Chapter - 1: 0781913905 Risk Management at Centeral Bank of India

0781913905 RISK MANAGEMENT AT
CENTERAL BANK OF INDIA
CHAPTER - 1
INTRODUCTION
GITARATTAN INTERNATIONAL BUSINESS SCHOOL 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.
Meaning of Risk and Risk Management
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.
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.

Source: James T Gleason, 2001

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.”
Risk as Opportunity:
“The ordinary rate of profit always rises……with the risk”
Hence, Risk Management is an attempt to identify, to measure, to monitor and to

manage uncertainty. It does not aim at risk elimination, but enables the banks to bring
their risks to manageable proportions while not severely affecting their income.
International Financial Risk Institute defines Risk Management as “The application of

financial analysis and diverse financial instruments to control and typically the reduction
of selected type of Risks.” While non-performing assets are the legacy of the past in the
present, risk management system is the pro-active action in the present for the future.
Managing risk is nothing but managing the change before the risk manages.
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.

The broad parameters of risk management function encompass:
1. Organizational structure.
2. Comprehensive risk measurement approach.
3. Risk management policies approved by the Board, which should be 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.
5. Strong MIS for reporting, monitoring and controlling risks.
6. Well laid out procedures, effective control and comprehensive risk reporting
framework.
7. Separate risk management, framework independent of operational departments
and with clear delineation of levels of responsibility for management of risk.
8. Periodical review and evaluation.
Risk Management Structure:
Establishing an appropriate risk management organization structure is choosing between

a centralized and decentralized structure. The global trend is towards centralizing risk
management with integrated treasury management function to benefit from information
on aggregate exposure, natural netting of exposures, economies of scale and easier
reporting to top management. The primary responsibility is of understanding the risks run
by the bank and ensuring that the risks are appropriately managed and vested with the
Board of Directors. The Board sets risk limits by assessing the bank’s risk and risk-
bearing capacity. At organizational level, overall risk management is assigned to an
independent Risk Management Committee or Executive Committee of the top executives
that reports directly to the Board of Directors. The purpose of this top level committee is
to empower one group with full responsibility of evaluating over all risk faced by the

bank and determining the level of risk which will be in the best interest of the bank. At
the same time the committee holds the line management more accountable for the risks
under their control and the performance of the bank in that area. The risk management is
a complex function and it requires specialized skills and expertise. Large banks and those
operating in international markets have developed internal risk management models to be
able to compete effectively with their competitors. At a more sophisticated level, the core
staff at Head Offices is trained in risk modeling and analytical tools.
Internationally, a committee approach to risk management is being adopted. While the

Asset-Liability Management Committee (ALCO) deal with different types of market risk,
the Credit Policy Committee (CPC) oversees the credit/counter party risk and country
risk. Thus, market and credit risks are managed in a parallel two-track approach in banks.
Generally, the policies and procedures for market risk are articulated in the ALM policies
and credit risk is addressed in Loan Policies and Procedures.
Risk Management: Components
The process of risk management has three identifiable steps viz. Risk identification, Risk
measurement, and Risk control.
 Risk Identification
Risk identification means defining each of risks associated with a transaction or a type of
bank product or service. There are various types of risk which bank face such as credit
risk, liquidity risk, interest rate risk, operational risk, legal risk etc.
 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:
1) Avoid the exposure
2) Reduce the impact by reducing frequency of severity
3) Avoid concentration in risky areas
4) Transfer the risk to another party
5) Employ risk management instruments to cover the risks
Steps for implementing Risk Management in Banks
1) Establishing a risk management long term vision and strategy
Risk management implementation strategy is established depending on bank vision,

focus, positioning and resource commitments.
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
3) Construction of risk management index and Sub indices
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.
a. Risk Based Supervision requirements
b.Basel II compliance
c. Using risk strategy in the decision making process
Capital allocation
 Provisioning
 Pricing of products
 Streamlining procedures and reducing operating costs
 By rolling out the action steps in phases the bank measure the progress of the
implementation.
5) Establish Risk measures and early warning indicators
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.
6) Executing the key requirements:
At an operational level checklist of key success factors and quantitative benchmark is

generated. Models to be applied are tested and validated on a prototype basis. Moreover,
evaluation scores on the benchmark levels specified helps to build up a risk process
implementation score.
7) Integrate Risks Management/Strategy into bank internal decision making

process

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.
Types of Risks
 Credit Risks: Credit Risk is defined by the losses in to event of default of borrower
to repay his obligations or in event of deterioration of the borrower’s credit quality.
 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.
 Strategic (Business) Risks: It is the risk in which entire lines of business is succumb
to competition or obsolescence as strategic risks occurs when a bank is not ready or
unable to compete in a newly developing line of business.
 Human Risks: It is risk, which is concurrent with the risk of inadequate loss of key
personnel or misplaced motivation among management personnel.
 Legal Risks: It is the risk that makes transaction proves to be unenforceable in law or
has been inadequately documented.
 Operational Risks: It is the risk of loss resulting from failed or inadequate systems,
people and processes or from external events.
 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.
 Liquidity Risks : Liquidity Risk consists of :
 Market liquidity risks : arises when a firm is unable to conclude a large transaction
in a particular instrument anything near the current market prices.
 Funding liquidity risks: is defined as inability to obtain funds to meet cash flow
obligations.
 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.
NII = Gap * Change in Interest Rate
 Forex Risks: It is the risk that a bank suffers loss due to adverse exchange rate
movement during a period in which it has an open position either spot or forwards
both in same foreign currency.
 Country Risks: This is the risk that arises due to cross-border transactions owing to
economic liberalization and globalization as it is the possibility that a country is
unable to service or repay debts to foreign lenders in time.
Hence, risk management focus on the identification of potential unanticipated events and
on their possible impact on the financial performance of the firm and at the limit on its
survival. Risk Management in its current form is different from what the banks used to
practice earlier. Risk environment has changed and according to the draft Basel II norms
the focus is more on the entire risk return equation.
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.

OPTIMIZING THE RISK RETURN EQUATION

Losses
Profits
DEGREE OF RISK

RBI Guidelines on Risk Management
RBI has issued guidelines from time to time, which are being implemented by banks
through various committees. So far RBI has issued guidelines in respect of following:
A & L Management Systems in Banks Feb., 1999
Risk Management Systems October, 1999
Risk Based Supervision August, 2001
Risk Focused Internal Audit Dec., 2002
Credit and Market risk Management Jan., 2003
RBI suggests that
(a) Banks must equip themselves with an ability to identify, to measure, to monitor
and to control the various risks with New Capital Adequacy provisions in due
course.
(b) For integrated management of risk there must be single risk management
committee.
(c) For managing credit risk, portfolio approach must be adopted.
(d) Appropriate credit risk modeling in the future must be adopted.
(e) For measurement of market risk banks are advised to develop expertise in
internal models
(f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks

operating in international markets.
(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.
To enhance risk management function banks should move towards risk based
supervision and risk focused internal audit.
Significance of the Study
Good risk management is good banking. And good banking is essential for profitable
survival of institution. It brings stability in earnings and increases efficiency in
operations.
The present study proposes to: -
 Enhance shareholders value with
Value creation
Value preservation
Capital optimization
 Enhance capital allocation.
 Improvement of portfolio identification and action plans.
 An understanding of key business processes.
 Integration of risk management within corporate governance framework.
 Improved Information Security.
 Corporate Reputation.

 Instill confidence in the market place.
 Alleviate regulatory constraints and distortions thereof.
In real world risk management creates value. Hence, it is an essential part of a financial
institution as it involves stakeholder’s interest among others.
Objectives of the Study
The following objectives have been fixing for making thus study:
1. To know need for risk management.
To know various types of risks are faced by banks.
2. To analyze different types of risk such as
- Credit Risk
- Market risk, which includes Liquidity risk and Interest rate risk
- Operational risk
3. To know the guidelines set up by RBI for banks.
4. To know how to measure and monitor various risks.
5. To know about Basel II Accord and Risk Based Supervision Requirements.
6. To study about the Risk Management approach adopted by Central Bank of India
7. To know newer methodologies to quantify risk in light of newer businesses and

challenges.

Scope of the Study
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, and 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.
Limitations of the Study

However, I have made every possible effort at my great extent level to show how selected
sample of banks analyze 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.

Chapter2
Company/Industry profile

Overview of the Industry
The Banking system is an integral sub-system of the financial system. It represents an

important channel of collecting small savings from the households and lending it to the
corporate sector.
The Indian Banking system has The Reserve Bank of India (RBI) as the apex body for all
matters relating to the banking system. It is the ‘Central bank’ of India. It is the banker to
all other banks.
Functions of RBI:
1. Currency issuing authority
2. Banker to the Government
3. Banker to other banks
4. Framing of Monetary Policy
5. Exchange control
6. Custodian to Foreign Exchange and Gold Reserves.
7. Developmental activities
8. Research and Development in the banking sector.
Following is the classification of banks:
1. Non Scheduled Banks:
These are banks which are not included in the Second Schedule of the Banking
Regulation Act, 1965. It means they do not satisfy the conditions laid down by that
schedule. They are further classified as follows:
a) Central Co-operative Banks and Primary Credit Societies.
b) Commercial Banks.
2. Scheduled Banks:

Scheduled Banks are banks which are included in the Second Schedule of
the Banking Regulation Act, 1965. According to this schedule a scheduled
bank:
a. Must have paid-up capital and reserve of not less than Rs.500,000;
b. Must also satisfy the RBI that its affairs are not conducted in a manner
detrimental to the interests of its depositors.
Scheduled banks are sub-divided as:
• State Co-operative Banks:
These are Co-operatives owned and managed by the state.
• Commercial Banks:
1. These are business entities whose main business is accepting deposits and
extending loans. Their main objective is profit maximization and adding
shareholder value.
These are further sub-divided as:
1. Indian Banks:
These banks are companies registered in India under the Companies Act.
Their place of origin is in India.
These are also sub-divided as:
• State Bank of India and its Subsidiaries:
This group comprises of the State Bank of India (SBI) and its
seven subsidiaries viz., State Bank of Patiala, State Bank of
Hyderabad, State Bank of Travancore, State Bank of Bikaner and
Jaipur, State Bank of Mysore, State Bank of Saurastra, State Bank
of Indore.
• Other Nationalised Banks:

This group consists of private sector banks that were
Nationalised. The Government of India Nationalised 14 private
banks in 1969 and another 6 in the year 1980.
• Regional Rural Banks:
These were established by the RBI in the year1975 of Banking

Commission. It was established to operate exclusively in rural
areas to provide credit and other facilities to small and marginal
farmer, agricultural laborers, artisans and small entrepreneurs.
• Old Private Sector Banks
This group consists of banks that were established by the privy

states, community organisations or by a group of professionals for
the cause of economic betterment in their area of operations.
Initially their operations were concentrated in a few regional
areas. However, their branches slowly spread throughout the
nation as they grew.
2. New Private Sector banks:
These banks were started as profit oriented companies after the RBI
opened the banking sector to the Private sector. These banks are
mostly technology driven and better managed than other banks.
3. Foreign Banks
These are banks that were registered outside India and had originated in a foreign
country.

Latest Trends in Banking Industry
I. Universal Banking
Universal banking refers to Financial Institution offering all types of financial

services under one roof. Thus, for example, besides borrowing and lending for the
long term, the Development Financial Institutions will be able to borrow/lend for
the short-term as well.
This flexibility brings about a sea change in the bottom line of the Institution.
Impact on DFI:
Two key aspects of the business are affected. The institution can have access to
cheap retail deposits and the breadth of its advances increase to include short-term
working capital loans to corporates. The Institution has greater operational
flexibility. Also they can now effectively compete with the commercial banks.
Indian Scenario:
In India the five DFIs that are frontrunners in the race to convert to Universal
Bank are:
1. Industrial Credit and Investment Corporation of India (ICICI)
2. Industrial Development Bank of India (IDBI)
3. Export Import Bank (EXIM Bank)
4. Industrial Finance Corporation of India (IFCI)
5. Industrial Investment Bank of India (IIBI)
ICICI is already a virtual bank with subsidiaries like ICICI Bank engaged in
banking business. Thus with clearing of legal hurdles it just has to work out the
modalities to formally call itself a universal bank.

Similarly other DFIs are charting out aggressive plans to stay ahead in this race.
Also recently Bank of Baroda, a commercial bank has indicated its intention to
convert to a Universal Bank.
II. RBI Norms:
The norms stipulated by RBI treat DFIs at par with the existing commercial
banks. Thus all Universal banks have to maintain the CRR and the SLR
requirement on the same lines as the commercial banks. Also they have to fulfill
the priority sector lending norms applicable to the commercial banks. These are
the major hurdles as perceived by the institutions, as it is very difficult to fulfill
such norms without hurting the bottomline
Effect on the Banking Sector:
However, with large Term lenders converting into Commercial banks, the existing
players in the industry are likely to face stiff competition, lower bottomline
ultimately leading to a shakeout in the industry with only the operationally
efficient banks will stay into the business, irrespective to the size.
III. Mergers & Acquisitions
The Indian Banking Sector is more overcrowded then ever. There are 96
commercial banks reporting to the RBI. Ever since the RBI opened up the sector
to private players, there have been nine new entrants. All of them are growing at a
scorching pace and redefining the rules of the business. However they are
dwarfed by many large public and old private sector banks with a large network
of branches spread over a diverse geographical area. Thus they are unable to make
a significant dent in the market share of the old players. Also it is impossible to
exponentially increase the number of branches. The only route available for these
banks is to grow inorganically via the M & A route. Hence the new banks are
under a tremendous pressure to acquire older banks and thus increase their
business.
Currently most of the institutionally promoted banks have already gobbled

smaller banks. ICICI Bank has acquired ITC Classic, Anagram Finance and Bank
of Madura within a period of two years. HDFC Bank has merged Times Bank
with itself. UTI bank had almost completed its merger with Global Trust Bank
before it ran into rough weather. Also Nationalised Banks like Bank of Punjab,
Vyasa Bank are wooing IDBI Bank for a merger. Among foreign banks, Standard
& Chartered Bank has acquired ANZ Grindlays Bank’s Asian and Middle East
operations
The above happenings clearly indicate that the M & A scenario in the Indian
banking sector is far from over. Strong banks will continue to takeover weak and
inefficient banks to increase their size.
IV. Multiple Delivery Channels
Today the technology driven banks are finding various means to reduce
costs and reach out to as many customers as possible spread over a diverse
area. This has led to using multiple channels of delivery of their products.
1. ATM (Automatic Teller Machine):
An ATM is basically a machine that can deliver cash to the customers on demand
after authentication. However, nowadays we have ATMs that are used to vend
different FMCG products also. An ATM does the basic function of a bank’s
branch, i.e., delivering money on demand. Hence setting of newer branches is not
required thereby significantly lowering infrastructure costs.
Cost reduction is however possible only when these machines are used. In
India, the average cash withdrawal per ATM per day has fallen from 100 last year
to 70 this year. Though the number of ATMs has increased since last year, it is
not in sync with the number of cards issued. Also, there are many dormant
cardholders who do not use the ATMs and prefer the teller counters. Inspite of
these odds, Indian banks are increasing the number of ATMs at a feverish pace.
These machines also hold the keys to future operational efficiency.

2. Net Banking:
Net banking means carrying out banking transactions via the Internet.
Thus the need for a branch is completely eliminated by technology. Also
this helps in serving the customer better and tailoring products better
suited for the customer
A customer can view his account details, transaction history, order

drafts, electronically make payments, transfer funds, check his account
position and electronically communicate with the bank through the
Internet for which he may have wanted to visit the bank branch.
Net banking helps a bank spread its reach to the entire world at a
fraction of the cost.
3. Phone Banking:
This means carrying out of banking transaction through the telephone. A

customer can call up the banks help line or phone banking number to
conduct transactions like transfer of funds, making payments, checking of
account balance, ordering cheques, etc,. This also eliminates the customer
of the need to visit the bank’s branch.
4. Mobile Banking:
Banks can now help a customer conduct certain transactions through

the Mobile Phone with the help of technologies like WAP, SMS, etc,. This
helps a bank to combine the Internet and telephone and leverage it to cut
costs and at the same time provide its customer the convenience.
Thus it can be seen that tech savvy banks are tapping all the above
alternative channels to cut costs improve customer satisfaction.

V. VRS (Voluntary Retirement Scheme):
VRS or the ‘Golden Handshake’ is picking up very fast in the recent times
due to the serious attention of the government towards overstaffing in the
banks, especially among the public sector banks. The government had also
cleared a uniform VRS framework for the sector giving the banks a seven
months time frame to cut flab. The scheme was open till 31st march, 2001.
Company’s Profile
Established in 1911, Central Bank of India was the first Indian commercial bank which
was wholly owned and managed by Indians. The establishment of the Bank was the
ultimate realisation of the dream of Sir Sorabji Pochkhanawala, founder of the Bank. Sir
Pherozesha Mehta was the first Chairman of a truly 'Swadeshi Bank'. In fact, such was
the extent of pride felt by Sir Sorabji Pochkhanawala that he proclaimed Central Bank as
the 'property of the nation and the country's asset'. He also added that 'Central Bank lives
on people's faith and regards itself as the people's own bank'.
During the past 95 years of history the Bank has weathered many storms and faced many
challenges. The Bank could successfully transform every threat into business opportunity
and excelled over its peers in the Banking industry.
A number of innovative and unique banking activities have been launched by Central
Bank of India and a brief mention of some of its pioneering services are as under:
 1921: Introduction to the Home Savings Safe Deposit Scheme to build

saving/thrift habits in all sections of the society.
 1924: An Exclusive Ladies Department to cater to the Bank's women clientele.
 1926: Safe Deposit Locker facility and Rupee Travellers' Cheques.
 1929: Setting up of the Executor and Trustee Department.

 1932: Deposit Insurance Benefit Scheme.

 1962: Recurring Deposit Scheme.
Subsequently, even after the nationalisation of the Bank in the year 1969, Central Bank
continued to introduce a number of innovative banking services as under:
• 1976: The Merchant Banking Cell was established.

• 1980: Centralcard, the credit card of the Bank was introduced.
• 1986: 'Plantinum Jubilee Money Back Deposit Scheme' was launched.
• 1989: The housing subsidiary Cent Bank Home Finance Ltd. was started with
its headquarters at Bhopal in Madhya Pradesh.
• 1994: Quick Cheque Collection Service (QCC) & Express Service was set up
to enable speedy collection of outstation cheques.
Further in line with the guidelines from Reserve Bank of India as also the Government of
India, Central Bank has been playing an increasingly active role in promoting the key
thrust areas of agriculture, small scale industries as also medium and large industries. The
Bank also introduced a number of Self Employment Schemes to promote employment
among the educated youth.
Among the Public Sector Banks, Central Bank of India can be truly described as an All
India Bank, due to distribution of its large network in 27 out of 28 States as also in 4 out
of 7 Union Territories in India. Central Bank of India holds a very prominent place
among the Public Sector Banks on account of its network of 3169 branches and 267
extension counters at various centres throughout the length and breadth of the country
In view of its large network of branches as also number of savings and other innovative
services offered, the total customer base of the Bank at over 25 million account holders is
one of the largest in the banking industry.
Customers' confidence in Central Bank of India's wide ranging services can very well be
judged from the list of major corporate clients such as ICICI, IDBI, UTI, LIC, HDFC as
also almost all major corporate houses in the country. In line with the Basel II and RBI

guidelines, Central Bank of India has installed an enterprise wide ALM and risk
management solution.
Products and Services
The three types of products or services offered by the Central bank Of India:-
1. Deposit schemes
2. Credit schemes
3. Other schemes
The different types of deposit schemes are:-
• Money Multiplier Deposit Certificate (Mmdc)

• Monthly Interest Deposit Receipt (Midr)
• Quarterly Interest Deposit Receipt (Qidr)
• Cent Uttam Scheme
• Central's Senior Citizen Deposit Scheme
• Central's Flexi Yield Deposit Scheme
• Cent Bachat Khata
• Cent Tax Saving Deposit
The different types of credit schemes are:-
• Cent Suvidha
• Cent Home Loan Plus
• Loan Policy
• Cent Vivah
• Cent Safar
• Cent Jewel
• Cent VEHICLE

• Cent Buy
• Housing Finance Scheme
• Cent Kalyani
• Centvyapari Scheme
• Personal Loan Scheme(Corporate)
• Personal Loan Scheme(Noncorporate)
• Cent Rentals
• Cent Mortgage
• Cent Trade
• Cent Computer Loan
• Loans to Pensioners Drawing Pension
• CentVidyarthi
• Central Kisan Credit Card
• Cent Multipurpose
• Cent Liquid Scheme
• Personal Loan To Teachers
The other services offered by Central Bank of India:-
• Central Card Electronic

• Central Card
• Debit Card
• Traveller's Cheques
• Gift Cheques
• Cash Management Services
• Cent Billpay
• Bancassurance

Chapter3
Research methodology

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.
Problem Definition
Importance of defining a problem can be judged from the fact that unless a problem has
been defined, it is very difficult to point out or decide whether or not the research work
has been useful in helping the researcher understand all the nuances of the situation
resulting in a hazy understanding of the situation.
The problem for present research can be clearly and precisely stated as follows:
“Necessity of the bank to respond to the array of new and more complex risks”
Nature of the Study

An analytical study has been carried out to analyze the impact of Risk on Indian Banking.

Method of Data Collection
The data is collected from the Secondary Sources through journals, books, web etc.
Information has also been obtained through desk research such as:
(a) Annual reports of the Central bank of India
(b) Indian Bank Association Bulletin
(c) RBI Bulletin
(d) Report on trends and progress of banking in India
Tools of Analysis
The following techniques have been applied for analysis: -
 Ratio Analysis
To evaluate the financial condition, performance and profitability banks requires

certain yardsticks .The following various accounting tools have been used.
• 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)
The impact of volatility on the short-term profits is measured by Net Interest

Margin.
Return on Average Assets (ROA) = This ratio is relationship between the net
profit (after tax and interest) and the total assets of the bank. It is calculated as
follows:
Net profit after tax + Interest /Total assets

Return on Equity (ROE) = Shareholders are the real owner of the organisation,
so they are more interested in profitability and performance of an organisation.
This is calculated as follows:
Net profit after interest, tax and Preference dividend /Equity Shareholders
Funds.
Capital Adequacy Ratio
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.

CHAPTER-4
CREDIT RISK MANAGEMENT

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 management of credit risk receives the top management’s attention and the process
encompasses: -
(a) Measurement of risk through credit rating or scoring.
(b) Quantifying the risk through estimating expected loan losses and unexpected loan
losses.
(c) Risk pricing on a scientific basis.
(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 corporate 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.

Instruments of Credit Risk Management
1) Credit Approving Authority
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 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.
4) Risk Pricing
Risk-return pricing is a fundamental tenet of risk management. Banks link loan pricing to
expected loss and high-risk category borrowers are priced high. Banks build historical
database on the portfolio quality and provisioning to equip themselves to price the risk.
Across the world many banks have put in place RAROC (Risk Adjusted Return on
Capital) framework for pricing of loans which calls for data on portfolio behaviour and
allocation of capital that commensurate with credit risk inherent in loan proposals.
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 linkages between
different categories of risk.
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 make 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.
Managing Credit Risks
 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.
 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- 5
MARKET RISK MANAGEMENT

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
Liquidity planning is an important facet of risk management framework in banks. It is the

ability to efficiently accommodate deposit, reduction in liabilities, to fund the loan
growth and possible funding of the off balance sheet claims. The liquidity risk of banks
arises from funding of long-term assets by short-term liabilities thereby making the
liabilities subject to refinancing risk.
The liquidity risk in banks manifest in different dimension:
1. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non

renewal of deposits.
2. Time Risk: need to compensate for non-receipt of expected inflows of funds i.e
performing assets turning into non-performing assets.
3. Call Risk: due to crystallization of contingent liabilities and unable to undertake

profitable business opportunities when desirable.

Liquidity measurement is quite a difficult task and can be measured though stock or cash
flow approaches.
Core Deposits/Total Assets
Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits
For Central Bank of India this ratio is 0.883% for year 2005. This implies
that the liquidity position of CBI 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.
Credit Deposit Ratio
Credit Deposit Ratio = Loans & Advances/Total Deposits
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 in case of CBI 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
recommended as a standard tool.

The assets and liabilities are classified in different maturity buckets:
1. 1 to 14 days
2. 15 to 28 days
3. 29 days and upto 3 months
4. Over 3 months and upto 6 months
5. Over 6 months and upto 1 year
6. Over 1 year and upto 3 years
7. Over 3 years and upto 5 years
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.
♦ Interest Rate Risk
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.

Managing Interest Rate Risk
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 interest rates.
Interest Rate Futures
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.
A financial futures contract is an agreement between a buyer and a seller reached at this
point of time that calls for the delivery of a particular security in exchange for cash at
some future date.
Interest Rate Swaps
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). An Interest Rate Swap (IRS) is defined as a contractual
agreement entered into between two banks under which each agrees to make periodic
payment to other for an agreed period of time based upon a notional amount of principal.
The principal amount is notional because there is no need to exchange actual amounts of
principal. A notional amount of principal is required in order to compute the actual cash
amounts that will be periodically exchanged. An IRS is way to change an institution
exposure interest rate fluctuation and also achieve lower borrowing cost. Swaps can
transform cash flows through a bank to more closely match the pattern of cash flows
desired by management.

CHAPTER-6
OPERATIONAL RISK MANAGEMENT

Defining operational risks
Basel Committee on Banking Supervision (BCBS; September 2001) defines operational

risk as the risk of monetary loss resulting from inadequate or failed internal processes,
people, systems or from external events. It is an evolving and important risk factor faced
by banks and banks need to hold capital to protect against losses from it. The recent
happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential
losses on account of operational risk.
The key drivers of Operational Risk:
Regulatory pressure (Basel II), Increased awareness, Opportunity for performance

improvement.
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
(b) Inadequate Staff
(c) Hiring Unsuitable Staff
(d) Loss of key personnel
(e) Insufficient training
(f) Insufficient succession
Process Risk –
(a) Transaction without proper authority
(b) Erroneous cash movements
(c) Limit Breaches
(d) Unlawful Access
(e) Incorrect recording/reporting of information
Technical Risk –
(a) Programming errors
(b) Incomplete/Inaccurate/Irrelevant MIS
(c) Network failure
(d) Telecommunication failure
(e) Inadequate system protection
(f) Lack of IT support services
(g) Inadequate back-up systems

External Risk –
(a) Natural Disasters (flood, fire etc)
(b) War/terrorism
(c) Sabotage/crime
(d) Collapse in market
Legal, Reputation and Other Risk –
(a) Incomplete Documentation
(b) Breaches of statutory Requirements
(c) Failure to follow regulatory guidelines
(d) Changes in business activities not incorporated
(e) Group Risk
Measuring operational risk
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.
Basel Committee has identified following –10 principles for successful management of
Operational Risk:
 Board of Directors should be aware of major aspects of operational risk of the

organisation as distinct risk category.
 The Board of Directors should ensure that operational management framework of the
organisation provides for effective &comprehensive internal audit.
 Senior management of the organisation should consistently implement approved

operational management framework of the organisation.
 In all material products, activities, processes and systems operational risk contract
should be identified and assessed.
 Regular Monitoring System of operational risk profiles and material exposures to

losses should be in place.
 Policies, processes and procedures to control/mitigate operational risk should be

evolved.
 Contingency and business continue plans should be evolved.
 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.
 Regulatory Authorities should review periodically about organisation approach to

identify, assess, monitor, and control/mitigate operational risk.
 Adequate public disclosures to be made to enable market participants to assess

organisations approach to operational risk.

Chapter-7
BASEL II COMPLIANCE & RISK
BASED SUPERVISION

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 structure of New Accord – II consists of three pillars approach which are as follows:
Pillar Focus area
I Pillar Minimum capital requirement
II Pillar Supervisory review
III Pillar Market discipline
Minimum Capital Requirement
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.
The minimal ration of capital assigned to risk is calculated as follows:
Total Capital (unchanged)

Bank’s Capital Ratio (min 8%) = ----------------------------------------------------------
(RBI prescribes 9 %) Credit risk + Market risk + Operational risk
For Credit Risks three alternative approaches are suggested. The first is a standardised
approach in which RWA (risk weighted assets) is determined except that the risk weights

are no longer determined in asset once but are revised depending upon the ratings of the
counter parties by external credit rating agencies (ECRA). There is also greater
differentiation across risk categories. In the second approach 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.
For meeting operational risk Accord II has specified three alternative approaches- basic
indicator, standardised and internal measurement approach. For operational risk capital
charges are computed directly and then multiplied by 12.5 to make it comparable to
RWA.
Thus D (denominator of the capital adequacy ratio) is defined as
D =RWA + 12.5 * (Sum of capital charges due to market and operational risk)
The numerator N consists of
N = Tier I + Tier II + Tier III
Subject to the proviso that
Tier I + Tier II > 0.08(RWA +12.5{capital charges on account of 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 different banks. Capital adequacy
in relation to economic risk is a necessary condition for the long-term 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.
Capital Adequacy Ratio (%)

2005 2006
SBI 14 14.4
ICICI 11.1 10.36
HDFC 10.5 12.2
IDBI 9.56 10.4
OBC 12.8 10.9
CBI 9.47 11.3
Capital Adequacy Ratio (%)
16
14
12
10
8
6
4
2
0
SBI ICICI HDFC IDBI OBC CBI
Banks
2005 2006
Supervisory Review Process
It entails allocation of supervisory resources and paying supervisory attention in

accordance with risk profile of each bank, optimizes utilization of supervisory resources,
continuous monitoring and evaluation of the risk profiles of the supervised institution
and construction of a risk matrix of each institution. The process requires supervisors to

ensure that each bank has sound internal processes in place to assess the adequacy of its
capital based on through evaluation of its risk.
Market Discipline
The potential of market discipline to reinforce capital regulation depends on the

disclosure of reliable and timely information with a view to enable banks counter parties
to make well founded risk assessments. Moreover, banks are encouraged to disclose ways
in which they allocate capital among different activities. In a recent paper the BIS has
elaborated the recommendations of the Basel II concerning the nature of information to
be disclosed:
1) Structure and components of bank capital.
2) The terms and main features of capital instruments.
3) Breakdown of risk exposures.
4) Its capital ratio and other data related to its capital adequacy on a consolidated basis.
 Reservations about Basel II
 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.
 Basel II involve shift in direct supervisory focus away to implementation issues and
that banks and the supervisors would be required to invest large resources in
upgrading their technology and human resources to meet minimum standards.
 Only those banks likely to benefit from IRB will adopt approach, other banks will
hold on to the standardised approach.
 Fears of disintermediation have also been expressed.

ANALYSIS OF PERFORMANCE INDICATORS
Table showing key performance indicators determining the profitability of bank
CBI
2005 2006
ROA (%) 0.8 1.2
ROE (%) 21.5 23.8
Capital Adequacy Ratio (%) 9.47 11.3
Net Interest Margin (%) 3.79 3.79
Some of the ratios used for analyzing the aspect of risk management are as follows: -
 Cost of Funds = Total Interest Expense / Interest bearing liabilities
where Interest bearing liabilities = Deposit + Borrowings
On analyzing this ratio we see that the bank has the lower cost of funds in year 2006 as
compared to 2005. The reason for this is the larger retail base that result in being able to
raise capital in small lots.
 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 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 3.7%, for CBI in year 2005. Central Bank of

India is the bank which is able to stabilize short-term profits as net interest margin for
year 2005 and 2006 is same (3.79%).
 Spread = Yield – Cost of Funds
Where Yield = Total Interest Earned/Earning Assets
On having a closer look at the yield curve of CBI we see that there is clear trend towards
convergence over the period 2005-2006.
 Overhead Efficiency = Non Interest Income/Non Interest Expense
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.
 Profit Margin =Net Income/ Total Revenue
This increased competition in the industry has resulted in lowering the spreads under
which banks operate.
 Asset Utilization = Total Revenue/Total Assets
The asset utilization ratio for the CBI is around 10% over the two-year period. 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.

CHAPTER – 8
OBSERVATIONS AND SUGGESTION

This chapter is divided into two sections. First part consists of major observations of
study and second part comprises of its suggestions.
The observations 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
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 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.
 Regulatory and legal issues are not taken into account while setting up of risk
management system.
 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, data warehousing and in
sophisticated statistical models as aggregation and analysis of the vast amount of data
is needed for successful risk management system.
The following recommendations are worth mentioning:
 Risk Management System should be in place to deal with current and potential risks.
 The system needs to be developed in line with organization goals and objective.
 For measuring and managing risk the comprehensive and credible system need to be
placed by a specified date which is much more longer before sufficient data
aggregation could be carried out for introduction of sophisticated quantitative
approaches.
 Regulatory and legal issues need to be taken into account while setting up the risk
management system.
 There should be an active participation of senior management and main line

functional staff in setting up of risk management system, which will enhance the
acceptability of adopting the risk management measures by the employees.
 An efficient asset liability management system should be there, which is an adequate

tool to identify and mitigate market risks.
 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.
 Monitoring and reviewing risk management process with dynamically changing

global environment needs to be undertaken.
 Selection processes of vendors for outsourcing the software solution should not be
long drawn.

 New system calls for skilled expertise sophisticated IT infrastructure and a
comprehensive database.
 Measuring and disclosing various risks requires sound MIS. A technological

application in the form of networking and data warehousing is indispensable.
 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.
Conclusion
Risk management is a continuously evolving mix of science and art. Losses are
inevitable, but one must keep learning from the past. Risk itself is not bad, but risk that is
misplaced, mismanaged, misunderstood, or unintended is bad. Each institution needs to
assess which method best suits its objectives, its business, its view of the world and its
pockets. A clear distinction should be made between risk management and risk taking.
Risk management oversees and ensures the integrity of the process with which risks are
taken. To maintain the objectivity, risk management cannot be a part of the risk taking
process. Individuals who manage risk need to be completely independent from
individuals who are responsible for taking risk. Currently only very few mid sized IT
companies offer integrated Risk Management package. In future not only banks, but most
of the financial Services companies will be in a need an integrated risk management and
mitigation packages. Banks need risk management packages not only to adhere Basel II,
also for effective risk management and mitigation, effective capital allocation, gain
competitive advantage, develop the robust system and process, improve reporting
systems and transparency, and cost reduction through detailed data analysis.

Bibliography
Mark, Robert.P (2000),” Risk Management”, Mcgraw Hill
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0781913905 RISK MANAGEMENT AT

CENTERAL BANK OF INDIA

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 1

Meaning of Risk and Risk Management

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 2

Source: James T Gleason, 2001

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 3

“The ordinary rate of profit always rises……with the risk”

Hence, Risk Management is an attempt to identify, to measure, to monitor and to

International Financial Risk Institute defines Risk Management as “The application of

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 4

The broad parameters of risk management function encompass:

8. Periodical review and evaluation.

Risk Management Structure:

Establishing an appropriate risk management organization structure is choosing between

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 5

Internationally, a committee approach to risk management is being adopted. While the

Risk Management: Components

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 6

1) Avoid the exposure

2) Reduce the impact by reducing frequency of severity

3) Avoid concentration in risky areas

4) Transfer the risk to another party

5) Employ risk management instruments to cover the risks

Steps for implementing Risk Management in Banks

1) Establishing a risk management long term vision and strategy

Risk management implementation strategy is established depending on bank vision,

3) Construction of risk management index and Sub indices

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 7

a. Risk Based Supervision requirements

c. Using risk strategy in the decision making process

 Streamlining procedures and reducing operating costs

5) Establish Risk measures and early warning indicators

6) Executing the key requirements:

At an operational level checklist of key success factors and quantitative benchmark is

7) Integrate Risks Management/Strategy into bank internal decision making

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 8

 Liquidity Risks : Liquidity Risk consists of :

NII = Gap * Change in Interest Rate

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 10

OPTIMIZING THE RISK RETURN EQUATION

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 11

RBI Guidelines on Risk Management

A & L Management Systems in Banks Feb., 1999

Risk Management Systems October, 1999

Risk Based Supervision August, 2001

Risk Focused Internal Audit Dec., 2002

Credit and Market risk Management Jan., 2003

RBI suggests that

(c) For managing credit risk, portfolio approach must be adopted.

(d) Appropriate credit risk modeling in the future must be adopted.

(f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by banks

Significance of the Study

The present study proposes to: -

 Enhance shareholders value with

 Enhance capital allocation.

 Improvement of portfolio identification and action plans.

 An understanding of key business processes.

 Integration of risk management within corporate governance framework.

 Improved Information Security.

GITARATTAN INTERNATIONAL BUSINESS SCHOOL 13

 Alleviate regulatory constraints and distortions thereof.