Session-1 & 2

Overview of Banking Risk

Income Recognition & Asset Classification (IRAC)

Concept of Risk
What is Risk?
➢ According to International Organization for
Standardization (ISO), the RISK is a combination of
probability of an event and its consequences.
➢ Risk is the probability that an accidental phenomenon
produces in a given point of the effects of a given
potential gravity, during one given period.
➢ Risks can be classified into three types: Business Risk,
Non-Business Risk, and Financial Risk.
Concept of Risk
Risk may occur in:
➢ Business ( Domestic & International)
➢ Investment (Gold, Real Estate, Money & Commodities)
➢ Personal life like:
▪ Health
▪ Education
▪ Career
➢ Process /Operations
Concept of Risk
▪ Risk implies future uncertainty about deviation from
projected /expected earnings of the business /activity.
▪ Risk measures the uncertainty that an investor is willing
to take to realize a gain from its investment.
▪ A probability /treat of damage, injury, liability, loss or
any other or any other negative occurrence that is caused
by external or internal vulnerabilities and that may be
avoided through pre-emptive action.
▪ In finance, the probability that an actual return on an
investment will be lower /higher than the expected
return.
Concept of Banking Risk
Banking Risk
➢ Risks in the banking sector are defined as the possibility
of loss that may rise due to myriad reasons and
uncertainties.
➢ However, they are mainly categorized as a chance
wherein an outcome or investment's actual return will
not be the same as expected.

Banking Risk Management

Banking Risk Management (BRM) is the process of a bank
identifying, evaluating, and taking steps to mitigate the
chance of something bad happening from its operational or
investment decisions.
Concept of Financial Risk
Financial Risk
Financial risk refers to the likelihood of losing money on a
business or investment decision. Risks associated with
finances can result in capital losses for individuals and
businesses.

Financial Risks are of:

Basic Risk, Capital Risk, Country Risk, Default Risk, Delivery
Risk, Economic Risk, Exchange Risk, Interest Rate Risk,
Liquidity Risk, Operational Risk, Payment system Risk, Political
Risk, Refinancing Risk, Reinvestment Risk, Settlement Risk,
Sovereign Risk & Underwriting Risk.
❖ Financial Risks are ascertainable although not always
quantifiable.
Principles of Risk Management
The ISO has identified certain principles of RM.
Accordingly, RM should:
➢ Create Value
➢ Be a part of Organizational Process
➢ Be a part of decision making
➢ Explicitly address uncertainty
➢ Be systematic and structured
➢ Be based on the best available information
➢ Be tailored to suit the policy of the management
➢ Take in to account human factors
➢ Be transparent & inclusive
➢ Be dynamic, iterative and responsive to changes
➢ Be capable of continual improvement and enhancement
Risk Management Process
Risk Management Process consists of steps as follows:
➢ Identify the Risk
➢ Analyze the Risk
➢ Planning and mapping the Risk
▪ Scope of RM
▪ Objective of Risk
▪ Constraints of RM process
➢ Evaluate or Rank the Risk
➢ Manage /Mitigate /Treat the Risk
➢ Monitor the Risk
➢ Review the Risk
Risk in Finance
RM in Financial Market Trends are leading to:
▪ The rising importance of risk management In financial
institutions

▪ More complex markets

➢ Global markets
➢ Greater product Complexity
➢ New businesses (e-banking,
Increased
➢ merchant banking,…)
➢ Increasing competition
Risk
➢ New players
➢ Regulatory imbalances

11
 Indirect Finance

Funds Financial
Intermediary Funds
Borrowers
1.Individuals
2.Business House
3.Government
4.Foreigners
Funds
Landers & Depositors
1.Individuals
2.Business House
3.Government
4.Foreigners
Financial Markets Funds
Funds

Direct Finance
Banking Risk
What are Banking Risks?
▪ 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.
▪ Risk management in bank operations includes risk
identification, measurement and assessment and its objective is
to minimize negative effects risks can have on the financial
result and capital of a bank.
▪ Banks are therefore required to form a special organizational
unit in charge of risk management.
▪ Also, they are required to prescribe procedures for risk
identification, measurement and assessment, as well as
procedures for risk management.
Banking Risk
Bank being a financial intermediary experience risk,
which is usually referred as the potential loss to a bank
due to the occurrence of particular events.
They analyze risk from multiple point of views like:
➢ From Banks Point of View
➢ Customers Point of View
➢ Statutory Requirement
Banking Risk Management

Avoid

Reduce Accept

Risk
Transfer Manage

Mitigate
Risk Management in Banking
Top Management of banks attach considerable importance to
improve the ability to identify, measure, monitor and control the
overall level of risks undertaken.
The banking industry in the US supports the world’s largest
economy with the greatest diversity in banking institutions and
concentration of private credit.
▪ The banking industry has awakened to risk management,
especially since the global crisis during 2007-08.
▪ But what are the day to day risks and the long term risks faced
by banks?
▪ Why do dedicated risk management practices at companies
exist?
Banks have to take risks all the time. Any bank has to take on risk to
make money. This includes full-service banks, traditional banks,
investment banks like Goldman Sachs and Morgan Stanley.
Risk Management in Banking
Several Risks in Banking
“With great risks comes great reward,” especially in
banking:
➢ Banks are in the business of taking on financial risk to
generate profit.
➢ However, the stakes are high, and the downside
potential is huge.
➢ This includes legal repercussions, which have increased
steadily since the 2008 financial crisis.
Types of Banking Risks
Types of Risks
The major risks in banking business as commonly referred by
RBI are:
a. Market Risk
b. Interest Rate Risk
c. Liquidity Risk
d. Credit Risk
e. Operational Risk

As per Goldman Sachs

a. Market Risk
b. Liquidity Risk
c. Credit Risk
d. Operational Risk
e. Regulatory Risk
Types of Banking Risks
As per London Institute of Banking & Finance:
a. Credit risk
b. Market risk
c. Operational risk, including data governance risk and
reporting risk
d. Liquidity risk
e. Technology and information risk, including cyber risk,
and
f. Strategic risk.
Types of Banking Risks
Several Risks in Banking
Banks experience both Financial Risk as well as Non-
Financial Risks.
Types of Financial Risks:
1. Market Risk
2. Interest Rate Risk
3. Liquidity Risk
4. Credit Risk
5. Model Risk
Types of Banking Risks
Non-financial risks (NFR) are all of the risks which are not
covered by traditional financial risk management.
Types of Non-Financial Risks
1. Business Risk
2. Strategic Risk
3. Operational Risk
4. Financial Crime
5. Supplier Risk
6. Conduct Risk
7. Reputational Risk
8. Cyber Risk
Types of Banking Risks
A. Major Risks
▪ Market Risks
▪ Credit Risks
▪ Operational Risk
▪ Foreign Exchange Risk

B. Other Significant Risks

▪ Liquidity Risks
▪ Business Risks
▪ Reputational Risks
▪ Statutory Risk
Risk Management in Banking
C. Unrelated Risks
▪ Systemic Risk
▪ Moral Hazard

Market Risk
a. Equity Risk
b. Interest Rate Risk
▪ Trading Risk (Specific Risk & General Market Risk)
▪ Gap Risk
c. Commodity Risk
Risk Management in Banking
Credit Risk
▪ Portfolio Concentration Risk
▪ Transaction Risk
➢ Counterparty Risk
➢ Issuer Risk
➢ Issue Risk

Operational Risk
▪ Internal Control Risk (Barings Bank : Nick Leeson)
▪ Human Risk
▪ IT /System Risk
▪ Process Risk
Risk Management in Banking
Why banks manage risk
There are many reasons why banks manage risks,
including to:
➢ Prevent loss
➢ Ensure long term survival
➢ Protect their reputation
➢ Safeguard stakeholders’ interests
➢ Comply with regulations and laws
➢ Protect the bank’s credit ratings.
Risk Management in Banking
Foreign Exchange Risk
Foreign exchange risk, also known as exchange rate risk, is the
risk of financial impact due to exchange rate fluctuations. In
simpler terms, foreign exchange risk is the risk that a business’
financial performance or financial position will be impacted by
changes in the exchange rates between currencies.

The three types of foreign exchange risk include:

a. Transaction Risk
b. Translation Risk
c. Economic Risk
Risks of Banks
Risks Banks are facing
As a result of the 2008 financial crisis, the risk management
strategies used by banks have undergone a significant
change
➢ Banks today face risks that extend beyond their
depositors' balances and loan portfolios. They are:
▪ Cybercrime
▪ Consumer protection
▪ Financial Regulation
Objectives of Risk Management
Risk management supports the organization in the
achievement of their goals by ensuring that all activities are
running on their normal track.
It develops a safe and secure work environment for all staff
and customers and increases the stability of business
operations. Hence main objectives of RM would be:
➢ Identifies and Evaluates Risk
➢ Reduce and Eliminate Harmful Threats
➢ Supports Efficient Use of Resources
➢ Better Communication of Risk Within Organisation
➢ Reassures Stakeholders
➢ Support Continuity of Organisation
Insurance and Risk Management
Importance of Insurance in Risk Management
Insurance has developed as a means of protecting people's
assets from loss and confusion.
➢ It can be viewed as a social device that helps to
minimize or remove the chance of death or property
loss.
➢ The following are the reasons for the importance of
Insurance in a business:
• The Risk of company losses is reduced
• Insurance improves the productivity of a company
• Promotes Economic Growth
• Credit improvement
• Business continuity
Insurance and Risk Management
Business Risk Management helps companies manage
their risks by helping to identify the types of threats the
company faces and their likelihood.
➢ Every day, your company faces risk — especially when it's
growing.
➢ Thankfully, the practice of business risk management can
help prevent an operational, financial or compliance-related
risk from becoming a catastrophic loss.
➢ At the heart of an effective business risk management
program sits insurance, which allows your company to
transfer some of its risk to an insurance company, in
exchange for a monthly premium.
➢ Buying the right insurance provides more than just a safety
net, it can actually help your company minimize its operating
costs.
Insurance and Risk Management
Managing Risk With Insurance
List of insurance products that businesses use to transfer
risk and limit their financial and nonfinancial losses.
a. General Liability Insurance: Protects against a broad
range of losses including claims involving bodily injury,
property damage and lawsuits.
b. Property Insurance: Covers property used by the
business against loss or damage.
c. Errors and Omission (E&O) Insurance: When a client
sues alleging some form of negligence, E&O insurance
pays the legal expenses and judgments, up to the policy
limit (often used by companies that offer advice such as
accountants, lawyers and engineers).
d. Directors and Officers Insurance: Protects directors
and officers if sued for their role in managing or
governing a company
Insurance and Risk Management
Managing Risk With Insurance
e. Worker's compensation: Replaces a portion of lost
wages for an employee who is injured on the job.
f. Cyber Insurance: Protects against internet-related risks
such as data theft, or loss, as well extortion and hacking.
g. Business interruption insurance: Covers the losses that
result when a business stops operating due to a fire, a
man-made or natural disaster.
h. Umbrella Insurance: Provides additional liability
coverage above the stated policy limits in other
insurance policies
Some insurance companies streamline the buying process
by packaging insurance policies in a bundle.
Bank’s Capital & Capital Adequacy Ratio
Bank’s Capital & Capital Adequacy Ratio (CAR)
a. Bank‘s Capital is the value of the bank's assets minus its
liabilities, or debts. Assets include cash, loans and
securities, while liabilities cover customer deposits, and
money owed to other banks and bondholders.
b. Capital Adequacy Ratio (CAR) also known
as Capital to Risk (Weighted) Assets Ratio (CRAR), is
the ratio of a bank's capital to its risk.
▪ National regulators track a bank's CAR to ensure that it
can absorb a reasonable amount of loss and complies with
Statutory Capital requirements. It is a measure of a
bank's capital.
Bank’s Capital & CAR
c. Capital Ratio or Core Capital Ratio or Tier 1 Capital
Ratio:
➢ It is the percentage of a bank's capital to its risk-
weighted assets. Weights are defined by risk-
sensitivity ratios whose calculation is dictated under
the relevant Accord.
➢ Basel II requires that the total capital ratio must not
be lower than 8%.
Capital Requirement of Banks
What is a 'Capital Requirement‘?
▪ Capital requirement is the standardized requirement in
place for Banks /FIs /NBFCs /MFIs and other
depository institutions that determines how
much liquidity is required to be held for a certain level of
assets.
▪ These requirements are set by regulatory agencies, such
as the Reserve Bank of India or Central Bank of the
country.
➢ These requirements are set to ensure that banks and FIs are not
holding investments that increase the risk of default.
➢ They also ensure that these institutions have enough capital to
sustain operating losses while honouring withdrawals.
➢ A capital requirement is also known as regulatory capital.
Capital Requirement of Banks
Regulatory Capital is the minimum capital requirement as
demanded by the regulators.
▪ It is the amount a bank must hold in order to operate.
▪ A regulator’s primary concern is that there is sufficient capital to
buffer a bank against large losses so that deposits are not at risk,
with the possibility of further disruption in the financial system
being minimized.
▪ Regulatory capital could be seen as the minimum capital
requirement in a “liquidation / runoff” view, whereby, if a bank has
to be liquidated, whether all liabilities can be paid off.
▪ Regulatory capital is a standardised calculation for all banks,
although, there would be differences to various regulatory regimes.
▪ The process by which it is calculated is also transparent, this allows
meaningful comparisons between banks under Pillar 3 disclosures.
Capital Requirement of Banks
Economic Capital (EC) could be seen as the minimum
capital requirement in a “Going Concern” that ensure its
survival.
▪ Economic capital was originally developed by banks as a tool for
capital allocation and performance assessment.
▪ For these purposes, it did not need to measure risk in an absolute, but
only in the relative sense.
▪ Over the time, with advances in risk quantification methodologies
and the supporting technological infrastructure, the use of EC has
extended to applications that require accuracy in the measurement of
risk.
▪ EC is used to set minimum capital requirement, banks will have a
conflict of interest in producing low estimates to minimise its capital
holding.
▪ Since EC modelling is an internal measurement, there is no
standardisation across the banking industry, which in turn, makes
regulation difficult
Capital Requirement of Banks
Rating Agency Capital is the minimum capital a bank needs
to hold in order to meet a certain Credit Rating.
▪ The amount of capital and the type of capital (Tier 1 & 2) a bank
holds in relation to its total risk weighted assets is a crucial input to
the mechanism in which rating agencies use to assess a bank’s capital
adequacy and its subsequent credit rating.
▪ Since credit ratings provide important signals to the market on a
bank’s financial strength, they can have significant downstream
impact on a bank’s ability to raise funds, and also the cost at which
the funds are raised.
▪ Therefore, having sufficient capital to meet rating agency
requirement becomes an important consideration for senior
management.
▪ Rating agency capital differs to regulatory and economic capital in
that it seeks to neutralize the impacts of different regulatory regimes,
Basel II Options and individual banks’ Risk Assessments.
Capital Adequacy
Capital Adequacy Ratio (CAR) is a measure of the amount
of a bank's Core Capital expressed as a percentage of its
Risk Weighted Assets.
CAR set standards for banks by looking at a bank’s ability to pay
liabilities, and respond to credit risks and operational risks. A
bank that has a good CAR has enough capital to absorb potential
losses.
 CAR is the ratio, which determines the bank's capacity to meet
the time liabilities and other risks such as Credit Risk,
Operational Risk etc.
 Bank's capital is the "cushion" for potential losses, and protects
the bank's depositors and other lenders.
 Banking Regulation in most countries define and monitor
CAR to protect depositors, thereby maintaining confidence in
the banking system
Capital Adequacy
Capital Adequacy Ratio
➢ National regulators track a bank's CAR to ensure that it
can absorb a reasonable amount of loss and complies with
Statutory Capital requirement .
➢ Regulators try to ensure that banks and other financial
institutions have sufficient capital to keep them out of
difficulty.
➢ Capital Adequacy of banks is tightly regulated
worldwide in order to better ensure the stability of the
financial system and the global economy.
➢ It also provides additional protection for depositors.
Risk Weighted Asset
Risk-Weighted Assets (RWA) are used to determine the
minimum amount of capital that must be held by banks
and other institutions to reduce the risk of insolvency.

➢ RWA are the total assets owned by the Banks, however,

the value of each asset is assigned a risk weight.
➢ RWA refer to the fund based assets such as Cash, Loans,
Investments and other assets.
For example:
▪ 100% for corporate loans
▪ 50% for mortgage loans
▪ Credit equivalent amount of all off-balance sheet
activities
Capital Adequacy
Under the Basel Accord, a bank's capital consists of:
a. Tier 1 Capital
b. Tier 2 Capital
c. Tier 3 Capital

a. Tier 1 Capital
Tier 1 Capital is the bank's core capital
 Paid up Capital
 Statutory Reserves
 Other disclosed free reserves
 Capital Reserves which represent surplus arising out of the
sale proceeds of the assets. Investment Fluctuation
 Reserves Innovative Perpetual Debt Instruments (IPDIs)
 Perpetual Noncumulative Preference Shares.
Capital Adequacy
a. Tier 1 Capital (cont...)
Less
 Equity Investment in subsidiaries.
 Intangible assets.
 Losses (Current period + past carried forward)
➢ Tier 1 capital is intended to measure a bank's Financial
Health and is used when a bank must absorb losses without
ceasing business operations.
➢ Under Basel III, the minimum Tier 1 Capital Ratio is 6%,
which is calculated by dividing the Tier 1 Capital by its total
Risk-Based Assets.
For example, bank ABC has shareholder’s equity of Rs 300 million and
retained earnings of Rs 200 million, so its tier 1 capital is Rs 500
million.
Capital Adequacy
Tier-II Capital
 Undisclosed reserves and cumulative perpetual preference
shares.
 Revaluation Reserves General Provisions and loss reserves
 Hybrid debt capital instruments such as bonds.
 Long term unsecured loans Debt Capital Instruments.
 Redeemable cumulative Preference shares
 Perpetual cumulative preference shares.

The RBI stipulated 9% for India and within that the Tier 1 Capital would
be 6% (By 31.3.2010)
As per the Basel II accords, the banks have to maintain the Minimum
Total CRAR of 8%.
Most banks prefer to hold at least 12% CAR at all points of time because
a lower CAR increases their cost of resource.
Capital Adequacy
c. Tier 3 Capital
Tier 3 Capital is tertiary capital held by banks to meet part of
their market risks, that includes a greater variety of debt than
tier 1 and tier 2 capitals. Tier 3 capital debts may include a
greater number of subordinated issues, undisclosed reserves and
general loss reserves compared to Tier 2 Capital.

Breaking down 'Tier 3 Capital'

➢ Tier 3 capital is used to support Market Risk, Commodities
Risk and Foreign Currency Risk.
➢ To qualify as tier 3 capital, assets must be limited to 250% of a
banks Tier 1 Capital, be unsecured, subordinated and have a
minimum maturity of two years.
 Take risks
“if you win, you will be happy; if you
lose, you will be wise."