*RISK MANAGEMENTRisk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.

*RISK MANAGEMENTTypes of Risk

OperationalMarketCredit

*OPERATIONAL RISKThe risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This includes legal risk but excludes strategic & reputational risk.

*RISK MANAGEMENTInternal Fraud.

Unauthorized Activity.Transactions not reported.Transaction type unauthorized.Mismarking of position.Theft and Fraud.Fraud/credit fraud/worthless deposits.Theft/extortion/embezzlement/robbery.Misappropriation of assets.Account take-over/impersonation.Bribes/kickbacks.Money laundering.Willful blindness.

OPERATIONAL RISK

*OPERATIONAL RISK2.External Fraud.Theft and Fraud.Theft / Robbery.Forgery.Check kiting.Elder financial abuse.Systems Security.Hacking damage.Theft of information (with monetary loss).

*OPERATIONAL RISK3.Employment Practices and Workplace Safety :Employee Relations.Compensation, benefit, termination issues.Organized labor issues.Safe Environment.General liability Employee health and safety rules. Workers compensation.Diversity and Discrimination.All discrimination types.Harassment.Equal Employment Opportunity (EEO).

*OPERATIONAL RISK4.Clients, Products and Business Practices :Suitability, Disclosure and Fiduciary.Fiduciary breaches/guideline violations.Suitability/disclosure issues.Retail consumer disclosure violations.Breach of privacy/Lender liability.Inadequate product offerings.Misuse of confidential information.Improper Business or Market Practices .Improper trade /market practice.Market manipulation.Insider trading (on firms account).Unlicensed activity/Money laundering.

*OPERATIONAL RISK4.Clients, Products and Business Practices (CONTINUED).Selection, Sponsorship and Exposure.Failure to investigate client as per guidelines.Exceeding client exposure limits.Advisory Activities.Disputes over performance or advisory activities.

*OPERATIONAL RISK 5. Damage to Physical Assets :Disasters and Other Events.Natural disaster losses.Human losses from external sources (terrorism, vandalism).

6.Business Disruption and System FailuresSystems.Hardware.Software.Telecommunications.Utility outage/disruptions.

*OPERATIONAL RISK

Transaction Capture, Execution and Maintenance.Miscommunication/Delivery FailureData entry, maintenance or loading errors.Missed deadline or responsibility.Accounting errorRecord retention.Documentation maintenance.Collateral management failure.Reference data maintenance. contd.

7. Execution, Delivery and Process Management.

*OPERATIONAL RISKMonitoring and Reporting. Failed mandatory reporting obligations.Inaccurate external loss (loss incurred).Customer Intake and Documentation.Unapproved access given to accounts.Incorrect client records (loss incurred).Negligent loss or damage of client assets.Trade Counterparties.Non-client counterparty misperformance.Vendors and Suppliers.Outsourcing.Vendor disputes.

*OPERATIONAL RISKSTEPS TO BE TAKEN BY BANKS :To minimize operational risk & strengthen internal control, the objective of the Bank is to develop an appropriate policy, procedures, strategy, framework, and risk culture by adopting best practices to achieve the goal set by the Bank. To find out the extent of Banks Operational Risk exposure and to allocate capital for operational risk.

*OPERATIONAL RISK The New Capital Adequacy Framework outlines three methods for calculating operational risk capital charges for increasing sophistication and risk sensitivity:

(i) the Basic Indicator Approach (BIA) - Under this Approach, banks must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (presently 15% by BCBS) of positive annual gross income (Net interest + Net non-interest income).

*OPERATIONAL RISK(ii) The Standardised Approach (TSA) : Banking activities have been mapped into 8 business lines: (on average gross income of last 3 yrs)1.Corporate finance 2. Trading & Sales 3. Retail Banking 4. Commercial Banking 5. Asset Management 6. Retail brokerage 7. Agency service 8. Payment settlement . ( w.e.f. 30.09.2010)

*OPERATIONAL RISK(iii) Advanced Measurement Approaches (AMA) Basel II - Banks can use this approach only subject to approval from their local regulators :Its board of directors and senior management, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources for use of approach in major business lines, control & audit areas. (Implemented by 31.03.2014)

*OPERATIONAL RISK

Employee training.Close management vigil.Segregation of duties.Employee background checks.Procedures and process.Purchase of insurance.Exit from certain businesses.Capitalization of risks.

Operational Risk Checklist :

*MARKET RISKMarket risk is, risk of losses in on-balance sheet and off balance-sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are :

*MARKET RISKThe risks pertaining to interest rate related instruments and equities in the trading book

Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading*books). [*Investment/securities]

*MARKET RISKRBI GUIDELINES :

Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day.

*MARKET RISKMEASURES :Prudential gap limits are fixed and reviewed periodically for the liquidity and interest rate risk of the banks books.The ALM solution would encompass the Global operations of the bank.Behavioral studies shall continue to be done for assessing and apportioning volatile and non-volatile portion of various non-maturity products of both assets and liabilities.

*MARKET RISK4.Minimum capital requirement be calculated separately for (i) Specific Risk - charge for each security to protect against an adverse movement in the price of an individual security (Capital charge for Capital Market Investments will be higher of 11.25% and Security Receipts 13.5% or 125% & 150% of Risk Wieght) (ii)General Market Risk - charge towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives) in different securities or instruments can be offset.(Starting 2.5% extra for HFT(Held for Trading)/AFS(Available for sale) not now.

*MARKET RISKThe banks Foreign Exchange Risk position in each currency should be calculated by summing : net spot position, net forward position, Guarantees, Net future income/ expenses (capital charge for foreign exchange risk and gold open position presently is 9 per cent).6.Duration gap analysis (measure the percentage change in the economic value of a position) continue to be carried out at Monthly (since April 2012 earlier Qtly) intervals to assess the interest rate risk of both banking book and trading book.

*MARKET RISKForeign Exchange risk be regularly monitored and managed through exposure limits i.e. Day Light Limit, Overnight Limit, Stop Loss limits, Inter Bank Exposure Limits etc. Maturity Position and Interest Sensitivity of Forex Open positions are assessed on monthly basis and put up to ALCO. Bank may enter into Interest Rate Swaps (IRS) & Forward Rate Agreement (FRA) selectively with the objective of hedging actual balance sheet exposures and to meet the requirements of corporate clients.

*MARKET RISK10.VaR (Value-at-risk) a measure of the worst expected loss over a given time interval under normal market conditions at a given confidence level shall be computed on the trading book of the Investment Portfolio on daily basis 11.Earnings at risk (EAR) measure the quantity by which net income might change in the event of an adverse change in interest rates.VAR looks at the change in the entire value over the forecast horizon, EAR looks at potential changes in cash flows or earnings.

*MARKET RISK12.RBI said : Banks should identify their major sources of risk and carry out stress tests appropriate to them, may be run daily or weekly, monthly or at quarterly intervals. This stress testing would also form a part of preparedness for Pillar 2 of the Basel II framework.It is another modern risk management practice which has found wide acceptability in Indian Banking System, for determining the required buffer size of capital is an important risk management issue for banks

*CREDIT RISKCredit Risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter-parties. In a banks portfolio, losses stem from: Outright default due to inability or unwillingness of a customer or counter-party to meet commitments in relation to lending, trading, settlement and other financial transactions.Reduction in portfolio value arising from actual or perceived deterioration in credit quality.

*CREDIT RISKCredit risk incorporates following three risks: -Counterparty Risk: Risk to each party of a contract that other party (or parties) will not live up to their obligations under the contract. In most financial contracts, counterparty risk is default risk i.e. failure to make payments because of bankruptcy. To reduce the potential of counterparty risk, margin is taken in the accounts.Credit Spread Risk: It arises due to changes in the credit quality of the obligor between a rating horizon. Example - If credit quality of a borrower deteriorates after last rating but before next rating becomes due, in that case bank is not compensated for taking additional risk if loan price is not revised. However, if the borrowers credit quality improves between a rating horizon, it is beneficial for the bank.

*CREDIT RISKConcentration Risk: Refers to additional portfolio risk by increased exposure to one obligor or groups of correlated obligors (e.g., by industry, by location, etc.). It includes:Significant exposures to an individual counterparty or group of related counterparties;Credit exposures to counterparties in the same economic sector or geographic region; Credit exposures to counterparties whose financial performance is dependent on the same activity or commodity; andIndirect credit exposures arising from a banks Credit Risk Mitigation (CRM) activities (e.g. exposure to a single collateral type or to credit protection provided by a single counterparty).

*CREDIT RISK MANAGEMENTCredit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at the level of individual borrower as well as for Bank as a whole. The quality of the credit risk management function is one of the key drivers of the level of shareholders return. Industry analysis has demonstrated that the average shareholder return of the best credit performance US banks during 1989 1997 was 56% higher than their peers.*** *** (Source: Guidance note on Credit Risk Management by RBI, dated 20.09.2001)

Expected LossThe Expected Loss (in absolute terms) EL = PD * EAD * LGDIf expressed in percentage terms of the EAD EL = PD * LGD.The bank should incorporate an expected loss rate in the estimation of the total spread to be charged on the loan. Expected Loss is the banks cost of doing business. Expected loss is not a measure of risk as it is anticipated.

Probability of Default (PD)Loss given Default (LGD)Exposure at Default (EAD)

Unexpected Loss (UL):Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.Mathematically, Unexpected Loss is the standard deviation of the change in the asset value at the end of the horizon. This implies that unexpected loss is the estimated volatility of potential loss in portfolio value around the expected loss.

*Credit Management Vs Credit Risk Management

Credit ManagementCredit Risk ManagementIt involves selecting and identifying the borrower/ counter-party.It involves identifying and analyzing risk in a credit transaction.It revolves around examining three Ps of borrowers:People, Purpose & ProtectionIt revolves around measuring, managing and controlling credit risk in the context of an organization's credit philosophy and credit appetite. It is predominantly based on accounting information and Judgment and is subjective in nature.It is data driven, scientific and is more objective in nature.

*Tools for Credit Risk AssessmentThe credit risk rating system and credit scoring system provides a common language and uniform framework across bank for assessing credit risk. The system enables the bank to evaluate and track risk on individual borrowers on a continuing basis.

Risk Rating models are mostly based on the financials of the borrowers whereas credit scoring models are based on the personal attributes of an individual.

*Advantages of Credit Rating or Credit ScoringCredit Selection/RejectionEvaluation of borrower in totality and of any particular exposure /facilityTransaction level analysis and credit pricing & tenure.Activity wise/Sector wise portfolio study keeping in view the macro-level position.Fixing outer limits for taking up/maintaining an exposure arising out of risk rating.Monitoring exposure already in the books and deciding exit strategies in appropriate cases.

*Allocation of risk capital for credit sanctions.Avoiding over concentration of exposure in specific risk grades, which may not be major concern at a particular point of time, but may in the future pose problems if the concentration continues.Clarity and consistency, together with transparency in rating a particular borrower/exposure, enabling a proper control mechanism to check risks associated in the exposure.Advantages of Credit Rating (Contd)

*Credit Risk Rating SystemIn order to create and stabilize robust credit risk management system, bank has been continuously monitoring the ratings and their migration. To provide a standard definition and benchmarks under the credit risk rating system, seven rating grades for performing loans have been specified.To ensure the quality and consistency of credit risk ratings, vetting of the rating is also done.The credit risk rating of a borrower becomes due for updation after the expiry of 12 months from the month of previous rating. Thus fresh rating in the accounts is conducted annually.Out of the seven rating grades, B and above are treated as Investment Grade. The average annual default rates in these rating grades is under 2%

*

*Approaches to Credit Risk Management under Basel II

*BASEL-II: IRB APPROACHTwo ApproachesIRB Foundation ApproachIRB Advanced Approach

Banks estimated potential future loss Main elementsRisk ComponentRisk WeightMinimum Requirement

*BASEL-II: IRB APPROACH (Contd.)Risk ComponentProbability of Default (PD)Loss given Default (LGD)Exposure at Default (EAD)Maturity (M)Risk Weights: Dependent on PD, LGD, and effective maturity (M).

Minimum Requirements: Credit Rating System for all categories.Track record of using internal ratings for min. 3 yrs.Risk quantification i.e. EAD and LGD covering one economic cycle.Validation of internal estimates.Stress testing process for assessment of capital adequacy.Disclosure requirements.

*Probability of Default (PD)Probability of default measures the likelihood that the borrower will default over a given time-horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year? Calculated for a one-year horizon, this may be called the expected default frequency.Risk Components

*Loss Given Default (LGD)Loss Given Default is the credit loss incurred if an obligor of the bank defaults. LGD = 1 Recovery Ratewhere, Recovery = Present Value of { Cash flows received from borrower after the date of default - Costs incurred by the bank on recovery }

Recovery rate = Recovery (as calculated above)/ Exposure on the date of default

Risk Components

*Exposure at Default (EAD)EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISKRisk Components

*Maturity (M)It measures the remaining economic maturity of the exposure.Determines framework for comparing different exposures.Risk Components

Sheet1

Framework for developing model for Calculation of Capital Charge for OR under AMA

Scenario GenerationInternal Loss DatabaseExternal Loss Database

Scaling

Integration of data BL-wise/Loss type wise

Risk Based Indicator ApproachSelf Assessment Survey

Key Risk IndicatorGenerating Distribution of FrequencyGenerating Distribution of Severity

Analysis of Qualitative adjustment Factor

Capital Charge- By running M.C. Simulation

Capital Charge after adjusting Qualitative factor

Risk Mitigants

Final Capital Charge after adjusting for Qualitative factor & Risk Mitigants

Projects Involved

1Methodology for conducting Scenario & deriving frequency & severity distribution from scenario.

2Scaling of External Data/Internal Data to account for inflation, size effects etc.

3Methodology for estimation of frequency and severity distribution for cells having no data/less data.

4Integration of results from Scenario, Internal & External data.

5Introducing the impact of correlation between different BLs/LTs in capital estimates.

6Introducing the impact of correlation between frequency & severity

7Evolving framework for assessment of qualitative factors like RBIA, SAS, KRI &

methodology for introducing their impact in capital estimate.

8Introducing effect of Risk mitigants on capital charge calculation.

176803818.8854022038.881768720100010013530055.28304108.2817930.6

Book for MLEMathematical statistics by V K Kapoor

Loan Amount

1

2

3

4

5

Sheet2

Loan Amount10000

Rate of Interest10%

Repayment4In 5 Equated annual installment

Installment3,154.71

Period (t)Payment received per period (CFt)t*CFtEconomic Maturity

13,154.713154.71

23,154.716309.42

33,154.719464.12

43,154.7112618.83

12,618.8331547.082.5

1833.330.0801335094

2771.60.1483950316

10399.27

Sheet3

Principal & outstanding balance10000

Opening Date of Loan1/1/13

Contractual date of Maturity of Loan12/31/15

Contractual and Discount Rate of Interest9.00%

Freq. of int. payment per annum1

Tenor/Maturity (Years)3

Time Period in yearsCash flowPresent Value of Cash Flow(A) x (c)

(A)(B)(c)

1900825.69825.69

2900757.511515.02

3109008416.8025250.40

Total ------------------------>10000.0027591.11

Economic Maturity =27591.11= 2.76

10000.00

*Internal Rating Based (IRB) approaches IRB Foundation ApproachUnder the foundation approach, banks, which comply with certain minimum requirements viz. comprehensive credit rating system with capability to quantify Probability of Default (PD) could assign preferential risk weights, with the data on Loss Given Default (LGD) and Exposure at Default (EAD) provided by the national supervisors. Internal Rating Based (IRB) approaches IRB Advanced ApproachBanks need to estimate all three risk inputs i.e PD,EAD, & LGD internally.This will help the bank to calculate the expected and unexpected loss. Based on unexpected loss, capital is allocated.

*Expected Loss (EL)Expected Loss is the banks cost of doing business. Expected Loss has to be provided for. The Expected Loss (in currency amounts) EL = PD * EAD * LGDIf expressed as a percentage figure of the EAD EL = PD * LGD.The bank should also proactively incorporate an expected loss rate in the estimation of the total spread to be charged on the loan. Expected loss is not a measure of risk as it is anticipated.

*Unexpected Loss (UL)Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.

*BASEL-II: IRB APPROACH (Contd.)IRB Foundation Approach Banks need to provide own assessment of PD whereas estimates of EAD and LGD will be provided by supervisor.

IRB Advanced ApproachBanks need to estimate all three risk inputs i.e PD,EAD, & LGD internally.

*Foundation IRB Vs Advanced IRB Approach

Foundation IRB ApproachAdvanced IRB ApproachValues for Loss Given Default (LGD) and exposure at default (EAD) are provided by the regulatory authority.Values for Loss Given Default (LGD) and exposure at default (EAD) are determined by each bank through internal modeling with a data of 5-7 years.Assessment of values of credit mitigants is done by the regulatory authority.Banks may assess the value of its credit mitigants.For retail exposure, there is no foundation IRB (only advanced IRB where besides PD, the bank concerned will have to estimate LGD & EAD.)Advanced IRB is applicable to retail exposure also.

**All eligible credit exposures beyond a threshold limit are individually risk rated through internal credit risk rating models. Default Rates for large corporate model generated for last six years. The default rates are satisfactory and comparable with international standards. Migration of ratings analysed since last five years.Implementing Foundation IRB approach in PNB

*Gaps in the existing systems for adoption of advanced IRB approach are being identified.Data collection for estimation of LGD started and model is being prepared for computation of the same. Data requirements as well as application tools for Risk Management finalized and shall be implemented alongwith the data warehouse project. Establishment of Enterprise wide Data Warehouse and application tools for Credit Risk, Operational Risk, Market Risk, ALM and FTP (Fund Transfer Price) are under process. Implementing Advanced IRB approach

*

*Benefits and drivers of Credit Risk ManagementHelps in establishing a system for measuring, monitoring and managing risk scientifically.Introduction of rating framework for improved selection of clients according to their risk profileImproved pricing of productsReduces Concentration riskOptimized allocation of economic capitalSupports portfolio optimization (Minimising ratio of risk to return)Assuming that we have capital of Rs. 13.50 with a option of lending to BB rated assets or AAA rated assets *

The position works out as under:

ParticularsBBAAAMaximum Exposure100750Total Interest Income @11% for BB & 9.75% for AAA11.0073.10Cost:Cost of Funds (assumed) 4.5%4.5033.75Cost of Operations (Estimated)1.002.00Risk Premium (assuming 1% EL for BB and 0.1% for AAA)1.000.75Capital Charge @10% 1.351.35Total Cost7.8537.10Return on Capital3.1536.00It can be inferred from the above that lending to AAA assets at 9.75% would be more remunerative vis--vis lending to BB at 11%.Our natural choice for selection of borrowers would shift from BB & upwards under Basel I to AAA & downwards under Basel II (SA).In case sufficient number of AAA assets are not available at lease our order of preference would be AA, A and then BB.

Inherent Risk in Different ActivitiesManufacturingTradingLendingUnlimited Up SideLimited Up SideVery Limited Up SideUnlimited Down SideLimited Down SideUnlimited Down Side

What is Credit Risk Rating? Credit risk rating is a rating assigned to borrowers, based on detailed analysis of their ability and willingness to repay the debt taken from the bank. Credit risk ratings help a bank to assign a probability of default for borrower according to its risk category. The probability of default increases in an exponential manner as the credit risk rating deteriorates.

BENEFITS OF CREDIT RISK ASSESSMENTIt is an important tool for taking credit decisions, i.e. whether to lend to a Borrower or not.Assessing Banks Risk Bearing Capacity.Quantification of Estimated Loan Loss.Better ProvisioningRisk based Pricing (ROI) of Loans. Product Mix (switching one facility to another).Level (Authority) of decision Making.Frequency of Renewal / Monitoring.Credit Risk Rating Mechanism means Measurement of Risk and Quantification of the same through Credit Rating.

Unexpected Loss (UL):Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.Mathematically, Unexpected Loss is the standard deviation of the change in the asset value at the end of the horizon. This implies that unexpected loss is the estimated volatility of potential loss in portfolio value around the expected loss.

GENERAL GUIDELINES Latest Audited Financial Statements only (not more than 1 Yr old).Each parameter to be evaluated and no parameter should be left un-assessed.Careful analysis & evaluation of each parameter.Subjective parameters need qualitative evaluation and continuous updating knowledge about the business & industry.To improve information base about management and conduct of the accounts - through regular visit of the industry, interaction valuable insight beyond financial data.

GENERAL GUIDELINES ContdInformation about borrower to be collected from all possible sources. Data used to assign rating should be annualized and comparable. Financials of the Co. should be made comparable with peers in case of change in accounting policies, merger, de-merger, acquisition, sell-off etc. For multi-divisional Co. more than one activity/ product/ industry Business parameters to be evaluated separately for each of 3 major activities.The complete rating sheet, justification, financial ratios (if computed manually) and other relevant information must be sent to vetting authority for each rating.

GENERAL GUIDELINES ContdRecord of rating exercise & history of ratings should be kept on record for further reference, uses, audit etc.Final/ approved rating to be informed to the original rating office after vetting by competent authority. The credit risk rating along with date of approval & date of B/sheet to be mentioned in all references made to competent authority for taking credit decisions.Other guidelines mentioned in manuals of individual credit rating models to be followed strictly.Maintaining utmost secrecy of the rating mechanism and to prevent its misuse.

Basel IBoth the above assets are investment grade.As a prudent banker our natural choice is for BB asset vis--vis AAA asset because BB is more remunerative.

RatingExposureROIRISK WEIGHTCapital ChargeAAA1009%100%9BB10011%100%9

Basel II (Standardised Approach)Risk weights under Standardised Approach are more Risk Sensitive.Because of the risk weights are more risk sensitive, we can do 7.5 times more business for AAA assets vis--vis BB assets, which will be more remunerative.

RatingExposureROIRISK WEIGHTCapital ChargeAAA1009%20%1.8BB10011%150%13.5

Results :

It can be inferred from the above that lending to AAA assets at 9% would be more remunerative vis--vis lending to BB at 11%.Our natural choice for selection of borrowers would shift from BB & upwards under Basel I to AAA & downwards under Basel II (SA).In case sufficient number of AAA assets are not available at lease our order of preference would be AA, A and then BB.

**