WEL COME ALL OF

YOU

IN

Briefing session on

RISK MANAGEMENT IN COMMERCIAL

BANKS

ByByMalik DilawarMalik DilawarVice President/PrincipalVice President/PrincipalSenior Training Manager, North,Senior Training Manager, North,UBL Training Centre, Islamabad, UBL Training Centre, Islamabad, Pakistan.Pakistan.Phone: 0092-51-2820674(Off.), Phone: 0092-51-2820674(Off.), Fax: 0092-51-2821521Fax: 0092-51-2821521

Risk management by commercial banks -- Time to hammer out the chinks Financial markets the world over have

undergone far-reaching changes in the last decade, spurred by deregulation and liberalization, as well as rapid developments in communication and Internet technologies. Banks in Pakistan have, however, generally not paid enough attention to the potential risks and to evolve mechanisms and systems to control and manage them in line with the global standards and procedures.

Risk management by commercial banks -- Time to hammer out the chinks

As the banks no longer operate in a protected and regulated environment, there is an imperative need for them to develop and improve their capability to understand the changes in their economic environment and other circumstances having a critical bearing on their business activities.

Risk management by commercial banks -- Time to hammer out the chinks

Risk management is a comprehensive process adopted by an organization that seeks to minimize the adverse effects it is exposed to due to various factors -- economic, political or environmental, some of them inherent to the business, others unforeseen and unexpected.

Risk management by commercial banks -- Time to hammer out the chinks

Present practices/situation Prevalent at commercial banks requires a hard look and call for a greater understanding by bank managements and boards of the risks involved in their operations.

What is RISK ? It is the potential that events expected or

unexpected, may have an adverse effect on a financial institution’s capital or earnings.

Risk is inherent in all business and financial activities.

The greater the RISK associated with an activity the greater potential to generate a high return.

Banks do take RISKS – The biggest RISK is Not Taking A RISK.

Definition of Risk Management

Risk Management is the process of identifying, measuring, monitoring and controlling risks

These four points are essential to risk management

This presentation will cover the main identified risks in banks and determine how well risks are being managed.

Identifying Risks

Where Risks should be IdentifiedInstitution-wideBusiness linesProductsTransactions

Serving the Needs of Depositor

Borrowers and Banks Commercial Bank

lending/Investment involves three parties :

1. The suppliers of funds (The depositor)

2. The users of funds (The borrowers)

3. A financial intermediary (Bank) s

SupplierSupplier BankBank BorrowerBorrower

Challenge in Banking

“Banking is an art of striking a

balance between Risk and

Revenue.”

[Swiss Banking Corporation’s Credit Manual]

TYPICAL BALANCE SHEET OF A BANK[Amounts in millions USD]

Assets: Amounts Percent

Cash 461 8.29

Balances with Other Banks 418 7.52

Money at Call & Short Notice 380 6.84

Investment [Net of Provisions] 962 17.31

Loans and Advances [Net of Provisions] 2,785 50.11

Operating Fixed Assets 98 1.76

Capital w-i-p

Other Assets 354 6.37

Deferred Tax Asset 100 1.80

TOTAL ASSETS 5,558 100.00

TYPICAL BALANCE SHEET OF A BANK [Amounts in millions USD]

Assets as per previous slide 5,558 100.00

LiabilitiesDeposits & Other Accounts 4,720 84.92

Borrowings from other Banks, Agents 391 7.03

Bills Payable 90 1.62

Other Liabilities 144 2.59

TOTAL LIABILITIES 5,345 96.16

NET ASSETS [ 1] 213 3.83

Represented By:

Share Capital 203 3.64

Reserves 106 1.91

Other Tier 1 Capital 136 2.45

Accumulated Loss 284 5.11

Surplus on revaluation of Fixed Assets 52 0.94

NET ASSETS [1] 213 3.83

RISK MANAGEMENT ORAGNIZATION

Risk management is a decentralized process guided by centrally established policies and rules .Senior staff committees define credit culture and established overall policies and rules.Line management designs lending procedures and controls risk.There are usually five major organization groups that participate in risk management process.These groups are responsible for defining ,implementation ,and/or reviewing risk management policies,rules and procedures within the bank.

Banking Risk Taking risks can almost be said to be the business of bank management.A bank that is run on the principle of avoiding all risks or as many of them as possible, will be a stagnant institution ,and will not adequately serve the legitimate credit needs of its society.On the other hand a bank that takes excessive risks or credit is more likely ,takes them without recognizing their extent or their existence will surely run into difficulty.

All business involves some type of risk and banking is no exception.Credit risk is major category of risk of the bank.It occurs whenever there is a possibility that is the customer cannot meet contractual obligations to the bank in term of :

- The delivery of documents or commodities where the bank bears the whole risk OR

- The payment of principal ,interest ,fees or commissions.

The overall objective of Risk Management is to increase enterprise value

INCREASE VALUE BY

Providing Appropriate

Level and

Allocation of Capital

Providing Appropriate

Level and

Allocation of Capital

Increasing Return on

Capital

Increasing Return on

Capital

Improving Consistency of Earnings

Improving Consistency of Earnings

The best way to reach this objective is to understand the full risk environment within which you operate...

ExternalEnvironment

Economic Conditions

Competition

Natural Catastrophes

Social/Legal Trends

Political/Regulatory Climate

Technology

Expansion/Diversification

People

Culture

Distribution

Processes

Risk Appetite

InternalEnvironment

Financial RiskFinancial Risk

Asset RiskAsset Risk

Operational RiskOperational Risk

Liability RiskLiability Risk

Business RiskBusiness Risk

Event RiskEvent Risk

…and the complete set of strategies that are available to you...

Financial Strategies

Pricing

Securitisation

Capital Structure

Product Mix

Asset Allocation

Operational Strategies

Incentive Programs

Technology

Internal Controls

Distribution

Products

Customer Service

Market Strategy

Hiring/Training

Asset RiskAsset Risk

Liability RiskLiability Risk

Business RiskBusiness Risk

Event RiskEvent Risk

Financial RiskFinancial Risk

Operational RiskOperational Risk

…and to apply this knowledge in a holistic risk management framework, to drive value

HolisticallyManage

Financial and Operational

Risks

HolisticallyManage

Financial and Operational

Risks

Optimise Financial and Operational

Strategies

Understand Internal and

External EnvironmentC

ap

ital

Retu

rn

Con

sis

ten

cy

Increase Value

To accomplish all this in a consistent manner, it is necessary to implement a continual management process

Develop Best

Strategies

Develop Best

Strategies

Implement StrategiesImplement Strategies

MonitorPerformance and

Environment

MonitorPerformance and

Environment

In summary, Enterprise Risk Management:

Allows you to determine the necessary capital level, deploy unneeded capital and improve return on capital

Encourages proper allocation of capital to segments and supports performance tracking

Provides a method for ensuring that enterprise owners receive proper compensation for risks assumed

Provides Competitive AdvantageProvides Competitive Advantage

RISKS

MUST BE:

- KNOWN

- UNDERSTOOD

- QUANTIFIABLE

- CONTROLLABLE / ACCEPTABLE / BANKABLE

RISKS FACED BY BANKSCREDIT RISKMARKET RISK INTEREST RISKLIQUIDITY RISKOPERATIONAL RISKCOUNTRY RISKOWNERSIP / MANAGEMENT RISK

CREDIT RISKTHE RISK THAT THE OBLIGOR (BORROWER) WILL

NOT BE ABLE TO REPAY THE DEBT (LOAN) UNDER

THE TERMS OF THE ORIGINAL AGREEMENT (LOAN

AGREEMENT).

• MOST CRITICAL RISK IN BANKING

• REQUIRES MOST SUBJECTIVE JUDGEMENT

• MUST BE MANAGED CAREFULLY

MARKET RISK

CHANGES IN MARKET RATES AND PRICES WILL

IMPAIR AN OBLIGOR’S ABILITY TO PERFORM

UNDER THE CONTRACT NEGOTIATED BETWEEN

THE PARTIES.

• NEEDS MONITORING OF CHANGES IN PRICES OF COMMODITIES, REAL ESTATE, ETC.

INTEREST RATE RISK

INTEREST RATE RISK IS THE EXPOSURE OF AN

INSTITUTION'S FINANCIAL CONDITION TO ADVERSE

MOVEMENTS IN INTEREST RATES, WHETHER

DOMESTIC OR WORLD-WIDE.

• ANOTHER CRITICAL RISK

• RE-PRICING/ MISMATCHES NEED TO BE ADDRESSED

LIQUIDITY RISKTHE RISK THAT A BANK WILL BE UNABLE TO

ACCOMMODATE DECREASES IN LIABILITIES OR

TO FUND INCREASES IN ASSETS. SUCH RISKS

ARISE WHEN THE REPRICING OR MATURITIES OF

ASSETS DO NOT MATCH THOSE OF LIABILITIES.

• CRITICAL RISK

• MATURITY MISMATCHES

• BASED ON MARKET CONDITIONS & PERCEPTIONS

OPERATIONAL RISK THIS RISK ARISES FROM THE LACK OF

EFFECTIVE INTERNAL CONTROLS AND AUDITING

PROCEDURES. PARTICULARLY IMPORTANT IS

THAT THE BANK SHOULD HAVE GOOD INTERNAL

CONTROLS Risk of a failure in the bank’s procedures

whether from external causes or as a result of error or fraud within the institution.

COUNTRY RISKRISK ASSOCIATED WITH THE ECONOMIC,

SOCIAL AND POLITICAL ENVIRONMENT OF THE

BORROWER’S COUNTRY. COUNTRY RISK IS

MOST APPARENT WHEN LENDING TO FOREIGN

GOVERNMENTS/ THEIR AGENCIES AND OTHER

CUSTOMERS.

• BANK’S HAVING GLOBAL PRESENCE

OWNERSHIP RISKTHE RISK THAT OWNERS / SHAREHOLDERS,

DIRECTORS OR SENIOR MANAGEMENT MIGHT BE

UNFIT FOR THEIR RESPECTIVE ROLES OR THEY

ARE ACTUALLY DISHONEST.

• ALSO A CRITICAL RISK

• ”THE BEST WAY TO ROB A BANK IS TO OWN IT”

RISK MANAGEMENTFamiliarisation of Management with

Risks Implementation of Internal ControlsSound Internal Audit SystemEfficient MIS in PlaceCompetent Group of Risk ManagersPrompt Action & Monitoring

Risk Quantification

Risk quantification techniques becoming important to determine capital requirements

More reliance on banks’ own systems for identifying and managing risk

Not only quantitative; also processes and ‘culture’:

scrutiny of model design data integrity risk management resources validation independent audit management understanding

04/08/23

DEPOSITS IN A BANK REPRESENTS WHAT ? “Commercial Banks support a mountain of RISK

on a slender capital base. The bulk of their liabilities is redeemable at PAR and on DEMAND, with depositors regarding their money as perfectly safe.”

“Yet bank assets are subject to credit risk, market risk, and settlement risk. With international lending, there is foreign exchange risk and transfer risk. Also there is management risk and risk of fraud.”

GENERAL Many of The Risks Overlap.

Need To Be Evaluated In The Context Of

Individual Institution With On-site Presence. Evaluation of Risks Requires An

Understanding of The Bank, its Customer Mix, its Assets & Liabilities And The Economic And Competitive Environment.

INTERNAL CONTROLS RISK RATING SYSTEM FOR CREDITS CLOSE MONITORING OF OPERATIONS COMPETENT CREDIT MANAGERS DUAL CONTROLS SYSTEM TO STUDY THE INDUSTRIAL

AND ECONOMIC DEVELOPMENT FOR ESTABLISHING TARGET AREAS OF INVESTMENT

Reliance on Internal Control ?

Once the management system is in place, supervisors can determine that the systems are working properly by testing the systems. If the systems are inadequate, the scope of the inspection can be expanded so that risks are properly identified, quantified and corrective action initiated.

Principles of Control

Segregation of duties

Dual control

Rotation of assignments or duties

Two weeks continuous vacation

Adequate Compensation

INTERNAL AUDIT SYSTEM

IMPLEMENTATION OF INTERNAL CONTROLS

PROVIDES SECONDARY RISK REVIEW INDEPENDENC.

Objective of Internal AuditThe overall objective of internal

auditing is to assist all members of management in the effective discharge of their responsibilities by furnishing them with objective analysis, appraisals, recommendations and pertinent comments concerning the activities reviewed. The internal auditor, therefore, should be concerned with any phase of banking activity wherein he can be any service to management

Inspection Procedures for Internal Auditors Work

Organizational Structure of the Audit Department

Independence of the Audit FunctionAuditors Qualifications Audit Staff QualificationsContent and Utilization of the Audit

Frequency and Scope Schedule

MIS AN ADEQUATE “MIS” HELPS IN TIMELY

IDENTIFICATION OF RISKS REPORTS ON MATURITY OR INTEREST

RATE MISMATCHES REPORTS ON PROBLEM CREDITS REPORTS ON CREDITS SHOWING

DETERIORATING TREND IN RISK RATING

RISK MANAGERS

QUALIFIED OBJECTIVE ENJOY ADEQUATE AUTHORITY ABILITY TO CORRECTLY ANALYSE FOR

CURRENT ACTION AND FUTURE PREDICTIONS

PROMPT IN ACTION