COMMERCIAL

BANKING
OPERATIONS
Risk and Banking Business
 What is Risk?
• Chance/probability to fail
• Possibility of outcome of an action or event could bring adverse
impact on bank’s capital, profitability and reputation.
• It can cause erosion of capital fund or imposition of constraints on a
bank \’s ability and its business objectives.
• Banking sector is well regulated to be mitigated from risk
• Stops sudden adverse effect in balance sheet and profit and loss
account of the bank
• Risk can be mitigated but not eliminated completely
• Losses are absorbed by equity, hence there is always focus to
increase the equity base or capital fund of the bank
• Many statutory provisions for requirement of reserves are the step
towards increasing the risk absorbing capacity of banks
• Relating bank’s earning assets with capital fund is another
milestone towards the increasing risk absorbing capacity of banks
 What is Financial Risk?
Financial risk is the possibility of incurring loss in monetary
terms by any type of events. In banks such risks may cause
immediate adverse effect on profitability and long-term
effect by bringing erosion of capital.
• Credit Risk
• Operational Risk
• Market Risk
– Interest Rate Risk
– Exchange Rate Risk
– Equity Price Risk
– Commodity Price Risk
• Liquidity Risk
• Legal Risk
 Other Risk
Apart from the financial risks, there are other risks as well which can
derail the banks from its main objective of winning public confidence,
accumulating business and maintaining growth. Some of them are
mentioned below.
• Strategic Risk
• Reputational Risk
• Country Risk
• Political Risk
• Contagion Risk
• Risk from Calamities
• Compliance Risk
 How do bank cope up with risk?
(Risk mitigation)
• Quality management
• Diversification
• Deposit and Credit Insurance
• Insurance of hypothecated stocks and mortgaged properties
• Strong Capital Fund
• Following strong compliance culture
• Preparing and strictly implementing competent policies and process
guidelines
• Using top notch (well known) software
• Training employees towards risk management
 Risk Management Function
Identification, assessment and prioritization of risks followed by well
coordinated and economical application of resources towards the control
for the minimization of the impact.
Risk management function function must cover:
• Best Suitable Organizational Structure (Authorities should be
specified)
• Strong internal audit
• Comprehensive approach towards risk measurement
• Strictly follow the prudential and procedural guidelines
• Strong MIS (Reporting, Monitoring and Controlling Risk)
• Well laid down policies, procedures and guidelines
• Periodical review/evaluation on the risk management perspective
Process of Mitigating Banking Risks

• Risk Identification
• Risk Measurement
• Risk Mitigation
• Risk Monitoring
 Risk Management Structure
• Formation of IRMC (Internal Risk Management
Committee) and IRMD (Internal Risk Management
Department)
– To identify, monitor and measure risks
– To formulate and up to date policies, guidelines, manuals etc
– To conduct internal risk rating of credit customers
– To prepare or assist pricing of complex products
– To foresee the market dynamics and estimate as well as
manage any new risk to come
 Principles/Features of effective risk
management
• Value creation (No hurdle creation)
• Integral part of organization
• Part of decision making
• Systemic and structured
• Use of best available information
• Consider human factor
• Transparent and inclusiveness
• Dynamism and responsive to change
• Directed towards continuous improvement
 Credit Risk

• Risk of default in a loan which arises due to nonperformance

of borrower i.e., when the borrower does not pay their
periodical interest and principal obligation as per contract
made at the time of taking the loan.
• Adversely affects the profitability and bank’s capital both.
• It doesn’t necessarily occur in isolation rather it may be
created due to bad portfolio as well.
• Credit risk can further attract liquidity risk
 Mitigation of Credit Risk
• Bank must set up experienced credit management team to ensure better
appraisal quality analysis all risk associated with it.
• Credit exposure should be set up at both customer level and sector level
– Single borrower Obligor limit
• Full appraisal practice should be carried out for non-fund-based limit like LC
and BG as it at any point can change into contingent liability
• Adequate and marketable collateral security to be obtained as back up for
loans and advances or any contingent liabilities.
• Exposure limits should be put in place covering counterparty and business
group for on and off-balance sheet items. No exposure above approved
limits should be allowed.
• Full adherence to be done with KYC norms.
• Regulator’s compliance guideline to be duly followed up
• Effective credit administration to ensuring correct documentation and safe
keeping of files cum security documents.
• Effective loan monitoring and follow up practices to be followed up.
• Timely initiation of legal action for recovery including auction of property
and suing in DRT.
• Timely blacklisting of default borrower.
 Operational Risk
• Risk whish arises from the mistakes or events related to
people, process, system and external environment.
• May range from small to big which may collapse even a
strong bank or jeopardize its whole existence
• Direct or indirect loss due to failed or inadequate internal
process, people and system or external events.
• Legal risk is also included in operational risk, it ignores
reputational and strategic risks due to measurement issues.
• Legal risk is the loss incurred primarily due to defective
transaction or a claim or counter claim being made or
occurring some other event which results in liability or other
loss or failing to take appropriate measures to protect assets
or due to change in law.
• May cause outright loss, regulatory overhead and
reputational damage of the bank
 Operational Risk (Types)…..
– Internal fraud
(fraud by staffs)
– External Fraud
(bank fraud by third party, hacking etc)
– Clients, product and business practices
(intentional and unintentional events that fail to meet customer
expectation)
– Employment Practices and workplace safety
(separate practice if done other than law)
– Damage to physical assets
(Damage to assets from natural phenomenon or man-made events)
– Business disruption and system failure
(Distribution channel and system failure)
– Execution, delivery and process management
(Failure to execute transactions and manage processes correctly. Issues
such as data entry error and unfinished legal documents can cause
unprecedented loss to bank.)
 Mitigation of Operational Risk
• Following prudent banking practice
• Preparing proper guideline and manuals for each banking function and follow it up
meticulously without any laxity on personal preference.
• Following the prudential guidelines and circulars of regulators
• Maintain effective cross check mechanism
• Have strong risk based internal audit system with all type audits like concurrent audit
and LC audit etc
• Taking safety measures like CC TV surveillance, attended guards and other safety
precautions like fire extinguisher, alarm system etc
• Maintaining safe structure of bank with effective control system
• Obtaining proper documents from customer and duly verifying it with originals and re-
verifying them from referrals as well as far as available.
• Using top notch and updated system and establish effective password policy to stop the
unauthorized use of the software.
• Use of adequate firewall in order to avoid any breach of security
• Availability of alternative channel of data transmission of system for emergency
• Setting up effective disaster recovery system and off-site data storage for data safety
• Conduct timely IT and system audit
• Timely review of products, policies and procedural guidelines
• Establishment of strong IRMD and make Operational Risk Management Committee at
various levels.
• Training regarding procedures, products, system operations and banking ethics should
be given to staffs.
 Market Risk
• Risk to a bank due to movement in the market
especially from the movements of interest rate,
foreign exchange rate and price of equity and
commodities.
• Market risk may be explicit to the portfolio of
commodities and stock traded whereas it is implicit
with the adverse movement on interest rate and
exchange rate.
• The market risk is of four types;
– Interest Rate Risk
– Foreign Exchange Rate Risk
– Equity Price Risk
– Commodity Price Risk
 Market Risk…………..
• Interest Rate Risk: Effect on bank’s profitability
and capital fund due to adverse movement of
interest rate in the market.
• Foreign Exchange Rate Risk: Effect on bank’s
profitability and capital fund due to adverse
movement of foreign exchange rate in the market.
• Equity Price Risk: Adverse effect on bank’s
portfolio of invested equities due to adverse
movement of their prices in the market.
• Commodity Price Risk: Adverse effect on bank’s
portfolio of invested commodities due to adverse
movement of their prices in the market.
 Mitigations of Interest Rate Risks and Foreign
Exchange Risk
• Establish effective system to address risk created from changes in interest
rate as well as change in foreign exchange rate.
• Assessment of effect on bank’s asset and liability due to change in interest
rate.
• Adequate pricing practice should be followed up for new products by
analyzing the effect of interest rate change as well.
• To absorb this type of risk, practice of maintaining foreign exchange
fluctuation reserve is to be created.
• The currency wise matching for asset and liabilities should be done for each
currency for short term and long term and the open position should be
always within the prescribed limit, square position is preferred or hedging of
exposed risk is prescribed.
• Sound investment policy to be followed up investing in commodities and
equity and effective decision shall be made at the time of buying and selling
them with proper fundamental and technical anlysis.
 Liquidity Risk
• It is the banking risk of being almost emptied or out of liquid fund to make
payment for its liability holders and its credit customers for already
committed credit line or any liability created from nonfunded activities for
the payment of which bank has already entered in a contract. In such
situation the demand of liquid fund rises to a risky level and bank may
suffer hard time to match with the maturity of the funds from the
repayment of the loans and liquidation of other assets to meet the
payment requirements.
• Liquidity risk can affect the bank very badly. It may ruin the image and
drag the bank out of the business even though the net worth and
profitability of the bank is satisfactory. Bank management should be
extremely serious towards the liquidity position, and liquidity management
should be provided with the priority to grasp it as the central and
uncompromising function of effective and efficient bank management as
well.
• Liquidity position of bank may come into risk in two ways.

– Due to internal or bank specific reason (Unsystemic Risk)

– Due to distress in the whole economy (Systemic Risk)
 Liquidity Risk ……
• When there is mismatch between the maturities of the various
financial instruments at liability and asset side of the bank, the bank
cannot arrange funds to make payments. On the other hand, if there
is run in the bank due to certain fraudulent activities or huge loss of
brand image, the pace of draining of liability side becomes far faster
and more uncontrollable than the possible pace of liquidation of
assets.

• Sometime, such situation arises due to liquidity problem in the whole

economy. Government collects revenues from us and in return
invests in the development activities but due to the administration
hassles and other incapability, the Government functionaries fail to
expend the allocated budget in time. In this situation, there is
shortage of money supply in the economy as all the money which
need to be circulated in the economy remains as the balance with
the Government account. Sometimes, the same situation arises
when there is global recession as well.
 Mitigations of Liquidity Risk

• Periodical returns as suggested in the prescribed format mentioned in NRB

Directives form no 5.1 shall be prepared quarterly and sent to the NRB
within 15 days to assist in their data compilation function and for their
detailed study.
• To overcome the liquidity risk, bank need to resort to control the
mismatches between the maturities of assets and liabilities.
• Such maturity mismatches should be within manageable limit and well
equipped with the strategy to fulfill the required gap predicted for various
time intervals.
• To comply the NRB guidelines of maintaining CD ratio and liquid assets ratio
to address the liquidity position of the bank. The required CD ratio is 90%
and liquid asset to deposit ratio is 20%.
• To predict and manage any unforeseen event which may cause liquidity
problem in bank.
 Other Risk
• Strategic Risk
– Risk that may arise due to lack of long-term vision or
planning of the managing team or due to unsuccessful
plan
• Reputational Risk
– Risk which can hamper the image of a bank market
positioning and dignity.
• Country Risk
– Country risk arises when bank fails to collect claims from
entities for reason arising from political, economic or
social conditions in that entity’s country of origin.
 Other Risk
• Political Risk
– Risk to bank due to changed policies and laws from
Government or any decisions of Government like foreign
relations ..
• Contagion Risk
– Transmission of risk between countries like market distress
in recession or economic slowdown.
• Compliance Risk
– Risk arose due noncompliance of law of country and
guidelines of central bank. It affects reputation and not only
attracts fine to banks but also punishment to involved
bankers as per banking offense act.