Risk Management in Banks

Risk Management in Banks
Chapter 1
Introduction of Risk :

Risk management is a systematic approach to minimizing an organization's
exposure to risk. A risk management system includes various policies,
procedures and practices that work in unison to identify analyses, evaluate,
address and monitor risk. Risk management information is used along with
other corporate information, such as feasibility, to arrive at a risk
management decision. Transferring risk to another party, lessening the
negative affect of risk and avoiding risk altogether are considered risk
management strategies. xamples of risk management practices include
purchasing insurance, installing security systems, maintaining cash
reserves and diversification. Traditional risk management works to reduce
vulnerabilities that are associated with accidents, deaths and lawsuits, among
others. !inancial risk management focuses on minimizing risks through the
use of financial tools and instruments including various trading techni"ues
and financial analysis. #any large corporations employ teams of risk
management personnel.

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Chapter 2
Introduction of risk management in bank :
Risk management in Indian banks is a relatively
newer practice, but has already shown to increase efficiency in governing of
these banks as such procedures tend to increase the corporate governance of
a financial institution. %n times of volatility and fluctuations in the market,
financial institutions need to prove their mettle by withstanding the market
variations and achieve sustainability in terms of growth and well as have a
stable share value. &ence, an essential component of risk management
framework would be to mitigate all the risks and rewards of the products and
service offered by the bank. Thus the need for an efficient risk management
framework is paramount in order to factor in internal and external risks.
The financial sector in various economies like that of %ndia is
undergoing a monumental change factoring into account world events such
as the on'going (anking )risis across the globe. %t has highlighted the need
for banks to incorporate the concept of Risk #anagement into their regular
procedures. The various aspects of increasing global competition to %ndian
(anks by !oreign banks, increasing *eregulation, introduction of innovative
products, and financial instruments as well as innovation in delivery
channels have highlighted the need for %ndian (anks to be prepared in terms
of risk management.
%ndian (anks have been making great advancements in terms of progress in
terms of technology, "uality, "uantity as well as stability such that they have
started to expand and diversify at a rapid rate. &owever, such expansion
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brings these banks into the context of risk especially at the onset of
increasing ,lobalization and -iberalization. %n banks and other financial
institution risk plays a ma.or part in the earnings of a bank. &igher the risk,
higher is the return/ hence, it is most essential to maintain parity between
risk and return. &ence, management of !inancial risk incorporating a set
systematic and professional methods especially those defined by the (asel %%
norms because an essential re"uirement of banks. The more risk averse a
bank is, the safer is their )apital base.

0
Chapter 3
Risk Management Framework for Indian Banks:

(anks must ensure that risk management is a custodian of overall
banking activities to mitigate the risks.
Risk management is relatively new and emerging practice as far as
%ndian banks are concerned and has been proved that it1s a mirror of efficient
corporate governance of a financial institution. ,lobalization and significant
competition between foreign and domestic banks, survival and optimizing
returns are very crucial for banks and financial institutions. &owever,
selecting the efficient customer and providing innovative and value added
financial products and services are another paramount factors. %n a volatile
and dynamic market place for achieving sustainable business growth and
shareholder1s value, it is essential to develop a link between risks and
rewards of all products and services of the bank. &ence, the banks should
2
have efficient risk management framework to mitigate all internal and
external risks.
The presence of accurate measures of bank'wide risk management practice
increase shareholder1s returns and allows the risk'taking behavior of bank to
be more closely aligned with strategic ob.ectives. (ank'wide risk
management practice should aim to enhance the drivers of shareholder1s
value such as3 '
,rowth
Risk ad.usted performance measurement
)onsistency of earnings and
4uality and transparency of management
The important steps of the efficient framework of banking concern
should ensure all risks are identified, prioritized, "uantified, controlled and
managed in order to achieve an optimal risk'reward profile. This entails
ideal and dedicated coordination of risk management across the bank1s
various business units. &owever, the approach to monitoring and enforcing
the adherence of business units within the bank may vary. The factors that
influence this decision are3
The feasibility decisions of the business unit.
The regulatory re"uirements in respect of the business unit.
The cost of effective monitoring and controlling steps.
5
(enefits of (ank'wide risk management
Risk management is a line function that needs to be addressed by
each individual cost center and business unit. &owever, a centralized bank'
wide risk management framework has certain advantages for the (ank. The
advantages are3 '
%mproving capital efficiency by
$. 6roviding an ob.ective basis for allocating resources
+. Reducing expenditures on immaterial risks and
0. xploring natural hedges and portfolio effects
7upporting informed decision making by
$. 8ncovering areas of high potential adverse impact on drivers of share
value, and
+. %dentifying and exploiting areas of risk'based advantage context.
(uilding investor confidence by
$. stablishing a process to stabilize results by protecting them from
disturbances, and
+. *emonstrating proactive risk stewardship
*efine cost and profitability centers
$. 6rofitability and cost allocation on customer, product, services and
branch wide.
9
Risk Management Framework
The important factors for how risks are managed in the bank and the
institution1s risk management philosophy and practice are as follows3
$. :rganizational structure of the bank and the control arrangements that are
embedded in it, such as segregation of duties and ;four eyes1 principle
+. Role of the board and board committees
0. Role of #anagement and management committees
2. #andate of the board and management committees
5. *iscussion of policies, procedures and limits/ risk monitoring/ and
internal controls for each risk
9. Role of the Risk #anagement function
<. Role of the compliance function
=. Role of %nternal Audit
>. 6in pointed risk owner of each risk and reporting lines.
$?.Risk monitoring reports, their fre"uency and distribution.
Chapter 4
<
!pes of Financia" risks
$@ )redit risk
+@ %nterest rate risk
0@ #arket risk
2@ )apital risk
5@ -i"uidity risk
Credit risk:
)redit risk is the risk of counter party failure in performing repayment
obligation on due date is known as credit risk. )redit risk management is a
primary challenge for all the banks. The mismanagement of credit risk may
lead to failure of the banks itself.
)redit risk is managed by credit policy or loan policy of the bank. The
bank may take preventive measures or curative measures to avoid this risk.
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)redit risk depends on external and internal factors A7udden hike in steel
and cement prices affect the builder@, stock market, foreign exchange rates
and interest rates, etc. The internal factors are bad loan policies, bad
appraisal of the borrowers and his credit worthiness, etc. The preventive
measures include checking the credit worthiness of the borrower, checking
type of security and the amount of security offered by the borrower. )urative
measures include selling the security offered by the borrower to recover the
amount of loan making the guarantor to pay the loan amount or extending
concessional measures to enable the borrower to repay the loan. )redit risk
is caused by market risk variable and thus the management of such risk
becomes a part of A-#.
Market risks:
#arket risk is the risk of adverse movement in the share price of the
bank. #anagement should have control over the market risk. #arket risk is
relatively more now because of transparency in the market, fre"uency of
transactions and superior technology.
Capita" risk:
(anks re"uire capital to protect themselves from various risks that
they undertake i.e. credit risk, li"uidity risk, interest rate risk, adverse
movement of share prices, etc. Therefore it becomes important for the
banks to understand the relevance of capital ade"uacy and manage capital
risk. (anks can manage capital risk by bringing in more capital either
through promoters or %6:.
>

#i$uidit! risk3
(anks need to maintain li"uidity to meet deposit withdrawals and to
fund loan demand. There could be a mismatch in the maturity of assets and
liabilities leading to li"uidity risk. The variability of loan demand and
variability of deposit determine banks li"uidity needs.
-i"uidity risk is potential inability of the banks to cope up with
declining deposits. -i"uidity risk arises when the banks do not have
ade"uate cash when it is re"uired. To manage li"uidity risk banks need to
study customer withdrawal pattern and make provisions for the same.
For %&amp"e3 There are heavy withdrawals on the first and the last day of
the week and even on the day before and after a public holiday.
(anks need to maintain li"uid assets which can be converted into cash
"uickly to meet customer re"uirements and thereby manage li"uidity risk.
Interest rate risk 3
Till $><?1s regulatory restrictions on banks greatly reduced many risks
of the banks. The deposits were taken at a fixed mandatory rate and loans
were given at legally established rate. There were no changes in the interest
rates. Therefore, banks had to consider only credit risk and li"uidity risk.

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%n $><?, banks interest rates were deregulated which exposed the
banks to interest rate risk. #any banks failed because of poor management
of interest rate risk. &owever, today fre"uent changes in the interest rates
have become a common risk and almost all banks are able to cope up with
interest rate risk.
%nterest rate risk is exposure of banks financial conditions to adverse
movements in interest rates. Accepting this risk is a normal part of banking
company, however, excessive interest rate risk can create significant threats
to the banks earnings. )hanges in the interest rates affect the banks earnings
because of changes in B%%. %nterest rate risk refers to volatility in B%%. An
effective risk management process that maintains interest rate risks in
controllable level is essential for safety and soundness of the banks. #ost of
the banks have already identified interest rate risk as a drag on profitability
and have started assessing the magnitude of it.

Chapter '
$$
Risk Management (rocess:
The process of financial risk management is an on'going
one. 7trategies need to be implemented and r ef i ned as t he mar ket and
r e"ui r ement s change.
Ref i nement s may r ef l ect changi ng expectations about market rates,
changes to the business environment, or changing international political
conditions, for example. %n general, the process can be summarized as
follows3
C %dentify and prioritize key financial risks.
C *etermine an appropriate level of risk tolerance.
C %mplement risk management strategy in accordance with policy.
C #easure, report, monitor, and refine as needed.
Risk management needs to be looked at as an
organizational approach, as management of risks independently cannot have
the desired effect over the long term. This is especially necessary as risks
result from various activities in the firm and the personnel responsible for
the activities do not always understand the risk attached to them. The steps
in risk management process are3
1) *etermining +b,ecti-es:.
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*etermination of ob.ectives is the first step in the risk
management function. The ob.ective may be to protect profits, or to develop
competitive advantages. The ob.ectives of risk management need to be
decided upon by the management.

2) Identif!ing Risks :.
very organization faces different risks, based on
its business, the economic, social and political factors, the features of the
industry it operates in D like the degree of competition, the strengths and
weakness of its competitors, availability of raw material, factors internal to
the company like the competence and outlook of the management, state of
industry relations, dependence on foreign markets for inputs, sales or
finances, capabilities of its staff and other innumerable factors.
3) Risk %-a"uation:.
:nce the risks are identified, they need to be evaluated for
ascertaining their significance. The significance of a particular risk depends
upon the size of the loss that it may result in, and the probability of the
occurrence of such loss. :n the basis of these factors, the various risks
faced by the corporate need to be classified as critical risks, important
risks and not'so'important risks. )ritical risks are those that may result in
bankruptcy of the firm. %mportant risks are those that may not result in
bankruptcy, but may cause severe financial distress.
4) *e-e"opment of po"ic!:.
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(ased on the risk tolerance level of the firm, the risk management policy
needs to be developed. The time frame of the policy should be
comparatively long, so that the policy is relatively stable. A policy
generally takes the form of a declaration as to how much risk should be
covered.

') *e-e"opment of /trateg!:.
(ased on the policy, the firm then needs to develop the strategy to be
followed for managing risk. A strategy is essentially an action plan, which
specifies the nature of risk to be managed and the timing. %t also
specifies the tools, techni"ues and instruments that can be used to manage
these risks. A strategy also deals with tax and legal problems. Another
important issue that needs to be specified by the strategy is whether
the company would try to make profits out of risk management
or would it stick to covering the existing risks.
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0) Imp"ementation:.
:nce the policy and the strategy are in place, they are to be implemented
for actually managing the risks. This is the operational part of risk
management. %t includes finding the best deal in case of risk transfer,
providing for contingencies in case of risk retention, designing and
implementing risk control programs etc.
1) Re-iew:.
The function of risk management needs to be reviewed periodically
depending on the costs involved. The factors that affect the risk management
decisions keep changing, thus necessitating the need to monitor the
effectiveness of the decisions taken previously.
Chapter 0
$5
Importance of Risk management :
Risk management is a paramount consideration for the banking
industry, with higher proportions of banking executives A<2 percent@
identifying it as a high priority than the overall survey average of 9? percent.
This focus on risk management has increased in the last two years D more
than in other industries D and banks plan a relatively high level of
investment to develop risk management capabilities.
7lightly higher percentages of banks and other financial services
companies, compared with other industries, report that their risk function has
become a source of competitive advantage. Across the survey, about half the
companies A2> percent@ see their risk organization as a critical driver for
enabling long term profitable growth/ another 2+ percent believe their risk
management capabilities are EimportantF to growth.

Almost identical numbers A2= percent@ see risk management as critical
to sustained future profitability, with another 25 percent believing it to be
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Eimportant.F These are high percentages. 6ut another way, >$ percent and >0
percent of executives, respectively, believe that the risk management
function is important or critical to growth and profitability.
The Risk *irector for an Asia 6acific bank states this importance
explicitly3
E:ur risk organization and functions were established to support and enable
our organization to achieve strategic goals such as sustainable growth and
profitability, competitive advantages and capital management. 6ut simply,
we recognize risk as a part of the strategic agenda.F
The mind'set of risk management as a differentiator is also correlated with
risk mastery. Almost two'thirds of #asters across the global survey A92
percent@ indicate that their risk management capabilities provide competitive
advantage to Ea great extent,F compared with only 2+ percent of the peer set.
These companies are also more likely to identify risk as a higher priority.
Chapter 1
$<
M2324%M%3 +F RI/5/:

An independent Risk #anagement department is functioning
for ffective risk management enterprise wide. Risk is managed through
following three Apex committees viz.
(i) )redit Risk #anagement )ommittee A)R#)@
(ii) Asset and -iability #anagement )ommittee AA-#)@ and
(iii) :perational Risk #anagement )ommittee A:R#)@
These committees work within the overall guidelines and policies
approved by the Risk #anagement )ommittee of the (oard. The (ank has
put in place various policies to manage the risk. To analyses the
risk enterprise wide and with the ob.ective of integrating all the risks of the
(ank %ntegrated Risk #anagement 6olicy has also been put in place. The
important risk policies comprise of )redit Risk 6olicy, Asset and -iability
#anagement 6olicy, :perational Risk, #anagement 6olicy,
(usiness )ontinuity 6lanning, Ghistle (lower 6olicy and 6olicy
on )orporate ,overnance.
#anagement of risks begins with identification and its "uantification. %t
is only after risks are identified and measured we may decide to accept the
risk or to accept the risk at a reduced level by undertaking steps to mitigate
the risk, either fully or partially. %n addition pricing of the transaction should
be in accordance with the risk content of the transaction. &ence management
of risks may be sub'divided into following five processes3'
$=
H Risk %dentification
H Risk measurement
H Risk pricing
H Risk monitoring and control
H Risk mitigation
!urther, approach to manage risks at transaction level' i.e. at branch level
where business transactions are undertaken' and at aggregate level' i.e., sum
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total of all transactions undertaken at all the branches' differs. This is
because of risk diversification that take place at aggregate level.
-ike in case of any other business, risks in banking business would
depend upon the variability of its net cash flow at the aggregate level.
Therefore, managing variability in aggregate cash flow is e"ually important
and portfolio risks also need to be managed. Therefore, risk management in
banking business is directed at transaction level and as well as at aggregate
level.
RI/5 I*%3IFIC2I+3:
Bearly all transaction undertaken would have one or more of the ma.or risks
i.e.
-i"uidity risk
%nterest rate risk
#arket risk
)redit risk I
:perational risk.
Although all these risks are contracted at the transaction level, certain
risks such as li"uidity risk and interest rate risk are managed at the aggregate
or portfolio level. Risks such as credit risk, operational risk and market risk
arising from individual transactions are taken cognizance of at transaction
level as well as at the portfolio level.
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Risk identification consist of identifying various risks associated with
the risk taking at the transaction level and examining its impact on the
portfolio and capital re"uirement. As we would see later risk content of a
transaction is also instrumental in pricing the exposure as risk ad.usted
return is the key driving force in the management of banks.
RI/5 M%2/6R%M%3:
Risk management relies on "uantities measures of risk. The risk
measures seems to capture variations in earnings, market value, losses due to
default, etc.Areferred to as target variables@, arising out of uncertainties
associated with various risk elements. 4uantitative measures of risks can be
classified into three categories3'
H (ased on sensitivity
H (ased on volatility
H (ased on down side potential
/ensiti-it!:
7ensitivity captures deviation of a target variable due to unit movement
of a single market parameter. :nly those market parameters, which drive the
value of the target variable, are relevant for the purpose. !or example,
change in market value due to$J change in interest rate would be a
sensitivity'based measure. :ther examples of market parameters could be
exchange rates and stock prices. The interest rate gap is the sensitivity of the
interest rate margin of the banking book. *uration is the sensitivity of
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investment portfolio or trading book. 8sually, market risk models use
sensitivities fairly widely. This measure suffers from couple of drawbacks.
!irst, it is only with reference to one market parameter and does not
consider impact of other parameters, which may also change simultaneously.
7econdly, sensitivities depend on prevailing conditions and change as
market environment changes.
7+#2I#I8:
%t is possible combine sensitivity of target variables with the instability
of the underlying parameters. The volatility characterizes the stability or
instability of any random variable. %t is the common statistical measure of
dispersion around the average of any random variable such as earnings,
mark'to'market values, market value, losses due to default, etc. volatility is
the standard deviation of the values of these variables. 7tandard deviation is
the s"uare root of the variance of the random variable.
%t is feasible to calculate historical volatility using any set of historical
data, whether or not they follow a normal distribution. Alternatively, implicit
volatility may also be computed using option prices, if "uoted in the market
using (lack and 7choles option pricing formula. %mplicit volatility has an
advantage as it is forward looking since option price being "uoted is also
forward looking. The calculation of historical mean and volatility re"uires
time series. *efining a time series re"uires defining the period of
observation and the fre"uency of observation.
++
RI/5 (RICI34:
Risk in banking transactions impact banks in two ways. !irstly,
banks have to maintain necessary capital, at least as per regulatory
re"uirements. The capital re"uired is not without costs. The cost of capital
arises from the need to pay investors in banks e"uity and internal generation
of capital necessary for business growth. ach banking transaction should be
able to generate necessary surplus to meet this costs. The pricing of
transaction must take that into account.
The actual costs incurred are cost of funds that has gone into the
transactions and costs incurred in giving the services, which are incurred by
way of maintaining the infrastructure, employees and other relevant
expenses. 6ricing, therefore, should take into account the following3
C )ost of *eployable funds
C :perating xpenses
C -oss probabilities
C )apital charge
%t should also be mention here that cost of funds should correspond to
the term for which it is deployed. This is because five year funds may have a
different cost than one year fund due to time value of money.
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RI/5 MII42I+3:
7ince risk arises from uncertainties1 associated with the risk elements,
risk reduction is achieved by adopting strategies that eliminate or reduce the
uncertainties1 associated with the risk elements. This is called 1R%7K
#%T%,AT%:B1.
%n banking we come across a variety of financial instruments and
number of techni"ues that can be used to mitigate risks. The techni"ues to
mitigate the different types of risk are different. !or mitigating credit risk
banks have been using traditional techni"ues such as collateralizations by
first priority claims with cash or securities or landed properties, third party
guarantees etc. (anks may buy credit derivatives to offset various forms of
credit risk. !or mitigating interest rate risk bank use interest rates swaps,
forward rate agreements or financial future. 7imilarly, for mitigating forex
risks banks use forex forward contract, forex options or futures and for
mitigating e"uity price risk, e"uity options.
Risk mitigation measures aim to reduce downside variability in net
cash flow but it also reduces upside potential simultaneously. %n fact, risk
mitigation measures reduce the variability in net cash flow. %n addition, risk
mitigation would involve counter party and it will always be associated with
counter party risk. %t may also may be stated here that markets have
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responded to the counter party risk bye establishing ;xchanges1 such as
stock exchange, commodity exchange, future and option exchanges.
Chapter 9
M2R5% RI/5 I3 B235/

I3R+*6CI+3
#uch of the debate in recent year s concerning the management of
market risk within banks has focused on the appropriateness of so'called
Lalue'at'Risk ALaR@ models. These models are designed to estimate, for a
given trading portfolio, the maximum amount that a bank could lose over a
specific time period with a given probability. %n this way they provide a
summary measure of the risk exposure generated by a given portfolio. *raft
guidelines$ released by the Reserve (ank in August $>>9 give banks the
option Asub.ect to supervisory approval@ of using LaR models to measure
market risk on traded instruments in determining appropriate regulatory
capital charges.
LaR models can be developed to varying degrees of complexity. The
simplest approach takes as its starting point estimates of the sensitivity of
each of the components of a portfolio to small price changes Afor example, a
one basis point change in interest rates or a one per cent change in exchange
rates@, then assumes that market price movements follow a particular
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statistical distribution Ausually the normal or log'normal distribution@. This
simplifies the analysis by enabling a risk manager to use statistical theory to
draw inferences about potential losses with a given degree of statistical
confidence. !or example on a given portfolio, it might be possible to show
that there is a >> per cent probability that a loss over any one'week period
will not exceed, say, M$ million.

M2324%M%3 +F M2R5% RI/5
1)1 RI/5 I*%3IFIC2I+3
All products and transaction should be analyzed for risks associated
with them. Ghile various risks associated with a standardized product
stands analyzed, that in case of a non'standard product needs to be
analyzed. Therefore, approach to deal in standard and non D standard
products differs. Ge have seen under general approach to risk management/
guidance for risk taking at the transaction level comes from the corporate
level. %t applies to the management of market risk also.
- 8sually all standard products would have Eproduct programmerF for each of
them. All risk taking units operate within an approved Eproduct
programmeF. 6roduct program defines procedures, limits I control for all
+9
aspects of the products. The product programme also specifies market risk
measurement at an individual product level and at aggregate portfolio level.
- Bew products or non'standard products may operate under a Eproduct
transaction memorandumF on a temporary basis while a full market risk
product programme is being prepared.
6roduct approved at corporate level shall provide for screening procedures.
Appropriate safe guards, product wise limit on exposure, and necessary
guidelines in risk taking. %n fact, the guidelines help in standardizing risk
content in the business undertaken at the transaction level.
1)2 RI/5 M%2/6R%M%3:
#arket risk management framework is heavily dependent upon
"uantitative measures of risk. The market risk measures seek to capture
variation in market value arising out of uncertainties associated with
various risk elements. These provide an ob.ective measure of market risk in
a transaction or of a portfolio. #arket risk measures are based on
'''' 7ensitivity
'''' *ownside potential
- /ensiti-it!:
7upply'demand position, interest rate, market li"uidity, inflation,
exchange rate, stock prices etc.., are the market parameters, which drive
market value .sensitivity is measured as change in market value due to unit
change in the variables.
- Basis point -a"ue :B(7;
+<
This is the change in value due to $ basis A?.?$J@ change in market
yield. This is used as a measure of risk. The higher the (6L is "uite simple.
- *uration :
This is e"uivalent to time, on average, that the holder of the bond must
wait to receive the cash flows. %n other words this represents cash flow
Ecentre of gravityF. %t implies that if a five year 9J bond face value of Rs
$?? with semi'annual interest has #c)auley1s duration say 0.< years, then
total cash flow to be received Rs $0? at the end of 0.< years as a bullet
payment.
- *ownside potentia" :
Risk materializes only when earnings deviate adversely. *ownside
potential only captures possible losses ignoring profit potential. *ownside
risk is the most comprehensive measures of risk as it integrates sensitivity
and volatility with the adverse effect of uncertainty. This is the measure that
is most relied upon by banking and financial service industry as also the
regulators.
1)3 RI/5 M+3I+RI34 23* C+3R+#:
Risk monitoring I control calls for implementation of risk and
business policies simultaneously. %t consist of setting market risk limits or
controlling market risk, based on economic measures of risk while ensuring
best risk ad.usted return. )ontrolling market risk means keeping the
variation of the value of a given portfolio within given boundary values
through actions on limits which are upper bounds imposed on risks. This is
achieved through the following3
$. 6olicy guideline limiting roles I authority.
+=
+. limits structure and approval process.
0. *efined policy for mark to market.
2. -imit monitoring and reporting.
5. 6erformance measurement and resource allocation
Role of risk measurement in controlling and monitoring involves setting up
of limits and triggers and monitoring them. Risk position should also be
reported to designated authority.
1)4 RI/5 MII42I+3 :
#arket risk arises due to volatility of financial instruments. The
volatility of financial instruments is instrumental for both profits and risk.
Risk mitigation in market risk i.e. reduction in market risk is achieved by
adopting strategies that eliminate or reduce the volatility of the portfolio.
&owever, there are couples of issues that are also associated with risk
mitigation measures.
- Risk mitigation measures aim to reduce downside variability in net cash
flow but it also reduces upside potential or profit potential simultaneously.
- %n addition, risk mitigation strategies, which involve counter party will
always be associated with counterparty risk. :f course, where counterparty
is an established ;exchange1, counterparty risk gets reduced very
substantially. %n :T) deals, counterparty risk would depend upon the risk
level associated with party to the contract.
+>
Chapter <
Credit Risk in Banking
I3R+*6CI+3
)redit risk is easily understandable. Ge all know that credit
risk arise from the lending activities of the bank. %t arises when a borrower
does not pay interest or installments as and when it falls due or in case
where a loan is repayable on demand, the borrower fails to make the
payment as and when demanded. This is the risk that arises from lending
activities.
)redit risk in banks not only arises in course of direct lending when funds
are not repaid, it also arises in course of issuing guarantees or letter of credit
when funds will not be forth coming upon crystallization of the liability, or
in the course of transactions involving treasury products when series of
payment due from the counterparty cease or are not forthcoming, or in case
of trading of securities if settlement is not effected or in case of cross border
exposure where free transfer of currency is restricted or ceases.

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*%F26# RI/5
*efault risk is driven by the potential failure of a borrower to make
promised payments, either partly or wholly. %n the event of default, a
fraction of the obligations will normally be paid. This is known as the
recovery rate.
' CR%*I /(R%2* RI/5 +R *+=34R2*% RI/5)
%f a borrower does not default, there is still risk due to worsening in
credit "uality. This result in the possible widening of the credit' spread.
This is credit spread risk. These may arise from a rating change.
-oans are not usually marked'to'market. )onse"uently, the only important
factor is whether or not the loan is in default today.
*efault risk and downgrade risks. Risks associated with credit portfolio as
a whole is termed portfolio risks. 6ortfolio risk has two components'
7ystematic or intrinsic risk
)oncentration risk
0$
$. 7ystematic or intrinsic risk
%f a portfolio is fully diversified across geographies, industries,
borrowers, markets, etc., e"uitable, then the portfolio risk is reduced to a
minimum level.
+. )oncentration risk
%f the portfolio is not diversified that is to say that it has higher
weight in respect of a borrower or geography or industry etc., the portfolio
gets concentration risk.
1)1 RI/5 M%2/6R%M%3:
#easurement of credit risk consist of
Aa@ #easurement of risk through credit ratingNscoring/
Ab@ 4uantifying the risk through estimating expected loan losses i.e. the
amount of loan losses that bank would experience over a chosen time
horizon Athrough tracking portfolio behavior over 5 or more years@ and the
unexpected loan losses i.e. the amount by which actual losses exceed the
expected loss Athrough standard deviation of losses or the difference
between expected loan losses and some selected target credit loss
"uintiles@.
0+
1)2CR%*I RI/5 C+3R+# 23* M+3I+RI34:
Risk taking through lending activities needs to be supported by a
very effective control and monitoring mechanism, firstly because this
activity is widespread, and secondly, because of very high share of credit
risk in the total risk taking activity of a bank.
)onse"uently, credit risk control and monitoring is directed both at
transaction level and portfolio level.
1)3 CR%*I RI/5 MII42I+3:
)redit risk mitigation is an essential part of credit risk management. This
refers to the process through which credit risk is reduced or it is transferred
to a counter party. 7trategies for risk reduction level differ from that sat
portfolio level.
At transaction level banks use a number of techni"ues to mitigate the credit
risks to which they are exposed, they are mostly traditional techni"ue and
need no elaboration. They are, for examples, exposures collateralized by
first priority claims, either in whole or in part, with cash or securities, or an
exposure guaranteed by a third party. Recent techni"ues include buying a
credit derivative to offset credit risk at transaction level.
00
At portfolio level, assets securitization, credit derivatives, etc. are used to
mitigate risks in the portfolio. They are also used to achieve desired
diversification in the portfolio as also to develop a portfolio with desired
characteristic. %t must be noted that while the use of )R# techni"ues
reduces or transfers credit risk, it simultaneously may increase other risk
such as legal, operational, li"uidity and market risk. Therefore, it is
imperative that banks employ robust procedures and processes to control
these risks as well. %n fact, advantage of risk mitigation must be weighed
against the risk ac"uired and its interaction with the bank1s overall risk
profile.
Chapter 1>
I3%R%/ R2% RI/5 I3 B235/:

The risk that an investment's value will change due to a
change in the absolute level of interest rates, in the spread between two rates,
in the shape of the yield curve or in any other interest rate relationship. 7uch
changes usually affect securities inversely and can be reduced by
diversifying Ainvesting in fixed'income securities with different durations@ or
hedging Ae.g. through an interest rate swap@
xposure to loss resulting from a change in interest rates.
&edging strategies are designed to minimize, possibly eliminate, interest'
rate risk. %nterest rate risk affects the value of bonds more directly than
stocks, and it is a ma.or risk to all bondholders. As interest rates rise, bond
02
prices fall and vice versa. The rationale is that as interest rates increase, the
opportunity cost of holding a bond decreases since investors are able to
realize greater yields by switching to other investments that reflect the
higher interest rate.
For e&amp"e, a 5J bond is worth more if interest rates decrease since the
bondholder receives a fixed rate of return relative to the market, which is
offering a lower rate of return as a result of the decrease in rates.
%nterest rate risk management is critical to the overall profitability of your
bank. ven if managing interest rate risk is not part of your day'to'day
responsibilities, if you oversee and manage the process, you need a clear,
definitive understanding of the issues so your bank can stay profitable.
&istorically, banks have offset the risk associated with funding
fixed rate loans with variable'rate assets, such as customer deposits, by
lengthening the duration of the bank's assets. To do this, a bank would
purchase fixed'rate government securities with maturities that correspond
with the expected maturities of the bank's fixed'rate loans. Assets ac"uired
to lengthen the duration of the bank's assets are commonly known as
Obalancing assets.O &owever, many banks have realized that the same goal is
achieved more efficiently by using derivatives to manage interest rate risk
)ollars.

05

Another method to manage interest rate risk is the OcostlessO collar.
A collar consists of an interest rate cap and floor, usually based on the
-ondon %nter'(ank :ffered Rate A-%(:R@. To enter into a collar, a bank
would simultaneously purchase an interest rate cap and sell an interest rate
floor in the derivatives market. An interest rate cap is a series of interest rate
call options set at the same exercise rate and that have expiration dates at
each point when the underlying liability Ain this case, customer deposits@ is
expected to reprise. :n the other hand, an interest rate floor is a series of
interest rate put options with the same exercise rate that have expiration
dates at each point when the underlying liability is expected to reprise. %f
interest rates rise, the interest rate cap calls for the seller of the cap to pay the
bank the difference of -%(:R and the predetermined cap rate. %f interest
rates fall, the interest rate floor calls for the bank to pay the buyer the
difference between the floor rate and -%(:R. Therefore, a bank knows its
future interest rate expense regardless of whether interest rates rise or fall.
The word costless means that the premium paid to purchase the interest rate
cap is roughly e"ual to the premium received on the floor, excluding
brokerage fees. (y entering into a collar, a bank is in neither a short nor a
long interest rate position in the derivatives market. %n a rising'interest'rate
environment, a bank that wants to offset only the interest rate risk associated
with rising interest rates could take a long position in the derivatives market
by purchasing only the interest rate cap. (y having a negative interest rate
gap, a bank would naturally be in a short interest rate position.
09
Chapter 11
+(%R2I+32# RI/5 I3 B235/:
The banking environment has dramatically changed in the recent
past. At times, the change was felt to be comforting/ more so, when it threw
open new opportunities. Bevertheless, more often than not its accompanying
risks were "uite threatening. :ne such all' pervasive risk that bank face is
operational risk. %t is one of the oldest risks that all along has been managed
"uite informally, but of late, has suddenly caught everyone1s attention for
reasons galore. The (asel committee, having identified operational risk as an
important risk faced by banks, proposed allocation of certain minimum
capital by banks to protect themselves from such losses. The (asel %%
directives for allocating capital against operational risk have further
enhanced banks interest in the operational risk.
0<

:perational risk is as old as banking. %t even precedes market and credit
risks, and yet there is no universally accepted definition of it. :perational
risk is often defined by what it is not3 Any risk that is not related to credit
market and li"uidity risk is identified as operational risk. *ifferent banks
perceive it in different ways as could be gauged from the following3
Any risk that is not categorized as market or credit risk/
Any risk of loss arising from various types of human or technical error/
Risk associated with settlement or payment risk and business interruption
and legal risk/
Risk of frauds by employees and outsiders/ unauthorized transaction by
employees and errors relating to computer and telecommunication
systems.
The potential exposure to missed opportunity or to unexpected financial
reputational or other damage resulting from the way in which an
organization operates and pursues its business ob.ectives.
0=

The (asel )ommittee on (anking 7upervision defined operational risk as
Ethe risk of loss resulting from inade"uate or failed internal processes,
people and systems or from external events.F This definition had indeed
captured the whole horizon of operational risk except for the critical
Ebusiness'strategic risk.F This definition excludes strategic and reputational
risk, but includes legal risk.
:perational risk arises due to inade"uate control systems,
operational problems and breaches in internal controls, fraud and unforeseen
catastrophes resulting in unexpected losses for the banks. #any of the
operational'risk related functions such as regulatory compliance, finance'
management, frauds, %T, legal and insurance are carried out by the staff and
thus human resources itself becomes a cause for operational risk. !inancial
losses could also arise from external events such as fires and other disasters.
:perational risk is perceived to be highly capable of impacting business
lines that have high volume and high turnover coupled with low'margins.
+perationa" Risk . /ources of Risk
0>
1 M2324%M%3 +F +(%R2I+32# RI/5
1)1 RI/5 M+3I+RI34 ? C+3R+# (R2IC%/
Risk monitoring and control practices encompass the following3
)ollection of operational risk data Aincident reporting framework@
Regular monitoring and feedback mechanism in place for monitoring
any deterioration in operational risk profile.
)ollation of incident reporting data to assess fre"uency and
probability of occurrence of operational risk events.
#onitoring and controlling of management of large exposures. The
modalities to be prescribed in the loan policy documents.
2?
:perational
Risk
(usiness
6rocesses
6eople
)onstant
)hange
)ontrol
7ystems
%T7 7ystems
(usiness
7trategy
(usiness
nvironment
1)2 +(%R2I+32# RI/5 MII42I+3
The mitigation of operational risk basically lies in the "ualitative approach
in operational risk framework adopted and its implementation.
%nsurance cover, where available, may provide mitigation of risk. )apital
allowance under insurance is available only where A#A has adopted
estimating capital for operational risk and is sub.ect to certain conditions.
E8nder the A#A, a bank will be allowed to recognize the risk mitigation
impact of insurance in the measures of operational risk used for regulatory
minimum capital re"uirements. The recognition of insurance mitigation will
be limited to +?J of the total operational risk capital charge calculated
under the A#A. A bank1s ability to take advantage of such risk mitigation
will depend on compliance with the few criteriaF.
Chapter 12
F+R%I43 %@CA234% RI/5
Foreign %&change Risk maybe defined as the risk that a bank may
suffer losses as a result of adverse exchange rate movements during a period
in which it has an open positionB either spot or forward, or a combination of
the two, in an individual foreign currency.
The banks are also exposed to interest rate risk, which arises from the
maturity mismatching of foreign currency positions. ven in cases where
spot and forward positions in individual currencies are balanced, the
maturity pattern of forward transactions may produce mismatches. As a
result, banks may suffer losses as a result of changes in premiaNdiscounts of
the currencies concerned.
2$
%n the forex business, banks also face the risk of default of the
counterparties or settlement risk. Ghile such type of risk crystallisation
does not cause principal loss, banks may have to undertake fresh
transactions in the cashNspot market for replacing the failed transactions.
Thus, banks may incur replacement cost, which depends upon the currency
rate movements. (anks also face another risk called time'zone risk or
&erstatt risk which arises out of time'lags in settlement of one currency in
one centre and the settlement of another currency in another time'zone. The
forex transactions with counterparties from another country also trigger
sovereign or country risk Adealt with in details in the guidance note on credit
risk@.
The three important issues that need to be addressed in this regard are3
Bature and magnitude of exchange risk
The strategy to be adopted for hedging or managing exchange risk.
The tools of managing exchange risk.
2+

3ature and Magnitude of Risk
The first aspect of management of foreign exchange risk is to
acknowledge that such risk does exist and that it must be managed to avoid
adverse financial conse"uences. #any banks refrain from active
management of their foreign exchange exposure because they feel that
financial forecasting is outside their field of expertise or because they find it
difficult to measure currency exposure precisely. &owever not recognising a
risk would not make it go away. Bor is the inability to measure risk any
excuse for not managing it. &aving recognized this fact the nature and
magnitude of such risk must now be identified.
The basic difficulty in measuring exposure comes from the fact that
available accounting information which provides the most reliable base to
calculate exposure Aaccounting or translation exposure@ does not capture the
actual risk a bank faces, which depends on its future cash flows and their
associated risk profiles Aeconomic exposure@. Also there is the distinction
20
between the currency in which cash flows are denominated and the currency
that determines the size of the cash flows.
For e&amp"e. A borrower selling .ewellery in urope may keep its records
in Rupees, invoice in uros, and collect uro cash flow, only to find that its
revenue stream behaves as if it were in 8.7. dollarsP This occurs because
uro'prices for the exports might ad.ust to reflect world market prices which
could be determined in 8.7. dollars.
!or a bank, being a financial entity, it is relatively easier to gauge the
nature as well as the measure of forex risk simply because all financial
assetsNliabilities are denominated in a currency. A bank1s future cash streams
are more predictable than those of a non'financial firm. %ts net exposure, or
position, completely encapsulates the measure of its exposure to forex risk.
%n order to manage forex risk some forex market relationships need to
be understood well. The first and most important of these is the covered
interest parity relationship. %f there is free and unrestricted mobility of
capital, the interest differential between two currencies will e"ual the
forward premiumNdiscount for either of the currency. This relationship must
hold under the assumptions/ otherwise arbitrage opportunities will arise to
restore the relationship. &owever, in the case of Rupee, since it is not totally
convertible, this relationship does not hold exactly. Although interest rate
differentials are the driving factor for the *ollar premium against the Rupee,
it also is a factor of forward demand N supply factors. This brings in typical
complications to forward hedging which must be taken into account.
22
!rom the above it can easily be determined that a currency with a
lower interest rate will be at a premium to a currency with a higher interest
rate. The other relationships in the forex market are not as deterministic as
the covered interest parity, but needs to be recognised to manage forex
exposure because they are the theoretical tools used for predicting exchange
rate movements, essential to any hedging strategy particularly to economic
risk as opposed to accounting risk. The most important of these is the
6urchasing 6ower 6arity relationship which says exchange rate changes are
determined by inflation differentials. The 8ncovered %nterest 6arity theory
says that the forward exchange rate is the best and unbiased predictor of
future spot rates under risk neutrality. These relationships have to be clearly
understood for any meaningful forex risk management process.
Managing Foreign %&change Risk
!or a bank therefore the first ma.or decision on forex risk
management is for the management to fix its open foreign exchange position
limits. Although typically this is a management decision, it could also be
sub.ect to regulatory capital and could also be re"uired to be in tune with the
regulatory environment that prevails. These open position limits have two
aspects, the *a!"ight "imit and the +-ernight "imit. The daylight limit
could typically be substantially higher for two reasons, Aa@ %t is easier to
manage exchange risk when the market is open and the bank is actively
present in the market and Ab@ the bank needs a higher limit to accommodate
25
client flows during business hours. :vernight position, being sub.ect to more
uncertainty and therefore being more risky should be much lower.
&aving decided on the overall open position limits, the next step is to
allocate these limits among different operating centres of the bank Ain the
case of banks which hold positions at multiple centres@. Githin a centre there
could be a further allocation among different dealers. %t must however be
ensured that the bank has a system to monitor the overall open position limit
for the bank on a rea" time basis.
oo"s and echni$ues for managing fore& risk
There are various tools, often substitutes, available for hedging of
foreign exchange risk like over the counter forwards, futures, money market
instruments, options and the like. #ost currency management instruments
enable the bank to take a long or a short position to hedge an opposite short
or long position. %n e"uilibrium and in an efficient market the cost of all will
be the same, according to the fundamental relationships. The tools differ to
the extent that they hedge different risks. %n particular, symmetric hedging
tools like futures cannot easily hedge contingent cash flows where risk is
non'linear3 options may be better suited to the latter.
Risk Contro" /!stems 3
The management of the bank need to lay out clear and unambiguous
performance measurement criteria, accountability norms and financial limits
in its treasury operations. #anagement must specify in operational terms the
goals of exchange risk management. %t must also clearly recognise the risks
29
of trading arising from open positions, credit risks, and operations risks. The
bank must also keep in place a system to independently evaluate through
marking to market the net positions taken. #arking to market should ideally
be based on ob.ective market prices provided by an external agency. All
position limits should be made explicit and expressed in simple terms for
easy control.
Chapter 13
2<
Current state of Risk management practices in
Indian banks:.
#ost of the banks do not have dedicated risk management
team, policy, procedures and framework in place. Those banks have risk
management department, the risk manager1s role is restricted to prefect and
post fact analysis of customer1s credit and there is no segregation of credit,
market, operational and strategic risks. There are few banks have articulated
framework and risk "uantification. &owever, the outputs are far formatting
the stressed or actual losses due to usage of un'compatible implications.
The traditional lending practices, assessment of credits, handling of
market risks, treasury functionality and culture of risk'rewards are hauls of
public sector banks.
The sheer size and wide coverage of banks is a big hurdle to
integrate and generate a cost effective real time operational data for mapping
the risks. #ost of the financial institutions processes are encircled to
;functional silos1 follows bureaucratic structure and yet to come up with a
transparent and appropriate corporate governance structure to achieve the
stated strategic good artivle
Chapter 14
2=
Risk Management in Future
The bank of the future will be recognized around a new vision. To
succeed, it will have to be able to respond to opportunities as they present
themselves. And it will have to strive to improve the portfolio management
of its balance sheet and capital.
To manage conflicting ob.ectives, it will need to determine a number
of policy variables such as a target risk'ad.usted rate of returns ARAR:)@,
target regulatory return, target tier $ ratio, target li"uidity, and so on.
%n turn, this will mean transforming the risk management function. Risk
management will need to encompass limit management, risk analysis,
RAR:), and active portfolio management of risk AA6#R@. These changes
in the risk management will be induced by3
$. Advances in technology
+. %ntroduction of more sophisticated regulatory measures
0. Rapidly accelerating market forces
2. )omplex legal environment
Chapter 1'
2>
C2/% /6*8:
ICICI Bank-
Risk management is a key focus area at ICICI Bank
Risk management is a key focus area at %)%)% (ank and viewed as a
strategic tool for competitive advantage. %n the %ndian context %)%)% (ank
has been doing pioneering work in this area since $>>9, when a specialized
risk management group was set up within the (ank.
R)A, is a centralized group based at #umbai with the
responsibility of enterprise wide risk management. R)A, is headed by a
senior executive of the rank of ,eneral #anager who reports to the
xecutive *irector A)orporate )entre@. The philosophy at %)%)% (ank is to
have a separate risk management group Aindependent of the business group@
whose mandate is to analyses, measure, and monitor and manage risks. Risk
management is done under the overall supervision of the (oard of *irectors
and sub committees of the (oard ' Risk )ommittee, )redit )ommittee and
Audit )ommittee.

5?
RC24 is comprised of si& groups C
Corporate Credit RiskB
Retai" RiskB
Market RiskB
Credit (o"icies ?
Comp"ianceB
Risk 2na"!tics and
Interna" 2udit
Corporate Credit Risk ,roup carries out analysis of various industries
and does a credit rating of each borrowerN transaction in the portfolio.
The group has evolved risk analysis and rating methodologies suitable for
various industriesN products, including structured finance products. These
methodologies have been developed through a combination of rigorous
internal analysis and extensive interaction with domestic and
international rating agencies. ach analyst in the group tracks a few
industries and the prospects of the companies within that industry. very
proposal has to be rated by the )redit Risk ,roup prior to sanction. The
(ank's portfolio is fully rated internally and risk based pricing
methodology for credit products has been implemented, which is a
significant achievement in the emerging markets context.
The retai" portfo"io of the (ank comprises a wide range of products
including auto loans, housing loans, construction e"uipment, commercial
5$
vehicles, two wheelers, credit cards etc. Retail Risk ,roup is responsible
for approving all product policies and monitoring the performance of the
retail portfolio. Approval of this group is mandatory before any product
policy is referred to the management. Analysis of the portfolio is done on
a regular basis across products, geographic locations etc.
Market risk group analyses the interest rate risk, li"uidity risk, foreign
exchange risk and commodity risk. )ontemporary tools such as gap
analysis, duration, convexity and Lalue at Risk ALAR@ are used to
manage market risks. This group also works on limit setting and
monitoring adherence to the limits.
Credit (o"icies ? Comp"iance ,roup is responsible for design and
review of all credit policies, ensuring regulatory compliance in all
activities of the (ank and coordinating the inspections of Reserve (ank
of %ndia.
Risk 2na"!tics ,roup provides the "uantitative analysis and modeling
support for risk management. This group is working on areas such as
analysis of default rates, loss rates/ risk based pricing, economic capital
allocation and portfolio modeling. The group consists of analysts with a
strong academic background and work experience in "uantitative
analysis.
Interna" 2udit is responsible for managing :perational risk, which is an
area of significant importance in a large, growing organization with
multiple products such as %)%)% (ank. Gith the growth of retail business
and introduction of technology based products, the challenges on this
5+
group have increased. The %nternal Audit ,roup has developed a
sophisticated methodology for conducting risk based audit, is e"uipped to
handle %7 Audit and has obtained %7: >??$ certification.
%)%)% bank is at the forefront of evolving and implementing risk
management concepts in the %ndian context. There is a constant endeavor
towards further improvement and benchmarking with international best
practices. The bank focuses on providing training, learning opportunities
to facilitate the move towards implementation of global best practices in
risk management. The analysts from R)A, undergo training provided by
renowned experts within %ndia as well as overseas. R)A, regularly
deputes analysts to specialized seminars and facilitates networking with
international risk management experts in rating agencies, banks etc.
The desired key attributes for analysts in R)A, are ' strong conceptual
knowledge, ability to identify and analyze key issues, spot trends and
interlink ages between issues, take a logical, independent position under
pressure and communication skills.
50
Chapter 10
Conc"usion:
Risk is an opportunity as well as a threat and has different
meanings for different users. The banking industry is exposed to different
risks such as forex volatility risk, variable interest rate risk, market play risk,
operational risks, credit risk etc. which can adversely affect its profitability
and financial health.
Risk management has thus emerged as a new and challenging area
in banking. (asel %% intended to improve safety and soundness of the
financial system by placing increased emphasis on bank's own internal
control and risk management process and models. The supervisory review
and market discipline. %ndeed, to enable the calculation of capital
re"uirements under the new accord re"uires a bank to implement a
comprehensive risk management framework. :ver a period of time, the risk
management improvements that are the intended result may be rewarded by
lower capital re"uirements.
&owever, these changes will also have wide'ranging effects on a
bank's information technology systems, process, people and business,
beyond and regulatory compliance, risk management and finance function.
52
Chapter 11
Recommendations:
(anks should have a strong risk management solution because they are
the backbone of the economy.
(anks should have a comprehensive risk scoring rating system that
serves as a single point indicator of diversed risk factor of a
borrowerNcounter party and for taking credit decisions in a consistent
manner.
*eregulation increased competition between players unprepared by
their past experience thereby resulting in increasing risks of the system.
Therefore, they have to be regulated strongly.
The risk rating system should be drawn up in a structured manner,
incorporating, financial analysis, pro.ection and sensitivity, industrial
and management risks.
%ndian banks need to strengthen their risk management systems to better
deal with li"uidity risks and those arising out of off'balance sheet and
derivatives deals.
%n the coming years, banks need to strengthen their risk management
framework in view of the domestic and international developments,
particularly in emerging areas of risks.
55
Bib"iograph!:
Book
Risk management by %ndian institute of banking and finance'
A.ay Kumar, *.6. )hatter.ee,

Risk management '$ by Association of certified Treasury.
Risk #anagement in (anks.
%ndian !inancial 7ystems.
=ebsites:
www.rbi.org
www.idbibank.com
www.icicibank.com
www.marketingteacher.com
www.financialQedu.com

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