RISK MANAGEMENT-

MODULE B

MARKET RISK

The risk that the value of “on” or “off” balance sheet positions will be adversely affected by movements in equity, interest rate markets, currency exchange rates and commodity prices.

A L M CONCEPT

• The fundamental objectives of ALM are to maximise Net Interest Income (NII) or Net Interest Margin (NIM) and Market Value of Equity (MVE)

A L M CONCEPT

• Earnings Perspective involves analysing the impact of changes on earnings in near term.

• Economic Value Perspective involves analysing the impact of interest on expected cash flows from assets minus expected cash flows from liabilities in long term and its impact on equity or net worth of the bank.

FOREIGN EXCHANGE RISK

The risk that the BANK may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two in an individual foreign currency.

LIQUIDITY RISK

• Ability of an organisation to meet its commitments as and when they fall due.

• Liquidity needs can be met by– Creation/assumption of fresh liability - Liability

management.– Conversion of an existing asset - Asset

management.

MEASUREMENT OF LIQUIDITY RISK

• Stock approach

- fixing Balance Sheet ratios

• Flow approach

- Liquidity Ladder or Gap Method

STOCK APPROACH• Volatile Liability Dependence Ratio

Volatile Liabilities minus Temporary Investments to Earning Assets net of Temporary investments

• Shows the extent to which bank’s reliance on volatile funds to support LT assets

• Growth in Core Deposits to growth in assets Higher the ratio the better• Purchased Funds to Total Assets• Loan losses to Net Loans

LIQUIDITY PARAMETERS• Cap on daily Call Lending

– Allowed to lend maximum 50 % of Capital funds on any given day during the fortnight.

• Cap on average Call Lending on a fortnightly basis– Average basis not to exceed 25 % of capital funds.

• Cap on Daily Borrowing– Allowed to borrow upto 125 % of capital funds on any

day during the fortnight.

• Cap on average Borrowing– Average basis not to exceed 100 % of capital funds

LIQUIDITY PARAMETERS• Cap on Purchased funds

– Gross borrowings from Banks, RBI and other FI including Certificate of Deposits and Institutional deposit should not exceed 25 % of Cash, balances with Banks, lending in call money market and total investments.

• Cap on Gross Credit to Core Deposit.– Gross credit should not exceed 85 % of the core deposits

(total deposits less interbank deposits and bulk deposits of Rs. 10 cr and above.)

• Cap on Gross Credit to Total Assets.– Maximum total credit to total assets will be 65 %.

INTEREST RATE RISK

• Basle committee:– Interest rate risk is the exposure of a bank's

financial condition to adverse movements in interest rates.

• Changes in Interest rates is a threat to:– Earnings– Capital base

INTEREST RATE RISKS

• Repricing Risk.

• Basis Risk.

• Yield Curve Risk.

• Embedded Option risk.

REPRICING RISK

• Arises on account of mismatches in rates• Can be measured by the measure of risk

in different time buckets• Information needed

– Balance sheet -on & off on a particular day– Business plan & expected income/ exp.

ignored– Static vs Dynamic

BASIS RISK

• Interest rates on assets and liabilities do not change in the same proportion.

• When Bank Rate was raised by 2%, PLR was raised by 1% and deposit rates by 1.5%

• Interest rates movement is based on market perception of risk and also market imperfections.

• Therefore, basis risk arises when interest rates of different assets and liabilities change in different magnitudes.

YIELD CURVE RISK

• Even if interest rates on liabilities and assets are of floating nature, there is danger of Interest Rate Risk

• If the floating rates are based on different benchmarks for assets and liabilities

• Bank prices its liabilities linked to 100 bp above 91-day TREASURY BILLS and assets to 300 bp above 364-day TREASURY BILLS

YIELD CURVE RISK

• Assume funding a 2 year loan through a 91 day deposit -

• Deposit interest related to 100 basis points over 91 day T-bill

• Loan was priced 300 basis points above 364 days T-bill resetting quarterly

• If the Yield Curve is flat NII is 200 basis points

YIELD CURVE RISK - contd..

EMBEDDED OPTION RISK

• Pre-payment of loans in a falling interest rate scenario ( for contracting new loan at low rate )

• Premature withdrawal of deposits in rising interest rate scenario ( for reinvestment at higher rate )

• In either case, bank will receive lower than anticipated NII

MEASUREMENT OF IRR

• Maturity Gap Analysis – to measure interest rate sensitivity of earnings or NII

• Duration Gap Analysis – to measure interest rate sensitivity of equity

• Simulation• Value at Risk

MATURITY GAP ANALYSIS

• A maturity/repricing schedule –distribute all interest sensitive assets & liabilities into time bands.

• Time bands – Related to maturities-if fixed interest– Related to next repricing- if floating interest

• Relative differences in each time band – represents the sensitivity in that band.

IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NIICOL1 COL2 COL3 COL4 COL5

Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR0.25 % DECREASE

1- 14 DAYS 18785.27 15920.09 -2865.18 7.1615 - 28 DAYS 31772.55 31161.34 -611.21 1.5329 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78)3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61)6-ONE YEAR 101260.22 98917.23 -2342.99 5.86ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.993-5 YEARS 114558.21 124538.91 9980.7 (-24.95)ABOVE 5 YRS 134964.33 137905.36 2941.03 -7.35

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