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CERTIFICATE

Certified that the research project MARKET RISK MANAGEMENT IN

BANKS Done by GURPREET SINGH during the period of his study under

my guidance, and that the research project has not previously the basis for

the award of any degree, diploma, associate ship , fellowship or similar this

titles and that it is independent work done by his. It may beset for

evaluation.

Date Dr.M.S. Kanchi

Place

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CONTENTS

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CONTENTS

Chapter no. Chapter name

Declaration

Certificate

Acknowledgement

Preface

Executive summary

Chapter 1 Introduction

Indian Banking System

Risk Management

Chapter 2 Review of literature

Chapter 3 Research methodology

Objectives of study

Research design

Collection of data

Limitations of study

Chapter 4 Analysis & interpretationChapter 5 Findings & suggestion

BIBLIOGRAPHY

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Complementing the roles of the nationalized and private banks are the specialized

financial institutions or Non Banking Financial Institutions (NBFCs). With their focused

portfolio of products and services, these Non Banking Financial Institutions act as an

important catalyst in contributing to the overall growth of the financial services sector.

NBFCs offer loans for working capital requirements; facilitate mergers and acquisitions,

IPO finance, etc. apart from financial consultancy services. Trends are now changing as

banks (both public and private) has now started focusing on NBFC domains like long and

medium-term finance, working cap requirements. IPO financing to etc. to meet the

multifarious needs of the business community.

Nationalized banks are banks on which government has its ownership. These banks are

controlled and regulated by government. The government of India nationalized 14 major

banks in 1969, which has deposits of more than 50 crores. On April 15, 1980six more

banks were nationalized which has deposits of more than Rs. 200 crores. Nationalization

has increased public confidence in banking system. Presently there are 19 nationalized

banks excluding SBI and its associates. SBI, the biggest commercial bank stands in a

class by itself was formed on 1st July 1955 on recommendation of All India Rural Credit

Survey Committee. After then in 1950, according to SBI act, following banks were

declared as subsidiary banks of SBI.

RISK MANAGEMENT IN BANKS

Jonathan Charkhan in Guidance for the Directors of Banks (2003) issued by the Global

Corporate Governance Forum defined risk management as under:

Risk management is the systematic process for identifying the risks the business

faces; evaluating them according to the likelihood of their occurring and the damage that

could ensue; deciding whether to bear, avoid, control or insure against them (or any

combination of these four); allocating responsibility for dealing with them; ensuring that

the process actually works and reporting material problems as quickly as possible to the

right level.

The operation of a bank or financial institution inevitably means facing risks of

many kinds. The board will know that handling risks of any kind will start with a

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systematic analysis of the two elements of materiality: probability and impact. Probability

is likelihood of the event occurring, and impact is the damage that might be caused if it

did.

There are major three types of risks that banks manage viz. credit risk, market risk

and operational risk.

Credit Risk Management

Credit risk is the most fundamental of all the risks faced by a bank. The lender always

faces the risk of counterparty not repaying the loan or not making due payment in time.

Banks are in the business of taking credit risk in exchange for a certain return above the

risk-free rate. This is mainly due to Portfolio Risk and Transaction Risk. Transaction

Risk arises from fraud, error and inability to deliver products and services. Itencompasses product development and delivery, transaction processing, system

management, complexity of products and internal control environment.

Market Risk Management

Market Risk may be defined as the possibility of loss to a bank caused by changes in

the market variables. The Bank for Internal 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 banks 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 banks ability to meet its obligation as and when they fall due. In other words, it

should be ensured that the bank is not exposed to Liquidity Risk. This Guidance Note

would, 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, liquidity risk.

Interest Rate Risk: Refers to exposure of the banks earnings or economic value of

assets, liabilities and off-Balance sheet instruments to adverse movement in interest rates.

Forex Risk: Arisesfrom conversion of Banks financial statements from one currency to

another.

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Liquidity Risk: Arises from inability of bank to accommodate decrease in liabilities or

to fund increase in assets.

Commodity Price Risk: Arises due change in commodity price and positions in the

market.

Equity Price Risk: Arises due to change in prices of equity.

Operational Risk Management

Operational Risk results from inadequate or failed internal processes, people and system

or from external events. Of three major types of risks, operational risk is least developed

as the conceptual framework and database is still in its infancy. As such, management of

operational risk poses a major challenge for the banks. However the process is likely to

gather momentum in view of phenomenal increase in the volume of transactions, highdegree of structural changes and complex support systems. Capital requirement for

operational risk under Basel II capital adequacy norms will accelerate the process.

Measuring operational risk requires both estimating the probability of an operational risk

requires both estimating the probability of an operational loss event. For this purpose,

several quantitative methods are being employed on experimental basis, but the difficulty

lies in identification of the right statistical distribution that captures the severity and

frequently of the particular category of operational risk. As of present, internal control

and internal audit are the principle tools for controlling operational risk. It is categorized

into Reputational risk, IT risk, legal risk, management risk.

Reputational Risk: Arises from operational failures, failure to comply with relevant

laws, regulations and negative public opinion impacting depositors and market

confidence on the banks.

IT Risk or Technology Risk: Results from system failure, breach in system security,

programming errors, telecommunication failure, absence of disaster recovery plan,

computer related fraud etc.

Legal Risk: Arises from inadequate or incorrect legal advice or documentation resulting

in enforceable contracts or adverse judgments.

Management Risk: Arises from incompetent board or senior management and

breakdown incorporate governance.

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Chapter-2

MARKET RISK MANAGEMENT

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MARKET RISK MANAGEMENT

Market Risk may be defined as the possibility of loss to a bank caused by changes in the

market variables. The Bank for Internal 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 banks 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 banks ability to meet its obligation as and

when they fall due. This Guidance Note would, 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.

RISK MANAGEMENT PROCESS

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

marked risk, risk reporting, etc. These aspects are elaborately discussed in the ensuring

paragraphs.

1) Risk Identification

All Risk Taking Units must operate within an approved Market Risk Product Programme:

this should define procedures, limits and controls for all aspects of the product.

New products may operate under a Product Transaction Memorandum on a temporary basis

while a full Market Risk Product Programme is being prepared. At the minimum this should

include procedures, limits and controls. The final product transaction program should include

market risk measurement at an individual product and aggregate portfolio level.

2) Limits and Trigger

All trading transactions will be booked on systems capable of accurately calculating relevant

sensitivities on a daily basis: usage of Sensitivity and value at Risk limits for trading portfolios

and limits for accrual portfolios (as prescribed for ALM) must be measured daily. Where market

risk is not measured daily, Risk Taking Units must have procedures that monitor activity to

ensure that they remain within approved limits at all times.

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Mandatory market risk limits are required for Factor Sensitivities and Value at Risk for mark of

trading and appropriate limits for accrual positions including Available-for-Sale portfolios.

Requests for limits should be submitted annually for approval by the Risk Policy Committee.

The approval will take into consideration the Risk Taking Units capacity and capability to

perform within those limits evidenced by the experience of the Traders, controls and risk

management, audit ratings and trading revenues.

Approved Management Action Triggers or stop loss are required for all mark to market risk

taking activities.

Risk Taking Units are expected to apply additional, appropriate market risk limits, including

limits for basis risk, to the p0roducts involved: these should be detailed in the Market Risk

Product Programme.

3) Risk Monitoring

A rate reasonability process is required to ensure that all transactions are executed and revalued

at prevailing market rates: rates used at inception or for periodic marking to market for risk

management or accounting purposes must be independently verified.

Financial Models used for revaluations for income recognition purposes or to measure or

monitor Price Risk must be independently tested and certified.

Stress tests must be performed preferably quarterly for both trading and accrual portfolios. This

may be done when the underlying assumptions of the model/ market conditions significantly

change as decided by the Asset Liability Committee.

4) Models of analysis

Line Management must ensure that the software used in Financial Models that value positions or

measure market risk is performing appropriate calculations accurately.

The risk Policy Committee is responsible for administering the model control and certification

policy. Providing technical advice through qualified and competent personnel. It is left to the

bank to seek any independent certification.

Financial Models must be fully documented and minimum standards of documentation must

be established.

Someone other than the person who wrote the software code must perform certification of

models: testers must be competent in designing and conducting tests: records of testing must be

kept,. including details of the type of tests and their results. Assumptions contained in the

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Financial Models must be documented as part of the initial certification and reviewed annually.

Unusual parameter sourcing conventions require annual approval by the risk Policy Committee.

Any mathematical model that uses theory, formulae or numerical techniques involving more

than simple arithmetic operations must be validated to ensure that the algorithm employed is

appropriate and accurate.

Persons who are acceptable to the Risk Policy committee and independent of the area

creating the models must validate models in writing. It is left to the bank to decide on who

should validate, whether internal or external, at the discretion of the Risk Policy Committee.

Models to calculate risk measures like Sensitivities to market factor either at transaction or

portfolio level and value-at-risk should be validated independently.

Unauthorised or unintended changes should not be made to the models. These standards

should also apply to models that are run on spreadsheets until development of fully automated

processors for generating valuations and risk measurements.

The models should also be subject to model assumption review on a periodic basis. The

purpose of this review is to ensure applicability of the model over time and that the model is

valid for its original intended use. The review consists of evaluating the components of the

financial model and the underlying assumptions, if any.

5) Risk Reporting

Risk report should enhance risk communication across different levels of the bank, from the

trading desk to the CEO. In order of importance, senior management reports should:

be timely

be reasonably accurate

highlight portfolio risk concentrations

include written commentary, and

be concise.

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ORGANISATIONAL SET UP

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 management should 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.

Successful implementation of any risk management process has to emanate from the top

management in the bank with the demonstration of its strong commitment to integrate basic

operation s and strategic decision making with risk management. Ideally, the organization set up

for Market Risk Management should be as under:-

The Board of Directors

The Risk Management Committee

The Asset-Liability Management Committee (ALCO)

The ALM support group/ Market Risk Group.

1) Board of Directors

Itshould have the overall responsibility for management of risks. The Board should decide the

risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange

and equity police risks.

2) Risk Management Committee

It will be a Board level Sub Committee including CEO and heads of Credit, Market and

Operational Risk Management Committees. It will decide the policy and strategy for integrated

risk management containing various risk exposures of the bank including the market risk. The

responsibilities of Risk Management Committee with regard to market risk managementaspects include:

Setting policies and guidelines for market risk measurement, management and reporting.

Ensuring that market risk management processes (including people, systems, operations,

limits and controls) satisfy banks policy.

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ORGANISATIONAL STRUCTURE FOR RISK MANAGEMENT

BOARD OF DIRECTORS

(Decide overall risk management policy and strategy)

RISK MANAGEMENT COMMITTEE

Board Sub Committee including CEO and Heads of Credit Market and

operational Risk Management Committee

(Policy and strategy for integrated risk management)

ASSET LIABILITY

COMMITTEE

(ALCO)

Headed by CEO/CMD/ED,

including Chief of investment,

credit, Resource/Fund

Ensure adherence to the limits,

monitoring and control, articulatinginterest rate view/ funding/ transfer

ricin olic etc. and submit to

CREDIT RISK

MANAGEMENT

COMMITTEE

Credit RiskManagement

Department

(CRMD)

Credit

Administration

Department (CAD)

OPERATIONAL

RISK

MANAGEMENT

COMMITTEE

ALM SUPPORT GROUP/RISK

MANAGEMENT GROUP

MIDDLE OFFICE

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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 liquidityas the market and players are unidirectional. This 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 behavior of assets, liabilities

and off-balance sheet items. In other words, Banks should have to analyze the behavioral

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 behavior

of on / off-balance sheet items. Apart from the above cash flows, 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 the date on which liabilities fall due, the earliest date a liability holder could exercise

an early repayment option or the earliest date contingencies could be crystallized.

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 banks future liquidity surplus or deficit, at a

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series of points of time. The banks should also consider putting in place certain prudential

limits as detailed below to avoid liquidity crisis.

i) Cap on inter-bank borrowings, especially call borrowings

ii) Purchased funds vis--vis- liquid assets

iii) Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, statutory Liquidity Ratio

and loans

iv) Duration of liabilities and investment portfolio

v) Maximum Cumulative Outflows across all time bands

vi) Commitment Ratio- track the total commitments given to corporate/ banks and other financial

institutions to limit the off- balance sheet exposure:

vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency 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 increase in the amount of drawdowns from cash credit/overdraft accounts, contingent

liabilities like letters of credit etc.

The liquidity profile of the banks could be analyzed on a static basis, wherein the assets and

liabilities and off-balance sheet items are pegged on a particular day and the behavioral 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:

1) Seasonal pattern of deposits /loans:

2) Potential liquidity needs for meeting new loan demands, unvalied credit limits, potential

deposit losses, investment obligations, statutory obligations, etc.

Contingency Funding Plan

- All banks are required to produce a Contingency Funding Plan. These plans are to be approved

by ALCO, submitted annually as part of the Liquidity and Capital plan, and reviewed quarterly.

The preparation and the implementation of the plan may be entrusted to the treasury.

- Contingency funding plans are liquidity stress tests designed to quantify the likely impact of an

event on the balance sheet and the net potential cumulative gap over a 3-month period. The plan

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Foreign Currency Liquidity Management

For banks with an international presence, the treatment of assets and liabilities in multiple

currencies adds a layer of complexity to liquidity management for two reasons. First, banks

are often less well known to liability holders in foreign currency markets. Therefore, in the

event of market concerns, especially if they relate to a banks domestic operating

environment, these liability holders may not be able to distinguish rumour from fact as well

or as quickly as domestic currency customers. Second, in the event of a disturbance, a bank

may not always be able to mobilize domestic liquidity and the necessary foreign exchange

transactions in sufficient time to meet foreign currency funding requirements. These issues

are particularly important for banks with positions in currencies for which the foreign

exchange market is not highly liquid in all conditions.

Banks should, therefore, have a measurement, monitoring and control system for liquidity

positions in the major currencies in which it is active. In addition to assessing its aggregate

foreign currency liquidity needs and the acceptable mismatch in combination with its

domestic currency commitments, a bank should also undertake separate analysis of its

strategy for each currency individually.

When dealing in foreign currencies, bank is exposed to the risk that a sudden change in

foreign exchange rates or market liquidity, or both, could sharply widen the liquidity

mismatches being run. These shifts in market sentiment might result either from domestically

generated factors or from contagion effects of developments in other countries. In either

event, a bank may find that the size of its foreign currency funding gap has increased.

Moreover, foreign currency assets may be impaired, especially where borrowers have not

hedged foreign currency risk adequately. The Asian crisis of the late 1990s demonstrated the

importance of banks closely managing their foreign currency liquidity on a day- to -day.

The particular issues to be addressed in managing foreign currency liquidity will depend on

the nature of the banks business. For some banks, the use of foreign currency deposits and

short-term credit lines to fund domestic currency assets will be the main area of vulnerability,

while for others it may be the funding of foreign currency assets with domestic currency. As

with overall liquidity risk management, foreign currency liquidity should be analysed under

various scenarios, including stressful conditions.

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adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and

relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-

statistical concept such as stop loss and gross/net positions can be used.

Banking Book

The changes in market interest rates have earnings and economic value impacts on the banks

book. Thus, given the complexity and range of balance sheet products, banks should have IRR

measurement systems that assess the effects of the rate changes on both earnings and economic

value. The variety of technique ranges from simple maturity (fixed rate) and repricing (floating

rate) gaps and duration gaps to static simulation, based on current on and off balance sheet

positions, to highly sophisticated dynamic modeling techniques that incorporate assumptions on

behavioral pattern of assets, liabilities and off balance sheet items and can easily capture the full

range of exposures against basis risk, embedded option risk, yield curve risk etc.

Rigidities and remedial measures

However, there are certain rigidities at micro level of banks and also at systematic level, which

the bank the banks have to strengthen their Management Information System(MIS) and computer

processing capabilities for accurate measurement of interest rate risk in their banking books,

which impact, in short term, their net interest income (NII) or net interest margin (NIM) or

spread and in long term, the economic value of the bank.

At the systematic level, rigidities are the following:

Most of the liabilities of banks, like deposits and borrowings are on fixed interest rate

basis while their assets like loans and advances are on floating rate basis.

There is still some regulation in place on interest rates in the system, such as savings bank

deposit, export credit, refinances, etc.

There is no definite interest rate repricing dates for floating Prime Lending Rate (PL:R)

based products like loans and advances, thereby placing them in accurate time buckets for

measurement of interest rate risk difficult.

The RBI has taken a number of measures to correct the systemic rigidities, like introduction of :

Floating rate deposits,

Fixed rate lending,

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Equity Position Risk Management

Internationally banks use VaR models for management of equity position risk. The banks should

devise specific price risk structure (like sensitivity limits, VAR, stop-loss limits) and the methods

to measure liquidity of shares to mitigate equity position risk.

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FOREIGN EXCHANGE RISK MANAGEMENT

The risk inherent in running open foreign exchange positions have been heightened in recent

years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk

profile of banks balance sheets. Foreign Exchange Risk may be defined as the risk that a

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. The banks are also exposed to interest rate risk, which arises from

the maturity mismatching of foreign currency position. Even in cases where spot and forward

positions in individual currencies are balanced, the maturity pattern of forward transactions may

produce mismatches. As a result, banks may suffer losses as a result of changes in

premia/discounts of the currencies concerned.

In the forex business, banks also face the risk of default of the counterparties or settlement risk.

While such type of risk crystallization does not cause principal loss, banks may have to

undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus,

banks may incur replacement cost, which depends upon the currency rate movements. Banks

also face another risk called time-zone risk or Herstatt risk which arises out of time lags in

settlement of one currency in one center and the settlement of another currency in other time-

zone . The forex transactions with counterparties from another country also trigger sovereign or

country risk (dealt with in details in the guidance note on credit risk.).The three important issues that need to be addressed in this regard are:

Nature and magnitude of exchange risk

The strategy to be adopted for heading or managing exchange risk

The tools of managing exchange risk.

Nature and Magnitude of Risk

The first aspect of management of foreign exchange risk is to acknowledge that such risk doesexist and that it must be managed to avoid adverse financial consequences. Many banks refrain

from active management of their foreign exchange exposure because they feel that financial

forecasting is outside their field of expertise or because they find it difficult to measure currency

exposure precisely. However not recognizing a risk would not make it go away. Nor is the

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inability to measure risk any excuse for not managing it. Having recognized this fact the nature

and magnitude of such risk must now be identified.

The basic difficulty in measuring exposure comes from the fact that available accounting

information which provides the most reliable base to calculate exposure (accounting or

translation exposure) does not capture the actual risk a bank faces, which depends on its future

cash flows and their associated risk profiles (economic exposure). Also there is the distinction

between the currency in which cash flows are denominated and the currency that determines the

size of the cash flows. For instance a borrower selling jewellery in Europe may keep its records

in Rupees, invoice in Euros, and collect Euro cash flow, only to find that its revenue stream

behaves as if it were in U.S. dollars | This occurs because Euro-prices for the exports might

adjust to reflect world market prices which could be determined in U.S. dollars.

Another dimension of exchange risk involves the element of time. In the very short run, virtually

all local currency prices for goods and services (although not necessarily for financial assets)

remain unchanged after an unexpected exchange rate change. However, over a longer period of

time, price and costs respond to price changes. It is therefore necessary to determine the time

frame within which the bank can react to ( unexpected) rate changes.

For a bank, being a financial entity, it is relatively easier to gauge the nature as well as the

measure of forex risk simply because all financial assets/liabilities are denominated in a

currency. A banks future cash streams are more predictable than those of a non-financial firm.

Its net exposure, or position, completely encapsulates the measure of its exposure to forex risk.

In order to manage forex risk some forex market relationships need to be understood well. The

first and most important of these is the covered interest parity relationship. If there is free and

unrestricted mobility of capital, the interest differential between two currencies will equal the

forward premium / discount for either of the currency. This relationship must hold under the

assumptions: otherwise arbitrage opportunities will arise to restore the relationship. However, in

the case of Rupee; since it is not totally convertible, this relationship does not hold exactly.

Although interest rate differentials are the driving factor for the Dollar premium against the

Rupee, it also is a factor of forward demand/ supply factors. This brings in typical complications

to forward hedging which must be taken in to account.

From the above it can easily be determined that a currency with a lower interest rate will be at a

premium to a currency with a higher interest rate. The other relationships in the forex market are

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hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge

contingent cash flows where risk is non-linear: options may be better suited to the latter.

Foreign exchange forward contracts are the most common means of hedging transactions in

foreign currencies. However since they require future performance, and if one party is unable to

perform on the contract, the hedge disappears, bringing in replacement risk which could be high.

This default risk also means that many banks may not have access to the forward market to

adequately hedge their exchange exposure. For such situations, futures may be more suitable,

where available, since they are exchange traded and effectively minimize default risk. However,

futures are standardised and therefore may not be as versatile in terms of quantity and tenor as

over the counter forward contracts. This in turn gives rise to assumption of basis risk.

Money market borrowing to invest in interest-bearing assets to offset a foreign currency

payment-also serves the same purpose as forward contracts. This follows from the covered

interest parity principle. Since the carrying cost of a position is the same in both, the forex or the

money market hedging can also be done in either market. For instance, let us say a bank has a

short forward Dollar position. It can of course hedge the position by buying forward Dollar.

Alternatively it can borrow Rupees now, buy Dollar with the proceeds, and place the Dollars in a

forward deposit to meet the short Dollar position on maturity. The Rupees received on the sale

on maturity are used to pay off the Rupee borrowing. The cost of this money market hedge is the

difference between the Rupee interest rate paid and the US dollar interest rate earned. According

to the interest rate parity theorem, the interest differential equals the forward exchange premium,

the percentage by which the forward rate differs from the spot exchange rate. So the cost of the

money market hedge should be the same as the forward or futures market hedge.

Currency options are another tool for managing forex risk. A foreign exchange option is a

contract for future delivery of a currency in exchange for another, where the holder of the option

has the right to buy(or sell) the currency at an agreed price, the strike or exercise price, but is not

required to do so. The right to buy is a call: the right to sell, a put. For such a right he pays a

price called the option premium. The option seller receives the premium and is obliged to make

(or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the

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BCBS PRINCIPLES FOR INTEREST RATE RISK

MANAGEMENT

Board and senior management oversight of interest rate riskPrinciple 1:

In order to carry out its responsibilities, the board of directors in a bank should approve strategies

and policies with respect to interest rate risk management and ensure that senior management

takes the steps necessary to monitor and control these risks. The board of directors should be

informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring

and controlling of such risk.

Principle 2:

Senior management must ensure that the structure of the banks business and the level of interest

rate risk it assumes are effectively managed, that appropriate policies and procedures are

established to control and limit these risks, and that resources are available for evaluating and

controlling interest rate risk.

Principle 3:

Banks should clearly define the individuals and/or committees responsible for managing interest

rate risk and should ensure that there is adequate separation of duties in key elements of the risk

management process to avoid potential conflicts of interest. Banks should have risk

measurement, monitoring and control functions with clearly defined duties that are sufficiently

independent from position-taking functions of the bank and which report risk exposures directly

to senior management and the board of directors.

Adequate risk management policies and procedures

Principle 4:

It is essential that banks interest rate risk policies and procedures are clearly defined andconsistent with the nature and complexity of their activities. These policies should be applied on

a consolidated basis and, as appropriate, at the level of individual affiliates, especially when

recognizing legal distinctions and possible obstacles to cash movements among affiliates.

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Principle 5:

It is important that banks identify the risks inherent in new products and activities and ensure

these are subject to adequate procedures and controls before being introduced pr undertaken.

Risk measurement, monitoring and control functions

Principle 6:

It is essential that banks have interest rate risk measurement systems that capture all material

sources of interest rate risk and that assess the effect of interest rate changes in ways that are

consistent with the scope of their activities. The assumptions underlying the system should be

clearly understood by risk managers and bank management.

Principle 7:

Banks must establish and enforce operating limits and other practices that maintain exposures

within levels consistent with their internal policies.

Principle 8:

Banks should measure their vulnerability to loss under stressful market conditions including the

breakdown of key assumptions and consider those results when establishing and reviewing their

policies and limits for interest rate risk.

Principle 9:

Banks must have adequate information systems for measuring, monitoring, controlling andreporting interest rate exposures. Reports must be provided on a timely basis to the banks board

of directors, senior management and, where appropriate, individual business line managers.

Internal controls

Principle 10:

Banks must have an adequate system of internal controls over their interest rate risk management

process. A fundamental component of the internal control system involves regular independent

reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that

appropriate revisions or enhancements to internal controls are made. The results of such reviews

should be available to the relevant supervisory authorities.

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Information for supervisory authorities

Principle 11:

Supervisory authorities should obtain from banks sufficient and timely information with which to

evaluate their level of interest rate risk. This information should take appropriate account of therange of maturities and currencies in each banks portfolio, including off-balance sheet items, as

well as other relevant factors, Such as the distinction between trading and non-trading activities.

Capital adequacy

Principle 12:

Banks must hold capital commensurate with the level of interest rate risk they undertake.

Disclosure of interest rate risk

Principle 13:

Banks should release to the public information on the level of interest rate risk and their policies

for its management.

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SOURCES, EFFECTS AND MEASUREMENT OF INTEREST

RATE RISK

Interest rate risk is the exposure of a banks financial condition to adverse movements in interest

rates. Accepting this risk is a normal part of banking and can be an important source of

profitability and shareholder value. However, excessive interest rate risk can post a significant

threat to a banks earnings and capital base. Changes in interest rates affect a banks earnings by

changing its net interest income and the level of other interest-sensitive income and operating

expenses. Changes in interest rates also affect the underlying value of the banks assets.

Liabilities and off-balance sheet instruments because the present value of future cash flows (and

in some cases, the cash flows themselves change when interest rates change.

A. Sources of Interest Rate Risk

Repricing risk:

Asfinancial intermediaries, banks encounter interest rate risk in several ways. The primary and

most often discussed form of interest rate risk arises from timing differences in the maturity (for

fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS)

positions. While such repricing mismatches are fundamental to the business of banking, they can

expose a banks income and underlying economic value to unanticipated fluctuations as interest

rates vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit

could face a decline in both the future income arising from the position and its underlying value

if interest rates increase. These declines arise because the cash flows on the loan are fixed over

its lifetime, while the interest paid on the funding is variable, and increases after the short-term

deposit matures.

Yield curve risk:

Repricing mismatches can also expose a bank to changes in the slope and shape of the yield

curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effectson a banks income or underlying economic value. For instance, the underlying economic value

of a long position in 10- year government bonds hedged by a short position in 5- year

government notes could decline sharply if the yield curve steepens, even if the position is hedged

against parallel movements in the yield curve.

Basis risk:

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Another important source of interest rate risk (commonly referred to as basis risk) arises from

imperfect correlation in the adjustment of the rates earned and paid on different instruments with

otherwise similar repricing characteristics. When interest rates change these differences can give

rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and

OBS instruments of similar maturities or repricing frequencies.

Optionality:

An additional and increasingly important source of interest rate risk arises from the options

embedded in many bank assets, liabilities and OBS portfolios. Formally, an option provides the

holder the right, but not the obligation, to buy sell, or in some manner alter the cash flow of an

instrument or financial contract. Options may be stand alone instruments such as exchange-

traded options and over-the-counter (OTC) contracts, or they may be embedded within otherwise

standard instruments. While banks use exchange-traded and OTC options in both trading and

non-trading accounts, instruments with embedded options are generally most important in non-

trading activities. They include various types of bonds and notes with call or put provisions,

loans which give borrowers the right to prepay balances, and various types of non-maturity

deposit instruments which give depositors the right to withdraw funds at any time, often without

any penalties. If not adequately managed, the asymmetrical payoff characteristics of instrument

with optionality features can pose significant risk particularly to those who sell them, since the

options held, both explicit and embedded, are generally exercised to the advantage of the holder

and the disadvantage of the seller. Moreover, an increasing array of options can involve

significant leverage that can magnify the influences (both negative and positive) of option

positions on the financial condition of the firm.

B. Effects of Interest Rate Risk

As the discussion above suggests, changes in interest rates can have adverse effects both on a

banks earnings and its economic value. This has given rise to two separate, but complementary,

perspectives for assessing a banks interest rate risk exposure.

Earnings perspective:

In the earnings perspective, the focus of analysis is the impact of changes in interest rates on

accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken

by many banks. Variation in earnings is an important focal point for interest rate risk analysis

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because reduced earnings or outright losses can threaten the financial stability of an institution by

undermining its capital adequacy and by reducing market confidence. In this regard, the

component of earnings that has traditionally received the most attention is net interest income

(i.e. the difference between total interest in come and total interest expense). This focus reflects

both the importance of net interest income in banks overall earnings and its direct and easily

understood link to changes in interest rates. However, as banks have expanded increasingly into

activities that generate fee-based and other non-interest income, a broader focus on overall net

income incorporating both interest and non-interest income and expenses-has become more

common. The non-interest income arising from many activities, such as loan servicing and

various assets securitization programs can be highly sensitive to market interest rates. For

example, some banks provide the servicing and loan administration function for mortgage loan

pools in return for a fee based on the volume of assets it administers. When interest rates fall, the

servicing bank may experience a decline in its fee income as the underlying mortgages prepay. In

addition, even traditional sources of non-interest income such as transaction processing fees are

becoming more interest rate sensitive. This increased sensitivity has led both bank management

and supervisors to take a broader view of the potential effects of changes in market interest rates

of bank earnings and to factor these broader effects in to their estimated earnings under different

interest rate environments.

Economic value perspective:

Variation in market interest rates can also affect the economic of a banks assets, liabilities and

OBS positions. Thus ,the sensitivity of a banks economic value to fluctuations in interest rates is

a particularly important consideration of shareholders, management and supervisors alike. The

economic value of an instrument represents an assessment of the present value of its expected net

cash flows, discounted to reflect market rates. By extension, the economic value of a bank can be

viewed as the present value of banks expected net cash flows, defined as the expected cash

flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on

OBS positions. In this sense, the economic value perspective reflects one view of the sensitivity

of the net worth of the bank to fluctuations in interest rates. Since the economic value

perspective considers the potential impact of interest rate changes on the present value of all

future cash flows, it provides a more comprehensive view of the potential long-term effects of

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Duration is a measure of the percent change in the economic value of a

position that will occur given a small change in the level of interest rates.

Duration may also be defined as the weighted average of the time until expected cash flows from

a security will be received, relative to the current price of the security. The weights are thepresent values of each cash flow divided by the current price. In its simplest form, duration

measures changes in economic value resulting from a percentage change of interest rates under

the simplifying assumptions that changes in value are proportional to changes in the level of

interest rates and that the timing of payments is fixed.

Modified duration is standard duration divided by 1+r, where r is the level of

market interest rates - is an elasticity, As such, it reflects the percentage change in the

economic value of the instrument for a given percentage change in 1+r. As with simple duration,

it assumes a linear relationship between percentage changes in value and percentage changes in

interest rates.

In other words, Modified Duration = Macaulays Duration/ (1+r), where

Macaulays Duration [CFt (t)/ (1+r)/ {CFt/(1+r) to the power t

CFt= Rupee value of cash flow at time t

T= Number of periods of time until the cash flow payment

R= Periodic yield to maturity of the security generating cash flow andk= the number of cash flows

Duration reflects the timing and size of cash flows that occur before the instruments contractual

maturity. Generally, the longer the maturity or next repricing date of the instrument and the

smaller the payments that occur before maturity (e.g. coupon payments), the higher the duration

(in absolute value). Higher duration implies that a given change in the level of interest rates will

have a larger impact on economic value.

Duration-based weights can be used in combination with a maturity/repricing schedule to

provide a rough approximation of the change in a banks economic value that would occur given

a particular change in the level of market interest rates. Specifically, an average duration is

assumed for the positions that fall into each time band. The average durations are then multiplied

by an assumed change in interest rates to construct a weight for each time band. In some cases,

different weights are used for different positions that fall within a time band, reflecting broad

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VALUE AT RISK (VaR)

Definition:

VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of

assets/liabilities over a given holding period at a given level of certainty.

VaR measures risk. Risk is defined as the probability of the unexpected happening- the

probability of suffering a loss. VaR is an estimate of the loss likely to suffer, not the actual loss.

The actual loss may be different from the estimate. It measures potential loss, not potential gain.

Risk management tools measure potential loss as risk has been defined as the probability of

suffering a loss. VaR measures the probability of loss for a given time period over which the

position is held. The given time period could be one day or a few days or a few weeks or a year.

VaR will change if the holding period of the position changes. The holding period for n

instrument/ position will depend on liquidity of the instrument/ market. With the help of VaR,

we can say with varying degrees of certainty that the potential loss will not exceed a certain

amount. This means that VaR will change with different levels of certainty an instrument/

position will depend on liquidity of the instrument/ market. With the help of VaR, we can say

with varying degrees of certainty that the potential loss will not exceed a certain amount. This

means that VaR will change with different levels of certainty.

The bank for international Settlements (BIS) has accepted VaR as a measurement of

market risks and provision of capital adequacy for market risks, subject to approval by

banks supervisory authorities.

VaR Methodologies

VAR can be arrived as the expected loss on a position from the adverse movement in identified

market risk parameter(s) with a specified probability over a nominated period of time.

Volatility in financial markets is usually calculated as the standard deviation of t he percentage

change in the relevant assets price over a specified asset period . The volatility for calculation

of VaR is usually specified as the standard deviation of the percentage change in the risk factor

over the relevant risk horizon.

The following table describes the three main methodologies to calculate VaR:

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for back testing has been established, banks using internal VaR models for market risk capital

requirements must backtest their models on a regular basis. Banks should generally

backtest risk models on a monthly or quarterly basis to verify accuracy in these tests, they should

observe whether trading results fall within pre-specified confidence bands as predicted by

the VaR models. If the models perform poorly, they should probe further to find the cause (e.g.,

check integrity of position and market data, model parameters, methodology). The BIS outlines

back testing best practices in its January 1996 publication Supervisory framework for the use

of back testing in conjunction with the internal models approach to market risk capital

requirements.

Stress Testing

Stress testing has been adopted as a generic term describing various techniques used by banks

to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing

addresses the large moves in key market variables of that king that lie beyond day-to-day risk

monitoring but that could potentially occur. The process of stress testing, therefore, involves first

identifying these potential movements, including which market variables to stress, how much to

stress them by, and what time frame to run the stress analysis over. Once these market

movements and underlying assumptions are decided upon, shocks are applied to the portfolio.

Revaluing the portfolios allows one to see what the effect of a particular market movement has

on the value of the portfolio and the overall Profit and Loss.Stress test reports can be constructed that summarize the effects of different shocks of different

magnitudes. Normally, then there is some kind of reporting procedure and follow P with

traders and management to determine whether any action needs to be taken in response.

Stress Testing Techniques : Stress testing covers many different techniques. The four

discussed here are listed in the Table below along with the information typically referred to as

the result of that type of a stress test.

Stress Testing Techniques

Technique What is the Stress test result

Simple Sensitivity Test Change in portfolio value for one or more

shocks to a single risk factor

Scenario Analysis (hypothetical or historical) Change in portfolio value if the scenario were

to occur

Maximum loss Sum of individual trading units worth case

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different reasons. First, under Mertons model the firm defaults only atmaturity of the debt, a scenario that is at odds with reality. Second, for themodel to be used in valuing default-risky debts of a firm with more than oneclass of debt in its capital structure (complex capital structures), thepriority/seniority structures of various debts have to be specified. Also, this

framework assumes that the absolute-priority rules are actually adhered toupon default in that debts are paid off in the order of their seniority.However, empirical evidence, such as in Franks and Torous (1994), indicatesthat the absolute-priority rules are often violated. Moreover, the use of alognormal distribution in the basic Merton model (instead of a more fat taileddistribution) tends to overstate recovery rates in the event of default.

3. Second-generation structural-form models

In response to such difficulties, an alternative approach has been developedwhich still adopts the original Merton framework as far as the default processis concerned but, at the same time, removes one of the unrealistic

assumptions of the Merton model; namely, that default can occur only atmaturity of the debt when the firms assets are no longer sufficient to coverdebt obligations. Instead, it is assumed that default may occur anytimebetween the issuance and maturity of the debt and that default is triggeredwhen the value of the firms assets reaches a lower threshold level3. Thesemodels include Kim, Ramaswamy and Sundaresan (1993), Hull and White(1995), Nielsen, Sa-Requejo, and Santa Clara (1993), Longstaff andSchwartz (1995) and others.

Under these models, the RR in the event of default is exogenous and

independent from the firms asset value. It is generally defined as a fixedratio of the outstanding debt value and is therefore independent from thePD. For example, Longstaff and Schwartz (1995) argue that, by looking at thehistory of defaults and the recovery rates for various classes of debt ofcomparable firms, one can form a reliable estimate of the RR. In their model,they allow for a stochastic term structure of interest rates and for somecorrelation between defaults and interest rates. They find that thiscorrelation between default risk and

Using Moodys corporate bond yield data, they find that credit spreads arenegatively related to interest rates and that durations of risky bonds dependon the correlation with interest rates.the interest rate has a significant effect on the properties of the creditspread4. This approach simplifies the first class of models by bothexogenously specifying the cash flows to risky debt in the event ofbankruptcy and simplifying the bankruptcy process. The latter occurs when

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by the BD. These value-at-risk (VaR) models include J.P. MorgansCreditMetrics (Gupton, Finger and Bhatia [1997] now provided by the RiskMetrics Group), Credit Suisse Financial Products CreditRisk+ (1997),McKinseys CreditPortfolioView (Wilson, 1998), Moodys KMVsCreditPortfolioManager, and Kamakuras Risk Manager.

Credit VaR models can be gathered in two main categories:

1) Default Mode models (DM) and

2) Mark-to-Market (MTM) models. In the former, credit risk is identified withdefault risk and a binomial approach is adopted. Therefore, only two possibleevents are taken into account: default and survival. The latter includes allpossible changes of the borrower creditworthiness, technically called creditmigrations. In DM models, credit losses only arise when a default occurs. Onthe other hand, MTM models are multinomial, in that losses arise also when

negative credit migrations occur. The two approaches basically differ for theamount of data necessary to feed them: limited in the case of default modemodels, much wider in the case of mark-to-market ones.

The main output of a credit risk model is the probability density function(PDF) of the future losses on a credit portfolio. From the analysis of such aloss distribution, a financial institution can estimate both the expected lossand the unexpected loss on its credit portfolio. The expected loss equals the(unconditional) mean of the loss distribution; it represents the amount the

investor can expect to lose within a specific period of time (usually one year).On the other side, the unexpected loss represents the deviation fromexpected loss and measures the actual portfolio risk. This can in turn bemeasured as the standard deviation of the loss distribution. Such a measureis relevant only in the case of a normal distribution and is therefore hardlyuseful for credit risk measurement: indeed, the distribution of credit losses isusually highly asymmetrical and fat-tailed. This implies that the probability oflarge losses is higher than the one associated with a normal distribution.Financial institutions typically apply credit risk models to evaluate theeconomic capital necessary to face the risk associated with their creditportfolios. In such a framework, provisions for credit losses should cover

expected losses6, while economic capital is seen as a cushion forunexpected losses. Indeed, Basel II in its final iteration (BIS, June 2004)

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6 As discussed in Jones and Mingo (1998), reserves are used to coverexpected losses.7 For a comprehensive analysis of these models, see Crouhy, Galai and Mark(2000) and Gordy (2000).

separated these two types of losses.

Credit VaR models can largely be seen as reduced-form models, where theRR is typically taken as an exogenous constant parameter or a stochasticvariable independent from PD. Some of these models, such as CreditMetrics, treat the RR in the event of default as a stochastic variable generally modeled through a beta distribution - independent from the PD.Others, such as Credit Risk+, treat it as a constant parameter that must bespecified as an input for each single credit exposure. While a comprehensiveanalysis of these models goes beyond the aim of this review7, it is important

to highlight that all credit VaR models treat RR and PD as two independentvariables.

6. Recent contributions on the PD-RR relationshipand their impact

During the last several years, new approaches explicitly modeling andempirically investigating the relationship between PD and RR have beendeveloped. These models include Bakshi et al. (2001), Jokivuolle and Peura(2003). Frye (2000a and 2000b), Jarrow (2001), Hu and Perraudin (2002),

and Carey and Gordy (2003), Altman, Brady, Resti and Sironi (2001, 2003and 2005), and Acharya, Bharath and Srinivasan (2007).

Bakshi et al. (2001) enhance the reduced-form models presented in section 4to allow for a flexible correlation between the risk-free rate, the defaultprobability and the recovery rate. Based on some evidence published byrating agencies, they force recovery rates to be negatively associated withdefault probability. They find some strong support for this hypothesisthrough the analysis of a sample of BBB-rated corporate bonds: moreprecisely, their empirical results show that, on average, a 4% worsening in

the (risk-neutral) hazard rate is associated with a 1% decline in (risk-neutral)recovery rates.

A rather different approach is the one proposed by Jokivuolle and Peura(2003). The authors present a model for bank loans in which collateral valueis correlated with the PD. They use the option pricing framework for

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modeling risky debt: the borrowing firms total asset value triggers the eventof default. However, the firms asset value does not determine .

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LIMITATIONS OF THE STUDY

1) Sample size was small i.e. 10 Managers. Survey was conducted on selected banks

because it is usually impossible to include all the banks. Therefore it cannot give

the true picture.

2) Moreover due to some restrictions of the banks and also being engaged in annual

closing and inspection, restricted me to go in more detailed study.

3) The assignment being very challenging and of exhaustive in nature requires time.

It was impossible to accomplish ideally within prescribed time period of semester.

4) Efforts were made to distribute questionnaire in such a manner that study is either

of public banks or private bank but responses received were not in similar

proportion.

5) As the study is basically based on primary data, the probability of personal bias

cannot be overruled.

6) Main root of this research study was questionnaire & interview, which has its own

limitations, for example we cant measure the reliability, enthusiasm dissonance

etc.

7) As the analysis has been done manually, few error are bound to appear.

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Only manager of SBI said that they manage risk by reducing/eliminating risk otherwise all other

banks reduce risk by managing opportunity.

How often is the Risk Management Policy audited?

Table-2

How often is the Risk Management Policy audited? Frequency of Banks

Annually 8

Two yearly 2

Occasionally 0

Table 2 indicates that 80% banks audit their risk management policy annually. Amongst thebanks selected for survey, all banks except UCO Bank and Indusind Bank audit risk management

policy annually. UCO Bank and Indusind Bank audit risk management policy two yearly.

Guidelines of New Basel Capital Accord

All banks are following guidelines of New Basel Capital Accord. This helps them to deal with

risk more effectively. RBIs instructions to prepare accounting books strictly in conformance

with US GAAP standards helps to strengthen their Risk Management Process. Allahabad bank

does not use these instruction to strengthen their policy.

Committees are set up for measuring and managing risk in banks

COMMITTEES BANKS HAVING THE COMMITTEE

Risk Management Committee (RMC) all banks

Credit Policy Committee (CPC) all banks

Assets Liability Committee (ALCO) all banks

Investment Committee all banks except Indusind Bank &

Punjab National Bank

System & Procedure Committee all banks except Indusind Bank

Credit Risk Management Committee all banks except Indusind Bank

ALCO\Operational Risk Management Support Group all banks except Indusind Bank

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All the banks surveyed have a formal Contingency Funding Plan to meet the possibility of

liquidity disruption or crises.

At what interval the funding plan is submitted/reviewed by ALCO?

Monthly - PNB, Indusind Bank

Quarterly - UBI, BOB

Bi-annually - Allahabad Bank, Canara Bank

Annually - SBI, SBP, OBC, UCO

Table-9

At what interval the funding plan is

submitted/reviewed by ALCO?

Frequency of Banks

Monthly 2Quarterly 2

Bi-annually 2

Annually 4

40% banks review the funding plan annually.

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Clear segregation between Banking Book and Trading Book in banks

All the banks except Allahabad Bank have made clear segregation between banking books and

trading books.

How frequently does your bank use Derivatives as a tool of Market Risk Management?

Never - OBC, Allahabad Bank, UCO, Canara Bank

Sometimes - UBI, State Bank of Patiala, Indusind Bank, BOB

Always - SBI, PNB

Table-10

How frequently derivatives used as tool of Market

Risk Management?

Frequency of Banks

Never 4Sometimes 4

Always 2

Which category of Derivative enjoys relatively more importance in your bank?

Forwards contracts are used as tool market risk management in banks who use derivatives. SBI

& PNB uses options as well to manage risk.

Relative importance of task performed before accepting the investment proposal

Table-11

Task Performed Frequency of weightage assigned to

each ratio

Total

Score

0 1 2 3 4 5

Detailed appraisal & rating 3 3 4 41

Risk Evaluation 1 1 4 4 41

Study of Exposure 3 1 5 1 30

Quality Standards 3 1 3 3 24

Maturity Profile 3 4 2 1 31

Table 11 indicates that before accepting the investment proposal, banks do detailed appraisal and

rating and evaluate risk.

At what frequency the variations in portfolio quality are tracked?

Monthly - UBI, Indusind Bank

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Annually - Allahabad Bank, SBP, OBC, Canara Bank

Quarterly - SBI, BOB, UCO

Weekly - PNB

Table-12

At what frequency the variations in portfolio

quality are tracked?

Frequency of Banks

Monthly 2

Quarterly 3

Biannually 1

Annually 4

40% of banks track the variations in portfolio quality annually. 30% banks track quarterly, 20%

track monthly and only 10% banks track variations in portfolio quality biannually.

Approach used for calculating Capital Charge for Market Risk

There are mainly two approaches :

Model Based Approach andStandardized Approach

All the banks use standardized approach to calculate capital charge.

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Amongst the various types of market risk, banks mainly face interest rate risk and

equity price risk. All the banks included in survey except UBI, OBC and Allahabad

Bank, Canara Bank are having risk taking unit. It works as per Market Risk Product

Programme.

In State Bank of India and Oriental Bank of Commerce, independent unit is

responsible for managing market risk but in all other banks ALCO manages the

market risk.

Risk is monitored by top management committee is almost all banks.

50% of banks receive market risk report monthly. Many banks receive this report

weekly.

All the banks surveyed are having a system to measure or calculate the sensitivity

of daily trading transaction.

Extent to which all maturing assets and liabilities are renewed is most important

factor.

Loans/Total Assets is the most common ratio that is calculated for liquidity

measurement in banks.

Most of banks forecast forex risk more frequently.

All the banks use standardized approach to calculate capital charge. Before accepting the

investment proposal, banks do detailed appraisal and rating and evaluale risk.

Forwards contracts are used as tool market risk management in banks who use derivatives.

SBI & PNB uses options as well to manage risk. Till now derivatives are used by few banks

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BIBLIOGRAPHY

BOOKS

Kothari,C.R., Research Methodology, Wishwas Parkashan, New Delhi,

1990.

Reddy, K.Ramakrishna, Risk Management

JOURNALS

Risk Management in Banks in India, IBA Bulletin (July 2002)

Risk Management in Banks for improved Corporate Governance, The

Management Accountant, November, 2005

WEBSITES

www.ficci.com

www.rbi.org.in

www.pnbindia.com

www.sbiindia.com

www.business.com

risk-management.guide.for-you.com

www.domain-b.com

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