risk management in banks (2)

8/10/2019 Risk Management in Banks (2)

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Risk Management in Banks

Chapter 1

Introduction of Risk :

Risk managementis a systematic approach to minimizing an organization's

exposure to risk. A risk management system includes various policies,

procedures and practices that work in unison to identify analyses, evaluate,

address and monitor risk. Risk management information is used along with

other corporate information, such as feasibility, to arrive at a risk

management decision. Transferring risk to another party, lessening the

negative affect of risk and avoiding risk altogether are considered risk

management strategies. xamples of risk management practices include

purchasing insurance, installing security systems, maintaining cash

reservesand diversification. Traditional risk management works to reduce

vulnerabilities that are associated with accidents, deaths and lawsuits, among

others. !inancial risk management focuses on minimizing risks through the

use of financial tools and instruments including various trading techni"ues

and financial analysis. #any large corporations employ teams of risk

management personnel.

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Chapter 2

Introduction of risk management in bank:

Risk managementin Indian banksis 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. %n 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. &ence, 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 %ndia is

undergoing a monumental change factoring into account world events such

as the ongoing (anking )risis across the globe. %t has highlighted the needfor banks to incorporate the concept of Risk #anagement into their regular

procedures. The various aspects of increasing global competition to %ndian

(anksby !oreign banks, increasing *eregulation, introduction of innovative

products, and financial instruments as well as innovation in delivery

channels have highlighted the need for %ndian (anksto be prepared in terms

of risk management.

%ndian (ankshave been making great advancements in terms of progress in

terms of technology, "uality, "uantity as well as stability such that they have

started to expand and diversify at a rapid rate. &owever, such expansion

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

increasing lobalization and -iberalization. %n banks and other financial

institution risk plays a maor part in the earnings of a bank. &igher the risk,

higher is the return/ hence, it is most essential to maintain parity between

risk and return. &ence, management of !inancial riskincorporating a set

systematic and professional methods especially those defined by the (asel %%

norms because an essential re"uirement of banks. The more risk averse a

bank is, the safer is their )apital base.

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Chapter 3

Risk Management Framework for Indian Banks:

(anks must ensure that risk management is a custodian of overall

banking activities to mitigate the risks.

Risk management is relatively new and emerging practice as far as

%ndian banks are concerned and has been proved that it1s a mirror of efficient

corporate governance of a financial institution. lobalization and significant

competition between foreign and domestic banks, survival and optimizing

returns are very crucial for banks and financial institutions. &owever,

selecting the efficient customer and providing innovative and value addedfinancial products and services are another paramount factors. %n a volatile

and dynamic market place for achieving sustainable business growth and

shareholder1s value, it is essential to develop a link between risks and

rewards of all products and services of the bank. &ence, the banks should

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have efficient risk management framework to mitigate all internal and

external risks.

The presence of accurate measures of bankwide risk management practice

increase shareholder1s returns and allows the risktaking behavior of bank to

be more closely aligned with strategic obectives. (ankwide risk

management practice should aim to enhance the drivers of shareholder1s

value such as3

rowth

Risk adusted performance measurement

)onsistency of earnings and

4uality and transparency of management

The important steps of the efficient framework of banking concern

should ensure all risks are identified, prioritized, "uantified, controlled and

managed in order to achieve an optimal riskreward profile. This entails

ideal and dedicated coordination of risk management across the bank1s

various business units. &owever, the approach to monitoring and enforcing

the adherence of business units within the bank may vary. The factors that

influence this decision are3

The feasibility decisions of the business unit.

The regulatory re"uirements in respect of the business unit.

The cost of effective monitoring and controlling steps.

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(enefits of (ankwide risk management

Risk management is a line function that needs to be addressed by

each individual cost center and business unit. &owever, a centralized bank

wide risk management framework has certain advantages for the (ank. The

advantages are3

%mproving capital efficiency by

$. 6roviding an obective basis for allocating resources

+. Reducing expenditures on immaterial risks and

0. xploring natural hedges and portfolio effects

7upporting informed decision making by

$. 8ncovering areas of high potential adverse impact on drivers of share

value, and

+. %dentifying and exploiting areas of riskbased advantage context.

(uilding investor confidence by

$. stablishing a process to stabilize results by protecting them from

disturbances, and

+. *emonstrating proactive risk stewardship

*efine cost and profitability centers

$. 6rofitability and cost allocation on customer, product, services and

branch wide.

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Risk Management Framework

The important factors for how risks are managed in the bank and the

institution1s risk management philosophy and practice are as follows3

$. :rganizational structure of the bank and the control arrangements that are

embedded in it, such as segregation of duties and ;four eyes1 principle

+. Role of the board and board committees

0. Role of #anagement and management committees

2. #andate of the board and management committees

5. *iscussion of policies, procedures and limits/ risk monitoring/ and

internal controls for each risk

9. Role of the Risk #anagement function

. 6in pointed risk owner of each risk and reporting lines.

$?.Risk monitoring reports, their fre"uency and distribution.

Chapter 4


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!pes of Financia" risks

$@ )redit risk

+@ %nterest rate risk

0@ #arket risk

2@ )apital risk

5@ -i"uidity risk

Credit risk:

)redit risk is the risk of counter party failure in performing repayment

obligation on due date is known as credit risk. )redit risk management is a

primary challenge for all the banks. The mismanagement of credit risk may

lead to failure of the banks itself.

)redit risk is managed by credit policy or loan policy of the bank. The

bank may take preventive measures or curative measures to avoid this risk.

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)redit risk depends on external and internal factors 7udden hike in steel

and cement prices affect the builder@, stock market, foreign exchange rates

and interest rates, etc. The internal factors are bad loan policies, bad

appraisal of the borrowers and his credit worthiness, etc. The preventive

measures include checking the credit worthiness of the borrower, checking

type of security and the amount of security offered by the borrower. )urative

measures include selling the security offered by the borrower to recover the

amount of loan making the guarantor to pay the loan amount or extending

concessional measures to enable the borrower to repay the loan. )redit risk

is caused by market risk variable and thus the management of such risk

becomes a part of A-#.

Market risks:

#arket risk is the risk of adverse movement in the share price of the

bank. #anagement should have control over the market risk. #arket risk is

relatively more now because of transparency in the market, fre"uency of

transactions and superior technology.

Capita" risk:

(anks re"uire capital to protect themselves from various risks that

they undertake i.e. credit risk, li"uidity risk, interest rate risk, adverse

movement of share prices, etc. Therefore it becomes important for the

banks to understand the relevance of capital ade"uacy and manage capital

risk. (anks can manage capital risk by bringing in more capital either

through promoters or %6:.

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#i$uidit! risk3

(anks need to maintain li"uidity to meet deposit withdrawals and tofund loan demand. There could be a mismatch in the maturity of assets and

liabilities leading to li"uidity risk. The variability of loan demand and

variability of deposit determine banks li"uidity needs.

-i"uidity risk is potential inability of the banks to cope up with

declining deposits. -i"uidity risk arises when the banks do not have

ade"uate cash when it is re"uired. To manage li"uidity risk banks need tostudy customer withdrawal pattern and make provisions for the same.

For %&amp"e3 There are heavy withdrawals on the first and the last day of

the week and even on the day before and after a public holiday.

(anks need to maintain li"uid assets which can be converted into cash

"uickly to meet customer re"uirements and thereby manage li"uidity risk.

Interest rate risk3

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Risk Management (rocess:

The process of financial risk management is an ongoing

one. 7trategies need to be implemented and ref ined as the market and

re"ui rements change.

Refinements may reflect changing expectations about market rates,

changes to the business environment, or changing international political

conditions, for example. %n general, the process can be summarized as

follows3

C %dentify and prioritize key financial risks.

C *etermine an appropriate level of risk tolerance.

C %mplement risk management strategy in accordance with policy.

C #easure, report, monitor, and refine as needed.

Risk management needs to be looked at as anorganizational approach, as management of risks independently cannot have

the desired effect over the long term. This is especially necessary asrisks

result from various activities in the firm and the personnel responsible for

the activities do not always understand the risk attached to them. The steps

in risk management process are3

1) *etermining +b,ecti-es:.

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*etermination of obectives is the first step in the risk

management function. The obective may be to protect profits, or to develop

competitive advantages. The obectives of risk management need to be

decided upon by the management.

2) Identif!ing Risks :.

very organization faces different risks, based on

its business, the economic, social and political factors, the features of the

industry it operates in D like the degree of competition, the strengths and

weakness of its competitors, availability of raw material, factors internal to

the company like the competence and outlook of the management, state of

industry relations, dependence on foreign markets for inputs, sales or

finances, capabilities of its staff and other innumerable factors.

3) Risk %-a"uation:.

:nce the risks are identified, they need to be evaluated for

ascertaining their significance. The significance of a particular risk depends

upon the size of the loss that it may result in, and the probability of the

occurrence of such loss. :n the basis of these factors, the various risks

faced by the corporate need to be classified as critical risks, important

risks and notsoimportant risks. )ritical risks are those that may result in

bankruptcy of the firm. %mportant risks are those that may not result in

bankruptcy, but may cause severe financial distress.

4) *e-e"opment of po"ic!:.

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(ased on the risk tolerance level of the firm, the risk management policy

needs to be developed. The time frame of the policy should be

comparatively long, so that the policy is relatively stable. A policy

generally takes the form of a declaration as to how much risk should be

covered.

') *e-e"opment of /trateg!:.

(ased on the policy, the firm then needs to develop the strategy to be

followed for managing risk. A strategy is essentially an action plan, which

specifies the nature of risk to be managed and the timing. %t also

specifies the tools, techni"ues and instruments that can be used to manage

these risks. A strategy also deals with tax and legal problems. Another

important issue that needs to be specified by the strategy is whether

the company would try to make profits out of risk management

or would it stick to covering the existing risks.

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Importance of Risk management :

Risk management is a paramount consideration for the banking

industry, with higher proportions of banking executives percent@ see their risk organization as a critical driver for

enabling long term profitable growth/ another 2+ percent believe their risk

management capabilities are EimportantF to growth.

Almost identical numbers 2= percent@ see risk management as critical

to sustained future profitability, with another 25 percent believing it to be

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Eimportant.F These are high percentages. 6ut another way, >$ percent and >0

percent of executives, respectively, believe that the risk management

function is important or critical to growth and profitability.

The Risk *irector for an Asia 6acific bank states this importance

explicitly3

E:ur risk organization and functions were established to support and enable

our organization to achieve strategic goals such as sustainable growth and

profitability, competitive advantages and capital management. 6ut simply,

we recognize risk as a part of the strategic agenda.F

The mindset of risk management as a differentiator is also correlated with

risk mastery. Almost twothirds of #asters across the global survey 92

percent@ indicate that their risk management capabilities provide competitive

advantage to Ea great extent,F compared with only 2+ percent of the peer set.

These companies are also more likely to identify risk as a higher priority.

Chapter

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M%M% +F RI/5/:

An independent Risk #anagement department is functioning

for ffective risk management enterprise wide. Risk is managed through

following three Apex committees viz.(i) )redit Risk #anagement )ommittee )R#)@(ii) Asset and -iability #anagement )ommittee A-#)@ and(iii) :perational Risk #anagement )ommittee :R#)@

These committees work within the overall guidelines and policies

approved by the Risk #anagement )ommittee of the (oard. The (ank has

put in place various policies to manage the risk. To analyses the

risk enterprise wide and with the obective of integrating all the risks of the

(ank %ntegrated Risk #anagement 6olicy has also been put in place. The

important risk policies comprise of )redit Risk 6olicy, Asset and -iability

#anagement 6olicy, :perational Risk, #anagement 6olicy,

(usiness )ontinuity 6lanning, Ghistle (lower 6olicy and 6olicy

on )orporate overnance.

#anagement of risks begins with identification and its "uantification. %t

is only after risks are identified and measured we may decide to accept the

risk or to accept the risk at a reduced level by undertaking steps to mitigate

the risk, either fully or partially. %n addition pricing of the transaction should

be in accordance with the risk content of the transaction. &ence management

of risks may be subdivided into following five processes3

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H Risk %dentification

H Risk measurement

H Risk pricing

H Risk monitoring and control

H Risk mitigation

!urther, approach to manage risks at transaction level i.e. at branch level

where business transactions are undertaken and at aggregate level i.e., sum

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total of all transactions undertaken at all the branches differs. This is

because of risk diversification that take place at aggregate level.

-ike in case of any other business, risks in banking business would

depend upon the variability of its net cash flow at the aggregate level.

Therefore, managing variability in aggregate cash flow is e"ually important

and portfolio risks also need to be managed. Therefore, risk management in

banking business is directed at transaction level and as well as at aggregate

level.

RI/5 I*%IFICI+:

Bearly all transaction undertaken would have one or more of the maor risks

i.e.

-i"uidity risk

%nterest rate risk

#arket risk

)redit risk I

:perational risk.

Although all these risks are contracted at the transaction level, certainrisks such as li"uidity risk and interest rate risk are managed at the aggregate

or portfolio level. Risks such as credit risk, operational risk and market risk

arising from individual transactions are taken cognizance of at transaction

level as well as at the portfolio level.

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Risk identification consist of identifying various risks associated with

the risk taking at the transaction level and examining its impact on the

portfolio and capital re"uirement. As we would see later risk content of a

transaction is also instrumental in pricing the exposure as risk adusted

return is the key driving force in the management of banks.

RI/5 M%/6R%M%:

Risk management relies on "uantities measures of risk. The risk

measures seems to capture variations in earnings, market value, losses due to

default, etc.referred to as target variables@, arising out of uncertainties

associated with various risk elements. 4uantitative measures of risks can be

classified into three categories3

H (ased on sensitivity

H (ased on volatility

H (ased on down side potential

/ensiti-it!:

7ensitivity captures deviation of a target variable due to unit movement

of a single market parameter. :nly those market parameters, which drive the

value of the target variable, are relevant for the purpose. !or example,

change in market value due to$J change in interest rate would be asensitivitybased measure. :ther examples of market parameters could be

exchange rates and stock prices. The interest rate gap is the sensitivity of the

interest rate margin of the banking book. *uration is the sensitivity of

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investment portfolio or trading book. 8sually, market risk models use

sensitivities fairly widely. This measure suffers from couple of drawbacks.

!irst, it is only with reference to one market parameter and does not

consider impact of other parameters, which may also change simultaneously.

7econdly, sensitivities depend on prevailing conditions and change as

market environment changes.

7+#I#I8:

%t is possible combine sensitivity of target variables with the instability

of the underlying parameters. The volatility characterizes the stability or

instability of any random variable. %t is the common statistical measure of

dispersion around the average of any random variable such as earnings,

marktomarket values, market value, losses due to default, etc. volatility is

the standard deviation of the values of these variables. 7tandard deviation isthe s"uare root of the variance of the random variable.

%t is feasible to calculate historical volatility using any set of historical

data, whether or not they follow a normal distribution. Alternatively, implicit

volatility may also be computed using option prices, if "uoted in the market

using (lack and 7choles option pricing formula. %mplicit volatility has an

advantage as it is forward looking since option price being "uoted is also

forward looking. The calculation of historical mean and volatility re"uires

time series. *efining a time series re"uires defining the period of

observation and the fre"uency of observation.

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RI/5 (RICI:

Risk in banking transactions impact banks in two ways. !irstly,

banks have to maintain necessary capital, at least as per regulatory

re"uirements. The capital re"uired is not without costs. The cost of capital

arises from the need to pay investors in banks e"uity and internal generation

of capital necessary for business growth. ach banking transaction should be

able to generate necessary surplus to meet this costs. The pricing of

transaction must take that into account.

The actual costs incurred are cost of funds that has gone into the

transactions and costs incurred in giving the services, which are incurred by

way of maintaining the infrastructure, employees and other relevant

expenses. 6ricing, therefore, should take into account the following3

C )ost of *eployable funds

C :perating xpenses

C -oss probabilities

C )apital charge

%t should also be mention here that cost of funds should correspond to

the term for which it is deployed. This is because five year funds may have a

different cost than one year fund due to time value of money.

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RI/5 MIII+:

7ince risk arises from uncertainties1 associated with the risk elements,

risk reduction is achieved by adopting strategies that eliminate or reduce the

uncertainties1 associated with the risk elements. This is called 1R%7K

#%T%AT%:B1.

%n banking we come across a variety of financial instruments and

number of techni"ues that can be used to mitigate risks. The techni"ues to

mitigate the different types of risk are different. !or mitigating credit risk

banks have been using traditional techni"ues such as collateralizations by

first priority claims with cash or securities or landed properties, third party

guarantees etc. (anks may buy credit derivatives to offset various forms of

credit risk. !or mitigating interest rate risk bank use interest rates swaps,

forward rate agreements or financial future. 7imilarly, for mitigating forex

risks banks use forex forward contract, forex options or futures and for

mitigating e"uity price risk, e"uity options.

Risk mitigation measures aim to reduce downside variability in netcash flow but it also reduces upside potential simultaneously. %n fact, risk

mitigation measures reduce the variability in net cash flow. %n addition, risk

mitigation would involve counter party and it will always be associated with

counter party risk. %t may also may be stated here that markets have

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responded to the counter party risk bye establishing ;xchanges1 such as

stock exchange, commodity exchange, future and option exchanges.

Chapter 9

MR5% RI/5 I B5/

IR+*6CI+

#uch of the debate in recent year s concerning the management of

market risk within banks has focused on the appropriateness of socalled

LalueatRisk LaR@ models. These models are designed to estimate, for a

given trading portfolio, the maximum amount that a bank could lose over a

specific time period with a given probability. %n this way they provide a

summary measure of the risk exposure generated by a given portfolio. *raft

guidelines$ released by the Reserve (ank in August $>>9 give banks the

option subect to supervisory approval@ of using LaR models to measure

market risk on traded instruments in determining appropriate regulatory

capital charges.

LaR models can be developed to varying degrees of complexity. The

simplest approach takes as its starting point estimates of the sensitivity of

each of the components of a portfolio to small price changes for example, a

one basis point change in interest rates or a one per cent change in exchange

rates@, then assumes that market price movements follow a particular

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aspects of the products. The product programme also specifies market risk

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

- Bew products or nonstandard products may operate under a Eproduct

transaction memorandumF on a temporary basis while a full market risk

product programme is being prepared.

6roduct approved at corporate level shall provide for screening procedures.

Appropriate safe guards, product wise limit on exposure, and necessary

guidelines in risk taking. %n fact, the guidelines help in standardizing risk

content in the business undertaken at the transaction level.

1)2 RI/5 M%/6R%M%:

#arket risk management framework is heavily dependent upon

"uantitative measures of risk. The market risk measures seek to capture

variation in market value arising out of uncertainties associated with

various risk elements. These provide an obective measure of market risk ina transaction or of a portfolio. #arket risk measures are based on

7ensitivity

*ownside potential

- /ensiti-it!:

7upplydemand position, interest rate, market li"uidity, inflation,

exchange rate, stock prices etc.., are the market parameters, which drive

market value .sensitivity is measured as change in market value due to unit

change in the variables.

- Basis point -a"ue B(7;

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This is the change in value due to $ basis ?.?$J@ change in market

yield. This is used as a measure of risk. The higher the (6L is "uite simple.

- *uration :

This is e"uivalent to time, on average, that the holder of the bond must

wait to receive the cash flows. %n other words this represents cash flow

Ecentre of gravityF. %t implies that if a five year 9J bond face value of Rs

$?? with semiannual interest has #c)auley1s duration say 0.< years, then

total cash flow to be received Rs $0? at the end of 0.< years as a bullet

payment.

- *ownside potentia" :

Risk materializes only when earnings deviate adversely. *ownside

potential only captures possible losses ignoring profit potential. *ownside

risk is the most comprehensive measures of risk as it integrates sensitivity

and volatility with the adverse effect of uncertainty. This is the measure that

is most relied upon by banking and financial service industry as also the

regulators.

1)3 RI/5 M+I+RI * C+R+#:

Risk monitoring I control calls for implementation of risk and

business policies simultaneously. %t consist of setting market risk limits or

controlling market risk, based on economic measures of risk while ensuring

best risk adusted return. )ontrolling market risk means keeping thevariation of the value of a given portfolio within given boundary values

through actions on limits which are upper bounds imposed on risks. This is

achieved through the following3

$. 6olicy guideline limiting roles I authority.

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+. limits structure and approval process.

0. *efined policy for mark to market.

2. -imit monitoring and reporting.

5. 6erformance measurement and resource allocation

Role of risk measurement in controlling and monitoring involves setting up

of limits and triggers and monitoring them. Risk position should also be

reported to designated authority.

1)4 RI/5 MIII+ :

#arket risk arises due to volatility of financial instruments. The

volatility of financial instruments is instrumental for both profits and risk.

Risk mitigation in market risk i.e. reduction in market risk is achieved by

adopting strategies that eliminate or reduce the volatility of the portfolio.

&owever, there are couples of issues that are also associated with risk

mitigation measures.

-Risk mitigation measures aim to reduce downside variability in net cash

flow but it also reduces upside potential or profit potential simultaneously.

- %n addition, risk mitigation strategies, which involve counter party will

always be associated with counterparty risk. :f course, where counterparty

is an established ;exchange1, counterparty risk gets reduced very

substantially. %n :T) deals, counterparty risk would depend upon the risk

level associated with party to the contract.

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Chapter


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1 M%M% +F +(%RI+# RI/5

1)1 RI/5 M+I+RI ? C+R+# (RIC%/

Risk monitoring and control practices encompass the following3

)ollection of operational risk data incident reporting framework@

Regular monitoring and feedback mechanism in place for monitoring

any deterioration in operational risk profile.

)ollation of incident reporting data to assess fre"uency and

probability of occurrence of operational risk events.

#onitoring and controlling of management of large exposures. The

modalities to be prescribed in the loan policy documents.

2?

:perationalRisk

(usiness6rocesses

6eople

)onstant)hange

)ontrol7ystems

%T7 7ystems

(usiness7trategy

(usinessnvironment


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1)2 +(%RI+# RI/5 MIII+

The mitigation of operational risk basically lies in the "ualitative approach

in operational risk framework adopted and its implementation.

%nsurance cover, where available, may provide mitigation of risk. )apital

allowance under insurance is available only where A#A has adopted

estimating capital for operational risk and is subect to certain conditions.

E8nder the A#A, a bank will be allowed to recognize the risk mitigation

impact of insurance in the measures of operational risk used for regulatory

minimum capital re"uirements. The recognition of insurance mitigation will

be limited to +?J of the total operational risk capital charge calculated

under the A#A. A bank1s ability to take advantage of such risk mitigation

will depend on compliance with the few criteriaF.

Chapter 12

F+R%I %@CA% RI/5

Foreign %&changeRisk maybe 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 positioneither 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 positions. ven in cases wherespot 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 premiaNdiscounts of

the currencies concerned.

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%n the forex business, banks also face the risk of default of the

counterparties or settlement risk. Ghile such type of risk crystallisation

does not cause principal loss, banks may have to undertake fresh

transactions in the cashNspot market for replacing the failed transactions.

Thus, banks may incur replacement cost, which depends upon the currency

rate movements. (anks also face another risk called timezone risk or

&erstatt risk which arises out of timelags in settlement of one currency in

one centre and the settlement of another currency in another timezone. 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 are3

Bature and magnitude of exchange risk

The strategy to be adopted for hedging or managing exchange risk.

The tools of managing exchange risk.

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ature and Magnitude of Risk

The first aspect of management of foreign exchange risk is to

acknowledge that such risk does exist and that it must be managed to avoid

adverse financial conse"uences. #any 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. &owever not recognising a

risk would not make it go away. Bor is the inability to measure risk any

excuse for not managing it. &aving 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 tocalculate 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

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between the currency in which cash flows are denominatedand the currency

that determinesthe size of the cash flows.

For e&amp"e.A borrower selling ewellery in urope may keep its records

in Rupees, invoice in uros, and collect uro cash flow, only to find that its

revenue stream behaves as if it were in 8.7. dollarsP This occurs because

uroprices for the exports might adust to reflect world market prices which

could be determined in 8.7. dollars.

!or 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 financialassetsNliabilities are denominated in a currency. A bank1s future cash streams

are more predictable than those of a nonfinancial firm. %ts net exposure, or

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

%n 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. %f there is free and unrestricted mobility of

capital, the interest differential between two currencies will e"ual the

forward premiumNdiscount for either of the currency. This relationship must

hold under the assumptions/ otherwise arbitrage opportunities will arise to

restore the relationship. &owever, 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 *ollar premium against the Rupee,it also is a factor of forward demand N supply factors. This brings in typical

complications to forward hedging which must be taken into account.

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!rom 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 not as deterministic as

the covered interest parity, but needs to be recognised to manage forex

exposure because they are the theoretical tools used for predicting exchange

rate movements, essential to any hedging strategy particularly to economic

risk as opposed to accounting risk. The most important of these is the

6urchasing 6ower 6arity relationship which says exchange rate changes are

determined by inflation differentials. The 8ncovered %nterest 6arity theory

says that the forward exchange rate is the best and unbiased predictor of

future spot rates under risk neutrality. These relationships have to be clearly

understood for any meaningful forex risk management process.

Managing Foreign %&change Risk

!or a bank therefore the first maor decision on forex risk

management is for the management to fix its open foreign exchange position

limits. Although typically this is a management decision, it could also be

subect to regulatory capital and could also be re"uired to be in tune with the

regulatory environment that prevails. These open position limits have two

aspects, the *a!"ight "imit and the +-ernight "imit. The daylight limit

could typically be substantially higher for two reasons, a@ %t is easier to

manage exchange risk when the market is open and the bank is actively

present in the market and b@ the bank needs a higher limit to accommodate

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of trading arising from open positions, credit risks, and operations risks. The

bank must also keep in place a system to independently evaluate through

marking to market the net positions taken. #arking to market should ideally

be based on obective market prices provided by an external agency. All

position limits should be made explicit and expressed in simple terms for

easy control.

Chapter 13

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Current state of Risk management practices in

Indian banks:.

#ost of the banks do not have dedicated risk management

team, policy, procedures and framework in place. Those banks have risk

management department, the risk manager1s role is restricted to prefect and

post fact analysis of customer1s credit and there is no segregation of credit,

market, operational and strategic risks. There are few banks have articulated

framework and risk "uantification. &owever, the outputs are far formatting

the stressed or actual losses due to usage of uncompatible implications.

The traditional lending practices, assessment of credits, handling of

market risks, treasury functionality and culture of riskrewards are hauls of

public sector banks.

The sheer size and wide coverage of banks is a big hurdle to

integrate and generate a cost effective real time operational data for mappingthe risks. #ost of the financial institutions processes are encircled to

;functional silos1 follows bureaucratic structure and yet to come up with a

transparent and appropriate corporate governance structure to achieve the

stated strategic good artivle

Chapter 14

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Risk Management in Future

The bank of the future will be recognized around a new vision. To

succeed, it will have to be able to respond to opportunities as they present

themselves. And it will have to strive to improve the portfolio management

of its balance sheet and capital.

To manage conflicting obectives, it will need to determine a number

of policy variables such as a target riskadusted rate of returns RAR:)@,

target regulatory return, target tier $ ratio, target li"uidity, and so on.

%n turn, this will mean transforming the risk management function. Risk

management will need to encompass limit management, risk analysis,

RAR:), and active portfolio management of risk A6#R@. These changes

in the risk management will be induced by3

$. Advances in technology

+. %ntroduction of more sophisticated regulatory measures0. Rapidly accelerating market forces

2. )omplex legal environment

Chapter 1'

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C/% /6*8:

ICICI Bank-

Risk management is a key focus area at ICICI Bank

Risk management is a key focus area at %)%)% (ank and viewed as a

strategic tool for competitive advantage. %n the %ndian context %)%)% (ank

has been doing pioneering work in this area since $>>9, when a specialized

risk management group was set up within the (ank.

R)A is a centralized group based at #umbai with theresponsibility of enterprise wide risk management. R)A is headed by a

senior executive of the rank of eneral #anager who reports to the

xecutive *irector )orporate )entre@. The philosophy at %)%)% (ank is to

have a separate risk management group independent of the business group@

whose mandate is to analyses, measure, and monitor and manage risks. Risk

management is done under the overall supervision of the (oard of *irectors

and sub committees of the (oard Risk )ommittee, )redit )ommittee and

Audit )ommittee.

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RC is comprised of si& groups

Corporate Credit Risk

Retai" Risk

Market Risk

Credit (o"icies ?

Comp"iance

Risk na"!tics and

Interna" udit

Corporate Credit Riskroup carries out analysis of various industries

and does a credit rating of each borrowerN transaction in the portfolio.

The group has evolved risk analysis and rating methodologies suitable for

various industriesN products, including structured finance products. These

methodologies have been developed through a combination of rigorous

internal analysis and extensive interaction with domestic and

international rating agencies. ach analyst in the group tracks a few

industries and the prospects of the companies within that industry. very

proposal has to be rated by the )redit Risk roup prior to sanction. The

(ank's portfolio is fully rated internally and risk based pricing

methodology for credit products has been implemented, which is asignificant achievement in the emerging markets context.

The retai" portfo"ioof the (ank comprises a wide range of products

including auto loans, housing loans, construction e"uipment, commercial

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vehicles, two wheelers, credit cards etc. Retail Risk roup is responsible

for approving all product policies and monitoring the performance of the

retail portfolio. Approval of this group is mandatory before any product

policy is referred to the management. Analysis of the portfolio is done on

a regular basis across products, geographic locations etc.

Market riskgroup analyses the interest rate risk, li"uidity risk, foreign

exchange risk and commodity risk. )ontemporary tools such as gap

analysis, duration, convexity and Lalue at Risk LAR@ are used to

manage market risks. This group also works on limit setting andmonitoring adherence to the limits.

Credit (o"icies ? Comp"ianceroup is responsible for design and

review of all credit policies, ensuring regulatory compliance in all

activities of the (ank and coordinating the inspections of Reserve (ank

of %ndia.

Risk na"!ticsroup provides the "uantitative analysis and modeling

support for risk management. This group is working on areas such as

analysis of default rates, loss rates/ risk based pricing, economic capital

allocation and portfolio modeling. The group consists of analysts with a

strong academic background and work experience in "uantitative

analysis.

Interna" uditis responsible for managing :perational risk, which is an

area of significant importance in a large, growing organization with

multiple products such as %)%)% (ank. Gith the growth of retail business

and introduction of technology based products, the challenges on this

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group have increased. The %nternal Audit roup has developed a

sophisticated methodology for conducting risk based audit, is e"uipped to

handle %7 Audit and has obtained %7: >??$ certification.

%)%)% bank is at the forefront of evolving and implementing risk

management concepts in the %ndian context. There is a constant endeavor

towards further improvement and benchmarking with international best

practices. The bank focuses on providing training, learning opportunities

to facilitate the move towards implementation of global best practices in

risk management. The analysts from R)A undergo training provided by

renowned experts within %ndia as well as overseas. R)A regularly

deputes analysts to specialized seminars and facilitates networking with

international risk management experts in rating agencies, banks etc.

The desired key attributes for analysts in R)A are strong conceptual

knowledge, ability to identify and analyze key issues, spot trends and

interlink ages between issues, take a logical, independent position under

pressure and communication skills.

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Chapter 10

Conc"usion: Risk is an opportunity as well as a threat and has different

meanings for different users. The banking industry is exposed to different

risks such as forex volatility risk, variable interest rate risk, market play risk,

operational risks, credit risk etc. which can adversely affect its profitability

and financial health.

Risk management has thus emerged as a new and challenging area

in banking. (asel %% intended to improve safety and soundness of the

financial system by placing increased emphasis on bank's own internal

control and risk management process and models. The supervisory review

and market discipline. %ndeed, to enable the calculation of capital

re"uirements under the new accord re"uires a bank to implement a

comprehensive risk management framework. :ver a period of time, the risk

management improvements that are the intended result may be rewarded by

lower capital re"uirements.

&owever, these changes will also have wideranging effects on a

bank's information technology systems, process, people and business,

beyond and regulatory compliance, risk management and finance function.

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Chapter 1

Recommendations:

(anks should have a strong risk management solution because they are

the backbone of the economy.

(anks should have a comprehensive risk scoring rating system that

serves as a single point indicator of diversed risk factor of a

borrowerNcounter party and for taking credit decisions in a consistentmanner.

*eregulation increased competition between players unprepared by

their past experience thereby resulting in increasing risks of the system.

Therefore, they have to be regulated strongly.

The risk rating system should be drawn up in a structured manner,

incorporating, financial analysis, proection and sensitivity, industrial

and management risks.

%ndian banks need to strengthen their risk management systems to better

deal with li"uidity risks and those arising out of offbalance sheet and

derivatives deals.

%n the coming years, banks need to strengthen their risk management

framework in view of the domestic and international developments,

particularly in emerging areas of risks.

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Bib"iograph!:

Book

Risk management by %ndian institute of banking and finance

Aay Kumar, *.6. )hatteree,

Risk management $ by Association of certified Treasury.

Risk #anagement in (anks.

%ndian !inancial 7ystems.

=ebsites:

www.rbi.org

www.idbibank.com

www.icicibank.com

www.marketingteacher.com

www.financialQedu.com

/earch %ngines:

59
http://www.rbi.org/http://www.idbibank.com/http://www.marketingteacher.com/http://www.rbi.org/http://www.idbibank.com/http://www.marketingteacher.com/


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