Summer Project ReportOn

“Risk Management in Urban Co-operative Banks”

FORReserve Bank of India, Mumbai

Submitted toProf. P.V.Dabli

DIRECTOR, SIMSREE

In partial fulfillment of

POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT(2005-2007)

Submitted by

Shashank P PaiPGDBM 534

Finance

Sydenham Institute of Management Studies

Research and Entrepreneurship Education

1

Acknowledgement

Emergence of risk management in the financial sector especially in the banks following

the aggressive push given to de-regulation and liberalization of Indian banks provides a

challenging field of knowledge involving almost every aspect of a bank. For a novice

Post Graduate student like me, this project was an incredible learning experience.

I, therefore, thank Reserve Bank of India, Mumbai for giving me the valuable opportunity

of working on this immensely interesting project.

It would have been very difficult for me to do justice and complete this project in all

respects in the limited time at my disposal, without the stimulating guidance and

invaluable suggestions I received from my project guide, Mr. Sathyan David, General

Manager, UBD. I would take this opportunity to express my earnest gratitude to Mr.

Vishwanathan Chief General Manager, UBD who not only encouraged me to put in my

best in the project but also gave me the full benefit of his vast knowledge by giving me

right directions for preparing this Report.

I also thank Mr. Vivek Mandlik, Senior Investment and Tresury manager, And Mrs. Bina

Dixit for giving me the opportunity to undertake my study at Shamrao Vitthal Bank. I

also acknowledge my debt to Mr Jagdish Pai from Risk Management Department

Saraswat Bank for sharing with me their vast repertoire of knowledge and experience in

the field of Risk Management and providing me with all the necessary guidance and help

I also wish to acknowledge the help and support provided to me by Mr Shinde and many

others of the Central office, UBD without which the completion of the project would

have not been possible.

2

July 29th 2006 Shashank Padmanabh Pai

The following Project Report titled “Risk Management in

Urban Co-operative Banks” has been prepared as a part

of the Summer Training Programme undergone at Reserve

Bank of India as well as other leading Urban Co-operative

Banks. It is an academic exercise carried out based on the

reading material provided by the institutions mentioned

above as also individual study. The views expressed and

the observations recorded in the Report are of the author

and not of the organizations where the study has been

undertaken.

3

Certificate

This is to certify that Mr Shashank Padmanabh Pai,

PGDBM 2005-07 students from Sydenham Institute of

Management Studies and Research & Enterpreneurship

Education, Mumbai has undergone summer training under

my guidance at the Department of Banking Supervision,

Reserve Bank of India, Mumbai from May 2 2, 2006 to

July 22, 2006. The title of his project is ‘Risk

Management in Urban Co-operative Banks’.

Mr. Sathyan David

GM, UBD, RBI

4

Executive Summary

Economic reforms and liberalization gave a new dimension to the playing field in

financial markets especially banks; in fact in many ways the rules of the game, too. By

definition, they tend to reduce the arbitrage opportunities as market imperfections are

eliminated. Increased competition from both domestic and foreign players puts pressure

on the margins and reduces the cushion for absorbing the losses even as the potential for

business losses increases due to higher market volatility. Just a few years ago market set

up for banks were not as complex as it is today. Interest rates were regulated, financial

assets moved within a narrow band, foreign exchange rate was pegged, by and large roles

of all financial intermediaries were well defined and banks had a stable and well known

set of customers and counterparties to deal with.

Deregulation and Internationalization

Within a fairly short span of time, the canvas has changed drastically. The sheer

movements of major macroeconomic parameters over the past few years have been

breathtaking. This volatility in the financial sector results in not only from domestic

deregulation but is also an inevitable product of opening up of the economy. It also brings

in its own influences. In a liberalizing environment, the competitive framework also

undergoes a change. Many new players have entered market. These players enter across

different financial market segments and became more dynamic with more deregulation,

inter linkages between them begin to develop and become more pronounced. It can be

exemplified saying – forex and exchange market.

The Process of Liberalization

The Indian banking industry, till 1985, was largely under regulatory provision from the

Reserve Bank of India and the Government of India. The regulations were felt necessary

5

to direct the scarce savings uniformly for all sectors of the economy, more so towards the

neglected sector.

The regulations in the initial stage did give a thrust to expand the banking activities to

every nook and corner of the country. There were positive sides of such directed bank

lending. Along with it were negative indicators too like high level of Non-Performing

Assets, Low Profitability, Low Level of Technology and Poor Customer Service.

Simultaneously, there were significant changes in the global scenario, which had its

effect on the Indian economy too. The gradual integration in the world economy

prompted Indian economy to become a part of it. The Indian banking system being the

backbone of the economy could not remain far behind. It had to accept the world

standards of accounting, transparencies in balance sheets, and prudential norms for

classification of assets.

Throughout the world, both in developed as well as the developing countries, the banking

system had to move from deregulated environment to a more gradual liberalized

environment. In Indian, the process of liberalization was initially introduced in 1985,

more on an experimental basis and from 1991, more vigorously. It continues even today.

The focus here was to open up the banking sector to more competition, diversifying of

banking activities, freeing of interest rates, transparencies in performance, convertibility

of rupee to foreign currency etc.

Post Liberalization – an experience

The experience of Indian banks in the post liberalization era had been of mixed feelings.

Due to the importance given to capital adequacy norms, the equity of banks has

increased. However, deposit and credit growth has been slow and sluggish. The Growth

in investment had been uptrend as banks found it safe to invest in government securities

than to lend money to borrowers. The private sector banks have shown relatively better

results as compared to the public sector banks and co-operative banks.

6

In fact, in this era of fast economic growth, banks would be one of the biggest

beneficiaries, on which they can capitalize. However, what is needed is better

management of funds available and various risks to which the banks are exposed.

Banking Risk Spectrum

Banks in the process of financial intermediation are confronted with various kinds of

financial and non-financial risks as mentioned below: -

Under Financial Risks: Balance Sheet Structure, Income Statement Structure and

Profitability, Capital Adequacy, Credit Risk, Liquidity Risk, Interest Rate Risk, Market

Risk and Currency Risk.

Under Operational Risk: the business strategy risk, Internal System, Operational Risk,

Technology Risk, Mismanagement & Fraud and Reputation Risk.

Under Banking Risk: the legal risk, macro policy risk, financial infrastructure and

systemic risk.

Under Event Risk: the political risk and other exogenous risks.

Risk management is important for banks in a globalization era. In the world of advanced

technology and economic liberalization, where financial markets are connected to each

other, a good risk management system is important to stay competitive. Effective RMS

will enable to accurately assess the acceptable level of risks, prepare adequate level of

capital as a buffer against loss and appropriately incorporate risk into price setting.

By definition, “Risk” is the potential that events expected or unanticipated may have an

adverse impact on a financial institution’s capital or earnings.

7

A formalized universal approach to credit risk was from set out in the BIS Accord 1988.

Banks were required by their regulators to set aside a flat fixed percentage of their risk-

weighted assets as regulatory capital. However, this regulatory framework for measuring

capital adequacy has come under severe criticism for various reasons such as inadequate

differentiation of credit risk, ignoring diversification benefits, etc.

Banks will require regulatory capital changes for “Operational Risk” and “Market Risk”.

The Operational risk was the cause of various well-publicized financial disasters such as

collapse of Barings bank in 1995. The bank lacked adequate operational controls.

The Basle committee has proposed a revised Capital Adequacy framework in June 1999,

envisaged to remove shortcomings of the 1988 Accord and remove deficiencies in its

risk-weighting model. The new framework uses three-pillar approach consisting of (a)

minimum capital requirements, (b) supervisory review process to ensure that bank’s

capital is aligned to its actual risk profile and (c) market discipline to enhance the role of

other market participants in ensuring that appropriate capital is held by prescribing

greater disclosure. The revised framework lays more emphasis on bank’s internal risk

management systems. The three pillars are critically interdependent and the success of

the new framework hinges on ensuring the proper functioning of all three of them.

The ultimate goal of the New Capital Accord is to ensure that the regulatory capital

requirement is sufficient to address the underlying risks of banks. Hence, it is an attempt

to narrow the gap between regulatory and economic capital, driven by increasing

sophistication of risk management techniques in banks. Improving standards of risk

management will enable the banking sector to prosper in future.

The Basle Capital Accord is primarily targeted towards internationally active banks.

However, Reserve Bank of India has issued various guidelines to Indian banks in line

with the committee’s proposal for the purpose of effective Risk Management, in order to

8

sustain them in the increasingly competitive environment

INDEX

Sr. No. Topic Page no.

1 Introduction

2 The Essence of Urban Co-operative

Banks

3 Risk and risk management concepts

4 Risk Management System in Banks

(Introduction)

5 Credit Risk

6 Market Risk

7 Operational Risk

8 Case Study

9

INTRODUCTION

“The fact is that bankers are in the business of managing risk,

pure and simple, that is the business of banking.”

Walter Wriston – Chairman and CEO, CITICORP (1970-84)

Risk Management has assumed greater significance in the past decade or so for the

following key environmental factors that has changed in the financial services industry

and has required the industry to improve both its monitoring and its management of risk

exposures:

I - Industry Consolidation

I - Increased Competition

T - Technological Changes

M - Management

These factors are of course, not the only ones affecting the industry, but their combined

influence has clearly altered the management challenges.

Let us understand in brief the above 4 factors, starting with Consolidation: Twenty years

ago, America's largest bank was Citicorp, with assets of around $120 billion. Though

Citicorp had a major international banking presence, its domestic banking operation was

contained largely in the State of New York. Its major national credit card operation was

its most significant departure from traditional banking lines. In contrast, today's Citigroup

has $1 trillion in assets and is a highly diversified financial services provider operating

not only throughout the United States but also internationally. Citigroup's expanded

scope is by no means unique. Rather, it is typical of the bank and non-bank consolidation

that has taken place. Today, thirteen financial holding companies hold more than $100

10

billion in assets. However, there are more than 6,000 separate banking organizations in

United States, and the largest organizations of them now have nationwide presence and

offer a broad array of financial products.

Let's move on to competition. Despite the consolidation that has taken place, the

financial services industry remains highly competitive. Not only do banks face intra-

industry competition, but they also face competition from non-bank financial service

providers. As of all of you know, virtually every financial product offered by the banking

industry is also offered--either identically or by a close substitute--outside the regulated

financial services industry.

Let me touch on several ways that technology has changed the banking industry. First,

technological advances from the past decade have allowed real-time access to credit

information and public records. This ability to mine data allows providers of financial

products to identify target markets with minimal geographic restraint. Secondly,

technology has allowed organizations to separate the various business functions, such as

product marketing, credit review and administration, and asset funding, and to locate

each of these functions based on separate criteria, such as the availability of labor or the

tax environment. Thirdly, technology has helped institutions monitor and manage risk by

hedging exposure to credit risk and interest rate risk or by selling certain assets in

secondary markets.

The fourth environmental factor is the virtually unanimous corporate goal of maximizing

shareholder value by the management. The motivation for this goal is obvious. The

stock market has accorded a price-earnings premium to financial institutions that

consistently outperform their competitors. This premium translates into highly receptive

capital markets and enhanced compensation to employees through stock options and

provides the institution with a strong currency with which to pursue mergers or

acquisitions.

11

Thus far we have understood only the positive aspects of each of these environmental

factors, but each also has potential negatives.

The consolidation that has created these giant institutions has also created many new risk-

management challenges.

Enhanced competition has brought increased pressure on interest-rate spreads and, when

combined with the continual pressure for earnings performance, can encourage either

imprudent risk-taking or a push for aggressive accounting treatment. Sophisticated

technology can at times be its own risk as a system failure or software error can have

extremely negative consequences.

With the globalization of economies world-over, the concepts like capital adequacy, asset

classification and income recognition have pride of place in the glossaries of financial

sector. Post Barings episode, the focus of supervisory concern has shifted from Asset

Quality to Risk Management. Instead of merely addressing the credit quality issues,

financial sector in general and banks in particular are laying emphasis on overall risk

profile.

Over the past few decades, there has been increased financial volatility in the financial

markets worldwide, which was triggered by the breakdown of the fixed exchange rate

system in the 1970s and fuelled further by the introduction of new financial products, the

quantum leap in technological capabilities that blurred financial boundaries, regulatory

initiatives and the thrust on profitability. This volatility has manifested itself as increased

risk and the failure to manage this risk has seen several institutions collapse across the

globe.

12

Historically, the focus in the areas of risks and controls in Indian banking has been on the

elements of management oversight, control and monitoring i.e. the operational risks. Risk

assessment of financial nature (credit, liquidity, market) has not traditionally been a

component of the risk recognition and control systems. In part, this has been due to the

fact that only operational and credit risks were the key concerns of the banks since they

were not exposed to market risks till recently. This contextual focus is evident from the

fact that the measures generally associated with assessment and control of the financial

risks viz. ALM, limit setting etc. have been implemented in 1986 itself for the overseas

branches of Indian Banks which operate in such market driven environment, whereas

such prescriptions had not been made for the domestic operations.

In the last decade, banking in India has undergone significant transformation due to the

increased market orientation of the banks, the increased competition brought out by the

entry of new banks in the private sector, deregulation of interest rates and the higher

levels of technology absorption in the industry. The arising of new risks and the

heightened awareness of existing ones has accompanied this transformation. The business

risks faced by Indian banks today can be classified as follows:

Financial Intermediation Risk

A] Financial Risks:

Credit Risk

1. Contingency Risk

2. Market Risk

- Interest Rate Risk

- Liquidity Risk

- Foreign Exchange Risk

- Equity Prices Risk, and;

- Commodities Prices Risk

- Capital Risks

- Solvency Risk

13

B] Non-Financial Risks:

1. Operational Risk

2. Systemic Risk

3. Legal Risks

4. Reputation Risk

Over a period of time, regulations have been introduced by apex bank and regulator

Reserve Bank of India, requiring banks to provide for capital against credit risk in line

with the BIS capital accord. With interest rate risks becoming a reality only in the last

couple of years following the deregulation of administered rates, banks have been

advised to set up ALM committees to manage interest rate and liquidity risks. ALM

guidelines have also been drawn up which are already been advised to banks, and which

will put in place internal reporting systems required for the management of the risks. The

focus of supervision has also shifted towards a risk-based approach.

Banks are however yet to put in place comprehensive Risk Management Systems as

indicated in the Basle Core Principles and have essentially been reacting to regulatory

and reporting requirements in their risk management efforts. In an environment where the

risk-reward tradeoff can have immediate and systemic implications, having risk

management systems in place is no longer a matter of choice. These systems must be

proactive enough to constantly scan the external environment in the search of emerging

market risks and simultaneously be reactive and firmly entrenched in systems and

procedures to be able to carry out a continuous self-assessment and trigger corrective

action. These systems must also recognize that their purpose is not to contain or remove

risk but to assist the organization in exploiting potential business opportunity in a manner

so as to enhance shareholders value without endangering the assets of the firm.

14

The broad parameters of risk management function are as under.

(i) The main components of a sound risk management focus are: competitive

risk measurement approach; a detailed structure of limits, guidelines and

other parameters used to govern risk taking; and a strong management

information system for controlling, monitoring and reporting risks.

(ii) The risk appetite of a bank is decided by its Board of Directors who

should approve all significant policies relating to the management of risks,

throughout the bank. These policies have to be consistent with the broader

business strategies, capital strength, management expertise and overall

willingness to take risk.

(iii) Senior management should be responsible for ensuring that there are

adequate policies and procedure for conducting various businesses. This

responsibility includes ensuring that there are clear delineation of lines of

responsibility for managing risk, adequate systems for measuring risk,

appropriately structured limits on risk taking, effective internal controls

and a comprehensive risk reporting framework

(iv) The risk management function should be an independent function

(v) Management should ensure that the various components of the

institution’s risk management process are regularly reviewed and

evaluated.

(vi) A sound internal control system should promote effective operations;

reliable financial and regulatory reporting; and compliance with relevant

laws, regulation and policies. Internal auditors have to evaluate the

independence and overall effectiveness of the bank’s risk management

functions.

Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework

for management of risks in India. The design of risk management functions should be

bank specific, dictated by the size, complexity of functions, the level of technical

expertise and the quality of MIS. The guidelines outlined by Reserve Bank of India in

15

October 1999, only provides broad parameters and each bank may evolve their own

systems compatible to their risk management architecture and expertise.

The Broad objective of this paper is to analyze the risk management system followed in

urban cooperative Banks vis-à-vis RBI guidelines.

16

The Essence of Urban Co-operative Banks

Definition of co-operation

The word co-operation has been defined in different ways by economists, lawmakers and

others.

According to co-operative planning Committee appointed by the Government of India in

1945 known as Saraiya Committee the definition of co-operation is:

“Cooperation is a form of organization in which persons the bonds of moral solidarity

between them, voluntarily associate and come together on the basis of equality for the

promotion of their economic interests. Those who come together have a common

economic aim which they cannot achieve by individual isolated action because of the

weakness of economic position of a large majority of them. This element of individual

weakness can be overcome by pooling their resources by making self help effective

through mutual aid and by strengthening”.

What is an Urban Co-operative Bank?

The urban co-operative banks were first started in Germany in 1888 and in Italy in 1898.

Thus urban co-operative banks are more than 100 years old.

In India first urban co-operative bank was started by Mr Vitthal Laxman Kavthekar in

1889. The guiding principles of voluntary and open membership, equal economic

participation and concern for the community were the basis.

17

Co-operative Banks in India have come a long way since the enactment of the

agricultural Credit Co-operative Societies Act 1904. The century old co-operative

banking structure is viewed as an important instrument of banking access to the rural

masses and thus a vehicle for democratization of Indian financial System. Co-operative

Banks mobilize deposits and purvey agricultural and rural credit with a wider outreach.

They have also been an important instrument for various development schemes,

particularly subsidy based programmes for the poor.

The co-operative banking structure in India comprises urban co-operative banks and rural

co-operative credit institutions. Urban co-operative banks consist of single tier viz.

primary co-operative, commonly referred to as urban co-operative banks (UCBs). The

rural co-operative credit structure has traditionally been bifurcated into two parallel

wings viz. short term and long term. Short term co-operative and credit institutions have a

federal three tier structure consisting of a large number of primary agricultural credit

societies (PACS) at the grassroot level, central co-operative banks (CCBs) at the district

level and State co-operative banks (StCBs) at the state/apex level. The smaller States and

union territories have a two tier structure with the StCBs directly meeting the credit

requirements of PACS. The long term rural co-operative structure has two tiers, viz. State

co-operative agriculture and rural development banks (SCARDBs) at the state level and

primary co-operative and rural development banks (PCARDBs) at the taluka/tehsil level.

However some states have a unitary structure with the State level banks operating

through their own branches: three States have a mixed structure incorporating both

unitary and federal systems.

Till end of March 2005 the number of UCBs was 1872 and till end of March 2004 the

count of rural co-operative credit institutions was 1,06,919 with short term having a

majority share of 1,06,131 institutions and long term having 788.Out of short term StCBs

had 31 CCBs had 365 and PACS had 1,05,735 institutions respectively. In long term

SCARDBs had 20 and PCARDBs had 768 institutions respectively.

18

How do Urban Cooperative Banks differ from others?

Unlike commercial banks which are promoted by institutions or the government and are

in the nature of a joint stock company, co-operative banks are promoted by a group of

individuals to fulfill their needs.

The co-operative banks are owned by the customers or the users. Thus to borrow funds

from a cooperative bank one has to be a shareholder of the bank. The shareholders in turn

elect a managing committee which runs the bank. Various state governments have placed

limitations on maximum share holding by an individual to ensure that no single

individual or group obtains control of the bank.

19

Objectives of the co-operative banks

The co-operative system world over has emerged with a distinct objective namely to

safeguard the interests of its members and to provide financial assistance to those who are

unable to get financial help from other institutions. Still a large number of people in the

urban, semiurban and villages are unable to receive the benefits. They have not benefited

from the new developments to a desired extent. The co-operatives can play a very

significant role in the traditional areas like small borrowers; retail and petty traders

transport operators and other weaker sections of the society.

Primary urban co-operative banks play an important role in meeting the growing credit

needs of urban and semi-urban areas. UCBs mobilize savings from the middle and lower

income groups and purvey credit to small sections of the society.

The basic idea of establishing the co-operative bank is still relevant but they have to

change their working style and adopt modern means of ICT. Hence it would be useful to

discuss in brief the basic philosophy behind establishing the cooperative institutions.

Today there are over 2000 primary urban cooperative banks with a deposit of over Rs

60000 crores.

Early history of cooperative movement through out the world shows that cooperative

organizations began with consumers cooperatives. The first Co-operative society known

as Rochdale Pioneer was formed by 28 flannel weavers in England in 1843 to protect

themselves against the organized sector. The movement later spread on to the other fields

of economic activities. But the ultimate aim of co-operatives was the protection of poor

sections of the society by pooling the available sources with them to help their members

by providing financial assistance to face the competition from the organized sector.

Risk and Risk Management

20

Risk analysis and management is just as common to our everyday existence as the very

concept of self-preservation. It is very much a part of human psyche, yet so eluding.

Interestingly, organizations are no exception to these paradoxes. Many in the

organizations still view risk as a scientific or engineering tool but not as an essential

metric. It is not hard to understand the reasons behind it.

Firstly, 'risk' raises many questions viz., are all risks bad, is risk a natural metric, can risk

be measured directly, in what units is risk measured, can risk be added and subtracted;

than answers about its nature. Secondly, to anyone trying to understand risk there appears

to be no frame of reference within which it could be understood. Thirdly, we cannot

attach a probe to a device and measure risk. Fourthly, risk is an abstract parameter,

requiring a degree of intellect that may, perhaps, be unique to human beings, to quantify

it. Any of them could be the reasons why risk-related discussions even today sound

theoretical if not philosophical and for most of the part, irrelevant to many in

organizations.

Definition of Risk

The word 'risk' is derived from an Italian word "risicare" which means 'to dare'. It means

risk is more 'a choice' than 'a fate'. An extension of this analogy further reveals that risk is

not something to be faced but a set of opportunities open to choice.

There is however, no one precise definition of risk that captures its entire spectra but a

plethora of opinions:

Possibility of loss or injury; Peril

A dangerous element or factor.

A chance of loss and the degree of probability of such loss.

The possibility of suffering harm or loss; danger; hazard.

A factor, element or course involving uncertain danger.

The danger or probability of loss.

21

Risk is just the chance of losing money.

Risk is a chance of gaining less money than normally expected.

In statistical terms, risk is defined as the degree of variability of possible outcomes for a

particular event. In financial parlance, risk is always associated with loss that is expected

to be incurred or less profit to be incurred due to the happening or non-happening of

certain events or activities. It arises as a deviation between what happens and what was

expected to happen. Therefore, how people view hazards will greatly influence their

perception of associated risk. In a way this is a good thing for, if everyone valued every

risk in precisely the same way, many risk opportunities would be passed by.

Risks can be dealt in any one or the combination of following ways:

1. Risk Avoidance – Avoiding taking risks.

2. Risk Reduction – Risk reduction through safety measures.

3. Risk Retention – One can retain the risks on to their own books.

4. Risk Transfer – By way of Insurance or Hedging.

Survey on Corporate risk management published by the Economist makes the following

observations:

Risk Management must be regarded as a core skill by every firm.

Risk Management is not an ivory tower for arcane specialists.

Increased disclosure of risk assessments and responses is the best course of

action, not increased regulation or aversion of employing financial instruments

that can reduce risk if used properly.

Risk Management must be senior management strategic responsibility, not solely

assigned to finance department.

22

The primary message of this survey is that the firms need to understand all the main risks

to which their future cash flows are exposed, not just the narrowly defined financial ones.

Over focus on one type of risk or another simply perpetuates the outmoded fragmented

approach to the management of risk.

The aforesaid clearly brings out the need to have proper understanding of framework for

risk management including the concept, generating of risk profile and the process.

Risk Management Concept

Risk Management is the continuous process of identifying and capitalizing on appropriate

opportunities while avoiding inappropriate exposures in such a way to maximize the

value of the enterprise. Exposures in the aggregate result from diverse activities, executed

from many locations by numerous people. Identifying exposure - its worthiness or

otherwise, is the greatest challenge in the risk management. Ultimately how exposures

and risks are managed depends upon the organizational culture, goals and risk tolerance.

Risk Management is the primary duty of line managers. It is based on separation of

responsibilities principle. It is fundamentally a managerial process, reflective of

organizations risk characteristics.

There is a mistaken belief that risk management is window dressing for regulators. Risk

Management is neither an added layer of bureaucracy nor an impediment to quick

execution and superior customer service. Risk Management is critical to the conduct of

safe and sound banking activities. New technologies, new products and size and speed of

financial transactions have added impetus to the risk management issues. Along with

financial performance of an institution equal importance is given to risk management

practices.

The Risk Management procedures need to address the following issues:

23

Ability to manage risk inherent in lending, trading and other transactions.

Soundness of implicit and explicit assumptions - both qualitative and quantitative

in the risk management system.

Consistency of policies/guidelines with lending/trading activities, managements

experience level and overall financial strength.

Appropriateness of MIS and communication network vis-à-vis level of business

activity, and;

Managerial capacity to identify and accommodate new risks.

A fully integrated risk management system that effectively identifies and controls all

major types of risks including those from new products and changing environment would

facilitate long-term growth and stability.

Risk is a multidimensional concept and risk management is a continuous activity. As

such, practically everyone throughout the organization is concerned with identifying and

managing risk. What is required is anticipating and preventing risk at the source and the

continuous monitoring of risk controls and ineffective processes which are the primary

source of risk. Hence, risk management needs to address to the process issue. Risk

Management encompasses three activities viz., Risk Identification, Risk Measurement

and Risk Control. Risk Identification, as a starting point consists of naming and defining

each risk associated with a type of transaction or a product or a service. When the

transactions are many and the chain of communication is long a formal risk identification

system is necessary. The second component is risk measurement. It is the estimation of

size, probability and timing of potential loss under various scenarios. This is a difficult

component due to variety of available methods, degree of sophistication and costs

involved. For example, asset/liability analysis is considered as a measure for estimating

impact of changes in interest rates on portfolio value. Various interest rate scenarios

24

could be developed for appreciation of risk involved.

Risk control has two sub-categories. The first relates to policy administrative control,

while the second is risk-mitigating activity. Having proper policies/procedures, helps to

define each person's role, limit to which he can take risk, reporting mechanism and the

like. The goal of each such policy is to keep the outcome within risk tolerance ranges.

Uniformity of language is useful while defining each risk precisely from department to

department. The other aspect of risk control is risk-mitigating activity. The available

options could be risk transfer (insurance or hedging), elimination or avoidance (staying

out of risky business), reduction (specification and adherence to limit) and risk retention.

Prerequisites of Effective Risk Management Systems in Banks

Establishment of a sound risk management system presupposes specification of and

adherence to certain qualitative and quantitative criteria. The quantitative requirements

provide a level of consistency necessary for a capital standard, while the qualitative

requirements include aspects, which may take the shape of

a) Having risk control unit independent of the operating unit

b) Implementing a regular program for validation

c) Laying down procedures for periodic stress testing to evaluate the impact of

unusual transactions

d) Adopting internal policies/procedures/controls which are documented, and;

e) Conducting independent review of risk management process by internal auditors.

For a sound risk management system to meet these quantitative and qualitative criteria,

each organization has to address to certain pre-requisites. They are:

25

1. Active Board and Senior Management Oversight

2. Adequate Risk Management Policies and Limits

3. Appropriate Risk Measurement and Reporting Systems, and;

4. Comprehensive Internal Control System

Active Board and Senior Management Oversight

Boards of Directors have the ultimate responsibility to determine the level of risks

undertaken by the organization. Board needs to approve overall business strategies/

policies including managing and undertaking risks.

Ensuring capability of senior management to conduct the risk management task is also

the board’s responsibility. Board therefore needs to have a clear understanding of the

types of risks, the institution is exposed to. They should receive in meaningful terms

reports identifying the size and significance of risks. It may be useful to have briefing

from outside experts so that the board is capable to guide its institution on the level of

acceptable risk. This would also facilitate that the senior management implements the

procedures and controls necessary to comply with adopted policies.

Senior Management is responsible for implementing strategies that limit risks associated

with each strategy and ensures compliance with laws and regulations. Adopting policies,

devising control mechanisms and risk monitoring systems, delineating accountability and

lines of authority creating and communicating awareness of internal controls as also

ethical standards are all tasks of senior management.

Adequate Risk Management Policies and Limits

26

There can be nothing like proto-type policies or procedures for risk management. The

size of operations, sophistication, level of technology, managerial capacity and ability to

undertake risks are some of the determinants while documenting policies and procedures.

The policies and procedures are tailored according to the types of risks that arise from the

activities of the organization. They provide detailed guidelines on implementation and

prescribe limits designed to protect the organization from excessive and imprudent risks.

The core of these policies is to address to the material areas of risk and their necessary

modification to respond to significant changes to bank activities or business environment.

These policies and procedures provide risk management framework based on

management experience level, goals, objectives and overall financial strength of the

banking organization. Delineating accountability and lines of authority across the

organizational activities and review of activities new to the bank are also facilitated

through such policies.

Monitoring and Management Information Systems

Risk management related activity i.e., identification, measurement, and monitoring/

control need to be supported by a proper Management Information System (MIS). Such

MIS provides reports on financial condition, operational performance and risk exposures.

Line Managers can expect to obtain more detailed feedback on day-to-day operating

activities. Complexity and diversity of institutions financial transactions would dictate

sophistication of MIS. MIS for example will include daily financials including profit/loss

details, a watch list of troubled loans, etc. Whenever trading activities are on a larger

scale, more detailed activity reports across the whole organization may be necessary. The

purpose is to ultimately ensure that policies and procedures address to material risks areas

and that they are modifies to respond to the changes in activities, business conditions and

environment.

Comprehensive Internal Control System

27

Internal control structure is critical for safety and soundness of any organization. As the

instances of Daiwa/ Barings have proved, failure to implement/ maintain separation of

duties can result in serious financial and reputation losses. A properly placed internal

control system aims at:

• Promoting effective operations and reliable reporting

• Safeguarding assets, and;

• Ensuring regulatory/ policy compliance

Effective internal controls need to be looked into by internal auditors, who would report

directly to the top management. The internal controls primarily check the

policies/procedures in terms of their adequacy and effectiveness. The prescription for

proper policies and procedures do equally hold good for internal controls.

RISK MANAGEMENT SYSTEMS IN BANKS

28

Introduction

Banks in the process of financial intermediation are confronted with various kinds of

financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity,

equity price, commodity price, legal, regulatory, reputation, operational, etc. These risks

are highly interdependent and events that affect one area of risk can have ramifications

for a range of other risk categories. Thus, top management of banks should attach

considerable importance to improve the ability to identify measure, monitor and control

the overall level of risks undertaken.

The broad parameters of risk management function should encompass:

i) Organizational structure;

ii) Comprehensive risk measurement approach;

iii) Risk management policies approved by the Board which should be consistent with

the broader business strategies, capital strength, management expertise and overall

willingness to assume risk;

iv) Guidelines and other parameters used to govern risk taking including detailed

structure of prudential limits;

v) Strong MIS for reporting, monitoring and controlling risks;

vi) Well laid out procedures, effective control and comprehensive risk reporting

framework;

vii) Separate risk management framework independent of operational Departments and

with clear delineation of levels of responsibility for management of risk; and

viii) Periodical review and evaluation.

Risk Management Structure

29

A major issue in establishing an appropriate risk management organization structure is

choosing between a centralized and decentralized structure. The global trend is towards

centralizing risk management with integrated treasury management function to benefit

from information on aggregate exposure, natural netting of exposures, economies of scale

and easier reporting to top management. The primary responsibility of understanding the

risks run by the bank and ensuring that the risks are appropriately managed should clearly

be vested with the Board of Directors. The Board should set risk limits by assessing the

bank’s risk and risk-bearing capacity. At organizational level, overall risk management

should be assigned to an independent Risk Management Committee or Executive

Committee of the top Executives that reports directly to the Board of Directors. The

purpose of this top level committee is to empower one group with full responsibility of

evaluating overall risks faced by the bank and determining the level of risks which will

be in the best interest of the bank. At the same time, the Committee should hold the line

management more accountable for the risks under their control, and the performance of

the bank in that area. The functions of Risk Management Committee should essentially

be to identify, monitor and measure the risk profile of the bank. The Committee should

also develop policies and procedures, verify the models that are used for pricing complex

products, review the risk models as development takes place in the markets and also

identify new risks. The risk policies should clearly spell out the quantitative prudential

limits on various segments of banks’ operations. Internationally, the trend is towards

assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and

Earnings at Risk and Value at Risk (market risk). The Committee should design stress

scenarios to measure the impact of unusual market conditions and monitor variance

between the actual volatility of portfolio value and that predicted by the risk measures.

The Committee should also monitor compliance of various risk parameters by operating

Departments.

A prerequisite for establishment of an effective risk management system is the existence

of a robust MIS, consistent in quality. The existing MIS, however, requires substantial

30

up gradation and strengthening of the data collection machinery to ensure the integrity

and reliability of data.

The risk management is a complex function and it requires specialized skills and

expertise. Banks have been moving towards the use of sophisticated models for

measuring and managing risks. Large banks and those operating in international markets

should develop internal risk management models to be able to compete effectively with

their competitors. As the domestic market integrates with the international markets, the

banks should have necessary expertise and skill in managing various types of risks in a

scientific manner. At a more sophisticated level, the core staff at Head Offices should be

trained in risk modeling and analytical tools. It should, therefore, be the endeavor of all

banks to upgrade the skills of staff.

Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework

for management of risks in India. The design of risk management functions should be

bank specific, dictated by the size, complexity of functions, the level of technical

expertise and the quality of MIS. The proposed guidelines only provide broad parameters

and each bank may evolve their own systems compatible to their risk management

architecture and expertise.

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

Asset - Liability Management Committee (ALCO) deal with different types of market

risk, the Credit Policy Committee (CPC) oversees the credit /counterparty risk and

country risk. Thus, market and credit risks are managed in a parallel two-track approach

in banks. Banks could also set-up a single Committee for integrated management of

credit and market risks. Generally, the policies and procedures for market risk are

articulated in the ALM policies and credit risk is addressed in Loan Policies and

Procedures.

31

Currently, while market variables are held constant for quantifying credit risk, credit

variables are held constant in estimating market risk. The economic crises in some of the

countries have revealed a strong correlation between unhedged market risk and credit

risk. Forex exposures, assumed by corporates who have no natural hedges, will increase

the credit risk which banks run vis-à-vis their counterparties. The volatility in the prices

of collateral also significantly affects the quality of the loan book. Thus, there is a need

for integration of the activities of both the ALCO and the CPC and consultation process

should be established to evaluate the impact of market and credit risks on the financial

strength of banks. Banks may also consider integrating market risk elements into their

credit risk assessment process.

32

Credit Risk

General

Lending involves a number of risks. In addition to the risks related to creditworthiness of

the counterparty, the banks are also exposed to interest rate, forex and country risks.

Credit risk or default risk involves inability or unwillingness of a customer or

counterparty to meet commitments in relation to lending, trading, hedging, settlement and

other financial transactions. The Credit Risk is generally made up of transaction risk or

default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and

concentration risk. The credit risk of a bank’s portfolio depends on both external and

internal factors. The external factors are the state of the economy, wide swings in

commodity/equity prices, foreign exchange rates and interest rates, trade restrictions,

economic sanctions, Government policies, etc. The internal factors are deficiencies in

loan policies/administration, absence of prudential credit concentration limits,

inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in

appraisal of borrowers’ financial position, excessive dependence on collaterals and

inadequate risk pricing, absence of loan review mechanism and post sanction

surveillance, etc.

Another variant of credit risk is counterparty risk. The counterparty risk arises from non-

performance of the trading partners. The non-performance may arise from counterparty’s

refusal/inability to perform due to adverse price movements or from external constraints

that were not anticipated by the principal. The counterparty risk is generally viewed as a

transient financial risk associated with trading rather than standard credit risk.

The management of credit risk should receive the top management’s attention and the

process should encompass:

33

a) Measurement of risk through credit rating/scoring;

b) Quantifying the risk through estimating expected loan losses i.e. the amount of loan

losses that bank would experience over a chosen time horizon (through tracking portfolio

behavior over 5 or more years) and unexpected loan losses i.e. the amount by which

actual losses exceed the expected loss (through standard deviation of losses or the

difference between expected loan losses and some selected target credit loss quantity);

c) Risk pricing on a scientific basis; and

d) Controlling the risk through effective Loan Review Mechanism and portfolio

management.

The credit risk management process should be articulated in the bank’s Loan Policy,

duly approved by the Board. Each bank should constitute a high level Credit Policy

Committee, also called Credit Risk Management Committee or Credit Control

Committee etc. to deal with issues relating to credit policy and procedures and to analyze,

manage and control credit risk on a bank wide basis. The Committee should be headed by

the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury,

Credit Risk Management Department (CRMD) and the Chief Economist. The Committee

should, inter alia, formulate clear policies on standards for presentation of credit

proposals, financial covenants, rating standards and benchmarks, delegation of credit

approving powers, prudential limits on large credit exposures, asset concentrations,

standards for loan collateral, portfolio management, loan review mechanism, risk

concentrations, risk monitoring and evaluation, pricing of loans, provisioning,

regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk

Management Department (CRMD), independent of the Credit Administration

Department. The CRMD should enforce and monitor compliance of the risk parameters

and prudential limits set by the CPC. The CRMD should also lay down risk assessment

systems, monitor quality of loan portfolio, identify problems and correct deficiencies,

develop MIS and undertake loan review/audit. Large banks may consider separate set up

for loan review/audit. The CRMD should also be made accountable for protecting the

quality of the entire loan portfolio. The Department should undertake portfolio

34

evaluations and conduct comprehensive studies on the environment to test the resilience

of the loan portfolio.

Instruments of Credit Risk Management

Credit Risk Management encompasses a host of management techniques, which help the

banks in mitigating the adverse impacts of credit risk.

Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers. The

banks should also evolve multi-tier credit approving system where the loan proposals are

approved by an ‘Approval Grid’ or a ‘Committee’. The credit facilities above a specified

limit may be approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers

and invariably one officer should represent the CRMD, who has no volume and profit

targets. Banks can also consider credit approving committees at various operating levels

i.e. large branches (where considered necessary), Regional Offices, Zonal Offices, Head

Offices, etc. Banks could consider delegating powers for sanction of higher limits to the

‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. The spirit of the

credit approving system may be that no credit proposals should be approved or

recommended to higher authorities, if majority members of the ‘Approval Grid’ or

‘Committee’ do not agree on the creditworthiness of the borrower. In case of

disagreement, the specific views of the dissenting member/s should be recorded.

The banks should also evolve suitable framework for reporting and evaluating the quality

of credit decisions taken by various functional groups. The quality of credit decisions

should be evaluated within a reasonable time, say 3 – 6 months, through a well-defined

Loan Review Mechanism.

35

Prudential Limits

In order to limit the magnitude of credit risk, prudential limits should be laid down on

various aspects of credit:

a) Stipulate benchmark current/debt equity and profitability ratios, debt service coverage

ratio or other ratios, with flexibility for deviations. The conditions subject to which

deviations are permitted and the authority therefore should also be clearly spelt out in the

Loan Policy;

b) Single /group borrower limits, which may be lower than the limits prescribed by

Reserve Bank to provide a filtering mechanism;

c) Substantial exposure limit i.e. sum total of exposures assumed in respect of those

single borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15%

of capital funds. The substantial exposure limit may be fixed at 600% or 800% of

capital funds, depending upon the degree of concentration risk the bank is exposed;

d) Maximum exposure limits to industry, sector, etc. should be set up. There must also

be systems in place to evaluate the exposures at reasonable intervals and the limits should

be adjusted especially when a particular sector or industry faces slowdown or other

sector/industry specific problems. The exposure limits to sensitive sectors, such as,

advances against equity shares, real estate, etc., which are subject to a high degree of

asset price volatility and to specific industries, which are subject to frequent business

cycles, may necessarily be restricted. Similarly, high-risk industries, as perceived by the

bank, should also be placed under lower portfolio limit. Any excess exposure should be

fully backed by adequate collaterals or strategic considerations; and

e) Banks may consider maturity profile of the loan book, keeping in view the market risks

inherent in the balance sheet, risk evaluation capability, liquidity, etc.

Risk Rating

Banks should have a comprehensive risk scoring / rating system that serves as a single

point indicator of diverse risk factors of counterparty and for taking credit decisions in a

consistent manner. To facilitate this, a substantial degree of standardization is required in

36

ratings across borrowers. The risk rating system should be designed to reveal the overall

risk of lending, critical input for setting pricing and non-price terms of loans as also

present meaningful information for review and management of loan portfolio. The risk

rating, in short, should reflect the underlying credit risk of the loan book. The rating

exercise should also facilitate the credit granting authorities some comfort in its

knowledge of loan quality at any moment of time.

The risk rating system should be drawn up in a structured manner, incorporating, inter

alia, financial analysis, projections and sensitivity, industrial and management risks. The

banks may use any number of financial ratios and operational parameters and collaterals

as also qualitative aspects of management and industry characteristics that have bearings

on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the

years to which they represent for giving importance to near term developments. Within

the rating framework, banks can also prescribe certain level of standards or critical

parameters, beyond which no proposals should be entertained. Banks may also consider

separate rating framework for large corporate / small borrowers, traders, etc. that exhibit

varying nature and degree of risk. Forex exposures assumed by corporates who have no

natural hedges have significantly altered the risk profile of banks. Banks should,

therefore, factor the unhedged market risk exposures of borrowers also in the rating

framework. The overall score for risk is to be placed on a numerical scale ranging

between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a

quantitative definition of the borrower, the loan’s underlying quality, and an analytic

representation of the underlying financials of the borrower should be presented. Further,

as a prudent risk management policy, each bank should prescribe the minimum rating

below which no exposures would be undertaken. Any flexibility in the minimum

standards and conditions for relaxation and authority therefore should be clearly

articulated in the Loan Policy.

The credit risk assessment exercise should be repeated biannually (or even at shorter

intervals for low quality customers) and should be delinked invariably from the regular

renewal exercise. The updating of the credit ratings should be undertaken normally at

37

quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the

portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate

changes in credit quality and expected loan losses from the credit portfolio. Thus, if the

rating system is to be meaningful, the credit quality reports should signal changes in

expected loan losses. In order to ensure the consistency and accuracy of internal ratings,

the responsibility for setting or confirming such ratings should vest with the Loan Review

function and examined by an independent Loan Review Group. The banks should

undertake comprehensive study on migration (upward – lower to higher and downward –

higher to lower) of borrowers in the ratings to add accuracy in expected loan loss

calculations.

Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting,

borrowers with weak financial position and hence placed in high credit risk category

should be priced high. Thus, banks should evolve scientific systems to price the credit

risk, which should have a bearing on the expected probability of default. The pricing of

loans normally should be linked to risk rating or credit quality. The probability of default

could be derived from the past behavior of the loan portfolio, which is the function of

loan loss provision/charge offs for the last five years or so. Banks should build historical

database on the portfolio quality and provisioning / charge off to equip themselves to

price the risk. But value of collateral, market forces, perceived value of accounts, future

business potential, portfolio/industry exposure and strategic reasons may also play

important role in pricing. Flexibility should also be made for revising the price (risk

premia) due to changes in rating / value of collaterals over time. Large sized banks

across the world have already put in place Risk Adjusted Return on Capital (RAROC)

framework for pricing of loans, which calls for data on portfolio behavior and allocation

of capital commensurate with credit risk inherent in loan proposals. Under RAROC

framework, lender begins by charging an interest mark-up to cover the expected loss –

expected default rate of the rating category of the borrower. The lender then allocates

enough capital to the prospective loan to cover some amount of unexpected loss-

38

variability of default rates. Generally, international banks allocate enough capital so that

the expected loan loss reserve or provision plus allocated capital cover 99% of the loan

loss outcomes.

There is, however, a need for comparing the prices quoted by competitors for borrowers

perched on the same rating /quality. Thus, any attempt at price-cutting for market share

would result in mispricing of risk and ‘Adverse Selection’.

Portfolio Management

The existing framework of tracking the Non Performing Loans around the balance sheet

date does not signal the quality of the entire Loan Book. Banks should evolve proper

systems for identification of credit weaknesses well in advance. Most of international

banks have adopted various portfolio management techniques for gauging asset quality.

The CRMD, set up at Head Office should be assigned the responsibility of periodic

monitoring of the portfolio. The portfolio quality could be evaluated by tracking the

migration (upward or downward) of borrowers from one rating scale to another. This

process would be meaningful only if the borrower-wise ratings are updated at quarterly /

half-yearly intervals. Data on movements within grading categories provide a useful

insight into the nature and composition of loan book.

The banks could also consider the following measures to maintain the portfolio quality:

1) Stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e.

certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2

to 4 or 4 to 5, etc.;

2) Evaluate the rating-wise distribution of borrowers in various industry, business

segments, etc;

3) Exposure to one industry/sector should be evaluated on the basis of overall rating

distribution of borrowers in the sector/group. In this context, banks should weigh the pros

and cons of specialization and concentration by industry group. In cases where portfolio

39

exposure to a single industry is badly performing, the banks may increase the quality

standards for that specific industry;

4) Target rating-wise volume of loans, probable defaults and provisioning requirements

as a prudent planning exercise. For any deviation/s from the expected parameters, an

exercise for restructuring of the portfolio should immediately be undertaken and if

necessary, the entry-level criteria could be enhanced to insulate the portfolio from further

deterioration;

5) Undertake rapid portfolio reviews, stress tests and scenario analysis when external

environment undergoes rapid changes (e.g. volatility in the forex market, economic

sanctions, changes in the fiscal/monetary policies, general slowdown of the economy,

market risk events, extreme liquidity conditions, etc.). The stress tests would reveal

undetected areas of potential credit risk exposure and linkages between different

categories of risk. In adverse circumstances, there may be substantial correlation of

various risks, especially credit and market risks. Stress testing can range from relatively

simple alterations in assumptions about one or more financial, structural or economic

variables to the use of highly sophisticated models. The output of such portfolio-wide

stress tests should be reviewed by the Board and suitable changes may be made in

prudential risk limits for protecting the quality. Stress tests could also include

contingency plans, detailing management responses to stressful situations.

6) Introduce discriminatory time schedules for renewal of borrower limits. Lower rated

borrowers whose financials show signs of problems should be subjected to renewal

control twice/thrice a year.

Banks should evolve suitable framework for monitoring the market risks especially forex

risk exposure of corporates who have no natural hedges on a regular basis. Banks should

also appoint Portfolio Managers to watch the loan portfolio’s degree of concentrations

and exposure to counterparties. For comprehensive evaluation of customer exposure,

banks may consider appointing Relationship Managers to ensure that overall exposure to

a single borrower is monitored, captured and controlled. The Relationship Managers

have to work in coordination with the Treasury and Forex Departments. The Relationship

Managers may service mainly high value loans so that a substantial share of the loan

40

portfolio, which can alter the risk profile, would be under constant surveillance. Further,

transactions with affiliated companies/groups need to be aggregated and maintained close

to real time. The banks should also put in place formalized systems for identification of

accounts showing pronounced credit weaknesses well in advance and also prepare

internal guidelines for such an exercise and set time frame for deciding courses of action.

Many of the international banks have adopted credit risk models for evaluation of credit

portfolio. The credit risk models offer banks framework for examining credit risk

exposures, across geographical locations and product lines in a timely manner,

centralizing data and analyzing marginal and absolute contributions to risk. The models

also provide estimates of credit risk (unexpected loss) which reflect individual portfolio

composition. The Altman’s Z score forecasts the probability of a company entering

bankruptcy within a 12-month period. The model combines five financial ratios using

reported accounting information and equity values to produce an objective measure of

borrower’s financial health. J. P. Morgan has developed a portfolio model

‘CreditMetrics’ for evaluating credit risk. The model basically focuses on estimating the

volatility in the value of assets caused by variations in the quality of assets. The volatility

is computed by tracking the probability that the borrower might migrate from one rating

category to another (downgrade or upgrade). Thus, the value of loans can change over

time, reflecting migration of the borrowers to a different risk-rating grade. The model

can be used for promoting transparency in credit risk, establishing benchmark for credit

risk measurement and estimating economic capital for credit risk under RAROC

framework. Credit Suisse developed a statistical method for measuring and accounting

for credit risk which is known as CreditRisk+. The model is based on actuarial

calculation of expected default rates and unexpected losses from default.

The banks may evaluate the utility of these models with suitable modifications to Indian

environment for fine-tuning the credit risk management. The success of credit risk

models impinges on time series data on historical loan loss rates and other model

variables, spanning multiple credit cycles. Banks may, therefore, endeavor building

41

adequate database for switching over to credit risk modeling after a specified period of

time.

Loan Review Mechanism (LRM)

LRM is an effective tool for constantly evaluating the quality of loan book and to bring

about qualitative improvements in credit administration. Banks should, therefore, put in

place proper Loan Review Mechanism for large value accounts with responsibilities

assigned in various areas such as, evaluating the effectiveness of loan administration,

maintaining the integrity of credit grading process, assessing the loan loss provision,

portfolio quality, etc. The complexity and scope of LRM normally vary based on banks’

size, type of operations and management practices. It may be independent of the CRMD

or even separate Department in large banks.

The main objectives of LRM could be:

• to identify promptly loans which develop credit weaknesses and initiate timely

corrective action;

• to evaluate portfolio quality and isolate potential problem areas;

• to provide information for determining adequacy of loan loss provision

• to assess the adequacy of and adherence to, loan policies and procedures, and to

monitor compliance with relevant laws and regulations; and

• to provide top management with information on credit administration, including

credit sanction process, risk evaluation and post-sanction follow-up.

Accurate and timely credit grading is one of the basic components of an effective LRM.

Credit grading involves assessment of credit quality, identification of problem loans, and

assignment of risk ratings. A proper Credit Grading System should support evaluating

the portfolio quality and establishing loan loss provisions. Given the importance and

subjective nature of credit rating, the credit ratings awarded by Credit Administration

Department should be subjected to review by Loan Review Officers who are independent

of loan administration.

42

3.2.7 Banks should formulate Loan Review Policy and it should be reviewed annually by

the Board. The Policy should, inter alia, address:

• Qualification and Independence

The Loan Review Officers should have sound knowledge in credit appraisal, lending

practices and loan policies of the bank. They should also be well versed in the relevant

laws/regulations that affect lending activities. The independence of Loan Review

Officers should be ensured and the findings of the reviews should also be reported

directly to the Board or Committee of the Board.

• Frequency and Scope of Reviews

The Loan Reviews are designed to provide feedback on effectiveness of credit sanction

and to identityncipient deterioration in portfolio quality. Reviews of high value loans

should be undertaken usually within three months of sanction/renewal or more frequently

when factors indicate a potential for deterioration in the credit quality. The scope of the

review should cover all loans above a cut-off limit. In addition, banks should also target

other accounts that present elevated risk characteristics. At least 30-40% of the portfolio

should be subjected to LRM in a year to provide reasonable assurance that all the major

credit risks embedded in the balance sheet have been tracked.

• Depth of Reviews

The loan reviews should focus on:

• Approval process;

• Accuracy and timeliness of credit ratings assigned by loan officers;

• Adherence to internal policies and procedures, and applicable laws / regulations;

Compliance with loan covenants;

• Post-sanction follow-up;

43

• Sufficiency of loan documentation;

• Portfolio quality; and

• Recommendations for improving portfolio quality

The findings of Reviews should be discussed with line Managers and the corrective

actions should be elicited for all deficiencies. Deficiencies that remain unresolved should

be reported to top management.

The Risk Management Group of the Basle Committee on Banking Supervision has

released a consultative paper on Principles for the Management of Credit Risk. The

Paper deals with various aspects relating to credit risk management. The Paper is

enclosed for information of banks.

Credit Risk and Investment Banking

Significant magnitude of credit risk, in addition to market risk, is inherent in investment

banking. The proposals for investments should also be subjected to the same degree of

credit risk analysis, as any loan proposals. The proposals should be subjected to detail

appraisal and rating framework that factors in financial and non-financial parameters of

issuers, sensitivity to external developments, etc. The maximum exposure to a customer

should be bank-wide and include all exposures assumed by the Credit and Treasury

Departments. The coupon on non-sovereign papers should be commensurate with their

risk profile. The banks should exercise due caution, particularly in investment proposals,

which are not rated and should ensure comprehensive risk evaluation. There should be

greater interaction between Credit and Treasury Departments and the portfolio analysis

should also cover the total exposures, including investments. The rating migration of the

issuers and the consequent diminution in the portfolio quality should also be tracked at

periodic intervals.

44

As a matter of prudence, banks should stipulate entry level minimum ratings/quality

standards, industry, maturity, duration, issuer-wise, etc. limits in investment proposals as

well to mitigate the adverse impacts of concentration and the risk of illiquidity.

Credit Risk in Off-balance Sheet Exposure

Banks should evolve adequate framework for managing their exposure in off-balance

sheet products like forex forward contracts, swaps, options, etc. as a part of overall credit

to individual customer relationship and subject to the same credit appraisal, limits and

monitoring procedures. Banks should classify their off-balance sheet exposures into

three broad categories - full risk (credit substitutes) - standby letters of credit, money

guarantees, etc, medium risk (not direct credit substitutes, which do not support existing

financial obligations) - bid bonds, letters of credit, indemnities and warranties and low

risk - reverse repos, currency swaps, options, futures, etc.

The trading credit exposure to counterparties can be measured on static (constant

percentage of the notional principal over the life of the transaction) and on a dynamic

basis. The total exposures to the counterparties on a dynamic basis should be the sum

total of:

1) The current replacement cost (unrealized loss to the counterparty); and

2) The potential increase in replacement cost (estimated with the help of VaR or other

methods to capture future volatilities in the value of the outstanding contracts/

obligations).

The current and potential credit exposures may be measured on a daily basis to evaluate

the impact of potential changes in market conditions on the value of counterparty

positions. The potential exposures also may be quantified by subjecting the position to

market movements involving normal and abnormal movements in interest rates, foreign

exchange rates, equity prices, liquidity conditions, etc.

45

Inter-bank Exposure and Country Risk

A suitable framework should be evolved to provide a centralized overview on the

aggregate exposure on other banks. Bank-wise exposure limits could be set on the basis

of assessment of financial performance, operating efficiency, management quality, past

experience, etc. Like corporate clients, banks should also be rated and placed in range of

1-5, 1-8, as the case may be, on the basis of their credit quality. The limits so arrived at

should be allocated to various operating centres and followed up and half-yearly/annual

reviews undertaken at a single point. Regarding exposure on overseas banks, banks can

use the country ratings of international rating agencies and classify the countries into low

risk, moderate risk and high risk. Banks should endeavor for developing an internal

matrix that reckons the counterparty and country risks. The maximum exposure should be

subjected to adherence of country and bank exposure limits already in place. While the

exposure should at least be monitored on a weekly basis till the banks are equipped to

monitor exposures on a real time basis, all exposures to problem countries should be

evaluated on a real time basis.

46

Market Risk

Traditionally, credit risk management was the primary challenge for banks. With

progressive deregulation, market risk arising from adverse changes in market variables,

such as interest rate, foreign exchange rate, equity price and commodity price has become

relatively more important. Even a small change in market variables causes substantial

changes in income and economic value of banks. Market risk takes the form of:

1) Liquidity Risk

2) Interest Rate Risk

3) Foreign Exchange Rate (Forex) Risk

4) Commodity Price Risk and

5) Equity Price Risk

Market Risk Management

Management of market risk should be the major concern of top management of banks.

The Boards should clearly articulate market risk management policies, procedures,

prudential risk limits, review mechanisms and reporting and auditing systems. The

policies should address the bank’s exposure on a consolidated basis and clearly articulate

the risk measurement systems that capture all material sources of market risk and assess

the effects on the bank. The operating prudential limits and the accountability of the line

management should also be clearly defined. The Asset-Liability Management

Committee (ALCO) should function as the top operational unit for managing the balance

sheet within the performance/risk parameters laid down by the Board. The banks should

also set up an independent Middle Office to track the magnitude of market risk on a real

time basis. The Middle Office should comprise of experts in market risk management,

economists, statisticians and general bankers and may be functionally placed directly

under the ALCO. The Middle Office should also be separated from Treasury Department

and should not be involved in the day to day management of Treasury. The Middle Office

should apprise the top management / ALCO / Treasury about adherence to prudential /

47

risk parameters and also aggregate the total market risk exposures assumed by the bank at

any point of time.

Liquidity Risk

Liquidity Planning is an important facet of risk management framework in banks.

Liquidity is the ability to efficiently accommodate deposit and other liability decreases,

as well as, fund loan portfolio growth and the possible funding of off-balance sheet

claims. A bank has adequate liquidity when sufficient funds can be raised, either by

increasing liabilities or converting assets, promptly and at a reasonable cost. It

encompasses the potential sale of liquid assets and borrowings from money, capital and

forex markets. Thus, liquidity should be considered as a defense mechanism from losses

on fire sale of assets.

The liquidity risk of banks arises from funding of long-term assets by short-term

liabilities, thereby making the liabilities subject to rollover or refinancing risk.

The liquidity risk in banks manifest in different dimensions:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-

renewal of deposits (wholesale and retail);

ii) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e.

performing assets turning into non-performing assets; and

iii) Call Risk - due to crystallization of contingent liabilities and unable to undertake

profitable business opportunities when desirable.

The first step towards liquidity management is to put in place an effective liquidity

management policy, which, inter alia, should spell out the funding strategies, liquidity

planning under alternative scenarios, prudential limits, liquidity reporting / reviewing,

etc.

48

Liquidity measurement is quite a difficult task and can be measured through stock or cash

flow approaches. The key ratios, adopted across the banking system are:

i) Loans to Total Assets

ii) Loans to Core Deposits

iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus)

Temporary Investments, where large liabilities represent wholesale deposits which are

market sensitive and temporary Investments are those maturing within one year and those

investments which are held in the trading book and are readily sold in the market;

iv) Purchased Funds to Total Assets, where purchased funds include the entire inter-

bank and other money market borrowings, including Certificate of Deposits and

institutional deposits; and

v) Loan Losses/Net Loans.

While the liquidity ratios are the ideal indicator of liquidity of banks operating in

developed financial markets, the ratios do not reveal the intrinsic liquidity profile of

Indian banks which are operating generally in an illiquid market. Experiences show that

assets commonly considered as liquid like Government securities, other money market

instruments, etc. have limited liquidity as the market and players are unidirectional.

Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring

and managing net funding requirements, the use of maturity ladder and calculation of

cumulative surplus or deficit of funds at selected maturity dates is recommended as a

standard tool. The format prescribed by RBI in this regard under ALM System should be

adopted for measuring cash flow mismatches at different time bands. The cash flows

should be placed in different time bands based on future behavior of assets, liabilities and

off-balance sheet items. In other words, banks should have to analyze the behavioral

maturity profile of various components of on / off-balance sheet items on the basis of

assumptions and trend analysis supported by time series analysis. Banks should also

undertake variance analysis, at least, once in six months to validate the assumptions. The

assumptions should be fine-tuned over a period which facilitate near reality predictions

about future behavior of on / off-balance sheet items. Apart from the above cash flows,

banks should also track the impact of prepayments of loans, premature closure of deposits

49

and exercise of options built in certain instruments which offer put/call options after

specified times. Thus, cash outflows can be ranked by the date on which liabilities fall

due, the earliest date

A liability holder could exercise an early repayment option or the earliest date

contingencies could be crystallized.

The difference between cash inflows and outflows in each time period, the excess or

deficit of funds becomes a starting point for a measure of a bank’s future liquidity surplus

or deficit, at a series of points of time. The banks should also consider putting in place

certain prudential limits to avoid liquidity crisis:

1. on inter-bank borrowings, especially call borrowings;

2. Purchased funds vis-à-vis liquid assets;

3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve

Ratio and Loans;

4. Duration of liabilities and investment portfolio;

5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches

across all time bands;

6. Commitment Ratio – track the total commitments given to corporates/banks and

other financial institutions to limit the off-balance sheet exposure;

7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency

sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-

bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash

flows arising out of contingent liabilities in normal situation and the scope for an increase

in cash flows during periods of stress should also be estimated. It is quite possible that

market crisis can trigger substantial increase in the amount of draw downs from cash

credit/overdraft accounts, contingent liabilities like letters of credit, etc.

50

The liquidity profile of the banks could be analyzed on a static basis, wherein the assets

and liabilities and off-balance sheet items are pegged on a particular day and the

behavioral pattern and the sensitivity of these items to changes in market interest rates

and environment are duly accounted for. The banks can also estimate the liquidity profile

on a dynamic way by giving due importance to:

1) Seasonal pattern of deposits/loans;

2) Potential liquidity needs for meeting new loan demands, unavailed credit limits,

loan policy, potential deposit losses, investment obligations, statutory obligations, etc.

Alternative Scenarios

The liquidity profile of banks depends on the market conditions, which influence the cash

flow behavior. Thus, banks should evaluate liquidity profile under different conditions,

viz. normal situation, bank specific crisis and market crisis scenario. The banks should

establish benchmark for normal situation; cash flow profile of on / off balance sheet

items and manages net funding requirements.

Estimating liquidity under bank specific crisis should provide a worst-case benchmark.

It should be assumed that the purchased funds could not be easily rolled over; some of the

core deposits could be prematurely closed; a substantial share of assets have turned into

non-performing and thus become totally illiquid. These developments would lead to

rating down grades and high cost of liquidity. The banks should evolve contingency plans

to overcome such situations.

The market crisis scenario analyses cases of extreme tightening of liquidity conditions

arising out of monetary policy stance of Reserve Bank, general perception about risk

profile of the banking system, severe market disruptions, failure of one or more of major

players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of

high value customer deposits and purchased funds could extremely be difficult besides

51

flight of volatile deposits / liabilities. The banks could also sell their investment with

huge discounts, entailing severe capital loss.

Contingency Plan

Banks should prepare Contingency Plans to measure their ability to withstand bank-

specific or market crisis scenario. The blue-print for asset sales, market access, capacity

to restructure the maturity and composition of assets and liabilities should be clearly

documented and alternative options of funding in the event of bank’s failure to raise

liquidity from existing source/s could be clearly articulated. Liquidity from the

Reserve Bank, arising out of its refinance window and interim liquidity adjustment

facility or as lender of last resort should not be reckoned for contingency plans.

Availability of back-up liquidity support in the form of committed lines of credit,

reciprocal arrangements, liquidity support from other external sources, liquidity of assets,

etc. should also be clearly established.

Interest Rate Risk (IRR)

The management of Interest Rate Risk should be one of the critical components of market

risk management in banks. The regulatory restrictions in the past had greatly reduced

many of the risks in the banking system. Deregulation of interest rates has, however,

exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII)

or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates.

Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating

assets or liabilities), expose banks’ NII or NIM to variations. The earning of assets and

the cost of liabilities are now closely related to market interest rate volatility.

Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of

Equity (MVE), caused by unexpected changes in market interest rates. Interest Rate Risk

can take different forms:

52

Types of Interest Rate Risk

Gap or Mismatch Risk:

A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet

items with different principal amounts, maturity dates or repricing dates, thereby creating

exposure to unexpected changes in the level of market interest rates.

Basis Risk

Market interest rates of various instruments seldom change by the same degree during a

given period of time. The risk that the interest rate of different assets, liabilities and

off-balance sheet items may change in different magnitude is termed as basis risk. The

degree of basis risk is fairly high in respect of banks that create composite assets out of

composite liabilities. The Loan book in India is funded out of a composite liability

portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite

visible in volatile interest rate scenarios. When the variation in market interest rate

causes the NII to expand, the banks have experienced favorable basis shifts and if the

interest rate movement causes the NII to contract, the basis has moved against the banks.

Embedded Option Risk

Significant changes in market interest rates create another source of risk to banks’

profitability by encouraging prepayment of cash credit/demand loans/term loans and

exercise of call/put options on bonds/debentures and/or premature withdrawal of term

deposits before their stated maturities. The embedded option risk is becoming a reality in

India and is experienced in volatile situations. The faster and higher the magnitude of

changes in interest rate, the greater will be the embedded option risk to the banks’ NII.

53

Thus, banks should evolve scientific techniques to estimate the probable embedded

options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to

realistically estimate the risk profiles in their balance sheet. Banks should also endeavour

for stipulating appropriate penalties based on opportunity costs to stem the exercise of

options, which is always to the disadvantage of banks.

Yield Curve Risk

In a floating interest rate scenario, banks may price their assets and liabilities based on

different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc.

In case the banks use two different instruments maturing at different time horizon for

pricing their assets and liabilities, any non-parallel movements in yield curves would

affect the NII. The movements in yield curve are rather frequent when the economy

moves through business cycles. Thus, banks should evaluate the movement in yield

curves and the impact of that on the portfolio values and income.

Price Risk

Price risk occurs when assets are sold before their stated maturities. In the financial

market, bond prices and yields are inversely related. The price risk is closely associated

with the trading book, which is created for making profit out of short-term movements in

interest rates. Banks which have an active trading book should, therefore, formulate

policies to limit the portfolio size, holding period, duration, defeasance period, stop loss

limits, marking to market, etc.

Reinvestment Risk

Uncertainty with regard to interest rate at which the future cash flows could be reinvested

is called reinvestment risk. Any mismatches in cash flows would expose the banks to

variations in NII as the market interest rates move in different directions.

54

Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing towards

profitability of banks. When banks have more earning assets than paying liabilities,

interest rate risk arises when the market interest rates adjust downwards. Thus, banks

with positive net interest positions will experience a reduction in NII as the market

interest rate declines and increases when interest rate rises. Thus, large float is a natural

hedge against the variations in interest rates.

Measuring Interest Rate Risk

Before interest rate risk could be managed, they should be identified and quantified.

Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to

measure the degree of risks to which banks are exposed. It is also equally impossible to

develop effective risk management strategies/hedging techniques without being able to

understand the correct risk position of banks. The IRR measurement system should

address all material sources of interest rate risk including gap or mismatch, basis,

embedded option, yield curve, price, reinvestment and net interest position risks

exposures. The IRR measurement system should also take into account the specific

characteristics of each individual interest rate sensitive position and should capture in

detail the full range of potential movements in interest rates.

There are different techniques for measurement of interest rate risk, ranging from the

traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings),

Duration (to measure interest rate sensitivity of capital), Simulation and Value at Risk.

While these methods highlight different facets of interest rate risk, many banks use them

in combination, or use hybrid methods that combine features of all the techniques.

Generally, the approach towards measurement and hedging of IRR varies with the

segmentation of the balance sheet. In a well functioning risk management system, banks

55

broadly position their balance sheet into Trading and Investment or Banking Books.

While the assets in the trading book are held primarily for generating profit on short-term

differences in prices/yields, the banking book comprises assets and liabilities, which are

contracted basically on account of relationship or for steady income and statutory

obligations and are generally held till maturity. Thus, while the price risk is the prime

concern of banks in trading book, the earnings or economic value changes are the main

focus of banking book.

Trading Book

The top management of banks should lay down policies with regard to volume,

maximum maturity, holding period, duration, stop loss, defeasance period, rating

standards, etc. for classifying securities in the trading book. While the securities held in

the trading book should ideally be marked to market on a daily basis, the potential price

risk to changes in market risk factors should be estimated through internally developed

Value at Risk (VaR) models. The VaR method is employed to assess potential loss that

could crystallize on trading position or portfolio due to variations in market interest rates

and prices, using a given confidence level, usually 95% to 99%, within a defined period

of time. The VaR method should incorporate the market factors against which the market

value of the trading position is exposed. The top management should put in place bank-

wide VaR exposure limits to the trading portfolio (including forex and gold positions,

derivative products, etc.) which is then disaggregated across different desks and

departments. The loss making tolerance level should also be stipulated to ensure that

potential impact on earnings is managed within acceptable limits. The potential loss in

Present Value Basis Points should be matched by the Middle Office on a daily basis vis-

à-vis the prudential limits set by the Board. The advantage of using VaR is that it is

comparable across products, desks and Departments and it can be validated through ‘back

testing’. However, VaR models require the use of extensive historical data to estimate

future volatility. VaR model also may not give good results in extreme volatile conditions

or outlier events and stress test has to be employed to complement VaR. The stress tests

provide management a view on the potential impact of large size market movements and

56

also attempt to estimate the size of potential losses due to stress events, which occur in

the ’tails’ of the loss distribution. Banks may also undertake scenario analysis with

specific possible stress situations (recently experienced in some countries) by linking

hypothetical, simultaneous and related changes in multiple risk factors present in the

trading portfolio to determine the impact of moves on the rest of the portfolio. VaR

models could also be modified to reflect liquidity risk differences observed across assets

over time. International banks are now estimating Liquidity adjusted Value at Risk

(LaVaR) by assuming variable time horizons based on position size and relative turnover.

In an environment where VaR is difficult to estimate for lack of data, non-statistical

concepts such as stop loss and gross/net positions can be used.

Banking Book

The changes in market interest rates have earnings and economic value impacts on the

banks’ banking book. Thus, given the complexity and range of balance sheet products,

banks should have IRR measurement systems that assess the effects of the rate changes

on both earnings and economic value. The variety of techniques ranges from simple

maturity (fixed rate) and repricing (floating rate) to static simulation, based on current on-

and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques

that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance

sheet items and can easily capture the full range of exposures against basis risk,

embedded option risk, yield curve risk, etc.

Maturity Gap Analysis

The simplest analytical techniques for calculation of IRR exposure begins with maturity

Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet

positions into a certain number of pre-defined time-bands according to their maturity

(fixed rate) or time remaining for their next repricing (floating rate). Those assets and

liabilities lacking definite repricing intervals (savings bank, cash credit, overdraft, loans,

export finance, refinance from RBI etc.) or actual maturities vary from contractual

57

maturities (embedded option in bonds with put/call options, loans, cash credit/overdraft,

time deposits, etc.) are assigned time-bands according to the judgment, empirical studies

and past experiences of banks.

A number of time bands can be used while constructing a gap report. Generally, most of

the banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly

or one year. It is very difficult to take a view on interest rate movements beyond a year.

Banks with large exposures in the short-term should test the sensitivity of their assets and

liabilities even at shorter intervals like overnight, 1-7 days, 8-14 days, etc.

In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each

time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a

repricing ‘Gap’ for that time band. The positive Gap indicates that banks have more

RSAs than RSLs. A positive or asset sensitive Gap means that an increase in market

interest rates could cause an increase in NII. Conversely, a negative or liability sensitive

Gap implies that the banks’ NII could decline as a result of increase in market interest

rates. The negative gap indicates that banks have more RSLs than RSAs. The Gap is used

as a measure of interest rate sensitivity. The Positive or Negative Gap is multiplied by the

assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method

facilitates to estimate how much the earnings might be impacted by an adverse movement

in interest rates. The changes in interest rate could be estimated on the basis of past

trends, forecasting of interest rates, etc. The banks should fix EaR which could be based

on last/current year’s income and a trigger point at which the line management should

adopt on-or off-balance sheet hedging strategies may be clearly defined.

The Gap calculations can be augmented by information on the average coupon on assets

and liabilities in each time band and the same could be used to calculate estimates of the

level of NII from positions maturing or due for repricing within a given time-band, which

would then provide a scale to assess the changes in income implied by the gap analysis.

58

The periodic gap analysis indicates the interest rate risk exposure of banks over distinct

maturities and suggests magnitude of portfolio changes necessary to alter the risk profile.

However, the Gap report quantifies only the time difference between repricing dates of

assets and liabilities but fails to measure the impact of basis and embedded option risks.

The Gap report also fails to measure the entire impact of a change in interest rate (Gap

report assumes that all assets and liabilities are matured or repriced simultaneously)

within a given time-band and effect of changes in interest rates on the economic or

market value of assets, liabilities and off-balance sheet position. It also does not take into

account any differences in the timing of payments that might occur as a result of changes

in interest rate environment. Further, the assumption of parallel shift in yield curves

seldom happen in the financial market. The Gap report also fails to capture variability in

non-interest revenue and expenses, a potentially important source of risk to current

income.

In case banks could realistically estimate the magnitude of changes in market interest

rates of various assets and liabilities (basis risk) and their past behavioral pattern

(embedded option risk), they could standardize the gap by multiplying the individual

assets and liabilities by how much they will change for a given change in interest rate.

Thus, one or several assumptions of standardized gap seem more consistent with real

world than the simple gap method. With the Adjusted Gap, banks could realistically

estimate the EaR.

Duration Gap Analysis

Matching the duration of assets and liabilities, instead of matching the maturity or

repricing dates is the most effective way to protect the economic values of banks from

exposure to IRR than the simple gap model. Duration gap model focuses on managing

economic value of banks by recognising the change in the market value of assets,

liabilities and off-balance sheet (OBS) items. When weighted assets and liabilities and

OBS duration are matched, market interest rate movements would have almost same

59

impact on assets, liabilities and OBS, thereby protecting the bank’s total equity or net

worth. Duration is a measure of the percentage change in the economic value of a

position that will occur given a small change in the level of interest rates.

Measuring the duration gap is more complex than the simple gap model. For

approximation of duration of assets and liabilities, the simple gap schedule can be used

by applying weights to each time-band. The weights are based on estimates of the

duration of assets and liabilities and OBS that fall into each time band. The weighted

duration of assets and liabilities and OBS provide a rough estimation of the changes in

banks’ economic value to a given change in market interest rates. It is also possible to

give different weights and interest rates to assets, liabilities and OBS in different time

buckets to capture differences in coupons and maturities and volatilities in interest rates

along the yield curve.

In a more scientific way, banks can precisely estimate the economic value changes to

market interest rates by calculating the duration of each asset, liability and OBS position

and weigh each of them to arrive at the weighted duration of assets, liabilities and OBS.

Once the weighted duration of assets and liabilities are estimated, the duration gap can be

worked out with the help of standard mathematical formulae. The Duration Gap measure

can be used to estimate the expected change in Market Value of Equity (MVE) for a

given change in market interest rate.

The difference between duration of assets (DA) and liabilities (DL) is bank’s net

duration. If the net duration is positive (DA>DL), a decrease in market interest rates will

increase the market value of equity of the bank. When the duration gap is negative (DL>

DA), the MVE increases when the interest rate increases but decreases when the rate

declines. Thus, the Duration Gap shows the impact of the movements in market interest

rates on the MVE through influencing the market value of assets, liabilities and OBS.

60

The attraction of duration analysis is that it provides a comprehensive measure of IRR for

the total portfolio. The duration analysis also recognizes the time value of money.

Duration measure is additive so that banks can match total assets and liabilities rather

than matching individual accounts. However, Duration Gap analysis assumes parallel

shifts in yield curve. For this reason, it fails to recognize basis risk.

Simulation

Many of the international banks are now using balance sheet simulation models to gauge

the effect of market interest rate variations on reported earnings/economic values over

different time zones. Simulation technique attempts to overcome the limitations of Gap

and Duration approaches by computer modeling the bank’s interest rate sensitivity. Such

modeling involves making assumptions about future path of interest rates, shape of yield

curve, changes in business activity, pricing and hedging strategies, etc. The simulation

involves detailed assessment of the potential effects of changes in interest rate on

earnings and economic value. The simulation techniques involve detailed analysis of

various components of on-and off-balance sheet positions. Simulations can also

incorporate more varied and refined changes in the interest rate environment, ranging

from changes in the slope and shape of the yield curve and interest rate scenario derived

from Monte Carlo simulations.

The output of simulation can take a variety of forms, depending on users’ need.

Simulation can provide current and expected periodic gaps, duration gaps, balance sheet

and income statements, performance measures, budget and financial reports.

The simulation model provides an effective tool for understanding the risk exposure

under variety of interest rate/balance sheet scenarios. This technique also plays an

integral-planning role in evaluating the effect of alternative business strategies on risk

exposures.

61

The simulation can be carried out under static and dynamic environment. While the

current on and off-balance sheet positions are evaluated under static environment, the

dynamic simulation builds in more detailed assumptions about the future course of

interest rates and the unexpected changes in bank’s business activity.

The usefulness of the simulation technique depends on the structure of the model, validity

of assumption, technology support and technical expertise of banks.

The application of various techniques depends to a large extent on the quality of data and

the degree of automated system of operations. Thus, banks may start with the gap or

duration gap or simulation techniques on the basis of availability of data, information

technology and technical expertise. In any case, as suggested by RBI in the guidelines on

ALM System, banks should start estimating the interest rate risk exposure with the help

of Maturity Gap approach. Once banks are comfortable with the Gap model, they can

progressively graduate into the sophisticated approaches.

Funds Transfer Pricing

The Transfer Pricing mechanism being followed by many banks does not support good

ALM Systems. Many international banks which have different products and operate in

various geographic markets have been using internal Funds Transfer Pricing (FTP). FTP

is an internal measurement designed to assess the financial impact of uses and sources of

funds and can be used to evaluate the profitability. It can also be used to isolate returns

for various risks assumed in the intermediation process. FTP also helps correctly identify

the cost of opportunity value of funds. Although banks have adopted various FTP

frameworks and techniques, Matched Funds Pricing (MFP) is the most efficient

technique. Most of the international banks use MFP. The FTP envisages assignment of

specific assets and liabilities to various functional units (profit centers) – lending,

investment, deposit taking and funds management. Each unit attracts sources and uses of

funds. The lending, investment and deposit taking profit centers sell their liabilities to

and buys funds for financing their assets from the funds management profit centre at

62

appropriate transfer prices. The transfer prices are fixed on the basis of a single curve

(MIBOR or derived cash curve, etc) so that asset-liability transactions of identical

attributes are assigned identical transfer prices. Transfer prices could, however, vary

according to maturity, purpose, terms and other attributes.

The FTP provides for allocation of margin (franchise and credit spreads) to profit centers

on original transfer rates and any residual spread (mismatch spread) is credited to the

funds management profit centre. This spread is the result of accumulated mismatches.

The margins of various profit centers are:

• Deposit profit centre:

Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads.

• Lending profit centre:

Loan yields + TP on deposits – TP on loan financing – cost of deposits –

deposit insurance - overheads – loan loss provisions.

• Investment profit centre:

Security yields + TP on deposits – TP on security financing – cost of deposits – deposit

insurance - overheads – provisions for depreciation in investments and loan loss.

• Funds Management profit centre:

TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads.

For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month

deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and

one year @ 8% and 10.5% p.a., respectively. Let us also assume that the bank’s Loan

63

profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and

mismatch spreads of bank is as under:

Profit Centres

--------------------------------------

Total

-----------Deposit Funds Loan

Interest Income 8.0 10.5 13.5 13.5Interest Expenditure 6.5 8.0 10.5 6.5Margin 1.5 2.5 3.0 7.0Loan Loss Provision (expected) - - 1.0 1.0Deposit Insurance 0.1 - - 0.1Reserve Cost (CRR/ SLR) - 1.0 - 1.0Overheads 0.6 0.5 0.6 1.7NII 0.8 1.0 1.4 3.2

Under the FTP mechanism, the profit centers (other than funds management) are

precluded from assuming any funding mismatches and thereby exposing them to market

risk. The credit or counterparty and price risks are, however, managed by these profit

centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the

funds management profit centre.

The FTP allows lending and deposit raising profit centers determine their expenses and

price their products competitively. Lending profit centre which knows the carrying cost

of the loans needs to focus on to price only the spread necessary to compensate the

perceived credit risk and operating expenses. Thus, FTP system could effectively be

used as a way to centralize the bank’s overall market risk at one place and would support

an effective ALM modeling system. FTP also could be used to enhance corporate

communication; greater line management control and solid base for rewarding line

management.

Foreign Exchange (Forex) Risk

64

The risk inherent in running open foreign exchange positions have been heightened in

recent years by the pronounced volatility in forex rates, thereby adding a new dimension

to the risk profile of banks’ balance sheets.

Forex risk is 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. The banks are also exposed to

interest rate risk, which arises from the maturity mismatching of foreign currency

positions. Even in cases where spot and forward positions in individual currencies are

balanced, the maturity pattern of forward transactions may produce mismatches. As a

result, banks may suffer losses as a result of changes in premia/discounts of the

currencies concerned.

In the forex business, banks also face the risk of default of the counterparties or

settlement risk. While such type of risk crystallization does not cause principal loss,

banks may have to undertake fresh transactions in the cash/spot market for replacing the

failed transactions. Thus, banks may incur replacement cost, which depends upon the

currency rate movements. Banks also face another risk called time-zone risk or Herstatt

risk which arises out of time-lags in settlement of one currency in one centre and the

settlement of another currency in another time-zone. The forex transactions with

counterparties from another country also trigger sovereign or country risk.

Forex Risk Management Measures

1. Set appropriate limits – open positions and gaps.

2. Clear-cut and well-defined division of responsibility between front, middle and

back offices.

The top management should also adopt the VaR approach to measure the risk associated

with exposures. Reserve Bank of India has recently introduced two statements viz.

65

Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of

forex risk exposures. Banks should use these statements for periodical monitoring of

forex risk exposures.

Capital for Market Risk

The Basle Committee on Banking Supervision (BCBS) had issued comprehensive

guidelines to provide an explicit capital cushion for the price risks to which banks are

exposed, particularly those arising from their trading activities. The banks have been

given flexibility to use in-house models based on VaR for measuring market risk as an

alternative to a standardized measurement framework suggested by Basle Committee.

The internal models should, however, comply with quantitative and qualitative criteria

prescribed by Basle Committee.

Reserve Bank of India has accepted the general framework suggested by the Basle

Committee. RBI has also initiated various steps in moving towards prescribing capital for

market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments

in Government and other approved securities, besides a risk weight each of 100% on the

open position limits in forex and gold. RBI has also prescribed detailed operating

guidelines for Asset-Liability Management System in banks. As the ability of banks to

identify and measure market risk improves, it would be necessary to assign explicit

capital charge for market risk. In the meanwhile, banks are advised to study the Basle

Committee’s paper on ‘Overview of the Amendment to the Capital Accord to Incorporate

Market Risks’ – January 1996 (copy enclosed). While the small banks operating

predominantly in India could adopt the standardized methodology, large banks and those

banks operating in international markets should develop expertise in evolving internal

models for measurement of market risk.

The Basle Committee on Banking Supervision proposes to develop capital charge for

interest rate risk in the banking book as well for banks where the interest rate risks are

significantly above average (‘outliers’). The Committee is now exploring various

66

methodologies for identifying ‘outliers’ and how best to apply and calibrate a capital

charge for interest rate risk for banks. Once the Committee finalizes the modalities, it

may be necessary, at least for banks operating in the international markets to comply with

the explicit capital charge requirements for interest rate risk in the banking book.

Operational Risk

67

Managing operational risk is becoming an important feature of sound risk management

practices in modern financial markets in the wake of phenomenal increase in the volume

of transactions, high degree of structural changes and complex support systems. The

most important type of operational risk involves breakdowns in internal controls and

corporate governance. Such breakdowns can lead to financial loss through error, fraud, or

failure to perform in a timely manner or cause the interest of the bank to be

compromised.

Generally, operational risk is defined as any risk, which is not categoried as market or

credit risk, or the risk of loss arising from various types of human or technical error. It is

also synonymous with settlement or payments risk and business interruption,

administrative and legal risks. Operational risk has some form of link between credit and

market risks. An operational problem with a business transaction could trigger a credit or

market risk.

Measurement

There is no uniformity of approach in measurement of operational risk in the banking

system. Besides, the existing methods are relatively simple and experimental, although

some of the international banks have made considerable progress in developing more

advanced techniques for allocating capital with regard to operational risk.

Measuring operational risk requires both estimating the probability of an operational loss

event and the potential size of the loss. It relies on risk factor that provides some

indication of the likelihood of an operational loss event occurring. The process of

operational risk assessment needs to address the likelihood (or frequency) of a particular

operational risk occurring, the magnitude (or severity) of the effect of the operational risk

on business objectives and the options available to manage and initiate actions to reduce/

mitigate operational risk. The set of risk factors that measure risk in each business unit

such as audit ratings, operational data such as volume, turnover and complexity and data

on quality of operations such as error rate or measure of business risks such as revenue

68

volatility, could be related to historical loss experience. Banks can also use different

analytical or judgmental techniques to arrive at an overall operational risk level. Some of

the international banks have already developed operational risk rating matrix, similar to

bond credit rating. The operational risk assessment should be bank-wide basis and it

should be reviewed at regular intervals. Banks, over a period, should develop internal

systems to evaluate the risk profile and assign economic capital within the RAROC

framework.

Indian banks have so far not evolved any scientific methods for quantifying operational

risk. In the absence any sophisticated models, banks could evolve simple benchmark

based on an aggregate measure of business activity such as gross revenue, fee income,

operating costs, managed assets or total assets adjusted for off-balance sheet exposures or

a combination of these variables.

Risk Monitoring

The operational risk monitoring system focuses, inter alia, on operational performance

measures such as volume, turnover, settlement facts, delays and errors. It could also be

incumbent to monitor operational loss directly with an analysis of each occurrence and

description of the nature and causes of the loss.

Control of Operational Risk

Internal controls and the internal audit are used as the primary means to mitigate

operational risk. Banks could also explore setting up operational risk limits, based on the

measures of operational risk. The contingent processing capabilities could also be used

as a means to limit the adverse impacts of operational risk. Insurance is also an important

mitigator of some forms of operational risk. Risk education for familiarizing the complex

operations at all levels of staff can also reduce operational risk.

Policies and Procedures

69

Banks should have well defined policies on operational risk management. The policies

and procedures should be based on common elements across business lines or risks. The

policy should address product review process, involving business, risk management and

internal control functions.

Internal Control

One of the major tools for managing operational risk is the well-established internal

control system, which includes segregation of duties, clear management reporting lines

and adequate operating procedures. Most of the operational risk events are associated

with weak links in internal control systems or laxity in complying with the existing

internal control procedures.

The ideal method of identifying problem spots is the technique of self-assessment of

internal control environment. The self-assessment could be used to evaluate operational

risk along with internal/external audit reports/ratings or RBI inspection findings. Banks

should endeavor for detection of operational problem spots rather than their being pointed

out by supervisors/internal or external auditors.

Along with activating internal audit systems, the Audit Committees should play greater

role to ensure independent financial and internal control functions.

The Basle Committee on Banking Supervision proposes to develop an explicit capital

charge for operational risk.

Risk Aggregation and Capital Allocation

Most of internally active banks have developed internal processes and techniques to

assess and evaluate their own capital needs in the light of their risk profiles and business

70

plans. Such banks take into account both qualitative and quantitative factors to assess

economic capital. The Basle Committee now recognizes that capital adequacy in relation

to economic risk is a necessary condition for the long-term soundness of banks. Thus, in

addition to complying with the established minimum regulatory capital requirements,

banks should critically assess their internal capital adequacy and future capital needs on

the basis of risks assumed by individual lines of business, product, etc. As a part of the

process for evaluating internal capital adequacy, a bank should be able to identify and

evaluate its risks across all its activities to determine whether its capital levels are

appropriate.

Thus, at the bank’s Head Office level, aggregate risk exposure should receive increased

scrutiny. To do so, however, it requires the summation of the different types of risks.

Banks, across the world, use different ways to estimate the aggregate risk exposures. The

most commonly used approach is the Risk Adjusted Return on Capital (RAROC). The

RAROC is designed to allow all the business streams of a financial institution to be

evaluated on an equal footing. Each type of risks is measured to determine both the

expected and unexpected losses using VaR or worst-case type analytical model. Key to

RAROC is the matching of revenues, costs and risks on transaction or portfolio basis

over a defined time period. This begins with a clear differentiation between expected and

unexpected losses. Expected losses are covered by reserves and provisions and

unexpected losses require capital allocation which is determined on the principles of

confidence levels, time horizon, diversification and correlation. In this approach, risk is

measured in terms of variability of income. Under this framework, the frequency

distribution of return, wherever possible is estimated and the Standard Deviation (SD) of

this distribution is also estimated. Capital is thereafter allocated to activities as a function

of this risk or volatility measure. Then, the risky position is required to carry an expected

rate of return on allocated capital, which compensates the bank for the associated

incremental risk. By dimensioning all risks in terms of loss distribution and allocating

capital by the volatility of the new activity, risk is aggregated and priced.

71

The second approach is similar to the RAROC, but depends less on capital allocation and

more on cash flows or variability in earnings. This is referred to as EaR, when employed

to analyze interest rate risk. Under this analytical framework also frequency distribution

of returns for any one type of risk can be estimated from historical data. Extreme

outcome can be estimated from the tail of the distribution. Either a worst case scenario

could be used or Standard Deviation 1/2/2.69 could also be considered. Accordingly,

each bank can restrict the maximum potential loss to certain percentage of past/current

income or market value. Thereafter, rather than moving from volatility of value through

capital, this approach goes directly to current earnings implications from a risky position.

This approach, however, is based on cash flows and ignores the value changes in assets

and liabilities due to changes in market interest rates. It also depends upon a subjectively

specified range of the risky environments to drive the worst case scenario.

Given the level of extant risk management practices, most of Indian banks may not be in

a position to adopt RAROC framework and allocate capital to various businesses units on

the basis of risk. However, at least, banks operating in international markets should

develop suitable methodologies for estimating economic capital.

Risk Management in Saraswat Bank

72

The mission of the bank has been “To emerge as one of the premier and most

preferred banks in the country by adopting highest standard of professionalism and

excellence in all areas of working”. We therefore strive sincerely to adopt best

practices, offer a wide spectrum of products, maintain the highest service levels and

comply with all of the regulatory requirements.

According to Mr Pai of the Risk Management department, risk management is

identifying, measuring, managing and mitigating risks emanating from different business

activities. Risk management of the Bank has remained active in its efforts to contain

various types of risks namely credit risk, market risk and operational risk.

Procedure Of risk Management in the Bank

Ownership

• Head of risk management department shall be responsible for implementing the

policy in the bank

• The owner shall co-ordinate the tasks with the Business Head and treasury head

for implementing the policy in a cohesive manner.

Some Definitions

• Risk means probability of loss pecuniary or otherwise which may damage the

reputation of the bank or otherwise affect its fundamentals.

• Credit risk means the ability or willful default on the part of customer/counter

party to honor due commitments in relation to trading, lending, hedging,

settlement and other financial transactions.

• Market risks means risks which may cause loss to the bank due to the market

forces

73

• Mismatch means the difference in the interest sensitive assets and liabilities in the

given time bucket and or in the cash inflow and cash outflow in the given time

bucket.

Credit Risk

• Owner shall manage credit risk inherent in the loan as well as investment

portfolio of the bank

• Owner shall evolve mechanism to measure the credit risk in quantifiable terms

using appropriate internal rating model and or any other techniques

• Owner shall continuously review and monitor the credit as well as investment

portfolio to ensure that the measured risk is mitgated

Market Risk

• Treasury Head shall manage market risk associated with investment portfolio in

particular and all other portfolios in general

• He shall ensure that the investments are consistent with the bank’s investment

policy

• In it’s endeavor to mange market risk bank shall manage associated risks such as

interest rate risk, liquidity risk, foreign exchange rate risk.

• In managing these risks bank shall use tools such as gap analysis/mismatch as

suggested RBI

Asset liability Statement

• Owner shall draw the statement of structural liquidity, interest sensitivity and

dynamic liquidity on a monthly basis

• Owner shall analyze the mismatches vis-à-vis past trend and suggest ways and

means of managing it for safeguarding bank’s interest.

74

• Owner shall ensure that the norms/limits suggested by RBI in regard to

mismatches are adhered to

• Owner shall calculate mismatch in interest sensitive assets and liabilities and

suggest steps to be taken by the bank to maintain Net interest income

Operational Risk

• Vigilance officer of the bank as well Audit department shall ensure that KYC

policy as well as the deposit policy is adhered o while managing the deposit

portfolio of the bank

• Owner shall ensure that IT related policies are complied by the banks IT

Subsidiary Saraswat Infotech Limited while delivering core banking solutions and

other systems in banks.

• Vigilance officer shall be guided in minimizing the frauds being committed by the

officials of the bank.

• The respective heads shall ensure compliance to statutory requirements as

prescribed by the Law and or RBI, Central Registrar and or any other governing

body.

Review

• Owner shall review the policy at periodic intervals depending on the exigencies

and not later than once in a year

The guidelines followed by the bank in respect of the asset-liability management are

on the basis of those given by the Reserve Bank of India which is as follows

75

Asset Liability Management

Introduction to ALM

Considering their structure, balance sheet profile and skill levels of personnel of UCBs,

RBI found it necessary to provide technical support for putting in place an effective ALM

framework. These Guidelines lay down broad framework for measuring liquidity, interest

rates and forex risks. The initial focus of the ALM function would be to enforce the risk

management discipline viz. managing business after assessing the risks involved. The

objective of good bank management is to provide strategic tools for effective risk

management systems.

UCBs need to address the market risk in a systematic manner by adopting necessary

sector–specific ALM practices than has been done hitherto. ALM, among other

functions, also provides a dynamic framework for measuring, monitoring and managing

liquidity, interest rate and foreign exchange (forex) risks. It involves assessment of

various types of risks and altering balance sheet (assets and liabilities) items in a dynamic

manner to manage risks.

The ALM process rests on three pillars:

• ALM Information Systems

⇒ Management Information Systems (MIS)

⇒ Information availability, accuracy, adequacy and expediency

• ALM Organization

⇒ Structure and responsibilities

⇒ Level of top management involvement

• ALM Process

⇒ Risk parameters

⇒ Risk identification

76

⇒ Risk measurement

⇒ Risk management

⇒ Risk policies and procedures, prudential limits and auditing,

reporting and review.

ALM Information Systems

ALM has to be supported by a management philosophy which clearly specifies the

risk policies and procedures and prudential limits. This framework needs to be built

on sound methodology with necessary information system as back up. Thus,

Information is the key to the ALM process. It is, however, recognized that varied

business and customer profiles of UCBs do not make the adoption of a uniform

ALM System for all banks feasible. There are various methods prevalent world-wide

for measuring risks. These range from easy-to-comprehend and simple ‘Gap analysis’ to

extremely sophisticated and data intensive `Simulation’ methods. However, the central

element for the entire ALM exercise is the availability of timely, adequate and

accurate information. The existing systems in many UCBs do not generate

information in the manner required for ALM. Collecting accurate data in a timely

manner will be the biggest challenge before the UCBs taking full scale

computerization. However, the introduction of the essential information system for ALM

has to be addressed urgently. As commercial banks have already been prescribed with

ALM system and are in the process of adopting capital adequacy for market risk, it is

imminent for UCBs to put in an efficient information system for initiating ALM

process.

Considering the customer profile and inadequate support system for collecting

information required for ALM which analyses various components of assets and

liabilities on the basis of residual maturity (remaining term to maturity) and behavioral

pattern, it will take some time for UCBs some time to get the requisite information. The

problem of ALM data needs to be addressed by following an ABC approach i.e.

77

analyzing the behavior of asset and liability products in the sample branches accounting

for significant business (at least 60-70% of the total business) and then making rational

assumptions about the way in which assets and liabilities would behave in other branches.

Unlike in the case of commercial banks that have large network of branches, UCBs are

better placed in view of their compact area of operation and two-tier hierarchical

structure to have greater access to the data. Further, in respect of foreign exchange [at

present there are only 2 Authorized Dealers (ADs)], investment portfolio and money

market operations, in view of the centralized nature of functions, it would be much easier

to collect reliable data. The data and assumptions can then be refined over time as UCBs

gain experience of conducting business within an ALM environment. The spread of

computerization will also help UCBs in accessing data at a faster pace.

ALM Organization

Successful implementation of the risk management process would require strong

commitment on the part of their boards and senior management. The board should have

overall responsibility for management of risks and should decide the risk management

policy and procedures, set prudential limits, auditing, reporting and review mechanism in

respect of liquidity, interest rate and forex risks.

The Asset - Liability Committee (ALCO) consisting of the bank's senior management

including CEO should be responsible for ensuring adherence to the policies and limits

set by the Board as well as for deciding the business strategy (on the assets and

liabilities sides) in line with the bank’s business and risk management objectives.

The ALM Support Groups consisting of operating staff should be responsible for

analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also

prepare forecasts (simulations) showing the effects of various possible changes in market

conditions related to the balance sheet and recommend the action needed to adhere to

bank’s internal limits.

78

The ALCO is a decision making unit responsible for balance sheet planning from risk-

return perspective including the strategic management of liquidity, interest rate and forex

risks. The business and risk management strategy of the bank should ensure that the bank

operates within the limits / parameters set by the Board. The business issues that an

ALCO considers, inter alia, includes pricing of both deposits and advances, desired

maturity profile and mix of the incremental assets and liabilities, etc. In addition to

monitoring the risk levels of the bank, the ALCO should review the results of and

progress in implementation of the decisions made in the previous meetings. The ALCOs

future business strategy decisions should be based on the banks views on current interest

rates. In respect of the funding policy, for instance, its responsibility would be to decide

on source and mix of liabilities or sale of assets. Towards this end, it will have to develop

a view on future direction of interest rate movements and decide on funding mixes

between fixed vs. floating rate funds, wholesale vs. retail deposits, short term vs. long

term deposits etc. Individual UCBs will have to decide the frequency for holding their

ALCO meetings.

Composition of ALCO

The size (number of members) of ALCO would depend on the size of each UCB, level of

business and organizational structure. To ensure commitment of the Top Management

and timely response to market dynamics, the CEO or the Secretary should head the

Committee. The Chiefs of Investment/ Treasury including forex, Credit, Planning, etc can

be members of the Committee. In addition, the Head of the Information Technology

Division, if a separate division exists should also be an invitee for building up of

Management Information System (MIS) and related IT network. UCBs may at their

discretion even have Sub-committees and Support Groups.

79

ALM Process

The scope of ALM function can be described as follows:

•Liquidity risk management

•Interest rate risk management

•Trading (Price) risk management

•Funding and capital planning

•Profit planning and business projection

Liquidity Risk Management

Measuring and managing liquidity needs are vital for effective operation of UCBs. By

assuring an UCBs ability to meet its liabilities as they become due, liquidity

management can reduce the probability of an adverse situation developing. The

importance of liquidity problem of an UCB need not necessarily confine to itself but its

impact may be felt on other UCBs/banks as well. UCBs should measure not only the

liquidity positions on an ongoing basis but also examine how liquidity requirements are

likely to evolve under different assumptions/scenarios. Liquidity measurement is quite a

difficult task and can be measured through stock or cash flow approaches. The stock

approach uses certain liquidity ratios viz. credit deposit ratio, loans to total assets, loans

to core deposits, etc. While the liquidity ratios are the ideal indicators of liquidity of

banks operating in developed financial markets, the ratios do not reveal the real liquidity

profile of Indian banks including UCBs, which are operating generally in an illiquid

market. Experience shows that assets commonly considered as liquid like Government

securities, other money market instruments, etc. have limited liquidity when the market

and players move in one direction. Thus, analysis of liquidity involves tracking of cash

flow mismatches (flow approach). The maturity ladder is generally used as a standard

tool for measuring the liquidity profile under the flow approach, at selected maturity

bands. The format of the Statement of Structural Liquidity under static scenario without

reckoning future business growth is given in Annexure I.

80

The Maturity Profile as given in Appendix I could be used for measuring the future

cash flows of UCBs in different time bands. The time bands, given the Statutory

Reserve cycle of 14 days may be distributed as under:

i) 1 to 14 days

ii) 15 to 28 days

iii) 29 days and upto 3 months

iv) Over 3 months and upto 6 months

v) Over 6 months and upto 1 year

vi) Over 1 year and upto 3 years

vii) Over 3 years and upto 5 years

viii) Over 5 years

The investments in SLR securities and other investments are generally assumed as

illiquid due to lack of depth in the secondary market and are therefore required to be

shown under respective residual maturity bands, corresponding to the residual maturity.

However, some of the UCBs may be maintaining few securities in the trading book,

which are kept distinct from other investments made for complying with the Statutory

Reserve requirements and for retaining relationship with customers. Securities held in the

trading book are subject to certain preconditions such as:

i)The composition and volume are clearly defined;

ii)Maximum maturity/duration of the portfolio is restricted;

iii)The holding period not exceeding 90 days;

iv)Cut-loss limit prescribed; (The level up to which loss could be ascribed

by liquidating an asset. Illustrating, if a security bought at Rs. 100 is

quoted in the market on a given day at Rs. 98 and the board of

management fixed the maximum loss which may be incurred on this

particular transaction at not more than Rs.2.00, the cut loss limit is placed

81

at Rs.2.00 for this particular security. The cut loss limit varies from

security to security based on bank’s loss / risk bearing capacity).

Defeasance periods (product-wise) i.e. time taken to liquidate the position

on the basis of liquidity in the secondary market is prescribed. The

defeasance period is dynamic and in volatile environments, such period

also undergoes changes on account of product-specific or general market

conditions;

v)Marking to market on a weekly basis and the revaluation gain/loss

absorbed in the profit and loss account; etc.

UCBs which maintain such trading books and complying with the above

requirements are permitted to show the trading securities under 1-14 days, 15-28

days and 29-90 days time bands on the basis of the defeasance periods. The ALCO

of the UCBs should approve the volume, composition, holding/defeasance period,

cut loss, etc. of the trading book.

Within each time band there could be mismatches depending on cash inflows and

outflows. While the mismatches up to one year would be relevant since these provide

early warning signals of impending liquidity problems, the main focus should be on the

short-term mismatches viz., 1-14 and 15-28 days time bands. UCBs, however, are

expected to monitor their cumulative mismatches (running total) across all time bands by

establishing internal prudential limits with the approval of the Board. The mismatches

(negative gap between cash inflows and outflows) during 1-14 and 15-28 days time

bands in normal course should not exceed 20% of the cash outflows in each time band.

If an UCB in view of its current asset-liability profile and the consequential

structural mismatches needs higher tolerance level, it could operate with higher

limit sanctioned by RBI for a limited period.

The Statement of Structural Liquidity (Annexure I) may be prepared by placing all cash

inflows and outflows in the maturity ladder according to the expected timing of cash

flows. A maturing liability will be a cash outflow while a maturing asset will be a cash

82

inflow. It would also be necessary for UCBs with AD licenses to take into account the

rupee inflows and outflows on account of their forex operations. While determining the

probable cash inflows / outflows, UCBs have to make a number of assumptions

according to their asset - liability profiles. While determining the tolerance levels, the

UCBs may take into account all relevant factors based on their asset-liability base, nature

of business, future strategy, etc.

In order to enable the banks to monitor their short-term liquidity on a dynamic basis over

a time horizon spanning from 1-90 days, UCBs may estimate their short-term liquidity

profiles on the basis of business projections and other commitments for planning

purposes. An indicative format (Annexure III) for estimating Short-term Dynamic

Liquidity is enclosed.

Currency Risk

Floating exchange rate arrangement has brought in its wake pronounced volatility adding

a new dimension to the risk profile of banks’ balance sheets. The increased capital flows

across free economies following deregulation have contributed to increase in the volume

of transactions. Large cross border flows together with the volatility has rendered the

banks’ balance sheets vulnerable to exchange rate movements. Although UCBs

predominantly confined to domestic operations, in view of few UCBs being ADs in

foreign exchange, it is necessary to address forex risk also.

Managing currency risk is one more dimension of ALM. Mismatched currency

position besides exposing the balance sheet to movements in exchange rate also

exposes it to country risk and settlement risk. Ever since the RBI (Exchange

Control Department) introduced the concept of end of the day near square position

in 1978, ADs have been setting up overnight limits and selectively undertaking

active day time trading. Following the introduction of “Guidelines for Internal

Control over Foreign Exchange Business” in 1981, maturity mismatches (gaps) are

also subject to control. Following the recommendations of Expert Group on Foreign

83

Exchange Markets in India (Sodhani Committee), the calculation of exchange

position has been redefined and banks have been given the discretion to set up

overnight limits linked to maintenance of capital to Risk-Weighted Assets Ratio of

9% of open position limit.

Presently, the ADs are also free to set gap limits with RBI’s approval but are required to

adopt Value at Risk (VaR) approach to measure the risk associated with forward

exposures. Thus the open position limits together with the gap limits form the risk

management approach to forex operations. For monitoring such risks banks should

follow the instructions contained in Circular A.D (M. A. Series) No.52 dated

December 27, 1997 issued by the Exchange Control Department.

Interest Rate Risk (IRR)

The phased deregulation of interest rates and the operational flexibility given to banks in

pricing most of the assets and liabilities imply the need for the banking system to hedge

the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates

might adversely affect a bank’s financial condition. The changes in interest rates affect

banks in a larger way. The immediate impact of changes in interest rates is on bank’s

profits by changing its spread [Net Interest Income (NII)]. A long-term impact of

changing interest rates is on bank’s Market Value of Equity (MVE) or Net Worth as the

marked to market value of bank’s assets, liabilities and off-balance sheet positions get

affected due to variation in market rates. The interest rate risk when viewed from these

two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective,

respectively. The risk from the earnings perspective can be measured as changes in the

NII or Net Interest Margin (NIM). There are many analytical tools for measurement and

management of Interest Rate Risk. In the context of poor MIS, slow pace of

computerization and the absence of total deregulation, the traditional `Gap Analysis’ is

considered as a suitable method to measure the Interest Rate Risk in the first place.

84

The Gap or Mismatch risk can be measured by calculating Gaps over different time

intervals as at a given date. Gap analysis measures mismatches between rate sensitive

liabilities and rate sensitive assets (including off-balance sheet positions). An asset or

liability is normally classified as rate sensitive if:

i) within the time interval under consideration, there is a cash flow ; for instance,

repayment of installments of term loans etc

ii) The interest rate resets/reprices contractually during the interval. For instance,

charges made in the interest on CC accounts, term loan accounts before maturity.

iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, Minimum

Lending Rate(MLR), DRI advances, Refinance, CRR balance, etc.) in cases where

interest rates are administered; and

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-

balance sheet positions into time bands according to residual maturity or next repricing

period, whichever is earlier. The difficult task in Gap analysis is determining rate

sensitivity. All investments, advances, deposits, borrowings, etc. that mature/reprice

within a specified timeframe are interest rate sensitive. Similarly, any repayment of loan

installment is also rate sensitive if the bank expects to receive it within the time horizon.

This includes final principal payment and periodical installments. Certain assets and

liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are

repriced at pre-determined intervals and are rate sensitive at the time of repricing. While

the interest rates on term deposits are fixed during their currency, the advance portfolio of

the banking system is basically floating. The interest rates on advances could be repriced

any number of occasions.

The Gaps may be identified in the following time bands:

i) Upto 3 months

ii) Over 3 months and upto 6 months

iii) Over 6 months and upto 1 year

iv) Over 1 year and upto 3 years

85

v) Over 3 years and upto 5 years

vi) Over 5 years

vii) Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may

be classified as explained in Appendix - II and the Reporting Format for interest rate

sensitive assets and liabilities is given in Annexure II.

The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive

Liabilities (RSL) for each time band. The positive Gap indicates that it has more RSAs

than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports

indicate whether the institution is in a position to benefit from rising interest rates by

having a positive Gap (RSA > RSL) or whether it is in a position to benefit from

declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used

as a measure of interest rate sensitivity.

Each bank should set prudential limits on individual Gaps with the approval of the

Board. The prudential limits should have a bearing on the Total Assets, Earning Assets

or Equity. The banks may also work out Earnings at Risk (EaR) i.e. 20–30% of the last

years NII or Net Interest Margin (NIM) based on their views on interest rate movements.

When the UCBs gain sufficient experience in operating ALM system, RBI may

introduce capital adequacy for market risk in due course.

Behavioral Patterns

The classification of various components of assets and liabilities into different time bands

for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in

Appendices I & II is the benchmark. Banks which are better equipped to reasonably

estimate the behavioral pattern of various components of assets and liabilities on the basis

of past data / empirical studies could classify them in the appropriate time bands, subject

to approval from the ALCO.

86

Strategic Analysis

SWOT analysis

In order to better understand the cooperative banks and the environment in which they

function (taking into consideration Fund management, Risk management, Asset and

Liability management), a SWOT analysis has been undertaken.

STRENGTHS :

• Cooperative banks have less number of branches and that to in a small area.

Thus it is easier for them to control and regulate their overall operation.

• These banks have limited and known customer base, which give them more

potential to control credit risk

• These banks are free from market risk arising due to fluctuations in the market

• These banks are free from risk arising out of Para-banking activities.

• As these banks are localized they are able to maintain a personal touch with

depositors and borrowers.

• These banks can avail of cheaper labor and thus can maintain low costs.

WEAKNESS :

• These banks suffer from dual accountability to both the regulators (RBI) ant

the state government.

• These banks suffer from lack of corporate governance. The BOD as well as

the staff members lacks professional banking knowledge and expertise.

• These banks have very limited avenues for expanding and diversifying loan as

well as investment portfolios.

87

• These banks are unable to raise additional capital by making public issue of

capital.

• Reluctance of state government to give up control over cooperative banks and

political involvement in the management of banks further worsens the state of

these banks.

• Lack of internal control systems makes these banks vulnerable to fraud and

scams.

• The cooperative spirit no more exists in these banks. The distance between the

members and the cooperatives has widened.

• Smaller size and lesser profit make it difficult for the banks to adopt latest

MIS systems and other technologies.

OPPORTUNITIES

• These banks have the opportunity to tap local resources fir mobilizing

deposits and granting advances.

• They can provide better customized services thus leading to longer

relationships and customer satisfaction.

• As these banks are area specific, it will be easier for them to consolidate

information necessary for putting in place ALM systems.

THREATS

• These banks face serious threats form then private banks and foreign banks,

which use advanced techniques and technologies for risks and fund

management. As public sector banks have also joined the competition,

cooperative banks face threats form these banks too.

• Cooperative banks suffer from threats of frauds, scams and misinterpretations

as well as from lack of professionalism.

88

Recommendations and Suggestions

The comparison of practices of different commercial banks, and the survey results of

UCBs as well as a detailed theoretical study of UCBs, brings out the high need for

introducing Funds Management, Risk management and Assets liability management in

UCBs.

• Many a time, the populist policies of the Government such as loan waivers have

done a great harm to the cooperative agricultural credit and banking institutions.

The Government has provided a big budgetary support to commercial banks and

RRBs to cleanse their balance sheet. But in case of cooperative banking

institutions, the Government has not provided such support. Since cooperative

credit and banking institutions constitute a very important segment of financial

sector particularly in the context of effective flow of credit to the agriculture and

priority sectors, the Government should also provide such support to them.

• An important contributory factor for this positive feature is the fact that these

banks have maintained close proximity with their borrowers. An indiscriminate

branch expansion would perhaps erode this vital strength. UCBs would, therefore,

do well to keep this in mind while planning their expansion in terms of branches.

• One of the problem areas in the supervision of UCBs is the duality in control by

the State Government and the Reserve Bank. Since UCBs are primarily credit

institutions meant to be run on commercial lines, the responsibility for their

supervision devolves on the Reserve Bank. Therefore, while the banking

operations pertaining to branch licensing, expansion of areas of operations,

interest fixation on deposits and advances, audit and investments are under the

jurisdiction of the RBI, the managerial aspects of these banks relating to

registration, constitution of management, administration and recruitment, are

controlled by the State Governments under the provisions of the respective State

Cooperative Societies Act. This duality of control needs to be done away with and

89

RBI needs to be given the full control. This will require amendment of the Multi-

State Cooperative Societies Act, 1984; State Cooperative Societies Act, and the

Banking Regulation Act.

• One issue of serious concern regarding UCBs is the delay/ non-submission of

returns within the stipulated time frame. In particular, PCBs are required to

submit two types of returns (statutory returns and control returns) to the Reserve

Bank with a view to exercise adequate supervision over them. Unfortunately,

there is often a serious delay in the submission of these returns by individual

banks. Non-availability of adequate and timely data would no doubt have serious

effect on timely policy action. In this context, PCBs have to improve their

statistical reporting system and bridge the wide gap in data availability as

compared to that of commercial banks.

• There are serious doubts over the accuracy and credibility of the data sent by the

UCBs to RBI. It is only when an on-site inspection is carried out that exact

financial position of a particular UCB can be determined. However, the on-site

inspections are carried out at a very low frequency, sometimes even 2 to 3 years

for a bank. There is a dire need to increase the frequency of on-site inspections to

at least 6 months.

• Training for bank executives is very necessary for any system to run smoothly.

Banks should be asked to send their employees for regular training in Risk

management, Funds management and Assets and liability management to training

centers and colleges. RBI can distribute a detailed list of institutes where such

training is given to all UCBs. In house training can also prove to be useful.

• Banks should be asked to employ professional MBAs, CAs, or CFAs- well versed

in prudent financial practices. Banks can also go for professional executives

90

having experience in Commercial Banking Sector. Attempts should be made to

make such norms compulsory.

• Sharing of defaulters’ list amongst the UCBs would help them to contain risk to

some extent.

• In order to increase transparency in operations, the banks should be asked to give

more information through their published balance sheets, Cash flow statements,

NPA and provision disclosures, Maturity profiles of assets and liabilities, etc. are

some of the items that the banks can be made to disclosed annually.

• RBI should undertake ratings of cooperative banks or should appoint an agency to

do so and make their ratings public. This would support competition in the

cooperative sector and motivate banks to increase their profitability and improve

their functioning.

• Strict penalties should be levied for inaccurate reporting or misreporting by UCBs

to RBI.

91

Personal Learning’s

• The most significant value-addition was a good exposure to the banking sector. It

was interesting to look at the banking world from two different angles, a central

bank perspective which is supposed to exercise control, and co-operative banks,

which are demanding more autonomy.

• It was an enriching experience to work with highly knowledgeable people with

excellent people skills and banking experience running in decades.

• The project helped me apply theoretical inputs to practical situations. This has

greatly enhanced my understanding of the basic principles of banking.

• I interacted with many people during tenure of my project. This helped me to

improve my soft skills.

92

Bibliography

A. Magazines

• Banking Finance

• Professional Banker

• Analyst

• Vision

B. RBI Publications

• Master Circulars

• Trend and Progress Reports

• Notifications

• Draft Vision document on UCBs

C. Books

• Value at Risk – Phillipe Jorion

• Managing Indian Banks – The Challenges Ahead, Vasant and Vinay Joshi

•

D. Internet

• www.rbi.org.in

• www.indiainfoline.com

• www.banknetindia.com

• www.bankersindia.com

• www.google.com

• www.erisk.com

93

94