Risk Management in Banking Sector.

Introduction.
The significant transformation of the banking industry in India is clearly evident from the changes that have occurred in the financial markets, institutions and products. While deregulation has opened up new vistas for banks to argument revenues, it has entailed greater competition and consequently greater risks. Cross- border flows and entry of new products, particularly derivative instruments, have impacted significantly on the domestic banking sector forcing banks to adjust the product mix, as also to effect rapid changes in their processes and operations in order to remain competitive to the globalized environment. These developments have facilitated greater choice for consumers, who have become more discerning and demanding compelling banks to offer a broader range of products through diverse distribution channels. The traditional face of banks as mere financial intermediaries has since altered and risk management has emerged as their defining attribute. Currently, the most important factor shaping the world is globalization. The benefits of globalization have been well documented and are being increasingly recognized. Integration of domestic markets with international financial markets has been facilitated by tremendous advancement in information and communications technology. But, such an environment has also meant that a problem in one country can sometimes adversely impact one or more countries instantaneously, even if they are fundamentally strong. There is a growing realisation that the ability of countries to conduct business across national borders and the ability to cope with the possible downside risks would depend, interalia, on the soundness of the financial system. This has consequently meant the adoption of a strong and transparent, prudential, regulatory, supervisory, technological and institutional framework in the financial sector on par with international best practices. All this necessitates a transformation: a transformation in the mindset, a transformation in the business processes and finally, a transformation in knowledge management. This process 1

Risk Management in Banking Sector.

is not a one shot affair; it needs to be appropriately phased in the least disruptive manner. The banking and financial crises in recent years in emerging economies have demonstrated that, when things go wrong with the financial system, they can result in a severe economic downturn. Furthermore, banking crises often impose substantial costs on the exchequer, the incidence of which is ultimately borne by the taxpayer. The World Bank Annual Report (2002) has observed that the loss of US $1 trillion in banking crisis in the 1980s and 1990s is equal to the total flow of official development assistance to developing countries from 1950s to the present date. As a consequence, the focus of financial market reform in many emerging economies has been towards increasing efficiency while at the same time ensuring stability in financial markets. From this perspective, financial sector reforms are essential in order to avoid such costs. It is, therefore, not surprising that financial market reform is at the forefront of public policy debate in recent years. The crucial role of sound financial markets in promoting rapid economic growth and ensuring financial stability. Financial sector reform, through the development of an efficient financial system, is thus perceived as a key element in raising countries out of their 'low level equilibrium trap'. As the World Bank Annual Report (2002) observes, a robust financial system is a precondition for a sound investment climate, growth and the reduction of poverty . Financial sector reforms were initiated in India a decade ago with a view to improving efficiency in the process of financial intermediation, enhancing the effectiveness in the conduct of monetary policy and creating conditions for integration of the domestic financial sector with the global system. The first phase of reforms was guided by the recommendations of Narasimham Committee.

The approach was to ensure that the financial services industry operates on the basis of operational flexibility and functional autonomy with a view to 2

Risk Management in Banking Sector.

enhancing efficiency, productivity and profitability'.

The second phase, guided by Narasimham Committee II, focused on strengthening the foundations of the banking system and bringing about structural improvements. Further intensive discussions are held on important issues related to corporate governance, reform of the capital structure, (in the context of Basel II norms), retail banking, risk management technology, and human resources development, among others. Since 1992, significant changes have been introduced in the Indian

financial system. These changes have infused an element of competition in the financial system, marking the gradual end of financial repression characterized by price and non-price controls in the process of financial intermediation. While financial markets have been fairly developed, there still remains a large extent of segmentation of markets and non-level playing field among participants, which contribute to volatility in asset prices. This volatility is exacerbated by the lack of liquidity in the secondary markets. The purpose of this paper is to highlight the need for the regulator and market participants to recognize the risks in the financial system, the products available to hedge risks and the instruments, including derivatives that are required to be developed/introduced in the Indian system. The financial sector serves the economic function of intermediation by ensuring efficient allocation of resources in the economy. Financial intermediation is enabled through a four-pronged transformation mechanism consisting of liability-asset transformation, size transformation, maturity transformation and risk transformation. Risk is inherent in the very act of transformation. However, prior to reform of 1991-92, banks were not exposed to diverse financial risks mainly because interest rates were regulated, financial asset prices moved within a narrow band

Risk Management in Banking Sector.

and the roles of different categories of intermediaries were clearly defined. Credit risk was the major risk for which banks adopted certain appraisal standards. Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements of this transformation process have been 1. The deregulation of coupon rate on Government securities. 2. Substantial liberalization of bank deposit and lending rates. 3. A gradual trend towards disintermediation in the financial system in the wake of increased access of corporates to capital markets. 4. Blurring of distinction between activities of financial institutions. 5. Greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks. 6. Emergence of new private sector banks and other financial institutions, and, 7. The rapid advancement of technology in the financial system.

Definition of Risk?
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Risk Management in Banking Sector. What is Risk? "What is risk?" And what is a pragmatic definition of risk? Risk means different things to different people. For some it is "financial (exchange rate, interest-call money rates), mergers of competitors globally to form more powerful entities and not leveraging IT optimally" and for someone else "an event or commitment which has the potential to generate commercial liability or damage to the brand image". Since risk is accepted in business as a trade off between reward and threat, it does mean that taking risk bring forth benefits as well. In other words it is necessary to accept risks, if the desire is to reap the anticipated benefits. Risk in its pragmatic definition, therefore, includes both threats that can materialize and opportunities, which can be exploited. This definition of risk is very pertinent today as the current business environment offers both challenges and opportunities to organizations, and it is up to an organization to manage these to their competitive advantage. What is Risk Management - Does it eliminate risk? Risk management is a discipline for dealing with the possibility that some future event will cause harm. It provides strategies, techniques, and an approach to recognizing and confronting any threat faced by an organization in fulfilling its mission. Risk management may be as uncomplicated as asking and answering three basic questions: 1. What can go wrong? 2. What will we do (both to prevent the harm from occurring and in the aftermath of an "incident")? 3. If something happens, how will we pay for it? Risk management does not aim at risk elimination, but enables the organization to bring their risks to manageable proportions while not severely

Risk Management in Banking Sector. affecting their income. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing the risks to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. This transformation takes place due to the interlinkage present among the various risks. The focal point in managing any risk will be to understand the nature of the transaction in a way to unbundle the risks it is exposed to. Risk Management is a more mature subject in the western world. This is largely a result of lessons from major corporate failures, most telling and visible being the Barings collapse. In addition, regulatory requirements have been introduced, which expect organizations to have effective risk management practices. In India, whilst risk management is still in its infancy, there has been considerable debate on the need to introduce comprehensive risk management practices. Objectives of Risk Management Function Two distinct viewpoints emerge

One which is about managing risks, maximizing profitability and creating opportunity out of risks And the other which is about minimising risks/loss and protecting corporate assets. The management of an organization needs to consciously decide on

whether they want their risk management function to 'manage' or 'mitigate' Risks.

Managing risks essentially is about striking the right balance between risks and controls and taking informed management decisions on opportunities and threats facing an organization. Both situations, i.e. over or under controlling risks are highly undesirable as the former means higher costs and the latter means possible exposure to risk.

Mitigating or minimising risks, on the other hand, means mitigating all risks even if the cost of minimising a risk may be excessive and outweighs the

Risk Management in Banking Sector. cost-benefit analysis. Further, it may mean that the opportunities are not adequately exploited. In the context of the risk management function, identification and management of Risk is more prominent for the financial services sector and less so for consumer products industry. What are the primary objectives of your risk management function? When specifically asked in a survey conducted, 33% of respondents stated that their risk management function is indeed expressly mandated to optimise risk. Risks in Banking Risks manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks. The case discusses the various risks that arise due to financial intermediation and by highlighting the need for asset-liability management; it discusses the Gap Model for risk management. Typology of Risk Exposure Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to taking into consideration practical issues including the limitations of models and theories, human factor, existence of frictions such as taxes and transaction cost and limitations on quality and quantity of information, as well as the cost of acquiring this information, and more.

Risk Management in Banking Sector.

FINANCIAL RISKS

MARKET RISK

LIQUIDITY RISK

OPERATIONAL RISK

HUMAN FACTOR RISK

CREDIT RISK

LEGAL & REGULATORY RISK

FUNDING LIQUIDITY RISK

TRADING LIQUIDITY RISK

TRANSACTION RISK

PORTFOLIO CONCENTRATION

ISSUE RISK

ISSUER RISK

COUNTERPARTY RISK

EQUITY RISK

INEREST RATE RISK

CURRENCY RISK

COMMODITY RISK

TRADING RISK

GAP RISK

GENERAL MARKET RISK

SPECIFIC RISK

Risk Management in Banking Sector. MARKET RISK Market risk is that risk that changes in financial market prices and rates will reduce the value of the banks positions. Market risk for a fund is often measured relative to a benchmark index or portfolio, is referred to as a risk of tracking error market risk also includes basis risk, a term used in risk management industry to describe the chance of a breakdown in the relationship between price of a product, on the one hand, and the price of the instrument used to hedge that price exposure on the other. The market-Var methodology attempts to capture multiple component of market such as directional risk, convexity risk, volatility risk, basis risk, etc. CREDIT RISK Credit risk is that risk that a change in the credit quality of a counterparty will affect the value of a banks position. Default, whereby a counterparty is unwilling or unable to fulfill its contractual obligations, is the extreme case; however banks are also exposed to the risk that the counterparty might downgraded by a rating agency. Credit risk is only an issue when the position is an asset, i.e., when it exhibits a positive replacement value. In that instance if the counterparty defaults, the bank either loses all of the market value of the position or, more commonly, the part of the value that it cannot recover following the credit event. However, the credit exposure induced by the replacement values of derivative instruments are dynamic: they can be negative at one point of time, and yet become positive at a later point in time after market conditions have changed. Therefore the banks must examine not only the current exposure, measured by the current replacement value, but also the profile of future exposures up to the termination of the deal. LIQUIDITY RISK Liquidity risk comprises both

Funding liquidity risk

Risk Management in Banking Sector.

Trading-related liquidity risk. Funding liquidity risk relates to a financial institutions ability to raise the

necessary cash to roll over its debt, to meet the cash, margin, and collateral requirements of counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding liquidity risk is affected by various factors such as the maturities of the liabilities, the extent of reliance of secured sources of funding, the terms of financing, and the breadth of funding sources, including the ability to access public market such as commercial paper market. Funding can also be achieved through cash or cash equivalents, buying power , and available credit lines. Trading-related liquidity risk, often simply called as liquidity risk, is the risk that an institution will not be able to execute a transaction at the prevailing market price because there is, temporarily, no appetite for the deal on the other side of the market. If the transaction cannot be postponed its execution my lead to substantial losses on position. This risk is generally very hard to quantify. It may reduce an institutions ability to manage and hedge market risk as well as its capacity to satisfy any shortfall on the funding side through asset liquidation. OPERATIONAL RISK It refers to potential losses resulting from inadequate systems, management failure, faulty control, fraud and human error. Many of the recent large losses related to derivatives are the direct consequences of operational failure. Derivative trading is more prone to operational risk than cash transactions because derivatives are, by heir nature, leveraged transactions. This means that a trader can make very large commitment on behalf of the bank, and generate huge exposure in to the future, using only small amount of cash. Very tight controls are an absolute necessary if the bank is to avoid huge losses. Operational risk includes fraud, for example when a trader or other employee intentionally falsifies and misrepresents the risk incurred in a transaction. Technology risk, and principally computer system risk also fall into the operational risk category.

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Risk Management in Banking Sector.

LEGAL RISK Legal risk arises for a whole of variety of reasons. For example, counterparty might lack the legal or regulatory authority to engage in a transaction. Legal risks usually only become apparent when counterparty, or an investor, lose money on a transaction and decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk is the potential impact of a change in tax law on the market value of a position. HUMAN FACTOR RISK Human factor risk is really a special form of operational risk. It relates to the losses that may result from human errors such as pushing the wrong button on a computer, inadvertently destroying files, or entering wrong value for the parameter input of a model.

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Risk Management in Banking Sector.

Market Risk
What is Market Risk? Market Risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices". Thus, Market Risk is the risk to the bank's earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on the management of Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc. Types of market risk

Interest rate risk: Interest rate risk is the risk where changes in market interest rates might

adversely affect a bank's financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank's networth since the economic value of a bank's assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as 'earnings perspective' and 'economic value' perspective, respectively. 12

Risk Management in Banking Sector. Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective. Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense. Economic Value perspective involves analyzing the changes of impact on interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps. The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose bank's NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Banking Books. While the assets in the trading book are held primarily for

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Risk Management in Banking Sector. generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

Equity price risk: The price risk associated with equities also has two components General

market risk refers to the sensitivity of an instrument / portfolio value to the change in the level of broad stock market indices. Specific / Idiosyncratic risk refers to that portion of the stocks price volatility that is determined by characteristics specific to the firm, such as its line of business, the quality of its management, or a breakdown in its production process. The general market risk cannot be eliminated through portfolio diversification while specific risk can be diversified away.

Foreign exchange risk: Foreign Exchange Risk maybe defined as the risk that a bank may suffer

losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned. In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallization does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur

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Risk Management in Banking Sector. replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one center and the settlement of another currency in another time-zone. The forex transactions with counterparties from another country also trigger sovereign or country risk (dealt with in details in the guidance note on credit risk). The three important issues that need to be addressed in this regard are: 1. Nature and magnitude of exchange risk 2. Exchange managing or hedging for adopted be to strategy> 3. The tools of managing exchange risk

Commodity price risk: The price of the commodities differs considerably from its interest rate risk

and foreign exchange risk, since most commodities are traded in the market in which the concentration of supply can magnify price volatility. Moreover, fluctuations in the depth of trading in the market (i.e., market liquidity) often accompany and exacerbate high levels of price volatility. Therefore, commodity prices generally have higher volatilities and larger price discontinuities. Measuring Market Risk The measurement of risk has changed over time. It has evolved from the simple indicators, such as Face value/ Notional amount for an individual security to the latest methodologies of computing VaR. the quest for better and more accurate measure of market risk is ongoing; each new market turmoil reveals the limitations of even the most sophisticated measure of market risk. 1. The Notional Amount Approach: Until recently, trading desks in major banks were allocated economic capital by reference to notional amount. The notional approach measures risk as the notional, or nominal, amount of a security, or the sum of the notional values of the holdings for a portfolio. This method is flawed since it does not: 15

Risk Management in Banking Sector. 1. Differentiate between short and long positions. 2. Reflect price volatility and correlation between prices. Moreover, in the case of derivative positions in the over the counter market, there are often very large discrepancies between true amount of market exposure, which is often small, and the notional amount which may be huge. For example, two call options on the same underlying instrument with the same notional value and same maturity, with one option being in the money and the other one out-of-the-money, have very different market values and risk exposures. 2. Value At Risk (VaR): Value at risk can be defined as the worst loss that might be expected from holding a security or portfolio over a given period of time (say a single day, 10 days for the purpose of regulatory capital reporting), given a specified level of probability (known as the confidence level) For example, if we say that a position has a daily VaR of Rs. 10 million at the 99% confidence level, we mean that the realized daily losses from the position will, on average, be higher than Rs. 10 million on only one day every 100 trading days ( i.e., two to three days each year).VaR offers probability statement about the potential change in the value of a portfolio resulting from a change in the market factors, over a specified period of time. VaR is the answer to the following question: What is the maximum loss over a given period of time period such that there is a low probability, say a 1% probability, that the actual loss over the given period will be larger? Note that the VaR measure does not state by how much actual losses will exceed the VaR figure; it simply states how likely ( or unlikely) it is that the VaR figure will be exceeded. Most VaR models are designed to measure risk over a short period of time, such as one day or, in the case of the risk measurements required by the regulators to report regulatory capital, 10 days. BIS 1998 imposes a confidence level, c, of 99% .however, for the purposes of allocating internal capital, VaR may be derived at a higher confidence level, say c=99.96%, which is consistent with an AA rating.

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Risk Management in Banking Sector. Calculating VaR involves following steps: 1. Derive the forward distribution of the portfolio, or alternatively returns on the portfolio, at the chosen horizon, H (of, say, one day or 10 days). The distribution can be derived directly from historical price distributions (nonparametric VaR) or the distributions may be assumed to be analytic; e.g., it is common practice to assume that the prices are log-normally distributed, or equivalently that returns follow a normal distribution (parametric VaR). 2. Assuming that the confidence level is 99%, calculate the first percentile of this distribution; if the confidence level is 99.96%, and then calculate the 4-bp quantile. The VaR is the maximum loss at the 99% confidence level, measured relative to the expected value of the portfolio at the target horizon, i.e., VaR is the distance of the first percentile from the mean of the distribution. VaR = Expected profit/loss Worst case loss at 99% confidence level. (1) An alternative definition of VaR is that is that it represents the worst case loss at the 99% confidence level: VaR = Worst case loss at the 99% confidence level. (2) VaR is also known as absolute VaR . Only the first definition of VaR is consistent with economic capital attribution and RAROC calculations. Indeed, in VaR the expected profit/loss is already priced in, and accounted for, in the return calculation. Capital is provided only as a cushion against unexpected losses. Note that the VaR relates to the economic capital that shareholders should invest in the firm to limit the probability of default to a given predetermined level, 1-c, while the regulatory capital is the minimum amount of capital imposed by the regulator. Economic capital differs from regulatory capital because the confidence level and the time horizon chosen are different. Most of the time, banks choose a higher confidence level that the 99% set by the regulator to determine their economic capital. However, the time horizon in economic capital calculations may vary from one day for very liquid positions, such as a

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Risk Management in Banking Sector. Government bond desk, to several weeks for illiquid positions, such as longdated OTC derivatives portfolios. More formally, if V = the current marked-to-market value of the position. R = the return over the horizon H = the expected return [ = E(R)] R* = the return corresponding to the worst case loss at the c V* = V (1+ R*) VaR (H; c) = E (V) V* = V (1 + ) V ( R*) VaR (H; c) = -VR*

The following table describes the three main methodologies to calculate VaR: Methodology Description Estimates VaR with equation that specifies Parametric parameters such as volatility, correlation, delta, and gamma Estimates VaR by Monte Carlo simulation simulating random scenarios and revaluing positions in the portfolio Estimates Var by reliving history; Applications Accurate for traditional assets and linear derivatives, but less accurate for non linear derivatives Appropriate for all types of instruments, linear and nonlinear Takes actual historical Historical simulation rates and revalues positions for each change in the market There are three main approaches to calculating value-at-risk: the correlation method, also known as 1. The variance/covariance matrix method; 2. Historical simulation 18

Risk Management in Banking Sector. 3. Monte Carlo simulation. All three methods require a statement of three basic parameters

Holding period Confidence interval and The historical time horizon over which the asset prices are observed. Under the correlation method, the change in the value of the position is

calculated by combining the sensitivity of each component to price changes in the underlying asset(s), with a variance/covariance matrix of the various components' volatilities and correlation. It is a deterministic approach. The historical simulation approach calculates the change in the value of a position using the actual historical movements of the underlying asset(s), but starting from the current value of the asset. It does not need a variance/covariance matrix. The length of the historical period chosen does impact the results because if the period is too short, it may not capture the full variety of events and relationships between the various assets and within each asset class, and if it is too long, may be too stale to predict the future. The advantage of this method is that it does not require the user to make any explicit assumptions about correlations and the dynamics of the risk factors because the simulation follows every historical move. The Monte Carlo simulation method calculates the change in the value of a portfolio using a sample of randomly generated price scenarios. Here the user has to make certain assumptions about market structures, correlations between risk factors and the volatility of these factors. He is essentially imposing his views and experience as opposed to the naive approach of the historical simulation method. At the heart of all three methods is the model. The closer the models fit economic reality, the more accurate the estimated VAR numbers and therefore the better they will be at predicting the true VAR of the firm. There is no

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Risk Management in Banking Sector. guarantee that the numbers returned by each VAR method will be anywhere near each other. Stress Testing "Stress testing" has been adopted as a generic term describing various techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing addresses the large moves in key market variables of that kind that lie beyond day to day risk monitoring but that could potentially occur. The process of stress testing, therefore, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over. Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss. Stress test reports can be constructed that summaries the effects of different shocks of different magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders and management to determine whether any action need to be taken in response Stress testing and value-at-risk* Stress tests supplement value-at-risk (VaR). VaR is thought to be a critical tool for tracking the riskiness of a firm's portfolio on a day-to-day level, and for assessing the risk-adjusted performance of individual business units. However, VaR has been found to be of limited use in measuring firms' exposures to extreme market events. This is because, by definition, such events occur too rarely to be captured by empirically driven statistical models. Furthermore, observed correlation patterns between various financial prices (and thus the correlations that would be estimated using data from ordinary times) tend to change when the price movements themselves are large. Stress tests offer a 20

Risk Management in Banking Sector. way of measuring and monitoring the portfolio consequences of extreme price movements of this type. Stress Testing Techniques Stress testing covers many different techniques. The four discussed here are listed in the Table below along with the information typically referred to as the "result" of that type of a stress test. Technique 1. Simple Sensitivity Test What is the "stress test result" Change in portfolio value for one or

more shocks to a single risk factor 2. Scenario Analysis (hypothetical or Change in portfolio value if the scenario historical) 3. Maximum loss 4. Extreme value theory were to occur Sum of individual trading units' worstcase scenarios Probability distribution losses of extreme

A simple sensitivity test isolates the short-term impact on a portfolio's value of a series of predefined moves in a particular market risk factor. For example, if the risk factor were an exchange rate, the shocks might be exchange rate changes of +/_ 2 percent, 4 percent, 6 percent and 10 percent. A scenario analysis specifies the shocks that might plausibly affect a number of market risk factors simultaneously if an extreme, but possible, event occurs. It seeks to assess the potential consequences for a firm of an extreme, but possible, state of the world. A scenario analysis can be based on an historical event or a hypothetical event. Historical scenarios employ shocks that occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks thought to be plausible in some foreseeable, but unlikely circumstances for which there is no exact parallel in recent history. Scenario analysis is currently the leading stress testing technique.

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Risk Management in Banking Sector. A maximum loss approach assesses the riskiness of a business unit's portfolio by identifying the most potentially damaging combination of moves of market risk factors. Interviewed risk managers who use such "maximum loss" approaches find the output of such exercises to be instructive but they tend not to rely on the results of such exercises in the setting of exposure limits in any systematic manner, an implicit recognition of the arbitrary character of the combination of shocks captured by such a measure. Extreme value theory (EVT) is a means to better capture the risk of loss in extreme, but possible, circumstances. EVT is the statistical theory on the behavior of the "tails" (i.e., the very high and low potential values) of probability distributions. Because it focuses only on the tail of a probability distribution, the method can be more flexible. For example, it can accommodate skewed and fattailed distributions. A problem with the extreme value approach is adapting it to a situation where many risk factors drive the underlying return distribution. Moreover, the usually unstated assumption that extreme events are not correlated through time is questionable. Despite these drawbacks, EVT is notable for being the only stress test technique that attempts to attach a probability to stress test results.

How should risk managers use stress tests Stress tests produce information summarizing the firm's exposure to

extreme, but possible, circumstances. The role of risk managers in the bank should be assembling and summarizing information to enable senior management to understand the strategic relationship between the firm's risktaking (such as the extent and character of financial leverage employed) and risk appetite. Typically, the results of a small number of stress scenarios should be computed on a regular basis and monitored over time. Some of the specific ways stress tests are used to influence decisionmaking are to: 1. manage funding risk

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Risk Management in Banking Sector. 2. provide a check on modeling assumptions 3. set limits for traders 4. determine capital charges on trading desks positions 1. Manage funding risk: Senior managers use stress tests to help them make decisions regarding funding risk. Managers have come to accept the need to manage risk exposures in anticipation of unfavorable circumstances. The significance of such information will vary according to a bank's exposure to funding or liquidity risk. 2. Provide a check on modeling assumptions: Scenario analysis is also used to highlight the role of particular correlation and volatility assumptions in the construction of banks' portfolios of market risk exposures. In this case, scenario analysis can be thought of as a means through which banks check on the portfolio's sensitivity to assumptions about the extent of effective portfolio diversification. 3. Set limits for traders: Stress tests are also used to set limits. Simple sensitivity tests may be used to put hard limits on bank's market risk exposures. 4. Determine capital charges on trading desks' positions: Banks may also initiate capital charges based on hypothetical losses under certain stress scenarios. The capital charges are deducted from each business unit's bonus pool. This procedure may be designed to provide each business unit with an economic incentive to reduce the risk of extreme losses. Limitations of Stress Tests Stress testing can appear to be a straightforward technique. In practice, however, stress tests are often neither transparent nor straightforward. They are based on a large number of practitioner choices as to what risk factors to stress, how to combine factors stressed, what range of values to consider, and what time frame to analyze. Even after such choices are made, a risk manager is

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Risk Management in Banking Sector. faced with the considerable tasks of sifting through results and identifying what implications, if any, the stress test results might have for how the firm should manage its risk-taking activities. A well-understood limitation of stress testing is that there are no probabilities attached to the outcomes. Stress tests help answer the question "How much could be lost?" The lack of probability measures exacerbates the issue of transparency and the seeming arbitrariness of stress test design. Systems incompatibilities across business units make frequent stress testing costly for some firms, reflecting the limited role that stress testing had played in influencing the firm's prior investments in information technology. Treatment of Market Risk in the Proposed Basel Capital Accord The Basle Committee on Banking Supervision (BCBS) had issued comprehensive guidelines to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The banks have been given flexibility to use in-house models based on VaR for measuring market risk as an alternative to a standardized measurement framework suggested by Basle Committee. The internal models should, however, comply with quantitative and qualitative criteria prescribed by Basle Committee. Reserve Bank of India has accepted the general framework suggested by the Basle Committee. RBI has also initiated various steps in moving towards prescribing capital for market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in Government and other approved securities, besides a risk weight each of 100% on the open position limits in forex and gold. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. As the ability of banks to identify and measure market risk improves, it would be necessary to assign explicit capital charge for market risk. While the small banks operating predominantly in India could adopt the standardized methodology, large banks and those banks operating in

24

Risk Management in Banking Sector. international markets should develop expertise in evolving internal models for measurement of market risk. The Basle Committee on Banking Supervision proposes to develop capital charge for interest rate risk in the banking book as well for banks where the interest rate risks are significantly above average ('outliers'). The Committee is now exploring various methodologies for identifying 'outliers' and how best to apply and calibrate a capital charge for interest rate risk for banks. Once the Committee finalizes the modalities, it may be necessary, at least for banks operating in the international markets to comply with the explicit capital charge requirements for interest rate risk in the banking book. As the valuation norms on banks' investment portfolio have already been put in place and aligned with the international best practices, it is appropriate to adopt the Basel norms on capital for market risk. In view of this, banks should study the Basel framework on capital for market risk as envisaged in Amendment to the Capital Accord to incorporate market risks published in January 1996 by BCBS and prepare themselves to follow the international practices in this regard at a suitable date to be announced by RBI. The Proposed New Capital Adequacy Framework The Basel Committee on Banking Supervision has released a Second Consultative Document, which contains refined proposals for the three pillars of the New Accord - Minimum Capital Requirements, Supervisory Review and Market Discipline. It may be recalled that the Basel Committee had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework for comments. However, the proposal to provide explicit capital charge for market risk in the banking book which was included in the Pillar I of the June 1999 Document has been shifted to Pillar II in the second Consultative Paper issued in January 2001. The Committee has also provided a technical paper on evaluation of interest rate risk management techniques. The Document has defined the criteria for identifying outlier banks. According to the proposal, a bank may be defined as an outlier whose economic value declined by more than 20% of the 25

Risk Management in Banking Sector. sum of Tier 1 and Tier 2 capital as a result of a standardized interest rate shock (200 bps.) The second Consultative Paper on the New Capital Adequacy framework issued in January, 2001 has laid down 13 principles intended to be of general application for the management of interest rate risk, independent of whether the positions are part of the trading book or reflect banks' non-trading activities. They refer to an interest rate risk management process, which includes the development of a business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. In particular, they address the need for effective interest rate risk measurement, monitoring and control functions within the interest rate risk management process. The principles are intended to be of general application, based as they are on practices currently used by many international banks, even though their specific application will depend to some extent on the complexity and range of activities undertaken by individual banks. Under the New Basel Capital Accord, they form minimum standards expected of internationally active banks. The principles are given in Annexure II.

Credit risk
What is Credit Risk? Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio 26

Risk Management in Banking Sector. value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign. Credit risk may take the following forms

In the case of direct lending: principal/and or interest amount may not be repaid; In the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability; In the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases;

In the case of securities trading businesses: funds/ securities settlement may not be effected; In the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or the sovereign may impose restrictions.

Types of Credit Rating Credit rating can be classified as: 2. External credit rating. 3. Internal credit rating External credit rating: A credit rating is not, in general, an investment recommendation concerning a given security. In the words of S&P, A credit rating is S&P's opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors. In Moody's words, a rating is, an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed-income security. Since S&P and Moody's are considered to have expertise in credit rating and are regarded as unbiased evaluators, there ratings are widely accepted by market participants and regulatory agencies. Financial institutions, when required

27

Risk Management in Banking Sector. to hold investment grade bonds by their regulators use the rating of credit agencies such as S&P and Moody's to determine which bonds are of investment grade. The subject of credit rating might be a company issuing debt obligations. In the case of such issuer credit ratings the rating is an opinion on the obligors overall capacity to meet its financial obligations. The opinion is not specific to any particular liability of the company, nor does it consider merits of having guarantors for some of the obligations. In the issuer credit rating categories are a) Counterparty ratings b) Corporate credit ratings c) Sovereign credit ratings The rating process includes quantitative, qualitative, and legal analyses. The quantitative analyses. The quantitative analysis is mainly financial analysis and is based on the firms financial reports. The qualitative analysis is concerned with the quality of management, and includes a through review of the firms competitiveness within its industry as well as the expected growth of the industry and its vulnerability to technological changes, regulatory changes, and labor relations. Internal credit rating: A typical risk rating system (RRS) will assign both an obligor rating to each borrower (or group of borrowers), and a facility rating to each available facility. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should offer a carefully designed, structured, and documented series of steps for the assessment of each rating. The following are the steps for assessment of rating: a) Objectivity and Methodology: The goal is to generate accurate and consistent risk rating, yet also to allow professional judgment to significantly influence a rating where it is appropriate. The expected loss is the product of an exposure (say, Rs. 100) and the probability of default (say, 2%) of an obligor (or borrower) and the loss rate given default (say, 50%) in any specific credit facility. In this example,

28

Risk Management in Banking Sector. The expected loss = 100*.02*.50 = Rs. 1 A typical risk rating methodology (RRM) a. Initial assign an obligor rating that identifies the expected probability of default by that borrower (or group) in repaying its obligations in normal course of business. b. The RRS then identifies the risk loss (principle/interest) by assigning an RR to each individual credit facility granted to an obligor. The obligor rating represents the probability of default by a borrower in repaying its obligation in the normal course of business. The facility rating represents the expected loss of principal and/ or interest on any business credit facility. It combines the likelihood of default by a borrower and conditional severity of loss, should default occur, from the credit facilities available to the borrower.

Risk Rating Continuum (Prototype Risk Rating System) RISK RR Corresponding Probable S&P or Sovereign Low 0 1 2 3 4 5 Moody's Rating Not Applicable AAA AA A BBB+/BBB BBB-

Investment Grade

Average

29

Risk Management in Banking Sector. 6 7 8 9 10 11 12 BB+/BB BBB+/B BCCC+/CCC CCIn Default Below Investment Grade

High

The steps in the RRS (nine, in our prototype system) typically start with a financial assessment of the borrower (initial obligor rating), which sets a floor on the obligor rating (OR). A series of further steps (four) arrive at the final obligor rating. Each one of steps 2 to 5 may result in the downgrade of the initial rating attributed at step 1. These steps include analyzing the managerial capability of the borrower (step 2), examining the borrowers absolute and relative position within the industry (step 3), reviewing the quality of the financial information (step 4) and the country risk (step 5). The process ensures that all credits are objectively rated using a consistent process to arrive at the accurate rating. Additional steps (four, in our example) are associated with arriving at a final facility rating, which may be above OR below the final obligor rating. These steps include examining third-party support (step 6), factoring in the maturity of the transaction (step 7), reviewing how strongly the transaction is structured. (step 8), and assessing the amount of collateral (step 9). b) Measurement of Default Probability and Recovery Rates. Credit rating systems can be compared to multivariate credit scoring systems to evaluate their ability to predict bankruptcy rates and also to provide estimates of the severity of losses. Altman and Saunders (1998) provide a detailed survey of credit risk management approaches. They compare four methodologies for credit scoring: 1. The linear probability model 2. The logit model 3. The probit model 4. The discriminant analysis model

30

Risk Management in Banking Sector. The logit model assumes that the default probability is logistically distributed, and applies a few accounting variables to predict the default probability. The linear probability model is based on a linear regression model, and makes use of a number of accounting variables to try to predict the probability of default. The multiple discriminant analysis (MDA), proposed and advocated by Aitman is based on finding a linear function of both accounting and market based variables that best discriminates between two groups: firms that actually defaulted and firms that did not default. The linear models are based on empirical procedures. They are not found in theory of the firm OR any theoretical stochastic processes for leveraged firms. Credit Risk Management In this backdrop, it is imperative that banks have a robust credit risk management system which is sensitive and responsive to these factors. The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long term success of any banking organization. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures. Building Blocks of Credit Risk Management: In a bank, an effective credit risk management framework would comprise of the following distinct building blocks:

Policy and Strategy Organizational Structure Operations/ Systems Policy and Strategy The Board of Directors of each bank shall be responsible for approving

and periodically reviewing the credit risk strategy and significant credit risk policies. Credit Risk Policy

31

Risk Management in Banking Sector. 1. Every bank should have a credit risk policy document approved by the Board. The document should include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk control/ mitigation techniques, documentation, legal issues and management of problem loans. 2. Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management. 3. The credit risk policies approved by the Board should be communicated to branches/controlling offices. All dealing officials should clearly understand the bank's approach for credit sanction and should be held accountable for complying with established policies and procedures. 4. Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board.</P< LI> Credit Risk Strategy 1. Each bank should develop, with the approval of its Board, its own credit risk strategy or plan that establishes the objectives guiding the bank's credit-granting activities and adopt necessary policies/ procedures for conducting such activities. This strategy should spell out clearly the organizations credit appetite and the acceptable level of risk-reward trade-off for its activities. 2. The strategy would, therefore, include a statement of the bank's willingness to grant loans based on the type of economic activity, geographical location, currency, market, maturity and anticipated profitability. This would necessarily translate into the identification of target markets and business sectors, preferred levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts. 3. The credit risk strategy should provide continuity in approach as also take into account the cyclical aspects of the economy and the resulting shifts in 32

Risk Management in Banking Sector. the composition/ quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles. 4. Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board. Organizational Structure Sound implementation basic features: 1. The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. The Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk. For this purpose, this Committee should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any. It is imperative that the independence of this Committee is preserved. The Board should, therefore, ensure that this is not compromised at any cost. In the event of the Board not accepting any recommendation of this Committee, systems should be put in place to spell out the rationale for such an action and should be properly documented. This document should be made available to the internal and external auditors for their scrutiny and comments. The credit risk strategy and policies adopted by the committee should be effectively Operations / Systems organizational of an structure is sine risk qua non for successful The effective credit management system.

organizational structure for credit risk management should have the following

33

Risk Management in Banking Sector. Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases: 1. Relationship management phase i.e. business development. 2. Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement. 3. Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans 4. On the basis of the broad management framework stated above, the banks should have the following credit risk measurement and monitoring procedures: 5. Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures/weak credits

Credit Risk Models A credit risk model seeks to determine, directly or indirectly, the answer to the following question: Given our past experience and our assumptions about the future, what is the present value of a given loan or fixed income security? A credit risk model would also seek to determine the (quantifiable) risk that the promised cash flows will not be forthcoming. The techniques for measuring credit risk that have evolved over the last twenty years are prompted by these questions and dynamic changes in the loan market. The increasing importance of credit risk modeling should be seen as the consequence of the following three factors: 34

Risk Management in Banking Sector. 1. Banks are becoming increasingly quantitative in their treatment of credit risk. 2. New markets are emerging in credit derivatives and the marketability of existing loans is increasing through securitization/ loan sales market." 3. Regulators are concerned to improve the current system of bank capital requirements especially as it relates to credit risk.

Importance of Credit Risk Models

Credit Risk Models have assumed importance because they provide the decision maker with insight or knowledge that would not otherwise be readily available or that could be marshalled at prohibitive cost. In a marketplace where margins are fast disappearing and the pressure to lower pricing is unrelenting, models give their users a competitive edge. The credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play increasingly important roles in banks' risk management and performance measurement processes, customer profitability analysis, risk-based pricing, active portfolio management and capital structure decisions. Credit risk modeling may result in better internal risk management and may have the potential to be used in the supervisory oversight of banking organizations. Techniques for Measuring Credit Risk In the measurement of credit risk, models may be classified along three different dimensions: 1. the techniques employed, 2. the domain of applications in the credit process and 3. the products to which they are applied. Techniques: The following are the more commonly used techniques: 1. Econometric Techniques such as linear and multiple discriminant analysis, multiple regression, logic analysis and probability of default, etc.

35

Risk Management in Banking Sector. 2. Neural networks are computer-based systems that use the same data employed in the econometric techniques but arrive at the decision model using alternative implementations of a trial and error method. 3. Optimization models are mathematical programming techniques that discover the optimum weights for borrower and loan attributes that minimize lender error and maximize profits. 4. Rule-based or expert are characterized by a set of decision rules, a knowledge base consisting of data such as industry financial ratios, and a structured inquiry process to be used by the analyst in obtaining the data on a particular borrower. 5. Hybrid Systems. In these systems simulation are driven in part by a direct causal relationship, the parameters of which are determined through estimation techniques. RBI Guidelines on Credit Risk New Capital Accord: Implications for Credit Risk Management The Basel Committee on Banking Supervision had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework with the intention of replacing the current broad-brush 1988 Accord. The Basel Committee has released a Second Consultative Document in January 2001, which contains refined proposals for the three pillars of the New Accord Minimum Capital Requirements, Supervisory Review and Market Discipline. The Committee proposes two approaches, for estimating regulatory capital. viz., 1. Standardized and 2. Internal Rating Based (IRB) Under the standardized approach, the Committee desires neither to produce a net increase nor a net decrease, on an average, in minimum regulatory capital, even after accounting for operational risk. Under the Internal Rating Based (IRB) approach, the Committee's ultimate goals are to ensure that the overall level of regulatory capital is sufficient to address the underlying credit 36

Risk Management in Banking Sector. risks and also provides capital incentives relative to the standardized approach, i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB approach) and 90% of the capital requirement under foundation approach for advanced IRB approach to encourage banks to adopt IRB approach for providing capital. The minimum capital adequacy ratio would continue to be 8% of the riskweighted assets, which cover capital requirements for market (trading book), credit and operational risks. For credit risk, the range of options to estimate capital extends to include a standardized, a foundation IRB and an advanced IRB approaches. RBI Guidelines for Credit Risk Management Credit Rating Framework A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a simplistic and broad classification of loans/exposures into a "good" or a "bad" category. The CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. In spite of the advancement in risk management techniques, CRF is continued to be used to a great extent. These frameworks have been primarily driven by a need to standardize and uniformly communicate the "judgment" in credit selection procedures and are not a substitute to the vast lending experience accumulated by the banks' professional staff. Broadly, CRF can be used for the following purposes: 1. Individual credit selection, wherein either a borrower or a particular exposure/ facility is rated on the CRF 2. Pricing (credit spread) and specific features of the loan facility. This would largely constitute transaction-level analysis. 3. Portfolio-level analysis. 4. Surveillance, monitoring and internal MIS 37

Risk Management in Banking Sector. Assessing the aggregate risk profile of bank/ lender. These would be relevant for portfolio-level analysis. For instance, the spread of credit exposures across various CRF categories, the mean and the standard deviation of losses occurring in each CRF category and the overall migration of exposures would highlight the aggregated credit-risk for the entire portfolio of the bank.

Operational Risk
What is Operational Risk? Operational risk is the risk associated with operating a business. Operational risk covers such a wide area that it is useful to subdivide operational risk into two components:

Operational failure risk. Operational strategic risk. Operational failure risk arises from the potential for failure in the course

of operating the business. A firm uses people, processes and technology to achieve the business plans, and any one of these factors may experience a failure of some kind. Accordingly, operational failure risk can be defined as the risk that there will be a failure of people, processes or technology within the business unit. A portion of failure may be anticipated, and these risks should be built into the business plan. But it is unanticipated, and therefore uncertain, failures that give rise to key operational risks. These failures can be expected to

38

Risk Management in Banking Sector. occur periodically, although both their impact and their frequency may be uncertain. The impact or severity of a financial loss can be divided into two categories:

An expected amount An unexpected amount.

The latter is itself subdivided into two classes: an amount classed as severe, and a catastrophic amount. The firm should provide for the losses that arise from the expected component of these failures by charging expected revenues with a sufficient amount of reserves. In addition, the firm should set aside sufficient economic capital to cover the unexpected component, or resort to insurance. Operational strategic risk arises from environmental factors, such as a new competitor that changes the business paradigram, a major political and regulatory regime change, and earthquakes and other such factors that are outside the control of the firm. It also arises from major new strategic initiatives, such as developing a new line of business or re-engineering an existing business line. All business rely on people, processes and technology outside their business unit, and the potential for failure exists there too, this type of risk is referred to as external dependency risk. Operational Risk

Operational failure risk (Internal operational risk) The risk encountered in pursuit of a particular strategy due to:

Operational strategic risk (External operational risk) The risk of choosing an inappropriate strategy in response to environmental factor, such as
Political Taxation Regulation Government Societal of Operational Risk Competition, etc.

People Process Technology

Figure:

39 Two Broad Categories

Risk Management in Banking Sector.

The figure above summarizes the relationship between operational failure risk and operational strategic risk. These two principal categories of risk are also sometimes defined as internal and external operational risk. Operational risk is often thought to be limited to losses that can occur in operating or processing centers. This type of operational risk, sometimes referred as operations risk, is an important component, but it by no means covers all of the operational risks facing the firm. Our definition of operational risk as the risk associated with operating the business means significant amounts of operational risk are also generated outside the processing centers. Risk begins to accumulate even before the design of the potential transaction gets underway. It is present during negotiations with the client (regardless of whether the negotiation is a lengthy structuring exercise or a routine electronic negotiation.) and continues after the negotiation as the transaction is serviced. A complete picture of operational risk can only be obtained if the banks activity is analyzed from beginning to end. Several things have to be in place before a transaction is negotiated, and each exposes the firm to operational risk. The activity carried on behalf of the client by the staff can expose the institution to people risk. People risk are not only in the form of risk found early in a transaction. But they further rely on using sophisticated financial models to price the transaction. This creates what is called as Model risk which can arise because of wrong parameters like input to the model, or because the model is used inappropriately and so on. Once the transaction is negotiated and a ticket is written, errors can occur as the transaction is recorded in various systems or reports. An error here may result in the delayed settlement of the transaction, which in turn can give rise to fines and other penalties. Further an error in market risk and credit risk report

40

Risk Management in Banking Sector. might lead to the exposures generated by the deal being understated. In turn this can lead to the execution of additional transactions that would otherwise not have been executed. These are examples of what is often called as process risk The system that records the transaction may not be capable of handling the transaction or it may not have the capacity to handle such transactions. If any one of the step is out-sourced, then external dependency risk also arises. However, each type of risk can be captured either as people, processes, technology, or an external dependency risk, and each can be analyzed in terms of capacity, capability or availability Who Should Manage Operational Risk? The responsibility for setting policies concerning operational risk remains with the senior management, even though the development of those policies may be delegated, and submitted to the board of directors for approval. Appropriate policies must be put in place to limit the amount of operational risk that is assumed by an institution. Senior management needs to give authority to change the operational risk profile to those who are the best able to take action. They must also ensure that a methodology for the timely and effective monitoring of the risks that are incurred is in place. To avoid any conflict of interest, no single group within the bank should be responsible for simultaneously setting policies, taking action and monitoring risk.

Internal Audit

Senior Management

Business Management

Risk Management

Legal Insurance Operations Finance Information Technology 41

Risk Management in Banking Sector.

Policy Setting The authority to take action generally rests with business management, which is responsible for controlling the amount of operational risk taken within each business line. The infrastructure and the governance groups share with business management the responsibility for managing operational risk. The responsibility for the development of a methodology for measuring and monitoring operational risks resides most naturally with group risk management functions. The risk management function also needs to ensure the proper operational risk/ reward analysis is performed in the review of existing businesses and before the introduction of new initiatives and products. In this regard, the risk management function works very closely with, but independent from, business management, infrastructure, and other governance group Senior management needs to know whether the responsibilities it has delegated are actually being tended to, and whether the resulting processes are effective. The internal audit function within the bank is charged with this responsibility. Key to Implementing Bank-wide Operational Risk Management: The eight key elements are necessary to successfully implement a bankwide operational risk management framework. They involve setting policy and identifying risk as an outgrowth of having designed a common language, constructing business process maps, building a best measurement methodology, providing exposure management, installing a timely reporting capability, performing risk analysis inclusive of stress testing, and allocating economic capital as a function of operational risk. EIGHT KEY ELEMENTS TO ACHIEVE BEST OPERATIONAL RISK MANAGEMENT. 1. Policy 42

Risk Management in Banking Sector.

8. Economic Capital

2.Risk Identification

7. Risk Analysis

Best Practice

3. Business Process

6. Reporting

4. Measuring Methodology 5. Exposure Management

1. Develop well-defined operational risk policies. This includes explicitly articulating the desired standards for the risk measurement. One also needs to establish clear guidelines for practices that may contribute to a reduction of operational risk. 2. Establish a common language of risk identification. For e.g., the term people risk includes a failure to deploy skilled staff. Technology risk would include system failure, and so on. 3. Develop business process maps of each business. For e.g., one should create an operational risk catalogue which categories and defines the various operational risks arising from each organizational unit in terms of people, process, and technology risk. This catalogue should be tool to help with operational risk identification and assessment. Types of Operational Failure Risk 1. People Risk 2. Process Risk Model Risk TR 1. Model/ methodology error 2. Mark-to-model error. 1. Execution error. 2. Product complexity. 43

1. Incompetancy. 2. Fraud.

Risk Management in Banking Sector. 3. Booking error. OCR 4. Settlement error. 1. Exceeding limits. 2. Security risk. 3. Technology Risk 3.Volume risk. 1. System failure. 2. Programming error. 3. Information risk. 4. Telecommunications failure.

4. Develop a comprehensible set of operational risk metrics. Operational risk assessment is a complex process. It needs to be performed on a firm-wide basis at regular intervals using standard metrics. In early days, business and infrastructure groups performed their own assessment of operational risk. Today, self-assessment has been discredited. Sophisticated financial institutions are trying to develop objective measures of operational risk that build significantly more reliability into the quantification of operational risk. 5. Decide how to manage operational risk exposure and take appriate action to hedge the risks. The bank should address the economic question of th cost-benefit of insuring a given risk for those operational risks that can be insured. 6. Decide how to report exposure. 7. Develop tools for risk analysis, and procedures for when these tools should deploped. For e.g., risk analysis is typically performed as part of a new product process, periodic business reviews, and so on. Stress testing should be a standard part of risk analysis process. The frequency of risk assessment should be a function of the degree to which operational risks are expected to change over time as businesses undertake new initiatives, or as business circumstances evolve. This frequency might be reviewed as operational risk measurement is rolled out across the bank a bank 44

Risk Management in Banking Sector. should update its risk assessment more frequently. Further one should reassess whenever the operational risk profile changes significantly. 8. Develop techniques to translate the calculation of operational risk into a required amount of economic capital. Tools and procedures should be developed to enable businesses to make decisions about operational risk based on risk/reward analysis. Four-Step Measurement Process For Operational Risk Clear guiding principle for the operational risk measurement process should be set to ensure that it provides an appropriate measure of operational risk across all business units throughout the bank. This problem of measuring operational risk can be best achieved by means of a four-step operational risk process. The following are the four steps involved in the process: 1. Input. 2. Risk assessment framework. 3. Review and validation. 4. Output. 1. Input: The first step in the operational risk measurement process is to gather the information needed to perform a complete assessment of all significant operational risks. A key source of this information is often the finished product of other groups. For example, a unit that supports the business group often publishes report or documents that may provide an excellent starting point for the operational risk assessment. Sources of Information in the Measurement Process of Operational Risk :The Inputs (for Assessment) Likelihood of Occurrence Audit report Regulatory report Management report Expert opinion Business Recovery Plan Severity Management interviews Loss history

45

Risk Management in Banking Sector. Business plans Budget plans Operations plans For example, if one is relying on audit documents as an indication of the degree of control, then one needs to ask if the audit assessment is current and sufficient. Have there been any significant changes made since the last audit assessment? Did the audit scope include the area of operational risk that is of concern to the present risk assessment? As one diligently works through available information, gaps often become apparent. These gaps in the information often need to be filled through discussion with the relevant managers. Typically, there are not sufficient reliable historical data available to confidently project the likelihood or severity of operational losses. One often needs to rely on the expertise of business management, until reliable data are compiled to offer an assessment of the severity of the operational failure for each of the risks. The time frame employed for all aspects of the assessment process is typically one year. The one-year time horizon is usually selected to align with the business planning cycle of the bank. 2. Risk Assessment Framework The input information gathered in the above step needs to be analyzed and processed through the risk assessment framework. Risk assessment framework includes: 1. Risk categories: The operational risk can be broken down into four headline risk categories like the risk of unexpected loss due to operational failure in people, process and technology deployed within the business Internal dependencies should each be reviewed according to a set of factors. We examine these 9nternal dependencies according to three key components of capability, capacity and availability. External dependencies can also be analyzed in terms of the specific type of external interaction. 2. Connectivity and interdependencies

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Risk Management in Banking Sector. The headline risk categories cannot be viewed in isolation from one another. One needs to examine the degree of interconnected risk exposures that cut across the headline operational risk categories, in order to understand the full impact of risk. 3. Change, complexity, compliancy: One may view the sources that drive the headline risk categories as falling under the broad categories of Change refers to such items as introducing new technology or new products, a merger or acquisition, or moving from internal supply to outsourcing, etc. Complexity refers to such items as complexity of products, process or technology. Complacency refer to ineffective management of the business. 4. Net likelihood assessment The likelihood that an operational failure might occur within the next year should be assessed, net of risk mitigants such as insurance, for each identified risk exposure and for each of the four headline risk categories. Since it is often unclear how to quantify risk, this assessment can be rated along five point likelihood continuum from very low, low, medium, high and very high. 5. Severity assessment Severity describes the potential loss to the bank given that an operational risk failure has occurred. It should be assessed for each identified risk exposure. 6. Combined likelihood and severity into the overall Operational Risk Assessment Operational risk measures are constrained in that there is not usually a defensible way to combine the individual likelihood of loss and severity assessments into overall measure of operational risk within a business unit. To do so, the likelihood of loss would need to be expressed in numerical terms. This cannot be accomplished without statistically significant historical data on operational losses. 7. Defining Cause and Effect:

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Risk Management in Banking Sector. Loss data are easier to collect than data associated with the cause of loss. This complicates the measurement of operational risk because each loss is likely to have several causes. This relationship between these causes, and the relative importance of each, can be difficult to assess in an objective fashion.

8. Sample of a risk assessment report. Risk Assessment Report Risk Category Cause Effect Source of Probability & Magnitude of Loss Data People Loss of key staff, due to defection to a competitor. Variance in revenue / profit Delphic technique based on business Process Declining productivity as volume grows Variance in process costs from predicted levels, excluding process malfunctions Technology Year 2000 upgrade expenditure Variance in technology running costs from predicted levels assessment. Historical variance. Suppliers estimates Industry benchmarking Historical variance. Suppliers estimates Industry

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Risk Management in Banking Sector. benchmarking 3. Review and validation: Once the report is generated. First the centralised operational risk management group (ORMG) reviews the assessment results with senior business unit management and key officers, in order to finalize the proposed operational risk rating. Second, one may want an operational risk rating committee to review the assessment a validation process similar to that followed by credit rating agencies. This takes the form of review of the individual risk assessments by knowledgeable senior committee personnel to ensure that the framework has been consistently applied across businesses, that there has been sufficient scrutiny to remove any imperfections, and so on. The committee should have representation from business management, audit, and functional areas, and be chaired by risk management unit. 4. Output The final assessment of operational risk will be formally reported to business management, the centralised risk-adjusted return on capital (RAROC) group, and the partners in corporate governance such as internal audit and compliance. The output of the assessment process has two main uses: 1. The assessment provides better operational risk information to management for use in improving risk management decisions. 2. The assessment improves the allocation of economic capital to better reflect the extent of the operational riskier, being taken by a business unit. 3. The over all assessment of the likelihood of operational risk & severity of loss for a business unit can be shown as: Medium Risk High Risk Mgmt. Attention

Severity of Loss ($)

Low Risk

Medium Risk

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Risk Management in Banking Sector.

Likelihood of Loss ($) A business unit may address its operational risks in several ways. First, one can invest in business unit. Second, one can avoid the risk by withdrawing from business activity. Third, one can accept and manage risk through effective monitoring and control. Fourth, one can transfer risk to another party. Of course, not all-operational risks are insurable, and in that case of those that are insurable the required premium may be prohibitive. The strategy and eventually the decision should be based on cost benefit analysis.

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Risk Management in Banking Sector.

Risk Management in Future

The bank of the future will be recognized around a new vision. To succeed, it will have to be able to respond to opportunities as they present themselves. And it will have to strive to improve the portfolio management of its balance sheet and capital. To manage conflicting objectives, it will need to determine a number of policy variables such as a target risk-adjusted rate of returns (RAROC), target regulatory return, target tier 1 ratio, target liquidity, and so on. (Figure 17.1) Target RAROC by: Transaction Customer Product Line of Business Target Regulatory Return by: 1. Transaction 2. Customer 3. Product 4. Line of Business Target Return on Equity Target Senior Debt Rating

Target Tier 1 Ratio

Target Liquidity

Target Leverage Ratio

Target Risk Weighted Assets (RWA) 51

Risk Management in Banking Sector.

In turn, this will mean transforming the risk management function. Risk management will need to encompass limit management, risk analysis, RAROC, and active portfolio management of risk (APMR). These changes in the risk management will be induced by: 1. Advances in technology 2. Introduction of more sophisticated regulatory measures 3. Rapidly accelerating market forces 4. Complex legal environment 1. Advances in technology: Banking is moving into an era in which complex mathematical model programmed into risk engines will provide the foundation of portfolio management. Banks with sophisticated risk engine will be able to measure the risk of sophisticated products, compute and implement hedging strategies, and understand the relative risk-adjusted return almost instantaneously. Given the current trend toward consolidation, vast and complex organizations will diverse businesses. Technology will allow risk management information to be integrated into overall management reporting- including intraday risk reporting. The Internet and intranet will become the delivery vehicles of choice for the results of risk analyses. Infrastructure investment will be required within many banks to improve performance in a variety of tasks. The task includes information collection and normalization, storage and dimensioning, and analytics processing as well as information sharing and distribution. One method of deployment for information, as shown in figure 17.3, will be via either the intranet or the Internet. There should only be official risk measure demand the ability to quickly and consistently provide key decision-support tools for comparing profitability measures and risk tolerance for

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Risk Management in Banking Sector. from a fully integrated risk infrastructure. Real-time access will be provided to the risk system via web-based technologies. Independent risk calculators may exist for offline use, but these will be able to use the same analytics as the official reporting process. The benefits of this type of infrastructure are consistency-one source for one answer; efficiency work is executed once to serve multiple purposes; and ease of use- one place, one view. The risk database will include transaction details (e.g., cash flows, principle amount, currencies); cross-references to other internal systems, which house critical data (e.g., credit rating, counterparty, instrument); external data (e.g., yield curve, prices, industry classifications); and a variety of dimension indicators (e.g., product identification codes, asset class, currency). The infrastructure will include appropriate linkages within a robust environment for data collection and scrubbing, data warehousing, and risk analytics as well as the appropriate data and systems maintenance components. Above all, the risk management information system (risk MIS) should be designed to provide full risk transparency from the bottom to the top of the house. 2. Regulatory Measures and Market Forces: In the future, the regulatory review process (e.g., review of bank internal models) will become more sophisticated. Regulators will hire staff with a greater risk management expertise. Regulators will increasingly sever as a catalyst for quantifying risk ( market, credit, operational, liquidity,etc.) through their imposition of new capital regimes as discussed in the Basle Accord Consultative Paper (Basle 1999). Market forces will also bring change. External users of financial information will demand better information on which to make investment decisions. In the future there will be more detailed and more frequent reporting of risk positions to company shareholders, creditors, etc. this will lead to generally accepted reporting principles (GARP) for risk along the lines of the existing generally accepted accounting principles (GAAP) for financial statements.

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Risk Management in Banking Sector. There will be increasing growth in consulting services such as data providers, risk advisory service bureaus, treasury transaction services, etc. independent external reviewers may even be hooked up to a banks systems to allow them to offer regular automated independent risk reviews. The reviews will be intended to provide comfort to senior managers and regulators, and to show that internal systems provide sound risk measures. The risk management function will be fully independent from the business and centralized. Risk management processes will be fully and seamlessly integrated into the business process. Risk/ return will be assessed for new business opportunities and incorporated into the design of new products. All risks-credit, market, operational, liquidity, and so on will be combined, reported, and managed on an ever more integrated basis. The total figures for credit risk by counterparty will use credit value-at-risk methodologies to combine the risk arising from more traditional lending. The problem of liquidating portfolios during turbulent markets will also become an important factor in the total risk numbers. The banks of the future will have a sophisticated central risk engine capable of measuring the risk and the price of anything that the bank trades and originates. Risk management will be a value added never center for trading, ideas and deal structuring as well as provide the impetus for new marketing initiaties, while pricing will become more complex and competitive. The risk management function will become much more tightly integrated with profit & loss reporting. Risk capital will be charged to a business unit according to its contribution to the total risk of the firm, not according to its contribution to the total risk of the firm, not according to the volatility of the business lines revenues. And the balance sheet will be supplemented by business unit value-at-risk (VaR) report. Information will pass back and forth between the risk management function and the business units, and they will work in parternership to balance risk and return. 3. Legal Environment: Legal risk is the risk that contracts are not legally enforceable or documented correctly. Legal risks should be limited and managed through

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Risk Management in Banking Sector. policies developed by the institution's legal counsel (typically in consultation with officers in the risk management process) that have been approved by the institution's senior management and board of directors. At a minimum, there should be guidelines and processes in place to ensure the enforceability of counterparty agreements. Prior to engaging in derivatives transactions, an institution should reasonably satisfy itself that its counterparties have the legal and necessary regulatory authority to engage in those transactions. In addition to determining the authority of a counterparty to enter into a derivatives transaction, an institution should also reasonably satisfy itself that the terms of any contract governing its derivatives activities with counterparty are legally sound. An institution should adequately evaluate the enforceability of its agreements before individual transactions are consummated. Participants in the derivatives markets have experienced significant losses because they were unable to recover losses from a defaulting counterparty when a court held the counterparty had acted outside of its authority in entering into such transactions. An institution should ensure that its counterparties have the power and authority to enter into derivatives transactions and that the counterparties' obligations arising from them are enforceable. Similarly, an institution should also ensure that its rights with respect to any margin or collateral received from counterparty are enforceable and exercisable. The advantages of netting arrangements can include a reduction in credit and liquidity risks, the potential to do more business with existing counterparties within existing credit lines and a reduced need for collateral to support counterparty obligations. The institution should ascertain that its netting agreements are adequately documented and that they have been executed properly. Only when a netting arrangement is legally enforceable in all relevant jurisdictions should an institution monitor its credit and liquidity risks on a net basis. The institution should have knowledge of relevant tax laws and interpretations governing the use of derivatives instruments. Knowledge of these laws is necessary not only for the institution's marketing activities but also for its own use of these products.

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Risk Management in Banking Sector. 4. Building Block to Create Shareholders Value: To use a sporting analogy, first-class risk management is not only about outstanding goal keeping, but also about the ability to move upfield and help the team score. Advances in leading edge risk and capital management tools suggest that banks are ready to move to this next stage of implementation. RAROC will be used to drive pricing, performance measurement, portfolio management, and capital management. The new paradigm of a total risk enabled enterprise (TREE) will increase shareholders value at tactical and strategic level, as well as attracting new clients. Dynamic economic capital management has already emerged as a powerful competitive weapon. The challenge is to pull all these component parts together to create and sustain shareholders value. The evolution of risk management towards simultaneously serving both internal and client-related needs is natural. Risk management tools that have been developed to serve internal bank purposes also have significant external commercial value. The structure of a total risk enabled enterprise (TREE) is therefore likely to evolve from attempts to leverage risk management skills in a whole variety of ways. The trunk of the TREE represents policy, methodology, and infrastructure elements that were built for internal risk management purposes. The branches of the TREE make use of elements of this framework to serve both tactical and strategic bank ambitions. The tactical elements touch on pricing, portfolio management, and incentive compensation issues, and thus provide bottom-up shareholder value. The strategic elements shape business management, business development, capital allocation, and earnings volatility, while helping management to provide top-down shareholder value. The branches of TREE also reach out to connect with bank client and to serve their objectives. An Idealized Bank Of The Future: The efficient bank of the future will be driven by a single analytical risk engine that draws its data from a single logical data repository. This engine will power front-, middle-, and back-office functions, and supply information about

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Risk Management in Banking Sector. enterprise-wide risk. The ability to control and manage risk will be finely tuned to meet specific business objectives. For example, far fewer significantly large losses, beyond a clearly articulate tolerance for loss, will be incurred and the return to risk profile will be vastly improved. With the appropriate technology in place, financial trading across all asset classes will move from the current vertical, product-oriented environment (e.g., swaps, foreign exchange, equities, loans, etc.) to a horizontal, customer-oriented environment in which complex combinations of asset types will be traded. There will be less need for desks that specialize in single product lines. The focus will shift to customer needs rather than instrument types. The management of limits will be based on capital, set in such a manner so as to maximize the risk-adjusted return on capital for the firm. Business managers will be remunerated on their risk-adjusted earnings rather than on earnings alone, orienting them much more consistently with the goals of the firm. The firms exposure will be known and disseminated in real time. Evaluating the risk of a specific deal will take into account its effect on the firms total risk exposure, rather than simply the exposure of the individual deal. Banks that dominate this technology will gain a tremendous competitive advantage. Their information technology and trading infrastructure will be cheaper than todays by orders of magnitude. Conversely, banks that attempt to build this infrastructure in-house will become trapped in a quagmire of large, expensive IT departments-and poorly supported software. The successful banks will require far fewer risk systems. Most of which will be based on a combination of industry standard, reusable, robust risk software and highly sophisticated proprietary analytics. More importantly, they will be free to focus on their core business and offer products more directly suited to their customers desired return to risk profiles.

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Study of Operational Risk of ICICI Bank

About ICICI Bank ICICI Bank is one of the leading private sector bank in the country. It has established its position further through the acquisition of Bank of Madura in March 2001. The bank now has presence in 17 states in India, with a branch network of 395 and over 3.7mn customers accounts. ICICI Bank has the largest network of ATM in the country. The promoters of ICICI divested part of its stake to comply with the RBIs bank licensing condition. ICICI now holds only 47% stake in ICICI Bank and it has ceased to be subsidiary of ICICI. It offers wide spectrum of domestic and international banking services. It is the first bank to start the Internet banking service in India and has around 110000 Internet banking accounts. Operational Risk ICICI Bank is exposed to many types of operational risk. Operational risk can result from a variety of factors, including: 1. Failure to obtain proper internal authorizations, 2. Improperly documented transactions, 3. Failure of operational and information security procedures, 4. Computer systems, 5. Software or equipment, 6. Fraud, 7. Inadequate training and employee errors. ICICI Bank attempts to mitigate operational risk by maintaining a comprehensive system of internal controls, establishing systems and procedures to monitor

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Risk Management in Banking Sector. transactions, maintaining key backup procedures and undertaking regular contingency planning. I. Operational Controls and Procedures in Branches ICICI Bank has operating manuals detailing the procedures for the processing of various banking transactions and the operation of the application software. Amendments to these manuals are implemented through circulars sent to all offices. When taking a deposit from a new customer, ICICI Bank requires the new customer to complete a relationship form, which details the terms and conditions for providing various banking services. Photographs of customers are also obtained for ICICI Banks records, and specimen signatures are scanned and stored in the system for online verification. ICICI Bank enters into a relationship with a customer only after the customer is properly introduced to ICICI Bank. When time deposits become due for repayment, the deposit is paid to the depositor. System generated reminders are sent to depositors before the due date for repayment. Where the depositor does not apply for repayment on the due date, the amount is transferred to an overdue deposits account for follow up. ICICI Bank has a scheme of delegation of financial powers that sets out the monetary limit for each employee with respect to the processing of transactions in a customer's account. Withdrawals from customer accounts are controlled by dual authorization. Senior officers have delegated power to authorize larger withdrawals. ICICI Banks operating system validates the check number and balance before permitting withdrawals. Cash transactions over Rs. 1 million (US$ 21,030) are subject to special scrutiny to avoid money laundering. ICICI Banks banking software has multiple security features to protect the integrity of applications and data. ICICI Bank gives importance to computer security and has s a comprehensive information technology security policy. Most of the information technology assets including critical servers are hosted in centralised data centers, which are subject to appropriate physical and logical access controls.

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Risk Management in Banking Sector. II. Operational Controls and Procedures for Internet Banking In order to open an Internet banking account, the customer must provide ICICI Bank with documentation to prove the customer's identity, including a copy of the customer's passport, a photograph and specimen signature of the customer. After verification of the same, ICICI Bank opens the Internet banking account and issues the customer a user ID and password to access his account online. III. Operational Controls and Procedures in Regional Processing Centers & Central Processing Centers To improve customer service at ICICI Banks physical locations, ICICI Bank handles transaction processing centrally by taking away such operations from branches. ICICI Bank has centralized operations at regional processing centers located at 15 cities in the country. These regional processing centers process clearing checks and inter-branch transactions, make inter-city check collections, and engage in back office activities for account opening, standing instructions and auto-renewal of deposits. In Mumbai, ICICI Bank has centralized transaction processing on a nationwide basis for transactions like the issue of ATM cards and PIN mailers, reconciliation of ATM transactions, monitoring of ATM functioning, issue of passwords to Internet banking customers, depositing post-dated cheques received from retail loan customers and credit card transaction processing. Centralized processing has been extended to the issuance of personalized check books, back office activities of non-resident Indian accounts, opening of new bank accounts for customers who seek web broking services and recovery of service charges for accounts for holding shares in book-entry form. IV. Operational Controls and Procedures in Treasury ICICI Bank has a high level of automation in trading operations. ICICI Bank uses technology to monitor risk limits and exposures. ICICI Banks front office, back office and accounting and reconciliation functions are fully segregated in both the domestic treasury and foreign exchange treasury. The respective middle offices use various risk monitoring tools such as counterparty limits, position limits, exposure limits and individual dealer limits. Procedures for reporting breaches in

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Risk Management in Banking Sector. limits are also in place. ICICI Banks front office treasury operation for rupee transactions consists of operations in fixed income securities, equity securities and inter-bank money markets. ICICI Banks dealers analyze the market conditions and take views on price movements. Thereafter, they strike deals in conformity with various limits relating to counterparties, securities and brokers. The deals are then forwarded to the back office for settlement. The inter-bank foreign exchange treasury operations are conducted through Reuters dealing systems. Brokered deals are concluded through voice systems. Deals done through Reuters systems are captured on a real time basis for processing. Deals carried out through voice systems are input in the system by the dealers for processing. The entire process from deal origination to settlement and accounting takes place via straight through processing. The processing ensures adequate checks at critical stages. Trade strategies are discussed frequently and decisions are taken based on market forecasts, information and liquidity considerations. Trading operations are conducted in conformity with the code of conduct prescribed by internal and regulatory guidelines. The Treasury Middle Office Group, which reports to the Executive Director, Corporate Centre, monitors counterparty limits, evaluates the mark-to-market impact on various positions taken by dealers and monitors market risk exposure of the investment portfolio and adherence to various market risk limits set up by the Risk, Compliance and Audit Group. ICICI Banks back office undertakes the settlement of funds and securities. The back office has procedures and controls for minimizing operational risks, including procedures with respect to deal confirmations with counterparties, verifying the authenticity of counterparty checks and securities, ensuring receipt of contract notes from brokers, monitoring receipt of interest and principal amounts on due dates, ensuring transfer of title in the case of purchases of securities, reconciling actual security holdings with the holdings pursuant to the records and reports any irregularity or shortcoming observed. V. Audit

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Risk Management in Banking Sector. The Internal Audit Group undertakes a comprehensive audit of all business groups and other functions, in accordance with a risk-based audit plan. This plan allocates audit resources based on an assessment of the operational risks in the various businesses. The Internal Audit group conceptualizes and implements improved systems of internal controls, to minimize operational risk. The audit plan for every fiscal year is approved by the Audit Committee of ICICI Banks board of directors. The Internal Audit group also has a dedicated team responsible for information technology security audits. Various components of information technology from applications to databases, networks and operating systems are covered under the annual audit plan. The Reserve Bank of India requires banks to have a process of concurrent audits at branches handling large volumes, to cover a minimum of 50.0% of business volumes. ICICI Bank has instituted systems to conduct concurrent audits, using reputed chartered accountancy firms. Concurrent audits have also been arranged at the Regional Processing Centers and other centralized processing Operations to ensure existence of and adherence to internal controls.

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Bibliography

Books:
Risk Management---Galai, Mark, Crouny. Risk. The new Management Imperative in Finance---James. t. Gleason. Credit Risk Management---Anthony Saunders. Risk Management---Bell. Schleiferr.

WEBSITES:
www.rbi.org www.bis.com www.iib.org www.google.co.in

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