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CAIIB- Bank Financial Management- Vaibhav Awasthi-7600273309- Yuva Upanishad Surat Page 1

What is risk? To understand it in financial terms, a business is done keeping in mind

certain expected cash flows. These cash flows represent money which will be

generated by doing that business. The money generated should cover all costs

incurred and estimated profits. Now let’s say a business is expecting the following

net flows which will cover all its costs and give required profits for survival and

expansion:

Year I II III IV

Expected net

flow

1000 2000 3000 4000

Actual net flow 1100 1900 3100 3500

Variance 100 (100) 100 (500)

As can be seen cash flows in Year I & III is more than expected but cash flow in

Year II & IV is lower than expected. Why cash flows are different from as projected?

Because of various uncertainties, these uncertainties can either be favourable or

unfavorable, only the unfavourable variance in cash flow is known as risk.

Few points need to be understood in this regard:

1. Risk is not bad.

2. Risk cannot be completely eliminated

3. Risk needs to be managed.

4. Higher the risk, higher the return and thus higher is the capital.

First to understand that risk is not bad. Risk also returns in higher reward and often

results in better and unique methods to do a business. Secondly risk cannot be

completely eliminated while doing a business, risk will always be there, it is for a firm

to decide its goal and risk appetite. Why risk needs to be managed? Reckless risk

taking can result into losses which cannot be afforded and business has to shut

down. How risk and capital are related? Capital

“represents that amount of fund in the business which is necessary to start and grow

the business and which is assumed to be in the business as long as the business is

run. Capital is necessary to absorb losses. If a business involves high risk, losses

could be high and thus capital needed would be high to cover those losses.

Basic Risk Management Framework:

As already explained earlier, risk cannot be eliminated altogether and thus it has to

be managed based upon the risk appetite of the firm. For this there must be a risk

management framework, the basic spirit of which is common to all organizations.

From now, onwards we will study risk management framework with respect to banks.

A risk management framework basically involves the following 6 steps:

1. Organization for risk management:

2. Risk Identification

Unit 8 – Risk and Basic Risk Management Framework


3. Risk measurement

4. Risk pricing

5. Risk Monitoring and control

6. Risk Mitigation.

1.Organization for Risk Management:

It must consist of

(i) Board of Directors: They have overall responsibility of management of risk. They

decide the risk management policy keeping in mind the corporate goal of the bank

(ii) Risk Management committee of board: A board level sub- committee, it sets

guidelines as to risk management and its reporting, set up prudential limits and their

review,ensure risk management process is robust and ensure proper manning of it

(iii) Senior Level executives: They implement the policy.

(iv) Risk management support group: Functionaries involved in analyzing, monitoring

and reporting.

2. Risk Identification:

This is most important function. It is to known what are the risks a bank will face in

doing business. They can emerge from products, processes, policies.

3. Risk Measurement:

Once you know what all risks will be there, it is important to know how much of it is

there. For example A Bank comes up with a product loan against property. What

risks can be identified? Since loan is only against security of property how will it be

repaid? From where the income to repay loan will come? For what purpose to give,

can we give for investing in stock market or buying properties? Whom to give?

Should it be given to businessmen or salaried people? How much value of property

should be given?All the above are the identified risks. Now question arises how

much is the risk. Can we measure that risk?

There are 3 methods to measure risks

(a) Sensitivity :deviation of a target variable due to unit movement of a single

market parameter. For example, change in value of portfolio due to 1% change in

interest rate

(b) Volatility: is common statistical measure of dispersion around the average of

any random variable. Volatility over a time horizon “T” is calculated as

(c) Downside potential which is measured by VaR ( Value at risk)

All the three parameters are discussed in details later in the unit.

4. Risk Pricing:

Once risk is identified and measured it should be priced accordingly.How to price it?

It is priced by adding risk premium on the interest charged to it. For example, let’s

say based on measure of past data it is observed that AAA rated accounts have 1 %

probability of default and rate of interest charged to them is 10 % and AA rated

accounts have 4 % probability of default thus bank needs to charge higher rate of

interest on them let’s say 12 %. This 2 % represent risk premium and method to

price the risk.


Pricing takes into account the following 4 components:

(a) Cost of fund

(b) Operating expenses

(c) Loss probability

(d) Capital charge

For example, Bank A has taken a FD @ 10 % rate of interest for 3 years. This is cost

of fund. Now cost of staff, branch expenses work out to 1 %. Bank gives loan to AAA

rated borrower where probability of loss is 1 % and finally Bank has to keep capital

of 1 % as provisions Thus final rate at which loan can be given is 10+1+1+1=14 %.

(Please remember this is a very crude example for sake of simple understanding)

Risk Monitoring & Control:

Most important component of risk monitoring & control is Management Information

system ie MIS. Bank to continuously monitor that all the policy guidelines are

followed, powers are exercised as per delegation, stop loss limits etc are followed. A

separate and independent risk management department must be there which can

ensure proper assessing of risk and its monitoring and reporting.

Risk Mitigation:

Strategies to reduce risks are known as risk mitigation. Risk mitigation can be done

through various techniques like taking collateral, third party guarantee or can be

done through buying derivatives or portfolio diversification. Risk mitigation measures

reduce downside variability in net cash flow and also upside potential.

Unity Banking business can be divided into three lines:

1. Banking book: Includes advances, deposits of the banks. They also represents

fixed assets of the banks and any borrowings made by them .The banking book is

exposed to credit risk, operational risk, liquidity risk and interest rate risk. They are

normally held till maturity and accrual system of accounting is applied.

2. Trading Book: These generally consists assets which are exposed to markets. For

e.g. Treasury Department of the Bank invests in various government bonds, stock,

foreign currency, corporate bonds. Trading book apart from credit, operational,

market and liquidity is also exposed to market risk. They are normally not held

until maturity and positions are liquidated in the market after holding it for a

period and mark to market system is followed.

3. Off Balance Sheet exposure: These are exposures which may convert into asset

or liability based upon the happening of a certain event. These do not appear in

Balance sheet but are shown as notes to Balance sheet. For example, Bank issues

guarantees on behalf of their customers, in case that guarantee is invoked by the

beneficiary, bank will have to immediately make payment to beneficiary then it will

become liability of the bank and reflect in Balance sheet. Can off balance sheet

exposures be asset too? Yes, suppose a Bank is involved in litigation and judgment

Unit -9 Risks in Banking Business


comes in favor of Bank and Court directs the other party to pay some amount as

compensation to Bank then that will result as asset. Off valance sheet exposures

may convert into exposure of banking book or trading book depending upon the

nature of off balance sheet exposure.

Before we go any further and understand various risks faced by Bank, we need to

understand certain concepts which are related with valuation of assets and liabilities.

1. Mark to Market: Mark to market simply means that assets and liabilities should be

shown at their market value. Mark to market relates to trading book in banks. Why?

Banks hold government securities, bonds, stocks their prices changes daily,

Suppose a Bank holds a government bond valued at Rs 1000 on 01.01.2014, on

01.02.2014 it is valued at Rs 1200, now this Rs 200 is profit and must be recognized

as profit and bond must now be shown in books at Rs 1200.This procedure of

showing the securities at their market price is known as mark to market.

There are 6 types of investments hold by a bank (i) Government Securities (ii) Other

Approved Securities (iii) Shares (iv) Debentures and Bonds (v) Investments in

Subsidiaries/Joint Ventures (vi) Other Investments.

Now these securities can be held under three methods:

(a) Held Till Maturity (HTM): These comprise investments the Bank intends to hold till

maturity. Investments included in this category are carried at their acquisition cost.

(b) Held for Trading(HFT) :Investments acquired with the intention to trade within 90

days from the date of purchase are classified under this head.The individual scrip in

the category will be marked to market at quarterly or at more frequent intervals.

(c) Available for Sale (AFS) Investments which are not classified either as “HTM” or

“HFT” are classified as AFS. They are marked to market at monthly intervals.

Assets and liabilities in banking books are hold till maturity and thus always appear

at acquisition cost. For example Bank purchases computers for bank for Rs 1 crore.

These computers will appear at Rs 1 crore in the books of the company.

Risk in Banking

1. Liquidity Risk: It arises because long term assets (loans) are financed by

short term liabilities (deposits). For eg a Bank has Rs 1 crore FD for 3 years. Now

Bank gives Rs 1 crore loan for 5 years. After 3 years bank has to repay this FD

amount but loan will be repaid only after 5 years, so how will bank pay back this

amount to depositor? This is known as liquidity risk.

They are of 3 types

(i) Funding risk: Now suppose in the above example bank has given loan for 3

years only, but depositor withdraws the FD after 1 year then how to fund this is

known as funding risk

(ii) Time risk: If loan repayment is not regular,ie cash inflows are not regular it is

known as time risk.

(iii) Call risk: If off balance sheet exposures or contingent liabilities crystalize it is

known as call risk. Let’s say bank has issued bank guarantee of Rs 1 lakh on behalf


of its customer. Guarantee is issued after obtaining a specific margin for a fee. Now

if the guarantee is invoked by the beneficiary bank will have to make payment of Rs

1 lakh, but how to have money for this Rs 1 lakh, this is known as call risk.

2. Interest rate risk : If interest rates changes, banks income will change which

will affect profit, this is known as interest rate risk. They can be classified into

following 6 categories

(i) Gap or mismatch risk: It arises because of difference in time, amount, etc of

assets and liabilities

(ii) Basis risk. Suppose repo rate rate is reduced by 1 % now this will mean that

loan rates need to be reduced by let’s say 0.5 % but banks may not be able to

reduce deposit rate by 0.5 %. This is called basis risk that same reduction or

increase in interest rate will affect price of deposits and advances differently.

(iii) Yield curve risk: This is seen in case of investments in government securities,

bonds etc. They are of varying maturity period. For example 91 days T Bills, 182

days T bill, 364 days T Bill, prices of these securities change when interest rate

change, but same percentage change will not change prices of securities in similar

degree. For example, a 1 % increase in interest rate will cause prices of t bills to fall,

but the fall amount will be different for all the maturities. This is called yield curve

risk.

(iv) Embedded option risk: Risk that embedded options may be used. For

example, a FD can be withdrawn before time.

(v) Reinvestment risk: Let’ say Bank has taken FD of Rs 3 lakh at 10 % for 3 and

gives loan of Rs 3 lakh at 12 % for 3 years. Thus bank earns 2 % profit. But this

loan is repaid 1 lakh every year, here arises the problem the amount of Rs 1 lakh

which is repaid must again be re invested at 12 % if bank wants to maintain 2% profit

ratio.

(vi) Net interest position risk: If bank has more advances then paying liabilities

(deposits) then reduction in interest rate would means net interest income of bank

decreases.

3. Market Risk: Also known as price risk is, reduction in the value of securities

due to adverse price movement. For example bank hold share of Rs 100, and price

of the share falls to Rs 90, this is market or price risk.

4. Credit Risk: The risk that counterparty will default on payment, due to refusal

or inability. It can be (a) Counter party risk or (b) country risk

5. Operational Risk:Operational risk is the risk of loss resulting from inadequate

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

risk and reputation risk are not a part of operational risk It includes Fraud risk.

Communication risk. Competence risk. Model risk, Cultural risk, External events risk.

Legal risk, Regulatory risk, Compliance risk. System risk and so on.

Transaction Risk= is the risk arising from fraud, both internal and external,

failed business processes and the inability to maintain business continuity and

manage information.

Compliance Risk= risk of legal or regulatory sanction, financial loss or

reputation loss that a bank may suffer as a result of its failure to comply with any or

all of the applicable laws, regulations, codes of conduct and standards of good

practice. It is also called integrity risk


From here we will study Basel, how Basel framework evolved, what were the pillars

prescribed, what risk were recognized, how it is applied in Indian context.

Why Banks are important? Ever heard of Too Big to Fail (TBTF)? TBTF became

popular after global meltdown crisis and failure of Bank’s like Lehman. It meant that

these institutions are so big and their survival so vital that they must not be allowed

to fail and must be protected at every cost. This is the importance of Banks in an

economy, failure of one bank can create failure of whole banking system because of

huge mutual lending and borrowings and commitments between Banks. Thus it is

very important to regulate the banking industry and ensure that banking system

remains robust and flourishing and is not engaged in reckless lending or taking

unwarranted or extraordinary risks.

Basel Committee on banking supervision (BCBS): on 26th June 1974 a number

of banks have released Deutschmarks( former currency of Germany) to Bank

Herstatt ( a German bank) in in Frankfurt in exchange for dollars which were to be

delivered in New York. However due to differences in time zone there was delay in

time payment. In the meantime German regulators liquidated Bank Herstatt. Result ?

Banks who had given Deutschmarks were faced with credit risk. Thus risk of

settlement that arises from time difference came to be known as Herstatt risk. This

prompted G-10 countries to for Basel Committee on banking supervision in 1974.

First Basel accord 1988:

The first Basel accord primarily focused on placing a framework for minimum capital

requirements to address credit risk. Once again we reiterate why capital is

important? In its simplest form, capital represents the portion of a bank’s assets

which have no associated contractual commitment for repayment. It is, therefore,

available as a cushion in case the value of the bank’s assets declines or its liabilities

rise. Thus when BCBS focused on credit risk, which means that money lent will not

be received back and loss would be suffered, it prescribed minimum capital

known as CRARwhich must be there to absorb these losses or shocks so that

Bank’s do not go bankrupt.

The accord provided for detailed definition of Tier I and Tier II capital. It also

classified Bank assets into 5 buckets. 0, 10 %, 20 % 50 % and 100 %

Category Risk weight assigned

Sovereigns 0%

Banks 20%

Public sector enterprises 50%

Others 100

[

Unit 10 – Risk regulations in Banking Industry


What does this risk weight mean? Understand this, suppose a bank ABC Ltd in India

which has capital(Tier I + Tier II) of Rs 40 lakh and has given loans of Rs 100 lakh

to Government of India (GOI), Rs 200 lakh to State Bank of India and Rs 300 lakh to

Reliance company. What would be risk weighted assets (RWA) of ABC ltd ?

Exposure to Amount Risk weight RWA

GOI 100 0 0

SBI 200 20 40

Reliance 300 100 300

Thus as we see from above example, RWA of Banks are 340, So CRAR of the bank

would be

Total Capital Funds

(RWA for Credit Risk)

= 40/340= 11.76 %. This was how initially CRAR was calculated with only capital

for credit risk being considered.

1996 Amendment to include market risk.In 1996 amendments were made to 1988

basel accord and market risk was also recognized and methods to measure it were

prescribed. Salient features are given as below:

(i) Banks to identify a trading book and hold capital for market risk under trading book

and organization wide foreign exchange exposures.

(ii) Capital charge to be measured based on 10-day 95 percent VaR metric. Market

requirements were equal to the greater of either the previous day’s VaR, or the

average VaR over the previous 6 days multiplied by 3.

Basel- II Accord- Need and Goals

Basel I accord understood the importance of viability and robust systems for

supervision of Banking Industry on a global basis and focused on maintaining

regulatory capital to absorb any business losses or shocks. However credit risk

assessment under Basel –I was not risk sensitive enough.

How? There were fixed risk weight buckets; if exposure was to a corporate it

attracted uniform risk weight of 100%. For example Company A which is very strong

and has good fundamentals will also be given 100% risk weight and a Company B

which doesn’t have very good net worth or business fundamentals will also be given

100 % risk weight. [

So how it affected Banks?

Not all commercial loan recipients have the same amount of risk. A loan to a well-

established company is far less risky than a loan to a start-up company. The effect of

this shortcoming in Basel I’s risk-weighting methodology is that banks have an

incentive to engage in what is known as regulatory arbitrage.

Essentially, regulatory arbitrage describes a situation where, if a bank is presented

with two options, both of which receive the same regulatory treatment, but each of

which result in differing profit-making opportunities, the bank will choose the more


lucrative option. In the commercial loan example above, from a regulatory

perspective, it doesn’t matter whether the bank makes the loan to the start-up

company or the well-established company; in either case the bank will have to

include 100% of the loan in its risk-weighted assets. However, from a profit-making

perspective, the loan to the start-up company will be riskier, and therefore will

demand a higher interest rate.

Consequently, the bank will have an incentive to make the loan to the start-up

company. Given this situation, the bank will usually pursue the opportunity with

higher earning potential. However, as seen with the example of the start-up

company, pursuing greater profit usually means that the bank is taking on higher

risk. This again leads to a situation where the level of capital required under the

Basel I methodology is not sufficiently commensurate with the risk in the bank’s

assets.

Also Basel I did not recognize the role of credit risk mitigants such as credit

derivatives, securitizations, collaterals and guarantees in reducing credit risk. It also

did not take into account operation risks of the banks.

Thus After several years of negotiations and consultations, the BCBS released a set

of revisions to Basel I, entitled “International Convergence of Capital Measurement

and Capital Standards: A Revised Framework,” also known as Basel II on 26th June

2004 (exactly 30years after Herstatt Bank went into liquidation)

Structure of Basel II:

While Basel I was just focused on minimum capital requirement, basel II accord is

based on there pillars:

(i) Minimum Capital Requirement

(ii) Supervisory Review Process

(iii) Market Discipline

In this unit we will concern ourselves with calculation of Minimum capital

requirement.

Pillar 1- Minimum Capital Requirement.

As we have seen above Basel accord 1988 prescribed minimum capital requirement

for credit risk. Subsequently in 1996, capital for market risk was also prescribed.

However Basel II accord also recognized operational risk and provided for

maintaining capital for it.

Before we proceed and understand how capital charge for all the three risks (i)

Credit (ii) Market & (iii) Operational risk is calculated, we need to first understand

what all forms part of capital funds:

Capital is divided into Tier I capital also known as Core capital and Tier II capital

Tier I Capital:

1. Paid up equity capital, statutory reserves and other disclosed free reserves

2. Capital Reserves arising out of sale proceeds of assets

3. Innovative Perpetual Debt Instruments (IPDIs) which meet the regulatory

requirements advised by RBI for the purpose limited to maximum 15% of total Tier-1

capital as on 31st march of the previous financial year.


4. Perpetual non-cumulative preference shares (PNCPS), which meet the

regulatory requirements advised by RBI for the purpose subject to a limit such that

total of IPDIs and PNCPS doesn’t exceed 40% of Tier I capital at any point of time.

Tier II Capital:

1. Revaluation reserves at a discount of 55 %

2. General provision on standard assets, floating provisions, provisions held for

country exposure, investment reserve accounts and excess provision subject to a

maximum of 1.25% of total RWA

3. Upper Tier II capital which includes PNCPs, redeemable non-cumulative

preference shares (RNCPS) and redeemable cumulative preference shares (RCPS)

issued in accordance with the regulatory guidelines for the purpose.

4. Subordinated dents issued and computed in accordance with the regulatory

guidelines for the purpose.

5. IPDI and PNCPS held in the books in excess of prescribed limit and not

included for computing Tier I capital

The Tier II capital cannot be more than Tier I capital

Numericals & Case Studies - Calculation of Capital:

Case 1. Bank of Indians had paid up capital of Rs 500 crore, Reserves of Rs

250 cr, , Revaluation reserve of Rs 100 cr, Perpetual non cumulativeprefence shares

(PNCPS) of Rs 50 cr and subordinated debts of Rs 200 cr. Calculate Tier I and Tier

II capital of Bank of Indians and total capital fund of the Bank.

Tier I capital of the Bank = Paid up capital + Reserves+PNCPS

= 500 + 250+ 50 = 800 cr

Tier II Capital = Revaluation reserves at the discount of 55% +

Subordinated Debt

= 45* + 200 = 245 cr

*(Remember 55% of discount means, only 45% of revaluation reserve will be

considered)

Total Capital of Bank = 800+245 = 1145 cr

Case 2.Lena Bank has paid up capital of800 crore and Free reserves of Rs 500 cr.

Bank during the yea sold one of its building recording profit of Rs 50 cr which were

capitalized. Bank also had general provision and contingency reserves of Rs 400 cr.

RWA for credit and operational risk for Bank were 7000 cr and RWA for market risk

was 2000 cr. Subordinate debt stood at 250 cr. Calculate Tier I, II and total capital of

Bank.

Tier I = Paid up capital+ Free reserve + capital reserve arising out of sale proceeds

of assets

= 800 + 500 + 50 = 1350 cr


Tier II = Provisions for Contingency reserves + Subordinated Debt

= 112.50 + 250 = Rs 362.50

Total Capital funds = 1712.50 cr

Structure of Basel-II

Pillar 1 — Minimum Capital Requirement

1. Capital for Credit Risk

(i) Standardised Approach (ii) Internal Ratings Based (IRB) Foundation Approach

(iii) Internal Ratings Based (IRB) Advanced Approach

2. Capital for Market Risk

(i) Standardised Approach (Maturity Method) (ii) Standardised Approach (Duration

Method) (iii) Internal Models Method

3. Capital for Operational Risk

(i) Basic Indicator Approach (ii) Standardised Approach (iii) Advanced Measurement

Approach

Pillar 2 - Supervisory Review Process

1. Evaluate risk assessment

2. Ensure soundness and integrity of banks' internal process to assess the

adequacy of capital

3. Ensure maintenance of minimum capital - with PCA for shortfall.

4. Prescribe differential capital, where necessary - i.e., where the internal

processes are slack.

Pillar 3 - Market Discipline

1. Enhance disclosure

2. Core disclosures and supplementary disclosures

3. Timely - semi annual

Pillar 1 - Minimum Capital Requirement

Basel 1 Accord and the 1996 amendment thereto has defined capital requirement as

Capital = Min. Capital Ratio (8%) x (Credit Risk + Market Risk)

The Revised Capital Accord or Basel II defines the capital requirement as Capital =

Min. Capital Ratio (8%) x (Credit Risk + Market Risk + Operation Risk) It is to be

noted that there is no change -

• In the definition of capital

• In the minimum capital ratio, which remains 8%

• In the calculation of market risk and it remains as per 1996 Amendment

The changes are in

• Method of calculating risk in credit exposures& inclusion of operational risk

Capital Charge for Credit Risk:


1) Standardised Approach: Banks are required to slot credit exposures into

supervisory and risk weight is accorded

The risk weights for sovereign, inter-bank, and corporate exposures are

differentiated based on external credit assessments.

[[

2. Internal Rating Based approach: IRB approach has two options Foundation IRB

and Advance IRB. In IRB approach bank ‘s internal assessment of key risk

parameters serve as primary inputs to capital calculation. In IRB capital requirement

of each exposure is calculated. For eg Bank has given loans to 100 corporates with

AAA rating. If bank followed standardized approach all these 100 loans would be

assigned a specific risk weight of 20%. However, under IRB approach bank will

compute capital charge for each loan individually based on certain specified

parameters.

The IRB Approach computes the capital requirements of each exposure directly

before computing the risk-weighted assets. Capital charge computation is a function

of the following parameters:

1. Probability of default (PD):which measures the likelihood that the borrower will

default over a given time horizon

2. Loss given default (LDG) :which measures the proportion of the exposure that

will be lost if a default occurs

3. Exposure at default (EAD): which for loan commitment measures the amount of

the facility that is likely to be drawn in the event of a default.

4. Maturity (M): which measures the remaining economic maturity of the exposure.

Foundation IRB Advanced IRB

PD: provided by bank, based on own

estimates

PD: estimated by bank, based on own

estimates through historical records

LGD: Given by Supervisor LGD: Provided by bank, based on own

estimates

EAD: Given by Supervisor EAD: Provided by bank, based on own

estimates

M: Provided by bank, based on own

estimates

M: Provided by bank, based on own

estimates

Risk weight: Function provided by the

committee

Risk weight: Function provided by the

committee

Data Requirements: Historical data to

estimate PD ( 5 years )

Data Requirements: Historical data to

estimate LGD ( 7 years ) and historical

exposure data to estimate EAD (7 years)

plus that for PD estimation


Market risk means risk of reduction in the value of securities held in the portfolio due

to fall in the prices of securities. A bank in its trading books holds the following

financial instruments (i) Debt securities (ii) Equity (iii) Foreign Exchange

(iv)Commodities (v) Derivatives held for trading.

As has been explained earlier, the trading book of the bank is marked to market,

when portfolio is marked to market; there is risk of adverse price movement which

will result in decline in value of the portfolio.

For example a Bank has Rs 1, 00,000 in the form of Government bonds as on

01.01.2014. The government bonds are tradable just like shares and thus there

value changes daily. On 01.04.2014, value of these bonds reduces to Rs 90,000.

Thus bank has suffered loss of Rs 10,000 on account of decline in value. This is

called market risk.

Market risk can be categorized into (i) Interest rate risk (ii) equity price risk (iii)

foreign exchange risk (iv) commodity risk.

(i) Interest rate risk: Interest rate and value of securities are inversely related.

As interest rate rise, bonds value fall and vice versa.

(ii) Equity price risk : Stock prices may move on account of general market

factors or firm specific factor.

(iii) Foreign exchange risk : Movement in the prices of currency creates, foreign

exchange risk

(iv) Commodity risk: Trading of various commodities such as gold, silver,

cereals, and crude oil etc. is done. Banks take positions in these commodities. Any

adverse movement in the prices of commodities result in loss to the bank.

Market Risk Management-

(A) Framework Organisational Structure:

(I) Board of Directors: They have overall responsibility for management of risk. They

decide the risk management policy of bank and set limits for liquidty, interest rate,

foreign exchange and equity price risk.

(II) Risk Management committee: It is a board level sub committee. They ensure (i)

setting guidelines for market risk management and sub committee. (ii) ensure market

risk management conforms to overall risk policy of the bank. (iii) set up prudential

limits and its periodical review (iv) ensure robustness of measurement of risk models

(v) ensure proper manning.

(III) Asset liability Committee : ALCO is responsible for implementation of risk and

business policies. They ensure (i) product pricing for deposits and advances (ii)

maturity profile and mix of incremental assets and liabilities (iii) interest rate view of

bank (iv) funding policy(v)transfer pricing (vi) balance sheet management.

Unit 11 Market Risk


(B) Risk identification: All products and transactions should be analyzed for risks

associated with them.

(C) Risk Measurement :Its based on (a) sensitivity (b) downside potential

a) Sensitivity: sensitivity captures change in market price due to unit movement of

a single market parameter. These parameters can be supply demand position,

interest rate, market liquidity, inflation, exchange rate etc. This measure suffers from

demerit that it doesn’t take into consideration the combined effect of various

parameters. Sensitivity generally measures the change in the value of security due

to movement of interest rate and is generally measured by (i) basis point value (ii)

Duration

(i) Basis point value: This is the change in value of security due to 1 basis point

(0.01%) change in market yield.

Illustration 1. Federal Bank made investment in Govt. Securities worth Rs 4 crore.

Maturity period of bond is 5 years and face value is Rs 100 and coupon rate is 10.

Bond has market yield of 1 2 % and price of bond is 90. Now market yield increases

to 12.05 and price of bond changes to 89.50. Calculate (i) basis point value of

bond(ii) what will be change in the value of investment

(i) When yield changes by 0.05(5 basis point) % ie from 12 to 12.05 price changes

by 0.50 ie from 90 to 89.50 so basis point value of bond ie change in price for 1

basis point is is

= 0.50* 0.01 = 0. 10%

0.05

(ii) change in value of investment: Change per Rs 100 is 0.10 so change for Rs 4

crore will be will Rs 40,000

(ii) Duration :Duration (also known as Macaulay Duration) of a bond is a measure of

the time taken to recover the initial investment in present value terms. In simplest

form, duration refers to the payback period of a bond to break even, i.e., the time

taken for a bond to repay its own purchase price. Duration is expressed in number

of years.

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