Dissertation Project Report

On

COMPARATIVE STUDY:
RISK MANAGEMENT IN BANKS

Submitted in partial fulfillment of MBA Programme

AMITY BUSINESS SCHOOL

AMITY UNIVERSITY UTTAR PRADESH

Faculty Guide:
Prof. Akhil Swami
Faculty
ABS, Noida

Submitted by:
Anish Saurabh
A0101908663
MBA(G) 2008-2010
 CERTIFICATE

This is to certify that Anish Saurabh, a student of MBA (General) class 2010 ABS,
AUUP has taken Dissertation Project under my close supervision and guidance. He
has conducted a study and completed the project Comparative Study:Risk
Management In Banks

This project is prepared in partial fulfillment of Internal Evaluation of MBA

(General) to be awarded by AUUP.

To best of my knowledge, this piece of work is original and no part of this report has
been submitted to any other institution/University earlier.

[Prof. Akhil Swami]

Faculty Member
ABS
Noida

ii
 DECLARATION

I here by declare that the topic Comparative Study: Risk Management In Banks
is submitted to vision future for the partial fulfillment of the continuous evaluation
of summer internship MBA (GEN) 2010.

This report is a record of original project work done by me under guidance of Prof.
Akhil Swami.

Submitted by:
Anish Saurabh
A0101908663
MBA (GEN)-2010

iii
 ACKNOWLEDGEMENT

It is an honor to present this project report titled as

This partial fulfillment of curriculum has provided me a great opportunity to

experience the market practices in the banking sector.

To prepare this report efforts are made not by an individual only but the , Faculty
members of Amity Business School and with the cooperation of respondents.

I also like to convey my thanks and gratitude to Prof. Akhil Swami (Faculty)
Amity Business School, Noida for his constant encouragement, guidance and
support to my study.

I would like to thank each and every member of Amity Business School for their
immense guidance and suggestions, the respondents for providing factual
information without which I would not have been able to complete the project.

Yours Sincerely
Anish Saurabh

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 CONTENTS

Certificate..ii
Declaration...iii
Acknowledgementiv
Executive Summary...1
Literature Review........ 2-4
Chapter I INTRODUCTION................................................................5-17
(a) Introduction
(b) Meaning of Risk and Risk Management
(c) Risk management Structure
(d) Risk management Components
(e) Steps for implementing risk management in bank
(f) Types of risks
(g) RBI Guidelines on risk management
Chapter II RESEARCH METHODOLOGY ...................................18-26
(a) Need of Study
(b) Objective of Study
(c) Significance of Study
(d) Scope of Study
(e) Research Design
(f) Data Collection
(g) Techniques of Analysis
(h) Limitations of Study
Chapter III BANKS PROFILE .......................................................27-32
Chapter IV CREDIT RISK MANAGEMENT.................................33-43
a (a) Meaning of Credit Risk
(b) Objectives of Credit Risk Management
(c) Instruments of Credit Risk Management
(d) Methods for Measuring Credit Risk
(e) Strategies for Managing Credit Risk
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Chapter V MARKET RISK MANAGEMENT...............................44-63
(a) Meaning of Market Risk
(b) Meaning of Liquidity Risk
(c) Methods for measuring Liquidity Risk
(d) Strategies for Managing Liquidity Risk
(e) Meaning of Interest Rate Risk
(f) Methods for measuring Interest Rate Risk
(g) Strategies for managing Interest Rate Risk
Chapter VI OPERATIONAL RISK MANAGEMENT.....................64-70
(a) Definition of Operational Risk
(b) Risk Mapping/Profiling
(c) Measuring Operational Risk
(d) Mitigating Operational Risk
(e) Capital Budgeting for Operational Risk
Chapter VII BASEL II COMPLIANCE............................................71-78
(a) Three pillar approach
(b) Reservation about Basel II
Risk Based Supervision Requirement
(a) Background
(b) Risk based supervision a new approach
(c) Features of RBS approach
Chapter VIII ANALYSIS OF SURVEY RESPONSES.....................79-86
Chapter IX OBSERVATION AND SUGGESTIONS........................87-92
(a) Major Findings of Study
(b) Suggestions
ANNEXURES AND BIBLIOGRAPHY...93-96

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 EXECUTIVE SUMMARY

Risk Management underscores the fact that the survival of an organization depends
heavily on its capabilities to anticipate and prepare for the change rather than just
waiting for the change and react to it. The objective of risk management is not to
prohibit or prevent risk taking activity but to ensure that the risks are consciously
taken with full knowledge, clear purpose and understanding so that it can be
measured and mitigated.

The present study is on Risk Management in Banks. The core of the study is to
analyze various kinds of risk i.e credit, interest rate, liquidity and operational risk and
how to measure and monitor these risk. The study undertakes sample of six banks,
which includes both public and private sector.

The entire dissertation has been divided into nine chapters. The first chapter contains
discussion on the meaning and concept of risk, risk management, its functions, types
of risk, RBI guidelines. Chapter Second contains the Research Methodology, which
includes need, objective, significance of study. The Third chapter contains profiles of
State Bank of India, ICICI bank, Central Bank of India, HDFC bank, Oriental Bank
of Commerce and IDBI bank. In the forth, fifth and sixth chapter analyses of credit
risk, market risk and operational risk is undertaken.

Basel II norms and Risk Based Supervision Requirements are discussed in seventh
chapter. Analysis of survey responses and profitability analysis, which is the central
point of financial analysis, is included in eighth chapter. Chapter ninth presents the
major findings of the study with some concluding remarks.

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 LITERATURE REVIEW

1.) Inter RISK MANAGEMENT IN COMMERCIAL BANKS - (A CASE

STUDY OF PUBLIC AND PRIVATE SECTOR BANKS), Indian Institute of
Capital Markets 9th Capital Markets Conference PapeR, BY Prof. Rekha

Objective:
To analyze the trends in Non-Performing Assets of commercial banks in
India.
To evaluate the credit risk management practices in public sector banks vis--
vis private sector banks and suggest a broad outline for the same.

Synopsis:
Risk is the fundamental element that drives financial behavior. Without risk, the
financial system would be vastly simplified. However, risk is omnipresent in the real
world. Financial Institutions, therefore, should manage the risk efficiently to survive
in this highly uncertain world. The future of banking will undoubtedly rest on risk
management dynamics. Only those banks that have efficient risk management system
will survive in the market in the long run. The effective management of credit risk is
a critical component of comprehensive risk management essential for long-term
success of a banking institution.
Foremost among them is the wind of economic liberalization that is blowing across
the globe. India is no exception to this swing towards market driven economy. Better
credit portfolio diversification enhances the prospects of the reduced concentration
credit risk as empirically evidenced by direct relationship between concentration
credit risk profile and NPAs of public sector banks. NPAs are the primary indicators
of credit risk. Capital Adequacy Ratio (CAR) is another measure of credit risk.
The study also intends to throw some light on the two most significant developments
impacting the fundamentals of credit risk management practices of banking industry
New Basel Capital Accord and Risk Based Supervision.

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Conclusion:
Asset quality is one of the important parameters based on which the performance of a
bank is assessed by the regulation and the public. The very complexion of credit risk
is likely to undergo a structural change in view of migration of Tier- I borrowers and,
more particularly, the entry of new segments like retail lending in the credit portfolio.
These developments are likely to contribute to the increased potential of credit risk
and would range in their effects from inconvenience to disaster.

2.) MARKET RISK MANAGEMENT OF BANKS

Objective:
to compare the performance of a number of simple Value-at-Risk (VaR) models based
on the backtesting criteria of the Basle Committee.
Synopsis:
Currently central banks in major money centres, under the auspices of the Basle
Committee of the Bank of International settlement, adopt the VaR system to evaluate
the market risk of their supervised banks. Banks are required to report VaRs to bank
regulators with their internal models. These models must comply with Basle's
backtesting criteria. If a bank fails the VaR backtesting, higher capital requirements
will be imposed. VaR is a function of volatility forecasts. Past studies mostly
conclude that ARCH and GARCH models provide better volatility forecasts.
However, the paper finds that ARCH- and GARCH-based VaR models consistently
fail to meet Basle's backtesting criteria. These findings suggest that the use of ARCH-
and GARCH-based models to forecast their VaRs is not a reliable way to manage a
bank's market risk.
Conclusion:
Past studies mostly conclude that ARCH and GARCH models can provide better
volatility forecasts. Although VaR is just a function of volatility forecasts, this paper
finds that ARCH- and GARCH-based VaR models consistently fail to pass in
backtesting. This is robust across the whole period and the different subperiods in our
study. This implies that the use of ARCH- and GARCHbased models is not a reliable
way for a bank to forecast VaRs and to manage its market risks.

3
3.) How do Banks Manage Interest Rate Risk: Hedge or Bet?, Journal of

Banking and Finance, luis Vasco LourencoPinheiro, Miguel A Ferreira

Objective:
To check how dynamic and specific has been banks interest rate risk management,
duration management, and beyond duration management (slope, convexity and credit
risk, foreign exchange risk); and to evaluate banks forecasting capacity and
respective hedging policies over the period in analysis.
Synopsis:
Banks deal with many types of risks such as interest rate, credit, liquidity, insolvency,
operational, commodity and foreign exchange. The importance of interest rate risk is
inherent to the very nature of the banking business, loans versus deposits. In order to
measure the effects of interest rate changes there are two different approaches
commonly used, the repricing model (or funding gap) and the duration model. Some
banks do not hedge with derivatives and engage into natural hedging practices.
Derivatives carry advantage over other hedging tools, as they are cheap, fast and
flexible instruments to use. The derivative market increased the potential for banks to
manage risk and attain the desired levels of interest rate exposure.
The sample period is from 1980 to 2003. This period is selected in the research paper
because it is of significant interest rate volatility and also a period where derivatives
such as interest rate swaps increased significantly, and were used by banks for risk
management.

Conclusion:
Financial institutions are not duration neutral and also that duration varies
throughout the years from positive to negative.
Bank managers lack predicting power over the evolution of interest rates, as
they are not anticipating accordingly their duration gap measure. Hence,
majority of banks should focus more on the core business (loans and deposits)
instead of viewing the asset and liability management as a profit center.

4
 CHAPTER - I

INTRODUCTION

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

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

Meaning of Risk and Risk Management

The etymology of the word Risk is traced to the Latin word Rescum meaning
Risk at sea or that which cuts. Risk is an unplanned event with financial
consequences resulting in loss or reduced earnings. It stems from uncertainty or
unpredictability of the future. Therefore, a risky proposition is one with potential
profit or a looming loss.

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 Risk is the potentiality of both expected and unexpected events which have an
adverse impact on bank capital or earnings. In one of the publications Price
Waterhouse Cooper has interpreted the word risk in two distinct senses.

Risk as Hazard:

Danger; (exposure to) the possibility of loss, injury or other adverse circumstance.
Exposure to the possibility of commercial loss apart of economic enterprise and the
source of entrepreneurial profit.

Risk as Opportunity:

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The ordinary rate of profit always riseswith the risk

Hence, Risk Management is an attempt to identify, to measure, to monitor and to

manage uncertainty. It does not aim at risk elimination, but enables the banks to bring
their risks to manageable proportions while not severely affecting their income.

International Financial Risk Institute defines Risk Management as The application

of financial analysis and diverse financial instruments to control and typically the
reduction of selected type of Risks. While non-performing assets are the legacy of
the past in the present, risk management system is the pro-active action in the present
for the future. Managing risk is nothing but managing the change before the risk
manages.

Till recently all the activities of banks are regulated and hence operational
environment was not conducive to risk taking. Better insight sharp intuition and
longer experience were adequate to manage the limited risks. Risk is inherent in any
walk of life in general and in financial sectors in particular. Of late, banks have
grown from being a financial intermediary into a risk intermediary at process. In the
process of financial intermediation, the gap of which becomes thinner and thinner
banks are exposed to severe competition and are compelled to encounter various
types of financial and non-financial risks viz, credit, interest rate, foreign exchange
rate, liquidity, equity price, commodity price, legal, regulatory, reputational,
operational, etc. These risks are highly interdependent and events that affect one area
of risk can have ramifications for a range of other risk categories. Thus, top
management of banks attach considerable importance to improve the ability to
identify, measure, monitor and control the overall level of risks undertaken.

The broad parameters of risk management function encompass:

1. Organizational structure.

2. Comprehensive risk measurement approach.

3. Risk management policies approved by the Board, which should be consistent

with the broader business strategies, capital strength, management expertise and
overall willingness to assume risk.

8
4. Guidelines and other parameters used to govern risk taking including detailed
structure of prudential limits.

5. Strong MIS for reporting, monitoring and controlling risks.

6. Well laid out procedures, effective control and comprehensive risk reporting
framework.

7. Separate risk management, framework independent of operational departments

and with clear delineation of levels of responsibility for management of risk.

8. Periodical review and evaluation.

Risk Management Structure:

Establishing an appropriate risk management organisation structure is choosing

between a centralised and decentralised structure. The global trend is towards
centralising risk management with integrated treasury management function to
benefit from information on aggregate exposure, natural netting of exposures,
economies of scale and easier reporting to top management. The primary
responsibility is of understanding the risks run by the bank and ensuring that the risks
are appropriately managed and vested with the Board of Directors. The Board sets
risk limits by assessing the banks risk and risk-bearing capacity. At organisational
level, overall risk management is assigned to an independent Risk Management
Committee or Executive Committee of the top executives that reports directly to the
Board of Directors. The purpose of this top level committee is to empower one group
with full responsibility of evaluating over all risk faced by the bank and determining
the level of risk which will be in the best interest of the bank. At the same time the
committee holds the line management more accountable for the risks under their
control and the performance of the bank in that area. The risk management is a
complex function and it requires specialized skills and expertise. Large banks and
those operating in international markets have developed internal risk management
models to be able to compete effectively with their competitors. At a more
sophisticated level, the core staff at Head Offices is trained in risk modelling and
analytical tools.

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Internationally, a committee approach to risk management is being adopted. While
the Asset-Liability Management Committee (ALCO) deal with different types of
market risk, the Credit Policy Committee (CPC) oversees the credit/counter party risk
and country risk. Thus, market and credit risks are managed in a parallel two-track
approach in banks. Generally, the policies and procedures for market risk are
articulated in the ALM policies and credit risk is addressed in Loan Policies and
Procedures.

Risk Management: Components

The process of risk management has three identifiable steps viz. Risk identification,
Risk measurement, and Risk control.

Risk Identification

Risk identification means defining each of risks associated with a transaction or a

type of bank product or service. There are various types of risk which bank face such
as credit risk, liquidity risk, interest rate risk, operational risk, legal risk etc.

Risk Measurement

The second step in risk management process is the risk measurement or risk
assessment. Risk assessment is the essemination of the size probability and timing of
a potential loss under various scenarios. This is the most difficult step in the risk
management process and the methods, degree of sophistication and costs vary
greatly. The potential loss is generally defined in terms of Frequency and Severity.

Risk Control

After identification and assessment of risk factors, the next step involved is risk
control. The major alternatives available in risk control are:

1) Avoid the exposure

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2) Reduce the impact by reducing frequency of severity

3) Avoid concentration in risky areas

4) Transfer the risk to another party

5) Employ risk management instruments to cover the risks

Steps for implementing Risk Management in Banks

1) Establishing a risk management long term vision and strategy

Risk management implementation strategy is established depending on bank vision,

focus, positioning and resource commitments.

2) Risk Identification

The second step is identification of risks, which is carried out to assess the current
level of risk management processes, structure, technology and analytical
sophistication at the bank. Typically banks distinguish the following risk categories:

- Credit risk

- Market risk

- Operational risk

3) Construction of risk management index and Sub indices

Bank roll out a customized benchmark index based on its vision and risk
management strategy. Then it develops a score for the current level of bank risk
practices that already exists. For example assuming that the current risks
management score is 30 out of 100. For the gap in score of 70 roadmap is developed
for achieving the milestones.

4) Defining Roadmap

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Based on the target risk management strategy/gap analysis bank develops unique
work plans with quantifiable benefits for achieving sustainable competitive
advantage.

a. Risk Based Supervision requirements

b. Basel II compliance

c. Using risk strategy in the decision making process

Capital allocation

Provisioning

Pricing of products

Streamlining procedures and reducing operating costs

By rolling out the action steps in phases the bank measure the progress of the
implementation.

5) Establish Risk measures and early warning indicators

Depending on the lines of business as reflected in bank balance sheet and business
plans, the relative importance of market, credit and operational risk in each line of
activity is determined The process workflow organisation, risk control and mitigation
procedures for each activity line is to be provided.

6) Executing the key requirements:

At an operational level checklist of key success factors and quantitative benchmark is

generated. Models to be applied are tested and validated on a prototype basis.
Moreover, evaluation scores on the benchmark levels specified helps to build up a
risk process implementation score.

7) Integrate Risks Management/Strategy into bank internal decision

making process

The objective is to integrate risk management into business decision making process
which evolves risk culture through awareness and training, development of
12
integrated risk reports and success measures and alignment of risk and business
strategies.

Types of Risks

Credit Risks: Credit Risk is defined by the losses in to event of default of

borrower to repay his obligations or in event of deterioration of the
borrowers credit quality.

Regulatory Risks: It is the risk in which firms earnings value and cash
flows is influenced adversely by unanticipated changes in regulation such as
legal requirements and accounting rules.

Strategic (Business) Risks: It is the risk in which entire lines of business

is succumb to competition or obsolescence as strategic risks occurs when a
bank is not ready or unable to compete in a newly developing line of business.

Human Risks: It is risk, which is concurrent with the risk of inadequate

loss of key personnel or misplaced motivation among management personnel.

Legal Risks: It is the risk that makes transaction proves to be

unenforceable in law or has been inadequately documented.

Operational Risks: It is the risk of loss resulting from failed or

inadequate systems, people and processes or from external events.

Market Risks: Market Risk is the risk to the banks earnings and capital
due to changes in the market level of interest rates or prices of securities,
foreign exchange equities as well as volatilities of prices.

Liquidity Risks : Liquidity Risk consists of :

Market liquidity risks : arises when a firm is unable to conclude

a large transaction in a particular instrument anything near the current
market prices.

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 Funding liquidity risks : is defined as inability to obtain funds to
meet cash flow obligations.

Interest Rate Risk: It is the potential negative impact on the Net

Interest Income and refers to vulnerability of an institutions financial;
condition to the movement in interest rates.

NII = Gap * Change in Interest Rate

Forex Risks: It is the risk that a bank suffer loss due to adverse
exchange rate movement during a period in which it has an open
position either spot or forward both in same foreign currency.

Country Risks: This is the risk that arises due to cross-border

transactions owing to economic liberalization and globalization as it is
the possibility that a country is unable to service or repay debts to
foreign lenders in time.

Hence, risk management focus on the identification of potential unanticipated events

and on their possible impact on the financial performance of the firm and at the limit
on its survival. Risk Management in its current form is different from what the banks
used to practice earlier. Risk environment has changed and according to the draft
Basel II norms the focus is more on the entire risk return equation.

Moreover, banks now a days seek services of Global Consultants like KPMG,
PricewaterhouseCoopers (PwC), Tata Consultancy Services (TCS), Boston
Consulting Group (BCG), The Credit Rating and Investment Services of India Ltd.
(Crisil), I Flex Solutions and Infosys Technologies who have vast experience in risk
modelling as these players identify the gap in the system and help the banks in
devising a risk return model.

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 15
OPTIMIZING THE RISK RETURN EQUATION
Profits

DEGREE OF RISK
Losses
RBI Guidelines on Risk Management

RBI has issued guidelines from time to time, which are being implemented by banks
through various committees.

RBI suggests that

(a) Banks must equip themselves with an ability to identify, to measure, to

monitor and to control the various risks with New Capital Adequacy
provisions in due course.

(b) For integrated management of risk there must be single risk management
committee.

(c) For managing credit risk, portfolio approach must be adopted.

(d) Appropriate credit risk modelling in the future must be adopted.

(e) For measurement of market risk banks are advised to develop expertise in
internal models

(f) RAROC (Risk Adjusted Return on Capital) framework is to be adopted by

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 banks operating in international markets.

(g) Banks should upgrade credit risk management system to optimize use of
capital.

(h) Banks are advised by RBI to initiate action in five specific areas to prepare
themselves for risk based supervision. One of the five specific areas is
effective Risk Management Architecture to ensure adequate internal risk
management practices.

(i) The limits to sensitive sectors like advances against equity shares, real estates
which are subject to a high degree of asset price volatility as well as to
specific industries which are subject to frequent business cycles should be
restricted. Similarly, high-risk industries as perceived by the bank should be
placed under lower portfolio limit.

(j) To enhance risk management function banks should move towards risk based
supervision and risk focussed internal audit.

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 CHAPTER - II

RESEARCH METHODOLOGY

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 Need of the Study

The need of the study arises because of following factors: -

Increasing liberalization, deregulation and internationalization of banking sector

in India.

External pressures on senior management to increase profit and decrease costs.

Necessity of the banks to respond to the array of new and more complex risks
caused by:

- Rapidly increasing pace of change in technology

- Recession

- Globalization

- Mergers and acquisitions

- Downsizing

- Regulatory changes

The need forever increasing flexible financing.

Increasing competition in the banking sector in India.

Growing sophistication in banking operations, derivative trading securities

underwriting, on-line electronic banking, payment of services have made risk
management extremely critical and indispensable.

Risk management is an attempt to identify, to measure, to monitor and to manage

uncertainty. However, not much has been done on the practical implementation
of this technique as assessing and managing risks still remains a challenging
task for banks, which raises the issue of how to identify the optimal strategies
to curtail these risks. Hence, the need of the study arises so as to study the
formulation and implementation of risk management in various banks.

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 Objectives of the Study

The following objective have been fix for making thus study:

1. To know need for risk management.

2. To know various types of risks faced by banks.

3. To analyse different types of risk such as

- Credit Risk

- Market risk, which includes Liquidity risk and Interest rate risk

- Operational risk

4. To know the guidelines set up by RBI for banks.

5. To know how to measure and monitor various risks.

6. To know about Basel II Accord and Risk Based Supervision Requirements.

7. To study about the Risk Management approach adopted by six banks, which
includes banks in both public as well as private sector.

8. To know newer methodologies to quantify risk in light of newer businesses and

challenges.

Significance of the Study

Good risk management is good banking. And good banking is essential for profitable
survival of institution. It brings stability in earnings and increases efficiency in
operations.

The present study proposes to: -

Enhance shareholders value with

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 value creation

value preservation

capital optimization

Enhance capital allocation.

Improvement of portfolio identification and action plans.

An understanding of key business processes.

Integration of risk management within corporate governance framework.

Improved Information Security.

Corporate Reputation.

Instill confidence in the market place.

Alleviate regulatory constraints and distortions thereof.

In real world risk management creates value. Hence, it is an essential part of a

financial institution as it involves stakeholders interest among others.

Scope of the Study

Risk is intrinsic to banking business as the major risks confronting banks are credit
risk, interest rate risk, liquidity risk and operational risk. Irrespective of the nature of
the risk the best way for banks to protect themselves is to identify risk, accurately
measure, price it and maintain appropriate levels of reserves and capital. If Indian
banks are to compete globally then they have to institute sound and robust risk
management practices, which will improve efficiency of banks.

The scope of this study involves analyzing and measuring major risks i.e credit risk,
liquidity risk, interest rate risk and operational risk of six banks (public and private
sector). The present study evaluates key performance indicators of various banks in
terms of credit deposit ratio, net interest margin, spread, overhead efficiency, Gap
analysis and maturity ladder. While putting the risk management in place banks often
find it difficult to collect reliable data. The challenge is mainly in the area of

21
operational risk where there is dearth of reliable historic data and not a great deal of
clarity on the measurement of such risk.

Data Collection

The present study is based on both primary and secondary sources.

Primary Research

Questionnaire has been prepared and sent to selected six banks to ascertain their
degree of readiness for risk management on various parameters and information is
collected through in depth interview of senior officers and employees of six banks.

Secondary Sources

Information has also been obtained through desk research such as

(a) Annual reports of the banks

(b) Indian Bank Association Bulletin

(c) RBI Bulletin

(d) Report on trends and progress of banking in India

Sample Size

The sample comprises of six banks both in public as well as private sector. Following
banks are included in the sample size.

State Bank of India

ICICI Bank
Central Bank of India
HDFC Bank
Oriental Bank of Commerce
IDBI Bank
The study is divided into following chapters.

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1. Introduction

2. Research Methodology

3. Bank Profiles

4. Credit Risk Management

5. Market Risk Management

6. Operational Risk Management

7. Basel II Compliance and Risk Based Supervision Requirements

8. Analysis of Survey Responses

9. Observations and Suggestions

Research Design

A research design is the arrangement of conditions for collection and analysis of data
in a manner that aims to combine relevance to the research purpose with economy in
procedure. In fact, the research design is the conceptual structure within which
research is conducted. It constitutes the framework for the collection, measurement
and analysis of data. It provides the empirical and logical basis for getting knowledge
and drawing conclusions.

The research design in the study is of exploratory research. Various methods are
utilized in order to gain the information and to interpret it in most rational and
objective manner.

Techniques of Analysis

The following techniques have been applied for analysis: -

Ratio Analysis

To evaluate the financial condition, performance and profitability banks requires

23
 certain yardsticks .The following various accounting tools have been used.

Core Deposits/Total Assets

Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits

Volatile Liabilities/Total Assets

Where Volatile liabilities = Demand + Term deposits of other banks

Short term Assets/Total Assets

Where short term assets = Cash & Bank Balance + Receivable + Bills Receivable
+ short term /demand advances

Credit Deposit Ratio: Higher deposit ratio indicates poor liquidity position
of a bank & vice versa. The ratio is calculated as follows:

Loans and Advances/Total Deposits

Cost of Funds: Total Interest Expense/Interest bearing liabilities where

interest bearing liabilities = Deposits + Borrowings

Net Interest Margin : Net Interest Income/Earning Assets where Net Interest
Income = Total Interest Income Total Interest Expenses

Earning Assets = All Interest earning assets (Total Assets Cash Balances -
Fixed Assets - Other Asset)

The impact of volatility on the short-term profits is measured by Net Interest

Margin.

Spread = Yield Cost of funds

where yield = Total Interest earned/ Earning Assets

Return on Average Assets (ROA) = This ratio is relationship between the

net profit (after tax and interest) and the total assets of the bank. It is calculated as

24
 follows:

Net profit after tax + Interest /Total assets

Return on Equity (ROE) = Shareholders are the real owner of the

organization, so they are more interested in profitability and performance of an
organization. This is calculated as follows:

Net profit after interest, tax and Preference dividend /Equity Shareholders Funds.

Capital Adequacy Ratio

This ratio strengthens the capital base of bank. The paid up capital reserves of
bank form an adequate percentage of assets of banks, their investments, loans and
advances. All these items are assigned weights according to prescribed risks and
the ratio so computed is known as capital adequacy ratio.

Overhead Efficiency = This is calculated as follows:

Non-Interest Income/Non Interest Expense

Profit Margin = This is calculated as follows:

Net Income/Total Revenue

Burden/Spread

where Burden is the Net Non Interest Income and Spread is the Net

Interest Expense

Gap Analysis

Maturity Ladder

Limitations of the Study

However, I have made every possible effort at my great extent level to show how
selected sample of banks analyse the major risks i.e credit, market and operational
risks. But the study at the disposal of a researcher on this level is limited. In addition
to other factor such as time that plays a very important role in every field of todays

25
life has also an important bearing on research work. The main limitations of the
present study are as follows:

All data and information collected is true to some specific period of time.

The study hasnt got the wider scope as only six banks are being considered for
evaluating risk management.

It was difficult to have group discussions with experts due to their busy
schedules.

26
CHAPTER III

BANKS PROFILE

27
State Bank of India

The origin of the State Bank of India goes back to the first decade of the nineteenth
century with the establishment of the Bank of Calcutta in Calcutta on 2nd
June, 1806.Three years later the bank received its charter and was redesigned
as the Bank of Bengal (2nd January 1809). A unique institution it was the first
joint stock bank of British India sponsored by the government of Bengal/The
Bank of Bombay (15th April, 1840 and the Bank of Madras (1 July, 1843)
followed the Bank of Bengal. These three banks remained at the apex of
modern banking in India till their amalgamation as the Imperial Bank of India
on 27 January, 1921.An act was accordingly passed in Parliament in May,
1955 and the State Bank of India was constituted on 1 July, 1955. More than a
quarter of the resources of the Indian banking system thus passed under the
direct control of the state. Later, the State Bank of India (Subsidiary Banks)
Act was passed in 1959 enabling the State Bank of India to take over eight
former State associated banks as its subsidiaries. The State Bank of India was
thus born with a new sense of social purpose aided by the 480 offices
comprising branches, sub offices and three local head offices inherited from
Imperial Bank.

The Banks aim is to reach global best standards in the area of risk management and
to ensure that risk management processes are sufficiently robust and efficient. The
Risk Management Committee of the board overseas the policy and strategy for
integrated risk management relating to various risk exposures of the bank & Credit
Risk Management Committee (CRMC) monitors banks domestic credit portfolio.
Moreover SBI has developed sensitive to

ols to hedge and minimize the risk arising out of movements in interest rates. The
Bank is using Risk Manager module (part of the ALM software) to strengthen the
processes of risk management an operational risk management policy duly approved

28
by central board of the bank is in place. The bank has an in built internal control
system with well-defined responsibilities at each level. (RFIA) Risk Focused Internal
Audit, an adjunct to risk based supervision has been introduced in the banks audit
system on 1.4.03.Duly aligned with (RFIA) the Credit audit examines probability of
default and suggests risk mitigation measures.

HDFC Bank

The Housing Development Finance Corporation Limited (HDFC) was amongst the
first to receive an in principle approval from Reserve Bank of India (RBI) to set up
a bank in the private sector as part of RBIs liberalisation of the Indian banking
industry in 1994. The bank was incorporated in August, 1994 in the name of HDFC
Bank Limited with its registered office in Mumbai, India. HDFC Bank commenced
its operations as a scheduled commercial bank in January, 1995.

To implement the effective strategy in risk management HDFC Bank has distinct
policies and processes in place for the wholesale and retail asset business. For
wholesale credit exposures management of credit risk is done through target market
definition, appropriate credit approval processes, ongoing post disbursement
monitoring and remedial management procedures. Overall portfolio diversification
and reviews also facilitate risk management in the bank.

ICICI Bank

29
ICICI Bank is among largest private sector banks in country. It was established on
Jan 5, 1955 to assist industrial enterprises in private sector. Its excellent
performance is a result of its increase client focus and ability to structure
financial solutions that meet client specific ends. New products, new services,
new organisation structures and new business models have been the hallmarks
of ICICI business strategy. Risk is an integral part of the banking business and
ICICI bank aim at delivery of superior shareholder value but an achieving an
appropriate tradeoff between risk returns. The policies and procedures
established for this purpose are continuously benchmarked with international
best practices. A comprehensive range of quantitative and modelling tools are
developed by dedicated risk analytic team that supports the risk management
function. The risk management group, the compliance and audit group that
are responsible for assessment, management and mitigation of risk in ICICI
bank. These groups form a part of Corporate Center is completely
independent of all business operations and is accountable to the Risk and
Audit Committees of the Board of Directors. RMG is further organised into
Credit Risk Management Group, Market Risk Management group, Retail Risk
Management group and Risk Analytics group. CAG is further organised into
credit policies, RBI Inspection and Anti- Laundering Group and Internal
Audit Group.

IDBI Bank

The IDBI was established in July, 1964 under the Industrial Development Bank of
India Act, as wholly owned subsidiary of RBI. However in February, 1976 it was

30
delinked from the Reserve Bank and has emerged as an independent organisation. It
now serves as an apex financial institution.

A few of such institutions built by IDBI are The National Stock Exchange (NSE),
The National Depository Services Ltd. (NSDL), Stock Holding Corporation OF India
(SHCIL) etc. IDBI is a strategic investor in a plethora of institutions, which have
revolutionized the Indian financial markets. IDBI promoted IDBI bank to mark the
formal array of the IDBI group into commercial banking. The initiative has
blossomed into a major success story, IDBI bank which began with an equity capital
base of Rs 1000 million (Rs 800 million contributed by IDBI and Rs 200 million by
SIDBI), commenced its first branch at Indore in November, 1995. Thereafter in less
than seven years the bank has attained a front ranking position in the Indian Banking
Industry.

IDBI Bank successfully completed its public issue in February, 1999 which led to its
paid up capital expanding to Rs 1400 million.

IDBI has deployed optimum resources in developing & implementing risk analytics
to more finely assessing the quantum and severity of all types of risks such as credit,
market and operational risk. The corporate credit rating system has developed
significant degree of stability and is supplemented with an internally developed
facility-rating model. As bank rating and scoring models effectively manage the risk
of individual/credit portfolio. VaR (Value at risk) technique is used by IDBI for
measuring market risk on the balance sheet in respect of government securities and
other traded portfolio. It has centrally controlled & an independent Internal Audit
Department that maintains a risk based focus, which evaluates adequacy and
effectiveness of internal controls for various business and operational activities
within bank.

Central Bank of India

31
Central Bank of India is a public sector bank of the government of India. Established
in 1911,Central Bank of India has business interests in diversified areas of banking
and finance. In line with the Basel II and RBI guidelines, Central Bank of India has
installed an enterprise wide ALM and risk management solution.

Oriental Bank of Commerce

Establi
shed in Lahore on 19th February 1943, Oriental Bank of Commerce made a
modest beginning under its founding father late Rai Bahudar Lal Sohan Lal,
the first Chairman of the bank. On 15th April 1980,the date when
nationalization of the bank was announced the bank had 307 branches with
Rs.282.61 crores as deposits and Rs 152.69 crores as advances. Thereafter the
bank registered phenomenal growth and noticeable improvement was
observed under all performance parameters.

OBC has put in place an independent Risk Management System in the Bank and Risk
Management Committee of the Board of Directors and top executives of the Bank
oversees its implementation. The credit risk management policy for the Bank is
framed and implemented which includes exposure limits for Single/Group Borrower;
Sector-wise, Industry-wise, Exposure to Capital Market, un-secured exposure and
lays down thrust areas and restricted areas of lending. The Bank has put in place
Credit Risk Rating Models for rating of Large Corporate Borrowers and Retail
Loans. Intensive training is imparted to the field functionaries in respect of rating
models. The structural liquidity and interest rate sensitivity position of the bank is
prepared and analyzed on fortnightly basis. OBC has strengthened the internal
control system through simplification of documentation procedures and revision in
the audit procedures, updating operational manuals and implementation of related

32
strategies and monitoring of their efficacy. There has also been considerable progress
with regard to implementation of Risk Based Internal Audit in the Bank.

33
 CHAPTER - IV
CREDIT RISK MANAGEMENT

34
Credit Risk is the possibility of default due to nonpayment or delayed payment.
Hence, it is defined by the losses in the event of default of the borrower to repay his
obligations or in the event of a deterioration of the borrowers credit quality. In a
banks portfolio, losses stem from outright default due to inability or unwillingness of
a customer or counter party to meet commitments in relating to lending, trading,
settlement and other financial transactions. Credit risk is inherent to the business of
lending funds to the operations linked closely to market risk variables. It consists of
two components Quantity of risk, which is outstanding loan balance as on the date of
default and Quality of risk, which is severity of loss, defined by the recoveries that
could be made in the event of default. It is a combined outcome of Default risk and
Portfolio Risk. The elements of credit risk in portfolio risk comprise of Intrinsic risk
and Concentration risk.

TABLE: 1 RISKS IN LENDING

INTRINSIC RISKS CONCENTRATION RISKS

(a) Deficiencies in Loan policies a. State of economy
and procedures

35
(b) Absence of prudential credit (b) Volatility in Equity markets,
conc.limits Commodity markets, FX
markets, Interest rates

(c) Inadequately defined lending (c) Trade restrictions

limits

(d) Deficiency in appraisal (d) Economic sanctions

(e) Excessive dependence on (e) Government policies

collateral

Objectives of Credit Risk Management

The credit risk management has different objectives at two levels namely Transaction
level and Portfolio level.

At Transaction level, the objectives of credit risk management are:

Setting an appropriate credit risk environment.

Framing a sound credit approval process.

Maintaining an appropriate credit administration, measurement and monitoring

process.

Employing sophisticated tools/techniques to enable continuous risk evaluation on

a scientific basis.

Ensuring adequate pricing formula to optimize risk return relationship.

At Portfolio level the objectives of credit risk management are:

Development and monitoring of methodologies and norms to evaluate and

mitigate risks arising from concentrating by industry, group and product etc.

Ensuring adherence to regulatory guidelines.

36
 Driving asset growth strategy.

The transaction level pursues value creation and the portfolio level pursues value
preservation.

The management of credit risk receives the top managements attention and the
process encompasses: -

(a) Measurement of risk through credit rating or scoring.

(b) Quantifying the risk through estimating expected loan losses and unexpected loan
losses.

(c) Risk pricing on a scientific basis.

(d) Controlling the risk through effective Loan review mechanism and portfolio
management.

The credit risk management process is articulated in the banks Loan Policy, duly
approved by the Board. Each bank constitute a high level Credit Policy Committee,
also called Credit Risk Management Committee to deal with issues relating to credit
policy and procedures. The Committee is headed by the Chairman/CEO/ED, and
comprise of heads of Credit Department, Treasury, Credit Risk Management
Department (CRMD) and the Chief economist. The Committee formulates clear
policies on standards for presentation of credit proposals, financial covenants, rating
standards and benchmarks, delegation of credit approving powers, prudential limits
on large credit exposures, asset concentrations, portfolio management, loan review
mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans,
provisioning, regulatory/legal compliance etc. Concurrently, each bank also set up
Credit Risk Management Department (CRMD) independent of the Credit
Administration Department that enforce and monitor compliance of the risk
parameters and prudential limits set by the CPC.

In the global scenario, the increased credit risk arises due to two reasons. First, banks
have been forced to lend to riskier clients because well-rated corporates have moved
away from banks as they have access to low cost funds through disintermediation.

37
The other reason is the lurking fear of global recession. Recession in the economy
could lead to low industrial output which may lead to defaults by the industry under
recession culminating into credit risk.

Instruments of Credit Risk Management

1) Credit Approving Authority

One of the instruments of credit risk management is multi- tier credit approving
system where an Approval Grid or a Committee approves loan proposals. The
Grid or Committee comprises of at least 3 or 4 officers and invariably one officer
is represented as CRMD. For better rated/quality customers banks delegate powers
for sanction of higher limits to the Grid. The quality of credit decisions is evaluated.

2) Prudential Limits

It is linked to capital funds - say 15% for individual borrower entity, 40% for a group
with additional 10% for infrastructure undertaken by group. Threshold limit is fixed
at a level lower than prudential exposure; substantial exposure, which is the sum total
of the exposures beyond threshold limit and does not exceed 600% to 800% of the
capital funds of the bank. Banks also consider maturity profile of the loan book.

3) Risk Rating

Banks set up comprehensive risk rating system on six to nine point scale which
serves as a single point indicator of diverse risk factors of a counter party and for
taking credit decisions in consistent manner. Rating reflects underlying credit risk of
loan book, encompass industry risk, business risk, financial risk, management risk
and specify cutoff standards. Moreover, there is separate rating framework for large
corporates, small borrowers and traders. Banks clearly defines rating threshold and
reviews the rating periodically preferably at half yearly intervals. Rating migration is
mapped to estimate the expected loss.

38
Business risk consists of systematic risk (such as changes in economic policies, fiscal
policies of government, infrastructural changes) and unsystematic risk (such as
labour strike, machinery breakdown) which are market driven. Assessment of
financial risks involves of the financial strength of unit based on its performance and
financial indicators like liquidity, coverage and turnover. Management risk consists of
integrity, track record, structure and systems, expertise, commitment and competence.

Some of the risks rating methodologies are:

Altmans Z score model involves forecasting the probability of a company

entering bankruptcy. It separates defaulting borrower from non-defaulting
borrower on the basis of certain financial ratios, which is converted into simple
index..

Credit Metrics focus on estimating the volatility of asset value caused by the
variation in the quality of assets. It tracks rating migration which is the
probability that borrower migrates from one risk rating to another risk rating.

Credit Risk +, a statistical method based on the insurance industry for

measuring credit risk. It is based on actuarial rates and unexpected losses from
defaults.

KMV, through its Expected Default Frequency (EDF) methodology derives the
actual probability of default for each obligator based on the functions of capital
structure, current asset value. It calculates the asset value of a firm from the
market value of its equity using an option pricing based approach that recognizes
equity as a call option on the underlying asset of the firm.

4) Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. Banks link loan

pricing to expected loss and high-risk category borrowers are priced high. Banks
build historical database on the portfolio quality and provisioning to equip
themselves to price the risk. Across the world many banks have put in place RAROC

39
(Risk Adjusted Return on Capital) framework for pricing of loans which calls for data
on portfolio behaviour and allocation of capital that commensurate with credit risk
inherent in loan proposals.

5) Portfolio Management

The need for credit portfolio management emanates from the necessity to optimize
the benefits associated with diversification and to reduce the potential adverse impact
of concentration of exposures to a particular borrower, sector or industry. To maintain
portfolio quality banks adopt certain measures such as stipulate quantitative ceiling
on aggregate exposures on specific rating categories, distribution of borrowers in
various industry, business group and conducting rapid portfolio reviews, stress test.
The stress test reveals undetected areas of potential credit risk exposure and linkages
between different categories of risk. Portfolio models such as default mode model,
which distinguishes between default, and non-default of borrower is assessed in
terms of probability of occurrence to determine loss given default. Mark to Market
model evaluates credit portfolio in terms of market value and the risk the bank incurs
if market value changes.

6) Loan Review Mechanism

This is done independent of credit operations referred as Credit Audit covering

review of sanction process, compliance status, review of risk rating, pick up of
warning signals and recommendation of corrective action with the objective of
improving credit quality. It targets all loans above certain cut off limit ensuring that at
least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that
all major credit risks embedded in balance sheet are tracked. Hence, the focus of
credit audit is to be broadened from account level to overall portfolio level. Regular,
proper and prompt reporting to top management should be ensured. Credit Audit is
conducted on site, i.e. at the branch that has appraised the advance and where the
main operative limits are made available. However, it is not required to visit
borrower factory/office premises.

Credit Risk arises because promised cash flows on the primary securities held by
banks may or may not be paid in full. Banks would not face any credit risk if all the

40
financial claims held by them were paid in full on maturity and interest payments
were made on their promised dates. Moreover, banks lend to sensitive sectors such as
capital market sector, real estate sector and the commodities sector. The risk involved
in this lending is what determines the credit risk faced by the bank. The level of
credit risk that a bank is prepared to accept is what in turn determines the level of
lending to each of these sectors.

Interpretation

The banks with higher credit risk makes larger provisions in their Profit and Loss
Statements so as to cover credit risk. This follows the concept of conservatism that
needs to be exercised by banks while preparing the accounts. The figures obtained
conform to the fact private sector banks make higher investments in sensitive sectors.
Public sector banks come out with figures outlining their exposures in three sensitive
sectors i.e stock markets, real estate and commodities sector. This is followed by the
analysis of the same. (See Annexure 1.1)

Credit Risk Measurement

The risk measurement and quantification at the transaction level is of prime

importance in CRM, as it requires few statistical tools.

An increasingly popular model to evaluate (and price) credit risk based on market
data is the RAROC model. The RAROC (Risk Adjusted Return on Capital) is
pioneered by Bankers Trust (acquired by Deutsche Bank in 1998) and now virtually
adopted by large banks. It is a risk adjusted profitability measurement and
management framework for measuring risk adjusted financial performance and for
providing consistent view of profitability across business. Hence it is defined as ratio
of risk adjusted return to economic capital.

Spread (Direct income earned on loan) + fees on loan (one year

income on loan ) - Expected loss Operating cost - Taxes
RAROC = -----------------------------------------------------------------------
Loan (Asset) risk or capital at risk

41
A loan is approved only if RAROC is sufficiently high relative to benchmark return
on capital (ROE) for the FI, where ROE measures the return stockholders on their
equity investment in the FI.

The Basel Committee has suggested the two alternative approaches for calculation of
regulatory capital for credit risks.

The Standardised Approach

Under this approach, RWA (Risk Weighted Assets) is determined as the counter
parties are grouped into Sovereigns, Banks and Corporates. Instead of assigning a
uniform risk weight to all borrowers differential risk weights are assigned on the
basis of external risk assessments by the external credit rating agencies (ECRA). For
Sovereigns, the risk weights range from 0% to 100% and for banks and corporate the
range is from 20% to 150%. This approach ensures that a bank knows the quality of
its exposures to strengthen its capital base according to risks it takes. Its a tool for the
bank to review its exposure and if it finds that its exposures are leaning towards risky
areas, it can take timely corrections.

Counterparty Sovereigns
Credit assessment Risk weights
AAA to AA- 0%
A + to A - 20%
BBB + to BBB - 50%
BB + to B - 100%
<B- 150%
Unrated 100%

Counterparty Other Banks

Credit assessment Risk weights
AAA to AA- 20%
A + to A - 50%
BBB + to BBB - 50%
BB + to B - 100%
<B- 150%
Unrated 50%

42
 Counterparty Corporates
Credit assessment Risk weights
AAA to AA- 20%
A + to A - 50%
BBB + to BBB - 100%
BB + to B - 100%
<B- 150%
Unrated 100%

Internal Ratings Based (IRB)Approach

IRB Approach is more sophisticated as in respect of each exposure (sovereigns,

corporates, other banks, retail loans, project finance, equity investment) banks are
asked to foresee the possibility of a shift in the asset quality over a period of time
which can be done by working out probability of default (PD), the probability of loss
in the event of default (LGD) and the exposure at default.

Probability of Default: A borrower is in default when the obligations to pay

principal and interest are not met. On this basis a loan is deemed to be in default if it
is classified as sub standard. For estimating the PD time horizon is important. Loss
given Default measures the extent of loss on a given exposure in the event of default.
Its a fraction of total exposure whose exact value depends upon the extent of
collateralisation and expressed as a percentage of exposure. Finally the loss to the
bank depends on the value of Exposure at Default. The banks internal model is
expected to produce reliable estimates of PD, LGD, EAD. These estimates must be
based on at least 1-year data sampled over a minimum of 4 quarters. Risk
components derived above are translated into risk weights called Risk Weight
Function.

For corporate exposures, the risk weight function gives the following risk weight for
given PD, LGD, EaD

RWC = Min. ({LGD/50}*BC; 12.5*LGD)

43
Here, LGD is expressed as a whole number (i.e. a 75% loss given default is written as
75) while BC is a benchmark risk weight for corporates prescribed by the supervisor
based on statistical calibration and related to PD. Each calculated risk weight RWC is
multiplied by the corresponding EAD and aggregating over all exposure categories
yields an estimate of RWA for credit.

Managing Credit Risks

Credit Derivatives

The banks can make use of various credit derivative instruments to reduce the
credit risk associated with its loan portfolio. For example removing a pool of
loans from banks balance sheet reduces or disposes of the banks credit risk
exposures from these loans. Similarly, a bank that has just made loans to some of
its customers can sell these loans to other investors who take on the credit risks
inherent in these loans.

Credit Swaps

A Credit Swap is where two lenders agree to exchange portion of their customers
loan repayments. Each bank is granted the opportunity to further spread out the
risk in its loan portfolio especially if the banks involved are located indifferent
market areas. A credit swap permits each institution to broaden the number of
markets from which it collects loan revenue and loan principal thus reducing each
bank dependence on one or narrow set of market areas.

Credit Options

Credit Options guards against losses in the value of a credit asset or helps to off
set higher borrowing cost that occur due to changes in credit ratings.

Securitization of loans:
In case of Securitization selected loans are transferred to a company set up. The
securities are linked directly with the default risk of the tranche they securitize.

44
The securitizing bank provides liquidity facilities to make securities attractive.

CHAPTER- V

MARKET RISK MANAGEMENT

45
Market Risk is defined as the possibility of loss to bank earnings and capital due to
changes in the market variables. It is the risk that the value of on/off balance sheet
positions is adversely affected by movements in equity, interest rate market, currency
exchange rate and commodity prices.

Management of Market Risk is the major concern of top management. The board
clearly articulates market risk management policies, procedures, prudential risk
limits, review mechanisms, reporting and auditing systems. The Asset Liability
Management Committee (ALCO) functions as the top operational unit for managing
the balance sheet within the risk parameters laid down by the board. Moreover, the
banks set up an independent middle office (comprises of experts in market risk
management, economists, bankers, statisticians) to track the magnitude of market risk
on a real time basis. The Treasury Department is separated from middle office and is
not involved in day to day work. The Middle Office apprises top
management/ALCO/Treasury about adherence to risk parameters and aggregate total
market risk exposures.

Liquidity Risk

Liquidity planning is an important facet of risk management framework in banks. It

is the ability to efficiently accommodate deposit, reduction in liabilities, to fund the
loan growth and possible funding of the off balance sheet claims. The liquidity risk of
banks arises from funding of long-term assets by short-term liabilities thereby
making the liabilities subject to refinancing risk.

The liquidity risk in banks manifest in different dimension:

1. Funding Risk: need to replace net outflows due to unanticipated withdrawal/non

renewal of deposits.

2. Time Risk: need to compensate for non-receipt of expected inflows of funds i.e
performing assets turning into non-performing assets.

46
3. Call Risk: due to crystallization of contingent liabilities and unable to undertake
profitable business opportunities when desirable.

Liquidity measurement is quite a difficult task and can be measured though stock or
cash flow approaches. The key ratios adopted across the banking system are (See
Annexure 3):

Core Deposits/Total Assets

Where Core Deposits = 20% of Demand Deposits + 80% of Savings Deposits

For State Bank of India, Central Bank of India and Oriental Bank of Commerce this
ratio is 0.181%, 0.883%, 0.870% while it is 0.065%, 0.128 %and 0.189% for ICICI
bank, IDBI and HDFC bank. This seems to show that PSU banks have a much more
stable deposit base than private sector. This implies that the liquidity position of PSU
banks is more stable which can be attributed to their larger customer /retail base. But
over the years the private sector also has been improving upon his ratio.

Volatile Liabilities/Total Assets

Where volatile liabilities = Demand + Term deposits of other banks

This ratio shows that the State Bank of India face less risk than the ICICI, IDBI and
HDFC bank as these banks rely more heavily on large deposits made by other banks
with them, which are inherently unstable. This exposes the private banks to higher
levels of liquidity risks.

Credit Deposit Ratio

Credit Deposit Ratio = Loans & Advances/Total Deposits

This is a popular measure of the liquidity position of banks. Higher Deposit Ratio
indicates poor liquidity position of the bank while lower figures indicates more
comfortable liquidity positions.

47
 Investments/Total Assets

This ratio is highest for public sector banks reflecting the higher levels of
conservatism in their policies. This is because investments are mainly government
securities and other forms of relatively less risky instruments as compared to loans
and advances, which entail a high level of risk.

The liquidity ratios are the ideal indicator of liquidity of banks operating in
developed markets as the ratios do not reveal the intrinsic liquidity profile of Indian
banks, which are operating generally in an illiquid market. 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 assets and liabilities are classified in different maturity buckets:

1. 1 to 14 days

2. 15 to 28 days

3. 29 days and upto 3 months

4. Over 3 months and upto 6 months

5. Over 6 months and upto 1 year

6. Over 1 year and upto 3 years

7. Over 3 years and upto 5 years

8. Over 5 years

The cash flows are placed indifferent time bands based on future behaviour of assets,
liabilities and off balance sheet items. A maturing liability will be a cash outflow
while a maturing asset will be a cash inflow. The difference between cash inflows and
outflows in each time period the excess of deficit of funds becomes the starting point
for the measure of a banks future liquidity surplus or deficit at a series of points of
time.

48
 Strategies for managing Liquidity risk

The risk arises because of two reasons - liability side reasons (i.e whenever a bank
depositors come to withdraw their money) and asset side reasons (which arises as a
result of lending commitments). The cause and effect of liquidity risk is primarily
linked to nature of assets and liabilities of a bank.

The two approaches used for managing the liquidity risk dimension are:-

(a) Fundamental Approach

(b) Technical Approach

Fundamental Approach

The fundamental approach involves two aspects:

Asset management

This approach aim at eliminating liquidity risk by holding near cash assets that can be
turned into cash whenever required. Likewise the sale of securities from the
investment portfolio can enhance liquidity. Investment can be put in the call market,
government securities or instruments of other corporate as when the funds are put in
the call market they are invested only for the short period where liquidity is ensured
but have lower yield. The risk perceived is low as participants are banks .As investing
in the government securities generally offer higher yields with less risk involved.

Liability Management

In this approach the bank does not maintain any surplus funds but tries to achieve it
through by borrowing funds when the need arises. The disadvantage is that since
funds are raised from various sources and markets any rate fluctuations in a market
enhance the cost of borrowing.

Technical Approach

The technical approach focuses on the liquidity position of the bank in the short run.

49
Liquidity in the short run is linked to cash flows arising due to operational
transactions. Thus if the technical approach is adopted to eliminate liquidity risk it is
the cash flows position that needs to be tackled.

We have analyse the

Call Money Market

The Repo Market and

Liquidity Adjustment Facility (LAF)

Call Money Market

Call money is borrowings between banks for a period ranging from 1 to 14 days.

Factors that affect its demand:

Cash Reserve Ratio

As per the RBI Act 1934, CRR is to be maintained on an average daily basis during a
reporting fortnight by all scheduled banks. This system provides maneuverability to
banks to adjust their cash reserves on a daily basis depending upon intra fortnight
variations in cash flows. For the computation of CRR to be maintained during the
fortnight, a lagged reserve system has been introduced effective November, 1999
whereby banks have to maintain CRR on the net demand and time liabilities (NDTL)
of the second preceding fortnight. With this, banks are able to assess their liability
positions and the corresponding reserve requirements. With a view to provide further
flexibility to banks and enable them to choose an optimum strategy of holding
reserve depending upon their intra-period cash flows, RBI have decided to reduce the
requirements of a minimum of 85 percent of the CRR balance to 65 percent with
effect from beginning May 6, 2000. This has resulted in smoother adjustment of
liquidity between surplus and deficit units and enables better cash management by
banks. The CRR rate currently is 5.75%.

50
Liquidity requirements:

This arises from a liquidity mismatch, which forces banks to borrow for the very
short term.

Speculation

That is, wanting to profit from any arbitrage opportunities between the forex and
money markets. Banks borrow call money at say, 5-6 % and deploy the proceeds to
speculate on the rupee dollar moments in the forex market. Given the general bias on
rupee depreciation, these banks invariably profit from the cross-market deployment.

If the call rates in the meanwhile shoot up the borrowing banks have three options.
First, borrow again in the call market at the higher rate and repay the earlier loan.
Second, sell dollars in the market and buy rupees to repay the loan. Third, attract
deposits from small savers to fund the loan repayment. Mostly banks resort to the
third alternative by hiking deposit rates. In January 1999,for instance, bank raised its
short-term deposit rate to about 18% per annum. It was forced to take this step, as it
had to repay loans on calls and rates in that market which shot up to a high of 140%.
The RBI has banned banks from borrowing in call and trading in the forex market.

Policy Variables

Just before any policy announcement, the overnight rates (or the call rates) seem to
be very volatile largely due to an expectation of a fall in interest rate.

Repo Market

Repo is a money market instrument, which enables collateralized short term

borrowing and lending through sale / purchase operation in debt instruments. Under a
repo transaction a holder of securities sells them to an investor with an agreement to
repurchase at a predetermined date and rate. In case of a repo, the forward clean
price of the bonds is set in advance at a level which is different from the spot clean
price by adjusting the difference between repo interest and coupon earned on the
security. In the money market this transaction is nothing but collateralized lending as

51
the terms of the transaction are structured to compensate for the funds lent and the
cost of the transaction is the repo rate. In other words the inflow of cash from the
transaction can be used to meet temporary liquidity requirement in the short-term
money market at comparable cost.

A reverse repo is the same operation but seen from the other point of view, the
buyers, In a reverse repo the buyer trades money for the securities agreeing to sell
them later. The banks, which hold a large inventory of bonds and G- Secs, use repo to
amass additional funds. Using the securities as collateral they borrow using repo.
Hence whether transaction is a repo or a reverse repo is determined only in terms of
who initiated the first leg of the transaction. When the reverse repurchase transaction
matures the counter party returns the security to the entity concerned and receives its
cash along with a profit spread. One factor that encourages an organisation to enter
into reverse repo is that it earns some extra income on its otherwise idle cash.

Substitutability of the Call money market and the Repo market

The rise in the call money rates often forces met borrowers in the money market such
as private banks today to increasingly resort to repo (short for sale and purchase
agreement) of Government securities for their financing requirements rather than
borrowing from overnight call money market.

At present, the RBI regularly conducts only a three/four day fixed repo. As for the
likely near term trend a relatively calm rupee may prompt the RBI to cut the repo rate
in stages to the earlier levels.

Liquidity Adjustment Fund (LAF)

The aim of the Liquidity Adjustment Facility (replacing Interim Liquidity Adjustment
Facility) is to improve the operational flexibility and the effectiveness of the
monetary policy. It is also appropriate as the financial markets move towards indirect
instruments. It was recommended by the Narasimhan Committee Report on the
Banking Reforms and was announced in the Monetary and the Credit policy for the
year 2000-2001. The LAF operates though repo (for absorption of liquidity) reverse
repo (for injection of liquidity) to set a corridor for money market interest rates. The

52
existing Fixed Rate Repo will be discontinued. So also the liquidity support extended
to all commercial banks (excluding RRBs) and Primary dealers though Additional
Collateralized Lending Facility (ACLF) and finance/reverse repo under level II
respectively will be withdrawn.

Interim Liquidity Adjustment Facility (ILAF)

RBI had introduced collateralized lending against government securities as Interim

Liquidity Adjustment Facility (called Collateralized Lending Facility) to provide
liquidity support to banks in replacement of the General Refinance. The banks could

borrow up to 25 basis points of the fortnightly average outstanding aggregate

deposits in 1997-98 at the bank rate for a period of two weeks. An additional
collateral (called Additional Collateralized Lending Facility) of similar amount was
also made available to banks at 200 basis points over bank rate. CLF and ACLF
availed for periods beyond two weeks were subject to penal rate of 200 basis points
for the next two weeks. However during the period of availing the CLF or ACLF the
banks continue to participate in the money market. The funds from this facility used
by the banks for their day to day mismatches in liquidity. In April 1999, an Interim
Liquidity Adjustment Facility was introduced pending further up gradation in
technology and legal/procedural changes to facilitate electronic transfer and
settlement. The ILAF was operated through a combination of repo, export credit
refinance, collateralized-lending facilities. The ILAF served its purpose as a
transitional measure for providing reasonable access to liquid funds at set rates of
interest. It provided a ceiling and the Fixed Rate Repo were continued to provide a
floor for the money market rates.

For purpose of monitoring liquidity risk RBI requires banks to disclose a statement

on maturity pattern of their assets and liabilities classified in different time buckets.

Liabilities consist of deposits and bank borrowing classified into different time

buckets. Assets consist of loans and advances and investments. Investments in

53
corporate and government debt are combined into one category and bucketed

according to their time to maturity.

Interest Rate Risk

It is the potential negative impact on the Net Interest Income and refers to the
vulnerability of an institutions financial condition to the movement in interest rates.
Changes in interest rate affect earnings, value of assets, liability off balance sheet
items and cash flow. Interest rate risk is particularly important for banks owing to
high leverage and arises from maturity and repricing mismatches.

From the Earning perspective, the focus of analysis is the impact of changes in
interest rate on accrual or reported earnings. This is the traditional approach to
interest rate risk assessment taken by many banks and is measured by measuring
changes in Net Interest Income (NII) or Net Interest Margin (NIM). Economic value
perspective involves analyzing the expected cash in flows on assets minus expected
cash out flow on liabilities plus the net cash flows on off balance sheet items. It
identifies risk arising from long-term interest rate gaps.

In India from 1993 onwards, administrative restrictions upon interest rates have been

54
steadily eased. This has given an unprecedented regime of enhanced interest rate
volatility. In particular, interest rates have fallen sharply in last four years. If interest
rate goes up in future it would hurt banks, which have funded long maturity assets
using short maturity liabilities. By International standards, banks in India have
relatively large fraction of assets held in government bonds and is partly driven by
large reserve requirements. In India, large reserve requirement implies a policy of
stretching out yield curve which innately involves forcing banks to increase the
maturity of their assets.

Banks are faced with different types of interest rate risks:

(a) Gap/Mismatch Risk: It arises from holding assets/liabilities and off balance
sheet items with different principal amounts, maturity dates there by creating
exposure to unexpected changes in the level of market interest rates.

(b) Basis Risk: It is the risk that the interest rate of different assets/liabilities and
off balance items changes in different magnitude.

(c) Embedded Option Risk: It is the option of pre-payment of loan and fore-
closure of deposits before stated maturities.

(d) Yield Curve Risk: It is the movement in yield curve and the impact of that on
portfolio values and income.

(e) Reprice Risk: When assets are sold before maturities.

(f) Reinvestment Risk: Its the uncertainty in regard to interest rate at which the
future cash flows could be reinvested.

(g) Net Interest Position Risk: When banks have more earning assets than

Share of Banking Sector in

Interest Rate Risk

PSBs
11% 3%
Private Sector
Bank 55

86% Foreign Sector

Bank
 paying liabilities, net interest position risk arises in case market interest rates
adjust downwards.

Share of Banking Sectors in total

G -Sec Investment
PSBs
14% 5%
Private Sector
Bank
81% Foreign Sector
Bank

There are different techniques as (a) traditional maturity gap analysis to

measure interest rate sensitivity (b) Duration gap analysis to measure interest rate
sensitivity of capital (c) simulation (d) value at risk for measurement of interest rate
risk. The approach towards measurement and hedging interest rate risk varies with
segmentation of banks balance sheet. Banks broadly bifurcate asset into trading book
and banking book as trading book comprises of assets held for generating profits on
short term differences in prices and banking book consists of assets/liabilities on
account of relationship or steady income and are generally held till maturity by
counter party.

Gap Analysis

The Gap or Mismatch risk can be measured by calculating gaps over different time
intervals as at a given date. Gap Analysis measures mismatches between rate
sensitive liabilities and rate sensitive assets (including off balance sheet positions).

The Gap may be identified in the following time buckets: (See Annexure 2.1 2.6)

1. 1-28 days

2. 29 days and upto 3 months

3. 3 Over 3 months and upto 6

months

56
 4. 4 Over 6 months and upto 1
year

5. 5 Over 1 year and upto 3

years

6. 6 Over 3 years and upto 5

years

7. 7 Over 5 years

8. Non - sensitive

The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket. The positive gap indicates that it has more
RSAs whereas the negative gap indicates that it has more RSLs. The gap reports
indicate whether the institution is in a position to benefit from rising interest rates by
having the positive gap (RSA>RSL) or whether it is in a position to benefit from
declining interest rate by the negative Gap (RSL >RSA).

The Gap can, therefore, be used as a measure of interest rate sensitivity.

Relationships in Gap Analysis

GAP Change in Change in Interest Change in Interest Change in Net
Interest Rates Income Expense Interest Expense

Positive Increase Increase > Increase Increase

Positive Decrease Decrease > Decrease Decrease
Negative Increase Increase < Increase Decrease
Negative Decrease Decrease < Decrease Decrease
Zero Increase Increase = Increase None
Zero Decrease Decrease = Decrease None
Annexure 2.1-2.6 shows the calculation of GAP analysis in the sample banks
Gap Analysis

Bank 1-14 days 15-28 days 29daysto 3 3 6 mths 6m-1 yr. 1-3 yr. 3-5yr Above 5yr Non rate
months sensitive
SBI 9967.9 -374.8 -2149.3 -7256.7 -9191.5 -127890 -28058.8 42953.2 -360853.464
ICICI 14837.3 8932.5 -34777.9 -53580 -24757.4 -112132.2 67133.7 239193.3 -90529.95
CBI 9967.9 -374.8 -2149.3 -7256.7 -9191.5 -24070.1 -28058.8 42953.2 1532.246
OBC -762.75 -624.01 -2626.77 -3837.54 -5315.8 -3496.19 3061.72 15077.98 -106772
HDFC 19255.3 2071.5 35140.4 2825 -3583 -56591.4 25545.4 16848.5 -47987.4
IDBI -148959.1 -641906.5 -793128.3 -1338751.5 -739898.2 -1843325 521801.6 4758892.6 -1548

57
 Bank RSA/RSL Bank RSA/RSL

SBI 0.634039 OBC 0.789439

ICICI 1.01254 HDFC 0.985092

CBI 0.973785 IDBI 0.981659

Duration Analysis

Duration is the time weighted average maturity of the present value of the cash flows
from assets, liabilities and off balance sheet items. It measures the relative sensitivity
of the value of instruments to changing interest rates (the average term to re - pricing)
and therefore reflects how changes in interest rates affects the institutions economic
value that is the present value of equity. The longer the term to maturity of an
investment, the greater the chance of interest rate movements and hence unfavourable
price changes.

Duration measure how price sensitive an asset/liability or off balance sheet item is to
small changes in interest rates by using a single number to index the institution
interest rate risk. This index represents the average term to maturity of the cash flows.
Hence, the Duration method is used to measure the expected change in market value
of equity (MVE) for a given change in market interest rate.

The difference between duration of assets (DA) and liabilities (DL) is banks net
duration. If the net duration is positive (DA>DL), a decrease in market interest rates
will increase the market value of equity of the bank. When the duration gap is
negative (DL>DA) increase in market interest rate will decrease the market value of
equity of the Bank.

Simulation Models

Simulation model is a valuable to complement gap and duration analysis. It analyse

interest rate risk in a dynamic context and evaluate interest rate risk arising from both
current and future business and provides a way to evaluate the effects of strategies to
increase earnings or reduce interest rate risks. Simulation model is useful tool for

58
strategic planning; it permits a member institution to effectively integrate risk
management and control into planning process. Their forecasts are based on a
number of assumptions including:

Future levels and directional changes of interest rates

The slope of yield curve and the relationship between the various indices that the
institution uses to price credits and deposits

Pricing strategies for assets and liabilities as they mature

The growth volume and mix future business

Simulation is used to measure interest rate risk by estimating what effect changes in
interest rates, business strategies and other factors will have on net interest income,
net income and interest rate risk positions.

Value At Risk

VaR is an alternative framework for risk measurement. If the VaR with respect to
interest rate risk of bank is desired, at a 99 % level of significance on a one-year
horizon then we would need to go through following steps:

1. Model the data generating process for zero coupon yield curve.

2. Simulate N draws from yield curve on a date one-year away.

3. Reprice assets and liabilities at each of these draws.

4. Computethe 1th percentile of distribution of profit/loss seen in Nth realisation.

This procedure is difficult to implement primarily because existing state of

knowledge on data generating process for yield curve is weak.

Interpretation:

In actual, banks measure interest rate risk using two different alternative
methodologies: (a) Accounting disclosures by banks: here vectors of future cash

59
flows that make up assets and liabilities are imputed. This are then repriced under
certain interest rate scenarios that are based on BIS norms and gives an estimate of
impact of interest rate shock upon equity capital of bank. In addition, interest rate
risks of various banks are perceived by (b) stock market. When interest rate
fluctuate, stock market speculators utilise their understanding of exposure for each
bank in forming share price.

Measurement of market risk

Market Risk: Standardised Approach

Under the standardised approach five distinct sources of market risk are identified
viz. Interest rate risk, Equity position risk, Foreign exchange risk, Commodities Risk
and Risk from options.

Market Risk IRB Approach

Here, banks are allowed to base market risk charges on their own on internal models
but additionally a process called stress testing is to be included.

The crucial input in the IRB approach is a VaR (value at risk) model. A VaR estimate
is an appropriate percentile of the bank portfolio loss distribution. For any given bank
portfolio one can calculate a loss distribution showing the probability of various
amounts of loss.

The three crucial concepts in a VaR are:

The confidence coefficient (whether 95%,99%,or 99.9%).

The Historical period used for estimating the model.

The holding period i.e the period over which the portfolio is considered to beheld
constant. Portfolios cannot be adjusted instantaneously because of transaction
costs, lock in periods etc.

The Basel Accord II proposes a confidence coefficient of 99% a holding period of 10

60
days and a historical period of observation of at least 1 year. The VaR estimate is to
be computed on a daily basis incorporating additional information becoming
available on a daily basis.

Each bank must meet on a daily basis, a capital requirement expressed as the higher
of the following two factors

Previous days VaR estimate (An average of the VaR of the preceding 60 business
days)*m

Here m is a multiplication factor set as

m = 3+plus factor

Where plus factor is related to the performance of the particular banks VaR model.
The value ranges from 0 (exceptionally good performance) to 1(poor performance)

Stress Testing is an important dimension of the IRB approach.

Managing Interest Rate Risk

Interest Rate Risk is a very critical problem for banks and they use a number of
derivative instruments to hedge against Interest Rate Risk. Some of the instruments
used by banks are Interest Rate Futures, Interest Rate Options, Interest Rate Caps,
Collars and Interest rate Swaps. This risk is considerably enhanced during a period
when decline in the interest rates bottom out and begins to move in the opposite
direction. In India, this risk is further exacerbated since it is the Reserve Bank of
India (RBI) --- and not the market forces --- which still dictate the prevailing level of
interest rates.

Interest Rate Futures

A bank whose asset portfolio has an average duration longer than the average
duration of it liabilities has a positive duration gap. A rise in the market interest rate
will cause the value of bank assets to decline faster than the liabilities reducing the
banks net worth and vice versa.

61
A financial futures contract is an agreement between a buyer and a seller reached at
this point of time that calls for the delivery of a particular security in exchange for
cash at some future date.

Interest Rate Swaps

After the Reserve Bank of India gave a green signal to banks to hedge themselves
again interest rate uncertainties through plain --vanilla interest rate swaps (IRSs) and
forward rate agreements (FRAs) in the April 1999 monetary policy, the banks have
used this as a major tool in interest rate risk management. There are many players in
market---- HDFC bank, ICICI bank.

An Interest Rate Swap (IRS) is defined as a contractual agreement entered into

between two banks under which each agrees to make periodic payment to other for
an agreed period of time based upon a notional amount of principal. The principal
amount is notional because there is no need to exchange actual amounts of principal.
A notional amount of principal is required in order to compute the actual cash
amounts that will be periodically exchanged. An IRS is way to change an institution
exposure interest rate fluctuation and also achieve lower borrowing cost. Swaps can
transform cash flows through a bank to more closely match the pattern of cash flows
desired by management.

Rationale behind an Interest Rate Swap

Interest Sensitive Gap = Rate Sensitive Assets Rate Sensitive Liabilities

Table No.5

Interest Rate Gap Interest Rate Increase Interest Rate Decrease

Positive Gap Favorable Position Unfavorable Position

Negative Gap Unfavorable Position Favorable Position

62
 Fixed for- Floating Rate Swap

A series of payments calculated by applying a fixed rate of interest to a notional

principal amount is exchanged for a stream of payments similarly calculated but
using a floating rate of interest. Swap participants can convert from fixed to floating
or vice versa and more closely match the maturities of their assets and liabilities.

Overnight Index Swaps (OIS)

The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate
is linked to an overnight /call money index. The interest is computed on a notional
principal amount and the swap settles on a net basis at maturity.

Quality Swap

Under the terms of the agreement called a Quality Swap, a borrower with a lower
credit rating typically a smaller bank enters into an agreement to exchange interest
payment with a borrower having a higher credit rating, typically a large nationalized
bank. In this case the lower credit rated bank agrees to pay the higher-credit-rated
bank fixed long term borrowing cost. In effect, the low credit-rated bank receives a
long - term loan at a much lower interest cost than the low rated bank could
otherwise obtain. At the same time the bank with the higher-credit-rating covers all or
a portion of the lower rated banks short term floating loan rate, thus converting a
fixed long term interest rate into amore flexible and possibly cheaper short term
interest rate. Swaps are often employed to deal with asset liability maturity
mismatches.

Interest Rate Hedging Devices

Interest Rate Caps

It protects its holder against rising market interest rates. In return for paying an up
front premium, borrower are assured that institutions lending them money cannot
increase their loan rate above level of the cap. The bank may alternatively purchase

63
an interest rate cap from a third party (say from financial institutions) which promises
to reimburse borrowers from any additional interest they owe their creditors beyond
the cap. Thus the banks effective borrowing rate can float over time but can never
increase the cap. Banks buy interest rate caps when conditions arise that could
generate losses such as bank finds itself funding fixed rate assets with floating rate
liabilities, possesses longer term assets than liabilities or perhaps holds a large
portfolio of bonds that will drop in value when interest rates rise.

Interest Rate Floors

Banks can also lose earnings in periods of falling interest rates especially when rates
on floating rate loan decline. A Bank can insist on establishing an interest rate floor
under its loans so that no matter how far loan so that no matter how far loans rates
tumble, it is guaranteed some minimum rate of return.

Interest Rate Collars

This instrument combines in one agreement a rate floor and rate cap. The collar
purchaser pays a premium for a rate cap while receiving a premium for accepting a
rate floor. The net premium paid for the collar can be positive or negative, depending
upon the outlook for interest rates and the risk aversion of the borrower and the
lender at the time of the agreement. Banks can use collars to protect their earnings
when interest rates appear to be unusually volatile.

64
 CHAPTER VI
OPERATIONAL RISK
MANAGEMENT

65
 Defining operational risks

Basel Committee on Banking Supervision (BCBS; September 2001) defines

operational risk as the risk of monetary loss resulting from inadequate or failed
internal processes, people, systems or from external events. It is an evolving and
important risk factor faced by banks and banks need to hold capital to protect against
losses from it. The recent happenings such as WTC tragedy, Barings debacle etc. has
highlighted the potential losses on account of operational risk.

The key drivers of Operational Risk:

Regulatory pressure (Basel II), Increased awareness, Opportunity for performance

improvement.

Banks are however, still not entirely clear on how to implement the capital
requirements for operational risk.

Risk Mapping/Profiling

Risk Mapping is a process of breaking down the banks business into various
functional lines and assessing the various risk elements involved in each of these
lines. It involves listing out of the existing controls for identified risks. Both the risks
listed and existing controls are graded as low, medium and high categories. It is a
dynamic exercise and subject to continuous review based on experience gained from
various loss events. The operational risk relates to failure of people, technical, legal
and internal processes.

People Risk
(a) Internal/External Frauds

(b) Inadequate Staff

(c) Hiring Unsuitable Staff

(d) Loss of key personnel

(e) Insufficient training

(f) Insufficient succession

66
Process Risk
(a) Transaction without proper authority

(b) Erroneous cash movements

(c) Limit Breaches

(d) Unlawful Access

(e) Incorrect recording/reporting of information

Technical Risk

(a) Programming errors

(b) Incomplete/Inaccurate/Irrelevant MIS

(c) Network failure

(d) Telecommunication failure

(e) Inadequate system protection

(f) Lack of IT support services

(g) Inadequate back-up systems

External Risk
(a) Natural Disasters (flood, fire etc)

(b) War/terrorism

(c) Sabotage/crime

(d) Collapse in market

Legal, Reputation and Other Risk

(a) Incomplete Documentation

(b) Breaches of statutory Requirements

(c) Failure to follow regulatory guidelines

(d) Changes in business activities not incorporated

(e) Group Risk

67
 Measuring operational risk

A key component of risk management is measuring the size and scope of the firms
risk exposures. As yet, however, there is no clearly established, single way to
measure operational risk. Instead, several approaches have been developed. An
example is the matrix approach in which losses are categorized according to the
type of event and the business line in which the events have occurred. The bank
hopes to identify which events have the most impact across the entire firm and which
business practices are most susceptible to operational risk.

Once potential loss events and actual losses are defined, a bank analyze in
constructing databases for monitoring such losses and creating risk indicators, which
summarize these data. Potential losses are categorized broadly arising from high
frequency, low impact(HFLI) events such as minor accounting errors or bank teller
mistakes, and low frequency, high impact(LFHI) events, such as terrorist attacks or
major fraud. Data on losses arising from HFLI events are generally available from a
banks internal auditing systems. However, LFHI events are uncommon and thus
limit a single bank from having sufficient data for modelling purposes. For such
events, a bank needs to supplement its data with that from other firms. Although
quantitative analysis of operational risk is an important input to bank risk
management systems, these risks cannot be reduced to pure statistical analysis.
Hence, a qualitative assessment, such as scenario analysis will be an integral part of
measuring a banks operational risks.

Mitigating operational risk

In broad terms, risk management is the process of mitigating the risks faced by the
bank, either by hedging financial transactions, purchasing insurance, or even
avoiding specific transactions. With respect to operational risk, several steps should
be taken to mitigate such losses. For example, damages due to natural disaster can be
insured against. Losses due to internal reasons, such as employee fraud or product
flaws are harder to identify and insure against, but they can be mitigated with strong
internal auditing procedures. Banks are yet to get clarity on the issues that are to be
included in operational risk but system vendors have identified that proper workflow

68
and process automation can help in reducing and detecting errors. Right levels of
audit and control, good management information systems and contingency planning
is necessary for effective operational risk management.

The framework consists of two general categories. The first includes general
corporate principles for developing and maintaining a banks operational risk
management environment. For example banks governing board of directors should
recognize operational risk as a distinct area of concern and establish internal
processes for periodically reviewing operational. To foster an effective risk
management environment the strategy should be integral to a banks regular activities
and should involve all levels of bank personnel. The second category consists of
general procedures for actual operational risk management. For example, banks
should implement monitoring systems for operational risk exposures and losses for
major business lines. Policies and procedures for controlling or mitigating operational
risk should be in place and enforced through regular internal auditing.

Since, all the banks have introduced internet banking, to mitigate the operational risk
in internet banking multi layer security like digital certification, encryption, two level
passwords have been introduced.

Capital budgeting for operational risk

Banks hold capital to absorb possible losses from their risk exposures, and the
process of capital budgeting for these exposures, including operational risk, is a key
component of bank risk management. In parallel with industry developments, BCBS
proposed in 2001 that an explicit capital charge for operational risk be incorporated
into the new Basel Capital Accord. The committee initially proposed that the
operational risk charge constitutes 20% of a banks overall regulatory capital
requirement, but after a period of review, the committee lowered the percentage to
12%. To encourage banks to improve their operational risk management systems, the
new Basel Accord have also set criteria for implementing more advanced approaches
to operational risk. Such approaches are based on banks internal calculations of the
probabilities risk events occurring and the average losses from those events. The use
of these approaches will generally result in a reduction of the operational risk capital

69
requirement, as is currently done for market risk capital requirements and is proposed
for credit risk capital requirements.

TCS (Tata Consultancy Services) has developed a meta model to capture capital
allocation for operational risk in terms of guidelines laid down by New Capital
Accord.

The ultimate goal of Basel proposal is to measure operational risk and computation of
capital charges, but what is to be done at present by all the surveyed banks is to start
implementing the Basel proposal in phased manner and carefully plan in that
direction.

Basel Accord II offers tentative suggestions on the treatment of operational risk

which are expected to be developed more fully in the coming months.

Basel Committee has identified following 10 principles for

successful management of Operational Risk:

Board of Directors should be aware of major aspects of operational risk of the

organisation as distinct risk category.

The Board of Directors should ensure that operational management framework of

the organisation provides for effective &comprehensive internal audit.

Senior management of the organisation should consistently implement approved

operational management framework of the organisation.

In all material products, activities, processes and systems operational risk contract
should be identified and assessed.

Regular Monitoring System of operational risk profiles and material exposures to

losses should be in place.

Policies, processes and procedures to control/mitigate operational risk should be

evolved.

70
 Contingency and business continue plans should be evolved.

Regulatory Authorities may ensure that appropriate mechanisms are put in place
to allow them to remain apprised of position of operational risk management of
the supervised organisations.

Regulatory Authorities should review periodically about organisation approach to

identify, assess, monitor, and control/mitigate operational risk.

Adequate public disclosures to be made to enable market participants to assess

organisations approach to operational risk.

71
 CHAPTER VII
BASEL II COMPLIANCE & RISK
BASED SUPERVISION

72
 BASEL II COMPLIANCE

The 1988 Capital Accord suffered from several drawbacks as it exclusive focus on
credit risk, it does not differentiate between sound and weak banks using one hat fit
all approach, it acquire broad brush structure. Hence, in order to remedy the Basel
Committee published a New Accord in Dec 2001, which was implemented by most
countries by 2006.Basel II focuses on achieving a high degree of bank-level
management, regulatory control and market disclosure.

The structure of New Accord II consists of three pillars approach

which are as follows:

Pillar Focus area

I Pillar Minimum capital requirement

II Pillar Supervisory review

III Pillar Market discipline

Minimum Capital Requirement

The major change in the first pillar is in measurement of risk weighting. It allows
banks certain latitude in determining their or own capital requirements based on
internal models and focus on credit risk, market risk and operational risk.

The minimal ration of capital assigned to risk is calculated as follows:

Total Capital (unchanged)

Banks Capital Ratio (min 8%) = ----------------------------------------------------------
(RBI prescribes 9 %) Credit risk + Market risk + Operational risk
For Credit Risks three alternative approaches are suggested. The first is a
standardised approach in which RWA (risk weighted assets) is determined except
that the risk weights are no longer determined in asset once but are revised depending
upon the ratings of the counter parties by external credit rating agencies (ECRA).
There is also greater differentiation across risk categories. In the second approach

73
called the internal ratings based approach (IRB) banks rates the borrower and results
are translated into estimates of a potential future loss amount which forms the basis
of minimum capital requirement. In Advanced internal rating based approach the
range of risk weights are well diverse.

For Market Risks also a similar twin track approach is followed. Here capital
charges are determined and then multiplied by 12.5 to make them comparable to the
RWA. Secondly a special type of capital (Tier3) is introduced for meeting market risk
only.

For meeting operational risk Accord II has specified three alternative

approaches- basic indicator, standardised and internal measurement approach. For
operational risk capital charges are computed directly and then multiplied by 12.5 to
make it comparable to RWA.

Thus D (denominator of the capital adequacy ratio) is defined as

D =RWA + 12.5 * (Sum of capital charges due to market and operational risk)

The numerator N consists of

N = Tier I + Tier II + Tier III

Subject to the proviso that

Tier I + Tier II > 0.08(RWA +12.5{capital charges on account of operational risk})

To meet market risk special type of capital viz. Tier III capital has been introduced in
the New Accord which consist of short term subordinated debt but with a minimum
original maturity of 2 years. Tier III capital cannot exceed 250% of the Tier I capital
to meet market risk.

The column chart shows the capital adequacy ratios of surveyed banks. Capital
adequacy in relation to economic risk is a necessary condition for the long-term
soundness of banks. The maintenance of capital adequacy is like aiming at a moving
target as the composition of risk weighted assets gets changed every minute on

74
account of fluctuation in a risk profile of bank. Minimum capital adequacy ratio of 8
% implies holding of Rs. 8 by way of capital for every Rs. 100 risk
assets.weighted

Capital Adequacy Ratio (%)

2008 2009
SBI 14 14.4
ICICI 11.1 10.36
HDFC 10.5 12.2
IDBI 9.56 10.4
OBC 12.8 10.9
CBI 9.47 11.3

Supervisory Review Process

It entails allocation of supervisory resources and paying supervisory attention in

accordance with risk profile of each bank, optimise utilisation of supervisory
resources, continuous monitoring and evaluation of the risk profiles of the supervised
institution and construction of a risk matrix of each institution. The process requires
supervisors to ensure that each bank has sound internal processes in place to assess

75
the adequacy of its capital based on through evaluation of its risk.

Market Discipline

The potential of market discipline to reinforce capital regulation depends on the

disclosure of reliable and timely information with a view to enable banks counter
parties to make well founded risk assessments. Moreover, banks are encouraged to
disclose ways in which they allocate capital among different activities. In a recent
paper the BIS has elaborated the recommendations of the Basel II concerning the
nature of information to be disclosed:

1) Structure and components of bank capital.

2) The terms and main features of capital instruments.

3) Breakdown of risk exposures.

4) Its capital ratio and other data related to its capital adequacy on a consolidated
basis.

Reservations about Basel II

One of the major critiques of the New Basel Accord pertains to the adoption of an
internal rating based (IRB) system as the application of IRB is costly,
discriminates against smaller banks and exacerbate cyclical fluctuations.

Basel II involve shift in direct supervisory focus away to implementation issues

and that banks and the supervisors would be required to invest large resources in
upgrading their technology and human resources to meet minimum standards.

Only those banks likely to benefit from IRB will adopt approach, other banks will
hold on to the standardised approach.

Fears of disintermediation have also been expressed.

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 RISK BASED SUPERVISION REQUIREMENTS

Background

RBI Governor in assistance with PriceWaterHouse Coopers (PWC) an international

consultant laid an overall plan for developing Risk Based Supervision. The CAMELS
(capital adequacy, asset quality, management, earnings, liquidity, systems &
controls)/CALCS (capital adequacy, asset quality, liquidity, compliance & systems)
approach to supervisory risk assessments and ratings, tightening of exposure and
enhancement in disclosure standards are all introduced by RBI to align the Indian
banking system to International best practices.

Current Supervisory Approach

The current on site inspection driven approach of RBI is supplemented by off site
monitoring and surveillance system (OSMOS) and supervisory follow up. It provides
an opportunity to the regulator to monitor banks performance based on
CAMELS/CALCS approach.

The major features of current supervisory are:

Annual Financial Inspection (AFI) of banks.

Asset size determines the length of inspection.

All areas of banks operations are covered.

Focus remains on transaction and asset valuation, compliance with regulations

and banking laws.

Focus of follow up remains on rectification rather than prevention.

Risk Based Supervision (RBS) A New Approach

RBS looks at how well a bank (supervised) identifies, measures, controls and
monitors risks. It not only tries to identify systemic risks caused by the economic
environment in which banks operate but also management ability to deal with them.

77
Focussed approach under RBS entails allocation of supervisory resources and paying
attention in accordance with the risk profile of supervised (bank) which would further
optimise utilisation of supervisory resources. It involves assessing and monitoring the
risk profile of banks on an on going basis in relation to business and exposures and
prompt banks to develop systems rather than transactions.

RBI decided to switch over to RBS due to autonomy of banks, increased competition,
globalisation, automation and market disclosure / transparency.

Features of RBS Approach

1) Risk Profiling of Banks: CAMELS rating is one of the core of risk profile
compilation and the risk profiling of each bank draws upon a wide range of
information such as market intelligence reports, onsite findings, adhoc data from
external and internal auditors. Risk profile document contains SWOT analysis,
Sensitivity analysis, Monitorable action plan and banks progress to date.

2) Supervisory Cycle: It varies according to risk profile of each bank, the

principle being higher the risk shorter will be the cycle of supervision. In short
term supervisory cycle remains at 12 months but it can be extended beyond 12
months for low risk banks.

3) Supervisory Programme: It is prepared at the beginning of supervisory

cycle. On site inspection is targeted to specific areas and a MAP (monitorable
action plan) is drawn up for follow up to mitigate risks to supervisory objectives
posed by individual banks.

4) Supervisory Organisation: It is the focal point for main conduit for

information and communication between banks and RBI.

5) Enforcement process and Incentive framework: RBS ensures that the

banks with a better compliance record and a good risk management control
system is entitled to an incentive package like longer supervisory cycle.
Moreover, banks that fails to show improvement in response to MAP is subject to
frequent supervisory examination.

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The effectiveness of RBS depends on bank preparedness. Hence, RBI
initiates banks to set up Risk Management Architecture, adopts Risk Focussed
Internal Audit (RFIA), strengthen MIS. There should be well-defined standard of
corporate governance, well-documented policies and practices with clear demarcation
of lines of responsibility and accountability. Moreover, for effectiveness of RBS
formation of separate Quality Assurance Team (QAT) should be there where
members are not involved in preparation of Risk Profile Templates (RPTs). RPTs is
defined as a standardized and dynamic document that captures, catalogues, assesses
and aggregate risks that bank are exposed to. It works as a comprehensive guide to
RBI for informed and focussed supervisory action in high-risk areas in banks, fix up
supervisory cycle and supervisory tools.

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 CHAPTER VIII
ANALYSIS OF SURVEY
RESPONSES

80
There are certain parameters on which bank degree of readiness for risk management
is ascertained.

Documented Risk Management Policy

All the private sector banks surveyed have 100% documented risk management
policy i.e it covers credit, market and operational risk. Among the PSU its only
SBI and Central Bank of India, which covers all the three aspects of risks.
Oriental Bank of Commerce concentrates only on credit risks.

All the banks follow Integrated Risk Management Practices.

Internal Credit Rating Models

All the banks follow internal credit rating model. This high percentage among
banks shows an adoption of scientific approach to credit risks in Indian Banking
sector.

Compilation of Migration and Default Statistics

Its only SBI which track probability of default and rating migration and same is
in case of tracking loss given default. However, there were no comments on this
from other banks. Moreover, all the six banks report that contingent liabilities fall
within purview of their risk management processes.

On the matter of Exposure Limits all the banks surveyed define it in terms of
counter party, group and industry

Frequency of Loan account review

In this parameter ICICI, HDFC, IDBI, SBI, OBC review loans after every three
months or six months whereas Central Bank of India still follows 12-month cycle.
As regular analysis of the loans portfolio feed into banks lending strategy.

81
 Evaluating Credit Risk at Portfolio level

To have a comprehensive understanding of credit risk banks evaluate credit risk at

portfolio level. ICICI,IDBI, HDFC banks carries out such analysis whereas in
public sector banks this analysis is carried out only by SBI. Over 85 % of the
corporate credit portfolio is now rated A and above in IDBI. HDFC bank is also
termed to be the best in industry in portfolio quality.

NII (Net Interest Income) Sensitivity Analysis

The surveyed banks are carrying out regular NII Sensitivity Analysis.

Periodic Review of Liquidity Position

SBI, ICICI, HDFC periodically review their liquidity position under normal and
stress scenarios whereas OBC, IDBI does not review the liquidity position
periodically.

interest rate shocks Our result shows that in addition to credit risk, interest rate
risk is also important in Indian banking system. The potential impact of upon
equity capital of surveyed banks in system seems to be economically significant.

Daily Mark-to-Market of Trading Portfolio

In this area a substantial divergence of practices is found between private sector

banks and public sector banks. SBI, OBC, ICICI and IDBI bank are carrying out
daily mark to market trading portfolio whereas Central Bank of India and HDFC
bank didnt comment on this.

Daily VaR (Value at Risk ) of Investment Portfolio

IDBI, SBI, ICICI Banks calculate a daily Value at Risk (VaR) of trading portfolio
where as rest of banks have fixed their own timeframe for moving to Value at
Risk and Duration approach for measurement of interest rate risk.

Limits on Derivative transactions

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 This is one of the essential components of market risk control. ICICI, SBI,
HDFC, IDBI, OBC, CBI banks have placed limits on derivative transactions This
is all due to strong monitoring and control system that derivative activity takes
place in these banks.

SBI, IDBI, OBC, ICICI banks maintain a certain level of investment fluctuation
reserve to guard against any possible reversal of interest rate.

OBC, IDBI Bank stand out as banks, which have large exposures by both,
approaches i.e accounting disclosures and stock market approach.

Among the six banks in our sample no bank proves to have significant reverse
exposures in the sense that they stand to earn profits in event of when interest
rate goes up.

It is striking to observe that three banks with best stock market liquidity SBI,
ICICI, HDFC bank there is good agreement between the results from two
approaches.

ICICI Bank, HDFC Bank and SBI seem to fairly hedged w.r.t interest rate risk.

SBI, ICICI banks have operational risk management system but rest of the
surveyed banks did not have, as its the area where structural focus is relatively
nascent.

While putting the risk management in place HDFC, IDBI, Central bank of India
finds difficult to collect reliable data. The challenge is mainly in the area of
operational risk where there is dearth of reliable historic data and not a great deal
of clarity of the measurement of risk. Banks like Oriental Bank of Commerce and
ICICI bank have sophisticated technologies.

Banks following Score card approach

Scorecard approach is followed for operational risk mitigation. None of the banks
surveyed follow this approach, as they didnt comment on this.

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 Bank conducting Risk Based Internal Audit

IDBI, SBI, OBC and ICICI bank conduct Risk Based Internal Audit as per RBI
guidelines whereas central bank of India & HDFC Bank did not comment on this.

Bank on Inhouse/Outsource software for risk management

All the three surveyed private banks go for readymade solutions since creating in
house system proves to be expensive whereas established public sector banks like
SBI, OBC for whom funds are not constraint thinks of developing in house
software but they still go for outsourcing as the chief benefit of it is the speed of
implementation and it temporarily reduce the load of the back office employees.
If bank has in house software then there is nothing like it in terms of delivery
time since changes can be incorporated in an expeditious manner. Moreover, bank
need to have a separate department of IT professionals working full time on
product design and development. But finally the decision regarding this rest on
efficiency and accuracy in valuation and consequent risk analysis.

State Bank of India is teaming with KPMG Consulting Pvt. Ltd. (international
consultant) for software solutions. However, other banks did not comment on
this.

Capture of Risk data on regular basis

Banks such as SBI, ICICI, OBC captures risk data on regular basis whereas other
bank do not capture data on regular basis.

Information systems for live aggregation of risk parameters

Only SBI and ICICI bank follow the presence of information system, which
aggregate risk parameters on live basis.

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 Table No. 6
Table showing key performance indicators determining the profitability of banks

Key Performance (Financial) Indicators

SBI ICICI HDFC IDBI OBC CBI
2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009
ROA (%) 0.89 1.05 1.2 1.4 0.91 1.5 0.9 1.02 0.86 1.03 0.8 1.2
ROE (%) 18.65 20.16 18.3 21.8 20.1 20.4 21.7 27.5 20.3 22.5 21.5 23.8
Capital Adequacy 14.03 14.4 11.1 10.36 10.5 11.21 9.56 10.36 12.8 10.9 9.47 11.3
Ratio (%)
Net Interest 3.09 3.2 1.4 1.8 3.8 3.9 2.75 3.1 3.9 4.7 3.79 3.79
Margin (%)

Some of the ratios used for analyzing the aspect of risk management
are as follows: -

Cost of Funds = Total Interest Expense / Interest bearing liabilities

where Interest bearing liabilities = Deposit + Borrowings

On analyzing this ratio we see that all the six banks have the lower cost of funds in
year 2009 as compared to 2008. The reason for this is the larger retail base that result
in being able to raise capital in small lots.

Net Interest Margin = Net Interest Income/Earning Assets

where Net Interest Income = Total Interest Income - Total Interest Expenses

Earning Assets = All Interest earning assets (Total Assets - Cash Balance - Fixed
Assets - Other Asset)

This figure is critical component of the analysis of the risks faced by banks and
other financial institutions. The impact of volatility on the short-term profits is
measured by Net Interest Margin. It is at level of 3%, 3.7%, 4.7% for SBI, CBI
and OBC bank in year 2009 while it is 1.7%, 2.8%, 3.5% for ICICI bank, IDBI
and HDFC bank. Only Central Bank of India is the bank among all the six banks,

85
 which is able to stabilize short-term profits as net interest margin for year 2008
and 2009 is same (3.79%).

Spread = Yield Cost of Funds

where Yield = Total Interest Earned/Earning Assets

The level of spread at which each bank operates is different. The private banks have
narrower spread as compared to the PSU bank. They do not differ significantly and
the difference is in range of 1%.

On having a closer look at the yield curves of the various subdivisions with in each
sector on the basis of size we see that there is clear trend towards convergence over
the period 2008-2009.

Overhead Efficiency = Non Interest Income/Non Interest Expense

This ratio gives us an idea of the ability of banks from the fee-based activities
undertaken by them. This is becoming a very critical component of the probability of
a bank as the spreads are becoming thinner and thinner over the years as a result of
increased competition. This is a good method of improving their top line as this
increased income can be generate without any significant additions to the fixed assets
as well as without there being the need to raise additional deposits or borrowings
from the market.

AssetUtilization = Total Revenue/Total Assets

The asset utilization ratio for the public sector banks namely SBI, OBC, and CBI is
around 10% over the two-year period whereas HDFC, ICICI and IDBI bank asset
utilization is of 8%, which is lower than that of the PSU banks. This makes sense that
asset utilization capability of the banks cannot be change rapidly over a short period
of time.

Burden/Spread

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Burden is the Net Non Interest Income and Spread is the Net Interest expense. This
gives us an insight into the proportion of income coming from the fee based activities
of banks as against those that are derived from the fund based activities. This in turn
tells us the kind of areas where bank is focusing on a present and the pattern which
they a likely to follow in the future.

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 CHAPTER IX
OBSERVATIONS AND
SUGGESTIONS

88
The present chapter is divided into two sections. First part consists of major
observations of study and second part comprises of its suggestions. Observations
initiate further refinements in the existing structure while suggestions provide better
guidelines in the efficient working of the organisation.

Hence, based on the responses to the questionnaire and the personal meetings with
senior risk professionals in banks a few major findings of study are:

There is much greater awareness across the banking sector about the need for risk
management and the various categories of risk which banks are exposed to. A
separate credit risk department distinct from credit function has been set up in all
the surveyed banks. This implies substantial progress from three years ago when
risk management was new concept for all except the most advanced and
sophisticated banks.

Degree of readiness for integrated risk management among banks differs widely.
As there are banks which have several years risk data and sophisticated risk
models, there are also other banks, which have started the process of systematic
capturing of risk data. Degree of readiness also differs with regard to the risk
elements covered.

While putting the risk management in place banks surveyed often find it difficult
to collect reliable data. The challenge is mainly in the area of operational risk
where there is dearth of reliable historic data and not a great deal of clarity on the
measurement of risk.

Risk Management System is not in line with organisation goals and objective.

Risk management is review and control exercise which requires independent

functioning in maintaining reporting lines distinct from operating managers of
corresponding departments but its not there within banks. Hence, proper
organisational structure is an essential component of risk management effort.
Implementing the necessary structure is the key task for all the banks surveyed.

89
 With increased awareness there has come about a need to ensure harmony of
understanding and direction across banks. Absence of standardised definition and
measurement divergences lead delays in installing and integrating the
components of an integrated risk management system.

Regulatory and legal issues are not taken into account while setting up of risk
management system.

Methodologies for measuring and assessing market risk and credit risks are
inconsistent throughout the banking sector.

Quarterly progress reports are not made in order to keep the track record for the
progress of bank.

Moreover each bank going for risk management implementation is faced with
question of whether to outsource and if so how much and to whom. Selection
processes for vendors are long drawn and implementation gets delayed on
account of time taken to freeze requirements and fine-tunes specifications.

Banks are facing significant challenge in rolling out IT networks. The banks on
the software front could not entail investments in databases, datawarehousing and
in sophisticated statistical models as aggregation and analysis of the vast amount
of data is needed for successful risk management system.

Procedural Audit reporting risk management is not done.

There is absence of binding time frame as for measuring and managing risk
comprehensive and credible system is not placed by the specified date. Its much
longer before sufficient data aggregation could be carried out for the introduction
of sophisticated quantitative approaches demanding sufficient internal
measurements.

Issues relating to internal audit system, loan review system and timeliness of
internal ratings are not observed in most of the banks.

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 Training for supervisory cadres is not given in banks for understanding the
critical issues raised under Basel II.

There is a lack of conceptual clarity in some of the fields of risk management.

Banks surveyed dont have expertise in risk modelling. Thats why they seek the
services of global consultants like KPMG, Price house water coopers, TCS and
many more. These consultants identify the gaps in system and help banks in
devising risk return model.

Selection processes of vendors for outsourcing the software solution are long
drawn.

The risk management software solutions market is almost nine percent of the
entire IT budget of the global financial industry.

Risk management solutions have been mainly used to calculate credit risk. Its in
the area of operational risk that most firms will make fresh investments.

In recent times much have been done in the area of credit risk management.

Banks surveyed did not comply with Basel II norms and still follow rudimentary
risk models.

In the current interest rate environment, banks find more profitable to invest in
government securities.

The following recommendations are worth mentioning:

Risk Management System should be in place to deal with current and potential
risks.

The system needs to be developed in line with organisation goals and objective.

Timeliness is recommended for progress of the components of risk management.

91
 Quarterly progress reports should be made which is an effective way of keeping
track of progress made by each bank.

There should be an active participation of senior management and main line

functional staff in setting up of risk management system, which will enhance the
acceptability of adopting the risk management measures by the employees.

Procedural Audit of all banks reporting risk management should be done.

An efficient asset liability management system should be there which is an

adequate tool to identify and mitigate market risks.

Appropriate internal controls and audit, risk based supervision, proper manpower
planning, selection training and development and efficient compliance officer
should be there in addressing risk management issues.

Monitoring and reviewing risk management process with dynamically changing

global environment needs to be undertaken.

Selection processes of vendors for outsourcing the software solution should not
be long drawn.

New system calls for skilled expertise sophisticated IT infrastructure and a

comprehensive database.

Measuring and disclosing various risks requires sound MIS. A technological

application in the form of networking and data warehousing is indispensable.

Simple handbooks must be published on risk management demystifying the

subject and making it accessible to the line managers who eventually need to
implement and use it.

Organisation of Seminars and workshops should be conducted for training of risk

management professionals as its important not only in terms of concepts and
methodologies but also to get across vital communication tools and techniques.

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 Banks should place more emphasis on the cash flow based lending rather than
traditional securities based lending.

With view to build up adequate reserves too guard against any possible reversal
of interest rate banks should maintain a certain level of investment fluctuation
reserve.

Banks should comply with Basel II norms

There is no alternative to an efficient risk management system covering all aspects of

risk for healthy growth of the organisation. The regulators must work closely with
banks to ensure that banks take up the issue seriously.

93
ANNEXURE AND

BIBLIOGRAPHY

94
 QUESTIONNAIRE
Name of Bank ________ Dated _______
Name of Person ________
Designation ________

Regarding Risk Management

1. Do you follow Risk Management in your bank?
Yes ___ No ___

2. What structure of Risk Management does your

bank follows?
Centralized ___ Decentralized____

3. Does your bank goes for documented risk

management policy?
Yes ___ No____

4. Does your bank has independent credit risk

management department?
Yes ___ No___

5. Do you go for Internal Credit Rating Model?

Yes ___ No___

6. What is the frequency of loan account review

in your bank?

3 month ___ 6 month ___ 12 month___

7. Does your bank evaluates credit risk at

portfolio level?
Yes ___ No____

95
9. Does your bank carry out NII (Net Interest Income) sensitivity
analysis?
Yes____ No ____

10. Does your bank periodically review its liquidity position?

Yes____ No_____

11. Does your bank maintain certain level of investment fluctuation

reserve to guard against any possible reversal of interest rate?
Yes ___ No___

12. Does your bank comply with Basel II norms?

Yes____ No___

13. Does your bank has documented operational risk management

committee?
Yes ___ No___

14. Does your bank follow scorecard approach towards operational

risk
mitigation?
Yes___ No___

20.Does your bank carry out Risk Focussed Internal Audit (RFIA)?
Yes ___ No___

21. Does your bank captures risk data on regular basis?

Yes___ No___

22. Do you follow MIS in your bank?

Yes ___ No___

23. Does your bank outsource or develop in house software for risk
management solutions?
Yes ___ No___

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24.Do you feel that there is need to bring a cultural change in
organisations towards risk culture?
Yes ___ No___

Signature_______

BIBLIOGRAPHY

Basel Committee on Banking Supervision.2001. Working Paper on the

Regulatory Treatment of Operational Risk(September).

Basel Committee on Banking Supervision.2001. Sound Practices for the

Management and Supervision of Operational Risk (December)..

Reserve Bank of India, Report on Trend and progress of Banking in India

(various years).

Annual Report of all banks.

IBA Bulletin.

Websites of all banks studied.

http://www.rbi.org.in/
http://www.papers.ssrn.com/
http://search.ebscohost.com/
http://xtra.emeraldinsight.com/
http://rbi.org.in/scripts/AnnualReportPublications.aspx?year=2009

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