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Submitted in Partial Fulfillment of The Requirement For The Award of Degree of
Submitted in Partial Fulfillment of The Requirement For The Award of Degree of
ON
COMPARATIVE STUDY:
“RISK MANAGEMENT IN BANKS”
I have taken considerable help and support in making this project report a reality.
First and foremost, I would like to thank my respectable and learned guide Mr. Ashu
Jain for whose untiring, persevering and unflinching help, this project would not have
seen the light of day. It was he who initiated the development of the project and was
thus instrumental in showing the right direction in the field of operation in practice.
He provided encouragement and boost in the transformation of my inherent internal
knowledge into a real work for external audience. He mustered internal support and
sponsorship that I needed to make this a reality. has always been a key discussion
partner friend, a philosopher, and guide for me. I am thankful to him for seeing me
through such a rough weather.
The realization of this project marks the beginning of an ever - growing and valuable
learning experience in my life. Throughout the period of this project every day was a
new turning point in my career. It would be worthwhile here to mention the
contributions made by people around me which lead to the successful completion of
this project. I express my gratitude for all that I have learnt so far and continue
learning with each passing day.
Lastly, I would like to bestow my special regards and gratitude to the , a premier
management institute of the country, for creating a knowledge building culture in me
and vocal supporter for creating a strong marketing knowledge and corporate
financial foundation.
ii
PREFACE
Risk Management underscores the fact that the survival of an organisation depends
heavily on its capabilities to anticipate and prepare for the change rather than just
waiting for the change and react to it. The objective of risk management is not to
prohibit or prevent risk taking activity but to ensure that the risks are consciously
taken with full knowledge, clear purpose and understanding so that it can be
measured and mitigated.
The present study is on Risk Management in Banks. The core of the study is to
analyze various kinds of risk i.e credit, interest rate, liquidity and operational risk and
how to measure and monitor these risk. The study undertakes sample of six banks,
which includes both public and private sector.
The entire dissertation has been divided into nine chapters. The first chapter contains
discussion on the meaning and concept of risk, risk management, its functions, types
of risk, RBI guidelines. Chapter Second contains the Research Methodology, which
includes need, objective, significance of study. The Third chapter contains profiles of
State Bank of India, ICICI BANK, CENTRAL BANK OF INDIA, HDFC BANK,
ORIENTAL BANK OF COMMERCE AND IDBI BANK. In the forth, fifth and
sixth chapter analyses of credit risk, market risk and operational risk is undertaken.
Basel II norms and Risk Based Supervision Requirements are discussed in seventh
chapter. Analysis of survey responses and profitability analysis, which is the central
point of financial analysis, is included in eighth chapter. Chapter ninth presents the
major findings of the study with some concluding remarks.
iii
CONTENTS
Acknowledgement……………………………………………………….ii
Certificate………………………………………………...……………..iii
Preface ……………………………………………………………....…..iv
Chapter I INTRODUCTION...................................................................1-13
(a) Introduction
(b) Meaning of Risk and Risk Management
(c) Risk management Structure
(d) Risk management Components
(e) Steps for implementing risk management in bank
(f) Types of risks
(g) RBI Guidelines on risk management
Chapter II RESEARCH METHODOLOGY ..........................................14-22
(a) Need of Study
(b) Objective of Study
(c) Significance of Study
(d) Scope of Study
(e) Research Design
(f) Data Collection
(g) Techniques of Analysis
(h) Limitations of Study
Chapter III BANKS PROFILE .............................................................23-28
Chapter IV CREDIT RISK MANAGEMENT.....................................29-40
a (a) Meaning of Credit Risk
(b) Objectives of Credit Risk Management
(c) Instruments of Credit Risk Management
(d) Methods for Measuring Credit Risk
(e) Strategies for Managing Credit Risk
iv
Chapter V MARKET RISK MANAGEMENT...............................41-60
(a) Meaning of Market Risk
(b) Meaning of Liquidity Risk
(c) Methods for measuring Liquidity Risk
(d) Strategies for Managing Liquidity Risk
(e) Meaning of Interest Rate Risk
(f) Methods for measuring Interest Rate Risk
(g) Strategies for managing Interest Rate Risk
Chapter VI OPERATIONAL RISK MANAGEMENT.........................61-67
(a) Definition of Operational Risk
(b) Risk Mapping/Profiling
(c) Measuring Operational Risk
(d) Mitigating Operational Risk
(e) Capital Budgeting for Operational Risk
Chapter VII BASEL II COMPLIANCE................................................68-75
(a) Three pillar approach
(b) Reservation about Basel II
Risk Based Supervision Requirement
(a) Background
(b) Risk based supervision – a new approach
(c) Features of RBS approach
Chapter VIII ANALYSIS OF SURVEY RESPONSES.......................76-83
Chapter IX OBSERVATION AND SUGGESTIONS..........................84-89
(a) Major Findings of Study
(b) Suggestions
ANNEXURES.....................................................................................90-97
QUESTIONNAIRE..............................................................................98-99
BIBLIOGRAPHY ..................................................................................100
v
CHAPTER - I
INTRODUCTION
1
The financial sector especially the banking industry in most emerging economies
including India is passing through a process of change .As the financial activity has
become a major economic activity in most economies, any disruption or imbalance in
its infrastructure will have significant impact on the entire economy. By developing a
sound financial system the banking industry can bring stability within financial
markets.
Deregulation in the financial sector had widened the product range in the developed
market. Some of the new products introduced are LBOs, credit cards, housing
finance, derivatives and various off balance sheet items. Thus new vistas have
created multiple sources for banks to generate higher profits than the traditional
financial intermediation. Simultaneously they have opened new areas of risks also.
During the past decade, the Indian banking industry continued to respond to the
emerging challenges of competition, risks and uncertainties. Risks originate in the
forms of customer default, funding a gap or adverse movements of markets.
Measuring and quantifying risks in neither easy nor intuitive. Our regulators have
made some sincere attempts to bring prudential and supervisory norms conforming to
international bank practices with an intention to strengthen the stability of the
banking system.
The etymology of the word ‘Risk’ is traced to the Latin word ‘Rescum’ meaning
Risk at sea or that which cuts. Risk is an unplanned event with financial
consequences resulting in loss or reduced earnings. It stems from uncertainty or
unpredictability of the future. Therefore, a risky proposition is one with potential
profit or a looming loss.
2
Source: James T Gleason, 2001
Risk is the potentiality of both expected and unexpected events which have an
adverse impact on bank capital or earnings. In one of the publications Price
Waterhouse Cooper has interpreted the word risk in two distinct senses.
Risk as Hazard:
“Danger; (exposure to) the possibility of loss, injury or other adverse circumstance.
Exposure to the possibility of commercial loss apart of economic enterprise and the
source of entrepreneurial profit.”
3
Risk as Opportunity:
Till recently all the activities of banks are regulated and hence operational
environment was not conducive to risk taking. Better insight sharp intuition and
longer experience were adequate to manage the limited risks. Risk is inherent in any
walk of life in general and in financial sectors in particular. Of late, banks have
grown from being a financial intermediary into a risk intermediary at process. In the
process of financial intermediation, the gap of which becomes thinner and thinner
banks are exposed to severe competition and are compelled to encounter various
types 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. Thus, top
management of banks attach considerable importance to improve the ability to
identify, measure, monitor and control the overall level of risks undertaken.
1. Organizational structure.
4
consistent with the broader business strategies, capital strength, management
expertise and overall willingness to assume risk.
4. Guidelines and other parameters used to govern risk taking including detailed
structure of prudential limits.
6. Well laid out procedures, effective control and comprehensive risk reporting
framework.
5
Risk Management Structure:
6
Risk Management: Components
The process of risk management has three identifiable steps viz. Risk identification,
Risk measurement, and Risk control.
Risk Identification
• Risk Measurement
The second step in risk management process is the risk measurement or risk
assessment. Risk assessment is the essemination of the size probability and timing of
a potential loss under various scenarios. This is the most difficult step in the risk
management process and the methods, degree of sophistication and costs vary
greatly. The potential loss is generally defined in terms of ‘Frequency’ and
‘Severity’.
Risk Control
After identification and assessment of risk factors, the next step involved is risk
control. The major alternatives available in risk control are:
7
♦ Steps for implementing Risk Management in Banks
2) Risk Identification
The second step is identification of risks, which is carried out to assess the current
level of risk management processes, structure, technology and analytical
sophistication at the bank. Typically banks distinguish the following risk categories:
- Credit risk
- Market risk
- Operational risk
Bank roll out a customized benchmark index based on its vision and risk
management strategy. Then it develops a score for the current level of bank risk
practices that already exists. For example assuming that the current risks
management score is 30 out of 100. For the gap in score of 70 roadmap is developed
for achieving the milestones.
4) Defining Roadmap
Based on the target risk management strategy/gap analysis bank develops unique
work plans with quantifiable benefits for achieving sustainable competitive
advantage.
b. Basel II compliance
8
c. Using risk strategy in the decision making process
Capital allocation
Provisioning
Pricing of products
By rolling out the action steps in phases the bank measure the progress of the
implementation.
Depending on the lines of business as reflected in bank balance sheet and business
plans, the relative importance of market, credit and operational risk in each line of
activity is determined The process workflow organisation, risk control and mitigation
procedures for each activity line is to be provided.
The objective is to integrate risk management into business decision making process
which evolves risk culture through awareness and training, development of
integrated risk reports and success measures and alignment of risk and business
strategies.
9
Types of Risks
Regulatory Risks: It is the risk in which firm’s earnings value and cash
flows is influenced adversely by unanticipated changes in regulation such as
legal requirements and accounting rules.
Market Risks: Market Risk is the risk to the bank’s earnings and capital
due to changes in the market level of interest rates or prices of securities,
foreign exchange equities as well as volatilities of prices.
10
• Interest Rate Risk: It is the potential negative impact on the Net
Interest Income and refers to vulnerability of an institution’s financial;
condition to the movement in interest rates.
• Forex Risks: It is the risk that a bank suffer loss due to adverse
exchange rate movement during a period in which it has an open
position either spot or forward both in same foreign currency.
Moreover, banks now a days seek services of Global Consultants like KPMG,
PricewaterhouseCoopers (PwC), Tata Consultancy Services (TCS), Boston
Consulting Group (BCG), The Credit Rating and Investment Services of India Ltd.
(Crisil), I – Flex Solutions and Infosys Technologies who have vast experience in
risk modelling as these players identify the gap in the system and help the banks in
devising a risk return model.
11
OPTIMIZING THE RISK RETURN
EQUATION
Profits
Losses
DEGREE OF RISK
RBI has issued guidelines from time to time, which are being implemented by banks
through various committees.
12
(b) For integrated management of risk there must be single risk management
committee.
(e) For measurement of market risk banks are advised to develop expertise in
internal models
(g) Banks should upgrade credit risk management system to optimize use of
capital.
(h) Banks are advised by RBI to initiate action in five specific areas to prepare
themselves for risk based supervision. One of the five specific areas is
effective Risk Management Architecture to ensure adequate internal risk
management practices.
(i) The limits to sensitive sectors like advances against equity shares, real estates
which are subject to a high degree of asset price volatility as well as to
specific industries which are subject to frequent business cycles should be
restricted. Similarly, high-risk industries as perceived by the bank should be
placed under lower portfolio limit.
(j) To enhance risk management function banks should move towards risk based
supervision and risk focussed internal audit.
13
CHAPTER - II
RESEARCH METHODOLOGY
14
♦ Need of the Study
Necessity of the banks to respond to the array of new and more complex risks
caused by:
- Globalization
- Downsizing
- Regulatory changes
15
♦ Objectives of the Study
The following objective have been fix for making thus study:
- Credit Risk
- Market risk, which includes Liquidity risk and Interest rate risk
- Operational risk
6. To study about the Risk Management approach adopted by six banks, which
includes banks in both public as well as private sector.
value creation
value preservation
capital optimization
16
Enhance capital allocation.
Corporate Reputation.
Risk is intrinsic to banking business as the major risks confronting banks are credit
risk, interest rate risk, liquidity risk and operational risk. Irrespective of the nature of
the risk the best way for banks to protect themselves is to identify risk, accurately
measure, price it and maintain appropriate levels of reserves and capital. If Indian
banks are to compete globally then they have to institute sound and robust risk
management practices, which will improve efficiency of banks.
The scope of this study involves analyzing and measuring major risks i.e credit risk,
liquidity risk, interest rate risk and operational risk of six banks (public and private
sector). The present study evaluates key performance indicators of various banks in
terms of credit deposit ratio, net interest margin, spread, overhead efficiency, Gap
analysis and maturity ladder. While putting the risk management in place banks often
find it difficult to collect reliable data. The challenge is mainly in the area of
operational risk where there is dearth of reliable historic data and not a great deal of
clarity on the measurement of such risk.
17
Data Collection
Primary Research
‘Questionnaire’ has been prepared and sent to selected six banks to ascertain their
degree of readiness for risk management on various parameters and information is
collected through in depth interview of senior officers and employees of six banks.
Secondary Sources
Sample Size
The sample comprises of six banks both in public as well as private sector. The banks
are selected on the basis of their net profit during the year. Following banks are
included in the sample size (Business India; August 2005) which are shown in
sequence from high profit banks to low profit banks.
18
The study is divided into following chapters.
1. Introduction
2. Research Methodology
3. Bank Profiles
♦ Research Design
A research design is the arrangement of conditions for collection and analysis of data
in a manner that aims to combine relevance to the research purpose with economy in
procedure. In fact, the research design is the conceptual structure within which
research is conducted. It constitutes the framework for the collection, measurement
and analysis of data. It provides the empirical and logical basis for getting knowledge
and drawing conclusions.
The research design in the study is of exploratory research. Various methods are
utilized in order to gain the information and to interpret it in most rational and
objective manner.
19
Techniques of Analysis
Ratio Analysis
Where short term assets = Cash & Bank Balance + Receivable + Bills Receivable
+ short term /demand advances
• Credit Deposit Ratio: Higher deposit ratio indicates poor liquidity position
of a bank & vice versa. The ratio is calculated as follows:
• Net Interest Margin : Net Interest Income/Earning Assets where Net Interest
Income = Total Interest Income – Total Interest Expenses
Earning Assets = All Interest earning assets (Total Assets – Cash Balances -
Fixed Assets - Other Asset)
20
• Spread = Yield – Cost of funds
Net profit after interest, tax and Preference dividend /Equity Shareholders Funds.
This ratio strengthens the capital base of bank. The paid up capital reserves of
bank form an adequate percentage of assets of banks, their investments, loans and
advances. All these items are assigned weights according to prescribed risks and
the ratio so computed is known as capital adequacy ratio.
• Burden/Spread
where Burden is the Net Non Interest Income and Spread is the Net
Interest Expense
Gap Analysis
Maturity Ladder
21
Limitations of the Study
However, I have made every possible effort at my great extent level to show how
selected sample of banks analyse the major risks i.e credit, market and operational
risks. But the study at the disposal of a researcher on this level is limited. In addition
to other factor such as time that plays a very important role in every field of today’s
life has also an important bearing on research work. The main limitations of the
present study are as follows:
All data and information collected is true to some specific period of time.
The study hasn’t got the wider scope as only six banks are being considered for
evaluating risk management.
It was difficult to have group discussions with experts due to their busy
schedules.
22
CHAPTER – III
BANKS PROFILE
23
The origin of the State Bank of India goes back to the
first decade of the nineteenth century with the
establishment of the Bank of Calcutta in
Calcutta on 2nd June, 1806.Three years later
the bank received its charter and was redesigned as the Bank of Bengal (2nd
January 1809). A unique institution it was the first joint stock bank of British
India sponsored by the government of Bengal/The Bank of Bombay (15th
April, 1840 and the Bank of Madras (1 July, 1843) followed the Bank of
Bengal. These three banks remained at the apex of modern banking in India
till their amalgamation as the Imperial Bank of India on 27 January, 1921.An
act was accordingly passed in Parliament in May, 1955 and the State Bank of
India was constituted on 1 July, 1955. More than a quarter of the resources of
the Indian banking system thus passed under the direct control of the state.
Later, the State Bank of India (Subsidiary Banks) Act was passed in 1959
enabling the State Bank of India to take over eight former State associated
banks as its subsidiaries. The State Bank of India was thus born with a new
sense of social purpose aided by the 480 offices comprising branches, sub
offices and three local head offices inherited from Imperial Bank.
The Bank’s aim is to reach global best standards in the area of risk management and
to ensure that risk management processes are sufficiently robust and efficient. The
Risk Management Committee of the board overseas the policy and strategy for
integrated risk management relating to various risk exposures of the bank & Credit
Risk Management Committee (CRMC) monitors banks domestic credit portfolio.
Moreover SBI has developed sensitive tools to hedge and minimize the risk arising
out of movements in interest rates. The Bank is using “Risk Manager” module (part
of the ALM software) to strengthen the processes of risk management an operational
risk management policy duly approved by central board of the bank is in place. The
bank has an in built internal control system with well-defined responsibilities at each
level. (RFIA) Risk Focused Internal Audit, an adjunct to risk based supervision has
been introduced in the banks audit system on 1.4.03.Duly aligned with (RFIA) the
Credit audit examines probability of default and suggests risk mitigation measures.
24
ICICI Bank is among largest private sector
banks in country. It was established on
Jan 5, 1955 to assist industrial
enterprises in private sector. Its excellent performance is a result of its
increase client focus and ability to structure financial solutions that meet
client specific ends. New products, new services, new organisation structures
and new business models have been the hallmarks of ICICI business strategy.
Risk is an integral part of the banking business and ICICI bank aim at
delivery of superior shareholder value but an achieving an appropriate
tradeoff between risk returns. The policies and procedures established for this
purpose are continuously benchmarked with international best practices. A
comprehensive range of quantitative and modelling tools are developed by
dedicated risk analytic team that supports the risk management function. The
risk management group, the compliance and audit group that are responsible
for assessment, management and mitigation of risk in ICICI bank. These
groups form a part of Corporate Center is completely independent of all
business operations and is accountable to the Risk and Audit Committees of
the Board of Directors. RMG is further organised into Credit Risk
Management Group, Market Risk Management group, Retail Risk
Management group and Risk Analytics group. CAG is further organised into
credit policies, RBI Inspection and Anti- Laundering Group and Internal
Audit Group.
25
The Housing Development Finance Corporation Limited (HDFC) was amongst the
first to receive an in –principle approval from Reserve Bank of India (RBI) to set up
a bank in the private sector as part of RBI’s liberalisation of the Indian banking
industry in 1994. The bank was incorporated in August, 1994 in the name of HDFC
Bank Limited with its registered office in Mumbai, India. HDFC Bank commenced
its operations as a scheduled commercial bank in January, 1995.
To implement the effective strategy in risk management HDFC Bank has distinct
policies and processes in place for the wholesale and retail asset business. For
wholesale credit exposures management of credit risk is done through target market
definition, appropriate credit approval processes, ongoing post disbursement
monitoring and remedial management procedures. Overall portfolio diversification
and reviews also facilitate risk management in the bank.
OBC has put in place an independent Risk Management System in the Bank and Risk
Management Committee of the Board of Directors and top executives of the Bank
oversees its implementation. The credit risk management policy for the Bank is
framed and implemented which includes exposure limits for Single/Group Borrower;
26
Sector-wise, Industry-wise, Exposure to Capital Market, un-secured exposure and
lays down thrust areas and restricted areas of lending. The Bank has put in place
Credit Risk Rating Models for rating of Large Corporate Borrowers and Retail
Loans. Intensive training is imparted to the field functionaries in respect of rating
models. The structural liquidity and interest rate sensitivity position of the bank is
prepared and analyzed on fortnightly basis. OBC has strengthened the internal
control system through simplification of documentation procedures and revision in
the audit procedures, updating operational manuals and implementation of related
strategies and monitoring of their efficacy. There has also been considerable progress
with regard to implementation of Risk Based Internal Audit in the Bank.
A few of such institutions built by IDBI are The National Stock Exchange (NSE),
The National Depository Services Ltd. (NSDL), Stock Holding Corporation OF India
(SHCIL) etc. IDBI is a strategic investor in a plethora of institutions, which have
revolutionized the Indian financial markets. IDBI promoted IDBI bank to mark the
formal array of the IDBI group into commercial banking. The initiative has
blossomed into a major success story, IDBI bank which began with an equity capital
base of Rs 1000 million (Rs 800 million contributed by IDBI and Rs 200 million by
SIDBI), commenced its first branch at Indore in November, 1995. Thereafter in less
than seven years the bank has attained a front ranking position in the Indian Banking
Industry.
IDBI Bank successfully completed its public issue in February, 1999 which led to its
paid up capital expanding to Rs 1400 million.
27
IDBI has deployed optimum resources in developing & implementing risk analytics
to more finely assessing the quantum and severity of all types of risks such as credit,
market and operational risk. The corporate credit rating system has developed
significant degree of stability and is supplemented with an internally developed
facility-rating model. As bank rating and scoring models effectively manage the risk
of individual/credit portfolio. VaR (Value at risk) technique is used by IDBI for
measuring market risk on the balance sheet in respect of government securities and
other traded portfolio. It has centrally controlled & an independent Internal Audit
Department that maintains a risk based focus, which evaluates adequacy and
effectiveness of internal controls for various business and operational activities
within bank.
28
CHAPTER - IV
CREDIT RISK MANAGEMENT
29
Credit Risk is the possibility of default due to nonpayment or delayed payment.
Hence, it is defined by the losses in the event of default of the borrower to repay his
obligations or in the event of a deterioration of the borrower’s credit quality. In a
banks portfolio, losses stem from outright default due to inability or unwillingness of
a customer or counter party to meet commitments in relating to lending, trading,
settlement and other financial transactions. Credit risk is inherent to the business of
lending funds to the operations linked closely to market risk variables. It consists of
two components Quantity of risk, which is outstanding loan balance as on the date of
default and Quality of risk, which is severity of loss, defined by the recoveries that
could be made in the event of default. It is a combined outcome of Default risk and
Portfolio Risk. The elements of credit risk in portfolio risk comprise of Intrinsic risk
and Concentration risk.
The credit risk management has different objectives at two levels namely Transaction
level and Portfolio level.
30
At Transaction level, the objectives of credit risk management are:
The transaction level pursues value creation and the portfolio level pursues value
preservation.
The management of credit risk receives the top management’s attention and the
process encompasses: -
(b) Quantifying the risk through estimating expected loan losses and unexpected loan
losses.
31
(d) Controlling the risk through effective Loan review mechanism and portfolio
management.
The credit risk management process is articulated in the bank’s Loan Policy, duly
approved by the Board. Each bank constitute a high level Credit Policy Committee,
also called Credit Risk Management Committee to deal with issues relating to credit
policy and procedures. The Committee is headed by the Chairman/CEO/ED, and
comprise of heads of Credit Department, Treasury, Credit Risk Management
Department (CRMD) and the Chief economist. The Committee formulates clear
policies on standards for presentation of credit proposals, financial covenants, rating
standards and benchmarks, delegation of credit approving powers, prudential limits
on large credit exposures, asset concentrations, portfolio management, loan review
mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans,
provisioning, regulatory/legal compliance etc. Concurrently, each bank also set up
Credit Risk Management Department (CRMD) independent of the Credit
Administration Department that enforce and monitor compliance of the risk
parameters and prudential limits set by the CPC.
In the global scenario, the increased credit risk arises due to two reasons. First, banks
have been forced to lend to riskier clients because well-rated corporates have moved
away from banks as they have access to low cost funds through disintermediation.
The other reason is the lurking fear of global recession. Recession in the economy
could lead to low industrial output which may lead to defaults by the industry under
recession culminating into credit risk.
One of the instruments of credit risk management is multi- tier credit approving
system where an ‘Approval Grid’ or a ‘Committee’ approves loan proposals. The
‘Grid’ or ‘Committee’ comprises of at least 3 or 4 officers and invariably one officer
is represented as CRMD. For better rated/quality customers banks delegate powers
32
for sanction of higher limits to the ‘Grid’. The quality of credit decisions is
evaluated.
2) Prudential Limits
It is linked to capital funds - say 15% for individual borrower entity, 40% for a group
with additional 10% for infrastructure undertaken by group. Threshold limit is fixed
at a level lower than prudential exposure; substantial exposure, which is the sum total
of the exposures beyond threshold limit and does not exceed 600% to 800% of the
capital funds of the bank. Banks also consider maturity profile of the loan book.
3) Risk Rating
Banks set up comprehensive risk rating system on six to nine point scale which
serves as a single point indicator of diverse risk factors of a counter party and for
taking credit decisions in consistent manner. Rating reflects underlying credit risk of
loan book, encompass industry risk, business risk, financial risk, management risk
and specify cutoff standards. Moreover, there is separate rating framework for large
corporates, small borrowers and traders. Banks clearly defines rating threshold and
reviews the rating periodically preferably at half yearly intervals. Rating migration is
mapped to estimate the expected loss.
Business risk consists of systematic risk (such as changes in economic policies, fiscal
policies of government, infrastructural changes) and unsystematic risk (such as
labour strike, machinery breakdown) which are market driven. Assessment of
financial risks involves of the financial strength of unit based on its performance and
financial indicators like liquidity, coverage and turnover. Management risk consists
of integrity, track record, structure and systems, expertise, commitment and
competence.
33
index..
Credit Metrics focus on estimating the volatility of asset value caused by the
variation in the quality of assets. It tracks rating migration which is the
probability that borrower migrates from one risk rating to another risk rating.
KMV, through its Expected Default Frequency (EDF) methodology derives the
actual probability of default for each obligator based on the functions of capital
structure, current asset value. It calculates the asset value of a firm from the
market value of its equity using an option pricing based approach that recognizes
equity as a call option on the underlying asset of the firm.
4) Risk Pricing
5) Portfolio Management
The need for credit portfolio management emanates from the necessity to optimize
the benefits associated with diversification and to reduce the potential adverse impact
of concentration of exposures to a particular borrower, sector or industry. To
maintain portfolio quality banks adopt certain measures such as stipulate quantitative
ceiling on aggregate exposures on specific rating categories, distribution of borrowers
in various industry, business group and conducting rapid portfolio reviews, stress
test. The stress test reveals undetected areas of potential credit risk exposure and
34
linkages between different categories of risk. Portfolio models such as default mode
model, which distinguishes between default, and non-default of borrower is assessed
in terms of probability of occurrence to determine loss given default. Mark to Market
model evaluates credit portfolio in terms of market value and the risk the bank incurs
if market value changes.
Credit Risk arises because promised cash flows on the primary securities held by
banks may or may not be paid in full. Banks would not face any credit risk if all the
financial claims held by them were paid in full on maturity and interest payments
were made on their promised dates. Moreover, banks lend to sensitive sectors such as
capital market sector, real estate sector and the commodities sector. The risk involved
in this lending is what determines the credit risk faced by the bank. The level of
credit risk that a bank is prepared to accept is what in turn determines the level of
lending to each of these sectors.
Interpretation
The banks with higher credit risk makes larger provisions in their Profit and Loss
Statements so as to cover credit risk. This follows the concept of conservatism that
needs to be exercised by banks while preparing the accounts. The figures obtained
conform to the fact private sector banks make higher investments in sensitive sectors.
Public sector banks come out with figures outlining their exposures in three sensitive
35
sectors i.e stock markets, real estate and commodities sector. This is followed by the
analysis of the same. (See Annexure 1.1)
Stock Markets
None of the public sector bank except OBC (in 2004) has more than 1% of its total
advance portfolio dedicated to capital market. In a recent RBI directive it has directed
banks to tread cautiously on capital markets exposure. However it has given banks
freedom to decide on the margin of the IPO financing.
Real Estate
In the analysis of the exposures of risk in real estate OBC tops the list with 1701.55
crores (2003-2005).
Commodities Sector
In this sector SBI has not been contributing till the year 2004 but among other public
sector bank OBC ranks the highest.
Capital Market
ICICI bank exposure in capital market has raised from 169.27 crores to 248.93 crores
but on the other hand IDBI exposure has been reduced to 16.48 crores from 82.69
crores.
Real Estate
When it comes to exposure in real estate, ICICI bank tops the league in the analyzed
banks followed by IDBI bank.
36
Commodities market
ICICI bank ranks the highest contribution in absolute terms 380.51 crores from year
2003-05.
An increasingly popular model to evaluate (and price) credit risk based on market
data is the RAROC model. The RAROC (Risk Adjusted Return on Capital) is
pioneered by Bankers Trust (acquired by Deutsche Bank in 1998) and now virtually
adopted by large banks. It is a risk adjusted profitability measurement and
management framework for measuring risk adjusted financial performance and for
providing consistent view of profitability across business. Hence it is defined as ratio
of risk adjusted return to economic capital.
Table No. 2
Table showing return on equity capital (%)
Year 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005
ROE % 18.65 20.2 18.3 21.8 18.21 20.56 20.1 20.4 18.9 21.2 21.7 27.5
37
The Basel Committee has suggested the two alternative approaches for calculation of
regulatory capital for credit risks.
Under this approach, RWA (Risk Weighted Assets) is determined as the counter
parties are grouped into Sovereigns, Banks and Corporates. Instead of assigning a
uniform risk weight to all borrowers differential risk weights are assigned on the
basis of external risk assessments by the external credit rating agencies (ECRA). For
Sovereigns, the risk weights range from 0% to 100% and for banks and corporate the
range is from 20% to 150%. This approach ensures that a bank knows the quality of
its exposures to strengthen its capital base according to risks it takes. Its a tool for the
bank to review its exposure and if it finds that its exposures are leaning towards risky
areas, it can take timely corrections.
Counterparty Sovereigns
Credit assessment Risk
weights
AAA to AA- 0%
A + to A - 20%
BBB + to BBB - 50%
BB + to B - 100% Counterparty Corporates
<B- 150% Credit assessment Risk weights
unrated 100% AAA to AA- 20%
A + to A - 50%
BBB + to BBB - 100%
BB + to B - 100%
<B- 150%
unrated 100%
Counterparty Other
Banks
Credit assessment Risk weights
AAA to AA- 20%
38
A + to A - 50%
BBB + to BBB - 50%
BB + to B - 100%
<B- 150%
unrated 50%
Source: The Journal of Indian Institute of Banking and Finance Oct-Dec 2004
For corporate exposures, the risk weight function gives the following risk weight for
given PD, LGD, EaD
39
Here, LGD is expressed as a whole number (i.e. a 75% loss given default is written as
75) while BC is a benchmark risk weight for corporates prescribed by the supervisor
based on statistical calibration and related to PD. Each calculated risk weight RWC is
multiplied by the corresponding EAD and aggregating over all exposure categories
yields an estimate of RWA for credit.
Credit Derivatives
The banks can make use of various credit derivative instruments to reduce the
credit risk associated with its loan portfolio. For example removing a pool of
loans from banks balance sheet reduces or disposes of the banks credit risk
exposures from these loans. Similarly, a bank that has just made loans to some of
its customers can sell these loans to other investors who take on the credit risks
inherent in these loans.
Credit Swaps
A Credit Swap is where two lenders agree to exchange portion of their customers
loan repayments. Each bank is granted the opportunity to further spread out the
risk in its loan portfolio especially if the banks involved are located indifferent
market areas. A credit swap permits each institution to broaden the number of
markets from which it collects loan revenue and loan principal thus reducing each
bank dependence on one or narrow set of market areas.
Credit Options
Credit Options guards against losses in the value of a credit asset or helps to off
set higher borrowing cost that occur due to changes in credit ratings.
40
Securitization of loans:
In case of Securitization selected loans are transferred to a company set up. The
securities are linked directly with the default risk of the tranche they securitize.
The securitizing bank provides liquidity facilities to make securities attractive for
investors. Furthermore, the bank usually keep the ‘first loss piece’ on their own
books which is equivalent to portfolio expected loss. Thus, only the risk of
unexpected rating deterioration is passed onto investors.
CHAPTER- V
41
Market Risk is defined as the possibility of loss to bank earnings and capital due to
changes in the market variables. It is the risk that the value of on/off balance sheet
positions is adversely affected by movements in equity, interest rate market, currency
exchange rate and commodity prices.
Management of Market Risk is the major concern of top management. The board
clearly articulates market risk management policies, procedures, prudential risk
limits, review mechanisms, reporting and auditing systems. The Asset Liability
Management Committee (ALCO) functions as the top operational unit for managing
the balance sheet within the risk parameters laid down by the board. Moreover, the
banks set up an independent middle office (comprises of experts in market risk
management, economists, bankers, statisticians) to track the magnitude of market risk
on a real time basis. The Treasury Department is separated from middle office and is
not involved in day to day work. The Middle Office apprises top
management/ALCO/Treasury about adherence to risk parameters and aggregate total
market risk exposures.
Liquidity Risk
42
banks arises from funding of long-term assets by short-term liabilities thereby
making the liabilities subject to refinancing risk.
2. Time Risk: need to compensate for non-receipt of expected inflows of funds i.e
performing assets turning into non-performing assets.
Liquidity measurement is quite a difficult task and can be measured though stock or
cash flow approaches. The key ratios adopted across the banking system are (See
Annexure 3):
For State Bank of India, Central Bank of India and Oriental Bank of Commerce this
ratio is 0.181%, 0.883%, 0.870% for year 2004 while it is 0.065%, 0.128 %and
0.189% for ICICI bank, IDBI and HDFC bank. This seems to show that PSU banks
have a much more stable deposit base than private sector. This implies that the
liquidity position of PSU banks is more stable which can be attributed to their larger
customer /retail base. But over the years the private sector also has been improving
upon his ratio.
This ratio shows that the State Bank of India face less risk than the ICICI, IDBI and
HDFC bank as these banks rely more heavily on large deposits made by other banks
with them, which are inherently unstable. This exposes the private banks to higher
43
levels of liquidity risks.
Where short term assets = Cash & Bank balance + Receivable + Bills Receivable +
Short term/demand advances
This ratio has shown steady over the period 2002-2003 to 2003-2004 for all
categories of banks. The percentage of short-term assets to total assets is minimum
for private banks with a very large standard deviation among them. A possible reason
for this could be the fact that the management of each of them has a different
emphasis regarding their lending policies. This ratio is essential for liquidity strategy
of the bank.
This is a popular measure of the liquidity position of banks. Higher Deposit Ratio
indicates poor liquidity position of the bank while lower figures indicates more
comfortable liquidity positions.
Investments/Total Assets
This ratio is highest for public sector banks reflecting the higher levels of
conservatism in their policies. This is because investments are mainly government
securities and other forms of relatively less risky instruments as compared to loans
and advances, which entail a high level of risk.
The liquidity ratios are the ideal indicator of liquidity of banks operating in
developed markets as the ratios do not reveal the intrinsic liquidity profile of Indian
banks, which are operating generally in an illiquid market. Analysis of liquidity
involves tracking of cash flow mismatches.
For measuring and managing net funding requirements the use of maturity ladder
and calculation of cumulative surplus or deficit of funds at selected maturity dates is
44
recommended as a standard tool.
1. 1 to 14 days
2. 15 to 28 days
8. Over 5 years
The cash flows are placed indifferent time bands based on future behaviour of assets,
liabilities and off –balance sheet items. A maturing liability will be a cash outflow
while a maturing asset will be a cash inflow. The difference between cash inflows
and outflows in each time period the excess of deficit of funds becomes the starting
point for the measure of a banks future liquidity surplus or deficit at a series of points
of time.
The risk arises because of two reasons - liability side reasons (i.e whenever a bank
depositors come to withdraw their money) and asset side reasons (which arises as a
result of lending commitments). The cause and effect of liquidity risk is primarily
linked to nature of assets and liabilities of a bank.
The two approaches used for managing the liquidity risk dimension are:-
45
Fundamental Approach
Asset management
This approach aim at eliminating liquidity risk by holding near cash assets that can be
turned into cash whenever required. Likewise the sale of securities from the
investment portfolio can enhance liquidity. Investment can be put in the call market,
government securities or instruments of other corporate as when the funds are put in
the call market they are invested only for the short period where liquidity is ensured
but have lower yield. The risk perceived is low as participants are banks .As
investing in the government securities generally offer higher yields with less risk
involved.
Liability Management
In this approach the bank does not maintain any surplus funds but tries to achieve it
through by borrowing funds when the need arises. The disadvantage is that since
funds are raised from various sources and markets any rate fluctuations in a market
enhance the cost of borrowing.
Technical Approach
The technical approach focuses on the liquidity position of the bank in the short run.
Liquidity in the short run is linked to cash flows arising due to operational
transactions. Thus if the technical approach is adopted to eliminate liquidity risk it is
the cash flows position that needs to be tackled.
46
Call Money Market
Call money is borrowings between banks for a period ranging from 1 to 14 days.
As per the RBI Act 1934, CRR is to be maintained on an average daily basis during a
reporting fortnight by all scheduled banks. This system provides maneuverability to
banks to adjust their cash reserves on a daily basis depending upon intra fortnight
variations in cash flows. For the computation of CRR to be maintained during the
fortnight, a lagged reserve system has been introduced effective November, 1999
whereby banks have to maintain CRR on the net demand and time liabilities (NDTL)
of the second preceding fortnight. With this, banks are able to assess their liability
positions and the corresponding reserve requirements. With a view to provide further
flexibility to banks and enable them to choose an optimum strategy of holding
reserve depending upon their intra-period cash flows, RBI have decided to reduce the
requirements of a minimum of 85 percent of the CRR balance to 65 percent with
effect from beginning May 6, 2000. This has resulted in smoother adjustment of
liquidity between surplus and deficit units and enables better cash management by
banks.
The CRR currently as on 31st march 2004 was 4.75% of the anticipated total demand
and time liabilities. When a bank falls short of its CRR requirement, it resorts to
borrowing from the call market. As more banks resort to such borrowing, demand for
money in that market shoots up, leading to high call rates. This is what happened
during the run-up to the credit policy in March 2000. Banks had invested their
surplus cash in government securities. That placed them in a corner so far as meeting
CRR requirement was concerned.
Liquidity requirements:
This arises from a liquidity mismatch, which forces banks to borrow for the very
short term.
47
Speculation
That is, wanting to profit from any arbitrage opportunities between the forex and
money markets. Banks borrow call money at say, 5-6 % and deploy the proceeds to
speculate on the rupee dollar moments in the forex market. Given the general bias on
rupee depreciation, these banks invariably profit from the cross-market deployment.
If the call rates in the meanwhile shoot up the borrowing banks have three options.
First, borrow again in the call market at the higher rate and repay the earlier loan.
Second, sell dollars in the market and buy rupees to repay the loan. Third, attract
deposits from small savers to fund the loan repayment. Mostly banks resort to the
third alternative by hiking deposit rates. In January 1999,for instance, bank raised its
short-term deposit rate to about 18% per annum. It was forced to take this step, as it
had to repay loans on calls and rates in that market which shot up to a high of 140%.
The RBI has banned banks from borrowing in call and trading in the forex market.
Arbitrage
Banks have also started taking advantage of the arbitrage opportunity between the
call money and the Government securities market. In March 2003, with inter bank
call rates hovering around 6 % and the current yield on Government securities
ranging from 8.5% - 9.5 %, the borrowing banks in the money market had an
opportunity to make money. The call money was ruling tight following advanced tax
outflows from the market. In order to maintain the cash reserve ratio requirements,
these banks borrowed at 6%. The money put in the CRR is invested in government
securities at the current yield of 8.5% - 9.5% over various maturities. In this way,
banks earn an arbitrage of around 2.5 % - 3.5%.
Policy Variables
Just before any policy announcement, the overnight rates (or the call rates) seem to
be very volatile largely due to an expectation of a fall in interest rate.
48
Repo Market
A reverse repo is the same operation but seen from the other point of view, the
buyers, In a reverse repo the buyer trades money for the securities agreeing to sell
them later. The banks, which hold a large inventory of bonds and G- Secs, use repo to
amass additional funds. Using the securities as collateral they borrow using repo.
Hence whether transaction is a repo or a reverse repo is determined only in terms of
who initiated the first leg of the transaction. When the reverse repurchase transaction
matures the counter party returns the security to the entity concerned and receives its
cash along with a profit spread. One factor that encourages an organisation to enter
into reverse repo is that it earns some extra income on its otherwise idle cash.
The rise in the call money rates often forces met borrowers in the money market such
as private banks today to increasingly resort to repo (short for sale and purchase
agreement) of Government securities for their financing requirements rather than
borrowing from overnight call money market.
At present, the RBI regularly conducts only a three/four day fixed repo. As for the
likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate
in stages to the earlier levels.
49
Liquidity Adjustment Fund (LAF)
50
transitional measure for providing reasonable access to liquid funds at set rates of
interest. It provided a ceiling and the Fixed Rate Repo were continued to provide a
floor for the money market rates.
For purpose of monitoring liquidity risk RBI requires banks to disclose a statement
on maturity pattern of their assets and liabilities classified in different time buckets.
Liabilities consist of deposits and bank borrowing classified into different time
buckets. Assets consist of loans and advances and investments. Investments in
corporate and government debt are combined into one category and bucketed
according to their time to maturity.
It is the potential negative impact on the Net Interest Income and refers to the
vulnerability of an institution’s financial condition to the movement in interest rates.
Changes in interest rate affect earnings, value of assets, liability off balance sheet
items and cash flow. Interest rate risk is particularly important for banks owing to
high leverage and arises from maturity and repricing mismatches.
From the Earning perspective, the focus of analysis is the impact of changes in
interest rate on accrual or reported earnings. This is the traditional approach to
interest rate risk assessment taken by many banks and is measured by measuring
changes in Net Interest Income (NII) or Net Interest Margin (NIM). Economic value
perspective involves analyzing the expected cash in flows on assets minus expected
cash out flow on liabilities plus the net cash flows on off balance sheet items. It
identifies risk arising from long-term interest rate gaps.
In India from 1993 onwards, administrative restrictions upon interest rates have been
steadily eased. This has given an unprecedented regime of enhanced interest rate
volatility. In particular, interest rates have fallen sharply in last four years. If interest
rate goes up in future it would hurt banks, which have funded long maturity assets
using short maturity liabilities. By International standards, banks in India have
relatively large fraction of assets held in government bonds and is partly driven by
large reserve requirements. In India, large reserve requirement implies a policy of
51
stretching out yield curve which innately involves forcing banks to increase the
maturity of their assets.
(a) Gap/Mismatch Risk: It arises from holding assets/liabilities and off balance
sheet items with different principal amounts, maturity dates there by creating
exposure to unexpected changes in the level of market interest rates.
(b) Basis Risk: It is the risk that the interest rate of different assets/liabilities and
off balance items changes in different magnitude.
(c) Embedded Option Risk: It is the option of pre-payment of loan and fore-
closure of deposits before stated maturities.
(d) Yield Curve Risk: It is the movement in yield curve and the impact of that on
portfolio values and income.
(f) Reinvestment Risk: It’s the uncertainty in regard to interest rate at which the
future cash flows could be reinvested.
(g) Net Interest Position Risk: When banks have more earning assets than
paying liabilities, net interest position risk arises in case market interest rates
adjust downwards.
52
Shareof BankingSector in
Interest RateRisk
PSBs
11% 3%
PrivateSector
Bank
86% ForeignSector
Bank
Shareof BankingSectorsintotal
G-SecInvestment
PSBs
14% 5%
Private Sector
Bank
81% Foreign Sector
Bank
Gap Analysis
The Gap or Mismatch risk can be measured by calculating gaps over different time
intervals as at a given date. Gap Analysis measures mismatches between rate
sensitive liabilities and rate sensitive assets (including off balance sheet positions).
53
The Gap may be identified in the following time buckets: (See Annexure 2.1 –2.6)
1. 1-28 days
7. 7 Over 5 years
8. Non - sensitive
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket. The positive gap indicates that it has more
RSAs whereas the negative gap indicates that it has more RSLs. The gap reports
indicate whether the institution is in a position to benefit from rising interest rates by
having the positive gap (RSA>RSL) or whether it is in a position to benefit from
declining interest rate by the negative Gap (RSL >RSA).
Table No.4
Relationships in Gap Analysis
GAP Change in Change in Change in Change in Net
Interest Rates Interest Income Interest Expense Interest Expense
Positive Increase Increase > Increase Increase
Positive Decrease Decrease > Decrease Decrease
Negative Increase Increase < Increase Decrease
Negative Decrease Decrease < Decrease Decrease
Zero Increase Increase = Increase None
Zero Decrease Decrease = Decrease None
54
Annexure 2.1-2.6 shows the calculation of GAP analysis in the sample banks
Gap Analysis
Bank 1-14 days 15-28 days 29daysto 3 3 –6 mths 6m-1 yr. 1-3 yr. 3-5yr Above 5yr Non rate
months sensitive
SBI 9967.9 -374.8 -2149.3 -7256.7 -9191.5 -127890 -28058.8 42953.2 -360853.464
ICICI 14837.3 8932.5 -34777.9 -53580 -24757.4 -112132.2 67133.7 239193.3 -90529.95
CBI 9967.9 -374.8 -2149.3 -7256.7 -9191.5 -24070.1 -28058.8 42953.2 1532.246
OBC -762.75 -624.01 -2626.77 -3837.54 -5315.8 -3496.19 3061.72 15077.98 -106772
HDFC 19255.3 2071.5 35140.4 2825 -3583 -56591.4 25545.4 16848.5 -47987.4
IDBI -148959.1 -641906.5 -793128.3 -1338751.5 -739898.2 -1843325 521801.6 4758892.6 -1548
Duration Analysis
Duration is the time weighted average maturity of the present value of the cash flows
from assets, liabilities and off balance sheet items. It measures the relative sensitivity
of the value of instruments to changing interest rates (the average term to re - pricing)
and therefore reflects how changes in interest rates affects the institutions economic
value that is the present value of equity. The longer the term to maturity of an
investment, the greater the chance of interest rate movements and hence unfavourable
price changes.
Duration measure how price sensitive an asset/liability or off balance sheet item is to
small changes in interest rates by using a single number to index the institution
interest rate risk. This index represents the average term to maturity of the cash
flows. Hence, the Duration method is used to measure the expected change in market
value of equity (MVE) for a given change in market interest rate.
The difference between duration of assets (DA) and liabilities (DL) is banks net
duration. If the net duration is positive (DA>DL), a decrease in market interest rates
will increase the market value of equity of the bank. When the duration gap is
negative (DL>DA) increase in market interest rate will decrease the market value of
equity of the Bank.
55
Simulation Models
The slope of yield curve and the relationship between the various indices that the
institution uses to price credits and deposits
Simulation is used to measure interest rate risk by estimating what effect changes in
interest rates, business strategies and other factors will have on net interest income,
net income and interest rate risk positions.
Value At Risk
VaR is an alternative framework for risk measurement. If the VaR with respect to
interest rate risk of bank is desired, at a 99 % level of significance on a one-year
horizon then we would need to go through following steps:
56
4. Computethe 1th percentile of
distribution of profit/loss seen in Nth realisation.
Interpretation:
In actual, banks measure interest rate risk using two different alternative
methodologies: (a) Accounting disclosures by banks: here vectors of future cash
flows that make up assets and liabilities are imputed. This are then repriced under
certain interest rate scenarios that are based on BIS norms and gives an estimate of
impact of interest rate shock upon equity capital of bank. In addition, interest rate
risks of various banks are perceived by (b) stock market. When interest rate
fluctuate, stock market speculators utilise their understanding of exposure for each
bank in forming share price.
Under the standardised approach five distinct sources of market risk are identified
viz. Interest rate risk, Equity position risk, Foreign exchange risk, Commodities Risk
and Risk from options.
Here, banks are allowed to base market risk charges on their own on internal models
but additionally a process called stress testing is to be included.
The crucial input in the IRB approach is a VaR (value at risk) model. A VaR estimate
is an appropriate percentile of the bank portfolio loss distribution. For any given bank
portfolio one can calculate a loss distribution showing the probability of various
amounts of loss.
57
The confidence coefficient (whether 95%,99%,or 99.9%).
The holding period i.e the period over which the portfolio is considered to beheld
constant. Portfolios cannot be adjusted instantaneously because of transaction
costs, lock in periods etc.
Each bank must meet on a daily basis, a capital requirement expressed as the higher
of the following two factors
Previous days VaR estimate (An average of the VaR of the preceding 60 business
days)*m
m = 3+plus factor
Where plus factor is related to the performance of the particular banks VaR model.
The value ranges from 0 (exceptionally good performance) to 1(poor performance)
Interest Rate Risk is a very critical problem for banks and they use a number of
derivative instruments to hedge against Interest Rate Risk. Some of the instruments
used by banks are Interest Rate Futures, Interest Rate Options, Interest Rate Caps,
Collars and Interest rate Swaps. This risk is considerably enhanced during a period
when decline in the interest rates bottom out and begins to move in the opposite
direction. In India, this risk is further exacerbated since it is the Reserve Bank of
India (RBI) --- and not the market forces --- which still dictate the prevailing level of
58
interest rates.
A bank whose asset portfolio has an average duration longer than the average
duration of it liabilities has a positive duration gap. A rise in the market interest rate
will cause the value of bank assets to decline faster than the liabilities reducing the
banks net worth and vice versa.
After the Reserve Bank of India gave a green signal to banks to hedge themselves
again interest rate uncertainties through plain --vanilla interest rate swaps (IRSs) and
forward rate agreements (FRAs) in the April 1999 monetary policy, the banks have
used this as a major tool in interest rate risk management. There are many players in
market---- HDFC bank, ICICI bank.
59
Table No.5
The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate
is linked to an overnight /call money index. The interest is computed on a notional
principal amount and the swap settles on a net basis at maturity.
Quality Swap
Under the terms of the agreement called a Quality Swap, a borrower with a lower
credit rating typically a smaller bank enters into an agreement to exchange interest
payment with a borrower having a higher credit rating, typically a large nationalized
bank. In this case the lower credit rated bank agrees to pay the higher-credit-rated
bank fixed long term borrowing cost. In effect, the low credit-rated bank receives a
long - term loan at a much lower interest cost than the low rated bank could
otherwise obtain. At the same time the bank with the higher-credit-rating covers all
or a portion of the lower rated banks short term floating loan rate, thus converting a
fixed long term interest rate into amore flexible and possibly cheaper short term
interest rate. Swaps are often employed to deal with asset liability maturity
mismatches.
60
Interest Rate Hedging Devices
It protects its holder against rising market interest rates. In return for paying an up
front premium, borrower are assured that institutions lending them money cannot
increase their loan rate above level of the cap. The bank may alternatively purchase
an interest rate cap from a third party (say from financial institutions) which promises
to reimburse borrowers from any additional interest they owe their creditors beyond
the cap. Thus the banks effective borrowing rate can float over time but can never
increase the cap. Banks buy interest rate caps when conditions arise that could
generate losses such as bank finds itself funding fixed rate assets with floating rate
liabilities, possesses longer term assets than liabilities or perhaps holds a large
portfolio of bonds that will drop in value when interest rates rise.
Banks can also lose earnings in periods of falling interest rates especially when rates
on floating rate loan decline. A Bank can insist on establishing an interest rate floor
under its loans so that no matter how far loan so that no matter how far loans rates
tumble, it is guaranteed some minimum rate of return.
This instrument combines in one agreement a rate floor and rate cap. The collar
purchaser pays a premium for a rate cap while receiving a premium for accepting a
rate floor. The net premium paid for the collar can be positive or negative, depending
upon the outlook for interest rates and the risk aversion of the borrower and the
lender at the time of the agreement. Banks can use collars to protect their earnings
when interest rates appear to be unusually volatile.
61
CHAPTER – VI
OPERATIONAL RISK
MANAGEMENT
62
♦ Defining operational risks
Banks are however, still not entirely clear on how to implement the capital
requirements for operational risk.
♦ Risk Mapping/Profiling
Risk Mapping is a process of breaking down the bank’s business into various
functional lines and assessing the various risk elements involved in each of these
lines. It involves listing out of the existing controls for identified risks. Both the risks
listed and existing controls are graded as low, medium and high categories. It is a
dynamic exercise and subject to continuous review based on experience gained from
various loss events. The operational risk relates to failure of people, technical, legal
and internal processes.
People Risk –
(a) Internal/External Frauds
63
Process Risk –
(a) Transaction without proper authority
Technical Risk –
64
External Risk –
(a) Natural Disasters (flood, fire etc)
(b) War/terrorism
(c) Sabotage/crime
A key component of risk management is measuring the size and scope of the firm’s
risk exposures. As yet, however, there is no clearly established, single way to
measure operational risk. Instead, several approaches have been developed. An
example is the “matrix” approach in which losses are categorized according to the
type of event and the business line in which the events have occurred. The bank
hopes to identify which events have the most impact across the entire firm and which
business practices are most susceptible to operational risk.
Once potential loss events and actual losses are defined, a bank analyze in
constructing databases for monitoring such losses and creating risk indicators, which
summarize these data. Potential losses are categorized broadly arising from “high
frequency, low impact”(HFLI) events such as minor accounting errors or bank teller
mistakes, and “low frequency, high impact”(LFHI) events, such as terrorist attacks or
major fraud. Data on losses arising from HFLI events are generally available from a
bank’s internal auditing systems. However, LFHI events are uncommon and thus
65
limit a single bank from having sufficient data for modelling purposes. For such
events, a bank needs to supplement its data with that from other firms. Although
quantitative analysis of operational risk is an important input to bank risk
management systems, these risks cannot be reduced to pure statistical analysis.
Hence, a qualitative assessment, such as scenario analysis will be an integral part of
measuring a bank’s operational risks.
In broad terms, risk management is the process of mitigating the risks faced by the
bank, either by hedging financial transactions, purchasing insurance, or even
avoiding specific transactions. With respect to operational risk, several steps should
be taken to mitigate such losses. For example, damages due to natural disaster can be
insured against. Losses due to internal reasons, such as employee fraud or product
flaws are harder to identify and insure against, but they can be mitigated with strong
internal auditing procedures. Banks are yet to get clarity on the issues that are to be
included in operational risk but system vendors have identified that proper workflow
and process automation can help in reducing and detecting errors. Right levels of
audit and control, good management information systems and contingency planning
is necessary for effective operational risk management.
The framework consists of two general categories. The first includes general
corporate principles for developing and maintaining a banks operational risk
management environment. For example banks governing board of directors should
recognize operational risk as a distinct area of concern and establish internal
processes for periodically reviewing operational. To foster an effective risk
management environment the strategy should be integral to a banks regular activities
and should involve all levels of bank personnel. The second category consists of
general procedures for actual operational risk management. For example, banks
should implement monitoring systems for operational risk exposures and losses for
major business lines. Policies and procedures for controlling or mitigating operational
risk should be in place and enforced through regular internal auditing.
Since, all the banks have introduced internet banking, to mitigate the operational risk
66
in internet banking multi layer security like digital certification, encryption, two level
passwords have been introduced.
Banks hold capital to absorb possible losses from their risk exposures, and the
process of capital budgeting for these exposures, including operational risk, is a key
component of bank risk management. In parallel with industry developments, BCBS
proposed in 2001 that an explicit capital charge for operational risk be incorporated
into the new Basel Capital Accord. The committee initially proposed that the
operational risk charge constitutes 20% of a bank’s overall regulatory capital
requirement, but after a period of review, the committee lowered the percentage to
12%. To encourage banks to improve their operational risk management systems, the
new Basel Accord have also set criteria for implementing more advanced approaches
to operational risk. Such approaches are based on bank’s internal calculations of the
probabilities risk events occurring and the average losses from those events. The use
of these approaches will generally result in a reduction of the operational risk capital
requirement, as is currently done for market risk capital requirements and is proposed
for credit risk capital requirements.
TCS (Tata Consultancy Services) has developed a meta model to capture capital
allocation for operational risk in terms of guidelines laid down by New Capital
Accord.
The ultimate goal of Basel proposal is to measure operational risk and computation of
capital charges, but what is to be done at present by all the surveyed banks is to start
implementing the Basel proposal in phased manner and carefully plan in that
direction.
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Basel Committee has identified following –10 principles for
successful management of Operational Risk:
In all material products, activities, processes and systems operational risk contract
should be identified and assessed.
Regulatory Authorities may ensure that appropriate mechanisms are put in place
to allow them to remain apprised of position of operational risk management of
the supervised organisations.
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CHAPTER VII
BASEL II COMPLIANCE & RISK
BASED SUPERVISION
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♦ BASEL II COMPLIANCE
The 1988 Capital Accord suffered from several drawbacks as it exclusive focus on
credit risk, it does not differentiate between sound and weak banks using “one hat fit
all” approach, it acquire broad brush structure. Hence, in order to remedy the Basel
Committee published a New Accord in Dec 2001, which is expected to be
implemented by most countries by 2006.Basel II focuses on achieving a high degree
of bank-level management, regulatory control and market disclosure.
The major change in the first pillar is in measurement of risk weighting. It allows
banks certain latitude in determining their or own capital requirements based on
internal models and focus on credit risk, market risk and operational risk.
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called the internal ratings based approach (IRB) banks rates the borrower and results
are translated into estimates of a potential future loss amount which forms the basis
of minimum capital requirement. In Advanced internal rating based approach the
range of risk weights are well diverse.
For Market Risks also a similar twin track approach is followed. Here capital
charges are determined and then multiplied by 12.5 to make them comparable to the
RWA. Secondly a special type of capital (Tier3) is introduced for meeting market
risk only.
D =RWA + 12.5 * (Sum of capital charges due to market and operational risk)
To meet market risk special type of capital viz. Tier III capital has been introduced in
the New Accord which consist of short term subordinated debt but with a minimum
original maturity of 2 years. Tier III capital cannot exceed 250% of the Tier I capital
to meet market risk.
The column chart shows the capital adequacy ratios of surveyed banks. Capital
adequacy in relation to economic risk is a necessary condition for the long-term
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soundness of banks. The maintenance of capital adequacy is like aiming at a moving
target as the composition of risk weighted assets gets changed every minute on
account of fluctuation in a risk profile of bank. Minimum capital adequacy ratio of 8
% implies holding of Rs. 8 by way of capital for every Rs. 100 risk weighted assets.
16
14
12
10
2003
8
2004
6
4
2
0
SBI ICICI HDFC IDBI OBC CBI
Banks
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Supervisory Review Process
Market Discipline
4) Its capital ratio and other data related to its capital adequacy on a consolidated
basis.
One of the major critiques of the New Basel Accord pertains to the adoption of an
internal rating based (IRB) system as the application of IRB is costly,
discriminates against smaller banks and exacerbate cyclical fluctuations.
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Only those banks likely to benefit from IRB will adopt approach, other banks will
hold on to the standardised approach.
Background
The current on site inspection driven approach of RBI is supplemented by off site
monitoring and surveillance system (OSMOS) and supervisory follow up. It provides
an opportunity to the regulator to monitor banks performance based on
CAMELS/CALCS approach.
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Risk Based Supervision (RBS) – A New Approach
RBS looks at how well a bank (supervised) identifies, measures, controls and
monitors risks. It not only tries to identify systemic risks caused by the economic
environment in which banks operate but also management ability to deal with them.
Focussed approach under RBS entails allocation of supervisory resources and paying
attention in accordance with the risk profile of supervised (bank) which would further
optimise utilisation of supervisory resources. It involves assessing and monitoring the
risk profile of banks on an on going basis in relation to business and exposures and
prompt banks to develop systems rather than transactions.
RBI decided to switch over to RBS due to autonomy of banks, increased competition,
globalisation, automation and market disclosure / transparency.
1) Risk Profiling of Banks: CAMELS rating is one of the core of risk profile
compilation and the risk profiling of each bank draws upon a wide range of
information such as market intelligence reports, onsite findings, adhoc data from
external and internal auditors. Risk profile document contains SWOT analysis,
Sensitivity analysis, Monitorable action plan and banks progress to date.
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banks with a better compliance record and a good risk management control
system is entitled to an incentive package like longer supervisory cycle.
Moreover, banks that fails to show improvement in response to MAP is subject to
frequent supervisory examination.
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CHAPTER VIII
ANALYSIS OF SURVEY
RESPONSES
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There are certain parameters on which bank degree of readiness for risk management
is ascertained.
All the private sector banks surveyed have 100% documented risk management
policy i.e it covers credit, market and operational risk. Among the PSU it’s only
SBI and Central Bank of India, which covers all the three aspects of risks.
Oriental Bank of Commerce concentrates only on credit risks.
All the banks follow internal credit rating model. This high percentage among
banks shows an adoption of scientific approach to credit risks in Indian Banking
sector.
Its only SBI which track probability of default and rating migration and same is
in case of tracking loss given default. However, there were no comments on this
from other banks. Moreover, all the six banks report that contingent liabilities fall
within purview of their risk management processes.
On the matter of Exposure Limits all the banks surveyed define it in terms of
counter party, group and industry
In this parameter ICICI, HDFC, IDBI, SBI, OBC review loans after every three
months or six months whereas Central Bank of India still follows 12-month cycle.
As regular analysis of the loan portfolio feed into banks lending strategy.
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Evaluating Credit Risk at Portfolio level
The surveyed banks are carrying out regular NII Sensitivity Analysis.
SBI, ICICI, HDFC periodically review their liquidity position under normal and
stress scenarios whereas OBC, IDBI does not review the liquidity position
periodically.
interest rate shocks Our result shows that in addition to credit risk, interest rate
risk is also important in Indian banking system. The potential impact of upon
equity capital of surveyed banks in system seems to be economically significant.
IDBI, SBI, ICICI Banks calculate a daily Value at Risk (VaR) of trading portfolio
where as rest of banks have fixed their own timeframe for moving to Value at
Risk and Duration approach for measurement of interest rate risk.
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This is one of the essential components of market risk control. ICICI, SBI,
HDFC, IDBI, OBC, CBI banks have placed limits on derivative transactions This
is all due to strong monitoring and control system that derivative activity takes
place in these banks.
SBI, IDBI, OBC, ICICI banks maintain a certain level of investment fluctuation
reserve to guard against any possible reversal of interest rate.
OBC, IDBI Bank stand out as banks, which have large exposures by both,
approaches i.e accounting disclosures and stock market approach.
Among the six banks in our sample no bank proves to have significant ‘reverse
exposures’ in the sense that they stand to earn profits in event of when interest
rate goes up.
It is striking to observe that three banks with best stock market liquidity SBI,
ICICI, HDFC bank there is good agreement between the results from two
approaches.
ICICI Bank, HDFC Bank and SBI seem to fairly hedged w.r.t interest rate risk.
SBI, ICICI banks have operational risk management system but rest of the
surveyed banks did not have, as it’s the area where structural focus is relatively
nascent.
While putting the risk management in place HDFC, IDBI, Central bank of India
finds difficult to collect reliable data. The challenge is mainly in the area of
operational risk where there is dearth of reliable historic data and not a great deal
of clarity of the measurement of risk. Banks like Oriental Bank of Commerce and
ICICI bank have sophisticated technologies.
Scorecard approach is followed for operational risk mitigation. None of the banks
surveyed follow this approach, as they didn’t comment on this.
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Bank conducting Risk Based Internal Audit
IDBI, SBI, OBC and ICICI bank conduct Risk Based Internal Audit as per RBI
guidelines whereas central bank of India & HDFC Bank did not comment on this.
All the three surveyed private banks go for readymade solutions since creating in
house system proves to be expensive whereas established public sector banks like
SBI, OBC for whom funds are not constraint thinks of developing in house
software but they still go for outsourcing as the chief benefit of it is the speed of
implementation and it temporarily reduce the load of the back office employees.
If bank has in house software then there is nothing like it in terms of delivery
time since changes can be incorporated in an expeditious manner. Moreover,
bank need to have a separate department of IT professionals working full time on
product design and development. But finally the decision regarding this rest on
efficiency and accuracy in valuation and consequent risk analysis.
State Bank of India is teaming with KPMG Consulting Pvt. Ltd. (international
consultant) for software solutions. However, other banks did not comment on
this.
Banks such as SBI, ICICI, OBC captures risk data on regular basis whereas other
bank do not capture data on regular basis.
Only SBI and ICICI bank follow the presence of information system, which
aggregate risk parameters on live basis.
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Table No. 6
Table showing key performance indicators determining the profitability of banks
Some of the ratios used for analyzing the aspect of risk management
are as follows: -
On analyzing this ratio we see that all the six banks have the lower cost of funds in
year 2005 as compared to 2004. The reason for this is the larger retail base that result
in being able to raise capital in small lots.
where Net Interest Income = Total Interest Income - Total Interest Expenses
Earning Assets = All Interest earning assets (Total Assets - Cash Balance - Fixed
Assets - Other Asset)
This figure is critical component of the analysis of the risks faced by banks and
other financial institutions. The impact of volatility on the short-term profits is
measured by Net Interest Margin. It is at level of 3%, 3.7%, 4.7% for SBI, CBI
and OBC bank in year 2005 while it is 1.7%, 2.8%, 3.5% for ICICI bank, IDBI
and HDFC bank. Only Central Bank of India is the bank among all the six banks,
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which is able to stabilize short-term profits as net interest margin for year 2004
and 2005 is same (3.79%).
The level of spread at which each bank operates is different. The private banks have
narrower spread as compared to the PSU bank. They do not differ significantly and
the difference is in range of 1%.
On having a closer look at the yield curves of the various subdivisions with in each
sector on the basis of size we see that there is clear trend towards convergence over
the period 2004-2005.
This ratio gives us an idea of the ability of banks from the fee-based activities
undertaken by them. This is becoming a very critical component of the probability of
a bank as the spreads are becoming thinner and thinner over the years as a result of
increased competition. This is a good method of improving their top line as this
increased income can be generate without any significant additions to the fixed assets
as well as without there being the need to raise additional deposits or borrowings
from the market.
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The asset utilization ratio for the public sector banks namely SBI, OBC, and CBI is
around 10% over the two-year period whereas HDFC, ICICI and IDBI bank asset
utilization is of 8%, which is lower than that of the PSU banks. This makes sense that
asset utilization capability of the banks cannot be change rapidly over a short period
of time.
Burden/Spread
Burden is the Net Non Interest Income and Spread is the Net Interest expense. This
gives us an insight into the proportion of income coming from the fee based activities
of banks as against those that are derived from the fund based activities. This in turn
tells us the kind of areas where bank is focusing on a present and the pattern which
they a likely to follow in the future.
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CHAPTER – IX
OBSERVATIONS AND
SUGGESTIONS
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The present chapter is divided into two sections. First part consists of major
observations of study and second part comprises of its suggestions. Observations
initiate further refinements in the existing structure while suggestions provide better
guidelines in the efficient working of the organisation.
Hence, based on the responses to the questionnaire and the personal meetings with
senior risk professionals in banks a few major findings of study are:
There is much greater awareness across the banking sector about the need for risk
management and the various categories of risk which banks are exposed to. A
separate credit risk department distinct from credit function has been set up in all
the surveyed banks. This implies substantial progress from three years ago when
risk management was new concept for all except the most advanced and
sophisticated banks.
Degree of readiness for integrated risk management among banks differs widely.
As there are banks which have several years risk data and sophisticated risk
models, there are also other banks, which have started the process of systematic
capturing of risk data. Degree of readiness also differs with regard to the risk
elements covered.
While putting the risk management in place banks surveyed often find it difficult
to collect reliable data. The challenge is mainly in the area of operational risk
where there is dearth of reliable historic data and not a great deal of clarity on the
measurement of risk.
Risk Management System is not in line with organisation goals and objective.
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With increased awareness there has come about a need to ensure harmony of
understanding and direction across banks. Absence of standardised definition and
measurement divergences lead delays in installing and integrating the
components of an integrated risk management system.
Regulatory and legal issues are not taken into account while setting up of risk
management system.
Methodologies for measuring and assessing market risk and credit risks are
inconsistent throughout the banking sector.
Quarterly progress reports are not made in order to keep the track record for the
progress of bank.
Moreover each bank going for risk management implementation is faced with
question of whether to outsource and if so how much and to whom. Selection
processes for vendors are long drawn and implementation gets delayed on
account of time taken to freeze requirements and fine-tunes specifications.
Banks are facing significant challenge in rolling out IT networks. The banks on
the software front could not entail investments in databases, datawarehousing and
in sophisticated statistical models as aggregation and analysis of the vast amount
of data is needed for successful risk management system.
There is absence of binding time frame as for measuring and managing risk
comprehensive and credible system is not placed by the specified date. It’s much
longer before sufficient data aggregation could be carried out for the introduction
of sophisticated quantitative approaches demanding sufficient internal
measurements.
Issues relating to internal audit system, loan review system and timeliness of
internal ratings are not observed in most of the banks.
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Training for supervisory cadres is not given in banks for understanding the
critical issues raised under Basel II.
Banks surveyed don’t have expertise in risk modelling. That’s why they seek the
services of global consultants like KPMG, Price house water coopers, TCS and
many more. These consultants identify the gaps in system and help banks in
devising risk return model.
Selection processes of vendors for outsourcing the software solution are long
drawn.
The risk management software solutions market is almost nine percent of the
entire IT budget of the global financial industry.
Risk management solutions have been mainly used to calculate credit risk. It’s in
the area of operational risk that most firms will make fresh investments.
In recent times much have been done in the area of credit risk management.
Banks surveyed did not comply with Basel II norms and still follow rudimentary
risk models.
In the current interest rate environment, banks find more profitable to invest in
government securities.
Risk Management System should be in place to deal with current and potential
risks.
The system needs to be developed in line with organisation goals and objective.
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Quarterly progress reports should be made which is an effective way of keeping
track of progress made by each bank.
Appropriate internal controls and audit, risk based supervision, proper manpower
planning, selection training and development and efficient compliance officer
should be there in addressing risk management issues.
Selection processes of vendors for outsourcing the software solution should not
be long drawn.
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Banks should place more emphasis on the cash flow based lending rather than
traditional securities based lending.
With view to build up adequate reserves too guard against any possible reversal
of interest rate banks should maintain a certain level of investment fluctuation
reserve.
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ANNEXURE
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QUESTIONNAIRE
Name of Bank ________ Dated _______
Name of Person ________
Designation ________
8. Does your bank carry out NII (Net Interest Income) sensitivity
analysis?
100
Yes____ No ____
Yes____ No_____
20.Does your bank carry out Risk Focussed Internal Audit (RFIA)?
Yes ___ No___
23. Does your bank outsource or develop in house software for risk
management solutions?
Yes ___ No___
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organisations towards risk culture?
Yes ___ No___
Signature_______
BIBLIOGRAPHY
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