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Risk analysis on Indian Banking Sector
Submitted in partial fulfillment of the requirements for
MASTER IN MANAGEMENT STUDIES
M.M.S II
2009-2011
SUBMITTED BY
Name: AMREEN PARKAR
M.M.S 2nd year
Roll No. 35
Batch: 2009 - 2011
H K Institute of Management Studies and Research,
Jogeshwari,
Mumbai 400102
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CERTIFICATE
This is to certify that the dissertation submitted in partial
fulfillment for the award of M.M.S of HKIMSR is the result
of the bonafide research work carried out by Ms. AMREEN
PARKAR under my supervision and guidance, no part of
this report has been submitted for award of any other
degree, diploma, fellowship or other similar titles or
prizes. The work has also not been published in anyjournals/ magazines.
Date: 29/01/2011
Place : MUMBAI
Project Guide:
Prof. NEHA GORADIA
Core Faculty
HKIMSR
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ACKNOWLEDGEMENT
During The Perseverance Of This Project, I Was Supported By
Different People, Whose Names If Not Mentioned Would Be
Inconsiderate On My Part. I Would Like To Extend My Sincere
Gratitude And Appreciation To Prof. NEHA GORADIA Who
Initiated Me Into The Study Of RISK ANALYSIS ON INDIAN
BANKING SECTOR
It Has Indeed Been A Great Experience Working Under Them
During The Course Of The Project For Their Invaluable Advice And
Guidance Provided Through Out This Project. I Also Owe My
Sincere Gratitude To Mr. K. C. PANDEY Director Of Our College.
I Would Also Like To Thank The Following People Who Through
Their Experience Have Enlightened Me On The Practical Aspects
Of This Subject Without Whom The Study Would Not Have Been
Carried Out Successfully. I Would Also Like To Give My Sincere
Gratitude To All My College Librarian Staff Because Of Whom I Am
Able To Complete MyProject.
EXECUTIVE SUMMARY
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The pace of development for the Indian banking industry has been tremendous
over thepast decade. As the world reels from the global financial meltdown,
Indias banking sectorhas been one of the very few to actually maintain
resilience while continuing to providegrowth opportunities, a feat unlikely to be
matched by other developed markets around theworld. A majority of the
respondents, almost 69% of them, felt that the Indian bankingIndustry was in avery good to excellent shape, with a further 25% feeling it was ingo od shape and
only 6.25% of the respondents feeling that the performance of the
industry was just average.This optimism is reflected in the fact that 53.33% of
respondents were confident ina growth rate of 15-20% for the banking industry
in 2009-10 and a greater than20% growth rate for 2014-15. Some of the major
strengths of the Indian banking industry, which makes itresilient in the current
economic climate wereregulatory system (93.75%), economic growth (75%),
and relative insulation fromexternal market (68.75%).
The new decade is predicted to be more transformational than the first decade
of this millennium for the Indian economy and the Indian financial system. If the
last ten years have seen transformation in terms of consistently higher growth
rates, adoption of core banking solutions, transformation in the payments
systems and greater integration with the global economy, the coming decade
will see unprecedented volume of business for the Indian financial system as it
tries to meet the challenges and requirements of rapid and inclusive growth.
Information Technology (IT) has made it possible for banks to deal with large
numbers and such growth in volume and value of business will obviously imply
huge challenges for risk management, which in turn will have to depend on
human resources. Respondents perceived ever rising customer expectations and
risk management asthe greatest challenge for the industry in the current
climate.93.75% of our respondents saw expansion of operations as important in
thefuture, with branch expansion and strategic alliances the most important
organicand inorganic means for global expansion respectively.
The characteristics of present banking system is exposed to diverse market andnon-market risks, which has put risk management in these sectors to a core
functionary within the financial institutions. This has been essentially done to
protect not only the interests of the stakeholders, but more obviously, in
protection to the shareholders and creditors. The growing economy demands a
safe and sound banking system, and as such, risk management has become a
critical task for the banking sectors, bringing in stability in the financial markets.
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A good supervision of all the factors involved, would lead to identifying,
assessing, and promoting a secured risk management system.
The banking sector is increasingly faced with tougher challenges in meeting
various risk management requirements, and no matter how tough it is, the
present day operations requires the risk managers to be vigilant, and unusually
diligently perceptive towards the causes of protecting the interest of the people
concerned. In the practical scenario, risk management is very much fragmented,
spread across in pockets, resulting in inconsistency in reporting, inadequate
measurements, and poor quality of management. Poor data availability is one of
the major causes in inefficient risk management, making it difficult for the bank
to manage and control in an institution-wide environment.
In order that a consolidated step could be taken towards a better risk
management, there has been much interaction between the public and private
sectors, with an attempt to evolve techniques, mostly pertinent to the bankingsector, which represents the largest and most internationally active industry in
the world. Through these deliberations, Basel Committee (BCBS) in Basel,
Switzerland, in 1988, came out with Basel I framework proposal, which brought
together closer ties between the banks capital holding, and the risks that are
involved. This brought in higher capital level. The banking sector is growing
rapidly, and with its large and complex operations, Basel I have become
inadequate in continuing with the improvement of the advanced method of risk
management that the banking sectors have today. A more comprehensive
guideline was evolved in Basel II. This regulation envisaged that, the banking
sector should ensure a proper handling of the capital, separate the operational
risk from the credit risk while quantifying both, and distribute capital vis--vis
the economic risk.
INTRODUCTION
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Recent time has witnessed the world economy develop serious difficulties in
terms of lapseof banking & financial institutions and plunging demand.
Prospects became very uncertaincausing recession in major economies.
However, amidst all this chaos Indias banking sectorhas been amongst the few
to maintain resilience.
A progressively growing balance sheet, higher pace of credit expansion,expandingprofitability and productivity similar to banks in developed markets,
lower incidence of nonperformingassets and focus on financial inclusion have
contributed to making Indianbanking vibrant and strong. Indian banks have
begun to revise their growth approach andre-evaluate the prospects on hand to
keep the economy rolling. The way forward for theIndian banks is to innovate to
take advantage of the new business opportunities and at thesame time ensure
continuous assessment of risks.
A rigorous evaluation of the health of commercial banks, recently undertaken by
theCommittee on Financial Sector Assessment (CFSA) also shows that thecommercial banks arerobust and versatile. The single -factor stress tests
undertaken by the CFSA divulge that thebanking system can endure
considerable shocks arising from large possible changes in creditquality, interest
rate and liquidity conditions. These stress tests for credit, market andliquidity
risk show that Indian banks are by and large resilient.Thus, it has become far
more imperative to contemplate the role of the Banking Indus try infostering the
long term growth of the economy. With the purview of economic stability
andgrowth, greater attention is required on both political and regulatory
commitment to longterm development programme.
Liberalization and de-regulation process started in 1991-92 has made a sea
change in the banking system. From a totally regulated environment, we have
gradually moved into a market driven competitive system. Our move towards
global benchmarks has been, by and large, calibrated and regulator driven. The
pace of changes gained momentum in the last few years. Globalization would
gain greater speed in the coming years particularly on account of expected
opening up of financial services under WTO. Four trends change the banking
industry world over, viz. 1) Consolidation of players through mergers and
acquisitions, 2) Globalization of operations, 3) Development of new technology
and 4) Universalisation of banking. With technology acting as a catalyst, we
expect to see great changes in the banking scene in the coming years. It entails
emergence of an integrated and diversified financial system. The move towards
universal banking has already begun. This will gather further momentum
bringing non-banking financial institutions also, into an integrated financia l
system.
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The traditional banking functions would give way to a system geared to meet all
the financial needs of the customer. We could see emergence of highly varied
financial products, which are tailored to meet specific needs of the customers in
the retail as well as corporate segments. The advent of new technologies could
see the emergence of new financial players doing financial intermediation. For
example, we could see utility service providers offering say, bill paymentservices or supermarkets or retailers doing basic lending operations. The
conventional definition of banking might undergo changes.
The competitive environment in the banking sector is likely to result in
individual players working out differentiated strategies based on their strengths
and market niches. For example, some players might emerge as specialists in
mortgage products, credit cards etc. whereas some could choose to concentrate
on particular segments of business system, while outsourcing all other functions.
Some other banks may concentrate on SME segments or high net worth
individuals by providing specially tailored services beyond traditional bankingofferings to satisfy the needs of customers they understand better than a more
generalist competitor.
Industry overview
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The predi ent of the banks in the developed countries owing to excessive
leverage andnegligent regulatory system has time and again been compared with
somewhat unscathed IndianBanking Sector. An attempt has been made to
understand the general sentiment withregards to the performance, the challenges
and the opportunities ahead for the IndianBanking Sector.A majority of therespondents, almost 69% ofthem, feltthatthe Indian banking Industrywas in a
very good to excellent shape, with a further 25% feeling it was in good shape
andonly 6% ofthe respondents feeling thatthe performance ofthe industry was
just average. Infact, an overwhelming majority (93.33%) ofthe respondents felt
thatthe banking industrycompared with the best ofthe sectors ofthe economy,
including pharmaceuticals,infrastructure, etc.Most of the respondents were
positive with regard to the growth rate (Fig. 1) attainable bythe Indian banking
industry forthe year 2009-10 and 2014-15, with 53.33% ofthe view thatgrowth
would be between 15-20% forthe year 2009-10 and greater than 20% for 2014-15.
Fig. 1: Projected growth rates of banks
The major strength ofthe Indian banking industry, which makes itresilientin the
current economic climate; 93.75% respondents feel the regulatory system tobe
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the major strength, 75% economic growth, 68.75% relative insulation from
externalmarket, 56.25% credit quality, 25% technological advancement and
43.75% our riskassessment systems.
Change is the only constant feature in this dynamic world and banking is not an
exception.The changes staring in the face of bankers relates to the fundamental
way of banking-whichis going through rapid transformation in the world oftoday. Adjust, adapt and changeshould be the key mantra. The major challenge
faced by banks today (Fig. 2) is the everrising customer expectation as well as
risk management and maintaining growth rate.Following are the results of the
biggest challenge faced by the banking industry (on a mode scale of 1 to 7 with
1 being the biggest challenge):
Fig. 2: Challenges faced by the banking industry
India on certain essential banking parameters
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(Regulatory Systems, Risk Assessment Systems, Technological System and
Credit Quality) incomparison with other countries i.e. China, Japan, Brazil,
Russia, Hong Kong, Singapore, UKand USA.
Fig. 3: Comparison across Regulatory systems
The recent financial crisis has drawn attention to under-regulation of banks
(mainlyinvestment banks) in the US. Though, the Indian story is quite different.
Regulatory systemsof Indian banks (Fig. 3) were rated betterthan China, Brazil,
Russia, and UK; at par withJapan, Singapore and Hong Kong where as all our
respondents feel that we are above par orat par with USA. On comparing the
results with our previous survey where the respondentshad rated Indian
Regulatory system below par the US and UK system, we see that post
thefinancial crisis Indian Banks are more confident on the Indian Regulatory
Framework.
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Fig. 4: Comparison across Risk Assessment systems
Risk management framework is a key strength for sustainable growth of
banks.Indias Risk management systems (Fig. 4) ismore advanced than China,
Brazil and Russia.The perception of Indias Risk management systems being
below parthan Singapore, US andUK as had been highlighted.
Fig. 5: Comparison ofCredit Quality
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The global meltdown started as a banking crisis triggered by the credit quality.
Indian banksseem to have paced up in terms of Credit Quality (Fig. 5). Credit
quality of banks has beenrated above par than China, Brazil, Russia, UK and
USA but at par with Hong Kong andSingapore Thus,we see that the resilience
the Indian Banks showed at the time of financial crisis has led toan attitudinal
shift of our respondents with the past survey indicating Credit quality ofIndianbanks being below parthan that of US and UK.
Fig. 6: Comparison across Technological systems
As technology ingrains itselfin all aspects of a banks functioning, the challenge
lies inexploiting the potential for profiting from investments made in
technology. A lot needs tobe done on the technological front to keep in pace
with the global economies, as is evidentfrom the survey results (Fig. 6).
Technology systems of Indian banks have been rated moreadvanced than Brazil
and Russia but below par with China, Japan, Hong Kong, Singapore, UKandUSA. We find no change on introspection which also highlighted theneed for
Indian banks to pace up in adoption of advanced technology.
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BANKING ACTIVITIE
Over the last three decades, there has been a remarkable increase in the size,
spread andscope of activities of banks in India. The business profile of banks has
transformeddramatically to include non-traditional activities like merchant
banking, mutual funds, newfinancial services and products and the humanresource development.Our survey finds that within retail operations, banks rate
product development anddifferentiation; innovation and customization; cost
reduction; cross selling and technologicalupgradation as equally importantto the
growth of their retail operations. Additionally a fewrespondents also find pro-
active financialinclusion, credit discipline and income growth ofindividuals and
customer orientation to be significant factors fortheir retail growth.There is, at
the same time, an urgent need for Indian banks to move beyond retail
banking,and further grow and expand their fee- based operations, which has
globally remained oneofthe key drivers of growth and profitability. In fact, over80% of banks haveonly up to 15% of their total incomes constituted by fee-
based income; and barely 13%have 20-30% oftheirtotalincome constituted by
fee-based income.
Fig. 8: Most profitable non-interestincome opportunities
Out of avenues for non-interest income (Fig. 8), we see that Bancassurance
(85.71%) andForex Management (71.43%) remain most profitable for banks.
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Derivatives, understandably,remains the least profitable business opportunity for
banks as the market for derivatives isstill in its nascent stage in India.
There is nevertheless a visibly increased focus on fee based sources of income.
71% of banksin our survey saw an increase in their fee based income as a
percentage of their totalincome for the FY 2008-09 as compared to FY 2007-08.
Indian banks are fast realizing thatfee-based sources of income have to beactively looked at as a basis for future growth, if theindustry is to become a
global force to reckon with.
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CORE BANKING SOLUTIONS
Unlike their western counterparts, Indian banks had the opportunity to leapfrog
throughtechnologicalinnovations as they started off with a comparatively clean
slate. CBS enablesbanks to consolidate their technology platforms across
functions and geographiesleveraging cost and at the same time acquiringflexibility and scalability to adapt to a fastchanging and competitive
environment. The shiftto IFRS standards by 2011 with valuationof assets on the
basis of current rather than historical cost would be one of the majordriving
forces for the implementation of Core Banking Solutions.73.33% of our
respondents are cent per cent compliant with core banking solutionrequirements,
with the remainder, mostly public sector banks, lagging behind
inimplementation within rural areas. Integrating CBS with common inter-bank
paymentsystems can benefit banks and financialinstitutions in terms of facilities
such as CRM,customer profiling and differentiation for improved customerservice. Amongstthoserespondents that have not yetimplemented Core banking
solutions, 75% expect completeimplementation of CBS within 0-1 years, with
the rest expecting implementation within thenext 2 years atthe maximum.
Fig. 9: Benefits ofCore Banking Solutions
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The future would require banks to have increased business agility and
operationalefficiency, which makes the implementation of Core Banking
Systems (CBS) by banksincreasingly important. It found effective control and
monitoring bythe top management, lower business operation costs and instant
availability of accuratedata to be some of the valuable by products of Core
banking Solutions.
Fig. 10: Challenges in implementation ofCBS
As seen from the above graph (Fig. 10), CBS has not been smooth sailing for
banks. Amajority of the respondents (84.62%) found that the proper & timely
management ofchanges was their biggest test in the implementation of Core
Banking Solutions, closelyfollowed by the large number of transactions and
branches involved (76.92%), and BusinessProcess re-engineering (76.92%).
Availability of financing (23.08%), on the other hand, wasnot considered to be a
serious deterrentto implementation ofCBS processes.
HUMAN RESOURCES
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Up till now, PSU banks which are a dominating force in the Indian banking
system have lackeda proactive HR environment. However, much has changed
with the opening of other sectorsand increased competition from newer banks in
the system.
Banks are increasingly beginning to recognize Human resources as a possiblearea of corecompetence, and seek to pursue and retain the best talent in the
industry. There is arealization that skill developmentis extremely important for
staff retention as well as thequality of manpower, and had in place a system of
continuousprofessionallearning. A process of revamping theirtrainingprocesses
and emphasis is being laid on hard as well as soft skills. Banks are keen to tie
upwith externaltraining agencies forin-house training. Some have even roped in
topuniversities and business schools to help them in theirinitiative, while others
have their ownstaff colleges fortraining employees.81.25% feelthatthe current
economic situation is in factadvantageous for them, as it provides them withaccess to quality manpower. 62.50% ofbanks also feelthatthey have sufficient
autonomy to offer attractive incentivepackages to employees to ensure their
commitment levels.Major HR threats faced by their organization (Fig. 11) ona
scale of 1-4 (with 1 being the greatest threat). The results are presented inthe
following graph:
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Fig. 11: HRThreats forBanks
Thus, on the whole, we see that Public Sector Banks, Private Sector Banks as
well as ForeignBanks view difficulty in hiring highly qualified youngsters as
their biggest HR threat ahead ofhigh staff cost overheads, poaching of skilled
quality staff and high attrition rates.
CRE IT FLOW AND INDUSTRY
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India Inc is completely dependent on the Banking System for meeting its
fundingrequirement. One of the major complaints from the industry has in fact
been high lendingrates in spite of massive cuts in policy rates by the RBI. None
ofthe banks considered the cap on bank deposit rates to be one ofthecauses of
inflexible lending rates. Due to long-term maturity, the trend seems tobechanging. However, there are other factors which have led to the stickiness of
lending ratessuch as wariness of corporate credit risk (33.33%), competition
from government smallsavings schemes (26.67%). Benchmarking of SM and
export loans against PLR (20.00%) onthe other hand, do not seem to have as
significant an influence over lending rates accordingto banks.The great Indian
industrial engine has nevertheless continued to buzz its way through mostofthe
year long crisis.The sectors which banks consider to be mostprofitable in the
coming years (Fig. 12). All were confidentin the infrastructuresectorleading the
profitability forthe industry, followed by retailloans (73.33%) and others.
Fig. 12: Sectors profitable in the coming years
SM s, Cement, and the IT and Telecom sector were viewed as equally
profitable in the nearfuture by banks. Not surprisingly, the Real estate and
housing sector were ranked the lowestin terms of future profitability.
LOAN DISBURSEMENT AND LENDING PRACTICES
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Around 60% feel that there is an umbrella effect for credit disbursements for
individualcompanies, wherein companies are graded on the basis of the overall
performance of thegroup as a whole, and further 60% of the opinion that there a
need to revise the groupexposure limits imposed by the regulator.When quizzed
on farm lending practices, 87.50% disagreed with thenotion that banks view
lending to SMEs and farm sector as an avenue for forced lendingrather than aprofitable avenue. However, 75% of them agreed that a lack of sufficientsupport
systems to farmers such as inputs, irrigation, marketing facilities, etc is a
hinderingfactor for the farm sector lending, followed by 50% stressing on the
cost of reaching EndUser as a deterrent. A poor legal system for recovery was
another barrier to farm sectorlending.With regards to loan disbursement, 71.43%
felt that there was no need for standardizedcredit appraisal across the industry.
But at the same time, 73.33% felt thatthere is scope for a further reduction in
turnaround times for loan sanctioning. Stepsundertaken by participant banks to
this effect include effectively implementing the conceptof single level appraisaland mechanising the entire loans sanction process, EstablishingCentral
Processing Units for Retail and SMEs, as well as increased discretionary powers
across all levels.
CREDIT QUALITY
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The global financial meltdown which has its origins in the sub-prime mortgage
crisisoriginating in the United States has led banks to be more conservative in
their lendingpractices, and consequently a rise in capital costs for corporates.
The Reserve Bank of Indiahas however played a key role is assisting the
banking sector in managing its liquidity anddespite recent events, the medium-
to-long-term India growth story remains intact.Capital adequacy is seen asimportant to the stability of the banking system. The minimumCapital to Risk-
weighted Asset Ratio (CRAR) in India as required by the RBI is placed at
9%,one percentage point above the Basel II requirement. Public sector banks are
furtherrequired to maintain a CRARof 12% by the Government of India.In fact,
over 92% of the participants firmly concur with recent stress test results that
Indianbanks have the ability to absorb twice the amount of their current NPA
levels. However, thecurrent crisis has exposed certain vulnerabilities and
weaknesses within the system thatbanks continue to remain wary of.
Fig. 13: Segments expected to show increase in NPAs
Almost 80% of the banks see personal loans (Fig. 13) as having the greatest
potential fordefault, followed by corporate loans and credit cards. Many banksadditionally perceived alevel of riskiness in the SM and farm loan sector.
RISK MANAGEMENT
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The basic concept of risk management involves making an assessment of the
risk and then developing a strategy to manage that risk. Risks ensuing out of
physical or legal causes, such as, natural disasters or fires, accidents, death, and
lawsuits, are one of those which are traditionally focused. But, in banking
sectors, the focus is mainly on risk factors involved with traded financial
instruments. In an ideal situation, the risks concerned with substantial losses andthe high probability of its occurrence, are handled first, and given the highest
priority in risk management. The lesser probable ones comes next. In doing so, it
is quite difficult to maintain the balance between the combination of different
scenarios, viz., risks with a high probability of occurrence but lower loss vs. a
risk with high loss but lower probability of occurrence.
In meeting the basic characteristics in banking sectors, there is a need to provide
human and financial resources through-out the organisation, enough to meet the
purpose of an effective compliance risk management system. In proving such
resources, it is necessary to delegate proper authority and independence in the
working method. There needs to be a sense of ownership in the compliance
function, in order that the organisation can keep itself focused on its compliance
risk management responsibility. A comprehensive database should be in place,
along with monitoring and measuring of the risks involved in any k ind of
circumstances, which, in combination, may provide meaningful reports based on
the laws and regulations governing compliance risks, associated with existing or
new products, and new business activities.
The banking sector need to understand operation al risk exposure at the
organisational level, where the concerned risk factors are consolidated into one,
making it somewhat easier to have a verification of operational risk involved.
We shall examine in the consequent articles the problems that banking s ector
finds most difficult to address, which are deficient in the current methodology
used. There are gaps in analysis of risk elements in the current procedures
adapted, in establishing risk management and risk control.
Risk is inherent in any commercial activity and banking is no exception to this
rule. Rising global competition, increasing deregulation, introduction ofinnovative products and delivery channels have pushed risk management to the
forefront of todays financial landscape. Ability to gauge the risks and take
appropriate position will be the key to success. It can be said that risk takers
will survive, effective risk managers will prosper and risk averse are likely to
perish. In the regulated banking environment, banks had to primarily d eal with
credit or default risk. As we move into a perfect market economy, we have to
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deal with a whole range of market related risks like exchange risks, interest rate
risk, etc. Operational risk, which had always existed in the system, would
become more pronounced in the coming days as we have technology as a new
factor in todays banking. Traditional risk management techniques become
obsolete with the growth of derivatives and off-balance sheet operations,
coupled with diversifications. The expansion in E-banking will lead tocontinuous vigilance and revisions of regulations. Building up a proper risk
management structure would be crucial for the banks in the future. Banks would
find the need to develop technology based risk management tools. The com plex
mathematical models programmed into risk engines would provide the
foundation of limit management, risk analysis, computation of risk -adjusted
return on capital and active management of banks risk portfolio. Measurement
of risk exposure is essential for implementing hedging strategies.
Under Basel II accord, capital allocation will be based on the risk inherent in the
asset. The implementation of Basel II accord will also strengthen the regulatory
review process and, with passage of time, the review process will be more and
more sophisticated. Besides regulatory requirements, capital allocation would
also be determined by the market forces. External users of financial
information will demand better inputs to make investment decisions. More
detailed and more frequent reporting of risk positions to banks shareholders
will be the order of the day. There will be an increase in the growth of
consulting services such as data providers, risk advisory bureaus and risk
reviewers.These reviews will be intended to provide comfort to the bankmanagements and regulators as to the soundness of internal risk management
systems.
Risk management functions will be fully centralized and independent from the
business profit centres. The risk management process will be fully integrated
into the business process. Risk return will be assessed for new business
opportunities and incorporated into the designs of the new products. All risks
credit, market and operational and so on will be combined, reported and
managed on an integrated basis. The demand for Risk Adjusted Returns on
Capital (RAROC) based performance measures will increase. RAROC will beused to drive pricing, performance measurement, portfolio management and
capital management.
Risk management has to trickle down from the Corporate Office to branches or
operating units. As the audit and supervision shifts to a risk based approach
rather than transaction orientation, the risk awareness levels of line functionaries
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also will have to increase. Technology related risks will be another area where
the operating staff will have to be more vigilant in the coming days.
Banks will also have to deal with issues relating to Reputational Risk as they
will need to maintain a high degree of public confidence for raising capital and
other resources. Risks to reputation could arise on account of operational lapses,
opaqueness in operations and shortcomings in services. Systems and internalcontrols would be crucial to ensure that this risk is managed well.
The legal environment is likely to be more complex in the years to come.
Innovative financial products implemented on computers, new risk management
software, user interfaces etc., may become patentable. For some banks, this
could offer the potential for realizing commercial gains through licensing.
The major challenge is, clearly, having the human resources of the right kind
and numbers and the ability to retain skilled personnel. From having personnel
to deliver banking services to the po orest, to having the expertise to deliversophisticated financial products and adopt consistent risk management practices
across the organisation, will be the key to managing huge organisations
optimally.
If one of the reasons for the global financial crisis was that the financial sector
grew out of sync with the real sector in the advanced economies, in India the
position is different in that the financial system has to ensure that it meets the
requirements of the growing real sector. Risk is inherent in banking as banks
essentially trade in risk in the process of maturity transformation. Therefore,
banks cannot afford to be risk avoiders. At the same time bankers prudence,
something that is critical to safety of the depositors funds, has to be the
underlying philosophy at all times. The risk return relationship has to be
optimally balanced for welfare enhancing outcomes
The crisis has thrown up some critical issues relevant to risk management
policies:
Banks that were extremely aggressive in the trading books were clearly more
affected. Those that had a fair degree of traditional banking were less affected.
There has to be an intuitive approach to risk. Despite huge growth in leverage
and huge expansion of on and off-balance sheet items, complex risk models
threw up measures of risk that seemed to be quite capable of being absorbed.
There was obviously a clear limitation to these models especially in times of
stress. The inadequacies stemmed from two perspectives
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(a) Use of past data without adequately factoring in the data from acute periods
of stress and
(b) The presumption that the highly sophisticated mathematical models could be
as successful as they are in physical sciences.
The latter presumption is clearly wrong inasmuch as financial events are heavily
influenced by largely unpredictable or irrational human behaviour which modelscannot capture. Nevertheless, these are useful when considered as one of the
inputs supplemented by stress/ scenario analysis and informed judgement. The
other aspect which causes serious concern is that the comprehension of these
models remains confined to a small group of Quants and it becomes very
difficult for the top management and boards to comprehend th e actual risk
undertaken by the organization. These lessons will have to be kept in view now
that some of the banks will move towards advanced approaches.
Pricing of risk is important. There is a temptation to under-price risk wheneverthere is excess liquidity and pressure to generate profits. Pricing below cost can
be risky and the risk cost is very often not captured adequately. Moreover, this
gives rise to asset price bubbles with attendant implications.
While credit, market and operational risk are captured in the capital framework
under Pillar I of Basel II, liquidity risk, concentration risks, strategic risk,
reputation risk and risks arising out of securitization, off balance sheet vehicles,
valuation practices need to be recognized. Banks Boards need to focus on all
these risks and set firm wide limits on the principal risk relevant to banks
activities. Banks should focus on robust stress testing. Compensation packages
should also form part of risk management policies.
This crisis has also highlighted the importance of internal controls, good
corporate governance and risk management. As shown in the Senior Supervisors
Group Report on Risk Management, some banks with strong risk management
systems weathered the current crisis much better than many banks that had poor
or inadequate risk management systems.
For banks that are part of financial conglomerates, the process of risk
management must focus on intra group exposures and transactions as also group
wide exposures to sectors and borrowers.
The new element recognised in this crisis is that even while sound risk
management policies are observed at the firm level there could be systemic risks
over which individual banks have no control and this calls for risk management
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at the systemic level viz. ensuring financial stability by financial regulators
and policy makers.
I will now turn to the key areas where banks need to focus while planning their
businesses for higher growth, keeping in view the on-going international
regulatory initiatives. The Basel Committee has brought out on December 17,
2009, two consultative documents containing key proposals that will be taken up
for an impact study before adoption. These proposals cover raising quality and
coverage of capital to ensure loss absorbency on a going and gone concern basis,
greater stress on Tier-I and common equity component, introduction of leverage
ratio, measures to deal with pro cyclicality such as capital buffers and forward
looking provisioning, introduction of minimum liquid ity ratios and enhanced
capital for trading book securitisations and counterparty credit exposures.
While our assessment is that Indian banks will be generally able to meet these
enhanced requirements, it is useful to see on a rough and ready basis what thepresent position is in this regard. Our assessment shows that:
The common equity component as percent of total assets stood at 7 per cent in
March 2009 for Indian banking sector as against a range of 3 per cent to 4
percent for large international b anks. Total CRAR is 13.75 percent with Tier I at
9.4 per cent. Thus Indian banks are in a position to meet the growth
requirements currently and have reasonable period to plan and raise required
capital for future growth.
The leverage ratio for Indian banks including credit equivalents of off -balance
sheet) was about 17 per cent in March 2009 and can be considered reasonable.
While the SLR has stood us in good stead, banks would do well to assess their
liquidity risk against the more calibrated liquidity ratios put out in the
consultative document such as the proposed short term liquidity coverage ratio
and long term net stable funding ratio. This should be a regular exercise for
banks that have significant share of bulk deposits and CDs.
The Basel proposals for forward looking provisioning are based on advancedapproaches using through the cycle PDs etc. In India, banks ar e yet to adopt
advanced approaches. The gross NPAs for the banking sector have increased
from 2.4 per cent as on March 31, 2008 to 2.6 per cent as on September 30,
2009. In the context of the rising NPAs and the likely slippages in the
restructured accounts, we had introduced the 70 per cent provisioning coverage
ratio for NPAs as a forward looking requirement. Most banks currently meet this
ratio. For standard assets, in alignment with the Basel proposals for forward
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looking provisioning, more work needs to be done based on sectoral trends and
measurements of estimated loss based on something like the Spanish dynamic
provisioning model.
In the case of capital for trading book and counterparty exposures, while some
enhancements have been made for forex de rivatives, more work will be required
for counterparty exposures and other derivatives. Nevertheless, looking at the
interest rate risk for the entire balance sheet rather than the trading book alone,
duration gap analysis could be a useful tool for managi ng interest rate risk.
y The areas where banks need to be sensitive to risk:
While overall, credit growth in the banking sector has been slower in the
current year, certain sectors like real estate, infrastructure and NBFCs have seen
higher rates of growth. Credit to commercial real estate (CRE) has fallen in the
half year ended September 2009 evidencing higher risk perception. Howevercredit to NBFCs and infrastructure continues to be high. While the country
needs infrastructure financing of significant magnitude, banks that essentially
mobilise short term resources do face risk on account of ALM, large size
exposures and some risks beyond their control such as implementation hurdles.
The emergence of long term investors such as pension and insurance fund s,
development of corporate bond market, and single name CDS may help in de -
risking to a certain extent banks exposures to infrastructure.
A phenomenon that RBI has brought to attention of banks recently is the large
investments by banks into debt oriented mutual funds. MFs have invested large
amounts in bank CDs. Banks that have a significant part of their liabilities in
form of CDs have to be sensitive to the rollover risk. Equally, banks that have
large investments in MFs have to be sensitive to the l iquidity risk in the event of
the need for sudden redemption by large investors at the same time. This
distortion -whereby MFs are apparently acting as intermediaries in what should
otherwise have been intermediated in the interbank market - is something that
needs to be addressed. Besides there are concerns about the direction of flow of
resources through MF intermediation.
In the case of lending to NBFCs engaged in micro finance treated as priority
sector lending by banks, there is a risk that multiple lending and high interest
rates could lead to deterioration in asset quality. As originator of these loans no
longer have stake in them, banks would do well to assess the credit quality of
these loans by better oversight at the grass root level on a sample basis.
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While banks have been diversifying their operations and are into new
businesses, it is necessary to recognise the reputation risk, especially when
promoting VCFs and other such funds. As is now well known, internationally
many banks had previously offloaded certain items from their balance sheet to
specialised investment vehicles. During the market crunch the banks had to take
back those assets on their balance sheets.
Securitisation of assets by banks in India during the year ended March 31,
2009 showed a decline of about 30% over the previous year. This might affect
the profitability of banks which have been undertaking securitisation activity as
one of the main business lines. However, the securitisation activity may pick up
once the retail loan segment starts growing again. RBI would shortly issue
guidelines on minimum retention requirement and minimum holding period for
securitisable loans.
While hedging or remaining unhedged is the prerogative of the borrowers,banks must remember that the unhedged position of their borrowers can quickly
translate into severe stress on their asset quality and hence it is absolutely
necessary that the unhedged position of the corporates are closely monitored and
this is built into the credit and other rat ing assessment of the borrowers while
extending facilities to them.
Excess liquidity in the system has once again led to the familiar phenomenon
of sub PLR short-term lending; banks would do well to recognise re -pricing and
rollover risk.
To remove the credit information asymmetry, RBI has taken long term steps
inasmuch as it has issued in-principle authorisation for setting up four credit
information companies. This may take some time to become operational. It must
however be recognised that the system will function only to the extent timely
and accurate information is made available and made use of. I understand that
these are not happening both in providing information to CIBIL as well as
making full use of the range of information available particu larly for corporate
credit.
While introduction of technology in banking has increased the speed and
accuracy of service delivery, it has also increased banks vulnerability to cyber
frauds. Banks need to put in place appropriate control mechanisms to pr event
such frauds.
It is necessary for the banks now to take technology from the core banking
solution to a higher level to build up adequate MIS capability. Unless this is
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done, risk management cannot be of the highest order and banks will not be able
to meet the challenge of an increasingly sophisticated financial system.
In the area of housing loans, teaser rates are increasingly being offered which
is a cause for concern. I hope banks are ensuring that borrowers are well aware
of the implications of such rates and the appraisal takes into account repaying
capacity of the borrowers when the rates become normal.
Current experience worldwide has called for robust stress testing practices in
the banks. Stress testing alerts bank management to advers e unexpected
outcomes related to a variety of risks and provides an indication of how much
capital might be needed to absorb losses should large shocks occur. In India,
banks should not take stress testing exercise a mere compliance requirement but
accord due importance to it to facilitate the development of risk mitigation or
contingency plans across a range of stressed conditions.
To conclude, Indian banking system which has shown resilience in
withstanding the global crisis is well placed to meet the r equirements of the
rapid inclusive growth. Even in the new paradigm under Basel, the system is
well placed in terms of capital and liquidity. Strong HR and sound risk
management practices will stand the banks in good stead while they strive to
meet the challenges of the next decade.
RISK MANAGEMENT PROCESS
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The process of financial risk management is an ongoing one.Strategies need to
be implemented and refined as the market and requirements change.
Refinements may reflect changing expectations about market rates, changes to
the business environment, or changing international political conditions, for
example. In general, the process can be summarized as follows:
Identify and prioritize key financial risks.
Determine an appropriate level of risk tolerance.
Implement risk management strategy in accordance with policy.
Measure, report, monitor, and refine as needed.
Risk management needs to be looked at as an organizational approach, as
management of risks independently cannot have the desir ed effect over the long
term. This is especially necessary as risks result from various activities in thefirm and the personnel responsible for the activities do not always understand
the risk attached to them.
The steps in risk management process are:
1. Determining objectives: - determination of objectives is the first step in
the risk management function. The objective may be to protect profits, or to
develop competitive advantage. The objective of risk management needs to be
decided upon by the management. So that the risk manager may fulfill his
responsibilities in accordance with the set objectives.
2. Identifying Risks :- Every organization faces different risks, based on its
business, the economic, social and political factors, the features of the industry it
operates in like the degree of competition, the strengths and weakness of its
competitors, availability of raw material, factors internal to the company like the
competence and outlook of the management, state of industry relations,
dependence on foreign markets for inputs, sales or finances, capabilities of its
staff and other innumerable factors.
3. Risk Evaluation: - Once the risks are identified, they need to be evaluated
for ascertaining their significance. The significance of a particula r risk depends
upon the size of the loss that it may result in, and the probability of the
occurrence of such loss. On the basis of these factors, the various risks faced by
the corporate need to be classified as critical risks, important risks and not -so-
important risks. Critical risks are those that may result in bankruptcy of the firm.
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Important risks are those that may not result in bankruptcy, but may cause
severe financial distress.
4. Development of policy : - Based on the risk tolerance oevel of the firm,
the risk management policy needs to be developed. The time frame of the policy
should be comparatively long , so that the policy is relatively stable. A policy
generally takes the form of a declaration as to how much risk should be covered.
5. Development of strategy: - Based on the policy, the firm then needs to
develop the strategy to be followed for managing risk. A strategy is essentially
an action plan, which specifies the nature of risk to be managed and the timing.
It also specifies the tools, techniques and instruments that can be used to manage
these risks. A strategy also deals with tax and legal problems. Another important
issue that needs to be specified by the strategy is whether the company would try
to make profits out of risk management or would it stick to covering the existing
risks.
6. Implementation: - Once the policy and the strategy are in place, they are
to be implemented for actually managing the risks. This is the operational part of
risk management. It includes finding the best deal in case of risk transfer,
providing for contingencies in case of risk retention, designing and
implementing risk control programs etc.
7. Review: - The function of risk management needs to be reviewed
periodically, depending on the costs involved. T he factors that affect the risk
management decisions keep changing, thus necessitating the need to monitor the
effectiveness of the decisions taken previously .
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FINANCIAL RISK MANAGEMENT
Broadly speaking, risk management can be defined as a discipline for Living
with the possibility that future events may cause adverse effects. In the context
of risk management in financial institutions such as banks or insurance
companies these adverse effects usually correspond to large losses on a portfo lio
of assets. Specific examples include: losses on a portfolio of market -traded
securities such as stocks and bonds due to falling market prices (a so -called
market risk event); losses on a pool of bonds or loans, caused by the default of
some issuers or borrowers (credit risk); losses on a portfolio of insurance
contracts due to the occurrence of large claims (insurance - or underwriting risk).
An additional risk category is operational risk, which includes losses resulting
from inadequate or failed internal processes, fraud or litigation.
In financial markets, there is in general no so -called free lunch or, in other
words, no profit without risk. This is the reason why financial institutionsactively take on risks. The role of financial risk management i s to measure and
manage these risks. Hence risk management can
be seen as a core competence of an insurance company or a bank: by using its
expertise and its capital, a financial institution can take on risks and manage
them by various techniques such as d iversification, hedging, or repackaging
risks and transferring them back to markets, etc.
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Risk Management in INDIAN BANK
Risk faced by the bank can be segmented into three separable types from the
management perspective viz.
a. Risks that can be eliminated or avoided by simple business practices
b. Risks that can be transferred to other business participants (eg. Insurance
policy) and
c. Risks that can be actively managed at the Bank level.
Risk is any real or potential event, action or omission, internal or external, which
will have an adverse impact on the achievement of Banks defined objectives.
Risk is inherent in every business. Risk cannot be totally eliminated but is to be
managed. Risks are to be categorised into high risk, m edium risk and low risk
and then managed.
Risks can be classified into three broad categories:
1. Credit Risk
2. Market Risk (Interest Rate Risk, Liquidity Risk)
3. Operational Risk
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Types of risk faced by banks
A bank has many risks that must be managed carefully, especially since a bank
uses a large amount of leverage. Without effective management of its risks, it
could very easily become insolvent. If a bank is perceived to be in a financially
weak position, depositors will withdraw their funds, other banks won't lend to itnor will the bank be able to sell debt securities in the financial markets, which
will aggravate the bank's financial condition even more. The fear of bank failure
was one of the major causes of the 2007 2009 credit crisis and of other
financial panics in the past.
Although banks share many of the same risks as other businesses, the major
risks that especially affect banks are liquidity risk, interest rate risks, credit
default risks, and trading risks.
Major types of risks:-
Credit Risk:-
Credit Risk is defined as the possibility of losses associated with decrease in the
credit quality of borrowers or counterparties. In a banks portfolio, losses stem
from outright default due to inability or unwillingness of a customer or
counterparty to meet commitments in relation to lending, trading, settlement and
other financial transactions. Credit risk emanates from banks dealings withindividuals, Corporate, bank, financial institution or a sovereign.
Credit Risk may take the following forms :
In the case of direct lending; principal / and or interest amount may not be
repaid
In the case of treasury operations; the payment or series of payments due from
the counter parties under the respective contracts may not be forthcoming or
ceases
In the case of securities trading businesses: funds / securities settlement may
not be effected
In the case of cross-border exposure: the availability and free transfer of
foreign currency funds may either cease or restrictions may be imposed by the
sovereign
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Credit default risk occurs when a borrower cannot repay the loan. Eventually,
usually after a period of 90 days of nonpayment, the loan is written off. Banks
are required by law to maintain an account for loan loss reserves to cover these
losses.
Banks reduce credit risk by screening loan applicants, requiring collateral for a
loan, credit risk analysis, and by diversification.
Banks can substantially reduce their credit risk by lending to their customers,
since they have much more information on them than on others, which helps to
reduce adverse selection. Checking and savings accounts can reveal how well
the customer handles money, their minimum income and monthly expenses, and
the amount of their reserves to hold them over financially stressful times. Ban ks
will also verify incomes and employment history, and get credit reports and
credit scores from credit reporting agencies.
Collateral for a loan greatly reduces credit risk not only because the borrower
has greater motivation to repay the loan, but also because the collateral can be
sold to repay the debt in case of default.
When banks make loans to others who are not customers, then the bank has to
rely more on credit risk analysis to determine the credit risk of the loan
applicant. Credit risk analysis is the determination of how much risk a potential
borrower poses and what interest rate should be charged. The potential risk of a
borrower is quantified into a credit rating that depends on information about the
borrower and well as statistical models of the business or individual applicant.
There are credit rating agencies for businesses, such as Moody's or Standard
Poor for larger entities and Dun & Bradstreet for smaller businesses and
Experian, TransUnion, and Equifax for individuals. Most of these cre dit
reporting agencies assign a number or other code that signifies the potential risk
of the borrower. A bank will also look at other information, such as the
borrower's income and history.
A bank can also reduce credit risk by diversifyingmaking loans to businesses
in different industries or to borrowers in different locations.
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Market Risk:-
Market Risk may be defined as the possibility of loss to a bank caused by
changes in the market variables. Market Risk is the risk to the banks earnings
and capital due to changes in the market level of interest rates or prices of
securities, foreign exchange and equities, as well as the volatilities of those
prices.
Segments of Market Risk:-
y Liquidity Risk:-
Liquidity risk is the potential inability to meet the banks liabilities as they
become due. It arises when the banks are unable to generate cash to cope
with a decline in deposits or increase in assets. It originates from the
mismatches in the maturity pattern of assets and liabilities
Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their
money, or to lend money as part of a credit line. A basic expectation of any bank
is to provide funds on demand, such as when a depositor withdraws money from
a savings account, or a business presents a check for payment, or borrowers may
want to draw on their credit lines. Another need for liquidity is simply to pay
bills as they come due.
The main problem in liquidity management for a b ank is that, while bills are
mostly predictable, both in timing and amount, customer demands for funds are
highly unpredictable, especially demand deposits (checking accounts).
Another major liquidity risk is off-balance sheet risks, such as loan
commitments, letters of credit, and derivatives. A loan commitment is a line of
credit that a bank provides on demand. Letters of credit include commercial
letters of credit, where the bank guarantees that an importer will pay the exporter
for imports and a standby letter of credit which guarantees that an issuer of
commercial paper or bonds will pay back the principal.
Derivatives are a significant off-balance sheet risk, as evidenced by the collapseof American International Group (AIG) in 2008. Banks participate in 2 major
types of derivatives: interest rate swaps and credit default swaps. Interest rate
swaps are agreements where one party exchanges fixed interest rate payments
for floating rates. Credit default swaps (CDSs) are agreements where one party
guarantees the principal payment of a bond to the bondholder.
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Liquidity management is achieved by asset and liability management. Asset
management requires keeping cash and keeping liquid assets that can be sold
quickly at little cost. Liability management is borr owing.
Types of liquidity risk:-
y Asset liquidity - An asset cannot be sold due to lack of liquidity in themarket - essentially a sub-set of market risk. This can be accounted for
by:
- Widening bid/offer spread
- Making explicit liquidity reserves
- Lengthening holding period for VaR calculations
y Funding liquidity - Risk that liabilities:
-Cannot be met when they fall due
- Can only be met at an uneconomic price
- Can be name-specific or systemic
Causes of liquidity risk:-
Liquidity risk arises from situations in which a party interested in trading
an asset cannot do it because nobody in the market wants to trade that asset.
Liquidity risk becomes particularly important to parties who are about to hold or
currently hold an asset, since it affects their ability to trade.
Liquidity risk is financial risk due to uncertain liquidity. An institution might
lose liquidity if its credit rating falls, it experiences sudden unexpected cash
outflows, or some other event causes counterparties to avoid trading with or
lending to the institution. A firm is also exposed to liquidity risk if markets onwhich it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a
position in an illiquid asset, its limited ability to liquidate that position at short
notice will compound its market risk.
Suppose a firm has offsetting cash flows with two diffe rent counterparties on a
given day. If the counterparty that owes it a payment defaults, the firm will have
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y Liquidity risk elasticity:-
The change of net of assets over funded liabilities that occur when the liquidity
premium on the bank's marginal funding cost rises by a small amount as the
liquidity risk elasticity. For banks this would be measured as a spread over libor,
for nonfinancial the Liquidity Risk Elasticity would be measured as a spread
over commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel
changes in funding spread across all maturities and that it is only accurate for
small changes in funding spreads.
Interest Rate Risk:-
Interest rate risk is the risk where changes in market interest rates mightadversely affect a banks financial condition. The immediate impact of changes
in interest rates is on the Net Interest Income.
A bank's main source of profit is converting the liabilities of deposits and
borrowings into assets of loans and securities. It profits by paying a lower
interest on its liabilities than it earns on its assetsthe difference in these rates
is the net interest margin.
However, the terms of its liabilities are usually shorter than the terms of its
assets. In other words, the interest rate paid on deposits and short-term
borrowings are sensitive to short-term rates, while the interest rate earned on
long-term liabilities is fixed. This creates interest rate risk, which, in the case of
banks, is the risk that interest rates will rise, causing the bank to pay more for its
liabilities, and, thus, reducing its profits.
For instance:-
If a bank has a loan for $100 for which it receives $7 annually in interest, and a
deposit of $100 for which it pays $3 per year in interest, that is a net interestmargin of $4. But if current market interest rates for deposits rises to 4%, then
the bank will have to start paying $4 for the $100 deposit while still receiving
7% on the long-term loan, decreasing its profit in this scenario by $1.
All short-term and floating-rate assets and liabilities are interest-rate sensitive
the interest received on assets and paid on liabilities changes with ma rket rates.
Long-term and fixed-rate assets and liabilities are not interest-rate sensitive.
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Interest-rate sensitive assets include savings deposits and interest -paying
checking accounts. Long-term CDs are not interest-rate sensitive.
So for a bank to determine its overall risk to changing interest rates, it must
determine how its income will change when interest rates change.
Banks faces four types of interest rate risk:
y Basis risk:-
The risk presented when yields on assets and costs on liabilities are based on
different bases, such as the London Interbank Offered Rate (LIBOR) versus the
U.S. prime rate. In some circumstances different bases will move at different
rates or in different directions, which can cause erratic changes in revenues and
expenses.
y Yield curve risk:-
The risk presented by differences between short-term and long-term interest
rates. Short-term rates are normally lower than long-term rates, and banks earn
profits by borrowing short-term money (at lower rates) and investing in long-
term assets (at higher rates). But the relationship between short -term and long-
term rates can shift quickly and dramatically, which can cause erra tic changes in
revenues and expenses.
y Repricing risk:-
The risk presented by assets and liabilities that reprice at different times and
rates. For instance, a loan with a variable rate will generate more interest income
when rates rise and less interest income when rates fall. If the loan is funded
with fixed rated deposits, the bank's interest margin will fluctuate.
y Option risk:-
It is presented by optionality that is embedded in some assets and liabilities. For
instance, mortgage loans present significant option risk due
to prepayment speeds that change dramatically when interest rates rise and fall.
Falling interest rates will cause many borrowers to refinance and repay their
loans, leaving the bank with uninvested cash when interest rates have declined.
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Alternately, rising interest rates cause mortgage borrowers to repay slower,
leaving the bank with more loans based on prior, lower interest rates. Option
risk is difficult to measure and control.
Hedging interest rate risk
Interest rate risks can be hedged using fixed income instruments or interest rateswaps.
Interest rate risk can be reduced by buying bonds with shorter duration, or by
entering into a fixed-for-floating interest rate swap.
Measuring interest rate risk:-
Gap analysis and duration analysis are 2 common tools for measuring the
interest rate risk of bank portfolios.
Gap analysis:-
Gap analysis is the difference between the value of the interest rate sensitive
assets minus the value of the interest rate sensitive liabilities (the gap)
multiplied by a change in interest rate of 1%.
Gap = Value of Interest Rate Sensitive Assets Value of Interest Rate Sensitive
Liabilities.
Gap x Change in Interest Rate = Change in Bank's Profit.
Example :-
Gap Analysis - Calculating the Change in a Bank's Profit After a Change in the
Market Interest Rate
Consider $100 of the bank's assets bought with $100 worth of liabilities. How
much will a bank's profit decline if the interest rate on both assets and liabilities
that are interest rate sensitive increases by 1% and if:
y Value of Interest Rate Sensitive Assets = $20
o Bank has $80 worth of assets that are not interest rate sensitive, but
we won't consider either the assets or liabilities that are not interest
rate sensitive, since they will not be affected by a change in interest
rates.
o Bank receives 7% interest on the $20.
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$20 x 7% = $1.40
After interest rate rises by 1%, revenue increases to:
$20 x 8% = $1.60
y Value of Interest Rate Sensitive Liabilities = $60
o Bank initially pays 3% on its liabilities.
$60 x 3% = $1.80
Although this is more than what it is earning on its interest
rate sensitive assets, it is making a lot more on its assets that
aren't interest rate sensitive. Remember, we are only
interested in the change in profits.
After the interest rate rises by 1%, the equation becomes:
$60 x 4% = $2.40
y Originally, the difference in revenue was:
o $1.40 - $1.80 = - $0.40
y After the interest rate increase, the revenue becomes:
o $1.60 - $2.40 = - $0.80
y Thus, the profit declines by $0.40 from -$0.40 to - $0.80 for every $100 in
assets.
But there is a much simpler way to calculate the change in profits. Since the gap
in interest rate sensitive assets and liabilities is -$40, we simply multiply this gap
by the change in interest rate to obtain the same result as above :
y Gap = $20 - $60 = -$40
y Change in Profit = -$40 x 1% = -$0.40.
Remember, this profit is negative because the value of the interest rate sensitive
liabilities is much larger than the value of the interest rate sensitive assets. The
bank is, however, making much more profit overall because the proportion of
assets that are not sensitive to interest rates is twice as large as the corresponding
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liabilities. So considering only the assets and liabilities that are not interest rate
sensitive, we have:
y Interest received on assets = $80 x 7% = $5.60
y Interest paid on liabilities = $40 x 3% = $1.20
y Profit on assets which aren't interest rate sensitive to corresponding
liabilities: $5.60 - $1.20 = $4.40
When the interest rate margin is added from both categories of assets and
liabilities, then, before the interest rate change:
y Profit = $4.40 - $0.40 = $4.00
After the interest rate rises by 1%:
y
Profit = $4.40 - $0.80 = $3.60
So the bank's overall profit decreases by 40 cents for every $100 in assets, which
is a change of 40 basis points (1 basis point = 0.01%).
More sophisticated gap analysis takes into account the different terms of the
different assets and also convexity, but the calculations are far more
complicated.
Since interest rates affect the prices of bank assets and liabilities in the same
way that they affect bonds, bankers also use a tool commonl y used in bondportfolio analysisduration analysis.
Duration measures the change in the price of a bond when the interest rate
changes by 1%. A bank calculates its duration gap by subtracting the weighted
average duration of its assets minus the weighted average duration of its
liabilities.
Reducing Interest Rate Risk:-
Banks could reduce interest rate risk by matching the terms of its interest rate
sensitive assets to it liabilities, but this would reduce profits. It could also make
long-term loans based on a floating rate, but many borrowers demand a fixed
rate to lower their own risks. In addition, floating-rate loans increase credit risk
when rates rise because the borrowers have to pay more each month on their
loans, and, thus, may not be able to afford it. This is best exemplified by the
many homeowners who defaulted because of rising interest rates on their
adjustable rate mortgages (ARMs) during the 2007 2009 credit crisis.
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Increasingly, banks are using interest rate swaps to reduce their credit risk,
where banks pay the fixed interest rate they receive on their a ssets to a
counterparty in exchange for a floating rate payment.
y Foreign Exchange Risk:-
Foreign Exchange Risk may be defined as the risk that a bank may suffer losses
as a result of adverse exchange rate movements during a period in which it has
an open position, either spot or forward, or a combination of the two, in an
individual foreign currency.
International banks trade large amounts of currencies, which introduces foreign
exchange risk, when the value of a currency falls with respect to another. A bank
may hold assets denominated in a foreign currency while holding liabilities in
their own currency. If the exchange rate of the foreign currency falls, then both
the interest payments and the principal repayment will be worth less than when
the loan was given, which reduces a bank's profits.
Banks can hedge this risk with forward contracts, futures, or currency
derivatives which will guarantee an exchange rate at some future date or provide
a payment to compensate for losses arising from an adverse move in currency
exchange rates. A bank, with a foreign branch or subsidiary in the country, c an
also take deposits in the foreign currency, which will match their assets with
their liabilities.
Operational Risk:-
Operational risk, as defined by the Basel Committee, is the risk of loss resulting
from inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic and
reputational risks.
Operational risk is the risk of direct or indirect loss resulting from inadequate or
failed internal processes, people and systems or from external events. Internal
processes include activities relating to accounting, reporting, operations, tax,
legal, compliance and personnel management etc.
Broadly the following can be grouped under Operational Risk
1. Internal Fraud
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2. External Fraud
3. Non adherence of systems and procedures
4. Poor documentation
5. Business disruption due to Computer Systems failure
6. Lack of succession planning
7. Failure of customer due diligence
Some of the important causes of operational risk are: -
y Internal frauds due to employees' intentional involvement;
y External frauds due mainly to robbery and forgery/falsification ofdocuments;
y Workers compensation claims, violation of employee health and safetyrules;
y Misuse of confidential customer information, money-laundering, sale ofunauthorized and unfamiliar products;
y Damage to physical assets due to terrorism, earthquakes, fires and floods;
y Business disruption and system failures due to software, power ornetwork problems,
y Execution errors on account of wrong data entry or incomplete legaldocumentation.
Operational risk arises from faulty business practices or when buildings,equipment, and other property required to run the business are damaged or
destroyed. For instance, banks in the vicinity of the Worl d Trade Center suffered
considerable losses as a result of the terrorist attacks on September, 11, 2001,
which knocked out power and communications in the surrounding area. Barings
Bank collapsed because its audit controls did not detect the calamitous los ses
suffered by its rogue trader, Nick Leeson, early enough to prevent its
collapse.Many types of operational risk, such as the destruction of property, are
covered by insurance. However, good management is required to prevent losses
due to faulty business practices, since such losses are not insurable.
Other types of risks faced by banks:-
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y Asset Management:-
The primary key to using asset management to provide liquidity is to keep both
cash and liquid assets. Liquid assets can be sold quickly for what they are worth
minus a transaction cost or bid/ask spread. Hence, liquid assets can be convertedinto a means of payment for little cost.
The primary liquidity solution for banks is to have reserves, which are also
required by law. Reserves are the amount of money held either as vault cash or
as cash held in the bank's account at the Federal Reserve, often referred to as
federal funds. It can also include cash that a bank has in an account at a
correspondent bank. In the United States, the Federal Reserve determines the
amount of required reserves (aka legal reserves, primary reserves), which is
expressed as a required reserve ratio, which is the amount of reserves as apercentage of the bank's demand deposits. A bank may even k eep excess
reserves in its Federal Reserve account for greater liquidity, especially since the
Federal Reserve has started paying interest on these accounts since October,
2008.
Although reserves provide liquidity, they earn little or no money. Vault cash
pays no interest at all and Federal Reserve accounts have paid 1% or less. By
buying liquid assets, a bank can earn money while maintaining liquidity. The
most liquidand safestasset is United States Treasuries, of which banks are
major buyers.
Banks can also sell loans, especially those that are regularly securitized, such as
mortgages, credit card and auto loan receivables.
A bank can also increase liquidity by not renewing loans. Many loans are short -
term loans that are constantly renewed, such as when a bank buys commercial
paper from a business. By not renewing the loan, the bank receives the principal.
However, most banks do not want to use this method because most short -term
borrowers are business customers, and not renewing a loan could alienate thecustomer, prompting them to take their business elsewhere.
y Liability Management:-
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A bank can increase liquidity by borrowing, either by taking out a loan or by
issuing securities. Banks predominantly borrow from each other in an interbank
market known as the federal funds market where banks with excess reserves
loan to banks with insufficient reserves. Banks can also borrow directly from the
Federal Reserve, but they only do so as a last resort.
Banks are big users of a debt instrument known as a repurchase agreement (aka
repo), which is a short-term collateralized loan where the borrower exchanges
collateral for the loan with the intent of reversing the transaction at a specified
time, along with the payment of interest. Most repos are overnight l oans, and the
most common collateral is Treasury bills. Repos are usually made with
institutional investors, such as investment and pension funds, who often have
cash to invest.
The major security that banks sell is the large certificate of deposit (CD), which
is highly negotiable, and can be easily sold in the money markets. A large CD isa time deposit of $100,000 or more. (Banks also sell small CDs to retail
customers, but these can't be sold in the financial markets.) Other major
securities sold by banks include commercial paper and bonds.
The Necessity of Asset Liability Management:-
The asset-liability management in the Indian banks is still in its nascent stage.
With the freedom obtained through reform process, the Indian banks have
reached greater horizons by exploring new avenues. The government ownership
of most banks resulted in a carefree attitude towards risk management. This
complacent behavior of banks forced the Reserve Bank to use regulatory tactics
to ensure the implementation of the ALM. Al so, the post-reform banking
scenario is marked by interest rate deregulation, entry of new private banks, and
gamut of new products and greater use of information technology. To cope with
these pressures banks were required to evolve strategies rather than ad hoc fire
fighting solutions. Imprudent liquidity management can put banks earnings and
reputation at great risk. These pressures call for structured and comprehensive
measures and not just ad hoc action. The Management of banks has to base theirbusiness decisions on a dynamic and integrated risk management system and
process, driven by corporate strategy. Banks are exposed to several major risks
in the course of their business credit risk, interest rate risk, foreign exchange
risk, equity / commodity price risk, liquidity risk and operational risk. It is,
therefore, important that banks introduce effective risk management systems that
address the issues related to interest rate, currency and liquidity risks.
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Implementation of asset liability management (ALM) system:-
ALM framework rests on three pillars
y ALM Organisation: The ALCO consisting of the banks senior
management including CEO should be responsible for adhering to the
limits set by the board as well as for deciding the business strategy of thebank in line with the banks budget and decided risk management
objectives. ALCO is a decision-making unit responsible for balance sheet
planning from a risk return perspective including strategic management of
interest and liquidity risk. Consider the procedure for sanctioning a loan.
The borrower, who approaches the bank, is appraised by the credit
department on various parameters like industry prospects, operational
efficiency, financial efficiency, management evaluation and others which
influence the working of the client company. On the basis of this appraisal
the borrower is charged certain rate of interest to cover the credit risk. Forexample, a client with credit appraisal AAA will be charged PLR. While
somebody with BBB rating will be charged PLR + 2.5 %, say. Naturally,
there will be certain cut-off for credit appraisal, below which the bank
will not lend e.g. Bank will not like to lend to D rated client even at a
higher rate of interest. The guidelines for the loan sanctioning procedure
are decided in the ALCO meetings with targets set and goals established
y ALM Information System: ALM Information System is used for the
collection of information accurately, adequately and expeditiously.Information is the key to the ALM process. A good information system
gives the bank management a complete picture of the banks balance
sheet.
y ALM Process: The basic ALM process involves identification,
measurement and management of risk parameters. The RBI in its
guidelines has asked Indian banks to use traditional techniques like Gap
Analysis for monitoring interest rate and liquidity risk. However RBI is
expecting Indian banks to move towards sophisticated techniques likeDuration, Simulation, VaR in the future.
y Trading Risk:-
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Generally, greater profits can be made by taking greater risks. A bank's leverage
ratio is limited by law, but it can try to earn greater profits by trading securities.
Although United States banks cannot, by law, own stocks, they can buy debt
securities and derivatives. For this, banks hire traders for a separate department
that specializes in trading securities.
The risk of trades is measured by standard statistical tools for measuring
investment risk: standard deviations and value at risk (VaR). However, many
banks use more sophisticated financial models to gauge risk and to increase their
profits, but the 2007 2009 credit crisis showed that many of these models were
faulty.
Also, rogue traders can cause stupendous losses for banks, even causing their
bankruptcy. Consider Barings Bank that started in 1762, and was considered to
be the most stable and safest bank for centuries. In 1995, Nick Leeson lost more
than 860 million pounds trading Japanese equities in Singapore. Barings was
unable to provide the cash to cover the losses, so it collapsed.
The 2007 - 2009 credit crisis has also shown the tremendous risks presented by
derivatives, which are securities whose value depends on an underlying asset or
index. The most common derivatives bought and sold by banks are mortgage -
backed securities (MBS), interest-rate swaps, and credit default swaps (aka
credit derivatives).
y Sovereign Risk:-
Many foreign loans are paid in U.S. dollars and repaid with dollars. Some of
these foreign loans are to countries with unstable governments. If political
problems arise in the country that threatens investments, investors will pull their
money out to prevent losses arising from sovereign risk. In t