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A man walks across the street and faces it: A car could spin out of control and accidentally run into him. A woman sits down in first-class sleeper seat 1A to cross the ocean on Airline Fly By Night and confronts it: A flight delay could cause her to be late to the crucial meeting that prompted her to spend $10,000 on her ticket, or the plane could end up in the ocean and she could miss the meeting in a more permanent sense. On a lighter note , you try to bunk a class and in the process bump into your director.

One is enjoying a stroll in the confines of your spacious garden and a coconut lands on your nut.
You are having a dinner date with a girl and half way through, your girlfriend walks in.
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It of course is risk. Risk is everywhere. RISK IS THE POSSIBILITY OF THE ACTUAL OUTCOME BEING DIFFERENT FROM THE EXPECTED OUTCOME

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INFORMATION SYSTEMS
. Three principle factors significantly influence risk: Rapid growth in centralization of data, and the information extraction processes Increasing dependence on employees with skills, talents, disciplines, and sometimes motivations, quite different from those with which management has been familiar in the past Increased proliferation of mini, micro and portable processing devices with an associated distribution of key data to remote nodes for data extraction, data update, and data addition.

Assessment Scope
Can be a serious point of contention. Some individuals want to limit consideration to catastrophic events such as fire, flood, earthquakes,and volcanoes. Others want to focus only on intentional misconduct such as fraud and embezzlement. The correct position is that consideration must be extended to the effects of all of the undesirable things that might happen to data or to the means of accessing and processing data. Care must be taken to insist that concern is limited to the effects of undesirable things and not extended to a virtually endless list of bad things the threat list. It is not until the cost of the undesired event and its estimated frequency have both been examined that a potential source of damage can be justifiably excluded from further consideration.

What is Banking
Section 5(b) defines banking Accepting for the purpose of lending or investment of deposits or money repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise
Risk taking is an inherent function of banking - Allan Greenspan
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Banks get affected by

Actions of Central Banks Actions of the Government Domestic and International Disturbances Inflation

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Deregulation
Banks are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advances Intense competition for business involving both the assets and liabilities together with increasing volatility in the interest rates has brought pressure on the management of banks to maintain a good balance among spreads
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Risks Faced by Banks

Credit Risk Market Risk
Liquidity Risk Interest Rate Risk

Operational Risk

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Effects of Risk Factors

Loss of Market Value Loss of Reserves Loss of stakeholders confidence

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WHAT IS RISK?
Risk is defined as uncertainty concerning the occurrence of a loss Any event or possibility of an event which can impair corporate earnings or cash flow over short / medium / long term horizon Risk can be defined as the likelihood of occurrence of an undesirable event combined to the magnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY

Certainty is the situation where it is known what will happen and the happening or non happening of an event carries a 100% probability. Risk is the situation where there are a number of specific, probable outcomes, but it is not certain as to which one of them will actually happen Uncertainty is where even the probable outcomes are unknown. It reflects a total lack of knowledge of what may happen
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Types of Risk according to Uncertainty perspective

Objective risk (Degree of Risk) The relative variation of actual loss from expected loss E.g.: Loss of property in a fire accident Subjective risk It is defined as uncertainty based on a persons mental condition or state or mind The impact of subjective risk varies depending on the individual i.e., different perception of risk E.g.: The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving.
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NATURE OF RISK
If we recognize that risky changes cannot be beneficial and choose to sit idle but the risky world evolves around us, will not allow us! How can we begin to develop a framework for managing risk responsibly? The answer to that question, in very broad terms, is that a healthy and responsible risk management framework that neither lends itself to over-caution nor to carelessness is a framework that avoids three basic fallacies. If risk management can be implemented without falling into these three traps, the groundwork for a healthy risk management program has been laid.
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CURRICULUM
Concept of risk - General Types of risk Case Studies Quantifying risk - Numericals Regulatory and Political risk Global Business set up Production and Operational risk Basics and Case Study IT and Risk Management Role of IT & MIS Tools for Risk Management Decision Trees, Hazop Models, Quality Tools Risk Governance Structures Organisational Strategy and Vision Internal Control Implementing a risk mgt process Assignment/ Project

SOURCES OF RISK ?

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SOURCES OF RISK
PRICES

TECHNOLOGY SOURCES OF RISK

MARKET SHARE

COMPETITION

PRODUCTIVITY

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TYPES OF RISK
From functional perspective
Credit risk Market risk Operational risk Other risks

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It is risk to each party of a contract that the other will not live up to its contractual obligations. In most of financial contracts, this risk is known as Default Risk Credit risk is of two types
Pre settlement risk Settlement risk

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Pre settlement and Settlement Risk

Pre-settlement risk is the bankruptcy of the counterparty prior to settlement Settlement risk arises with respect to the settlement of a transaction. The risk is such a situation is that one party may perform its obligations while the other does not.
CASE STUDY

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CASE STUDY : GERMAN HERSTATT BANK

It was the afternoon of 26 June 1974, and the Bank had received all its foreign currency receipts in Europe, but had not made any of its US Dollar Payments. This position continued till the end of the business day, when German banking regulators closed the bank due to insolvency. As a result, the counterparties were left holding unsecured claims against the bankrupt banks assets. BASEL COMMITTEE states that this risk arises when a counter party pays the currency it sold but does not receive the currency it bought. According to the consultative paper issued by the BASEL Committee on Banking Supervision, 1999, foreign exchange settlement failures can arise from Counterparty Default, operational problems, and market liquidity constraints among other factors. Foreign exchange settlement risk clearly has a credit risk dimension. If a bank cannot make the payment of the currency it sold conditional upon its final receipt of the currency it bought, it faces the possibility of losing the entire principal value of the transaction.

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It is the risk of fluctuations in portfolio value because of movements in such variables It is the risk of losses due to movements in financial market variables i.e., Interest rates, foreign exchange rates, security prices, etc.,

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CASE STUDY :BARINGS BANK

It is a British merchant bank The bank was expecting that the Japanese stock market index Nikkei would rise if they take position in buying futures The bank took position of around $8 billion However, because of a number of reasons and earthquake at Kobe, Nikkei crashed resulting in a $1.2 billion losses to bank in a months time which exceeded banks own net worth. The movement of prices or market index is sometimes driven by some events and this is called Event Risk

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TYPES OF MARKET RISK

Price risk Forex risk Country risk Liquidity risk Interest rate risk Technology risk

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Price Risk
The possibility of not realizing the expected price may be called the Price Risk
Eg : The problem most of the farmers are facing

Types of price risk

Symmetrical Vs. Unsymmetrical Absolute Vs. relative Asset liquidity Discontinuity and event Concentration Credit spread Volatility risk Systemic risk Systematic risk Vs. unsystematic risk

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Symmetrical Vs. Unsymmetrical

Symmetrical implies that the movement of an asset price in either direction leads to a corresponding impact on the position value In Unsymmetrical risk, the impact is unequal
E.g. : Consider an institution holding an equity security in its portfolio. An increase or decrease in the price of an equal dimension would result in corresponding change in the value of the position held by the institution, multiplied by the number of securities held
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Absolute Risk Vs. Relative Risk

Absolute risk is measured with reference to the initial investment Relative risk is measured relative to the benchmark index
E.g.: an investment of Rs.1,00,000 may decline in value to Rs.95,000 as a result of fall in prices There is an absolute negative return of 5% If the index during this period has dropped by 10% the relative return on the instrument is better compared to the return on the index

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Discontinuity and Event Risk

Discontinuity implies a large movement that occurs over a small time interval and potentially create a large loss It is very difficult to establish the probability of discontinuity. This may be a result of an observable political or government policy, wars, devaluation etc.,
E.g. : after 11 September, 2001, the stock markets all around the world witnessed a fall On 17 May 2002, there was a significant fall in the Indian Stock Markets in anticipation of a change in the Government

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Asset liquidity Risk

In case of assets which are not very liquid, it may not be possible to execute a large transaction at the market price. Trying to do so can result in a high cost i.e.., a sharp and unfavorable movement in share price
E.g. : A large sale order could quickly dampen the price, which is not in the sellers interest

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Concentration Risk
Lack of diversification leads to concentration risk This risk arises out of a very large exposure to a particular company, industry, geographic region or market

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Credit Spread Risk

Credit Spread is the difference between the yield on corporate bonds and treasury bonds Credit spread risk is the risk that yields on duration matched credit sensitive bonds and treasury bonds could move differently

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Volatility Risk
Volatility refers to the degree of unpredictable change in a financial variable over a period of time It results not from changes in levels of prices but their volatility

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Systemic Risk
It can arise in the context of a failure of a major market system or institution, sometimes called the Domino Effect, which has an adverse impact on several other institutions

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Systematic Risk Vs. Unsystematic Risk It is called an Undiversifiable risk since it is inherent to any security in a particular market
Economic, Political and Social Risk

Unsystematic risk are diversifiable risk which is unique to a firm

Management problem, labour problem etc.,

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Forex Risk
The risk of an investment's value changing due to changes in currency exchange rates. It is also known as "currency risk" or "exchange-rate risk".

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Country risk
It is also known as sovereign risk When a domestic banking institution may transform itself into an international one when it starts lending across its borders or invests in instruments issued by foreign organizations, the first risk that it encounters is country risk

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CASE STUDY
In early 80s, Brazilian and Mexican Governments announced debt repayment moratorium(CEASE) which delayed debt repayment to the lenders of US At that period, exposure of US banks to these countrys FIs and government was huge and they suffered heavy losses. The Citigroup alone had to provide $3 billion to cover expected losses. The same situation was also encountered by US, Japanese and European banks in early 90 in their exposure to country like Indonesia and Russia In the year 2001, Argentina also defaulted $130 billion in government issued debt because of an overvalued peso

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Liquidity Risk
LIQUDITY RISK

FUNDING RISK
It is the inability to raise funds at normal cost

ASSET LIQUIDITY RISK

It is the lack of trading depth in the market for a security or class of assets

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Interest rate risk

Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates

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IMPACT OF INTEREST RATE INCREASE AND DECLINE ON FIS PROFITABILITY

Suppose a Bank borrows Rs.100 crores from the market for 2 years @ 10% p.a. and creates an asset of the same amount for 5 years period @12% p.a. This mismatch between the two is quite visible Profitability of bank per year = 100 *2% = 2 crores In case, there is an upward trend of interest rate after 2 years and the cost of liability goes upto 13%, the bank will post a loss of rs. 1 crore If the movement in interest rate is downward and comes down to 8% for liability banks profit wil increase from Rs.2 crores to Rs. 4 crores
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Technology Risk
Technology needs a lot of money, time and effort in order to be implemented If the system implementation is too slow or the performance is ineffective, the risk is that the entire investment may not result in adequate repayment

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It could risk if procedures are not properly documented and examined for robustness The controls built into these procedures also have to be properly examined to ensure that errors are not inadvertently incorporated in processing Operational risk is reasonably significant in commercial and investment banks, wealth management businesses
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RISK FACTORS
INTERNAL RISK FACTORS PEOPLE Employee collusion and Fraud Employee error Employee misdeed Employers liability Employment law Health and safety Industrial action Lack of knowledge and skills Loss of key personnel PROCESSES Accounting error Capacity risk Contract risk Misspelling / suitability Product complexity Project risk Reporting error Settlement / Payment error Transaction error Valuation error SYSTEMS Data quality Programming errors Security breach Strategic risks System capacity System compatibility System delivery System failure System suitability

EXTERNAL RISK FACTORS EXTERNAL PHYSICAL Legal Money laundering Outsourcing Political Regulatory 20/03/2012 Supplier risk Tax Fire Natural disaster Physical security Terrorism Theft
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Off balance sheet risk

In additional to assets and liabilities recognized on a firms balance sheet, there are transactions that do not give rise to any asset or liability at present, but could do so in the future. These are off balance sheet items
Eg : a letter of credit issued on behalf of a customer, sometimes banks also offer underwriting facilities for issue of stocks and bonds. In such cases, there is no liability at that time for the bank In case of default by the customer or under subscription of stocks and bonds, the bank is required to pay up or subscribe to the undersubscribed portion.

Regulatory risk
Compliance with regulatory requirements is critical for the long term survival Non compliance can expose an organization to reputation risk arising out of structures passed by the regulators or fines or penalties levied by them or suspensions or cancellations of licenses ordered by them in extreme cases.

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 There is a major risk that a financial services product may become absolute or uncompetitive

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The capital market risk usually defines the risk involved in the investments. The stark potential of experiencing losses following a fluctuation in security prices is the reason behind the capital market risk. The capital market risk cannot be diversified. The capital market risk can also be referred to as the capital market systematic risk. While an individual is investing on a security, the risk and return cannot be separated. The risk is the integrated part of the investment.

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WHAT IS RISK MANAGEMENT?

Risk Management is the
identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events

It can also be defined as a process that identifies loss exposures faced by an organization and selects the most appropriate technique for treating such exposures Risk Management is the name given to a logical and systematic method of identifying, analyzing, treating and monitoring the risks involved in any activity or process.

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Who uses Risk Management?

Risk Management practices are widely used in public and the private sectors, covering a wide range of activities or operations.
These include:

Finance and Investment

Insurance

Health Care
Public Institutions Governments

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NEED FOR RISK MANAGEMENT

Globalization Share holders wealth maximization Risk have to be managed effectively, and on the other adequate returns have to be ensured An impact on one institution can have a fallout for other institutions in the market Separation of ownership and management Growing no. of transactions and complexity of products Increased volatility around the world

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SEBI AND RISK MANAGEMENT

According to Clause 49-IV of the listing agreement of the SEBI The company shall lay down procedures to inform the Board members about the risk assessment and minimization procedures. These procedures shall be periodically reviewed to ensure that executive management controls risk through means of a properly defined framework. The CEO and CFO have to certify to the Board that they have evaluated the effectiveness of internal controls and they have disclosed to the auditors and audit committee deficiencies in the design or operation of internal controls, if any, of which they are aware and the steps they have taken or propose to take to rectify these. Among the information to be placed before the Board: Quarterly details of forex exposures and the steps taken by management to limit the risks of adverse exchange rate movement, if material.

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OBJECTIVES OF RISK MANAGEMENT

Brings order and system to the process of risk quantification Enables the assigning of value to estimated risk of loss Flags extreme risky situations for necessary mitigate 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

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STEPS IN RISK MANAGEMENT PROCESS

Identify loss exposures

Analyze the loss exposures

Select the appropriate techniques for treating the loss exposures 1. Risk control 2. Risk Financing Avoidance Retention Loss prevention Non Insurance transfers Loss reduction Commercial Insurance

Implement and monitor the Risk Management Program

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1. Identify Loss Exposures

Property loss exposures Liability loss exposures Business income loss exposures Human resources loss exposures Crime loss exposures Employee benefit loss exposures Foreign loss exposures Reputation and public image of the company
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2. Analyze the loss exposure

Estimation of frequency and severity of loss
Loss frequency refers to the probable number of losses that may occur during some given time period Severity refers to the probable size of the losses that may occur

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3. Select appropriate techniques for treating the loss exposure

Risk control
Risk control refers to techniques that reduce the frequency and severity of losses
Avoidance Loss prevention Loss reduction

Risk Financing
It refers to techniques that provide for the funding of losses
Retention Non insurance transfers Commercial insurance

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AVOIDANCE
It refers to not holding such an asset/liability as a means of avoiding the risk E.g.: Exchange risk They have been assumed either voluntarily or because they could not be avoided. Objective of these measures is either to prevent a loss or to reduce the probability of loss E.g. Insurance Raising funds through floating rate bearing instruments Avoiding loss by disbursement of assets in different locations Diversification Storage (hard and soft) etc., Diversification Purchasing materials from multiple suppliers Risk can be transferred by transferring the asset/liability itself
Holding a Real Estate or Foreign exchange Leasing or currency swap Insurance policy

LOSS CONTROL

SEPARATION

COMBINATION

TRANSFER
Transferring the risk without transferring the asset/liability

Making a third party for the losses without actually transferring the risk

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4. Implement and Monitor the Risk Management Program

Risk management policy statement Risk management manual

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RISK MANAGEMENT MATRIX

TYPE OF LOSS LOSS FREQUENCY LOSS SEVERITY APPROPRIATE RISK MANAGEMENT TECHNIQUE RETENTION

LOW

LOW

HIGH

LOW

LOSS PREVENTION AND RETENTION INSURANCE

LOW

HIGH

HIGH

HIGH

AVOIDANCE

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RISK MANAGEMENT APPROACHES The goal of risk management is not to eliminate risk, but to ensure that risk remains at a predetermined level of acceptability Risk and reward often go together
Higher expectations Of rewards Higher level of risk Higher returns

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Risk avoidance Loss control

Approaches to Risk Management:

It is an attempt to reduce either the possibility of a loss or the quantum of loss Lending @ floating rate Investing @ floating rate Combining more than one business activity in order to reduce the overall risk of the firm WIPRO

Combination

Separation Risk transfer Risk retention

Risk is retained when nothing is done to avoid, reduce, or transfer it. It may be retained consciously because the other techniques of managing risk are too costly or because it is not possible to employ other techniques
It is a combination of Risk Retention and Risk Transfer A particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it E.g.: a firm and its supplier may enter into an agreement, whereby if the market price of the commodity exceeds a certain price in the future, the seller foregoes a part of the benefit in favor of the firm, and if the future market price is lower than predetermined price, the firm passes on a part of the benefit to the seller
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Risk sharing

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RISK MANAGEMENT TOOLS

Risk management information systems (RIMS) Risk management intranets and Websites Risk maps Value at Risk (VaR) analysis Hedging Derivatives Hybrid debt securities
Convertible bonds Floating rate Notes
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RMIS
It is a computerized database that permits the risk manager to store and analyze risk management data and to use such data to predict and attempt to control future loss levels It is useful for
Decision making Property exposures Listing of claims Tracking employees

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RISK MANAGEMENT INTRANETS AND WEB SITES

Departments can establish websites, which includes FAQs and a wealth of other information An intranet is a website with search capabilities designed for a limited, internal audience Through intranet employees can obtain a list of procedures to follow

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Risk Maps
Risk maps are grids detailing the potential frequency and severity of risks faced by the organization It requires risk managers to analyze each risk that the organization faces before plotting it on the map Use of risk maps varies from simply graphing the exposures to employing simulation analysis to estimate likely loss scenarios

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Value at Risk Analysis (VaR)

It is the worst probable loss likely to occur in a given time period under regular market conditions at some level of confidence Based on VaR estimate, the risk level could be increased or decreased, depending on risk tolerance

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Hedging
It means identifying two exactly correlated assets as far as returns are concerned One can hedge the risk by buying one of the assets while simultaneously selling the others

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An Integrated Approach to Corporate Risk Management

- Why Total Risk Matters ?

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Why Total Risk Matters?

1.The adverse incentive problem Managers are more likely to choose high risk investments that benefit the share holders at the expense of debenture holders They have a tendency to exit promising lines of business or liquidate the entire firm when they have would otherwise continue to operate They may have an incentive to produce goods of inferior quality and provide a less safe work environment for their employees.

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2. The Effect on Sales

The incentive of companies in financial distress to produce lower quality products will scare off potential customers Risky firms become victims of lost consumer confidence Customers arent as willing to do business with a firm that might be going out of business
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3.The effect on operating costs

The value of investing in a long term relationship with a customer will depend on whether the customer is expected to survive in the long run The lower the likelihood of future survival, the more of these relationship costs the customer will have to bear up front in the form of higher prices or less closely tailored services and products Lower risk firms also have an easier time attracting and retaining good personnel
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4.The effect on financing cost

A company that expects to remain in business will generally be very protective of its credit reputation The value of a good credit reputation, however, is lower for firms that may not survive to reap the long run benefits Such firms have an incentive to borrow money under false pretenses and mistreat creditors in order to dealy the onset of bankruptcy.
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5. The problem of risk aversion

A temporary increase in risk can do permanent damage to the firm if some stakeholders leave in response to their perception of added personal risk In order to reconstitute the organization, the firm must bear a variety of fixed costs associated with replacing those risk averse stakeholders E.g.: Costs of hiring and training new managers, salespeople and other employees, adding new distributors, and finding new suppliers reduce the value of the firm as an ongoing entity

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6. Tax Effects
As the variability of operating profits increases, so does the probability that a firm will be unable to make full use of its tax credits and depreciation and interest expense tax deductions An increase in total risk will lead to a reduction in expected corporate cash flows

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CHARACTERISTICS OF FIRMS WITH HIGH COSTS OF FINANCIAL RISK

Industry specific factors Firm specific factors

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Industry Specific Factors

Products that require repairs Goods or services whose quality is an important attribute but is difficult to determine in advance Products for which there are switching costs Products whose value to customers depends on the services & complementary products supplied by independent co`s.

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Firm Specific Factors

High growth opportunities Substantial organizational assets Large excess tax deductions

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Methods of Reducing Total Risk

Restricting the Debt- Equity ratio Futures & Forwards contracts Insurance Avoiding high risk projects Reducing degree of operating leverage Merger with a larger more financially stable firm Product compatibility Off-the-shelf components Training programs USING MANUFACTURERS REPRESENTATIVES
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INDUSTRY SPECIFIC FIRM SPECIFIC

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To Summarise.

Effective Management Risk benefits .

Efficient allocation of capital to exploit different risk / reward pattern across business Better Product Pricing Early warning signals on potential events impacting business Reduced earnings Volatility Increased Shareholder Value

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No Risk

No Gain!
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