Project Mba[2]

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PROJECT SYNOPSIS ON

RISK MANAGEMENT IN BANKS

1. INTRODUCTION

Risk is inherent and absolutely unavoidable in baking. Risk is the potential loss, an asset ora portfolio is likely to suffer due to a variety of reasons. As a financial intermediary, bankassumes or restructures risks for its clients. A bank while operating on behalf of thecustomers as well as on its own behalf, has to face various types of risks associated withthose transactions.

Risk in financial terms is the possibility of adverse impact of certain developments inbusiness and operations of the banks/financial institutions on their profit and loss accountsituation. The various risks include operational, fiduciary, transactional, competitive,managerial, legal, disaster concentration and documentation.

2. NEED FORS STUDY

During post nationalization period of Indian Banking Industry different concepts haveattained significance over different times. Initially, it was social banking in the seventies,followed by IRDP upto mid-eighties ending with rationalization/computerization by lateeighties. Liberalization and deregulation of interest rates, prudential norms, capitaladequacy, asset liability management as also RISK MANAGEMENT have become the

buzzwords of the nineties.

With happenings like BCCI, BARINGS and DAIWA, consciousness about the Risk factoris gaining prime importance. In the context of Indian Banks, asset classification norms

pronounced by Narasimham committee have brought the risk into sharper focus.

with the globalisation of financial sector operations, the contours of risk have alsobroadened multifold. When the thrust of operations is on profit, i.e., reward, the emphasison risk is bound to go up. The uncertainty of future, impact of past and instability of present,all give risk to risk.

Prudent banking lies in identifying, assessing and minimizing these risks, In a competitive

market environment, a banks rate or return will be greatly influenced by its riskmanagement skills. An attempt is made to have an overview of Bank Risk Management.

with the collapse of Barings Bank, the inquiry team has stated as under:

A number of industry studies have strongly advocated the establishment within a financialinstitution of an independent risk management function overseeing all activities includingtrading activities and covering all aspects of risk.

A primary objective of the risk management function is to ensure that limits are set for each

business. These limits should reflect the risks being run and the level of risk thatmanagement is willing to take. The function should also serve as an independent check toensure that traders operate within their limits.


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3. OBJECTIVES OF THE STUDY

The objectives of RISK MANAGEMENT for any organization can be summarized as

under :

a. Survival of the organizationb. Efficiency in operationc. Identifying and achieving acceptable levels of worryd. Earnings stabilitye. Uninterrupted operationsf. Continued growth andg. Preservation of reputations.

Having extensively quoted as above, there is very little that could be further emphasizedregarding the need for risk management. Suffice it to say that BETTER WE MANAGE

RISK OR ELSE RISK WILL MANAGE US.

Risks in banking are many. These risks can be broadly classified into three categories viz.,

a. Balance Sheet Risks/ Financial Risk]

b. Transaction Risks and

c. Operating and Liquidity Risks.

The Balance Sheet Risks generally arise out of the mis-match between the currency,maturity and interest rate structure of Assets and Liabilities resulting in :

a. Interest Rate mis-match risk

b. Liquidity risk and

c. Foreign Exchange risk

Financial Risks Types :

The types of financial risks are as under :

a. Credit Risk

b. Interest Rate Risk

c. Liquidity Risk

d. Market Risk

e. Capital Risk


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Transaction Risks essentially involve two types of risks. They are :

a. Credit Risk which is the risk of loss on lending investment etc., due to counter party

default.

b. Price risks which include the risks of loss due to change in value of assets andliabilities.

The factors contributing to price risks are :

i. Market Liquidity Risk

ii. Issuer Risk

iii. Instrument Risk and

iv. Changes in commodity prices etc.,

The Operating and Liquidity Risks encompasses two types of risks viz.,

a. Risk of loss due to technical failure to execute or settle a transaction and

b. Risk of loss due to adverse changes in the cash flows of transactions

The components of Operational Risk are :

a. Equipment risk,

b. Product risk and

c. People risk

The risk contributors interest with each other in both direct and indirect pathways as

explained in the following diagram.

EQUIPMENT PRODUCTION

RISK

PEOPLE


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MAJOR CONTRIBUTORS TO OPERATIONAL RISK

The objectives of the study are

a. To understand the concept of risk management

b. Analyse the impact of the different types of risks on the profitability of the banks.

4. SCOPE OF THE STUDY

Banking industry in general and Indian Banking in particular.

The scope of the study, methodology and database, period of the study is confined to Risk

Profile of Indian Banks.

Risk Profile Indian Banks :

The risks faced by the Indian Banks, particularly in the past five years have been described

below:

a. Currency risk

b. Currency fluctuations

c. Interlinkages in domestic pricing of money and forex position as reflected in

simultaneous occurrence of falling rupee value.

d. Concentration of credit to particular single or group borrowers.

e. Risks involved in already financed sunset industries.

f. Uncertainty associated with lending to weaker sections in the absence of backward and

forward linkages.

g. Likely competition from private and foreign banks.

h. Regulatory guidelines.

i. Partial and ad-hoc interest rates deregulation

j. Social issues etc.,

The whole gamut of risk factors gives rise to the need of a solution Risk Management.

It is all a question of risk management and size is not necessary and advantage. What needs


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to be seen is the quality of assets. Mergers of bank was a recent trend, several countries like

Japan and the United States have seen the successful survival of smaller banks.

There have cases of very big Japanese banks going bust and what a banker needs to see is

the quality of assets. It is all a question of risk management and size is not necessarily an

advantage. The problem that banks have been facing now is one of lending or deploying

funds at a profit.

Banks corporate mission is to provide the threshold of banking service, both retail and

corporate. In order to achieve this, the areas to look after by the banks are :

a. Risk

b. Corporate

c. Finance

d. HRD and administration

e. Information technology and

f. Audit

The treasury systems in the banks were geared to meet the challenges of capital account

convertibility.

5. METHODOLOGY

Asset classification norms as suggested by Narasimham Committee for the study purposes

6. PERIOD OF STUDY 1992 98

Banking industry in general and Indian Banks in particular.

7. CHAPTERISATION

The plan of study in the context of Indian Banks is as follows :

a. Concept of risk and its components

b. Risk situation in Indian Banks

c. Possible option to manage risks


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d. Prerequisites for risk management.

( K. MALLIKARJUNA RAO)

CONTENTS

Details Title Page No.

Chapter No. I Conceptual Framework for Risk Management

Chapter No. II Risk Management in Banks

Chapter No. III Bank Risk Management : A Risk Pricing Model

Chapter No. IV Trends in Risk Management in Banks

Chapter No. V Summary, Conclusions and Suggestions

Reference: . .


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CHAPTER I

CONCEPTUAL FRAMEWORK FOR RISK MANAGEMENT

With the globalization of economies world-over, the concepts like capital adequacy, assetclassification and income recognition have pride of place in the glossaries of financialsector. Post Daiwa/ Barings episodes, the focus of supervisory concern has shifted fromAsset Quality to RISK MANAGEMENT. Instead of merely addressing the credit qualityissues, financial sector in general and banks in particular are laying emphasis on overall risk

profile. Variety of risks are created and are required to be managed to encompass credit/interest rate/pricing/environmental/legal/systemic/currency/reputation risks.

Risk is the volatility of future income and net present value of equity that results fromchanging environmental conditions. This write up endeavors to provide a conceptualframework for risk management in banks. Defining risk management concept with itscomponents is followed by the description of pre-requisites to be complied with formanaging risks. Generation of a banks risk profile and process involved in commencementof risk management function have been discussed thereafter.

Survey on corporate Risk Management published by the Economists makes the followingobservations:

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

b. Risk Management is not an ivory tower for arcane specialists

c. Increased disclosure of risk assessments and responses is the best course of action, not

increased regulation or aversion of employing financial instruments that can reduce risk

if used properly.

d. Risk Management must be a senior managements strategic responsibility, not solely

assigned to finance department.

The primary message of this survey is that firms need to understand all the main risks towhich their future cash flows are exposed, not just the narrowly defined financial ones. Overfocus on one type of risk or another simply perpetuates the outmoded fragmented approachto the management of risk.

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

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


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Risk Management Concept: -- Risk Management is the continuous process of identifyingand capitalizing on appropriate opportunities while avoiding inappropriate exposures insuch a way to maximize the value of the enterprise. Exposures in the aggregate result fromdiverse activities, executed from many locations by numerous people. Identifying exposure-its worthiness or otherwise, is the greatest challenge in the risk management. Ultimatelyhow exposures and risks are managed, depends on organizational culture, goals and risktolerance. Risk Management is the primary duty of line managers. It is based on separationof responsibilities. It is fundamentally a managerial process, reflective of organizations riskcharacteristics.

There is a mistaken belief that risk management is window dressing for regulators. RiskManagement is neither an added layer of bureaucracy nor an impediment to quick executionand superior customer service. Risk Management is critical to the conduct of safe and sound

banking activities. New technologies, new products and size and speed of financialtransactions have added impetus to the risk management issues. Along with financial

performance of an institution equal importance is given to risk management practices.

Under the ROC-A(R: Risk Management, O: Operations, C: Compliance and A: AssetQuality) rating system for reflecting safety and soundness of US based foreign banks,Federal Reserve has accorded top most weight age to R factor. R has been made the majordeterminant of composite rating. The risk management procedures need to address thefollowing issues namely (a) ability to manage risk inherent in lending, trading and othertransactions, (b) soundness of implicit and explicit assumptions both qualitative andquantitative in the risk management system, (c) consistency of policies/ guidelines withlending/trading activities, managements experience level and overall financial strength,

(d) appropriateness of MIS and communication network viz-a- viz level of business activityand (e) managerial capacity to identify and accommodate new risks. A fully integrated riskmanagement system that effectively identifies and controls all major types of risks includingthose from new products and changing environment would facilitate or assure best R ratingunder the ROC-A system.

Risk is a multidimensional concept and risk management is a continuous activity. As such,practically everyone throughout the organization is concerned with identifying andmanaging risk. What is required is anticipating and preventing risk at the source and thecontinuous monitoring of the risk controls and ineffective processes which are the primary

source of risk. Hence, risk management encompasses three activities viz., risk identification,risk measurement and risk control. Risk identification, as the starting point consists ofnaming and defining each of the risks associated with a type of transaction or a product or aservice. When the transactions are many and the chain of communication is long a formalrisk identification system is necessary. The second component is risk measurement. It is theestimation of size, probability and timing of potential loss under various scenarios. This is adifficult component due to variety of available methods, degree of sophistication and costsinvolved. For example, assets/liability analysis is considered as a measure of estimatingimpact of changed interest on portfolio value. Various interest rate scenarios could bedeveloped for appreciation of risk involved. Risk control has two sub-categories. The firstrelates to policy administrative control, while the second is risk mitigating activity. Having

proper policies/procedures, helps to define each persons role, limit to which he can take risk,


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reporting mechanism and the like. The goal of each such policy is to keep the outcomewithin risk tolerance ranges. Uniformity of language is useful while defining each risk

precisely from department to department. The other aspect of risk control is risk mitigating

Activity. The available options could be risk transfer(insurance or hedging), elimination oravoidance(staying out of risky business), reduction( specification and adherence to limit )

and risk retention.

THE PRE-REQUISITES

Establishment of a sound risk management system pre supposes specification of andadherence to certain qualitative and quantitative criteria. The quantitative requirements

provide a level of consistency necessary for a capital standard, while the qualitativerequirements include aspects which may take the shape of (a) having risk control unitindependent of the operating unit, (b) implementing a regular programme for validation,

(c) laying down procedures for periodic stress testing to evaluate the impact of unusualtransactions, (d) adopting internal policies/procedures/controls which are documented and(e) conducting independent review of risk management system to meet these quantitativeand qualitative criteria, each organization has to address to certain pre-requisites. They are(a) adequate risk management policies and limits, (c) appropriate risk management andreporting systems and (d) comprehensive internal control system.

Board and Senior Management Oversight:

Board of Directors have the ultimate responsibility to determine the level of risk undertaken

by the organization. Board need to approve overall business strategies/policies includingmanaging and undertaking risks.

Ensuring capability of senior management to conduct the risk management task is also theBoards responsibility. Board, therefore needs to have clear understanding of the types ofrisks, the institution is exposed to. They should receive in meaningful terms reportsidentifying the size and significance of risks. It may be useful to have briefing from outsideexperts so that the Board is capable to guide its institution on the level of acceptable risk.This would also facilitate ensuring that the senior management implements the proceduresand controls necessary to comply with adopted polices.

Senior Management is responsible for implementing strategies that limit risk associated witheach strategy and ensures compliance with laws and regulations. Adopting policies, devisingcontrol mechanisms and risk monitoring systems, delineating accountability and lines ofauthority creating and communicating awareness of internal controls as also ethicalstandards are all the tasks of senior management. The adequacy or other wise of board andsenior management oversight can be assessed through the following tests : (a) identification,understanding and working knowledge of inherent risks, as also the efforts made to remaininformed of these risks, (b) adoption and review of appropriate policies to limit risksrelevant to activities like lending, investing, trading and other products, (c) familiarity with

and reliance on records and reporting systems to monitor/measure the major sources of risk,(d) review of strategies, risk exposure limits as also possible reaction of market conditions,


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(e) management ensuring that business lines are started by personnel of required knowledge,experience and expertise, (f) provision of adequate supervisory mechanism at all levels on aday-to-day basis and (g) responsiveness to changes in environment or from marketinnovations.

Adequate policies/procedures:

There can be nothing like proto-type policies or procedures for risk management. The sizeof operations, sophistication, level of technology, managerial capacity and ability toundertake risks are some of the determinants while documenting policies and procedures.The policies and procedures are tailored according to the types of risks that arise from theactivities of the organization. They provide detailed to protect the organization fromexcessive and imprudent risks. The core of these policies is to address to the material areasof risk and their necessary modification to respond to significant changes in the banksactivities or business environment. These policies/procedures provide risk managementframework based on management experience level, goals, objectives and overall financial

strength of the banking organization. Delineating accountability and lines of authorityacross the organizational activities and review of activities new to the bank are alsofacilitated through such policies.

Monitoring and Management Information System (MIS):

Risk Management related activities i.e., identification , measurement and monitoring/controlneed to be supported by a proper Management Information System(MIS). Such MIS

provides reports on financial condition, operating performance and risk exposures. LineManagers can expect to obtain more detailed feedback on day-to-day operating activitities.

Complexity and diversity of institutions financial transactions would dictate sophisticationof MIS. MIS, for example, could include daily financial including profit/loss details, awatch list for potential troubled loans, interest risk reports, past due loans, etc. Whenevertrading activities are on a larger scale, more detailed activity reports across the wholeorganization may be necessary. The purpose is ultimately to ensure that polices/proceduresaddress to material risk areas and that they are modified to respond to the changes inactivities, business conditions and environment. The following tests are generally applied toassess the adequacy of MIS, (a) risk monitoring practices/reports address to all materialrisks, (b) assumptions, data sources and procedures used are appropriate, adequatelydocumented and tested for validity on a continuous and are structured not only to monitor

exposure but to facilitate compliance with laid down exposure limits by having varianceanalysis, (d) reports are accurate and timely containing sufficient information for decision-makers. This should lead to probing adverse trends and evaluating level of risk faced by theinstitution.

Internal Control:

Internal Control structure is critical for safely and soundness of any organization. As theinstances of Daiwa/Barings have proved, failure to implement/maintain separation of dutiescan result in serious financial and reputation losses. A properly placed internal control

system aims at (a) promoting effective operations and reliable reporting , (b) safeguardingassets and (c) ensuring regulatory/policy compliance. Effective internal controls need to be


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looked into by internal auditors, who would report directly to the top management. Theinternal controls primarily check the policies/procedures in terms of their adequacy andeffectiveness. The prescriptions for proper policies and procedures do equally hold good forinternal controls.

The description of the pre-conditions is followed by the discussion on determination of risk

profile and management thereof.

RISK PROFILE

In a banking situation, the business risk is inherent, arising out of probability of loss ofearning or reputation as a result of a banking or non-banking activity. It is a cost of doing

business. What risk management does is to reduce the inherent business risk by ensuringadequacy of managerial controls and making risk mitigation efforts. What is normallyendeavored to be controlled is the impact of risk in terms of losses. Elimination of risk in

business is a utopia and nearly impossible proposition. The risk management involves two

separate but simultaneous processes, first is determining risk profile and second relates toorganizing the risk management process itself.

Deciding risk profile is synonymous to drawing a risk picture of and organization andinvolves the following steps:

1. Identifying and prioritizing the inherent risk-this would involve conducting a sort ofrisk audit checking product by product and area by area exposures undertaken by the

bank, Larger transactions could be the matter of focus in the initial stages. Havinglisted all risk areas, sorting of critical ones on a probabilistic basis is another task.

The risk audit will involve (a) holding discussions with managers having differentportfolio responsibilities.

(b) analysis of historical trends in relation to business cycle, competition andregulatory requirements.

While prioritiing the risks, consideration should be given to theirmateriality/quantification, highly expected losses, very volatile losses andaccidental/one time losses. Examples thereof could be, (a) high volatility/lowexpected losses associated with trading or natural disaster, (b) high volatility/high

expected losses like commercial real estate or bank wide operational failure, (c) lowvolatility/high expected losses like losses from credit cards and (d) low volatility/lowexpected losses like teller loses or crimes

2. Suring and scoring inherent risks-this part involves study/analysis of industry outlookand trends. A view on the industry by national and international rating agencies willalso be useful. The composition of earnings and the fluctuations therein shall providesome clues about the historical aspects. The level of economic activity and stage of

business cycle can standards for evaluation may be simple and normative on a gradeof 1 to can standards for evaluation may be simple and normative on a grade of 1 to

5, where 1 represents the lowest risk and 5 the highest. Grade 1 may signify smallpotential for a significantly adverse impact on earnings, capital, stability or


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reputation. Under grade 2 and 3, the impact would be considered modest. Grade 4 &5 would denote serious and substantial impact. Refinements could be made as therisk management system goes along.

3. Establishing standards for each risk component the framework for establishingstandards is provided by prudent banking practices based on current environment,

industrys best practices and regulatory expectations. The components and theirexamples are (a) organization/staffing(separation of responsibilities, reportingrelationships and approved checks and balances, (b) policies/procedures (currencycomprehensiveness, exactness, user-friendly and applicability), (c) process controls(well defined, standardized controls and practices matching policies, (d)measurement/monitoring (specific/quantitative performance measures, appropriatemethodology and identified risk factors ), (e) MIS/ reporting (reliability/timeliness/accuracy of data and appropriate distribution thereof), (f) communications(formal process, common understanding and reciprocity and (g) performance (resultsmeeting set standards).

4. Evaluating and scoring the quality of managerial controls-the first step would be tospecify the standards of control. Having extensive controls would mean that theorganization has significant resources and well-defined policies/procedures/controland that they are properly implemented. Average standard would reflect modest levelof policies/procedures/controls. While minimal standard would indicate that theorganization has limited resources and few controls in the area of risk management.The various risk components are tabulated to provide a chart of current practices vis--vis standards, showing relevant strengths/weaknesses. The tabulation can besupplemented according to numerical score or a grade to reflect extensiveness orotherwise of the standards.

Scoring of managerial controls involves survey of the controls, consultation with theexternal/internal audit reports and regulatory examination with the external/internalaudit reports and regulatory examination reports

5. Developing risk tolerance levels-the exposure matrix provides the indications onadequacy or otherwise of the of the managerial controls in terms of the risk involved.The options are to increase control or to reduce exposure or both. A view onhistorical performance/information is use full. This can be supplemented with a view

on expected changes for the future. The contribution of risk mitigants and theirimpact on risk profile could also be analyzed. It may be useful to have risk withmitigants and control, rather than taking risk at all.

Based on all aforesaid, the risk strategies are to be developed and finalized. Thedetermination or risk profile is undertaken as a part or organizing for riskmanagement function. This involves:

Establishing scope of the risk management process-this entails creation of aseparate organization, positioning proper executive at managerial level, initiating the

process of risk thinking and awareness, redefining role of chief executives as the top


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most risk manger, delineating specific jobs/responsibilities and clarifying relationshipwith other departments.

Defining and communication implications-this involves the determination ofspecific role and responsibilities. For CEO, the tasks may be setting riskstrategy/budget and enforcing the same. The risk managers activities may includes

confirming measurements guiding line mangers, ensuring consistency in reporting,co-ordinating relevant operations and above all, maintaining independence. Similartasks could be assigned to audit and loan review, as also risk management committee.

Organizing support the last stage in the process involves establishing clear cutresponsibilities, determining/ providing technological support, arranging training

programmes and the like.

INDIAN CONTEXT

A question can now be posed whether such an elaborate risk management process isrelevant in Indian context. The answer has to be an affirmative for a variety ofreasons. The process would facilitate better understanding of risks and theirmanagement by comparison on risk return matrix. Acceptance of such aninternationally recognized procedure 5 may be the demand of the next phase offinancial sector reforms. Thirdly, proper risk management cannot only put incomesteam on good stead, but also can serve as useful manpower development strategy.Risk management goes much beyond routine audits. It is a managerial function-postfacto operation but pro-active to avoid future losses. More than the auditors, cadresof system specialists with finance background could be developed through

introduction of the process. Assessing and documenting risks as a part of appraisalmemos in credit and alike decisions will not only develop processing skills, butwould facilitate to separate willful negligence from erroneous business judgment.Baste committee norms on capital adequency are hereto stay so also the practices likerisk management. Hence, better prepare to internalize them.

BENEFITS TO THE BANK

The risk assignment will result in significant benefits to the banks in the form ofdevelopment and operationlisation of an integrated and comprehensive risk

management system.

The establishment of a sound risk management system would help the bank in:

- Improved risk management practices

- Improved business perspective

- Improved progitability

- Better management control

-Increases compliance with established policies and standards.


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-Inproved morale of employees

-Healthy growth

MID-TERM REVIEW OF MONETARY AND CREDIT POLICY FOR 1998-99

Risk management systems are designed to incorporate all the provisions andstatutory requirements of the RBI, proposed by the Narsihmam committee onBanking Sector reforms, which were announced by the RBI Governer Dr. BimalJalan on 30th October, 1998 in the mid-term review of the monetary and credit policyfor 1998-99. They also have the in-built flexibility of enabling the bank to adopt toany changes or additions made in the future policies and guideline of the ReserveBank of India.

The RBI has announced guidelines on comprehensive Asset-LiabilityManagement practices on credit risk, market risk, interest rate risk, operational risk,

etc., to be followed by all banks with effect from April 1, 1999. It has also specifiedthe risk weights to be attached to the various categories of assets, including theweights to be attached to government advances and government guaranteedadvances. This will help the banks to comply with the regulatory environment asstipulated by the Reserve Bank or India.

Risk such as credit risk, market risk, liquidity risk, operational and systemrisk is a fundamental aspect of financial institution management. Thus, as a financialinstitution our goal to maximize corporate value can be realized through controllingthose risks in a satisfactory level and range. By effectively managing the individual

risk according to its character, we are able to achieve financial soundness andincrease business profitability, which enables us to meet stockholders demands formaximizing corporate value.

CHAPTER II

RISK MANAGEMENT IN BANKS

(i). INTEREST RISK MANAGEMENT

The deregulation of the financial system in Indian has put in place a lot of operationalfreedom to the financial institutions. The entry of new players and product hasrapidly transformed the financial market and most of the rigid regulations are on theway out. The deregulation of forex and domestic resources base of banks has broughtin various types of liabilities, free from reserve requirements, interest rate regime andother types of regulatory restrictions to the balance sheet of banks. The pricing ofthese liabilities has also been left to the commercial judgment of banks. The earningsand costs of these liabilities are closely related to interest rate volatility. Thus, theinterest rate risk, a term totally unknown to the banking industry in Indian hassuddenly became relevant. Most of the banks identified interest rate risk as a drain on

their profitability and have started assessing the magnitude of interest rate riskembedded in their balance sheets.


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Interest rare risk refers to volatility in net interest margin or variations in net interestincome due to changes in interest rate. In other words, where assets and liabilities arecontracted on a floating rate basis, a banks exposure to interest rate risk arises fromfluctuations in the interest rate on repricing maturity dates i.e., roll over rate. Interestrate risks are broadly classified into. Mismatched or gap risk, basis risk, net interest

position risk, embedded option risk, yield curve risk, price risk and reinvestmentrisk.

1. GAP OR MISMATCH RISK

A gap or mismatch arises from holding assets and liabilities with a different principalmount, maturity dates or repricing dates, thereby creating exposure to changes in thelevel on interest rates. The gap is the difference between the amount of assets andliabilities on which the interest rates are rest during a given period. In other words,when assets and liabilities fall due for repricing in different periods, then they cancreate a mismatch. Such a mismatch or gap may lead to gain or loss depending upon

how interest rates in the market tend to move. For example, if a bank has invested 90days 8 per cent and maturing on the same day as the deposit, the bank will havematched gap. As defined by gap there would be no interest rate risk. If the interestrate rise by 100 basis points during the 90 days term of the deposit, the deposit will

be renewed at 9 per cent and the fixed rare loan will also mature and can be repricedat 11per cent. This the 2 percent net interest margin will be preserved. If the proceedsof the 90 days while the deposit are reinvested in a floating rate loan (repricing atevery 30 days) with an initial rate of 10 per cent, the interest earned on the loan willchange twice during 90 days while the deposit rate remains unchanged. Since theasset is repricing much more rapidly than the liability during this period, the bank isasset sensitive. The asset sensitive bank can produce a large net interest margin if theinterest rate rise because interest rate on floating rate loan move higher during the 90days period while the interest rate being paid on the deposited remains at 8 per cet.Conversely asset sensitive gap position would cause compression in the net interestmargin as interest rate declines. If a bank uses the 8% 90 days term deposit to find a30 year fixed rate mortgaged loan at 10%, the loan will continue to earn 10% whilethe deposit reprises at every 90 days interval. The bank is now liability sensitive

because the interest rate paid on its deposits is reset more rapidly than the rate beingreceived on the loan. A rise or fall in interest rate in a liability sensitive situation hasthe opposite effect on the net interest margin an asset sensitive bank. Any increasesin interest rate will cause an erosion of the liability sensitive banks net interestmargin. Mismatched repricing periods of assets and liabilities in only one form ofinterest rate risk. There are other forms of interest rate risks inherent in every banks

balance sheet that can severely affect their earnings.

2. BASIS RISK

In a perfectly matched gap position there is no timing difference between the resetdates; the magnitude of change in the deposit rate would be exactly matched by themagnitude of change in the loan rate. However, interest rates of two different instrumentswill seldom change by the same degree during the same period of time. In the example of a

bank with a matched gap position, in case the 90 days deposit rate changes from 8 per cent


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to 9 per cent, the rate earned on 90 days fixed rate loan can also be changed from 10 percent to 11 per cent and preserve the 2 per cent net interest margin. If the risk premium inlending rate remains constant at 25 per cent of the 90 days deposite, as the 90 days deposit

rate move from 10 per cent (8 1.25) to 11.25% (9 1.25), which will produce as 25 basis

point increase in net interest margin. Risk premium, however, changes over time, as theperception of risk changes in the market place. If the existing 25 per cent risk premiumshrinks to 19.4% per cent, a 100 basis point increase in the deposit rate produces only a 75

basis point increase in the loan ( 9 1.94 = 10.75), the net interest margin contracts by 25

basis points

The fact that bank gap remains perfectly matched while changes in the level ofinterest rates cause wide swings in the banks profits clearly indicates another form ofinterest rate risk in the balance sheet of banks

When the variation in the rate causes the net interest rate margin to expand, the bank

has experienced a favorable basis shifts and if the interest rate movement causes the interestmargin to contract, the basis has moved against the bank.

3. NET INTEREST POSITION RISK

The banks net interest position also exposes the bank to additional interest rate risk.If a bank has more assets on which it earns interest than it has liabilities on which it paysinterest, interest rate risk arises when interest rate earned on assets changes while the cost offunding of the liabilities remains unchanged at zero per cent. Thus, a bank with a positivenet interest position will experience a reduction in its net interest margin as interest ratedecline and an expansion in its net interest, margin as interest rate rises. A large positive netinterest position accounts for most of the profits generated at many financial institutions.

4. EMBEDDED OPTION RISK

Large changes in the general level of interest rates create another source of risk tobanks profit by encouraging per-payment of loans and bonds and/or withdrawal of thedeposits for prepayments of loans, the borrowers have a natural tendency to pay off theirloans when a decline interest rate occurs. In such cases, the bank will receive only a lowernet interest margin. Take the case of a bank disbursed a 90 days loan at a rate of 10 per centand rate of interest declines to 9 per cent after 30 days and the borrower pays off his loanimmediately, the bank will receive only 200 basis points interest margin for 30 days ratherthan the anticipated 90 days. In the remaining 60 days of the 90 days term, the net interestmargin will be only 100 basis points

When the interest rate rises, the net interest margin becomes exposed to the sameembedded option risk on the liability side of the balance sheet as well. If there are nosubstantial penalties for early withdrawal, the depositor will withdraw the term deposit

before maturity, so the funds can be redeposited in a new deposit account at a higher rate ofinterest. For example, if a 100 basis points rise in rate occurs 30 days after the deposite isfixed, the depositor would close 8 per cent 90 days deposit and open a new 90 days termdeposit at 9 per cent. This action of the depositor will cause the bank net interest margin todecline 100 basis points during the last 60 days of the originally 90 days term.


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As interest rate rise and fall, the banks are exposed to some degree of risk ascustomers exercise the embedded options inherent in their loans and deposit contracts. Thefaster the changes in rates and higher the magnitude of the changes the greater will beembedded option risks to the banks net interest margin.

Most of the banks protect themselves from these risks by imposing penalties for pre-

payment of loans and early withdrawal of deposits. However, most banks have foundcustomers resist paying large penalties and must reduce the penalties to more modest levelsas a competitive strategy to attract additional business.

5. YIELD CURVE RISK

An yield curve is a line on a graph connecting the yields of all the maturities of aparticular bond. As the economy moves through the business cycle, the yield curve changesrather frequently. During most of the business cycles, the yield curve has a positive slopei.e., short term rates are lower than longer term rates at the intervention of Government of

India/Reserve Bank, the yield curve can be twisted to negatively slopped i.e., short terminterest rates are higher than long term interest rate. A negatively slopped yield curve isfrequently referred to a inverted yield curve. Yield curve risk occurs with the variation inyield curves between securities of different maturities.

Positive and negative yield curve on different dates are shown below:

To illustrate how a change in the shape of the yield curve affects the bank net interestmargin, let us assume that Bharat Bank Ltd has deliberately placed itself in a liabilitysensitive gap position on 30th June 1993 by using 90 days certificate of deposit to fund one

year floating rate loans. If the bank pays 100 basis points above the 6.60 per cent 91 daystreasury bills rate on its 90 days C.D. and charges 250 basis points above the one year T. B.rate climbing to 9 per cent and one year T. B. rate of 8% on its loans, a net interest margin


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of 290 basis points is produced if the yield curve becomes inverted on 1 st January 1994 with91 days T. B rate climbing to 9 per cent and one T. B. remaining at 8 per cent and the spreadrelationship of the deposits and loans to treasury bills rates remain constant, the net interestmargin will be reduced to 50 basis points.

6. PRICE RISK

Price risk occurs when assets are sold before their maturity dates. For example, theprice of 10 years 10 per cent government of India loan will receive only lower price thanoriginally paid for when interest rates on bonds of 10 year Government of India loan havegone up to 13.5% per cent.

7. REINVESTMENT RISK

The difference in the timing of interest cash flows between various assets andliabilities create reinvestment risk.

Measuring interest rate risk

Before risk can be managed, they must be identified and quantified. Unless thequantum of risk inherent in a banks balance sheet is measured, it is impossible to measurethe degree risk to which the bank is exposed. It is also equally impossible to developeffective risk management strategies without being able to understand the current risk

position of the bank.

The interest rate risk is measured by calculating gaps over different time intervals

based on aggregate balance sheet data at a fixed point of time. Gap analysis measuresmismatches between rate sensitive assets and rate sensitive liabilities. The gap values

provide an indication of the effects of movement of interest rated on met interest margin.

An institutions interest rate position is the cumulative result of thousands ofindividual deposits, loans, investments etc., comprising the balance sheet date. Eachdeposits, advances etc., has its own cahs flow characteristics. In order to fully comprehendthe risks inherent in banks balance sheet, each loan, deposit etc, should be related to theirflows and repricing to a change in the general level of interest rates.

The gap report is generated by grouping assets and liabilities into buckets accordingto maturity or time until the fast possible repricing.

The principal portion of an asset and liability that can be priced is classified as ratesensitive. The gap then equals the rupee difference between Rate Sensitive Assets (RAS)and Rate Sensitive Liabilities (RSL) for each time interval. Any number of periods can beused while constructing gap report. Most mangers focus their attention on the near term

periods viz, monthly, quarterly, half yearly or one year. The gas reports indicates whether itis in a position to benefit from rising interest rates by having a positive gap position (RAS >RSL) or whether it is in a position to benefit from declining interest rate by its negative gap

(RSL > RSA). The size of the gap indicates the degree to which an institution will benefitfrom favourable movement in interest rates. The negative gap indicates that the bank hasmore RSLS than RSAS. When interest rates rises during a specified time period, the bank


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pay higher rates on all repriciable liabilities and earns higher yield on the reprice ableassets. If all rates rise by equal amounts at a time, interest expenses rises more than interestincome because more liabilities are repriced and the spread declines. When interest rate fallduring the interval, more liabilities than assets are repriced at lower rates, the average yieldwidens. A positive gap indicates that the bank has more RSAS than RSLS. When short terminterest rate rises, interest income increases more than interest expenses because more assetsare repriced. The spread and net interest margin similarly. Any fall in short term interest ratehas the opposite effect. The change in net interest rate margin rises because amount or ratesensitive assets defers from the amount of rate sensitive liabilities. It is also linked to yieldcurves. A positive gap is desirable when the yield curve is shifting from a flat position to anegative or humped shape. In a negative gap sloping yield curve is profitable.

The impact of interest rate movement on different gap situation is illustrated in thefollowing table:

GAP SUMMARY

Gap position Change in Change in Change in Change in

Interest Interest Interest Net interest

Income Expansion Margin

POSITIVE Increase Increase > Increase Increases

POSITIVE Decrease Decrease > Decreases Decreases

NEGATIVE Increase Increase < Increases Decreases

NEGATIVE Decrease Decrease < Decrease Increase

ZERO Increases Increases = Increases Increases

ZERO Decrease Decrease = Decreases Decreases

Although the gap report has been used as a primary measure of interest rate risk, it failed toprovide all the information necessary to measure total interest rate exposure. Gap reportquantifies only the time difference between repricing of assets and liabilities but fails tomeasure impact of basis, embedded etc., risks. The gap report also fails to measure theentire impact of a change in interest rate on net interest margin or the effect of a change ininterest rate on the market value of banks assets and liabilities. The most accurate estimateof the impact of interest rate change at banks market value can be assessed by conducting a

net present value analysis. This analysis determines the net present value of all the cashflows which are induced either by assets or liabilities.


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STRATEGIES FOR CONTROLLING INTEREST RATE RISK

Interest rate risk management process should begin with strategies that change thebanks interest rate sensitivity by altering various components of the balance sheet. Theactual management of banks assets and liabilities focuses on cont rolling the gap betweenRSA and RSL. Some banks pursue a strategy of mismatching assets and liabilities maturity

as closely as possible to reduce the gap to zero and reduce the volatility of net interestmargin.

Aggressive bankers, however, vary the gap in line with their interest rate forecasts. Ifthey expect interest rat to increase, they widen the gap by repricing the assets morefrequently than their liabilities. The banks have been following various balance sheets etc.,strategies to limit the stocks of interest rate volatility. The basic strategy of the banks isfocused on bridging the gap position. The strategies for reducing assets and liabilitiessensitivity are:

Reducing asset sensitivity

- Extend investment portfolio maturities

- Increase floating rate deposit

- Increase short term deposit

- Increase fixed rate lending

- Sell adjustable rate loans

- Increase short term borrowings

- Increase floating rate long term debt

Reducing liability sensititvity

- reduce investment portfolio maturities

- increase longer term deposits

- sell fixed rate loans

- increase fixed rate long term debt

The basic balance sheet strategy to alter banks interest rate exposure is to effect changes inthe portfolio composition. A variation in portfolio mix potentially alters net interest income.The assets sensitivity situation can be tackled by pricing more loans on floating rate basis orshortening maturities of investment securities. The banks can also consider selling fixed

income securities and reinvesting the proceeds in securities with a different maturity.


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High level of interest rate risk in several banks is the direct off-shoot of aggressive pricingpolicies on loans and deposits. To address these problems, banks may have too developfloating rate loans with interest rates that can be reset at a near term intervals. The base ratethat can be used an index on adjustable rate loan may be treasury bills rate with samematurity as the reset period. For example, the rate on floating one-year loan may be basedon a fixed spread above the prevailing one year treasury bill rate at the time of resetting.

The impact of an asset sensitivity situation can be managed by securitisation of variousloans portfolio backed by cash flow. IT greatly increases the liquidity and eliminate theinterest rate risk embedded in the balance sheet.

The other options available to the banks are :

i. match long term assets with non- interest bearing liabilities.

ii. match repriceable assets with a similar repriceable liabilities.

iii. Swaps, options and financial futures to construct synthetic securities and thus hedge

against any exposure to interest rate risk; and

iv. Maturity mismatch is accentuated by Non-Performing Assets

(NPA) and loan renegotiations. Sound loaning policies and effective post sanction

monitoring and recovery steps can contain the volume of NPA.

Risk averse banks management would always endeavor for a matched book. Full match inrepricing assets and liabilities is neither feasible nor expedient. The adverse impact on netinterest margin due to mis-matches can be minimized by fixing appropriate tolerance limitsshould be relatively lower in the shorter ends or proximate time bands. Thus the bankshould constantly review finances with a view to protecting interest rate margins.

(ii) CREDIT RISK MANAGEMENT

Credit risk is a contingent risk which arises when the counterparty in a foreign exchangetransaction fails to honour the commitment. Credit risk can be classified into:

Contract Bank

Credit Riks

Clean Risk


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Contract Risk: where the failure of the counterparty is known prior to the performance ofbanks commitment in the contract; the contract has to be treated as cancelled and the risk isto the extent of loss resulting from an adverse movement in exchange rates while coveringthe transaction on going market rates.

Clean Risk at Settlement: Through currencies are exchanged at settlement on the same

value date, the time zone differences between different centers would result in one currencybeing paid before the other is received. If the failure of the counterparty occurs after youhave settled your portion of the commitment, it would result in the loss of the entire value ofthe contract. The case of Bank Herstatt in Germany, which failed in 1974 in the afternoonafter receiving Deutschemark funds but before delivering counter value dollar funds, is aclassic example of the clean risk at settlement of funds.

Control over credit risk is exercised by fixing limits on aggregate value of outstandingcommitments for merchants as also inter bank counterparties. The limits are constantlymonitored and the dealing room suitably advised if the limits are close to being breached.

Limits are fixed on the aggregate outstanding commitments and separately for the amount offunds to be settled on a single day. The letter limit would be smaller and is intended tocontrol the clean risk at settlement.

In the Indian context, prior to computerization of the foreign exchange operations not muchattention was paid to credit risk and its control. This was perhaps due to the difficulty inmonitoring the limits by a manual system and also a complacency that the possibility of any

participant in the Indian forex market failing is rather remote. In the interest of developingcomprehensive control and also computerization of dealing operations on on-line basis suchcomplacency is not warranted.

Sovereign Risk: Sovereign risk is the political side of the credit risk when a countrysuspends or imposes restrictions on payments. Thus, even if the counterparty is willing andable to honour commitments, sovereign action could frustrate the contract. This risk is

present not merely in dealing room activity but also the entire volume of assets is prone tosuch a risk. The exposure limits for different countries should take into consideration factorssuch as political stability health of the economy, possibility of state interference, availabilityof infrastructure for legal recourse, etc.,

MISMATCHED MATURITIES OR GAP RISK

Guided by asset liability management principles, we are inclined to know and find that theassets and liabilities constituting the exchange position would generally have differentmaturites and mismatches in cash flows would also result. If uncorrected this wouldtranslate in cash flows would also result. If uncorrected this would translates into problemsof overdrafts or idle surpluses not only in quantum but also in maturity, Deposit theseefforts it does not materialize because:

(a) Uncertainty attendant with merchant transactions. Option periods availability under

forward contracts as also early/delayed receipt of export payments.

(b) Non- availability of matching forward cover in the market.


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(c) Even in interbank contracts the buyer bank has option of pick-up within the period of

the contract.

(d) Deliberate attempt to hold gaps and to cover them subsequently to minimize swap costs

or to earn swap gains.

The risk the bank runs in carrying the gaps is that when the gap has to be covered by asuitable swap the forward differentials could do against the bank and costs more than

provided for, could result. The Indian derivative market handles mainly forwards, swaps andfor options, it is quite thin and can move very sharply. In the overseas market forex as wellas money markets are integrated and the swap differentials reflect interest rate differentials.Uniquely in the Indian context banks are not allowed to lend or borrow forward currencies,thus forward margins are driven purely by demand and supply for forward cover whichcould change quite dramatically as observed recently annualized 6 months premium for

USD/Rupee went up approximately by 26 percent.This enhances the risks of maintainingmismatches. RBI has thus placed restrictions on banks maintaining mismatches.

Segregating assets and liabilities maturity wise and quantifying the net inflow or outflow foreach period exercise control of gap at monthly intervals. Banks thereafter take thecumulative effect of these period-wise mismatches to quantify the cumulative inflow andoutflow, on the quantum of which limits are placed.

This is the way the net outflow or inflow is measured and subject to an individual mismatchor gap limit. For all the periods, instead of the concept of cumulative outflow of inflow, the

individual gaps are grossed without set off and subject to an aggregate limit. RBI has alsoprescribed that the aggregate of aggregate limits of all currencies should be within us$100million or 6 times the owned funds of the bank whichever is less. The rationale behindcomputing the aggregate gap limit in the manner suggested in the guidelines is oftenquestioned, since what is really relevant is cumulative effect of inflows and outflows.However, RBIs intent in fixing the aggregate limit as above seems to be not only riskcontrol but also to avoid excessive trading in the ambiguous forward market.

The Sodhani Committee is of the view that AGL in its present form represents only the sumof the monthly mismatches and does not adequately take into account the period of the

exposure and attendant interest rate risk and the committee has recommended thatauthorized dealers interest rate exposure should be reviewed with a view to extending limitsalso to rupee transactions as a part of general banking supervision. However the committeefor the present want the gap discipline may only apply to foreign currency only and the topmanagement of banks may be permitted to fix the AGL and IGL in relations to their forexoperations, risk taking capacity etc.,

REVISED BIS PROPOSALS ABOUT MARKET RISKS AND CAPITAL

ADEQUACY


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The 1988 Balse Committee on Banking Supervision has considered mainly the credit risk,for capital requirements. Now the Basle committee has set out to develop a framework forintegrating into the 1988 Accord an approach to assessing explicit capital charges for marketrisk. Under the shorthand method, the nominal amount or net present value of the net

position in each foreign currency and in gold is converted at spot into the reportingcurrency. The overall net open position is measured by aggregating: the sum of net short

positions or the sum of the net long positions, whichever is the greater plus net positionshort or long in gold, regardless or sign. The capital charges will be 8 per cent of the overallnet open position. In banks own internal models methodology, price and position dataarising from the banks trading activities are entered into a computer model that generates ameasure of the banks market risk exposure, typically expressed in terms of value-at-risk.This method calculates the maximum loss during a holding period of say ten days, with agiven confidence level for either stimulated or historical position changes, and 8 per cent ofthe maximum loss is assigned for capital charges.

OPERATIONAL RISKS

Operational risks arise out a wide variety of situations ranging from humor errors toadministrative inadequacies, provisions flaws in systems and procedures etc., It is essentialthat we recognize them early and ensure that they are controlled and corrected. We canidentify some major areas of operations and the probable nature of operational errors thatcould occur.

Segregation of dealing and accounting functions: It is essential that the dealingdecision and its execution be separated and performed by different functionaries. Thisensures that a check is maintained on the dealers activities and the dealer of course cannot

execute a dealing decision without involving the accounts section. In some cases in Indianand abroad huge dealing losses emanated from concealed exchange position, the situationlargely arose because of the lack of functional segregation.

Follow-up of deal slips and contract confirmations; A dealing decision is taken orallyby telephone, or through unauthenticated messages. It is essential to have this follow-up bywritten/authenticated confirmations. This requires the follow-up of the deal slip, the brokersnote and contract confirmations. In several cases mistakes in understanding of nay essentialdetail of the contract came to light so much later that there correction become very painful.The duidelines do require banks to follow up unconfirmed outstanding contracts. This

aspect has been taken care of largely where dealing operations are put on the dealing screen.

Control over settlement of local and foreign funds: A dealing decision can be totallyfrustrating if the funds are not settled appropriately and marginal profits on exchange arelikely to be more than loss by way of interest on delayed settlement of funds. Whileexecution of funds transfer instructions are to be prompt, the bank requires to be equallyvigilant and quick in locating and rectifying and delays in settlement of funds.

Brach reports and pipeline transactions: One of the major areas of operationaldifficulties is managing of exchange cover for forex transactions affect the banks position

immediately notwithstanding the fact that they are advised by the branch much later. Such


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an exposure has to be maintained under control and any significant delay in a branchreporting a transaction has to be followed-up.

Overdoes bills and contracts: Export bills and forward contracts have to be monitoredto ensure that they are delivered as per their tenor. Failing this the bank is likely to incurconsiderable swap costs in maintaining these items in position.

Nostro reconciliation: The Nostro Account is the logical end of any forex transaction.When a transaction is ultimately transferred to the mirror account in the books of the bank,it must find a corresponding entry in the statement of account sent by the correspondent

bank. Reconciliation of the entries and balance has to be done periodically to identify andfollow-up the outstanding items. Keeping in mind A, B, C control reconciliation is requiredto be taken up by staff other than those who operate the accounts to avoid possibilities ofany cover up of errors or fraudulent transactions. The problem often lies in situationsconsidering the exercise complete on reconciling the balance. The fact is that the job beginswith identification of the unrecognized which have to be followed-up with the concerned

branches, counter parties or the correspondents. Managements are often lulled intocomplacency by considerations like:

Un reconciled debits and credits are in aggregate more or less equal and theirreconciliation process will not result in net outflows. Only unreconciled debits have to befollow-up.

It is obvious that such reasoning is shallow. Efforts towards improving reconciliationinclude:

a. Where there is a large branch network allocation of separate nostro accounts forspecific groups of branches, convenience on reconciliation obtaining from a limitednumber of branches operating on an account should of course be weighed against thecost of maintaining several nostro accounts.

b. More than one account maintained with the same correspondent often results inmisdirection of transactions by the correspondent and can be avoided.

c. Responding entries remaining unreconciled signal an error and while following upthe unreconciled entries priority therefore has to be given to such entries.

d. Bank changes debited to the account has to be promptly responded to. The problemoften arises when the customer on whose account the charges arose is not making

payment or is not available. Where the charges have been levied entry has toresponded promptly and where the customer is not available the bank absorbs thecharge.

e. Set-offs of unreconciled debits and unreconciled credits has to be totally avoidedsince while apparently reducing the unreconciled items they will render futurereconciliation into further disarray.

The RBI has required banks to have a vigorous follow up of reconciliation andsubmit periodical statements on the volume of unreconciled items. While follow-up


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of unreconciled item could be quite laborious, it must be borne in mind that what isnow difficult is only likely to become impossible, if postponed further . Control overoperational errors and failures would be exercised through a system of record andfollow up of such errors supported by concurrent or periodic audits. Periodic reportsneed to be submitted to the management who could then review the system inoperation.

SKILL AND EXPERTISE

It has been observed that the Indian banks as of now, do not generally, deal in a bigway in a number of sophisticated activities, particularly forex and money markets. Itis mainly due to the hesitations arising out of lack of appreciation of operation of the

products and skills to handle them. Efforts have already been initiated to break thisvicious circle to be able to expand our range of services and augment fee income. Itwill facilitate and enable Indian Banks to handle derivative products beyond forwardsand swaps to futures, options and FRAS within the ambit of forex dealing/trading

operations and also to ensure that the activity is in consonance with the frame work atthe international level.

Conclusion: The progressive globalization of the economy has exposed the Indianforex market to the volatility in international markets. In order to appreciate theissues relating to products available for hedging forex risk, scope for furtherdevelopment of the market and introduction of new derivative products and otherrelated matters let us take stock of the situation, analyze and accept tested devices,regulate efforts facilitating the process to mange risk in the given situations.

As the market develops the cost of note taking an in depth approach increases but thebenefits of an intelligent and well informed approach to the system increases faster.In the name of volatile forex market and believing in SURVIVAL OF THE FITTESTmarket players find and anticipate further challenging task before. Surely it is hightime to harness the potential Indian forex market promise and to book advantage ofavailable latent talent in activating the forex market. The implementation of theSodhani Committee Recommendtions on Foreign Exchange Markets in India isexpected to deepen and broaden the forex market and provide an opportunity tointegrate ultimately with the global activity still further in the days ahead.

OPERATIONAL RISK MEASUREMENT

Time, money and people do not always lend themselves to so comprehensive aprogram. In these situations, Operational Risk Management (ORM) provides analternative approach that requires less time and fewer human resources.

Reliability of risk-centered maintenance are functional risk measurements thatconsider what can happen, that in they take an in-depth look at all possible failuremodes and incorporate them all into maintenance planning. There is no question thatsuch functional risk measurements are beneficial, especially for developing a

complete maintenance plan and for managing low-frequency. High consequenceevents. However, when there is a need for quick, low-cost reductions in risk,


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operational risk measurement is an excellent alternative. Operational riskmeasurement is performed only on process critical equipment. It involves areorientation of data normally collected in plan operation and used that data toidentify areas of high risk and just as important areas of low risk. Its principles areapplicable to the e consider only events that have already occurred, here we also limitour scope to identifying and quantifying only risk contributors that are within the

plant boundaries. For example, companies that have plants on foreign soil in volatileareas of the world may find social instabilities a factor in risk management. With thismethod, however, we restrict ourselves to within the plant itself and deal with risksolely from a plant operational point of view, regardless of its location in the world.

Our discussions of computing operational risk measurement will include its datarequirements. There are three fundamental characteristics that are common to allapplications: (1) the time/date of failures; (2) the nature of the failures, and (3) thecosts associated with the failures

Accurate recording of the time of failure may appear to be an obvious and routineactivity. Unfortunately, it is nor always. In many cases, people will use the date thework repair order was opened as the failure occurrence time. Depending on what elseis happening in the plant, this could be on the same day or could be several dayslater. The time of day information is usually not recorded at all. This information isvery useful for analyzing the potential for subtle, synergistic effects, on is usually notrecorded at all. This information is very useful for analyzing the potential for subtle,synergistic effects, such as circadian influences, and is relatively simple to capture.Capture of the failure time is common with automated control systems like thoseinvolved in process control. For these systems, it is a simple matter of computer

programming to record failure times.

The nature of the failure simply identifies what failed and how. A good way touniformly and systematically record this information is with the use of failure codes.This minimizes the time required to record the event either in a computermanagement system or paper-oriented system. To some extent, it relieves the

personnel demands in writing descriptions and also standardizes reporting responses.You want the codes to be as accurate as possible to capture the valuable failure causeor effect information. I use the word accurate here with deliberate intent. The

personnel deciding on what code or codes to apply should be able to select theappropriate codes by scanning a list. You want to minimize the number of failurewith the miscellaneous or other codes, I have seen upto 33% of all failures of one

plant in the miscellaneous category. In this case, it meant that without interviewingthe personnel directly who did the repairs, no information was available on thefailure cause. Thus, from a practical point of view, no improvement could be madeon 33% of the plants failures (this has been corrected since the observation wasmade). Now work orders cannot be closed unless at least one failure code has beenassigned. The failure code is a simple piece of information that is obvious to

personnel at the time of repair. Unfortunately, it rapidly fades from memory as newproblems continuously arise. That is why recording this information at the time whenit is fresh in peoples memory is invaluable for risk reduction.


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The cost of failure is the most complex of the date items required for operational riskmeasurement. Cost cannot be readily entered at the time of the failure occurrence

because it includes many factors. These range from tangible items, such as cost ofparts and labour, to those which are less obvious, including lost production, insuranceincreases resulting from the failure, workers compensation and litigation costs. Costsof failure is the fundamental measure of operational risk.

Components of Operational Risk:

Before we can measure operational risk, we must first identify its primarycomponents, which are (1) equipment risk, (2) product risk, and (3) people risk. Therisk contributors interacts with each other in both direct and indirect pathways. Every

plant has unique factors that compose its specific risk components.

Operational risk measurement begins with data gathering and summarizing. The datafor this process are normally collected during plant operations. Here is an overview

of the steps involved:

1. Look at the frequency and costs attributable to equipment failures. This involvesgathering the numbers that tell you how money left the company to pay for costsincurred as a result of equipment failures and how often. Costs will includeequipment replacement, purchase of parts, and both company and contract labourfees. These expenses should be accrued over a fixed time period, which is generallyone year.

2. Gather information about the frequency and costs incurred because of production

failures. This actually means summarizing information about how much money didnot come into the company because of production failures and how often these lossesof income occurred.

(iii) RISK MANAGEMENT IN BANK GUARANTEES

Broadly, risk is the volatility of potential outcomes. For banks, engaged in thebusiness of managing risk, that means the volatility of future income. But byestimating the likelihood of risk, banks have a better change or making sensibledecisions. Those who best define, anticipate and manage risk will have a competitive

advantage and should stand to profit.

Banks, in the ordinary course of business are required to issue a variety of guaranteeson behalf of the customers. Issuing guarantees is a non-fund based business and solong as the business continues to be non-fund based it is remunerative with noattendant risk. But it is very important to bear in mind the associate risk inherent indifferent types of guarantees as perforce may be required to fund borrowers activates.Bank guarantees may be classified according to the period, as short term and deferred

payment guarantees; short term may extend even upto 3 years. They may also beclassified according to purpose as performance and financial guarantees.


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Short term guarantees, could either be performance or financial performanceguarantees assure the beneficiary that the customer will perform a contract inaccordance with the terms. Financial guarantees relate to the payment of certain sumof money advanced by the beneficiary to the customer, i.e., guarantees coveringadvance payments under a contract.

The degree and nature of risks inherent in different types of guarantees are given inthe following TABLE:

Types of Guarantees Degrees & nature of risk

Performance guarantees HIGH RISK

Performance over a period of time

Likely to be affected by cost overruns.

Uncertainties due to market condition.

Financial guarantees HIGH RISK

(Guarantees for advance May result in indirect funding of un

derlying contract.

payments ) It is generally followed by performanceguarantee.

Guarantees of release of LOW RISK

retention money/ Liability may crystallize only when,

delivery of goods. There is a serious irregularity of

Guarantees for supply of dishonesty on the part of the client.

Material on credit

Deferred Payment To be treated as part of funded working

Guarantee Capital facility and appropriate security tobe obtained.


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To be treated on par with/part of termloans.

Projects to be appraised fully and debt

service coverage ratios should be foundadequate for meeting installment payments.

Misc. Guarantees Risk depends on specific purpose andnature of underlying contracts.

No guarantee should be issued without fullyappreciating the underlying contractual

obligations.

RISK MANAGEMENT:- In order to contain risk in bank guarantees, the followingaspects should be taken into consideration:

i. Customer: Verification of antecedents of customers in terms of integrity, experience and

capacity to perform a contract is crucial. As a matter of rule, the guarantees shouldnot be issued to strangers or to customers who do not have credit facilities. In case ofcustomers maintaining only current account, it should be ensured that they do notenjoy credit facilities with any other bank before acceding to their request. In case ofgood business opportunity, such request from the client who have credit facilitieselsewhere may be considered only with prior permission from competent authoritiesin corporate/ Head Office.

ii. Security: While security is an important consideration for issue of guarantee, it should

be appreciated that the degree of underlying risk does not vary with the quality ofsecurity. The best security remains to be an ability of the customer to dischargeobligation under the guarantee promptly. To this extent, security is not a substitutefor credit judgment.

Security is to be negotiated with reference to specific cases. General principles maybe stated as under:

a. In cases of all corporate clients, charge on current assets should be extended to cover the

guarantee facilities too.


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b. As a rule, all deferred guarantees or all guarantees for suppliers credit should be securedby the underlying assets i.e., mortgage of fixed assets or hypothecation of current assets inthe same manner as security for a term loan/working capital facility is obtained.

RISK RIDDEN GUARANTEES:- There are certain guarantees which banks shouldgenerally avoid. These are:

a. For unlimited amount or for long period.

b. In respect of contracts which are likely to lead to dispute about their actual

performance.

c. Which are anomalous in their nature and content and create unknown and undefined

responsibilities and liabilities to the bank.

d. Which are transferable and assignable by the beneficiaries

e. On account of payment of income-tax.

f. Which may restrict the rights of the bank to pay the amount guaranteed.

g. Of an unusual natural or with onerous clause

h. For amount exceeding prudential norms.

GURANTEES AND THIR RISK WEIGHT:- Balance-sheet assets, non-funded itemsand other off-balance sheet exposures are assigned weights according to the

prescribed risk weights. Banks are required to maintain minimum unimpaired capitalfunds of 8% on the aggregate risk weighted assets on an ongoing basis.

Non-funded items such as bank guarantees are first multiplied by Credit ConversionFactor (CCF) and the derived value is thereafter multiplied by the weightsattributable to the relevant funded risk assets. In the case of financial guarantees, the

CCF is 100% and for performance guarantees 50%. Depending upon, whether thesebank guarantees are counter-guaranteed by Government etc., relevant risk weights(0-100) of funded assets are applied.

In order to meet the capital adequacy norm, the following points should be kept inmind while entertaining guarantee business. Whenever possible endeavor should bemade to obtain:

a. Government guarantees/counter guarantees so that the advance will attractzero risk weight and

b. Higher cash margin/deposits so that the amount can be netted off beforeapplying the risk weight. Banks must embrace risk if they are to make profits.


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So the hazards of errors and omissions are always present. But with better riskmanagement banks can take risks consciously, plan for the consequence andcan make the mistakes less costly.

(iv) FOREX OPERATIONS AND RISK MANAGEMENT

Forex Market in India:- The forex market in India is developed principallyto facilitate forex services to the customers. The RBI has allowed 96

banks(Ads) to deal in forex, to trade among themselves in foreign currenciesdirectly or through forex brokers. The market operates from major centersviz., Mumbai, Calcutta, Delhi, Chennai, Bangalore and Kochi. Besides banks,financial institutions such as IFCI, IDBI, ICICI, etc., have also been givenlicenses to undertake forex business incidental to their main businessactivities.

The forex market trades in spot and forward exchange contracts in USD/

Rupee and cross currencies. The turnover is estimated to be around USD 3BNper day. The Indian forex market is a skewed one with around 30 percent ofmerchant business emanating form SBI and foreign banks account for 55

percent turnover of interbank transactions. Business turnover has beenshowing an increasing trend over the years.

The interbank segment of the forex market is the biggest one in India as its iselsewhere. The arbitrage opportunities arise, within the constraints of givenregulations between call money markets and the foreign exchange markets.Also often, a demand arises for forward dollar from banks who are rolling

over the FCNR deposits. In India the link between call money rate and not tohave a proper rupee yield curve and a very dep and liquid money market andwhatever may be the form, its lack of integration with the forex markets.

RISKS IN FOREX

In view of the volume, volatility in currencies, market structure, liberalizationin trade and exchange control, integration of the Indian forex market to globalmarket, sophistication of mechanism and skill to handle dealing operations,we are to remember that a risk does not vanish one just prefers to ignore it.

It is better to face, quantify and manage risk exposure. Forex business,however, places risks; the management of which requires understanding andappreciation of controls separate from those applicable to domestic operations.

As these risks arise as a consequence of certain unique features forex business hasgiven birth to various aspects:

- Operations are transnational-obviously subject to controls restrictions,monetary and fiscal policies.

- Involve dealing in currencies whose value is volatile due to a variety of factors- Operations are integrated with a vast global market spread in all time zones.


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- Quick decentralized decision taking involving large values without losingsight of the main theme of profit earnings at acceptable risk levels

- Requirement of compliance with exchange control in India

It is pertinent to note that forex trading by the authorized dealers is not seen freely as

a source of foreign exchange innings. RBI restrictions also exist on dealings inoverseas markets. It is neither desirable nor even possible to totally restrict access tooverseas markets to cover merchant transactions. The RBI has evolved a set ofguidelines are in no way unique to banks in India. While the RBI has, through itscirculars and inspections, endeavoured to ensure compliance with these guidelines. Itis imperative that the banks appreciate and understand the purpose behind the controland observe them truly as internal controls rather than transform them into ReserveBank requirements.

The risk in forex business can be broadly classified as:

Position or Rate Risk: There are inherent risks involved in forex business. Dealingsin forex involves acquisition of assets and liabilities denominated in foreigncurrencies whose values against the domestic currency change, the bank is exposedto a rate risk. A total quantitative match between assets and liabilities denominated inone currency is normally not practicable because of the following facts

Merchant sales and purchases are not likely to match and the consequent cover in themarket may not be immediately taken up.

Market participants deal in standard lots and it may not be worthwhile goingfor cover of small amounts.

Transactions entered into by the branches effect the exchange position butmay come to the notice of the dealing room later.

Open positions may be built up and held deliberately to the advantage ofprospective rate movements.

Control over position risk generally is through currency wise limit on the size

of the exposure (i.e., the mismatch between assets and liabilities in that currency).The limit would generally be fixed on the following considerations:

Exposure Limits ++ Volume of business

++ Branches network being covered

++ Volatility of rate movement


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++ Loss bearing capacity of the bank

While no empirical relationship is fixed, it is obvious that the first two deal withmerchant generated exposure while the last two deal with the potential loss onexposure and the banks ability to bear it. Separate limits are generally fixed for theexposure during the trading hours- the DAYLIGHT LIMIT and the exposure left at

the closure of the day the OVVERNIGHT LIMIT. The overnight limit shouldnecessarily be smaller, since the exposure allowed is prone to a greater risk as itremains unattended till the next trading day. RBI has permitted individual banks tohave an open position at the close of the day subject to a maximum of Rs. 15 crores.With the implementation of the Sodhani Committee, it is to be decided by the banksindividually. Consequently overnight limits should be conservatively set. Whilefixing the overnight limit it is advisable to consider the impact of small valuetransactions though individually small cold collectively direct the closing position ofthe bank. It is hence suggested that banks periodically estimate the volume of suchsmall value transactions and their impact on the exchange position. This would notonly enable banks to review the limits set for he branches to report transactions bytelex/fax/phone but also given the dealer an indication of the extent of possibledistortion so that the overnight exposure could be so managed to offset suchdistortion. Daylight limit should allow for greater exposure since the bank canmonitor its exposure constantly and undertake market operations to maximize itsreturns on the exchange position. Generally the exposure limit is fixed currency wise.Banks also fix an overall exposure limit expressed in terms of a single currency, sayus in Indian perspectives. This limit functions as an override to ensure that theexposure is lower than the sum of all the currency wise limits when cross currency

positions are built, arguments are often advanced, that in monitoring limitscomplementary position should be measured as an exposure only in currency, sincethe correction of the position in the currency automatically squares thecomplementary position. While there is substance in the argument, it is preferable foreasy monitoring, to have individual currency exposure measured and limited.Complementary positions can be identified and used to substantiate any excess in the

position beyond the limits. After all limits are not absolute bans on theirtransgression but are only meant to identify such transgression for supervisoryscrutiny.

CUT LOSS LIMIT

The limit serves to restrict the quantum of loss a bank is willing to risk on its openposition during the day. The limit operates within the exposure limit, i.e., the daylightlimit, and is a function of the exposure of the exposure size as also the extent towhich rates have moved adversely. The moment the rates moves adversely totranslate into a loss equivalent to the limit, the position has to be liquidated and theloss booked. This serves to avoid holding on to a position in anticipation of reversalof movement of rates. While the quantum of loss should be explicit, for easymonitoring it is better to translate is into the number of points on the exchange rate

before an adverse movement can be accepted. When so translating it, it is alsoessential to relate is to the size of the exposure. For instance, if a permissible amountof loss translates to a 50 points movement on the rate on a position of USD 1 million


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the cut loss should operate when 25 point movement affects a position of USD 2million.

Banks generally have the practice of consolidating the balance in the differentposition accounts and tallying the net position with the closing position of the dealer.This is an operational procedure to ensure no transaction has been omitted either by

the dealer or the accounting section. An attempt is also sometimes made to convertthis operation in all the accounts and of all currencies into a single exposure againstthe local currency. This does not serve any purpose as an exposure control device andonly is an expression of the banks exposure to the home currency.

CHAPTER III

BANK RISK MANAGEMENT A RISK PRICING MODEL

Risk is inherent and absolutely unavoidable in banking. Risk is the potential loss an asset or

portfolio is likely to suffer due to a variety of reasons. As a financial intermediary, bankassumes or

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