Risk Definition

&
Identification of Different Risks
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 Hierarchy of Financial Risks
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Liquidity Risk
“Specific
Risk”
Equity Risk Trading Risk
Market Risk General
Interest Rate Risk
Market
Gap Risk Risk
Financial Currency Risk
Credit Risk
Risks Commodity Risk
Counterparty
Operational Risk
Risk
Transaction Risk
Issuer Risk
Portfolio
Concentration
Risk Issue Risk
 Market risk
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 Old wisdom dictates that one should avoid putting all eggs in the
same basket.
 Diversification does not reduce risk below a minimum level.
 The minimum level of risk which is attributable to factors which
are external to portfolio is MARKET or SYSTEMATIC RISK.

 The component of risk which can be reduced by diversification is

NON SYSTEMATIC RISK.
 The possibility of loss to a Business caused by changes in market
variables.
 Risk to the Bank’s Earnings & Capital due to changes in the
market level of Interest rates or prices of Securities, Foreign
Exchange, Commodities & Equities as well as volatilities in the
prices
5 Market Risk -- Types

Liquidity Risk Interest rate Forex Risk Equity price Commodity

Risk Risk price Risk
6 What is liquidity?
 Ability to fund increases in assets & meet payment obligations on due date efficiently &
economically.

What is liquidity Risk?

• “ Potential inability to meet the Bank’s liabilities on the due date.”
• Arises due to :

• 1. Inability to generate cash to cope with decline in deposits or increase in assets.

• 2. Mismatches in maturity pattern of assets & liabilities.
7 Why we should manage liquidity risk?
 Demonstrates safety of Bank & provides confidence.
 Necessary to nurture relationship.
 Avoid unprofitable sale of assets.
 Lowers the default risk premium.
 Reduces the need to resort to borrowings from the Central Bank.

Liquidity risk - Dimensions

• Funding Risk
• Time Risk
• Call Risk
 8 Liquidity Risk – How to Manage?
 Have an effective Liquidity management policy

 Funding Strategies,  Prudential limits,

 Liquidity planning under alternative scenario,  Liquidity reporting & reviewing

• Tracking of cash flow mismatches. Track the impact of prepayment of loans & pre mature
closure of deposits.
• Monitoring high value deposits.
• Seasonal pattern of deposits/loans.
• Potential liquidity needs for meeting new loan demands, un-availed credit limits, potential
deposit losses, investment obligations, statutory obligations etc.
• Contingency funding plans.
9 Liquidity Risk – How to manage?

 Purchased funds vis-à-vis core assets.

 Core deposits vis-à-vis Core assets.
 Duration of liabilities & Investment portfolio
 Cumulative mismatches across all time bands.
 Commitment ratio – tracking commitments given
10 Interest rate risk
 Deregulation of interest rates has exposed the Banks to adverse impact of Interest rate risk.
 Risk that value of Assets & Liabilities as also Net Interest Income get affected due to movements in
interest rates.
 Mismatch in cash flows or re-pricing dates of assets & liabilities expose Bank’s NII or NIM to
variations

Interest rate risk -- Types

• Mismatch or Gap Risk. • Reinvestment Risk.

• Embedded Option Risk. • Price Risk
11 Rigidities on interest rate risks
 Most liabilities are on Fixed rate basis while assets are on the floating rate basis.
 There is no definite interest rate re-pricing date for floating rate.
 Banks have to strengthen the MIS & Computer processing capabilities for accurate measurement
of IRR

Interest Rate Risk Management

• Floating Rate Deposits
• Fixed Rate Lending
• Derivative products like Forward Rate Agreements
India interest rate volatility
India historical inflation rate
14 Foreign exchange risk

 Risk that Bank may suffer loss as result of adverse exchange rate movements during the period in
which it has open position.
 Risk arises whenever business has income/expenditure, asset/liability in a currency other than
balance sheet currency.

Types of Forex Risks

• Open or Mismatch positions. • Country Risk.
• Price Risk. • Operating Risk.
• Credit Risk. • Legal Risk.
15 Forex risk management

 Set appropriate limit for open position/gaps.

 Clear cut & well defined division of responsibility between
front, middle & back office.
 Use of hedging tools like forwards, futures & options.
 India Exchange Rate Volatility

USD VS INR
80

70

60

50

40

30

20

10

0
0 1 2 3 4 5 5 6 7 8 9 0 0 1 2 3 4 5 5 6 7 8 9 0 0 1 2 3 4 5 5 6 7 8 9
c -9 t-9 g -9 n -9 r-9 b -9 c -9 t-9 g -9 n -9 r-9 b -0 c -0 t-0 g -0 n -0 r-0 b -0 c -0 t-0 g -0 n -0 r-0 b -1 c -1 t-1 g -1 n -1 r-1 b -1 c -1 t-1 g -1 n -1 r-1
e c u p e e c u p e e c u p e e c u p e e c u p e e c u p
- D -O -A u -J -A -F -D -O -A u -J -A -F -D -O -A u -J -A -F -D -O -A u -J -A -F -D -O -A u -J -A -F -D -O -A u -J -A
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
 Equity Price Risk
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 Changes in Equity prices can result losses to the bank holding Equity portfolio.
 Banks are not allowed to sell the securities with out holding the same.
 Banks are free to acquire Shares/Debs/Units of equity oriented mutual funds subject to ceiling of
5% of the total domestic credit

Equity Price Risk Management

• Build up adequate exposure to equity market • Review of Investment portfolio – on going basis.

• Formulate transparent policy & procedure for • Fixing prudential exposure

investment in shares.
• Formation of Investment committee.
18 Commodity price risk

 Banks have very little exposure to

commodities in their trading book.
 Price rise/movement in commodities
is more complex & volatile.
 Banks in developed countries use
derivatives to hedge commodity
price risk.
 Banks in India have to acquire the
skills to manage as & when they get
exposed to commodity price risk.
 Credit risk
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 Credit risk is the possibility of a loss

resulting from a borrower's failure to repay
a loan or meet contractual obligations
 Consumer credit risk can be measured by
the five Cs:
 credit history
 capacity to repay
 capital
 the loan's conditions
 associated collateral.
 Consumers posing higher credit risks
usually end up paying higher interest rates
on loans.
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Credit risk

Transaction risk
 Transaction risk refers to the adverse effect that foreign
exchange rate fluctuations can have on a completed
transaction prior to settlement. It is the exchange rate
risk associated with the time delay between entering into
a contract and settling it.
 Transaction risk tends to increase when there is a long
period of time between entering into a contract and
settling it.
 Transaction risk can be reduced by utilizing forwards and
options contracts to hedge adverse exchange rate moves.
21 Credit risk
portfolio concentration risk

 Portfolio Concentration risk is a banking term describing the level

of risk in a bank’s portfolio arising from concentration to a single
counterparty, sector or country.
 There are two types of concentration risk based on sources.
 Concentration risk can arise from uneven distribution of exposures (or
loan) to its borrowers. Such a risk is called name concentration risk.

 Another type is sectoral concentration risk, which can arise from

uneven distribution of exposures to particular sectors, regions, industries
or products
 A key component to the management of concentration risk is accurately
defining thresholds across various concentrations to minimize the
combined risks across concentrations.
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Credit risk

counterparty, issuer risk

 Counterparty risk is the likelihood or probability that one of those

involved in a transaction might default on its contractual
obligation. Counterparty risk can exist in credit, investment, and trading
transactions.
 Issuer risk , means the probability of incurring losses due to changes in
the value of the financial instrument arising from changes in the
financial condition of the issuer of the instrument. E.g. bonds issued by
IL&FS, Cox & Kings, DHFL etc
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Operational risk

 The risk of loss resulting from inadequate or

failed internal processes, people and systems or
from external events
 Generally, operational risk events can be
subdivided into:
 internal process risk
 people risk
 systems risk
 external risk
 legal risk
 Managing operational risk
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