditworthiness of the borrower. Rating is assigned based on the ability ofthe borrower (company) to repay the debt and his willingness to do so. The

higher the rating of a company, the lower the probability of its default. The

companies assigned with the same credit rating have similar probability of

default.

Use in decision-making

Credit rating helps the bank in making several key decisions regarding credit

including:

Whether to lend to a particular borrower or not; what price to charge?

What are the products to be offered to the borrower and for what tenor?

At what level should sanctioning be done?

What should be the frequency of renewal and monitoring?

It should, however, be noted that credit rating is one of the inputs used in taking

credit decisions. There are various other factors that need to be considered in

taking the decision (e.g., adequacy of borrowers cash flow, collateral provided,

and relationship with the borrower). The rating allows the bank to ascertain a

probability of the borrowers default based on past data.

Main features of the rating tool:

Comprehensive coverage of parameters. Extensive data requirement. Mix of subjective and objective parameters.


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Includes trend analysis. 13 parameters are benchmarked against other players in the segment. The

tool contains the latest available audited data/ratios of other players in the

segment. The data is updated at intervals.

Captures industry outlook. Eight grade ratings broadly mapped with external credit rating agencys

ratings prevalent in India.

Special features of the web based credit rating tool

Centralised data base. Easy accessibility and faster computation of scores. Selective access to users based on the area of operation. Branches have

access to the data pertaining to their branch only, Zonal offices have

access to the data pertaining to all the branches under their control and

the Credit Department and Risk Department at Central Office have access

to all accounts.

Adequate security system and provision of audit trails for confidentiality. Maintaining of past rating records in the system for collection of

empirical data on rating migrations. This will enable the bank to arrive at

PDs (Probability of Default) factor.

Rating is the process by which an alphabetic or numerical rating is assigned to a

credit facility extended by a bank to a borrower based on a detailed analysis of

his character and matching it with the characteristics of facility that is extended

to him. The rating carried out by a bank is very much similar to the credit rating

carried out by external rating agencies such as CRISIL, ICRA, etc. The only

difference is that while the rating by the external agency is available in the

public domain for anyone to use, the internal ratings carried out by a bank is

confidential and is used for specific purpose only. Moreover, the internal ratings


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of banks are usually finer than the ratings of rating agencies. This is to facilitate

better distinction between credit qualities and pricing of loan in an accurate

manner. The rating scale used by CRISIL for long-term instruments such asdebentures issued by corporate.

Table-1- Long term rating scale by CRISIL

Rating Description

CRISIL AAA

(Highest Safety)

Instruments with this rating are considered to have the

highest degree of safety regarding timely servicing of

financial obligations. Such instruments carry lowest credit

risk.

CRISIL AA(High Safety) Instruments with this rating are considered to have highdegree of safety regarding timely servicing of financial

obligations. Such instruments carry very low credit risk

CRISIL A

(Adequate Safety)

Instruments with this rating are considered to have adequate

degree of safety regarding timely servicing of financial

obligations. Such instruments carry low credit risk.

CRISIL BBB

(Moderate Safety)

Instruments with this rating are considered to have

moderate degree of safety regarding timely servicing of

financial obligations. Such instruments carry moderate

credit risk.

CRISIL BB

(Moderate Risk)

Instruments with this rating are considered to have

moderate risk of default regarding timely servicing of

financial obligations

CRISIL B

(High Risk)

Instruments with this rating are considered to have high risk

of default regarding timely servicing of financial

obligations.

CRISIL C

(Very High Risk)

Instruments with this rating are considered to have very

high risk of default regarding timely servicing of financial

obligations.

CRISIL DDefault

Instruments with this rating are in default or are expected tobe in default soon


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Market Risk Management:

raditionally, credit risk management was the primary challenge for banks.

With progressive deregulation, market risk arising from adverse changes

in market variables, such as interest rate, foreign exchange rate, equity price and

commodity price has become relatively more important. Even a small change in

market variables causes substantial changes in income and economic value of

banks. Market risk takes the form of:

1. Liquidity Risk,2. Interest Rate Risk,3. Foreign Exchange Rate (Forex) Risk,4. Commodity Price Risk, and5. Equity Price Risk.

MARKET RISK MANAGEMENT

Management of market risk should be the major concern of top management of

banks. The Boards should clearly articulate market risk management policies,

procedures, prudential risk limits, review mechanisms and reporting and

auditing systems. The policies should address the banks exposure on a

consolidated basis and clearly articulate the risk measurement systems that

capture all material sources of market risk and assess the effects on the bank.

The operating prudential limits and the accountability of the line managementshould also be clearly defined. The Asset-Liability Management Committee

(ALCO) should function as the top operational unit for managing the balance

sheet within the performance/risk parameters laid down by the Board. The

banks should also set up an independent Middle Office to track the magnitude

of market risk on a real time basis. The Middle Office should comprise of

experts in market risk management, economists, statisticians and general

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bankers and may be functionally placed directly under the ALCO. The Middle

Office should also be separated from Treasury Department and should not be

involved in the day to day management of Treasury. The Middle Office shouldapprise the top management / ALCO / Treasury about adherence to prudential /

risk parameters and also aggregate the total market risk exposures assumed by

the bank at any point of time.

Liquidity Risk Management

iquidity Planning is an important facet of risk management framework in

banks. Liquidity is the ability to efficiently accommodate deposit and

other liability decreases, as well as, fund loan portfolio growth and the possible

funding of off-balance sheet claims. A bank has adequate liquidity when

sufficient funds can be raised, either by increasing liabilities or converting

assets, promptly and at a reasonable cost. It encompasses the potential sale of

liquid assets and borrowings from money, capital and forex markets. Thus,

liquidity should be considered as a defense mechanism from losses on fire sale

of assets.

The liquidity risk of banks arises from funding of long-term assets by short-term

liabilities, thereby making the liabilities subject to rollover or refinancing risk.

The liquidity risk in banks manifest in different dimensions:

Funding Risk need to replace net outflows due to unanticipatedwithdrawal/non-renewal of deposits (wholesale and retail);

Time Risk need to compensate for non-receipt of expected inflows offunds, i.e. performing assets turning into non-performing assets; and

Call Risk due to crystallisation of contingent liabilities and unable toundertake profitable business opportunities when desirable.

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The first step towards liquidity management is to put in place an effective

liquidity management policy, which, inter alia, should spell out the funding

strategies, liquidity planning under alternative scenarios, prudential limits,liquidity reporting /reviewing, etc. Liquidity measurement is quite a difficult

task and can be measured through stock or cash flow approaches. The key

ratios, adopted across the banking system are Loans to Total Assets, Loans to

Core Deposits, Large Liabilities (minus) Temporary Investments to Earning

Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan

Losses/Net Loans, etc. While the liquidity ratios are the ideal indicator of

liquidity of banks operating in developed financial markets, the ratios do not

reveal the intrinsic liquidity profile of Indian banks which are operating

generally in an illiquid market. Experiences show that assets commonly

considered as liquid like Government securities, other money market

instruments, etc. have limited liquidity as the market and players are

unidirectional. Thus, 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 format

prescribed by RBI in this regard under ALM System should be adopted for

measuring cash flow mismatches at different time bands. The cash flows should

be placed in different time bands based on projected future behaviour of assets,

liabilities and off-balance sheet items. In other words, banks should have to

analyse the behavioural maturity profile of various components of on / off-

balance sheet items on the basis of assumptions and trend analysis supported by

time series analysis. Banks should also undertake variance analysis, at least,

once in six months to validate the assumptions. The assumptions should be fine-

tuned over a period which facilitate near reality predictions about future

behaviour of on / off-balance sheet items. Apart from the above cash flows,


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banks should also track the impact of prepayments of loans, premature closure

of deposits and exercise of options built in certain instruments which offer

put/call options after specified times. Thus, cash outflows can be ranked by thedate on which liabilities fall due, the earliest date a liability holder could

exercise an early repayment option or the earliest date contingencies could be

crystallised.

The difference between cash inflows and outflows in each time period, the

excess or deficit of funds becomes a starting point for a measure of a bank's

future liquidity surplus or deficit, at a series of points of time. The banks should

also consider putting in place certain prudential limits as detailed below to avoid

liquidity crisis:

Cap on inter-bank borrowings, especially call borrowings. Purchased funds vis--vis liquid assets; Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Statutory

Liquidity Ratio and Loans;

Duration of liabilities and investment portfolio; Maximum Cumulative Outflows across all time bands; Commitment Ratio - track the total commitments given to

corporate/banks and other financial institutions to limit the off-balance

sheet exposure.

Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreigncurrency sources.

Banks should also evolve a system for monitoring high value deposits (other

than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities.

Further, the cash flows arising out of contingent liabilities in normal situation

and the scope for an increase in cash flows during periods of stress should also

be estimated. It is quite possible that market crisis can trigger substantial


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increase in the amount of draw downs from cash credit/overdraft accounts,

contingent liabilities like letters of credit, etc.

The liquidity profile of the banks could be analysed on a static basis, whereinthe assets and liabilities and off-balance sheet items are pegged on a particular

day and the behavioural pattern and the sensitivity of these items to changes in

market interest rates and environment are duly accounted for. The banks can

also estimate the liquidity profile on a dynamic way by giving due importance

to:

Seasonal pattern of deposits/loans;

Potential liquidity needs for meeting new loan demands, unavailed creditlimits, potential deposit losses, investment obligations, statutory

obligations, etc.

Liquidity management in a bank has essentially five important functions:

(i) It demonstrates to the market place that the bank is safe andtherefore capable of repaying its borrowings. It provides the

confidence factor.

(ii) It enables the bank to meet its prior loan commitments and thusnecessary to relationship.

(iii) It enables the bank to avoid unprofitable sale of assets (fire sale).(iv) It lowers the default risk premium the bank must pay for funds, as

a bank with strong balance sheet will be perceived by the market asbeing liquid and safe.

(v) It reduces the need to resort to borrowings from the Central bank;excessive use of Central bank liquidity by a bank will be

interpreted as consequence of imprudent liquidity management by

the bank.


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Sound liquidity management can reduce the probability of serious problems.

Importance of liquidity transcends the individual banks, since a liquidity

shortfall at a single institution can have system wide repercussions. As a resultnot only a bank need to measure its own liquidity on an ongoing basis but also

examine how funding requirements are likely to evolve under various scenarios,

including adverse conditions developed in the market.

Liquidity risk can be managed through maturity or cash flow mismatches. The

RBI has advised banks to adopt the use of a maturity ladder and calculation of

cumulative surplus / deficit of funds at selected maturity dates (timebuckets)

as a standard tool for measuring and managing net funds requirements.

The prescribed time buckets are distributed as follows:

i) 1 to 14 daysii) 15 to 28 daysiii) 29 days up to 3 monthsiv) Over 3 months and up to 6 monthsv) Over 6 months and up to 1 yearvi) Over 1 year and up to 3 yearsvii) Over 3 years and up to 5 yearsviii) Over 5 years

The outflows and inflows of cash during each time buckets are to be estimated.

Banks are required to focus on shorter maturity mismatches viz. 114 days and1528 days. Three conditions have been placed by RBI in this regard:

(a) The cumulative mismatches or running total across all time bucketsshould be monitored by establishing internal prudential limits duly

approved by the Board.


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(b) The negative gap representing mismatches during 1-14 days and 15-28days in the normal course should not exceed 20 percent of the cash

outflows in each time bucket.(c) The mismatches in each time bucket should be within the tolerance

limit / level approved by the board.

Potential areas of focus in updating the Basel Committee on Banking

Supervisions sound practice guidance in liquidity management include:

The identification and measurement of the full range of liquidity risks,including contingent liquidity risks associated with off-balance sheetvehicles;

Stress testing, including greater emphasis on market-wide stresses and thelinkage of stress tests to contingency funding plans.

The role of supervisors, including communication and cooperationbetween supervisors, in strengthening liquidity risk management

practices.

The management of intra-day liquidity risks arising from payment andsettlement obligations both domestically and across borders (working

with the Committee on Payment and Settlement Systems).

Documents

Risk Management in Banks-Chapter1