Table of Contents

1 INTRODUCTION TO RISK MANAGEMENT ............................................................................................... 2 1.1 1.2 2 Meaning of Risk............................................................................................................................. 2 Meaning of Risk Management ...................................................................................................... 2

Risks in Banking Sector.......................................................................................................................... 3 2.1 Credit Risk and Risk Management ................................................................................................ 3 Risk Management for Credit Risk can be done by following ways: ...................................... 3

2.1.1 2.2

Market Risk and Risk Management .............................................................................................. 4

Liquidity Risk and Management............................................................................................................ 4 Interest Rate Risk .................................................................................................................................. 4 2.3 2.4 3 Risk Management for Operation Risk ........................................................................................... 5 PROBLEM ...................................................................................................................................... 5

Concept of ALM..................................................................................................................................... 6 3.1 3.2 3.3 3.4 3.4.1 3.4.2 3.4.3 3.4.4 3.4.5 3.5 3.6 3.7 3.8 3.9 Scope and objectives of ALM ........................................................................................................ 6 A sound ALM system should focus on .......................................................................................... 6 ALM-An Exercise for Risk Return Trade-Off .................................................................................. 7 Interest Rate Risk .......................................................................................................................... 8 Repricing risk ............................................................................................................................. 9 Yield curve risk ...................................................................................................................... 9 Basis risk ................................................................................................................................ 9 Optionally .............................................................................................................................. 9 Effects of Interest Rate Risk .................................................................................................... 11 Foreign Exchange Risk ................................................................................................................. 12 Commodity Risk .......................................................................................................................... 12 Stock Market Risk........................................................................................................................ 12 Liquidity Risk ............................................................................................................................... 13 Capital Risk .................................................................................................................................. 14

INTRODUCTION TO RISK MANAGEMENT

Risk management is recognised in todays business world as an integral part of good management practice. In its broadest sense, it entails the systematic application of management policies, procedures and practices to the tasks of identifying, analysing, assessing, treating and monitoring risk. The past decade has also heralded enormous developments in new financial products. Mortgages and residential mortgages have given institutional and individual investors powerful new tools with which to disperse risk both domestically and internationally. Advances in complex financial products, together with improvements in technology, have lowered the cost of and expanded opportunities for hedging risk. With the raid growth in new tools, quantifying risk and interpreting risk measurements have never been more important. These developments have enabled all companies to take a more proactive view towards risk. Instead of only associating risk as a potential downside of their operations, increasing numbers of firms are considering how risk can be managed positively to enhance the firms value.

1.1 Meaning of Risk

Risk is Exposure to Uncertainty. So, there are two important words one is exposure and the other Uncertainty in Risk.

1.2 Meaning of Risk Management

ISO 3100 Risk Management is the identification, assessment and prioritization of risks followed by coordinated and economical application of resources to minimize, monitors, and controls the probability and/or impact of unfortunate events or to maximize the realization of opportunities. The recent experience of 2007-08 financial crisis in which major banks like Layman Brothers, Global Trust Bank and AIG had to close major part of its global business because of not having a proper risk management policy.

RISKS IN BANKING SECTOR

As per RBI guidelines issued in 1999, there are basically three types of risks encountered in Banking Sector and these are Credit Risk, Market Risk and Operational Risk. The changes in business dimension and competition has resulted in further more additional risks in the form of Liquidity Risk, Regulatory Risk, Environmental risk, Technology risk and Governance Risk.

2.1 Credit Risk and Risk Management

Credit Risk is a risk which arises due to default of borrower not repaying the debt according to agreed terms. According to BCBS (Basel Committee on Banking Supervision) defines credit risk as the potential that a borrower or counter party will fail to meet its obligation in accordance with the agreed terms. Credit Risk is most common risk which occurs in banking business, these are some what which is known and if proper care is taken risk can be minimized.

2.1.1 Risk Management for Credit Risk can be done by following ways: 1. Ceiling Credit Limits of customers Extending loans based on the credit worthiness of customers will help in reducing the risk. Each and every customer is rated on different parameters and accordingly credit limits are fixed. Rating agencies like CRISIL, ICRA, and CARE etc can provide vital financial information about the customers which can be used for fixing credit limits. 2. Portfolio Management Diversifying the lending process will help in spreading over the credit to different channels. To some extent risk gets spread over and controls can be envisaged in right directions. 3. Risk Rating Model Setting up of Risk rating system on a scale and frequent monitoring and reviewing the ratings on the scale will help in understanding the risk and preemptive decisions can be taken before the Risk triggers and causes maximum loss. 4. Credit Monitoring Lending norms differs with types of banks. Commercial banks have their own sort of lending norms and Non commercials banks follow their own norms. This is resulting in lot of confusion in finding the approaches for fixing credit and evaluating customers. Strengthening Credit monitoring system at different levels in banking structure would reduce credit risk. Timely evaluating the risk through a monitoring policy can help in brining stability in lending and also help

in timely recovery.

2.2 Market Risk and Risk Management

Market Risk in simple means the possibility of loss to bank caused by the changes in market variables. Market variables are interest rates, foreign exchange, prices of equity and commodity. This risk is something which is caused or influenced by external factors for which the Banks dont have control. Liquidity Risk and Management - It is the financial risk from the possible loss of liquidity. There can be either Specific Liquidity Risk which is applicable to a specific bank or it may be Systematic Liquidity risk which will affect all the participants in markets. Credit and Monitory Policy announced by RBI caters to manage this Risk. Timely control on credit and deposits by changing SLR and CRR will help in managing the risk to some extent. But, internally each Banks can have a proper Asset -Liability Management Policy which aims at having time to time matching of Assets and Liabilities. It is very difficult to foresee and predict the behaviors of customers and managing liquidity risk is a very challenging task so, it is advisable to have a tolerance level fixed for each and every maturities based on the asset-liability mix. Interest Rate Risk This risk arises when the fixed and floating interest rates of Banks is not so sensitive to variations in market interest rates. Banks can manage such risk by first valuing returns on their portfolios held with that of market rates. Duration Gaps shows the indication for interest rate risk needs to be assessed at regular intervals and this can be used for taking up strategic decisions. In this process of identifying the duration gaps, bank can look-in to the various dimension of resulting risks like Yield curve risk, reinvestment risk, reprice risk etc.. 3. Exchange Risk - This is a risk caused due to potential loss in exchange rates. Such risk can be managed by going for future contracts and agreeing for a limit based rates. Policy with respect to exchange rates should be clear cut and out of the market experience and economic situation exchange rates should be agreed at time of setting terms. Operational Risk and Risk Management

BCBS defined Operation Risk as the risk of loss resulting from inadequate or failed internal process, people and systems or from external events. Such risk is in the form of avoidable risk and if preemptive plan of action is designed then such risk can be minimized.

2.3 Risk Management for Operation Risk

1. Backups - Just like how the financial service industries have BCP in its business modules even Banks can have similar type of Backups for its operations. So, when ever there is a system breakage or persons affected then immediately their backups can jump up in to action. 2. Internal Controls and Checklists - Having well designed internal controls and a system designed checklists will help in accomplishing the task according to set guidelines and procedures. Monitoring and reviewing the controls from time to time will act as a good Risk management process. 3. Internal Audit - Carrying on Internal Audit will help in detection of fraud and other issues before it does huge damage to the Banking sector. 4. Effective Corporate Governance - Corporate Governance is one of the effective and efficient tools which bring together management and other stake holder sunder one platform. A Strong Corporate Governance will help in bridging better relationships between different stakeholders and also it will help in resolving issues at initial stages.

2.4 PROBLEM
Bank in the process of financial intermediation are confronted with various kinds of financial and non financial risk viz,credit risk, liquidity risk, forex risk etc. These risk are highly interdependent and event that affect one area of risk can have ramification for a range of other risk categories so based on this problem we are going to do our research that how commercial banks monitor such risk and control the overall level of risk.

CONCEPT OF ALM

ALM has gradually gained currency in Indian conditions in the wake of the financial sector reforms during the last decade with particular emphasis on interest rate deregulation. The technique of managing both assets and liabilities has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and adverse business environments including the recessionary trends in global economy, if any. Simply put, asset-liability management is the management of total balance sheet dynamics with regard to its size and quality. It involves, a) Quantification of risk and b) Conscious decision making with regard to asset-liability structure in order to maximize interest earnings within the framework of perceived risk. The profitable growth and at times survival of a financial institution depends on effective ALM.

3.1 Scope and objectives of ALM

The primary objectives of ALM is not to eliminate risk ; but to manage it in such a way that volatility of net interest income is minimized in the short term time horizon and net economic value of the organization is protected in a long term time horizon. In banking scenario, this would controlling the volatility of net income, net interest margin, capital adequacy, and liquidity risk and finally ensuring an acceptable balance between profitability, growth, and risk.

3.2 A sound ALM system should focus on

sets and liabilities

--vis projections in respect of net profit, interest spread and other balance sheet ratios

3.3 ALM-An Exercise for Risk Return Trade-Off

Risk is an inherent part of banking business and in simple words may be defined as a profitability of loss or damage. Given the complexities of banks balance sheets and rapidity of changes, chances of loss or risks are only complex in nature but also varied in dimension. Broadly speaking, banks are exposed to both categories of risk viz.credit risk and market risk. While credit risk which is mainly on account of the counter party failure in performing the repayment obligation on due date i.e. loan defaults are managed by the credit policy of the bank, the market risk is related to the Asset Liability Management process and is caused by changes in market variables, involving one or more of the following:

ALM as a process not only encompasses market risk but also involves liquidity management, funding and capital planning, profitability growth and at times management of certain credit risks which are caused by market risk variables for e.g. in a highly volatile interest rate environment, loan defaults may increase thereby deteriorating the credit quality.

3.4 Interest Rate Risk

The Basle Committee on Banking Supervision whose recommendations have been accepted by the Banking Community throughout the world has called for the Banks to have a comprehensive risk management process in place that effectively identifies, measures, monitors and control interest rate risk exposure and that is subject to appropriate board and senior management oversight (source-www.bis.org; Amendment to the Capital Accord to Incorporate Market Risks, January 1996).

Traditionally, interest rate risk means changes in the interest income due to changes in the rate of interest. While this focus is not misplaced, it is definitely incomplete in as much as it overlooks an important aspect-changes in interest rate resulting in the value of assets/liabilities. Thus, interest rate risk may be viewed from two different complementary perspectives- earning sensitivity to rate fluctuations and price sensitivity of instruments/products to changes in interest rate. Changes in interest rates can affect banks with regard to changes in a) Market value of assets/liabilities and off balance sheet (OBS) items; ultimately having impact on the value of net worth. b) Net interest income arising out of mismatch in the repricing terms of the assets and liabilities; c) Net income as a result of changes in interest income; d) Net income margin owing to changes in interest income and sensitivity of non-interest income to rate changes and e) Capital-asset ratio due to changes in net margin. The supervisory capital requirements established by Basle Committee from the end of 1997 covers interest rate risks in the trading activities of banks. Accordingly, interest Rate risks in the trading activities of banks. Accordingly, interest rate risk management process has been constituted to include development of business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. The focus has been on the need for

effective interest rate risk measurement, monitoring, and control functions within the interest rate risk management process (Source- Principles for management of interest rate risk by BIS). According to the studies conducted by Basle Committee based on working experience of Banks in more than 100 countries, the banks are normally exposed to following forms of interest rate risk. 3.4.1 Repricing risk

3.4.2 Yield curve risk 3.4.3 Basis risk 3.4.4 Optionally Repricing risk: arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of banks assets , liabilities and off balance sheet (OBS) positions while such repricing mismatches are fundamental to the business of banking , they can expose a banks income and underlying economic value to unanticipated fluctuations as interest rate varies. For instance, a bank that funded a long term fixed rate loan with a short term deposit could face a decline in both the future income arising from the position and its underlying value if the interest rate increases. These declines arises because the cash flows on the loan are fixed over its lifetime , while the interest paid on the funding is variable, and increases after the short term deposits matures. Yield Curve Risk: arises when unanticipated shifts of the yield curve have adverse effects on a banks income or underlying economic value. For example, the underlying economic value of a long position in 10 yr government bonds hedged by a short position in 5yr government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve. Basis Risk: arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates changes, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies for example a strategy of funding one year loan that reprices monthly based on one month LIBOR,

exposes the institution to the risk that the spread between the two index rates may change unexpectedly. The concept of basis risk is applicable for any set of two different interest rates. For example, basis risk between thee following the following rates can be analyzed:

Certificate of deposits/LIBOR

The reasons for basis risk depend on particula4r set of rates, for example, Prime/LIBOR basis risks are as follows: a) Prime is an administered rate while LIBOR is market rate. The LIBOR changes everyday, but the prime changes infrequently. b) In US context, prime is a rate applicable for loans in the US_LIBOR is applicable for intermediated outside the US. Thus other things remaining the same, costs of certain types of regulation (e.g. Deposit Insurance Premium Change) may impact prime only and not LIBOR. c) During a declining rate environment, Prime tends to lag changes in LIBOR, leading to wider spread. In an increasing rate environment, there is an urgency to increase Prime Rate, resulting in declining spread. This kind of pricing is usual in products market also when costs are increasing, prices go up quickly, when costs are declining, and prices go down slowly. The rate of change is different in different environments. Optionality: option provides the holder the right but not the obligations to buy, sell or in some manner alter the cash flow of an instrument or financial contract. Options, may be in the form of standard alone instruments such as exchange traded options or embedded within an otherwise standard instrument like the various type of bonds and notes with caller put provisions, loans

which give

borrowers the right to repay balances and various type of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical pay off characteristic of options held both explicit and embedded are generally exercised to the advantage of the holder and disadvantage of seller. 3.4.5 Effects of Interest Rate Risk

Interest rate risk effects both on banks earning as well as its economic value. Earnings, comprising of net interest income i.e., difference between total interest income and total interest expense has been the focus of main attention traditionally, and the impact of interest rate change on net interest income has been accepted from time to time. However, in the emerging new scenario increasing focus on fee-based income and other non-interest bearing income and expenses have led to changes in the dimension of the game. The noninterest income arising from many activities can also be highly sensitive to market interest rates. In international arena, banks are providing the servicing and loan-administration function for mortgage loan pools in return for a feebased on the volume of assets it administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages get prepared. In addition, even traditional sources of non-interest income such as transaction processing fee are becoming more interest rate sensitive. This increased sensitivity has led both bank management and supervisors to take a broader view of potential effects of changes in market interest rates on bank earnings and to factor these broader effects into their estimated earnings under different interest rates environment. The economic value, of a banks assets, liabilities, and OBS position can get affected due to fluctuation in interest rates. The economic value of a bank can be viewed as the present value of banks expected net cash, defined as the expected cash flow on liabilities plus the expected net cash flows on OBS positions. Since economic value considered the potential impacting interest rate changes on the present value of all future cash flows, it provides a comprehensive view of the potential long term effects of changes in interest rates. Than is offered by the earlier earnings perspectives

While the above two perspectives focus on the impact of changes in future interest rates on a banks future performances, evaluation of impact past interest rate changes may have on future performance is also of great significance. In particular instruments that are not marked to market may already contain embedded gains or losses due to past rate movements and may ultimately affect bank earnings. For example, a long term fixed rate loan entered into when interest rates were low and refunded more recently with liabilities bearing a higher rate of interest will over its remaining, represent a drain on banks resources 3.5

Foreign Exchange Risk

It refers to potential impact of movement in foreign exchange rates. The risk here is that the adverse fluctuations in exchange rates may result in a loss. Foreign exchange risk arises when there are unhedged current mismatches in an institution assets and liabilities. This risk persists until the open position is covered by means of hedging transactions. The amount at risk is a function of the magnitude of the potential exchange rate changes and the size and duration of the foreign currency exposures. Indian banks normally do not undertake currency exposure for funding operation (i.e. unhedged conversion of resources in one currency for funding assets in another currency). Currency position in Indian banks is concentrated in dealing rooms and these are subjected to constant monitoring through separate daylight and overnight limits and exception reporting.

3.6 Commodity Risk

It is a risk associated with trading in commodities. Commodity trading is not practiced by Banks and Financial Institutions in India.

3.7 Stock Market Risk

Arises primarily because of movement of portfolio value, which may have an overall impact on Banks financial position in adverse condition. The liquidation of Barings and Daiwa Bank is related to the market related risk associated with over exposure to stock market to influence their profitability and long term viability. In addition to market risk associated with Asset and Liability Management process the two

other important aspects which are also of importance while discussing asset liability management include a) Liquidity Risk Management b) Capital risk and capital planning

3.8 Liquidity Risk

It is the potential inability to generate cash to cope with the decline in deposits or increase in assets. Liquidity risk originates from mismatches in the maturity patterns of assets and liabilities since banks deal with assets and liabilities with varied maturity patterns and risk profile, they need to strike a trade-off between been overtly liquid and relatively liquid. An effective measurement and monitoring process assessing all of banks cash inflows against its outflow to identify the potential for any net shortfalls going forward forms an essential ingredient to overall liquidity risk management. This includes funding requirements for off balance sheet commitments. As all banks are affected by changes in the economic climate and market conditions, the monitoring of economic and market trends is also a key to liquidity risk management. Traditionally, banks have been relying on core deposits for their funding. However, in todays environment, banks have resorted to other means of sources also for managing the liquidity on ongoing basis. Cash inflows arise from such things as maturing assets, saleable non-maturing assets, access to deposit liabilities, established credit lines that can be tapped and in developed world through asset securitization also. These need to be matched against cash flows stemming from liabilities and contingent liabilities falling due, especially committed lines of credit that can be drawn down. A maturity ladder is therefore a useful device to compare cash outflows and cash inflows both on a day to day basis and over a period of time. The banks historical experience of the patterns of flows and knowledge of market conventions can also guide a banks decision on liquidity risk management especially in a difficult scenario Use of what if analysis situations can also help in building different liquidity scenarios for practical applications. An effective system of internal control in banks against liquidity risk will involve:t

3.9 Capital Risk

Maintaining adequate capital on a continuous basis is the sine quo-non for sound banking practice. In a business situation, banks require capital to insulate themselves from the risks of business that they undertake. The capital accord of 1988 calls for detailed guidelines for maintaining adequate capital by banks to mitigate themselves from problems arising in business development on account of inadequate capital structure