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MAJOR RESEARCH PROJECT

On

“OPERATIONAL RISK ANALYSIS IN BANK’S”

(A PERCEPTUAL STUDY OF PUBLIC & PRIVATE SECTOR BANK’S)

Submitted in the partial fulfillment of Degree of

MBA (FT) (2011-2013)

Guided by:- Submitted by:

Dr. Swaranjeet Arora Hemant Singh Sisodiya

MBA (FT)

CONTENTS

Chapter :- 1Introduction

- Conceptual framework- Types of risk- An overview of Operational Risk

Chapter :- 2

- Literature ReviewRational Of study

Chapter :- 3 - Objective’s- Research Methodology

Chapter :- 4- Data Presentation & Interpretation

Chapter :- 5- Finding’s- Suggestion’s- Limitations

Chapter :- 6- Referance

Student declaration

I declare that the project entitled “operational risk analysis by bank’s”(a Perceptual study of public & private sector bank’s). Is an original done by me and no part of the project is taken from any other project or material published or otherwise or submitted earlier to any other college or university.

(Hemant Singh)

DECLARATION CERTIFICATE

This is to certify that the work presented in the project entitled “Operational risk

analysis by bank’s” (a Perceptual study of public & private sector bank’s). in

partial fulfilment of the requirement for the award of degree of ‘M.B.A,

PRESTIGE INSTITUTE OF MANAGEMENT AND RESEARCH INDORE,

is an authentic work carried out under my supervision and guidance.

To the best of my knowledge, the content of this project does not form a basis for

the award of any previous degree to anyone else.

Date:

(Dr.Swarnjeet Arora )

INTRODUCTION

Conceptual framework

The financial sector especially the banking industry in most emerging economies including India is passing through a process of change .As the financial activity has become a major economic activity in most economies, any disruption or imbalance in its infrastructure will have significant impact on the entire economy. By developing a sound financial system the banking industry can bring stability within financial markets.

Deregulation in the financial sector had widened the product range in the developed market. Some of the new products introduced are LBOs, credit cards, housing finance, derivatives and various off balance sheet items. Thus new vistas have created multiple sources for banks to generate higher profits than the traditional financial intermediation. Simultaneously they have opened new areas of risks also. During the past decade, the Indian banking industry continued to respond to the emerging challenges of competition, risks and uncertainties. Risks originate in the forms of customer default, funding a gap or adverse movements of markets. Measuring and quantifying risks in neither easy nor intuitive. Our regulators have made some sincere attempts to bring prudential and supervisory norms conforming to international bank practices with an intention to strengthen the stability of the banking system.

Growing number of high-profile operational loss events worldwide have led banks and supervisors to increasingly view operational risk management as an integral part of the risk management activity. Management of specific operational risks is not a new practice; it has always been important for banks to try to prevent fraud, maintain the integrity of internal controls, reduce errors in transaction processing, and so on. However, what is relatively new is the view of operational risk management as a comprehensive practice comparable to the management of credit and market risk. 'Management' of operational risk is taken to mean the 'identification, assessment, and / or measurement, monitoring and control /mitigation' of this risk.

Banks in India work in a controlled regime similar to several other countries. The focus of the research is to test the operational risk of sample banks operating in India and identify the extent to which banks are capable of bearing operational risks. The capital adequacy criteria to account for the operational risk using the Basic Indicator Approach points out that several banks do not meet the regulatory requirements. Risk management strategies of banks to reflect the price behaviour have been examined and banks that have adequate exposure to risk cover have been contrasted with banks having inadequate risk exposure cover. Growing number of high-profile operational loss events worldwide have

led banks and supervisors to increasingly view operational risk management as an integral part of risk management activity.

Growing number of high-profile operational loss events worldwide have led banks and supervisors to increasingly view operational risk management as an integral part of the risk management activity. Management of specific operational risks is not a new practice; it has always been important for banks to try to prevent fraud, maintain the integrity of internal controls, reduce errors in transaction processing,and so on. However, what is relatively new is the view of operational risk management as a comprehensive practice comparable to the management of credit and market risk. 'Management' of operational risk is taken to mean the 'identification, assessment, and / or measurement, monitoring and control /mitigation' of this risk.

Management of specific operational risks is not a new practice; it has always been important for banks to try to prevent fraud, maintain the integrity of internal controls, reduce errors in transaction processing, and so on. However, what is relatively new is the view that operational risk management is a comprehensive practice comparable to the management of credit and market risks.Operational Risk differs from other banking risks in that it is typically not directly taken in return for an expected reward but is implicit in the ordinary course of corporate activity and has the potential to affect the risk management process. However, it is recognised that in some business lines with minimal credit or market risks, the decision to incur operational risk, or compete based on the perceived ability to manage and effectively price this risk, is an integral part of a bank's risk reward calculus. At the same time, failure to properly manage operational risk can result in a misstatement of an institution's risk profile and expose the institution to significant losses. 'Management' of operational risk is taken to mean the 'identification, assessment or measurement, monitoring and control / mitigation' of this risk.

Operational Risk Management policies, processes, and procedures should be documented and communicated to appropriate staff i.e., the personnel at all levels in units that incur material operational risks. The policies and procedures should outline all aspects of the institution's Operational Risk Management framework, including: -

• The roles and responsibilities of the independent bank-wide Operational Risk Management function and line of business management.

• A definition for operational risk, including the loss event types that will be monitored.

• The capture and use of internal and external operational risk loss data including data potential events (including the use of Scenario analysis).

• The development and incorporation of business environment and internal control factor assessments into the operational risk framework.

• A description of the internally derived analytical framework that quantifies the operational risk exposure of the institution.

• A discussion of qualitative factors and risk mitigants and how they are incorporated into the operational risk framework.

• A discussion of the testing and verification processes and procedures.

• A discussion of other factors that affect the measurement of operational risk.

• Provisions for the review and approval of significant policy and procedural exceptions.

• Regular reporting of critical risk issues facing the banks and its control/mitigations to senior management and Board.

• Top-level reviews of the bank's progress towards the stated objectives.

• Checking for compliance with management controls.

• Provisions for review, treatment and resolution of non-compliance issues.

• A system of documented approvals and authorisations to ensure accountability at an appropriate level of management.

• Define the risk tolerance level for the bank, break it down to appropriate sublimits and prescribe reporting levels and breach of limits.

• Indicate the process to be adopted for immediate corrective action.

VARIOUS TYPE OF RISK’S

a) Business Related Risk Credit Risk Market Risk Country Risk Business Environment Risk Operational Risk Group Risk

b) Control Related Risk

OPERATIONAL RISK :- “The risk of direct or indirect loss resulting from

inadequate or failed internal processes, people and systems or from externalevents” (BIS, 1988).

Always banks live with the risks arising out of human error, financial fraud and natural disasters. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter-linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that is not categorized as market or creditrisk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit systems are used as the primary means.

Growing number of high-profile operational loss events worldwide have led banksand supervisors to increasingly view operational risk management as an integral part of the risk management activity. Management of specific operational risks is not a new practice; it has always been important for banks to try to prevent fraud, maintain the integrity of internal controls, reduce errors in transaction processing, and so on. However, what is relatively new is the view of operational risk management as a comprehensive practice comparable to the management of credit and market risk. 'Management' of operational risk is taken to mean the'identification, assessment, and / or measurement, monitoring and control /mitigation' of this risk. Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. Insurance cover is one of the important mitigators of operational risk. Operational risk events are associated with weak links in internal control procedures. The key to management of operational risk lies in the bank’s ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios.

Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective risk management tool. Bank should strive to promote a shared understanding of operational risk within the organization,especially since operational risk is often interwined with market or credit risk and it is difficult to isolate.

Over a period of time, management of credit and market risks has evolved a more sophisticated fashion than operational risk, as the former can be more easily measured,monitored and analysed. And yet the root causes of all the financial scams and losses are the result of operational risk caused by breakdowns in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on subsequent data/feedback, it was reduced to 12%. While measurement of operational risk and

computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is start implementing the Basel proposal in a phased manner and carefully plan in that direction.The incentive for banks to move the measurement chain is not just to reduce regulatory capital but moreimportantly to provide assurance to the top management that the bank holds the required capital.

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, external events or reputational risk. The most important types of operational risk involve breakdowns in internal controls and corporategovernance. 21st century business runs under clouds of technology, these clouds can rainfor survival and growth of business if managed properly or there can be catastrophe, which destroy business, if risks management fails. Apart from many things, Corporate Governance provides the high-level framework for IT governance. Corporate Governance lays down framework for creating long-term trust between company and its stakeholders.This trust is created by rationalizing and monitoring risks of a company, limiting liability of top management by carefully articulating decision making process, ensuring integrity of financial reports, and finally providing a degree of confidence necessary for proper functioning of an organization.

The exact approach for operational risk management chosen by banks will depend on a range of factors. Despite these differences, clear strategies and oversight by the Board of Directors and senior management, a strong operational risk management culture, effective internal control and reporting, contingency planning are crucial elements for an effective operational risk management framework. Initiatives required to be taken by banks in this regard will include thefollowing:

ᴥ The Board of Directors is primarily responsible for ensuring effective management of the operational risks in banks. The bank's Board of Directors has the ultimate responsibility for ensuring that the senior management establishes and maintains an adequate and effective systemof internal controls.

ᴥ Operational risk management should be identified and introduced as an independent risk management function across the entire bank/ banking group.

ᴥ The senior management should have clear responsibilities for implementing operational risk management as approved by the Board of Directors.

ᴥ The board of directors and senior management are responsible for creating an awareness of Operational Risks and establishing a culture within the bank that emphasises and demonstrates to all the levels of personnel the importance of Operational Risk.

ᴥ The direction for effective operational risk management should be embedded in the policies and procedures that clearly describe the key elements for identifying, assessing, monitoring and controlling / mitigating operational risk.

ᴥ The internal audit function assists the senior management and the Board by independently reviewing application and effectiveness of operational risk management procedures and practices approved by the Board/ senior management.

ᴥ The New Capital Adequacy Framework has put forward various options for calculating operational risk capital charge in a "continuum" of increasing sophistication and risk sensitivity and increasing complexity. Despite the fact that banks may adopt any one of these options for computing capital charge, it is intended that they will benchmark their operational risk management systems with the guidance provided in this Note and aim to move towards more sophisticated approaches.

AN OVERVIEW OF THE OPERATIONAL RISK MEASUREMENT METHODOLOGIES IN BASEL II

The Basel framework (2004) proposes a range of approaches for setting aside regulatory capital for operational risk under Pillar 1: The Basic Indicator Approach (BIA), The Standardised Approach (TSA) and the Advanced Measurement Approach (AMA). All the three approaches differ in their complexity and the banks are encouraged to move along the spectrum of approaches as they obtain more sophistication in their risk management practices. The Basic Indicator Approach is the simplest approach for estimating regulatory capital, wherein banks are required to set apart an amount equal to the average over the previous three years of 15% of positive annual gross income. The Standardised Approach is a slightly modified version of the Basic Indicator Approach. In The Standardised Approach, banks’ activities are divided into eight business lines: Corporate finance, Trading & Sales, Retail Banking, Commercial Banking, Payment & Settlement, Agency Services, Asset Management and Retail Brokerage. While gross income continues to be the main indicator of operational risk as under the Basic Indicator Approach, the specific amount to be set apart as a percentage of the gross income varies between business lines, ranging from 12 to 18% , as compared to the 15% overall under the Basic Indicator Approach. This approach is more refined than the Basic Indicator Approach as it takes into the account the fact that some business lines are riskier than others and therefore a higher proportion of capital has to be set apart for those business lines. The Advanced Measurement Approach (AMA) is based on the banks’ internal models to quantify operational risk. The framework gives flexibility to the banks in the characteristics of the choice of internal models, though it requires banks to demonstrate that the operational risk measures meet a soundness standard comparable to a one-year holding period and a 99.9% confidence level, which means that a banks capital charge should be equal to at least 99.9% quantile of their annual aggregate loss distribution. Banks are required to factor in four key elements in designing their Advanced Measurement Approach framework: internal loss data, external loss data, scenario analysis and bank specific business environmental and internal control factors. The Accord also specifies the standard matrix of business lines and risk types to facilitate validation across the Advanced Measurement Approaches. The methodologies under the advanced approach are evolving and there are a range of methods in practice in banks internationally (BCBS 2006).

LITERATURE REVIEW

Literature Review

Bagchi (2003) examined the credit risk management in banks. He examined risk identification, risk measurement, risk monitoring, risk control and risk audit as basic considerations for credit risk management. The author concluded that proper credit risk architecture, policies and framework of credit risk management, credit rating system, monitoring and control contributes in success of credit risk management system.

Froot and Stein (1998) found that credit risk management through active loan purchase and sales activity affects banks’ investments in risky loans. Banks that purchase and sell loans hold more risky loans (Credit Risk and Loss loans and commercial real estate loans) as a percentage of the balance sheet than other banks. Again, these results are especially striking because banks that manage their credit risk (by buying and selling loans) hold more risky loans than banks that merely sell loans (but don’t buy them) or banks that merely buy loans(but don’t sell them).

Rajagopal (1996) made an attempt to overview the bank’s risk management and suggests a model for pricing the products based on credit risk assessment of the borrowers. He concluded that good risk management is good banking, which ultimately leads to profitable survival of the institution. A proper approach to risk identification, measurement and control will safeguard the interests of banking institution in long run

Ferguson (2001) analyzed the models and judgments related to credit risk management.The author concluded that proper risk modelling provides a formal systematic and disciplined way for firms to measure changes in the riskiness of their portfolio and help them in designingproper strategic framework for managing changes in their risk

Powell (2002) has presented a review of the new proposals from the Basel Committee of Banking Supervision to reform the 1988 Capital Accord from the standpoint of emerging countries and identified that the 1988 Accord was a tremendous success and is probably the most successful of all 'financial standards'. Tiwari (2004) has examined the impact of several obstacles that exist in the path of a healthy banking system and includes narrow and broad banking; various associated risks and bank failures and has identified CAR as a means to a

healthy banking system and explores other tools adopted by Reserve Bank Of India (RBI) and other regulators in maintaining stability and efficiency of the banking system in India

Rationale of the study

There seems to be a gap in knowledge in terms of the nature of relationship between some critically important variables. The propensity of such variables needs to be explored in order to identify Risk management system in Indian banks and to highlight the approach of RBI towards the risk management techniques. The Indian banking industry has come a long way since the nationalization of banks in 1969. Reforms in the banking sector have enabled banks to explore new business opportunities rather than remaining confined to generating revenues from conventional streams, which has increased operational risk component into the banking system. The Reserve Bank of India (RBI) has already instructed banks to take measures in order to manage the operational risk and to identify the areas that need strengthening. Various research studies have already been published about operational risk management nationally as well as internationally but there are very few empirical studies, which have been performed in this regard in India. To fill this void, the present study was undertaken with an aim to study and analyze operational risk management system of Indian Banks. This study would generate the roadmap for implementation of effective operational risk management system in Public and Private Sector banks of India. This mass of knowledge that could be meaningfully used by the policy makers and practitioners to provide incentives for banks to enhance their operational risk measurement and management capabilities and contribute in maintaining India’s position as a leading international financial center. It will thereby augment market discipline thereby, fostering excellence in competitive environment.

Objective &Methodology

Objective of study

1. To explore operational risk management practices followed by the Indian public sector and Private sector banks.

2. To compare whether Public & Private sector banks analyze operational risk management Practices in Bank.

3. Explore the Factors contributing to operational risk management practices in bank.

4. To open up new vistas of research & develop a base for application of the findings in terms of implication of study.

RESEARCH METHODOLOGY

The Study

The present study is exploratory and examines the Operational Risk management System in public and Private sector banks.

The Sample

The present research is to be conducted on a sample of 140 employees of public and private sector banks of Chhatarpur / Indore region (Madhya Pradesh).The respondents will be selected on a convenient sampling basis.

The Tools

(A) USED FOR DATA COLLECTION

The primary data would be collected through survey method with the help of self-developed structured, non-disguised questionnaire based on 5 point Likert scale on which the respondents would be asked to indicate the degree of agreement. The secondary data would be collected through various research magazines, journals and newspapers.

(B) USED FOR DATA ANALYSIS

Statistical Tools- graphs & charts

Cross Tabulation Of Data

Data Presentation & Analysis

Series donates the no. of question

No. of respondent in each compression in 35

0 donated none

1 donated Strongly Disagree

2 donated Disagree

3 donated Neutral

4 donate Agree

5 donates Strongly Agree

UNDERSTANDING THE OPERATION RISK IN DIFFERENT BANKING SECTOR’S

IN SBI & ASSOCIATE:

IN OTHER PUBLIC SECTOR’S

IN PRIVATE BANKING’S (OLD)

IN PRIVATE BANKING’S (NEW)

INTERPRETATION;-

The understanding power of new private sector bank’s is much higher than other banking

sector’s. New private banks try to reduce the orerational risk during the orperation’s.

OPERATION RISK INDIFICATION

SBI AND ASSOCIATION

OTHER PUBLIC SECTOR BANK’S

PRIVATE SECTOR BANK’S (OLD)

PRIVATE SECTORBANK’S(NEW)

INTERPRETATION:-

Risk identification is much better in SBI & Accosiation compare than other public & private

sector’s.

OPERATION RISK ASSESSMENT AND ANALYSIS

SBI AND ASSOCIATION




INTERPRETATION

In addition to identifying the risk events, banks should assess their vulnerability to these risk events. Effective risk assessment allows a bank to better understand its risk profile and most effectively target risk management resources. It applicable on the only in New Private bank’s

OPERATION RISK MONITORING AND ANALYSIS

SBI AND ASSOCIATION




INTERPRETATION

Banks may develop risk assessment techniques that are appropriate to the size and complexities of their portfolio, their resources and data availability. A good assessment model must cover

certain standard features.Both private bank’s performs very smoothly the assessment policy and they obey the guide line given by RBI.

OPERATION RISK MANAGEMANT PRACTICES

SBI AND ASSOCIATION




INTERPRETATION

An effective monitoring process is essential for adequately managing operational risk. In SBI & association Regular monitoring activities can offer the advantage of quickly detecting and correcting deficiencies in the policies, processes and procedures for managing operational risk. Promptly detecting and addressing these deficiencies can substantially reduce the potential frequency and/or severity of a loss event. Compare than the other’s

Findings & Conclusion

FINDING’S

The operational risk management framework provides the strategicdirection and ensures that an effective operational risk m anagement and measurement process is adopted throughout the institution. Each institution's operational risk profile is unique and requires a tailored risk management approach appropriate for the scale and materiality of the risk present, and the size of the institution. There is no single framework that would suit every institution; different approaches will be needed for different institutions. In fact, many operational risk management techniques continue to evolve rapidly to keep pace with new technologies, business models and applications. Operation risk is more a risk management than measurement issue. The key elements in the Operational Risk Management process include –

• Appropriate policies and procedures;

• Efforts to identify and measure operational risk

• Effective monitoring and reporting

• A sound system of internal controls; and

• Appropriate testing and verification of the Operational Risk Framework.

SUGGESTION

Operational Risk Management policies, processes, and procedures should be documented and communicated to appropriate staff i.e., the personnel at all levels in units that incur material operational risks. The policies and procedures should outline all aspects of the institution's Operational Risk Management framework, including: -

• The roles and responsibilities of the independent bank-wide Operational Risk Management function and line of business management.

• A definition for operational risk, including the loss event types that will be monitored.

• The capture and use of internal and external operational risk loss data including data potential events (including the use of Scenario analysis).

• The development and incorporation of business environment and internal control factor assessments into the operational risk framework.

• A description of the internally derived analytical framework that quantifies the operational risk exposure of the institution.

• A discussion of qualitative factors and risk mitigants and how they are incorporated into the operational risk framework.

• A discussion of the testing and verification processes and procedures.

• A discussion of other factors that affect the measurement of operational risk.

• Provisions for the review and approval of significant policy and procedural exceptions.

• Regular reporting of critical risk issues facing the banks and its control/mitigations to senior management and Board.

• Top-level reviews of the bank's progress towards the stated objectives.

• Checking for compliance with management controls.

• Provisions for review, treatment and resolution of non-compliance issues.

• A system of documented approvals and authorisations to ensure accountability at an appropriate level of management.

• Define the risk tolerance level for the bank, break it down to appropriate sublimits and prescribe reporting levels and breach of limits.

• Indicate the process to be adopted for immediate corrective action.

Limitations

The research study is however,is imposed with some limitations inherent to it . They are:-

1. The conclusions arrived at are just a simple of the universe and as such cannot be relied heavily on. It’s very small part of the small universe ,which might have a very different view point on the same object.

2. The response of the respondents are not free from limitations. These are few who do not wish to give an honest reply on the question directed to them and as such give false replies which males the result faulty

.3. Few respondents go further to the extent of not answering the question

4. The research study is quickie report on the issue as it as a time boundation and can not be done leisurely. There for not very reliable

5. The geographical area coverd is only Chhatarpur & Indore and hence the view point of the banker’s of the other part could not be coverd.

6. Cost factor has also impaired the reliability of the project report

Chapter 6

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2. Bellu, G. (2003), “Basel II: The Challenge of the Decade”, Tata Consultancy Services3. BIS, Basel Committee on Banking Supervision (2000) "The Internal Ratings-Based

Approach" Consultative Document, Bank for International settlements, Switzerland. 4. BIS, Basel Committee on Banking Supervision (2001) "Operational Risk” Consultative

Document, Bank for International settlements, Switzerland.5. Carey, A. (2001), “Effective risk management in financial institutions: the Turnbull

approach”, Balance Sheet, Vol. 9 No. 3, pp. 24-7.6. Gupta, V and Srinivasan, K. (2005), “Basel II Accord: impact on Indian Banks” ICRA

Rating Feature, pg.1-87. Kothari, C. (2000), “Research Methodology”, Wishwa Prakashan8. Leeladhar, V. (2005), “Basel II Accord and its implications” Speech at Bankers’ Club,

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13. Upadhyay, S. (2006), “Basel Norms- New Challenges for Indian Banks” Investime, pg.52-54

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15. Raghu Palat “ Retial Banking” Indian Book Distributers

16. Basel Committee on Banking Supervision, Sound Practices for the Management and Supervision of Operational Risk, February 2003.

17. Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards – A Revised Framework, June 2004

18. Basel Committee on Banking Supervision, Framework for Internal Control Systems in Banking Organisations, September 1998

19. Ashby, S. (2008). Operational risk: lessons from non-financial organizations. Journal of RiskManagement in Financial Institutions 1(4), 406–415.

20. Grody, A. D. (2008). The financial crisis and or management: unfinished business. Journal of Risk Management in Financial Institutions 2(1), 4–6.