RISK MANAGEMENT

(FOR PRIVATE CIRCULATION ONLY)

2016
PROGRAMME COORDINATOR
Prof. Prashant Ubarhande

COURSE DESIGN AND REVIEW COMMITTEE

Prof. Dalip Mehra Prof. Sudhir Gijre
Prof. Arun Vartak Dr. Swati Oza
Prof. Avinash Nene Dr. N.M. Vechlekar
Dr. Ravi Chitnis Dr. Shruti Jain

COURSE WRITERS
Dalip Mehra Rajul Agarwal
Avinash Nene Avinash Tripathi

EDITOR
Ms. Kumkum Tripathi

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2012 (Revison 01, 2014)

Copyright © 2016 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.

Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
 PREFACE

Today almost all the banks in the process of financial intermediation are confronted with various
kinds of financial and non-financial risks, viz. credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputational, operational etc. These risks are highly
interdependent and events that affect one area of risk can have ramifications for a range of other risk
categories.
This course on “Risk Management” has been developed to help distance learners to analyse
why risk management is critical to banks. This course will assist them to understand how risks are
identified, quantified in terms of their impact on earnings and monitored and managed within banks.
This will help them to become better equipped to identify and quantify the bank’s vulnerability to
credit, market, liquidity, operational, regulatory and reputational risks; understand and learn best
practice procedures to monitor and manage these risks and their impact on revenues and relate these
risks to bank capital. This course has been designed to improve the learner’s ability to identify,
measure, monitor and control the overall level of risks undertaken.
We are living in a much dynamic environment; hence, distance learners must keep themselves
updated for changes occurring in bank/financial regulations.

Dalip Mehra
Rajul Agarwal
Avinash Nene
Avinash Tripathi

iii
 ABOUT THE AUTHORS

Dalip Mehra has academic qualifications of M.Sc. LL.B CAIIB, DBM. He is Ex-Deputy General
Manager, Bank of Maharashtra. He has written over 37 books on various subjects such as Banking,
Risk Management, Finance, Economics, Law and Management. Two of his books have been
recognized and awarded by Ministry of Finance and Ministry of Agriculture.
Rajul Agarwal has completed her CA from The Institute of Chartered Accountants of India. She has
also done her Diploma in Information System Audit and holds AMFI Certification. Rajul Agarwal
has over 10 years of domain knowledge and she is well acquainted with the functioning of the Indian
Accounting and Taxation system.
Avinash Nene has vast 40 years of experience. He is an alumnus of Jamnalal Bajaj Institute of Mgmt
Studies Mumbai. His qualifications are B.E. (Mech.), B.E. (Elect.), PGD in Operations Management
and PGD in Managerial Accounting. He had held various senior positions in industries and now he
is visiting faculty to various reputed business schools.
Avinash Tripathi has varied experience and academic qualifications. He possesses UGC-NET,
M.B.A., EPM-IIT(B), M.A.(English), PGD in Banking & Finance, PGD in Financial advising, and
PGD in Higher education. He has more than 12 years of experience in industries and academics.
His areas of research interest are Corporate Finance, e-Financial services, Market Microstructure,
Strategic Management and Corporate Governance.

iv
 CONTENTS
Unit
TITLE Page No.
No.
1. Introduction to Risk Management 1 - 20
1.1 Introduction
1.2 Components of Banking Risk
1.3 Overview of Risk Management Framework in Banks
1.4 Credit Risk Framework
1.5 Market Risk Management Framework
1.6 Operational Risk Framework
1.7 Strategic and Reputational Risks Framework
1.8 Future of Risk Management of Banks
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2. Asset Liability Management in Banks 21 - 34
2.1 Introduction
2.2 Asset Liability Management (ALM)
2.3 Objectives of Asset Liability Management in Banks
2.4 Scope and Responsibilities of the ALM Process
2.5 The Asset Liability Management Process
2.5.1 ALM Information Systems
2.5.2 Organisation of ALM through ALCO
2.5.3 Identification, Measurement and Management of Risk, Setting
up Risk Policies and Tolerance Levels
2.6 Important ALM Concepts
2.7 ALM Strategies
2.8 RBI Guidelines on ALM
2.9 Benefits of ALM
2.10 ALM Policy
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

v
 Unit
TITLE Page No.
No.
3. Managing Credit Risk 35 - 56
3.1 Introduction
3.2 Forms of Credit Risk
3.3 Types of Credit Risk
3.4 Credit Risk Management Process
3.5 Building Blocks of Credit Risk
3.6 Instruments of Credit Risk Management
3.7 Loan Review Mechanism (LRM)
3.8 Credit Risk Models
3.9 Credit Risk and Investment Banking
3.10 Credit Risk in Off Balance Sheet Exposure
3.11 Inter-bank Exposure and Country Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
4. Managing Market Risk 57 - 76
4.1 Introduction
4.2 Classification of Market Risk
4.3 Market Risk Management
4.4 Risk Appetite and Major Considerations in Developing Risk
Management Policies and Procedures
4.5 Senior Management Oversight
4.6 Risk Limits
4.7 Market Risk Management Function
4.8 Market Risk Management Information System
4.9 Market Risk Management Reporting
4.10 Basel Market Risk Charges
4.11 Market Risk Measurement and Assessment Systems
4.11.1 Sensitivity Analysis and Stress Testing
4.11.2 Back-Testing
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

vi
Unit
TITLE Page No.
No.
5. Managing Liquidity Risk 77 - 94
5.1 Introduction
5.2 Potential Sources of Liquidity for Banks
5.3 Aspects of Liquidity Risk Management
5.4 Liquidity Risk Management Cycle
5.5 Liquidity Risk Management Disclosures
5.6 Basel Principles for Sound Liquidity Risk Management and
Supervision
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
6. Managing Interest Rate Risk 95 - 114
6.1 Introduction
6.2 Sources of Interest Rate Risk
6.3 Effects of Interest Rate Risk
6.4 Sound Interest Rate Risk Management Practices
6.5 Interest Rate Risk Measurement Techniques
6.6 Principles for Management and Supervision of Interest Rate Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

vii
 Unit
TITLE Page No.
No.
7. Managing Foreign Exchange Risk 115 - 128
7.1 Introduction
7.2 Types of Foreign Exchange Risk
7.3 Foreign Currency Exposure of Commercial Banks
7.4 Foreign Exchange Risk Management
7.5 Steps in Management of Foreign Exchange Risk
7.6 Methods of Measuring Foreign Exchange Risk
7.7 Methods of Managing Foreign Exchange Risk
7.8 Foreign Exchange Settlement Risk
7.8.1 Dimensions of FX Settlement Risk
7.8.2 Duration of FX Settlement Exposure
7.8.3 Measurement of FX Settlement Exposures
7.8.4 Contingency Planning
7.8.5 Use of Bilateral Netting
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
8. Operational Risk Management 129 - 150
8.1 Introduction
8.2 Definitions of Operational Risk Management
8.3 Likely Forms of Manifestation of Operational Risk
8.4 Need for Operational Risk Management for Banks
8.5 Management of Operational Risk
8.6 Principles for Management of Operational Risk
8.7 Organisational Setup and Key Responsibilities
8.8 Identification and Assessment of Operational Risk
8.9 Monitoring of Operational Risk
8.10 Controls /Mitigation of Operational Risk
8.11 Methodologies for Calculating Capital Charge
8.12 Evaluation of the Operational Risk Function
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

viii
Unit
TITLE Page No.
No.
9. Derivatives in Banks and Risk Management Strategies 151 - 172
9.1 Introduction
9.2 Derivatives: Meaning
9.3 Derivative Markets/Contracts
9.4 Types of Derivatives
9.5 Permissible Derivative Instruments in India
9.6 Economic Functions of Derivative Markets
9.7 Application of Derivatives for Risk Management
9.8 Use of Derivatives by Banks
9.9 Reasons for Popularity of Derivatives
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
10. Enterprise-Wide Risk Management in Banks 173 - 190
10.1 Introduction
10.2 Definitions of ERM
10.3 Benefits of ERM
10.4 The COSO ERM Framework
10.5 Components of ERM and the ERM Process
10.6 Risk Appetite
10.6.1 Elements of Risk Appetite
10.7 Key Risk Indicators vs. Key Performance Indicators
10.7.1 Leading Indicators of Risk Event
10.8 Internal Control
10.8.1 Role of Internal Auditor
10.9 Role of Board of Directors in Oversight of ERM
10.10 Future of Enterprise Risk Management
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

ix
 Unit
TITLE Page No.
No.
11. The New Basel Accord: Implications for Banks and 191 - 210
Latest Capital Adequacy Regulatory Guidelines
11.1 Introduction
11.2 Capital Adequacy
11.3 The Basel Capital Accords
11.4 RBI Guidelines on Implementation of Basel III
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

x
Introduction to Risk Management
UNIT

1
Structure:

1.1 Introduction
1.2 Components of Banking Risk
1.3 Overview of Risk Management Framework in Banks
1.4 Credit Risk Framework
1.5 Market Risk Management Framework
1.6 Operational Risk Framework
1.7 Strategic and Reputational Risks Framework
1.8 Future of Risk Management of Banks
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Introduction to Risk Management 1

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the components of a bank’s risk management framework
----------------------
• Appraise market risk and asset liability management and risks
---------------------- associated with it.
• Name the tools for the mitigation of various risks
----------------------
• Illustrate how regulatory requirements help in risk management
----------------------

----------------------
1.1 INTRODUCTION
----------------------
The banking industry has undergone radical changes all over the world in
---------------------- the last two or three decades and India is no exception. The 1992-93 financial
crisis in India, 1998-99 financial disaster in South East Asia, the 2008-09 global
---------------------- financial meltdown and recent Greece crises have all highlighted the importance
of Risk Management of Financial Services especially Banking.
----------------------
Risk Management is defined as “The identification, analysis, assessment,
---------------------- control and avoidance, minimisation or elimination of unacceptable risks.”
---------------------- Like other enterprises, banks also take risks for increasing profits. In
today’s fiercely competitive business environment, the investors are unforgiving
---------------------- to companies who do not make impressive profit. If business compulsions make
---------------------- it necessary for the banks to take risks, it has become equally important to
develop techniques of managing such risks. The process of risk management
---------------------- consists of identification, measurement, monitoring and control. Banking
being a very sensitive industry from the point of view of people’s well-being,
---------------------- governments have to act as watchdogs and regulate the industry to prevent
---------------------- disasters happening. Governments indeed have to do the tightrope walk of
deregulating and liberalising the industry for the purpose of national growth
---------------------- on one hand and to bring the roadblocks of regulation on the other. Bank
for International Settlements has helped the central banks globally for Risk
---------------------- Management through Capital Adequacy Framework.
---------------------- In the last few decades, new banking and financial market products such
as derivatives, securitised debt, credit cards, retail banking products, housing
---------------------- loans, micro-credit etc. have provided new profit-making opportunities to
---------------------- the banks. However, many of these products are highly complex and risky.
Financial crisis led by the subprime bank lending underlined the limitations
---------------------- of the Risk Management practices that were being followed and the need for
tighter controls and more sophisticated Risk Management. Bankruptcy of
---------------------- Lehman Brothers, near bankruptcy and bailout of AIG, crisis of Royal Bank of
---------------------- Scotland, takeovers of Washington Mutual by Morgan Chase and Wachovia by
Wells Fargo, failure of Bear Stearns Bank and problems of Citibank and almost
---------------------- all large global banks were an eye opener for the Banking system with the result

2 Risk Management
that Banks and Regulatory Agencies have started taking Risk Management Notes
much more seriously than ever before.
----------------------
The financial system reform process globally was the result of the oil crises
of the seventies that led to failure of the Brettons Wood fixed parity system of ----------------------
exchange rates and rise of the floating exchange rates. The uncertainties also led
to floating interest rates. In India, the trigger was the foreign exchange crisis of ----------------------
1971. As a part of reforms, forward trading as well as other derivative products
----------------------
such as futures and options were allowed in Foreign Exchange and Interest
Rates in India progressively. The leveraging effect of derivates increased the ----------------------
exposure to risk substantially. Also licensing of New Private Banks and Foreign
Banks and deregulating interest rates created increased competition and hence ----------------------
increased risk taking by banks for survival and satisfying the ever-demanding
----------------------
stakeholders.
----------------------
1.2 COMPONENTS OF BANKING RISK
----------------------
The process of risk management consists of identification, measurement,
monitoring and control. The process covers Enterprise Wide Risk Management ----------------------
as well as specific risk areas such as Credit Risk, Operational Risk, Market Risk, ----------------------
Derivatives, Securitisation, Asset Liability Management, Foreign Exchange
and Dealing Room Operations of the bank’s Treasury. We would read about ----------------------
each of them in detail in the coming units. The summary of the each is given
below for your ready reference. ----------------------

A. Financial Risks ----------------------

1. Credit Risk ----------------------
Credit risk is the risk associated with loans and investments when a bank’s
----------------------
debtors fail to meet the terms of contract with the bank and a default
occurs either in the payment of interest or repayment of principal amount ----------------------
or both. Credit risk arises due to reasons given below.
----------------------
a. Improper credit rating system or a lack of system altogether
b. Unforeseen changes in the economic situation resulting in financial ----------------------
problems for bank’s customers and debt issuers ----------------------
c. Undue risk taking by bank for the temptation of higher spreads
----------------------
d. Improper or inadequate collateral
----------------------
e. Lack of control systems with timely alerts or warning
f. Exposure to Project Finance with limited or no recourse ----------------------
g. Credit Concentration ----------------------
2. Liquidity Risk ----------------------
Liquidity risk is the risk associated with a bank’s inability to meet its
----------------------
current liabilities due to inadequate cash flow. Liquidity is considered
as the lifeline of a bank and hence the lack of it can result into serious ----------------------

Introduction to Risk Management 3

 Notes consequences for the bank and a ‘run’ on the bank in extreme cases
as customers can lose confidence in the bank. Some of the reasons for
---------------------- liquidity risk are
---------------------- a. Improper Asset Liability Management (ALM)
b. Investment in illiquid assets
----------------------
c. Substantial Non Performing Assets
----------------------
d. Reluctance to sell assets involving booking of loss
---------------------- 3. Interest Rate Risk
---------------------- After banking reforms and due to Reserve bank of India’s frequent
intervention for either control of inflation or for injecting a trigger for
---------------------- growth of the economy, rates of interest in the financial markets have
---------------------- become volatile. Changes in rates of interest can affect bank’s profitability
in both the loans and investments as well as on the liability side. Many
---------------------- Indian Banks have large exposure to External Commercial Borrowings
through Eurobonds or Medium Term Notes with floating rates of interest
---------------------- based on benchmarks such as LIBOR or US treasuries etc. Therefore,
---------------------- banks face a risk related to global economic situation. Some of the reasons
for Interest Rate Risk occurrence are:
----------------------
a. Improper Asset Liability Management
---------------------- b. Changes in the shape of the Yield Curve
---------------------- c. Large exposure to External Commercial Borrowing

---------------------- d. Open positions in Interest Rate Derivatives such as Futures, FRAs

4. Foreign Exchange Risks
----------------------
In the last decade, foreign exchange markets have had an exponential
---------------------- growth due to increase in Foreign Trade, Remittances, External
Commercial Borrowings, ADR, GDRs, Bilateral and Multilateral Credit
----------------------
etc. Since there are restrictions on Capital Account in Balance of Payment
---------------------- Account, fortunately India is not exposed to Currency Mutual Funds that
can destabilise a currency. However exchange rates continue to fluctuate
---------------------- due to several reasons such as heavy buying and selling of shares by
Foreign Institutional Investors, government restrictions on FDI, policy
----------------------
paralysis and general economic boom or bust. Banks have to handle
---------------------- all foreign transactions through Interbank Wholesale Market or Retail
Market. Although in India there are several restrictions on banks such
---------------------- as no speculative trading allowed, limits on overnight open positions of
foreign exchange, banks face Transaction Risks if their exposure on behalf
----------------------
of the customer is not properly hedged. Banks with overseas branches or
---------------------- subsidiaries also face Translation Risk as well as Economic Risk.
5. Securities Price Risk
----------------------
Value of a bank’s investment in securities both equity and debt moves
---------------------- up and down with the market, which creates the Price or Valuation Risk.

4 Risk Management
 Equities move with the stock market whereas if the market interest rates Notes
go up, market prices of bonds and debentures go down and vice versa. This
risk may aggravate if investments are in illiquid securities and securities, ----------------------
which are not listed or not regularly quoted in the market. Also complex-
structured products including securitisation create valuation difficulties. ----------------------

6. Off-Balance Sheet Exposure Risk ----------------------

Exposure of banks to Guarantees, Letters of Credit without proper credit ----------------------

rating system and inadequate collateral securities lending (including
repos and reverse repos) create this risk. ----------------------

B. Operational Risk ----------------------

Operational risk occurs due to five main reasons. ----------------------

1. Failure of Systems ----------------------
Management Information Systems can fail due to improper design. Also ----------------------
failure can occur due to technological reasons. Modern banking is getting
day by day more and more technology intensive. Poor disaster management, ----------------------
as far as technological failures are concerned, can completely paralyse a
bank’s operation. Checks and balances to prevent failures and an early ----------------------
warning system are essential. It also includes management control system ----------------------
and internal audit failures.
----------------------
2. Failure of Internal Processes
Incorrect implementation and lack of understanding of the systems can ----------------------
result into failures of Internal Banking Processes. ----------------------
3. Failure of People
----------------------
People can fail in several ways.
----------------------
a. Internal frauds
----------------------
b. External frauds with or without collusion internally c.
Employment practices and workplace safety ----------------------
d. Employee / consultanterrors and negligence, including wrong ----------------------
documentation
----------------------
e. Damage to physical assets
----------------------
f. Customer Relationship Failure
C. Risks due to External Events ----------------------

a. Political- Unstable governments leading to unstable macroeconomic ----------------------

environment
----------------------
b. Contagion – spread of a regional crisis
----------------------
c. Global banking or economic crisis
----------------------

Introduction to Risk Management 5

 Notes D. Strategic and Reputational Risks
a. Strategic risk arising out of sub-standard strategic management
----------------------
b. Financial Infrastructure - Payment systems is an important element
---------------------- of financial infrastructure. Inefficient RTGS, ECS, NEFT or similar
systems can be a hazard. Similarly, sub-standard supervision, lack
----------------------
of adherence to international standards and lack of well-trained
---------------------- professionals create obstacles.
c. Reputational Risk- Bank loses its brand equity as a result of loss
----------------------
of reputation, which can happen due to several reasons such
---------------------- as misconduct of the management, frauds, liquidity problems,
mismanagement etc.
----------------------

---------------------- Check your Progress 1

----------------------
Fill in the Blanks.
---------------------- 1. The process of risk management consists of ___________,
__________, ____________ and ____________.
----------------------
2. Like any other enterprise, banks also take risks for increasing
---------------------- ____________.
----------------------

---------------------- 1.3 OVERVIEW OF RISK MANAGEMENT FRAMEWORK

IN BANKS
----------------------
A risk management framework encompasses the scope of risks to be
----------------------
managed, the process/systems and procedures to manage risk and the roles and
---------------------- responsibilities of individuals involved in risk management. The framework
should be comprehensive enough to capture all risks a bank is exposed to and
---------------------- have flexibility to accommodate any change in business activities. An effective
risk management framework includes
----------------------
a) Clearly defined risk management policies and procedures covering risk
---------------------- identification, acceptance, measurement, monitoring, reporting and
---------------------- control.
b) A well constituted organisational structure defining clearly roles and
---------------------- responsibilities of individuals involved in taking and managing the risk.
---------------------- Banks, in addition to risk management functions for various risk
categories, may institute a setup that supervises overall risk management
----------------------
at the bank.
---------------------- Such a setup could be in the form of a separate department or bank’s
Risk Management Committee (RMC) could perform that function. The
----------------------
structure should be such that ensures effective monitoring and control
---------------------- over risks being taken. The individuals responsible for review function

6 Risk Management
 (risk review, internal audit, compliance etc.) should be independent from Notes
risk taking units and report directly to board or senior management who
are also not involved in risk taking. ----------------------
c) There should be an effective management information system that ensures ----------------------
flow of information from operational level to top management and a
system to address any exceptions observed. There should be an explicit ----------------------
procedure regarding measures to be taken to address such deviations.
----------------------
d) The framework should have a mechanism to ensure an ongoing review of
systems, policies and procedures for risk management and procedure to ----------------------
adopt changes.
----------------------
Risk is an integral part of the functioning of any bank. Therefore it is
important to have a sound framework to control it. Risk control is meant not ----------------------
just to minimise the risks but also to ensure that the bank properly identifies
----------------------
measures and handles risks and prepares adequate and proper reports on all
these efforts. With this in mind, banks are expected to establish and operate ----------------------
mechanisms, which ensure a continuous assessment of relevant risks on an
individual basis as also the overall risk position of the banks. ----------------------
Risk Management is a board-driven function in the bank. The board ----------------------
should have oversight on all the risks assumed by the bank. Working under the
Risk Management Committee at the apex level there are separate committees ----------------------
for each type of risk, e.g. Credit Risk Management Committee, Market Risk ----------------------
Management Committee etc. These committees should be supported by
operational level committees of top executives for managing various risks. ----------------------
Some of the important committees at the apex level besides the main Risk
Committee, forming the risk management framework of the bank are Audit ----------------------
Committee, Credit committee, Asset Liability Committee, Risk Management ----------------------
Compliance Committee, Corporate Legal Group, Financial Crime Prevention,
Reputation management Committee etc. ----------------------
The identification, definition and recording of all potential risks in all ----------------------
banking activities and products is done through detailed analysis and vetting
the same by operational level committees and task forces. Risk profiling of ----------------------
the banks should be done on quarterly basis. Various tools and systems like
prudential limits, new Basel compliant credit rating models, credit audit, ----------------------
VaR models for market risks, Stress Testing and other Basel driven tools etc. ----------------------
are employed identifying and assessing the risks. Sound Data Warehousing,
Data Mining tools and efficient use of technology is essential for an effective ----------------------
framework.
----------------------
Banks in India have already migrated to New Capital Adequacy Framework
(Basel II) and RBI has already announced the timetable for adopting Basel III ----------------------
framework. There will be a six year phase-in period beginning 2013. The likely
impact of this we shall discuss in another section. ----------------------

Corporate Governance in case of banks has a great role to play as far ----------------------
as Risk Management Framework of the banks is concerned. In the case of
----------------------
manufacturing or service providing corporate, the issue of Corporate Governance

Introduction to Risk Management 7

 Notes relates safeguarding and maximising shareholders’ value. However, in the case
of banking, many other risk issues such as risk involved for the depositors,
---------------------- possibility of contagion as one bank’s failure can create a crisis of confidence
in public mind and in the markets. Therefore involvement of government is
---------------------- considerably higher in banks due to larger interest of the public and stability of
---------------------- the financial system of the country.

---------------------- Activity 1
----------------------
Fix a meeting with a bank manager and discuss with him what the operational
---------------------- risks at branch level are.
----------------------

---------------------- 1.4 CREDIT RISK FRAMEWORK

---------------------- All credit risk related aspects are governed by a credit and recovery policy
that outlines customer categories, targeted customer profile, credit approval
---------------------- process, credit limits and the type of products that can be offered. The credit
and recovery policy is approved by the Board of Directors. There should be a
----------------------
structured and standardised credit approval process that should include a well-
---------------------- established procedure of comprehensive credit appraisal and credit rating. Also
there should be board-established policies and processes for collateral valuation
---------------------- and management.
---------------------- Credit Risk Mitigation should be used as a proactive management tool
designed to protect the bank’s earnings from probable loss both in good and
---------------------- bad times. Banks employ various methods and techniques to reduce the impact
---------------------- of credit risks they are exposed to in their daily operations. Such a process is
termed as credit risk mitigation. Credit Risk Mitigants as recognised under the
---------------------- New Capital Adequacy Framework (Basel II) are i) collateralised transactions
ii) on-balance sheet-netting and iii) guarantees. We would read about these in
---------------------- detail in the later units.
---------------------- Collateral Management Policy should include minimum conditions for
the acceptance of collateral. For the collateral to be valid and enforceable, the
---------------------- policy should be to accept only marketable collaterals. Also the market value of
---------------------- the collateral should be readily determinable or should be reasonably established
and verified. For Internal Control purposes, the bank should have a list of types
---------------------- of assets acceptable as collateral and the maximum loan to value ratio for each
of these assets. Bank should also take into account regulatory restrictions while
---------------------- taking collaterals.
---------------------- Collateral Management Policy should give clear guidelines regarding the
following points:
----------------------
Enforceability
----------------------
●● Title and Ownership
---------------------- ●● Loan- to- value ratios

8 Risk Management
●● Valuation policy Notes
●● Safe keeping of collaterals and control to their access
----------------------
●● Additional Collaterals and Replacement of Collaterals
●● Insurance of assets used as collaterals ----------------------
●● Sale of collaterals ----------------------
Credit Management Tools
----------------------
Managing risk at the right time and right place helps the organisation
in achieving its objective with ease. Since risk and reward go hand in hand, ----------------------
your ability to manage the risk efficiently will reward you with higher profits. ----------------------
For this task, management may use various tools. These are mentioned briefly
below. We would have a detailed discussion in the unit on “Managing Credit ----------------------
Risk”
----------------------
1. Credit Approving Authority: Delegation of powers through multi-tier
risk based approving system. ----------------------
2. Prudential Limits: Single/Group borrowing limits with respect to credit ----------------------
rating and credit concentration guidelines.
----------------------
3. Risk Rating: Either rating by approved external agencies as per
standardised approach or internally developed rating system to be ----------------------
approved by RBI as per Internal Rating Based approach (IRB).
----------------------
4. Credit rating of borrowers/ Loan Review Mechanism for borrowal
accounts. ----------------------
5. Portfolio Management System for monitoring the overall composition
----------------------
and quality of various credit portfolios and investments.
Risk Management Organisation ----------------------

The Risk Management Committee at the apex level should be headed ----------------------
by the Chairman cum Managing Director and members should include
Independent Directors, Executive Directors, Heads of Credit and Market and ----------------------
Operational Risk Management Committees. Specific Committee for Credit ----------------------
Risk Management should also be headed by a director, other senior executives
involved with credit function and the Chief Risk Officer. ----------------------
The operational level committees implement the policy approved by the ----------------------
apex level committee/ Credit Risk Committee.
----------------------
There should be a Risk Management Department headed by the Chief
Risk Officer of General Manager rank. The department’s function is to measure, ----------------------
control and manage credit risk on bank wide basis within the limits set by the
Board/Risk Management Committee of the Board. ----------------------
Credit Monitoring Department is also headed by a General Manager. The ----------------------
department monitors the quality of loan portfolio, identifies problems and takes
steps to correct deficiencies. ----------------------
Credit Audit Department undertakes credit review and credit audit. ----------------------

Introduction to Risk Management 9

 Notes Control Ratios
Credit Risk Management Framework involves tracking some of the
----------------------
financial ratios – both regulatory mandatory ratio and some of the control ratios.
---------------------- Mandatory Regulatory Ratio: Capital Adequacy Ratio or CRAR
---------------------- Control Ratios related to Asset Quality

---------------------- Net Non-performing Assets Ratio = Net NPAs/ Average Net Advances
Incremental NPAs Ratio = New Addition to NPAs/ Average Net Advances
----------------------
Credit Concentration Ratio = Large Exposure in excess of 10%/ Net
---------------------- Owned funds (NOF)
---------------------- Loan Loss Provision Ratio = Loan Loss Provisions and Write-offs/ Gross
Advances
----------------------
Off Balance Sheet Exposure Ratio = Off-balance sheet items /Total Assets
---------------------- Investment Asset Quality Ratio = NPAs in Investments/ Total Investments
----------------------
Check your Progress 2
----------------------

---------------------- State True or False.

1. Risk is an integral part of the functioning of any bank.
----------------------
2. Risk control is meant not to just maximise the risks but also to ensure
---------------------- that the bank properly identifies measures and handles risks.
---------------------- 3. There should be a Risk Management Department headed by the
Branch Manager rank.
----------------------

----------------------
1.5 MARKET RISK MANAGEMENT FRAMEWORK
----------------------
As mentioned earlier, Market Risk Management Committee working
---------------------- under the Apex Committee shall be responsible for overseeing implementation
of policies related to the market risk. We would read more in the unit “Managing
---------------------- Market Risk.”
---------------------- Important policies covering market risk are Investment Policy, ALM
Policy, Derivatives Policy, Foreign Exchange Open Overnight Positions Policy
----------------------
and Treasury Management Policy.
---------------------- Elements of Market Risks include liquidity or funding risk, price risk in
the trading book, price risk on trading portfolios, interest rate risk in the banking
----------------------
book, exchange rate risk on foreign currency positions, credit spread risk and
---------------------- settlement risk. These risks are controlled through limits such as duration of
bonds, earnings at risk, value-at-risk, stop loss and liquidity gap limits. The
---------------------- limits are stated in the Market Risk Policy.
----------------------

10 Risk Management
Treasury Function of a Bank Notes
The sources of most of the Market Risks borne by a bank are in the
----------------------
Treasury Operations. At the same time, treasury acts also as a Profit Centre of
the Bank since treasury is required to identify and exploit market opportunities ----------------------
for profit making investments, profitable foreign exchange and derivative
positions. Treasury is also responsible for planning and maintaining liquidity of ----------------------
the bank. We can summarise functions of the treasury as under.
----------------------
1. Reserve management: CRR/SLR obligations
----------------------
2. Investment portfolio management
3. Foreign exchange management ----------------------
4. Liquidity and funds management ----------------------
5. Asset liability management ----------------------
6. Derivative products management
----------------------
7. Arbitrage opportunities management
----------------------
8. Risk management
9. International money transfer and settlement ----------------------

Exposure Limits ----------------------

Volatility of market prices leads to market risks. The risk is kept within ----------------------
acceptable limits with respect to the risk appetite of the bank and the regulatory
considerations by placing various limits. Limits are also placed on each dealer ----------------------
depending upon the dealer’s experience and his safety track record. Some of the
----------------------
limits are as follows:
Intra-day Limit or Daylight Limit: This limit on dealers is supposed ----------------------
to control the risk during trading hours. Dealers are strictly required to follow
----------------------
them. In forex, there are additional currency wise limits. The limit in securities
may stipulate % of the deals that can be routed through the brokers. In forex, ----------------------
daylight limits are higher than overnight limits as the volatility of exchange
rates during the day may be controllable through hedging. Call money markets ----------------------
require instant decisions and hence the limits are higher than the term money
----------------------
or bond markets.
Overnight Open Position Limit: From Sydney to Los Angeles, ----------------------
somewhere or the other, there is a trading time, so the global forex market is
----------------------
a seamless 24 hour market. Therefore, the exchange rate variations are likely
to be higher during the overnight period. The limit is decided by the Board of ----------------------
Directors based on guidelines issued by RBI. Generally, for every buy and sell
forward transaction, the bank immediately hedges its position by equivalent ----------------------
forward transaction. Overnight limit is meant for the unhedged transaction.
----------------------
Aggregate Gap Limit (AGL): The gaps, meaning the uncovered
positions in derivative instruments, are aggregated irrespective of the sign and ----------------------
a limit is assigned. ----------------------

Introduction to Risk Management 11

 Notes Stop Loss Limit: When for a position initiated in the equity market, the
market starts moving unfavourably creating a loss, the stop loss is triggered
---------------------- when the loss is equal to the set stop loss limit. This is like a damage control
exercise that prevents further loss. Stop loss limit can be per deal or per trading
---------------------- session or per day or per dealing room.
---------------------- Book Profit or Take Profit limit: This is a limit set up for the dealer to
not wait further and book profit. This is to prevent the risk of market reversal,
----------------------
leading to a loss.
---------------------- Value at Risk (VaR) Limit: This is a statistical tool that measures the
probability of a risk when a dealer has a particular position. There are various
----------------------
models of VaR available to choose from. Also the model involves the choice
---------------------- of the period for which the volatility is measured and the required confidence
level.
----------------------
Payment Settlement Risk
---------------------- When counterparty delivers a security or its value in cash as per an
---------------------- agreement, the bank, which is a go-between, faces the settlement risk. In
foreign exchange cross-border transactions, this risk is prominent due to time
---------------------- zone differences. It is sometimes called Herstatt Risk, named after a German
bank that went bankrupt due to this risk.
----------------------
To mitigate this risk, bank’s risk committee puts in place settlement limits
---------------------- on each counterparty.
---------------------- Asset Liability Management
Asset Liability Management is defined as the on-going process of
----------------------
formulating, implementing, monitoring and revising strategies related to assets
---------------------- and liabilities in an attempt to achieve financial objectives for a given set of
risk tolerances and constraints. We would read more on ALM in the unit “Asset
---------------------- Liability Management in Banks”
---------------------- ALCO or Asset Liability Management Committee is a very important
committee in the banking operations. Risk Management Framework. Liquidity,
---------------------- being the lifeline of the banking system tracking the tenor mismatch of assets
and liabilities, is very critical for banks. Also changes in the market interest
----------------------
rates can create losses for the bank. ALCO comprises of full time directors and
---------------------- executive directors of the bank.

---------------------- RBI regulates and monitors the entire ALM process. As regards the
organisational set up, RBI stipulates the following.
---------------------- ALM Organisation
---------------------- The Board should have overall responsibility for management of risks
and should decide the risk management policy of the bank and set limits for
---------------------- liquidity, interest rate, foreign exchange and equity price risks.
---------------------- The Asset-Liability Committee (ALCO) consisting of the bank’s senior
management, including CEO, should be responsible for ensuring adherence to
----------------------
the limits set by the Board as well as for deciding the business strategy of the

12 Risk Management
bank (on the assets and liabilities sides) in line with the bank’s budget and Notes
decided risk management objectives.
----------------------
The ALM desk consisting of the operating staff should be responsible
for analysing, monitoring and reporting the risk profiles to the ALCO. ----------------------
The staff should also prepare forecasts (simulations) showing the effects of
various possible changes in market conditions related to the balance sheet and ----------------------
recommend the action needed to adhere to bank’s internal limits.
----------------------
The ALCO is a decision making unit responsible for balance sheet
planning from risk - return perspective including the strategic management of ----------------------
interest rate and liquidity risks. Each bank will have to decide on the role of its
----------------------
ALCO, its responsibility as also the decisions to be taken by it. The business
and risk management strategy of the bank should ensure that the bank operates ----------------------
within the limits / parameters set by the Board. The business issues that an
ALCO would consider, inter alia, will include product pricing for both deposits ----------------------
and advances, desired maturity profile of the incremental assets and liabilities
----------------------
etc. In addition to monitoring the risk levels of the bank, the ALCO should
review the results of and progress in implementation of the decisions made in ----------------------
the previous meetings. The ALCO would also articulate the current interest
rate view of the bank and base its decisions for future business strategy on this ----------------------
view. In respect of the funding policy, for instance, its responsibility would be
----------------------
to decide on source and mix of liabilities or sale of assets. Towards this end, it
will have to develop a view on future direction of interest rate movements and ----------------------
decide on a funding mix between fixed vs. floating rate funds, wholesale vs.
retail deposits, money market vs. capital market funding, domestic vs. foreign ----------------------
currency funding etc. Individual banks will have to decide the frequency for
----------------------
holding their ALCO meetings.
Composition of ALCO ----------------------
The size (number of members) of ALCO would depend on the size of each ----------------------
institution, business mix and organisational complexity. To ensure commitment
of the Top Management, the CEO/CMD or ED should head the Committee. ----------------------
The Chiefs of Investment, Credit, Funds Management/Treasury (forex and ----------------------
domestic), International Banking and Economic Research can be members of
the Committee. ----------------------
In addition, the Head of the Information Technology Division should also ----------------------
be an invitee for building up of MIS and related computerisation. Some banks
may even have sub-committees. ----------------------

----------------------
Check your Progress 3
----------------------
Fill in the Blanks.
----------------------
1. When a counterparty delivers a security or its value in cash as per an
agreement the bank which is ago-between faces the _____________ ----------------------
risk. ----------------------

Introduction to Risk Management 13

 Notes 1.6 OPERATIONAL RISK FRAMEWORK
---------------------- Operational Risk includes legal risk but excludes strategic and reputational
---------------------- risks. Operational risk is inherent in the bank’s operations – both domestic and
international. It can result from a variety of factors, e.g. failure to obtain proper
---------------------- authorisation for a transaction, improper documentation, failure of information
security procedure or software /hardware failure, frauds, employee errors
---------------------- and lack of employee training. We would read more on this topic in the unit
---------------------- “Operational Risk Management”.
Operational Risk is required to be managed through a comprehensive
---------------------- system of internal controls with checks and balances, procedure manuals and
---------------------- a monitoring system to check whether procedures are being followed, key
back up procedures to make sure that the data is not lost, disaster management
---------------------- planning, trial runs etc.

---------------------- Operational Risk Management Committee oversees these functions to make

sure that policies related to above issues are implemented. Bank’s operations
---------------------- can be divided as Front Office (comprising business groups involving direct
customer contact), Middle Office (comprising treasury and credit functions) and
---------------------- Back Office (comprising support functions including technology support). While
---------------------- designing control systems, this categorisation should be taken into account.
Bank for International Settlements (BIS) draws attention of the banks to
----------------------
following factors with the potential of creating Operational Risk.
---------------------- Operational risk event types, which the Basel Committee on Banking
Supervision in co-operation with the industry has identified as having the
----------------------
potential to result in substantial losses, include:
---------------------- • Internal fraud, for example, intentional misreporting of positions,
employee theft and insider trading on an employee’s own account.
----------------------
• External fraud, for example, robbery, forgery, cheque kiting and damage
---------------------- from computer hacking.
---------------------- • Employment practices and workplace safety, for example, worker ’s
compensation claims, violation of employee health and safety rules,
---------------------- organised labour activities, discrimination claims and general liability.
---------------------- • Clients, products and business practices, for example, fiduciary breaches,
misuse of confidential customer information, improper trading activities
---------------------- on the bank’s account, money laundering and sale of unauthorised
---------------------- products.
• Damage to physical assets, for example, terrorism, vandalism, earthquakes,
----------------------
fires and floods.
---------------------- • Business disruption and system failures, for example, hardware and
software failures, telecommunication problems and utility outages.
----------------------
• Execution, delivery and process management, for example, data entry
---------------------- errors, collateral management failures, incomplete legal documentation,

14 Risk Management
 unapproved access given to client accounts, non-client counterparty Notes
misperformance and vendor disputes.
----------------------
The Bank for International Settlements’ (BIS) sound operational risk
management practices ----------------------
The Bank for International Settlements (BIS) is an intergovernmental
----------------------
organisation of central banks, which “fosters international monetary and financial
cooperation and serves as a bank for central banks.” It is not accountable to any ----------------------
national government. The BIS carries out its work through subcommittees, the
secretariats it hosts and through its Annual General Meeting of all members. ----------------------
It also provides banking services, but only to central banks or to international
----------------------
organisations like itself. BIS has also set 10 principles of sound operational risk
management practices; they expect these principles to form the base of bank’s ----------------------
operational risk management framework. These are as follows.
----------------------
Principle 1: The board of directors should be aware of the major aspects of
the bank’s operational risks as a distinct risk category that should be managed ----------------------
and it should approve and periodically review the bank’s operational risk
management framework. The framework should provide a firm-wide definition ----------------------
of operational risk and lay down the principles of how operational risk is to be ----------------------
identified, assessed, monitored and controlled/mitigated.
----------------------
Principle 2: The board of directors should ensure that the bank’s operational
risk management framework is subject to effective and comprehensive internal ----------------------
audit by operationally independent, appropriately trained and competent staff.
The internal audit function should not be directly responsible for operational ----------------------
risk management.
----------------------
Principle 3: Senior management should have responsibility for implementing the
operational risk management framework approved by the board of directors. The ----------------------
framework should be consistently implemented throughout the whole banking
----------------------
organisation and all levels of staff should understand their responsibilities with
respect to operational risk management. Senior management should also have ----------------------
responsibility for developing policies, processes and procedures for managing
operational risk in all of the bank’s material products, activities, processes and ----------------------
systems.
----------------------
Risk Management: Identification, Assessment, Monitoring and Mitigation/
Control ----------------------

Principle 4: Banks should identify and assess the operational risk inherent to all ----------------------
material products, activities, processes and systems. Banks should also ensure
----------------------
that before new products, activities, processes and systems are introduced
or undertaken, the operational risk inherent to them is subject to adequate ----------------------
assessment procedures.
----------------------
Principle 5: Banks should implement a process to regularly monitor operational
risk profiles and material exposures to losses. There should be regular reporting ----------------------
of pertinent information to senior management and the board of directors that
supports the proactive management of operational risk. ----------------------

Introduction to Risk Management 15

 Notes Principle 6: Banks should have policies, processes and procedures to control
and/or mitigate material operational risks. Banks should periodically review
---------------------- their risk limitation and control strategies and should adjust their operational
risk profile accordingly using appropriate strategies, in light of their overall risk
---------------------- appetite and profile.
---------------------- Principle 7: Banks should have in place contingency and business continuity
plans to ensure their ability to operate on an ongoing basis and limit losses in
----------------------
the event of severe business disruption.
---------------------- Role of Supervisors
---------------------- Principle 8: Banking supervisors should require that all banks, regardless of
size, have an effective framework in place to identify, assess, monitor and
---------------------- control/mitigate material operational risks as part of an overall approach to risk
management.
----------------------
Principle 9: Supervisors should conduct, directly or indirectly, regular
---------------------- independent evaluation of a bank’s policies, procedures and practices related to
---------------------- operational risks. Supervisors should ensure that there are appropriate mechanisms
in place, which allow them to remain apprised of developments at banks.
---------------------- Role of Disclosure
---------------------- Principle 10: Banks should make sufficient public disclosure to allow market
participants to assess their approach to operational risk management.
----------------------

---------------------- Activity 2
----------------------
Interact with a bank officer and enquire about various factors that can
---------------------- expose a bank to different risks.

----------------------
1.7 STRATEGIC AND REPUTATIONAL RISKS
----------------------
FRAMEWORK
----------------------
Bank’s top management, viz. the CEO and his team have following
---------------------- responsibilities regarding the overall Risk Management.

---------------------- • Develop and recommend strategic plans and risk management policies
for board approval.
---------------------- • Implement strategic plans and policies after the board approval.
---------------------- • Establish an institutional culture promoting high ethical standards and
integrity standards.
----------------------
• Ensure development of manuals containing policies, procedures and
---------------------- standards for bank’s key functions and risks.
---------------------- • Implement an effective internal control system, including continuous
assessment of all material risks that could adversely affect the achievement
---------------------- of the bank’s objectives.

16 Risk Management
• Ensure the establishment of risk limits and implementation of controls Notes
that enforce adherence to the same. Ensure immediate reporting of non-
compliance to management. ----------------------
• Ensure that the internal auditors review and assess the adequacy of ----------------------
controls and compliance with limits and procedures.
----------------------
• Develop and implement reporting systems that adequately reflect business
risks. ----------------------
• The Audit Committee and Internal Auditors are an extension of the Board’s
----------------------
Risk Management Function. Following are the goals of an internal audit
function. ----------------------
• Enable management to identify and manage business risks. ----------------------
• Provide an independent appraisal.
----------------------
• Evaluate effectiveness, efficiency and economy of operations.
----------------------
• Evaluate compliance with laws, policies and operating procedures.
• Evaluate the reliability of information produced by accounting and ----------------------
computer systems.
----------------------
• Provide investigative services to the line management.
----------------------
Reputational Risk
Reputational Risk is defined by RBI as the risk arising out of negative ----------------------
perception on the part of customers, counterparties, shareholders, investors, ----------------------
debt-holders, market analysts, other relevant parties or regulators that can
adversely affect a bank’s ability to maintain existing or establish new, business ----------------------
relationships and continued access to sources of funding. Reputational risk is
multi-dimensional reflects the perception of other participants ----------------------

Reputational Risk Framework ----------------------

A bank should identify potential sources of reputational risks to which ----------------------
it is exposed. These include the bank’s business lines, liabilities, affiliated
operations, off-balance-sheet vehicles or SPVs for securitised loans and the ----------------------
markets in which it operates. Bank management should have an appropriate
----------------------
policy in place to identify sources of reputational risk when entering new
markets, products or lines of business. Also the bank’s stress testing procedures ----------------------
should take into account reputational risks as well.
----------------------
1.8 FUTURE OF RISK MANAGEMENT OF BANKS ----------------------
As we have seen from the events like South East Asia currency crisis of ----------------------
1997-1999 and the great financial meltdown of 2008-2009, banks have been
at the centre of the crisis and did not come out with any great reputation as ----------------------
far as Risk Management is concerned. It was therefore imperative that tighter
----------------------
regulation of banking industry would be the need to safeguard the interest of
common people having their hard-earned money with the banks, investors ----------------------

Introduction to Risk Management 17

 Notes and even for the banking industry itself. The regulation has already come in
the form of Basel III and the implementation schedule is also announced. The
---------------------- world is repeatedly getting into financial crisis with banking as its driver, for
which some of the reasons are as follows.
----------------------
Banking products and other financial products like synthetic derivatives
---------------------- and securitised instruments with complex financial engineering are increasing
lure for profit but at times disproportionately increasing the risk also.
----------------------
Globalisation of Financial Markets spreads the contagion risk.
----------------------
Pressure on banks from investors and security analysts forever higher profits.
---------------------- Greed of executives to drive short-term profits that may ensure higher
---------------------- bonuses for themselves.
All the above factors imply that Bank Risk Management becomes more
---------------------- elaborate and more complex. The fall-out of this would be higher cost of Risk
---------------------- Management. It also means higher capital requirement and higher operating
cost, bringing further pressure on the margins. This can set a dangerous chain
---------------------- reaction. Effect of all this would also be global depression and either reduction
or even shrinking of the global Gross Domestic Product.
----------------------
Expected impact of Base III Framework on Indian Banks
----------------------
According to a study conducted by ICRA, proposed Basel III guidelines
---------------------- would require the Indian banks to raise additional capital of Rs 600,000 crores
over next 9 years, out of which substantial part may be tier I / core capital.
---------------------- Higher level of capital could dilute the return on equity for the banks. However,
the positive side is that most of the Indian banks have maintained core capital
----------------------
higher than the required regulatory norm under Basel II. Comparison of
---------------------- requirements under Basel II and III is as under.
Description Basel III Current Indian
----------------------
RBI norm Banks
---------------------- Common Equity (after deductions) 4.5% 3.6% 9.2%
Conservation Buffer 2.5% Nil Nil
---------------------- Countercyclical Buffer 0-2.5% Nil Nil
Total of above 7-9.5% 3.6% 9.2%
---------------------- Tier I (including buffer) 8.5-11% 6% 10%
Total Capital (including buffer) 10.5-13% 9% 14%
----------------------
[Note: Indian banks position is as on March 31, 2010.]
---------------------- Increase in risk-weighted assets would mean further increase of capital
---------------------- requirement. ICRA’s estimate of Rs. 6,00,000 assumes 20% increase in risk
weighted assets. Out of this, additional capital requirement, 75-80% will be
---------------------- from public sector banks and 20-25% from private sector banks. Thus, public
sector banks will be affected more.
----------------------
The net stable funding ratio (NSFR) is likely to be implemented from
---------------------- 2019. However, liquidity coverage ratio (LCR) has been implemented from
2015, which may necessitate banks to maintain additional liquidity that can
---------------------- have further impact on banks’ profit.

18 Risk Management
 Summary Notes

●● The process of risk management consists of identification, measurement, ----------------------

monitoring and control.
----------------------
●● Risk is an integral part of the functioning of any bank; therefore, it is
important to have a sound framework for risk control. ----------------------
●● Risk control is meant not to just minimise the risks but also to ensure ----------------------
that the bank properly identifies measures, handles risks and prepares
adequate and proper reports on all these efforts. ----------------------
●● Like any other enterprise, banks also take risks for increasing profits. ----------------------
●● Thus, banks have to adopt suitable measures to identify, analyse, assess,
control or avoid, minimise or eliminate unacceptable risks. ----------------------
●● With this in mind, banks are expected to establish and operate mechanisms ----------------------
and processes that ensure a continuous assessment of relevant risks on an
individual basis as also the overall risk position of the banks. ----------------------
●● The process covers Enterprise Wide Risk Management as well as specific ----------------------
risk areas such as Credit Risk, Operational Risk, Market Risk, Derivatives,
Securitisation, Asset Liability Management, Foreign Exchange and ----------------------
Dealing Room Operations of the bank’s Treasury. ----------------------
●● Tighter regulation of banking industry would be the need to safeguard
the interest of common people having their hard-earned money with the ----------------------
banks, investors and even for the banking industry itself. The regulation ----------------------
has already come in the form of Basel III and the implementation schedule
is also announced. ----------------------

----------------------
Keywords
----------------------
●● Risk: It is the potential that a chosen action or activity (including the
choice of inaction) will lead to a loss (an undesirable outcome). ----------------------
●● Framework: It is a basic structure underlying a system, concept or text. ----------------------

Self-Assessment Questions ----------------------

1. What are the components of a bank’s risk management framework? ----------------------

2. Explain the framework of credit management of a bank. ----------------------

3. Write short notes on: ----------------------
a. Market Risk Management of a bank
----------------------
b. Asset Liability Management of a bank
----------------------
c. What are the tools for mitigation of various risks?
----------------------

----------------------

Introduction to Risk Management 19

 Notes Answers to Check your Progress
---------------------- Check your Progress 1
---------------------- Fill in the Blanks.

---------------------- 1. The process of risk management consists of identification, measurement,

monitoring and control.
----------------------
2. Like any other enterprise, banks also take risks for increasing profits.
---------------------- Check your Progress 2
---------------------- State True or False.

---------------------- 1. True
2. True
----------------------
3. True
----------------------
Check your Progress 3
---------------------- Fill in the Blanks.
---------------------- 1. When a counterparty delivers a security or its value in cash as per an
agreement, the bank, which is a go-between, faces the settlement risk.
----------------------

---------------------- Suggested Reading

---------------------- 1. Risk Management Guidelines for Banks and Financial Institutions. 2010.
accessed October 2012.
----------------------
2. www.bot-tz.org/adverts/PressRelease/RMGS_2010.pdf
----------------------
3. Risk Management- Guidelines for Commercial Banks & DFIs, accessed
---------------------- October 2012, www.sbp.org.pk/riskmgm.pdf

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

20 Risk Management
Asset Liability Management in Banks
UNIT

2
Structure:

2.1 Introduction
2.2 Asset Liability Management (ALM)
2.3 Objectives of Asset Liability Management in Banks
2.4 Scope and Responsibilities of the ALM Process
2.5 The Asset Liability Management Process
2.5.1 ALM Information Systems
2.5.2 Organisation of ALM through ALCO
2.5.3 Identification, Measurement and Management of Risk, Setting up
Risk Policies and Tolerance Levels
2.6 Important ALM Concepts
2.7 ALM Strategies
2.8 RBI Guidelines on ALM
2.9 Benefits of ALM
2.10 ALM Policy
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Asset Liability Management in Banks 21

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Describe the concept of ALM in banks
----------------------
• Enlist the objectives of Asset Liability Management (ALM) in banks
---------------------- • Distinguish between various ALM concepts
---------------------- • Appraise the role and functions of ALCO

---------------------- • Assess various ALM strategies

• Explain the RBI guidelines on ALM in banks
----------------------

----------------------
2.1 INTRODUCTION
----------------------
The current diversified market place and factors like volatility in exchange
---------------------- and interest rates, changes/crises in the international markets have all started
influencing the domestic economy and have put severe competitive stress on
---------------------- banks and financial institutions. It is well known that banks are not completely
---------------------- immune to risks and that market risk is transmittable. This calls for unambiguous
management of both sides of the Balance Sheet- Assets and Liabilities- not only
---------------------- for facing the challenges ahead but also for improving the bottom lines and
thereby to improve the net worth of the bank.
----------------------
Through Asset Liability Management, banks not only equip themselves
---------------------- to price their assets and liabilities at appropriate levels but manage the related
risks also. Therefore, it is considered as an important tool for monitoring,
---------------------- measuring and managing the market risk of a bank.
----------------------
2.2 ASSET LIABILITY MANAGEMENT (ALM)
----------------------
Asset Liability Management (ALM) is defined as the process of adjusting
---------------------- bank liabilities to meet loan demands, liquidity needs and safety requirements.
---------------------- It is different from the passive acceptance of deposit liabilities from the public
for customary intermediation and maturity transformation into assets. ALM
---------------------- is a philosophy under which the banks can target asset growth by adjusting
liabilities to suit their needs. Therefore, management of assets and liabilities
---------------------- becomes a vital bank management function. The focus of ALM is supposed to
---------------------- be the bank profitability and long-term operating viability.
ALM in banks is a comprehensive and dynamic framework for measuring,
---------------------- monitoring and managing the market risk of a bank. In general terms, ALM is
---------------------- the management of the structure of balance sheet (liabilities and assets) in such
a way that the net earnings from interest is maximised within the overall risk-
---------------------- preference (present and future) of the institution. It has been described as a
continuous process of planning, organising and controlling Asset and Liability
---------------------- volumes, maturities, rates and yields’. As stated above, ALM is precisely defined

22 Risk Management
as the process of adjusting bank liabilities to meet loan demands, liquidity needs Notes
and safety requirements. In the process, it manages the Net Interest Margin
(NIM) within the overall risk bearing capacity of a bank. ----------------------
With the deregulation of interest regime in India, the banking industry ----------------------
has been exposed to the market risks. ALM is used to manage such risks, so
that the management is able to assess the risks and cover some of them by ----------------------
taking appropriate decisions. The ALM concept has been introduced in Indian
----------------------
Banking industry w.e.f. 1st April, 1999.
----------------------
Check your Progress 1
----------------------
Multiple Choice Multiple Response. ----------------------
1. ALM is an important tool for banks:
----------------------
i. Increasing profitability of the bank
----------------------
ii. Meet loan demands, liquidity and safety of the bank
iii. Matching the ssset and liability maturities ----------------------
iv. Improving efficiency of management ----------------------

----------------------
2.3 OBJECTIVES OF ASSET LIABILITY ----------------------
MANAGEMENT IN BANKS
----------------------
The short term objective of ALM in a bank is to ensure liquidity while
protecting the earnings and the long term goal is to maximise the ‘economic ----------------------
value of the bank’, which is defined by the Basel Committee on Banking ----------------------
Supervision as “the present value of bank’s 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 off balance sheet positions.”
----------------------
Major objectives of Asset Liability Management may be listed as under:
----------------------
(1) To protect/enhance the market value of net worth.
(2) To increase the Net Interest Income (NII). ----------------------
(3) To maintain/protect spreads or Net Interest Margin (NIM). ----------------------
Other objectives of ALM are summarised as maximising profitability, ----------------------
minimising of capital, ensuring structural liquidity, ensuring robustness in
market risk management etc. The eventual objective of the ALM process is to ----------------------
maintain/ enhance the profitability and long term operating viability of the bank
in an otherwise risky environment. ----------------------

----------------------
2.4 SCOPE AND RESPONSIBILITIES OF THE ALM
PROCESS ----------------------

The task of the ALM function is to keep different types of risks within ----------------------

Asset Liability Management in Banks 23

 Notes acceptable levels, whilst at the same time to sustain profitability. ALM is
concerned with the following six types of financial risks: (a) Credit risk (b)
---------------------- Liquidity risk (c) Interest rate risk (d) Capital risk (e) Currency risk and (f)
Contingent risk. The ALM functions thus extend to (a) liquidity risk management,
---------------------- (b) management of market risk, (c) trading risk management, (d) funding and
---------------------- capital planning and (e) profit planning and growth projection.
The first and principal task of ALM is to ensure that funds are made
----------------------
available at a competitive price as and when they are required. This involves
---------------------- achieving a proper mix of funds by keeping the level of non-interest funds
to the bare minimum, maximise the fund allocation to high profit areas while
---------------------- simultaneously ensuring availability of funds to meet all eventualities.
---------------------- Another important task of ALM is to ensure harmonising of assets and
liabilities over different time bands and keeping a tag on their pricing by limiting
---------------------- their exposure to interest rate risk.
---------------------- The final responsibility of the ALM process is to control the rates of
interest earned on assets and the rates of interest paid on the liabilities with a
---------------------- view to maximise the spread or net interest income.
----------------------
Activity 1
----------------------

---------------------- Go to the website of World Bank and find out the impact of the
various types of risks that can be addressed through Asset Liability
---------------------- Management.
----------------------

----------------------
2.5 THE ASSET LIABILITY MANAGEMENT PROCESS

---------------------- The system of managing assets and liabilities not as products but as a
composite picture is the essence of Asset Liability Management. ALM is
---------------------- concerned with risk management and provides a comprehensive and dynamic
framework for measuring, monitoring and managing liquidity, interest rate,
---------------------- foreign exchange and equity and commodity price risks of a bank that needs to
---------------------- be closely integrated with the banks’ business strategy. The ALM process rests
on three pillars:
---------------------- (1) ALM Information Systems
---------------------- (2) Organisation of ALM through ALCO
---------------------- (3) Identification, measurement and management of risk, setting up risk
policies and tolerance levels
----------------------
2.5.1 ALM Information Systems
---------------------- The ALM requires a proper management information system, which
---------------------- provides accurate and adequate information and this necessitates extensive
computerisation of the bank, so that the requisite information becomes readily
----------------------

24 Risk Management
available. In fact, the benefits of the application of Information Technology for Notes
building a strong and rich information system are well known.
----------------------
2.5.2 Organisation of ALM through ALCO
The Board of Directors of the bank has the overall responsibility for ----------------------
the ALM and risk management and it is expected to lay down the tolerance ----------------------
limits for liquidity and interest rate risk in line with the bank’s philosophy.
However, the Asset Liability Committee (ALCO) is responsible for deciding ----------------------
on the business strategies consistent with the laid-down policies and for their
implementation. Customarily, the Asset-Liability Committee (ALCO) is headed ----------------------
by the Chairman and Managing Director (CMD) or Executive Director (ED). ----------------------
It includes the functional heads of the departments like Resources/Deposit
Mobilisation, Credit/Advances, Treasury/Investments, Economic Research/ ----------------------
Market Intelligence, Corporate Policy Management, Information & Technology
etc. The ALCO is assisted by the ALM support Group/desk, which comprises ----------------------
of operational level staff. ALCO Support Group provides the data analysis, ----------------------
forecasts and scenario analysis for ALCO. The ALCO has to be supported by
efficient analytics providing detailed analysis, forecasts, scenario analysis and ----------------------
recommendation for action.
----------------------
Based on the Corporate Policy/Targets of the bank, ALCO draws up
strategy/ plans covering short term, medium term and long-term plans for Asset ----------------------
Liability Management. ALCO not only makes business decisions, but also
monitors their implementation and their impact. Further, it also takes action ----------------------
and initiates changes in response to the market dynamics. ----------------------
Operations of Asset Liability Committee
----------------------
The Asset Liability Committee (ALCO) meets periodically and reviews
the specific information/reports received from each department. Some of the ----------------------
periodic reports put up to ALCO by the different departments are as under:
----------------------
(a) Planning and resource management department submits a report on
the deposits; it contains analysis on the rate of interest, cost, maturities ----------------------
and interest sensitivity etc. It also includes information about projects ----------------------
and projections, plan/strategies undertaken and proposed to achieve the
projections. ----------------------
(b) The Credit department submits a report on its performance, projections ----------------------
and expectations.
(c) The Economic Research Cell submits a forecast on the market and its ----------------------
observations on the economic scenario and government/ RBI policies etc. ----------------------
(d) Similarly, Risk Management Department, Treasury/Investment
----------------------
Departments and the Mid Office submit their reports for the relevant
period. ----------------------
Based on the inputs regarding credit growth, resource mobilisation,
----------------------
forecast on market/interest rate movements, internal assessment of liquidity
etc., the ALCO, during its meetings, dwells on strategies of managing assets ----------------------

Asset Liability Management in Banks 25

 Notes and liabilities. Amongst others, it considers product pricing for deposits and
advances, the desired maturity profile of the incremental assets and liabilities,
---------------------- monitoring the risk levels of the bank. It also has to articulate current interest
rate views of the bank and base its decisions for future business strategy on this
---------------------- view.
---------------------- Functions of ALCO
---------------------- The job of ALCO is to accurately determine positions and put in place
suitable and proper remedial measures using appropriate risks. It provides a
---------------------- suitable framework to define, measure, monitor, modify and manage risks. To
---------------------- this end, some of the important functions of the ALCO may be listed as under:
(1) Review of actual performance of the bank vis-à-vis corporate projections.
----------------------
(2) Appraisal of the liquidity profile of the bank.
----------------------
(3) Estimation of the future interest rate scenario.
---------------------- (4) Monitoring spreads based on the changing scenario.
---------------------- (5) Assessing various risks in the balance sheet and drawing strategies to
hedge the risks perceived.
----------------------
(6) Monitoring the policies/strategies implemented and to alter/change if
---------------------- situation needs.

---------------------- (7) Providing appropriate/suitable guidance to the respective departments.

Responsibilities of ALCO
----------------------
The Asset Liability Committee has the overall responsibility of directing
---------------------- acquisition and allocation of funds to maximise earnings on an ongoing basis,
subject to adequate capital and liquidity constraints and also by complying with
----------------------
stipulations/guidelines issued by the bank’s board.
---------------------- 2.5.3 Identification, Measurement and Management of Risk, Setting up
---------------------- Risk Policies and Tolerance Levels
For banks, to maintain liquidity and safety of funds, managing asset
----------------------
liability maturities is very essential. Failing to maintain this asset-liability match,
---------------------- banks are prone to liquidity problems. To avoid this contingency, identification,
measurement and management of risk is an important task to be attended by
---------------------- banking institutions. Generally, a committee headed by one of the members of
the Board of Directors is assigned this important task of setting up risk policies
----------------------
and tolerance levels.
----------------------

----------------------

----------------------

----------------------

----------------------

26 Risk Management
 Notes
Check your Progress 2
----------------------
Multiple Choice Single Response. ----------------------
1. Main function of ALCO is:
----------------------
i. Managing assets and liabilities
----------------------
ii. Product pricing for deposits and advances
iii. Monitoring the risk levels strategy on this view ----------------------

2. Customarily, ALCO is headed by: ----------------------

i. Chief Financial Officer ----------------------
ii. Chairman and Managing Director (CMD) or Executive Director
----------------------
(ED)
iii. Chief Vigilance Officer ----------------------
3. Asset Liability Management Committee in a bank usually has ----------------------
functional heads from which departments?
----------------------
i. Only from Operations Department
ii. Resources/Deposit Mobilisation ----------------------

iii. Only from Information & Technology Department ----------------------

----------------------
2.6 IMPORTANT ALM CONCEPTS ----------------------

(1) Rate Sensitive Assets & Liabilities: An asset or liability is termed as rate ----------------------
sensitive when
----------------------
n Within the time interval under consideration, there is a cash flow. o
The interest rate resets/reprises contractually during the interval. o ----------------------
RBI changes interest rates where rates are administered.
----------------------
n It is contractually pre-payable before the stated maturities.
----------------------
Assets and liabilities, which receive or pay interest that varies with a
benchmark rate, are re-priced at pre-determined intervals and are rate ----------------------
sensitive at the time of re-pricing.
----------------------
(2) Residual Maturity: Residual maturity is the time period that a particular
asset or liability will still take to mature, i.e. become due for payment ----------------------
(once at a time, say in case of a term deposit or in installments, say in case
of term loan). ----------------------
(3) Gap: The Gap refers to the difference between rate sensitive assets and ----------------------
rate sensitive liabilities and it is to be used as a measure of interest rate
sensitivity ----------------------

----------------------

Asset Liability Management in Banks 27

 Notes (4) Maturity Buckets: Maturity buckets are different time intervals (10 for
the time being, namely Next day, 2-7 days, 8-14 days, 15-28, 29-90, 91-
---------------------- 180, 181-365 days, 1-3 years, 3-5 years and above 5 years) in which the
value of a particular asset or liability is placed depending upon its residual
---------------------- maturity.
---------------------- (5) Mismatch Position: When in a particular maturity bucket, the amount
of maturing liabilities or assets does not match, such position is called a
----------------------
mismatch position, which creates liquidity surplus or liquidity shortfall
---------------------- position. Depending upon the interest rate movement, such situation may
turn out to be risky for the bank.
----------------------

---------------------- 2.7 ALM STRATEGIES

---------------------- Asset Liability Management needs to be proactive, appropriate and

commensurate with the business cycle. Consideration has to be given to holding
---------------------- long-term or short-term assets/liabilities with fixed and variable interest rates.
ALM primarily employs a three-pronged strategy described below to ensure
---------------------- attainment of the objectives listed above (under 2.3) without exposing the bank
---------------------- to excessive risks. These three strategies are (a) Spread Management (b) Gap
Management (c) Interest Sensitivity Analysis.
----------------------
(a) Spread Management: The difference between interest earned on
---------------------- deployment and interest paid on the acquisition of financial resources is
referred to as Interest Spread or Interest Margin or Net Interest Spread/
---------------------- Margin or Net Interest Income (NII). The following strategies may prove
useful in ensuring spread maximisation.
----------------------
n Ensuring a steady but controlled growth as also gradual increase in
---------------------- profitability.
---------------------- n Reducing bank’s exposure to cyclical rates and stabilising earnings
over the long term.
----------------------
n Predicting rate changes and planning for such eventualities. o
---------------------- Coordinating rate structure.

---------------------- n Balancing default risk on loans and investments against probable

benefits.
---------------------- (b) Gap Management: Gap refers to the difference between assets and
---------------------- liabilities that can be impacted due the changes in the interest rates. Such
assets and liabilities are referred to as rate sensitive assets (RSA) and rate
---------------------- sensitive liabilities (RSL) respectively. For the gap management purpose,
the assets and liabilities are distributed over different time bands/buckets
---------------------- calling for
---------------------- n Identifying and matching assets and liabilities over different time
bands.
----------------------
n Optimising the earnings over a complete economic cycle without
---------------------- moving to an extreme position during any one phase.

28 Risk Management
 n Building a mechanism to expand and contract assets/liabilities in Notes
response to rate cycle phases.
----------------------
(c) Interest Sensitivity Analysis: This analysis is an extrapolation of gap
management strategy. It concerns with the analysis of the impact of interest ----------------------
change on the bank’s spread/margin and resultant overall earnings. The
strategy includes: ----------------------
n Sorting out fixed and variable interest rate components of the ----------------------
balance sheet.
----------------------
n Recording assumptions regarding rate, volume and mix of the
projected portfolio. ----------------------
n Making alternative assumptions on rise and fall in interest rates. ----------------------
n Testing the impact of assumed changes in the volume and
composition of the portfolio against both rising and falling interest ----------------------
rate scenarios. ----------------------

2.8 RBI GUIDELINES ON ALM ----------------------

Reserve Bank of India had issued guidelines on ALM system on February ----------------------
10, 1999, which covered, among others, interest rate risk and liquidity risk ----------------------
measurement / reporting framework and prudential limits.
As per RBI guidelines, commercial banks were advised to distribute the ----------------------
outflows/ inflows in different residual maturity period known as time buckets. ----------------------
The Assets and Liabilities were earlier divided into 8 maturity buckets (1-14
days, 15-28 days, 29-90 days, 91-180 days, 181-365 days, 1-3 years, 3-5 years ----------------------
and above 5 years), based on the remaining period to their maturity (also called
residual maturity). All the liability figures are outflows while the asset figures ----------------------
are inflows. In September 2007, considering the international practices, the ----------------------
level of sophistication of banks in India, the need for a sharper assessment of
the efficacy of liquidity management and with a view to providing a stimulus ----------------------
for development of the term ‘money market’, RBI revised these guidelines as
follows: ----------------------

a. The banks may adopt a more granular approach to measurement of ----------------------

liquidity risk by splitting the first time bucket (1-14 days at present) in the
Statement of Structural Liquidity into three time buckets viz. next day, ----------------------
2-7 days and 8-14 days. ----------------------
b. The Statement of Structural Liquidity may be compiled on best available
----------------------
data coverage, in due consideration of non-availability of a fully networked
environment. Banks may, however, make concerted and requisite efforts ----------------------
to ensure coverage of 100 % data in a timely manner.
----------------------
c. The net cumulative negative mismatches during the Next day, 2-7 days,
8-14 days and 15-28 days buckets should not exceed 5%, 10%, 15% and ----------------------
20% of the cumulative cash outflows in the respective time buckets in
order to recognise the cumulative impact on liquidity. ----------------------

Asset Liability Management in Banks 29

 Notes d. Banks may undertake dynamic liquidity management and should
prepare the Statement of Structural Liquidity on daily basis. The
---------------------- Statement of Structural Liquidity, may, however, be reported to RBI
once a month- on the third Wednesday of every month.
----------------------
The Boards of the Banks have been entrusted with the overall responsibility
---------------------- for the management of risks and are required to decide the risk management
policy and set limits for liquidity, interest rate, foreign exchange and equity
----------------------
price risks.
----------------------
Check your Progress 3
----------------------

---------------------- Multiple Choice Multiple Response.

1. Reserve Bank of India guidelines on ALM system covers.
----------------------
i. Valuation of Assets & Liabilities
----------------------
ii. Interest rate risk and liquidity risk associated with Assets &
---------------------- Liabilities
iii. Measurement / reporting framework and prudential limits
----------------------
regarding Assets & Liabilities
----------------------

---------------------- Activity 2
----------------------
Visit the RBI website and study the guidelines issued by RBI regarding
---------------------- ALM.
----------------------

---------------------- 2.9 BENEFITS OF ALM

---------------------- Asset Liability Management (ALM) is essentially management of the
timing and the value of the cash flows in banks and the consequential risks. ALM
---------------------- assumes decisive significance in banking because the banks typically borrow
---------------------- short and lend long and therefore, the mismatch between cash inflows and cash
outflows is inherent in banking. It is a tool that enables bank managements to
---------------------- take business decisions in a more informed framework with an eye on the risks
that bank is exposed to. It is an integrated approach to financial management,
---------------------- requiring simultaneous decisions about the types of financial assets and liabilities
---------------------- mix and volume to be used considering complexities of the financial markets.

---------------------- 2.10 ALM POLICY

---------------------- The Asset Liability Policy of a bank is drafted and updated by the bank’s
Asset Liability Committee. The ALM policy requires that board of directors
----------------------
and the ALCO follow a formal procedure. The Policy covers bank’s position on
---------------------- all risks (credit risk, market risk, liquidity risk etc). The ALM policy of a bank

30 Risk Management
needs to change with the changes in the market on a regular and continuous Notes
basis.
----------------------
Activity 3 ----------------------

Go to a nearby bank and prepare a list of the terms relevant to the ----------------------
ALM in banks. ----------------------

----------------------
Summary
----------------------
l ALM is concerned with risk management and provides a comprehensive
and dynamic framework for measuring, monitoring and managing ----------------------
liquidity, interest rate, foreign exchange and equity and commodity price
----------------------
risks of a bank, which needs to be closely integrated with the banks’
business strategy. ----------------------
l ALM is defined as the process of adjusting bank liabilities to meet loan ----------------------
demands, liquidity needs and safety requirements. It is different from the
passive acceptance of deposit liabilities from the public for customary ----------------------
intermediation and maturity transformation into assets.
----------------------
l The focus of ALM is supposed to be the bank profitability and long term
operating viability. ----------------------
l ALM is precisely defined as the process of adjusting bank liabilities ----------------------
to meet loan demands, liquidity needs and safety requirements. In the
process, it manages the Net Interest Margin (NIM) within the overall risk ----------------------
bearing capacity of a bank. The ALM concept has been introduced in
----------------------
Indian Banking industry w.e.f. 1st April, 1999.
l Major objectives of Asset Liability Management are ----------------------
n To protect/enhance the market value of net worth, o To increase ----------------------
the Net Interest Income (NII)
----------------------
n To maintain/protect spreads or Net Interest Margin (NIM).
Other objectives of ALM are summarised as maximising ----------------------
profitability, minimising of capital, ensuring structural liquidity, ----------------------
ensuring robustness in market risk management etc.
l ALM is concerned with the following six types of financial risks. ----------------------

n Credit Risk ----------------------

n Liquidity risk ----------------------
n Interest rate risk
----------------------
n Capital risk
----------------------

----------------------

Asset Liability Management in Banks 31

 Notes n Currency risk
n Contingent Risk.
----------------------
The ALM functions thus extend to:
----------------------
n Liquidity risk management. o Management of market risk. o Trading
---------------------- risk management.

---------------------- n Funding and capital planning.

n Profit planning and growth projection.
----------------------
l The first and principal task of ALM is to ensure that funds are made
---------------------- available at a competitive price as and when they are required. Another
important task of ALM is to ensure harmonising of assets and liabilities
---------------------- over different time bands and keeping a tag on their pricing by limiting
---------------------- their exposure to interest rate risk. The final responsibility of the ALM is
to control the rates of interest earned on assets and the rates of interest
---------------------- paid on the liabilities with a view to maximise the spread or net interest
income.
----------------------
l The Asset Liability Management (ALM) process rests on three pillars
---------------------- (a) ALM Information Systems (b) ALM Organisation (c) ALM Process,
covers Identification, Measurement and Management of risk, setting up
----------------------
Risk policies and tolerance levels.
---------------------- l The Board of Directors of the bank has the overall responsibility for the
ALM and risk management and it is expected to lay down the tolerance
----------------------
limits for liquidity and interest rate risk in line with the bank’s philosophy.
---------------------- However, the Asset Liability Committee (ALCO) is responsible for
deciding on the business strategies consistent with the laid-down policies
---------------------- and for their implementation.
---------------------- l The ALCO is assisted by the ALM support Group/desk, which comprises
of operational level staff. ALCO Support Group provides the data analysis,
---------------------- forecasts and scenario analysis for ALCO. Based on the corporate policy/
---------------------- targets of the bank, the Asset Liability Committee (ALCO) draws up
strategy/ plans covering short term, medium term and long term plans for
---------------------- Asset Liability Management.

---------------------- l Some of the functions of the ALCO are:

n Review of actual performance of the bank vis-à-vis corporate
---------------------- projections.
---------------------- n Appraisal of the liquidity profile of the bank.
---------------------- n Estimation of the future interest rate scenario.
n Monitoring spreads based on the changing scenario.
----------------------
n Assessing various risks in the balance sheet and drawing strategies
---------------------- to hedge the risks perceived.
----------------------

32 Risk Management
 n Monitoring the policies/strategies implemented and to alter/change Notes
if situation needs.
----------------------
n Providing appropriate / suitable guidance to the respective
departments. ----------------------
●● The job of ALCO is to accurately determine positions and put in place
----------------------
suitable and proper remedial measures using appropriate risks. It provides
a suitable framework to define measure, monitor, modify and manage ----------------------
risks.
----------------------
●● Asset Liability Management needs to be proactive, appropriate and
commensurate with the business cycle. Consideration has to be given to ----------------------
holding long-term or short-term assets/liabilities with fixed and variable
interest rates. ALM primarily employs a three-pronged strategy to ensure ----------------------
attainment of the objectives listed above without exposing the bank to
----------------------
excessive risks. These three strategies are Spread Management, Gap
management and Interest Sensitivity Analysis. ----------------------

Keywords ----------------------

----------------------
●● I nterest sensitivity analysis: It concerns with the analysis of the impact
of interest change on the bank’s spread/margin and resultant overall ----------------------
earnings.
----------------------
●● Gap analysis: Gap refers to the difference between assets and liabilities
that can be impacted due the change in the interest rates. ----------------------
●● Interest spread: The difference between interest earned on deployment
----------------------
and interest paid on the acquisition of financial resources is referred to as
Interest Spread or Interest Margin or Net Interest Spread/Margin or Net ----------------------
Interest Income (NII).
----------------------
Self-Assessment Questions ----------------------
1. Explain the scope of Asset Liability Management. Do we need Asset ----------------------
Liability Management in banks?
----------------------
2. Discuss the role of ALCO in the entire picture of Asset Liability
Management. ----------------------
3. Write short notes on: ----------------------
a. Residual maturity
----------------------
b. Gap management
----------------------
c. Rate sensitive assets/liabilities
d. Interest sensitivity analysis ----------------------

----------------------

----------------------

Asset Liability Management in Banks 33

 Notes Answers to Check your Progress
---------------------- Check your Progress 1
---------------------- Multiple Choice Multiple Response.

---------------------- 1. ALM is an important tool for banks:

ii. Meet loan demands, liquidity and safety of the bank
----------------------
iii. Matching the Asset and Liability maturities
----------------------
Check your Progress 2
---------------------- Multiple Choice Single Response.
---------------------- 1. Main function of ALCO is:
---------------------- i. Managing assets and liabilities
2. Customarily ALCO is headed by
----------------------
ii. Chairman and Managing Director (CMD) or Executive Director
---------------------- (ED)
---------------------- 3. Asset Liability Management Committee in a bank usually has functional
heads from which departments?
----------------------
ii. Resources/Deposit Mobilisation
---------------------- Check your Progress 3
---------------------- Multiple Choice Multiple Response.
---------------------- 1. Reserve Bank of India guidelines on ALM system covers
i. Valuation of assets and liabilities
----------------------
ii. Interest rate risk and liquidity risk associated with assets and
---------------------- liabilities
----------------------
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
----------------------
California: Academic Foundation.
---------------------- 2. Benton E. Gup, and James W. Kolari. 2007. Commercial Banking: The
Management of Risk. Australia: John Wiley & Sons.
----------------------
3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
---------------------- Vision Books.
---------------------- 4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic. 2003. Analyzing
and Managing Banking Risk: Framework for Assessing Corporate
---------------------- Governance and Financial Risk. World Bank Publication.
----------------------

----------------------

34 Risk Management
Managing Credit Risk
UNIT

3
Structure:

3.1 Introduction
3.2 Forms of Credit Risk
3.3 Types of Credit Risk
3.4 Credit Risk Management Process
3.5 Building Blocks of Credit Risk
3.6 Instruments of Credit Risk Management
3.7 Loan Review Mechanism (LRM)
3.8 Credit Risk Models
3.9 Credit Risk and Investment Banking
3.10 Credit Risk in Off Balance Sheet Exposure
3.11 Inter-Bank Exposure and Country Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Credit Risk 35

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Reproduce the concept, forms and types of credit risk
----------------------
• Enlist the essential features of credit risk management process
---------------------- • Explain the role played by strategy, organisation and operations in
credit risk management
----------------------
• Assess various credit risk measurement models used by banks
----------------------
• Comment on loan review mechanism adopted by banks
---------------------- • Identify the techniques of managing credit risk in investment banking,
---------------------- off balance sheet exposure and inter- bank exposure

----------------------
----------------------
3.1 INTRODUCTION
----------------------
The importance of risk management in banking framework is discussed
----------------------
in the previous unit. Banks are exposed to different risks and follow different
---------------------- techniques to manage them. The main business of banks is to lend to their
customers. The process of lending exposes the bank to various types of risks. In
---------------------- the upcoming units, we are going to cover in detail different types of risks faced
by banks and the methods to manage the same. The first and the most common
----------------------
type of risk is credit risk, which is the risk of non-recovery of the amount of
---------------------- loan, diminution in credit quality of borrower or reduction in the value of asset.
Other parameters included in credit risk are pre-payment risk, resulting in the
---------------------- loss of opportunity to the bank to earn high interest income. Excess exposure
to a single borrower, industry or geographical area can also impose credit risk.
----------------------
Credit risk arises when a borrower is expecting to use future cash flows to pay
---------------------- a current debt and he is unable to get those cash flows.

---------------------- 3.2 FORMS OF CREDIT RISK

----------------------
Credit risk is a very wide term and has different dimensions. We may say
---------------------- that each and every transaction of a bank has some element of credit risk in
it. RBI has provided an exhaustive list of some of the very common forms of
---------------------- credit risk as under:
---------------------- • In the case of direct lending, funds may not be repaid.
• In the case of guarantees or letters of credit, funds may not be forthcoming
----------------------
from the customer upon crystallisation of the liability under the contract.
---------------------- • In the case of treasury products, the payment or series of payments
---------------------- due from the counterparty under the respective contracts may not be
forthcoming or ceases.
36 Risk Management
• In the case of securities trading businesses, settlement may not be effected. Notes
• In the case of cross-border exposure, the availability and free transfer of
----------------------
currency may be restricted or ceases.
The diversification of banking system has forced the banks to have ----------------------
intricate systems to protect themselves from a wide variety of risks. Credit risk
----------------------
management enables banks to identify, assess, manage proactively and optimise
their credit risk at an individual level or at an entity level or at the level of a ----------------------
country. Given the fast changing, dynamic world scenario with the pressures of
globalisation, liberalisation, consolidation and disintermediation, it is important ----------------------
that banks have robust credit risk management policies and procedures, which
----------------------
are sensitive and responsive to these changes.
----------------------
3.3 TYPES OF CREDIT RISK
----------------------
After covering the forms of credit risk, we will now see that credit risk
----------------------
can arise due to three main reasons and accordingly, it is classified into the
following three broad headings. ----------------------
1. Credit Default Risk: Risk of loss on account of default on part of the
----------------------
borrower to honor his obligations in terms of repayment of principal or
interest or both. ----------------------
2. Concentration Risk: Risk associated with any single exposure to
----------------------
a particular client, industry segment or geographical location. Such
exposures can threaten the bank’s core operations. ----------------------
3. Country Risk: The risk of loss arising when a sovereign state freezes ----------------------
foreign currency payments (transfer/conversion risk) or when it defaults
on its obligations (sovereign risk). ----------------------

----------------------
3.4 CREDIT RISK MANAGEMENT PROCESS
----------------------
The management of credit risk should receive the top management’s
attention and, as per guidelines issued by RBI, the process should encompass ----------------------
the following:
----------------------
a) Measurement of risk through credit rating/scoring.
b) Quantifying the risk through estimating expected loan losses, i.e. the ----------------------
amount of loan losses that the bank would experience over a chosen time ----------------------
horizon (through tracking portfolio behaviour over 5 or more years) and
unexpected loan losses, i.e. the amount by which actual losses exceed ----------------------
the expected loss (through standard deviation of losses or the difference
between expected loan losses and some selected target credit loss ----------------------
quantile). ----------------------
c) Risk pricing on a scientific basis.
----------------------
d) Controlling the risk through effective Loan Review Mechanism and
portfolio management. ----------------------

Managing Credit Risk 37

 Notes
Check your Progress 1
----------------------

---------------------- State True or False.

1. The process of lending exposes the bank to various types of risks.
----------------------
Fill in the Blanks.
----------------------
1. Credit risk is the risk of __________ the amount of loan, ________ in
---------------------- credit quality of borrower or ________ in the value of asset.

----------------------

---------------------- Activity 1

---------------------- 1. Meet a bank manager and enquire about various factors that can
---------------------- expose a bank to credit risk.
2. Interview the Credit Manager of any bank on the steps involved in
---------------------- credit risk management process of banks.
----------------------

---------------------- 3.5 BUILDING BLOCKS OF CREDIT RISK

---------------------- In any bank, the corporate goals and credit culture are closely linked and
---------------------- an effective credit risk management framework requires the following distinct
building blocks:
---------------------- 1. Strategy and Policy
----------------------  his covers issues such as the definition of the credit appetite, the
T
development of credit guidelines and the identification and the assessment
----------------------
of the credit risk.
---------------------- 2. Organisation
---------------------- his would entail the establishment of competencies and clear
T
accountabilities for managing the credit risk.
----------------------
3. Operations/Systems
----------------------
 IS requirements of the senior and middle management and the
M
---------------------- development of tools and techniques will come under this domain.

---------------------- We will now cover each of these building blocks in detail:

4. Strategy and Policy
----------------------
 very bank should have its own credit risk strategy clearly defining the
E
---------------------- following:
---------------------- • Objectives for the credit granting function.

---------------------- • Credit appetite of the bank.

38 Risk Management
• Acceptable risk levels. Notes
• Bank’s willingness to grant loans based on the type of economic activity,
----------------------
geographical location, currency, market, maturity and anticipated
profitability. ----------------------
• Identification of target markets and business sectors.
----------------------
• Preferred levels of diversification and concentration.
----------------------
• The cost of capital in granting credit and the cost of bad debts.
The credit risk strategy should take into account the cyclical aspects of ----------------------
any economy and should be viable in the long run and through various credit ----------------------
cycles.
The policy document should cover issues such as: ----------------------

• Organisational responsibilities. ----------------------

• Risk measurement and aggregation techniques. ----------------------
• Prudential requirements. ----------------------
• Risk assessment and review.
----------------------
• Reporting requirements.
----------------------
• Risk grading, product guidelines, documentation, legal issues and
management of problem loans. ----------------------
Loan policies, apart from ensuring consistency in credit practices, should
----------------------
also provide a vital link to the other functions of the bank. It has been empirically
proved that organisations with sound and well-articulated loan policies have ----------------------
been able to contain the loan losses arising from poor loan structuring and
perfunctory risk assessments. ----------------------
As per RBI, in order to keep the credit risk under control, banks should ----------------------
have the following in place:
----------------------
• Dedicated policies and procedures to control exposures to designated
higher risk sectors such as capital markets, aviation, shipping, property ----------------------
development, defence equipment, highly leveraged transactions, bullion
etc. ----------------------

• Sound procedures to ensure that all risks associated with requested credit ----------------------
facilities are promptly and fully evaluated by the relevant lending and
credit officers. ----------------------

• Systems to assign a risk rating to each customer/borrower to whom credit ----------------------

facilities have been sanctioned.
----------------------
• A mechanism to price facilities depending on the risk grading of the
customer and to attribute accurately the associated risk weightings to the ----------------------
facilities.
----------------------
• Efficient and effective credit approval process operating within the
approval limits authorised by the Boards. ----------------------

Managing Credit Risk 39

 Notes • Procedures and systems that allow for monitoring financial performance
of customers and for controlling outstanding within limits.
----------------------
• Systems to manage problem loans to ensure appropriate restructuring
---------------------- schemes. A conservative policy for the provisioning of non-performing
advances should be followed.
----------------------
• A process to conduct regular analysis of the portfolio and to ensure on-
---------------------- going control of risk concentrations.
The credit policies and procedures should necessarily have the following
----------------------
elements:
---------------------- • Banks should have written credit policies that define target markets,
---------------------- risk acceptance criteria, credit approval authority, credit origination and
maintenance procedures and guidelines for portfolio management and
---------------------- remedial management.

---------------------- • Banks should establish proactive credit risk management practices such
as annual / half yearly industry studies and individual obligor reviews,
---------------------- periodic credit calls that are documented, periodic plant visits and at least
quarterly management reviews of troubled exposures/weak credits.
----------------------
• Business managers in banks will be accountable for managing risk and in
---------------------- conjunction with credit risk management framework for establishing and
maintaining appropriate risk limits and risk management procedures for
---------------------- their businesses.
---------------------- • Banks should have a system of checks and balances in place around the
extension of credit, which are:
----------------------
n An independent credit risk management function
----------------------
n Multiple credit approvers
---------------------- n An independent audit and risk review function
---------------------- • The Credit Approving Authority to extend or approve credit will be granted
to individual credit officers based upon a consistent set of standards of
---------------------- experience, judgment and ability.
---------------------- • The level of authority required to approve credit will increase as amounts
and transaction risks increase and as risk ratings worsen.
----------------------
• Every obligor and facility must be assigned a risk rating.
----------------------
• Banks should ensure that there are consistent standards for the origination,
---------------------- documentation and maintenance for extensions of credit.

---------------------- • Banks should have a consistent approach towards early problem

recognition, classification of problem exposures and remedial action.
---------------------- • Banks should maintain a diversified portfolio of risk assets in line with
---------------------- the capital desired to support such a portfolio.
• Credit risk limits include, but are not limited to, obligor limits and
---------------------- concentration limits by industry or geography.

40 Risk Management
• In order to ensure transparency of risks taken, it is the responsibility Notes
of banks to accurately, completely and in a timely fashion, report the
comprehensive set of credit risk data into the independent risk system. ----------------------
Organisation Structure ----------------------
An independent group responsible for credit risk management is one of ----------------------
the most common features of a successful bank. The board of the bank should
ensure that the independence of this department is not compromised at any ----------------------
point of time (Figure 3.1).
----------------------
Depending on the size of the organisation or loan book, the bank may
constitute a high level Credit Policy Committee also called Credit Risk ----------------------
Management Committee or Credit Control Committee. This committee will
deal with issues relating to credit policy and procedures and analyze, manage ----------------------
and control credit risk on a bank wide basis. ----------------------
The Committee should be headed by the Chairman/CEO/ED and should
comprise heads of Credit Department, Treasury, Credit Risk Management ----------------------
Department (CRMD) and the Chief Economist. The Committee should, inter ----------------------
alia, formulate clear policies on standards for the following:
----------------------
• Presentation of credit proposal.
• Financial covenants. ----------------------
• Rating standards and benchmarks. ----------------------
• Delegation of credit approving powers. ----------------------
• Prudential limits on large credit exposures.
----------------------
• Asset concentrations.
----------------------
• Standards for loan collateral.
• Portfolio management. ----------------------
• Loan review mechanism. ----------------------
• Risk concentrations, monitoring and evaluation. ----------------------
• Pricing of loans.
----------------------
• Provisioning.
----------------------
• Regulatory/legal compliance.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Credit Risk 41

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- (Source: http://www.fujitsu.com)

Fig. 3.1: Organisation Structure
----------------------
Concurrently, each bank may also set up Credit Risk Management
---------------------- Department (CRMD), independent of the Credit Administration Department.
---------------------- The CRMD should enforce and monitor compliance of the risk parameters and
prudential limits set by the CPC. The main responsibilities of the credit risk
---------------------- management team include:

---------------------- • Formulate credit policies, procedures and controls extending to all areas
of credit risk.
---------------------- • Provide overview of portfolio trends, concentration risk across banks and
---------------------- individual lines of business.
• Provide inputs to Asset Liability Management Committee.
----------------------
• Conduct industry and sectoral studies.
----------------------
• Provide inputs for strategic and annual operating plans.
---------------------- • Monitor quality of loan portfolio, identify problems and correct
---------------------- deficiencies.
• Protect quality of overall loan portfolio.
----------------------
• Take a periodical review of credit related processes and operating
---------------------- procedures.
---------------------- The credit risk strategy and policies should be effectively communicated
throughout the organisation. All lending officers should clearly understand the
---------------------- bank’s approach to granting credit and should be held accountable for complying
with the policies and procedures.
----------------------
Operations and Systems
----------------------
Banks should have in place an appropriate credit administration,
---------------------- measurement and monitoring process. As per RBI, the credit process typically
involves the following phases:
----------------------
a) Relationship management phase, i.e. business development.
----------------------

42 Risk Management
b) Transaction management phase covers risk assessment, pricing, Notes
structuring of the facilities, obtaining internal approvals, documentation,
loan administration and routine monitoring and measurement. ----------------------
c) Portfolio management phase entails the monitoring of the portfolio at a ----------------------
macro level and the management of problem loans.
----------------------
Successful credit management requires experience, judgment and a
commitment to technical development. Each bank should have a clear, well- ----------------------
documented scheme of delegation of limits. Authorities should be delegated
to executives depending on their skill and experience levels. The banks should ----------------------
have systems in place for reporting and evaluating the quality of the credit
----------------------
decisions taken by the various officers.
The credit approval process should aim at efficiency, responsiveness and ----------------------
accurate measurement of the risk. This will be achieved through a comprehensive
----------------------
analysis of the borrower’s ability to repay, clear and consistent assessment
systems, a process that ensures that renewal requests are analyzed as carefully ----------------------
and stringently as new loans and constant reinforcement of the credit culture by
the top management team. ----------------------
Commitment to new systems and IT will also determine the quality of ----------------------
the analysis being conducted. There is a range of tools available to support the
decision-making process. These are: ----------------------

a) Traditional techniques such as financial analysis. ----------------------

b) Decision support tools such as credit scoring and risk grading. c) - - - - - - - - - - - - - - - - - - - - - -
Portfolio techniques such as portfolio correlation analysis.
----------------------
The key is to identify the tools that are appropriate to the bank.
Banks should develop and utilise internal risk rating systems in managing - - - - - - - - - - - - - - - - - - - - - -
credit risk. The rating system should be consistent with the nature, size and
----------------------
complexity of the bank’s activities.
Banks must have an MIS, which will enable them to manage and measure - - - - - - - - - - - - - - - - - - - - - -
the credit risk inherent in all on- and off-balance sheet activities. The MIS ----------------------
should provide adequate information on the composition of the credit portfolio,
including identification of any concentration of risk. Banks should price their ----------------------
loans according to the risk profile of the borrower and the risks associated with
the loans. ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Credit Risk 43

 Notes
Check your Progress 2
----------------------

---------------------- Fill in the Blanks.

1. The credit approval process should aim at _______, __________ and
----------------------
measurement of the risk.
---------------------- 2. Banks must have an ________, which will enable them to manage
and measure the risk inherent in all balance sheet activities.
----------------------

----------------------
Activity 2
----------------------

---------------------- 1. Visit www.bis.org/bcbs/events/b2earoc.pdf and note down your

views on the three pillars of credit risk management.
----------------------
2. Visit a nearby bank and interview the manager to find out what role
---------------------- does sound IT system play in managing credit risk.
----------------------

---------------------- 3.6 INSTRUMENTS OF CREDIT RISK MANAGEMENT

---------------------- Credit Risk Management encompasses a host of management techniques,
which help the banks in mitigating the adverse impacts of credit risk.
----------------------
Credit Approving Authority
----------------------
Credit approving authority plays a very important role in credit risk
---------------------- management.

---------------------- The exposure to credit risk starts at this stage and if credit is not sanctioned
diligently, then it can have an impact on credit risk of the bank. Following are
---------------------- the salient features of credit approving authority:

---------------------- a. Carefully formulated scheme of delegation of powers.

b. Multi-tier credit approving system where the loan proposals are approved
---------------------- by an ‘Approval Grid’ or a ‘Committee’.
---------------------- c. The credit facilities above a specified limit may be approved by the ‘Grid’
or ‘Committee’, comprising at least 3 or 4 officers. Invariably, one officer
----------------------
should represent the CRMD, who has no volume and profit targets.
---------------------- d. Credit approving committees at various operating levels, i.e. large
branches (where considered necessary), Regional Offices, Zonal Offices,
----------------------
Head Offices etc.
---------------------- e. Delegation of powers for sanction of higher limits to the ‘Approval Grid’
or the ‘Committee’ for better rated / quality customers.
----------------------
f. No credit proposals should be approved or recommended to higher
---------------------- authorities, if majority members of the ‘Approval Grid’ or ‘Committee’

44 Risk Management
 do not agree on the credit worthiness of the borrower. Notes
g. Suitable framework for reporting and evaluating the quality of credit
----------------------
decisions taken by various functional groups.
h. Well-defined Loan Review Mechanism. ----------------------
Prudential Limits ----------------------
In order to limit the magnitude of credit risk, prudential limits should be ----------------------
laid down on various aspects of credit:
----------------------
a. Benchmark current/debt equity and profitability ratios, debt service
coverage ratio or other ratios should be clearly defined and there should ----------------------
be sufficient flexibility for deviations. The loan policy document should
clearly mention the conditions under which deviation will be allowed and ----------------------
the authority thereof.
----------------------
b. A filtering mechanism should be established by setting up single/group
borrower limits, which may be lower than the limits prescribed by the ----------------------
Reserve Bank.
----------------------
c. Substantial exposure limit to be set up, i.e. sum total of exposures assumed
in respect of those single borrowers enjoying credit facilities in excess ----------------------
of a threshold limit, say 10% or 15% of capital funds. The substantial
----------------------
exposure limit may be fixed at 600% or 800% of capital funds, depending
upon the degree of concentration risk to which the bank is exposed. ----------------------
d. Maximum exposure limits to industry, sector etc. should be set up. There ----------------------
must also be systems in place to evaluate the exposures at reasonable
intervals and the limits should be adjusted especially when a particular ----------------------
sector or industry faces slowdown or other sector / industry-specific
problems. The exposure limits to sensitive sectors such as advances ----------------------
against equity shares, real estate, etc., which are subject to a high degree ----------------------
of asset price volatility and to specific industries, which are subject to
frequent business cycles, may necessarily be restricted. ----------------------
e. Banks may consider maturity profile of the loan book, keeping in view ----------------------
the market risks inherent in the balance sheet, risk evaluation capability,
liquidity etc. ----------------------
Risk Rating ----------------------
Banks should have a comprehensive risk scoring / rating system that
----------------------
serves as a single point indicator of diverse risk factors of counterparty and
for taking credit decisions in a consistent manner. The following should be the ----------------------
salient features of an efficient risk rating system in a bank:
----------------------
a. Standardisation in ratings across borrowers.
b. Rating system should be designed to reveal the overall risk of lending, ----------------------
critical input for setting pricing and non-price terms of loans as also ----------------------
present meaningful information for review and management of loan
portfolio. ----------------------

Managing Credit Risk 45

 Notes c. The rating exercise should facilitate the credit granting authorities some
comfort in its knowledge of loan quality at any moment of time.
----------------------
d. Well-structured rating system should incorporate financial analysis,
---------------------- projections and sensitivity, industrial and management risks.
e. Risk rating mechanism should use various financial ratios and operational
----------------------
parameters and collaterals as also qualitative aspects of management and
---------------------- industry characteristics that have bearings on the creditworthiness of
borrowers.
----------------------
f. Well defined level of standards or critical parameters beyond which no
---------------------- proposals should be entertained.

---------------------- g. Separate rating framework for large corporate/small borrowers, traders

etc. that exhibits varying nature and degree of risk.
---------------------- h. Due weightage to the unhedged market risk exposures of borrowers in the
---------------------- rating framework.
i. The overall score for risk is to be placed on a numerical scale ranging
---------------------- between 1-6, 1-8 etc. on the basis of credit quality. For each numerical
---------------------- category, a quantitative definition of the borrower, the loan’s underlying
quality and an analytic representation of the underlying financials of the
---------------------- borrower should be presented.
---------------------- j. Bank should prescribe the minimum rating below which no exposures
would be undertaken. Any flexibility in the minimum standards and
---------------------- conditions for relaxation and authority thereof should be clearly articulated
in the Loan Policy.
----------------------
Risk Pricing
----------------------
Risk-return pricing is a fundamental tenet of risk management (Figure
---------------------- 3.2). In a risk-return setting, borrowers with weak financial position and hence
placed in high credit risk category should be priced high. Thus, banks should
---------------------- evolve scientific systems to price the credit risk, which should have a bearing
---------------------- on the expected probability of default.

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 3.2: Risk-Return-Supervision Development
---------------------- [Source: http://1.bp.blogspot.com/]

46 Risk Management
 The pricing of loans normally should be linked to risk rating or credit Notes
quality. The probability of default could be derived from the past behaviour of
the loan portfolio, which is the function of loan loss provision/charge offs for ----------------------
the last five years or so. Banks should build historical database on the portfolio
quality and provisioning / charge off to equip themselves to price the risk. ----------------------
Various factors that need to be taken into account while pricing a loan are as ----------------------
under:
----------------------
• Probability of default.
• Value of collateral. ----------------------
• Market forces. ----------------------
• Perceived value of accounts. ----------------------
• Future business potential.
----------------------
• Portfolio/industry exposure.
----------------------
Flexibility should also be made for revising the price (risk premia) due to
changes in rating/value of collaterals over time. ----------------------
Portfolio Management ----------------------
The existing framework of tracking the Non Performing Loans around
the balance sheet date does not signal the quality of the entire Loan Book. ----------------------
Banks should evolve proper systems for identification of credit weaknesses ----------------------
well in advance. Most of international banks have adopted various portfolio
management techniques for gauging asset quality. The CRMD set up at Head ----------------------
Office should be assigned the responsibility of periodic monitoring of the
portfolio. ----------------------

Following techniques could be used for evaluating the portfolio quality. ----------------------
• Tracking the migration (upward or downward) of borrowers from one ----------------------
rating scale to another.
----------------------
• Stipulate quantitative ceiling on aggregate exposure in specified rating
categories, i.e. certain % of total advances should be in the rating category ----------------------
of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5 etc.
----------------------
• Evaluate the rating-wise distribution of borrowers in various industry,
business segments etc. ----------------------
• Exposure to one industry/sector should be evaluated on the basis of ----------------------
overall rating distribution of borrowers in the sector/group.
• Target rating-wise volume of loans, probable defaults and provisioning ----------------------
requirements is a prudent planning exercise. For any deviation/s from the ----------------------
expected parameters, an exercise for restructuring of the portfolio should
immediately be undertaken and if necessary, the entry level criteria could ----------------------
be enhanced to insulate the portfolio from further deterioration.
----------------------
• Undertake rapid portfolio reviews, stress tests and scenario analysis
when external environment undergoes rapid changes (e.g. volatility in ----------------------

Managing Credit Risk 47

 Notes the forex market, economic sanctions, changes in the fiscal/monetary
policies, general slowdown of the economy, market risk events, extreme
---------------------- liquidity conditions etc.). The stress tests would reveal undetected areas
of potential credit risk exposure and linkages between different categories
---------------------- of risk. In adverse circumstances, there may be substantial correlation of
---------------------- various risks, especially credit and market risks.
• Introduce discriminatory time schedules for renewal of borrower limits.
----------------------
Lower rated borrowers whose financials show signs of problems should
---------------------- be subjected to renewal control twice/thrice a year.
----------------------
3.7 LOAN REVIEW MECHANISM (LRM)
----------------------
LRM is an effective tool introduced by RBI for constantly evaluating
---------------------- the quality of loan book and to bring about qualitative improvements in credit
administration. Banks should, therefore, put in place proper Loan Review
----------------------
Mechanism for large value accounts with responsibilities assigned in various
---------------------- areas such as evaluating the effectiveness of loan administration, maintaining
the integrity of credit grading process, assessing the loan loss provision, portfolio
---------------------- quality etc. The complexity and scope of LRM normally vary based on bank
size, type of operations and management practices. It may be independent of
----------------------
the CRMD or even a separate department in large banks. The main objectives
---------------------- of LRM could be:
• To identify promptly loans, which develop credit weaknesses and initiate
----------------------
timely corrective action.
---------------------- • To evaluate portfolio quality and isolate potential problem areas.
---------------------- • To provide information for determining adequacy of loan loss provision.

---------------------- • To assess the adequacy of and adherence to loan policies and procedures
and to monitor compliance with relevant laws and regulations.
---------------------- • To provide top management with information on credit administration,
---------------------- including credit sanction process, risk evaluation and post-sanction
follow- up.
----------------------
Accurate and timely credit grading is one of the basic components of
---------------------- an effective LRM. Credit grading involves assessment of credit quality,
identification of problem loans and assignment of risk ratings. A proper
---------------------- Credit Grading System should support evaluation of the portfolio quality and
establishment of loan loss provisions. Given the importance and subjective
----------------------
nature of credit rating, the credit ratings awarded by Credit Administration
---------------------- Department should be subjected to review by Loan Review Officers who are
independent of loan administration.
----------------------
Banks should formulate Loan Review Policy and it should be reviewed
---------------------- annually by the Board. The Policy should, inter alia, address the following:

---------------------- • Qualification and Independence - The Loan Review Officers should

48 Risk Management
 have sound knowledge in credit appraisal, lending practices and loan Notes
policies of the bank. They should also be well versed in the relevant
laws/regulations that affect lending activities. The independence of Loan ----------------------
Review Officers should be ensured and the findings of the reviews should
also be reported directly to the Board ----------------------

• Frequency and Scope of Reviews - The Loan Reviews are designed ----------------------
to provide feedback on effectiveness of credit sanction and to identify
----------------------
incipient deterioration in portfolio quality. Reviews of high value loans
should be undertaken usually within three months of sanction/renewal or ----------------------
more frequently when factors indicate a potential for deterioration in the
credit quality. The scope of the review should cover all loans above a cut- ----------------------
off limit.
----------------------
• Depth of Reviews - The loan reviews should focus on the following:
----------------------
n Approval process.
n Accuracy and timeliness of credit ratings assigned by loan officers. ----------------------

n Adherence to internal policies and procedures and applicable laws / ----------------------

regulations.
----------------------
n Compliance with loan covenants.
----------------------
n Post-sanction follow-up.
n Sufficiency of loan documentation. ----------------------
n Portfolio quality. ----------------------
n Recommendations for improving portfolio quality. ----------------------
The findings of Reviews should be discussed with line Managers and
corrective actions should be elicited for all deficiencies. Deficiencies that ----------------------
remain unresolved should be reported to top management. ----------------------

Activity 3 ----------------------

----------------------
1. Suppose you are a bank manager. What techniques will you suggest
the bank to monitor its portfolio quality? ----------------------
2. Visit www.rbidocs.rbi.org.in/rdocs/notification/PDFs/9492.pdf and ----------------------
outline the points mentioned for Risk Management Systems in Banks.
----------------------

----------------------
3.8 CREDIT RISK MODELS
----------------------
RBI has introduced various credit risk modlesto aid banks in quantifying,
----------------------
aggregating and managing risk across geographical and product lines. The
outputs of these models also play increasingly important roles in banks’ risk ----------------------
management and performance measurement processes, including performance-
based compensation, customer profitability analysis, risk-based pricing ----------------------

Managing Credit Risk 49

 Notes and active portfolio management and capital structure decisions. Credit risk
modelling may result in better internal risk management and may have the
---------------------- potential to be used in the supervisory oversight of banking organisations.
---------------------- In the measurement of credit risk, models may be classified along three
different dimensions, which are explained below.
----------------------
• The techniques employed.
---------------------- • The domain of applications in the credit process.
---------------------- • The products to which they are applied.

---------------------- Techniques
The following are the more commonly used techniques:
----------------------
(a) Econometric Techniques such as linear and multiple discriminant
---------------------- analysis, multiple regression, logic analysis and probability of default or
the default premium, as a dependent variable whose variance is explained
----------------------
by a set of independent variables.
---------------------- (b) Neural networks are computer-based systems that use the same data
---------------------- employed in the econometric techniques but arrive at the decision model
using alternative implementations of a trial and error method.
---------------------- (c) Optimisation models are mathematical programming techniques that
---------------------- discover the optimum weights for borrower and loan attributes that
minimise lender error and maximise profits.
---------------------- (d) Rule-based or expert systems are characterised by a set of decision rules,
---------------------- a knowledge base consisting of data such as industry financial ratios and
a structured inquiry process to be used by the analyst in obtaining the data
---------------------- on a particular borrower.
---------------------- (e) Hybrid Systems using direct computation, estimation and simulation are
driven in part by a direct causal relationship, the parameters of which
---------------------- are determined through estimation techniques. An example of this is
the KMV model, which uses an option theoretic formulation to explain
----------------------
default and then derives the form of the relationship through estimation.
---------------------- Domain of application
---------------------- These models are used in a variety of domains:
---------------------- (a) Credit approval: Models are used by themselves or in conjunction with a
judgmental override system for approving credit in the consumer lending
---------------------- business. The use of such models has expanded to include small business
lending and first mortgage loan approvals. They are generally not used in
----------------------
approving large corporate loans, but they may be one of the inputs to a
---------------------- decision.
(b) Credit rating determination: Quantitative models are used in deriving
----------------------
‘shadow bond rating’ for unrated securities and commercial loans. These
---------------------- ratings in turn influence portfolio limits and other lending limits used

50 Risk Management
 by the institution. In some instances, the credit rating predicted by the Notes
model is used within an institution to challenge the rating as signed by the
traditional credit analysis process. ----------------------
(c) Credit risk models may be used to suggest the risk premiums that should ----------------------
be charged in view of the probability of loss and the size of the loss given
default. Using a mark-to-market model, an institution may evaluate the ----------------------
costs and benefits of holding a financial asset. Unexpected losses implied
----------------------
by a credit model may be used to set the capital charge in pricing.
(d) Financial early warning: Credit models are used to flag potential ----------------------
problems in the portfolio to facilitate early corrective action.
----------------------
(e) Common credit language: Credit models may be used to select assets
from a pool to construct a portfolio acceptable to investors or to achieve ----------------------
the minimum credit quality needed to obtain the desired credit rating.
----------------------
Underwriters may use such models for due diligence on the portfolio
(such as a collateralised pool of commercial loans). ----------------------
(f) Collection strategies: Credit models may be used in deciding on the best ----------------------
collection or workout strategy to pursue. If, for example, a credit model
indicates that a borrower is experiencing short-term liquidity problems ----------------------
rather than a decline in credit fundamentals, then an appropriate workout
may be devised. ----------------------

Relevance to the decision maker ----------------------

Credit Risk Models have assumed importance because they provide the ----------------------
decision maker with an insight or knowledge that would not otherwise be readily
available or that could be marshalled at prohibitive cost. In a marketplace where ----------------------
margins are fast disappearing and the pressure to low cost is unrelenting, models
----------------------
give their users a competitive edge.
----------------------
3.9 CREDIT RISK AND INVESTMENT BANKING
----------------------
Significant amount of credit risk is inherent in investment banking and
----------------------
hence investment proposals should be subjected to same degree of risk analysis
as a loan proposal. There should be detailed appraisal and rating framework, ----------------------
which takes into account financial and non-financial parameters of issuer,
sensitivity to external developments etc. The investment proposals are not ----------------------
rated and hence special care should be taken while doing risk evaluation. There
----------------------
should be greater interaction between Credit and Treasury Departments and the
portfolio analysis should also cover the total exposures, including investments. ----------------------
The rating migration of the issuers and the consequent diminution in the
portfolio quality should also be tracked at periodic intervals. ----------------------
As a matter of prudence, banks should stipulate entry-level minimum ----------------------
ratings/ quality standards, industry, maturity, duration, issuer wise etc. limits in
investment proposals as well to mitigate the adverse impacts of concentration ----------------------
and the risk of illiquidity.
----------------------

Managing Credit Risk 51

 Notes 3.10 CREDIT RISK IN OFF BALANCE SHEET EXPOSURE
---------------------- Banks should evolve an adequate framework for managing their exposure
in off-balance sheet products like forex forward contracts, swaps, options, etc.
---------------------- as a part of overall credit to individual customer relationship and subject to the
same credit appraisal, limits and monitoring procedures.
----------------------
Banks should classify their off-balance sheet exposures into three broad
---------------------- categories.
---------------------- 1. Full risk (credit substitutes): standby letters of credit, money guarantees,
etc.
----------------------
2. Medium risk (not direct credit substitutes, which do not support existing
---------------------- financial obligations): bid bonds, letters of credit, indemnities and
warranties.
----------------------
3. Low risk: reverse repos, currency swaps, options, futures, etc.
----------------------
The total exposures to the counterparties on a dynamic basis should be the
---------------------- sum total of the current replacement cost (unrealised loss to the counterparty)
and the potential increase in replacement cost (estimated with the help of VaR
---------------------- or other methods to capture future volatilities in the value of the outstanding
contracts/ obligations).
----------------------
The current and potential credit exposures may be measured on a daily
---------------------- basis to evaluate the impact of potential changes in market conditions on the
---------------------- value of counterparty positions.

---------------------- 3.11 INTER-BANK EXPOSURE AND COUNTRY RISK

---------------------- A suitable framework should be evolved to provide a centralised overview
on the aggregate exposure on other banks. Bank-wise exposure limits could be
----------------------
set on the basis of assessment of financial performance, operating efficiency,
---------------------- management quality, past experience, etc. Like corporate clients, banks should
also be rated and placed in range of 1-5, 1-8, as the case may be, on the basis
---------------------- of their credit quality. The limits so arrived at should be allocated to various
operating centres, followed up and half-yearly/annual reviews undertaken at a
----------------------
single point. Regarding exposure on overseas banks, banks can use the country
---------------------- ratings of international rating agencies and classify the countries into low risk,
moderate risk and high risk. Banks should endeavour for developing an internal
---------------------- matrix that reckons the counterparty and country risks. The maximum exposure
should be subjected to adherence of country and bank exposure limits already
----------------------
in place. While the exposure should at least be monitored on a weekly basis till
---------------------- the banks are equipped to monitor exposures on a real time basis, all exposures
to problem countries should be evaluated on a real time basis.
----------------------
The key financial parameters to be evaluated for any bank are:
---------------------- a) Capital Adequacy: It needs to be appropriate to the size and structure of
---------------------- the balance sheet as it represents the buffer to absorb losses during difficult

52 Risk Management
 times, whereas over capitalisation can impact overall profitability. Related Notes
to the issue of capitalisation is also the ability to raise fresh capital as and
when required. ----------------------
b) Asset Quality: The asset portfolio in its entirety should be evaluated ----------------------
and should include an assessment of both funded lines and off-balance
sheet items. The quality of the loan book will be reflected in the non- ----------------------
performing assets and provisioning ratios, while exposure to the capital
----------------------
market and sensitive sectors will be indicated by high volatility, affecting
both valuations and earnings. ----------------------
c) Liquidity: Commercial bank deposits generally have a much shorter
----------------------
contractual maturity than loans and liquidity management needs to provide
a cushion to cover anticipated deposit withdrawals. The key ratios to be ----------------------
analyzed are Total Liquid Assets/Total Assets ratio (the higher the ratio,
the more liquid the bank is), Total Liquid Assets/Total Deposits ratio (this ----------------------
measures the bank’s ability to meet withdrawals), Loans/Deposits ratio
----------------------
and the inter-bank ratio.
d) Profitability: A consistent year on year growth in profitability is required ----------------------
to provide an acceptable return to shareholders and retain resources to
----------------------
fund future growth. The key ratios to be analyzed are Return on Average
Assets (measures a bank’s growth/decline in comparison to its balance ----------------------
sheet expansion/contraction), Return on Equity (provides an indication
of how well the bank is performing for its owners), Net Interest Margin ----------------------
(measures the difference between interest paid and interest earned and
----------------------
therefore a bank’s ability to earn interest income) and Operating Expenses/
Net Revenue (the cost/income ratio of the bank). ----------------------

Check your Progress 3 ----------------------

----------------------
State True or False.
----------------------
1. Credit Risk Models have assumed importance because they provide
the decision-maker with insight or knowledge that is freely and ----------------------
readily available.
----------------------
Fill in the Blanks.
----------------------
1. Significant amount of ___________ risk is inherent in investment
banking. ----------------------
2. There should be greater interaction between _________ Departments ----------------------
in a risk management process.
----------------------
3. Banks should evolve adequate _______ for managing their exposure
in off- balance sheet products like ________, forward contracts, ----------------------
swaps, options etc.
----------------------

----------------------

Managing Credit Risk 53

 Notes
Activity 4
----------------------

---------------------- Visit any nearby bank and study its loan review policy document.

----------------------

---------------------- Summary
----------------------
●● Credit risk is the risk of non-recovery of the amount of loan, diminution
---------------------- in credit quality of borrower or reduction in the value of asset.
●● Credit risk can be classified as credit default risk, concentration risk and
---------------------- country risk.
---------------------- ●● Credit risk management process includes risk measurement, risk
quantification, risk pricing and controlling.
----------------------
●● The three most important building blocks of credit risk management are
---------------------- strategy and policy, organisation and operations/ systems.

---------------------- ●● The credit risk strategy of the bank should clearly define the objectives,
credit appetite, acceptable risk levels, risk measurement, assessment and
---------------------- review process.

---------------------- ●● Dedicated policies and procedures, risk rating system, efficient credit
approval process and regular portfolio analysis are some of the essential
---------------------- features to keep credit risk under control.
●● epending on the size of the organisation or loan book, the bank should
D
----------------------
constitute a high level Credit Policy Committee, also called Credit Risk
---------------------- Management Committee or Credit Control Committee.
●● The credit management team in the bank is responsible for formulation
----------------------
of policies, overview of portfolio trends, conduct industry and sectoral
---------------------- studies, provide inputs for strategic decision-making and review credit
processes and procedures.
----------------------
●● The credit process involves three phases of relationship management,
---------------------- transaction management and portfolio management.
●● The credit approving authority should have proper delegation of authority
----------------------
and power, multi-tier approval system and a well-defined loan review
---------------------- mechanism.
●● Benchmark ratios, filtering mechanism, minimum and maximum exposure
---------------------- limits should be clearly defines by banks
---------------------- ●● Banks should have a comprehensive risk scoring / rating system that
serves as a single point indicator of diverse risk factors of counterparty
---------------------- and for taking credit decisions in a consistent manner.
---------------------- ●● Banks should consider various factors like default probability, value of
collateral, market forces, business potential, industry exposure etc while
---------------------- taking loan pricing decisions.

54 Risk Management
●● Banks should continuously evaluate portfolio quality by using techniques Notes
such as tracking borrower migration, ceiling on exposure, portfolio
reviews etc. ----------------------
●● LRM is an effective tool for constantly evaluating the quality of loan book ----------------------
and to bring about qualitative improvements in credit administration.
●● The main objectives of loan review mechanism include identification of ----------------------
areas of credit weakness, isolation of problem areas in portfolio, provide ----------------------
information for loan loss provision, ensure adherence of loan policies and
procedures and provide inputs to top management for strategic decision- ----------------------
making.
----------------------
●● The credit risk models are intended to aid banks in quantifying, aggregating
and managing risk across geographical and product lines. ----------------------
●● In the measurement of credit risk, models may be classified along three
----------------------
different dimensions- the techniques employed, the domain of applications
in the credit process and the products to which they are applied. ----------------------
●● The off balance sheet exposures of the banks should be continuously
----------------------
evaluated and managed and divided into full risk, medium risk and low
risk categories. ----------------------
●● anks consider various parameters such as capital adequacy, asset quality,
B
----------------------
liquidity and profitability in order to evaluate the performance of other
banks. ----------------------

Keywords ----------------------

----------------------
●● Consortium: It denotes a cooperative underwriting of loans by a select
group of banks; also called a syndicate. ----------------------
●● Credit concentration risk: It is the risk stemming from a single large
----------------------
exposure or group of smaller exposures that are adversely impacted by
similar variations in conditions, events or circumstances. ----------------------
●● Credit event: It can be a default on a loan or similar exposure or delays
----------------------
making full or partial interest and/or principal payments; may also include
the impact of reduced external credit rating. ----------------------
●● Credit risk capital: It is capital allocated against possible credit losses.
----------------------
●● Credit spread: It is the yield differential between different securities,
caused by differences in their credit quality. ----------------------

----------------------
Self-Assessment Questions
----------------------
1. Explain in your words the concept, forms and types of credit risk.
----------------------
2. What are the essential features of credit risk management process?
3. Elaborate on the role played by strategy, organisation and operations in ----------------------
credit risk management. ----------------------

Managing Credit Risk 55

 Notes 4. Discuss various credit risk measurement models used by banks with
examples.
----------------------
5. Sketch the diagram of the loan review mechanism adopted by banks.
----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
State True or False.
----------------------
1. True
---------------------- Fill in the Blanks.
---------------------- 1. Credit risk is the risk of non-recovery of the amount of loan, diminution
in credit quality of borrower or reduction in the value of asset.
----------------------
Check your Progress 2
---------------------- Fill in the Blanks.
---------------------- 1. The credit approval process should aim at efficiency, responsiveness and
accurate measurement of the risk
----------------------
2. Banks must have an MIS, which will enable them to manage and measure
---------------------- the credit risk inherent in all on- and off-balance sheet activities.
---------------------- Check your Progress 3

---------------------- State True or False.

1. False
----------------------
Fill in the Blanks.
----------------------
1. Significant amount of credit risk is inherent in investment banking.
---------------------- 2. There should be greater interaction between Credit and Treasury
Departments in a risk management process.
----------------------
3. Banks should evolve an adequate framework, for managing their exposure
---------------------- in off-balance sheet products like forex, forward contracts, swaps, options,
---------------------- etc.

---------------------- Suggested Reading

----------------------
1. Baesens, Bart, and Gestel Tony van. 2009. Credit Risk Management:
---------------------- Basic Concepts. USA: Oxford University Press.
2. info.worldbank.org/etools/docs/library/86252/carmichael02[1].ppt
----------------------
3. Risk Management in Banks, www.icai.org/resource_file/11490p841-851.
----------------------

----------------------

----------------------

56 Risk Management
Managing Market Risk
UNIT

4
Structure:

4.1 Introduction
4.2 Classification of Market Risk
4.3 Market Risk Management
4.4 Risk Appetite and Major Considerations in Developing Risk Management
Policies and Procedures
4.5 Senior Management Oversight
4.6 Risk Limits
4.7 Market Risk Management Function
4.8 Market Risk Management Information System
4.9 Market Risk Management Reporting
4.10 Basel Market Risk Charges
4.11 Market Risk Measurement and Assessment Systems
4.11.1 Sensitivity Analysis and Stress Testing
4.11.2 Back-Testing
Summary
Key words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Market Risk 57

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the concept of market risk
----------------------
• Classify the variables that constitute market risk
---------------------- • Explain the risk management function and its roles and responsibilities
---------------------- • Appraise the characteristics, role and importance of risk management
information system
----------------------
• Compare the tools and techniques of risk measurement and assessment
----------------------

----------------------
4.1 INTRODUCTION
----------------------
In the previous unit, we have covered the various parameters of credit
---------------------- risk and measures taken by banks to cover it. In this unit, we will move to
the next parameter of risk, which is market risk. The Bank for International
----------------------
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
---------------------- we can say that market risk is the probability of possible loss to the bank due
to change in market variables. Such risk is common to an entire class of assets
----------------------
or liabilities. The value of investments may decline over a given period of time
---------------------- due to change in economic conditions affecting a particular class of assets.

---------------------- 4.2 CLASSIFICATION OF MARKET RISK

---------------------- Market risk is the risk to banks’ earnings and capital due to change in
---------------------- various market variables like securities, foreign exchange, equity and commodity
prices as well as the volatility of those changes. Even a small change in any of
---------------------- the variables can have a substantial impact on the income and economic value
of banks.
----------------------
Based on the various variables impacting the market risk, it can be
---------------------- classified into the following categories:
---------------------- ●● Liquidity risk: It is the risk of not being able to maintain adequate
liquidity in order to meet commitments as and when they are due and
---------------------- undertake transactions at the right time in order to get maximum profit.
---------------------- ●● Interest rate risk: It is the risk arising due to fluctuation in interest rates
resulting in loss of revenue for the bank.
----------------------
●● Foreign exchange risk: It is the risk arising on account of maintenance
---------------------- of positions in forex operations.
●● Commodity price risk: It is the risk arising on account of fluctuation in
---------------------- commodity prices having an impact on the revenues of the bank.

58 Risk Management
●● Equity price risk: It is the risk of loss arising on account of movement Notes
in equity prices.
----------------------
4.3 MARKET RISK MANAGEMENT
----------------------
Management of market risk should be the major concern of the top
----------------------
management of banks. The banks’ board should clearly articulate market risk
management policies, procedures, prudential risk limits, review mechanisms ----------------------
and reporting and auditing systems. The policies should address the bank’s
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. ----------------------
We have already learnt the functioning of the Asset-Liability Management ----------------------
Committee (ALCO) in Unit 2. The Asset-Liability Management Committee
should function as the top operational unit for managing the balance sheet ----------------------
within the performance/risk parameters laid down by the board. The banks
should also set up an independent middle office to track the magnitude of market ----------------------
risk on a real- time basis. The middle office should comprise experts in market ----------------------
risk management, economists, statisticians and general bankers and may be
functionally placed directly under the ALCO. The middle office should also be ----------------------
separated from the Treasury Department and should not be involved in the day-
to-day management of the Treasury. The middle office should apprise the top ----------------------
management/ALCO/ Treasury about adherence to prudential/risk parameters ----------------------
and also aggregate the total market risk exposures assumed by the bank at any
point of time. ----------------------

----------------------
4.4 RISK APPETITE AND MAJOR CONSIDERATIONS
IN DEVELOPING RISK MANAGEMENT POLICIES ----------------------
AND PROCEDURES
----------------------
Risk appetite refers to the level of risk a bank is willing to take. The bank’s
----------------------
board is responsible for determining the risk appetite and framing decisions
based on that. There is no pre-determined format for risk appetite statement, but ----------------------
usually it should have the following features:
----------------------
●● It should be comprehensive.
●● It should include appropriate and contingent risk targets. ----------------------
●● It should have suitable risk measurement metrics to facilitate effective ----------------------
monitoring and provide responses to adverse events.
----------------------
●● It should be suitable to the size and complexity of the bank’s operations.
All relevant risks, quantifiable and unquantifiable, on and off balance ----------------------
sheet, should be covered.
----------------------
The risk appetite should be reviewed by the board on a regular basis (refer
to Figure 4.1). Any change in the market conditions having an impact on the ----------------------

Managing Market Risk 59

 Notes risk appetite should be incorporated in the statement. Any change in the risk
appetite should be well documented along with the reason.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 4.1: Approaches to Risk Appetite
---------------------- Following are the major considerations, which banks should keep in mind
---------------------- while developing market risk management policies and procedures:
●● The overall business strategy of the bank and the activities that expose the
----------------------
bank to market risk.
---------------------- ●● The nature, size and complexity of operations that expose the bank to
market risk.
----------------------
●● The overall risk appetite of the bank related to market risk.
---------------------- ●● The level of sophistication of monitoring capability, management system
---------------------- and processes related to market risk.
●● The level of exposure of the bank to market risk and its impact.
----------------------
●● The results of risk analysis tools like stress test and sensitivity analysis.
---------------------- ●● Regulatory requirements and best practices followed by others.
---------------------- ●● Bank’s past experience.

----------------------
Activity 1
----------------------

---------------------- Find out different market risks faced by SBI.

----------------------

---------------------- 4.5 SENIOR MANAGEMENT OVERSIGHT

---------------------- The effective implementation and functioning of a risk management

framework depends to a large extent on the level of involvement of the board and
---------------------- senior management of the bank. Market risk management should be considered
as an essential aspect of business and sufficient resources should be allocated
---------------------- by the senior management for the risk control unit. The broad responsibilities
---------------------- of the board and senior management towards market risk management are as
under:
----------------------
●● Approve all key elements and major changes to the bank’s market risk
---------------------- management system.

60 Risk Management
●● Have a clear understanding of the design and functioning of the system Notes
and be capable of using the reports generated by the system for strategic
decision- making. ----------------------
●● Ensure that the system fulfils all regulatory requirements. ----------------------
●● Ensure that there is a reporting system within the bank to provide sufficient
information to them regularly. It will enable them to exercise sufficient ----------------------
oversight and make informed decisions relating to the bank’s market risk ----------------------
exposure.
----------------------
Check your Progress 1
----------------------
Fill in the Blanks. ----------------------
1. Market risk involves risks broadly of ___________ types.
----------------------
2. In the definition of market risk by BIS, ______ or _______ balance
sheet positions are considered. ----------------------

3. ALCO is formed mainly with a view to managing balance sheet ----------------------

within the _____ and ______ parameters.
----------------------

----------------------
4.6 RISK LIMITS
----------------------
Risk limit helps to control a bank’s exposure to various quantifiable limits
associated with different risk-taking activities. The risk limits set by a bank ----------------------
should be: ----------------------
●● Documented and approved by senior management.
----------------------
●● Regularly reviewed and assessed based on the changes in market conditions.
●● Consistent with the risk appetite of the bank. ----------------------
●● Compatible to the size and complexity of the bank’s operations. ----------------------
●● Clearly communicated to various units.
----------------------
●● Stating clearly the person responsible to approve exceptions.
----------------------
Banks use various types of limits simultaneously in market risk
management. Some of them are: ----------------------
1. Value-at-risk limits: It is a sensitivity limit which restricts potential loss
----------------------
to an approved % of projected earnings or capital.
2. Loss control limits: It is a type of limit which requires management ----------------------
action if they are approached or breached. ----------------------
3. Tenor or gap limits: It is a limit designed to reduce price risk by limiting
the maturity or controlling the volume of transactions that matures or ----------------------
reprises in a given time period. ----------------------
4. Notional or volume limits: It is a limit used for controlling operational
capacity and liquidity risk. ----------------------

Managing Market Risk 61

 Notes 5. Options limits: It limits specific to option exposure of the banks.
6. Product concentration limits: It is a type of limit useful to ensure that a
----------------------
concentration in any one product does not significantly increase the price
---------------------- risk of the portfolio as a whole.

---------------------- Check your Progress 2

----------------------
Fill in the Blanks.
----------------------
1. ____________ is the risk of not being able to maintain adequate
---------------------- liquidity in order to meet commitments as and when they are due
and undertake transactions at the right time in order to get maximum
---------------------- profit.
---------------------- 2. ______________ is the probability of possible loss to the bank due
to change in market variables.
----------------------
----------------------
4.7 MARKET RISK MANAGEMENT FUNCTION
----------------------
Daily coordination and performance of risk management activities
---------------------- is an essential feature of the risk management mechanism. A dedicated risk
---------------------- management department needs to be set up to ensure the effectiveness of market
risk management function.
---------------------- Features of Risk Management Department
---------------------- The main features of the risk management department are:
---------------------- ●● Clearly defined responsibilities and authorities.
●● Direct reporting line to the relevant senior management or specialised
----------------------
committee set up by the board.
---------------------- ●● Independent from the risk-taking and operational units (e.g., trading unit
and settlement unit) that it reviews.
----------------------
●● Direct access to information from risk-taking and operational units in
---------------------- order for it to carry out the market risk management and control function.
---------------------- ●● Supported by an effective risk management information system.
Responsibilities of Risk Management Department
----------------------
The market risk management function should generally be responsible for:
---------------------- ●● I dentification, assessment and measurement of all possible market risk
---------------------- exposures of the bank.
●● Design, selection, implementation and effective functioning of bank’s
---------------------- risk management function.
---------------------- ●● On-going review and monitoring the use of risk limits in order to ensure
that all quantifiable risks are within the approved limits.
----------------------

62 Risk Management
●● Preparation and analysis of MIS for risk management including evaluation Notes
of the relationship between measures of market risk exposures (e.g.,
value- at-risk, stress tests) and trading limits. ----------------------
●● Prompt reporting of market risk exposures to the senior management ----------------------
and specialized committees, as well as alerting the board and the senior
management to any other matters that may have a significant impact on ----------------------
the bank’s financial position and risk profile.
----------------------
●● Regular testing for verification of bank’s internal models.
●● aintenance of comprehensive and clear documentation of internal
M ----------------------
models and policies, controls and procedures related to market risk ----------------------
management.
●● Actively participating in strategic decision-making and development of ----------------------
new products having implication on market risk management.
----------------------
4.8 MARKET RISK MANAGEMENT INFORMATION ----------------------
SYSTEM
----------------------
An essential prerequisite for effective implementation of risk management
----------------------
system is timely and accurate availability of data for reporting of various risks.
Proper information is required for strategic decision-making, setting up the risk ----------------------
appetite of the bank and managing risks accordingly. The information received
should also be in line with the rapidly changing market and economic conditions. ----------------------
The critical role played by information in risk management makes ----------------------
it essential for banks to establish and maintain a market risk management
information system. The system should be supported by adequate technology ----------------------
and processing capacity to effectively measure and report the market risk ----------------------
exposure of the bank.
The key features of an effective market risk management information ----------------------
system should be: ----------------------
• Capability to produce timely, accurate and reliable reports for the board,
senior management, specialised committees, risk-taking units and risk ----------------------
management and control units. These reports should be used to support ----------------------
decision-making at different levels, e.g., strategy formulation and risk
budgeting and to enable early identification of emerging market risk. ----------------------
• Capability to measure market risk of a product or transaction based on the ----------------------
approved measurement models of the bank.
----------------------
• Supporting customised identification and aggregation of risk concentration
within the bank. ----------------------
• Aggregating data on a product, trading venue, counterparty, portfolio, ----------------------
trading unit and sub-unit, currency, etc.
• Capability to incorporate hedging and other risk mitigation actions. ----------------------

----------------------

Managing Market Risk 63

 Notes • Capability to produce reports at timely intervals and ad-hoc reports in
time of stress.
----------------------
• Providing transparent and easy access to data, processes, model
---------------------- specifications and parameters.
• Conducting sensitivity analysis, back-testing of risk measurement, stress
----------------------
testing or other market risk analysis required to be performed by the
---------------------- market risk management function.
The market risk management information system may be developed
----------------------
internally by the bank or purchased from a third-party vendor. When the
---------------------- information system is purchased from a third-party vendor it should be ensured
that the models used are properly validated initially as well as on an on-going
---------------------- basis. Banks use information system for other business activities and are always
exposed to information technology risks. The following precautions should be
----------------------
taken by banks to safeguard the information system from technology risks:
---------------------- • A robust authentication and access control security system should be in
---------------------- place.
• All system changes should be well documented and controlled.
----------------------
• In case of third-party vendors, proper management of technology service
---------------------- providers is necessary.
---------------------- • Regular and timely technology audit is a must.

---------------------- Activity 2
----------------------
Study more on designing an information system for risk management from
---------------------- www. bis.org/publ/ecsc07f.pdf
----------------------

---------------------- 4.9 MARKET RISK MANAGEMENT REPORTING

---------------------- A bank’s risk management system will work smoothly and efficiently if
the risk exposures and strategies are communicated throughout the bank with
---------------------- sufficient frequency. Effective horizontal and vertical communication facilitates
---------------------- effective decision-making resulting in safe and sound banking and helps prevent
decisions that may result in amplifying risk exposures.
---------------------- The formality and frequency of reporting should be directly related to the
---------------------- level of risk-taking activities and risk exposures. The recipients of these reports
may also vary depending on the bank’s organisational structure.
----------------------
Board and senior management
---------------------- The board and senior management require timely and accurate information
in an understandable format in order to make strategic decisions. At times of
----------------------
stress and financial trouble, this becomes all the more important as prompt
---------------------- decisions are required. If the board and senior management have incomplete or

64 Risk Management
inaccurate information, their decisions may magnify risks rather than mitigate Notes
them.
----------------------
The board should clearly define the type and periodicity of reports it
requires for decision-making. The following reports could be suitable for the ----------------------
board:
----------------------
• Trends in aggregate price risk.
• Compliance with board-approved policies and risk limits. ----------------------
• Summary of performance relative to objectives that articulates risk- ----------------------
adjusted return.
----------------------
• Results of stress testing.
• Summary of current risk measurement techniques and management ----------------------
practices (annually). ----------------------
Senior management
----------------------
The following reports could be suitable for the senior management or the
specialised committee responsible for the supervision of market risk: ----------------------
• Trends in exposure to applicable price risk factors, e.g., interest rates, ----------------------
volatilities, etc.
----------------------
• Compliance with policies and aggregate limits by major business.
• Summary of performance relative to objectives that articulates risk- ----------------------
adjusted return. ----------------------
• Major new product development or business initiatives.
----------------------
• Results of stress testing including major assumptions.
----------------------
• Summary of current risk measurement techniques and management
practices, including results of validation and back-testing exercises ----------------------
(annually).
----------------------
Risk-taking units
• The following reports could be suitable for the risk-taking units: ----------------------

• Detailed profit and loss statement by sub-unit (e.g., desk), product or ----------------------
individual.
----------------------
• Summary of major exposures.
----------------------
• Compliance with policies and procedures, including limits, which should
detail exception frequency and trends. ----------------------
• Aggregate exposure versus limits. ----------------------
• Summary of performance relative to objectives that articulates risk-
adjusted return. ----------------------

• Valuation reserve summary. ----------------------

• Major new product development or business initiatives. ----------------------

Managing Market Risk 65

 Notes • Results of stress testing including major assumptions.
• Periodic reports on market risk model development, which should include
----------------------
independent certifications and periodic validation and back-testing of
---------------------- models.
Dealing rooms
----------------------
The following reports could be suitable for dealing rooms of the risk-
---------------------- taking units:
---------------------- • Detailed profit and loss report by desk

---------------------- • Sensitivity modelling of significant exposures, e.g., position reports,

which can be selected by management or the risk control group and should
---------------------- include a sensitivity matrix indicating the vulnerability of the position to
various changes in the variables affecting price.
----------------------
• Compliance with limits.
----------------------
• Summary of performance versus objectives that articulates risk-adjusted
---------------------- return.
• New product developments or business initiatives.
----------------------
• Errors and omissions.
----------------------
Trading desk
---------------------- The following reports could be suitable for the trading desk level of the
---------------------- risk- taking units:
• Detailed breakdown of all positions including cash flows.
----------------------
• Detailed profit and loss report by portfolio and trader.
----------------------
• Sensitivity modelling of all positions, which should include a sensitivity
---------------------- matrix indicating the vulnerability of the position to various changes in
the variables affecting price.
----------------------
• Compliance with limits.
---------------------- • Errors and omissions.
---------------------- • Product specific detail, e.g., contracts maturing or expiring, pertinent
concentration information, etc.
----------------------
• Ideally, management reports should be generated by risk management or
---------------------- control functions independent of the risk-taking units. When risk-takers
provide information for management reports, senior management should
----------------------
be informed of the possible weaknesses in the data and these positions
---------------------- should be audited frequently.

----------------------

----------------------

----------------------

66 Risk Management
 Notes
Check your Progress 3
----------------------
State True or False. ----------------------
1. Only weekly coordination and performance of risk management
----------------------
activities is an essential feature of the risk management mechanism.
2. An essential prerequisite for effective implementation of risk ----------------------
management system is timely and accurate availability of data for
----------------------
reporting of various benefits
3. If the board and senior management have complete or accurate ----------------------
information, their decisions may magnify risks rather than mitigate ----------------------
them.
----------------------
4.10 BASEL MARKET RISK CHARGES ----------------------

Increase in the volume of proprietary trading activities of commercial ----------------------

banks forced the regulators to move their focus on market risk. The Capital
Accord was amended in 1996 to include a capital charge for market risk to ----------------------
be implemented by January 1, 1998, at the latest. The capital charge can be ----------------------
computed using two methods. The first method is based on the Standardised
Model, similar to the credit risk system with add-ons determined by the Basel ----------------------
rules. This method provides a rough but conservative measure of the capital
charge for market risk. ----------------------

The second method is called the Internal Model Approach (IMA), ----------------------
which is based on banks’ own risk management system and is not governed
by any standardised rules. The regulators relied on the bank’s internal system ----------------------
of determining capital charge for the first time. The internal models approach ----------------------
includes the system of back-testing which is a strong system for verification and
prevents banks from understating their market risk. ----------------------
The Standardised Model ----------------------
The main objective of the market risk amendment was to provide an
----------------------
appropriate cushion for price risk to which banks are exposed. Banks, if well
protected from market risk, will help in strengthening international banking ----------------------
system and financial market.
----------------------
In this model, a bank’s market risk is computed for each portfolio exposed
to interest rate risk, foreign currency risk, equity risk, commodity risk and option ----------------------
risk by following specific guidelines. All these risks are then added together to
assess the bank’s total risk. This model is considered very robust and easy to ----------------------
implement, but it is criticised on the following grounds: ----------------------
• Arbitrary risk classification: Different currencies, for example, have
different volatilities relative to dollar. However, a uniform capital charge ----------------------
is applied in this method. ----------------------

Managing Market Risk 67

 Notes • Conservative capital requirements: This method leads to very
conservative capital requirements because risk charges are added up
---------------------- across different risk sources, which ignores diversification. It assumes
that the worst loss will occur across all sources of risk at the same time. In
---------------------- reality, markets are not that perfectly correlated and the worst loss is less
---------------------- than the sum of individual worst losses.
These drawbacks forced the banks to develop a more realistic and flexible
---------------------- approach, which is the Internal Model Approach.
---------------------- Internal Models Approach

---------------------- As compared to the standardised approach, the Internal Models Approach

relies on the risk management system developed by banks internally. However,
---------------------- these internal models need to be approved by the appropriate authority and
have to satisfy certain qualitative requirements with detailed documentations
---------------------- and regular back-testing.
---------------------- The various qualitative standards which need to be satisfied by banks
in order to assure the regulators about the soundness of the risk management
---------------------- system are as follows:
---------------------- • The risk control unit should be independent of the trading unit and should
have direct reporting to senior management in order to prevent conflict of
---------------------- interest.
---------------------- • The internal models should be subject to continuous back-testing in order
to check accuracy of internal value at Risk (VAR )models.
---------------------- • Involvement of senior management in the risk management process with
sufficient resources is a must.
----------------------
• The internal risk models should be well integrated with day-to-day
---------------------- operations and should not be used only for regulatory purpose.
• Internal trading and exposure limits should be set by banks using the
----------------------
internal risk measurement systems.
---------------------- • Regular stress tests should be conducted and reviewed by senior
management and reflected in policies and limits set by top management.
----------------------
• Regular independent review of trading units and risk control units should
---------------------- be conducted and verified with back-testing.
• The policies should be properly documented and complied with. Once
----------------------
these requirements are satisfied, the market risk charge is computed
---------------------- according to these rules.
The computation of daily VAR shall be based on a set of uniform
---------------------- quantitative inputs. They are:
---------------------- • A horizon of 10 trading days or two calendar weeks; banks can, however,
scale their daily VAR by the square root of time.
---------------------- • A 99% confidence interval.
---------------------- • An observation period based on at least a year of historical data or if a
non- equal weighting scheme is used, there should be an average time lag
----------------------
of at least six months.

68 Risk Management
• At least a quarterly update or whenever prices are subject to material Notes
changes (so that a sudden increase in risk can be picked up).
----------------------
The general market capital charge shall be set at the higher of the
previous day’s VAR or the average VAR over the last 60 business days, times ----------------------
a multiplicative factor K. The exact value of this multiplicative factor is to be
determined by local regulators, subject to an absolute floor of 3. The purpose of ----------------------
this factor is two fold. Without this risk factor, a bank would be expected to have
----------------------
losses that exceed its capital in one 10-day period out of a 100 or about one in four
years. Secondly, the factor serves as a buffer against model misspecifications, ----------------------
for instance, assuming a normal distribution when the distribution has fat tails.
----------------------
A penalty component, called plus factor, shall be added to the multiplicative
factor, K, if verification of the VAR forecasts reveals that the bank systematically ----------------------
underestimates its risks.
----------------------
The banks’ market risk capital requirement will be either (a) the risk
charge obtained by the standardised methodology (the risk charge derived from ----------------------
an arithmetic summation across the five risk categories) or (b) the risk charge
obtained by the internal models approach. It can also be a a mixture of (a) and ----------------------
(b) summed arithmetically.
----------------------

Activity 3 ----------------------

----------------------
Read the article Risk Measurement: An Introduction to Value at Risk from
www. exinfm.com/training/pdfiles/valueatrisk.pdf ----------------------

----------------------
4.11 MARKET RISK MEASUREMENT AND ASSESSMENT ----------------------
SYSTEMS
----------------------
We have seen the importance of the market risk department in a banking
setup. For the smooth functioning of the department, it is essential that the ----------------------
department is able to measure various quantifiable market risks and assess the ----------------------
less quantifiable market risks. Banks should put in place effective systems and
tools in order to assess and monitor various market risks. Any adverse change ----------------------
in the market factors should be quickly assessed and remedial measures should
be taken promptly. The tools used should also predict the probability of future ----------------------
losses in different scenarios. ----------------------
The process of measuring market risk starts with measuring the risk
----------------------
exposures of transactions at fair value. These valuations are done by persons
independent of the risk-taking units. The trading positions are marked-to- ----------------------
market in order to get the latest fair values. Where sufficient market data is not
available, marked-to-model is performed to get the valuation. The system should ----------------------
be capable of providing data on outstanding positions and their unrealised profit
----------------------
or loss.
----------------------

Managing Market Risk 69

 Notes The risk measurement system should be well equipped to take into account
the changes in volume of transactions, method of valuation and launch of new
---------------------- products. The accuracy and reliability of risk measurement models should be
verified against actual results through regular back testing. Different methods
---------------------- and models may be used to measure each type of risk. The following factors
---------------------- need to be kept in mind while deciding upon the method or model to be used
for risk measurement:
----------------------
• Nature, scale and complexity of business activities.
---------------------- • Need and purpose of risk measurement and its implications.
---------------------- • General market trend of risk measurement, i.e., practice and tools used by
other banks to measure similar type of risks.
---------------------- • Extent of availability of market data which has to be used as input for risk
---------------------- measurement.
• Capability of the market risk management information system in terms of
---------------------- computational capacity.
---------------------- • Expertise and experience of staff.
The various models and tools used by banks for risk assessment should
----------------------
be properly documented covering their theoretical background and limitations.
---------------------- 4.11.1 Sensitivity Analysis and Stress Testing
---------------------- Sensitivity analysis is used to measure the sensitivity of valuation, profit
and loss or other risk measurements as a result of change in one or more market
---------------------- variables like interest rate, exchange rate, etc.
---------------------- Stress test is conducted to identify remote but possible events that can have
an impact on the overall risk profile of the bank thereby impacting its financial
---------------------- position. It also addresses the existing and potential risk concentrations and
---------------------- helps in development of risk mitigation tools under different stress conditions.
The scenarios considered for test should be comprehensive and forward looking
---------------------- and consider those risk factors which can have a significant impact on the bank.

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 4.2: An Overview of Stress Testing Process for Market Risk
----------------------

70 Risk Management
Stress test falls into three categories: Notes
1. Scenarios requiring no simulation: They include analysis of past losses
----------------------
over recent reporting period in order to understand the vulnerabilities
of the bank. This approach is backward looking and does not take into ----------------------
account changes in portfolio composition.
----------------------
2. Scenarios requiring simulation: They include running simulations of
current portfolio subject to large historical shocks. ----------------------
3. Bank-specific scenarios: They are driven more by the current position of
----------------------
the bank instead of historical experience. For instance, a strategy of going
long the off-the-run bond while shorting the equivalent on-the-run bond ----------------------
may appear safe based on recent historical patterns.
----------------------
 upervisors are required to conduct both sensitivity analysis and stress
S
test regularly on a firm-wide basis. Operations that increase the risk ----------------------
exposure of banks should be covered under these tests.
----------------------
4.11.2 Back-Testing
All risk measurement models of the bank need to be verified for accuracy at ----------------------
regular intervals.Back-testing, stress testing, independent review and oversight ----------------------
are some of the tools used by banks for verification.
----------------------
Back-testing is a statistical testing framework which checks whether the
actual trading loss is in line with VAR forecasts. Any instance of actual loss ----------------------
exceeding the forecasted VAR is termed as an exception.
----------------------
The Basel Committee has decided that up to four exceptions is acceptable,
which defines a “green” zone. If the number of exceptions is five or more, ----------------------
the bank falls into a “yellow” or “red” zone and incurs a progressive penalty
where the multiplicative factor is increased from three to four. The plus factor ----------------------
is described later in this unit.
----------------------
An incursion into the red zone generates an automatic, non-discretionary
penalty. This is because it would be extremely unlikely to observe more than 10 ----------------------
exceptions if the model was indeed correct. ----------------------
Table 4.1 The Basel Penalty Zones
----------------------
Zone Number of exceptions Potential increase in K
Green 0−4 0.00 ----------------------
Yellow 5
6 ----------------------
7 ----------------------
8
9 0.40 ----------------------
0.50
0.65 ----------------------
0.75
----------------------
0.85
Red >=10 1.00 ----------------------

Managing Market Risk 71

 Notes If the number of exceptions falls within the yellow zone, the supervisor can
exercise his discretion to apply penalty depending upon the cause of exception.
---------------------- The Basel Committee uses the following factors in determining the penalty:
---------------------- If the deviation has occurred due to incorrect reporting of positions or
error in the program code, it is considered as a very serious flaw and penalty
---------------------- should apply and corrective action should be taken.
---------------------- If the deviation has occurred because the model does not cover enough
risk factors, then also it is considered as a serious flaw and calls for a penalty.
---------------------- If the deviation has occurred due to a change in position during the day
---------------------- and is likely to disappear with the hypothetical return, penalty might not be
imposed.
---------------------- Banks operate in a very volatile market and exceptions may occur due to
changed correlation or high volatility once in a while. Such exceptions should
----------------------
not be considered as a deficiency in model and no penalty should be imposed.
----------------------
Check your Progress 4
----------------------

---------------------- Fill in the Blanks.

---------------------- 1. The process of measuring market risk starts with measuring the risk
exposures of transactions at ______ value.
----------------------
2. The system should be capable of providing data on outstanding
---------------------- positions and their ________ profit or loss.
3. Banks should put in place effective ______ and _______ in order to
----------------------
assess and monitor various market risks.
----------------------

---------------------- Summary
---------------------- ●● Market risk is 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.
---------------------- ●● Based on the various variables impacting the market risk, it is classified
into liquidity risk, interest rate risk, foreign exchange risk, commodity
----------------------
price risk and equity price risk.
---------------------- ●● Risk appetite refers to the level of risk a bank is willing to take. The
bank’s board is responsible for determining the risk appetite and framing
---------------------- decisions based on that.
---------------------- ●● The risk appetite statement should be comprehensive and should include
contingent risk targets, risk measurement metrics and cover all risks
---------------------- relevant to the nature and size of operations.
---------------------- ●● The effective implementation and functioning of a risk management
framework depends to a large extent on the level of involvement of the
---------------------- board and senior management of the bank.

72 Risk Management
●● Nature, size and complexity of business, overall market appetite, level Notes
of banks’ exposure to market risk, regulatory requirements and previous
experience are some of the factors that banks keep in mind while drafting ----------------------
risk management policies and procedure.
----------------------
●● Risk limit helps to control banks’ exposure to various quantifiable limits
associated with different risk-taking activities. ----------------------
●● Risk limits can be classified under value at risk limits, loss control limits, ----------------------
tenor limits, notional, optional and product concentration limits.
●● Daily coordination and performance of risk management activities is an ----------------------
essential feature of the risk management mechanism. A dedicated risk ----------------------
management department needs to be set up to ensure effectiveness of
market risk management function. ----------------------
●● The critical role played by information in risk management makes it
----------------------
essential for banks to establish and maintain a market risk management
information system. ----------------------
●● Risk management information system should produce timely and
----------------------
accurate reports, measure market risk, incorporate hedging and other risk
mitigation actions and provide transparent and easy access to data. ----------------------
●● Effective horizontal and vertical communication facilitates effective
----------------------
decision- making resulting in safe and sound banking. It also helps prevent
decisions that may result in amplifying risk exposures. ----------------------
●● The board and senior management, risk taking units, dealing rooms and
----------------------
trading desk require different reports at different points of time to control
market risk. ----------------------
●● The Basel Committee has introduced capital charge for market risk and
it covers two methods of computation of market risk – the standardised ----------------------
model and the internal models approach. ----------------------
●● The risk measurement system should be well equipped to take into
account the changes in volume of transactions, method of valuation and ----------------------
launch of new products. ----------------------
●● The accuracy and reliability of risk measurement models should be
verified against actual results through regular back-testing. ----------------------
●● Sensitivity analysis is used to measure the sensitivity of valuation, profit ----------------------
and loss or other risk measurement as a result of change in one or more
market variables like interest rate, exchange rate, etc. ----------------------
●● All risk measurement models of the bank need to be verified for accuracy ----------------------
at regular intervals. Back testing, stress testing, independent review and
oversight are some of the tools used by banks for verification. ----------------------

----------------------

----------------------

----------------------

Managing Market Risk 73

 Notes Keywords
----------------------
●● Market risk: The risk to banks’ earnings and capital due to change in
---------------------- various market variables like securities, foreign exchange, equity and
commodity prices as well as the volatility of those changes.
---------------------- ●● Interest rate risk: The risk arising due to fluctuation in interest rates
---------------------- resulting in loss of revenue for the bank.
●● Commodity price risk: The risk arising on account of fluctuation in
---------------------- commodity prices having an impact on the revenues of the bank.
---------------------- ●● Equity price risk: The risk of loss arising on account of movement in
equity prices.
----------------------

---------------------- Self-Assessment Questions

---------------------- 1. Elaborate the need and importance of market risk management function
in a banking setup.
----------------------
2. What are the broad responsibilities of the market risk management
---------------------- department?
---------------------- 3. List the variables that constitute market risk.

---------------------- 4. Who are the different users of market risk reports?

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1
---------------------- Fill in the Blanks.

---------------------- 1. Market risks involve risks broadly of five types.

2. In the definition of market risk by BIS, on or off balance sheet positions
---------------------- are considered.
---------------------- 3. ALCO is formed mainly with a view to managing balance sheet within
the performance and risk prarameters.
----------------------
Check your Progress 2
----------------------
Fill in the Blanks.
---------------------- 1. Liquidity risk is the risk of not being able to maintain adequate liquidity
---------------------- in order to meet commitments as and when they are due and undertake
transactions at the right time in order to get maximum profit.
---------------------- 2. Market risk is the probability of possible loss to the bank due to change in
---------------------- market variables.

----------------------

----------------------

74 Risk Management
Check your Progress 3 Notes
State True or False.
----------------------
1. False
----------------------
2. False
3. False ----------------------
Check your Progress 4 ----------------------
Fill in the Blanks. ----------------------
1. The process of measuring market risk starts with measuring the risk
----------------------
exposures of transactions at fair value.
2. The system should be capable of providing data on outstanding positions ----------------------
and their unrealised profit or loss.
----------------------
3. Banks should put in place effective systems and tools in order to assess
and monitor various market risks. ----------------------
----------------------
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
----------------------
California: Academic Foundation.
2. Benton E. Gup, and James W. Kolari 2007. Commercial Banking: The ----------------------
Management of Risk. Australia: John Wiley & Sons.
----------------------
3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books. ----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic 2003. Analyzing ----------------------
and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication. ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Market Risk 75

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

76 Risk Management
Managing Liquidity Risk
UNIT

5
Structure:

5.1 Introduction
5.2 Potential Sources of Liquidity for Banks
5.3 Aspects of Liquidity Risk Management
5.4 Liquidity Risk Management Cycle
5.5 Liquidity Risk Management Disclosures
5.6 Basel Principles for Sound Liquidity Risk Management and Supervision
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Liquidity Risk 77

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the concept of liquidity risk
----------------------
• Classify the different sources from which banks arrange their liquidity
---------------------- • Identify the different aspects of liquidity risk management
---------------------- • Write the different steps involved in liquidity risk management

---------------------- • Discuss the importance of stress test and scenario analysis in liquidity
risk management
---------------------- • Appraise the principles of sound liquidity risk management
----------------------
5.1 INTRODUCTION
----------------------
We have discussed in the previous units that liquidity is the ability of the
---------------------- bank to meet its obligations as and when they become due without incurring
---------------------- any unacceptable losses. It also includes the ability of the bank to fund increase
in assets on need basis.
---------------------- Liquidity risk arises in a bank because of the following two main reasons:
---------------------- • Funding liquidity risk: It is the risk that a bank will not be able to meet
efficiently the expected and unexpected current and future cash flows
----------------------
and collateral needs without affecting either its daily operations or its
---------------------- financial condition.
• Market liquidity risk: It is the risk that a bank cannot easily offset or
----------------------
eliminate a position at the prevailing market price because of inadequate
---------------------- market depth or market disruption.

---------------------- 5.2 POTENTIAL SOURCES OF LIQUIDITY FOR BANKS

----------------------
The following is the list of potential sources of liquidity for banks:
---------------------- 1. Holding cash or near-cash assets: This is an expensive proposition as
the providers of funds expect a high rate of return and are not willing to
----------------------
adjust downwards to reflect the lower risk associated with high liquidity.
---------------------- With the development of financial markets the level of cash holding by
banks has fallen considerably.
----------------------
2. Holding readily marketable securities (financial assets): There is high
---------------------- degree of volatility in the market price of these assets, which increases
the risk as the bank might have to sell them at reduced prices in depressed
---------------------- market in order to gain liquidity.
---------------------- 3. Holding securities which can be pledged as collateral for short-term
borrowings: The repurchase (repo) market, in which securities are sold
----------------------

78 Risk Management
 and simultaneously repurchased for delivery at a future date, has become Notes
an important tool for liquidity management of this sort.
----------------------
4. Lines of credit: Lines of credit or overdraft facility from other institutions
comes with the cost of establishment and maintenance of that facility in ----------------------
addition to the cost of borrowing.
----------------------
5. Commercial papers: This facility enables the organisation to issue
securities into the capital markets. It can be a new issue of securities or ----------------------
extension of maturity period of existing securities.
----------------------
6. Money at call or short-term loans: The banks can give loans to other
entities and can call for repayment whenever needed. Such loans carry ----------------------
the risk of default specially at times of stress in the financial markets.
Collateralising such loans against marketable securities can reduce the ----------------------
risk of default to some extent. Thus, ensuring that margin requirements
----------------------
are continually met and maintaining the value of collateral above the loan
value become important operational requirements. ----------------------
7. Sufficient credit rating: A good credit rating and terms with counterparties ----------------------
help banks to borrow at short notice in inter-bank markets. This is a very
importanct component of liquidity management in which banks having ----------------------
surpluses and deficits in their settlement account trade with each other
and correct those imbalances. In these situations banks having a good ----------------------
credit rating are in a better position to trade with other banks. ----------------------
8. Lender of last resort: These are very expensive loans and banks resort to
this option only in extreme situatuions. The lender of last resort is usually ----------------------
a country’s central bank, that offers loans to banks that face financial ----------------------
difficulty or are considered highly risky or near collapse.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 5.1: Sources of Liquidity for Banks
----------------------

Managing Liquidity Risk 79

 Notes 5.3 ASPECTS OF LIQUIDITY RISK MANAGEMENT
---------------------- Liquidity risk management can be divided into three broad headings:

---------------------- • Structural liquidity risk management: It ensures the ability to fund

structural long term on- and off-balance sheet exposures on time or at
---------------------- reasonable cost.

---------------------- • Daily liquidity risk management: It ensures that intraday and day-to-
day unanticipated payment obligations are met while maintaining balance
---------------------- between liquidity inflows and outflows.
---------------------- • Contingency liquidity risk management: It ensures that sufficient
contingency funding sources are in place to draw upon in times of
---------------------- economic stress.
---------------------- The various activities covered under each area of liquidity risk management
are mentioned in the following table.
----------------------
Table 5.1: Activities under Different Areas of LRM
---------------------- Structural LRM Daily LRM Contingency LRM
---------------------- • Liquidity risk tolerance • Managing intraday • Managing early
liquidity positions warning and key risk
• Liquidity strategy
---------------------- indicators
• Managing the daily
• ensuring substantial
payment queue • Performing stress
diversification over
---------------------- testing including
different funding • Monitoring the net
sensitivity analysis and
sources funding requirements
---------------------- scenario testing
• Assessing the impact • Forecasting cash flows
• Maintaining the
---------------------- of future funding and
• Perform short- term product behaviour and
liquidity needs taking
cash flow analysis optionality assumptions
---------------------- into account expected
for all currencies
liquidity shortfalls or • Ensuring that an
individually and in
---------------------- excesses adequate and diversified
aggregate
portfolio of liquid
• Setting the approach
---------------------- • Managing intra- group assets and buffers are in
to managing liquidity
liquidity place
in different currencies
----------------------
and from one country • Managing Central Bank • Maintaining the
to another clearing Setting the contingency funding
---------------------- approach to managing plan
• Ensuring adequate
liquidity in different
---------------------- liquidity ratios of
currencies
future funding and
---------------------- liquidity needs taking • Managing the net daily
into account expected cash positions
---------------------- liquidity shortfalls or
• Managing and
excesses
maintaining collateral
---------------------- • Ensuring an adequate
structural liquidity gap
----------------------
• Maintaining a funds
---------------------- transfer pricing
methodology and
---------------------- process

80 Risk Management
 Notes
Activity 1
----------------------
Visit the website of ICICI bank and note down the sources of liquidity for ----------------------
banks. Examine the merits and demerits of each source.
----------------------

5.4 LIQUIDITY RISK MANAGEMENT CYCLE ----------------------

----------------------
The entire liquidity risk management activity can be divided into six
stages: ----------------------
• Measuring liquidity risk
----------------------
• Risk strategy formulation
----------------------
• Daily fund management
• Early warning indicators ----------------------

• Stress testing ----------------------

• Monitoring liquidity risk ----------------------
• Contingency fund plan
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 5.2: Liquidity Risk Management Cycle
----------------------
1. Measuring Liquidity Risk: There are broadly two approaches for
measuring liquidity risk − stock approach and cash flow approach. ----------------------
• Stock-based approach: This approach measures the stock of ----------------------
financial assets that can promptly be liquidated to face a possible
liquidity shock. ----------------------

Managing Liquidity Risk 81

 Notes • Cash flow-based approach: This approach compares expected
cash inflows and outflows, grouping them in homogeneous maturity
---------------------- buckets and checking that cash inflows are large enough to cover
cash outflows.
----------------------
The cash flow-based approach of measuring liquidity risk involves
---------------------- tracking of the cash flow mismatches. The Reserve Bank of India has prescribed
a statement of structural liquidity under ALM system for measuring cash flow
----------------------
mismatches at various time bands and banks are adviced to adopt the same.
---------------------- The cash flows are required to be placed in different time bands based on the
residual maturity of the cash flows or the projected future behaviour of assets,
---------------------- liabilities and off-balance sheet items. The difference between cash inflows and
outflows in each time period thus becomes a starting point for the measure of a
----------------------
bank’s future liquidity surplus or deficit at a series of points of time.
---------------------- Bank can also assess their liquidity position with the help of the following
certain critical ratios, their significance and their benchmarks.These benchmarks
----------------------
are fixed based on the experience of last four to five years and are purely
---------------------- indicative. Banks can fix higher or lower benchmarks depending upon their risk
management capabilities and experience.
----------------------
Table 5.2: Benchmarks for Critical Ratios to assess Liquidity Position
----------------------
S. No. Ratio Significance Benchmark (%)
---------------------- 1 (Volatile liabilities It measures the extent 40
– temporary assets)/ to which hot money
---------------------- (Earning assets – supports banks’ basic
---------------------- temporary assets) earning assets. Since the
numerator represents
---------------------- short term, interest-
sensitive funds, a high
---------------------- and positive number
---------------------- implies some risk of
illiquidity.
---------------------- 2 Core deposits / Total It measures the extent to 50
assets which assets are funded
---------------------- through stable deposit
---------------------- base.
3 (Loan + Mandatory Loans including 80
---------------------- SLR + Mandatory CRR mandatory cash reserves
+ Fixed assets) / Total and statutory liquidity
----------------------
assets investments are least
---------------------- liquid and hence, a high
ratio signifies the degree
---------------------- of illiquidity embedded
in the balance sheet.
----------------------

----------------------

82 Risk Management
 4 (Loan + Mandatory It measures the extent to 150 Notes
SLR + Mandatory CRR which illiquid assets are
+ Fixed assets) / Core financed out of 1 means ----------------------
deposits purchased liquidity and ----------------------
less than 1 means stored
liquidity. ----------------------
5 Temporary assets / It measures the extent of 40
----------------------
Total assets available liquid assets.
A higher ratio could ----------------------
impinge on the asset
utilisation of the banking ----------------------
system in terms o f o p p
----------------------
ortunity costof h
o l d i n g liquidity. ----------------------
6 Temporary assets/ It measures the cover 60
Volatile liabilities of liquid investments ----------------------
relative to volatile ----------------------
liabilities. A ratio of
less than 1 indicates the ----------------------
possibility of a liquidity
problem. ----------------------
7 Volatile liabilities/ Total It measures the extent to 60 ----------------------
assets which volatile liabilities
fund the balance sheet. ----------------------
2. Risk strategy formulation: The liquidity policies of the bank should be ----------------------
approved by the board of directors. The details of the policy may vary
from bank to bank depending upon the risk profile, nature of operations ----------------------
and complexity, but the key elements of liquidity policy are the same.
----------------------
They key elements are as follows:
• The liquidity risk strategy should clearly mention the proportion of each ----------------------
component of asset and liability that the bank will hold at all times in
----------------------
order to maintain the required level of liquidity for its operations.
• The board of directors should provide guidance to source funds from ----------------------
diversified sources to fund its day-to-day liquidity requiremetns and also ----------------------
to ensure stability of those funding sources.
• The liquidity risk management strategy should indicate the ability of the ----------------------
bank to obtain funds in inter-bank and other wholesale markets as those ----------------------
markets constitute important sources of liquidity.
----------------------
• The liquidity strategy should be prepared for both long-term and short-
term time horizons clearly mentioning the goals and objectives of liquidity ----------------------
risk management, approving authorities and process.
----------------------
• The strategy should clearly mention the roles and responsibilities of
individuals performing liquidity risk management function including ----------------------

Managing Liquidity Risk 83

 Notes pricing, marketing, structural balance sheet management, contingency
planning, reporting, etc.
----------------------
• The strategy should provide continuity in approach and should be
---------------------- reviewed and amended whenever necessary.
• There should be periodic stress testing of assumptions underlying the
----------------------
liquidity strategy and the test results should be reviewed to evaluate the
---------------------- impact on business.
3. Daily Fund Management: Banks are required to prepare statement of
----------------------
structural liquidity on a daily basis and report to RBI on a fortnightly basis
---------------------- for domestic operations and on a quarterly basis for overseas operations.
The statement divides the banks’ operations into the following categories:
----------------------
• Domestic curreny – Indian operations
---------------------- • Foreign curreny – Indian operations
---------------------- • Consolidated Indian operations – Domestic and foreign currency
---------------------- • Overseas operations – Countrywise
• Consolidated bank operations
----------------------
• The behavioural maturity profile of all compopnents of off- and on-balance
---------------------- sheet items should be analysed using trend and time series analysis.
---------------------- The impact of prepayment of loans, pre-closure of deposits, exercise of
options (wherever applicable) should also be considered by banks while
---------------------- measuring liquidity risk.

---------------------- • Measurement of liquidity risk is largely dependent on assumptions used.

Hence, it is advisable that the bank should use reasonable and appropriate
---------------------- assumptions and document them properly.

---------------------- 4. Early Warning Indicators of Liquidity Problem: There are various

tools used by banks which help them in assessing liquidity problems in
---------------------- advance. Some general indicators of liquidity crisis are:
---------------------- • Rapid growth in assets, especially if funded with volatile liabilities.
• Growth in concentration in assets and liabilities.
----------------------
• Increased level of currency mismatches.
----------------------
• A reduction in weighted average maturity of liabilities.
---------------------- • Major reduction in banks’ earnings, asset quality and overall financial
---------------------- condition.
• Increased risk with a particular product line.
----------------------
• Repeated incidences of situations approaching or breaching internal or
---------------------- regulatory limits.
---------------------- • Reduction in stock price or increase in cost of debt.

---------------------- • Downgradation in credit rating.

84 Risk Management
• Negative publicity. Notes
• Widened debt or credit-default swap spreads.
----------------------
• Increase in cost of wholesale or retail funding.
----------------------
• Elimination or decrease in credit lines of correspondent banks.
• Increased retail deposit outflows. ----------------------

• Sudden increase in premature redemption of Certificate of Deposits ----------------------

(CDs).
----------------------
• Difficulty in accessing long-term funds and placing short-term liabilities.
----------------------
5. Stress Test: As discussed in the previous units, stress test is the process
of evaluation of the financial position of the bank under severe but ----------------------
possible scenerios to assist in strategic decision-making. Like all types
of risk management, stress test plays an important role in liquidity risk ----------------------
management as well. It provides a forward-looking assessment of risk and
----------------------
alerts the bank of adverse impact of unexpected situations. Banks should
have a stress testing framework in place to take care of liquidity risk. ----------------------
Some of the guidelines issued by RBI on stress testing are as follows:
----------------------
Scenarios and assumptions
----------------------
Stress tests should be conducted by banks on a regular basis for a variety of
short term and protracted scenerios, both individually and in combination. ----------------------
Various factors like banks’ business, activities, products, funding sources
and vulnerabilities should be considered while designing liquidity test ----------------------
scenerios. The scenarios should assist the bank in evaluating the potential ----------------------
adverse impact of various factors on its liquidity position.
I f the bank has significant market share in specific funding markets or it ----------------------
reliesheavily on any of them, then it should consider the linkage between ----------------------
reduction in market liquidity and constraints on funding liquidity while
designing the scenerios. The result of stress test on other types of risk and ----------------------
its impact on the liquidity position of bank should also be considered.
----------------------
A bank should recognise that stress events may simultaneously give rise
to immediate liquidity needs in different currencies and multiple payment ----------------------
and settlement systems. It should consider in the stress tests the likely
----------------------
behavioural response of other market participants to events of market
stress. It should also take into account the extent to which a common ----------------------
response might amplify market movements and exacerbate market strain
as also the likely impact of its own behaviour on that of other market ----------------------
participants.
----------------------
 ased on the type and severity of the scenario, a bank needs to consider
B
the appropriateness of a number of assumptions which are relevant to its ----------------------
business. The bank’s choice of scenarios and related assumptions should
----------------------
be well thought of, documented and reviewed together with the stress test
results. A bank should take a conservative approach when setting stress ----------------------
testing assumptions.
Managing Liquidity Risk 85
 Notes  anks should conduct stress tests to assess the level of liquidity they
B
should hold, the extent and frequency of which should be commensurate
---------------------- with the size of the bank and their specific business activities/liquidity for
a period over which it is expected to survive a crisis.
----------------------
Uses of stress test results
----------------------
The outcome of the stress test should be used for the following:
---------------------- • Identify and quantify sources of potential liquidity strain.
---------------------- •  nalyse impact of liquidity strain on banks’ cash flow, profitability
A
and solvency.
----------------------
• Identify the remedial action to be taken to reduce banks’ exposure.
---------------------- • Assist in banks, contingent funding planning,
---------------------- •  etermination of strategy and tactics to deal with events of liquidity
D
stress.
----------------------
The results of stress test should be properly documented and made
---------------------- available to
---------------------- RBI/appropriate authorities whenever required.

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 5.3: Liquidity Stress Testing Approach

6. Monitoring Liquidity Risk: Mismatches highlighted in the statement
----------------------
of structural liquidity up to one year are important as they provide an
---------------------- early warning of impending liquidity problem and gives time for remedial
measures. However, the banks’ main focus should be on short-term
---------------------- mismatches, for example, 28 days, as quick action is required. Banks
should set up internal prudential limits for mismatches and cumulative
----------------------
mismatch across all time buckets should be monitored regularly. The net
---------------------- cumulative negative mismatches in the domestic and overseas structural
liquidity statement during the next day, 2−7 days, 8−14 days and 15−28
---------------------- days bucket should not exceed 5%, 10%, 15%, 20% of the cumulative
cash outflows in the respective time buckets.
----------------------

86 Risk Management
 Apart from the statement of structural liquiditry, RBI has prescribed Notes
another statement of short-term dynamic liquidity, which helps the banks
to monitor short- term liquidity over a time horizon from 1−90 days. ----------------------
Banks estimate their short- term liquidity profiles based on the business
projections and other commitments for planning purposes. This statement ----------------------
has to be submitted to RBI on a monthly basis. ----------------------
In order to reduce the the extent of concentration on liability side of the
----------------------
banks, Basel III has prescribed some regulatory limits. Some of them are
as under: ----------------------
i. Inter-Bank Liability (IBL) limit: Currently, the IBL of a bank
----------------------
should not exceed 200% of its net worth as on March 31of the
previous year. However, individual banks may, with the approval ----------------------
of their board of directors,fix a lower limit for their inter-bank
liabilities, keeping in view their business model. The banks whose ----------------------
Capital to Risk-weighted Assets Ratio (CRAR) is at least 25% more
----------------------
than the minimum CRAR (9%), i.e., 11.25% as on March 31 of
the previous year, are allowed to have a higher limit up to 300% ----------------------
of the net worth for IBL. The limit prescribed above will include
only fund- based IBL within India (including inter-bank liabilities ----------------------
in foreign currency to banks operating within India). In other
----------------------
words, the IBL outside India are excluded. The above limits will not
include collateralised borrowings under Collateralised Borrowing ----------------------
and Lending Obligation (CBLO) and refinance from NABARD,
SIDBI, etc. ----------------------
ii. Call money borrowing limit: The limit on the call money ----------------------
borrowings as prescribed by RBI for call/notice money market
operations will operate as a sub-limit within the above limits. At ----------------------
present, on a fortnightly average basis, such borrowings should not
----------------------
exceed 100% of bank’s capital funds. However, banks are allowed
to borrow a maximum of 125% of their capital funds on any day ----------------------
during a fortnight.
----------------------
iii. Call money lending limit: Banks are also required to ensure
adherence to the call money lending limit prescribed by RBI for call/ ----------------------
notice money market operations, which at present, on a fortnightly
average basis, should not exceed 25% of its capital funds. However, ----------------------
banks are allowed to lend a maximum of 50% of their capital funds ----------------------
on any day, during a fortnight.
7. Contingency Fund Planning: Banks need to formulate a Contingency ----------------------
Fund Plan (CFP) in order to meet their funding requirements under ----------------------
different stress scenerios. The CFP consists of a set of policies and
procedures to help the bank in managing liquidity risk in a timely and ----------------------
reasonable manner in contingency situations. The CFP should forecast
the future cash flows of the bank under different scenerios like aggressive ----------------------
asset growth, rapid liability erosion, etc. To be effective, it is important ----------------------

Managing Liquidity Risk 87

 Notes that a CFP should represent management’s best estimate off- balance sheet
changes that may result from a liquidity or credit event. The CFP should
---------------------- be comprehensive in scope covering both asset and liability strategies.
----------------------
Check your Progress 1
----------------------
State True or False.
----------------------
1. The liquidity policies of the bank need not be approved by the board
---------------------- of directors.
---------------------- 2. The liquidity strategy should be prepared only for long-term time
horizon.
----------------------
3. A general indicator of liquidity crisis is increased level of currency
---------------------- mismatches.
---------------------- 4. Stress tests should be conducted by banks on a regular basis.

----------------------

----------------------
5.5 LIQUIDITY RISK MANAGEMENT DISCLOSURES

---------------------- As per the guidelines issued by the Basel Committee, a bank is required
to make the following disclosures related to liquidity management:
---------------------- • Various aspects of liquidity risk to which a bank is exposed and how the
---------------------- bank monitors the diversification of funding sources.
• Techniques used to mitigate liquidity risk.
----------------------
• The concepts utilised in measuring its liquidity position and liquidity risk,
---------------------- including additional metrics for which the bank is not disclosing data.
---------------------- Risk Management

---------------------- • An explanation of how asset market liquidity risk is reflected in the bank’s
framework for managing funding liquidity.
---------------------- • An explanation of how stress testing is used.
---------------------- • Description of various stress testing scenerios modelled.
• An outline of the bank’s contingency funding plans and an indication of
---------------------- how the plan relates to stress testing.
---------------------- • The bank’s policy on maintaining liquidity reserves.
• Regulatory restrictions on the transfer of liquidity among group entities.
----------------------
• The frequency and type of internal liquidity reporting.
----------------------
Activity 2
----------------------

---------------------- Visit the website of RBI and study more on benchmark rates fixed by RBI
for the ratios used by banks to assess their liquidity position.
----------------------

88 Risk Management
5.6 BASEL PRINCIPLES FOR SOUND LIQUIDITY RISK Notes
MANAGEMENT AND SUPERVISION
----------------------

In February 2008, the Basel Committee on Banking Supervision published ----------------------

Liquidity Risk: Management and Supervisory Challenges. The principles inter
alia provide detailed guidance on management of liquidity risk. ----------------------

Table 5.3: Principles for Sound Liquidity Risk Management ----------------------

Fundamental principles for management and supervision of liquidity ----------------------
risk
Principle 1 ----------------------
A bank is responsible for sound management of liquidity risk.
A bank should establish a robust liquidity risk management ----------------------
framework that ensures it maintains sufficient liquidity,
including a cushion of unencumbered, high-quality liquid ----------------------
assets to withstand a range of stress events, including those
----------------------
involving the loss or impairment of both unsecured and secured
funding sources. Supervisors should assess the adequacy of ----------------------
both the bank’s liquidity risk management framework and its
liquidity position and should take prompt action if a bank is ----------------------
deficient in either area in order to protect depositors and to
----------------------
limit potential damage to the financial system.
Governance of liquidity risk management ----------------------
Principle 2 A bank should clearly articulate a liquidity risk tolerance
----------------------
that is appropriate for its business strategy and its role in the
financial appropriate for its business strategy and its role in ----------------------
the financial system.
Principle 3 Senior management should develop a strategy, policies and ----------------------
practices to manage liquidity risk in accordance with the risk ----------------------
tolerance and to ensure that the bank maintains sufficient
liquidity. Senior management should continuously review ----------------------
information on the bank’s liquidity developments and report
to the board of directors on a regular basis. A bank’s board ----------------------
of directors should review and approve the strategy, policies ----------------------
and practices related to the management of liquidity at least
annually and ensure that senior management manages liquidity ----------------------
risk effectively.
Principle 4 A bank should incorporate liquidity costs, benefits and risks ----------------------
in the internal pricing, performance measurement and new ----------------------
product approval process for all significant business activities
(both on- and off-balance sheet), thereby aligning the risk- ----------------------
taking incentives of individual business lines with the liquidity
risk exposures their activities create for the bank as a whole. ----------------------

Measurement and management of liquidity risk ----------------------

----------------------

Managing Liquidity Risk 89

 Notes Principle 5 A bank should have a sound process for identifying, measuring,
monitoring and controlling liquidity risk. This process should
---------------------- include a robust framework for comprehensively projecting
---------------------- cash flows arising from assets, liabilities and off-balance sheet
items over an appropriate set of time horizons.
---------------------- Measurement and management of liquidity risk
---------------------- Principle 6 A bank should actively monitor and control liquidity risk
exposures and funding needs within and across legal entities,
---------------------- business lines and currencies, taking into account legal,
regulatory and operational limitations to the transferability of
---------------------- liquidity.
---------------------- Principle 7 A bank should establish a funding strategy that provides
effective diversification in the sources and tenor of funding.
---------------------- It should maintain an ongoing presence in its chosen funding
markets and strong relationships with fund providers to
---------------------- promote effective diversification of funding sources. A bank
---------------------- should regularly gauge its capacity to raise funds quickly from
each source. It should identify the main factors that affect
---------------------- its ability to raise funds and monitor those factors closely to
ensure that estimates of fund raising capacity remain valid.
----------------------
Principle 8 A bank should actively manage its intraday liquidity positions
---------------------- and risks to meet payment and settlement obligations on a
timely basis under both normal and stressed conditions and
---------------------- thus contribute to the smooth functioning of payment and
settlement systems.
----------------------
Principle 9 A bank should actively manage its collateral positions,
---------------------- differentiating between encumbered and unencumbered
assets. A bank should monitor the legal entity and physical
---------------------- location where collateral is held and how it may be mobilised
---------------------- in a timely manner.
Principle 10 A bank should conduct stress tests on a regular basis for a
---------------------- variety of short-term and protracted institution-specific
and market-wide stress scenarios (individually and in
----------------------
combination) to identify sources of potential liquidity strain
---------------------- and to ensure that current exposures remain in accordance
with a bank’s established liquidity risk tolerance. A bank
---------------------- should use stress test outcomes to adjust its liquidity risk
management strategies, policies and positions and to develop
----------------------
effective contingency plans.
---------------------- Principle 11 A bank should have a formal contingency funding plan (CFP)
that clearly sets out the strategies for addressing liquidity
---------------------- shortfalls in emergency situations. A CFP should outline
---------------------- policies to manage a range of stress environments, establish
clear lines of responsibility, include clear invocation and
---------------------- escalation procedures and be regularly tested and updated to
ensure that it is operationally robust.
90 Risk Management
Principle 12 A bank should maintain a cushion of unencumbered, high- Notes
quality liquid assets to be held as insurance against a range
of liquidity stress scenarios, including those that involve ----------------------
the loss or impairment of unsecured and typically available ----------------------
secured funding sources. There should be no legal, regulatory
or operational impediment to using these assets to obtain ----------------------
funding.
----------------------
Public disclosure
Principle 13 A bank should publicly disclose information on a regular ----------------------
basis that enables market participants to make an informed
judgement about the soundness of its liquidity risk management ----------------------
framework and liquidity position. ----------------------
Role of supervisors
Principle 14 Supervisors should regularly perform a comprehensive ----------------------
assessment of a bank’s overall liquidity risk management
----------------------
framework and liquidity position to determine whether they
deliver an adequate level of resilience to liquidity stress given ----------------------
the bank’s role in the financial system.
Principle 15 Supervisors should supplement their regular assessments of ----------------------
a bank’s liquidity risk management framework and liquidity ----------------------
position by monitoring a combination of internal reports,
prudential reports and market information. ----------------------
Principle 16 Supervisors should intervene for effective and timely remedial
----------------------
action by a bank to address deficiencies in its liquidity risk
management processes or liquidity position. ----------------------
Principle 17 Supervisors should communicate with other supervisors and
public authorities, such as central banks, both within and across ----------------------
national borders, to facilitate effective cooperation regarding ----------------------
the supervision and oversight of liquidity risk management.
Communication should occur regularly during normal times, ----------------------
with the nature and frequency of the information sharing
increasing as appropriate during times of stress. ----------------------

----------------------
Check your Progress 2
----------------------
Fill in the Blanks. ----------------------
1. A bank should conduct stress tests on a regular basis individually and
----------------------
in combination to identify sources of potential ________ strain.
2. Banks should calculate their intraday liquidity positions and risks to ----------------------
meet ________ and ________ obligations on a timely basis. ----------------------
3. Banks should publicly disclose information on a regular basis that
enables market participants to make an ________ judgement about ----------------------
bank liquidity position. ----------------------

Managing Liquidity Risk 91

 Notes
Activity 3
----------------------

---------------------- Visit a nearby bank and discuss with the branch manger about the role
played by the board of directors of the bank in the entire process of liquidity
---------------------- risk management.
----------------------

---------------------- Summary

---------------------- ●● Liquidity is the ability of the bank to meet its obligations as and when
they become due without incurring any unacceptable losses.
---------------------- ●● Potential sources of liquidity for banks include holding cash or near-cash
---------------------- assets, holding readily marketable securities, line of credit, commercial
papers, short-term borrowings and inter-bank borrowings.
---------------------- ●● A good credit rating helps banks to arrange liquidity at short notice in
---------------------- times of stress.
●● The three aspects of liquidity risk management include structural LRM,
---------------------- daily LRM and contingency LRM.
---------------------- ●● Structural liquidity risk management ensures the ability to fund structural
long-term on- and off-balance sheet exposures on time or at reasonable
---------------------- cost.
---------------------- ●● Daily liquidity risk management ensures that intraday and day-to-day
unanticipated payment obligations are met while maintaining balance
---------------------- between liquidity inflows and outflows.
---------------------- ●● Contingency liquidity risk management ensures that sufficient contingency
funding sources are in place to draw upon in times of economic stress.
----------------------
●● Stock approach and flow approach are used to measure liquidity risk by
---------------------- banks.
●● Banks use different ratios to measure the extent to which illiquid assets
----------------------
are financed by core deposits, extent of available liquid assets, extent of
---------------------- volatile liabilities used to fund balance sheet, etc.
●● The flow approach of measuring liquidity risk involves tracking of the
---------------------- cash flow mismatches by preparing the statement of structural liquidity
---------------------- prescribed by RBI.
●● Banks’ risk strategy should mention the areas of risk exposure, different
---------------------- sources of funds, approving authorities, long-term and short-term liquidity
---------------------- strategy, assumptions used for stress testing and contingency plan.
●● There are various early warning indicators like reduction in maturity
---------------------- of liabilities, increase in volatile liabilities, reduction in stock price,
---------------------- reduction in credit rating, increased risk with a particular product line,
increase in cost of funding, premature redemption of CDs, etc which
---------------------- provide indication to banks of upcoming liquidity crisis.

92 Risk Management
●● Stress test provides a forward looking assessment of risk and alerts the Notes
bank of adverse impact of unexpected situations.
●● Stress test results should be used to identify sources of potential liquidity ----------------------
strain, analyse its impact on profitability, assist in contingent funding ----------------------
planning and determine strategy to deal with liquidity stress.
●● The contingency fund plan consists of a set of policies and procedures ----------------------
to help the bank in managing liquidity risk in a timely and reasonable ----------------------
manner in contingent situations.
●● The Basel Committee has prescribed 17 principles for sound liquidity ----------------------
risk management covering various areas like governance, measurement, ----------------------
management of liquidity risk, necessary disclosures and the role of
supervisors in liquidity risk management. ----------------------
●● Banks are required to keep the principles of sound liquidity management
----------------------
in mind while drafting their risk management strategy.
----------------------
Keywords
----------------------
●● Volatile liabilities: Deposits + Borrowings and bills payable up to 1 year. ----------------------
●● Temporary assets: Cash + Excess CRR balances with RBI + Balances
with banks + Bills purchased discounted up to 1 year + Investments up to ----------------------
1 year + Swap funds (sell/buy) up to 1 year.
----------------------
●● Earning assets: Total assets – (Fixed assets + Balances in current accounts
with other banks + Other assets excluding leasing + Intangible assets). ----------------------
●● CASA deposits: Current deposits (CA) and Savings deposits (SA), i.e., ----------------------
CASA reported by the banks as payable within 1 year (as reported in
structural liquidity statement). ----------------------
●● Core deposits: All deposits including CASA above 1 year + Net worth. ----------------------

----------------------
Self-Assessment Questions
----------------------
1. How do banks manage liquidity risk on a daily basis?
2. What are the two main factors leading to liquidity risk? Why is it important ----------------------
for banks to manage liquidity risk? ----------------------
3. What are the different sources from which banks arrange their liquidity?
----------------------
4. What are the liquidity risk management disclosures specified by the Basel
Committee which banks should follow? ----------------------
5. Elaborate the various early warning indicators of liquidity crisis. ----------------------
6. Discuss the importance of stress test and scenario analysis in liquidity
----------------------
risk management.
----------------------

----------------------

Managing Liquidity Risk 93

 Notes Answers to Check your Progress
---------------------- Check your Progress 1

---------------------- State True or False.

1. False
----------------------
2. False
----------------------
3. True
---------------------- 4. True
---------------------- Check your Progress 2

---------------------- Fill in the Blanks.

1. A bank should conduct stress tests on a regular basis individually and in
---------------------- combination to identily sources of potential liquidity strain.
---------------------- 2. Banks should calculate their intraday liquidity positions and risks to meet
payment and settlement obligations on a timely basis.
----------------------
3. Banks should publicly disclose information on a regular basis that enables
---------------------- market participants to make an informed judgement about banks’ liquidity
position.
----------------------

---------------------- Suggested Reading

---------------------- 1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
---------------------- California: Academic Foundation.
2. Benton E. Gup, and James W. Kolari 2007. Commercial Banking: The
----------------------
Management of Risk. Australia: John Wiley & Sons.
---------------------- 3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books.
----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic 2003. Analyzing
---------------------- and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

94 Risk Management
Managing Interest Rate Risk
UNIT

6
Structure:

6.1 Introduction
6.2 Sources of Interest Rate Risk
6.3 Effects of Interest Rate Risk
6.4 Sound Interest Rate Risk Management Practices
6.5 Interest Rate Risk Measurement Techniques
6.6 Principles for Management and Supervision of Interest Rate Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Interest Rate Risk 95

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the concept of interest rate risk
----------------------
• Distinguish between types of interest rate risk
---------------------- • Examine the essential features of sound interest rate risk management
---------------------- • Appraise the techniques used by banks to measure interest rate risk

---------------------- • Memorise the recommendations of Basel Committee on sound interest

rate risk management
----------------------
6.1 INTRODUCTION
----------------------

---------------------- As covered in the previous unit, adverse movements in interest rates

expose the banks to interest rate risk. It refers to potential impact on net interest
---------------------- income and market value of equity caused by unexpected changes in market
interest rates. This risk is considered as an integral part of banking and is
---------------------- well accepted as a normal part of banking. If managed properly, it can be an
---------------------- important source of profitability and shareholders’ value. At the same time, it
can have a significant impact on a bank’s profitability and capital base. Change
---------------------- in interest rates results in change in interest income, thereby impacting the
bank’s earnings. It also has an impact on the underlying value of the bank’s
---------------------- assets, liabilities and off balance sheet items by changing the present value of
---------------------- cash flows.
Deregulation of interest rates has exposed banks to the adverse impacts of
---------------------- interest rate risk. The net interest income, earnings of assets and cost of liabilities
---------------------- are closely related to market interest rate volatility. Hence management of
interest rate risk should be a critical component of market risk management in
---------------------- banks. An efficient risk management process, which maintains the interest rate
limits within prudent limits, is essential for sound banking operations.
----------------------

---------------------- 6.2 SOURCES OF INTEREST RATE RISK

---------------------- Interest rate risk arises because of various factors, internal as well
as external. Some sources can have a greater impact on interest rate risk as
---------------------- compared to other sources. Let us study these sources in detail to understand
the impact of each source on interest rate risk.
----------------------
1. 
Repricing risk: All banks and financial institutions encounter interest rate
---------------------- risk in various forms, out of which risk arising from timing difference in
maturity for fixed rate loans and re pricing for floating rate loans are the
----------------------
most prominent ones. Repricing differences are unavoidable in banking
---------------------- business but exposure beyond prudent limits can have a major impact on
bank’s income and underlying economic value. For instance, if a bank
---------------------- funds a long-term fixed rate loan with a short term deposit and the interest

96 Risk Management
 rate increases in future, then it can face decline in future interest income Notes
from loan as well as its underlying value. 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.
----------------------
2. 
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 effects on a
bank’s 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.
----------------------
3. 
Basis risk: An imperfect correlation in the adjustment of rates earned
and paid on different instruments with otherwise similar repricing ----------------------
characteristics results in another form of interest rate risk called the basis
risk. Change in interest rates results in change in cash flows and earnings ----------------------
spread between assets, liabilities and off balance sheet instruments of
similar maturities. For example if a one year monthly repricing loan is ----------------------
funded by a one-year deposit that reprices monthly, based on one-month ----------------------
LIBOR, then the bank is exposed to the risk of unexpected change in the
spread between the two index rates. ----------------------
Optionality: Many bank assets, liabilities and off balance sheet
4.  ----------------------
instruments are embedded with options which become a source of
interest rate risk. Typically 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.
 xamples of instruments with embedded options include various types of
E ----------------------
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 that give depositors the right to withdraw funds at any time, ----------------------
often without any penalties. If not adequately managed, the 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. ----------------------

6. Price risk: Sale of assets before maturity results in price risk. The price ----------------------
risk is closely associated with the trading book, which is created for
making profit out of short-term movements in interest rates. Banks, which ----------------------
have an active trading book, should therefore formulate policies to limit ----------------------
the portfolio size, holding period, duration, defeasance period, stop loss
limits, marking to market etc. ----------------------
7. Reinvestment Risk: Uncertainty with regard to interest rate at which ----------------------
the future cash flows could be reinvested is called reinvestment risk. Any
mismatches in cash flows would expose the banks to variations in net ----------------------
interest income as the market interest rates move in different directions.
Managing Interest Rate Risk 97
 Notes 6.3 EFFECTS OF INTEREST RATE RISK
---------------------- As discussed above, changes in interest rates can have an adverse impact
both on a bank’s earnings and its economic value. Hence the bank’s interest rate
---------------------- risk exposure is assessed from two perspectives:
---------------------- 1.  Earnings perspective: Under this perspective, the impact of change in
interest rates on accrued or reported earnings of the bank is analyzed. This
---------------------- is a traditional approach followed by most of the banks for assessment of
their interest rate risk. Variation in earnings is an important focal point for
---------------------- interest rate risk analysis because reduced earnings or outright losses can
threaten the financial stability of an institution by undermining its capital
----------------------
adequacy and by reducing market confidence.
----------------------  The difference between the total interest income and total interest
expense is termed as net interest income and is regarded as an important
---------------------- component of banks earnings. It is directly linked to interest rate changes
---------------------- and has a direct impact on the overall earnings of the bank.
With the diversification in banking services, scope of fee-based and
---------------------- other non- interest incomes has increased and there is a broader focus on
overall net income incorporating both interest and non-interest incomes
---------------------- and expenses. Activities such as loan servicing and asset securitisation
---------------------- generate non-interest income for banks but are highly sensitive to market
interest rates. For example, banks provide the function of loan servicing
---------------------- and administration on mortgage loans and charge a fee based on volume
of assets it administers. With the fall in interest rates, a lot of mortgages
---------------------- prepay, resulting in decline in banks fee income. Even the transaction
processing fee gets impacted by interest rate changes. As a result, banks
----------------------
consider a broader view of potential effects of change in interest rates
---------------------- on banks’ earnings and factor the impact of change in interest rates on
estimated earnings of the bank.
---------------------- 2.  Economic value perspective: Variation in market interest rates can
also affect the economic value of a bank’s assets, liabilities and OBS
----------------------
positions. The shareholders, management and supervisors of the bank are
---------------------- equally interested in knowing the sensitivity of a bank’s economic value
to fluctuations in interest rates.
---------------------- The economic value of an instrument is calculated by assessing the present
value of its expected net cash flows, discounted to reflect market rates.
----------------------
Thus the economic value for the bank will be the expected cash flows on
---------------------- assets minus the expected cash flows on liabilities plus the expected net
cash flows on OBS positions. Thus it reflects how sensitive the net worth
---------------------- of the bank is to change in interest rates.
As compared to the earnings perspective, 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 impact of change in interest rates. The comprehensive
---------------------- view is very important as changes in short term earnings, as reflected by
earnings perspective, may not accurately indicate the impact of interest
----------------------
rate movements on bank’s overall position.
98 Risk Management
3. 
Embedded losses: We have seen that the earnings and economic value Notes
perspectives discussed till now emphasise on predicting the impact of
future changes in interest rates on bank’s financial performance. The bank ----------------------
should also consider the impact of past interest rates on future performance
in order to make a correct assessment of interest rate risk. In particular, ----------------------
instruments that are not marked to market may already contain embedded ----------------------
gains or losses due to past rate movements. For example, a long-term,
fixed-rate loan entered into when interest rates were low and refunded ----------------------
more recently with liabilities bearing a higher rate of interest will, over its
remaining life, represent a drain on the bank’s resources. ----------------------

----------------------
Activity 1
----------------------
Visit the RBI website and give your views on different perspectives of ----------------------
measuring interest rate risk exposure of a bank.
----------------------
----------------------
6.4 SOUND INTEREST RATE RISK MANAGEMENT
PRACTICES ----------------------

Sound interest rate risk management involves the application of four ----------------------
basic elements in the management of assets, liabilities and OBS instruments, as
explained below: ----------------------

1. Appropriate board and senior management oversight. ----------------------

2. Adequate risk management policies and procedures. ----------------------
3. Appropriate risk measurement, monitoring and control functions. ----------------------
4. Comprehensive internal controls and independent audits.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Fig. 6.1: Sound Interest Rate Risk Management Practices ----------------------

Managing Interest Rate Risk 99

 Notes 1. Appropriate board and senior management oversight: Like all risk
management processes, effective oversight and guidance by the board
---------------------- of directors and senior management is critical for sound interest rate
risk management. The board should have a clear understanding of the
---------------------- nature and level of interest rate risk taken by bank and should approve
---------------------- strategies and policies governing interest rate risk. Lines of authority and
responsibility for managing interest rate risk exposures should be clearly
---------------------- defined. The board should ensure that proper steps have been taken by the
management to identify, measure, monitor and control interest rate risk.
---------------------- They should also encourage discussions between its members and senior
---------------------- management and with others in the bank regarding risk exposure and
management processes. Periodical review and re-evaluation of policies
---------------------- and procedures is also the responsibility of the bank’s board.
---------------------- The senior management is responsible for ensuring that the risk
management policies and procedures are followed by all in the system
---------------------- on a long-term basis as well as day-to-day basis. They are responsible for
maintaining:
----------------------
• Limits on risk taking.
---------------------- Adequate standards of risk measurement.
---------------------- • Standards for valuing positions and measuring performance.

---------------------- Comprehensive risk reporting and management review process.

• Sound internal controls.
----------------------
Management should ensure that safeguards are in place to minimise
---------------------- inappropriate influencing of key control functions by individuals
initiating risk-taking positions. The nature and scope of such safeguards
---------------------- should be based on the size and structure of the bank as well as volume
and complexity of transactions. The personnel charged with measuring,
----------------------
monitoring and controlling interest rate risk should have a well-founded
---------------------- understanding of all types of interest rate risk faced throughout the bank.
2. Adequate risk management policies and procedures: Policies and
----------------------
procedures should be clearly defined for limiting and controlling interest
---------------------- rate risk. Some salient features of policies and procedures are as under:
• Consolidated application.
----------------------
• Clearly defined authority and responsibility.
---------------------- • Clearly defined authorised instruments, hedging strategies and
---------------------- position taking opportunities.
• Quantifiable parameters for risk measurement.
----------------------
• Periodical review and revision.
---------------------- • Clearly defined tolerable risk limits.
---------------------- • Clear set of institutional procedures for acquiring specific
instruments, managing portfolios and controlling the bank’s
---------------------- aggregate interest rate risk exposure.

100 Risk Management

 Bank should be extra careful before dealing in products and activities that Notes
are new to the bank. A careful pre acquisition review should be done to
ensure understanding and incorporation of all interest rate risks factors. ----------------------
Prior to introducing a new product, hedging or position-taking strategy,
management should ensure that adequate operational procedures and risk ----------------------
control systems are in place. ----------------------
3. Risk measurement, monitoring and control functions: Depending on the
----------------------
nature, size and complexity of operations, banks should have appropriate
interest rate risk measurement systems for measuring impact on both ----------------------
earnings and economic value. The risk measurement system should be
able to assess all material interest rate risks, utilise generally accepted ----------------------
financial concepts and risk measurement techniques and should be well-
----------------------
documented. We will cover the various risk measurement techniques used
by banks later in this unit. ----------------------
The goal of interest rate risk management is to maintain bank’s interest
----------------------
rate risk exposure within pre-defined limits. Banks should have a well
defined system to set boundaries for the level of interest rate risk and ----------------------
it should be allocated amongst individual portfolios, activities and
business units. The limits should be consistent with the overall approach ----------------------
to measuring interest rate risk and any deviation should receive prompt
----------------------
management attention. The limits so decided should be communicated to
the appropriate mangers in time. ----------------------
The risk measurement system should also support a meaningful evaluation
----------------------
of the effect of stressful market conditions on the bank. Stress testing
should be designed to provide information on the kinds of conditions ----------------------
under which the bank’s strategies or positions would be most vulnerable
and thus may be tailored to the risk characteristics of the bank. Possible ----------------------
stress scenarios might include abrupt changes in the general level of
----------------------
interest rates, changes in the relationships among key market rates (i.e.
basis risk), changes in the slope and the shape of the yield curve (i.e. yield ----------------------
curve risk), changes in the liquidity of key financial markets or changes in
the volatility of market rates. ----------------------
4. Interest rate risk monitoring and reporting: An accurate and timely ----------------------
information system is essential for the efficient interest rate risk
management. There should be regular reporting of risk measures and ----------------------
current exposures should be compared with policy limits and past forecasts ----------------------
with actual results to highlight the shortcomings of risk modelling, if any.
The risk reports should be reviewed by the board regularly and should ----------------------
include the following: ----------------------
• Summary of aggregate exposures.
----------------------
• Policy and limit compliance report.
----------------------
• Key assumptions.
• Stress test results. ----------------------

Managing Interest Rate Risk 101

 Notes • Summary of findings of review of interest rate risk policies and
procedures.
----------------------
Internal Controls
---------------------- Adequate internal controls should be in place to ensure integrity of interest
rate risk management process. They should promote effective and efficient
----------------------
operations, compliance with laws and regulations and should be an integral part
---------------------- of overall internal control system. An effective internal control system should
include the following:
----------------------
• Strong control environment.
---------------------- • Adequate process of identifying and evaluating risk.
---------------------- • Adequate information system.
---------------------- • Continuous review of established policies and procedures.
An important element of a bank’s internal control system over its interest
----------------------
rate risk management process is regular evaluation and review. This includes
---------------------- ensuring that personnel are following established policies and procedures, as
well as ensuring that the procedures that were established actually accomplish
---------------------- the intended objectives. Such reviews and evaluations should also address any
significant change that may impact the effectiveness of controls, such as changes
----------------------
in market conditions, personnel, technology and structures of compliance with
---------------------- interest rate risk exposure limits and should ensure that appropriate follow-up
with management has occurred for any limits that were exceeded.
----------------------

---------------------- Check your Progress 1

---------------------- State True or False.

---------------------- 1. Interest rate risk refers to potential impact on net interest income
and market value of equity caused by unexpected changes in market
---------------------- interest rates.
---------------------- 2. If managed properly, the interest rate risk can be an important source
of profitability and shareholders’ value.
----------------------
3. Interest rate risk is considered an integral part of banking and is well
---------------------- accepted as a normal part of banking.
----------------------

---------------------- Activity 2

----------------------
Visit a nearby bank and interview the bank officer about the sound interest
---------------------- rate risk management practices followed there.

----------------------

----------------------

102 Risk Management

6.5 INTEREST RATE RISK MEASUREMENT Notes
TECHNIQUES
----------------------
Banks follow various techniques to measure the exposure of earnings and
economic value to changes in interest rates. Techniques such as sample maturity ----------------------
and repricing tables, static simulations based on current on- and off-balance- ----------------------
sheet positions and dynamic modelling techniques incorporating assumptions
about behaviour of customer and bank in response to change in interest rates. ----------------------
Some general approaches are used to calculate exposure to interest rate risk
both from earnings and economic value perspective while some approaches are ----------------------
typically associated with only one of the two perspectives. ----------------------
The approaches also vary, based on their ability to capture different forms
----------------------
of interest rate exposures, wherein the simplest methods capture the risks arising
from maturity and repricing mismatches, while the more sophisticated methods ----------------------
can more easily capture the full range of risk exposures.
----------------------
Each approach has its own strengths and weaknesses based on its
capability to provide accurate and reasonable measure of interest rate risk. The ----------------------
approach followed by a bank towards measurement and hedging of interest rate
risk depends upon the segmentation of balance sheet. ----------------------
Before we continue to study the different approaches for interest rate risk ----------------------
measurement, we will study the concept of trading book and banking book.
----------------------
1. 
Trading Book: Assets in trading book are held for generating profits on
short term differences in prices. The banks management should lay down ----------------------
policies specifying the volume, maturity, holding period, duration, stop
loss, rating standards etc. for classifying securities in trading book. ----------------------

 he VaR (Value at Risk) method is employed to assess potential loss

T ----------------------
that could crystallise on trading position or portfolio due to variations in
market interest rates and prices, using a given confidence level, usually ----------------------
95% to 99%, within a defined period of time. The VaR models require ----------------------
extensive use of historical data to estimate future volatility and may not
give good results in extremely volatile market conditions. Stress tests on ----------------------
the other hand provide management with a view on potential impact of
large market movements and estimated loss due to stress events. Scenario ----------------------
analysis can also be conducted by banks with specific possible stress ----------------------
situations.
----------------------
2. 
Banking Book: The banking book comprises assets and liabilities, which
are contracted on account of relationship or for steady income and are ----------------------
generally held till maturity. Interest rate changes have an impact on
the earnings and economic value of banking book. Depending on the ----------------------
complexity of the balance sheet and the range of products, banks should
----------------------
have adequate risk measurement system to assess the effect of rate change
on both earnings and economic value. ----------------------
 aving understood the concept of trading book and banking book, we will
H
----------------------
now go through the different interest rate risk measurement techniques.

Managing Interest Rate Risk 103

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

---------------------- Fig. 6.2: Internet Rate Risk Measurement Techniques

A. Repricing schedules
----------------------
The simplest techniques for measuring a bank’s interest rate risk exposure
---------------------- begin with a maturity/repricing schedule that distributes interest-sensitive
assets, liabilities and OBS positions into a certain number of predefined
----------------------
time bands according to their maturity (if fixed-rate) or time remaining to
---------------------- their next repricing (if floating-rate). Those assets and liabilities lacking
definitive repricing intervals (e.g. sight deposits or savings accounts)
---------------------- or actual maturities that could vary from contractual maturities (e.g.
mortgages with an option for early repayment) are assigned to repricing
----------------------
time bands according to the judgement and past experience of the bank.
---------------------- 1. Gap analysis: Use of simple maturity/repricing schedules to assess the
---------------------- interest rate risk of current savings is termed as gap analysis. It is amongst
the first methods developed to measure bank’s exposure to interest rate
---------------------- risk and is most widely used by banks. Interest rate-sensitive liabilities
in each time band are subtracted from the corresponding interest rate-
---------------------- sensitive assets to produce a repricing “gap” for that time band. This
---------------------- gap can be multiplied by an assumed change in interest rates to yield an
approximation of the change in net interest income that would result from
---------------------- such an interest rate movement. The size of the interest rate movement
used in the analysis can be based on a variety of factors, including historical
---------------------- experience, simulation of potential future interest rate movements and the
---------------------- judgement of bank management.
A negative or liability-sensitive gap occurs when liabilities exceed
---------------------- assets (including OBS positions) in a given time band. This means that

104 Risk Management

 an increase in market interest rates could cause a decline in net interest Notes
income. Conversely, a positive or asset-sensitive gap implies that the
bank’s net interest income could decline as a result of a decrease in the ----------------------
level of interest rates.
----------------------
Although gap analysis is a very commonly used approach to assessing
interest rate risk exposure, it has a number of shortcomings. ----------------------
• It does not take into account variation in the characteristics of ----------------------
different positions within a time band.
----------------------
• It ignores differences in spreads between interest rates that could
arise as the level of market interest rates changes. ----------------------
• It does not take into account any changes in the timing of ----------------------
payments that might occur as a result of changes in the interest rate
environment. ----------------------
• It fails to capture variability in non-interest revenue and expenses, ----------------------
a potentially important source of risk to current income.
Hence, we can say that the gap analysis approach provides only a rough ----------------------
approximation of actual change in net interest income. ----------------------
2. Duration analysis: Impact of change in interest rates on bank’s economic
----------------------
value can be evaluated using a maturity/repricing schedule by applying
sensitivity weights to each time band. As per BIS (Bank for International ----------------------
Settlements) such weights are based on the estimated duration of the
assets and liabilities that fall in each time band. Duration is a measure of ----------------------
the % change in the economic value of a position that will occur given a
----------------------
small change in the level of interest rates.
In its simplest form, duration measures changes in economic value resulting ----------------------
from a % change of interest rates under the simplifying assumption that
----------------------
changes in value are proportional to changes in the level of interest rates
and that the timing of payments is fixed. 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 bank’s 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 ----------------------
differences in the coupon rates and maturities (for instance, one weight ----------------------
for assets and another for liabilities). In addition, different interest rate
changes are sometimes used for different time bands, generally to reflect ----------------------
differences in the volatility of interest rates along the yield curve. The
weighted gaps are aggregated across time bands to produce an estimate ----------------------

Managing Interest Rate Risk 105

 Notes of the change in economic value of the bank that would result from the
assumed changes in interest rates.
---------------------- B. Simulation Approaches
---------------------- Many banks (especially those using complex financial instruments or
otherwise having complex risk profiles) employ more sophisticated
---------------------- interest rate risk measurement systems than those based on simple
---------------------- maturity/repricing schedules. These simulation techniques typically
involve detailed assessments of the potential effects of changes in interest
---------------------- rates on earnings and economic value by simulating the future path of
interest rates and their impact on cash flows.
----------------------
It involves a more detailed breakdown of various categories of on- and
---------------------- offbalance- sheet positions, so that specific assumptions about the interest
and principal payments and non-interest income and expense arising
---------------------- from each type of position can be incorporated. In addition, simulation
---------------------- techniques can incorporate more varied and refined changes in the interest
rate environment, ranging from changes in the slope and shape of the yield
---------------------- curve to interest rate scenarios derived from Monte Carlo simulations.
1. Static simulation: In static simulations, the cash flows arising solely from
----------------------
the bank’s current on- and off-balance-sheet positions are assessed. For
---------------------- assessing the exposure of earnings, simulations estimating the cash flows
and resulting earnings streams over a specific period are conducted based
---------------------- on one or more assumed interest rate scenarios. Typically, although not
always, these simulations entail relatively straightforward shifts or tilts
----------------------
of the yield curve or changes of spreads between different interest rates.
---------------------- When the resulting cash flows are simulated over the entire expected lives
of the bank’s holdings and discounted back to their present values, an
---------------------- estimate of the change in the bank’s economic value can be calculated.
---------------------- 2. Dynamic simulation: In a dynamic simulation approach, the simulation
builds in more detailed assumptions about the future course of interest
---------------------- rates and the expected changes in a bank’s business activity over that time.
For instance, the simulation could involve assumptions about a bank’s
----------------------
strategy for changing administered interest rates (on savings deposits, for
---------------------- example), about the behaviour of the bank’s customers (e.g. withdrawals
from sight and savings deposits) and/or about the future stream of business
---------------------- (new loans or other transactions) that the bank will encounter. Such
simulations use these assumptions about future activities and reinvestment
----------------------
strategies to project expected cash flows and estimate dynamic earnings
---------------------- and economic value outcomes. These more sophisticated techniques
allow for dynamic interaction of payments streams and interest rates and
---------------------- better capture the effect of embedded or explicit options.
---------------------- As with other approaches, the usefulness of simulation-based interest rate
risk measurement techniques depends on the validity of the underlying
---------------------- assumptions and the accuracy of the basic methodology. The output of
sophisticated simulations must be assessed largely in the light of the
----------------------
validity of the simulation’s assumptions about future.

106 Risk Management

 Notes
Check your Progress 2
----------------------
Fill in the Blanks. ----------------------
1. The approach followed by bank towards measurement and hedging of
----------------------
interest rate risk depends upon the segmentation of ____________.
2. Adequate ____________ should be in place to ensure integrity of ----------------------
interest rate risk management process.
----------------------
3. An important element of a bank’s internal control system over its
interest rate risk management process is regular ____________ and ----------------------
____________. ----------------------

----------------------
Activity 3
----------------------
Read more on Internet about various simulation techniques used by banks ----------------------
for measurement of interest rate risk.
----------------------

6.6 PRINCIPLES FOR MANAGEMENT AND ----------------------

SUPERVISION OF INTEREST RATE RISK ----------------------
As part of its ongoing efforts to address international bank supervisory
issues, the Basel Committee on Banking Supervision issued a paper on principles ----------------------
for the management of interest rate risk in September 1997. ----------------------
The principles are intended to be of general application, based as they
----------------------
are on practices currently used by many international banks, even though
their specific application will depend to some extent on the complexity and ----------------------
range of activities undertaken by individual banks. Under the new capital
framework, they form minimum standards expected of internationally active ----------------------
banks. The principles set out here should be used in evaluating the adequacy
----------------------
and effectiveness of a bank’s interest rate risk management, in assessing the
extent of interest rate risk run by a bank in its banking book and in developing ----------------------
the supervisory response to that risk.
----------------------
Board and senior management oversight of interest rate risk
Principle 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 consistent with the approved strategies and policies.
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 against the board’s ----------------------
guidance on the levels of risk that are acceptable to the bank.
----------------------

Managing Interest Rate Risk 107

 Notes Principle 2 Senior management must ensure that the structure of the
bank’s 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. Larger or more complex banks should
have a designated independent unit responsible for the design
---------------------- and administration of the bank’s interest rate risk measurement,
monitoring and control functions.
---------------------- Adequate risk management policies and procedures
---------------------- Principle 4 It is essential that banks’ interest rate risk policies and
procedures are clearly defined and consistent 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 recognising legal
---------------------- distinctions and possible obstacles to cash movements among
affiliates.
---------------------- 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 or undertaken.
---------------------- Major hedging or risk management initiatives should be
approved in advance by the board or its appropriate delegated
---------------------- committee.
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.
----------------------

108 Risk Management

Principle 9 Banks must have adequate information systems for measuring, Notes
monitoring, controlling and reporting interest rate exposures.
Reports must be provided on a timely basis to the bank’s ----------------------
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.
----------------------
Information and 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 the range of maturities and currencies in each bank’s
----------------------
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. ----------------------
Supervisory treatment of interest rate risk in the banking book
Principle 14 Supervisory authorities must assess whether the internal ----------------------
measurement systems of banks adequately capture the interest
----------------------
rate risk in their banking book. If a bank’s internal measurement
system does not adequately capture the interest rate risk, ----------------------
the bank must bring the system to the required standard. To
facilitate supervisors’ monitoring of interest rate risk exposures ----------------------
across institutions, banks must provide the results of their
----------------------
internal measurement systems, expressed in terms of the threat
to economic value, using a standardised interest rate shock. ----------------------
Principle 15 If supervisors determine that a bank is not holding capital
commensurate with the level of interest rate risk in the banking ----------------------
book, they should consider remedial action, requiring the bank
----------------------
either to reduce its risk or hold a specific additional amount of
capital or a combination of both. ----------------------

----------------------

----------------------

Managing Interest Rate Risk 109

 Notes
Check your Progress 3
----------------------

---------------------- Fill in the Blanks.

1. Banks must have adequate information systems for measuring,
----------------------
monitoring, controlling and reporting interest rate ______________.
---------------------- 2. Major hedging or risk management initiatives should be approved
in advance by the ______________ or its appropriate delegated
----------------------
committee.
---------------------- 3. 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 ______________ and the ______________.

---------------------- 4. The board of directors in a bank should approve ______________

with ______________ with respect to interest rate risk management.
----------------------

----------------------

---------------------- Summary
---------------------- ●● Interest rate risk is the potential impact on net interest income and market
value of equity caused by unexpected changes in market interest rates.
----------------------
●● Deregulation of interest rates has exposed banks to the adverse impacts
---------------------- of interest rate risk.
---------------------- ●● Repricing risk, yield curve risk, basis risk, optionality, price risk and
reinvestment risk are the different forms of interest rate risk.
---------------------- ●● The bank’s interest rate risk exposure is assessed from two perspectives:
---------------------- Earnings perspective and Economic Value perspective.
●● Earnings perspective analyses the impact of change in interest rates on
---------------------- accrued or reported earnings of the bank.
---------------------- ●● Economic Value perspective measures the impact of variation in market
interest rates on the economic value of a bank’s assets, liabilities and OBS
---------------------- positions.
---------------------- ●● Management oversight, adequate policies and procedures, adequate risk
measurement, monitoring and control and effective internal controls are
---------------------- the sound interest rate risk management practices.
---------------------- ●● The senior management is responsible for ensuring that the risk
management policies and procedures are followed by all in the system on
---------------------- a long-term basis as well as day-to-day basis.
---------------------- ●● Consolidated application, clearly defined authority and responsibility,
quantifiable parameters, regular review and clear procedures are some of
---------------------- the salient features of sound policies and procedures.

110 Risk Management

●● An accurate and timely information system is essential for the efficient Notes
interest rate risk management.
●● Adequate internal controls should be in place to ensure integrity of interest ----------------------
rate risk management process. ----------------------
●● Assets in trading book are held for generating profits on short term
differences in prices. ----------------------
●● The banking book comprises assets and liabilities contracted on account ----------------------
of relationship or for steady income and are generally held till maturity.
----------------------
●● Techniques like sample maturity and repricing tables, static simulations
based on current on- and off-balance-sheet positions, dynamic modelling ----------------------
techniques incorporating assumptions about behaviour of customer and
bank in response to change in interest rates. ----------------------
●● Use of simple maturity / repricing schedules to assess the interest rate risk ----------------------
of current savings is termed as gap analysis.
----------------------
●● Impact of change in interest rates on banks economic value can be
evaluated using a maturity/repricing schedule by applying sensitivity ----------------------
weights based on duration to each time band.
----------------------
●● Simulation techniques involve detailed assessments of the potential
effects of change in interest rates on earnings and economic value by ----------------------
simulating the future path of interest rates and their impact on cash flows.
●● The Basel Committee on Banking Supervision has issued principles ----------------------
for management and supervision of interest rate risk, which serve as ----------------------
guidelines for banks for effective management of interest rate risk.
----------------------
Keywords ----------------------
●● Cost of credit: The interest rate, required return or other compensation ----------------------
associated with securing and using credit.
●● ixed interest rate: An interest rate that does not change over the life of
F ----------------------
a loan, bond or other form of credit. ----------------------
●● Fixed interest rate loan: A loan where the interest rate on the loan does
not change during the maturity of the loan. ----------------------

●● Floating interest rate: An interest rate other than a fixed interest rate, ----------------------
whichb may change depending on the performance of an underlying
index. ----------------------
●● rime lending rate: The rate the banks typically charge their best
P ----------------------
customers.
----------------------
●● Rate sensitive assets: Bank assets, mainly bonds, loans and leases and
the value of these assets is sensitive to changes in interest rates; these ----------------------
assets are either repriced or revalued as interest rates change.
----------------------
●● Rate sensitive liabilities: Bank liabilities, mainly interest-bearing
deposits and other liabilities and the value of these liabilities is sensitive ----------------------

Managing Interest Rate Risk 111

 Notes to changes in interest rates; these liabilities are either repriced or revalued
as interest rates change.
----------------------

---------------------- Self-Assessment Questions

---------------------- 1. What do you mean by interest rate risk? Why is it an essential component
of market risk management?
----------------------
2. Write short notes on:
---------------------- i. Basis risk
---------------------- ii. Repricing risk
---------------------- iii. Earnings perspective of interest rate risk
iv. Importance of internal controls in IRR management
----------------------
3. What are the various areas covered in the principles of management and
---------------------- supervision of interest rate risk issued by Basel Committee?
---------------------- 4. How do banks use gap analysis and duration analysis techniques to
measure interest rate risk? What are the drawbacks of each of them?
----------------------
5. Highlight the importance of management oversight and policies and
---------------------- procedures in management of interest rate risk.

---------------------- 6. What are the essential features of sound interest rate risk management?
7. Which are the different techniques used by banks to measure interest rate
----------------------
risk?
---------------------- 8. Make a list of the recommendations of Basel Committee on sound interest
rate risk management.
----------------------

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1
---------------------- State True or False.
1. True
----------------------
2. True
----------------------
3. True
---------------------- Check your Progress 2
---------------------- Fill in the Blanks.
---------------------- 1. The approach followed by a bank towards measurement and hedging of
interest rate risk depends upon the segmentation of balance sheet.
----------------------
2. Adequate internal controls should be in place to ensure integrity of interest
---------------------- rate risk management process

----------------------

112 Risk Management

3. An important element of a bank’s internal control system over its interest Notes
rate risk management process is regular evaluation and review.
----------------------
Check your Progress 3
Fill in the Blanks. ----------------------
1. Banks must have adequate information systems for measuring, monitoring, ----------------------
controlling and reporting interest rate exposures.
----------------------
2. Major hedging or risk management initiatives should be approved in
advance by the board or its appropriate delegated committee. ----------------------
3. 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.
----------------------
4. The board of directors in a bank should approve strategies and policies
with respect to interest rate risk management. ----------------------
----------------------
Suggested Reading
----------------------
1. www.bis.org
----------------------
2. www.garp.org
----------------------
3. www.rbi.org
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Interest Rate Risk 113

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

114 Risk Management

Managing Foreign Exchange Risk
UNIT

7
Structure:

7.1 Introduction
7.2 Types of Foreign Exchange Risk
7.3 Foreign Currency Exposure of Commercial Banks
7.4 Foreign Exchange Risk Management
7.5 Steps in Management of Foreign Exchange Risk
7.6 Methods of Measuring Foreign Exchange Risk
7.7 Methods of Managing Foreign Exchange Risk
7.8 Foreign Exchange Settlement Risk
7.8.1 Dimensions of FX Settlement Risk
7.8.2 Duration of FX Settlement Exposure
7.8.3 Measurement of FX Settlement Exposures
7.8.4 Contingency Planning
7.8.5 Use of Bilateral Netting
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Foreign Exchange Risk 115

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Discuss the concept of foreign exchange risk
----------------------
• Evaluate the different types of foreign exchange risk
---------------------- • Write the essential features of sound foreign exchange risk management
---------------------- • Discuss the techniques of measuring foreign exchange risk

---------------------- • Analyse the concept of foreign exchange risk settlement and its
dimensions
---------------------- • Appraise the use of bilateral netting in hedging FX
----------------------

---------------------- 7.1 INTRODUCTION

---------------------- Foreign exchange risk or forex risk is the risk that a bank may suffer
losses because 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. In simple words, foreign exchange risk arises
----------------------
when a bank holds assets or liabilities in foreign currency and the earnings
---------------------- and capital of the bank are impacted by an upward or downward movement in
currency rates.
----------------------
Foreign exchange risk can take various forms:
---------------------- • Mismatched foreign currency positions that can lead to interest rate risks.
---------------------- • Even in cases where spot and forward positions in individual currencies
are balanced, the maturity pattern of forward transactions may produce
---------------------- mismatches.
---------------------- • In forex business, banks also face the risk of default of the counterparties
or settlement risk.
----------------------
• Banks also face another risk called time-zone risk which arises out of
---------------------- time lags in settlement of one currency in one centre in one time zone and
the settlement of another currency in another time zone.
----------------------
• Forex transactions with counterparties from another country also trigger
---------------------- country risk.
----------------------
7.2 TYPES OF FOREIGN EXCHANGE RISK
----------------------
Prediction of future exchange rates with accuracy is very difficult. The
---------------------- volatility in forex rates has heightened the risk inherent in running open foreign
exchange positions in recent years, thereby adding a new dimension to the risk
----------------------
profile of bank’s balance sheet.
----------------------

116 Risk Management

Foreign currency exposures are generally categorised into the following Notes
three distinct types: transaction exposure, economic exposure and translation
exposure. ----------------------
• Transaction exposure: It arises as a result of unfavourable movement ----------------------
in exchange rate impacting the profitability from transactions in foreign
currency. It can be hedged using different techniques. ----------------------
• Translational risk: It is the accounting risk arising because of translation ----------------------
of assets held in foreign currency or abroad. It is usually retrospective and
short term in nature. ----------------------
• Economic exposure/Operating exposure: A firm has economic exposure ----------------------
(also known as operating exposure) to the degree that its market value is
influenced by unexpected exchange rate fluctuations. It arises because ----------------------
of currency fluctuations combined with price level changes resulting in
----------------------
alteration of future revenues and costs. It is usually prospective and long
term in nature and impacts the present value of future cash flows of the ----------------------
bank.
----------------------
7.3 FOREIGN CURRENCY EXPOSURE OF COMMERCIAL - - - - - - - - - - - - - - - - - - - - - -
BANKS
----------------------
Commercial banks are involved in various trading and non-trading foreign
exchange activities which continuously expose them to foreign exchange risk. ----------------------
A commercial bank is involved in the purchase and sale of foreign currencies ----------------------
for any of the following purposes:
• To allow customers to deal in international commercial trade transactions. ----------------------

• To allow customers to make various foreign real estate and financial ----------------------
investments.
----------------------
• To hedge customers’ exposure in foreign currency.
----------------------
• For speculative purpose.
These activities expose a bank to foreign exchange risk only to the extent ----------------------
it has not hedged or covered its position. Any unhedged position in a particular ----------------------
currency gives rise to forex risk and is termed as an open position. If a bank has
sold more foreign currency than what it has purchased, it is called net short and ----------------------
if it has purchased more foreign currency than what it has sold, it is called net
long. In either case, the bank is exposed to risk as the value of foreign currency ----------------------
may fall as compared to local currency, thereby resulting in substantial losses. ----------------------

----------------------

----------------------

----------------------

----------------------

Managing Foreign Exchange Risk 117

 Notes
Check your Progress 1
----------------------

---------------------- Fill in the Blanks.

1. Forex transactions with counterparties from another country also
----------------------
trigger ____________ risk.
---------------------- 2. In forex business, banks also face the risk of ____________ of
counterparties or settlement risk.
----------------------
3. Foreign exchange risk arises when a bank holds ____________ or
---------------------- ____________ in foreign currency and the earnings and capital of the
---------------------- bank are impacted by an upward or downward movement in currency
rates.
----------------------

----------------------
Activity 1
----------------------
Commercial banks are involved in various trading and non-trading foreign
---------------------- exchange activities, which continuously expose them to foreign exchange
---------------------- risk. Comment.

----------------------
7.4 FOREIGN EXCHANGE RISK MANAGEMENT
----------------------
Banks are required to put in place adequate risk management systems
----------------------
and other appropriate internal control mechanisms and procedures to identify,
---------------------- measure, monitor and control foreign exposure on both on and off balance sheet
positions.
----------------------
An effective foreign exchange risk management system should have the
---------------------- following features:

---------------------- 1. Board of directors and senior management oversight: The board of

directors of a bank should:
---------------------- • Approve foreign exchange risk policy.
---------------------- • Periodically review the policy, techniques, procedures and
information system referred to in that policy.
----------------------
• Ensure adherence to the policies, procedures and techniques.
----------------------
• Ensure foreign exchange risk is managed by qualified and competent
---------------------- staff.
• Require senior management to submit report on foreign exchange
----------------------
risk management at periodic time intervals.
----------------------

----------------------

118 Risk Management

2. Policy on foreign exchange operations: Banks should have a clearly Notes
documented and detailed policy to manage and control foreign exchange
risk exposures. As highlighted above, it is the responsibility of the board of ----------------------
directors of a bank to issue and review these policies and practices. It should
clearly define the internal approval and position limits for each foreign ----------------------
currency transaction and establish and maintain adequate accounting and ----------------------
information system as well as internal compliance controls. A bank should
have an internal audit system, which should be responsible for conducting ----------------------
internal audits at least on quarterly basis in order to ensure that foreign
exchange risk management policies and procedures are adhered to. The ----------------------
findings of the audit should be communicated to the appropriate authority ----------------------
and suitable action should be taken to keep the risk under control.
----------------------
Following are the salient features of the policy on foreign exchange risk:
• Well-defined principles and objectives governing the extent to ----------------------
which a bank is willing to take foreign exchange risk.
----------------------
• Clearly defined prudent limits on a bank’s exposure to foreign
exchange risk. ----------------------
• Clearly defined level of authority and responsibility for personnel ----------------------
dealing in foreign currency.
----------------------
• Proper identification of approved currencies for transactions within
the bank. ----------------------
3. Limits: Banks should set the minimum specific limit on their foreign ----------------------
exchange exposure in the following areas:
----------------------
• Overall foreign exchange exposure.
• Single currency exposure. ----------------------
• Intraday foreign exchange risk exposure. ----------------------
• Consolidated limits. ----------------------
• Risk Management
----------------------
4. Monitoring and control: Techniques should be developed and
implemented by banks for accurately and continuously measuring the ----------------------
exposure of banks to foreign exchange risk. It should also be capable of
----------------------
providing information of net foreign exchange gain or loss. An efficient
information system should be in place to incorporate these techniques and ----------------------
assist in foreign exchange risk management.
----------------------
5. Internal audit: In order to minimise risk, all foreign exchange and
settlement processes should be covered by internal audit. The board ----------------------
should ensure that the scope and frequency of foreign exchange internal
audit programme is appropriate to the risks involved. ----------------------
The audit findings should be communicated to the concerned personnel ----------------------
and corrective action should be taken and well documented. This should be
regularly reviewed by the board of directors and if required a follow-up audit ----------------------

Managing Foreign Exchange Risk 119

 Notes should be conducted. The audit findings should also mention other areas, which
are likely to be impacted by the areas of improvement identified for foreign
---------------------- exchange risk. This could include credit risk management, reconciliation
accounting, information system development etc.
----------------------
In an automated settlement processing, the internal audit department
---------------------- should have some level of specialisation in information technology auditing,
especially if the bank maintains its own computer facility.
----------------------

---------------------- 7.5 STEPS IN MANAGEMENT OF FOREIGN EXCHANGE

RISK
----------------------
Step 1: It involves identification and measurement of foreign exchange
---------------------- exposure of a bank. Various techniques are used by banks to measure foreign
exchange risk. Once the foreign exchange risk exposure is determined then
----------------------
the bank’s board defines the policies and procedures governing FX (foreign
---------------------- exchange) transactions in step two.
Step 2: There are various factors which are considered while deciding the
---------------------- policies and procedures in this step and they should be clearly communicated
---------------------- to the risk-taking departments. Various parameters like types of exposure, tools
and instruments to be used to measure risk, lines of authority and responsibility,
---------------------- measurement of performance of hedging action, reporting requirements etc. are
covered in the policies and procedures. The first two steps provide inputs for
---------------------- determining the foreign exchange risk exposure after which the risk is hedged
---------------------- in step three.
Step 3: Various hedging techniques like natural hedge, financial hedge,
---------------------- options, swaps etc. are used in this step by banks to hedge their foreign exchange
---------------------- risk.
Step 4: Since the global banking scenario is very dynamic, banks have
---------------------- to evaluate their exposure periodically and make adjustments on need basis.
It should also evaluate if hedging is properly reducing a bank’s exposure or a
----------------------
change is required in the hedging techniques.
----------------------

----------------------

----------------------
Fig. 7.1: Steps in Management of Foreign Exchange Risk
----------------------

---------------------- 7.6 METHODS OF MEASURING FOREIGN EXCHANGE

RISK
----------------------
There are many ways to measure foreign exchange risk, ranging from
---------------------- simple to quite complex. Sophisticated measures, such as value-at-risk, may be
mathematically complex and require significant computing power. Following
---------------------- are some simple measures used by banks to determine their foreign exchange
---------------------- risk:

120 Risk Management

1. Register of foreign currency exposures: One of the simplest methods is Notes
to maintain a register of foreign currency exposures and their associated
foreign exchange hedges. This type of approach is in line with the ----------------------
requirements of accounting standards and each hedge is recorded against
its relevant exposure. ----------------------

2. Table of projected foreign currency cash flows: Since banks deal ----------------------
in different currencies and there are both inflows and outflows in each
----------------------
currency, it is essential to measure the net surplus or deficit in each
currency. This can be done by preparing a projected foreign currency cash ----------------------
flow statement. Apart from giving information on surplus and deficit, it
also gives information on the timing of currency flows. ----------------------
3. Sensitivity analysis: Sensitivity analysis is the measurement of the ----------------------
potential impact of an adverse movement in exchange rate on the cash
flows and liquidity position of a bank. Movement in exchange rate can ----------------------
either be arbitrary or based on history.
----------------------
4. Value-at-risk: Banks extensively use the probability approach while
undertaking sensitivity analysis. This is known as value-at-risk. The ----------------------
value- at-risk indicates the risk that a bank is exposed due to uncovered
----------------------
position of mismatch and these gaps are to be valued on daily basis at the
prevalent forward market rates. ----------------------

Check your Progress 2 ----------------------

----------------------
Fill in the Blanks.
----------------------
1. Banks should set the _______ specific limit on their foreign exchange
exposure. ----------------------
2. A bank should have an _______ audit system, which should be ----------------------
responsible for conducting internal audits at least on quarterly basis
in order to ensure that foreign exchange risk management policies ----------------------
and procedures are adhered to.
----------------------
3. It is the responsibility of the _______ of a bank to issue and review
internal policies and practices. ----------------------
4. Banks should have a clearly _______ and _______ policy to manage ----------------------
and control foreign exchange risk exposures.
----------------------

----------------------
7.7 METHODS OF MANAGING FOREIGN EXCHANGE
RISK ----------------------

----------------------
Having identified and measured the foreign exchange exposure, the next
step is to manage it. There are various methods for hedging foreign exchange ----------------------
risk and selection of the best method depends upon the risk appetite of the bank.
Hedging refers to entering into an offsetting currency position so that the gain ----------------------

Managing Foreign Exchange Risk 121

 Notes or loss on the original currency exposure is offset by corresponding gain or loss
on the currency hedged. It can also be termed as coordinated buying and selling
---------------------- of currency to minimise exchange rate risk.
---------------------- Banks should design the hedging strategy very carefully as cost is
associated with it. It should be evaluated carefully considering the aspects of
---------------------- cost and tax benefit.
---------------------- Some of the commonly used methods of managing foreign exchange risk
are as follows:
----------------------
1. Forward exchange contract: These contracts enable a bank to protect
---------------------- itself from adverse movements in exchange rates by locking in an agreed
exchange rate up to an agreed date. All transactions take place at the
---------------------- agreed price within that lock-in time. The major disadvantage of this
method is that in case of advantageous rate movements, the bank is still
----------------------
under obligation to enter into transactions at the agreed price.
---------------------- 2. Foreign currency options: These enable an entity to purchase or sell
---------------------- foreign currency under an agreement that allows for the right but not the
obligation to undertake the transaction at an agreed future date.
---------------------- 3. Perfect hedge: It is a simple method to match any outgoing foreign
---------------------- currency payments against foreign currency inflows received at exactly
the same time. This method is rarely used due to the uncertainty of timing
---------------------- of the cash flows. The inflow and the outflow must occur at exactly the
same time to provide a perfect hedge.
----------------------

---------------------- Activity 2
----------------------
Visit the website of RBI and read more on the techniques used by banks to
---------------------- manage foreign exchange risk.

----------------------
7.8 FOREIGN EXCHANGE SETTLEMENT RISK
----------------------
Foreign exchange settlement risk is the risk of loss when a bank in a
----------------------
foreign exchange transaction pays the currency it sold but does not receive
---------------------- the currency it bought. There are various reasons for settlement failure like
counterparty default, operational problem, market liquidity constraint and other
---------------------- factors. Settlement risk exists for any traded product. However, the size of
the forex market makes FX transactions the biggest source of settlement risk
----------------------
for many market participants. It involves daily exposures of tens of billions
---------------------- of dollars for the largest banks. Most significantly, for banks of any size, the
amount at risk to even a single counterparty could, in some cases, exceed their
---------------------- capital.
---------------------- As compared to other forms of risks, banks should be well aware of how
FX settlement risk arises and based on this understanding, they need to draft
---------------------- policies and procedures to manage it. The risk measurement system should

122 Risk Management

be capable of providing appropriate and realistic estimates of FX settlement Notes
exposures on a timely basis. The procedures should enable the banks to take
prompt actions on problems and failed transactions. ----------------------
7.8.1 Dimensions of FX Settlement Risk ----------------------
FX settlement risk can take the following dimensions:
----------------------
1. Credit risk dimension: In a FX settlement transaction, there is always
a risk that the counterparty will default outright and the principal will ----------------------
be lost. Hence, banks should treat the FX exposure as an equivalent to
----------------------
credit exposures of the same size and duration. Under current market
practices, banks cannot make the payment of currency it sold conditional ----------------------
upon its final receipt of the currency it bought. Hence, the risk of losing
the full principal value will always be there. Such exposures can either be ----------------------
intraday or overnight or may even last for several days.
----------------------
2. Liquidity risk dimension: A temporary delay in settlement can create
liquidity pressure on the receiving bank. Banks have pre-plans of use of ----------------------
funds and delay in settlement of funds may result in difficulty to meet ----------------------
obligations to other parties. If the amount is large the extent of liquidity
risk can be severe and the bank may need to arrange funds from alternate ----------------------
sources at unreasonable price.
----------------------
3. Legal risk dimension: The liquidity or credit risk arising from FX
settlements can further worsen the situation if the bank gets involved ----------------------
in a legal issue as a result of FX settlement failure. Legal risk is more
complicated in foreign exchange transactions due to involvement of ----------------------
different jurisdictions. ----------------------
4. Systemic risk dimension: The size of some banks’ FX exposures relative
to their capital creates the real danger. The failure of foreign exchange ----------------------
transactions of a bank’s counterparty could lead to that bank’s insolvency. ----------------------
7.8.2 Duration of FX Settlement Exposure
----------------------
An FX payment transaction usually takes place in two steps: sending
payment order and actual transmission of funds. The first step is an instruction to ----------------------
make payment and is usually affected one or two days before the settlement date.
----------------------
The second step involves exchange of credit and debit between correspondent
accounts and accounts of central banks of currencies involved. The second ----------------------
step takes place on the settlement date itself. Hence, a bank’s FX settlement
exposure runs from the time the payment order is released with certainty and ----------------------
cannot be cancelled till the time currency purchased is received with certainty.
----------------------
7.8.3 Measurement of FX Settlement Exposures
----------------------
A bank’s minimum FX settlement exposure at a specified time includes
the value of all outstanding trades where payment is irrevocable; it also includes ----------------------
any known failed receipts since, by definition, the fact that the trade has failed
to settle means the funds have not yet been received. Since the irrevocable ----------------------
period can last for several days, the minimum measure of exposure can be equal ----------------------
to several days’ worth of trade.

Managing Foreign Exchange Risk 123

 Notes FX settlement exposures should be subject to adequate credit control
process including credit evaluation and review and determination of the
---------------------- maximum exposure the bank is willing to take with a particular counterparty.
Banks should use the same procedures as used for other exposures for setting
---------------------- up FX settlement exposure limits. Banks should ensure that all FX settlement
---------------------- deals should be within those limits.

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 7.2: Foreign Exchange Settlement Process

---------------------- 7.8.4 Contingency Planning
Contingency planning and stress testing should be an integral part of the
----------------------
FX settlement risk management process. The contingency plan should include
---------------------- a wide variety of stress tests and should cover events ranging from internal
operational failure to counterparty failure to broad market-related events. An
---------------------- ideal contingency plan for FX settlement exposure should have the following
key features:
----------------------
• Timely access to key information.
---------------------- • Well-developed procedures for obtaining information from correspondent
---------------------- institutions.
• Continuity of FX settlement operations even if main production site
---------------------- becomes unusable.
---------------------- • Well documented and supported by contracts with outside vendors.
• Well coordinated with planning for other problems.
---------------------- • Periodically tested.
---------------------- 7.8.5 Use of Bilateral Netting

---------------------- Banks can reduce the size of their counterparty exposures by entering into
legally binding agreements for bilateral net settlement of payments. A legally
---------------------- binding payment netting arrangement permits banks to offset trades against
each other so that only the net amount in each currency is paid or received by
---------------------- each institution. Such payment netting arrangements are contemplated in the
---------------------- industry standard bilateral master agreements covering FX transactions.
Depending on trading patterns, bilateral payment netting can significantly
---------------------- reduce the value of currencies settled. It also reduces the number of payments to
---------------------- one per currency either to or from each counterparty. Bilateral payment netting
is most valuable when the counterparties have a considerable two-way flow of
---------------------- business; consequently, it may only be attractive to the most active banks. To

124 Risk Management

take advantage of risk reducing opportunities, banks should be encouraged to Notes
establish procedures for identifying payment-netting opportunities.
----------------------
Use of bilateral payment netting requires some modification to the method
of measuring settlement exposures explained earlier. When bilateral payment ----------------------
netting is used, all the transactions with a particular counterparty due to settle
on that day have to be considered together. The bank will make a single payment ----------------------
to the counterparty in each of the currencies where it has a net debit position
----------------------
and receive a single payment in each of the currencies where it has a net credit
position. The maximum value of the resulting settlement exposure is equal to ----------------------
the sum of the amounts due to be received from the counterparty. However,
measuring the actual duration of the exposure is more complicated because ----------------------
netted transactions result in a set of payments in a number of currencies, no two
----------------------
of which can be paired to calculate the period of irrevocability.
Some banks use informal payment netting, i.e., where there is no ----------------------
formal netting contract between the counterparties, the back offices of each
----------------------
counterparty confer by telephone before settlement and agree to settle only the
net amount of the trades falling due. Since there may not be a sound legal basis ----------------------
underpinning such procedures, banks should ensure that they fully understand
and appropriately manage the legal, credit and liquidity risks of this practice. ----------------------

----------------------
Check your Progress 3
----------------------
State True or False. ----------------------
1. A bank’s minimum FX settlement exposure at a specified time excludes
the value of all outstanding trades where payment is irrevocable. ----------------------

2. An FX payment transaction usually takes place in two steps: sending ----------------------

payment order and actual transmission of funds.
----------------------
3. The liquidity or credit risk arising from FX settlements can further
improve the situation if the bank gets involved in a legal issue as a ----------------------
result of FX settlement failure.
----------------------
4. In an FX settlement transaction there is always a benefit that the
counterparty will default outright and the principal will be lost. ----------------------

----------------------

Summary ----------------------

●● orex risk is the risk that a bank may suffer losses as a result of adverse
F ----------------------
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. ----------------------
●● ransactional risk arises with the unfavourable movement in exchange
T
----------------------
rate impacting the profitability from transactions in foreign currency. It
can be hedged using different techniques. ----------------------

Managing Foreign Exchange Risk 125

 Notes ●● Translational risk is the accounting risk arising because of translation of
assets held in foreign currency or abroad.
---------------------- ●● Some of the key features for an effective foreign exchange risk management
---------------------- system are board and senior management oversight, well-defined policies
and limits, effective monitoring and control and internal audit.
---------------------- ●● Steps in FX risk management include identification and measurement
---------------------- of risk, development of policy, hedging and periodical evaluation and
adjustment.
---------------------- ●● Some of the methods adopted by banks to measure foreign exchange risk
---------------------- are maintaining a register of foreign currency exposure, preparing a table
of projected foreign currency cash flows, sensitivity analysis and using
---------------------- value at risk.
●● Foreign exchange risk can be managed by various hedging techniques
----------------------
like forwards, options, perfect hedges etc.
---------------------- ●● Foreign exchange settlement risk is the risk of loss when a bank in a
foreign exchange transaction pays the currency it sold but does not receive
----------------------
the currency it bought.
---------------------- ●● FX settlement risk can take various dimensions like credit risk, liquidity
risk, legal risk and systemic risk.
----------------------
●● An FX payment transaction usually takes place in two steps: sending
---------------------- payment order and actual transmission of funds.
---------------------- ●● Contingency planning and stress testing should be an integral part of the
FX settlement risk management process.
---------------------- ●● Banks can reduce the size of their counterparty exposures by entering into
---------------------- legally binding agreements to net settlement payments bilaterally.

---------------------- Keywords
---------------------- ●● Hedging: A hedging transaction is one, which protects an asset or liability
---------------------- against a fluctuation in the foreign exchange rate.
●● Translational risk: The accounting risk arising because of translation of
---------------------- assets held in foreign currency or abroad.
---------------------- ●● Contingency plan: A plan devised for an outcome other than in the usual
(expected) plan.
----------------------
●● Stress testing: A form of testing that is used to determine the stability of
---------------------- a given system or entity.

----------------------
Self-Assessment Questions
----------------------
1. What are the major types of foreign exchange risks?
----------------------
2. Explain the different steps in management of foreign exchange risk
---------------------- followed by banks with the help of a diagram.

126 Risk Management

3. How are the various methods of measuring foreign exchange risk Notes
beneficial to banks?
----------------------
4. Elaborate the various dimensions of FX settlement risk.
5. What is the duration of a typical FX settlement exposure and how can you ----------------------
measure it?
----------------------
6. Rewrite the salient features of the contingency plan of banks for FX
settlement risk. ----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
Fill in the Blanks.
1. Forex transactions with counterparties from another country also trigger ----------------------
country risk. ----------------------
2. In forex business, banks also face the risk of default of the counterparties
or settlement risk. ----------------------

3. Foreign exchange risk arises when a bank holds assets or liabilities in ----------------------
foreign currency and the earnings and capital of the bank are impacted by
an upward or downward movement in currency rates. ----------------------

Check your Progress 2 ----------------------

Fill in the Blanks. ----------------------
1. Banks should set the minimum specific limit on their foreign exchange ----------------------
exposure.
2. A bank should have an internal audit system, which should be responsible ----------------------
for conducting internal audits at least on quarterly basis in order to ensure ----------------------
that foreign exchange risk management policies and procedures are
adhered to. ----------------------
3. It is the responsibility of the board of directors of a bank to issue and ----------------------
review internal policies and practices.
----------------------
4. Banks should have a clearly documented and detailed policy to manage
and control foreign exchange risk exposures. ----------------------
Check your Progress 3
----------------------
State True or False.
----------------------
1. False
2. True ----------------------

3. False ----------------------
4. False ----------------------

----------------------

Managing Foreign Exchange Risk 127

 Notes
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
---------------------- California: Academic Foundation.
2. Benton E. Gup, and James W. Kolari 2007. Commercial Banking: The
----------------------
Management of Risk. Australia: John Wiley & Sons.
---------------------- 3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
---------------------- Vision Books.
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic 2003. Analyzing
---------------------- and Managing Banking Risk: Framework for Assessing Corporate
---------------------- Governance and Financial Risk. World Bank Publication.

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

128 Risk Management

Operational Risk Management
UNIT

8
Structure:

8.1 Introduction
8.2 Definitions of Operational Risk Management
8.3 Likely Forms of Manifestation of Operational Risk
8.4 Need for Operational Risk Management for Banks
8.5 Management of Operational Risk
8.6 Principles for Management of Operational Risk
8.7 Organisational Setup and Key Responsibilities
8.8 Identification and Assessment of Operational Risk
8.9 Monitoring of Operational Risk
8.10 Controls/Mitigation of Operational Risk
8.11 Methodologies for Calculating Capital Charge
8.12 Evaluation of the Operational Risk Function
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Operational Risk Management 129

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Describe the concept of operational risks
----------------------
• Analyse operational risk management
---------------------- • List out the needs for operational risk management
---------------------- • Discuss organisational setup for operational risk management

---------------------- • Evaluate the principles of identification/measurement/ control of

operational risk
---------------------- • Examine the methodologies for calculating capital charge
----------------------

---------------------- 8.1 INTRODUCTION

---------------------- As the name suggests, operational risk is a risk arising from execution
of a bank/ company’s business operations. Operational risk is a very broad
---------------------- concept, which focuses on risks arising from the people, systems and processes
through which a bank/Financial Institution/company operates. It also includes
----------------------
other types of risks such as environmental, physical and legal risks and fraud.
---------------------- It has always been important for banks/FI to try to prevent fraud, maintain
integrity of internal controls and reduce errors in transaction processing and
---------------------- so on. From the above it is clear that operational risk is not a new risk but it is
being increasingly realised by the bankers that many losses earlier described
----------------------
as credit or market risk, were in fact due to failing operational or internal
---------------------- processes. What is relatively new is the view of operational risk management as
a comprehensive practice comparable to the management of credit and market
---------------------- risk. Growing number of high-profile operational loss events worldwide have
led banks and supervisors to increasingly view operational risk management as
----------------------
an comprehensive discipline and an integral part of risk management activity.
----------------------
8.2 DEFINITIONS OF OPERATIONAL RISK
----------------------
MANAGEMENT
----------------------
An operational risk event is an incident/experience that has caused or has
---------------------- the potential to cause material loss to the bank directly or indirectly with other
incidents.
----------------------
Basel Committee on Banking Supervision (BCBS) has defined Operational
---------------------- Risk as the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. The above definition enunciated
---------------------- by the Basel Committee is based on the underlying causes of operational risk.
---------------------- It seeks to identify why a loss happened. At the broadest level, the definition
includes the breakdown by four causes: (a) People, (b) Processes, (c) Systems
---------------------- and (d) External factors. The Basel II definition of operational risk excludes, for

130 Risk Management

example, strategic risk - the risk of a loss arising from a poor strategic business Notes
decision.
----------------------
The Basel Committee on Banking Supervision (BCBS) has acknowledged
that managing Operational Risk is becoming a critical feature of sound risk ----------------------
management practice in modern-day financial markets. The Committee has
noted that the most important types of operational risk entail breakdowns ----------------------
in internal controls and corporate governance. Such breakdowns can lead to
----------------------
financial losses through error, fraud or failure to perform within accepted
time-lines or cause the interests of the bank to be compromised in some other ----------------------
way, for example by its dealers, lending officers or other staff exceeding their
authority or conducting business in an unethical or risky manner. Other aspects ----------------------
of operational risk include major failure of information technology systems or
----------------------
events such as major fires or other disasters.
Reserve Bank of India has defined Operational risk as the risk of loss ----------------------
resulting from inadequate or failed internal processes, people and systems or
----------------------
from external events. This definition includes legal risk, but excludes strategic
and reputational risk. Legal risk includes, but is not limited to, exposure to ----------------------
fines, penalties or punitive damages resulting from supervisory actions, as well
private settlements. ----------------------

----------------------
8.3 LIKELY FORMS OF MANIFESTATION OF
OPERATIONAL RISK ----------------------

The Basel Committee has identified the following types of operational ----------------------
risk events as having the potential to result in substantial losses: ----------------------
(a) Internal fraud: For example, intentional misreporting of positions,
employee theft and insider trading on an employee’s own account. ----------------------
(b) External fraud: For example, robbery, forgery, cheque kiting and damage ----------------------
from computer hacking.
(c) Employment practices and workplace safety: For example, workers ----------------------
compensation claims, violation of employee health and safety rules, ----------------------
organised labour activities, discrimination claims and general liability.
(d) Clients, products and business practices: For example, fiduciary ----------------------
breaches, misuse of confidential customer information, improper
----------------------
trading activities on the bank’s account, money laundering and sale of
unauthorised products. ----------------------
(e) Damage to physical assets: For example, terrorism, vandalism,
----------------------
earthquakes, fires and floods.
(f) Business disruption and system failures: For example, hardware and ----------------------
software failures, telecommunication problems and utility outages.
----------------------
(g) Execution, delivery and process management: For example: data entry
errors, collateral management failures, incomplete legal documentation ----------------------
and unauthorised access given to client accounts, non-client counterparty
defective performance and vendor disputes. ----------------------

Operational Risk Management 131

 Notes 8.4 NEED FOR OPERATIONAL RISK MANAGEMENT
FOR BANKS
----------------------
As a result of the deregulation and globalisation of financial services,
---------------------- coupled with growing sophistication of financial technology, the activities of
---------------------- banks and thus their profiles are becoming more complex. Evolving banking
practices suggest that risks other than credit risks and market risks can be
---------------------- substantial. Some of these new and growing risks faced by banks include:
---------------------- (a) Extensive use of Highly Automated Technology: As greater reliance
is placed on integrated systems, the increasing use of highly automated
---------------------- technology has the potential to transform risks from manual processing
errors to system failure risks.
----------------------
(b) Emergence of e-Commerce: Growth of e-commerce brings with it
---------------------- potential risks such as system securities issues and internal and external
frauds.
----------------------
(c) Growing Volume of Operations: Emergence of banks acting as very
---------------------- large volume service providers creates the need for continual maintenance
---------------------- of high-grade internal controls and back-up systems.
(d) Outsourcing: Growing use of outsourcing arrangements and the
---------------------- participation in clearing and settlement systems can mitigate some risks
---------------------- but can also present significant other risks to banks.
(e) Large-scale acquisitions, mergers, de-mergers and consolidations test the
---------------------- viability of new or newly integrated systems.
---------------------- (f) Banks may engage in risk mitigation techniques (e.g. collateral,
derivatives, netting arrangements and asset securitisations) to optimise
----------------------
their exposure to market risk and credit risk, but which in turn may give
---------------------- rise to other forms of risk such as legal risk.
The design and architecture for management of operational risk is
----------------------
generally oriented towards banks’ own requirements depending on its size and
---------------------- complexity of business, risk philosophy, market perception and the expected
level of capital. The exact approach may, therefore, differ from bank to bank
---------------------- (source: rbi.org.in).
----------------------
Activity 1
----------------------

---------------------- Download and go through the document “Basel Committee on Banking

Supervision, International Convergence of Capital Measurement and
---------------------- Capital Standards – A Revised Framework, June 2004” and list out the
various suggestions and recommendations of the BCBS.
----------------------

----------------------

----------------------

132 Risk Management

8.5 MANAGEMENT OF OPERATIONAL RISK Notes
‘Management’ of operational risk is taken to mean the ‘identification, ----------------------
assessment and / or measurement, monitoring and control /mitigation’ of this
risk. The basic components of a risk management system are identifying the ----------------------
risks the entity is exposed to, assessing their magnitude, monitoring them,
----------------------
controlling or mitigating them using a variety of procedures and setting aside
capital for potential losses (including expected losses and unexpected losses). ----------------------
There is no single framework that would suit every institution; different
approaches will be needed for different institutions. The exact approach for ----------------------
operational risk management chosen by banks depends on an array of factors.
----------------------
Despite individual differences, crucial elements for an effective operational
risk management framework are clear strategies and oversight by the Board ----------------------
of Directors and senior management, a strong operational risk management
culture, effective internal control and reporting, contingency planning etc. ----------------------
The key elements in the Operational Risk Management process include: ----------------------
(a) Appropriate policies and procedures ----------------------
(b) Efforts to identify and measure operational risk
----------------------
(c) Effective monitoring and reporting
----------------------
(d) A sound system of internal controls
(e) Appropriate testing and verification of the Operational Risk Framework ----------------------

The strategic approach of the risk management function should be oriented ----------------------
towards:
----------------------
(a) Emphasis on minimising and eventually eliminating losses and customer
dissatisfaction due to failures in processes. ----------------------
(b) Focus on flaws in products and their design that can expose the ----------------------
institution to losses due to fraud etc.
----------------------
(c) Align business structures and incentive systems to minimise conflicts
between employees and the institution. ----------------------
(d) Analyse the impact of failures in technology / systems and develop
----------------------
mitigants to minimise the impact. The bank can decide upon the mitigants
for minimising operational risks rationally, by looking at the costs of ----------------------
putting in mitigants as against the benefit of reducing the operational
losses. ----------------------
(e) Develop plans for external shocks that can adversely impact the continuity ----------------------
of the institution’s operations (source: rbi.org.in).
----------------------

----------------------

----------------------

----------------------

Operational Risk Management 133

 Notes 8.6 PRINCIPLES FOR MANAGEMENT OF OPERATIONAL
RISK
----------------------
The Basel Committee has identified ten principles for successful management
---------------------- of Operational Risk:
---------------------- (1) Board of Directors should be aware of major aspects of operational risk
of the organisation as a distinct risk category.
----------------------
(2) The Board of Directors should ensure that operational management
---------------------- framework of the organisation provides for effective and comprehensive
internal audit.
----------------------
(3) Top Management should consistently implement approved operational
---------------------- management framework of the organisation.
---------------------- (4) In all material products, activities, processes and systems, operational
risk content should be identified and assessed.
---------------------- (5) Regular Monitoring System of operational risk profiles and material
---------------------- exposures to losses should be in place.
(6) Policies, processes and procedures to control/mitigate operational risk
---------------------- should be evolved.
---------------------- (7) Contingency and business continuity plans should be evolved.

---------------------- (8) Regulatory Authorities should review periodically organisation’s

approach to identify, assess monitor and control/mitigate operational risk.
---------------------- (9) Regulatory Authorities may ensure that appropriate mechanisms are put
in place to allow them to remain apprised of position of operational risk
----------------------
management.
---------------------- (10) Adequate Public disclosures to be made.
----------------------
Check your Progress 1
----------------------

---------------------- Multiple Choice Multiple Response.

1. Operational risk in banks includes the following:
----------------------
i. Incident/experience that has caused or has the potential to cause
---------------------- material loss
---------------------- ii. Loss that may arise directly or indirectly due to that incidence

---------------------- iii. Loss arising due to ooperating efficiency at branch level.

2. Major risks that a bank has to plan for protection are following:
----------------------
i. Environmental risk
----------------------
ii. Risk arising due to change in interest rates
---------------------- iii. Physical risk and legal risks
---------------------- iv. Fraud risk

134 Risk Management

8.7 ORGANISATIONAL SETUP AND KEY Notes
RESPONSIBILITIES
----------------------
Operational risk is intrinsic to a bank and as such should be a vital constituent
of its enterprise wide risk management systems. Successful implementation ----------------------
of risk management process has to start from the top management with the ----------------------
display of strong commitment to incorporate the same into the basic operations
and strategic decision-making processes. The board of directors and senior ----------------------
management are responsible for creating an awareness of Operational Risks
and establishing a culture within the bank that emphasises and demonstrates ----------------------
to personnel at all levels the importance of Operational Risk. The Board and ----------------------
the top management are expected to create an enabling organisational culture
placing high priority on effective operational risk management and adherence ----------------------
to sound operating procedures. Ideally, the organisational set-up for operational
risk management should include the following: ----------------------

(1) Board of Directors: The Board decides the overall policy and strategy. ----------------------
The policies and procedures of the bank should clearly describe the major
----------------------
elements of the Operational Risk Management framework including
identifying, assessing, monitoring and controlling / mitigating operational ----------------------
risk. The policies, processes and procedures should be documented and
communicated to the personnel at all levels in units that incur material ----------------------
operational risks. The policies and procedures should outline all aspects
----------------------
of the institution’s Operational Risk Management framework, including
the roles and responsibilities of the independent bank- wide Operational ----------------------
Risk Management function and line of business management. It should
also include a definition for operational risk, including the loss event types ----------------------
that should be monitored. The policy should amongst others incorporate
----------------------
provisions for top-level reviews of the bank’s progress towards the stated
objectives; checking for compliance and management controls and the ----------------------
review and approval of significant policy and procedural exceptions.
----------------------
(2) Risk Management Committee of the Board: This is a sub-committee
of the board. It should include the CEO and the heads of the Credit, ----------------------
Market and Operational Risk Management Committees. It deals with the
policy and strategy for integrated risk management. The Key functions ----------------------
of Risk Management Committee of Board (RMCB) are as under: (i)
----------------------
Approve operational risk policies and issues delegated to it by the Board
(ii) Review profiles of operational risk throughout the organisation (iii) ----------------------
Approve operational risk capital methodology and resulting attribution
(iv) Set and approve expressions of risk appetite within overall parameters ----------------------
set by the Board (v) Re-enforce the culture and awareness of operational
----------------------
risk management throughout the organisation.
(3) Operational Risk Management Committee: It has to be ensured that ----------------------
each type of major risk viz. Credit Risk, Market Risk and Operational ----------------------
Risk is managed as an independent function. Hence, banks/FI should
have corresponding risk management committees, which are assigned the ----------------------

Operational Risk Management 135

 Notes specific responsibilities. Accordingly, the Operational Risk Management
functions shall be looked after by the ORMC.
----------------------
The ORMC is an executive committee. It shall have as its principal objective
---------------------- the mitigation of operational risk within the institution by the creation
and maintenance of an explicit operational risk management process. The
---------------------- committee will be presented with detailed reviews of operational risk
exposures across the bank. Its goals are to take a cross-business view and
----------------------
assure that a proper understanding is reached and actions are being taken
---------------------- to meet the stated goals and objectives of operational risk management in
the bank/FI.
----------------------
Key roles of the Committee are:
---------------------- (a) Review the risk profile, understand future changes and threats and
concur on areas of highest priority and related mitigation strategy.
----------------------
(b) Assure adequate resources are being assigned to mitigate risks as
---------------------- needed.
---------------------- (c) Communicate to business areas and staff components the importance
of operational risk management and assure adequate participation
---------------------- and cooperation
---------------------- (d) Review and approve the development and implementation of
operational risk methodologies and tools, including assessments,
---------------------- reporting, capital and loss event databases.
---------------------- (e) Receive and review reports/presentations from the business lines
and other areas about their risk profile and mitigation programmes.
----------------------
(f) Monitor and ensure that appropriate operational risk management
---------------------- frameworks are in place.
---------------------- (g) Proactively review and mange potential risks that may arise from
regulatory changes/ changes in economic /political environment in
---------------------- order to keep ahead.
---------------------- (h) Discuss and recommend suitable controls/mitigations for managing
operational risk.
----------------------
(i) Analyse frauds, potential losses, non-compliance, breaches etc. and
---------------------- recommend corrective measures to prevent recurrences.
---------------------- (j) Discuss any issues arising / directions in any one business unit/
product which may impact the risks of other business/products.
----------------------
(k) Persistently promote risk awareness across all business units so that
---------------------- smugness does not set in.
(4) Operational Risk Management Department: Banks may structure the
----------------------
risk management departments as appropriate without compromising on
---------------------- the laid down principles. Accordingly, the Operational Risk Management
functions shall be looked after by the ORMD. The ORMD is responsible
---------------------- for coordinating all the operational risk activities of the bank, working

136 Risk Management

 towards achievement of the declared goals and objectives. ORMD works Notes
with the operational liaisons within the business units, staff areas and
with the corporate management staff. The group is organised within the ----------------------
Risk Management function. Specific activities of the ORMD include:
----------------------
(i) Coordinating work with all areas of the bank and assembling
information to build an overall risk profile of the institution, ----------------------
understanding and communicating these risks and analysing
----------------------
changes/trends in the risk profile.
(ii) It is responsible for the purchase or development and implementation ----------------------
of tools that the Bank is required to use in its operational risk
----------------------
management program.
(iii) It is jointly responsible with the department involved in capital ----------------------
management for development of a capital measurement methodology
----------------------
for operational risks. It will also coordinate the assembly of
required inputs, documentation of assumptions, gaining consensus ----------------------
with the business areas and coordination with other areas of the
bank for the use of the results in the strategic planning, performance ----------------------
measurement, cost benefit analysis and pricing processes.
----------------------
(iv) It is required to gather related information from all areas of the
bank, build a consolidated view of operational risk, assemble ----------------------
summary management reports and communicate the results to the ----------------------
risk committees or other interested parties. Key information will
include risk indicators, event data and self- assessment results and ----------------------
related issues.
----------------------
(v) It is responsible to analyse the data on a consolidated/ individual
and on a comparative basis. ----------------------
(vi) It is required to identify best practices from within the bank or from ----------------------
external sources and share these practices with management and
risk specialists across the Bank as beneficial. ----------------------
(vii) It is responsible for working with the Risk Specialists and ----------------------
the businesses as a team to provide advice on how to apply the
operational risk management framework, identify operational risks ----------------------
and work on solving problems and improving the risk profile of the
----------------------
Bank.
(viii) It is required to work with the Bank’s insurance area to determine ----------------------
optimal insurance limits and coverage to assure that the insurance
----------------------
policies the bank purchases are cost beneficial and align with the
operational risk profiles of the Bank. ----------------------
(ix) It is responsible for drafting, presenting, updating and interpreting, ----------------------
the operational risk policy.
(x) It is responsible for facilitating periodic self-assessments for the ----------------------
purpose of identifying and monitoring operational risks. ----------------------

Operational Risk Management 137

 Notes (xi) It is required to work closely with internal audit to plan assessments
and concerns about risks in the Bank. ORMD and Internal Audit
---------------------- should share information and coordinate activities so as to minimise
potential overlap of activities.
----------------------
(5) Chief Risk Officer: The CRO has supervisory responsibilities over the
---------------------- Operational Risk Management Department as well as responsibility over
market risk and credit risk. The Key functions of the Chief Risk Officer
----------------------
(CRO) are as under:
---------------------- (i) The CRO supervises the activities, reviews and approves the
recommendations of the ORMD before submission to the
----------------------
Operational Risk Committee or Risk Management Committee.
---------------------- (ii) The CRO assess interrelationships between Operational and other
risk types.
----------------------
The CRO is required to facilitate the analysis of risks and
---------------------- interrelationships of risks across market, credit and operational
---------------------- risks. The CRO ensures communication between risk functions
and that risk measures and economic capital measures reflect any
---------------------- interrelationships.

---------------------- (iii) The CRO helps in assuring that line and executive management
maintains an ongoing understanding of operational risks and
---------------------- participates in related risk management activities.
---------------------- (6) Support Group for Operational Risk Management: The bank-wide
support departments (e.g. Legal, Human Resources and Information
---------------------- Technology) shall assign a representative(s) to be designated as
Operational Risk Specialists. Their main responsibility is to work with
---------------------- ORMD and the departments/businesses to identify, analyse, explain and
---------------------- mitigate operational issues within their respective areas of expertise.
They also act as verifiers for their related risks in the self- assessment
---------------------- process. They accomplish this responsibility by involving themselves in
the following:
----------------------
(i) The Operational Risk Management Specialists are members of the
---------------------- committees and task forces related to operational risk management,
as applicable. They must be ready to discuss operational issues and
----------------------
recommend mitigation strategies.
---------------------- (ii) They assist in the development and review of appropriate risk
indicators, both on a bank-wide and business specific basis for their
----------------------
area of specialty.
---------------------- (iii) They assist in the review of Self-Assessment results and opine on
---------------------- the departmental/business assessment of risk types, quantification
and frequency.
---------------------- (iv) They assist in the timely identification and recording of operational
---------------------- loss data and explanations.

138 Risk Management

 (v) They ensure that all operational risk issues are brought to the Notes
attention of ORMD and the Department/business.
----------------------
(vi) They assist the department/business in the design and implementation
of risk mitigation strategies. ----------------------
(7) Business Operational Risk Managers: Each business/ functional area
----------------------
appoints a person responsible to coordinate the management of operational
risk. This responsibility may be assigned to an existing job, be a full time ----------------------
position or even a team of people, as the size and complexity justify.
Risk Managers report to their respective departments/businesses, but ----------------------
work closely with ORMD and with consistent tools and risk management
----------------------
framework and policy. The Operational Risk Management Committee is
required to assure that these liaisons are appointed and to approve their ----------------------
selection. The key responsibilities of the liaisons are:
----------------------
(i) They are required to help facilitate, partake and verify the results of
the self- assessment process. ----------------------
(ii) They help in design, collection, reporting and data capture of risk ----------------------
indicators and related reports. They monitor results and help work
with their respective departments on identified issues. ----------------------
(iii) They coordinate collection, recording and data capture of loss ----------------------
events within the businesses and regular reporting of these events,
the details, amounts. ----------------------
(iv) They are responsible for the timely follow-up, documentation ----------------------
and status of action plans, open issues (Internal Audit, External
Audit, Regulator and Inspector) and other initiatives waiting to be ----------------------
completed.
----------------------
(v) They are expected to be prepared to be called upon to attend
the Operational Risk Management Committee meetings, when ----------------------
necessary, to discuss operational risk issues.
----------------------
(vi) They are responsible for consulting/ advising the business units on
ways to mitigate risks. ----------------------
(8) Key Functions of Department Heads: Business/Functional area heads ----------------------
are responsible for risk taking, related controls and mitigation. They are
ultimately responsible for implementation of sound risk management ----------------------
practices and any resulting impact for operational losses. The department ----------------------
heads shall take ownership of the operational risks faced in their
departments/businesses. They are expected to present their risk profiles ----------------------
and action plans to the ORMC and are responsible for collection and
preparation of various risk indicator reports, identification of loss events ----------------------
within the businesses and regular reporting of these events, the details, ----------------------
amounts and circumstances to ORMD on a complete and timely basis.
They are also responsible for the periodic completion of self-assessments ----------------------
and for developing strategies for the mitigation of risk where required (or
managing those risks deemed to be acceptable) (source: rbi.org.in). ----------------------

Operational Risk Management 139

 Notes
Activity 2
----------------------

---------------------- Download and go through the document “Guidance note on management

of operational risk” issued by the Department of Banking Operations and
---------------------- Development Reserve Bank of India.
----------------------

---------------------- 8.8 IDENTIFICATION AND ASSESSMENT OF

---------------------- OPERATIONAL RISK
---------------------- In the wake of unparalleled increase in the volume of transactions, high
degree of structural changes and complex technological support systems,
---------------------- managing Operational Risk is emerging as an important feature of sound risk
---------------------- management practice in modern financial markets. In the past, banks relied
almost exclusively upon internal control mechanisms within business lines,
---------------------- supplemented by the audit function, to manage operational risk. While these
still continue to be important, there is need to adopt specific structures and
---------------------- processes aimed at managing operational risk. Several recent cases demonstrate
---------------------- that inadequate internal controls can lead to significant losses.
The types of control breakdowns may be grouped into five categories:
----------------------
(a) Lack of Control Culture: Management’s inattention and laxity in control
---------------------- culture, insufficient guidance and lack of clear management accountability.
---------------------- (b) Inadequate recognition and assessment of the risk of certain banking
activities, whether on-or-off-balance sheet. This may be either in the
---------------------- form of failure in recognising and assessing the risks of new products
and activities or failure in updating the risk assessment when significant
----------------------
changes occur in business conditions or environment. Many recent cases
---------------------- highlight the fact that control systems that function well for traditional
or simple products are unable to handle more sophisticated or complex
---------------------- products.
---------------------- (c) Absence/failure of key control structures and activities, such as segregation
of duties, approvals, verifications, reconciliations and reviews of operating
---------------------- performance.
---------------------- (d) Inadequate communication of information between levels of management
within the bank – upward, downward or cross-functional.
----------------------
(e) Inadequate/ineffective audit/monitoring programmes.
---------------------- As per the guidance note issued by the Reserve Bank of India some of
---------------------- the guiding principles for banks to mange operational risks are identification,
assessment, monitoring and control of these risks. These principles are dealt in
---------------------- detail below:
----------------------

140 Risk Management

(a) Identification of operational risk: Banks should identify and assess the Notes
operational risk inherent in all material products, activities, processes
and systems. Banks should also ensure that before new products, ----------------------
activities, processes and systems are introduced or undertaken, the
operational risk inherent in them is identified clearly and subjected to ----------------------
adequate assessment procedures. Risk identification is paramount for ----------------------
the subsequent development of a viable operational risk monitoring and
control system. Effective risk identification should consider both internal ----------------------
factors (such as the bank’s structure, the nature of the bank’s activities
and the quality of the bank’s human resources, organisational changes and ----------------------
employee turnover) and external factors (such as changes in the industry ----------------------
and technological advances) that could adversely affect the achievement
of the bank’s objectives. The first step towards identifying risk events is ----------------------
to list out all the activities that are susceptible to operational risk. Usually
this is carried out at several stages. To begin with, one can list: ----------------------

(i) The main business groups, viz. corporate finance, trading and ----------------------
sales, retail banking, commercial banking, payment and settlement,
----------------------
agency services, asset management and retail brokerage.
(ii) Analysis can be further carried out at the level of the product teams ----------------------
in these business groups, e.g. transaction banking, trade finance,
----------------------
general banking, cash management and securities markets.
(iii) Thereafter, the product offered within these business groups by ----------------------
each product team can be analysed, e.g. import bills, letter of credit,
----------------------
bank guarantee under trade finance.
After the products are listed, the various operational risk events associated ----------------------
with these products are recorded. Risk events are associated with the ----------------------
people, process and technology involved with the product. They can be
recognised by experience, judgment, intuition, experience from linked ----------------------
events in addition to this there are some specific events, which require
recognition as per regulatory requirements. ----------------------

(b) Assessment of Operational Risk: In addition to identifying the risk events, ----------------------
banks should assess their vulnerability to these risk events. Effective risk
assessment allows a bank to better understand its risk profile and most ----------------------
effectively target risk management resources. The following are some of ----------------------
the tools that may be used by banks for assessing operational risk:
(i) Self-risk assessment: A bank assesses its operations and activities ----------------------
against a menu of potential operational risk vulnerabilities. This ----------------------
process is internally driven and often incorporates checklists and/
or workshops to identify the strengths and weaknesses of the ----------------------
operational risk environment. Scorecards, for example, provide
a means of translating qualitative assessments into quantitative ----------------------
metrics that give a relative ranking of different types of operational ----------------------
risk exposures. Some scores may relate to risks unique to a specific
business line while others may rank risks that cut across business ----------------------

Operational Risk Management 141

 Notes lines. Scores may address inherent risks, as well as the controls to
mitigate them.
----------------------
(ii) Risk mapping: In this process, various business units, organisational
---------------------- functions or process flows are mapped by risk type. This exercise
can reveal areas of weakness and help prioritise subsequent
---------------------- management action.
---------------------- (iii) Key risk indicators: Key risk indicators are statistics and/or
metrics, often financial, which can provide insight into a bank’s
---------------------- risk position. These indicators should be reviewed on a periodic
basis (such as monthly or quarterly) to alert banks to changes that
----------------------
may be indicative of risk concerns. Such indicators may include the
---------------------- number of failed trades, staff turnover rates and the frequency and/
or severity of errors and omissions.
----------------------
(c) Measurement of Operational Risk: A key component of risk
---------------------- management is measuring the size and scope of the bank’s risk exposures.
There is no clearly established, single way to measure operational risk
---------------------- on a bank-wide basis. Banks develop risk assessment techniques that
are appropriate to the size and complexities of their portfolio, their
----------------------
resources and data availability. A good assessment model must cover
---------------------- certain standard features. An example is the “matrix” approach in which
losses are categorised according to the type of event and the business
---------------------- line in which the event occurred. Banks may quantify their exposure to
operational risk using a variety of approaches. For example, data on a
----------------------
bank’s historical loss experience could provide meaningful information
---------------------- for assessing the bank’s exposure to operational risk and developing a
policy to mitigate/control the risk.
----------------------
Risk assessment should also identify and evaluate the internal and
---------------------- external factors that could adversely affect the bank’s performance, information
and compliance by covering all risks faced by the bank that operate at all levels
---------------------- within the bank.
---------------------- Such an assessment should take account of both historical and potential
risk events (source: rbi.org.in).
----------------------

---------------------- 8.9 MONITORING OF OPERATIONAL RISK

---------------------- An effective monitoring process is essential for adequately managing
operational risk. Regular monitoring activities can offer the advantage of quickly
---------------------- detecting and correcting deficiencies in the policies, processes and procedures
---------------------- for managing operational risk. Promptly detecting and addressing these
deficiencies can substantially reduce the potential frequency and/or severity of
---------------------- a loss event. In addition to monitoring operational loss events, banks should
identify appropriate indicators that provide early warning of an increased risk
---------------------- of future losses. Such indicators (often referred to as early warning indicators)
---------------------- should be forward-looking and could reflect potential sources of operational

142 Risk Management

risk such as rapid growth, the introduction of new products, employee turnover, Notes
transaction breaks, system downtime and so on. When thresholds are directly
linked to these indicators, an effective monitoring process can help identify ----------------------
key material risks in a transparent manner and enable the bank to act upon
these risks appropriately. The frequency of monitoring should reflect the risks ----------------------
involved and the frequency and nature of changes in the operating environment. ----------------------
Monitoring should be an integrated part of a bank’s activities. The results of
these monitoring activities should be included in regular management and Board ----------------------
reports, as should compliance reviews performed by the internal audit and/or
risk management functions. Reports generated by (and/or for) intermediary ----------------------
supervisory authorities may also inform the corporate monitoring unit which ----------------------
should likewise be reported internally to senior management and the Board,
where appropriate. ----------------------
Management may also use reports prepared by external sources (auditors, ----------------------
supervisors) to evaluate the usefulness and reliability of internal reports.
Reports should be analyzed with a view to improving existing risk management ----------------------
performance as well as developing new risk management policies, procedures
----------------------
and practices (source: rbi.org.in).
----------------------
Check your Progress 2
----------------------
Multiple Choice Multiple Response. ----------------------
1. For monitoring operational risk in a bank, following has to be done.
----------------------
i. Detecting and addressing deficiencies
ii. Set up an Operations Dept in the Bank ----------------------
iii. Provide early warning signals ----------------------
iv. Check on new products, employee turnover, system downtime
----------------------
2. Operational risk in retail banking will mainly relate to:
i. Corporate Loans ----------------------
ii. Retail loans to priority sector
----------------------
iii. Brokers for banking business
----------------------

----------------------
8.10 CONTROLS/MITIGATION OF OPERATIONAL RISK
----------------------
Risk management is the process of mitigating the risks faced by a bank.
With regard to operational risk, various methods may be adopted for mitigating ----------------------
the risk. For example, losses that might arise on account of natural disasters ----------------------
can be insured against. Losses that might arise from business disruptions due
to telecommunication or electrical failures can be mitigated by establishing ----------------------
backup facilities. Loss due to internal factors, like employee fraud or product
flaws, which may be difficult to identify and insure against, can be mitigated ----------------------
through strong internal auditing procedures. Although a framework of formal, ----------------------

Operational Risk Management 143

 Notes written policies and procedures is critical, it needs to be armored through a
strong control culture that promotes sound risk management practices. Both the
---------------------- Board of Directors and senior management are responsible for establishing a
strong internal control culture in which control activities are an integral part of
---------------------- the regular activities of a bank, since such integration enables quick responses
---------------------- to changing conditions and avoids unnecessary costs.
The internal control process, which traditionally has been a mechanism
----------------------
for reducing instances of fraud, misappropriation and errors, has become more
---------------------- extensive, addressing all the various risks faced by banking organisations. It
is now recognised that a sound internal control process is critical to a bank’s
---------------------- ability to meet its established goals and to maintain its financial viability.
---------------------- An effective internal control system requires that
(i) An appropriate control structure is set up, with control activities defined at
----------------------
every business level. These should include top-level reviews; appropriate
---------------------- activity controls for different departments or divisions; physical
controls; checking for compliance with exposure limits and follow-up on
---------------------- noncompliance; a system of approvals and authorisations; and a system
of verification and reconciliation.
----------------------
(ii) There is appropriate segregation of duties and personnel are not assigned
---------------------- conflicting responsibilities. Areas of potential conflicts of interest should
---------------------- be identified, minimised and subject to careful, independent monitoring
(iii) There are adequate and comprehensive internal financial, operational and
---------------------- compliance data, as well as external market information about events and
---------------------- conditions that are relevant to decision making. Information should be
reliable, timely, accessible and provided in a consistent format.
---------------------- (iv) There are reliable information systems in place that cover all significant
---------------------- activities of the bank. These systems, including those that hold and use
data in an electronic form, must be secure, monitored independently and
---------------------- supported by adequate contingency arrangements.
---------------------- (v) Effective channels of communication to ensure that all staff fully
understand and adhere to policies and procedures affecting their duties
---------------------- and responsibilities and that other relevant information is reaching
the appropriate personnel. Adequate internal controls within banking
----------------------
organisations must be supplemented by an effective internal audit function
---------------------- that independently evaluates the control systems within the organisation.
Internal audit is part of the ongoing monitoring of the bank’s system of
---------------------- internal controls and of its internal capital assessment procedure, because
internal audit provides an independent assessment of the adequacy of and
----------------------
compliance with, the bank’s established policies and procedures.
---------------------- Operational risk can be more pronounced where banks engage in new
activities or develop new products (particularly where these activities or
----------------------
products are not consistent with the bank’s core business strategies), enter
----------------------

144 Risk Management

unfamiliar markets and/ or engage in businesses that are geographically distant Notes
from the head office. It is incumbent upon banks to ensure that special attention
is paid to internal control activities where such conditions exist. ----------------------
In some instances, banks may decide to either retain a certain level of ----------------------
operational risk or self-insure against that risk. Where this is the case and the
risk is material, the decision to retain or self-insure the risk should be transparent ----------------------
within the organisation and should be consistent with the bank’s overall business
----------------------
strategy and appetite for risk. The bank’s appetite as specified through the
policies for managing this risk and the bank’s prioritisation of operational risk ----------------------
management activities, including the extent of and manner in which, operational
risk is transferred outside the bank. The degree of formality and sophistication ----------------------
of the bank’s operational risk management framework should be commensurate
----------------------
with the bank’s risk profile.
Investment in appropriate processing technology and information ----------------------
technology security are also important for risk mitigation. However, banks
----------------------
should be aware that increased automation could transform high frequency-
low severity losses into low frequency-high severity losses. The latter may ----------------------
be associated with loss or extended disruption of services caused by internal
factors or by factors beyond the bank’s immediate control (e.g. external events). ----------------------
Such problems may cause serious difficulties for banks and could jeopardise an
----------------------
institution’s ability to conduct key business activities. Banks should establish
disaster recovery and business continuity plans that address this risk. ----------------------
Banks should also establish policies for managing risks associated with
----------------------
outsourcing activities. Outsourcing of activities can reduce the institution’s risk
profile by transferring activities to others with greater expertise and scale to ----------------------
manage the risks associated with specialised business activities. However, a
bank’s use of third parties does not diminish the responsibility of management ----------------------
to ensure that the third-party activity is conducted in a safe and sound manner
----------------------
and in compliance with applicable laws. Outsourcing arrangements should
be based on robust contracts and/or service level agreements that ensure a ----------------------
clear allocation of responsibilities between external service providers and the
outsourcing bank. Furthermore, banks need to manage residual risks associated ----------------------
with outsourcing arrangements, including disruption of services
----------------------
Banks should have in place contingency and business continuity plans to
ensure their ability to operate on an ongoing basis and limit losses in the event ----------------------
of severe business disruption. These plans needs to be stress tested annually ----------------------
and may be revised to appropriately address any new or previously unaddressed
parameters (source: rbi.org.in). ----------------------

----------------------
8.11 METHODOLOGIES FOR CALCULATING CAPITAL
CHARGE ----------------------

The New Capital Adequacy Framework outlines three methods for calculating ----------------------
Operational risk capital charges in a continuum of increasing sophistication and
risk sensitivity: ----------------------

Operational Risk Management 145

 Notes (I) The Basic Indicator Approach: based on annual revenue of the Financial
Institution
----------------------
(II) The Standardised Approach: based on annual revenue of each of the broad
---------------------- business lines of the Bank/Financial Institution
(III) Advanced Measurement Approaches (AMA): based on the internally
----------------------
developed risk measurement framework of the bank adhering to the
---------------------- standards prescribed
(I) Basic Indicator Approach (BIA): Under the Basic Indicator Approach
----------------------
(BIA), Capital required can be worked out as under:
---------------------- (i) A fixed % of gross annual income will be the requirement.
---------------------- (ii) Gross annual income will be worked out on the basis of average of
previous three years.
----------------------
(iii) Minimum 15% of such average annual income must be maintained.
---------------------- Gross Income for this purpose consists of Net Interest Income and
Non- Interest Income (extraordinary income/expenses are to be
---------------------- ignored).
---------------------- (II) Standardised Approach (SA): Under the Standardised Approach, bank’s
activities are to be divided into eight business lines, e.g. corporate finance,
----------------------
trading and sales, retail banking, commercial banking, agency services,
---------------------- asset management, payment and settlement and broking.
(i) Capital Charge for each business line is calculated by multiplying
----------------------
gross income by a factor assigned to a business line.
---------------------- (ii) Total capital charge is calculated as three-year average of simple
---------------------- summation across each business line in each year.
(III) Advanced Management Approach (AMA): Under the AMA, the capital
---------------------- requirement will be worked out taking into account the risk measure
---------------------- generated by bank’s integrated operational risk management system using
qualitative and quantitative criteria as laid down in the accord.
---------------------- As per RBI guidelines, banks are encouraged to move along the spectrum
---------------------- of available approaches as they develop more sophisticated operational risk
measurement systems and practices. The New Capital Adequacy Framework
---------------------- provides that internationally active banks and banks with significant operational
risk exposures be expected to use an approach that is more sophisticated than
---------------------- the Basic Indicator Approach and that is appropriate for the risk profile of the
---------------------- institution. However, to begin with, banks in India shall compute the capital
requirements for operational risk under the Basic Indicator Approach. Reserve
---------------------- Bank will review the capital requirement produced by the Basic Indicator
Approach for general credibility, especially in relation to a bank’s peers and in
---------------------- the event that credibility is lacking, appropriate supervisory action under Pillar
---------------------- 2 will be considered.

----------------------

146 Risk Management

 Notes
Activity 3
----------------------
Study and critically compare the three approaches for working out the ----------------------
Capital Allocation for Operational Risk in respect of banks.
----------------------

8.12 EVALUATION OF THE OPERATIONAL RISK ----------------------

FUNCTION ----------------------
The bank’s Board of Directors has the ultimate responsibility for ensuring ----------------------
that senior management establishes and maintains an adequate and effective
system of internal controls, a measurement system for assessing the various ----------------------
risks of the bank’s activities, a system for relating risks to the bank’s capital ----------------------
level and appropriate methods for monitoring compliance with laws, regulations
and supervisory and internal policies. ----------------------
Internal audit is part of the ongoing monitoring of the bank’s system of ----------------------
internal controls because internal audit provides an independent assessment
of the adequacy of and compliance with the bank’s established policies and ----------------------
procedures. As such, the internal audit function assists senior management
and the Board of Directors in the efficient and effective discharge of their ----------------------
responsibilities as described above. Banks should have in place adequate ----------------------
internal audit coverage to verify that operating policies and procedures have
been implemented effectively. The Board (either directly or indirectly through ----------------------
its Audit Committee) should ensure that the scope and frequency of the audit
programme is appropriate to the risk exposures. The scope of internal audit will ----------------------
broadly cover: ----------------------
(a) Examination and evaluation of the adequacy and effectiveness of the
internal control systems and the functioning of specific internal control ----------------------
procedures ----------------------
(b) Review of the application and effectiveness of operational risk
----------------------
management procedures and risk assessment methodologies
(c) Review of the management and financial information systems, including ----------------------
the electronic information system and electronic banking services
----------------------
(d) Review of the means of safeguarding assets
----------------------
(e) Review of the bank’s system of assessing its capital in relation to its
estimate of operational risk ----------------------
(f) Review of the systems established to ensure compliance with legal and ----------------------
regulatory requirements, codes of conduct and the implementation of
policies and procedures ----------------------
(g) Testing of the reliability and timeliness of the regulatory reporting ----------------------
(h) Mitigating risks through risk based audit
----------------------
(Source: rbi.org.in)
Operational Risk Management 147
 Notes
Activity 4
----------------------

---------------------- Analyse the organisational setup and key responsibility areas for
management of the operational risk in banks.
----------------------

---------------------- Summary
---------------------- ●● Basel Committee on Banking Supervision (BCBS) has defined
Operational Risk as the risk of loss resulting from inadequate or failed
---------------------- internal processes, people and systems or from external events. At the
---------------------- broadest level, the definition includes the breakdown by four causes: (a)
People, (b) Processes, (c) Systems and (d) External factors.
---------------------- ●● The Basel II definition of operational risk excludes, for example, strategic
risk - the risk of a loss arising from a poor strategic business decision.
----------------------
●● Reserve Bank of India has defined Operational risk as the risk of loss
---------------------- resulting from inadequate or failed internal processes, people and systems
or from external events. This definition includes legal risk, but excludes
---------------------- strategic and reputational risk. Legal risk includes, but is not limited to,
exposure to fines, penalties or punitive damages resulting from supervisory
----------------------
actions, as well private settlements.
---------------------- ●● The Basel Committee has identified the following types of operational risk
events as having the potential to result in substantial losses: (a) Internal
---------------------- fraud (b) External fraud (c) Employment practices and workplace safety
(d) Clients, products and business practices (e) Damage to physical assets
----------------------
(f) Business disruption and system failures (g) Execution, delivery and
---------------------- process management
●● The key elements in the Operational Risk Management process include
---------------------- (a) appropriate policies and procedures (b) efforts to identify and measure
operational risk (c) effective monitoring and reporting (d) a sound
----------------------
system of internal controls (e) appropriate testing and verification of the
---------------------- Operational Risk Framework.
●● Risk Management Committee of the Board is a sub-committee of the
---------------------- board.
---------------------- ●● It deals with the policy and strategy for integrated risk management.
●● Operational Risk Management Committee is an executive committee.
---------------------- It shall have as its principal objective the mitigation of operational risk
within the institution by the creation and maintenance of an explicit
---------------------- operational risk management process.
---------------------- ●● The Operational Risk Management functions are looked after by the
Operational Risk Management Department (ORMD). It is responsible
---------------------- for coordinating all the operational risk activities of the Bank, working
towards achievement of the declared goals and objectives.
---------------------- ●● The Chief Risk Officer (CRO) has supervisory responsibilities over the
---------------------- Operational Risk Management Department as well as responsibility over
market risk and credit risk.
148 Risk Management
●● Risk management is the process of mitigating the risks faced by a bank. Notes
With regard to operational risk, various methods may be adopted for
mitigating the risk. ----------------------
●● Both the Board of Directors and senior management are responsible for
----------------------
establishing a strong internal control culture in which control activities are
an integral part of the regular activities of a bank, since such integration ----------------------
enables quick responses to changing conditions and avoids unnecessary
costs. ----------------------
●● As per RBI guidelines, banks are encouraged to move along the spectrum
----------------------
of available approaches as they develop more sophisticated operational
risk measurement systems and practices. The New Capital Adequacy ----------------------
Framework provides that internationally active banks and banks with
significant operational risk exposures are expected to use an approach ----------------------
that is more sophisticated than the Basic Indicator Approach and that is
----------------------
appropriate for the risk profile of the institution.
----------------------
Keywords
----------------------
●● Operational risk: The risk of loss resulting from inadequate or failed
----------------------
internal processes, people and systems or from external events.
●● Basic indicator approach (BIA): Method for calculating operational ----------------------
risk capital charge based on annual revenue of the Financial Institution
----------------------
●● Standardised approach (SA): Method for calculating operational risk
capital charge based on annual revenue of each of the broad business lines ----------------------
of the Bank/Financial Institution
----------------------
●● Advanced measurement approaches (AMA): Method for calculating
operational risk capital charge based on the internally developed risk ----------------------
measurement framework of the bank adhering to the standards prescribed
----------------------
Self-Assessment Questions ----------------------

1. Define and discuss the nature of operational risks in case of banks and ----------------------
financial institutions.
----------------------
2. Describe the methodology involved in identification /assessment /
measurement /control and mitigation of operational risks in case of banks ----------------------
and financial institutions.
----------------------
3. Discuss the three approaches for working out the capital charge for
operational risk in case of banks and financial institutions. ----------------------
4. Write short notes on: ----------------------
i. Standardised approach
----------------------
ii. Basic indicator approach
iii. Mitigation of operational risk ----------------------
iv. Technological risks ----------------------

Operational Risk Management 149

 Notes Answers to Check your Progress
---------------------- Check your Progress 1

---------------------- Multiple Choice Multiple Response.

1. Operational risk in banks includes the following:
----------------------
i. Incident/experience that has caused or has the potential to cause
---------------------- material loss
---------------------- ii. Loss that may arise directly or indirectly due to that incidence
2. Major risks that a bank has to plan for protection are following:
----------------------
i. Environmental risk
----------------------
iii. Physical risk and legal risks
---------------------- iv. Fraud risk
---------------------- Check your Progress 2
---------------------- Multiple Choice Multiple Response.
1. For monitoring Operational risk in a bank, following has to be done.
----------------------
i. Detecting and addressing deficiencies
----------------------
iii. Provide early warning signals
----------------------
iv. Check on new products, employee turnover, system downtime
---------------------- 2. Operational risk in retail banking will mainly relate to:
---------------------- ii. Retail loans to priority sector

---------------------- iii. Brokers for banking business

---------------------- Suggested Reading

----------------------
1. Basel Committee on Banking Supervision, Framework for Internal
---------------------- Control Systems in Banking Organisations, September 1998.
2. Basel Committee on Banking Supervision, Sound Practices for the
----------------------
Management and Supervision of Operational Risk, February 2003.
---------------------- 3. Basel Committee on Banking Supervision, International Convergence
---------------------- of Capital Measurement and Capital Standards – A Revised Framework,
June 2004.
---------------------- 4. Guidance note on management of operational risk’ issued by the
---------------------- Department of Banking Operations and Development Reserve Bank of
India.
----------------------

----------------------

----------------------

150 Risk Management

Derivatives in Banks and Risk Management Strategies
UNIT

9
Structure:

9.1 Introduction
9.2 Derivatives: Meaning
9.3 Derivative Markets/Contracts
9.4 Types of Derivatives
9.5 Permissible Derivative Instruments in India
9.6 Economic Functions of Derivative Markets
9.7 Application of Derivatives for Risk Management
9.8 Use of Derivatives by Banks
9.9 Reasons for Popularity of Derivatives
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Derivatives in Banks and Risk Management Strategies 151

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define the concept of derivative instruments
----------------------
• Describe the various derivative products
---------------------- • Explain the application of derivatives for risk management in banks
---------------------- • Discuss the benefits of using derivatives

---------------------- • Identify the reasons for the popularity of derivatives

----------------------
9.1 INTRODUCTION
----------------------
Deregulation, liberalisation and globalisation have exposed the markets
---------------------- and its players to various types of risks, such as exchange rate risk, interest rate
risk, economic risk and political risk. It is well known that every asset whether
---------------------- commodity or metal or share is subject to depreciation in its value, which may be
---------------------- due to certain inherent factors or due to external factors like market, economic or
political conditions. In addition to the above, securitisation has brought with it
---------------------- the risk of default or counter-party risk. Under such situation, risk management
becomes a must for survival. There is, thus an imperative need for the market
---------------------- players to protect their profits by shifting some of the uncontrollable financial
---------------------- risks to those who are able to bear and manage them. In this context, derivatives
occupy an important place as risk-reducing machinery. Derivatives enable the
---------------------- users to transfer their financial risks to third parties, thus protecting them from
unforeseen risks.
----------------------
In general terms, derivatives are instruments that derive their value from
---------------------- an underlying asset. The features of the derivative instruments are:
---------------------- 1. They can be designed so as to cater to the varied requirements of the
users either by simply using any one of the instruments or by using a
---------------------- combination of two or more such instruments.
---------------------- 2. They can be traded based on the expectations regarding the future price
movements of the underlying assets.
----------------------
3. They are all off-balance sheet instruments.
---------------------- 4. They are used as a device for reducing the risks of fluctuations in asset
---------------------- values.
As the name suggests, a derivative instrument is one the value of which
---------------------- is derived from something backing it. This “something” could be a loan, asset,
---------------------- currency flow, share, interest rate, trade flow or commodity. In our context when
we talk about derivatives, we usually mean only financial derivatives, namely
---------------------- forward/ futures/options/swaps etc.

---------------------- Based on the above discussion, we may describe derivative instruments as

152 Risk Management

financial instruments, which derive their value from the value and characteristics Notes
of one or more underlying entities, such as an asset, index or interest rate.
----------------------
9.2 DERIVATIVES: MEANING ----------------------
As per Reserve Bank of India, derivative means a financial instrument to ----------------------
be settled at a future date, whose value is derived from change in some other
variable, such as interest rate, foreign exchange rate, market index, credit index, ----------------------
price of securities or goods, index of prices etc. (called underlying). In other
words, derivatives are financial instruments/contracts whose value depends ----------------------
upon the value of an underlying. ----------------------
The term “derivative” indicates that it has no independent value, i.e.,
its value is entirely derived from the value of the underlying asset. The term ----------------------
“derivative” means a forward, future, option or any other hybrid contract of pre- ----------------------
determined fixed duration, linked for the purpose of contract fulfilment to the
value of a specified real or financial asset of an index of securities. Similarly, in ----------------------
the financial sense, a derivative is a financial product, which has been derived
from a market for another product. ----------------------

The International Monetary Fund (IMF) defines derivatives as financial ----------------------

instruments that are linked to a specific financial instrument or indicator or
----------------------
commodity and through which specific financial risks can be traded in financial
markets in their own right. The value of a financial derivative is derived from ----------------------
the price of an underlying item, such as an asset or index.
----------------------
The Indian Securities Contracts (Regulation) Act, 1956 defines derivative
instruments to include a security derived from a debt instrument, share, secured/ ----------------------
unsecured loan, risk instrument or contract for differences or any other form of
security and a contract that derives its value from the prices/index of prices of ----------------------
underlying securities.
----------------------
9.3 DERIVATIVE MARKETS/CONTRACTS ----------------------

There are two distinct groups of contracts: ----------------------

i. Over-the-Counter (OTC) derivatives: Traded directly between two ----------------------
eligible parties, with/without use of an intermediary and without going
through an exchange. ----------------------
ii. Exchange-traded derivatives: Derivative products that are traded on an ----------------------
exchange.
----------------------

----------------------

----------------------

----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 153

 Notes
Check your Progress 1
----------------------

---------------------- Multiple Choice Multiple Response.

1. Following are derivative instruments:
----------------------
i. Interest rate
---------------------- ii. Foreign exchange rate
iii. Market index
----------------------
iv. Equity Shares
---------------------- v. Credit index
---------------------- vi. Convertible Debentures
2. Following are the characteristics of derivatives:
----------------------
i. Derivative instruments have their own value
---------------------- ii. Designed by using any one of the existing instruments or by
using a combination of two or more instruments
----------------------
iii. Can be traded in the market
---------------------- iv. Committed returns on derivative instruments can be claimed
----------------------

---------------------- Activity 1

---------------------- From a financial daily, note down the movement of one derivative
instrument- book value, market value, highest quoted price, volatility, etc.
----------------------

----------------------
9.4 TYPES OF DERIVATIVES
----------------------
The most common types of derivative contracts are as under:
---------------------- 1. Forward contracts: A forward contract is a customised contract between
---------------------- two entities, where settlement takes place on a specified future date at
today’s pre-agreed price. A forward contract is an agreement to buy or
---------------------- sell an asset on a specified date for specified price. One of the parties to
the contract assumes a long position and agrees to buy the underlying
---------------------- asset on a certain specified future date for a certain specified price. The
---------------------- other party assumes a short position and agrees to sell the asset on the
same date for the same price. The parties to the contract negotiate other
---------------------- contract details like delivery date, price and quantity bilaterally. Forward
contracts are normally traded outside stock exchanges. They are popular
---------------------- on the OTC market.
---------------------- Some of the salient features of forward contracts are as follows:
They are bilateral contracts and hence exposed to counterparty risk.
----------------------
n Each contract is customer designed and hence unique in terms of
---------------------- contract size, expiration date and asset type and quantity.

154 Risk Management

 n The contract price is generally not available in public domain. Notes
n On the expiry date, the contract has to be settled by delivery of the
----------------------
asset.
A typical hedging application of the forward contract may pertain to an ----------------------
exporter who expects to receive payment in US dollars, three months
----------------------
later. He is exposed to the risk of exchange rate fluctuations. By using
the currency forward market to sell dollars forward, he can lock-on a rate ----------------------
today and reduce his uncertainty. Similarly, an importer who is required
to make a payment of US dollars forward can reduce his exposure to ----------------------
exchange rate fluctuations by buying dollars forward.
----------------------
2. Futures: A futures is a standard contract based on an agreement to buy or
sell an asset at a certain price at a certain time in future. It is an obligation ----------------------
on the buyer to purchase the underlying instrument and the seller to sell it.
----------------------
The delivery under a futures contract is not a must. The buyers and sellers
can set-off the contract by packing the different amount at the current ----------------------
rate/ price of the underlying.
----------------------
As stated above, a futures contract is an agreement between two parties
to buy or sell an asset at a certain time in future, at a certain price. ----------------------
However, unlike forward contracts, futures contracts are standardised and
traded in stock exchanges. To facilitate liquidity in the futures contracts, ----------------------
the exchange specifies certain standard features for the contract. It is ----------------------
a standardised contract with a standard underlying instrument. The
standardised items in a futures contract are: (a) Quality and quantity of ----------------------
the underlying, (b) Date/month of delivery, (c) Units of price quotation
and minimum price change and (d) Location of settlement. ----------------------

3. Options: It is a contract that provides a right but does not impose any ----------------------
obligation to buy or sell a financial instrument (say a share or a security).
Options are fundamentally different from forward and futures contracts. ----------------------
An option gives the holder of the option the right to do something. The ----------------------
holder does not have to necessarily exercise this right. In contrast, in a
forward or futures contract, the two parties commit themselves to do ----------------------
something. It costs nothing (except margin requirements) to enter into a
future contract, the purchase of an option requires an up-front payment. ----------------------

The person who buys the option from option seller by making payment ----------------------
of option premium is known as the owner or buyer of the option. His
obligation under the option is up to payment of premium on option. The ----------------------
person who sells the option to the option buyer by charging the option ----------------------
premium is known as the writer or seller of the option.
----------------------
There are two variants of options (a) European option, where the holder
can exercise the right on the expiry date and (b) American option, where ----------------------
the holder can exercise the right anytime between the purchase date and
the expiry date ----------------------
Options have two components:,(a) Call option, where the owner (buyer) ----------------------

Derivatives in Banks and Risk Management Strategies 155

 Notes has the right to purchase and the seller has the obligation to sell and (b)
Put option, where the owner or the buyer has the right to sell and the seller
---------------------- has the obligation to buy.
---------------------- The cost of the option charged upfront from the buyer of the option is
called a premium. In other words, it is the fee paid for the option contract.
----------------------
4. Swap: A swap is a contract that binds two counterparties to exchange the
---------------------- different streams of payments over the specified period at specified rate. In
the context of foreign exchange, it means simultaneous sale and purchase
---------------------- of one currency for another. In the context of financial derivatives, swap
means exchange of two streams of cash flows over a definite period.
----------------------
n Currency swap: When pre-determined streams of payments in
---------------------- different currencies are exchanged on a pre-fixed period at pre-fixed
rate.
----------------------
n Interest rate swap: It is exchange of different streams of interest
---------------------- structures (and not the principal amount)
----------------------
Check your Progress 2
----------------------

---------------------- Multiple Choice Multiple Response.

1. What are the characteristics of a forward contract?
----------------------
i. They are bilateral contracts and hence exposed to counterparty
---------------------- risk.
---------------------- ii. The contract has to be executed at the time of agreement.

---------------------- iii. Each contract is customer designed.

iv. They are Unique in terms of contract size, expiration date and
----------------------
asset type and quantity.
---------------------- Match the Following.
---------------------- i. Options a. Exchange of payment streams

---------------------- ii. Futures b. Right but no obligation

iii. Snap c. Standard contract
----------------------

----------------------
9.5 PERMISSIBLE DERIVATIVE INSTRUMENTS IN
---------------------- INDIA
---------------------- Presently, the following types of derivative instruments are permitted by
---------------------- RBI.
Interest Rate Derivatives
----------------------
Interest Rate Derivatives are of the following different types as permitted
----------------------

156 Risk Management

by the Reserve Bank of India. Interest Rate Swap (IRS), Forward Rate Notes
Agreement (FRA) and Interest Rate Future (IRF):
----------------------
1. Interest rate swap: It is a financial contract between two parties
exchanging or swapping a stream of interest payments for a “notional ----------------------
principal” amount on multiple occasions during a specified period. Such
contracts generally involve exchange of “fixed to floating” or “floating ----------------------
to floating” rates of interest. On each payment date occurring during the
----------------------
swap period, cash payments based on fixed/floating rates are made by the
parties to one another. ----------------------
2. Forward rate agreement: A forward rate agreement is a financial
----------------------
contract between two parties to exchange interest payments for a “notional
principal” amount on settlement date, for a specified period from start ----------------------
date to maturity date. Accordingly, on the settlement date, cash payments
based on contract (fixed) and the settlement rates are made by the parties ----------------------
to one another.
----------------------
3. Interest rate future (IRF): It is a standardised, exchange-traded contract
with an actual or notional interest-bearing instrument as the underlying ----------------------
asset. RBI introduced IRF on a notional coupon bearing 10-year
----------------------
Government of India security and issued a direction dated August 28,
2009. The standardised IRF contract has the following features: ----------------------
i. The contract shall be on 10-year notional coupon bearing ----------------------
Government of India security.
ii. The notional coupon shall be 7% per annum with semi-annual ----------------------
compounding.
----------------------
iii. The contract shall be settled by physical delivery of deliverable
grade securities using the electronic book entry system of the ----------------------
depositories, National Securities Depository Limited (NSDL) or
CDSIL and Public Debt Office of RBI. ----------------------
iv. Deliverable grade securities shall comprise GOI securities maturing ----------------------
at least 7.5 years but not more than 15 years from the first day of
the delivery month with a minimum total outstanding stock of Rs ----------------------
10,000 crore.
----------------------
Interest Rate Futures (Reserve Bank) (Amendment) Directions, 2015
----------------------
 he Reserve Bank of India having considered it necessary in public
T
interest and to regulate the financial system of the country to its advantage, ----------------------
in exercise of the powers conferred by section 45W of the Reserve Bank
of India Act, 1934 and of all the powers enabling it in this behalf, hereby ----------------------
amends the Interest Rate Futures (Reserve Bank) Directions, 2013 dated ----------------------
December 5, 2013 (the Directions).
1. Short Title and Commencement ----------------------

 hese directions shall be referred to as the Interest Rate Futures

T ----------------------
(Reserve Bank) (Amendment) Directions, 2015
----------------------
These directions come into force with effect from June 12, 2015.
Derivatives in Banks and Risk Management Strategies 157
 Notes 2. Eligible Instruments
I n paragraph 3, in sub-paragraph (iii) of the Directions, after the
----------------------
words “Government of India security”, the following words shall
---------------------- be inserted:
“with residual maturity between 4 and 8 Years, 8 and 11 years and
----------------------
11 and 15 years”
---------------------- 3. Necessary conditions of the Interest Rate Futures contract
----------------------  he 10-Year cash settled Interest Rate Futures contracts shall have
T
two options as under:
----------------------
Option A: The underlying shall be a coupon bearing Government of

---------------------- India security of face value Rs. 100 and residual maturity between 8
and 11 years on the expiry of futures contract.
----------------------
Option B: The underlying shall be coupon bearing notional 10-

---------------------- year Government of India security with a face value of Rs. 100.
For each contract, there shall be basket of Government of India
---------------------- securities, with residual maturity between 8 and 11 years on the day
---------------------- of expiry of futures contract, with appropriate weight assigned to
each security in the basket.
----------------------
 he 6-Year cash settled Interest Rate Futures contracts shall have
T
---------------------- two options as under:
Option A:
----------------------
  he underlying shall be a coupon bearing Government of India
T
---------------------- security of face value Rs. 100 and residual maturity between 4 and
---------------------- 8 years on the expiry of futures contract.
Option B:
----------------------
  he underlying shall be coupon bearing notional 6-year Government
T
---------------------- of India security with a face value of Rs. 100. For each contract,
there shall be basket of Government of India securities, with
---------------------- residual maturity between 4 and 8 years on the day of expiry of
---------------------- futures contract, with appropriate weight assigned to each security
in the basket.
----------------------
 he 13-Year cash settled Interest Rate Futures contracts shall have
T
---------------------- two options as under:
Option A:
----------------------

The underlying shall be a coupon bearing Government of India
---------------------- security of face value Rs. 100 and residual maturity between 11 and
15 years on the expiry of futures contract.
----------------------
Option B:
----------------------
 he underlying shall be coupon bearing notional 13-year
T
---------------------- Government of India security with a face value of Rs. 100. For each

158 Risk Management

 contract, there shall be basket of Government of India securities, Notes
with residual maturity between 11 and 15 years on the day of
expiry of futures contract, with appropriate weight assigned to each ----------------------
security in the basket.
----------------------
 ther requirements for cash settled 6-year, 10-year and 13-year
O
Interest Rate Futures contracts shall be: ----------------------
Option A: ----------------------
a. The underlying security shall be decided by stock exchanges
----------------------
in consultation with the Fixed Income Money Market and
Derivatives Association (FIMMDA). ----------------------
b. The contract shall be cash-settled in Indian rupees. ----------------------
c.  he final settlement price shall be arrived at by calculating
T
the volume weighted average price of the underlying security ----------------------
based on prices during the last two hours of the trading on ----------------------
Negotiated Dealing System-Order Matching (NDS-OM)
system. If less than 5 trades are executed in the underlying ----------------------
security during the last two hours of trading, then FIMMDA
price shall be used for final settlement. ----------------------

Option B: ----------------------
a. The underlying security shall have coupon with semi-annual ----------------------
compounding.
----------------------
b.  xchanges shall disclose criteria for including securities in
E
the basket and determining their weights such as trading ----------------------
volumes in cash market, minimum outstanding etc.
----------------------
c. The contract shall be cash-settled in Indian rupees.
d.  he final settlement price shall be based on average settlement
T ----------------------
yield which shall be volume weighted average of the yields ----------------------
of securities in the underlying basket. For each security in
the basket, yield shall be calculated by determining weighted ----------------------
average yield of the security based on last two hours of the
trading in NDS-OM system. If less than 5 trades are executed ----------------------
in the security during the last two hours of trading, then ----------------------
FIMMDA price shall be used for determining the yields of
individual securities in the basket. “ ----------------------
Source: RBI ----------------------
Foreign Currency Derivatives
----------------------
As there is a variety of derivative instruments in local market to facilitate
international transactions, there are some derivative instruments, which are ----------------------
traded in international market. These instruments are in respective foreign currencies. ----------------------
They are Foreign Currency Forward, Currency Swap and Currency Option.
----------------------

Derivatives in Banks and Risk Management Strategies 159

 Notes 1. Foreign exchange forward: It is an over-the-counter contract under
which a purchaser agrees to buy from the seller and the seller agrees
---------------------- to sell to the purchaser, a specified amount of a specified currency on a
specified date in the future − beyond the spot settlement date − at a known
---------------------- price denominated in another currency (known as the forward price) that
---------------------- is specified at the time the contract is entered into.
2. Currency swap: It is an interest rate swap where the two legs of the
----------------------
swap are denominated in different currencies. Additionally, the parties
---------------------- may agree to exchange the two currencies normally at the prevailing spot
exchange rate with an agreement to reverse the exchange of currencies, at
---------------------- the same spot exchange rate, at a fixed date in the future, generally at the
maturity of the swap.
----------------------
3. Currency option: It is a contract where the purchaser of the option has
---------------------- the right but not the obligation to either purchase (call option) or sell (put
option) and the seller of the option agrees to sell (call option) or purchase
----------------------
(put option) an agreed amount of a specified currency at a price agreed in
---------------------- advance and denominated in another currency (known as the strike price)
on a specified date (European option) or by an agreed date (American
---------------------- option) in the future.
---------------------- 4. Currency futures: It is a standardised foreign exchange derivative
contract traded on a recognised stock exchange to buy or sell one currency
---------------------- against another on a specified future date at a price specified on the date of
contract (it excludes a forward contract). The currency futures market in
----------------------
India functions subject to the directions issued by RBI and Securities and
---------------------- Exchange Board of India (SEBI). The Currency Futures (Reserve Bank)
Directions, 2008 came into force with effect from August 6, 2008 and
---------------------- were amended on January 19, 2010.
----------------------
9.6 ECONOMIC FUNCTIONS OF DERIVATIVE MARKETS
----------------------
Derivative markets provide three essential economic functions:
----------------------
• Risk management
---------------------- • Price discovery
---------------------- • Transactional efficiency

---------------------- Risk management refers to the ability of the users to offset financial
risks through derivatives. The process is known as hedging. The hedgers
---------------------- use derivative contracts to shift unwanted price risk to third parties (usually
speculators) who are willing to assume risks in order to make profits.
----------------------
Derivatives can be used to hedge both credit and market risks. While
---------------------- credit risk represents the conventional counterparty risk, market risk refers to
all those market forces/variables, which may adversely affect an institution’s
----------------------
profitability and economic values. Market risk is characteristically represented
---------------------- by price risk of all types − interest rate risk, exchange rate risk, commodity
price risk, equity price risk etc.
160 Risk Management
 As stated above, derivatives are means of managing risks. They enable Notes
transfer of various financial risks to entities who are more willing or better
suited to take or manage them. The users can undertake derivative transactions ----------------------
to reduce or extinguish an existing identified risk or for transformation of risk
exposure. Market makers undertake transactions to act as counterparties in ----------------------
derivative transactions with users and also amongst themselves. The parties ----------------------
managing risks in the market are known as hedgers. Some people/organisations
are in the business of taking risks to earn profits. Such entities represent the ----------------------
speculators. The fourth type of players in the market are known as the arbitragers
who take advantage of the market mistakes. ----------------------

Derivatives can, therefore, be used in several ways by the following ----------------------

individuals and institutions:
----------------------
1. Market makers: Market makers are those who provide two-way quotes
for a given product and thereby run a position in that product. All ----------------------
commercial banks (excluding local area banks and regional rural banks)
----------------------
and primary dealers are market makers.
2. Hedgers: Hedgers are those who wish to protect their existing exposures ----------------------
and essentially are safety-driven. Hedging is the process of stabilising the
----------------------
value (including cash flows) of a given portfolio by neutralising adverse
market movements. ----------------------
3. Speculators: Speculators are willing risk-takers who are expectation- ----------------------
driven.
4. Arbitragers: Arbitragers are traders who deal in buying and selling ----------------------
derivative contracts hoping to profit from price differentials between ----------------------
different markets.
Hedging risks through derivatives is not similar to speculation. The gain ----------------------
or loss on a derivative deal is likely to be offset by an equivalent loss or gain in ----------------------
the values of underlying assets. Offsetting of risks is an important property of
hedging transactions. However, in speculation one deliberately takes up a risk ----------------------
knowingly. Some of the major differences between hedging and speculation are
summarised in the table below. ----------------------

Table 9.1: Distinctions between Hedging and Speculation ----------------------

No. Criterion Speculation Hedging ----------------------
1 Objectives Capture market Neutralise adverse
----------------------
movements market movements
2 Need to identify Market opportunities Specific exposures ----------------------

3 Decision based Expectations of market Fear of market ----------------------

upon movements movements ----------------------
4 Effective Increases profitability Stabilises cash flows
execution and reduces cost of ----------------------
capital
----------------------

Derivatives in Banks and Risk Management Strategies 161

 Notes
Check your Progress 3
----------------------

---------------------- Multiple Choice Multiple Response.

1. What type of investors generally use derivative instruments?
----------------------
i. Market makers
----------------------
ii. Subscribers to IPO
---------------------- iii. Hedgers
---------------------- iv. Speculators
---------------------- v. Brokers

----------------------

---------------------- Activity 2

---------------------- Select any derivative instrument trading in the market and state at least
---------------------- three criteria for which it is generally put to use.

----------------------
9.7 APPLICATION OF DERIVATIVES FOR RISK
---------------------- MANAGEMENT
----------------------
Derivatives have increasingly become important in the world markets as
---------------------- a tool for management of risks. Regardless of the type of institution where
derivatives are used for managing risks, some basic elements need to be kept in
---------------------- mind. Some of them are as under:
---------------------- 1. Internal education: There needs to be an on-going process of
systematically improving board, management and staff literacy regarding
---------------------- the various types of risks inherent in conducting business and how those
risks can be managed. The primary focus of this educational effort should
----------------------
be to assist the internalisation of the competence to make and implement
---------------------- risk management decisions in a normal, reliable and closely controlled
manner on a continuous basis.
----------------------
2. Risk identification and quantification: In case of financial intermediaries,
---------------------- there are five main risk types. These risks include: (a) Interest rate risk,(b)
Exchange rate risk, (c) Credit risk, (d) Price risk and (e) Prepayment risk.
---------------------- All these risks are capable of being managed to acceptable levels. Once
the type of risk to be managed has been identified, the next issue becomes
----------------------
the objective quantification of that risk. A few key elements need to be
---------------------- included in the quantification effort to enable subsequent risk management
decisions. These include:
----------------------
i. Underlying assets and liabilities creating the risk exposure: It is
---------------------- necessary to examine both the asset and liability side of the risk

162 Risk Management

 exposure to enable an understanding of the individual portfolio Notes
exposure as well as the net exposure created by the combination.
----------------------
ii. Term of risk exposure: Another key issue is to determine the length
of time the exposure is expected to exist. An important sub-issue ----------------------
is to determine if the exposure is a one-time event or if it is a
continuing series of events. ----------------------
iii. Direction of risk exposure: In addition to the above, one must ----------------------
also determine the directional interest rate, price or exchange
rate movement to which the underlying risk position is exposed. ----------------------
This is not a forecast; it is simply a determination of the market
----------------------
environment within which the underlying risk position is negatively
and/or positively impacted. ----------------------
3. Decision to manage or accept the risk exposure: The driving force of
----------------------
any effort to manage risk is the conscious decision by management to
either accept or modify the risk exposure quantified as being inherent in ----------------------
the underlying balance sheet or portfolio. Naturally, this type of decision
needs to be made within the context established by the goals and objectives ----------------------
that make up the institution’s business plan and the environment within
----------------------
which the resulting risk management strategies will be implemented.
4. Risk management alternatives: Once a conscious decision has been made ----------------------
to manage a given risk exposure, management’s attention should then ----------------------
turn to an evaluation of the effectiveness (risks, costs and benefits) of
the various risk management alternatives. As a rule, there are three main ----------------------
alternative risk management categories from which to draw. They are as
follows: ----------------------

i. Policy decisions: This category is made up of the business policy ----------------------

decisions management makes in their on-going effort to achieve
their competitive position and financial performance objectives. ----------------------
These are usually the least costly to implement, but are somewhat ----------------------
limited in their utility to manage all the exposure to be managed
without eliminating profit potential. Regardless of this limitation, ----------------------
this alternative, at minimum, should be exhausted before utilising
derivatives. ----------------------

ii. Cash market transactions: This category is made up of the usual ----------------------
transactions the institution employs to manage its balance sheet in
conformity with the industry practices and regulatory guidelines. ----------------------
For financial intermediaries these are usually money market, fixed ----------------------
income, mortgage-backed and equity securities related transactions.
These alternatives are best utilised when there is exposure remaining ----------------------
to be managed after management has exhausted policy decision
alternatives and before utilising derivatives. ----------------------

iii. Derivatives: These instruments include forward, futures, option, ----------------------

swap etc. Since this category tends to have more inherent risks,
----------------------

Derivatives in Banks and Risk Management Strategies 163

 Notes derivative alternatives should be utilised only when there is risk
remaining to be managed after management has exhausted all
---------------------- policy decision and cash market transaction alternatives.
---------------------- It is important to note that even though management may make a
conscious decision to manage a given portion of the institution’s risk exposure
---------------------- and may consciously act to carefully exhaust all policy decision and cash
market transaction alternatives, there still may remain some exposure yet to
----------------------
be managed. When this occurs, management’s attention needs to be focused
---------------------- on evaluating the risk/reward profile associated with utilising derivatives to
manage the remaining exposure.
----------------------
There are two markets where derivatives are traded. These are organised
---------------------- exchanges and over-the-counter (OTC). They are similar in many respects, but
do have important distinguishing features as illustrated in the table below.
----------------------
Table 9.2: Differences between Over-the-Counter and Exchange-Traded
---------------------- Derivatives

---------------------- Features Over-the-Counter (OTC) Exchange Traded

Market Networks of market makers Organised exchanges in
---------------------- who exchange price information capital markets around the
---------------------- and negotiate transactions world
Agreements Custom-tailored to meet specific Standardised contracts
---------------------- needs of counter- parties within
accepted guidelines
----------------------

---------------------- Risk Default/credit risk to the Guaranteed contract

counterparties performance
----------------------
Ability to Varies by market some have Daily settlement
---------------------- Value electronic posting, others and intraday prices
require individual inquiry and electronically posted
---------------------- valuation
---------------------- Examples Forwards, caps, floors, collars, Futures and options
swaps etc.
---------------------- 5. Strategic applications of derivatives: Derivatives, like most tools,
---------------------- are neutral until utilised. It is with utilisation that positive and negative
attributes can be identified. The main utilisation issue related to the use
---------------------- of derivatives is the use to which management is applying derivative
strategies − hedging or speculating. Hedging is generally perceived to
---------------------- be good and speculation is generally perceived to be bad. Regardless
---------------------- of whether management is hedging or speculating, there is one very
dominant consideration inherent in both, which is prudent management
---------------------- of the risks associated with the underlying activity.
---------------------- 6. Benefits to banks: Financial institutions, such as banks, have assets
and liabilities of different maturities and in different currencies and they
---------------------- are exposed to different risks of default from their borrowers. Thus,

164 Risk Management

 they are likely to use derivatives on interest rates and currencies and to Notes
manage credit risk. Risk management through derivative securities has
been an avenue for banks to refine risk management practices. Similar ----------------------
to other international markets, price and interest rate volatility in Indian
financial markets is also high; hence, the implications of not hedging the ----------------------
bank portfolio may prove to be disastrous. Derivatives give banks an ----------------------
opportunity to manage their risk exposure and to generate revenue.
----------------------
The intensity of derivatives’ usage by any institutional investor is a
function of its ability and willingness to use derivatives for one or more of the ----------------------
following purposes:
----------------------
• Risk containment: Using derivatives for hedging and risk containment
purposes. ----------------------
• Risk trading/market making: Running derivatives’ trading book for
----------------------
profits and arbitrage.
• Covered intermediation: On-balance sheet derivatives’ intermediation ----------------------
for client transactions, without retaining any net risk on the balance sheet ----------------------
(except credit risk).
----------------------
9.8 USE OF DERIVATIVES BY BANKS
----------------------
The core activities of banks can be summarised as under:
----------------------
1. Accepting deposits for the purposes of lending and investment.
----------------------
2. Borrowing from other banks for the purpose of lending and investment.
3. Transferring money from one place to another within and outside the ----------------------
country. ----------------------
4. Maintaing Cash Reserves Ratio (CRR) and Statutory Reserves Ratio
----------------------
(SLR).
The major risks faced by banks in its core activities are: ----------------------
• Interest rate risk on their deposits, advances and investments. ----------------------
• Foreign exchange risk on their activities involving conversion of rupee ----------------------
into foreign currency and vice versa.
Bank’s balance sheets have items, which are sensitive to interest ----------------------
rate movements and exchange rate fluctuations .As a result, importance of ----------------------
derivatives, which have interest rates and exchange rates as the “underlying”
come to the fore. Broadly, derivatives with interest rate as the underlying are ----------------------
used for the management of interest rate risks associated with deposits, advances
and investments, while derivatives with exchange rates as the underlying are ----------------------
used for management of risks associated with foreign exchange transactions. ----------------------
The derivative instrument used to manage interest rate risk is known as the
interest rate swap. ----------------------
The following example will illustrate how asset liability mismatch can be ----------------------
managed by a bank and what is its effect on return on funds.
Derivatives in Banks and Risk Management Strategies 165
 Notes Example 1
A bank, which is cash surplus has long-term liabilities and it lacks assets.
----------------------
It lends its surplus funds overnight and hence, runs asset liability mismatches
---------------------- and gets lower returns on funds. The bank can use Overnight Index Swap (OIS)
to park its surplus overnight funds. Let us presume the bank receives a deposit
---------------------- for one year at 10%. The options available to the bank are as under:
---------------------- Options Returns Liquidity ALM
Lend it in overnight market Low High Mismatch
----------------------
Buy one-year asset locked High Funds No mismatch
---------------------- Enter into an OIS (pay floating, High High No mismatch
receive fixed and continue to
---------------------- lend in overnight market)
---------------------- Overnight Index Swap is perhaps the most liquid segment in the Indian
swap market. The benchmark being the overnight index rate representing
----------------------
Mumbai Interbank Offered Rate (MIBOR), the OIS is widely used by banks
---------------------- and primary dealers for hedging their call rate funding risk as well as their bond
portfolio.
----------------------
Example 2
---------------------- Let us now take up a case of the use of derivatives in a situation where
banks garner deposits under a falling interest rate scenario. Let us assume
----------------------
that the term deposit interest rate for a three-year term deposit is 8%. In a
---------------------- falling interest rate scenario, the borrowers do not want to lock in their cost of
borrowing for a three- year period and prefer to ask for loans at floating rate
---------------------- of interest linked to interbank call money or MIBOR. If the MIBOR or the
Interbank Call Money rate is say 6% and the borrower is willing to pay 2.5%
----------------------
above the MIBOR for a three-year term loan and if no other avenue is available
---------------------- to the bank for deployment of the three-year term deposit mobilised at 8% p.a.,
the following options are available to the bank:
----------------------
i. Deploy the money in the call money market at 6% p.a. with the risk of
---------------------- call money rate falling lower to say 5% p.a. because of continued surplus
liquidity in the system and borrowers looking for borrowing at lower and
---------------------- lower rates.
---------------------- ii. Lend to the borrower at a floating rate of 2.5% plus MIBOR, which would
work out to 8.5% if the MIBOR rules at 6%. The risk in this transaction
---------------------- is that if the MIBOR falls to say 5%, the return to the bank would drop
---------------------- to 7.5% p.a. A third option available to the bank is to consider the loan as
above and to cover itself with an OIS.
---------------------- In the present case, the bank has mobilised a deposit at 8% p.a. when the
---------------------- MIBOR is 6% p.a. and the borrower is looking for a floating rate loan linked to
MIBOR. If the market-quoted rate for a three-year interest rate swap known as
---------------------- OIS is say 7.90%−8.00%, which means that the bank can receive fixed 7.90%
and pay floating MIBOR for three years. If the bank enters into a three-year OIS
----------------------

166 Risk Management

interest rate swap with another bank, it can lend to its borrower at MIBOR+2.5% Notes
p.a., while receiving a fixed rate of 7.90% from the other bank.
----------------------
The profitability of the bank A in the first year would be as under:
On Floating Leg: From Borrower Receive: MIBOR+2.5% To Swap Bank B ----------------------
Pay: MIBOR ----------------------
Inflow: (MIBOR+2.5% − MIBOR) = 2.5%
----------------------
On Fixed Leg From Swap Bank B Receive: 7.90% fixed To the depositor, Pay:
8.00% fixed Outflow: 0.10% ----------------------
Net Result: Inflow-Outflow = (2.5% − 0.10% = 2.40%) ----------------------
The above interest rate swap fully protects the bank’s interest margin at
----------------------
2.40% whether the interest rate falls or rises as long as the bank has a full three-
year term deposit from its customer. ----------------------
Example 3
----------------------
In order to fund its investment in one year Government Treasury bills
(T-Bills), a bank borrows in the interbank call money market. The bank expects ----------------------
MIBOR to be volatile over the next 30 days. It can hedge this risk through OIS ----------------------
(pay fixed- receive floating) and continue to enjoy carry by locking into the
swap rates. ----------------------
Example 4 ----------------------
Bank A raises USD foreign currency floating rate funds based on six-
month London Interbank Offered Rate (LIBOR) for a period of five years and ----------------------
decides to lend in Indian rupees to a corporate client at a fixed interest rate of say ----------------------
9%. Bank A would approach Bank B, which would give a quote for swapping
the USD into Indian rupees, which is foreign exchange swap. Since USD is at a ----------------------
premium to Indian rupee, Bank A would have to pay a premium for the dollars it
sells spot and purchases six-month forward to enable it to pay the interest on the ----------------------
USD borrowing and also purchase the principal at the end of the fifth year, if the ----------------------
principal is paid at the end of the tenure of the loan. To enable Bank A to meet
the USD/Indian rupee premium payable, Bank A would simultaneously take a ----------------------
five-year Mumbai Interbank Forward Offered Rate (MIFOR) quote from Bank
C, wherein it would pay a fixed 7.20% (to say) and receive six-month MIFOR. ----------------------

As MIFOR is constituted from six-month LIBOR and six-month USD/ ----------------------

INR premium, the six-month LIBOR received will be paid to the bank from
----------------------
whom the five- year dollar loan was raised. The six-month USD/INR premium
received would be used to pay the six-month USD/INR premium to Bank B, ----------------------
which quoted the FX Swap.
----------------------
As per this arrangement, Bank A can now lend the USD swapped into
rupees to a corporate client in India for five years at 9% and make a profit ----------------------
of 1.80%, i.e., the difference between the fixed rate of 9% received from the
corporate client and the fixed rate of 7.20% paid to Bank C. ----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 167

 Notes
Check your Progress 4
----------------------

---------------------- Fill in the Blanks.

1. Two important options available to bankers for ALM are buy ____
----------------------
and enter into a _____.
----------------------

---------------------- 9.9 REASONS FOR POPULARITY OF DERIVATIVES

---------------------- During the recent years, derivatives have become increasingly important
---------------------- for the following reasons:
1. Increased volatility in asset prices in financial markets.
---------------------- 2. Increased integration of national financial markets with the international
---------------------- markets.
3. Marked improvement in communication facilities and sharp decline in
---------------------- their costs.
---------------------- 4. Development of more sophisticated risk management tools, which provide
economic agents a wider choice of risk management strategies.
---------------------- 5. Innovations in the derivatives markets, which optimally combine the risks
---------------------- and returns over a large number of financial assets, which lead to higher
returns, reduced risks and transaction costs as compared to individual
---------------------- financial assets.
6. So far as the equity derivatives are concerned, futures and options on stock
----------------------
indices have gained more popularity than individual stocks, especially
---------------------- among institutional investors, who are the major users of index-linked
derivatives.
---------------------- 7. The lower costs associated with index derivatives vis-à-vis derivative
---------------------- product based on individual securities is another reason for their growing
use.
----------------------
Summary
----------------------

---------------------- ●● Financial products like asset-backed securities, derivatives, credit-default

swaps and collateralised debt obligations is the innovation of 21st century.
---------------------- ●● These instruments are used to hedge their risks and manage their regulatory
and economic capital more effectively.
----------------------
●● The term derivative indicates that it has no independent value, i.e., its
---------------------- value is entirely derived from the value of the underlying asset.
---------------------- ●● There are two distinct groups of derivative contracts: (a) traded directly
between two eligible parties, with/without use of an intermediary and
---------------------- without going through an exchange known as OTC products and (b)
products that are traded on an exchange.
----------------------

168 Risk Management

The most common types of derivative contracts are as under: Notes
●● Forward contract is a customised contract between two entities, where
----------------------
settlement takes place on a specified future date at today’s pre-agreed
price. A forward contract is an agreement to buy or sell an asset on a ----------------------
specified date for specified price. Forward contracts are popular on the
Over-the-Counter (OTC) market. ----------------------
●● Futures are standard contracts based on an agreement to buy or sell an ----------------------
asset at a certain price at a certain time in future. It is an obligation on the
buyer to purchase the underlying instrument and the seller to sell it. The ----------------------
delivery under a futures contract is not a must. The buyers and sellers can
set-off the contract by packing the different amount at the current rate/ ----------------------
price of the underlying. ----------------------
●● Options are contracts that provide a right but do not impose any obligation
to buy or sell a financial instrument (say a share or a security). Options ----------------------
are fundamentally different from forward and future contracts. There are ----------------------
two variants of options (a) European option where the holder can exercise
the right, on the expiry date and (b) American option where the holder ----------------------
can exercise the right anytime between purchase date and the expiry date.
Options have two components i.e. (a) Call Option wherein the owner ----------------------
(buyer) has the right to purchase and the seller has the obligation to sell ----------------------
(b) Put Option where the owner or buyer has the right to sell and the seller
has the obligation to buy. ----------------------
●● Swap is a contract that binds two counterparties to exchange the different ----------------------
streams of payments over the specified period at specified rate. In the
context of foreign exchange, it means simultaneous sale and purchase of ----------------------
one currency to another. In the context of financial derivatives, the swap
means the exchange of two streams of cash flows, over a definite period. ----------------------
Currency swap means when pre-determined streams of payments in ----------------------
different currencies are exchanged on a pre-fixed period at pre-fixed rate.
Interest Rate swap is exchange of different streams of interest structures ----------------------
(and not the principal amount).
----------------------
●● Derivatives are means of managing risks. They enable transfer of various
financial risks to entities who are more willing or better suited to take or ----------------------
manage them. The users can undertake derivative transactions to reduce
or extinguish an existing identified risk or for transformation of risk ----------------------
exposure. ----------------------

Keywords ----------------------

●● Derivative: A financial instrument to be settled at a future date, whose ----------------------

value is derived from change in some other variable such as interest rate, ----------------------
foreign exchange rate, market index, credit index, price of securities or
goods, index prices etc. ----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 169

 Notes ●● Over-the-counter derivatives: Derivatives traded directly between two
eligible parties, with/without use of an intermediary and without going
---------------------- through an exchange.
---------------------- ●● Exchange-traded derivatives: Derivative products that are traded on an
exchange.
---------------------- ●● Forward contract: A customised contract between two entities, where
---------------------- settlement takes place on a specified future date at today’s pre-agreed
price.
---------------------- ●● Futures: A standard contract based on an agreement to buy or sell an
---------------------- asset at a certain price at a certain time in future. It is an obligation on the
buyer to purchase the underlying instrument and the seller to sell it.
---------------------- ●● Options: A contract that provides a right but does not impose any
obligation to buy or sell a financial instrument.
----------------------
●● European option: An option contract where the holder can exercise the
---------------------- right, on the expiry date.
---------------------- ●● American option: An option where the holder can exercise the right
anytime between the purchase date and the expiry date.
----------------------
●● Call option: An option wherein the owner (buyer) has the right to
---------------------- purchase and the seller has the obligation to sell.
●● Put option: An option where the owner or buyer has the right to sell and
---------------------- the seller has the obligation to buy.
---------------------- ●● Swap: A contract that binds two counterparties to exchange the different
streams of payments over the specified period at specified rate.
----------------------
●● Currency swap: Pre-determined streams of payments in different
---------------------- currencies are exchanged on a pre-fixed period at pre-fixed rate.

---------------------- ●● Interest rate swap: It is exchange of different streams of interest

structures and not the principal amount.
---------------------- ●● Market makers: Those who provide two-way quotes for a given product
and thereby run a position in that product.
----------------------
●● Hedging: The process of stabilising the value (including cash flows) of a
---------------------- given portfolio by neutralising adverse market movements.
---------------------- ●● Speculators: Those who are willing risk takers and are expectation
driven.
----------------------
●● Arbitragers: Traders who deal in buying and selling derivative contracts
---------------------- hoping to profit from price differentials between different markets.

----------------------

----------------------

----------------------

----------------------

170 Risk Management

 Notes
Self-Assessment Questions
----------------------
1. Explain the term “Derivative Instruments”.
2. Distinguish between futures and forwards. ----------------------
3. List the points of distinction between options and futures. ----------------------
4. Mention at least three reasons for the popularity of derivatives. ----------------------
5. Explain the various steps to be followed while arriving at a decision on
----------------------
the use of derivatives for risk management.
6. Explain the benefits of using derivatives. ----------------------
7. Write short notes on: ----------------------
i. Forward contracts ----------------------
ii. Speculation
----------------------
iii. Application of derivatives for risk management
----------------------
iv. Currency futures
----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
Multiple Choice Multiple Response.
----------------------
1. Following are derivative instruments:
i. Interest rate ----------------------
ii. Foreign exchange rate ----------------------
iii. Market index ----------------------
v. Credit index
----------------------
2. Following are the characteristics of derivatives:
----------------------
ii. Designed by using any one of the existing instruments or by using
a combination of two or more instruments. ----------------------
iii. Can be traded in the market. ----------------------
Check your Progress 2
----------------------
Multiple Choice Multiple Response.
----------------------
1. What are the characteristics of a forward contract?
i. They are bilateral contracts and hence exposed to counterparty risk. ----------------------
iii. Each contract is customer designed. ----------------------
iv. They are unique in terms of contract size, expiration date and asset ----------------------
type and quantity.
----------------------

Derivatives in Banks and Risk Management Strategies 171

 Notes Match the Following.
i. b.
----------------------
ii. c.
----------------------
iii. a.
---------------------- Check your Progress 3
---------------------- Multiple Choice Multiple Response.

---------------------- 1. What type of investors generally use derivative instruments?

i. Market makers
----------------------
iii. Hedgers
----------------------
v. Speculators
---------------------- Check your Progress 4
---------------------- Fill in the Blanks.
---------------------- 1. Two important options available to bankers for ALM are to buy one-year
asset and enter into a QIS.
----------------------

---------------------- Suggested Reading

---------------------- 1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
California: Academic Foundation.
----------------------
2. Benton E. Gup, and James W. Kolari. 2007. Commercial Banking: The
---------------------- Management of Risk. Australia: John Wiley & Sons.
---------------------- 3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books.
----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic. 2003. Analyzing
---------------------- and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

172 Risk Management

Enterprise-Wide Risk Management in Banks
UNIT

10
Structure:

10.1 Introduction
10.2 Definitions of ERM
10.3 Benefits of ERM
10.4 The COSO ERM Framework
10.5 Components of ERM and the ERM Process
10.6 Risk Appetite
10.6.1 Elements of Risk Appetite
10.7 Key Risk Indicators vs. Key Performance Indicators
10.7.1 Leading Indicators of Risk Event
10.8 Internal Control
10.8.1 Role of Internal Auditor
10.9 Role of Board of Directors in Oversight of ERM
10.10 Future of Enterprise Risk Management
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Enterprise-Wide Risk Management in Banks 173

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Appreciate the benefits of ERM
----------------------
• Compare the components of ERM process
---------------------- • Identify the elements of risk appetite
---------------------- • Propose the Key Risk Indicators (KRI) for a particular organisation

---------------------- • Discuss the future of ERM

---------------------- 10.1 INTRODUCTION

---------------------- In units 1-9, we have studied all aspects of risk management of banks.
However, you may get an impression that each banking risk and its framework
----------------------
is an individual watertight compartment, which should not be so. Such an
---------------------- incorrect “individualistic approach” to risk management is known as the “silo”
approach.
----------------------
Nick Gibson, a former senior executive at ABN AMRO said, “If you
---------------------- look at risk across the silos then you rapidly realise that you have different silos
approaching similar risks in uncoordinated ways or failing to share information,
---------------------- which is a waste of effort or you have got areas where there are particular risks
that none of the silos are looking at properly”. In other words, the management
----------------------
should know how different risks are interrelated and accordingly adopt a risk
---------------------- portfolio approach.

---------------------- The risk function in banks has undergone continuous development. It

reached a stage where it was thought essential to have common criteria to
---------------------- measure and quantify the risks so that a common yardstick can be used by
the stakeholders to compare risk performance of different banks. The Basel
---------------------- Prudential Norms have helped in this regard. However, most banks have
---------------------- taken the Basel norms as another routine exercise of regulatory compliance.
Also considering the global expansion of many banks and the multiplicity
---------------------- and complexity of banking products, banks realised that there is a need to
look beyond the Basel regulatory norms to establish a comprehensive risk
---------------------- management system, which could help them to identify and mitigate risks
---------------------- across enterprise and develop an enterprise-wide approach to risk management.
This approach is called Enterprise Risk Management (ERM) and includes
---------------------- terms such as broader, holistic, integrated and strategic approach to bank risk
---------------------- management. With the ERM approach, relationship between various risks that
can have an impact on the same outcome is identified and addressed.
----------------------
ERM is a capability that involves identifying, measuring, monitoring,
---------------------- reporting and mitigating risks across an enterprise in such manner that the process
remains in line with the objectives and the risk appetite of the enterprise. All
---------------------- major risks, viz. compliance, financial, hazard, operational, as well as strategic

174 Risk Management

risks across all business divisions, branches and functions within an enterprise Notes
are addressed by ERM. ERM emphasises value creation and value preservation
and application of risk quantification techniques to develop a risk portfolio. ----------------------

----------------------
10.2 DEFINITIONS OF ERM
----------------------
ERM definitions generally have different aspects: description of the
process that underlines the ERM, identification of the output of the process and ----------------------
the impact or benefit that arises out of the process.
----------------------
1. Definition by the Committee of Sponsoring Organisations of the Treadway
Commission (COSO) ----------------------
Enterprise risk management is a process affected by an entity’s board of
directors, management and other personnel, applied in strategy setting ----------------------
and across the enterprise, designed to identify potential events that may ----------------------
affect the entity and manage risks to be within its risk appetite, to provide
reasonable assurance regarding the achievement of entity objectives. ----------------------
2. Definition by British Standard BS 31100 ----------------------
Enterprise risk management is the approach to managing all of an
organisation’s key business risks and opportunities with the intention of ----------------------
maximising shareholder value.
----------------------
3. Definition by Association of Corporate Treasurers (ACT)
Enterprise risk management is designed to enhance corporate decision- ----------------------
making, with tools being developed and implemented to support actions
----------------------
ranging from optimisation of the insurance programme to analysis of
overseas expansion plans, business mix or capital allocation. ----------------------
4. Definition by Institute of Internal Auditors (IIA)
----------------------
Enterprise risk management is a rigorous and coordinated approach to
assessing and responding to all risks that affect the achievement of an ----------------------
organisation’s strategic and financial objectives.
----------------------
The above definitions together capture the essence of what ERM is all
about. ----------------------

----------------------
Check your Progress 1
----------------------
Fill in the Blanks.
----------------------
1. ERM definitions generally have different aspects _____, ________
and _______. ----------------------
2. ERM is a capability that involves __________, _____________, ----------------------
_______, _______ and _______ risks across an enterprise.
----------------------
State True or False.
----------------------
1. There is no need to look beyond the Basel regulatory norms.
----------------------

Enterprise-Wide Risk Management in Banks 175

 Notes 10.3 BENEFITS OF ERM
---------------------- We have seen that the ERM process affects the entire entity and helps
to manage the risks based on its risk appetite. ERM offers numerous benefits
---------------------- to any organisation. We can categorise the various benefits of ERM into four
broad areas.
----------------------
1. Financial benefits: These are related to various key financial factors,
---------------------- such as cost, capital, profits and corporate governance.
---------------------- n Proper and adequate reporting of financial risks.
---------------------- n Reduced cost of financing and hence the cost of capital.
n Better assessment of capital investment projects.
----------------------
n Better allocation of funds.
----------------------
n Better profitability.
---------------------- n Effective corporate governance.
---------------------- 2. Infrastructure benefits: These benefits are aimed at low cost and higher
efficiency in an organisation.
----------------------
n Proper risk targeting leading to cost reduction.
----------------------
n Smooth working with no surprise hitches.
---------------------- n Higher efficiency.
---------------------- n Competitive advantage.

---------------------- n Enhanced stakeholder confidence.

3. Reputational benefits: These benefits are of long term and provide
----------------------
stability to an organisation.
---------------------- n Improved brand equity of the organisation.
---------------------- n Increased shareholder wealth.

---------------------- n Enhanced standing with the regulators.

n Improved public relations.
----------------------
n Increased auditor confidence.
----------------------
4. Marketplace benefits: These are market-related benefits to an
---------------------- organisation.
n Customer confidence leading to higher business.
----------------------
n Maximum market opportunities.
----------------------
n Improved market presence.
---------------------- n Increased market success rate.
---------------------- n Reduced market disasters.
----------------------

176 Risk Management

 Notes
Activity 1
----------------------
The risk function in banks has undergone continuous development. ----------------------
Comment.
----------------------

10.4 THE COSO ERM FRAMEWORK ----------------------

----------------------
The Committee of Sponsoring Organisations of the Treadway Commission
(COSO) is a joint initiative of five private sector organisations, namely, i) The ----------------------
American Accounting Association, ii) The American Institute of Certified
Public Accountants (AICPA), iii) Financial Executives International (FEI), iv) ----------------------
The Association of Accountants and Financial Professionals in Business (IMA)
----------------------
and v) The Institute of Internal Auditors (IIA).
COSO’s goal is to provide thought leadership dealing with three ----------------------
interrelated subjects: enterprise risk management, internal control and fraud
----------------------
deterrence.
In 2004, COSO issued the Enterprise Risk Management – Integrated ----------------------
Framework. COSO has also published several thought papers beginning in
----------------------
2009 relating to ERM.
COSO published the Internal Control– Integrated Framework in 1992 ----------------------
that dealt with internal control. In 1996, COSO published the Internal Control ----------------------
Issues in Derivatives Usage. In 2006, COSO published Internal Control over
Financial Reporting – Guidance for Smaller Public Companies, followed by ----------------------
Guidance on Monitoring Internal Control Systems in 2009. At the end of 2010,
COSO announced a project to update its 1992 Internal Control – Integrated ----------------------
Framework. ----------------------
Finally, in the area of fraud deterrence, COSO has published two research
studies. The first study released in 1999 was titled Fraudulent Financial ----------------------
Reporting: 1987-1997. A continuation study called Fraudulent Financial ----------------------
Reporting: 1998-2007 was released in 2010.
In a pioneering work on ERM, in 2001, COSO initiated a project and ----------------------
engaged PricewaterhouseCoopers to develop a framework that would be readily ----------------------
usable by managements to evaluate and improve their organisations’ enterprise
risk management. The project resulted in the publication of Enterprise Risk ----------------------
Management – Integrated Framework in 2004, which is now treated as a
standard guidance on ERM. ----------------------

The Framework is based on the premise that the basic purpose of an ----------------------
organisation’s existence is to provide value to its stakeholders. Every business
----------------------
faces uncertainties and uncertainty can be an opportunity as well as a risk.
ERM enables managements to effectively deal with the uncertainties, i.e., risks ----------------------
associated with the uncertainty
----------------------

Enterprise-Wide Risk Management in Banks 177

 Notes The framework consist of the following points that lead to balance
between the risk and the return on investment.
----------------------
• Aligning risk appetite and strategy
---------------------- • Enhancing risk response decisions
---------------------- • Reducing operational surprises and losses

---------------------- • Identifying and managing multiple and cross-enterprise risks

• Seizing opportunities
----------------------
• Improving deployment of capital
----------------------

----------------------
10.5 COMPONENTS OF ERM AND THE ERM PROCESS

---------------------- COSO has divided the ERM process into eight interrelated components.
1. Internal environment: This component focuses within the organisation
---------------------- and consists of the risk philosophy and the risk appetite of the management,
---------------------- integrity and ethical values of the organisation and the internal operating
environment. It establishes the entity’s risk culture.
----------------------
2. Objective setting: This component will ensure that the management
---------------------- has in place a process to set risk objectives supporting the organisation’s
mission and consistent with its risk appetite.
----------------------
3. Event identification: Events that may affect the achievement of
---------------------- organisational objectives need to be identified. They could be external or
internal and represent risks and opportunities. The opportunities need to
---------------------- be channelled to the corporate strategy or objective setting process.
---------------------- 4. Risk assessment: This component analyses risk, both inherent and
residual, based on the likelihood and impact of the risk.
----------------------
5. Risk response: The management’s choice to deal with the risk, viz
---------------------- avoiding, accepting, reducing or sharing are evaluated as possible
response and a set of actions to align risks with the organisation’s risk
---------------------- tolerance and risk appetite are developed.
---------------------- 6. Control activities: This component involves establishment of policies
and procedures and their implementation to make sure that risk responses
---------------------- are effectively carried out.
---------------------- 7. Information and communication: This component enables information
exchange that enables people to carry out their responsibilities. The
----------------------
communication is expected to be top-down, bottom-up as well as lateral.
---------------------- 8. Monitoring: Evaluation of the effectiveness of the ERM programme is
the function of this component. Any modification, if necessary, is also
----------------------
carried out. Ongoing management activities and special evaluations are
---------------------- used to accomplish the monitoring.
The ERM process is a multidimensional, iterative process where all the
----------------------
above components may influence each other. There is a direct relationship
178 Risk Management
between the objectives and the ERM components. COSO depicts this relationship Notes
in a three- dimensional matrix called the COSO ERM Cube (Figure 10.1).
----------------------
The vertical columns of the cube represent the four risk objective
categories, viz. strategic, operational, reporting and compliance whereas the ----------------------
horizontal rows represent the eight ERM components. The third dimension
shows that ERM is applied across the enterprise levels, viz. entity level, division ----------------------
level, business unit level and subsidiary level.
----------------------
The presence and functioning of these eight components is responsible for
effective enterprise risk management. When ERM is required to be effective in ----------------------
all the four risk objectives categories, the board of directors and the management
----------------------
of the entity need an assurance that they understand to what extent the strategic
and operational objectives are being achieved and that the entity’s reporting is ----------------------
reliable and regulatory norms are being complied with.
----------------------
It is possible that the eight objectives do not function identically in all
the organisations. Depending upon the size of the organisation, the structure ----------------------
of ERM can be less or more formal but all components must be present and
functioning for the maximum effect. ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 10.1: The COSO ERM Cube
----------------------
[Source: COSO, Enterprise Risk Management—Integrated Framework:
Executive Summary, AICPA, New York, 2004, p. 7.] ----------------------

----------------------

----------------------

----------------------

Enterprise-Wide Risk Management in Banks 179

 Notes
Activity 2
----------------------

---------------------- Visit the website http://www.coso.org and note down the latest
developments on the COSO ERM Framework.
----------------------

---------------------- 10.6 RISK APPETITE

----------------------
An organisation’s risk appetite is defined by British Standard BS 31100
---------------------- as the amount and type of risk that an organisation is prepared to seek, accept
or tolerate.
----------------------
Risk appetite can be stated either quantitatively or qualitatively or both.
---------------------- It can be expressed as a range also. It represents the boundaries of what the
organisation will be willing to do and what it will not be. Questions may be
---------------------- posed based on historic and hypothetical events to the stakeholders to gain their
perspective as to whether certain risks will be acceptable to them or not.
----------------------
10.6.1 Elements of Risk Appetite
----------------------
Risk appetite, according to COSO, can be viewed as consisting of the
---------------------- following four elements.

---------------------- 1. Existing risk profile: It deals with the existing level of risk and its
distribution across the different risk categories, such as credit risk, market
---------------------- risk, liquidity risk, legal risk, operational risk, reputational risk, etc.
---------------------- 2. Risk capacity: It deals with the maximum risk that an entity can bear and
remain solvent.
----------------------
3. Risk tolerance: It is a set of risk thresholds and limits and is related to
---------------------- specific objectives.
4. Desired level of risk: It is that level risk up to which a entity is desired to
----------------------
take.
---------------------- An organisation’s risk appetite is closely related to its management
---------------------- philosophy and its corporate culture. If an organisation is setting very aggressive
goals, then it must have an appetite for a proportionately higher level of risk and
---------------------- vice versa. When the board is considering a specific strategy to achieve a goal, it
must check whether the strategy falls within the boundaries of the risk appetite.
---------------------- Unless the board comprehends the level of risk that its stakeholders are willing
---------------------- to take in the value addition process, the board will not be able to fulfil its risk
oversight responsibility.
----------------------
10.7 KEY RISK INDICATORS VS KEY
----------------------
PERFORMANCE INDICATORS
----------------------
Key Risk Indicators (KRIs) are metrics used by organisations to provide
---------------------- an early signal of increasing risk exposures in different areas of an enterprise.

180 Risk Management

They provide timely warning about emerging risks. They are the measures of Notes
events or trigger points that might signal issues developing internally within the
operations of the company or external events, such as macroeconomic changes, ----------------------
regulatory changes or newly developing geopolitical situations that may affect
an organisation’s financial situation. The KRIs may be at times key ratios such ----------------------
as those used for CAMEL rating of banks related to: ----------------------
C: Capital adequacy
----------------------
A: Asset quality
M: Management ----------------------
E: Earnings
----------------------
L: Liquidity
S: Sensitivity to market risks ----------------------
Key Risk Indicators (KRIs) are ratios which the management track as
----------------------
indicators of evolving risks or emerging opportunities. However, KRIs is not
the same as Key Performance Indicators (KPIs). ----------------------
A Key Performance Indicator (KPI) for customer credit may include
----------------------
data about customer defaults and write-offs. Such data provides information
about a risk event only after the risk has already occurred and hence it is of ----------------------
reactive nature, whereas a KRI is required to anticipate potential future
customer collection issues so that the credit function could be more proactive in ----------------------
addressing customer payment trends before risk event occurs.
----------------------
Selection and design of effective KRIs are very critical activities in ERM.
To be effective, KRIs must be in line with the risk-related events that might ----------------------
affect the organisation’s objectives. Linkage of most important risks to core
----------------------
strategies could give information that might serve as leading indicators of an
emerging risk. ----------------------
10.7.1 Leading Indicators of Risk Event ----------------------

----------------------

----------------------

----------------------
Fig. 10.2: Indicators of Risk Event
In the above sequence, the earliest indicator is the root cause of a ----------------------
subsequent risk event. Hence, if it is tracked early then the bank may get time ----------------------
and space to prepare itself for the risk event. Interest rate increase by the Reserve
Bank, for example, becomes a risk event. A speech by the Governor of Reserve ----------------------
Bank hinting at the change is an intermediate event and the trend of increasing
inflation which is the root cause becomes the root cause event to be tracked ----------------------
proactively. ----------------------
Like in a balance scorecard there are leading and lagging indicators of
risk events, also known as driver measures and outcome measures. KRIs should ----------------------
be the lead indicators or the driver indicators and not the lag indicators or the ----------------------
outcome indicators.

Enterprise-Wide Risk Management in Banks 181

 Notes The core elements of robust and effective KRIs:
●● Are based on industry benchmarks.
----------------------
●● Are developed consistently across the enterprise.
---------------------- ●● Provide a clear and leading view of the impending risk event.
●● Allow for comparisons across units of the enterprise and across time.
----------------------
●● Indicate the impact of the risk on the performance.
---------------------- ●● Enable efficient use of resources.
---------------------- Effective KRIs are instrumental in enhancing value for the organisation.
Value addition can happen in the ways mentioned below.
---------------------- ●● Changes in macro environment can affect the risk appetite, which can
---------------------- help to change the risk tolerance and mitigate possible risk events.
●● Just as KRIs will alert management to anticipate risks, they can also
---------------------- highlight the emerging opportunities.
---------------------- ●● KRIs can trigger a revision of the corporate strategy.
●● KRIS can provide measurable data and improve risk reporting.
---------------------- ●● KRIs can help in effective compliance with regulatory norms.
---------------------- ●● KRIs can improve business processes and avoid disruptions as well as
help in enhancing customer experience.
----------------------
●● KRIs can reduce crisis episodes and improve workplace environment and
---------------------- employee morale.

---------------------- 10.8 INTERNAL CONTROL

---------------------- Internal control is concerned with the methods, processes and checks that
---------------------- are in place to ensure that an organisation meets its objectives. A strong system
of internal control is essential for an effective ERM. The Institute of Internal
---------------------- Auditors gives an Impact vs Probability Matrix for developing management
policy in risk mitigation. According to the matrix, internal control should be
---------------------- directed to both high impact and high probability risks.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 10.3: Impact vs Probability Matrix

---------------------- [Source: The Institute of Internal Auditors]

182 Risk Management

 The control environment in an organisation is the measure of its risk Notes
culture. The Criteria of Control (known as CoCo) framework, developed by
Canadian Institute of Chartered Accountants, is one of the popular methods ----------------------
dealing with internal control environment. The CoCo framework has four
components, which are represented as a continuous cycle: ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------
Fig. 10.4: Components of CoCo Framework
1. Purpose ----------------------
2. Commitment ----------------------
3. Capability ----------------------
4. Monitoring and learning
----------------------
Purpose gives a sense of direction, commitment gives a sense of identity,
capability gives a sense of competency and monitoring and learning gives a ----------------------
sense of evolution.
----------------------
CoCo defines three major objectives of controls.
----------------------
1. Effectiveness and efficiency of operations
2. Reliability of internal and external reporting ----------------------

3. Compliance with applicable laws, regulations and internal policies ----------------------

Scores related to the four components of control framework will enable ----------------------
the organisation to find out which are the weaker areas of control and take
necessary corrective actions. ----------------------
10.8.1 Role of Internal Auditor ----------------------
While every internal audit is unique, the process of internal auditing is ----------------------
similar for most engagements. The Chartered Institute of Internal Auditors,
through a diagram, illustrates the role of an internal auditor, which normally ----------------------
consists of four stages. The following diagram briefly explains what happens
during each stage and the questions and actions the internal auditor needs to ----------------------
address. ----------------------

----------------------

Enterprise-Wide Risk Management in Banks 183

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 10.5: The Process of Internal Auditing
----------------------
Following COSO’s release of the ERM framework, a serious debate began
---------------------- regarding the true role an internal audit could and should play in the entire
risk management process. The COSO framework directed internal auditors to
---------------------- assist management and the board of directors or audit committee by examining,
evaluating, reporting and recommending improvements to the adequacy and
----------------------
effectiveness of the entity’s enterprise risk management (COSO 2004). This
---------------------- shift in an internal audit’s stated roles in the risk management function from
a traditional monitoring and assurance role to one of consulting and general
---------------------- oversight of the entire process was not wholeheartedly embraced and was often
not fully understood. Many organisations went to either extreme in their use of
----------------------
internal auditing in their risk management approach. Some organisations began
---------------------- to have internal audit departments assume ownership over business risks, while
others restrained internal auditors to a strict monitoring role.
----------------------
The Institute of Internal Auditors lays down very clearly what the role of
---------------------- an internal auditor with respect to ERM should be and should not be.

---------------------- Core internal auditing roles in regard to ERM

●● Giving assurance on risk management processes.
----------------------
●● Giving assurance that risks are correctly evaluated.
---------------------- ●● Evaluating risk management processes.

184 Risk Management

●● Evaluating the reporting of key risks. Notes
●● Reviewing the management of key risks.
----------------------
●● Legitimate internal auditing roles with safeguards
●● Facilitating identification and evaluation of risks. ----------------------
●● Coaching management in responding to risks. ----------------------
●● Coordinating ERM activities.
----------------------
●● Consolidating the reports on risks.
----------------------
●● Maintaining and developing the ERM framework.
●● Championing the establishment of ERM. ----------------------
●● Developing risk management strategy for board approval. ----------------------
●● Roles internal auditing should not undertake
----------------------
●● Setting the risk appetite.
●● Imposing risk management processes. ----------------------
●● Giving assurance on risks on management’s behalf. ----------------------
●● Taking decisions on risk responses.
----------------------
●● Implementing risk responses on management’s behalf.
----------------------
●● Accountability for risk management.
----------------------
Activity 3
----------------------
Visit an organisation and interview the internal auditor there regarding ----------------------
his role with respect to ERM.
----------------------

----------------------
10.9 ROLE OF BOARD OF DIRECTORS IN OVERSIGHT
OF ERM ----------------------

According to the COSO framework, the role of independent directors is ----------------------

focused on aiding the boards of directors in strengthening their enterprise risk
oversight responsibilities. The recent economic crisis of 2010 has caused the ----------------------
role of the board of directors to become far more challenging than in the past. ----------------------
The COSO thought paper highlights the critical responsibilities of the board by
using four specific areas in COSO’s Enterprise Risk Management – Integrated ----------------------
Framework that contribute to board oversight of enterprise risk management.
The four board areas of responsibilities are as follows: ----------------------

●● nderstand the entity’s risk philosophy and concur with the entity’s risk
U ----------------------
appetite.
----------------------
●● now the extent to which management has established effective enterprise
K
risk management of the organisation. ----------------------

----------------------

Enterprise-Wide Risk Management in Banks 185

 Notes ●● Review the entity’s portfolio of risk and consider it against the entity’s
risk appetite.
---------------------- ●● Be apprised of the most significant risks and whether management is
---------------------- responding appropriately.
According to COSO, active oversight by the board of directors can
---------------------- help strengthen an organisation and better prepare them to face significant
---------------------- risk exposures. ERM increases risk awareness and encourages a proactive
management of those risks. The thought paper emphasises that it is critical for
---------------------- board members to be involved in governing risk management policies and help
management address strategic risk issues.
----------------------

---------------------- 10.10 FUTURE OF ENTERPRISE RISK MANAGEMENT

---------------------- Enterprise risk management has brought about a qualitative change in the
risk management philosophy and the risk culture all over the world. It is not
---------------------- a passing trend, but it is here to stay. In the banking industry, it is even more
important because banking essentially involves a high level of risk, which in
----------------------
turn affects the public. The importance of ERM has been underlined through
---------------------- several crises and frauds in the banking industry, such as:

---------------------- ●● Société Générale Bank (France), 2008, $7.2 billion – Stock Exchange
Futures
---------------------- ●● Amaranth Advisors (US), 2006, $6.6 billion – Natural Gas Futures
---------------------- ●● Allied Irish Bank (Ireland) 2002 $691 million – Currency Futures
●● Sumitomo Corporation (Japan), 1996, $2.6 billion – Copper Futures
----------------------
●● Barings Bank (UK), 1995, $1.6 billion – Nikkei Futures
----------------------
In the 2008−2009 financial meltdown, banks started collapsing one
---------------------- after the other and many had to be bailed out by the US and the European
governments; the one that was not bailed out − the investment bank Lehman
---------------------- Brothers − went bankrupt creating huge tremors in the financial markets. The
resulting losses to the banking sector topped $3 trillion. All this was due to
----------------------
the failure of risk management practices of banks and regulatory failure of the
---------------------- central banks. In retrospect, it is astonishing that the Chairman of the US Federal
Reserve was fighting for deregulation of the derivatives market! Markets and
---------------------- the regulators have turned a full circle after that and effective risk management
practices like ERM have come to the centre stage and are expected to continue
----------------------
to be so in future. One of the reasons the COSO framework was quickly adopted
---------------------- by organisations all over the world was that it was introduced in 2004 in the
wake of the Sarbanes-Oxley Act of 2002, which itself was the result of frauds in
---------------------- big US companies, such as Enron, Worldcom, Ford, GM and many more. The
frauds were again due to complete failure of risk management systems.
----------------------
Geopolitical problems and economic instability are on the rise, which
---------------------- means that business risks will have a rising trend. Hence, the future may bring
tighter regulatory norms and more comprehensive but effective risk management
----------------------

186 Risk Management

practices. In a recent survey covering risk professionals of Fortune 1000 Notes
companies, it was found that increased regulations in future were a certainty.
Also over 70% of them described their risk management and compliance as ----------------------
“siloed”. This means that ERM will certainly be on the growth path in future.
----------------------
Managing potential risks in the future enterprise environment will
require new architectures and information system safeguards to constantly ----------------------
and automatically monitor the quality of decision outcomes; in other words,
----------------------
implementing a sophisticated risk audit framework. It is also possible that on
the lines of chartered accountants or chartered engineers, a genre of chartered ----------------------
risk professionals emerges. It is certain that the years to come will pose greater
challenges to the risk managers in the organisational struggle to balance profits ----------------------
with managing risks.
----------------------
Check your Progress 2 ----------------------

State True or False. ----------------------

1. In the banking industry, ERM is less important. ----------------------

2. Enterprise risk management has not brought any qualitative change ----------------------
in the risk management philosophy and the risk culture all over the
world. ----------------------
Fill in the Blanks. ----------------------
1. The internal audit’s stated roles in the ERM function have shifted ----------------------
from a _______ monitoring and ________ role, to one of _______
and general _____________ of the entire process. ----------------------

----------------------
Summary ----------------------
●● ERM is a capability that involves identifying, measuring, monitoring, ----------------------
reporting and mitigating risks across an enterprise in such manner that
the process remains in line with the objectives and the risk appetite of the ----------------------
enterprise.
----------------------
●● All major risks, viz. compliance, financial, hazard, operational, as well as
strategic risks across all business divisions, branches and functions within ----------------------
an enterprise are addressed by ERM.
----------------------
●● The benefits of ERM include financial, infrastructure, reputational and
marketplace. ----------------------
●● The Committee of Sponsoring Organisations of the Treadway Commission ----------------------
(COSO) framework on ERM enables managements to effectively deal
with the uncertainties, i.e., with risks associated with the uncertainty as ----------------------
well as the opportunity it brings, resulting in enhanced value.
----------------------
●● COSO has divided the ERM process into eight interrelated components
− internal environment, objective setting, event identification, ----------------------

Enterprise-Wide Risk Management in Banks 187

 Notes risk assessment, risk response, control activities, information and
communication and monitoring. The ERM process is a multidimensional,
---------------------- iterative process where all these components may influence each other.
---------------------- ●● Key Risk Indicators are metrics used by organisations to provide an early
signal of increasing risk exposures in different areas of an enterprise.
---------------------- KRIs provide timely warning about emerging risks.
---------------------- ●● Internal control is concerned with the methods, processes and checks that
are in place to ensure that an organisation meets its objectives.
---------------------- ●● A strong system of internal audit and control is essential for effective
---------------------- ERM.
While every internal audit is unique, the process of internal auditing is
---------------------- similar for most engagements.
----------------------
Keywords
----------------------
●● Benefit shortfall: It results from the actual benefits of a venture being
---------------------- lower than the projected or estimated benefits of that venture.
---------------------- ●● Cost overrun: It is an unexpected cost incurred in excess of a budgeted
amount due to an underestimation of the actual cost during budgeting. It
---------------------- is also known as cost increase or budget overrun.
---------------------- ●● Credit risk: It refers to the risk that a borrower will default on any type
of debt by failing to make payments, which it is obligated to do.
----------------------
●● Default: In finance, default occurs when a debtor has not met his or her
---------------------- legal obligations according to the debt contract, e.g., a debtor has not
made a scheduled payment or has violated a loan covenant (condition) of
---------------------- the debt contract.
----------------------
Self-Assessment Questions
----------------------
1. Discuss the benefits of ERM in your words.
----------------------
2. Distinguish between the different components of ERM process based on
---------------------- the functions.
---------------------- 3. Group and table the elements of risk appetite.
4. Prepare a list of Key Risk Indicators in banking and financial services.
----------------------
5. What is your take on the future of ERM?
----------------------

----------------------

----------------------

----------------------

----------------------

188 Risk Management

Answers to Check your Progress Notes
Check your Progress 1 ----------------------
Fill in the Blanks. ----------------------
1. ERM definitions generally have different aspects: description of the
process that underlines the ERM, identification of the output of the ----------------------
process and the impact or benefit that arises out of the process. ----------------------
2. ERM is a capability that involves identifying, measuring, monitoring,
----------------------
reporting and mitigating risks across an enterprise.
State True or False. ----------------------
1. False ----------------------
Check your Progress 2 ----------------------
State True or False.
----------------------
1. False
----------------------
2. False
Fill in the Blanks. ----------------------
1. The internal audit’s stated roles in the ERM function have shifted from a ----------------------
traditional monitoring and assurance role to one of consulting and general
oversight of the entire process. ----------------------

----------------------
Suggested Reading
----------------------
1. Moeller, Robert. 2007. COSO Enterprise Risk Management:
----------------------
Understanding the New Integrated ERM Framework.
2. http://www.coso.org/documents/coso_erm_executivesummary.pdf ----------------------
3. http://en.wikipedia.org/wiki/Committee_of_Sponsoring_Organisations_ ----------------------
of_ theTreadway_Commission
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Enterprise-Wide Risk Management in Banks 189

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

190 Risk Management

The New Basel Accord: Implications for Banks and Latest
Capital Adequacy Regulatory Guidelines UNIT

Structure: 11
11.1 Introduction
11.2 Capital Adequacy
11.3 The Basel Capital Accords
11.4 RBI Guidelines on Implementation of Basel III
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 191
 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Explain the concept of capital adequacy
----------------------
• Elaborate on the features of various Basel Capital Accords
---------------------- • List out the features and shortcomings of Basel I recommendations
---------------------- • Identify the features of Basel II Accord

---------------------- • Specify the Basel III recommendations

• Describe the road map for implementation of Basel Accords in India
----------------------

----------------------

---------------------- 11.1 INTRODUCTION

---------------------- Banking activity involves taking and managing risks. Lending, for
---------------------- example, involves the risk that the borrower will not pay back the loan as
promised and paying a fixed rate of interest on term deposits involves the risk
---------------------- that rates will drop, leaving the bank earning less on its investments than it is
paying out on deposits. The position of banks in modern economies has made
---------------------- the management of banking risks ever more important to financial stability and
---------------------- economic growth. Because of banks’ multiple functions, the great degree of
leverage they employ in carrying out their economic role and their access to
---------------------- the safety net, society has a keen interest in the health and well-being of the
banking system.
----------------------
As part of the supervisory process, examiners have routinely evaluated
---------------------- the overall health of the institution as well as its risk-management capabilities.
In the process, they have also assessed bank loan portfolios and the general
---------------------- integrity of bank financial statements. Only in recent decades, the banking
---------------------- authorities throughout the globe have established specific standards for capital
in relation to the risk of loss rather than simply commenting on institutions’
---------------------- capital adequacy to managers and boards of directors on a case-by-case basis,
often in qualitative terms.
----------------------
In this regard, specific standards were first imposed in the United States in
---------------------- 1981, following a period in which already low capital ratios at large U.S. banks
continued to decline in the face of a substantial deterioration in the quality of
----------------------
loan portfolios primarily due to exposures to emerging economies. Prompted by
---------------------- the slow response of banks to these growing risks, the Federal Reserve and the
other U.S. banking agencies adopted the “primary capital’’ standard requiring
---------------------- that banks maintain a ratio of capital (essentially equity and loan-loss reserves)
to total assets of 5.5 %.
----------------------
Later on, synchronised international efforts led to the more elaborate,
---------------------- but relatively simple, Basel Capital Accord, which sets forth a framework for

192 Risk Management

capital adequacy standards for large, internationally active banks and serves as Notes
the basis for the risk- based capital adequacy standards currently in place for
the banking system all over the world. Now proposals are being considered ----------------------
to refine the current framework to take account of changes in banking and the
banking system since 1988─ the time the Basel-I Capital Accord was adopted ----------------------
(source: www.federalreserve.gov). ----------------------

11.2 CAPITAL ADEQUACY ----------------------

Capital Adequacy today is measured in terms of % of capital employed ----------------------

by a bank in reference to the adjusted value of its assets, like loans/advances, ----------------------
investments as appearing in balance sheet by applying certain standard risk
weights are considered for arriving at their real value. This is an important tool ----------------------
for judging the financial health of a bank. This is kept in the form of Capital
Adequacy Ratio (CAR) or Capital to Risk Assets Ratio (CRAR) ----------------------

A higher capital adequacy ratio means, the bank is sound and it has enough ----------------------
cushions to take care of its loan loss provision and payment of liabilities, if
demanded. ----------------------

----------------------
11.3 THE BASEL CAPITAL ACCORDS
----------------------
The Basel Committee on Banking Supervision established in 1974 is made
up of representatives of the central banks or other supervisory authorities of ----------------------
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, ----------------------
Spain, Sweden, Switzerland, the United Kingdom and the United States. The
committee, which meets and has its secretariat at the Bank for International ----------------------
Settlements in Basel, Switzerland, has no formal authority. It works to develop
broad supervisory standards and promote best practices in the expectation that ----------------------
each country will implement the standards in ways most appropriate to its ----------------------
circumstances. Agreements are developed by consensus, but decisions about
which parts of the agreements to implement and how to implement them are ----------------------
left to each nation’s regulatory authorities (source: www.federalreserve.gov).
----------------------
BASEL I ----------------------
The Basel Capital Accord, the international framework on capital ----------------------
adequacy, was adopted in 1988 by a group of central banks and other national
supervisory authorities, working through the Basel Committee on Banking ----------------------
Supervision. The accord was adopted internationally by the end of 1992. The
accord’s fundamental objectives are to promote the soundness and stability of the ----------------------
international banking system and to provide an equitable basis for competition ----------------------
among banks. Although it was intended specifically for internationally active
banks, the accord has, in practice, been applied beyond the largest institutions ----------------------
to cover most banking organisations all over the world.
----------------------

----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 193
 Notes Two basic principles of the first accord were:
(1) To ensure adequate level of capital in the international banking system
----------------------
(2) To create more level playing field in competitive terms so that banks
---------------------- could no longer build business volume without adequate capital backing
---------------------- As per the accord, internationally active banks were required to hold
capital of at least 8% of a basket of assets measured in different ways according
---------------------- to their riskiness.
---------------------- The accord sets forth a framework for measuring capital adequacy and a
minimum standard to be achieved by international banks in adopting countries.
---------------------- The original framework assessed capital mainly in relation to credit risk (the
---------------------- risk of loss due to the failure of counterparty to meet its obligations) and
addressed other risks only implicitly, effectively loading all regulatory capital
---------------------- requirements on measures of credit risk. In 1996, it was amended to take explicit
account of market risk in trading accounts (the risk of loss due to a change in
---------------------- market prices, such as equity prices or interest or exchange rates).
---------------------- Stated simply, the Basel Capital Accord requires that a bank has available
as “regulatory capital’’ (through combinations of equity, loan-loss reserves,
---------------------- subordinated debt and other accepted instruments) at least 8 % of the value of
---------------------- its risk-weighted assets (loans and securities, for example) and asset-equivalent
off-balance-sheet exposures (such as loan commitments, standby letters of
---------------------- credit and obligations on derivatives contracts). For purposes of determining
a bank’s assets, different types of assets are weighted according to the level of
---------------------- perceived risk that each type represents and each off-balance-sheet exposure is
---------------------- converted to its equivalent amount of assets and weighted as that type of asset
would be weighted. For example, commercial loans are weighted at 100 %,
---------------------- whereas loans on residential housing, considered less risky, are weighted at 50
%. Total risk- weighted assets are multiplied by 8 % to determine the bank’s
---------------------- minimum capital requirement.
---------------------- A bank’s capital ratio (its regulatory capital as a proportion of its risk-
weighted assets) and whether that ratio meets or exceeds the 8% minimum have
---------------------- become important indicators of the institution’s financial strength. The definition
---------------------- of capital has evolved over the years in response to financial innovation. The
definition of assets has also changed to address financial innovation, both on
---------------------- and off balance sheet. Although the framework sets forth many details, it allows
national supervisors a degree of discretion in adopting the standard to its specific
---------------------- institutions and markets.
---------------------- In India, a committee was appointed under the chairmanship of Shri M.
Narasimham on “Financial System Reforms”. One of the main recommendations
----------------------
of the committee was to reach a level of capital adequacy ratio of 8% by March
---------------------- 1996. (As per RBI guidelines, the minimum adequacy ratio was fixed at 9% of
the Risk Weighted Assets.
----------------------
The Reserve Bank of India decided in April 1992 to introduce a risk
---------------------- asset ratio system for banks (including foreign banks) in India as a capital

194 Risk Management

adequacy measure in line with the Capital Adequacy Norms prescribed by Notes
Basel Committee.
----------------------
Shortcomings of Basel I ----------------------
The Basel-I Capital Accord is widely viewed as having achieved its
----------------------
principal objectives of promoting financial stability and providing an equitable
basis for competition among internationally active banks. At the same time, ----------------------
it is also seen as having outlived its usefulness, at least in relation to larger
banking organisations. From the perspective of banking supervisors, Basel-I ----------------------
needs to be replaced, at least for the largest, most complex banks, for three
----------------------
major reasons: It has serious short-comings as it applies to these large entities;
the art of risk management has evolved at the largest banks; and the banking ----------------------
system has become increasingly concentrated.
----------------------
Basel I was a major step forward in capital regulation. Indeed, for most
banks world over Basel I is now and for the foreseeable future will be more ----------------------
than adequate as a capital framework. It is too simple, however, to address the
activities of the most complex banking organisations. As implemented in many ----------------------
countries, it specifies only four levels of risk, even though loans assigned the
----------------------
same risk weight (for example, 100 % for commercial loans) can vary greatly
in credit quality. The limited differentiation among degrees of risk means that ----------------------
calculated capital ratios are often uninformative and may provide mis-leading
information about a bank’s capital adequacy relative to its risks. ----------------------
The limited differentiation among degrees of risk also creates incentives ----------------------
for banks to “game’’ the system through regulatory capital arbitrage by selling,
securitising or otherwise avoiding exposures for which the regulatory capital ----------------------
requirement is higher than the market requires and pursuing those for which
----------------------
the requirement is lower than the market would apply to that asset, say, in the
economic enhancement necessary to securitise the asset. Credit card loans and ----------------------
residential mortgages are types of assets that banks securitise in large volumes
because they believe required regulatory capital to be more than market or ----------------------
economic capital. (Economic capital is a bank’s internal estimate of the capital
----------------------
needed to support its risk-taking activities.) (Source: www.federalreserve.gov)
Although banking regulators were able to evaluate the true risk position ----------------------
of a bank through the examination process, the regulatory minimum capital ----------------------
ratios of the larger banks were, as a result of capital arbitrage, becoming less
meaningful. Not only were creditors, counterparties and investors hampered ----------------------
in evaluating the capital strength of individual banks from the ratios being
calculated under Basel I, but regulations and statutory requirements tied to those ----------------------
ratios had less meaning as well. For the larger banks, in short, Basel I capital ----------------------
ratios neither reflected risk adequately nor measured bank strength accurately.
----------------------
BASEL II
----------------------
A version of the New Basel Capital Accord, popularly known as Basel
II, was released in a consultative paper in April 2003. The focus of the reform ----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 195
 Notes was on strengthening the regulatory capital framework for large, internationally
active banking organisations through minimum capital requirements that are
---------------------- more sensitive to an institution’s risk profile and that reinforce incentives for
strong risk management.
----------------------
The Basel II capital accord was more complex than its predecessor (Basel
---------------------- I) for several reasons. One reason is that the assessment of risk in an environment
of a growing number of financial instruments and strategies having subtle
----------------------
differences in risk-reward characteristics is inevitably complicated. Another is
---------------------- that the reform effort has multiple objectives:
(a) To improve risk measurement and management
----------------------
(b) To link, to the extent possible, the amount of required capital to the
---------------------- amount of risk taken
---------------------- (c) To further focus the supervisor-bank dialogue on the measurement and
management of risk and the connection between risk and capital
----------------------
(d) To increase the transparency of bank risk-taking to the customers and
---------------------- counterparties that ultimately fund and hence share these risk positions
---------------------- The second Basel Accord recognised that risk management is a dynamic
process and therefore has been designed to provide a risk sensitive framework
---------------------- giving a range of options to banks management to measure and manage
operational and credit risks as also to calculate capital consistent with bank’s
---------------------- risk profile.
---------------------- The Basel II framework is more flexible and forward looking in contrast
to the first accord, which has one ‘pillar’, i.e. minimum capital requirement,
----------------------
whereas the Basel II accord was built on three mutually reinforcing elements
---------------------- or ‘pillars’:
(1) Pillar 1 addresses minimum capital requirements - the rules by which
----------------------
a bank calculates its capital ratio and its supervisor assesses whether it complies
---------------------- with the minimum capital threshold. The concept of the capital ratio would
remain unchanged. As under Basel I, the numerator of the ratio would be an
---------------------- amount representing the capital available to the bank (its regulatory capital)
and the denominator would be an amount representing the risks faced by the
----------------------
bank (its risk-weighted assets). As proposed, the minimum required capital
---------------------- ratio (8 %) and the definition of regulatory capital (certain equity, reserves and
subordinated debt) would not change from Basel I.
----------------------
Under Basel II, the definition of risk-weighted assets—the methods
---------------------- used to measure the riskiness of the loans and investments held by the bank,
underwent a change. Specifically, Basel II made substantive changes in the
---------------------- treatment of credit risk and provided for specific treatment of securitisation, a
---------------------- risk-management technique not fully contemplated by Basel I. And it explicitly
took into account ‘operational risk’—the risk of loss resulting from inadequate
---------------------- or failed internal processes, people or systems or from external events. This
modified definition of risk-weighted assets, with its greater sensitivity to risk, is
---------------------- the hallmark of Basel II.

196 Risk Management

 For maintaing capital fund, three types of risks are taken into account: Notes
(a) Credit risk (b) Market risk (c) Operational risk.
----------------------
As per RBI guidelines, the Minimum Capital Standards are as under:
Minimum as per Basel II recommendations (% of RWA) 8% ----------------------
Minimum in India as per RBI guidelines 9% ----------------------
Minimum Tier I capital (% of RWA) 6%
Maximum Tier 2 Capital 100% of Tier I ----------------------
In addition to this, the minimum capital would be subjected to a prudential ----------------------
floor, which shall be higher of:
----------------------
(i) Minimum capital required to be maintained or
(ii) A specified % of minimum capital required for credit and market risk as ----------------------
per Basel I.
----------------------
Calculation of Capital Adequacy Ratio (CAR): The ratio is to be
calculated both for Tier I and for Total capital Fund as under: ----------------------

(Eligible Tier I Capital Funds) ----------------------

Tier I CRAR = x 100
(Credit Risk RWA+ Market Risk RWA + Operational Risk RWA ----------------------

----------------------
(Eligible Total Capital Funds) ----------------------
Total CRAR = x 100
(Credit Risk RWA+ Market Risk RWA + Operational Risk RWA ----------------------
Components of Capital Funds under Basel II: There are two tiers of ----------------------
capital funds, namely Tier I and Tier II. Tier I is the core capital and Tier II is
the supplementary capital. ----------------------
Tier I Capital consists of (i) Paid up capital, statutory reserves, other ----------------------
disclosed free reserves. (ii) Capital reserves representing surplus arising out
of sale proceeds of assets (iii) Innovative Perpetual Debt Instruments (iv) ----------------------
Perpetual Non Cumulative Preference shares (PNCPS) (v) Equity investment ----------------------
in subsidiaries (vi) Intangible assets and (vii) losses in the current period and
those brought forward from previous periods. ----------------------
Out of the both (iii) and (iv) i.e. IPDI and PNCPS not to be more than ----------------------
40% of Tier I. IPDI not to be more than 15% of Tier I. There is no maturity
period. There is call option after 10 years. PNCPS issued above the aggregate ----------------------
amount of 40% to be part of Tier 2 Capital.
----------------------
Tier II Capital consists of (i) Revaluation Reserves (to be taken at a
discount of 55% of their amount) (ii) General Provisions and Loss Reserves ----------------------
upto a maximum of 1.25% of risk weighted assets. These include floating
provision, Standard Asset Provision, Country exposure provision, Investment ----------------------
reserves account and excess provision for sale of NPA. (iii) Hybrid debt capital ----------------------
Instruments such as redeemable cumulative preference shares, redeemable
non-cumulative preference shares, perpetual cumulative preference shares. (iv) ----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 197
 Notes Subordinated debt (max 50% of Tier I Capital) not less than initial maturity of
five years or a residual maturity of not less than one year.
----------------------
Risk Weighted Assets (RWA):
---------------------- (a) Fund Based: In case of fund based assets such as cash, loans, investments
and other assets the RBI has assigned a degree of risk to each of them
----------------------
(under Standardised Approach) expressed as % weights.
---------------------- (b) Non-Funded: In case of off-balance sheet items such as Letter of Credit,
bank guarantees etc the credit risk attached to them is first calculated by
----------------------
multiplying the face amount of each off-balance sheet items by the credit
---------------------- conversion factor. This is again multiplied by the relevant risk weightage
to calculate the risk value.
----------------------
Approaches for risk calculation under Basel II: For calculation of risk-
---------------------- weighted assets to maintain capital, different approaches have been suggested
under Basel II. These are:
----------------------
Sr.No. Risk Type Approaches
---------------------- 1 Credit Risk Standard Approach, Internal Rating Based Approach
---------------------- (comprising of foundation approach & Advance
Approach
---------------------- 2 Market Risk Standard Approach (comprising maturity method &
duration method) Internal risk based approach
----------------------
3 Operational Basic Indicator Approach, Standard Approach,
---------------------- Advance Risk Measurement Approach

---------------------- (2). Pillar 2 addresses supervisory review process. It encompasses the concept
that well-managed banks should seek to go beyond simple compliance with
---------------------- minimum capital requirements and perform for them-selves a comprehensive
assessment of whether they have sufficient capital to support their own
---------------------- individual risk profile. It also promotes the notion that supervisors, based on
---------------------- their knowledge of industry practices at a range of institutions, should provide
constructive feedback to bank management on their internal assessments.
---------------------- The Supervisory Review Process (SRP) is intended to ensure that banks
---------------------- have adequate capital to support all the risk in their business and encourage
them to develop and use better risk management techniques in monitoring and
---------------------- managing their risk. Central banks are to evaluate as to how well banks are
assessing their capital needs considering their risk profile. The Basel committee
---------------------- has laid down four key principles in regard to the SRP and two of these principles
---------------------- deal with the role of the supervisors.
In India, as per RBI directives, the Pillar 2 requires banks to implement
---------------------- an internal process, called the Internal Capital Adequacy Assessment Process
---------------------- (ICAAP) for assessing their capital adequacy in relation to their risk profiles
as well as a strategy for maintaing the capital levels. It also requires RBI to
---------------------- subject all the banks to an evaluation process, called Supervisory Review and
Evaluation Process (SREP) under which the RBI will assess the overall capital
----------------------

198 Risk Management

adequacy of a bank through a comprehensive evaluation taking into account all Notes
relevant available information.
----------------------
(3) Pillar 3 seeks to complement these activities with stronger market
discipline by requiring banks to publicly disclose key information that enables ----------------------
market participants to assess an individual bank’s risk profile and level of
capitalisation. This pillar is seen as particularly important because some banks ----------------------
under Basel II would be allowed to rely more heavily on internal methods for
----------------------
determining risk, giving them greater discretion in determining their capital
needs ----------------------
While Basel I applied the same framework to all banks, Basel II offered
----------------------
three options for measuring credit risk and three for measuring operational risk.
The purpose of offering options is to allow each bank and its supervisors to ----------------------
select approaches that are most appropriate to the bank’s operations and its
ability to measure risk. ----------------------
(a) Credit risk: The options for calculating credit risk are the ----------------------
standardised approach and two internal-ratings-based (IRB) approaches—the
foundation approach and the advanced approach. The standardised approach ----------------------
is similar to the current framework in that bank assets are categorised and then
----------------------
weighted according to fixed risk weights for the various categories specified by
supervisors. However, the standardised approach adds more risk categories and ----------------------
makes use of external credit ratings to evaluate corporate risk exposures.
----------------------
Under this approach, the risk weightages are prescribed by RBI and
adopted by banks without any discretion to modify. This approach is based ----------------------
on ratings from external credit rating institutions for Governments, banks and
corporates. RBI has identified four external domestic rating agencies, namely ----------------------
CRISIL, ICRA, CARE and Fitch for use of their ratings. The international ----------------------
agencies are Fitch, Moody’s and Standard & Poor’s.
Under the two IRB approaches, each bank would evaluate its assets in ----------------------
terms of the most important elements of credit risk— the probability that a ----------------------
borrower will default during a given period; the likely size of the loss, should
default occur; the amount of exposure at the time of default and the remaining ----------------------
maturity of the exposure. Risk weights and thus capital requirements, would
be determined by a combination of bank-provided quantitative inputs and ----------------------
supervisor-provided formulas. ----------------------
The details for calculating capital charges would vary somewhat
according to type of exposure (corporate or retail, for example). The difference ----------------------
between the two IRB approaches is that the foundation approach would require ----------------------
the bank to determine only each loan’s probability of default and the supervisor
would provide the other risk inputs; under the advanced approach, the bank ----------------------
would determine all the risk inputs, under procedures validated by the super-
visor. Banks choosing to operate under either of the two IRB approaches ----------------------
would be required to meet mini-mum qualifying criteria pertaining to the ----------------------
comprehensiveness and integrity of their internal capabilities for assessing the
risk inputs relevant for its approach. ----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 199
 Notes (b) Market risk: Market risk is the risk of possible losses in holding,
on-balance sheet and off-balance sheet positions, due to movements in market
---------------------- prices. The market risk positions, for capital purpose are: (i) The risks pertaining
to interest rate related instruments and equities in the trading book and (ii) forex
---------------------- risk throughout the bank.
---------------------- The committee has suggested two broad methods for computation of
capital for market risks: (i) Standardised method and (ii) bank’s internal risk
----------------------
management models method. RBI has decided that, to start with, banks may
---------------------- adopt the standardised method.
Under the standardised method, there are two principal methods of
----------------------
measuring market risk, i.e. a ‘maturity method’ and a ‘duration method’. RBI
---------------------- has decided to adopt standardised duration method to arrive at the capital charge.
Banks are required to measure the general market risk charge by calculating the
---------------------- price sensitivity (modified duration) of each position separately.
---------------------- (c) Operational risk: Operational risk is the possibility of loss resulting
from inadequate or failed internal processes, people and systems or external
---------------------- events. This does not include strategic and reputational risk. The three proposed
options for calculating operational risk are the basic indicator approach, the
----------------------
standardised approach and the advanced measurement approaches (AMA).
---------------------- The basic indicator and standardised approaches are intended for banks having
relatively less significant exposure to operational risk. They require that banks
---------------------- hold capital against operational risk in an amount equal to a specified % of
the bank’s average annual gross income over the preceding three years. Under
----------------------
the basic indicator approach, the capital requirement would be calculated at
---------------------- the firm level; under the standardised approach, a separate capital requirement
would have to be calculated for each of eight designated business lines. Banks
---------------------- using these two approaches would not be allowed to take into account the risk-
mitigating effect of insurance.
----------------------
The AMA option is designed to be more sensitive to operational risk
---------------------- and is intended for internationally active banks having significant exposure
---------------------- to operational risk. It seeks to build on banks’ rapidly developing internal
assessment techniques and would allow banks to use their own methods for
---------------------- assessing their exposure, so long as those methods are judged by supervisors to
be sufficiently comprehensive and systematic.
----------------------
Internationally active banks and banks having significant exposure to
---------------------- operational risk would be expected to adopt the more risk sensitive AMA option
over time. No specific criteria for using the basic indicator approach would
---------------------- be set forth, but banks using that approach would be encouraged to comply
---------------------- with supervisory guidance on sound practices for managing and supervising
operational risk. Banks using either the standardised approach or the AMA
---------------------- approach would be required to have operational risk systems meeting certain
criteria, with the criteria for the AMA being more rigorous (source: www.
---------------------- federalreserve.gov).
----------------------

200 Risk Management

 To begin with, Banks in India have adopted basic indicator approach. Notes
Under this, a bank will have to hold capital, equal to average of previous three
years’ positive annual gross income (i.e. net interest income + net non-interest ----------------------
income) as a fixed charge % (denoted alpha i.e. 15%). If there is negative gross
income for any year, it will be excluded from both numerator and denominator. ----------------------

Annual positive gross income for three years ----------------------

Capital Requirement = x 15
----------------------
Number of years for which gross income is positive
The Banks in India have migrated to Basel II norms with effect from ----------------------
March 31, 2009. Banks have so far implemented Standardised approach for
----------------------
Credit and Market Risk and Basic Indicator Approach for operational Risk.
With a view to ensuring smooth transition to the Revised Framework and ----------------------
with a view to providing opportunity to banks to streamline their systems and
strategies, banks were advised to have a parallel run of the revised Framework. ----------------------
The Boards of the banks should review the results of the parallel run on a
----------------------
quarterly basis. The features of the parallel run are as under: i) Banks should
apply the prudential guidelines on capital adequacy – both guidelines viz. Basel ----------------------
I and these guidelines on the Revised Framework – on an ongoing basis and
compute their Capital to Risk Weighted Assets Ratio (CRAR) under both the ----------------------
guidelines. ii) An analysis of the bank’s CRAR under both the guidelines should
----------------------
be reported to the Board at quarterly intervals.
Having regard to the necessary upgradation of risk management ----------------------
framework as also capital efficiency likely to accrue to the banks by adoption
----------------------
of the advanced approaches envisaged under the Basel II Framework and the
emerging international trend in this regard, it was considered desirable to lay ----------------------
down a timeframe for implementation of the advanced approaches in India.
This would enable banks to plan and prepare for their migration to the advanced ----------------------
approaches for credit risk and operational risk, as also for the Internal Models
----------------------
Approach (IMA) for market risk. Keeping in view the likely lead-time that
may be needed by banks for creating the requisite technological and the risk ----------------------
management infrastructure, including the required databases, the MIS and the
skill up-gradation etc., ----------------------

----------------------
BASEL III
The sub prime crisis in the banking world happened despite the banks ----------------------
having implemented the Basel II norms the world over. This led to soul
----------------------
searching by the banking supervisors, which highlighted the need for updating
the existing Basel II framework, aimed to avert such crisis in the future. A new ----------------------
framework relating capital, liquidity and other requirements was adopted and
proclaimed by the BCBS in December 2010. The Basel III proposals have two ----------------------
main objectives:
----------------------
(a) To strengthen the regulations regarding capital base and liquidity of the
banks with the goal of promoting a more resilient banking sector ----------------------

----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 201
 Notes (b) To improve the banking sector’s ability to absorb shocks arising from
financial and economic stress.
----------------------
The objectives are proposed to be achieved by bringing in new norms and
---------------------- modifying some of the existing ones in the following three areas:
(1) Capital Reforms: The new proposals seek to raise the quality, consistency
----------------------
and transparency of the capital base. It is prescribed as under:
---------------------- (a) Tier I Capital:
---------------------- (i) In the total capital requirement of 8 %, the Tier I capital
requirement has been increased to 6 % from 4 %.
----------------------
(ii) Common equity and retained earnings should be the
---------------------- predominant components instead of debt instruments, well
above the current 50 % rule.
----------------------
(iii) The difference between the total requirement of 8 % and tier
---------------------- I requirement can be met by tier II Capital.
---------------------- (b) Core Tier I Capital:
(i) Under Tier I, the minimum capital of common equity (core
----------------------
capital) the highest form of loss absorbing capital will be
---------------------- raised from the current level of 2 % to 4.5 %.

---------------------- (ii) This is to be adhered to after making the necessary regulatory

adjustments
---------------------- (iii) This increase will be phased in to apply from Jan. 2016 and
---------------------- will come into full effect from Jan. 2019.
(c) Capital Conservation Buffer: In addition to the increased core
---------------------- capital, an additional core capital of 2.5 % is recommended as a
---------------------- capital conservation buffer. This is also to be met by common equity
only. This will take the minimum core equity requirement to 7 %.
---------------------- The purpose of this buffer is that it can be used to absorb losses on
a plausibly severe stressed financial and economic environment.
----------------------
The conservation buffer is also phased in to apply from January
---------------------- 2016 and will come into full effect from January 2019.
---------------------- (d) Counter Cyclical Buffer Capital: As per Basel III norms, the
national regulators can also specify a counter cyclical buffer capital
---------------------- up to 2.5 % (0 % to 2.5 %) from macro prudential objectives
according to the individual national circumstances. This is aimed at
----------------------
protecting the banking sector from periods of excess credit growth,
---------------------- say in excess of GDP growth.
(e) Additional Capital for Systemic Important Banks: Systemic
----------------------
Important banks are those, which are large enough, complex and
---------------------- deeply interconnected between themselves; as such, their failure
will create a risk for the entire financial system as a whole. In view
---------------------- of the above, it is recommended that systemically important banks

202 Risk Management

 should have comparatively more loss-absorbing capacity and hence Notes
the new norms stipulate that they should have capital beyond the
standards stated above. ----------------------
(f) Deductions from Tier I Capital: Some components of the existing ----------------------
Tier I capital will be disqualified under the new regime. This would,
inter alia include investment in financial subsidiaries and associates, ----------------------
goodwill, other tangibles, deferred tax assets, securitisation
----------------------
exposures etc.
The following table provides a comparison of the existing RBI norms ----------------------
with the capital requirements as per Basel II and Basel III norms:
----------------------
Basel II Basel III Existing
RBI ----------------------
Norms ----------------------
Tier I Tier I 4.00% 6.00% 6.00%
----------------------
Capital Core Tier I 2.00% 4.5% -
Tier I+II 8.00% 8.00% 9.00% ----------------------
Conservation Buffer - 2.5% -
----------------------
Counter Cyclical Buffer - 0-2.5% -
Total Capital Required 8.00% 10.5%- 9.00% ----------------------
13%
----------------------
(2) Leverage Ratios: In the banking business, the assets are largely funded
by borrowed funds, which include deposits from the public. The size of ----------------------
the deposits from the public exceeds the capital of banks manifold. The
Basel III norms seek to reduce the build up of excess leverage (ratio of ----------------------
Tier I capital to total assets) with a view to reduce the risk of failure. ----------------------
As per Basel III norms, the leverage ratio is set at 3 %, i.e. bank’s total assets
----------------------
including both on and off-balance sheet assets, should not be more than
33 times of its capital. The ratio will be effective from January 2018. ----------------------
However, the supervisory monitoring commences from January 2011 and
runs through January 2013. ----------------------
The new liquidity coverage ratios, suggested by Basel III, aim to ensure ----------------------
availability of adequate liquidity with the banks in the event of any market
dislocation or stress. ----------------------
(3) Other Measures: Other general measures to improve the stability of the ----------------------
banks primarily focus on strengthening the risk capturing ability of the
banks notably counterparty risk. ----------------------

----------------------

----------------------

----------------------

----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 203
 Notes
Check your Progress 1
----------------------

---------------------- Multiple Choice Multiple Response.

1. Managing Bank risk has become important due to which factors?
----------------------
i. Deposits and Advances
----------------------
ii. Assets and Liabilities
---------------------- iii. Financial stability and economic growth
---------------------- 2. Important function of Basel Committee is to:
---------------------- i. Regulate banking deposits and Lending
ii. Prescribe prudential norms for banks
----------------------
iii. Prescribe capital adequacy ratio
----------------------
----------------------
11.4 RBI GUIDELINES ON IMPLEMENTATION OF
----------------------
BASEL III
----------------------
In view of the implementation of Basel III Capital Regulations, banks need
---------------------- to improve and strengthen their capital planning processes. While conducting
the capital planning exercise, banks may consider the potential impact of the
---------------------- changing macro-economic conditions and the outcomes of periodic stress tests
on the adequacy and composition of regulatory capital. A forward looking
----------------------
capital planning process will enable banks to appropriately assess the level of
---------------------- capital needed to support their business strategies over the medium-term.

---------------------- The capital requirements may be substantially lower during the initial
years as compared to later years of full implementation of Basel III Guidelines.
---------------------- Accordingly, banks should keep this aspect in view while undertaking their
capital planning exercise. Boards of banks should actively engage themselves
---------------------- in the capital planning process and oversee its implementation.
---------------------- Of late, industry-wide concerns have been expressed about the potential
stresses on the asset quality and consequential impact on the performance /
---------------------- profitability of the banks. This may necessitate some lead time for banks to
---------------------- raise capital within the internationally agreed timeline for full implementation
of the Basel III Capital Regulations. Accordingly, the transitional period for
---------------------- full implementation of Basel III Capital Regulations in India is extended upto
March 31, 2019, instead of as on March 31, 2018. This will also align full
---------------------- implementation of Basel III in India closer to the internationally agreed date of
---------------------- January 1, 2019.
In addition to the above, certain other aspects of the guidelines, more
----------------------
specifically, those relating to the loss absorption features of non-equity capital
---------------------- instruments have been reviewed in response to clarifications sought in this regard.

204 Risk Management

 The revised transitional arrangements along with other modifications have Notes
been furnished in below. These guidelines become applicable with immediate
effect. ----------------------
Basel III Capital Regulations in India – Amendments Implementation of ----------------------
Basel III Capital Regulations in India – Capital Planning)
----------------------
1. Basel III Transitional Arrangements
I n terms of Basel III Capital Regulations issued by the Reserve Bank ----------------------
of India, the Capital Conservation Buffer (CCB) is scheduled to be
----------------------
implemented from March 31, 2015 in phases and would be fully
implemented as on March 31, 2018. It has been decided that the ----------------------
implementation of CCB will begin as on March 31, 2016. Consequently,
Basel III Capital Regulations will be fully implemented as on March 31, ----------------------
2019. The Transitional Arrangements as indicated is  revised as under:
----------------------
Transitional Arrangements-Scheduled Commercial Banks (excluding LABs and RRBs)
(% of RWAs) ----------------------
April March March March March March March
Minimum capital ratios 1, 2013 31, 31, 31, 31, 31, 31, ----------------------
2014 2015 2016 2017 2018 2019
Minimum Common Equity Tier 1 (CET1) 4.5 5 5.5 5.5 5.5 5.5 5.5
Capital conservation buffer (CCB) - - - 0.625 1.25 1.875 2.5
----------------------
Minimum CET1+ CCB 4.5 5 5.5 6.125 6.75 7.375 8
Minimum Tier 1 capital 6 6.5 7 7 7 7 7
----------------------
Minimum Total Capital* 9 9 9 9 9 9 9
Minimum Total Capital +CCB 9 9 9 9.625 10.25 10.875 11.5 ----------------------
     
Phase-in of all deductions from CET1 20 40 60 80 100 100 100 ----------------------
(in %)#
* The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be ----------------------
met with Tier 2 and higher forms of capital;
# The same transition approach will apply to deductions from Additional Tier 1 and Tier 2 capital. ----------------------
Minimum capital conservation standards for individual bank
Common Equity Tier 1 Ratio after including the current  Minimum Capital
----------------------
periods retained earnings Conservation Ratios
As on  As on  As on  (expressed as % of ----------------------
March 31, 2016 March 31, 2017 March 31, 2018 earnings)
5.5% - 5.65625% 5.5% - 5.8125% 5.5% - 5.96875% 100% ----------------------
>5.65625% - 5.8125% >5.8125% - 6.125% >5.96875% - 6.4375% 80%
>5.8125% - 5.96875% >6.125% - 6.4375% >6.4375% - 6.90625% 60% ----------------------
>5.96875% - 6.125% >6.4375% - 6.75% >6.90625% - 7.375% 40%
>6.125% >6.75% >7.375% 0%
----------------------
2. Loss Absorption Features of Non-Equity Capital Instruments
----------------------
 he criteria for Additional Tier 1 (AT1) capital instruments  inter
T
alia require that these instruments should have principal loss absorption ----------------------
through either (i) conversion into common shares or (ii) a write-down
mechanism which allocates losses to the instruments at an objective pre- ----------------------
specified trigger point. The pre-specified trigger is set at Common Equity ----------------------
Tier 1 (CET1) of 6.125% of risk weighted assets (RWAs). It has now
been decided that all Basel III compliant AT1 instruments issued before ----------------------
March 31, 2019 i.e., before the full implementation of Basel III, will have
two pre-specified triggers. A lower pre-specified trigger at CET1 of 5.5% ----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 205
 Notes of RWAs will apply and remain effective before March 31, 2019, after
which this trigger would be raised to CET1 of 6.125% of RWAs for all
---------------------- such instruments. AT1 instruments issued on or after March 31, 2019 will,
however, have pre-specified trigger at CET1 of 6.125% of RWAs only.
----------------------
Presently, in addition to conversion feature, both the temporary and
---------------------- permanent write-down features have been permitted at the pre-specified
trigger point for AT1 capital instruments. On a review, it has been decided
----------------------
that banks may issue AT1 capital instruments with conversion / permanent
---------------------- write-down features only. Similarly, with regard to write-off feature at
Point of Non-Viability (PONV) trigger, all non-equity capital instruments
---------------------- will have permanent write-off feature only, even in cases where there
is no public sector injection of funds. Further, it is clarified that Basel
----------------------
III compliant capital instruments issued with temporary write-off feature
---------------------- till the date of this circular will continue to be recognised as eligible
regulatory capital instruments.
----------------------
3. Dividend/Coupon Discretion on Capital Instruments
---------------------- As regards ‘distributable items’, it is clarified that:
----------------------  he dividend on common shares and perpetual non-cumulative preference
T
shares (PNCPS) will be paid out of current year’s profit only.
----------------------
I f the payment of coupons on perpetual debt instrument (PDI) is likely to
---------------------- result in losses in the current year, their declaration should be precluded
to that extent. Moreover, coupons on perpetual debt instruments should
---------------------- not be paid out of retained earnings / reserves. In other words, payment
---------------------- of coupons should not have the effect of reducing retained earnings /
reserves.
---------------------- 4. Dividend Payment by Banks
---------------------- Currently, dividend payment by banks is governed by the provisions
of  ‘Declaration of Dividends by Banks’. Further, Basel III framework
----------------------
also imposes certain constraints on distributions (i.e. payment of dividend
---------------------- or bonuses in any form etc.) in case the capital level of banks falls within
the stipulated range as prescribed by the capital buffers framework (i.e.
---------------------- capital conservation and countercyclical buffers, etc.). It is clarified that
the dividend payment by banks would be governed by the interaction of
----------------------
both these guidelines, once the capital buffer framework has kicked-in.
---------------------- I ncidentally, the reference to Basel II capital requirements under paragraph
5(d) on ‘Board Oversight’ of the above circular should be read as the
----------------------
prevailing capital adequacy framework implemented by the Reserve
---------------------- Bank of India and applicable to scheduled commercial banks operating in
India.
----------------------
5. Optionality of Capital Instruments
----------------------  ne of the essential criteria with regard to the optionality of Basel III
O
---------------------- compliant capital instruments is that a bank must not do anything which
creates an expectation that the call will be exercised. For example, to
206 Risk Management
 preclude such expectation of the instrument being called, the dividend / Notes
coupon reset date need not be co-terminus with the call date. Banks may,
at their discretion, consider having an appropriate gap between dividends ----------------------
/ coupon reset date and call date.
----------------------
Source: RBI
----------------------
Activity 1 ----------------------

Go through the revised comprehensive reform package document ----------------------

titled “Basel III: A global regulatory framework for more resilient banks and ----------------------
banking systems” issued by the Basel Committee on Banking Supervision
(BCBS) in June 2011 and make a summary of the recommendations made ----------------------
therein.
----------------------

----------------------
Summary
----------------------
●● Capital Adequacy is measured in terms of percentage of capital employed
by a bank. It is an important tool for gauging health of a bank. This is ----------------------
kept in the form of Capital Adequacy Ratio (CAR) or Capital to Risk
----------------------
Assets Ratio (CRAR). The Basel Committee on Banking Supervision has
stipulated broad supervisory standards for maintaining CAR. ----------------------
●● The Basel-I Capital Accord ‘s fundamental objective was to promote the
----------------------
soundness and stability of the international banking system and to provide
an equitable basis for competition among banks. ----------------------
●● Two basic principles of the first accord were: (1) To ensure adequate level
of capital in the international banking system (2) To create more level ----------------------
playing field in competitive terms so that banks could no longer build ----------------------
business volume without adequate capital backing. As per the accord,
internationally active banks were required to hold capital of at least 8% of ----------------------
a basket of assets measured in different ways according to their riskiness.
----------------------
●● For the purposes of determining a bank’s assets, different types of assets are
weighted according to the level of perceived risk that each type represents ----------------------
and each off-balance-sheet exposure is converted to its equivalent amount
of assets and weighted as that type of asset would be weighted. ----------------------
●● Basel II was released in a consultative paper in April 2003. The focus ----------------------
of the reform was on strengthening the regulatory capital framework for
large, internationally active banking organisations through minimum ----------------------
capital requirements that are more sensitive to an institution’s risk profile ----------------------
and that reinforce incentives for strong risk management.
●● The Basel II framework is more flexible and forward looking in contrast to ----------------------
the first accord which has one ‘pillar’, i.e. minimum capital requirement, ----------------------
whereas the Basel II accord was built on three mutually reinforcing
elements or ‘pillars’. ----------------------

The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 207
 Notes ●● The Banks in India have migrated to Basel II norms with effect from
March 31, 2009. Banks have so far implemented Standardised approach
---------------------- for Credit and Market Risk and Basic Indicator Approach for operational
Risk. RBI has laid down a time schedule for implementation of the
---------------------- advanced approaches for the regulatory capital measurement. It is proposed
---------------------- to complete the migration by March 31, 2014 in a phased manner.
●● BASEL III: The Basel III proposals have two main objectives: To
---------------------- strengthen the regulations regarding capital base and liquidity of the banks
---------------------- with the goal of promoting a more resilient banking sector and to improve
the banking sector’s ability to absorb shocks arising from financial and
---------------------- economic stress. The objectives are proposed to be achieved by bringing
in new norms and modifying some of the existing ones
----------------------
●● As per Basel III norms, the leverage ratio is set at 3 %, i.e. bank’s total
---------------------- assets including both on and off-balance sheet assets, should not be more
than 33 times of its capital. The ratio will be effective from January 2018.
----------------------
●● The Reserve Bank of India has issued detailed guidelines for
---------------------- implementation of the Basel III norms in May 2012. These guidelines
would become effective from January 1, 2013 in a phased manner. The
---------------------- Basel III capital ratios will be fully implemented as on March 31, 2018.
----------------------
Keywords
----------------------
●● Capital adequacy ratio: % of capital employed by a bank in reference to
---------------------- the adjusted value of its assets
---------------------- ●● Regulatory capital: The amount of Risk Capital prescribed by the
regulator that should be held by a financial institution/bank to enable it to
---------------------- survive any difficulties such as market, credit or operational risk.
---------------------- ●● Bank’s capital ratio: Its regulatory capital as a proportion of its risk-
weighted assets.
----------------------
●● Economic capital: Bank’s internal estimate of the capital needed to
---------------------- support its risk-taking activities.
●● Core capital: The minimum capital of common equity, the highest form
----------------------
of loss absorbing capital.
---------------------- ●● Capital conservation buffer: Minimum core equity buffer, which can
be used to absorb losses on a plausibly severe stressed financial and
----------------------
economic environment.
---------------------- ●● Systemic important banks: Those banks, which are large enough,
complex and deeply interconnected between themselves; as such, their
---------------------- failure will create a risk for the entire financial system as a whole.
----------------------

----------------------

----------------------

208 Risk Management

 Notes
Self-Assessment Questions
----------------------
1. Define the term Capital Adequacy and discuss its importance for the long-
term survival of any financial institution. ----------------------
2. Briefly outline the Basel II provisions and discuss its implications for
----------------------
banks.
3. Briefly explain the three pillars of the Basel II Accord. ----------------------

4. Enumerate the various prescriptions of the Basel III provisions and their ----------------------
importance in the light of the evolving scenario.
----------------------
4. Write short notes
----------------------
i. Supervisory Review Process (SRP)
ii. Capital to Risk Assets Ratio ----------------------
iii. Capital Conservation Buffer ----------------------
iv. Counter Cyclical Buffer ----------------------

Answers to Check your Progress ----------------------

Check your Progress 1 ----------------------

Multiple Choice Multiple Response. ----------------------
1. Managing bank risk has become important due to which factors? ----------------------
i. Deposits and Advances
----------------------
ii. Assets and Liabilities
----------------------
2. Important function of Basel Committee is to:
i. Regulate banking deposits and lending ----------------------

ii. Prescribe prudential norms for banks ----------------------

----------------------
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
California: Academic Foundation. ----------------------
2. Benton E. Gup, and James W. Kolari. 2007. Commercial Banking: The ----------------------
Management of Risk. Australia: John Wiley & Sons.
----------------------
3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books. ----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic. 2003. Analyzing ----------------------
and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication. ----------------------

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The New Basel Accord: Implications for Banks and Latest Capital Adequacy Regulatory Guidelines 209
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210 Risk Management