Risk Management in Banking Sector Main
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Transcript of Risk Management in Banking Sector Main
Sr. No.
TOPICSPAGE No.
1. INTRODUCTION
Objective of the study
Scope of the study
Limitation of the study
2. DEFINITION OF RISK
What is risk
What is risk management? Does it eliminate risk?
Risk in banking
3. TOPOLOGY OF RISK
Market risk
Credit risk
Operational risk
4. AN IDEALISED BANK OF THE FUTURE
5.STUDY OF OPERATIONAL RISK AT PUNJAB NATIONAL BANK
6. REFERENCES
OBJECTIVES
To study broad outline of management of credit, market and operational risks
associated with banking sector .
Though the risk management area is very wide and elaborated, still the project
covers whole subject in concise manner.
The study aims at learning the techniques involved to manage the various types
of risks, various methodologies undertaken. The application of the techniques
involves us to gain an insight into the following aspects:
An overview of the risks in general.
An insight of the various credit, market and operational risks
attached to the banking sector
The methodology related to the management of operational risk
followed at PNB.
Tools applied in for measurement and management of various
types of risks.
Having an insight into the practical aspects of the working of
various departments.
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SCOPE OF THE STUDY
The report seeks to present a comprehensive picture of the various risks inherent
in the bank. The risks can be broadly classified into three categories:
Credit risk
Market risk
Operational risk
Within each of these broad groups, an attempt has been made to cover as
comprehensively as possible, the various sub-groups
The computation of capital charge for market risk will also be taken practically as
also the assigning the ratings for individual borrowers. PNB is also under the key
process of testing and implementation of Reuters "KONDOR" software for its
VaR calculations and other aspects of market risk.
LIMITATION OF THE STUDY
1. The major limitation of this study shall be data availability as the data is
proprietary and not readily shared for dissemination.
2. Due to the ongoing process of globalization and increasing competition, no
one model or method will suffice over a long period of time and constant up
gradation will be required. As such the project can be considered as an overview
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of the various risks prevailing in Punjab National Bank and in the Banking
Industry.
3. Each bank, in conforming to the RBI guidelines, may develop its own methods
for measuring and managing risk.
4. The concept of risk management implementation is relatively new and risk
management tools can prove to be costly.
5. Out of the various ways in which risks can be managed, none of the method is
perfect and may be very diverse even for the work in a similar situation for the
future.
6. Due to ever changing environment , many risks are unexpected and the
remedial measures available are based on general experience from the past.
7. Selection of methods depends on the firms expectations as well as the risk
appetite. Also risks can only be minimized not completely erased.
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INTRODUCTION
The significant transformation of the banking industry in India is clearly
evident from the changes that have occurred in the financial markets, institutions
and products. While deregulation has opened up new vistas for banks to
argument revenues, it has entailed greater competition and consequently greater
risks. Cross- border flows and entry of new products, particularly derivative
instruments, have impacted significantly on the domestic banking sector forcing
banks to adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive to the globalized
environment. These developments have facilitated greater choice for consumers,
who have become more discerning and demanding compelling banks to offer a
broader range of products through diverse distribution channels. The traditional
face of banks as mere financial intermediaries has since altered and risk
management has emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The
benefits of globalization have been well documented and are being increasingly
recognized. Integration of domestic markets with international financial markets
has been facilitated by tremendous advancement in information and
communications technology. But, such an environment has also meant that a
problem in one country can sometimes adversely impact one or more countries
instantaneously, even if they are fundamentally strong.
There is a growing realisation that the ability of countries to conduct
business across national borders and the ability to cope with the possible
downside risks would depend, interalia, on the soundness of the financial
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system. This has consequently meant the adoption of a strong and transparent,
prudential, regulatory, supervisory, technological and institutional framework in
the financial sector on par with international best practices. All this necessitates a
transformation: a transformation in the mindset, a transformation in the business
processes and finally, a transformation in knowledge management. This process
is not a one shot affair; it needs to be appropriately phased in the least disruptive
manner.
The banking and financial crises in recent years in emerging economies
have demonstrated that, when things go wrong with the financial system, they
can result in a severe economic downturn. Furthermore, banking crises often
impose substantial costs on the exchequer, the incidence of which is ultimately
borne by the taxpayer. The World Bank Annual Report (2002) has observed that
the loss of US $1 trillion in banking crisis in the 1980s and 1990s is equal to the
total flow of official development assistance to developing countries from 1950s
to the present date. As a consequence, the focus of financial market reform in
many emerging economies has been towards increasing efficiency while at the
same time ensuring stability in financial markets.
From this perspective, financial sector reforms are essential in order to
avoid such costs. It is, therefore, not surprising that financial market reform is at
the forefront of public policy debate in recent years. The crucial role of sound
financial markets in promoting rapid economic growth and ensuring financial
stability. Financial sector reform, through the development of an efficient financial
system, is thus perceived as a key element in raising countries out of their 'low
level equilibrium trap'. As the World Bank Annual Report (2002) observes, ‘ a
robust financial system is a precondition for a sound investment climate, growth
and the reduction of poverty ’.
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Financial sector reforms were initiated in India a decade ago with a view to
improving efficiency in the process of financial intermediation, enhancing the
effectiveness in the conduct of monetary policy and creating conditions for
integration of the domestic financial sector with the global system. The first phase
of reforms was guided by the recommendations of Narasimham Committee.
The approach was to ensure that ‘the financial services industry operates
on the basis of operational flexibility and functional autonomy with a view
to enhancing efficiency, productivity and profitability'.
The second phase, guided by Narasimham Committee II, focused on
strengthening the foundations of the banking system and bringing about
structural improvements. Further intensive discussions are held on
important issues related to corporate governance, reform of the capital
structure, (in the context of Basel II norms), retail banking, risk
management technology, and human resources development, among
others.
Since 1992, significant changes have been introduced in the Indian
financial system. These changes have infused an element of competition in the
financial system, marking the gradual end of financial repression characterized
by price and non-price controls in the process of financial intermediation. While
financial markets have been fairly developed, there still remains a large extent of
segmentation of markets and non-level playing field among participants, which
contribute to volatility in asset prices. This volatility is exacerbated by the lack of
liquidity in the secondary markets. The purpose of this paper is to highlight the
need for the regulator and market participants to recognize the risks in the
financial system, the products available to hedge risks and the instruments,
including derivatives that are required to be developed/introduced in the Indian
system.
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The financial sector serves the economic function of intermediation by
ensuring efficient allocation of resources in the economy. Financial
intermediation is enabled through a four-pronged transformation mechanism
consisting of liability-asset transformation, size transformation, maturity
transformation and risk transformation.
Risk is inherent in the very act of transformation. However, prior to reform
of 1991-92, banks were not exposed to diverse financial risks mainly because
interest rates were regulated, financial asset prices moved within a narrow band
and the roles of different categories of intermediaries were clearly defined. Credit
risk was the major risk for which banks adopted certain appraisal standards.
Several structural changes have taken place in the financial sector since
1992. The operating environment has undergone a vast change bringing to fore
the critical importance of managing a whole range of financial risks. The key
elements of this transformation process have been
1. The deregulation of coupon rate on Government securities.
2. Substantial liberalization of bank deposit and lending rates.
3. A gradual trend towards disintermediation in the financial system in the
wake of increased access of corporates to capital markets.
4. Blurring of distinction between activities of financial institutions.
5. Greater integration among the various segments of financial markets and
their increased order of globalisation, diversification of ownership of public
sector banks.
6. Emergence of new private sector banks and other financial institutions,
and,
7. The rapid advancement of technology in the financial system.
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DEFINITION OF RISK
What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means
different things to different people. For some it is "financial (exchange rate,
interest-call money rates), mergers of competitors globally to form more powerful
entities and not leveraging IT optimally" and for someone else "an event or
commitment which has the potential to generate commercial liability or damage
to the brand image". Since risk is accepted in business as a trade off between
reward and threat, it does mean that taking risk bring forth benefits as well. In
other words it is necessary to accept risks, if the desire is to reap the anticipated
benefits.
Risk in its pragmatic definition, therefore, includes both threats that can
materialize and opportunities, which can be exploited. This definition of risk is
very pertinent today as the current business environment offers both challenges
and opportunities to organizations, and it is up to an organization to manage
these to their competitive advantage.
What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some
future event will cause harm. It provides strategies, techniques, and an approach
to recognizing and confronting any threat faced by an organization in fulfilling its
mission. Risk management may be as uncomplicated as asking and answering
three basic questions:
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1. What can go wrong?
2. What will we do (both to prevent the harm from occurring and in the
aftermath of an "incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the
organization to bring their risks to manageable proportions while not severely
affecting their income. This balancing act between the risk levels and profits
needs to be well-planned. Apart from bringing the risks to manageable
proportions, they should also ensure that one risk does not get transformed into
any other undesirable risk. This transformation takes place due to the inter-
linkage present among the various risks. The focal point in managing any risk will
be to understand the nature of the transaction in a way to unbundle the risks it is
exposed to.
Risk Management is a more mature subject in the western world. This is
largely a result of lessons from major corporate failures, most telling and visible
being the Barings collapse. In addition, regulatory requirements have been
introduced, which expect organizations to have effective risk management
practices. In India, whilst risk management is still in its infancy, there has been
considerable debate on the need to introduce comprehensive risk management
practices.
Objectives of Risk Management Function
Two distinct viewpoints emerge –
One which is about managing risks, maximizing profitability and creating
opportunity out of risks
And the other which is about minimising risks/loss and protecting
corporate assets.
The management of an organization needs to consciously decide on
whether they want their risk management function to 'manage' or 'mitigate' Risks.
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Managing risks essentially is about striking the right balance between risks
and controls and taking informed management decisions on opportunities
and threats facing an organization. Both situations, i.e. over or under
controlling risks are highly undesirable as the former means higher costs
and the latter means possible exposure to risk.
Mitigating or minimising risks, on the other hand, means mitigating all risks
even if the cost of minimising a risk may be excessive and outweighs the
cost-benefit analysis. Further, it may mean that the opportunities are not
adequately exploited.
In the context of the risk management function, identification and
management of Risk is more prominent for the financial services sector and less
so for consumer products industry. What are the primary objectives of your risk
management function? When specifically asked in a survey conducted, 33% of
respondents stated that their risk management function is indeed expressly
mandated to optimise risk.
Risks in Banking
Risks manifest themselves in many ways and the risks in banking are a
result of many diverse activities, executed from many locations and by numerous
people. As a financial intermediary, banks borrow funds and lend them as a part
of their primary activity. This intermediation activity, of banks exposes them to a
host of risks. The volatility in the operating environment of banks will aggravate
the effect of the various risks. The case discusses the various risks that arise due
to financial intermediation and by highlighting the need for asset-liability
management; it discusses the Gap Model for risk management.
Typology of Risk Exposure
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Based on the origin and their nature, risks are classified into various
categories. The most prominent financial risks to which the banks are exposed to
taking into consideration practical issues including the limitations of models and
theories, human factor, existence of frictions such as taxes and transaction cost
and limitations on quality and quantity of information, as well as the cost of
acquiring this information, and more.
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FINANCIAL RISKS
MARKETRISK
LIQUIDITY RISK
OPERATIONAL RISK
HUMAN FACTOR RISK
CREDIT RISK LEGAL & REGULATORY RISK
FUNDING LIQUIDITY RISK
TRADING LIQUIDITY RISK
TRANSACTION RISK
PORTFOLIO CONCENTRATION
ISSUE RISK ISSUER RISK COUNTERPARTY RISK
EQUITY RISK INEREST RATE RISK
CURRENCY RISK
COMMODITY RISK
1. MARKET RISK
Market risk is that risk that changes in financial market prices and rates
will reduce the value of the bank’s positions. Market risk for a fund is often
measured relative to a benchmark index or portfolio, is referred to as a “risk of
tracking error” market risk also includes “basis risk,” a term used in risk
management industry to describe the chance of a breakdown in the relationship
between price of a product, on the one hand, and the price of the instrument
used to hedge that price exposure on the other. The market-Var methodology
attempts to capture multiple component of market such as directional risk,
convexity risk, volatility risk, basis risk, etc.
2. CREDIT RISK
Credit risk is that risk that a change in the credit quality of a counterparty
will affect the value of a bank’s position. Default, whereby a counterparty is
unwilling or unable to fulfill its contractual obligations, is the extreme case;
however banks are also exposed to the risk that the counterparty might
downgraded by a rating agency.
Credit risk is only an issue when the position is an asset, i.e., when it
exhibits a positive replacement value. In that instance if the counterparty
defaults, the bank either loses all of the market value of the position or, more
commonly, the part of the value that it cannot recover following the credit event.
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TRADING RISK
GAP RISK
GENERAL MARKET RISK
SPECIFIC RISK
However, the credit exposure induced by the replacement values of derivative
instruments are dynamic: they can be negative at one point of time, and yet
become positive at a later point in time after market conditions have changed.
Therefore the banks must examine not only the current exposure, measured by
the current replacement value, but also the profile of future exposures up to the
termination of the deal.
3. LIQUIDITY RISK
Liquidity risk comprises both
Funding liquidity risk
Trading-related liquidity risk.
Funding liquidity risk relates to a financial institution’s ability to raise the
necessary cash to roll over its debt, to meet the cash, margin, and collateral
requirements of counterparties, and (in the case of funds) to satisfy capital
withdrawals. Funding liquidity risk is affected by various factors such as the
maturities of the liabilities, the extent of reliance of secured sources of funding,
the terms of financing, and the breadth of funding sources, including the ability to
access public market such as commercial paper market. Funding can also be
achieved through cash or cash equivalents, “buying power ,” and available credit
lines.
Trading-related liquidity risk, often simply called as liquidity risk, is the risk
that an institution will not be able to execute a transaction at the prevailing
market price because there is, temporarily, no appetite for the deal on the other
side of the market. If the transaction cannot be postponed its execution my lead
to substantial losses on position. This risk is generally very hard to quantify. It
may reduce an institution’s ability to manage and hedge market risk as well as its
capacity to satisfy any shortfall on the funding side through asset liquidation.
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4. OPERATIONAL RISK
It refers to potential losses resulting from inadequate systems,
management failure, faulty control, fraud and human error. Many of the recent
large losses related to derivatives are the direct consequences of operational
failure. Derivative trading is more prone to operational risk than cash transactions
because derivatives are, by heir nature, leveraged transactions. This means that
a trader can make very large commitment on behalf of the bank, and generate
huge exposure in to the future, using only small amount of cash. Very tight
controls are an absolute necessary if the bank is to avoid huge losses.
Operational risk includes” fraud,” for example when a trader or other
employee intentionally falsifies and misrepresents the risk incurred in a
transaction. Technology risk, and principally computer system risk also fall into
the operational risk category.
5. LEGAL RISK
Legal risk arises for a whole of variety of reasons. For example,
counterparty might lack the legal or regulatory authority to engage in a
transaction. Legal risks usually only become apparent when counterparty, or an
investor, lose money on a transaction and decided to sue the bank to avoid
meeting its obligations. Another aspect of regulatory risk is the potential impact of
a change in tax law on the market value of a position.
6. HUMAN FACTOR RISK
Human factor risk is really a special form of operational risk. It relates to
the losses that may result from human errors such as pushing the wrong button
on a computer, inadvertently destroying files, or entering wrong value for the
parameter input of a model.
15
MARKET RISK
What is Market Risk?
Market Risk may be defined as the possibility of loss to a bank caused by
changes in the market variables. The Bank for International Settlements (BIS)
defines market risk as “the risk that the value of 'on' or 'off' balance sheet
positions will be adversely affected by movements in equity and interest rate
markets, currency exchange rates and commodity prices". Thus, Market Risk is
the risk to the bank's 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 changes. Besides, it is equally concerned about the
bank's ability to meet its obligations as and when they fall due. In other words, it
should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on
the management of Liquidity Risk and Market Risk, further categorized into
interest rate risk, foreign exchange risk, commodity price risk and equity price
risk. An effective market risk management framework in a bank comprises risk
identification, setting up of limits and triggers, risk monitoring, models of analysis
that value positions or measure market risk, risk reporting, etc.
Types of market risk
16
Interest rate risk:
Interest rate risk is the risk where changes in market interest rates might
adversely affect a bank's financial condition. The immediate impact of changes in
interest rates is on the Net Interest Income (NII). A long term impact of changing
interest rates is on the bank's networth since the economic value of a bank's
assets, liabilities and off-balance sheet positions get affected due to variation in
market interest rates. The interest rate risk when viewed from these two
perspectives is known as 'earnings perspective' and 'economic value'
perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from
the maturity and repricing 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) or
Net Interest Margin (NIM) i.e. the difference between the total interest
income and the total interest expense.
Economic Value perspective involves analyzing the changes of
impact on interest on the expected cash flows on assets minus the
expected cash flows on liabilities plus the net cash flows on off-balance
sheet items. It focuses on the risk to networth arising from all repricing
mismatches and other interest rate sensitive positions. The economic
value perspective identifies risk arising from long-term interest rate gaps.
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.
17
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 bank's NII or NIM to variations. The earning
of assets and the cost of liabilities are now closely related to market interest rate
volatility
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 broadly position their balance sheet into Trading
and 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.
Equity price risk:
The price risk associated with equities also has two components” General
market risk” refers to the sensitivity of an instrument / portfolio value to the
change in the level of broad stock market indices.” Specific / Idiosyncratic” risk
refers to that portion of the stock’s price volatility that is determined by
characteristics specific to the firm, such as its line of business, the quality of its
management, or a breakdown in its production process. The general market risk
cannot be eliminated through portfolio diversification while specific risk can be
diversified away.
Foreign exchange risk:
18
Foreign Exchange Risk maybe defined as the risk that a bank may suffer
losses as a result of adverse exchange rate movements during a period in which
it has an open position, either spot or forward, or a combination of the two, in an
individual foreign currency. 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 center and the settlement of
another currency in another time-zone. The forex transactions with
counterparties from another country also trigger sovereign or country risk (dealt
with in details in the guidance note on credit risk).
The three important issues that need to be addressed in this regard are:
1. Nature and magnitude of exchange risk
2. Exchange managing or hedging for adopted be to strategy>
3. The tools of managing exchange risk
Commodity price risk:
The price of the commodities differs considerably from its interest rate risk
and foreign exchange risk, since most commodities are traded in the market in
which the concentration of supply can magnify price volatility. Moreover,
19
fluctuations in the depth of trading in the market (i.e., market liquidity) often
accompany and exacerbate high levels of price volatility. Therefore, commodity
prices generally have higher volatilities and larger price discontinuities.
Treatment of Market Risk in the Proposed Basel Capital
Accord
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. 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.
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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 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. As the valuation norms on
banks' investment portfolio have already been put in place and aligned with the
international best practices, it is appropriate to adopt the Basel norms on capital
for market risk. In view of this, banks should study the Basel framework on
capital for market risk as envisaged in Amendment to the Capital Accord to
incorporate market risks published in January 1996 by BCBS and prepare
themselves to follow the international practices in this regard at a suitable date to
be announced by RBI.
The Proposed New Capital Adequacy Framework
The Basel Committee on Banking Supervision has released a Second
Consultative Document, which contains refined proposals for the three pillars of
the New Accord - Minimum Capital Requirements, Supervisory Review and
Market Discipline. It may be recalled that the Basel Committee had released in
June 1999 the first Consultative Paper on a New Capital Adequacy Framework
for comments. However, the proposal to provide explicit capital charge for market
risk in the banking book which was included in the Pillar I of the June 1999
21
Document has been shifted to Pillar II in the second Consultative Paper issued in
January 2001. The Committee has also provided a technical paper on evaluation
of interest rate risk management techniques. The Document has defined the
criteria for identifying outlier banks. According to the proposal, a bank may be
defined as an outlier whose economic value declined by more than 20% of the
sum of Tier 1 and Tier 2 capital as a result of a standardized interest rate shock
(200 bps.)
The second Consultative Paper on the New Capital Adequacy framework
issued in January, 2001 has laid down 13 principles intended to be of general
application for the management of interest rate risk, independent of whether the
positions are part of the trading book or reflect banks' non-trading activities. They
refer to an interest rate risk management process, which includes the
development of a business strategy, the assumption of assets and liabilities in
banking and trading activities, as well as a system of internal controls. In
particular, they address the need for effective interest rate risk measurement,
monitoring and control functions within the interest rate risk management
process. The principles are intended to be of general application, based as they
are on practices currently used by many international banks, even though their
specific application will depend to some extent on the complexity and range of
activities undertaken by individual banks. Under the New Basel Capital Accord,
they form minimum standards expected of internationally active banks. The
principles are given in Annexure II.
CREDIT RISK
What is Credit Risk?
Credit risk is defined as the possibility of losses associated with diminution
in the credit quality of borrowers or counterparties. In a bank's portfolio, losses
22
stem from outright default due to inability or unwillingness of a customer or
counterparty to meet commitments in relation to lending, trading, settlement and
other financial transactions. Alternatively, losses result from reduction in portfolio
value arising from actual or perceived deterioration in credit quality. Credit risk
emanates from a bank's dealings with an individual, corporate, bank, financial
institution or a sovereign. Credit risk may take the following forms
In the case of direct lending: principal/and or interest amount may not be
repaid;
In the case of guarantees or letters of credit: funds may not be
forthcoming from the constituents upon crystallization of the liability;
In the case of treasury operations: the payment or series of payments due
from the counter parties under the respective contracts may not be
forthcoming or ceases;
In the case of securities trading businesses: funds/ securities settlement
may not be effected;
In the case of cross-border exposure: the availability and free transfer of
foreign currency funds may either cease or the sovereign may impose
restrictions.
Types of Credit Rating
Credit rating can be classified as:
2. External credit rating.
3. Internal credit rating
23
External credit rating:
A credit rating is not, in general, an investment recommendation
concerning a given security. In the words of S&P,” A credit rating is S&P's
opinion of the general creditworthiness of an obligor, or the creditworthiness of
an obligor with respect to a particular debt security or other financial obligation,
based on relevant risk factors.” In Moody's words, a rating is, “ an opinion on the
future ability and legal obligation of an issuer to make timely payments of
principal and interest on a specific fixed-income security.”
Since S&P and Moody's are considered to have expertise in credit rating
and are regarded as unbiased evaluators, there ratings are widely accepted by
market participants and regulatory agencies. Financial institutions, when required
to hold investment grade bonds by their regulators use the rating of credit
agencies such as S&P and Moody's to determine which bonds are of investment
grade.
The subject of credit rating might be a company issuing debt obligations.
In the case of such “issuer credit ratings” the rating is an opinion on the obligor’s
overall capacity to meet its financial obligations. The opinion is not specific to any
particular liability of the company, nor does it consider merits of having
guarantors for some of the obligations. In the issuer credit rating categories are
a) Counterparty ratings
b) Corporate credit ratings
c) Sovereign credit ratings
The rating process includes quantitative, qualitative, and legal analyses.
The quantitative analyses. The quantitative analysis is mainly financial analysis
and is based on the firm’s financial reports. The qualitative analysis is concerned
with the quality of management, and includes a through review of the firm’s
competitiveness within its industry as well as the expected growth of the industry
and its vulnerability to technological changes, regulatory changes, and labor
relations.
24
Internal credit rating:
A typical risk rating system (RRS) will assign both an obligor rating to each
borrower (or group of borrowers), and a facility rating to each available facility. A
risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust
RRS should offer a carefully designed, structured, and documented series of
steps for the assessment of each rating.
The following are the steps for assessment of rating:
a) Objectivity and Methodology:
The goal is to generate accurate and consistent risk rating, yet also to
allow professional judgment to significantly influence a rating where it is
appropriate. The expected loss is the product of an exposure (say, Rs. 100) and
the probability of default (say, 2%) of an obligor (or borrower) and the loss rate
given default (say, 50%) in any specific credit facility. In this example,
The expected loss = 100*.02*.50 = Rs. 1
A typical risk rating methodology (RRM)
a. Initial assign an obligor rating that identifies the expected probability of
default by that borrower (or group) in repaying its obligations in normal
course of business.
b. The RRS then identifies the risk loss (principle/interest) by assigning
an RR to each individual credit facility granted to an obligor.
The obligor rating represents the probability of default by a borrower in
repaying its obligation in the normal course of business. The facility rating
represents the expected loss of principal and/ or interest on any business credit
facility. It combines the likelihood of default by a borrower and conditional
severity of loss, should default occur, from the credit facilities available to the
borrower.
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Credit Risk Management
In this backdrop, it is imperative that banks have a robust credit risk
management system which is sensitive and responsive to these factors. The
effective management of credit risk is a critical component of comprehensive risk
management and is essential for the long term success of any banking
organization. Credit risk management encompasses identification, measurement,
monitoring and control of the credit risk exposures.
Building Blocks of Credit Risk Management:
In a bank, an effective credit risk management framework would comprise
of the following distinct building blocks:
Policy and Strategy
Organizational Structure
Operations/ Systems
Policy and Strategy
The Board of Directors of each bank shall be responsible for approving
and periodically reviewing the credit risk strategy and significant credit risk
policies.
Credit Risk Policy
26
1. Every bank should have a credit risk policy document approved by the
Board. The document should include risk identification, risk measurement,
risk grading/ aggregation techniques, reporting and risk control/ mitigation
techniques, documentation, legal issues and management of problem
loans.
2. Credit risk policies should also define target markets, risk acceptance
criteria, credit approval authority, credit origination/ maintenance
procedures and guidelines for portfolio management.
3. The credit risk policies approved by the Board should be communicated to
branches/controlling offices. All dealing officials should clearly understand
the bank's approach for credit sanction and should be held accountable for
complying with established policies and procedures.
4. Senior management of a bank shall be responsible for implementing the
credit risk policy approved by the Board.</P< LI>
Credit Risk Strategy
1. Each bank should develop, with the approval of its Board, its own credit
risk strategy or plan that establishes the objectives guiding the bank's
credit-granting activities and adopt necessary policies/ procedures for
conducting such activities. This strategy should spell out clearly the
organization’s credit appetite and the acceptable level of risk-reward
trade-off for its activities.
2. The strategy would, therefore, include a statement of the bank's
willingness to grant loans based on the type of economic activity,
geographical location, currency, market, maturity and anticipated
profitability. This would necessarily translate into the identification of target
markets and business sectors, preferred levels of diversification and
27
concentration, the cost of capital in granting credit and the cost of bad
debts.
3. The credit risk strategy should provide continuity in approach as also take
into account the cyclical aspects of the economy and the resulting shifts in
the composition/ quality of the overall credit portfolio. This strategy should
be viable in the long run and through various credit cycles.
4. Senior management of a bank shall be responsible for implementing the
credit risk strategy approved by the Board.
Organizational Structure
Sound organizational structure is sine qua non for successful
implementation of an effective credit risk management system. The
organizational structure for credit risk management should have the following
basic features:
1. The Board of Directors should have the overall responsibility for
management of risks. The Board should decide the risk management
policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks.
The Risk Management Committee will be a Board level Sub committee
including CEO and heads of Credit, Market and Operational Risk Management
Committees. It will devise the policy and strategy for integrated risk management
containing various risk exposures of the bank including the credit risk. For this
purpose, this Committee should effectively coordinate between the Credit Risk
28
Management Committee (CRMC), the Asset Liability Management Committee
and other risk committees of the bank, if any. It is imperative that the
independence of this Committee is preserved. The Board should, therefore,
ensure that this is not compromised at any cost. In the event of the Board not
accepting any recommendation of this Committee, systems should be put in
place to spell out the rationale for such an action and should be properly
documented. This document should be made available to the internal and
external auditors for their scrutiny and comments. The credit risk strategy and
policies adopted by the committee should be effectively
Operations / Systems
Banks should have in place an appropriate credit administration, credit risk
measurement and monitoring processes. The credit administration process
typically involves the following phases:
1. Relationship management phase i.e. business development.
2. Transaction management phase covers risk assessment, loan pricing,
structuring the facilities, internal approvals, documentation, loan
administration, on going monitoring and risk measurement.
3. Portfolio management phase entails monitoring of the portfolio at a macro
level and the management of problem loans
4. On the basis of the broad management framework stated above, the
banks should have the following credit risk measurement and monitoring
procedures:
5. Banks should establish proactive credit risk management practices like
annual / half yearly industry studies and individual obligor reviews,
periodic credit calls that are documented, periodic visits of plant and
29
business site, and at least quarterly management reviews of troubled
exposures/weak credits
Credit Risk Models
A credit risk model seeks to determine, directly or indirectly, the answer to
the following question: Given our past experience and our assumptions about the
future, what is the present value of a given loan or fixed income security? A credit
risk model would also seek to determine the (quantifiable) risk that the promised
cash flows will not be forthcoming. The techniques for measuring credit risk that
have evolved over the last twenty years are prompted by these questions and
dynamic changes in the loan market.
The increasing importance of credit risk modeling should be seen as the
consequence of the following three factors:
1. Banks are becoming increasingly quantitative in their treatment of credit
risk.
2. New markets are emerging in credit derivatives and the marketability of
existing loans is increasing through securitization/ loan sales market."
3. Regulators are concerned to improve the current system of bank capital
requirements especially as it relates to credit risk.
Importance of Credit Risk Models
Credit Risk Models have assumed importance because they provide the
decision maker with insight or knowledge that would not otherwise be readily
available or that could be marshalled at prohibitive cost. In a marketplace where
margins are fast disappearing and the pressure to lower pricing is unrelenting,
30
models give their users a competitive edge. The credit risk models are intended
to aid banks in quantifying, aggregating and managing risk across geographical
and product lines. The outputs of these models also play increasingly important
roles in banks' risk management and performance measurement processes,
customer profitability analysis, risk-based pricing, active portfolio management
and capital structure decisions. Credit risk modeling may result in better internal
risk management and may have the potential to be used in the supervisory
oversight of banking organizations.
RBI Guidelines on Credit Risk New Capital Accord:
Implications for Credit Risk Management
The Basel Committee on Banking Supervision had released in June 1999
the first Consultative Paper on a New Capital Adequacy Framework with the
intention of replacing the current broad-brush 1988 Accord. The Basel
Committee has released a Second Consultative Document in January 2001,
which contains refined proposals for the three pillars of the New Accord -
Minimum Capital Requirements, Supervisory Review and Market Discipline.
The Committee proposes two approaches, for estimating regulatory
capital. viz.,
1. Standardized and
2. Internal Rating Based (IRB)
Under the standardized approach, the Committee desires neither to
produce a net increase nor a net decrease, on an average, in minimum
31
regulatory capital, even after accounting for operational risk. Under the Internal
Rating Based (IRB) approach, the Committee's ultimate goals are to ensure that
the overall level of regulatory capital is sufficient to address the underlying credit
risks and also provides capital incentives relative to the standardized approach,
i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB
approach) and 90% of the capital requirement under foundation approach for
advanced IRB approach to encourage banks to adopt IRB approach for providing
capital.
The minimum capital adequacy ratio would continue to be 8% of the risk-
weighted assets, which cover capital requirements for market (trading book),
credit and operational risks. For credit risk, the range of options to estimate
capital extends to include a standardized, a foundation IRB and an advanced IRB
approaches.
RBI Guidelines for Credit Risk Management Credit Rating
Framework
A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations
associated with a simplistic and broad classification of loans/exposures into a
"good" or a "bad" category. The CRF deploys a number/ alphabet/ symbol as a
primary summary indicator of risks associated with a credit exposure. Such a
rating framework is the basic module for developing a credit risk management
system and all advanced models/approaches are based on this structure. In spite
of the advancement in risk management techniques, CRF is continued to be
used to a great extent. These frameworks have been primarily driven by a need
to standardize and uniformly communicate the "judgment" in credit selection
procedures and are not a substitute to the vast lending experience accumulated
by the banks' professional staff.
Broadly, CRF can be used for the following purposes:
32
1. Individual credit selection, wherein either a borrower or a particular
exposure/ facility is rated on the CRF
2. Pricing (credit spread) and specific features of the loan facility. This would
largely constitute transaction-level analysis.
3. Portfolio-level analysis.
4. Surveillance, monitoring and internal MIS
Assessing the aggregate risk profile of bank/ lender. These would be relevant for
portfolio-level analysis. For instance, the spread of credit exposures across
various CRF categories, the mean and the standard deviation of losses occurring
in each CRF category and the overall migration of exposures would highlight the
aggregated credit-risk for the entire portfolio of the bank.
OPERATIONAL RISK
What is Operational Risk?
Operational risk is the risk associated with
operating a business. Operational risk covers such a wide area that it is useful to
subdivide operational risk into two components:
Operational failure risk.
Operational strategic risk.
Operational failure risk arises from the potential for failure in the course
of operating the business. A firm uses people, processes and technology to
achieve the business plans, and any one of these factors may experience a
failure of some kind. Accordingly, operational failure risk can be defined as the
risk that there will be a failure of people, processes or technology within the
33
business unit. A portion of failure may be anticipated, and these risks should be
built into the business plan. But it is unanticipated, and therefore uncertain,
failures that give rise to key operational risks. These failures can be expected to
occur periodically, although both their impact and their frequency may be
uncertain.
The impact or severity of a financial loss can be divided into two
categories:
An expected amount
An unexpected amount.
The latter is itself subdivided into two classes: an amount classed as severe, and
a catastrophic amount. The firm should provide for the losses that arise from the
expected component of these failures by charging expected revenues with a
sufficient amount of reserves. In addition, the firm should set aside sufficient
economic capital to cover the unexpected component, or resort to insurance.
Operational strategic risk arises from environmental factors, such as a new
competitor that changes the business paradigram, a major political and
regulatory regime change, and earthquakes and other such factors that are
outside the control of the firm. It also arises from major new strategic initiatives,
such as developing a new line of business or re-engineering an existing business
line. All business rely on people, processes and technology outside their
business unit, and the potential for failure exists there too, this type of risk is
referred to as external dependency risk.
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Figure: Two Broad Categories of Operational Risk
Operational RiskOperational failure risk (Internal operational risk)
The risk encountered in pursuit of a particular strategy due to:
People Process Technology
Operational strategic risk (External operational risk)
The risk of choosing an inappropriate strategy in response to environmental factor, such as
Political Taxation Regulation Government Societal Competition, etc.
The figure above summarizes the relationship between operational failure risk
and operational strategic risk. These two principal categories of risk are also
sometimes defined as “internal” and “ external” operational risk.
Operational risk is often thought to be limited to losses that can occur in
operating or processing centers. This type of operational risk, sometimes referred
as operations risk, is an important component, but it by no means covers all of
the operational risks facing the firm. Our definition of operational risk as the risk
associated with operating the business means significant amounts of operational
risk are also generated outside the processing centers.
Risk begins to accumulate even before the design of the potential
transaction gets underway. It is present during negotiations with the client
(regardless of whether the negotiation is a lengthy structuring exercise or a
routine electronic negotiation.) and continues after the negotiation as the
transaction is serviced.
A complete picture of operational risk can only be obtained if the bank’s
activity is analyzed from beginning to end. Several things have to be in place
before a transaction is negotiated, and each exposes the firm to operational risk.
The activity carried on behalf of the client by the staff can expose the institution
35
to “people risk”. “People risk” are not only in the form of risk found early in a
transaction. But they further rely on using sophisticated financial models to price
the transaction. This creates what is called as Model risk which can arise
because of wrong parameters like input to the model, or because the model is
used inappropriately and so on.
Once the transaction is negotiated and a ticket is written, errors can occur
as the transaction is recorded in various systems or reports. An error here may
result in the delayed settlement of the transaction, which in turn can give rise to
fines and other penalties. Further an error in market risk and credit risk report
might lead to the exposures generated by the deal being understated. In turn this
can lead to the execution of additional transactions that would otherwise not have
been executed. These are examples of what is often called as “process risk”
The system that records the transaction may not be capable of handling
the transaction or it may not have the capacity to handle such transactions. If any
one of the step is out-sourced, then external dependency risk also arises.
However, each type of risk can be captured either as people, processes,
technology, or an external dependency risk, and each can be analyzed in terms
of capacity, capability or availability
Who Should Manage Operational Risk?
The responsibility for setting policies concerning operational risk remains
with the senior management, even though the development of those policies may
be delegated, and submitted to the board of directors for approval. Appropriate
policies must be put in place to limit the amount of operational risk that is
assumed by an institution. Senior management needs to give authority to change
the operational risk profile to those who are the best able to take action. They
must also ensure that a methodology for the timely and effective monitoring of
36
the risks that are incurred is in place. To avoid any conflict of interest, no single
group within the bank should be responsible for simultaneously setting policies,
taking action and monitoring risk.
Policy Setting
The authority to take action generally rests with business management,
which is responsible for controlling the amount of operational risk taken within
each business line. The infrastructure and the governance groups share with
business management the responsibility for managing operational risk.
The responsibility for the development of a methodology for measuring
and monitoring operational risks resides most naturally with group risk
management functions. The risk management function also needs to ensure the
proper operational risk/ reward analysis is performed in the review of existing
businesses and before the introduction of new initiatives and products. In this
regard, the risk management function works very closely with, but independent
from, business management, infrastructure, and other governance group
Senior management needs to know whether the responsibilities it has
delegated are actually being tended to, and whether the resulting processes are
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Internal Audit
Senior Management
Business Management Risk Management
Legal
Operations
Information Technology
Finance
Insurance
effective. The internal audit function within the bank is charged with this
responsibility.
Key to Implementing Bank-wide Operational Risk Management:
The eight key elements are necessary to successfully implement a bank-
wide operational risk management framework. They involve setting policy and
identifying risk as an outgrowth of having designed a common language,
constructing business process maps, building a best measurement methodology,
providing exposure management, installing a timely reporting capability,
performing risk analysis inclusive of stress testing, and allocating economic
capital as a function of operational risk.
EIGHT KEY ELEMENTS TO ACHIEVE BEST OPERATIONAL RISK
MANAGEMENT.
38
1. Policy
Best Practice
2.Risk Identification
3. Business Process
4. Measuring Methodology
8. Economic Capital
7. Risk Analysis
6. Reporting
5. Exposure Management
1. Develop well-defined operational risk policies. This includes explicitly
articulating the desired standards for the risk measurement. One also needs
to establish clear guidelines for practices that may contribute to a reduction of
operational risk.
2. Establish a common language of risk identification. For e.g., the term “people
risk” includes a failure to deploy skilled staff. “Technology risk” would include
system failure, and so on.
3. Develop business process maps of each business. For e.g., one should
create an “operational risk catalogue” which categories and defines the
various operational risks arising from each organizational unit in terms of
people, process, and technology risk. This catalogue should be tool to help
with operational risk identification and assessment.
Types of Operational Failure Risk
1. People Risk 1. Incompetancy.
2. Fraud.
2. Process Risk
Model Risk
TR
OCR
1. Model/ methodology error
2. Mark-to-model error.
1. Execution error.
2. Product complexity.
3. Booking error.
4. Settlement error.
1. Exceeding limits.
2. Security risk.
39
3.Volume risk.
3. Technology Risk 1. System failure.
2. Programming error.
3. Information risk.
4. Telecommunications failure.
4. Develop a comprehensible set of operational risk metrics. Operational risk
assessment is a complex process. It needs to be performed on a firm-wide
basis at regular intervals using standard metrics. In early days, business and
infrastructure groups performed their own assessment of operational risk.
Today, self-assessment has been discredited. Sophisticated financial
institutions are trying to develop objective measures of operational risk that
build significantly more reliability into the quantification of operational risk.
5. Decide how to manage operational risk exposure and take appriate action to
hedge the risks. The bank should address the economic question of th cost-
benefit of insuring a given risk for those operational risks that can be insured.
6. Decide how to report exposure.
7. Develop tools for risk analysis, and procedures for when these tools should
deploped. For e.g., risk analysis is typically performed as part of a new
product process, periodic business reviews, and so on. Stress testing should
be a standard part of risk analysis process. The frequency of risk assessment
should be a function of the degree to which operational risks are expected to
change over time as businesses undertake new initiatives, or as business
circumstances evolve. This frequency might be reviewed as operational risk
measurement is rolled out across the bank a bank should update its risk
assessment more frequently. Further one should reassess whenever the
operational risk profile changes significantly.
8. Develop techniques to translate the calculation of operational risk into a
required amount of economic capital. Tools and procedures should be
40
developed to enable businesses to make decisions about operational risk
based on risk/reward analysis.
Four-Step Measurement Process For Operational Risk
Clear guiding principle for the operational risk measurement process
should be set to ensure that it provides an appropriate measure of operational
risk across all business units throughout the bank. This problem of measuring
operational risk can be best achieved by means of a four-step operational risk
process. The following are the four steps involved in the process:
1. Input.
2. Risk assessment framework.
3. Review and validation.
4. Output.
1. Input:
The first step in the operational risk measurement process is to gather the
information needed to perform a complete assessment of all significant
operational risks. A key source of this information is often the finished product of
other groups. For example, a unit that supports the business group often
publishes report or documents that may provide an excellent starting point for the
operational risk assessment.
Sources of Information in the Measurement Process of Operational
Risk :The Inputs (for Assessment)
Likelihood of Occurrence Severity
Audit report Management interviews
Regulatory report Loss history
Management report
Expert opinion
41
Business Recovery Plan
Business plans
Budget plans
Operations plans
For example, if one is relying on audit documents as an indication of the
degree of control, then one needs to ask if the audit assessment is current and
sufficient. Have there been any significant changes made since the last audit
assessment? Did the audit scope include the area of operational risk that is of
concern to the present risk assessment? As one diligently works through
available information, gaps often become apparent. These gaps in the
information often need to be filled through discussion with the relevant managers.
Typically, there are not sufficient reliable historical data available to
confidently project the likelihood or severity of operational losses. One often
needs to rely on the expertise of business management, until reliable data are
compiled to offer an assessment of the severity of the operational failure for each
of the risks. The time frame employed for all aspects of the assessment process
is typically one year. The one-year time horizon is usually selected to align with
the business planning cycle of the bank.
2. Risk Assessment Framework
The input information gathered in the above step needs to be analyzed
and processed through the risk assessment framework. Risk assessment
framework includes:
1. Risk categories:
The operational risk can be broken down into four headline risk categories
like the risk of unexpected loss due to operational failure in people, process
and technology deployed within the business
42
Internal dependencies should each be reviewed according to a set of factors.
We examine these 9nternal dependencies according to three key
components of capability, capacity and availability.
External dependencies can also be analyzed in terms of the specific type of
external interaction.
2. Connectivity and interdependencies
The headline risk categories cannot be viewed in isolation from one another.
One needs to examine the degree of interconnected risk exposures that cut
across the headline operational risk categories, in order to understand the full
impact of risk.
3. Change, complexity, compliancy:
One may view the sources that drive the headline risk categories as falling
under the broad categories of “Change” refers to such items as introducing
new technology or new products, a merger or acquisition, or moving from
internal supply to outsourcing, etc. “Complexity’ refers to such items as
complexity of products, process or technology. “ Complacency” refer to
ineffective management of the business.
4. Net likelihood assessment
The likelihood that an operational failure might occur within the next year
should be assessed, net of risk mitigants such as insurance, for each
identified risk exposure and for each of the four headline risk categories.
Since it is often unclear how to quantify risk, this assessment can be rated
along five point likelihood continuum from very low, low, medium, high and
very high.
5. Severity assessment
Severity describes the potential loss to the bank given that an operational
risk failure has occurred. It should be assessed for each identified risk
exposure.
43
6. Combined likelihood and severity into the overall Operational
Risk Assessment
Operational risk measures are constrained in that there is not usually a
defensible way to combine the individual likelihood of loss and severity
assessments into overall measure of operational risk within a business unit.
To do so, the likelihood of loss would need to be expressed in numerical
terms. This cannot be accomplished without statistically significant historical
data on operational losses.
7. Defining Cause and Effect:
Loss data are easier to collect than data associated with the cause of loss.
This complicates the measurement of operational risk because each loss is
likely to have several causes. This relationship between these causes, and
the relative importance of each, can be difficult to assess in an objective
fashion.
3. Review and validation:
Once the report is generated. First the centralised operational risk
management group (ORMG) reviews the assessment results with senior
business unit management and key officers, in order to finalize the proposed
operational risk rating. Second, one may want an operational risk rating
committee to review the assessment – a validation process similar to that
followed by credit rating agencies. This takes the form of review of the individual
risk assessments by knowledgeable senior committee personnel to ensure that
the framework has been consistently applied across businesses, that there has
been sufficient scrutiny to remove any imperfections, and so on. The committee
should have representation from business management, audit, and functional
areas, and be chaired by risk management unit.
4. Output
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The final assessment of operational risk will be formally reported to
business management, the centralised risk-adjusted return on capital (RAROC)
group, and the partners in corporate governance such as internal audit and
compliance. The output of the assessment process has two main uses:
1. The assessment provides better operational risk information to
management for use in improving risk management decisions.
2. The assessment improves the allocation of economic capital to better
reflect the extent of the operational riskier, being taken by a business unit.
3. The over all assessment of the likelihood of operational risk & severity of
loss for a business unit can be shown as:
Mgmt. Attention
Severity of Loss ($)
A business unit may address its operational risks in several ways. First, one can
invest in business unit. Second, one can avoid the risk by withdrawing from
business activity. Third, one can accept and manage risk through effective
monitoring and control. Fourth, one can transfer risk to another party. Of course,
not all-operational risks are insurable, and in that case of those that are insurable
the required premium may be prohibitive. The strategy and eventually the
decision should be based on cost benefit analysis.
45
Medium Risk
High Risk
Medium Risk
Low Risk
An Idealized Bank Of The Future
The efficient bank of the future will be driven by a single analytical risk
engine that draws its data from a single logical data repository. This engine will
power front-, middle-, and back-office functions, and supply information about
enterprise-wide risk. The ability to control and manage risk will be finely tuned to
meet specific business objectives. For example, far fewer significantly large
losses, beyond a clearly articulate tolerance for loss, will be incurred and the
return to risk profile will be vastly improved.
With the appropriate technology in place, financial trading across all asset
classes will move from the current vertical, product-oriented environment (e.g.,
swaps, foreign exchange, equities, loans, etc.) to a horizontal, customer-oriented
environment in which complex combinations of asset types will be traded.
46
There will be less need for desks that specialize in single product lines.
The focus will shift to customer needs rather than instrument types. The
management of limits will be based on capital, set in such a manner so as to
maximize the risk-adjusted return on capital for the firm.
The firm’s exposure will be known and disseminated in real time.
Evaluating the risk of a specific deal will take into account its effect on the firm’s
total risk exposure, rather than simply the exposure of the individual deal.
Banks that dominate this technology will gain a tremendous competitive
advantage. Their information technology and trading infrastructure will be
cheaper than today’s by orders of magnitude. Conversely, banks that attempt to
build this infrastructure in-house will become trapped in a quagmire of large,
expensive IT departments-and poorly supported software.
The successful banks will require far fewer risk systems. Most of which will
be based on a combination of industry standard, reusable, robust risk software
and highly sophisticated proprietary analytics. More importantly, they will be free
to focus on their core business and offer products more directly suited to their
customers’ desired return to risk profiles.
Study of Operational Risk at Punjab National Bank
About Punjab National Bank
Established in 1895 at Lahore, undivided India, Punjab National Bank
(PNB) has the distinction of being the first Indian bank to have been started
solely with Indian capital.The bank was nationalised in July 1969 along with 13
other banks. From its modest beginning, the bank has grown in size and stature
to become a front-line banking institution in India at present. It is a professionally
managed bank with a successful track record of over 110 years.
It has the largest branch network in India - 4525 Offices including 432
Extension Counters spread throughout the country. With its presence virtually in
47
all the important centres of the country, Punjab National Bank offers a wide
variety of banking services which include corporate and personal banking,
industrial finance, agricultural finance, financing of trade and international
banking. Among the clients of the Bank are Indian conglomerates, medium and
small industrial units, exporters, non-resident Indians and multinational
companies. The large presence and vast resource base have helped the Bank to
build strong links with trade and industry.
Operational Risk
Punjab National Bank is exposed to many types of operational risk. Operational
risk can result from a variety of factors, including:
1. Failure to obtain proper internal authorizations,
2. Improperly documented transactions,
3. Failure of operational and information security procedures,
4. Computer systems,
5. Software or equipment,
6. Fraud,
7. Inadequate training and employee errors.
PNB attempts to mitigate operational risk by maintaining a comprehensive
system of internal controls, establishing systems and procedures to monitor
transactions, maintaining key back–up procedures and undertaking regular
contingency planning.
I. Operational Controls and Procedures in Branches
PNB has operating manuals detailing the procedures for the processing of
various banking transactions and the operation of the application software.
Amendments to these manuals are implemented through circulars sent to all
offices.
48
When taking a deposit from a new customer, PNB requires the new customer to
complete a relationship form, which details the terms and conditions for providing
various banking services.
Photographs of customers are also obtained for PNB’s records, and specimen
signatures are scanned and stored in the system for online verification. PNB
enters into a relationship with a customer only after the customer is properly
introduced to PNB. When time deposits become due for repayment, the deposit
is paid to the depositor. System generated reminders are sent to depositors
before the due date for repayment. Where the depositor does not apply for
repayment on the due date, the amount is transferred to an overdue deposits
account for follow up.
PNB has a scheme of delegation of financial powers that sets out the monetary
limit for each employee with respect to the processing of transactions in a
customer's account. Withdrawals from customer accounts are controlled by dual
authorization. Senior officers have delegated power to authorize larger
withdrawals. PNB’s operating system validates the check number and balance
before permitting withdrawals. PNB’s banking software has multiple security
features to protect the integrity of applications and data.
PNB gives importance to computer security and has s a comprehensive
information technology security policy. Most of the information technology assets
including critical servers are hosted in centralized data centers, which are subject
to appropriate physical and logical access controls.
II. Operational Controls and Procedures for Internet Banking
In order to open an Internet banking account, the customer must provide PNB
with documentation to prove the customer's identity, including a copy of the
customer's passport, a photograph and specimen signature of the customer.
49
After verification of the same, PNB opens the Internet banking account and
issues the customer a user ID and password to access his account online.
III. Operational Controls and Procedures in Regional
Processing Centers & Central Processing Centers
To improve customer service at PNB’s physical locations, PNB handles
transaction processing centrally by taking away such operations from branches.
PNB has centralized operations at regional processing centers located at 15
cities in the country. These regional processing centers process clearing checks
and inter-branch transactions, make inter-city check collections, and engage in
back office activities for account opening, standing instructions and auto-renewal
of deposits.
PNB has centralized transaction processing on a nationwide basis for
transactions like the issue of ATM cards and PIN mailers, reconciliation of ATM
transactions, monitoring of ATM functioning, issue of passwords to Internet
banking customers, depositing post-dated cheques received from retail loan
customers and credit card transaction processing. Centralized processing has
been extended to the issuance of personalized check books, back office activities
of non-resident Indian accounts, opening of new bank accounts for customers
who seek web broking services and recovery of service charges for accounts for
holding shares in book-entry form.
IV. Operational Controls and Procedures in Treasury
PNB has a high level of automation in trading operations. PNB uses technology
to monitor risk limits and exposures. PNB’s front office, back office and
accounting and reconciliation functions are fully segregated in both the domestic
treasury and foreign exchange treasury. The respective middle offices use
various risk monitoring tools such as counterparty limits, position limits, exposure
limits and individual dealer limits. Procedures for reporting breaches in
limits are also in place.
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PNB’s front office treasury operation for rupee transactions consists of operations
in fixed income securities, equity securities and inter-bank money markets.
PNB’s dealers analyze the market conditions and take views on price
movements. Thereafter, they strike deals in conformity with various limits relating
to counterparties, securities and brokers. The deals are then forwarded to the
back office for settlement.
The inter-bank foreign exchange treasury operations are conducted through
Reuters dealing systems. Brokered deals are concluded through voice systems.
Deals done through Reuters systems are captured on a real time basis for
processing. Deals carried out through voice systems are input in the system by
the dealers for processing. The entire process from deal origination to settlement
and accounting takes place via straight through processing. The processing
ensures adequate checks at critical stages. Trade strategies are discussed
frequently and decisions are taken based on market forecasts, information and
liquidity considerations. Trading operations are conducted in conformity with the
code of conduct prescribed by internal and regulatory guidelines.
The Treasury Middle Office Group, monitors counterparty limits, evaluates the
mark-to-market impact on various positions taken by dealers and monitors
market risk exposure of the investment portfolio and adherence to various market
risk limits set up by the Risk, Compliance and Audit Group.
PNB’s back office undertakes the settlement of funds and securities. The back
office has procedures and controls for minimizing operational risks, including
procedures with respect to deal confirmations with counterparties, verifying the
authenticity of counterparty checks and securities, ensuring receipt of contract
notes from brokers, monitoring receipt of interest and principal amounts on due
dates, ensuring transfer of title in the case of purchases of securities, reconciling
actual security holdings with the holdings pursuant to the records and reports any
irregularity or shortcoming observed.
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V. Audit
The Internal Audit Group undertakes a comprehensive audit of all business
groups and other functions, in accordance with a risk-based audit plan. This plan
allocates audit resources based on an assessment of the operational risks in the
various businesses. The Internal Audit group conceptualizes and implements
improved systems of internal controls, to minimize operational risk. The audit
plan for every fiscal year is approved by the Audit Committee of PNB’s board of
directors. The Internal Audit group also has a dedicated team responsible for
information technology security audits. Various components of information
technology from applications to databases, networks and operating systems are
covered under the annual audit plan.
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