RISK

MANAGEMENT
 Parameters of Risk management
Function
Operational
Org Structure Comprehensive Strategies
Independence
Periodical
Prudential Limits Strong MIS Risk Reporting
• Centralised? • Models • Balance Review
• Separate
•• Clearly
Committees-
set suitable
• Reliable between
• Well laid risk reporting
• Areas of
RMC, ALCO,
• Communicated •• Timely
Training and return
procedures • improvement
Clear
Operational
& followed • Integrating •• Comprehensive
Scenario responsibility
• Achievements
level Credit & building
risk reporting of risks
Market
Organisation
Board of directors for Risk Management
Risk Management
committee of Board
Overall responsibility
Committee of senior
executives/ALCO Setting guidelines ,processes
conform to policy, prudential limits,
review, robustness of models,
Risk Management
personnel
support group
Implementation of risk and business
policies, procedures, operating level
instructions for compliance
Independent analysis,
measurement, monitoring and
reporting ,stress testing and sharing
reports to senior executives
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 RISKS FACED BY BANKS
Operation
Credit Liquidity Country
al

Interest Technolog Complianc

Market
rate y e

Reputatio
Forex
n
 Risk Measurement
Downside
Sensitivity Volatility Potential

• Impact of • Standard deviation • Only adverse Based on

movement in 1 from average value impact is captured Confidenc
variable of any random • It has two
variable like
e level
• Interest rate gap- components-
Banking book, Earnings, MTM,LGD potential losses &
Duration of trading • Implicit volatility – probability of losses
book Black scholes • It requires prior
option pricing- modelling of
forward looking probability
• Volatility over time distribution of
period T = Daily potential losses.
volatility x square • VAR –Value at Risk –
root of T integrates Always forward looking
sensitivity, volatility
with adverse effect
of uncertainty
Risk Pricing – Transaction Level
• Risk pricing refers to factoring in risk into pricing.
• Interest rate on Loans
• Marginal cost of Funds (including marginal cost of borrowing &
return on networth)+ operating expenses + Negative carry of
CRR+ Tenor premium + credit risk premium ( Loss probability) +
Profit Margin+ capital charge(cost of excess capital required as
per BASEL norms depending on type of exposure)
• Board approved policy for deciding quantum of each component
of spread, range for a particular category borrower or type of
loan and delegation of powers for loan pricing
Risk Monitoring & Control
Org structure,
Measurement
approach, Policies,
Guidelines

Internal control ,
system to assess Feedback, strong MIS,
risks, develop system well laid out
to relate risk to procedures, risk
capital, monitor mgmt. independent
compliance

Review and
evaluation-changing
Changes in Bank’s risk profile, level and
strategy trend of
risks ,sensitivity of
key assumptions
Trading book, Banking Book, Off
Balance sheet

Banking book- Trading Book-not till

Off Balance sheet
maturity maturity
• Advances, • MTM • Guarantees, L/Cs,
deposits, • Fixed income Derivatives
borrowings- securities, Equities, • Liquidity risk,
commercial & FX, commodities , Interest rate risk,
retail Derivatives market risk, credit
• Accrual system, No • Subject to Market risk, operational
MTM risks, Credit risks, risk
• Credit risk charge, Liquidity risk,
Interest rate risk, operational risk
Liquidity risk,
operational risk
 Market Risk

• Market Risk- risk of adverse deviations of the mark-to-

market value of the trading portfolio
• Trading Liquidity Risk- Asset liquidity risk and Market
Liquidity Risk
• Credit and counterparty risk
Market Risk
Liquidity Risk

Interest Rate risk

Forex Risk

Commodity price Risk

Equity Price Risk

Market Risk Measurement

• Sensitivity
• Captures deviation of market price due to unit movement of
a single parameter
• Supply- demand position
• Interest rate
• Market liquidity
• inflation,
• Exchange rate
Credit Risk
Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet
commitments in relation to lending, trading, hedging, settlement and other financial transactions.

Credit Risk

Transaction Portfolio

Intrinsic/
Level 1 Level 2 Concentration
Systemic

Counterparty Country Default Downgrade

Credit Risk-Factors influencing Portfolio
risk

External Factors Internal factors

• State of Economy • Lack of risk pricing
• Govt Policies • Deficiency in Loan
• Swings in commodity policy & administration
prices and Forex rates • Lack of Prudential limits
• Interest rate • Deficiency in credit
movements appraisal
• Trade
restrictions/sanctions
Management of credit risk
• Credit Policy Committee

Loan Policy • Credit risk Management

independent of credit
• administration
Credit scoring: Altman Z
Measuremen Score, JP Morgan “Credit
metrices”, Credit Suisse

t
Credit risk +
• Expected & Unexpected
Losses

Risk Pricing
• RAROC
• Post disbursement review

Risk Control
• Loan Review Mechanism
• Portfolio Management
Article on Loan pricing

• [Link]
inadequately-pricing-risks-as-they-scurry-to-garner-
deposits-and-lend-more-says-sbis-ghosh/
[Link]
 Z score (calculated):

Altman Z Score <1.8 : Bankruptcy

1.8 to 3: Probable
bankruptcy
Above 3: stable Company
• Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
• X1 = Net working Capital/ Total assets ratio
• X2= Retained Earnings/ Total assets ratio
• X3 = earning before Interest and Tax/ Total Assets
ratio
• X4 = market value of equity/ Book Value of long term
debt Limitations:
New company
• X5 = Sales/ Total Assets Does not consider cashflow
 RAROC - Risk adjusted Return on
Capital
• RAROC( Risk adjusted Return on Capital) is a risk adjusted performance measuring
tool that compare profitability across different businesses with different levels of risk
and capital requirements.
• It helps to define the pricing of the loan based on the risk involved and capital .

• RAROC = Expected Return/ Economic Capital

• RAROC = Expected Return/ Value at Risk
• RAROC = [Net Income - Expected Losses]/Economic Capital
• Whereas,
• Net Income = Net Interest Income (NII) + Non-Interest/ Fee Income – Operating
Expenses
• Expected Losses= Exposure at Default (EAD)X Probability of Default (PD) X Loss Given
Default (LGD)
Instruments of Credit Risk
Management

Approving Prudential
Risk rating Risk Pricing
authority Limits

Portfolio Loan review

Inter bank and
Management- Mechanism
country Risk
risk Credit risk in Off
diversification B/S
Controlling Credit Through Loan
Review Mechanism
Objectives of LRM
• To promptly identify loans which develop credit weakness and initiate corrective
action
• To evaluate portfolio quality and isolate potential problems
• To provide information for determining adequacy of loan loss provision
• To access the adequacy of and adherence to loan policies and procedures and to
monitor compliance with relevant laws and regulations
• To provide top management with information on credit administration, including
credit sanction process. Risk evaluation and post sanction followup
• Qualification and independence- loan review officers should have sound
knowledge of credit appraisal
• Frequency and scope of review
 Operational Risk
• Risk incurred due to failure in people, internal
processes & policies and systems.
• Examples: service interruptions and security
breaches, poorly trained employees , technological
breakdowns, theft of information.
Risk Mitigation
Avoid

Credit Risk Market Risk Operational Risk

Reduce
• Tools of Credit • ALM • Well laid down
risk mgmt • Int rate swaps , procedures
• Collateral, FRA • Logging of loss
Margin • Forwards, events and
• Securitisation • Options reasons for the Transfer
same
• Bringing
changes in
procedures to
avoid
recurrence Retain
Obstacles/challenges –Risk
Management
Changes in Regulations

Rising customer expectations

Cybersecurity

Fraud and Identity theft

Inefficient Internal processes

Increasing Competition
Capital Adequacy and Basal Accord
• Liquidation of Herstatt Bank
• Bank for International Settlements (BIS)
• Established on 17 May 1930, the Bank for International
• Settlements (BIS) is the world's oldest international financial
• organisation. The BIS has 60 member central
• banks, representing countries from around the world that
• together make up about 95% of world GDP.
• The head office is in Basel, Switzerland and there are two representative
offices: in the Hong Kong Special Administrative Region of the People's
Republic of China and in Mexico City.
Bank for International
Settlements (BIS)

• The mission of the BIS is to serve central banks in

their pursuit of monetary and financial stability, to
foster international cooperation in those areas and to
act as a bank for central banks.
Capital Adequacy Requirements
Capital Adequacy Requirements (Bank’s Safety and Soundness)
•  Provide a buffer against bank losses
•  Protects creditors in the event of bank fails
•  Creates disincentive for excessive risk taking
•  Ensuring Solvency of Banks
•  Limits The Amount of Credit Creation (Capital adequacy ratios
• mandate that a certain amount of the deposits be kept aside whenever a
• loan is being made)
•  Multi-Tiered Capital
•  Risk Weighting
 Basel 1 vs Basel 2 vs Basel 3

Basel I Basel II Basel III

• Risk weighting into 5 • 3 triggers:1990 crisis, • Improve ability of
buckets Basel 1 limitations, IT banks to absorb
• Focus on credit risk advancement shocks by increasing
• Build Bal sheet with • 3 Pillars: Minimum capital requirement
minimum capital capital , Supervisory • Introduced liquidity
• Constituents of review process- and leverage
capital-Tier 1 & 2 ICAAP, Market monitoring ratios
• Static measure, ltd discipline-Disclosures • Improve quality of
collateral recognition • Credit risk +Market Tier 1 core capital –
Risk + Operational CCB and higher core
Risk Tier 1 ratio
• Credit risk – linked to • Countercyclical buffer
risk ratings & type of • Systematically
loan important FI: higher
capital req.
 Minimum Capital Requirements-BASEL
III
Description % of RWA Eligibilit Tier 1 Addition Tier 2
Minimum Tier 1 ratio 5.5% y ratio al Tier 1
Capital conservation 2.5% Tier 1
buffer(common equity) Capital
Minimum Tier 1 ratio(including 8.0% Additional
CCB) Tier 1
capital
Additional Tier 1 capital 1.5%
Tier 2
Tier 2 Capital 2.0% Capital
Minimum Total capital Ratio 11.5%
including CCB
Minimum Capital ratio (Total ) 9.0%
 Capital Adequacy

• Common equity Tier 1 ratio = Common Equity Tier 1 capital

Credit RWA+Mkt Risk RWA + Op Risk RWA

• Tier 1 ratio = Eligible Tier 1 capital

Credit RWA+Mkt Risk RWA + Op Risk RWA

• Total Capital ratio = Eligible Total capital

Credit RWA+Mkt Risk RWA + Op Risk RWA
 Credit Risk Measurement
• 1. Standardized Approach: Using external rating for
determining risk weights
• 2. Foundation Internal Ratings Based (IRB) Approach
(Bank computes only the probability of default)- PD,
LGD- Loss given default, EAD- Exposure at default)
• 3. Advanced IRB Approach: Bank computes all risk
components
(except effective maturity)
Operational Risk Measurement
• Pillar I also adds a new capital component for operational risk
• (Operational risk covers the risk of loss due to system
• breakdowns, fire, employee fraud or misconduct, errors in
• models or natural or man-made catastrophes, among others)
• a. Basic Indicator Approach- capital equal to avg last 3 years GTI x 15% x
12.5
• b. Standardized Approach- capital computed as per lines of business with
fixed %
• c. Advance Measurement Approach- statistical tools- generated by
bank’s measure of internal operation risk
 SREP –Pillar 2
• Supervisory Review Process
• a. Banks are advised to develop an internal capital
• assessment process and set targets for capital to
• commensurate with the bank’s risk profile
• b. Supervisory authority is responsible for evaluating how
• well banks are assessing their capital adequacy
• The internal processes would be subject to more rigorous
review and intervention by country’s central bank
Market Discipline – Pillar 3
•  Aims to reinforce market discipline through enhanced
disclosure by banks.
•  It is an indirect approach, that assumes sufficient
competition within the banking sector.
•  Regulatory disclosure is different from Accounting
Disclosure
•  Adjustment made for entities
•  Terms & conditions and main features of all Capital
Instruments
Measurement of capital Charge

Credit risk Market Risk Operational Risk

• Standardized • Specific risk – • Basic Indicator
approach- RW security wise-based approach OR
depends on type of on rating, residual • Standardised
claim, whom the tenor, type of Approach OR
claim is on, Rating security • Advanced
of the • General market risk- Measurement
counterparty/limit interest rate risk Approaches
• BIA= 15% of
adjusted total
income x 12.5 =
RWA
Measurement of Risk

Operational
Credit Risk Market Risk
Risk

Basic Advanced
Value at Standardize
Credit rating Duration Volatility Indicator Measureme
Risk d Approach
approach nt approach

Type of
Issuer
credit
Objectives of Basel III

• Improve the banking sector’s ability to absorb shocks

arising from financial and economic stress, whatever
the source
• Improve Risk management and governance
• Strengthen banks’ transparency and disclosures
Major Changes proposed in Basel III over Basel II

• a)Better Capital Quality: means higher loss-absorbing

capacity. In turn means the bank will become stronger and
better withstand periods of stress
• b) Capital Conservation Buffer: Banks are required to hold
a Capital Conservation buffer of 2.5%
• The aim is to ensure that banks maintain a cushion of
capital that can be used to absorb losses during financial
and economic stress
Major Changes proposed in Basel III
over Basel II

• C) Countercyclical Buffer: introduced with the

objective to increase capital requirements in good
time and decrease the same in bad times
• The buffer will range from 0% to 2.5% , consisting of
common equity or other fully loss-absorbing capital
Major Changes proposed in Basel III
over Basel II

• D) Minimum Capital Equity and tier I capital requirement:

• Minimum Requirement for capital equity has been raised under
Basel III from 2% to 4.5% of total RWA
• Overall Tier I Capital Requirement( common equity + other
qualifying financial instruments) will increase from 4% to 6%
• Minimum Capital requirement will remain at 9%
• Yet total capital required will increase to 11.5% when combined
with conservation buffer
• e) Leverage ratio
• A review of the financial crisis of 2008 has indicated that the
value of many assets fell quicker than assumed from historical
experiences
• Basel III includes a leverage ratio as a safety net
• A leverage ratio is the relative amount of capital to total
assets( not risk weighted)
• 3% Leverage ratio of Tier I will be tested
• F) LCR: Liquidity coverage ratio: Bank has sufficient
level of HQLA to pay its liabilities in next 30 days
• G) NSFR: Net stable funding Ratio: Bank should rely on
long term stable sources of funding for a 1 year period
rather than short term sources of funding
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