Final Risk and Insurance Management

7/29/2019 Final Risk and Insurance Management

1/34

RISK AND INSURANCE MANAGEMENT

PROJECT REPORT

COMPARISON OF RISK PROFILES OF PUNJAB NATIONAL BANK AND AXIS BANK

SUBMITTED TO:

PROF. HIMANSHU PURI

IILM

SUBMITTED BY:

ARSHDEEP SINGH

GAGANDEEP SINGH

HARENDRA PRATAP

RISHUB PAL

SATVINDER SINGH

UPASANA BISWAS


2/34

RISK MANAGEMENT IN A BANK

Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to

a regulated environment, banks could not afford to take risks. But of late, banks are exposed to same

competition and hence are compelled to encounter various types of financial and non-financial risks.

Risks and uncertainties form an integral part of banking which by nature entails taking risks. There are

three main categories of risks; Credit Risk, Market Risk & Operational Risk. Main features of these risksas well as some other categories of risks such as Regulatory Risk and Environmental Risk. Various tools

and techniques to manage Credit Risk, Market Risk and Operational Risk and its various components,

are also discussed in detail. Another has also mentioned relevant points of Basels New Capital Accord

and role of capital adequacy, Risk Aggregation & Capital Allocation and Risk Based Supervision (RBS),

in managing risks in banking sector.

TYPES OF RISKS

When we use the term Risk, we all mean financial risk or uncertainty of financial loss. If we consider

risk in terms of probability of occurrence frequently, we measure risk on a scale, with certainty of

occurrence at one end and certainty of non-occurrence at the other end. Risk is the greatest where theprobability of occurrence or non-occurrence is equal. As per the Reserve Bank of India guidelines issued

in Oct. 1999, there are three major types of risks encountered by the banks and these are Credit Risk,

Market Risk & Operational Risk. In August 2001, a discussion paper on move towards Risk Based

Supervision was published. Further after eliciting views of banks on the draft guidance note on Credit

Risk Management and market risk management, the RBI has issued the final guidelines and advised

some of the large PSU banks to implement so as to gauge the impact. A discussion paper on Country

Risk was also released in May 02. Risk is the potentiality that both the expected and unexpected events

may have an adverse impact on thebanks capital or earnings. The expected loss is to be borne by the

borrower and hence is taken care of by adequately pricing the products through risk premium and

reserves created out of the earnings. It is the amount expected to be lost due to changes in credit quality

resulting in default. Whereas, the unexpected loss on account of the individual exposure and the wholeportfolio in entirely is to be borne by the bank itself and hence is to be taken care of by the capital. Thus,

the expected losses are covered by reserves/provisions and the unexpected losses require capital

allocation. Hence the need for sufficient Capital Adequacy Ratio is felt. Each type of risks is measured to

determine both the expected and unexpected losses using VAR (Value at Risk) or worst-case type

analytical model.

CREDIT RISK

Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed

terms. There is always scope for the borrower to default from his commitments for one or the other

reason resulting in crystallization of credit risk to the bank. These losses could take the form outrightdefault or alternatively, losses from changes in portfolio value arising from actual or perceived

deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending

funds to the operations linked closely to market risk variables. The objective of credit risk management

is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining

credit exposure within the acceptable parameters. Credit risk consists of primarily two components,

Quantity of risk, which is nothing but the outstanding loan balance as on the date of default and the

quality of risk, the severity of loss defined by both Probability of Default as reduced by the recoveries

that could be made in the event of default. Thus credit risk is a combined outcome of Default Risk and

Exposure Risk. Theelements of Credit Risk are Portfolio risk comprisingConcentration Risk as well as


3/34

Intrinsic Risk andTransaction Risk comprising migration/down gradationrisk as well as Default Risk.At the transaction level, credit ratings are useful measures of evaluating credit risk that is prevalentacross the entire organization wheretreasury and credit functions are handled. Portfolioanalysis help inidentifying concentration of credit risk, default/migration statistics, recovery data, etc. In general,Default is not an abrupt process to happensuddenly and past experience dictates that, more oftenthannot, borrowers credit worthiness and asset quality declines gradually, which is otherwise known asmigration. Default is an extreme event of credit migration.Off balance sheet exposures such as foreignexchangeforward can tracks, swaps options etc are classified in to three broad categories such as fullRisk, Medium Risk and Low risk and then translated into risk Neighed assets through a conversionfactor and summed up.

The management of credit risk includes

a) Measurement through credit rating/ scoring,

b) Quantification through estimate of expected loan losses,

c) Pricing on a scientific basis and

d) Controlling through effective Loan Review Mechanism and Portfolio Management.

Tools of Credit Risk Management.The instruments and tools, through which credit risk management is carried out, are detailed below:

1. Exposure Ceilings:

Prudential Limit is linked to Capital Funds say 15% for individual borrower entity, 40% for a group

with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a

level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures

beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to

eight times).

2. Review/Renewal:

Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher delegated powers

for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench

marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated.

3. Risk Rating Model:

Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds

and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped

to estimate the expected loss.

4. Risk based scientific pricing:

Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historicaldata on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.

5. Portfolio Management:

The need for credit portfolio management emanates from the necessity to optimize the benefits

associated with diversification and to reduce the potential adverse impact of concentration of exposures

to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on

specific rating categories, distribution of borrowers in various industry, business group and conduct rapid

portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet

date does not signal the quality of the entire loan book. There should be a proper & regular on-going


4/34

system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired

portfolio quality and integrate portfolioreviews with credit decision-making process.

6. Loan Review Mechanism:

This should be done independent of credit operations. It is also referred as Credit Audit covering review

of sanction process, compliance status, review of risk rating, pick up of warning signals and

recommendation of corrective action with the objective of improving credit quality. It should target all

loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM

in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This

is done to bring about qualitative improvement in credit administration. Identify loans with credit

weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and

procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio

level. Regular, proper & prompt reporting to Top Management should be ensured. Credit Audit is

conducted on site, i.e. at the branch that

has appraised the advance and where the main operative limits are made available. However, it is not

required to visitborrowers factory/office premises.

Risk Rating Model

Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main

Operative limits are made available. However, it is not required to risk borrowers factory/office

premises. As observed by RBI, Credit Risk is the major component of risk management system and this

should receive special attention of the Top Management of the bank. The process of credit risk

management needs analysis of uncertainty and analysis of the risks inherent in a credit proposal. The

predictable risk should be contained through proper strategy and the unpredictable ones have to be faced

and overcome. Therefore an lending decision should always be preceded by detailed analysis of risks

and the outcome of analysis should be taken as a guide for the credit decision. As there is a significant

co-relation between credit ratings and default frequencies, any derivation of probability from such

historical data can be relied upon. The model may consist of minimum of six grades for performing and

two grades for non-performing assets. The distribution of rating of assets should be such that not more

than 30% of the advances are grouped under one rating. The need for the adoption of the credit risk-

rating model is on account of the following aspects.

Disciplined way of looking at Credit Risk.

Reasonable estimation of the overall health status of an account captured under Portfolio approach as

Contrasted to stand-alone or asset based credit management.

Impact of a new loan asset on the portfolio can be assessed. Taking a fresh exposure to the sector in

which there already exists sizable exposure may simply increase the portfolio risk although specific

unit level risk is negligible/minimal.

The co-relation or co-variance between different sectors of portfolio measures the inter relationship

Between assets. The benefits of diversification will be available so long as there is no perfect positiveCorrelation between the assets, otherwise impact on one would affect the other.

Concentration risks are measured in terms of additional portfolio risk arising on account of increased

Exposure to a borrower/group or co-related borrowers.

Need for Relationship Manager to capture, monitor and control the overall exposure to high value

Customers on real time basis to focus attention on vital few so that trivial many do not take much of

Valuable time and efforts.

Instead of passive approach of originating the loan and holding it till maturity, active approach of

Credit portfolio management is adopted through securitization/credit derivatives.

Pricing of credit risk on a scientific basis linking the loan price to the risk involved therein.


5/34

Rating can be used for the anticipatory provisioning. Certain level of reasonable over-provisioning as

Best practice.

Given the past experience and assumptions about the future, the credit risk model seeks to determine the

present value of a given loan or fixed income security. It also seeks to determine the quantifiable risk

that the promised cash flows will not be forthcoming. Thus, credit risk models are intended to aid banks

in quantifying, aggregating and managing risk across geographical and product lines. Credit models are

used to flag potential problems in the portfolio to facilitate early corrective action.

The risk-rating model should capture various types of risks such as Industry/Business Risk, Financial

Risk and Management Risk, associated with credit. Industry/Business risk consists of both systematic

and unsystematic risks which are market driven. The systematic risk emanates from General political

environment, changes in economic policies, fiscal policies of the government, infrastructural changes

etc. The unsystematic risk arises out of internal factors such as machinery break down, labour strike, new

competitors who are quite specific to the activities in which the borrower is engaged.

Assessment of financial risks involves appraisal of the financial strength of a unit based on its

performance and financial indicators like liquidity, profitability, gearing, leverage, coverage, turnover

etc. It is necessary to study the movement of these indicators over a period of time asAlso its comparison with industry averages wherever possible. A study carried out in the western

corporate world reveals that 45% of the projects failed to take off simply because the personnel entrusted

with the test were found to be highly wanting in qualitatively managing the project.

The key ingredient of credit risk is the risk of default that is measured by the probability that default

occurs during a given period. Probabilities are estimates of future happenings that are uncertain. We can

narrow the margin of uncertainty of a forecast if we have a fair understanding of the nature and level of

uncertainty regarding the variable in question and availability of quality information at the time of

assessment. The expected loss/unexpected loss methodology forces banks to adopt new Internal Ratings

Based approach to credit risk management as proposed in the

Capital Accord II. Some of the risk rating methodologies used widely is briefed below:

a. Altmans Z score Model involves forecasting the probability of a company entering bankruptcy. It

separates defaulting borrower from non-defaulting borrower on the basis of certain financial ratios

converted into simple index.

b. Credit Metrics focuses on estimating the volatility of asset values caused by variation in the quality of

assets. The model tracks rating migration which is the probability that a borrower migrates from one risk

rating to another risk rating.

c. Credit Risk +, a statistical method based on the insurance industry, is for measuring credit risk. The

model is base on actuarial rates and unexpected losses from defaults. It is based on insurance industrymodel of event risk.

d. KMV, through its Expected Default Frequency (EDF) methodology derives the actua probability of

default for each obligor based on functions of capital structure, the volatility of asset returns and the

current asset value. It calculates the asset value of a firm from the market value of its equity using an

option pricing based approach that recognizes equity as a call option on the underlying asset of the firm.

It tries to estimate the asset value path of the firm over a time horizon. The default risk is the probability

of the estimated asset value falling below a pre-specified default point.


6/34

MARKET RISK

Market Risk may be defined as the possibility of loss to bank caused by the changes in the market

variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by

movements in equity and interest rate markets, currency exchange rates and commodity prices. Market

risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or

prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market

Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and

managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank

that needs to be closely integrated with the banks business strategy.

Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a

given portfolio. Identification of future changes in economic conditions like economic/industry

overturns, market risk events, liquidity conditions etc that could have unfavorable effect on banks

portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keep

changing from time to time, output of the test should be reviewed periodically as market risk

management system should be responsive and sensitive to the happenings in the market.

Liquidity Risk

Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management

needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently

accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of

the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely

behavior of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time

Risk & Call Risk.

a. Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/non- Renewal of

deposits.

b. Time risk: It is the need to compensate for non receipt of expected inflows of funds, i.e. Performing

assets turning into non performing assets.

c. Call risk: It happens on account of crystallization of contingent liabilities and inability to undertake

profitable business opportunities when desired.

The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It

Implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to

ensuring a proper balance between funds mobilization and their deployment with respect to their

a) Maturity profiles,

b) Cost,

c) Yield,

d) Risk exposure, etc.

Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability

profile, deposit mix, nature of cash flow etc. Bank should track the impact of pre-payment of loans &

premature closure of deposits so as to realistically estimate the cash flow profile.


7/34

Interest Rate Risk

Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the

vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest

rate affect earnings, value of assets, liability off-balance sheet items and cash flow. Hence, the objective

of interest rate risk management is to maintain earnings, improve the capability, ability to absorb

potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk

return trade-off. Management of interest rate risk aims at capturing the risks arising from the maturity

and re-pricing mismatches and is measured both from the earnings and economic value perspective.

Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported

earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII)

equivalent to the difference between total interest income and total interest expense.

In order to manage interest rate risk, banks should begin evaluating the vulnerability of their portfolios to

the risk of fluctuations in market interest rates. One such measure is Duration of market value of a bank

asset or liabilities to a percentage change in the market interest rate. The difference between the average

duration for bank assets and the average duration for bank liabilities is known as the duration gap which

assess the banks exposure to interest rate risk. The Asset Liability Committee (ALCO) of a bank uses

the information contained in the duration gap analysis to guide and frame strategies. By reducing the sizeof the duration gap, banks can minimize the interest rate risk.

Economic Value perspective involves analyzing the expected cash in flows on assets minus expected

cash out flows on liabilities plus the net cash flows on off-balance sheet items. The economic value

perspective identifies risk arising from long-term interest rate gaps. The various types of interest rate

risks are detailed below:

a. Gap/Mismatch risk:

It arises from holding assets and liabilities and off balance sheet items with different principal amounts,

maturity dates & re-pricing dates thereby creating exposure to unexpected changes in the level of market

interest rates.

b. Basis Risk:

It is the risk that the Interest rat of different Assets/liabilities and off balance items may change in

different magnitude. The degree of basis risk is fairly high in respect of banks that create composite

assets out of composite liabilities.

c. Embedded option Risk:

Option of pre-payment of loan and Fore closure of deposits before their stated maturities constitute

embedded option risk.

d. Yield curve risk:

Movement in yield curve and the impact of that on portfolio values and income.

e. Reprice risk:

When assets are sold before maturities. Reinvestment risk: Uncertainty with regard to interest rate at

which the future cash flows could be reinvested.

f. Net interest position risk:

When banks have more earning assets than paying liabilities, net interest position risk arises in case

market interest rates adjust downwards. There are different techniques such as


8/34

I. The traditional Maturity Gap Analysis to measure the interest rate sensitivity,

II. Duration Gap Analysis to measure interest rate sensitivity of capital,

III. Simulation

IV. Value at Risk for measurement of interest rate risk.

The approach towards measurement and hedging interest rate risk varies with segmentation of banks

balance sheet. Banks broadly bifurcate the asset into Trading Book and Banking Book. While trading

book comprises of assets held primarily for generating profits on short term differences in prices/yields,

the banking book consists of assets and liabilities contracted basically on account of relationship or forsteady income and statutory obligations and are generally held till maturity/payment by counter party.

Thus, while price risk is the prime concern of banks in trading book, the earnings or changes in the

economic value are the main focus in banking book.

Value at Risk (VAR) is a method of assessing the market risk using standard statistical techniques. It is a

statistical measure of risk exposure and measures the worst expected loss over a given time interval

under normal market conditions at a given confidence level of say 95% or 99%. Thus VAR is simply a

distribution of probable outcome of future losses that may occur on a portfolio. The actual result will not

be known until the event takes place. Till then it is a random variable whose outcome has been

estimated.As far as Trading Book is concerned, bank should be able to adopt standardized method or internal

models for providing explicit capital charge for market risk.

Forex Risk

Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate

movement during a period in which it has an open position, either spot or forward or both in same

foreign currency. Even in case where spot or forward positions in individual currencies are balanced the

maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising

out of default of the counter party and out of time lag in settlement of one currency in one center and the

settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which

arises from the maturity mismatch of foreign currency position. The Value at Risk (VAR) indicates the

risk that the bank is exposed due to uncovered position of mismatch and these gap positions are to be

valued on daily basis at the prevalent forward market rates announced by FEDAI for the remaining

maturities.

Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal

and

return of the lending or investment. At times, banks may try to cope with this specific risk on the lending

side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk

does not get extinguished, but only gets converted in to credit risk.

By setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as overnightlimits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined

division of responsibilities between front, middle and back office the risk element in foreign exchange

risk can be managed/monitored.

Country Risk

This is the risk that arises due to cross border transactions that are growing dramatically in the recent

years owing to economic liberalization and globalization. It is the possibility that a country will be

unable to service or repay debts to foreign lenders in time. It comprises of Transfer Risk arising on


9/34

account of possibility of losses due to restrictions on external remittances; Sovereign Risk associated

with lending to government of a sovereign nation or taking government guarantees; Political Risk when

political environment or legislative process of country leads to government taking over the assets of the

financial entity (like nationalization, etc) and preventing discharge of liabilities in a manner that had

been agreed to earlier; Cross border risk arising on account of the borrower being a resident of a country

other than the country where the cross border asset is booked; Currency Risk, a possibility that exchange

rate change, will alter the expected amount of principal and return on the lending or investment.

In the process there can be a situation in which seller (exporter) may deliver the goods, but may not be

paid or the buyer (importer) might have paid the money in advance but was not delivered the goods forone or the other reasons.

As per the RBI guidance note on Country Risk Management published recently, banks should reckon

both fund and non-fund exposures from their domestic as well as foreign branches, if any, while

identifying, measuring, monitoring and controlling country risk. It advocates that bank should also take

into account indirect country risk exposure. For example, exposures to a domestic commercial borrower

with large economic dependence on a certain country may be considered as subject to indirect country

risk. The exposures should be computed on a net basis, i.e. gross exposure minus collaterals, guarantees

etc. Netting may be considered for collaterals in/guarantees issued by countries in a lower risk category

and may be permitted for banks dues payable to the respective countries.RBI further suggests that banks should eventually put in place appropriate systems to move over to

internal assessment of country risk within a prescribed period say by 31.3.2004, by which time the new

capital accord would be implemented. The system should be able to identify the full dimensions of

country risk as well as incorporate features that acknowledge the links between credit and market risks.

Banks should not rely solely on rating agencies or other external sources as their only country risk-

monitoring tool.

With regard to inter-bank exposures, the guidelines suggests that banks should use the country ratings of

international rating agencies and broadly classify the country risk rating into six categories such as

insignificant, low, moderate, high, very high & off-credit. However, banks may be allowed to adopt a

more conservative categorization of the countries.Banks may set country exposure limits in relation to the banks regulatory capital (Tier I & II) with

suitable sub limits, if necessary, for products, branches, maturity etc. Banks were also advised to set

country exposure limits and monitor such exposure on weekly basis before eventually switching over to

real tie monitoring. Banks should use variety of internal and external sources as a means to measure

country risk and should not rely solely on rating agencies or other external sources as their only tool for

monitoring country risk. Banks are expected to disclose the Country Risk Management policies in

their Annual Report by way of notes.

OPERATIONAL RISK

Always banks live with the risks arising out of human error, financial fraud and natural disasters. The

recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on

account of operational risk. Exponential growth in the use of technology and increase in global financial

inter-linkages are the two primary changes that contributed to such risks. Operational risk, though

defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from

inadequate or failed internal processes, people and systems or from external events.

In order to mitigate this, internal control and internal audit systems are used as the primary means.

Risk education for familiarizing the complex operations at all levels of staff can also reduce operational

risk. Insurance cover is one of the important mitigators of operational risk.


10/34

Operational risk events are associated with weak links in internal control procedures. The key to

management of operational risk lies in the banks ability to assess its process for vulnerability and

establish controls as well as safeguards while providing for unanticipated worst-case scenarios.

Operational risk involves breakdown in internal controls and corporate governance leading to error,

fraud, performance failure, compromise on the interest of the bank resulting in financial loss. Putting in

place proper corporate governance practices by itself would serve as an effective risk management tool.

Bank should strive to promote a shared understanding of operational risk within the organization,

especially since operational risk is often intertwined with market or credit risk and it is difficult to

isolate.Over a period of time, management of credit and market risks has evolved a more sophisticated fashion

than operational risk, as the former can be more easily measured, monitored and analyzed. And yet the

root causes of all the financial scams and losses are the result of operational risk caused by breakdowns

in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not

been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on

sub sequent data/feedback; it was reduced to 12%. While measurement of operational risk and

computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be

done at present is start implementing the Basel proposal in a phased manner and carefully plan in that

direction. The incentive for banks to move the measurement chain is not just to reduce regulatory capital

but moreImportantly to provide assurance to the top management that the bank holds the required capital.

REGULATORY RISK

When owned funds alone are managed by an entity, it is natural that very few regulators operate and

supervise them. However, as banks accept deposit from public obviously better governance is expected

of them. This entails multiplicity of regulatory controls. Many Banks, having already gone for public

issue, have a greater responsibility and accountability. As banks deal with public funds and money, they

are subject to various regulations. The very many regulators include Reserve Bank of India (RBI),

Securities Exchange Board of India (SEBI), Department of Company Affairs (DCA), etc.

Moreover, banks should ensure compliance of the applicable provisions of The Banking Regulation Act,

The Companies Act, etc. Thus all the banks run the risk of multiple regulatory-risks which inhibits free

growth of business as focus on compliance of too many regulations leave little energy and time for

developing new business. Banks should learn the art of playing their business activities within the

regulatory controls.

ENVIRONMENTOL RISK

As the years roll by and technological advancement take place, expectation of the customers change and

Enlarge. With the economic liberalization and globalization, more national and international players are

operating the financial markets, particularly in the banking field. This provides the platform for

environmental change and exposes the bank to the environmental risk. Thus, unless the banks improvetheir delivery channels, reach customers, innovate their products that are service oriented; they are

exposed to the environmental risk resulting in loss in business share with consequential profit.

BASELS NEW CAPITAL ACCORD

Bankers for International Settlement (BIS) meet at Basel situated at Switzerland to address the common

Issues concerning bankers all over the world. The Basel Committee on Banking Supervision (BCBS) is a

committee of banking supervisory authorities of G-10 countries and has been developing standards and

establishment of a framework for bank supervision towards strengthening financial stability throughout


11/34

the world. In consultation with the supervisory authorities of a few non-G-10 countries including India,

core principles for effective banking supervision in the form of minimum requirements to strengthen

current supervisory regime, were mooted.

The 1988 Capital Accord essentially provided only one option for measuring the appropriate capital in

relation to the risk-weighted assets of the financial institution. It focused on the total amount of bank

capital so as to reduce the risk of bank solvency at the potential cost of banks failure for the depositors.

As an improvement on the above, the New Capital Accord was published in 2001, to be implemented by

the financial year 2003-04. It provides spectrum of approaches for the measurement of credit, market andOperational risks to determine the capital required. The spread and nature of the ownership structure is

Important as it impinges on the propensity to induct additional capital. While getting support from a

large body ofshareholders is a difficult proposition when the banks performance is adverse, a smaller

shareholder base constrains the ability of the bank to garner funds. Tier I capital is not owed to anyone

and is available to cover possible unexpected losses. It has no maturity or repayment requirement, and is

expected to remain a permanent component of the core capital of the counter party. While Basel

standards currently require banks to have a capital adequacy ratio of 8% with Tier I not less than 4%,

RBI has mandated the banks to maintain CAR of 9%. The maintenance of capital adequacy is like

aiming at a moving target as the composition of risk-weighted assets gets changed every minute on

account of fluctuation in the risk profile of a bank. Tier I capital is known as the core capital providingpermanent and readily available support to the bank to meet the unexpected losses.

In the recent past, owner of PSU banks, the government provided capital in good measure mainly to

weaker banks. In doing so, the government was not acting as a prudent investor as return on such capital

was never a consideration. Further, capital infusion did not result in any cash flow to the receiver, as all

the capital was required to be reinvested in government securities yielding low interest. Receipt of

capital was just a book entry with the only advantage of interest income from the securities.

CAPITAL ADEQUACY

Subsequent to nationalization of banks, capitalization in banks was not given due importance as it was

felt necessary for the reason that the ownership of the banks rested with the government, creating the

required confidence in the mind of the public. Combined forces of globalization and liberalization

compelled the public sector banks, hitherto shielded from the vagaries of market forces, to come to terms

with the market realitieswhere certain minimum capital adequacy has to be maintained in the face of

stiff norms in respect of income recognition, asset classification and provisioning. It is clear that multi

pronged approach would be required to meet the challenges of maintaining capital at adequate levels in

the face of mounting risks in the banking sector.

In banks asset creation is an event happening subsequent to the capital formation and deposit

mobilization. Therefore, the preposition should be for a given capital how much asset can be created?

Hence, in ideal situation and taking a radical view, stipulation of Asset Creation Multiple (ACM), in lieu

of capital adequacy ratio, would be more appropriate and rational. That is to say, instead of MinimumCapital Adequacy Ratio of 8 percent (implying holding of Rs 8 by way of capital for every Rs 100 risk

weighted assets), stipulation of Maximum Asset Creation Multiple of 12.5 times (implying for maximum

Asset Creation Multiple of 12.5 time for the given capital of Rs 8) would be more meaningful. However

as the assets have been already created when the norms were introduced, capital adequacy ratio is

adopted instead of asset creation multiple. At least in respect of the new banks (starting from zero), Asset

Creation Multiple (ACM) may be examined/thought of for strict implementation.


12/34

Minimum Capital Requirement

The capital Adequacy Ratio is the percentage of banks Capital Funds in relation to the Risk Weighted

Assets of the bank. In the New Capital Accord, while the definition of Capital Fund remains the same,

the method of calculation of Risk Weighted Assets has been modified to factor market risk and

operational risk, in addition to the Credit Risk that alone was reckoned in the 1988 Capital Accord.

Banks may adopt any of the approach suitable to them for arriving at the total risk weighted assets.

Various approaches, to be chosen from under each of the risk are detailed below:

Credit Risk Menu:

1) Standardized Approach: The bank allocates a risk weight to each assets as well as off balance sheet items

and produces a sum of R W A values (RW of 100% may entail capital charge of 8% and RW of 20%

may entail capital charge of 1.6%.) The risk weights are to be refined by reference to a rating provided

by an external credit assessment institution that meets certain strict standards.

2) Foundation Internal Rating Based Approach : Under this, bank rates the borrower and results are

translated into estimates of a potential future loss amount which forms the basis of minimum capital

requirement.3) Advanced Internal Rating Based Approach: In Advanced IRB approach, the range of risk weights will be

well diverse.

Market Risk Menu:

1) Standardized Approach

2) Internal Models Approach

Operational Risk Menu:

1) Basic Indicator Approach (Alpha) Hence, one indicator for operational risk is identified such as interest

income, Risk Weighted Asset etc.

2) Standardized Approach (Beta) This approach specifies different indicators for different lines/units of

business and the summation of different business lines such as Corporate Finance, Retail Banking Asset

Management, etc to be done.

3) Internal Measurement Approach (Gamma) Based on the past internal loss data estimation, for each

combination of business line, bank is required to calculate an expected loss value to ascertain the

required capital to be allocated/assigned.

RISK AGGREGATION & CAPITAL ALLOCATION

Capital Adequacy in relation to economic risk is a necessary condition for the long-term soundness of

banks. Aggregate risk exposure is estimated through Risk Adjusted Return on Capital (RAROC) and

Earnings at Risk (EaR) method. Former is used by bank with international presence and the RAROC

process estimates the cost of Economic Capital & expected losses that may prevail in the worst-case

scenario and then equates the capital cushion to be provided for the potential loss.

RAROC is the first step towards examining the institutions entire balance sheet on a mark to market

basis, if only to understand the risk return trade off that have been made. As banks carry on the business

on a wide area network basis, it is critical that they are able to continuously monitor the exposures across

the entire organization and aggregate the risks so than an integrated view is taken.


13/34

The Economic Capital is the amount of the capital (besides the Regulatory Capital) that the firm has to

put at risk so as to cover the potential loss under the extreme market conditions. In other words, it is the

difference in mark-to-market value of assets over liabilities that the bank should aim at or target. As

against this, the regulatory capital is the actual Capital Funds held by the bank against the Risk Weighted

Assets. After measuring the economic capital for the bank as a whole, banks actual capital has to be

allocated to individual business units on the basis of various types of risks. This process can be

continued till capital is allocated at transaction/customer level.

RISK BASED SUPERVISION (RBS)

The Reserve Bank of India presently has its supervisory mechanism by way of on-site inspection and

off-site monitoring on the basis of the audited balance sheet of a bank. In order to enhance the

supervisory mechanism, the RBI has decided to put in place, beginning from the last quarter of the

financial year 02-03, a system of Risk Based Supervision. Under risk based supervision, supervisors are

expected to concentrate their efforts on ensuring that financial institutions use the process necessarily to

identify measure and control risk exposure. The RBS is expected to focus supervisory attention in

accordance with the risk profile of the bank. The RBI has already structured the risk profile templates to

enable the bank to

Make a self-assessment of their risk profile. It is designed to ensure continuous monitoring andevaluation of risk profile of the institution through risk matrix. This may optimize the utilization of the

supervisory resources of the RBI so as to minimize the impact of a crises situation in the financial

system. The transaction based audit and supervision is getting shifted to risk focused audit.

Risk based supervision approach is an attempt to overcome the deficiencies in the traditional point-in-

time; transaction-validation and value based supervisory system. It is forward looking enabling the

supervisors to differentiate between banks to focus attention on those having high-risk profile.

The implementation of risk based auditing would imply that greater emphasis is placed on the internal

Auditors role for mitigating risks. By focusing on effective risk management, the internal auditor would

not only offer remedial measures for current trouble-prone areas, but also anticipate problems to play an

active role in protecting the bank from risk hazards.


14/34

PANJAB NATIONAL BANK

INTRODUCTION OF PNB:

Punjab National Bank (PNB) is one of the leading nationalized banks having its head office at New Delhiand has more than 4700 branches all over the country. It has 58 circle offices controlling these branches

besides specialized service branches, training establishment and Circle Inspectorates.

Bank has deployed Centralized Banking Solution (CBS) through FINACLE banking software procuredfrom M/s Infosys Technologies in more than 4700 locations. It has also introduced Internet BankingServices and additional delivery channels like ATMs, Kiosks etc.

PNB is a member of Indian Financial Network (INFINET), SWIFT and is also a member of ReserveBank of India's various payment and settlement systems like RTGS, SFMS, and EFT etc.Besides this PNB has video conferencing facility at 70 locations. For running above applications, PNB

has setup Robust, Reliable, Redundant and Scalable network designed in a four-tier full meshed networkarchitecture wherein the branches /offices are connected to a Network Center (NC).

PNB was founded in the year 1895 at Lahore (presently in Pakistan) as an off-shoot of the

Swadeshi Movement. Among the inspired founders were Sardar Dayal Singh Majithia, Lala

HarKishen Lal, Lala Lalchand, Shri Kali Prosanna Roy, Shri E.C. Jessawala, Shri PrabhuDayal, Bakshi Jaishi Ram, Lala Dholan Dass.

With a common missionary zeal they set about establishing a national bank; the first one with

Indian capital owned, managed and operated by the Indians for the benefit of the Indians.The Lion of Punjab, Lala Lajpat Rai, was actively associated with the management of theBank in its formative years.

The Bank made steady progress right from its inception. It has shown resilience to tide over

many a crisis. It withstood the crisis in banking industry of 1913 and the severe depression ofthe thirties.

It survived the most critical period in its history

the Partlition of 1947

when it wasuprooted from its major area of operations. It was the farsightedness of the management that

the registered office of the Bank was shifted from Lahore to Delhi in June 1947even beforethe announcement of the Partition.

With the passage of time the Bank grew to strength spreading its wings from one corner of the country to another.Some smaller banks like, The Bhagwan Dass Bank Limited, Universal Bank of India, The Bharat Bank Limited,

The Indo-Commercial Bank Limited, The Hindustan Commercial Bank Limited and The Nedungadi Bank werebrought within its fold.

PNB has the privilege of maintaining accounts of the illustrious national leaders like Mahatma Gandhi, ShriJawahar Lal Nehru, Shri Lal Bahadur Shastri and Shrimati Indira Gandhi besides the account of the famous

Jalianwala Bagh Committee.

Nationalisation of the fourteen major banks on 19th July, 1969 was a major step for the banking industry. PNBwas one amongst these. As a result, banking was given a new direction and thrust.

The banks were expected to reach people in every nook and corner, meet their needs, and work for their economicupliftment. Removal of poverty and regional imbalances were accorded a high priority.

PNB has always responded enthusiastically to the nation's needs. It has been earnestly engaged in the task ofnational development. In the process, the bank has emerged as a major nationalized bank.


15/34

DISCLOSURES UNDER THE NEW CAPITAL ADEQUACY FRAMEWORK

(BASEL II GUIDELINES) FOR THE YEAR ENDED 31 March, 2012:

1. Capital Structure;

Banks Tier I capital comprises of Equity Shares, Reserves and Innovative Perpetual Bonds. Bank has

issued Innovative Perpetual Bonds (Tier 1 capital) and also other bonds eligible for inclusion in Tier 2capital.

2. Capital Adequacy:

The bank believes in the policy of total risk management. Bank believes that risk management is one ofthe foremost responsibilities of top/senior management. The Board of Directors decides the overall riskmanagement policies and approves the Risk Management Philosophy & Policy, Credit Management &Risk policy, Investment policy, ALM policy, Operational Risk Management policy, Policy for internal

capital adequacy assessment process (ICAAP), Credit Risk Mitigation & Collateral Management Policy,Stress Testing Policy and Policy for Mapping Business Lines/Activities, containing the direction andstrategies for integrated management of the various risk exposures of the Bank. These policies, interalia,contain various trigger levels, exposure levels, thrust areas etc.


16/34

The bank has constituted a Board level subcommittee namely Risk Management Committee. Thecommittee has the overall responsibility of risk management functions and oversees the function ofCredit Risk Management Committee (CRMC), Asset Liability Committee (ALCO) and Operational RiskManagement Committee (ORMC). The meeting of RMC is held at least once in a quarter. The bankrecognizes that the management of risk is integral to the effective and efficient management of the

organization.

3. Credit risk: General disclosures

Any amount due to the bank under any credit facility is overdue if it is not paid on the due date fixed by

the bank. Further, an impaired asset is a loan or an advance where:

(i) Interest and/or installment of principal remains overdue for a period of more than 90 days in

respect of a term loan.

(ii) The account remains out of order in respect of an overdraft/cash credit for a period of more than 90

days.

Account will be treated out of order, if:

- The outstanding balance remains continuously in excess of the limit/drawing power.

- In cases where the outstanding balance in the principal operating account is less than the sanctioned

limit/drawing power, but there are no credits continuously for 90 days as on the date of balance sheet

or credits are not enough to cover the interest debited during the same period

(iii) In case of bills purchased & discounted, the bill remains overdue for a period of more than 90 days


17/34

(iv) The installment or principal or interest thereon remains overdue for two crop seasons for short

duration and the installment of principal or interest thereon remains overdue for one crop season for

long duration crops.

Credit approving authority, prudential exposure limits, industry exposure limits, credit risk rating

system, risk based pricing and loan review mechanisms are the tools used by the bank for credit risk

management. All these tools have been defined in the Credit Management & Risk Policy of the bank.

At the macro level, policy document is an embodiment of the Banks approach to understand measure

and manage the credit risk and aims at ensuring sustained growth of healthy loan portfolio while

dispensing the credit and managing the risk. Credit risk is measured through sophisticated models,

which are regularly tested for their predictive ability as per best practices.

Credit Risk Management

Credit Risk Management Committee (CRMC) headed by CMD is the top-level functional committee forCredit risk. The committee considers and takes decisions necessary to manage and control credit riskwithin overall quantitative prudential limit set up by Board. The committee is entrusted with the job ofapproval of policies on standards for presentation of credit proposal, fine-tuning required in various

models based on feedbacks or change in market scenario, approval of any other action necessary tocomply with requirements set forth in Credit Risk Management Policy/ RBI guidelines or otherwise

required for managing credit risk.

Bank has developed comprehensive risk rating system that serves as a single point indicator of diverse

risk factors of counterparty and for taking credit decisions in a consistent manner. The risk rating systemis drawn up in a structured manner, incorporating different factors such as borrowers specific

characteristics, industry specific characteristics etc. Risk rating system is being applied to the loanaccounts with total limits above Rs.50 lacs. Bank is undertaking periodic validation exercise of its ratingmodels and also conducting migration and default rate analysis to test robustness of its rating models.

Small & Medium Enterprise (SME) and Retail advances are subjected to Scoring models which support

Accept/ Reject decisions based on the scores obtained. All SME and Retail loan applications arenecessarily to be evaluated under score card system. Scoring model Farm sector has been developed and

implementation process is under progress. The bank plans to cover each borrowable account to beevaluated under risk rating/ score framework.

Recognizing the need of technology platform in data handling and analytics for risk management, thebank has placed rating/ scoring systems at central server network. All these models can be assessed bythe users on line through any office of the bank.

Additionally, to monitor the default rates, the pool/segment rating methodology is applied to the

retails/small loan portfolio. Default rates are assigned to identify pool/segment to monitor the trends ofhistorical defaults. The pools are created based on homogeneity.

For monitoring the health of borrowable accounts at regular intervals, bank has put in place a tool called

Preventive Monitoring System (PMS) for detection of early warning signals with a view toprevent/minimize the loan losses.

Bank is in the process of implementing enterprise-wide data warehouse (EDW) project, to cater to the

requirement for the reliable and accurate historical data base and to implement the sophisticated riskmanagement solutions/ techniques and the tools for estimating risk components {PD (Probability ofDefault), LGD (loss Given Default), EAD (Exposure at Default)} and quantification of the risks in theindividual exposures to assess risk contribution by individual accounts in total portfolio and identifying

buckets of risk concentrations.


18/34

As an integral part of Risk Management System, bank has put in place a well-defined Loan ReviewMechanism (LRM). This helps bring about qualitative improvements in credit administration. A separateDivision known as Credit Audit & Review Division has been formed to ensure LRM implementation.

The credit risk ratings are vetted/ confirmed by an independent authority. The risk rating and vetting

process are done independent of credit appraisal function to ensure its integrity and independency.

All loan proposals falling under the powers of GM & above at HO/ Field General Manager and Circle

Head at field are routed through Credit Committee. To ensure transparency and to give wider coverage,

the committee consists of one representative each from risk management department, Credit Departmentand one representative from an area not connected with credit. The proposals are deliberated in theCredit Committee from business objectives, risk management objectives, and policies perspectives.

The rating category wise portfolio of loan assets is reviewed on quarterly basis to analyze mix of qualityof assets etc.

In order to provide a robust risk management structure, the Credit Management and Risk policy of thebank aims to provide a basic framework for implementation of sound credit risk management system in

the bank. It deals with various areas of credit risk, goals to be achieved, current practices and futurestrategies.

Though the bank has implemented the Standardized Approach of credit risk, yet the bank shall continueits journey towards adopting Internal Rating Based Approaches. As such, the credit policy deals with

short term implementation as well as long term approach to credit risk management. The policy of thebank embodies in itself the areas of risk identification, risk measurement, risk grading techniques,reporting and risk control systems /mitigation techniques, documentation practice and the system formanagement of problem loans

NPA (NON PERFORMING ASSET)

Non Performing Asset means a loan or an account of borrower, which has been classified by a

bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the

directions or guidelines relating to asset classification issued by RBI


19/34

Once the borrower has failed to make interest or principal payments for 90 days the loan is

considered to be a non-performing asset.

Non-performing assets are problematic for financial institutions since they depend on interest

payments for income.

Asset Classification for NPAs

Standard Assets: A standard asset is a performing asset. Standard assets generate continuous

income and repayments as and when they fall due. Such assets carry a normal risk and are notNPA in the real sense. So, no special provisions are required for Standard Assets.

Sub-Standard Assets: All those assets (loans and advances) which are considered as non-

performing for a period of 12 months are called as Sub-Standard assets.

Doubtful Assets: All those assets which are considered as non-performing for period of more

than 12 months are called as Doubtful Assets.

Loss Assets: All those assets which cannot be recovered are called as Loss Assets.


20/34

4. Credit Risk Mitigation: disclosures for standardized approaches:

Qualitative disclosures:

Bank has put in place Board approved Credit Risk Mitigation and Collateral ManagementPolicy which, interalia, covers policies and processes for various collaterals including financial

collaterals and netting of on and off balance sheet exposure. However, the bank is not makinguse of the on-balance sheet netting in its capital calculation process.

The collaterals used by the Bank as risk mitigants (for capital calculation under standardized

approach) comprise of the financial collaterals (i.e. bank deposits, govt./postal securities, lifepolicies, gold jewellery, units of mutual funds etc.). A detailed process of calculation of correctvaluation and application of haircut thereon has been put in place by developing suitable

software.

Guarantees, which are direct, explicit, irrevocable and unconditional, are taken intoconsideration by Bank for calculating capital requirement. Use of such guarantees for capital

calculation purposes is strictly as per RBI guidelines on the subject.

Majority of financial collaterals held by the Bank is by way of own deposits and governmentsecurities, which do not have any issue in realization. As such, there is no risk concentration onaccount of nature of collaterals.

5. Market Risk in Trading Book:RBI prescribed Standardized Measurement Method (duration based) for computation of capital charge

for market risk has been adopted by Bank. Being fully compliant with Standardized Measurement

Method as per RBI guidelines, now Bank is preparing for the Internal Model Approach (Advanced

Approach on Market risk) based on Value at Risk (VaR) model, which is under implementation.

The capital requirements for market risk are as under:

Market Risk & Liquidity Risk:

The investment policy covering various aspects of market risk attempts to assess and minimize risksinherent in treasury operations through various risk management tools. Broadly, it incorporates policy

prescriptions for measuring, monitoring and managing systemic risk, credit risk, market risk, operationalrisk and liquidity risk in treasury operations.

Besides regulatory limits, the bank has put in place internal limits and ensures adherence thereof oncontinuous basis for managing market risk in trading book of the bank and its business operations.

Bank has prescribed entry level barriers, exposure limits, stop loss limits, VaR limit, Duration limits andRisk Tolerance limit for trading book investments. Bank is keeping constant track on Migration of credit

ratings of investment portfolio. Limits for exposures to counter-parties, industry segments and countriesare monitored. The risks under Forex operations are monitored and controlled through Stop Loss Limits,Overnight limit, Daylight limit, Aggregate Gap limit, Individual gap limit, Value at Risk (VaR) limit,

Inter-Bank dealing and investment limits etc.

For the Market Risk Management of the bank, Mid-Office with separate Desks for Treasury & AssetLiability Management (ALM) has been established.


21/34

Asset Liability Management Committee (ALCO) is primarily responsible for establishing the market riskmanagement and asset liability management of the bank, procedures thereof, implementing riskmanagement guidelines issued by regulator, best risk management practices followed globally andensuring that internal parameters, procedures, practices/policies and risk management prudential limits

are adhered to. ALCO is also entrusted with the job of fixing Base rate and pricing of advances & depositproducts and suggesting revision of BPLR to Board.

The policies for hedging and/or mitigating risk and strategies & processes for monitoring the continuing

effectiveness of hedges/mitigates are discussed in ALCO and based on views taken by /mandates ofALCO, hedge deals are undertaken.

Liquidity risk of the bank is assessed through gap analysis for maturity mismatch based on residual

maturity in different time buckets as well as various liquidity ratios and management of the same is donewithin the prudential limits fixed thereon. Advance techniques such as Stress testing, simulation,

sensitivity analysis etc. are used on regular intervals to draw the contingency funding plan under differentliquidity scenarios.

Interest Rate Risk in the Banking Book (IRRBB):

The interest rate risk is managed through gap analysis and duration gap analysis.

Duration gap analysis is being carried out at quarterly intervals to assess the interest rate risk ofboth banking book and trading book. Prudential limits have been fixed for impact on Net

Interest Income (NII), Net Interest Margin (NIM), minimum ROA & minimum duration gap for

the bank.Behavioral studies are being done for assessing and apportioning volatile and nonvolatile

portion of various non-maturity products of both assets and liabilities.

The tools used are:Earning Approach(Interest rate sensitivity Statement- Net Gaps)

Table 1: Interest rate sensitivity - net gaps


22/34

The reprising assumptions on assets and liabilities are taken as per RBI guidelines. The floating rateadvances are assumed to be reprised in 29 days to 3 months. Earning at Risk: Impact of 0.5 % changeupward/downward in interest rate on NII/NIM

Operational Risk:

The bank adopts three lines of defense for management of operational risk, the first line of defenserepresented by Various HO Divisions which are Control Units(CU), Business Units(BU) or Support

Units(SU) ; Second line of defense represented by independent Corporate Operational Risk ManagementFunction (CORF) being Operational Risk Management Department(ORMD) as envisaged under Basel

guidelines ; Third lines of defense represented by Inspection & Audit Division/Management AuditDivision(IAD/MARD) which is a challenge function to the first two lines of defenseOperational Risk Management Committee (ORMC) headed by CMD with both the EDS and key

divisional heads as members is the Executive level committee to oversee the entire operational risk

management of the bank.


23/34

AXIS BANK

INTRODUCTION OF AXIS BANK:

Axis Bank Limited is an Indian financial services firm headquartered in Mumbai, Maharashtra. It had

begun operations in 1994, after the Government of India allowed new private banks to be established. The

Bank was promoted jointly by the Administrator of the Specified Undertaking of the Unit Trust of

India (UTI-I), Life Insurance Corporation of India (LIC), General Insurance Corporation Ltd., National

Insurance Company Ltd., The New India Assurance Company, The Oriental InsuranceCorporation and United India Insurance Company UTI-I holds a special position in the Indian capital

markets and has promoted many leading financial institutions in the country. As on the year ended 31

March, 2012, Axis Bank had operating revenue of 13,437 crores and a net profit of 4,242 crores. Axis

Bank (UTI Bank) opened its registered office in Ahmedabad and corporate office in Mumbai in

December 1993. The first branch was inaugurated in April 1994 in Ahmedabad by Dr. Manmohan Singh,

then the Honorable Finance Minister.

The Bank, as on 31st March, 2012, is capitalized to the extent of Rest. 413.20 crores with the public

holding (other than promoters and GDRs) at 54.08%.


24/34

DISCLOSURES UNDER THE NEW CAPITAL ADEQUACY FRAMEWORK

(BASEL II GUIDELINES) FOR THE YEAR ENDED 31 March, 2012:

1. SCOPE OF APPLICATION:

Axis Bank Limited (the Bank) is a commercial bank, which was incorporated on 3 December, 1993.The Bank is the controlling entity for all group entities that include its six wholly owned subsidiaries.While computing the consolidated Banks Capital to Risk-weighted Assets Ratio (CRAR), the Banksinvestment in the equity capital of the wholly-owned subsidiaries is deducted, 50% from Tier 1 Capital

and 50% from Tier 2 Capital. The subsidiaries of the Bank are not required to maintain any regulatorycapital.

2. Capital Structure:

Summary

As per RBIs capital adequacy norms capital funds are classified into Tier-1 and Tier-2 capital. Tier-1capital of the Bank consists of equity capital, statutory reserves, other disclosed free reserves, capital

reserves and innovative perpetual debt instruments eligible for inclusion in Tier-1 capital that complieswith the requirement specified by RBI. The Tier-2 capital consists of general provision and loss reserves,upper Tier-2 instruments and subordinate debt instruments eligible for inclusion in Tier-2 capital. AxisBank has issued debt instruments that form a part of Tier-1 and Tier-2 capital. The terms and conditionsthat are applicable for these instruments comply with the stipulated regulatory requirements. Tier-1

bonds are non-cumulative and perpetual in nature with a call option after 10 years. Interest on Tier-1bonds is payable either annually or semi-annually. Some of the Tier-1 bonds have a step-up clause oninterest payment ranging up to 100 bps. The Upper Tier-2 bonds have an original maturity of 15 yearswith a call option after 10 years. The interest on Upper Tier-2 bonds is payable either annually or semi-annually. Some of the Upper Tier-2 debt instruments have a step-up clause on interest payment ranging

up to 100 bps. The Lower Tier-2 bonds have an original maturity between 5 to 10 years. The interest onlower Tier-2 capital instruments is payable either semi-annually or annually.

Equity Capital

The Bank has authorized share capital of `500.00 crores comprising 500,000,000 equity shares of `10/-each. As on 31 March, 2012 the Bank has issued, subscribed and paid-up equity capital of `413.20crores, constituting 413,203,952 numbers of shares of `10/- each. The Banks shares are listed on the

National Stock Exchange and the Bombay Stock Exchange. The GDRs issued by the Bank are listed on

the London Stock Exchange (LSE).During the year, the Bank has also allotted equity shares toemployees under its Employee Stock Option Plan. The provisions of the Companies Act, 1956 and otherapplicable laws and regulations govern the rights and obligations of the equity share capital of the Bank.

Debt Capital Instruments

The Bank has raised capital through Innovative Perpetual Debt Instrument (IPDI) eligible as Tier 1

Capital and Tier 2 Capital in the form of Upper Tier 2 and Subordinated bonds (unsecured redeemablenon-convertible debentures.


25/34

3. CAPITAL ADEQUACY:

Axis Bank is subject to the capital adequacy guidelines stipulated by RBI, which are based on the

framework of the Basel Committee on Banking Supervision. As per the capital adequacy guidelinesunder Basel I, the Bank is required to maintain a minimum ratio of total capital to risk weighted assets(CRAR) of 9.0%, at least half of which is required to be Tier 1 Capital. As per Basel II guidelines, Axis

Bank is required to maintain a minimum CRAR of 9.0%, with minimum Tier 1 Capital ratio of 6.0%. Interms of RBI guidelines for implementation of Basel II, capital charge for credit and market risk for thefinancial year ended 31 March, 2012 will be required to be maintained at the higher levels implied by

Basel II or 80% of the minimum capital requirement computed as per the Basel I framework. For theyear ended 31 March, 2012, the minimum capital required to be maintained by Axis Bank as per Basel II

guidelines is higher than that required at 80% of the capital requirements under Basel I guidelines.


26/34

4. RISK MANAGEMENT: OBJECTIVES AND ORGANIZATION STRUCTURE

The wide variety of businesses undertaken by the Bank requires it to identify, measure, control, monitorand report risks effectively. The key components of the Banks risk management rely on the risk

governance architecture, comprehensive processes and internal control mechanism. The Banks riskgovernance architecture focuses attention on key areas of risk such as credit, market and operational riskand quantification of these risks wherever possible for effective and continuous monitoring.

Objectives and Policies

The Banks risk management processes are guided by well-defined policies appropriate for various risk

categories, independent risk oversight and periodic monitoring through the sub-committees of the Boardof Directors. The Board sets the overall risk appetite and philosophy for the Bank. The Committee of

Directors, the Risk Management Committee and the Audit Committee of the Board, which are sub-committees of the Board, review various aspects of risk arising from the businesses of the Bank. Varioussenior management committees operate within the broad policy framework as illustrated below.

The Bank has put in place policies relating to management of credit risk, market risk, operational riskand asset-liability both for the domestic as well as overseas operations. The overseas policies are drawn

based on the risk perceptions of these economies and the Banks risk appetite. The Bank has formulateda comprehensive Stress Testing policy to measure impact of adverse stress scenarios on the adequacy of

capital.56

Structure and Organization:

The Risk Department reports to the Executive Director and CFO and the Risk Management Committeeof the Board oversees the functioning of the Department. The Department has three separate teams for


27/34

Credit Risk, Market Risk and Operational Risk and the head of each team reports to the Chief RiskOfficer.

5. CREDIT RISK: Credit risk covers the inability of a borrower or counter-party to honorcommitments under an agreement and any such failures, which have an adverse impact on the

financial performance of the Bank. The Bank is exposed to credit risk through lending and capitalmarket activities

Credit Risk Management Policy:

It lays down the roles and responsibilities, risk appetite, key processes and reporting framework.

The Board of Directors establishes the parameters for risk appetite, which are defined

quantitatively and qualitatively through strategic businesses plan as well as the Corporate Credit

Policy.

Corporate credit is managed through risk vetting of individual exposures at origination and

through periodic review after sanctioning.

Retail credit to individuals and small business is managed through definition of product criteria,

appropriate credit filters and subsequent portfolio monitoring.

Credit Rating System:

The foundation of credit risk management rests on the internal rating system.

i. Rating linked single borrower exposure norms,

ii. Delegation of powers,

iii. Review frequency

These methods have been adopted by the Bank.

The Bank has developed rating tools specific to market segments such as large and mid corporate,

SME, financial companies, microfinance companies and project finance to objectively underlying

risk associated with such exposures.

The credit rating tool uses a combination of quantitative inputs and qualitative inputs to arrive at a

point-in-time view of the risk profile of counterparty.

Each internal rating grade corresponds to a distinct probability of default over one year.

Go/No-Go score cards are used for various SME schematic products and retail agri schemes.

Statistical application and behavioral scorecards have been developed for all major retail

portfolios.


28/34

Credit Sanction and related processes:

The guiding principles behind the credit sanction process are us under.

Know your Customer is a leading principle for all activities.

The acceptability of credit exposure is primarily based on the sustainability and adequacy of

borrowers normal business operations and not based solely on the availability of security.

Delegation of sanctioning powers is based on the size and rating of the exposures. The Bank hasput in place the following

hierarchical committee structure for credit sanction and review: Retail Agriculture Credit Committee (RACC) Central Agriculture Business Credit Committee (CABCC) Regional Credit Committee (RCC) Central Office Credit Committee (COCC) Committee of Executives (COE) Senior Management Committee (SMC) Committee of Directors (COD), a sub-committee of the Board.

All management level sanctioning committees require mandatory presence of a representativefrom Risk Department for quorum.

Review and Monitoring:

All credit exposures, once approved, are monitored and reviewed periodically against theapproved limits. Borrowers with lower credit rating are subject to more frequent reviews.

Credit audit involves independent review of credit risk assessment, compliance with internalpolicies of the Bank and with the regulatory framework, compliance of sanction terms andconditions and effectiveness of loan administration.

Customers with emerging credit problems are identified early and classified accordingly.Remedial action is initiated promptly to minimize the potential loss to the Bank.

Concentration Risk:

The Bank manages concentration riskby means of appropriate structural limits and borrower-wise limits based on creditworthiness. Credit concentration in the Banks portfolios is monitoredfor the following:

Large Exposures to Individual Clients or Group: The Bank has individual borrower-wiseexposure ceilings based on the internal rating of the borrower as well as group-wise borrowinglimits which are continuously tracked and monitored.

Geographic concentration on sensitive sectors. Residual maturity concentration of loans and advances. Concentration of unsecured loans to total loans and advances. Concentration by Industry: Industry analysis plays an important part in assessing the

concentration risk within the loan portfolio. Industries are classified into various categories basedon factors such as

i. Demand-supply,ii. Input related risks,

iii. Government policy stance towards the sector and financial strength of the sector in general.

Non-Performing Assets:

Advances are classified into performing and non-performing advances (NPAs) NPAs are further classified into sub-standard, doubtful and loss assets.


29/34

An asset, including a leased asset, becomes non-performing when it ceases to generate income forthe Bank.

An NPA is a loan or an advance where:

Interest and/or installment of principal remains overdue for a period of more than 90 days In respect of a term loan; the account remains out -of-order for a period of more than 90 days in

respect of an Overdraft or Cash Credit (OD/CC) The bill remains overdue for a period of more than 90 days in case of bills purchased and

discounted A loan granted for short duration crops will be treated as an NPA if the installments of principal

or interest thereon remain overdue for two crop seasons; and A loan granted for long duration crops will be treated as an NPA if the installments of principal or

interest thereon remain overdue for one crop season.

Impairment:

At each balance sheet date, the Bank ascertains if there is any impairment in its assets.

If such impairment is detected, the Bank estimates the recoverable amount of the asset. If the

recoverable amount of the asset or the cash-generating unit to which the asset belongs is less than

its carrying amount, the carrying amount is reduced to its recoverable amount.

The reduction is treated as an impairment loss and is recognized in the profit and loss account


30/34

6. CREDIT RISK MITIGATION:

The Bank uses various collaterals both financial as well as non-financial, guarantees and credit

insurance as credit risk mitigants.

The main financial collaterals include bank deposits, NSC/KVP/LIP and gold,

The main non-financial collaterals include land and building, plant and machinery, residential and

commercial mortgages.

The guarantees include guarantees given by corporate, bank and personal guarantees.

The Bank has in place a collateral management policy, which underlines the eligibility

requirements for credit risk mitigants (CRM) for capital computation as per Basel II guidelines.

The Bank revalues various financial collaterals at varied frequency depending on the type of collateral.

The Bank has a valuation policy that covers processes for collateral valuation.

7. SECURITISATION:

The primary objectives for undertaking securitisation activity by the Bank are enhancing liquidity,

optimization of usage of capital and churning of the assets as part of risk management strategy. Thesecuritisation of assets generally being undertaken by the Bank is on the basis of True Sale, which

provides 100% protection to the Bank from default. All risks in the securitised portfolio are transferredto a Special Purpose Vehicle (SPV), except where the Bank provides sub-ordination of cash flows toSenior Pass-Through Certificate (PTC) holders by retaining the junior tranche of the securitised pool.The Bank has not sponsored any special purpose vehicle which is required to be consolidated in theconsolidated financial statements as per accounting norms.

Bank may also invest in securitised instruments which offer attractive risk adjusted returns. During FY2012 no fresh investments in securitised instruments had been made. The Bank enters into purchase/sale

of corporate and retail loans through direct assignment/SPV. In most cases, post securitisation, the Bankcontinues to service the loans transferred to the assignee/SPV. The Bank also provides credit

enhancement in the form of cash collaterals and/or by subordination of cash flows to Senior PTCholders. The Bank however does not follow the originate to distribute model and pipeline andwarehousing risk is not material to the Bank.

Valuation of securitised exposures is carried out in accordance with FIMMDA/RBI guidelines. Gain onsecuritisation is recognized over the period of the underlying securities issued by the SPV. Loss on

securitisation is immediately debited to profit and loss account. In respect of credit enhancementsprovided or recourse obligations (projected delinquencies, future servicing etc.) accepted by the Bank,appropriate provision/disclosure is made at the time of sale in accordance with AS 29 Provisions,contingent liabilities and contingent assets.


31/34

The Bank follows the standardized approach prescribed by the RBI for the securitisation activities. TheBank uses the ratings assigned by various external credit rating agencies viz. CRISIL, ICRA, Fitch and

CARE for its securitisation exposures.

All transfers of assets under securitisation were affected on true sale basis. However in the financial yearended 31 March, 2012, the Bank has not securitised any asset.

8. MARKET RISK IN TRADING BOOK:

Market risk is the risk of loss to the Banks earnings and capital due to changes in the market level of

interest rates, price of securities, foreign exchange rates and equities, as well as the volatilities of thosechanges. The Bank is exposed to market risk through its investment activities and also trading activities,

which are undertaken for customers as well as on a proprietary basis. The bank adopts a comprehensiveapproach to market risk management for its trading, investment and asset and liability portfolios.

For market risk management the bank has:

Well laid down policies and guidelines which are aligned to the regulatory norms and based onexperiences gained over the years.

Mechanism for periodic review of the market risk management policies.

Management Information System (MIS) for timely market risk reporting to senior managementfunctionaries.

Statistical measures like Value at Risk (VaR); supplemented by stress tests, back tests and scenarioanalysis.

Non-statistical measures like position limits, marked-to-market (MTM), gaps and sensitivities (mark-to-market, position limits, duration, PVBP, option Greeks).

Market risk identification through elaborate mapping of the Banks main businesses for various marketrisks.

There are some risks limits like:

Position Limits

Stoploss Limits

Alarm Limits

Gaps & Sensitivities.

All the above mentioned risks are based on a number of criteria including regulatory guidelines, relevantmarket analysis, business strategy, management experience and the Banks risk apetitite. As a discreet

market risk management measure, risk limits are reviewed, at least, annually or more frequently, ifdeemed necessary, to align the limits with the Banks risk appetite, market conditions and tradingstrategies.

The bank calculates the VaR on the basis of the historical data. The model assumes that the risk factor

changes observed in the past are a good estimate of those likely to occur in the future and is, therefore,limited by the relevance of the historical data used. The Bank typically uses 250 days of historical dataor one year of relative changes in historical rates and prices. The method, however, does not make anyassumption about the nature or type of the loss distribution. The VaR models for different portfolios are

back-tested at regular intervals and the results are used to maintain and improve the efficacy of the

model. The VaR is computed on a daily basis for the trading portfolio and reported to the seniormanagement of the Bank.

The Bank is in the process of building its capabilities to migrate to advance approach i.e. Internal ModelsApproach for assessment of market risk capital. For this purpose, system capabilities are being

strengthened, newer processes are being introduced and employee skills are being improved.


32/34

Concentration Risk:

Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over

the number or variety of debtors to whom the bank has lent money. This risk is calculated using a"concentration ratio" which explains what percentage of the outstanding accounts each bank

loan represents.In order to remove concentration risk the Bank has allocated the internal risk limits wherever applicable.

For example, the Aggregate Gap Limit is allocated to various currencies and maturities as IndividualGap Limits to monitor concentrations. Similarly, stop-loss limits and duration limits have been set up for

different categories within a portfolio.

Liquidity Risk:

Liquidity risk arises from a banks inability to meet its short term, c urrent or future obligations on thedue date. It has got two dimensions:

1) Risk of being unable to fund portfolio of assets at appropriate maturity and rates (liability dimension)2) The risk of being unable to liquidate an asset in a timely manner at a reasonable price (asset dimension).

The goal of Liquidity Risk Management is to meet all commitments on the due date and funding new

investment opportunities. These objectives are ensured by setting up policies, operational level

committees, measurement tools and monitoring and reporting mechanism using effective use of ITsystems for availability of quality data.The Bank manages its liquidity on a static as well as dynamic basis using various tools such as gapanalysis, ratio analysis, dynamic liquidity statements and scenario analysis. The Banks ALM policy

defines the tolerance limits for its structural liquidity position. The liquidity profile of the Bank isanalyzed on a static basis by tracking all cash inflows and outflows in the mat

Final Risk and Insurance Management

Documents

Transcript of Final Risk and Insurance Management