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MANAGING RISK IN FINANCIAL SECTOR

By, Saad Khan & Mahrez Mohiuddin

Money & Banking

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What is Risk?

• Generally - Danger, Hazard, Adverse impact,

• Fear of loss

• Financially-Loss of earnings/capital

o May result in incapability of financial institution to meet

business goals

Money & Banking

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When it springs up?

• Arises when there is NO / LESS RETURN in

business

• Investors like Returns & dislike Risks.

• Therefore, people will invest in risky assets only

if they expect to receive higher returns.

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Loss

• Kinds of Losses

Expected – Occur with reasonable certainty

o Expected default rate of corporate loan/credit card

portfolio

Unexpected – associated with unforeseen events

o Falling interest rates being absorbed by banks,

using Capital as buffer

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How to increase returns?

• Banks must take

“Additional risks”

“Lower Risks

means

lower Returns”

Money & Banking

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.RISKS

Credit

Marketing

Liquidity

Operational

Strategic

Interest rate

Legal & Reputation

Political

Compliance

Systematic

Country

Foreign exchange

Default

Portfolio

Industry

Ownership

Audit

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Is there any global system to manage risks?

• BASEL II Accord

• Determines how much money banks must set aside for

dealing with emergencies

• Failure points –Credit, Market & Operational risks.

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Why we need strategies for Risk Management?

• Identify risks

• Assess impact

• Provide appropriate tools

• Developing methods for monitoring

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Risk Management

• Effective Risk management

i. Identifies threats

ii. Controls loss

iii. Safeguards against unauthorized use of funds

iv. Protects against injury

v. Takes appropriate actions

vi. Offers tools for financial loss

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Benefits of Risk Management

• Strategic planning

• Cost control

• Minimum losses & maximum opportunities

• Increase knowledge of understanding

• Well informed decision making

• Outside review

• Minimum disruptions

• Better utilization of resources

• Culture for continued improvement

• Quality organization

• Protect yourself, protect your organization

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FOUR MAJOR RISKSTO WHICH FINANCIAL INSTITUTIONS CAN BE EXPOSED TO:

1. Credit Risk

2. Market Risk

3. Liquidity Risk

4. Operational Risk

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Credit Risk (contract)

• “The possibility of one of the parties, to the

contract not fulfilling its obligation.”

• Arises when the obligor is unwilling to, or its

ability to perform that obligation is impaired

resulting in loss to bank.

• Any default in lending, trading, settlement &

other financial transactions result in liquidity

problem to the bank.

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Components of Credit Risk

Management

1. Board & Senior management

o Duty-to approve bank’s credit risk strategy & policies to get

implementation

2. Organizational structure

o CRMC (Credit Risk Management Committee) under the

CR management dept implement policies, monitoring,

approving loan limits, delegating credit approving powers,

regulatory legal compliances, risk concentration etc.

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3. Systems & Procedures

• Credit organization

o Assessment of the borrower’s industry before

new or expansion of the credit

o Purpose, source of repayment, track record,

proposed conditions & covenants, collaterals,

financial position of borrower, appropriate

sanctioning authority & repute financial position.

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•Limit setting oSize of the loan limits should be based on the credit

strength of the obligor, genuine requirement, economic

condition & institution risk tolerance, may be reviewed at

least annually.

•Credit administrationoComplete proper documentation, credit disbursement

after fulfillment of all formalities, its monitoring, timely

repayment, maintenance of file, collateral & security

documents.

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• Managing Credit risk

Credit risk rating framework – must incorporate first

Business Risk showing industry characteristics,

competitive positions & management.

Second-financial risk by showing financial position,

profitability, capital structure & cash flows of both

present and future.

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Internal Risk Rating

• Bank’s credit exposure.

• Facilitates bank in credit selection, price, tenure,

level of approving authority of loan & monitoring

provision for future loans.

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Architecture of Internal Rating System

• Point in time philosophy

• Through the cycle approach

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Operating design of rating system

• Exposures to rate

• Responsibility for grading

• Nature of rating review

• The rating process

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How to arrive at ratings?

• Borrower’s financial position

• Size

• Industry

• Position in industry

• Reliability of financial statement of borrower

• Quality of management

• Elements of transaction structure such as

covenants etc

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Rating review

• Revision & review of Risk Rating shall be done.

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Credit risk monitoring & control

• Policies are formed to relating to the:

• Roles and responsibilities for monitoring

• Assessment procedures

• Frequency of monitoring

• Examination of collaterals

• Covenants

• Frequency of sight visits

• Identification of any deterioration etc.

•

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Assessment of “Quality of Loan”

a. Financial position & Business conditions

b. Conduct of accounts

c. Loan covenants

d. Collateral valuation etc.

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RISK REVIEW

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Delegation of Authority

• Board of Directors should approve overall

lending authority to the senior management.

• Large banks – multiple credit approvers

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Managing problem credits

When loan is identified as a problem

oNegotiation & Follow up

oWorkout remedial strategies

oReview of collateral & security document

oStatus report & review

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MANAGING MARKET RISK

“The risk that an investment will not be as beneficial as

expected, due to fluctuations in rates/prices brought by

Market forces.”

On & off balance sheet position is adversely affected.

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Factors responsible for Market Risk

1. Interest rate risk

o Lending, funding, investment activities give rise to

it.

o Having effect on:

a. Net Interest Income (NII) or Net Interest Margin

(NIM)

b. Economic value perspective

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NIM Net Interest Margin

• Difference between the total interest income &

expense.

• Economic value perspective _ Present value of

Future cash flows

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2. Foreign exchange risk

• Impact of ADVERSE movement in currency

exchange rates on foreign currency position.

• Devaluation of Rupee with respect to $ will be

harmful for an Export company.

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3. Equity Price Risk

Risk to earnings/capital resulting from adverse changes in

value of equity related portfolios.

DEFINITION of 'Portfolio'

• A grouping of financial assets such as stocks, bonds and cash equivalents.

• Portfolios are held directly by investors and/or managed by financial

professionals.

EQUITY - In finance, generally - ownership in any asset after all debts

associated with that asset are paid off.

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Value at risk (VAR)

• Observation of market rates

• Prices volatility & correlation

• By VAR Models & JP Morgan’s Risk metrics

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MANAGING LIQUIDITY RISK

“Liquid assets are not sufficient enough to meet the

requirements.”

Solution – funds from market (depends on liquidity in market &

institution, as well)

• Could result in bankruptcy of the institution

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Indicators

• Negative trend in any area

• Concentration in Assets / Liabilities

• Quality compromise

• Income reduction

• Large size of OBS

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Strategy

• Senior management & Board

• ALCO (Asset & Liability Committee)

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LRMM (Liquidity Ratio

Measurement & Monitoring)

• Contingency funding plans

• Use of CFP for emergencies

• CFP (cash flow projection)– estimates inflows &

outflows

• Seasonal / cyclical cash flows

• Funding requirement

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Ratios & Limits

• Cash flow ratios and limits

• Liability concentration ratios & limits

• OBS ratios

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MANAGING OPERATIONAL

RISK (MOR)

“Risk of loss due to improper management.”

CAUSES

•Unauthorized trading

•Fraud

•Error concealment

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Operational risk management

Principles (ORMP)

• Board shall be accountable

• Board and senior management should ensure effective

ORM framework, control and reporting of key risks

• They should recognize all define categories of risks

• Policies & procedures should be aligned to the business

strategy

• All business functions shall be part of ORM framework

• Line management should establish processes for

identification, assessment, monitoring & reporting risks.

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Operational Risk Management

steps

• Code of conduct

• Delegation of

authority

• Segregation of

duties

• Audit

• Planning

• Mandatory leave

• Staff

compensation

• Recruitment &

training

• Dealing with

customers

• Complaint

handling

• Record keeping

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Contingency planning

• An alternative plan when plan A fails to work

• Referred as plan B

• To be used in case of disasters / undesirable

situations.

“A plan devised to be used if the original plan fails

to materialize or having the desired impact.”

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CONCLUSION

“We need honesty & integrity of the leading

authorities.”

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SUGGESTIONS

oBasel – II

oHuman resource to be trained accordingly to demands of today

oAll the deficiencies pointed out by Audit shall be quickly rectified &

no concealed

oReward & punishment system may be adopted

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