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Risk Management at Central Bank of India

Risk Management in Banks Introduction:

isks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an

organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance / legal / regulatory and reputation risks. Before overarching these risk categories, given below are some basics about risk management and some guiding principles to manage risks in banking organization. Risk management in Indian banks is a relatively newer practice, but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus the need for an efficient risk management framework is paramount in order to factor in internal and external risks. The financial sector in various economies like that of India is undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. The 2007present recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. The various aspects of increasing global competition to Indian Banks by Foreign banks, increasing Deregulation, introduction of innovative products, and financial instruments as well as

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Risk Management at Central Bank of India

innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management. Indian Banks have been making great advancements in terms of progress in terms of technology, quality, quantity as well as stability such that they have started to expand and diversify at a rapid rate. However, such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. In banks and other financial institution risk plays a major part in the earnings of a bank. Higher the risk, higher is the return, hence, it is most essential to maintain a parity between risk and return. Hence, management of Financial risk incorporating a set systematic and professional methods especially those defined by the Basel II norms because an essential requirement of banks. The more risk averse a bank is, the safer is their Capital base. Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. It involves identification, measurement, monitoring and controlling risks to ensure that The individuals who take or manage risks clearly understand it. The organizations Risk exposure is within the limits established by Board of Directors. Risk taking Decisions are in line with the business strategy and objectives set by BOD. The expected payoffs compensate for the risks taken Risk taking decisions are explicit and clear. Sufficient capital as a buffer is available to take risk

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Risk Management at Central Bank of India

In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels. Strategic level: It encompasses risk management functions performed by senior management and BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken. Macro Level: It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category. Micro Level: It involves On-the-line risk management where risks are actually created. This is the risk management activities performed by individuals who take risk on organizations behalf such as front office and loan origination functions. The risk management in those areas is confined to following operational procedures and guidelines set by management.

Various Steps Involved in Risk Management:


1. Identification

After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.

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Risk Management at Central Bank of India

Source analysis Risk sources may be internal or external to the system that is the target of risk management. Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport.

Problem analysis Risks are related to identified threats. For example: the threat of losing money, the threat of abuse of privacy information or the threat of accidents and casualties. The threats may exist with various entities, most important with shareholders, customers and legislative bodies such as the government.

2. Assessment Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan. After identifying and assessing the risk the bank shall consider any of the following risk methods:

Risk Avoidance- This can be done by means of elimination of risk. i.e., not to undertake or undergo those risks.

Risk Reduction- This can be done by reducing the risk of loss. It can be done either by creating enough security for the particular risk.

Risk Retention- This can be done through that, they shall retain the risk which is of small in nature or where the risk level is very less.

Risk Transfer- This can be done through that, the bank shall transfer the risk to other party by taking insurance or entering into third party contract.

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Risk Management at Central Bank of India

Benefits of Risk Management: Brings order and system to the process of risk quantification Enables the assigning of value to estimated risk of loss, e.g. VAR Flags extreme risky situations for necessary immediate action by management Improves risk awareness when it is actively courted by the company Results in increased valuation and reduced cost of capital More objective performance appraisal based on risk-adjusted capital employed

Types of Risk: The term Risk and the types associated to it would refer to mean financial risk or uncertainty of financial loss. The Reserve Bank of India guidelines issued in Oct. 1999 has identified and categorized the majority of risk into three major categories assumed to be encountered by banks. These belong to the clusters: Credit Risk Market Risk Operational Risk The type of risks can be fundamentally subdivided in primarily of two types, i.e. Financial and Non-Financial Risk. Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further subdivided into Credit Risk and Market Risk. Both Credit and Market Risk may be further subdivided. Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk, and Legal Risk.
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Risk Management at Central Bank of India

The following chart in nutshell shows the various risks that the banks shall get into. Chart 1.1- Types of Risk.

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Risk Management at Central Bank of India

Credit Risk Management:

hile financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems

continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties. Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation. Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise in a number of circumstances: A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan. A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company. A business or consumer does not pay a trade invoice when due. A business does not pay an employee's earned wages when due.

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Risk Management at Central Bank of India

A business or government bond issuer does not make a payment on a coupon or principal payment when due. An insolvent insurance company does not pay a policy obligation. An insolvent bank won't return funds to a depositor. A government grants bankruptcy protection to an insolvent consumer or business.

The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a banks portfolio depends on both external and internal factors. The external factors are the state of the economy, rates and interest rates, trade restrictions, economic sanctions, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The internal factors are deficiencies in loan policies/administration, absence of prudential credit concentration limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in appraisal of borrowers financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc. Another variant of credit risk is counterparty risk. The counterparty risk arises from non-performance of the trading partners. The non-performance may arise from counterpartys refusal/inability to perform due to adverse price movements or from external constraints that were not anticipated by the principal. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.

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Risk Management at Central Bank of India

The bank aims at minimizing this risk that could arise from individual borrowers or the entire portfolio. The former can be addressed by having welldeveloped systems to appraise the borrowers; the latter, on the other hand, can be minimized by avoiding concentration of credit exposure with a few borrowers who have similar risk profiles. Credit risk management becomes even more relevant in the light of the changes that have been brought about in the economic environment, including increasing competition and thinning spreads on both the sides of Balance sheet

Determinants of Credit Risk Factors determining credit risk of a banks portfolio can be divided into external and internal factors. The banks do not have control on external factors. These include factors across a wide spectrum ranging from the state of the economy to the correlation among different segments of industry. The risk arising out of external factors can be mitigated via diversification of the credit portfolio across industries especially in light of any expectations of adverse developments in the existing portfolio. Given that the banks have very little control over such external factors, the bank can minimize the credit risk that it faces mainly by managing the internal factors. These include the internal policies and processes of the bank like Loan policies, appraisal processes, monitoring systems etc. These internal factors can be taken care of, partly, via effective rating and monitoring systems, entry level criteria etc. These processes would enable improvement in the quality of credit decisions.

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Risk Management at Central Bank of India

This would effectively improve the quality (and hence profitability) of the portfolio. While monitoring systems are useful tool at post-sanction stage, rating systems act as important aid at the pre-sanction stage. The discussion of the credit risk management function is primarily focused on the loan portfolio, although the principles relating to the determination of creditworthiness, apply equally to the assessment of counter parties who issue financial instruments. Following are the important themes under credit risk management; Credit portfolio management Lending function and operations Credit portfolio quality review Nonperforming loan portfolio Credit risk management policies Policies to limit or reduce credit risk Asset classification Loan loss provisioning policy

Introduction to Credit Risk Management Tools The Bank has developed tools for better credit risk management. These focus on the areas of rating of corporate (pre-sanctioning of Loans) and monitoring of Loans (post-sanctioning). The focus of this manual is to familiarise the user with the credit rating tool.

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Risk Management at Central Bank of India

Credit Rating: Credit rating is the process of assigning a letter rating to borrowers indicating the creditworthiness of the borrower. Rating is assigned based on the ability of the borrower (company) to repay the debt and his willingness to do so. The higher the rating of a company, the lower the probability of its default. The companies assigned with the same credit rating have similar probability of default. Use in decision-making Credit rating helps the bank in making several key decisions regarding credit including: Whether to lend to a particular borrower or not; what price to charge? What are the products to be offered to the borrower and for what tenor? At what level should sanctioning be done? What should be the frequency of renewal and monitoring? It should, however, be noted that credit rating is one of the inputs used in taking credit decisions. There are various other factors that need to be considered in taking the decision (e.g., adequacy of borrowers cash flow, collateral provided, and relationship with the borrower). The rating allows the bank to ascertain a probability of the borrowers default based on past data. Main features of the rating tool: Comprehensive coverage of parameters. Extensive data requirement. Mix of subjective and objective parameters.

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Risk Management at Central Bank of India

Includes trend analysis. 13 parameters are benchmarked against other players in the segment. The tool contains the latest available audited data/ratios of other players in the segment. The data is updated at intervals. Captures industry outlook. Eight grade ratings broadly mapped with external credit rating agencys ratings prevalent in India. Special features of the web based credit rating tool Centralised data base. Easy accessibility and faster computation of scores. Selective access to users based on the area of operation. Branches have access to the data pertaining to their branch only, Zonal offices have access to the data pertaining to all the branches under their control and the Credit Department and Risk Department at Central Office have access to all accounts. Adequate security system and provision of audit trails for confidentiality. Maintaining of past rating records in the system for collection of empirical data on rating migrations. This will enable the bank to arrive at PDs (Probability of Default) factor. Rating is the process by which an alphabetic or numerical rating is assigned to a credit facility extended by a bank to a borrower based on a detailed analysis of his character and matching it with the characteristics of facility that is extended to him. The rating carried out by a bank is very much similar to the credit rating carried out by external rating agencies such as CRISIL, ICRA, etc. The only difference is that while the rating by the external agency is available in the public domain for anyone to use, the internal ratings carried out by a bank is confidential and is used for specific purpose only. Moreover, the internal ratings
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Risk Management at Central Bank of India

of banks are usually finer than the ratings of rating agencies. This is to facilitate better distinction between credit qualities and pricing of loan in an accurate manner. The rating scale used by CRISIL for long-term instruments such as debentures issued by corporate. Table-1- Long term rating scale by CRISIL Rating Description CRISIL AAA Instruments with this rating are considered to have the (Highest Safety) highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. CRISIL AA Instruments with this rating are considered to have high (High Safety) degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk CRISIL A Instruments with this rating are considered to have adequate (Adequate Safety) degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. CRISIL BBB Instruments with this rating are considered to have (Moderate Safety) moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. CRISIL BB Instruments with this rating are considered to have (Moderate Risk) moderate risk of default regarding timely servicing of financial obligations CRISIL B Instruments with this rating are considered to have high risk (High Risk) of default regarding timely servicing of financial obligations. CRISIL C Instruments with this rating are considered to have very (Very High Risk) high risk of default regarding timely servicing of financial obligations. CRISIL D Instruments with this rating are in default or are expected to Default be in default soon

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Risk Management at Central Bank of India

Market Risk Management:

raditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising from adverse changes

in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks. Market risk takes the form of: 1. Liquidity Risk, 2. Interest Rate Risk, 3. Foreign Exchange Rate (Forex) Risk, 4. Commodity Price Risk, and 5. Equity Price Risk.

MARKET RISK MANAGEMENT Management of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the banks exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. The Middle Office should comprise of experts in market risk management, economists, statisticians and general

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Risk Management at Central Bank of India

bankers and may be functionally placed directly under the ALCO. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. The Middle Office should apprise the top management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregate the total market risk exposures assumed by the bank at any point of time.

Liquidity Risk Management

iquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and

other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defense mechanism from losses on fire sale of assets. The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk. The liquidity risk in banks manifest in different dimensions: Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail); Time Risk need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

Call Risk due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

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Risk Management at Central Bank of India

The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting /reviewing, etc. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are Loans to Total Assets, Loans to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans, etc. While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on projected future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the behavioural maturity profile of various components of on / offbalance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be finetuned over a period which facilitate near reality predictions about future behaviour of on / off-balance sheet items. Apart from the above cash flows,
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Risk Management at Central Bank of India

banks should also track the impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallised. The difference between cash inflows and outflows in each time period, the excess or deficit of funds becomes a starting point for a measure of a bank's future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits as detailed below to avoid liquidity crisis: Cap on inter-bank borrowings, especially call borrowings. Purchased funds vis--vis liquid assets; Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans; Duration of liabilities and investment portfolio; Maximum Cumulative Outflows across all time bands; Commitment Ratio track the total commitments given to

corporate/banks and other financial institutions to limit the off-balance sheet exposure. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources. Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further, the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial

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Risk Management at Central Bank of India

increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc. The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: Seasonal pattern of deposits/loans; Potential liquidity needs for meeting new loan demands, unavailed credit limits, potential deposit losses, investment obligations, statutory obligations, etc. Liquidity management in a bank has essentially five important functions: (i) It demonstrates to the market place that the bank is safe and therefore capable of repaying its borrowings. It provides the confidence factor. (ii) It enables the bank to meet its prior loan commitments and thus necessary to relationship. (iii) (iv) It enables the bank to avoid unprofitable sale of assets (fire sale). It lowers the default risk premium the bank must pay for funds, as a bank with strong balance sheet will be perceived by the market as being liquid and safe. (v) It reduces the need to resort to borrowings from the Central bank; excessive use of Central bank liquidity by a bank will be interpreted as consequence of imprudent liquidity management by the bank.

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Risk Management at Central Bank of India

Sound liquidity management can reduce the probability of serious problems. Importance of liquidity transcends the individual banks, since a liquidity shortfall at a single institution can have system wide repercussions. As a result not only a bank need to measure its own liquidity on an ongoing basis but also examine how funding requirements are likely to evolve under various scenarios, including adverse conditions developed in the market. Liquidity risk can be managed through maturity or cash flow mismatches. The RBI has advised banks to adopt the use of a maturity ladder and calculation of cumulative surplus / deficit of funds at selected maturity dates (time buckets) as a standard tool for measuring and managing net funds requirements. The prescribed time buckets are distributed as follows: i) ii) iii) iv) v) vi) vii) 1 to 14 days 15 to 28 days 29 days up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years

viii) Over 5 years The outflows and inflows of cash during each time buckets are to be estimated. Banks are required to focus on shorter maturity mismatches viz. 1 14 days and 15 28 days. Three conditions have been placed by RBI in this regard: (a) The cumulative mismatches or running total across all time buckets should be monitored by establishing internal prudential limits duly approved by the Board.

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(b)

The negative gap representing mismatches during 1-14 days and 15-28 days in the normal course should not exceed 20 percent of the cash outflows in each time bucket.

(c)

The mismatches in each time bucket should be within the tolerance limit / level approved by the board.

Potential areas of focus in updating the Basel Committee on Banking Supervisions sound practice guidance in liquidity management include: The identification and measurement of the full range of liquidity risks, including contingent liquidity risks associated with off-balance sheet vehicles; Stress testing, including greater emphasis on market-wide stresses and the linkage of stress tests to contingency funding plans. The role of supervisors, including communication and cooperation between supervisors, in strengthening liquidity risk management practices. The management of intra-day liquidity risks arising from payment and settlement obligations both domestically and across borders (working with the Committee on Payment and Settlement Systems).

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