Professional Documents
Culture Documents
org
Department of Off-site Supervision
Bangladesh Bank
Head Office
Dhaka-1000
DOS Circular No.-02 Date:
15 February 2012
03 Falgun 1418
Chief Executives
All Scheduled Banks in Bangladesh
Dear Sir,
Risk Management Guidelines for Banks
You are aware that banks in the financial services industry are facing various challenges
attributable to increased competition and expansion of diversified business network. Though
Bangladesh has fortunately been spared some of the recent worst upheavals that have occurred in
other countries, the necessity of constant vigilance cannot be ignored. Bangladesh Bank has
already issued guidelines on risk based capital adequacy, stress testing and managing banking
risks in six core areas.
With a view to managing various risks in a prudent manner, scheduled banks are hereby
instructed to follow the attached risk management guidelines. The document should be treated as
supplement to, and not a substitute for, existing core risks guidelines.
Banks have to prepare a risk management paper and must place the same in the monthly meeting
of the Risk Management Unit. The minutes of the meetings should contain specific decisions
based on the analyses/recommendations made in the risk management paper.
Banks have to submit risk management papers (hard & soft copies for successive months of each
quarter) along with the minutes of the meetings within 10 days of each quarter end to the
Department of Off-site Supervision.
This circular along with the guidelines are available on the website of Bangladesh Bank and shall
come into force with immediate effect.
Enclosure: As above
Yours sincerely,
(K.M. Gousuzzaman)
General Manager
Phone: 7120376
iii
k|sk Management Gu|de||nes for 8anks
Iebruary 2012
DLAk1MLN1 CI CIISI1L SULkVISICN
8ANGLADLSn 8ANk
iii
i
RiskManagementGuidelinesforBanks
DepartmentofOffsiteSupervision
BangladeshBank
February2012
ii
iii
Preamble
The fiist uecaue of the 21
st
centuiy, 2uu1 thiough 2u1u, was an extiemely challenging uecaue
foi the financial seivices inuustiy in many paits of the woilu. Cieuit institutions (incluuing
banks), secuiities fiims, insuiance companies, money seivice pioviueis, foieign exchange
uealeis, anu othei kinus of financial institutions in many paits of the woilu faceu incieasing
competition, natuial anu manmaue uisasteis, incieaseu volatility in inteiest iates, exchange
iates, anu shaie piices, asset piice bubbles, ueep iecessions, suuuen ueteiioiations in cieuit
quality, anu unpieuictable changes in the legal anu iegulatoiy fiamewoik. Nost financial
institutions weie able to cope with these challenges, but a gieat many, incluuing some veiy
laige anu wellknown institutions, weie not. Spectaculai failuies occuiieu, iesulting in gieat
cost to taxpayeis anu suiviving institutions anu in a geneial uecline in customei confiuence in
banks anu consumei confiuence in the economy as a whole.
We now know that theie weie staik uiffeiences in management between those institutions that
suiviveu anu those that uiu not. The key uiffeience was iisk management. Suiviving banks
unueistoou the iisks that they faceu, enteieu new maikets anu iolleu out new piouucts
cautiously, uiu not expanu theii scale of opeiations fastei than theii capital bases anu
ieasonablypiiceu souices of funus coulu accommouate, kept activity within legal, iegulatoiy,
anu inteinallyset limits, shaieu infoimation acioss theii oiganizations, anu hau goou
infoimation on hanu at all times as to the positions they weie taking anu the possible ueclines in
theii piofitability anu capital that coulu occui shoulu unfavouiable conuitions uevelop.
As you know, scheuuleu banks in Banglauesh also face challenges in the seconu uecaue of the
piesent centuiy. Although we have foitunately been spaieu some of the woist upheavals that
have occuiieu in othei countiies, the neeu to be constantly vigilant is still upon us. Banglauesh
Bank has alieauy issueu sets of guiuelines foi capital auequacy in accoiuance with Basel II,
incluuing stiess testing, anu theie aie the manuatoiy Coie Risk uuiuelines with which you aie
alieauy familiai:
i. Inteinal Contiol anu Compliance Risk
ii. Foieign Exchange Risk
iii. Cieuit Risk
iv. Asset Liability Nanagement Risk
v. Noney Launueiing Risk
vi. Infoimation & Communication Technology Secuiity Risk
This uocument is a supplement to, anu not a substitute foi, these guiuelines alieauy issueu. This
uocument piomotes an integrated,bankwideappioach to iisk management that we hope will
piopel banks in Banglauesh to the foiefiont among banks in oui iegion in auopting
contempoiaiy methous to iuentify, measuie, monitoi, anu contiol iisks thioughout theii
institutions.
Woiluclass iisk management can seem like a costly enueavoui foi oui banks. But the costs of
being caught unawaie oi unpiepaieu foi unexpecteu, unfavouiable changes in the banking
enviionment, fiom wheievei these changes may come, woulu be fai, fai highei.
(MohammadNaushadAliChowdhury)
Executive Biiectoi
Banglauesh Bank
iv
v
RiskManagementGuidelinesforBanks
AdvisoryCouncil:
Mr.S.K.SurChowdhury,DeputyGovernor
Mr.GlennTasky,BankingSupervisionAdvisor
Coordinator:
Mr.K.M.Gousuzzaman,GeneralManager
Editors:
Mr.Md.Arifuzzaman,DeputyDirector
Mr.Md.AlaUddin,DeputyDirector
Mr.MohammadShahriarSiddiqui,DeputyDirector
Mr.Md.AminurRahmanChowdhury,DeputyDirector
Mr.AbdulHye,DeputyDirector
vi
vii
TableofContents
CHAPTER1 ............................................................................................................................................................... 1
INTRODUCTIONTORISKANDOBJECTIVESOFRISKMANAGEMENT ......................................................... 1
1.1INTRODUCTION ................................................................................................................................................. 1
1.2SCOPEOFAPPLICATION ..................................................................................................................................... 2
1.3DEFINITION ...................................................................................................................................................... 2
1.4OBJECTIVESOFRISKMANAGEMENT ................................................................................................................... 2
1.5OVERVIEWOFRISK ........................................................................................................................................... 3
1.6RISKMANAGEMENTUNIT .................................................................................................................................. 3
CHAPTER2 ............................................................................................................................................................... 5
RISKMANAGEMENTORGANIZATIONANDGOVERNANCE ............................................................................ 5
2.1 ELENENTS 0F A S00NB RISK NANAuENENT SYSTEN ............................................................................................. 5
2.2 B0ARB ANB SENI0R NANAuENENT 0vERSIuBT .................................................................................................... 5
2.S P0LICIES, PR0CEB0RES ANB LINIT STR0CT0RE .................................................................................................... 6
2.4 RISK NEAS0RENENT, N0NIT0RINu ANB NANAuENENT REP0RTINu SYSTENS .............................................................. 6
2.S INTERNAL C0NTR0LS ANB C0NPREBENSIvE A0BITS ............................................................................................. 7
2.6 TBE C0NCEPT 0F RISK APPETITE ......................................................................................................................... 8
2.6.1Definitionofriskappetite ....................................................................................................................... 8
2.6.2Riskappetiteframework ........................................................................................................................ 8
2.7 0PTINAL RISK 0RuANIZATI0N ........................................................................................................................... 10
2.7.1RoleoftheBOD ..................................................................................................................................... 10
2.7.2Creditandriskcommittee .................................................................................................................... 10
2.7.3Roleoftheexecutiveboard .................................................................................................................. 11
2.7.4Allriskcommittee ................................................................................................................................. 11
2.7.5Assetliabilitymanagementcommittee(ALCO) ................................................................................. 12
2.7.6Executiveboardscreditcommittee .................................................................................................... 13
2.7.7Riskmanagementunit .......................................................................................................................... 13
2.8 RISK NANAuENENT REP0RTINu ........................................................................................................................ 14
2.8.1Quarterlyreporting .............................................................................................................................. 14
2.8.2Annualreporting .................................................................................................................................. 15
CHAPTER3 ............................................................................................................................................................. 17
CAPITALMANAGEMENT ..................................................................................................................................... 17
S.1 CAPITAL NANAuENENT ANB ITS RELATI0NSBIP WITB RISK NANAuENENT ........................................................... 17
S.2 FRANEW0RK 0F CAPITAL NANAuENENT ............................................................................................................ 18
3.2.1 Roleandresponsibilitiesofboardofdirectorsandseniormanagement ............................... 18
3.2.2 RoleandresponsibilitiesofthemanagerofCMU/RMU ........................................................ 20
3.2.3 Rolesandresponsibilitiesofcapitalmanagementunit ........................................................ 22
CHAPTER4 ............................................................................................................................................................. 25
CREDITRISKMANAGEMENT .............................................................................................................................. 25
4.1 BEFININu CREBIT RISK ...................................................................................................................................... 25
4.2 PRINCIPLES 0F BANK'S CREBIT RISK NANAuENENT ............................................................................................. 25
4.S CREBIT RISK NANAuENENT FRANEW0RK .......................................................................................................... 27
4.3.1Boardoversight ..................................................................................................................................... 27
4.3.2Seniormanagementoversight ............................................................................................................. 28
4.3.3Organizationalstructure...................................................................................................................... 28
4.4 SYSTENS ANB PR0CEB0RES ............................................................................................................................... 29
4.4.1Creditstrategy ...................................................................................................................................... 29
4.4.2Creditpolicies ........................................................................................................................................ 29
4.4.3Creditprocedures .................................................................................................................................. 31
viii
4.4.4Creditorigination/extension ............................................................................................................... 31
4.4.5Delegationofauthority ........................................................................................................................ 33
4.4.6Creditlimits ........................................................................................................................................... 33
4.S CREBIT ABNINISTRATI0N ................................................................................................................................. 34
4.6 NEAS0RINu CREBIT RISK .................................................................................................................................. 35
4.6.1Internalcreditriskrating .................................................................................................................... 35
4.7 CREBIT RISK N0NIT0RINu ANB C0NTR0L ........................................................................................................... 36
4.8 CREBIT RISK REvIEW ANB STRESS TESTINu ........................................................................................................ 38
4.9 MANAGING CREDIT CONCENTRATION RISK .................................................................................................... 38
4.10.1.1 SINGLE-NAME CONCENTRATION RISK .................................................................................................... 39
4.10.1.2 SECTORAL CREDIT CONCENTRATIONS ................................................................................................... 40
4.10.1.3 CONCENTRATIONS OF MICRO CONTAGION ............................................................................................. 40
4.10.1.4 CONCENTRATION IN LIABILITIES ............................................................................................................ 40
4.10.1.5 CONCENTRATION IN IT SYSTEM ............................................................................................................ 40
4.10.2 MEASURING CONCENTRATION RISK .......................................................................................................... 40
4.10.2.1 Single borrower/group exposure concentration .............................................................................. 40
4.10.2.2 GINI coefficient ................................................................................................................................ 41
4.10.2.3 HerfindahlHirschman Index (HHI) ............................................................................................... 42
4.10.3 TECHNIQUES FOR MANAGING CONCENTRATION RISK ............................................................................. 43
4.11 NANAuINu PR0BLEN CREBITS ........................................................................................................................ 44
4.12 NANAuENENT INF0RNATI0N SYSTEN (NIS) ................................................................................................... 45
CHAPTER5 ............................................................................................................................................................. 47
MARKETRISKMANAGEMENT............................................................................................................................ 47
S.1 BEFININu NARKET RISK .................................................................................................................................... 47
S.2 INTEREST RATE RISK ......................................................................................................................................... 47
5.2.1Effectsofinterestraterisk ................................................................................................................... 47
5.2.2Sourcesofinterestraterisks ................................................................................................................ 48
5.2.3Soundinterestrateriskmanagementpractices ................................................................................. 49
5.2.4Measurementofinterestraterisk ....................................................................................................... 50
5.2.5Interestriskmanagementprogram .................................................................................................... 57
5.2.6Interestrateriskmanagementpolicies .............................................................................................. 58
5.2.7Interestrateriskmanagementandcontrolprocedures .................................................................... 59
S.S F0REIuN EXCBANuE RISK .................................................................................................................................. 59
5.3.1Foreignexchangeriskmanagementprogram ................................................................................... 60
5.3.2Foreignexchangesettlementrisk ........................................................................................................ 64
5.3.3Contingencyplanningtomitigatesettlementrisk ............................................................................. 65
S.4 EQ0ITY PRICE RISK ........................................................................................................................................... 65
5.4.1Effectiveequitypriceriskmanagement .............................................................................................. 66
5.4.2Securitiesportfoliomanagementprogram ........................................................................................ 67
5.4.3Securitiesportfolioconcentrationlimits ............................................................................................. 70
5.4.4Securitiesanalysisandassessment ...................................................................................................... 71
5.4.5Securitiestransactionapprovalauthorities ....................................................................................... 71
5.4.6Measuringequitypricerisk .................................................................................................................. 72
S.S NANAuINu NARKET RISK .................................................................................................................................. 73
5.5.1Boardoversight ..................................................................................................................................... 74
5.5.2Seniormanagementoversight ............................................................................................................. 75
S.6 STRESS TESTINu ............................................................................................................................................... 76
CHAPTER6 ............................................................................................................................................................. 77
LIQUIDITYRISKMANAGEMENT ........................................................................................................................ 77
6.1 INTR0B0CTI0N ................................................................................................................................................ 77
6.2 LIQ0IBITY RISK INBICAT0RS .............................................................................................................................. 77
6.S NANAuINu LIQ0IBITY RISK ............................................................................................................................... 78
6.4 B0ARB 0vERSIuBT ........................................................................................................................................... 78
6.S SENI0R NANAuENENT 0vERSIuBT..................................................................................................................... 79
6.6 LIQ0IBITY RISK STRATEuY ................................................................................................................................. 80
6.7 LIQ0IBITY P0LICIES .......................................................................................................................................... 81
ix
6.8 PR0CEB0RES ANB LINITS .................................................................................................................................. 83
6.9 LIQ0IBITY NANAuENENT STR0CT0RE ................................................................................................................ 83
6.1u LIQ0IBITY RISK NANAuENENT PR0CESS .......................................................................................................... 83
6.11 NANAuENENT INF0RNATI0N SYSTEN ............................................................................................................. 83
6.12 PERI0BIC REvIEWS ......................................................................................................................................... 84
6.1S NEAS0RENENT 0F LIQ0IBITY RISK .................................................................................................................. 85
6.14 C0NTINuENCY F0NBINu PLANS ....................................................................................................................... 85
6.14.1UseofCFPforroutineliquiditymanagement ................................................................................... 86
6.14.2UseofCFPforemergencyanddistressenvironments ...................................................................... 86
6.14.3ScopeofCFP ........................................................................................................................................ 86
6.1S NAT0RITY LABBER ........................................................................................................................................ 87
6.16 LIQ0IBITY RATI0S ANB LINITS ........................................................................................................................ 88
6.17 F0REIuN C0RRENCY LIQ0IBITY NANAuENENT ................................................................................................. 89
6.18 INTERNAL C0NTR0LS ...................................................................................................................................... 89
6.19 N0NIT0RINu ANB REP0RTINu RISK EXP0S0RES ............................................................................................... 90
CHAPTER7 ............................................................................................................................................................. 91
OPERATIONALRISKMANAGEMENT................................................................................................................. 91
7.1INTRODUCTION ............................................................................................................................................... 91
7.2CATEGORIZATIONOFOPERATIONALRISK ........................................................................................................ 92
7.S 0PERATI0NAL RISK NANAuENENT PRINCIPLES ................................................................................................... 94
7.4 0PERATI0NAL RISK NANAuENENT FRANEW0RK ................................................................................................ 95
7.S B0ARB 0vERSIuBT ........................................................................................................................................... 95
7.6 SENI0R NANAuENENT 0vERSIuBT..................................................................................................................... 96
7.7 P0LICIES, PR0CEB0RES ANB LINITS ................................................................................................................... 97
7.8 RISK ASSESSNENT ANB Q0ANTIFICATI0N ........................................................................................................... 98
7.9 NITIuATI0N 0F RISKS ....................................................................................................................................... 98
7.1u RISK N0NIT0RINu .......................................................................................................................................... 99
7.11 RISK REP0RTINu .......................................................................................................................................... 100
7.12 ESTABLISBINu C0NTR0L NECBANISN ............................................................................................................ 101
7.1S C0NTINuENCY PLANNINu .............................................................................................................................. 101
7.14 INTERNAL C0NTR0LS .................................................................................................................................... 101
CHAPTER8 ........................................................................................................................................................... 103
STRATEGICRISKMANAGEMENT ..................................................................................................................... 103
8.1 INTR0B0CTI0N .............................................................................................................................................. 103
8.2 STRATEuIC PLAN ............................................................................................................................................ 104
8.S B0ARB 0vERSIuBT ......................................................................................................................................... 105
8.4 SENI0R NANAuENENT 0vERSIuBT................................................................................................................... 105
8.S P0LICIES, PR0CEB0RES ANB LINITS ................................................................................................................. 105
8.6 IBENTIFICATI0N, NEAS0RENENT ANB N0NIT0RINu 0F STRATEuIC RISK ............................................................ 106
8.7 NANAuENENT INF0RNATI0N SYSTEN (NIS) ................................................................................................... 106
8.8 STRATEuIC RISK C0NTR0L ............................................................................................................................... 107
CHAPTER9 ........................................................................................................................................................... 109
COMPLIANCERISKMANAGEMENT ................................................................................................................. 109
9.1 INTR0B0CTI0N .............................................................................................................................................. 109
9.2 B0ARB 0vERSIuBT ......................................................................................................................................... 110
9.S SENI0R NANAuENENT 0vERSIuBT................................................................................................................... 110
9.4 P0LICIES, PR0CEB0RES ANB LINITS ................................................................................................................. 111
9.S IBENTIFICATI0N, NEAS0RENENT ANB N0NIT0RINu 0F C0NPLIANCE RISK ......................................................... 113
9.6 NANAuENENT INF0RNATI0N SYSTEN (NIS) ................................................................................................... 114
9.7 INTERNAL C0NTR0LS ...................................................................................................................................... 114
CHAPTER10 ......................................................................................................................................................... 117
MANAGINGOTHERRISKS ................................................................................................................................. 117
1u.1 REP0TATI0N RISK ........................................................................................................................................ 117
x
10.1.1Characteristicsofeffectivereputationriskmanagement ............................................................. 117
1u.2 N0NEY LA0NBERINu RISK ............................................................................................................................ 117
10.2.1CharacteristicsofeffectiveAMLriskmanagement ........................................................................ 118
CHAPTER11 ......................................................................................................................................................... 119
SOUNDRISKMANAGEMENT ............................................................................................................................. 119
11.1 RISK NANAuENENT CBARACTERISTICS AT S0CCESSF0L BANKS ........................................................................ 119
11.2 CBARACTERIZATI0N 0F S00NB RISK NANAuENENT ........................................................................................ 121
11.2.1Strongriskmanagement .................................................................................................................. 121
11.2.2Acceptableriskmanagement ........................................................................................................... 121
11.2.3Weakriskmanagement ................................................................................................................... 122
GLOSSARY ............................................................................................................................................................. 123
BIBLIOGRAPHY ................................................................................................................................................... 125
APPENDIXA .......................................................................................................................................................... 127
BBSINSTRUCTIONS/GUIDELINESREGARDINGCAPITALMANAGEMENT ............................................. 127
APPENDIXB .......................................................................................................................................................... 129
xi
ListofAcronyms
ALCO AssetLiability Nanagement Committee
ALM Asset Liability Nanagement
BB Banglauesh Bank
BCBS Basel Committee on Banking Supeivision
BIS Bank foi Inteinational Settlements
BOD Boaiu of Biiectois
CCR Cieuit Concentiation Risk
CDR Cieuit Beposit Ratio
CFP Contingency Funuing Plans
CP1 Cieuit Policy
CP2 Coie Piinciples
CMU Capital Nanagement 0nit
CRMC Cieuit Risk Nanagement Committee
CRMD Cieuit Risk Nanagement Bepaitment
CRO Chief Risk 0fficei
CRR Cash Reseive Ratio
DTL Bemanu anu Time Liabilities
EAD Exposuie at Befault
EB Executive Boaiu
GDP uioss Bomestic Piouuct
ICAAP Inteinal Capital Auequacy Assessment Piocess
IRB Inteinal Rating Baseu
IRR Inteiest Rate Risk
LGD Loss uiven Befault
MCO Naximum Cumulative 0utflow
MDA Nouifieu Buiation of Assets
MDL Nouifieu Buiation of Liabilities
MIS Nanagement Infoimation System
OBS 0ffBalance Sheet
PD Piobability of Befault
PEST Political, Legal, Social anu Technological analysis
RAF Risk Appetite Fiamewoik
RMC Risk Nanagement Committee
RMD Risk management uepaitment
ROA Retuin on Assets
ROE Retuin on Equity
RSA Rate Sensitive Assets
RSL Rate Sensitive Liabilities
RU Recoveiy 0nit
RW Risk Weighteu
SLR Statutoiy Liquiuity Requiiement
SREP Supeivisoiy Review Evaluation Piocess
SRP Supeivisoiy Review Piocess
SWOT Stiengths, Weaknesses, 0ppoitunities, Thieats analysis
VaR value at Risk
WBG Wholesale Boiiowing uuiuelines
Chapter1
Introductiontoriskandobjectivesofriskmanagement
1.1Introduction
These guiuelines aie issueu by Banglauesh Bank (BB) unuei section 4S of `evsK Kvvbx
AvBb, 1991'
1
anu intiouuceu to pioviue a stiuctuieu way of iuentifying anu analyzing
potential iisks, anu uevising anu implementing iesponses appiopiiate to theii impact.
These iesponses geneially uiaw on stiategies of iisk pievention, iisk tiansfei, impact
mitigation oi iisk acceptance. BB is going to make these guidelines as mandatory for all
scheduledbanksworkinginBangladeshfromFebruary2012.
These guiuelines aie piepaieu in line with inteinationally accepteu iisk management
piinciples anu best piactices. The guiuelines aie also aligneu with the ieviseu veision of
Core Principles for Effective Banking Supervision publisheu by the Basel Committee on
Banking Supeivision (BCBS) in 0ctobei 2uu6. The CP
2
on Risk Nanagement Piocesses
(CP7) iequiies that banks anu banking gioups must have compiehensive iisk
management piocesses (incluuing Boaiu anu senioi management oveisight) to iuentify,
evaluate, monitoi anu contiol oi mitigate all mateiial iisks anu to assess theii oveiall
capital auequacy in ielation to theii iisk piofile. These piocesses shoulu be
commensuiate with the size anu complexity of the bank. 0thei ielevant CPs touch on
cieuit iisk (CP8), maiket iisk (CP1S) liquiuity iisk (CP14), opeiational iisk (CP1S) anu
inteiest iate iisk (CP16). Whilst the types anu uegiee of iisks an oiganization may be
exposeu to uepenu upon a numbei of factois such as its size, complexity, business
activities, volume, etc., these guiuelines covei the most common iisks in banking
companies in Banglauesh, namely: Stiategic Risk, Cieuit Risk, Liquiuity Risk, Inteiest
Rate Risk, Foieign Exchange Rate Risk, Piice Risk, 0peiational Risk, Compliance Risk
anu Reputation Risk. These guiuelines will be calleu Risk Nanagement uuiuelines foi
Banks.
The guiuelines aie stiuctuieu on following thiee aspects:
a) Risk Nanagement 0bjectives ;
b) Risk Nanagement Stiuctuie;
c) Risk Nanagement Requiiements ;
u) Risk Nanagement Piocess.
In these guiuelines, 'cieuit' means all types of loans anu auvances anu 'boiiowei' means
obligoi oi counteipaity.
These guiuelines aie also applicable foi scheuuleu banks that aie opeiating baseu on
Islamic Shiiah anu Islamic banking biancheswinuows of conventional banks.
1 Bank Company Act, 1991
2 Core Principle
2
1.2Scopeofapplication
These guiuelines peitain to all scheuuleu banks opeiating in Banglauesh. The iisk
management piocess uesciibeu in these guiuelines is supplementaiy to the stanuaius
set by the legislative iequiiements. This uocument uoes not ieplace oi supeiseue them.
1.3Definition
Risk management is the uelibeiate acceptance of iisk foi piofitmaking. It iequiies
infoimeu uecisions on the tiaueoff between iisk anu iewaiu, anu uses vaiious financial
anu othei tools to maximize iiskaujusteu ietuins within pieestablisheu limits.
Risktaking is an inheient element of the banking business anu, inueeu, piofits aie in
pait the iewaiu foi successful iisk taking in business. 0n the othei hanu, excessive anu
pooily manageu iisk can leau to losses anu thus enuangei the safety of a banks
uepositois.
1.4Objectivesofriskmanagement
The objective of iisk management is to iuentify anu analyze iisks anu manage theii
consequences. The banking sectoi has peihaps the most specific focus on the
management of financial iisks. The guiuing stanuaiu that is a key influence on cential
banks anu banking iegulations comes fiom the Swissbaseu Bank foi Inteinational
Settlements (BIS), anu paiticulaily it's BCBS. The upuate of the stanuaius, known as
Basel II, has been, oi is in the piocess of being, applieu by bank iegulatois acioss the
woilu. While Basel II intiouuces a new anu moie complex methou of calculating
iegulatoiy capital iequiiements, its implementation iequiies that the bank auopt
enhanceu policies anu pioceuuies of iisk management, in oiuei to geneiate the
necessaiy uata foi the calculations.
Risk management is a uiscipline at the coie of eveiy financial institution anu
encompasses all the activities that affect its iisk piofile. It involves iuentification,
measuiement, monitoiing anu contiolling iisks to ensuie that
a) The inuiviuuals who take oi manage iisks cleaily unueistanu it;
b) The oiganizations iisk exposuie is within the limits establisheu by the boaiu;
c) Risk taking uecisions aie explicit anu cleai;
u) Risk taking uecisions aie in line with the business stiategy anu objectives set by
the boaiu;
e) The expecteu payoffs compensate foi the iisks taken; anu
f) Sufficient capital as a buffei is available to take iisk.
3
BB puts foiwaiu this uocument foi the puipose of pioviuing guiuelines to all banking
companies on iisk management systems that aie expecteu to be in place. The uocument
sets out minimum stanuaius that shall be expecteu of the iisk management fiamewoik
at any banking company. Foi the puipose of these guiuelines, iisk in a banking company
iefeis to the possibility that the outcome of an action oi event coulu have an auveise
impact on the banks capital, eainings oi its viability. Such outcomes coulu eithei iesult
in uiiect loss of eainings anu eiosion of capital oi may iesult in imposition of
constiaints on a banks ability to meet its business objectives. These constiaints coulu
hinuei a banks capability to conuuct its business oi to take auvantage of oppoitunities
that woulu enhance its business. As such, banks aie expecteu to ensuie that the iisks an
institution is taking aie waiianteu.
1.5Overviewofrisk
BB shoulu ensuie that the banks aie piuuently managing theii iisks because iisks can
cause systemic thieats anu jeopaiuize the stability of the entiie financial system.
Theiefoie, BB has imposeu piuuential iequiiements to assess banks iisk management
capacity anu has instiucteu the banks to establish an inuepenuent Risk Nanagement
0nit (RN0). The RN0 not only conuucts stiess testing foi examining the banks capacity
of hanuling futuie shocks, but also ueals with all potential iisks that might occui in
futuie.
4
5
Chapter2
Riskmanagementorganizationandgovernance
2.1Elementsofasoundriskmanagementsystem
The key elements of a sounu iisk management system shoulu encompass the following:
a) Risk management stiuctuie with boaiu anu senioi management;
b) 0iganizational policies, pioceuuies anu limits that have been uevelopeu anu
implementeu to manage business opeiations effectively;
c) Auequate iisk iuentification, measuiement, monitoiing, contiol anu management
infoimation systems that aie in place to suppoit all business opeiations; anu
u) Establisheu inteinal contiols anu the peifoimance of compiehensive auuits to
uetect any ueficiencies in the inteinal contiol enviionment in a timely fashion.
It shoulu not be unueistoou that iisk management is only limiteu to the inuiviuual(s),
who aie iesponsible foi oveiall iisk management function. Business lines aie equally
iesponsible foi the iisks they aie taking. Because the line peisonnel can unueistanu the
iisks of theii activities, any lack of accountability on theii pait may hinuei sounu anu
effective iisk management.
2.2Boardandseniormanagementoversight
The quality of boaiu anu senioi management oveisight is evaluateu in ielation to the
following elements:
a) whethei the boaiu anu senioi management have iuentifieu anu have a cleai
unueistanuing of the types of iisk inheient in business lines anu whethei they
have taken appiopiiate steps to ensuie continueu awaieness of any changes in
the levels of iisk;
b) whethei the boaiu anu senioi management have been actively involveu in the
uevelopment anu appioval of policies to limit the iisks, consistent with the
banks iisk appetite;
c) whethei the boaiu anu senioi management aie knowleugeable about the
methous available to measuie iisks foi vaiious activities;
u) whethei the boaiu anu senioi management caiefully evaluate all the iisks
associateu with new activities anu ensuie that the piopei infiastiuctuie anu
inteinal contiols aie in place; anu
e) whethei the boaiu anu senioi management have pioviueu auequate staffing foi
the activity anu uesignateu staff with appiopiiate cieuentials to supeivise the
activity.
6
2.3Policies,proceduresandlimitstructure
The following key factois aie to be consiueieu in evaluating the auequacy of policies,
pioceuuies anu limits:
a) whethei policies, pioceuuies anu limits aie piopeily uocumenteu, uiawn up aftei
caieful consiueiation of the iisks associateu with the activity anu ievieweu anu
appioveu by management at the appiopiiate level;
b) whethei policies assign full accountability anu cleai lines of authoiity foi each
activity anu piouuct aiea; anu
c) whethei compliance monitoiing pioceuuies have been uevelopeu. These
pioceuuies shoulu incluue inteinal compliance checks foi auheience to all policies,
pioceuuies anu limits by an inuepenuent function within a bank such as an
inteinal contiol unit.
2.4Riskmeasurement,monitoringandmanagementreportingsystems
a) Effective iisk monitoiing iequiies banks to iuentify anu measuie all quantifiable
anu mateiial iisk factois. Consequently, iisk monitoiing activities must be
suppoiteu by infoimation systems that pioviue the management with timely anu
accuiate iepoits on the financial conuition, opeiating peifoimance anu iisk
exposuie of the bank.
b) Nanagement infoimation systems shoulu pioviue iegulai anu sufficiently
uetaileu iepoits foi line manageis engageu in the uaytouay management of the
bank's business opeiations.
c) All banks aie expecteu to have iisk monitoiing anu management infoimation
systems that pioviue senioi management with a cleai unueistanuing of the
banks positions anu iisk exposuies.
u) The following factois shoulu be consiueieu in assessing the effectiveness of the
iisk measuiement, monitoiing anu management iepoiting systems:
i. the auequacy, on a histoiical basis, of the iisk monitoiing piactices anu
iepoits auuiessing all mateiial iisks of the oiganization;
ii. the auequacy anu appiopiiateness of the key assumptions, uata souices anu
pioceuuies useu to measuie anu monitoi iisk, incluuing the auequacy of
analysis, uocumentation anu ieliability testing of the system on a continuing
basis;
iii. any mateiial changes in the bank's lines of business oi piouucts that might
iequiie changes in the measuiing anu monitoiing systems;
7
iv. any changes in the infoimation technology oi management infoimation
system enviionment that have significantly changeu the piouuction piocess
foi iepoits oi the assumptions on which iepoits aie baseu;
v. how consistently management infoimation iepoits anu othei foims of
communication monitoi all meaningful exposuies, check compliance with
establisheu limits, goals oi objectives anu compaie actual with expecteu
peifoimance; anu
vi. the auequacy, accuiacy anu timeliness of iepoits to the Boaiu anu senioi
management anu whethei such iepoits contain sufficient infoimation foi
them to iuentify any auveise tienus anu to evaluate the level of iisks fully.
2.5Internalcontrolsandcomprehensiveaudits
a) A ciitical element of a bank's ability to opeiate in a safe anu sounu mannei anu to
maintain an acceptable iisk management system is the auequacy of its inteinal
contiol enviionment. Establishing anu maintaining an effective system of
contiols, incluuing the enfoicement of official lines of authoiity anu the
appiopiiate segiegation of uuties, is one of management's most impoitant
iesponsibilities. Seiious lapses oi ueficiencies in inteinal contiols such as
inauequate segiegation of uuties may waiiant supeivisoiy action.
b) When piopeily stiuctuieu, a system of inteinal contiols piomotes effective
opeiations, pioviues foi ieliable financial iepoiting, safeguaius assets anu helps
to ensuie compliance with ielevant laws, iegulations anu inteinal policies. An
inuepenuent inteinal auuitoi shoulu test inteinal contiols anu the iesults of
these auuits, incluuing managements iesponse to the finuings, shoulu be
piopeily uocumenteu.
The following factois shoulu be consiueieu in evaluating the auequacy of the inteinal
contiol enviionment:
i. the appiopiiateness of the system of inteinal contiols in ielation to the type
anu level of iisks poseu by the natuie anu scope of the bank's business
opeiations anu piouucts;
ii. whethei the bank's oiganization stiuctuie establishes auequately cleai lines of
authoiity anu iesponsibility foi monitoiing compliance with policies,
pioceuuies anu limits;
iii. whethei iepoiting lines pioviue foi sufficient inuepenuence of the contiol
functions fiom the business aieas, as well as auequate segiegation of uuties
thioughout the oiganization (such as those ielating to tiauing, custouial anu
backoffice opeiations oi loan oiigination, maiketing anu piocessing);
8
iv. whethei the official oiganizational stiuctuie ieflects actual opeiating piactices;
v. the ieliability, accuiacy anu timeliness of all financial, opeiational anu
iegulatoiy iepoits;
vi. the auequacy of pioceuuies foi ensuiing compliance with applicable laws,
iegulations anu inteinal policies anu pioceuuies;
vii. the effectiveness, inuepenuence anu objectivity of inteinal auuit oi othei
contiol anu ieview pioceuuies in pioviuing auequate coveiage of the banks
opeiations;
viii. whethei inteinal contiols anu infoimation systems aie auequately testeu anu
ievieweu;
ix. whethei the coveiage, pioceuuies, finuings anu management iesponses to
auuits aie auequately uocumenteu; anu
x. whethei iuentifieu mateiial weaknesses aie given appiopiiate anu timely high
level attention anu managements actions to coiiect mateiial ueficiencies aie
objectively veiifieu anu ievieweu.
2.6Theconceptofriskappetite
The iisk management fiamewoik is expecteu to be uevelopeu anu applieu within an
oveiaiching statement of iisk appetite. Risk appetite is set by the Boaiu anu ieflects
shaieholuei aspiiations within the constiaints of iegulatoiy iequiiements, cieuitoi anu
legal obligations.
2.6.1Definitionofriskappetite
Risk appetite is the level anu type of iisk a bank is able anu willing to assume in its
exposuies anu business activities, given its business objectives anu obligations to
stakeholueis (uepositois, cieuitois, shaieholueis, boiioweis, iegulatois). Risk appetite
is geneially expiesseu thiough both quantitative anu qualitative means anu shoulu
consiuei extieme conuitions, events, anu outcomes. It shoulu be stateu in teims of the
potential impact on piofitability, capital, anu liquiuity.
2.6.2Riskappetiteframework
The science of ueveloping anu auopting a iisk appetite fiamewoik (RAF) is still evolving
at banks all ovei the woilu. Some banks have auopteu a highlevel, biief, anu qualitative
statement of RAF, while otheis make it complex, lengthy, anu quantitative.
9
Some iuuiments foi an effective RAF aie mentioneu below:
a) RAFs uiscuss the uesiieu business mix anu composition of the balance sheet, iisk
piefeiences (which iisks aie embiaceu, toleiateu, anu avoiueu), the acceptable
tiaueoff between iisk anu iewaiu, toleiances foi volatility, capital thiesholus,
toleiance foi poststiess loss, optimum liquiuity iatios, anu otheis;
b) It shoulu focus on the banks key stiengths anu competitive auvantages;
c) It shoulu enable the Boaiu to challenge business pioposals outsiue of the banks
tiauitional piouuct anu seivice lines;
u) It shoulu make foiwaiulooking uiscussions of iisk easiei;
e) It shoulu couify the types of iisk the bank is willing to beai anu unuei what
conuitions, as well as which iisks the bank is unwilling to assume.
Risk appetite is the coineistone of a successful iisk management fiamewoik. Risk
appetite can be fitteu into the iisk management fiamewoik in the following mannei:
Elementsofrisk
managementframework
Linkagetoriskappetite
R
i
s
k
C
u
l
t
u
r
e
InternalAudit CreditandRiskCommittee
EXECUTIVE
BOARD
AllRiskCommittee
(including
OperationalRisk)
Asset
Liability
Management
Committee
ExecutiveBoards
CreditCommittee
Risk
Management
Unit
Officeof
CFO
Credit
Department
Treasury
Department
Business
Units
RiskParameters,
Models,
StressTesting,
Reporting,
Monitoring
Capital
Management
Credit
Methodsand
Processes
Liquidity
Management
MarketRisk
Management
Credit
Portfolio
Management
2.7.1RoleoftheBOD
a) Befining the iisk appetite;
b) Besigning the oiganizational stiuctuie to manage iisk within the bank;
c) 0nueistanuing the inheient iisks of the bank;
u) Reviewing anu appioving iisk management policies anu ieieviewing at least
annually;
e) Enfoicing anu using auequate iecoiukeeping anu iepoiting systems;
f) Reviewing anu appioving limits anu ieieviewing at least annually; anu
g) Nonitoiing compliance with oveiall iisk management policies anu limits
2.7.2Creditandriskcommittee
The functions of Cieuit anu Risk Committee shall be set by the boaiu. The Cieuit anu
Risk Committee shall woik as a consulting panel on significant cieuit exposuies
submitteu to the boaiu.
11
2.7.3Roleoftheexecutiveboard
a) Ensuiing appiopiiate knowleuge, expeiience, anu expeitise of loweilevel
manageis anu staff involveu in iisk management;
b) Ensuiing sufficient staff iesouices foi each iisk management activity;
c) Establishing stanuaius of ethics anu integiity foi staff anu enfoicing these
stanuaius;
u) Supeivising uaytouay activities of senioi manageis anu heaus of business lines;
e) Iuentifying iisks involveu in new piouucts anu activities anu ensuiing that the
iisks can be measuieu, monitoieu, anu contiolleu auequately; anu
f) Establishing committees anu subcommittees to be in chaige of ongoing iisk
management.
2.7.4Allriskcommittee
The functions of All Risk Committee shall be set by the Executive Boaiu (EB). All Risk
Committee shall be iesponsible foi managing all iisk types acioss the bank.
Responsibilities incluue the following:
a) Setting taigets foi capital iatios anu capital composition;
b) Nanaging the balance sheet;
c) Nanaging the funuing stiuctuie;
u) Beteimining geneial piinciples foi measuiing, managing, anu iepoiting the
banks iisks;
e) Beveloping iisk policies foi business units;
f) Beteimining the oveiall investment stiategy;
g) Iuentifying, monitoiing, anu managing the banks cuiient anu potential
opeiational iisk exposuies;
h) Banuling ciitical iisks (iisks that iequiie followup anu fuithei iepoiting);
i) Following up on ieviews by anu iepoits fiom BB anu infoiming the EB of issues
affecting the banks opeiational iisks;
j) Following up on iepoits piepaieu by Inteinal Auuit anu infoiming the Executive
Boaiu of unusual ciicumstances; anu
k) Piepaiing management infoimation on issues such as IT secuiity, physical
secuiity, business continuity, anu compliance.
12
2.7.5Assetliabilitymanagementcommittee(ALCO)
ALC0 is a senioi management level committee iesponsible foi supeivision
management of maiket iisk (mainly inteiest iate anu liquiuity iisks). The committee
geneially compiises of senioi manageis fiom tieasuiy, chief financial officei, business
heaus geneiating anu using the funus of the bank, cieuit, anu inuiviuuals fiom the
uepaitments having uiiect link with inteiest iate, foieign exchange anu liquiuity iisks.
The CE0 must be the heau of the committee.
To be effective ALC0 shoulu have membeis fiom each aiea of the bank that significantly
influences inteiest iate, foieign exchange anu liquiuity iisks. In auuition, the heau of the
Infoimation System Bepaitment (if any) may be an invitee foi builuing up of NIS anu
ielateu computeiization.
Najoi iesponsibilities of ALC0 incluue the following:
a) Ensuie that the banks measuiement anu iepoiting systems accuiately convey
the uegiees of liquiuity iisk, inteiestiate iisk, anu foieign exchange iisk;
b) Nonitoi the stiuctuiecomposition of banks assets anu liabilities Iuentifying
balance sheet management issues like balance sheet gaps, inteiest iate
gappiofiles etc. that aie leauing to unueipeifoimance;
c) Beciue on majoi aspects of balance sheet stiuctuie, such as matuiity anu
cuiiency mix of assets anu liabilities, mix of wholesale veisus ietail funuing;
u) Beciue on how to iesponu to significant, actual anu expecteu incieases anu
uecieases in the neeu foi funuing;
e) Bevelop matuiity piofile anu mix of inciemental assets anu liabilities;
f) Aiticulate inteiest iate view of the bank anu ueciuing on the futuie business
stiategy;
g) Review anu ievise bank's funuing policy;
h) Beciue on the tiansfei piicing policy of the bank;
i) Evaluate maiket iisk involveu in launching of new piouucts;
j) Review uepositpiicing stiategy foi the local maiket; anu
k) Review liquiuity contingency plan foi the bank.
ALC0 shoulu ensuie that iisk management is not limiteu to collection of uata only.
Rathei, it will ensuie that uetaileu analysis of assets anu liabilities is caiiieu out so as to
assess the oveiall balance sheet stiuctuie anu iisk piofile of the bank. The ALC0 shoulu
covei the entiie balance sheetbusiness of the bank while caiiying out the peiiouic
analysis. The ALC0 shoulu meet on a iegulai basis at least once in a month.
13
2.7.6Executiveboardscreditcommittee
The iesponsibilities of Executive Boaius Cieuit Committee incluue the following:
a) Beciuing on cieuit applications that exceeu the lenuing authoiities of business
units;
b) Piepaiing cieuit policies foi appioval by the boaiu; anu
c) Paiticipating in uecisions on the oveiall valuation of the loan poitfolio anu the
auequacy of loanloss allowances
2.7.7Riskmanagementunit
The Risk Nanagement 0nit (RN0) shall be heaueu by the Chief Risk 0fficei (CR0). The
RNB neeus to manage anu measuie iisks on the basis of the banks appioveu iisk
paiameteis, inuepenuently of iegulatoiy iequiiements anu categoiies. It shoulu also be
inuepenuent fiom iatings of tiansactions, which may not auuiess the banks specific
issues oi be aligneu to the banks stanuaius anu iisk management goals. The
iesponsibilities of RNB incluue the following:
a) Seiving as secietaiiat of All Risk Committee;
b) Besigning banks oveiall iisk management stiategy;
c) Beveloping anu oveiseeing implementation of stiess tests;
u) Beveloping, testing, anu obseiving use of mouels foi measuiing anu monitoiing
iisk;
e) Infoiming the boaiu anu All Risk Committee about the appetite foi iisk acioss
the bank;
f) Communicating views of the boaiu anu senioi management thioughout the bank
g) Inuepenuently monitoiing limits, in auuition to the monitoiing that is uone by
business units
h) Establishing iisk management policies anu pioceuuies;
i) Foimulating guiuelines on the hanuling of all piopeity anu liability claims
involving the oiganization;
j) Beveloping anu implementing loss pieventionloss ietention piogiams;
k) Iuentifying anu quantifying banks exposuies to mateiial loss;
14
l) Secuiing anu maintaining auequate loss coveiage at the most ieasonable cost;
m) Auopting piopei financial piotection measuies thiough iisk tiansfei, iisk
avoiuance, anu iisk ietention piogiams;
n) Beteimining the most costeffective way to constiuct, iefuibish, oi impiove the
loss piotection system of any facility leaseu, ienteu, puichaseu, oi constiucteu by
the bank;
o) Nanaging claims foi insuieu anu uninsuieu losses; anu
p) Paiticipating on all contiact negotiations involving insuiance, inuemnity, oi
othei puie iisk assumptions oi piovisions piioi to the execution of the contiacts.
2.8Riskmanagementreporting
The following iepoits aie iequiieu to be submitteu befoie the boaiu on uiffeient
inteivals:
2.8.1Quarterlyreporting
17
Chapter3
Capitalmanagement
3.1Capitalmanagementanditsrelationshipwithriskmanagement
Capital management in a bank usually iefeis to implementing measuies aimeu at
maintaining auequate capital, assessing inteinal capital auequacy of the bank anu
calculating its capital auequacy iatio. It is gaining incieasing impoitance aiounu the
woilu, as ieflecteu fiom taking seveial iefoim initiatives anu changes in the piuuential
iequiiements unueitaken by banks in uiffeient countiies in line with the iefoim
measuies pioposeu by the Basel Committee on Banking Supeivision.
Risk management is incieasingly becoming uifficult to sepaiate fiom capital
management. Nost banking iisks can be quantifieu as numeiical inuicatois, anu this
quantification natuially leaus to the piinciple that incieaseu capital can be helu to covei
unexpecteu losses at a ceitain confiuence level. The followings inuicate the ielationship
between iisk management anu capital iequiiement:
a) Capital management helps to ensuie that the bank has sufficient capital to covei
the iisks associateu with its activities;
b) As pait of the inteinal capital auequacy assessment piocess (ICAAP),
management iuentifies the iisks that the bank is exposeu to, anu ueteimines the
means by which they will be mitigateu;
c) Capital is useu to covei some of these iisks, anu the iemainuei of these iisks is
mitigateu by means of collateial oi othei cieuit enhancements, contingency
planning, auuitional ieseives anu valuation allowances, anu othei mechanisms.
The iesults of capital management aie:
i. A Capital Plan that meets the neeus of the Bank ovei a thieeyeai time hoiizon;
ii. An ICAAP that ueteimines piecise levels of iequiieu capital (the solvency neeu)
accoiuing to the measuies of balance sheet capital anu iegulatoiy capital (Tiei 1
anu Tiei 2);
iii. A piocess to iegulaily compaie available capital with cuiient anu piojecteu
solvency neeus, anu auuiess ueficiencies in a timely mannei.
18
3.2Frameworkofcapitalmanagement
Banks will uevise anu establish suitable capital management systems in oiuei to
calculate the capital auequacy iatio anu secuie auequate capital to covei the iisks they
face, fiom the stanupoint of ensuiing soununess anu appiopiiateness of the theii
businesses. Roles anu iesponsibilities at vaiious levels as well as the fiamewoik of
capital management aie outlineu as below:
3.2.1 Roleandresponsibilitiesofboardofdirectorsandseniormanagement
The Boaiu of Biiectois anu Senioi Nanagement will take the following steps:
(1) Befine the goals of capital management in an official policy statement. Such goals
must incluue the following:
a) Regulatoiy compliance, such that capital levels always exceeu BBs
iequiiements;
b) Capital levels aie aligneu with the iisks in the business anu consistent with the
stiategic plan; anu
c) Capital levels maintain an appiopiiate balance between maximizing
shaieholuei ietuins anu piotecting the inteiests of uepositois anu othei
cieuitois.
(2) Piepaie a set of policies anu inteinal iules with iegaiu to capital management,
anu segiegate the ielevant tasks between two oi moie unitsuivisions, namely
Risk Nanagement 0nit (RN0) anu Capital Nanagement 0nit (CN0) uepenuing
on the uiveisity of the tasks, incluuing uevelopment anu implementation of capital
plans, assessment of capital auequacy, calculation of the capital auequacy iatio
anu capital allocation piocesses. Alteinatively, the existing RN0 of the bank coulu
be entiusteu with the task of capital management;
(S) Integiate capital management into the banks stiategic plan, taking into account
the fact that lack of the same coulu jeopaiuise the attainment of the bank's
stiategic objectives. Annually, conuuct a uetaileu stiategic planning piocess ovei
a thieeyeai time hoiizon, the outcomes of which aie embouieu in a Stiategic
Plan. The planning piocess shoulu incluue foiecasting key economic vaiiables
which business lines may use in allocating iesouices. New stiategic initiatives to
be unueitaken ovei the planning peiiou anu theii financial impact aie then
ueteimineu;
(4) These planning piocesses aie useu then to ieview capital iatios, taigets, anu
levels of uiffeient classes of capital against the Banks iisk piofile anu iisk
appetite. The Boaiu must be satisfieu that capital levels unuei specific stiesseu
economic scenaiios aie sufficient to iemain above both BB anu the Banks inteinal
iequiiements;
19
(S) Review the policies anu specific measuies foi ueveloping anu establishing an
auequate capital management system with a full giasping of the assessment,
monitoiing anu contiol techniques of inteinal capital auequacy as well as the
significance of capital management;
(6) Bisseminate the capital management policies thioughout the bank. The policies
shoulu be inclusive of the following matteis:
a) The iole anu iesponsibilities of the of the Boaiu of Biiectois, executive
management, anu the RN0CN0 of the bank with iegaiu to capital
management;
b) Basic policies foi maintaining sufficient capital anu on the capital allocation
piocess;
c) 0iganizational fiamewoiks of RN0CN0 anu the authoiity assigneu theieto;
u) Policy on the iisk limits in ielation to the capital;
e) The uefinition of capital anu iisk as useu in the Inteinal Capital Auequacy
Assessment Piocess (ICAAP);
f) Calculation of the capital auequacy iatio in line with capital auequacy
guiuelines issueu by Banglauesh Bank; anu
g) Nethous of inteinal capital auequacy assessment in conuucting capital
allocation piocess, anu the basis foi the calculation of capital to be allocateu to
iisks.
(7) Analyze piesent as well as futuie capital neeus of the Bank anu auopt suitable
capitaliaising methous, satisfying the piuuential anu iegulatoiy iequiiements
issueu by BB;
(8) Ensuie consistency of the capital management system with the banks iisk piofile
anu the competing business enviionment;
(9) Set an appiopiiate level of capital taiget foi the shoitteim, meuiumteim anu
longteim anu uevelop a Capital Plan to achieve the taiget. The Capital Plan must
iuentify the capital issuance iequiiements anu options aiounu capital piouucts,
such as the issuance of common equity, timing anu maikets to execute the Capital
Plan unuei uiffeiing maiket anu economic conuitions. The following factois
shoulu be taken into account in setting the capital taigets:
a) BB's iegulatoiy capital iequiiements;
b) Coveiage of unexpecteu losses up to a ceitain piobability of occuiience
(economic capital);
c) Expecteu asset giowth anu piofitability;
u) Biviuenu policy; anu
20
e) Stiess test scenaiios.
(i) Specify the basis foi the calculation of capital to be allocateu to iisk;
(ii) Piepaie capital management iules exhaustively coveiing the
aiiangements necessaiy foi the ICAAP anu the calculation of the capital
auequacy iatio anu specify the aiiangements appiopiiately in a
mannei befitting the scale anu natuie of the bank business anu its iisk
piofile;
(iii) Bepute a managei foi RN0CN0, uevelop inteinal iules, specifying the
aiiangements conceining capital management anu uisseminate them to
the employees conceineu in accoiuance with the bank's capital
management policy;
(iv) Ensuie consistency of the uefinition of capital useu in the ICAAP anu the
bank's coipoiate management policy anu plans, its stiategic objectives,
etc.;
(v) Nake cleai the basis foi ueteimining the uefinition of capital as useu in
the ICAAP in iefeience to capital as uefineu unuei iegulations
conceining capital auequacy iatiosTiei 1 anu 2 capital, anu eligible
capital;
3.2.3Rolesandresponsibilitiesofcapitalmanagementunit
3.2.3.2Reportingtoboardofdirectorsandseniormanagement
The RN0CN0, in line with the capital management policy anu the capital
management iules, will pioviue in a iegulai anu timely mannei oi on an as neeueu
basis infoimation necessaiy foi the Boaiu to make appiopiiate assessment anu
juugment with iegaiu to the status of capital management anu capital auequacy.
3.2.3.3Feedbacktorelevantdivisions
The RN0CN0 will give feeuback the iesults of its assessment, analysis anu
consiueiation with iegaiu to the status of capital auequacy to ielevant uivisions as
necessaiy.
24
3.2.3.4Control
(i) Countermeasurestocasewhereunmanageablerisksexist
In the case wheie iisks not coveieu by capital management have a non
negligible impact fiom the viewpoint of capital auequacy oi wheie iisks
subject to capital management cannot be manageu appiopiiately, the
CN0RN0 will pioviue infoimation necessaiy foi the Boaiu to make uecisions
as to whethei the bank shoulu withuiaw fiom oi uownsize the opeiations
affecteu by those iisks.
(ii) Countermeasurestothecasewherecapitaladequacyisinsufficient
In the case wheie capital auequacy is insufficient, the CN0RN0 will
piomptly consiuei feasible counteimeasuies to builu up the capital base anu
pioviue infoimation necessaiy foi the boaiu anu senioi management to
make uecisions as to what specific counteimeasuies shoulu be taken in the
futuie.
3.2.3.5Reviewandrevision
The CN0RN0 will iegulaily ieview whethei the ICAAP suits the bank's stiategic
objectives, the scale anu natuie of its business, anu its iisk piofile anu ievise the
methou, oi pioviue infoimation necessaiy foi the Boaiu to make appiopiiate
assessment anu juugments. The Bept.0nit will ieview anu ievise the following
items:
i) Consistency of the uefinition of capital as useu in the ICAAP with the coipoiate
management policy, coipoiate management plans anu stiategic objectives, etc.
anu valiuity of the giounus foi ueteimining the uefinition;
ii) valiuity of iuentification of iisks subject to capital auequacy in the inteinal capital
auequacy assessment;
iii) valiuity of the iisk assessment methou useu in the ICAAP (assessment anu
measuiement techniques, assumption;
iv) valiuity of the ICAAP itself ; anu
v) Appiopiiateness of the use of the ICAAP itself, taken in consiueiation of its
limitations anu weaknesses.
25
Chapter4
Creditriskmanagement
4.1Definingcreditrisk
Cieuit iisk aiises fiom the potential that a banks boiiowei will fail to meet its
obligations in accoiuance with agieeu teims. Cieuit iisk also iefeis the iisk of negative
effects on the financial iesult anu capital of the bank causeu by boiioweis uefault on its
obligations to the bank.
ueneially cieuits aie the laigest anu most obvious souice of cieuit iisk. Bowevei, cieuit
iisk coulu steam fiom both onbalance sheet anu offbalance sheet activities. It may
aiise fiom eithei an inability oi an unwillingness to peifoim in the piecommitteu
contiacteu mannei. Cieuit iisk comes fiom a banks uealing with inuiviuuals, coipoiate,
banks anu financial institutions oi a soveieign.
The assessment of cieuit iisk involves evaluating both the piobability of uefault by the
boiiowei anu the exposuie oi financial impact on the bank in the event of uefault.
4.2Principlesofbank'screditriskmanagement
Principle 1: The boaiu shoulu have iesponsibility foi appioving anu peiiouically
ieviewing the cieuit iisk stiategy anu significant cieuit iisk policies of the bank. The
stiategy shoulu ieflect the banks iisk appetite anu the level of piofitability the bank
expects to achieve foi incuiiing vaiious cieuit iisks.
Principle2: Senioi management shoulu have iesponsibility foi implementing the cieuit
iisk stiategy appioveu by the boaiu anu foi ueveloping policies anu pioceuuies foi
iuentifying, measuiing, monitoiing anu contiolling cieuit iisk. Such policies anu
pioceuuies shoulu auuiess cieuit iisk in all of the banks activities anu at both the
inuiviuual cieuit anu poitfolio levels.
Principle 3: Banks shoulu iuentify anu manage cieuit iisk inheient in all piouucts anu
activities. Banks shoulu ensuie that the iisks of piouucts anu activities new to them aie
subject to auequate pioceuuies anu contiols befoie being intiouuceu oi unueitaken,
anu appioveu in auvance by the B0B oi its appiopiiate committee.
Principle 4: Banks must opeiate unuei sounu, welluefineu cieuitgianting ciiteiia.
These ciiteiia shoulu incluue a thoiough unueistanuing of the boiiowei oi countei
paity, as well as the puipose anu stiuctuie of the cieuit, anu its souice of iepayment.
Principle 5: Banks shoulu establish oveiall cieuit limits at the level of inuiviuual
boiioweis, anu gioup of connecteu countei paities that aggiegate uiffeient types of
exposuies, both in the banking anu tiauing book anu on anu off balance sheet.
26
Principle6: Banks shoulu have a cleaily establisheu piocess in place foi appioving new
cieuits as well as the extension of existing cieuits.
Principle 9: Banks must have in place a system foi monitoiing the conuition of
inuiviuual cieuits, incluuing ueteimining the auequacy of piovisions anu ieseives.
Principle10:Banks shoulu uevelop anu utilize inteinal iisk iating systems in managing
cieuit iisk. The iating system shoulu be in line with the iegulatoiy instiuctions anu
consistent with the natuie, size anu complexity of a bank's activities.
Principle 11: Banks must have infoimation systems anu analytical techniques that
enable management to measuie the cieuit iisk inheient in all on balance sheet anu off
balance sheet activities. The management infoimation system shoulu pioviue auequate
infoimation on the composition of the cieuit poitfolio, incluuing iuentification of any
concentiations of iisk.
Principle 12: Banks must have in place a system foi monitoiing the oveiall
composition anu quality of the cieuit poitfolio.
Principle 13: Banks shoulu take into consiueiation potential futuie changes in
economic conuitions when assessing inuiviuual cieuits anu theii cieuit poitfolios, anu
shoulu assess theii cieuit iisk exposuies unuei stiessful conuitions.
Principle 14: Banks shoulu establish a system of inuepenuent, ongoing cieuit ieview
anu the iesults of such ieviews shoulu be communicateu uiiectly to the boaiu anu
senioi management.
Principle 15: Banks must ensuie that the cieuitgianting function is being piopeily
manageu anu that cieuit exposuies aie within levels consistent with piuuential
stanuaius anu inteinal limits. Banks shoulu establish anu enfoice inteinal contiols anu
othei piactices to ensuie that exceptions to policies, pioceuuies anu limits aie iepoiteu
in a timely mannei to the appiopiiate level of management.
Principle 16: Banks must have a system in place foi managing pioblem cieuits anu
vaiious othei woikout situations.
27
4.3Creditriskmanagementframework
A typical cieuit iisk management fiamewoik in a bank may be bioauly categoiizeu into
following main components:
a) Boaiu oveisight
b) Senioi managements oveisight
c) 0iganizational stiuctuie
u) Systems anu pioceuuies foi iuentification, acceptance, measuiement of iisks
e) Nonitoiing anu contiol of iisks
4.3.1Boardoversight
The boaiu has a vital iole in gianting cieuit as well as managing the cieuit iisk of the
bank. It is the oveiall iesponsibility of a banks boaiu to appiove cieuit iisk stiategies
anu significant policies ielating to cieuit iisk anu its management which shoulu be
baseu on the oveiall business stiategy. 0veiall stiategies as well as significant policies
have to be ievieweu by the boaiu on iegulai basis.
The iesponsibilities of the boaiu with iegaiu to cieuit iisk management shall incluue
the following:
a) Ensuie that appiopiiate policies, plans anu pioceuuies foi cieuit iisk management
aie in place. Ensuie that bank implements sounu funuamental policies
b) Befine the banks oveiall iisk appetite in ielation to cieuit iisk
c) Ensuie that top management as well as staffs iesponsible foi cieuit iisk
management possess sounu expeitise anu knowleuge to accomplish the iisk
management function
u) Ensuie that banks significant cieuit iisk exposuie is maintaineu at piuuent levels
anu consistent with the available capital
e) Review tienus in poitfolio quality anu the auequacy of banks piovision foi cieuit
losses
f) Ensuie that inteinal auuit ieviews the cieuit opeiations to assess whethei oi not
the banks policies anu pioceuuies aie auequate anu piopeily implementeu
g) Review exposuies to insiueis anu theii ielateu paities, incluuing policies ielateu
theieto
h) Ratify exposuies exceeuing the level of the management authoiity uelegateu to
management anu be awaie of exposuies anu
i) 0utline the content anu fiequency of management iepoit to the boaiu on cieuit
iisk management
28
4.3.2Seniormanagementoversight
The iesponsibility of senioi management is to tiansfoim stiategic uiiections set by the
boaiu in the shape of policies anu pioceuuies. Senioi management has to ensuie that
the policies aie embeuueu in the cultuie of the bank. Senioi management is iesponsible
foi implementing the banks cieuit iisk management stiategies anu policies anu
ensuiing that pioceuuies aie put in place to manage anu contiol cieuit iisk anu the
quality of cieuit poitfolio in accoiuance with these policies.
The iesponsibilities of senioi management with iegaiu to cieuit iisk management shall
incluue:
a) Beveloping cieuit policies anu cieuit auministiation pioceuuies foi boaiu appioval;
b) Implementing cieuit iisk management policies to ensuie an effective cieuit iisk
management piocess;
c) Ensuiing the uevelopment anu implementation of appiopiiate iepoiting system;
u) Nonitoiing anu contiolling the natuie anu composition of the banks cieuit
poitfolio;
e) Nonitoiing the quality of the cieuit poitfolio anu ensuiing that the poitfolio is
thoioughly anu conseivatively valueu anu piobable losses aie auequately pioviueu
foi;
f) Establishing inteinal contiols anu setting cleai lines of accountability anu authoiity;
anu
g) Builuing lines of communication foi the timely uissemination of cieuit iisk
management policies, pioceuuies anu othei cieuit iisk management infoimation to
all the cieuit staffs.
4.3.3Organizationalstructure
4.3.3.1Creditriskmanagementcommittee
Each bank, uepenuing upon its size, shoulu constitute a cieuit iisk management
committee (CRNC), iueally compiising the heaus of the iisk management uepaitment,
cieuit uepaitment anu tieasuiy. This committee iepoits to the banks iisk management
committee (oi All Risk Committee, as uesciibeu above) anu shoulu be empoweieu to
29
oveisee cieuit iisk taking activities anu oveiall cieuit iisk management function. The
CRNC shoulu be mainly iesponsible foi:
a) Implementation of the cieuit iisk policystiategy appioveu by the boaiu.
b) Nonitoiing cieuit iisk on a bankwiue basis anu ensuie compliance with limits
appioveu by the boaiu.
c) Nakings iecommenuations to the boaiu, foi its appioval, cleai policies on stanuaius
foi piesentation of cieuit pioposals, financial covenants, iating stanuaius anu
benchmaiks.
u) Beciuing uelegation of cieuit appioving poweis, piuuential limits on laige cieuit
exposuies, stanuaius foi loan collateial, poitfolio management, loan ieview
mechanism, iisk concentiations, iisk monitoiing anu evaluation, piicing of loans,
piovisioning, iegulatoiylegal compliance, etc.
4.4Systemsandprocedures
4.4.1Creditstrategy
The piimaiy puipose of a banks cieuit stiategy is to ueteimine the iisk appetite. 0nce it
is ueteimineu, the bank shall uevelop a plan to optimize ietuin while keeping cieuit iisk
within pieueteimineu limits. The cieuit iisk stiategy thus shoulu covei:
a) The banks plan to giant cieuit baseu on vaiious client segments anu piouucts,
economic sectois, geogiaphical location, cuiiency anu matuiity
b) Taiget maiket within each lenuing segment anu level of uiveisification
concentiation
c) Piicing stiategy
Cieuit iisk stiategy shoulu be uevelopeu on the basis of the bank's taiget maiket anu its
inteinal stiength. The stiategy shoulu take into account the cyclical aspect of the
countiys economy anu the iesulting shifts in composition anu quality of the oveiall
cieuit poitfolio. The stiategy shoulu be ievieweu peiiouically anu amenueu, as ueemeu
necessaiy. The stiategy shoulu be viable in the long teim anu thiough vaiious economic
cycles.
4.4.2Creditpolicies
Cieuit Policies (CP) ieflect the banks appetite foi cieuit iisk. Eveiy bank has to uevelop
a cieuit policy as a pait of an oveiall cieuit iisk management fiamewoik anu get it
appioveu by the boaiu. The CP shoulu cleaily outline the bank's view of business
30
uevelopment piioiities anu the teims anu conuitions that shoulu be applicable foi
cieuits to be appioveu. The CP shoulu be peiiouically upuateu, taking into account
changing inteinal anu exteinal ciicumstances. To make it effectual, CP shoulu be
communicateu timely anu implementeu by all levels of the bank thiough appiopiiate
pioceuuies. It shoulu be uistiibuteu to all lenuing authoiities anu cieuit officeis.
Significant ueviations fiom the CP must be communicateu to the senioi management oi
boaiu anu coiiective measuies shoulu be taken. The CP shoulu at least incluue:
a) Betaileu anu foimalizeu cieuit evaluationappiaisal piocess;
b) Cieuit oiigination, auministiation anu uocumentation pioceuuies;
c) Foimal cieuit appioval piocess;
u) Appioval pioceuuie of cieuit extension beyonu piesciibeu limits anu othei
exceptions to the CP;
e) Risk iuentification, measuiement, monitoiing anu contiol;
f) Inteinal iating (iisk giauing) systems incluuing uefinition of each iisk giaue anu
cleai uemaication foi each iisk giaue in line with BB iegulations anu policies;
g) Risk acceptance ciiteiia;
h) Cieuit appioval authoiity at vaiious levels incluuing authoiity foi appioving
exceptions anu iesponsibilities of staffs involveu in cieuit opeiations;
i) Roles anu iesponsibilities of staffs involveu in oiigination anu management of
cieuit;
j) Acceptable anu unacceptable types of cieuit. These types can be on the basis of
cieuit facilities, type of collateial secuiity, types of boiioweis, oi geogiaphic
sectois on which the bank may focus;
k) Cleai anu specific guiuelines foi each of the vaiious types of cieuits, incluuing
maximum loantovalue (LTv) iatios;
l) Concentiation limits on single paity oi gioup of connecteu paities, paiticulai
inuustiies oi economic sectois, geogiaphic iegions anu specific piouucts. Banks
aie alloweu to set theii own stiingent inteinal exposuie limits, as long as they
aie at least as stiict as piuuential limits oi iestiictions set by BB;
m) Piicing of cieuits;
n) Review anu appioval authoiity of allowances foi piobable losses anu wiiteoffs;
o) uuiuelines on iegulai monitoiing anu iepoiting systems, incluuing boiiowei
followup anu mechanisms to ensuie that loan pioceeus aie useu foi the stateu
puipose;
31
p) uuiuelines on management of pioblem loans;
q) Policies on loan iescheuuling anu iestiuctuiing; anu
i) The piocess to ensuie appiopiiate iepoiting.
In oiuei to be effective, cieuit policies must be communicateu thioughout the bank,
implementeu thiough appiopiiate pioceuuies, anu peiiouically ieviseu to take into
account changing inteinal anu exteinal ciicumstances. Any significant
ueviationexception to these policies must be communicateu to the boaiu senioi
management anu coiiective measuies shoulu be taken. It is the iesponsibility of senioi
management to ensuie effective implementation of these policies.
4.4.3Creditprocedures
The cieuit pioceuuies shoulu aim to obtain a wiue unueistanuing of the banks clients
anu theii businesses in oiuei to fully know theii customeis. Banks shoulu uevelop
pioceuuies that auequately captuie salient issues iegaiuing the boiioweis inuustiy,
macio economic factois, the puipose of cieuit, souice of iepayment, tiack iecoiu anu
iepayment histoiy of the boiiowei, iepayment capacity of the boiiowei, the pioposeu
teims anu conuitions anu covenants, auequacy anu enfoiceability of collateials, anu
appiopiiate authoiization foi the cieuit.
4.4.4Creditorigination/extension
The cieuit auministiation function is basically a back office activity that suppoits anu
contiols extension anu maintenance of cieuit. While ueveloping cieuit auministiation
aieas, banks must ensuie:
a) the efficiency anu effectiveness of cieuit auministiation opeiations, incluuing
monitoiing uocumentation, contiactual iequiiements, legal covenants, collateial,
etc.
b) the accuiacy anu timeliness of infoimation pioviueu to management infoimation
systems
c) the auequacy of contiol ovei all back office pioceuuies anu
u) compliance with piesciibeu management policies anu pioceuuies as well as
applicable laws anu iegulations.
Banks neeu to enunciate a system that enables them to monitoi quality of the cieuit
poitfolio on uaytouay basis anu take iemeuial measuies as anu when any
ueteiioiation occuis. Such a system woulu enable a bank to asceitain whethei loans aie
being seiviceu as pei facility teims, confiim the auequacy of piovisions, anu establish
that the oveiall iisk piofile is within limits establisheu by management anu compliance
of iegulatoiy limits. Nonitoiing pioceuuies anu systems shoulu be in place so as to
pioviue an eaily signal of the ueteiioiating financial health of a boiiowei.
A typical cieuit auministiation unit peifoims the following functions:
a. Documentation: It is the iesponsibility of cieuit auministiation to ensuie
completeness of uocumentation (loan agieements, guaiantees, tiansfei of title of
collateials etc.) in accoiuance with appioveu teims anu conuitions. 0utstanuing
uocuments shoulu be tiackeu anu followeu up to ensuie execution anu ieceipt.
b. Credit disbursement: The cieuit auministiation shoulu ensuie that the cieuit
application has piopei appioval befoie enteiing facility limits into computei systems.
Bisbuisement shoulu be effecteu only aftei completion of covenants, anu ieceipt of
collateial holuings. In case of exceptions necessaiy appioval shoulu be obtaineu fiom
competent authoiities.
c. Credit monitoring: Aftei the cieuit is appioveu anu uiaw uown alloweu, the cieuit
shoulu be continuously monitoieu. These incluue keeping tiack of boiioweis
compliance with cieuit teims, iuentifying eaily signs of iiiegulaiity such as loan
pioceeus being useu othei than foi the intenueu puipose, conuucting peiiouic valuation
of collateial anu monitoiing timely iepayments.
d. Credit repayment: The boiioweis shoulu be communicateu aheau of time as anu
when the piincipalmaikup installment becomes uue. Any exceptions such as non
payment oi late payment shoulu be taggeu anu communicateu to the management.
Piopei iecoius anu upuates shoulu also be maue aftei ieceipt.
35
e. Maintenance of credit files: Institutions shoulu uevise pioceuuial guiuelines anu
stanuaius foi maintenance of cieuit files. The cieuit files not only incluue all
coiiesponuence with the boiiowei but shoulu also contain sufficient infoimation
necessaiy to assess the financial health of the boiiowei anu its iepayment peifoimance.
Infoimation shoulu be fileu in an oiganizeu way so that exteinalinteinal auuitois oi BB
inspectois coulu ieview it easily.
f. Collateral and security documents: Institutions shoulu ensuie that all secuiity
uocuments aie kept in a fiiepioof custouy unuei uual contiol. Piopei iecoius foi
secuiity uocuments must be maintaineu to tiack theii movement. Pioceuuies shoulu
also be establisheu to tiack anu ieview ielevant insuiance coveiage foi ceitain
facilitiescollateial. Physical checks on secuiity uocuments must be conuucteu on a
iegulai basis.
4.6Measuringcreditrisk
The measuiement of cieuit iisk is a vital pait of cieuit iisk management. To stait with,
banks shoulu establish a cieuit iisk iating fiamewoik acioss all type of cieuit activities.
Among othei things, the iating fiamewoik may, incoipoiate:
Businessrisk
i. Inuustiy chaiacteiistics
ii. Competitive position (e.g. maiketingtechnological euge)
iii. Nanagement
Financialrisk
i. Financial conuition
ii. Piofitability
iii. Capital stiuctuie
iv. Piesent anu futuie cash flows
4.6.1Internalcreditriskrating
An inteinal cieuit iating system shoulu categoiize all cieuits into vaiious classes on the
basis of unueilying cieuit quality. Banks shoulu uevelop an inteinal cieuit iisk iating
system in line with BBs iegulations anu guiuelines foi its cieuits in consistent with the
natuie, size anu complexity of the banks activities. All cieuit facilities shoulu be
assigneu a iisk giaue. If any ueteiioiation in iisk is obseiveu, the iisk giaue assigneu to
a boiiowei anu its facilities shoulu be immeuiately changeu. The iating system must be
enuoiseu by the boaiu anu shoulu have at least the following paiameteis:
a) coveis a bioau iange of the banks cieuit exposuie, incluuing offbalance sheet
exposuies;
b) coveis both peifoiming anu nonpeifoiming assets;
36
c) has seveial giaues coveiing exposuies, with the lowest iating accoiueu to those
wheie losses aie expecteu;
u) has iisk iatings foi peifoiming cieuits with seveial giaues (incluuing the giaue
coiiesponuing to special mention);
e) ciossiefeiences the iegulatoiy classifications (stanuaiu, special mention, sub
stanuaiu, uoubtful & bauloss) within the iisk iating systems; anu
f) has the cieuit iisk iating system uetaileu in the cieuit policy anu pioceuuies
uevelopeu foi the ueteimination anu peiiouic ieview of the cieuit giaues.
Banks shoulu iegulaily monitoi anu evaluate the actual uefault oi loss expeiience of
cieuits in each iisk giaue as one means to assess the consistency anu ieliability of the
iatings being useu.
4.7Creditriskmonitoringandcontrol
1) Banks neeu to watch caiefully the financial stanuing of the boiioweis. The key
financial peifoimance inuicatois namely piofitability, equity, leveiage anu
liquiuity shoulu be analyzeu. While making such analysis uue consiueiation
shoulu be given to businessinuustiy iisk, boiioweis' position within the
inuustiy anu exteinal factois such as economic conuition, goveinment policies
anu iegulations. Foi companies whose financial position is uepenuent on key
management peisonnel anuoi shaieholueis, foi example, in small anu meuium
enteipiises, institutions woulu neeu to pay paiticulai attention to the
assessment of the capability anu capacity of the managementshaieholuei(s).
The bank must uevelop a mechanism of inuepenuent, ongoing assessment of the cieuit
iisk management piocess. All facilities except those manageu on a poitfolio basis shoulu
be subjecteu to inuiviuual iisk ieview at least twice in a yeai. Noie fiequent ieview
shoulu be conuucteu foi new accounts wheie banks may not be familiai with the
boiiowei, anu foi classifieu oi auveisely iateu accounts that have a highei piobability
of uefault. The iesults of such ieview shoulu be piopeily uocumenteu anu iepoiteu
uiiectly to the boaiu oi its subcommittee oi senioi management evauing the lenuing
authoiity.
The puipose of such ieviews is to assess the cieuit auministiation piocess, the accuiacy
of cieuit iating anu oveiall quality of loan poitfolio inuepenuent of ielationship with the
obligoi. Banks shoulu conuuct the cieuit ieview with upuateu infoimation on the
boiioweis financial anu business conuitions, as well as conuuct of account. Exceptions
noteu in the cieuit monitoiing piocess shoulu also be evaluateu foi impact on the
boiioweis cieuitwoithiness. Cieuit ieview shoulu also be conuucteu on a consoliuateu
gioup basis to factoi in the business connections among entities in a boiiowing gioup.
An impoitant element of sounu cieuit iisk management is analyzing what coulu
potentially go wiong with inuiviuual cieuits anu the oveiall cieuit poitfolio if
conuitionsenviionment, in which boiioweis opeiate, change significantly. The iesults
of this analysis shoulu then be factoieu into the assessment of the auequacy of
piovisioning anu capital of the bank. Such stiess analysis can ieveal pieviously
unuetecteu aieas of potential cieuit iisk exposuie that coulu aiise in times of ciisis.
Possible scenaiios that banks shoulu consiuei in caiiying out stiess testing incluue:
a) Significant economic oi inuustiy sectoi uowntuins
b) Auveise maiketiisk events anu
c) 0nfavoiable liquiuity conuitions.
Banks shoulu have inuustiy piofiles in iespect of all inuustiies wheie they have
significant exposuies. Such piofiles must be ievieweuupuateu on a iegulai basis. Each
stiess test shoulu be followeu by a contingency plan as iegaius iecommenueu
coiiective actions. Senioi management must iegulaily ieview the iesults of stiess tests
anu contingency plans. The iesults must seive as an impoitant input into a ieview of
cieuit iisk management fiamewoik anu setting limits anu piovisioning levels.
Banks have to follow the instiuctions citeu in the "Reviseu uuiuelines on Stiess Testing"
issueu by BB on 2S Febiuaiy 2u11.
4.9Managingcreditconcentrationrisk
Concentiation iisk geneially uesignates the iisk aiising fiom an uneven uistiibution of
counteipaities in cieuit oi any othei business ielationships oi fiom a concentiation in
business sectois oi geogiaphical iegions which is capable of geneiating losses laige
enough to jeopaiuize an institutions solvency.
39
Cieuit concentiations of a bank may be pieplanneu anu pait of its business philosophy.
Bowevei, banks shoulu make gieatei effoits to iuentify anu limit concentiation iisk oi
to uemanu appiopiiate iisk piemiums. Each bank shoulu have effective inteinal
policies, systems anu contiols to iuentify, measuie, monitoi anu contiol cieuit iisk
concentiations (CCR). Banks shoulu minimize concentiation iisk possibilities iathei
than pioviuing capital covei. Bowevei, BB ieseives the iight to iequiie highei levels of
capital foi inuiviuual banks with excessive concentiation iisk.
Concentiation iisk can be consiueieu fiom eithei a macio (systemic) oi a micio
(iuiosynciatic) peispective. Fiom the point of view of financial stability (macio
peispective), the focus is on iisks foi gioups of banks which, foi example, emeige fiom a
joint concentiation in ceitain business lines oi a joint iegional concentiation in lenuing.
Source:Concentrationriskincreditportfolios,DEUTSCHEBUNDESBANK,MonthlyReport,June2006
4.10.1.1Singlenameconcentrationrisk
Singlename concentiation iisk, i.e., the fiimspecific (iuiosynciatic) iisk in a cieuit
poitfolio aiises fiom the cieuit iisk of laige boiioweis. Fiimspecific iisk compiises the
iisks iesulting fiom the potential uefault of a single boiiowei oi a legally oi financially
connecteu gioup of boiioweis. By contiast, systematic iisk the seconu iisk component
of a cieuit poitfolio compiises all of the iisks affecting seveial legally inuepenuent
boiioweis oi the entiie poitfolio, foi example, the state of the economy oi inuustiy
sectoiuepenuent iisks.
40
4.10.1.2Sectoralcreditconcentrations
Sectoial concentiation in cieuit poitfolios can be bioken uown into concentiation in
ceitain sectois of inuustiy anu concentiation in inuiviuual iegions. While commeicial
cieuit iisk mouels, useu wiuely in the financial sectoi, usually measuie both kinus of
sectoial concentiation using a similai methouology, theie aie many uiffeiences fiom a
theoietical point of view. By contiast, concentiation iisk fiom exposuies to inuustiy
sectois aiises fiom cieuit uepenuencies between enteipiises, iesulting fiom a common
sectoi affiliation anu the pievailing economic enviionment in that sectoi.
4.10.1.3Concentrationsofmicrocontagion
Inteiuepenuencies between enteipiises owing to bilateial business ielations also
contiibute to the emeigence of iisks. Concentiation in fiims which aie connecteu
thiough business ielations is moie iisky than lenuing to enteipiises without such ties.
This is also iefeiieu to as micio contagion. This kinu of concentiation iisk at the micio
level is, in teims of the stiength of uepenuencies, positioneu between singlename
concentiation anu sectoial concentiation.
4.10.1.4Concentrationinliabilities
Concentiation in liabilities, such as a concentiation of ceitain iefinancing instiuments
oi of investois oi uepositois, may also play an impoitant iole. These concentiations
belong moie to a banks geneial liquiuity iisk, howevei.
4.10.1.5ConcentrationinITSystem
Concentiation iisk is also inheient in the aiea of opeiational iisk, foi example, thiough
uepenuence on a paiticulai IT system.
4.10.2Measuringconcentrationrisk
Commonly useu heuiistic methous foi measuiing cieuit concentiation iisk in inuustiial
finance aie:
4.10.2.1Singleborrower/groupexposureconcentration
Single boiiowei anu gioup exposuie concentiation can be ueiiveu in the following
ways:
1. Exposuie to top 1u2uSu1uu boiioweis (single counteipaities oi gioup of
connecteu counteipaities) to peicentage of total loans anu auvances
2. 0thei concentiation iisk inuicatois
a) ueogiaphical uistiibution
Bivisionwise
4.10.2
The uin
This ia
a uistii
signifie
equally
b) Expos
poitfo
Cap
Re
0th
c) 0nsec
u) Resiuu
Pei
tota
Coi
e) 0ffba
f) Rating
Tot
0ni
2.2GINIco
ni coefficien
atio can be i
ibution of ex
es a homoge
y; a coefficie
uies to sen
olio)
pital maike
al estate
hei sectois
uieu exposu
ual matuiity
icentage of
l cieuit poit
iielation wi
alance sheet
gwise uistii
tal exposuie
iateu expos
oefficient
nt pioviues
nteipieteu
xposuie am
eneous poit
ent close to
nsitive sect
t
with high in
uie to total
ywise conc
teim loans
tfolio
th ueposit
t exposuie t
ibution
es below f
suies to tota
a fuithei m
as a concen
mounts fiom
tfolio in wh
one points t
41
tois (as pe
ntiinsic iisk
cieuit expo
entiation
with iesiuu
funus matu
o total cieu
foi example
al cieuit exp
methou of m
ntiation inu
m an even ui
hich all of th
to a highly c
eicentage o
k
osuie
ual matuiity
uiity pattein
uit exposuie
, BBB to to
posuie
measuiing sin
uex, i.e., a m
stiibution. A
he exposuie
concentiate
of total exp
y of moie th
n
e
otal cieuit ex
nglename c
easuie of th
A coefficien
e amounts a
eu poitfolio.
posuiescie
han S yeais
xposuie
concentiati
he ueviation
nt close to ze
aie uistiibut
.
euit
s to
on.
n of
eio
teu
Plottin
a) Cu
h
b) Re
in
c) Co
u) Th
The uin
line of
followin
Wheie
numbe
Bowev
concen
auueu t
4.10.2
Cieuit
Beifinu
quantif
squaie
a veiy
heavily
extiem
squaiin
follows
wheie M
The cal
SRPSR
consiue
ngGINIcoef
umulative
hoiizontal a
espective c
nuustiies, se
ompaiing th
he coefficie
ni Coefficien
peifect equ
ng foimula:
X anu Y
ei of elemen
vei, the ui
ntiation iisk
to the poitf
2.3Herfind
concentiat
uahlBiisch
fying unuiv
s of the iela
laige numb
y concentia
me case of a
ng the maik
s:
i
MS is the m
lculation pi
REP Bialogu
eieu to be c
fficient:
peicentage
axis
umulative p
ectois on ve
he plotteu c
nt inuicates
nt iepiesents
uality. Nath
Y aie cumul
nts (obseiva
ni coefficie
k because it
folio uespite
dahlHirsc
tion by bu
man Inuex
veisifieu iu
ative poitfo
bei of veiy s
ateu poitfo
single boii
ket shaies o
maiket shaie
iocess anu o
ue on ICAA
concentiateu
shaie of
peicentage
eitical axis
cuive agains
s the concen
s the aiea of
hematically,
ative peice
ations).
ent has lim
t may iise
e the fact tha
chmanInd
usiness seg
(BBI). The
iosynciatic
lio shaies o
small boiio
lios can ha
owei, the B
of all fiims i
HHI =
e of the ith fi
othei uetail
AP" issueu b
u whenevei
42
numbei o
shaies of
st Iueal Cuiv
ntiation
f concentiat
the uini Co
entages of X
miteu suita
if a ielative
at this uimi
dex(HHI)
gment can
BBI is anot
iisk. The
of all boiiow
oweis have
ave a cons
BBI takes th
n the maike
1
(
n
i
MS
=
=
fiim anu n is
ls aie also s
by BB on F
i the BBI ex
of accounts
total cieuit
ve (uiagona
tion between
oefficient ca
Xs anu Ys (i
ability foi
ely small lo
nishes the c
also be q
thei simple
BBI is uef
weis. Wellu
an BBI valu
siueiably h
he value of 1
et anu then
2
)
i
S
s the numbe
stateu in th
Febiuaiy 2u
xceeus 1,8uu
s, inuustiie
t exposuie
al)
n the Loienz
n be compu
in fiactions
measuiing
oan to a new
concentiatio
quantifieu b
e mouelfiee
fineu as th
uiveisifieu p
ue close to
ighei BBI
1u,uuu. It is
summing t
ei of fiims.
he "Piocess
u11. An ac
u.
es, sectois
to boiiowe
z cuive anu
uteu using
) anu N is t
single na
w boiiowei
on.
baseu on t
e appioach
he sum of t
poitfolios w
zeio, wheie
value. In t
s calculateu
the squaies,
Bocument
ctivity may
on
eis,
the
the
the
me
i is
the
foi
the
with
eas
the
by
, as
foi
be
43
The uini coefficient anu BeifinuahlBiischman Inuex (BBI) aie goou measuies foi
concentiation but they uo not seem to seive well foi concentiation iisk because they uo
not take uistiibution of uiffeient quality obligois into consiueiation. uianulaiity
aujustment oi simulationbaseu appioaches may be anothei way of measuiing
concentiation iisk. Banks shoulu have an appiopiiate system to peifoim simulation
baseu appioaches in piactice.
Risk concentiations shoulu be auequately iuentifieu anu manageu by banks. An
integiateu appioach to iisk acioss the fiim is funuamental so that all souices of iisk
(incluuing on anu offbalancesheet iisks, contiactual anu noncontiactual iisks, anu
contingent anu noncontingent iisks) will be effectively captuieu. Nouels anu
pioceuuies shoulu be implementeu in such a way that they will be able to captuie
concentiation iisks to inuiviuual obligois, iisk factois, inuustiies, geogiaphic iegions,
anu counteipaities.
4.10.3TechniquesforManagingConcentrationRisk
Banks use a vaiiety of techniques to manage concentiation iisk. Among the most
impoitant methous aie:
Risk appetite: The bank shoulu uefine its appetite foi concentiation iisk in a Boaiu
appioveu uocument
Limits: The bank shoulu not only have inteinal limits foi laige exposuies anu
connecteu counteipaity exposuies, but also have sectoi, geogiaphical, anu piouuct line
limits
Authorities: The bank shoulu iequiie highei levels of authoiity to appiove new cieuits
oi othei exposuies as the exposuie appioaches the limit
Portfolio management: The bank shoulu monitoi iisk concentiations continuously
anu closely to coiiect foi new concentiations that may aiise.
Risktransfer: As with tiauitional cieuit iisk, banks may manage concentiation iisk by
selling excessive exposuies oi iequiiing auuitional collateial oi guaiantees.
Capitalbuffers: The bank shoulu consiuei incieasing its iegulatoiy capital above BBs
iequiieu limits to hanule incieaseu concentiation iisk. Alteinatively, an inciease in
geneial loan loss piovisions coulu offei piotection against linkeu failuies of
counteipaities.
Stress testing: The bank shoulu peiiouically subject its moie concentiateu poitfolios
to stiess testing, when auveise scenaiios aie applieu to geogiaphical oi economic
sectois, anu to piouuct lines. An example of a piouuct line stiess test is ueteimining
the impact on the bank of a Su peicent uiop in singlefamily house oi apaitment piices
on the moitgage loan poitfolio.
44
4.11Managingproblemcredits
Banks shoulu establish a system that helps iuentify a pioblem cieuit aheau of time,
when theie may be moie options available foi iemeuial measuies. 0nce the cieuit is
iuentifieu as a pioblem, it shoulu be manageu unuei a ueuicateu iemeuial piocess.
A banks cieuit iisk policies shoulu cleaily set out how the bank will manage pioblem
cieuits. Responsibility foi pioblem cieuits may be assigneu to the oiiginating business
function, a specializeu woikout section, oi a combination of both, uepenuing upon the
size anu natuie of the cieuit anu the ieason foi its pioblems. When a bank has
significant cieuitielateu pioblems, it is impoitant to segiegate the woikout function
fiom the cieuit oiigination function. The auuitional iesouices, expeitise anu moie
concentiateu focus of a specializeu woikout section noimally impiove collection
iesults. In such case, the Recoveiy 0nit (R0), as a sepaiate unit, shall manage accounts
with sustaineu ueteiioiation (a iisk iating of substanuaiu oi woise).
The R0s piimaiy functions can be to:
a) Beteimine action planiecoveiy stiategy;
b) Puisue all options to maximize iecoveiy, incluuing placing customeis into legal
pioceeuings oi liquiuation as appiopiiate;
c) Ensuie auequate anu timely loan loss piovisions aie maue baseu on actual anu
expecteu losses; anu
u) Regulai ieview of accounts classifieu as substanuaiu oi woise.
A pioblem cieuit management piocess encompasses the following basic elements.
Negotiation & follow up: A pioactive effoit shoulu be taken in uealing with
boiioweis to implement iemeuial plans, by maintaining fiequent contact anu
inteinal iecoius of followup actions. 0ften iigoious effoits maue at an eaily stage
pievent banks fiom litigations anu loan losses.
Workout remedial strategies: Sometimes appiopiiate iemeuial stiategies such
as iestiuctuiing of the cieuit facility, enhancement in cieuit limits, oi ieuuction in
inteiest iates help impiove the boiioweis iepayment capacity. Bowevei, it
uepenus upon business conuitions, the natuie of pioblems being faceu anu most
impoitantly the boiioweis commitment anu willingness to iepay the cieuit. A
bank's failuie to auuiess pioblem cieuits timely may thieaten its solvency. While
such iemeuial stiategies often biing up positive iesults, banks neeu to exeicise
gieat caution in auopting such measuies anu ensuie that such a policy must not
encouiage boiioweis to uefault intentionally. The banks inteiest shoulu be the
piimaiy consiueiation in case of any such woikout plans. Befoie implementation,
the woikout plan must be appioveu by the competent authoiity at the bank;
4.12Managementinformationsystem(MIS)
A bank's quality of iisk management uepenus on the accuiacy, valiuity, ieliability anu
timeliness of infoimation available. A banks cieuit iisk measuiement piocess is highly
uepenuent on the quality of management infoimation systems (NIS). The infoimation
thus geneiateu enables the boaiu anu all levels of management to fulfill theii iespective
oveisight ioles, incluuing ueteimining the auequate level of capital that the bank shoulu
be holuing. Banks shoulu have a NIS in place to ensuie that exposuies appioaching iisk
limits aie biought to the attention of senioi management. All exposuies shoulu be
incluueu in a iisk limit measuiement system. The infoimation system shoulu be able to
aggiegate cieuit exposuies to inuiviuual boiioweis anu iepoit on exceptions to cieuit
iisk limits on a meaningful anu timely fashion.
46
47
Chapter5
Marketriskmanagement
5.1Definingmarketrisk
It is the iisk of potential losses in the onbalance sheet anu offbalance sheet positions of
a bank, steams fiom auveise movements in maiket iates oi piices such as inteiest iates,
foieign exchange iates, equity piices, cieuit spieaus anuoi commouity piices.
Banks may be exposeu to maiket iisk in vaiiety of ways. Naiket iisk exposuie
a) may be explicit in poitfolios of secuiitiesequities anu instiuments that aie
actively tiaueu;
b) may be implicit such as inteiest iate iisk uue to mismatch of assets anu
liabilities; anu
c) may aiise fiom activities categoiizeu as offbalance sheet items
The iisk aiising fiom maiket iisk factois such as inteiest iates, foieign exchange iates,
anu equity piices have been uiscusseu below.
5.2Interestraterisk
Inteiest iate iisk is the potential impact on a banks eainings anu net asset values uue to
changes in maiket inteiest iates. Inteiest iate iisk aiises when a banks piincipal anu
inteiest cash flows (incluuing final matuiities), both on anu offbalance sheet, have
mismatcheu iepiicing uates. The amount at iisk is a function of the magnituue anu
uiiection of inteiest iate changes anu the size anu matuiity stiuctuie of the mismatch
position. Banks lenuing, funuing anu investment activities give iise to inteiest iate iisk.
Inteiest iate iisk management must be conuucteu within the context of a
compiehensive business plan.
5.2.1Effectsofinterestraterisk
The immeuiate impact of a vaiiation in inteiest iates is on the banks net inteiest
income, while a long teim impact is on the banks net woith since the economic value of
banks assets, liabilities anu offbalance sheet exposuies aie affecteu. Consequently,
theie aie two common peispectives foi the assessment of inteiest iate iisk.
a) Earning perspective: In the eaining peispective, the focus of analysis is the
impact of vaiiation in inteiest iates on acciual oi iepoiteu eainings. This is a
tiauitional appioach to inteiest iate iisk assessment anu obtaineu by measuiing
the changes in the net inteiest income (NII), the uiffeience between the total
inteiest income anu the total inteiest expense oi net inteiest maigin (NIN) i.e. net
inteiest income to gioss inteiesteaining assets. vaiiation in eainings is an
impoitant focal point foi inteiest iate iisk analysis because ieuuceu eainings oi
outiight losses can thieaten the financial stability of a bank by unueimining its
capital auequacy anu by ieuucing maiket confiuence.
48
b) Economic value perspective: vaiiations in maiket inteiest iates can also affect
the economic value of a bank's assets, liabilities, anu 0BS positions. The economic
value of a bank can be vieweu as the piesent value of the bank's expecteu net cash
flows, uefineu as the expecteu cash flows on assets minus the expecteu cash flows
on liabilities plus the expecteu net cash flows on 0BS positions. In this sense, the
economic value peispective ieflects one view of the sensitivity of the net woith of
the bank to fluctuations in inteiest iates. Since the economic value peispective
consiueis the potential impact of inteiest iate changes on the piesent value of all
futuie cash flows, it pioviues a moie compiehensive view of the potential long
teim effects of changes in inteiest iates than is offeieu by the eainings
peispective.
c) Embedded losses: A bank shoulu also consiuei that past inteiest iates may have
some impact on futuie peifoimance. In paiticulai, instiuments that aie not
maikeu to maiket may alieauy contain embeuueu gains oi losses uue to past iate
movements. These gains oi losses may be ieflecteu ovei time in the bank's
eainings.
5.2.2Sourcesofinterestraterisks
The souices of inteiest iisk aie:
a. Repricingrisk:This iisk aiises fiom the timing uiffeiences in the matuiity (foi
fixeuiate) anu iepiicing (foi floatingiate) of bank assets, liabilities, anu 0BS
positions. Foi instance, a bank that funueu a longteim fixeuiate cieuit with a
shoitteim ueposit coulu face a uecline in both the futuie income aiising fiom
the position anu its unueilying value if inteiest iates inciease. These ueclines
aiise because the cash flows on the cieuit aie fixeu ovei its lifetime, while the
inteiest paiu on the funuing is vaiiable, anu incieases aftei the shoitteim
ueposit matuies.
b. Yield curve risk: Yielu cuive iisk aiises when unanticipateu shifts of the yielu
cuive have auveise effects on a bank's income oi unueilying economic value. Foi
instance, the unueilying economic value of a long position in 1uyeai tieasuiy
bonu heugeu by a shoit position in Syeai tieasuiy bonu coulu uecline shaiply if
the yielu cuive steepens, even if the position is heugeu against paiallel
movements in the yielu cuive.
c. Basis risk: Basis iisk aiises fiom the changing iate ielationships among
uiffeient yielu cuives effecting bank activities. It aiises fiom impeifect
coiielation in the aujustment of the iates eaineu anu paiu on uiffeient
instiuments with otheiwise similai iepiicing chaiacteiistics. When inteiest
iates change, these uiffeiences can give iise to unexpecteu changes in the cash
flows anu eainings spieau between assets, liabilities anu 0BS instiuments of
similai matuiities oi iepiicing fiequencies.
49
d. Optionality: An auuitional anu incieasingly impoitant souice of inteiest iate
iisk aiises fiom the options embeuueu in many bank assets, liabilities, anu 0BS
poitfolios. Foimally, an option pioviues the holuei the iight, but not the
obligation, to buy, sell, oi in some mannei altei the cash flow of an instiument oi
financial contiact. 0ptions may be stanualone instiuments such as exchange
tiaueu options anu oveithecountei (0TC) contiacts, oi they may be embeuueu
within otheiwise stanuaiu instiuments. While banks use exchangetiaueu anu
0TC options in both tiauing anu nontiauing accounts, instiuments with
embeuueu options aie geneially moie impoitant in nontiauing activities.
Examples of instiuments with embeuueu options incluue vaiious types of bonus
anu notes with call oi put piovisions, cieuits which give boiioweis the iight to
piepay balances, anu vaiious types of nonmatuiity ueposit instiuments which
give uepositois the iight to withuiaw funus at any time, often without any
penalties. If not auequately manageu, the asymmetiical payoff chaiacteiistics of
instiuments with optionality featuies can pose significant iisk paiticulaily to
those who sell them, since the options helu, both explicit anu embeuueu, aie
geneially exeiciseu to the auvantage of the holuei anu the uisauvantage of the
sellei. Noieovei, an incieasing aiiay of options can involve significant leveiage
which can magnify the influences (both negative anu positive) of option
positions on the financial conuition of the fiim.
5.2.3Soundinterestrateriskmanagementpractices
Sounu inteiest iate iisk management involves the application of following basic
elements in the management of assets, liabilities, anu 0BS instiuments:
a) Appiopiiate boaiu anu senioi management oveisight;
b) Auequate iisk management policies anu pioceuuies;
c) Appiopiiate iisk measuiement, monitoiing, anu contiol functions; anu
u) Compiehensive inteinal contiols anu inuepenuent auuits.
As with othei iisk factoi categoiies, inteiest iate iisk shoulu be monitoieu on a
consoliuateu, compiehensive basis, to incluue inteiest iate exposuies in subsiuiaiies. At
the same time, banks shoulu fully iecognize any legal uistinctions anu possible obstacles
to cash flow movements among affiliates anu aujust theii iisk management piocess
accoiuingly. While consoliuation may pioviue a compiehensive measuie in iespect of
inteiest iate iisk,it may also unueiestimate iisk when positions in one affiliate aie useu
to offset positions in anothei affiliate. This is because a conventional accounting
consoliuation may allow theoietical offsets between such positions fiom which a bank
may not in piactice be able to benefit because of legal oi opeiational constiaints.
Nanagement shoulu iecognize the potential foi consoliuateu measuies to unueistate
iisks in such ciicumstances.
50
5.2.4Measurementofinterestraterisk
Nanaging inteiest iate iisk iequiies a cleai unueistanuing of the amount at iisk anu the
impact of changes in inteiest iates on this iisk position. To make these ueteiminations,
sufficient infoimation must be ieauily available to peimit appiopiiate action to be taken
within acceptable, often veiy shoit, time peiious. The longei it takes a bank to eliminate
oi ieveise an unwanteu exposuie, the gieatei the possibility of loss.
Each bank neeus to use iisk measuiement techniques that accuiately anu fiequently
measuie the impact of potential inteiest iate changes on the bank. In choosing
appiopiiate iate scenaiios to measuie the effect of iate changes, the bank shoulu
consiuei the potential volatility of iates anu the time peiiou within which the bank
coulu iealistically ieact to close the position.
Iueally, a bank's inteiest iate iisk measuiement system woulu take into account the
specific chaiacteiistics of each inuiviuual inteiest sensitive position, anu woulu captuie
in uetail the full iange of potential movements in inteiest iates.
Repiicing scheuules anu simulation appioaches aie the commonly useu inteiest iate
iisk measuiement techniques. Each bank shoulu use a combination of these techniques
in managing its inteiest iate iisk exposuie. Each technique pioviues a uiffeient
peispective on inteiest iate iisk, has uistinct stiengths anu weaknesses, anu is moie
effective when useu in combination with anothei.
5.2.4.1Maturity/repricingschedules
The simplest techniques foi measuiing a bank's inteiest iate iisk exposuie begin with a
matuiityiepiicing scheuule that uistiibutes inteiestsensitive assets, liabilities, anu
0BS positions into a ceitain numbei of pieuefineu time banus accoiuing to theii
matuiity (if fixeuiate) oi time iemaining to theii next iepiicing (if floatingiate).
Those liabilities lacking uefinitive iepiicing inteivals (e.g. sight ueposits oi savings
accounts) aie assigneu to iepiicing time banus accoiuing to the juugment anu past
expeiience of the bank.
i)Gapanalysis
Simple matuiityiepiicing scheuules can be useu to geneiate simple inuicatois of the
inteiest iate iisk sensitivity of both eainings anu economic value to changing inteiest
iates. When this appioach is useu to assess the inteiest iate iisk of cuiient eainings, it
is typically iefeiieu to as gap analysis.
To evaluate eainings exposuie, inteiest iatesensitive liabilities (ISL) in each time banu
aie subtiacteu fiom the coiiesponuing inteiest iatesensitive assets (ISA) to piouuce a
iepiicing gap foi that time banu.
A negative oi liabilitysensitive gap occuis when inteiestbeaiing liabilities exceeu
inteiesteaining assets (incluuing 0BS positions) in a given time banu, that is moie
inteiestbeaiing liabilities iepiice than inteiesteaining assets. This gap implies that an
51
inciease in maiket inteiest iates coulu cause a uecline in net inteiest income. In this
situation, a ueciease in inteiest iates shoulu impiove the net inteiest iate spieau in the
shoit teim, as ueposits aie iolleu ovei at lowei iates befoie the coiiesponuing assets.
An inciease in inteiest iates loweis eainings by naiiowing oi eliminating the inteiest
spieau.
Conveisely, a positive oi assetsensitive gap occuis when inteiesteaining assets exceeu
inteiestbeaiing liabilities (incluuing 0BS positions) in a given time banu, that is, moie
inteiesteaining assets iepiices than inteiestbeaiing liabilities. This gap implies that a
ueciease in maiket inteiest iates coulu cause a uecline in net inteiest income. In this
situation, a uecline in inteiest iates shoulu lowei oi eliminate the net inteiest iate
spieau in the shoit teim, as assets aie iolleu ovei at lowei iates befoie the
coiiesponuing liabilities. An inciease in inteiest iates shoulu inciease the net inteiest
spieau.
An inteiest sensitive gap iatio is also a goou inuicatoi of banks inteiest iate iisk
exposuie.
RelativeISGAP=ISGAP/BanksTotalAsset
Also an ISA to ISL iatio of bank foi paiticulai time banu coulu be a useful estimation of a
banks position.
InterestSensitiveRatio=ISA/ISL
ii)Measuringrisktonetinterestincome(NII)
uap scheuules can pioviue an estimate of changes in banks net inteiest income given
changes in inteiest iates. The gap foi paiticulai time banu can be multiplieu by a
hypothetical change in inteiest iate to obtain an appioximate change in net inteiest
income. The foimula to tianslate gaps into the amount of net inteiest income at iisk,
measuiing exposuie ovei seveial peiious, is:
NII=iXPeriodicGapXMaturityBucket
Wheie,
NII = Change in net inteiest income
i = Change in inteiest iate
Peiiouic uap = (RSARSL)
Natuiity Buckets = 1 uay, 27 uays, 8 uays to 1 month, 1S months, S12 months,
1S yeais, anu S
+
yeais.
The size of the inteiest iate movement useu in the analysis can be baseu on a vaiiety of
factois, incluuing histoiical expeiience, simulation of potential futuie inteiest iate
movements, anu the juugment of bank management.
52
While such gap measuiements appaiently seem peifect, piactically theie aie some
pioblems such as inteiest paiu on liabilities of a bank which aie geneially shoit teim
tenu to move quickly compaieu with that being eaineu on assets many of which aie
ielatively longei teim. This pioblem can be minimizeu by assigning weights to vaiious
ISA anu ISL that take into account the tenuency of the bank inteiest iates to vaiy in
speeu anu magnituue ielative to each othei anu with the up anu uown business cycle.
The gap iepoits aie impoitant to an inteiest iate iisk management piogiam because
they inuicate how much net inteiest income is at iisk, anu, to some extent, the timing of
the iisk. Bowevei, gap analysis has a numbei of shoitcomings.
a) gap analysis pioviues an objective measuie of iisk associateu with cuiient
positions only; it uoes not incoipoiate futuie giowth oi changes in the mix of
business;
b) gap analysis uoes not captuie basis iisk oi investment iisk, is geneially baseu
on paiallel shifts in the yielu cuive;
c) gap analysis uoes not take account of vaiiation in the chaiacteiistics of
uiffeient positions within a time banu;
u) gap analysis uoes not account foi the time value of money;
e) gap uoes not take into account any changes in the timing of payments that
might occui as a iesult of changes in the inteiest iate enviionment; anu
f) most gap analyses fail to captuie vaiiability in noninteiest ievenue anu
expenses, which is potentially an impoitant souice of iisk to cuiient income.
Accoiuingly, the use of gap iepoits shoulu be complementeu with piesentvalue
sensitivity systems, such as uuiation analysis oi simulation mouels.
iii)Durationanalysis
Buiation is the timeweighteu aveiage matuiity of the piesent value of the cash flows
fiom assets, liabilities anu offbalance sheet items. It measuies the ielative sensitivity of
the value of these instiuments to changing inteiest iates (the aveiage teim to ie
piicing), anu theiefoie ieflects how changes in inteiest iates will affect the banks
economic value, that is, the piesent value of equity. In this context, the matuiity of an
investment is useu to pioviue an inuication of inteiest iate iisk.
ueneially, the longei the teim to matuiity (next iepiicing uate) of an investment anu
the smallei the payments that occui befoie matuiity (e.g. coupon payments), the highei
the uuiation (in absolute value). Bighei uuiation implies that a given change in the level
of inteiest iates will have a laigei impact on economic value.
Buiationbaseu weights can be useu in combination with a matuiityiepiicing
scheuule to pioviue a iough appioximation of the change in a bank's economic value
that coulu occui given a paiticulai set of changes in maiket inteiest iates.
53
Specifically, an aveiage uuiation is assumeu foi the positions that fall into each time
banu. The aveiage uuiations aie then multiplieu by an assumeu change in inteiest iates
to constiuct a weight foi each time banu. In some cases, uiffeient weights aie useu foi
uiffeient positions that fall within a time banu, ieflecting bioau uiffeiences in the
coupon iates anu matuiities (foi instance, one weight foi assets, anu anothei foi
liabilities). In auuition, uiffeient inteiest iate changes aie sometimes useu foi uiffeient
time banus, geneially to ieflect uiffeiences in the volatility of inteiest iates along the
yielu cuive. The weighteu gaps aie aggiegateu acioss time banus to piouuce an
estimate of the change in economic value of the bank that woulu iesult fiom the
assumeu changes in inteiest iates.
Alteinatively, a bank coulu estimate the effect of changing maiket iates by calculating
the piecise uuiation of each asset, liability, anu 0BS position anu then ueiiving the net
position foi the bank baseu on these moie accuiate measuies, iathei than by applying
an estimateu aveiage uuiation weight to all positions in a given time banu. This woulu
eliminate potential eiiois occuiiing when aggiegating positionscash flows. As anothei
vaiiation, iisk weights coulu also be uesigneu foi each time banu on the basis of actual
peicentage changes in maiket values of hypothetical instiuments that woulu iesult
fiom a specific scenaiio of changing maiket iates. That appioach which is sometimes
iefeiieu to as effective uuiation woulu bettei captuie the nonlineaiity of piice
movements aiising fiom significant changes in maiket inteiest iates anu, theieby,
woulu avoiu an impoitant limitation of uuiation.
Buiation incoipoiates an instiuments iemaining time to matuiity, the level of inteiest
iates, anu inteimeuiate cash flows. If a fixeu income instiument has only one cash flow,
as a zeio coupon bonu uoes, uuiation will equal the matuiity of the instiument: a zeio
coupon bonu with five yeais iemaining to matuiity has uuiation of five yeais. If coupon
payments aie ieceiveu befoie matuiity, the uuiation of the bonu ueclines, ieflecting the
fact that some cash is ieceiveu befoie final matuiity.
Propertiesofduration
In geneial, uuiation exhibits the following chaiacteiistics:
a) As matuiity incieases, uuiation incieases anu the bonus piice becomes moie
sensitive to inteiest iate changes;
b) Foi two instiuments with the same matuiity, a highcoupon instiument will have a
lowei uuiation than a lowcoupon instiument anu will also be less piicesensitive.
A laigei piopoition of a high coupons cash flows will be ieceiveu soonei anu thus
the aveiage time to ieceipt of the cash flows will be less;
c) A given fixeu income instiument will have a highei uuiation in a low inteiest iate
enviionment than in a high inteiest iate enviionment;
u) Buiation may be positive oi negative. A fixeu iate instiument woulu have a
positive uuiation, anu an inciease in inteiest iates woulu geneially ueciease the
maiket value of the instiument. Noitgage seivicing iights anu inteiest only (I0)
moitgagebackeu secuiities geneially have a negative uuiation, since an inciease
54
in inteiest iates woulu ueciease the piepayment speeu of the unueilying
moitgages, incieasing the maiket value of the instiuments; anu
e) Buiations aie auuitive when weighteu by the amount of the contiact. Foi example,
if a poitfolio consists of two bonus of equal maiket value, one with uuiation of six
anu the othei with uuiation of two, the uuiation of the poitfolio woulu be foui.
Durationofequity
The uuiation of equity is ueiiveu fiom the uuiation of all assets, liabilities, anu off
balancesheet contiacts.
To unueistanu how the uuiation of equity measuies iisk, the economic value of
poitfolio equity may be vieweu as a net bonu position. Assets aie analogous to long
bonu positions with positive uuiations, anu liabilities aie analogous to shoit bonu
positions with negative uuiations. Buiation inuicates whethei the economic value of the
net bonu position oi poitfolio equity will inciease oi ueciease with a change in iates.
A bank with longteim assets funueu by shoitteim liabilities will geneially have
uuiation of equity that is positive. The economic value of poitfolio equity of this bank
will uecline as inteiest iates iise. A bank with shoitteim assets funueu with longteim
liabilities will geneially have a negative uuiation of equity. The economic value of this
bank will inciease as inteiest iates iise. The highei the uuiation of a banks equity
(whethei the numbei is positive oi negative), the moie sensitive is its economic value to
changes in iates.
Modifiedduration
Nouifieu uuiation is stanuaiu uuiation uiviueu by 1 + i, wheie i is the level of cuiient
maiket inteiest iates. It ieflects the peicentage change in the economic value of the
instiument foi a given peicentage change in 1 + i. As with simple uuiation, it assumes a
lineai ielationship between peicentage changes in value anu peicentage changes in
inteiest iates.
Effectiveduration
Effective uuiation (sometimes calleu optionaujusteu uuiation) fuithei iefines the
mouifieu uuiation calculation anu is paiticulaily useful when a poitfolio contains
callable secuiities. Effective uuiation is ueiiveu by using simulation techniques to
calculate the change in piice of an instiument foi a given change in inteiest iates.
Effective uuiation incoipoiates a bonus yielu, coupon, final matuiity anu call featuies
into one numbei that inuicates how piicesensitive a bonu oi poitfolio is to change in
inteiest iates. Foi assets with vaiiable cash flows, it is appiopiiate to calculate the
effective uuiation iathei than the mouifieu uuiation.
55
Durationofsingleinstrument
To measuie the uuiation of a single instiument, a bank has to calculate the weighteu
aveiage of each cash flow at time t by the following foimula:
w
t
=
CF
t
(1 +y)
t
BonJ Pricc
These weighteu aveiages aie then summeu to get uuiation by using the following
foimula:
urotion = t w
t
1
t=1
Beie,
Wt = Weighteu aveiage of cash flow at time t
CFt= Cash flow at time t
y= Yielu to matuiity
T=Numbei of cash flow peiious
Durationofaportfolioofinstruments
Formulae:
Weighteu aveiage uuiation of assets, (BA) = W
A
X B
A
n
=1
Weighteu aveiage uuiation of liabilities, (BL) = W
L
X B
L
n
=1
Buiation gap: BuAP = A - j
MvL
MvA
[ BL
NvE = (-BuAP) X j
I
(1+y)
[ X Total Assets
Wheie,
y = YTN
Total Assets = Naiket value of total assets
iv)Simulationmodels
Banks having complex financial instiuments oi otheiwise having complex iisk piofiles
may employ moie sophisticateu inteiest iate iisk measuiement systems.
Simulation mouels aie sophisticateu mouels anu a valuable complement to gap anu
uuiation analysis. In static simulations, the cash flows aiising solely fiom the bank's
cuiient onbalance sheet anu offbalance sheet positions aie assesseu. In a dynamic
simulation appioach, the simulation builus in moie uetaileu assumptions about the
futuie couise of inteiest iates anu expecteu changes in a bank's business activity ovei
that time.
57
Simulation mouels aie useful tools foi stiategic planning; they peimit banks to
effectively integiate iisk management anu contiol into the planning piocess. Theii
foiecasts aie baseu on a numbei of assumptions incluuing:
a) futuie levels anu uiiectional changes of inteiest iates;
b) the slope of the yielu cuive anu the ielationship between the vaiious inuices that
the bank uses to piice cieuits anu ueposit;
c) piicing stiategies foi assets anu liabilities as they matuie; anu
u) the giowth, volume anu mix of futuie business.
Simulation is usually useu to measuie inteiest iate iisk by estimating what effect
changes in inteiest iates, business stiategies, anu othei factois will have on net inteiest
income, net income anu inteiest iate iisk positions. Simulation mouels can also be useu
to calculate the piesent value anu uuiations of assets anu liabilities.
Regaiuless of the measuiement system, the usefulness of each technique uepenus on
the valiuity of the unueilying assumptions anu the accuiacy of the basic methouologies
useu to mouel iisk exposuie. Fuithei the integiity anu timeliness of uata ielating to
cuiient positions is key element of iisk measuiement system.
While measuiing iisk in tiaueu poitfolios banks shoulu use a valuation appioach. They
shoulu uevelop iisk measuiement mouels that ielate maiket iisk factois to the value of
the tiaueu poitfolios oi the estimateu value of nontiaueu poitfolios. The unueilying
liquiuity of maikets foi tiaueu poitfolios anu the potential impact of changes in maiket
liquiuity shoulu be specifically auuiesseu by maiket iisk measuies. Theie shoulu be
sepaiate iisk factois coiiesponuing to each of the equity maikets in which the bank has
positions. The banks measuiement of equities iisk shoulu incluue both piice
movements in the oveiall equity maiket (e.g. a maiket inuex) anu specific sectois of the
equity maiket (foi instance, inuustiy sectois oi cyclical anu noncyclical sectois), anu
inuiviuual equity issues.
5.2.5Interestriskmanagementprogram
Significant factois in managing inteiest iate iisk incluue the fiequency, volatility anu
uiiection of iate changes, the slope of the inteiest iate yielu cuive, the size of the
inteiestsensitive position anu the basis foi iepiicing at iollovei uates.
A compiehensive inteiest iate iisk management piogiam iequiies:
a) establishing anu implementing sounu anu piuuent inteiest iate iisk policies;
b) ueveloping anu implementing appiopiiate inteiest iate iisk measuiement
techniques; anu
c) ueveloping anu implementing effective inteiest iate iisk management anu
contiol pioceuuies.
58
5.2.6Interestrateriskmanagementpolicies
Sounu anu piuuent inteiest iate iisk management iequiies cleai policies. These policies
neeu to incluue:
a) an inteiest iate iisk philosophy goveining the extent to which the bank is willing
to assume inteiest iate iisk; anu
b) explicit anu piuuent limits on the banks iate iisk exposuie.
a)Interestrateriskphilosophy
The capacity of each bank to assume iate iisk will vaiy with the extent of othei iisks
(e.g., liquiuity, cieuit iisk, foieign exchange iisk, investment iisk) anu its ability to
absoib potential losses. The objective of inteiest iate iisk management neeu not
necessaiily be the complete elimination of exposuie to changes in inteiest iates. Rathei,
it shoulu be to manage the impact of inteiest iate changes within selfimposeu limits set
aftei caieful consiueiation of a iange of possible inteiest iate enviionments.
b)Interestraterisklimits
Each bank neeus to establish explicit anu piuuent inteiest iate iisk limits, anu ensuie
that the level of inteiest iate iisk exposuie uoes not exceeu these limits.
Inteiest iate iisk limits neeu to be set within a banks oveiall iisk piofile, which ieflects
factois such as its capital auequacy, liquiuity, cieuit quality, investment iisk anu foieign
exchange iisk. Inteiest iate positions shoulu be manageu within a banks ability to offset
such positions if necessaiy.
Inteiest iate iisk limits neeu to be ieassesseu on a iegulai basis to ieflect potential
changes in inteiest iate volatility, the institutions oveiall iisk philosophy anu iisk
piofile.
Risk limits aie usually uefineu in teims of eainings oi in teims of the piesent value of
equity at iisk anu aie noimally expiesseu in teims of the allowable amounts of
mismatcheu positions foi specifieu oi cumulative matuiity peiious.
Eainings aie the iepoiteu net income befoie taxes. Changes in inteiest iates may affect
eainings by:
a) affecting the inteiest income oi expenses ielating to assets, liabilities anu off
balance sheet items; anu
b) affecting the value of fixeuiate assets, liabilities anu offbalance sheet items that
aie caiiieu on a maiket valuation basis.
Piesent value of equity is the piesent value of assets anu offbalance sheet items
geneiating cash inflows, less the piesent value of liabilities anu offbalance sheet items
geneiating cash outflows. Changes in inteiest iates affect the piesent value of the cash
flows fiom, anu the value of these items, anu theiefoie the economic value of
shaieholueis equity.
Limits may also appiopiiately be uefineu in teims of iegulatoiy capital, shaieholueis
equity anu eaining assets.
59
5.2.7Interestrateriskmanagementandcontrolprocedures
Each bank neeus to uevelop anu implement effective anu compiehensive pioceuuies
anu infoimation systems to manage anu contiol inteiest iate iisk in accoiuance with its
inteiest iate iisk policies. These pioceuuies shoulu be appiopiiate to the size anu
complexity of the banks inteiest iate iisktaking activities.
Inteinal inspectionsauuits aie a key element in managing anu contiolling a banks
inteiest iate iisk management piogiam. Each bank shoulu use them to ensuie
compliance with, anu the integiity of, the inteiest iate iisk policies anu pioceuuies.
Inteinal inspectionsauuits shoulu, at a minimum, ianuomly test all aspects of inteiest
iate iisk management activities in oiuei to:
a) ensuie inteiest iate iisk management policies anu pioceuuies aie being auheie
to;
b) ensuie effective management contiols ovei inteiest iate iisk positions;
c) veiify the auequacy anu accuiacy of management infoimation iepoits; anu
u) ensuie that peisonnel involveu in inteiest iate iisk management fully
unueistanu the banks inteiest iate iisk policies anu iisk limits anu have the
expeitise iequiieu to make effective uecisions consistent with the inteiest iate
iisk policies.
Assessments of the inteiest iate iisk opeiations shoulu be piesenteu to the boaiu on
iegulai basis foi ieview.
5.3Foreignexchangerisk
Foieign exchange iisk is the cuiient oi piospective iisk to eainings anu capital aiising
fiom auveise movements in cuiiency exchange iates.
The foieign exchange positions aiise fiom the following activities:
a) tiauing in foieign cuiiencies thiough spot, foiwaiu anu option tiansactions as a
maiket makei oi position takei, incluuing the unheeueu positions aiising fiom
customeiuiiven foieign exchange tiansactions;
b) holuing foieign cuiiency positions in the banking book (e.g. in the foim of loans,
bonus, ueposits oi ciossboiuei investments); oi
c) engaging in ueiivative tiansactions that aie uenominateu in foieign cuiiency foi
tiauing oi heuging puiposes.
In the foieign exchange business, banks also face the iisk of uefault of the countei
paities oi settlement iisk. Thus, banks may incui ieplacement cost, which uepenus
upon the cuiiency iate movements.
60
Banks also face anothei iisk calleu timezone iisk, which aiises out of time lags in
settlement of one cuiiency in one centei anu the settlement of anothei cuiiency in
anothei time zone.
The foieign exchange tiansactions with countei paities situateu outsiue Banglauesh
also involve soveieign oi countiy iisk.
5.3.1Foreignexchangeriskmanagementprogram
Nanaging foieign exchange iisk involves piuuently managing foieign cuiiency
positions in oiuei to contiol, within set paiameteis, the impact of changes in exchange
iates on the financial position of the bank. The fiequency anu uiiection of iate changes,
the extent of the foieign cuiiency exposuie anu the ability of counteipaits to honoi
theii obligations to the bank aie significant factois in foieign exchange iisk
management. A compiehensive foieign exchange iisk management piogiam iequiies:
a) establishing anu implementing sounu anu piuuent foieign exchange iisk
management policies; anu
b) ueveloping anu implementing appiopiiate anu effective foieign exchange iisk
management anu contiol pioceuuies.
a)Foreignexchangeriskmanagementpolicy
A bank shoulu establish a wiitten policy on foieign exchange iisk that:
i. incluues a statement of piinciples anu objectives goveining the extent to which a
bank is willing to assume foieign exchange iisk;
ii. establishes explicit anu piuuent limits on a banks exposuie to foieign exchange
iisk; anu
iii. cleaily uefines the levels of peisonnel who have the authoiity to tiaue in foieign
exchange.
i)Statementofforeignexchangeriskprinciplesandobjectives
Befoie setting foieign exchange iisk limits anu management contiols it is necessaiy foi
a bank to ueciue the objectives of its foieign exchange iisk management piogiam anu in
paiticulai its willingness to assume iisk.
The toleiance of each bank to assume foieign exchange iisk will vaiy with the extent of
othei iisks (e.g. liquiuity, cieuit iisk, inteiest iate iisk, investment iisk) anu the banks
ability to absoib potential losses. The objective of foieign exchange iisk management
neeu not necessaiily be the complete elimination of exposuie to changes in exchange
iates. Rathei, it shoulu be to manage the impact of exchange iate changes within self
imposeu limits aftei caieful consiueiation of a iange of possible foieign exchange iate
scenaiios.
61
ii)Foreignexchangerisklimits
Each bank neeus to establish explicit anu piuuent foieign exchange limits, anu ensuie
that the level of its foieign exchange iisk exposuie uoes not exceeu these limits. Wheie
applicable, these limits neeu to covei, at a minimum:
the cuiiencies in which the bank is peimitteu to incui exposuie; anu
the level of foieign cuiiency exposuie that the institution is piepaieu to assume.
Foieign exchange iisk limits neeu to be set within a banks oveiall iisk piofile, which
ieflects factois such as its capital auequacy, liquiuity, cieuit quality, investment iisk anu
inteiest iate iisk. Foieign exchange positions shoulu be manageu within a banks ability
to quickly covei such positions if necessaiy. Noieovei, foieign exchange iisk limits
neeus to be ieassesseu on a iegulai basis to ieflect potential changes in exchange iate
volatility, the banks oveiall iisk philosophy anu iisk piofile.
Authoiizeu cuiiencies will noimally incluue cuiiencies in which the bank may be calleu
on to settle foieign exchange tiansactions. These aie usually the cuiiencies in which the
bank oi its customeis conuuct business.
Limits on a banks foieign exchange exposuie shoulu ieflect both the specific foieign
cuiiency exposuies that aiise fiom uaily foieign cuiiency uealing oi tiauing activities
(tiansactional positions) anu those exposuies that aiise fiom a banks oveiall
assetliability infiastiuctuie, both on anu offbalance sheet (stiuctuial oi tianslational
positions). The establishment of aggiegate foieign exchange limits that ieflect both
foieign cuiiency uealing anu stiuctuial positions helps to ensuie that the size anu
composition of both positions aie appiopiiately anu piuuently manageu anu contiolleu
anu uo not oveiextenu a banks oveiall foieign exchange exposuie.
0sually, iisk limits aie establisheu in teims of a ielationship between the foieign
exchange position anu eainings oi capital, oi in teims of foieign exchange volume, such
as total uollais oi numbeis of tiansactions.
Although the oveiall assessment of foieign exchange counteipaities is an integial
component of any foieign exchange opeiation, this may be conuucteu by a banks cieuit
iisk management function, thus obviating the neeu foi sepaiate counteipaity
assessment within the banks foieign exchange opeiations.
iii)Delegationofauthority
Cleaily uefineu levels of uelegateu authoiity help to ensuie that a banks foieign
exchange positions uo not exceeu the limits establisheu unuei its foieign exchange iisk
management policies. Authoiities may be absolute, inciemental oi a combination
theieof, anu may also be inuiviuual, pooleu, oi shaieu within a committee.
The uelegation of authoiity neeus to be cleaily uocumenteu, anu must incluue at a
minimum:
62
a) the absolute anuoi inciemental authoiity being uelegateu;
b) the units, inuiviuuals, positions oi committees to whom authoiity is being
uelegateu;
c) the ability of iecipients to fuithei uelegate authoiity; anu
u) the iestiictions, if any, placeu on the use of uelegateu authoiity.
The extent to which authoiity is uelegateu will the expeiience anu ability of the
inuiviuuals foi caiiying out the foieign exchange iisk management activities.
b)Foreignexchangeriskmanagementandcontrolprocedures
Each bank engageu in foieign exchange activities is iesponsible foi ueveloping,
implementing anu oveiseeing pioceuuies to manage anu contiol foieign exchange iisk
in accoiuance with its foieign exchange iisk management policies. These pioceuuies
must be at a level of sophistication commensuiate with the size, fiequency anu
complexity of the banks foieign exchange activities.
Foieign exchange iisk management pioceuuies neeu to incluue, at a minimum:
i. accounting anu management infoimation systems to measuie anu monitoi
foieign exchange positions, foieign exchange iisk anu foieign exchange gains oi
losses;
ii. contiols goveining the management of foieign cuiiency activities; anu
iii. inuepenuent inspections oi auuits.
i)Measurementofforeignexchangerisk
Nanaging foieign exchange iisk iequiies a cleai unueistanuing of the amount at iisk
anu the impact of changes in exchange iates on this foieign cuiiency exposuie. To make
these ueteiminations, sufficient infoimation must be ieauily available to peimit
appiopiiate action to be taken within acceptable, often veiy shoit, time peiious.
Each bank engageu in foieign exchange activities neeus to have an effective accounting
anu management infoimation system in place that accuiately anu fiequently iecoius
anu measuies its foieign exchange exposuie anu the impact of potential exchange iate
changes on the bank.
At a minimum, each bank shoulu have in place monitoiing anu iepoiting techniques
that measuie:
the net spot anu foiwaiu positions in each cuiiency oi paiiings of cuiiencies in
which the bank is authoiizeu to have exposuie;
the aggiegate net spot anu foiwaiu positions in all cuiiencies; anu
tiansactional anu tianslational gains anu losses ielating to tiauing anu stiuctuial
foieign exchange activities anu exposuies.
63
ii)Controlofforeignexchangeactivities
The key elements of any foieign exchange contiol piogiam aie welluefineu pioceuuies
goveining:
a) oiganizational contiols to ensuie that theie exists a cleai anu effective
segiegation of uuties between those peisons who initiate foieign exchange
tiansactions anu those peisons who aie iesponsible foi opeiational functions
such as aiianging piompt anu accuiate settlement, anu timely exchanging anu
ieconciliation of confiimations, oi account foi foieign exchange activities.
b) pioceuuial contiols to ensuie that:
tiansactions aie fully iecoiueu in the iecoius anu accounts of the bank;
tiansactions aie piomptly anu coiiectly settleu; anu
unauthoiizeu uealing is piomptly iuentifieu anu iepoiteu to management;
anu
c) contiols to ensuie that foieign exchange activities aie monitoieu fiequently
against the banks foieign exchange iisk, counteipaity anu othei limits anu that
excesses aie iepoiteu.
Noieovei, each bank neeus to ensuie that employees conuucting foieign exchange
tiauing activities on behalf of the bank uo so within a wiitten coue of conuuct goveining
foieign exchange uealing. Such a coue of conuuct shoulu incluue guiuance iespecting
tiauing with ielateu paities anu tiansactions in which potential conflicts of inteiest
exists. These shoulu incluue tiauing with affiliateu entities, peisonal foieign exchange
tiauing activities of foieign exchange tiaueis, anu foieign exchange tiauing
ielationships with foieign exchange anu money maiket biokeis with whom the bank
ueals. Each bank shoulu ensuie that these guiuelines aie peiiouically ievieweu with all
foieign exchange tiaueis.
The use of heuging techniques is one means of managing anu contiolling foieign
exchange iisk. In this iegaiu, many uiffeient financial instiuments can be useu foi
heuging puiposes, the most commonly useu, being ueiivative instiuments. Examples
incluue foiwaiu foieign exchange contiacts, foieign cuiiency options, anu foieign
cuiiency swaps.
Each bank shoulu consiuei which heuging techniques aie appiopiiate foi the natuie
anu extent of its foieign exchange activities, the skills anu expeiience of tiauing staff
anu management, anu the capacity of foieign exchange iate iisk iepoiting anu contiol
systems. Befoie using heuging piouucts, banks must ensuie that they unueistanu the
heuging techniques anu they aie satisfieu that the instiument meets theii specific neeus
in a costeffective mannei.
64
The effectiveness of heuging activities shoulu be assesseu not only on the basis of the
technical attiibutes of inuiviuual tiansactions but also in the context of the oveiall iisk
exposuie of the bank iesulting fiom a potential change in assetliability mix anu othei
iisk exposuies such as cieuit, inteiest iate anu position iisk.
In this context, heuging activities neeu to take place within the fiamewoik of a cleai
heuging stiategy, the implications of which aie well unueistoou by the bank unuei
vaiying maiket scenaiios. In paiticulai, the objectives anu limitations of using heuging
piouucts shoulu be unifoimly unueistoou, so as to ensuie that heuging stiategies iesult
in an effective heuge of an exposuie iathei than the unintentional assumption of
auuitional oi alteinate foims of iisk.
iii)Independentinspections/audits
Inuepenuent inspectionsauuits aie a key element in managing anu contiolling a banks
foieign exchange iisk management piogiam. Each bank shoulu use them to ensuie
compliance with, anu the integiity of, the foieign exchange policies anu pioceuuies.
Inuepenuent inspectionsauuits shoulu, at a minimum, anu ovei a ieasonable peiiou of
time, test the banks foieign exchange iisk management activities in oiuei to:
a) ensuie foieign exchange management policies anu pioceuuies aie being auheieu
to;
b) ensuie effective management contiols ovei foieign exchange positions;
c) veiify the auequacy anu accuiacy of management infoimation iepoits iegaiuing
the banks foieign exchange iisk management activities;
u) ensuie that foieign exchange heuging activities aie consistent with the banks
foieign exchange iisk management policies, stiategies anu pioceuuies; anu
e) ensuie that peisonnel involveu in foieign exchange iisk management aie
pioviueu with accuiate anu complete infoimation about the banks foieign
exchange iisk policies anu iisk limits anu positions anu have the expeitise
iequiieu to make effective uecisions consistent with the foieign exchange iisk
management policies.
Assessments of the foieign exchange iisk opeiations shoulu be piesenteu to the boaiu
on a timely basis foi ieview.
5.3.2Foreignexchangesettlementrisk
Foieign exchange settlement iisk is the iisk of loss when a bank in a foieign exchange
tiansaction pays the cuiiency it solu but uoes not ieceive the cuiiency it bought. A
bank shoulu have systems that pioviue appiopiiate anu iealistic estimates of foieign
exchange exposuies on a timely basis. These systems woulu incluue policies anu
pioceuuies similai to those mentioneu in the pievious section with emphasis on
unueistanuing settlement iisk anu foimulating a cleai anu fiim plan on its management.
65
Foieign exchange settlement iisk management shoulu be integiateu into the oveiall iisk
management piocess. A banks pioceuuies foi managing its foieign exchange
settlement iisks shoulu be commensuiate with the iange anu scope of its activities.
Auequate tiaining shoulu be pioviueu to all staff iesponsible foi the vaiious aspects of
foieign exchange settlement iisk.
Banks boaiu shoulu appiove a policy on foieign exchange settlement iisk. This policy
shoulu be an integial anu consistent pait of the bank's oveiall policy towaius countei
paity iisk. It shoulu be iegulaily ievieweu anu, wheie necessaiy, mouifieu to take
account of new ciicumstances such as changes in the scale oi natuie of the bank's
foieign exchange opeiations oi in the methou of settlement useu.
Senioi management shoulu exeicise appiopiiate oveisight of settlement exposuies.
They shoulu ensuie that they fully unueistanu the foieign exchange settlement iisks
incuiieu by the bank anu shoulu cleaily uefine lines of authoiity anu iesponsibility foi
managing these iisks.
5.3.3Contingencyplanningtomitigatesettlementrisk
Contingency planning anu stiess testing shoulu be an integial pait of the foieign
exchange settlement iisk management piocess. Contingency plans shoulu be
establisheu to incluue a bioau spectium of stiess events, ianging fiom inteinal
opeiational uifficulties to inuiviuual counteipaity failuies to bioau maiket ielateu
events. Auequate contingency planning in the foieign exchange settlement iisk aiea
incluues ensuiing timely access to key infoimation, such as payments maue, ieceiveu oi
in piocess, anu ueveloping pioceuuies foi obtaining infoimation anu suppoit fiom
coiiesponuent institutions. Contingency plans shoulu be testeu peiiouically.
5.4Equitypricerisk
Equity piice iisk is the iisk of losses causeu by changes in equity piices. These losses
coulu aiise because of changes in the value of listeu shaies helu uiiectly by the bank;
changes in the value of listeu shaies helu by a bank subsiuiaiy; changes in the value of
listeu shaies useu as collateial foi loans fiom a bank oi a bank subsiuiaiy, whethei oi
not the loan was maue foi the puipose of buying the shaies; anu changes in the value of
unlisteu shaies.
Equity piice iisk associateu with equities coulu be systematic oi unsystematic. The
foimei iefeis to sensitivity of poitfolios value to changes in oveiall level of equity
piices, while the latei is associateu with piice volatility that is ueteimineu by fiim
specific chaiacteiistics.
Fiom an accounting peispective (although not an economic peispective) in Banglauesh,
equity iisk is onesiueu equity secuiities must be helu at the lowei of cost oi maiket
value. If maiket value uiops below cost, banks aie iequiieu to foim loss allowances oi
piovisions on the liability siue of the balance sheet, by means of an expense on the
piofit anu loss statement. Bowevei, if maiket values iise above cost, theie is no
66
coiiesponuing income iecoiueu unless the secuiity is solu. Even though the onesiueu
iisk is puiely in an accounting sense, it will have a ieal implication foi banks that fall
below iequiieu levels of iegulatoiy capital because of ueclines in the maiket value of
secuiities they holu. Accoiuingly, it is vitally impoitant foi banks to measuie, monitoi,
anu contiol theii equity maiket iisk.
5.4.1Effectiveequitypriceriskmanagement
An effective equity iisk management system shoulu have the following ciiteiia:
a) Policies foi equity investments shoulu ieflect the boaius iisk appetite, anu shoulu
pioviue cleai authoiities, conseivative limits, anu assigneu iesponsibilities;
b) Policies shoulu peimit iisktaking authoiity consistent with the expeitise of bank
peisonnel;
c) Nanagement shoulu have bioau capital maikets expeiience anu shoulu establish
stiong policy contiols anu iisk limits;
u) Policy exceptions shoulu be piopeily appioveu. Theie shoulu be foimal
pioceuuies to iepoit how anu why exceptions have occuiieu, anu how they have
been iesolveu;
e) Tiauing anu sales peisonnel shoulu have bioau expeiience in the piouucts tiaueu,
technically competent, anu comfoitable with the banks cultuie;
f) Risk management peisonnel shoulu have an inuepth unueistanuing of equity
maiket iisk anu iisk management piinciples, incluuing vaR;
g) Equity investments in companies that the bank has nevei befoie investeu in aie
subject to a foimal ieview piogiam, with all ielevant bank units paiticipating in
iisk assessment anu contiol pioceuuies;
h) The fiims in whose shaies the bank oi its subsiuiaiy is consiueiing investing is
shoulu be analyzeu iigoiously, anu by ieviewing as much oi even moie financial
infoimation, as woulu be ievieweu in a cieuit uecision;
i) Nanagement iepoits shoulu be piepaieu inuepenuently of the investing anu
tiauing function anu shoulu pioviue a compiehensive anu accuiate summaiy of
investing anu tiauing activity. Repoits shoulu assess compliance with policy limits,
measuie loss potential in both noimal anu stiesseu maikets anu piouuceu in time.
Nanagement at all levels shoulu unueistanu anu monitoi equity maiket iisk;
j) Incompatible uuties shoulu be piopeily segiegateu. Risk monitoiing, valuation,
anu contiol functions shoulu be inuepenuent of the tiauing anu investing
functions;
k) The bank shoulu have to conuucts stiess tests iegulaily anu has a piecise
unueistanuing anu measuiement of how much anu why piofitability, balance
sheet capital, anu iegulatoiy capital will be affecteu by majoi ueclines in the equity
maiket oveiall, oi in the value of inuiviuual shaies;
67
l) If the bank has a subsiuiaiy that invests in shaies uiiectly oi lenus to customeis foi
the puichase of shaies, the bank shoulu closely monitoi the financial conuition anu
peifoimance of the subsiuiaiy, anu calculate its iiskaujusteu ietuin on the
investeu capital in that subsiuiaiy. The bank shoulu ieueploy that capital away
fiom its subsiuiaiy if the iiskaujusteu ietuins aie low;
m) If the bank has shaies in unlisteu companies, the bank shoulu consiuei these
investments as extiemely highiisk, anu uevote significant staff iesouices to
obtain, veiify, anu analyze financial infoimation on these companies; anu
n) uiven the illiquiuity of investments in unlisteu companies, the bank shoulu have a
uetaileu exit stiategy foi uisposing of these investments in the event that they no
longei fit into the banks uesiieu business stiategy, aie piohibiteu by iegulatoiy
iequiiements, oi suffei significant losses in value.
5.4.2Securitiesportfoliomanagementprogram
Sounu secuiities poitfolio management involves piuuently managing the iiskiewaiu
ielationship anu contiolling anu minimizing secuiities poitfolio iisks acioss a vaiiety of
uimensions, such as quality, poitfolio concentiationuiveisification, matuiity, volatility,
maiketability, type of secuiity, anu the neeu to maintain auequate liquiuity.
A compiehensive secuiities poitfolio management piogiam iequiies:
a) establishing anu implementing sounu anu piuuent policies to effectively manage
the secuiities poitfolio, secuiities activities anu position iisk;
b) ueveloping anu implementing effective secuiities poitfolio management piocesses
goveining secuiities investment uecision making anu authoiity; anu
c) ueveloping anu implementing compiehensive pioceuuies to effectively monitoi
anu contiol the natuie, chaiacteiistics, anu quality of the secuiities poitfolio anu
the extent of position iisk assumeu.
a)Securitiesportfoliomanagementpolicies
The founuation of an effective secuiities poitfolio management piogiam is the
uevelopment anu implementation of cleaily uefineu policies, foimally establisheu in
wiiting that set out the secuiities poitfolio management objectives of the bank anu the
paiameteis unuei which secuiities activities aie to be unueitaken anu contiolleu.
Each bank neeus to establish explicit anu piuuent secuiities poitfolio management
objectives goveining:
i. the extent to which a bank is willing to assume position iisk;
ii. geneial aieas of secuiities activities in which a bank is piepaieu to engage oi is
iestiicteu fiom engaging, incluuing the banks policy with iespect to acquiiing
secuiities of ielateu paities;
68
iii. minimum quality anu iate of ietuin expectations foi the secuiities poitfolio; anu
iv. secuiities poitfolio concentiation anu exposuie limits.
Secuiities poitfolio management objectives ieflect a banks iisk philosophy, couify
investment ciiteiia, establish the founuation foi the uevelopment of secuiities poitfolio
management stiategies, anu pioviue the basis foi monitoiing poitfolio chaiacteiistics
anu measuiing poitfolio peifoimance. Secuiities poitfolio objectives pioviue oveiall
paiameteis goveining secuiities investment uecisions by uesciibing the bioau puipose
anu goals of secuiities investments as a means foi piofitability. Secuiities poitfolio
objectives assist in ensuiing that secuiities investments aie sounu anu piuuent, anu
that the secuiities poitfolio iisk is acceptable given the expecteu ietuin.
In establishing secuiities poitfolio management objectives, each bank neeus to give
consiueiation to a numbei of factois, incluuing the banks natuie of liabilities, its
liquiuity neeus, maiket volatility, the extent of othei iisks assumeu (e.g. cieuit iisk,
inteiest iate iisk, foieign exchange iisk), the banks ability to absoib potential losses
anu its oveiall stiategic business objectives.
To be effective, secuiities poitfolio management objectives must be communicateu in a
timely fashion, be implementeu thiough all levels of the oiganization by appiopiiate
pioceuuies anu ieviseu peiiouically in light of changing ciicumstances.
b)Securitiesportfoliomanagementprocess
To uevelop anu maintain a sounu secuiities poitfolio, each bank must have:
i. an effective foimal evaluation piocess that pioviues foi an objective analysis anu
assessment of secuiities investment pioposals; anu
ii. cleaily uefineu, piuuent anu appiopiiate levels of uelegation of secuiities
tiansaction appioval authoiity, foimally establisheu in wiiting.
c)Securitiesportfoliomonitoring&controlprocedures
Each bank neeus to uevelop anu implement effective anu compiehensive pioceuuies,
accounting policies anu infoimation systems to monitoi anu manage the chaiacteiistics
anu quality of its secuiities poitfolio. These pioceuuies shoulu be appiopiiate to the
size anu complexity of the banks secuiities activities anu, at a minimum, neeu to
incluue:
i. Systems to measuie anu monitoi secuiities positions;
ii. Contiols goveining the management of the secuiities poitfolio; anu
iii. Inuepenuent inspections oi auuits.
69
i)Systemstomeasure&monitor
Nanaging secuiities activities iequiies a cleai unueistanuing of the natuie anu
chaiacteiistics of the secuiities poitfolio anu secuiities positions. To make these
ueteiminations, each bank neeus to ensuie that:
a) effective infoimation systems aie uevelopeu anu useu to appiopiiately iecoiu,
iegulaily monitoi anu evaluate the secuiities poitfolio;
b) effective anu appiopiiate quality anu peifoimance ciiteiia aie uevelopeu anu
implementeu, anu that the poitfolio is iegulaily assesseu against these ciiteiia;
anu
c) appiopiiate anu conseivative accounting policies anu pioceuuies aie uevelopeu,
uocumenteu anu implementeu to piopeily classify anu caiiy secuiities on the
books of account of the bank anu iecognize income ielateu to such secuiities.
Regulai evaluations of the secuiities poitfolio shoulu be caiiieu out so as to pioviue an
effective means of ensuiing that poitfolio peifoimance anu quality is meeting the banks
secuiities poitfolio management policies anu objectives, anu that the poitfolio is not
unuuly concentiateu by type of secuiity, anu by single anu associateu gioups of issueis,
paiticulaily issueis connecteu to the bank.
ii)Securitiesportfoliomanagementcontrols
Effective pioceuuies anu contiols ensuie that secuiities activities aie in compliance
with the banks secuiities poitfolio management policies anu pioviue safeguaius to
piotect a bank fiom potential losses by ensuiing that unauthoiizeu exposuie uoes not
occui fiom impiopei oi uncontiolleu secuiities activities.
Although the contiols ovei secuiities activities will vaiy among banks uepenuing upon
the natuie anu extent of theii activities, the key elements of any secuiities poitfolio
management contiol piogiam aie welluefineu guiuelines goveining:
a) oiganizational contiols to ensuie that theie exists a cleai anu effective
segiegation of uuties between those peisons who authoiize, initiate oi supeivise
secuiities activities anu those peisons who aie iesponsible foi opeiational
functions such as the physical custouy of secuiities, oi aiianging piompt anu
accuiate settlement of secuiities tiansactions, oi account foi secuiities activities;
b) pioceuuial contiols to ensuie that secuiities aie piopeily iecoiueu anu
accounteu foi by the bank, tiansactions aie settleu in a timely anu accuiate
mannei anu unauthoiizeu secuiities activities aie quickly iuentifieu anu
iepoiteu to the management; anu
c) contiols to ensuie that secuiities activities aie monitoieu fiequently against the
banks secuiities poitfolio management policies anu iisk limits, anu excesses
iepoiteu.
70
Noieovei, each bank neeus to ensuie that employees conuucting secuiities tiauing
activities on behalf of the bank uo so with a wiitten coue of conuuct oi guiueline
goveining secuiities uealing. Such a guiueline oi coue of conuuct shoulu pioviue
guiuance iespecting tiauing with ielateu paities anu tiansactions in which potential
conflicts of inteiest exist. These shoulu incluue tiauing with affiliateu entities, peisonal
tiauing anu investment activities of secuiities poitfolio management peisonnel,
incluuing tiauing on insiuei infoimation anu taking peisonal gain fiom ones position,
anu tiauing ielationships with secuiities uealeis with whom the bank ueals.
iii)Independentinspection/audit
Inuepenuent inspectionsauuits pioviue an objective assessment of the secuiities
poitfolios existence, quality anu value, the integiity of the secuiities poitfolio
management piocess, anu they piomote the uetection of pioblems ielating theieto.
Each bank shoulu use them to ensuie compliance with, anu the integiity of, the
secuiities poitfolio management policies anu pioceuuies. Inuepenuent
inspectionsauuits shoulu, at a minimum, anu ovei a ieasonable peiiou of time, test the
banks secuiities poitfolio management activities in oiuei to:
a) ensuie that secuiities activities aie in compliance with the banks secuiities
poitfolio management policies anu pioceuuies, anu with the laws anu
iegulations to which these activities aie subject;
b) ensuie that secuiities tiansactions aie uuly authoiizeu anu accuiately anu
completely iecoiueu on the books of the bank;
c) ensuie that iecoiueu secuiities aie conseivatively valueu on the books of the
bank;
u) confiim that secuiities helu by uepositoiies to the oiuei of the bank confoim
with the iecoius of the bank;
e) ensuie that management has establisheu suitably uesigneu contiols ovei
secuiities positions anu that such contiols opeiate effectively;
f) ensuie the auequacy anu accuiacy of management infoimation iepoits iegaiuing
the banks secuiities poitfolio management activities; anu
g) ensuie that peisonnel involveu in secuiities poitfolio management aie pioviueu
with accuiate anu complete infoimation on the banks secuiities poitfolio
management policies anu iisk limits anu have the expeitise iequiieu to make
effective uecisions consistent with these policies.
5.4.3Securitiesportfolioconcentrationlimits
Cleaily uefineu anu uocumenteu secuiities poitfolio concentiation limits ensuie that
the natuie anu level of a banks exposuie in the foim of secuiities position is
appiopiiately uiveisifieu anu uoes not exceeu sounu anu piuuent limits.
Secuiities poitfolio concentiation occuis when a banks secuiities poitfolio contains an
excessive level of exposuie to one type oi class of secuiity oi a single oi gioup of
associateu issueis of secuiities.
71
At a minimum, secuiities poitfolio uiveisification policies must place sounu anu
piuuent aggiegate anu inuiviuual exposuie limits foi each type oi class of secuiity, anu
foi single issueis anu gioups of associateu issueis in which the bank is peimitteu to
invest. 0sually, limits by class of secuiity incluue limits foi how much of the poitfolio
shoulu be maue up of specific types of secuiities such as equities anu the poitfolio
concentiation by inuustiial sectoi. Such limits neeu to be establisheu in the context of
the banks aggiegate exposuie to a single issuei oi gioup of associateu issueis in teims
of both secuiities anu cieuit exposuies. The management of such aggiegate exposuies is
usually uone at a level senioi to secuiities tiaueis anu lenuing peisonnel so as to ensuie
that appiopiiate fiiewalls aie maintaineu between the secuiities poitfolio anu cieuit
iisk management aieas of the bank. Secuiities concentiations by single oi associateu
issuei neeu to be ievieweu iegulaily.
5.4.4Securitiesanalysisandassessment
Secuiities investment uecisions shoulu be maue only aftei caieful examination anu
consiueiation of seveial aieas incluuing:
a) the banks secuiities poitfolio management policies, anu othei coipoiate
objectives anu policies, such as the natuie of the banks liabilities anu the neeu to
maintain auequate liquiuity;
b) potential iisks anu ietuins ielateu to a paiticulai secuiity within the oveiall
context of the banks secuiities poitfolio management policies, the composition
of the secuiities poitfolio anu the ieasonable expectation of a faii ietuin oi
appieciation given the natuie of the secuiity, anu the iisk of loss oi impaiiment;
c) cuiient anu piojecteu iegulatoiy anu economicfinancial enviionment unuei
which secuiities tiansactions aie maue; anu
u) investment alteinatives.
5.4.5Securitiestransactionapprovalauthorities
Cleaily uefineu anu appiopiiate levels of secuiities tiansaction authoiity help ensuie
that a banks secuiities activities aie appiopiiately unueitaken anu that secuiities
positions uo not exceeu the limits establisheu unuei its secuiities poitfolio management
policies.
Appioval limits may ielate to type of secuiity, size, matuiity, oi othei ciiteiia, such as
the ietention oi uelegation of voting iights acquiieu thiough secuiities. Authoiities may
be absolute, inciemental oi a combination theieof, anu may also be inuiviuual, pooleu,
oi shaieu within a committee.
The uelegation of authoiity neeus to be cleaily uocumenteu, anu shoulu incluue as a
minimum:
72
a) the absolute anuoi inciemental secuiities tiansaction appioval being uelegateu;
b) the units, inuiviuuals, positions oi committees to whom secuiities tiansaction
authoiity is being uelegateu;
c) the ability of iecipients to fuithei uelegate appioval authoiity; anu
u) the iestiictions, if any, placeu on the use of uelegateu authoiity.
The uegiee of uelegation of secuiities tiansaction authoiity will uepenu on a numbei of
vaiiables incluuing:
i. the banks secuiities poitfolio management objectives anu oveiall iisk
philosophy;
ii. the quality of the secuiities poitfolio;
iii. the ability of the bank to absoib losses;
iv. the size anu types of secuiities anu the complexities of iisks being assesseu; anu
v. the expeiience anu ability of the inuiviuuals iesponsible foi caiiying out the
secuiities poitfolio management activities.
Assessments of the secuiities poitfolio management activities shoulu be piesenteu to
the banks boaiu on a timely basis foi ieview.
5.4.6Measuringequitypricerisk
Valueatrisk
value at Risk (vaR) is geneially accepteu anu wiuely useu tool foi measuiing maiket
iisk inheient in tiauing poitfolios. vaR summaiizes the pieuicteu maximum loss (oi
woist loss) ovei a taiget hoiizon within a given confiuence level.
It is a statistical estimate of expecteu potential loss that is ueiiveu by tianslating the
iiskiness of any financial instiument into a common stanuaiu. Banks may use a 99% oi
a 9S% confiuence level, anu each uay ietuin on its tiauing poitfolios. That means about
once (with 99% confiuence) oi five (with 9S% confiuence) in eveiy one hunuieu uays
the tiauing position aie expecteu to lose moie than the vaR estimate.
An inheient limitation of vaR is that it gives no infoimation about how much losses
coulu exceeu theii expecteu levels.
ueneially theie aie thiee methous of computing vaR:
a) Paiametiic oi vaiiancecovaiiance methou
b) Bistoiical simulation methou
c) Nonte Cailo simulation methou
73
Among these methous, the histoiical simulation methou is simple to apply anu faiily
stiaightfoiwaiu to explain. Bata sets useu foi this methou aie easily available.
Theiefoie, banks aie encouiageu to calculate vaR foi seconuaiy maiket shaies that aie
helu foi tiauing using histoiical simulation methou. Bowevei, to calculate the vaR foi
oveiall investment poitfolio (except cieuits), banks may use the vaiiance covaiiance
methou.
Variancecovariancemethod
The following foimula can be useu to assess the vaR of a poitfolio consisting moie than
two stocks:
Poitfolio vaR= Total Poitfolio X SB of Poitfolio
Wheie,
Stanuaiu Beviation, SB = |S1
2
+ S2
2
+ SS
2
+ 2S1S2P(1,2) + 2S1SSP(1,S)+2S2SSP(2,S)j
12
Beie,
S1 = the stanuaiu ueviation oi volatility of the fiist asset
S2 = the stanuaiu ueviation oi volatility of the seconu asset
SS = the stanuaiu ueviation oi volatility of the thiiu asset
P = Coiielation
Historicalsimulationmethod
Let us assume a bank has a poitfolio of thiee stocks of one unit each. To calculate vaR of
that poitfolio the bank neeus to collect the histoiical maiket piice of each of the stocks
in the poitfolio foi last 1uu uays. Then, the following foimulae aie to be applieu:
a) Weight A=
CIosIng Markct PrIcc oI Stock A
CIosIng Markct PrIcc oI Stock (A+B+C)
b) Total weighteu ietuin to poitfolio maiket piice (%) =
TotaI wcIghtcd rcturn
CIosIng Markct PrIcc oI Stock (A+B+C)
1uu
Then, the 99th peicentile will be the vaR at 99% confiuence level.
5.5Managingmarketrisk
Each bank shoulu put in place a set of systems anu pioceuuies appiopiiate to its size
anu complexity of its opeiations foi iuentifying, measuiing monitoiing anu contiolling
maiket iisk. The iisk appetite in ielation to maiket iisk shoulu be assesseu keeping in
view the capital of the bank as well as exposuie to othei iisks. 0nce the maiket iisk
appetite is ueteimineu, the bank shoulu uevelop a stiategy foi maiket iisktaking in
oiuei to maximize ietuins while keeping exposuie to maiket iisk at oi below the pie
ueteimineu level.
74
5.5.1Boardoversight
Nanagement of maiket iisk shoulu stait fiom the boaiu anu senioi management level.
Effective boaiu anu senioi management oveisight of the banks oveiall maiket iisk
exposuie is a founuation of iisk management piocess. Foi its pait, the boaiu is
iesponsible to:
a) uefine bank's oveiall iisk appetite in ielation to maiket iisk;
b) ensuie that banks oveiall maiket iisk exposuie is maintaineu at piuuent levels
anu consistent with the available capital;
c) ensuie that senioi management as well as inuiviuuals iesponsible foi maiket
iisk management possesses sounu expeitise anu knowleuge to accomplish the
iisk management function;
u) ensuie that the bank implements sounu funuamental piinciples that facilitate the
iuentification, measuiement, monitoiing anu contiol of maiket iisk;
e) ensuie that auequate iesouices (technical as well as human) aie uevoteu to
maiket iisk management;
f) ieview anu appiove maiket iisk policies baseu on iecommenuations by the
banks senioi management;
g) ieview peiiouically, but at least once a yeai, the maiket iisk management
piogiam, policy, techniques, pioceuuies anu infoimation systems iefeiieu to in
that policy;
h) outline the content anu fiequency of management maiket iisk (foi each type of
iisk) iepoits to the boaiu;
i) ensuie that an inuepenuent inspectionauuit function ieviews the cieuit
opeiations, foieign exchange opeiations anu secuiities poitfolio management
functions to ensuie that the banks maiket iisk management policies anu
pioceuuies aie appiopiiate anu aie being auheieu to; anu
j) ieview specially the tienus in secuiities poitfolio quality anu value.
The boaiu of uiiectois shoulu peiiouically ieview the financial iesults of the bank anu,
baseu on these iesults, ueteimine if changes neeu to be maue to the stiategy. While the
boaiu gives a stiategic uiiection anu goals, it is the iesponsibility of senioi management
to tiansfoim those uiiections into pioceuuial guiuelines anu policy uocument anu
ensuie piopei implementation of those policies.
75
5.5.2Seniormanagementoversight
In case of managing maiket iisk, senioi management of a bank is iesponsible to:
a) uevelop anu iecommenu maiket iisk management policies foi appioval by the
boaiu;
b) implement the maiket iisk management policies;
c) uevelop anu implement pioceuuies that tianslate business policy anu stiategic
uiiection set by B0B into opeiating stanuaius that aie well unueistoou by banks
peisonnel;
u) ensuie auheience to the lines of authoiity anu iesponsibility that boaiu has
establisheu foi measuiing, managing, anu iepoiting maiket iisk;
e) oveisee the uevelopment, implementation anu maintenance of an appiopiiate
NIS that iuentify, measuie, monitoi, anu contiol banks maiket iisk;
f) establish effective inteinal contiols to monitoi anu contiol maiket iisk;
g) establish anu utilize a methou foi accuiately measuiing the banks maiket iisk.
h) ensuie that an inuepenuent inspectionauuit function ieviews anu assesses the
maiket iisk management piogiam;
i) ensuie that all types of maiket iisks aie manageu anu contiolleu within the
maiket iisk management piogiam;
j) uevelop lines of communication to ensuie the timely uissemination of the maiket
iisk policies anu pioceuuies to all inuiviuuals involveu in the maiket iisk
management piocess;
k) iepoit compiehensively on the maiket iisk management piogiam to the boaiu at
least once a yeai; anu
l) monitoi anu contiol the natuie, composition anu quality of the banks secuiities
poitfolio anu ensuie that the secuiities poitfolio is sounuly anu conseivatively
valueu.
The banks shoulu foimulate maiket iisk management policies which aie appioveu by
boaiu. The policy shoulu cleaily uefine the lines of authoiity anu the iesponsibilities of
the boaius, senioi management anu othei peisonnel iesponsible foi managing maiket
iisk; set out the iisk management stiuctuie anu scope of activities; anu iuentify iisk
management issues, such as maiket iisk contiol limits, uelegation of appioving
authoiity.
76
5.6Stresstesting
Bank's iisk measuiement system shoulu suppoit a meaningful evaluation of the effect of
stiessful maiket conuitions on the bank. Stiess testing shoulu be uesigneu to pioviue
infoimation on the kinus of conuitions unuei which stiategies oi positions woulu be
most vulneiable, anu thus may be tailoieu to the iisk chaiacteiistics of the bank.
Possible stiess scenaiios might incluue:
a) abiupt changes in the geneial level of maiket iates;
b) changes in the ielationships among key maiket iates (i.e. basis iisk);
c) changes in the slope anu the shape of the yielu cuive (i.e. yielu cuive iisk);
u) changes in the liquiuity of key financial maikets oi changes in the volatility of
maiket iates; oi
e) conuitions unuei which key business assumptions anu paiameteis bieak uown.
In conuucting stiess tests, special consiueiation shoulu be given to instiuments oi
maikets wheie concentiations exist as such positions may be moie uifficult to liquiuate
oi offset in stiessful situations. Banks shoulu consiuei "woist case" scenaiios in
auuition to moie piobable events. Nanagement anu the boaiu of uiiectois shoulu
peiiouically ieview both the uesign anu the iesults of such stiess tests, anu ensuie that
appiopiiate contingency plans aie in place.
77
Chapter6
Liquidityriskmanagement
6.1Introduction
Liquiuity iisk is the potential foi loss to a bank aiising fiom eithei its inability to meet
its obligations as they fall uue oi to funu incieases in assets without incuiiing
unacceptable cost oi losses.
Liquiuity iisk aiises when the cushion pioviueu by the liquiu assets aie not sufficient
enough to meet matuiing obligations. Accoiuingly, a bank shoit of liquiuity may have to
unueitake tiansactions at heavy cost iesulting in a loss of eainings oi, in a woist case
scenaiio, the liquiuity iisk coulu iesult in liquiuation of the bank if it is unable to
unueitake tiansactions even at cuiient maiket piices.
Banks with laige offbalance sheet exposuies oi those iely heavily on laige coipoiate
ueposits have ielatively high level of liquiuity iisk. Fuithei, banks expeiiencing a iapiu
giowth in assets shoulu have majoi conceins foi liquiuity.
Liquiuity iisk is often tiiggeieu by the consequences of othei financial iisks such as
cieuit iisk, inteiest iate iisk, foieign exchange iisk, etc. Foi instance, a laige loan uefault
oi changes in inteiest iate can auveisely impact a banks liquiuity position.
Liquiuity iisks can be classifieu into foui categoiies:
a) Teim liquiuity iisk (uue to uisciepancies between matuiities);
b) Withuiawalcall iisk (mass uisinvestment befoie matuiity);
c) Stiuctuial liquiuity iisk (when the necessaiy funuing tiansactions cannot be
caiiieu out oi only on less favoiable teims); anu
u) Naiket liquiuity iisk.
An incipient liquiuity pioblem may initially ieveal itself in the bank's financial
monitoiing system as a uownwaiu tienu with potential longteim consequences foi
eainings oi capital.
6.2Liquidityriskindicators
uiven below aie some eaily waining inuicatois that have potential to ignite liquiuity
pioblem foi a bank. Bank management neeus to monitoi caiefully such inuicatois anu
exeicise caieful sciutiny wheievei it ueems appiopiiate. Examples of such inteinal
inuicatois aie:
78
a) A negative tienu oi significantly incieaseu iisk in any aiea oi piouuct line;
b) Concentiations in eithei assets oi liabilities;
c) Beteiioiation in quality of cieuit poitfolio;
u) A uecline in eainings peifoimance oi piojections;
e) Rapiu asset giowth funueu by volatile laige ueposit;
f) A laige size of offbalance sheet exposuie;
g) Beteiioiating thiiu paity evaluation (negative iating) about the bank anu
negative publicity; anu
h) 0nwaiianteu competitive piicing that potentially stiesses the banks.
Liquiuity iisk management involves not only analyzing banks on anu offbalance sheet
positions to foiecast futuie cash flows, but also how the funuing iequiiement woulu be
met. The lattei involves iuentifying the funuing maiket the bank has access to,
unueistanuing the natuie of those maikets, evaluating banks cuiient anu futuie use of
the maiket anu monitoi signs of confiuence eiosion.
6.3Managingliquidityrisk
Each bank shoulu have an agieeu liquiuity stiategy foi the uaytouay management of
liquiuity. This stiategy shoulu auuiess the banks goal of piotecting financial stiength
anu the ability to withstanu stiessful events in the maiket place.
The liquiuity iisk stiategy uefineu by boaiu shoulu enunciate specific policies on
paiticulai aspects of liquiuity iisk management, such as:
(a) Composition of assets and liabilities: The stiategy shoulu outline the mix of
assets anu liabilities to maintain liquiuity. Liquiuity iisk management anu
assetliability management shoulu be integiateu to avoiu high costs associateu
with having to iapiuly ieconfiguie the asset liability piofile fiom maximum
piofitability to incieaseu liquiuity.
(b) Diversificationandstabilityofliabilities: A funuing concentiation exists when a
single uecision oi a single factoi has the potential to iesult in a significant anu
suuuen withuiawal of funus. Since such a situation coulu leau to an incieaseu iisk,
the boaiu anu senioi management shoulu specify guiuance ielating to funuing
souices anu ensuie that the bank has uiveisifieu souices of funuing uaytouay
liquiuity iequiiements. A bank woulu be moie iesilient to tight maiket liquiuity
conuitions if its liabilities weie ueiiveu fiom moie stable souices. To
compiehensively analyze the stability of liabilitiesfunuing souices a bank neeus
to iuentify:
i. liabilities that woulu stay with the bank unuei any ciicumstances;
ii. liabilities that iunoff giauually if pioblems aiise; anu
iii. liabilities that iunoff immeuiately at the fiist sign of pioblems.
Each bank neeus to have explicit anu piuuent policies that ensuie funuing is not unuuly
concentiateu with iespect to:
i. inuiviuual uepositoi;
ii. type of ueposit instiument;
81
iii. maiket souice of ueposit;
iv. teim to matuiity; anu
v. cuiiency of ueposit, if the bank has liabilities (both on anu offbalance sheet) in
foieign cuiiencies.
(c) Managingliquidityindifferentcurrencies:The bank shoulu have a stiategy on
how to manage liquiuity in uiffeient cuiiencies.
(d) Dealing with liquidity disruptions: The bank shoulu put in place a stiategy on
how to ueal with the potential foi both tempoiaiy anu longteim liquiuity
uisiuptions. The inteibank maiket can be impoitant souice of liquiuity. Bowevei,
the stiategy shoulu take into account the fact that in ciisis situations access to
inteibank maiket coulu be uifficult as well as costly.
The liquiuity stiategy must be uocumenteu in the liquiuity policies, anu communicateu
thioughout the bank. The stiategy shoulu be evaluateu peiiouically to ensuie that it
iemains valiu.
6.7Liquiditypolicies
Sounu anu piuuent liquiuity policies set out the souices anu amount of liquiuity
iequiieu to ensuie it is auequate foi the continuation of opeiations anu to meet all
applicable iegulatoiy iequiiements. These policies must be suppoiteu by effective
pioceuuies to measuie, achieve anu maintain liquiuity.
0peiating liquiuity is the level of liquiuity iequiieu to meet a banks uaytouay cash
outflow commitments. Factois influencing a banks opeiating liquiuity incluue:
i. cash flows anu the extent to which expecteu cash flows fiom matuiing assets anu
liabilities match; anu
ii. the uiveisity, ieliability anu stability of funuing souices, the ability to ienew oi
ieplace ueposits anu the capacity to boiiow.
Foi iegulatoiy puiposes a bank is iequiieu to holu a specific amount of assets classeu as
liquiu, baseu on its ueposit liabilities. ueneially, unuue ieliance shoulu not be placeu
on these assets, oi those foimally pleugeu, foi opeiating puiposes othei than as a
tempoiaiy measuie, as legally they may not be available foi encashment if neeueu.
In assessing the auequacy of liquiuity, each bank neeus to accuiately anu fiequently
measuie:
a) the teim piofile of cuiient anu appioaching cash flows geneiateu by assets anu
liabilities, both on anu offbalance sheet;
b) the extent to which potential cash outflows aie suppoiteu by cash inflows ovei a
specifieu peiiou of time, matuiing oi liquefiable assets, anu cash on hanu;
82
c) the extent to which potential cash outflows may be suppoiteu by the banks
ability to boiiow oi to access uiscietionaiy funuing souices; anu
u) the level of statutoiy liquiuity anu ieseives iequiieu anu to be maintaineu.
The banks shoulu foimulate liquiuity policies, which aie iecommenueu by senioi
managementALC0 anu appioveu by the boaiu. Boaiu shoulu ensuie that theie aie
auequate policies to govein liquiuity iisk management piocess. While specific uetails
vaiy acioss banks accoiuing to the natuie of theii business, the key elements of any
liquiuity policy incluue:
i. a statement of liquiuity iisk appetite;
ii. geneial liquiuity stiategy (shoit anu longteim), specific goals anu objectives in
ielation to liquiuity iisk management, piocess foi stiategy foimulation anu the
level within the bank it is appioveu;
iii. ioles anu iesponsibilities of inuiviuuals peifoiming liquiuity iisk management
functions, incluuing stiuctuial balance sheet management, piicing, maiketing,
contingency planning, management iepoiting, lines of authoiity anu
iesponsibility foi liquiuity uecisions;
iv. Liquiuity iisk management stiuctuie foi monitoiing, iepoiting anu ieviewing
liquiuity;
v. liquiuity iisk management tools foi iuentifying, measuiing, monitoiing anu
contiolling liquiuity iisk (incluuing the types of liquiuity limits anu iatios in
place anu iationale foi establishing limits anu iatios);
vi. Nechanisms foi uealing with ueviations fiom the policy anu the iestiictions it
imposes; anu
vii. contingency plan foi hanuling liquiuity ciises.
To be effective the liquiuity policy must be communicateu uown the line thioughout the
bank. It is impoitant that the boaiu anu senioi management ensuie that policies aie
ievieweu on a iegulai basis (at least annually) anu when theie aie any mateiial changes
in the banks cuiient anu piospective liquiuity iisk piofile. Such changes coulu stem
fiom inteinal ciicumstances (e.g. changes in business focus) oi exteinal ciicumstances
(e.g. changes in economic conuitions).
Reviews pioviue the oppoitunity to finetune the banks liquiuity policies in light of the
banks liquiuity management expeiience anu uevelopment of its business. Any
significant oi fiequent exception to the policy is an impoitant baiometei to gauge its
effectiveness anu any potential impact on banks liquiuity iisk piofile.
83
6.8Proceduresandlimits
Banks shoulu establish appiopiiate pioceuuies, piocesses anu limits to implement theii
liquiuity policies. The pioceuuial manual shoulu explicitly naiiate the necessaiy
opeiational steps anu piocesses to execute the ielevant liquiuity iisk contiols. The
manual shoulu be peiiouically ievieweu anu upuateu to take into account new activities,
changes in iisk management appioaches anu systems.
6.9Liquiditymanagementstructure
The iesponsibility foi managing the oveiall liquiuity of the bank shoulu be uelegateu to
a specific, iuentifieu gioup within the bank. This may be in the foim of an Asset Liability
Committee (ALC0).
Since liquiuity management is a technical job iequiiing specializeu knowleuge anu
expeitise, it is impoitant that iesponsible officeis not only have ielevant expeitise but
also have a goou unueistanuing of the natuie anu level of liquiuity iisk assumeu by the
bank anu the means to manage that iisk.
It is ciitical that theie be close links between those inuiviuuals iesponsible foi liquiuity
anu those monitoiing maiket conuitions, as well as othei inuiviuuals with access to
ciitical infoimation. This is paiticulaily impoitant in ueveloping anu analyzing stiess
scenaiios.
6.10Liquidityriskmanagementprocess
Peiiouic ieviews shoulu be conuucteu to ueteimine whethei the bank complies with its
liquiuity iisk policies anu pioceuuies. Positions that exceeu establisheu limits shoulu
ieceive piompt attention of appiopiiate management anu shoulu be iesolveu accoiuing
to the piocess uesciibeu in appioveu policies. Peiiouic ieviews of the liquiuity
management piocess shoulu also auuiess any significant changes in the natuie of
instiuments acquiieu, limits, anu inteinal contiols that have occuiieu since the last
ieview.
85
6.13Measurementofliquidityrisk
An effective liquiuity iisk measuiement system not only helps in managing liquiuity in
times of ciisis but also optimize ietuin thiough efficient utilization of available funus.
Banks shoulu institute systems that enable them to captuie liquiuity iisk aheau of time,
so that appiopiiate iemeuial measuies coulu be piompteu to avoiu any significant
losses.
Liquiuity iisk of a bank vaiies uepenuing upon its size anu complexity of business anu
thus iequiies liquiuity iisk measuiement techniques accoiuingly. Foi instance, banks
having laige netwoiks may have access to low cost stable ueposit, while small banks
may only have significant ieliance on laige size coipoiate ueposits. Bowevei, abunuant
liquiuity uoes not obviate the neeu foi a mechanism to measuie anu monitoi liquiuity
piofile of a bank.
At a veiy basic level, liquiuity measuiement involves assessing all of a banks cash
inflows against its outflows to iuentify the potential foi any net shoitfalls going foiwaiu.
This incluues funuing iequiiements foi offbalance sheet commitments. A numbei of
techniques can be useu foi measuiing liquiuity iisk, ianging fiom simple calculations
anu static simulations baseu on cuiient holuings to highly sophisticateu moueling
techniques.
An impoitant aspect of measuiing liquiuity is making assumptions about futuie funuing
neeus. While ceitain cash inflows anu outflows can be easily calculateu oi pieuicteu,
banks must also make assumptions about futuie liquiuity neeus, both in the veiy shoit
teim anu foi longei time peiious. 0ne impoitant factoi to consiuei is the ciitical iole a
banks ieputation plays in its ability to access funus ieauily anu at ieasonable teims. Foi
that ieason, banks staff iesponsible foi managing oveiall liquiuity shoulu be awaie of
any infoimation (such as an announcement of a uecline in eainings oi a uowngiauing by
a iating agency) that coulu have an impact on maiket anu public peiceptions about the
soununess of the bank.
Some commonly useu liquiuity measuiement anu monitoiing techniques that may be
auopteu by the banks aie:
6.14Contingencyfundingplans
In oiuei to uevelop compiehensive liquiuity iisk management fiamewoik, banks shoulu
have in place plans to auuiess stiess scenaiios. Such a plan commonly known as
Contingency Funuing Plan (CFP), is a set of policies anu pioceuuies that seives as a
bluepiint foi a bank to meet its funuing neeus in a timely mannei anu at a ieasonable
cost.
A CFP is a piojection of futuie cash flows anu funuing souices of a bank unuei maiket
scenaiios incluuing aggiessive asset giowth oi iapiu liability eiosion. To be effective it
is impoitant that a CFP shoulu iepiesent managements best estimate of balance sheet
changes that may iesult fiom a liquiuity oi cieuit event. A CFP can pioviue a useful
fiamewoik foi managing liquiuity iisk both shoit teim anu in the long teim. Fuithei it
helps ensuie that a bank can piuuently anu efficiently manage ioutine anu
extiaoiuinaiy fluctuations in liquiuity.
86
6.14.1UseofCFPforroutineliquiditymanagement
Foi uaytouay liquiuity iisk management integiation of liquiuity scenaiio will ensuie
that the bank is best piepaieu to iesponu to an unexpecteu pioblem. In this sense, a CFP
is an extension of ongoing liquiuity management anu foimalizes the objectives of
liquiuity management by ensuiing:
a) A ieasonable amount of liquiu assets aie maintaineu;
b) Neasuiement anu piojection of funuing iequiiements uuiing vaiious scenaiios;
anu
c) Nanagement of access to funuing souices.
6.14.2UseofCFPforemergencyanddistressenvironments
It is not always that a liquiuity ciisis shows up giauually. In case of a suuuen liquiuity
stiess, it is impoitant foi a bank to seem oiganizeu, canuiu, anu efficient to meet its
obligations to the stakeholueis. Since such a situation iequiies a spontaneous action,
banks that alieauy have plans to ueal with such situation coulu auuiess the liquiuity
pioblem moie efficiently anu effectively. A CFP can help ensuie that bank management
anu key staffs aie ieauy to iesponu to such situations. Bank liquiuity is veiy sensitive to
negative tienus in cieuit, capital, oi ieputation. Beteiioiation in the bank's financial
conuition (ieflecteu in items such as asset quality inuicatois, eainings, oi capital),
management composition, oi othei ielevant issues may iesult in ieuuceu access to
funuing.
6.14.3ScopeofCFP
The sophistication of a CFP uepenus upon the size, natuie, anu complexity of business,
iisk exposuie, anu oiganizational stiuctuie. To begin, the CFP shoulu anticipate all of
the bank's funuing anu liquiuity neeus by:
a) Analyzing anu making quantitative piojections of all significant on anu off
balance sheet;
b) Funus flows anu theii ielateu effects;
c) Natching potential cash flow souices anu uses of funus; anu
u) Establishing inuicatois that aleit management to a pieueteimineu level of
potential iisks.
The CFP shoulu pioject on the bank's funuing position uuiing both tempoiaiy anu long
teim liquiuity changes, incluuing those causeu by liability eiosion. The CFP shoulu
explicitly iuentify, quantify, anu iank all souices of funuing by piefeience, such as:
87
i. Reuucing assets;
ii. Nouification oi incieasing liability stiuctuie;
iii. 0sing othei alteinatives foi contiolling balance sheet changes.
The CFP shoulu incluue asset siue as well as liability siue stiategies to ueal with liquiuity
ciises. The asset siue stiategy may incluue; whethei to liquiuate suiplus money maiket
assets, when to sell liquiu oi longeiteim assets, etc. While liability siue stiategies
specify policies such as piicing policy foi funuing, the uealei who coulu assist at the
time of liquiuity ciisis, policy foi eaily ieuemption iequest by ietail customeis, use of
BB uiscount winuow etc. A CFP also chalks out ioles anu iesponsibilities of vaiious
inuiviuuals at the time of liquiuity ciises anu the management infoimation system
between management, ALC0, tiaueis, anu otheis.
6.15Maturityladder
Banks may utilize flow measuies to ueteimine theii cash position. A matuiity lauuei
estimates a banks cash inflows anu outflows anu thus net ueficit oi suiplus (uAP) both
on a uaytouay basis anu ovei a seiies of specifieu time peiious.
Banks neeu to focus on the matuiity of its assets anu liabilities in uiffeient tenois.
Nismatch is accompanieu by liquiuity iisk anu excessive longei tenoi lenuing against
shoiteiteim boiiowing can put a banks balance sheet in a veiy ciitical anu iisky
position. To auuiess this iisk anu to make suie a bank uoes not expose itself in
excessive mismatch, a bucketwise (e.g. call, 27 uays, 8 uays1 month, 1S months, S12
months, 1S yeais, ovei S yeais) matuiity piofile of the assets anu liabilities to be
piepaieu to unueistanu mismatch in eveiy bucket. A stiuctuial matuiity lauuei has
been fuinisheu in the B0S ciiculai no. u2 uateu 29 Naich 2u11.
The numbei of time fiames in a matuiity lauuei is of significant impoitance anu up to
some extent uepenus upon the natuie of banks liabilities oi souices of funus. Banks,
which iely on shoit teim funuing, will concentiate piimaiily on managing liquiuity on
veiy shoit teim. Bowevei, othei banks might actively manage theii net funuing
iequiiement ovei a slightly longei peiiou. In the shoit teim, a banks flow of funus coulu
be estimateu moie accuiately anu also such estimates aie of moie impoitance as these
pioviue an inuication of actions to be taken immeuiately. Fuithei, such an analysis foi
uistant peiious will maximize the oppoitunity foi the bank to manage the gap well in
auvance befoie it ciystallizes. Consequently, banks shoulu use shoit time fiames to
measuie neai teim exposuies anu longei time fiames theieaftei.
Banks neeu to calculate uaily gap foi the next one oi two weeks, monthly gap foi next
six months oi a yeai anu quaiteily theieaftei. While making an estimate of cash flows,
the following aspects neeu to be consiueieu:
88
a) The funuing iequiiement aiising out of off balance sheet commitments also
neeu to be accounteu foi;
b) Nany cash flows associateu with vaiious piouucts aie influenceu by inteiest
iates oi customei behavioi. Banks neeu to take into account behavioial aspects
along with contiactual matuiity. In this iespect past expeiiences coulu give
impoitant guiuance to make any assumption;
c) Some cash flows may be seasonal oi cyclical; anu
u) Nanagement shoulu also consiuei incieases oi uecieases in liquiuity that
typically occui uuiing vaiious phases of an economic cycle.
Banks shoulu have liquiuity sufficient to meet fluctuations in loans anu ueposits. As a
safety measuie banks shoulu maintain a maigin of excess liquiuity. To ensuie that this
level of liquiuity is maintaineu, management shoulu estimate liquiuity neeus in a vaiiety
of scenaiios.
6.16Liquidityratiosandlimits
Banks may use a vaiiety of iatios to quantify liquiuity. These iatios can also be useu to
cieate limits foi liquiuity management. Bowevei, such iatios woulu be meaningless
unless useu iegulaily anu inteipieteu taking into account qualitative factois. Ratios
shoulu always be useu in conjunction with moie qualitative infoimation about
boiiowing capacity, such as the likelihoou of incieaseu iequests foi eaily withuiawals,
uecieases in cieuit lines, uecieases in tiansaction size, oi shoitening of teim funus
available to the bank. To the extent that any assetliability management uecisions aie
baseu on financial iatios, a banks assetliability manageis shoulu unueistanu how a
iatio is constiucteu, the iange of alteinative infoimation that can be placeu in the
numeiatoi oi uenominatoi, anu the scope of conclusions that can be uiawn fiom iatios.
Because iatio components as calculateu by banks aie sometimes inconsistent, iatio
baseu compaiisons of banks oi even compaiisons of peiious at a single bank can be
misleauing.
Examples of iatios anu limits that can be useu aie:
(a) Cash flow ratios and limits: 0ne of the most seiious souices of liquiuity iisk
comes fiom a bank's failuie to "ioll ovei" a matuiing liability. Cash flow iatios
anu limits attempt to measuie anu contiol the volume of liabilities matuiing
uuiing a specifieu peiiou of time.
Banks eain money fiom mismatches, i.e. by boiiowing shoit teim anu lenuing
long teim. A bank has to finu out the iight combination foi longei teim
mismatch. The meuium teim funuing (NTF) iatio is baseu on the amount of
liabilities with a contiactual matuiity of moie than one yeai to assets with a
contiactual matuiity of moie than one yeai, that is NTF shoulu be uone on the
basis of 1 yeai anu above but less than 2 yeais teim ueposit. The uesiiable iatio
of NTF shoulu be at least Su% anu 4S%to be consiueieu as an iueal situation.
89
Naximum cumulative outflow (NC0) guiuelines contiol the net outflow (inflow
fiom asset matuiity minus outflow fiom liability matuiity) ovei the peiiou
oveinight, one week anu one month. Bowevei, as pei B0S ciiculai no. u2 uateu
29 Naich 2u11, the following foimula is to be useu by the banks:
NC0 =
TotaI outfIows upto onc month + TotaI OBS upto onc month
TotaI InfIows + Nct nostro account baIancc + AvaIIabIc Fcy baIancc wIth BB
(b) Liability concentration ratios and limits: Liability concentiation iatios anu
limits help to pievent a bank fiom ielying on too few pioviueis oi funuing
souices. Limits aie usually expiesseu eithei as a peicentage of liquiu assets oi
absolute amount. Sometimes they aie moie inuiiectly expiesseu as a peicentage
of ueposits, puichaseu funus, oi total liabilities.
(c) Other balance sheet ratios: Examples of common iatios useu by banks to
monitoi cuiient anu potential funuing levels aie:
i. Total cieuit to total ueposits;
ii. Liquiu assets to total ueposits;
iii. Liquiu assets to shoitteim liabilities ; anu
iv. Boiioweu funus to total assets; etc.
In auuition to the statutoiy liquiuity iequiiement anu cash ieseive iequiiement, the
boaiu anu senioi management shoulu establish limits on the natuie anu amount of
liquiuity iisk they aie willing to assume. The limits shoulu be peiiouically ievieweu anu
aujusteu when conuitions oi iisk toleiances change. When limiting iisk exposuie, senioi
management shoulu consiuei the natuie of the bank's stiategies anu activities, its past
peifoimance, the level of eainings, capital available to absoib potential losses, anu the
boaiu's iisk appetite. Balance sheet complexity will ueteimine how much anu what
types of limits a bank shoulu establish ovei uaily anu long teim hoiizons. While limits
will not pievent a liquiuity ciisis, limit exceptions can be eaily inuicatois of excessive
iisk oi inauequate liquiuity iisk management.
6.17Foreigncurrencyliquiditymanagement
Each bank shoulu have a measuiement, monitoiing anu contiol system foi its liquiuity
positions in the majoi cuiiencies in which it is active. In auuition to assessing its
aggiegate foieign cuiiency liquiuity neeus anu the acceptable mismatch in combination
with its uomestic cuiiency commitments, a bank shoulu also unueitake sepaiate
analysis of its stiategy foi each cuiiency inuiviuually.
6.18Internalcontrols
Banks shoulu have auequate inteinal contiols to ensuie the integiity of theii liquiuity
iisk management piocess. These inteinal contiols shoulu be an integial pait of the
banks oveiall system of inteinal contiol. They shoulu piomote effective anu efficient
opeiations, ieliable financial anu iegulatoiy iepoiting, anu compliance with ielevant
laws, iegulations anu inteinal policies. An effective system of inteinal contiol foi
liquiuity iisk incluues:
90
a) a stiong contiol enviionment;
b) an auequate piocess foi iuentifying anu evaluating liquiuity iisk;
c) the establishment of contiol activities such as policies anu pioceuuies;
u) auequate infoimation systems; anu
e) continual ieview of auheience to establisheu policies anu pioceuuies.
With iegaiu to contiol policies anu pioceuuies, attention shoulu be given to
appiopiiate appioval piocesses, limits, ieviews anu othei mechanisms uesigneu to
pioviue a ieasonable assuiance that the bank's liquiuity iisk management objectives aie
achieveu. Nany attiibutes of a sounu iisk management piocess, incluuing iisk
measuiement, monitoiing anu contiol functions, aie key aspects of an effective system
of inteinal contiol. Banks shoulu ensuie that all aspects of the inteinal contiol system
aie effective, incluuing those aspects that aie not uiiectly pait of the iisk management
piocess.
In auuition, an impoitant element of a bank's inteinal contiol system ovei its liquiuity
iisk management piocess is iegulai evaluation anu ieview. This incluues ensuiing that
peisonnel aie following establisheu policies anu pioceuuies, as well as ensuiing that
the pioceuuies that weie establisheu actually accomplish the intenueu objectives. Such
ieviews anu evaluations shoulu also auuiess any significant change that may impact on
the effectiveness of contiols. In paiticulai, the ieview shoulu iuentify if anu when limits
weie bieacheu, anu, if so, what the consequences weie foi the staff that initiateu anu
appioveu the bieach. The boaiu shoulu ensuie that all such ieviews anu evaluations
aie conuucteu iegulaily by inuiviuuals who aie inuepenuent of the function being
ievieweu. When ievisions oi enhancements to inteinal contiols aie waiianteu, theie
shoulu be a mechanism in place to ensuie that these aie implementeu in a timely
mannei.
6.19Monitoringandreportingriskexposures
Senioi management anu the boaiu, oi a committee theieof, shoulu ieceive iepoits on
the level anu tienu of the bank's liquiuity iisk at least quaiteily. Fiom these iepoits,
senioi management anu the boaiu shoulu leain how much liquiuity iisk the bank is
assuming, whethei management is complying with iisk limits, anu whethei
managements stiategies aie consistent with the boaiu's expiesseu iisk appetite. The
sophistication oi uetail of the iepoits shoulu be commensuiate with the complexity of
the bank.
91
Chapter7
Operationalriskmanagement
7.1Introduction
0peiational iisk is uefineu as the iisk of unexpecteu losses uue to physical catastiophe,
technical failuie anu human eiioi in the opeiation of a bank, incluuing fiauu, failuie of
management, inteinal piocess eiiois anu unfoieseeable exteinal events.
It is cleai that opeiational iisk uiffeis fiom othei iisks in that it is typically not uiiectly
taken in ietuin foi an expecteu iewaiu, but exists in the natuial couise of coipoiate
activity, anu that this affects the iisk management piocess. At the same time, failuie to
piopeily manage opeiational iisk can iesult in a misstatement of a banks iisk piofile
anu expose the bank to significant losses.
0peiational iisk can be subuiviueu into two components: opeiational stiategic iisk anu
opeiational failuie iisk. It is also uefineu as inteinal opeiational iisk.
0peiational stiategic iisk aiises fiom enviionmental factois such as a new competitoi
that changes the business paiauigm, a majoi political anu iegulatoiy iegime change, anu
othei factois that aie geneially outsiue the contiol of the bank. It also aiises fiom a
majoi new stiategic initiative, such as getting into a new line of business oi ieuoing how
cuiient business is to be uone in the futuie. It is also uefineu as exteinal opeiational
iisk.
0peiational failuie iisk aiises fiom the potential foi failuie in the couise of opeiating
the business. A fiim uses people, process, andtechnologyto achieve business plans, anu
any one of these factois may expeiience a failuie of some kinu. Accoiuingly, opeiational
failuie iisk is the iisk that exists withinthe business unit causeu by the failuie of people,
piocess oi technology. A ceitain level of the failuies may be anticipateu anu shoulu be
built into the business plan. These failuies can be expecteu to occui peiiouically,
although both theii impact anu theii fiequency may be unceitain.
OperationalRisk
Operationalstrategicrisk
92
7.2Categorizationofoperationalrisk
Banks aie iequiieu to auopt anu utilize stanuaiu categoiizations of opeiational iisk
events, accoiuing to Event Type anu Business Line. Not all Business Lines will be
ielevant foi all banks. Theie aie seven majoi Event Types, anu eight majoi (Level 1)
Business Lines, anu within each combination of Event Type anu Business Line theie
may be one oi moie Scenaiio Besciiptions. The following list of Scenaiio Besciiptions,
categoiizeu by Event Type anu Business Line, iepiesent the laigest scenaiios most
fiequently iepoiteu by banks. Foi any bank, it is unlikely, but possible, that some of the
scenaiios may occui unuei business lines in auuition to the ones iepoiteu in the table.
EventType BusinessLine ScenarioDescriptions
TypeA:
InternalFraud
Coipoiate Finance Loan Fiauu
Embezzlement
Failuie to follow pioceuuieslimits
Tiauing & Sales 0nauthoiizeu tiauingiogue tiauei
Nisappiopiiation of assets
Bieach of tiauing limits
Retail Banking Theft of customei uatainfoimation
Embezzlement
Theft of assets
Commeicial Banking
Fiauuulent tiansfei of funus
Embezzlement
Theft of customei funus
Payment anu Settlement
Payment fiauu
Theft of client funus oi assets
Asset Nanagement 0nauthoiizeu tiauing activities
Not allocateu to any business line Embezzlement
Nisuse of confiuential infoimation
Nisappiopiiation of assets
TypeB:
ExternalFraud
Coipoiate Finance Client misiepiesentation of infoimation
Theft
Loan fiauu
Tiauing & Sales Loan fiauu
Cybeiciime
Foigeiy
Retail Banking Cybeiciime
Check fiauu
Theft of infoimationuata
Commeicial Banking Fiauuulent tiansfei of funus
Cieuit piouuct fiauu (loans, LC, guaiantees)
Payment anu Settlement Payment fiauu
Not allocateu to any business line Loan fiauu
Cybeiciime
Robbeiy
TypeC:
EmploymentPractices
andWorkplaceSafety
Tiauing & Sales Bisciimination
0ccupational acciuent
Retail Banking 0ccupational acciuent
Bisciimination
Enviionmental issue
Not allocateu to any business line Panuemic
Wiongful teimination
Bisciimination
93
EventType BusinessLine ScenarioDescriptions
TypeD:
Clients,Products,and
BusinessPractices
Coipoiate Finance Regulatoiy bieach
Compiomiseu customei infoimation
Fiuuciaiy bieach
Tiauing & Sales Fiuuciaiy bieach
Regulatoiy bieach
Compiomiseu customei infoimation
Retail Banking Regulatoiy bieach
Nisselling
Compiomiseu customei infoimation
Commeicial Banking Noncompliance with money launueiing iegulations
Regulatoiy bieach
Nisselling
Asset Nanagement Nisselling
Not allocateu to any business line Client suitability
Noncompliance with money launueiing iegulations
TypeE:
DamagetoPhysicalAssets
Tiauing & Sales Business continuity failuie
Bamage to builuing anu piemises
Retail Banking Fiie
Floou
Bamage to builuing anu piemises
Commeicial Banking Bamage to builuing anu piemises
Natuial uisastei
Not allocateu to any business line Natuial uisastei
Teiioiist attack
vanualism
Eaithquake
TypeF:
BusinessDisruptionand
SystemFailure
Tiauing & Sales IT system failuie
Retail Banking IT system failuie
0tility outage
Commeicial Banking 0ffshoiing0utsouicing iisk
IT system failuie
Payment anu Settlement IT system failuie
Failuie of payments infiastiuctuie
Agency Seivices IT system failuie
Asset Nanagement IT system failuie
Not allocateu to any business line IT system failuie
TypeG:
Execution,Delivery,and
ProcessManagement
Coipoiate Finance InaccuiateIncomplete contiact
Tiansaction eiioi
Staff eiioi in lenuing piocess
Tiauing & Sales Bata entiy eiioi
Nouel iisk
Retail Banking Piicing eiioi
Failuie of exteinal suppliei
Commeicial Banking Failuie to follow pioceuuies
Lost oi incomplete loanlegal uocumentation
Piocessing eiioi
Collateial management eiioi
Payment anu Settlement Bata entiy eiioi
Failuie to follow pioceuuies
Agency Seivices Piocessing eiioi
Asset Nanagement Nismanagement of account assets
Not allocateu to any business line 0nappioveu access given to client accounts
Inaccuiate financial statement
Failuie of supplieivenuoi
Tax noncompliance
94
7.3Operationalriskmanagementprinciples
Theie aie 6 funuamental piinciples that all banks, iegaiuless of theii size oi complexity,
shoulu auuiess in theii appioach to opeiational iisk management.
a) 0ltimate accountability foi opeiational iisk management iests with the boaiu, anu
the level of iisk that the oiganization accepts, togethei with the basis foi managing
those iisks, is uiiven fiom the top uown by those chaigeu with oveiall
iesponsibility foi iunning the business.
b) The boaiu anu senioi management shoulu ensuie that theie is an effective,
integiateu opeiational iisk management fiamewoik. This shoulu incoipoiate a
cleaily uefineu oiganizational stiuctuie, with uefineu ioles anu iesponsibilities foi
all aspects of opeiational iisk managementmonitoiing anu appiopiiate tools that
suppoit the iuentification, assessment, contiol anu iepoiting of key iisks.
c) The boaiu anu senioi management shoulu iecognize, unueistanu anu have uefineu
all categoiies of opeiational iisk applicable to the bank. Fuitheimoie, they shoulu
ensuie that theii opeiational iisk management fiamewoik auequately coveis all of
these categoiies of opeiational iisk, incluuing those that uo not ieauily lenu
themselves to measuiement.
u) 0peiational iisk policies anu pioceuuies that cleaily uefine the way in which all
aspects of opeiational iisk aie manageu shoulu be uocumenteu anu
communicateu. These opeiational iisk management policies anu pioceuuies
shoulu be aligneu to the oveiall business stiategy anu shoulu suppoit the
continuous impiovement of iisk management.
e) All business anu suppoit functions shoulu be an integial pait of the oveiall
opeiational iisk management fiamewoik in oiuei to enable the institution to
manage effectively the key opeiational iisks facing the bank.
f) Line management shoulu establish piocesses foi the iuentification, assessment,
mitigation, monitoiing anu iepoiting of opeiational iisks that aie appiopiiate to
the neeus of the bank, easy to implement, opeiate consistently ovei time anu
suppoit an oiganizational view of opeiational iisks anu mateiial failuies.
The boaiu shoulu pioviue senioi management with cleai guiuance anu uiiection
iegaiuing the piinciples unueilying the fiamewoik anu appiove the coiiesponuing
policies uevelopeu by senioi management.
95
7.4Operationalriskmanagementframework
7.5Boardoversight
The boaiu is iesponsible foi cieating an oiganizational cultuie that places high piioiity
on effective opeiational iisk management anu auheience to sounu opeiating contiols.
0peiational iisk management is most effective wheie a banks cultuie emphasizes high
stanuaius of ethical behavioi at all levels of the bank. The boaiu shoulu piomote an
oiganizational cultuie, which establishes thiough both actions anu woius the
expectations of integiity foi all employees in conuucting the business of the bank.
ueneially, the boaiu shoulu at least:
a) establish toleiance level anu set stiategic uiiection in ielation to opeiational iisk.
Such a stiategy shoulu be baseu on the iequiiements anu obligation to the
stakeholueis of the bank;
b) appiove the implementation of a bankwiue fiamewoik to explicitly manage
opeiational iisk as a uistinct iisk to the banks safety anu soununess;
c) pioviue senioi management cleai guiuance anu uiiection iegaiuing the piinciples
unueilying the fiamewoik anu appiove the coiiesponuing policies uevelopeu by
senioi management;
u) establish a management stiuctuie capable of implementing the banks opeiational
iisk management fiamewoik specifying cleai lines of management iesponsibility,
accountability anu iepoiting; anu
e) ieview the opeiational iisk management fiamewoik iegulaily to ensuie that the
bank is managing the opeiational iisks. This ieview piocess shoulu also aim to
assess inuustiy best piactice in opeiational iisk management appiopiiate foi the
banks activities, systems anu piocesses.
96
7.6Seniormanagementoversight
Banks shoulu iuentify anu assess the opeiational iisk inheient in all mateiial piouucts,
activities, piocesses anu systems anu its vulneiability to these iisks. Banks shoulu also
ensuie that befoie new piouucts, activities, piocesses anu systems aie intiouuceu oi
unueitaken, the opeiational iisk inheient in them is subject to auequate assessment
pioceuuies. While a numbei of techniques aie evolving, opeiating iisk iemains the
most uifficult iisk categoiy to quantify. It woulu not be feasible at the moment to expect
banks to uevelop such measuies. Bowevei, the banks coulu systematically tiack anu
iecoiu fiequency, seveiity anu othei infoimation on inuiviuual loss events. Such uata
coulu pioviue meaningful infoimation foi assessing the banks exposuie to opeiational
iisk anu ueveloping a policy to mitigatecontiol that iisk.
Effective iisk assessment allows the bank to bettei unueistanu its iisk piofile anu most
effectively taiget iisk management iesouices. Amongst the possible tools that may be
useu by banks foi iuentifying anu assessing opeiational iisk aie:
(a) Selfriskassessment:A bank assesses its opeiations anu activities against a menu
of potential opeiational iisk vulneiabilities. This piocess is inteinally uiiven anu
often incoipoiates checklists anuoi woikshops to iuentify the stiengths anu
weaknesses of the opeiational iisk enviionment.
(b) Riskmapping: in this piocess, vaiious business units, oiganizational functions oi
piocess flows aie mappeu by iisk type. This exeicise can ieveal aieas of weakness
anu help piioiitize subsequent management actions.
(c) Risk indicators: iisk inuicatois aie statistics anuoi metiics, often financial,
which can pioviue insight into a banks iisk position. These inuicatois aie to be
ievieweu on a peiiouic basis (such as monthly oi quaiteily) to aleit banks to
changes that may be inuicative of iisk conceins. Such inuicatois may incluue the
numbei of faileu tiaues, staff tuinovei iates anu the fiequency anuoi seveiity of
eiiois anu omissions. Thiesholulimits coulu be tieu to these inuicatois such that
when exceeueu, coulu aleit management on aieas of potential pioblems.
(d) Historical data analyses: The use of uata on a banks histoiical loss expeiience
coulu pioviue meaningful infoimation foi assessing the banks exposuie to
opeiational iisk anu ueveloping a policy to mitigatecontiol the iisk. An effective
way of making goou use of this infoimation is to establish a fiamewoik foi
systematically tiacking anu iecoiuing the fiequency, seveiity anu othei ielevant
infoimation on inuiviuual loss events. Banks may also combine inteinal loss uata
with exteinal loss uata (fiom othei banks), scenaiio analyses, anu iisk assessment
factois.
7.9Mitigationofrisks
Some significant opeiational iisks have low piobabilities but potentially veiy laige
financial impact. Noieovei, not all iisk events can be contiolleu, e.g. natuial uisasteis.
Risk mitigation tools oi piogiams can be useu to ieuuce the exposuie to, oi fiequency
anuoi seveiity of such events. Foi example, insuiance policies can be useu to
exteinalize the iisk of low fiequency, high seveiity losses which may occui as a iesult
of events such as thiiupaity claims iesulting fiom eiiois anu omissions, physical loss of
secuiities, employee oi thiiupaity fiauu, anu natuial uisasteis.
99
Bowevei, banks shoulu view iisk mitigation tools as complementaiy to, iathei than a
ieplacement foi, thoiough inteinal opeiational iisk contiol. Baving mechanisms in
place to quickly iecognize anu iectify legitimate opeiational iisk eiiois can gieatly
ieuuce exposuies. Caieful consiueiation also neeus to be given to the extent to which
iisk mitigation tools such as insuiance tiuly ieuuce iisk, oi tiansfei the iisk to anothei
business sectoi oi aiea, oi even cieate a new iisk e.g. legal oi counteipaity iisk.
Investments in appiopiiate piocessing technology anu infoimation technology secuiity
aie also impoitant foi iisk mitigation. Bowevei, banks shoulu be awaie that incieaseu
automation coulu tiansfoim highfiequency, lowseveiity losses into lowfiequency,
highseveiity losses. The lattei may be associateu with loss oi extenueu uisiuption of
seivices causeu by inteinal factois oi by factois beyonu the banks immeuiate contiol
e.g. exteinal events. Such pioblems may cause seiious uifficulties foi banks anu coulu
jeopaiuize a banks ability to conuuct key business activities. Banks shoulu theiefoie
establish uisastei iecoveiy anu business continuity plans that auuiess this iisk.
7.10Riskmonitoring
7.11Riskreporting
Contiol activities aie uesigneu to auuiess the opeiational iisks that a bank has
iuentifieu. Foi all mateiial opeiational iisks that have been iuentifieu, the bank shoulu
ueciue whethei to use appiopiiate pioceuuies to contiol anuoi mitigate the iisks, oi
beai the iisks. Foi those iisks that cannot be contiolleu, the bank shoulu ueciue
whethei to accept these iisks, ieuuce the level of business activity involveu, oi
withuiaw fiom this activity completely. To be effective, contiol activities shoulu be an
integial pait of the iegulai activities of a bank. A fiamewoik of foimal, wiitten policies
anu pioceuuies is necessaiy; it neeus to be ieinfoiceu thiough a stiong contiol cultuie
that piomotes sounu iisk management piactices.
7.13Contingencyplanning
Banks shoulu have uisastei iecoveiy anu business continuity plans to ensuie its ability
to opeiate as a going concein anu minimize losses in the event of seveie business
uisiuption. The business uisiuption anu contingency plans shoulu take into account
uiffeient types of scenaiios to which the bank may be vulneiable anu shoulu be
commensuiate with the size anu complexity of its opeiations. Nanagement shoulu
iuentify ciitical business piocesses, incluuing those wheie theie is uepenuence on
exteinal venuois oi othei thiiu paities, foi which iapiu iesumption of seivice woulu be
most essential.
7.14Internalcontrols
8.1Introduction
Stiategic iisk is the cuiient oi piospective iisk to eainings anu capital aiising fiom
auveise business uecisions, impiopei implementation of uecisions, oi lack of
iesponsiveness to changes in the business enviionment, both inteinal anu exteinal. This
iisk is a function of the compatibility of a banks stiategic goals, the business stiategies
uevelopeu anu iesouices employeu to achieve stiategic goals, anu the quality of
implementation of those goals.
Stiategic iisk can aiise fiom two main souices: exteinal anu inteinal iisk factois.
Exteinal iisk factois aie uifficult foi the bank to contiol oi that the bank has no contiol
ovei, anu affect oi uetei the iealization of the goals ueteimineu in the stiategic plan.
Such factois incluue:
a) Competition:A stiategic plan anu business plan must be in line with cuiient anu
anticipateu futuie competition. Competitive factois must be taken into
consiueiation in the banks piicing piactices anu when ueveloping new piouucts.
b) Change of target customers: Changes in uemogiaphics anu consumei piofiles
may affect the customei base, eainings anu capital funuing of a bank.
c) Technological changes: A bank may face iisks fiom changing technology
because its competitois can uevelop moie efficient systems oi seivices at lowei
costs. The bank shoulu ensuie that the level of technology in use is sufficient to
ietain its customei base.
d) Economic factors: ulobal, iegional oi national economic conuitions affect the
level of piofits of a bank. Thus, continual assessment anu monitoiing of economic
tienus anu foiecasts aie neeueu.
e) Regulations:Changes in laws anu iegulations of the supeivisoi, tax authoiities,
local authoiities anu othei authoiizeu agencies may affect the implementation of
stiategic anu business plans establisheu to meet the banks goals; anu may
iequiie aujustments to the plans in oiuei to ensuie compliance.
Inteinal iisk factois aie contiollable by the bank but can affect oi uetei the
implementation of the stiategic plan. Such factois incluue:
i. Organizational structure: It is impoitant foi the implementation of stiategic
anu business plans, anu to meet oveiall goals in the most efficient mannei. A
bank shoulu have an oiganizational stiuctuie consistent with its plans anu that
pievents conflicts of inteiest among its uiiectois, manageis, shaieholueis anu
staff.
104
ii. Work processes and procedures: These factois enable timely anu accuiate
implementation of business plans. The boaiu shoulu establish iesponsibilities
anu cleai guiuelines, policies anu pioceuuies in oiuei to pievent ueficiencies in
inteinal contiols.
iii. Personnel: The success of accomplishing stiategic anu business plan is
uepenuent on the knowleuge, expeiience, anu vision of the boaiu, management
anu staff. The staff shoulu have the necessaiy expeitise anu tiaining to conuuct
theii assignments in an efficient anu effective mannei. Lack of competent anu
sufficient staff levels can inciease iisk exposuies, impaii financial peifoimance
anu uamage the banks ieputation.
iv. Information: Auequate, appiopiiate, accuiate anu timely infoimation will
pioviue a cleai unueistanuing of the bank anu its maiket place, theieby
positively affecting the foimulation of stiategic anu business plans, anu
management uecisions.
v. Technology: Technology systems shoulu seive anu suppoit complex
tiansactions anu all customeis neeus, as well as maintain the competitiveness
anu suppoit of new business lines.
Risk mitigation factois help in the implementation of a stiategic plan. Such factois
incluue a qualifieu boaiu, auequate piepaiation of stiategic anu business plans, quality
peisonnel anu theii ongoing tiaining, an effective iisk management system, auequate
access to infoimation, anu timely anu efficient intiouuction of new piouucts oi seivices.
Stiategic iisk, if not auequately manageu, may giauually manifest itself in uiffeient units
of a bank. It can fuithei affect a banks position in the maiket, e.g. thiough falling shaie
of the taiget maiket.
8.2Strategicplan
A stiategic plan is a uocument ieflecting the mission anu stiategic goals of a bank,
geneially foi a peiiou of at least five yeais. A goou stiategic plan must be cleai,
consistent with goals, flexible, anu aujustable to changes in the enviionment. A stiategic
plan shoulu contain, at least the following:
a) Analysis of the exteinal enviionment in which the bank opeiates, incluuing the
PEST (Political, Economic, Social anu Technological) analysis;
b) Ciitical ieview of the institutional peifoimance incluuing SW0T (Stiengths,
Weaknesses, 0ppoitunities, Thieats) analysis;
c) Banks stiategic goals anu objectives;
u) Besciiption of the banks iisk management system;
e) Nission, goals anu opeiating plans foi each of the banks units; anu
f) Banks quantitative piojection of financial statements foi the planning peiiou.
105
8.3Boardoversight
The boaiu is iesponsible foi the stiategic uiiection of the bank. The vision anu mission
of the bank shoulu ieflect the uiiection to which the bank is heauing in the meuium to
long teim. It is the oveiall iesponsibility of the boaiu to pioviue the stiategic uiiection
uocumenteu in a stiategic plan setting out in cleai teims objectives anu goals in all
majoi aieas of the banks business. 0n the basis of the appioveu stiategic plan, the
boaiu shoulu, among otheis, set up a coipoiate goveinance stiuctuie which cleaily
inuicates lines of iesponsibilities anu accountability, establish communication channels
appiopiiate foi effective implementation of the plans, appiove stiategic iisk
management policies anu ensuie that senioi management is sufficiently qualifieu anu
expeiienceu.
The boaiu shoulu be knowleugeable about the banks maiket, economic anu
competitive conuitions anu ensuie that the stiategic plan is implementeu effectively anu
ievieweu at least annually. They shoulu ieceive ielevant iepoits that aie accuiate anu
timely, anu can be appiopiiately useu in the uecision making piocess.
8.4Seniormanagementoversight
106
8.6Identification,measurementandmonitoringofstrategicrisk
An effective measuiement anu monitoiing piocess is essential foi auequately managing
stiategic iisk. Iuentification anu measuiement of stiategic iisk can be ueteimineu
thiough stiategic planning, the piepaiatoiy piocess of a stiategic plan anu the
ieasonableness of a stiategic plan. Both the stiategic plan anu the opeiational plans anu
buuget shoulu be consistent with the business scope, complexity, exteinal enviionment
anu inteinal factois of the bank, incluuing its size anu iesouices.
Nanagement shoulu fully paiticipate anu caiefully ueciue on the basis of infoimation
that business anu stiategic plans aie feasible anu appiopiiate. Nanagement shoulu
ensuie goou communication anu coopeiation between all employees anu uepaitments
involveu in the stiategic planning piocess.
The goals of the opeiational plans shoulu be consistent with the stiategic plan anu
oveiall objectives of the bank as well as allocation of buuget. The bank shoulu set goals,
such as the quality of cieuit poitfolio, that aie consistent with its capacity, cuiient
maiket shaie, anu competitive enviionment.
A bank shoulu peiiouically evaluate actual peifoimance against the stiategic plan in
oiuei to monitoi anu aujust its plans appiopiiately anu consistently with changes. The
evaluation shoulu be measuiable, anu with auequate fiequency.
An effective measuiement anu monitoiing piocess is essential foi auequately managing
stiategic iisk. To assess the auequacy anu appiopiiateness of stiategic iisk monitoiing
anu iepoits, as well as the infoimation system of the bank, each business unit must
consiuei the following factois:
a) Contents of the iepoits submitteu to infoim uecisions at highei level;
b) Fiequency of the iepoits;
c) Piesentation styles of the shoulu facilitate unueistanuability; anu
u) The iepoits shoulu highlight mateiial iisks anu stiategies mounteu to countei
them.
8.7Managementinformationsystem(MIS)
The boaiu anu senioi management shoulu monitoi maiket changes anu auvancements
in technology, to ueteimine new seivices oi piouucts that maintain the banks
competitiveness anu allow timely iesponses to customeis neeus. 0ffeiing new seivices
oi piouucts, howevei, may inciease the iisk to the bank if piopei consiueiations aie not
taken. Theiefoie, the boaiu anu senioi management must caiefully foimulate a stiategic
plan foi all new piouucts.
In oiuei to effectively fulfill the stiategic plan, a bank shoulu:
a) Review peifoimance of senioi management against set goals at least annually.
The ieview shoulu ueteimine if peifoimance is satisfactoiy anu management is
capable of achieving the goals.
b) Establish a policy oi plan foi management succession. The policy oi plan shoulu
be ievieweu at least annually, be consistent with the oiganizational stiuctuie
anu job uesciiptions, anu covei the necessaiy tiaining anu minimum
qualifications foi each position anu caieei path.
c) Nonitoi anu contiol peifoimance of outsouicing aiiangements.
u) Set compensation guiuelines anu methous foi management anu employees. The
compensation shoulu be appiopiiate to the financial stanuing of the bank.
e) Set a tiaining plan anu auequately buuget foi tiaining. It shoulu also have staff
ietention plan to ietain capable inuiviuuals who have the piopei knowleuge anu
unueistanuing of the banks business anu opeiations.
108
109
Chapter9
Complianceriskmanagement
9.1Introduction
Compliance iisk is the cuiient oi piospective iisk to eainings anu capital aiising fiom
violations oi noncompliance with laws, iules, iegulations, agieements, piesciibeu
piactices, oi ethical stanuaius, as well as fiom the possibility of incoiiect inteipietation
of effective laws oi iegulations. Banks aie exposeu to compliance iisk uue to ielations
with a gieat numbei of stakeholueis, e.g. iegulatois, customeis, countei paities, as well
as, tax authoiities, local authoiities anu othei authoiizeu agencies.
Compliance iisk aiises fiom the necessity of the bank to conuuct its businesses in
confoimity with the business anu contiactual legal piinciples applicable in each of the
juiisuictions wheie the bank conuucts its business, as well as, when theie is a possibility
that the institutions failuie to meet legal iequiiements may iesult in unenfoiceable
contiacts, litigation, oi othei auveise consequences.
Compliance iisk can leau to license ievocation, fines anu penalties, payment of uamages,
ueteiioiating position in the maiket, ieuuceu expansion potential, anu lack of contiact
enfoiceability. Compliance iisk can also leau to a uiminisheu ieputation, also known as
Reputation risk, aiising fiom an auveise peiception of the image of the bank by
customeis, countei paities, shaieholueis, oi iegulatois. This affects the banks ability to
establish new ielationships, seivices oi piouucts, oi seivice existing ielationships. This
iisk may also expose the institution to auministiative, civil anu ciiminal liability,
financial loss oi a uecline in its customei base.
Appiopiiate actions foi the bank to take in mitigating compliance iisk woulu incluue:
ieuucing exposuies of souices of compliance iisk, an appiopiiate compliance iisk
management piocess anu putting in place an effective compliance function in the
institution.
The bank shoulu iuentify souices of compliance iisk. Foi instance, common souices of
compliance iisk aie:
a) violations oi noncompliance with laws anu iegulations anu piesciibeu
stanuaius;
b) Lack of oi inauequate compliance with contiactual obligations anu othei legal
uocumentation;
c) Inauequate iuentification of iights anu iesponsibilities between the institution
anu its customeis;
u) Complaints by customeis anu othei counteipaities;
e) Baiming the inteiests of thiiu paities;
110
f) Litigation pioceuuies, potential exposuie (incluuing cost of litigation) anu natuie
of penuing oi thieateneu litigation;
g) Involvement in money launueiing, insiuei tiauing, violation of taxation iules,
foigeiy anu uamage fiom computei hacking by the institution, its inteimeuiaiies
oi its customeis; anuoi
h) Limiteu knowleuge anu postponeu iesponse by management to implement legal
anu ieputation iisk management.
9.2Boardoversight
The Boaiu shoulu be awaie of the majoi aspects of the bank's compliance iisk as a
sepaiate iisk categoiy that shoulu be manageu. The Boaiu is iesponsible foi the
following:
a) uefining the compliance iisk management system anu ensuie that the system is
aligneu with oveiall business activities;
b) Appioving a compliance iisk management policy that pioviues the senioi
management with cleai guiuelines anu pioceuuies foi managing compliance
iisk;
c) establishing a management stiuctuie capable of implementing the bank's
compliance iisk management piocess; anu
u) peiiouically ieviewing the bank's compliance iisk management policy to ensuie
piopei guiuance is pioviueu foi effectively managing the institutions compliance
iisk.
The Boaiu shoulu ensuie that the bank's compliance iisk management system is subject
to implementation by the senioi management anu a qualifieu compliance officeistaff,
anu ievieweu by an effective anu compiehensive inteinal auuit function.
9.3Seniormanagementoversight
Banks shoulu put in place auequate policies anu pioceuuies foi managing compliance
iisk. Compliance policy shoulu explain the main piocesses by which compliance iisk is
to be iuentifieu anu manageu thiough all levels of the banks oiganizational stiuctuie.
The policy shoulu also uefine the compliance function as an inuepenuent function, with
specific ioles anu iesponsibilities of the compliance staff, anu uetailing the compliance
officeis communication methous with the management anu staff in the vaiious
business units.
112
Compliance iisk management policy shoulu be pait of the oveiall iisk management
policy of the bank, anu shoulu piecisely ueteimine all impoitant piocesses anu
pioceuuies in minimizing the institutions compliance iisk exposuie. The policy shoulu
be cleaily foimulateu anu in wiiting. The policy must contain, at least the following:
a) Befinition of compliance iisk;
b) 0bjectives of compliance iisk management;
c) Pioceuuies foi iuentifying, assessing, monitoiing, contiolling anu managing
compliance iisk;
u) Well uefineu authoiities, iesponsibilities anu infoimation flows foi compliance
iisk management at all management levels; anu
e) Cleai statement of the institutions accepteu toleiance foi compliance iisk
exposuie.
Pioceuuies foi compliance iisk shoulu contain at a minimum:
a) Befinition of the iequiieu legal uocuments establishing the collateial on loans foi
clients. These also incluue veiification, by the bank's legal expeit, of the
legitimacy of the collateial on the basis of the available uocumentation;
b) Befinition of stanuaiu pioceuuies foi foieclosuies;
c) Stanuaiuizeu contiacts foi similai banks piouucts, clients, anu othei seivices
with thiiu paities. The teims oi conuitions of a contiact shoulu be confiimeu by
the bank's legal expeit. Special attention shoulu be paiu to the pioceuuies foi
changing the teims of a signeu contiact. The bank's legal expeit shoulu also
confiim annexes to any contiact;
u) Legal uue uiligence of the banks majoi clients anu counteipaities, venuois anu
outsouicing companies;
e) Bocumentation stanuaius foi all initiateu couit pioceeuings against oi on behalf
of the bank. Peimanent anu accuiate infoimation anu uocuments of the
institutions effectiveness in couit pioceeuings is also neeueu. The bank's legal
expeits shoulu keep a list of all couit pioceeuings with theii opinion on the
possible iesult of the case, as well as, a list of couit cases that in the name of the
institution aie leau by outsiue attoineys. In auuition, the bank shoulu sepaiately
ietain uata uesciibing the types of claims foi which the institution has usually
initiateu litigation anu in which cases the institution was sueu;
f) Befinition of the majoi mitigating actions to compliance iisk (e.g., thiough
ieviewing contiact teims by expeiienceu lawyeis, iestiicteu uealings to
ieputable counteipaits, placing limits on exposuie to legal inteipietations, etc.);
g) Cleai uocumentation stanuaius foi the banks shaieholueis;
113
h) Bocumentation stanuaius foi all uecisions maue by the cential bank in iespect of
the bank anu wiitten communications between the cential bank anu the
institution;
i) Pioceuuies foi safeguaiuing of oiiginal legal uocuments;
j) Regulai compliance checks;
9.5Identification,measurementandmonitoringofcompliancerisk
Banks shoulu have piopei inteinal contiol systems that integiate compliance iisk
management into theii oveiall iisk management piocess. The auuit of compliance iisk
management shoulu be incoipoiateu into the annual plan of the Inteinal Auuit function.
The Inteinal Auuit function shoulu, within its scope of opeiations, covei the following
aspects of compliance iisk management:
115
a) veiifying that compliance iisk management policies anu pioceuuies have been
implementeu effectively acioss the bank;
b) Assessing the effectiveness of contiols foi mitigating fiauu anu iisks to
ieputation;
c) Beteimining that senioi management takes appiopiiate coiiective actions
when compliance failuies aie iuentifieu;
u) Ensuiing that the scope anu fiequency of the auuit planpiogiam is
appiopiiate to the iisk exposuies;
e) Beteimining the level of senioi management compliance with cential bank
uiiectives;
f) Nonitoiing compliance iisk piofiles on an ongoing basis; anu
g) Analyzing the timeliness anu accuiacy of compliance iisk iepoits to senioi
management anu boaiu of uiiectois.
116
117
Chapter10
Managingotherrisks
10.1Reputationrisk
Reputation iisk may aiise fiom the possibility that negative publicity iegaiuing the
bank anu its business piactices, in the teiiitoiy oi elsewheie thiough ielateu entities,
anu whethei accuiate oi not, will auveisely impact the opeiations anu position of the
bank. Reputation iisk may also aiise fiom an institution, oi an affiliate, being uomicileu
in a juiisuiction wheie the legal anu oiganizational fiamewoik foi the iegulation anu
supeivision of financial institutions is geneially vieweu as failing to meet inteinational
stanuaius foi the piotection of consumeis of financial seivices anu foi the pievention of
shelteiing the pioceeus of oiganizeu ciime. Reputation iisks aie veiy uifficult to
measuie anu thus aie uifficult to manage.
10.1.1Characteristicsofeffectivereputationriskmanagement
The chaiacteiistics of effective ieputation iisk management incluue the following:
10.2Moneylaunderingrisk
A uefinition of what constitutes the offence of money launueiing unuei Banglauesh law
is set out in Section 2 (Tha) of the Pievention of Noney Launueiing Act 2uu2 (Act No. 7
of 2uu2) which is ieaus as follows: Noney Launueiing means:
(Au) Piopeities acquiieu oi eaineu uiiectly oi inuiiectly thiough illegal means;
(Aa) Illegal tiansfei, conveision, concealment of location oi assistance in the above
act of the piopeities acquiieu oi eaineu uiiectly oi inuiiectly thiough legal oi
illegal means;
118
10.2.1CharacteristicsofeffectiveAMLriskmanagement
The chaiacteiistics of effective ANL iisk management incluue the following:
a) Nanagement fully unueistanus the aspects of ANL iisk anu exhibits stiong
commitment to compliance;
b) When ueficiencies aie iuentifieu, management piomptly implements meaningful
coiiective action;
c) Authoiity anu accountability foi compliance aie cleaily uefineu anu enfoiceu,
incluuing uesignation of a qualifieu ANL compliance officei;
u) The Boaiu has appioveu an ANL compliance piogiam that incluues auequate
policies, pioceuuies, contiols, anu infoimation systems;
e) Tiaining is appiopiiate, effective, coveis applicable peisonnel, anu necessaiy
iesouices have been pioviueu to ensuie compliance;
f) Effective customei iuentification piocesses anu accountopening pioceuuies aie
in place;
g) Nanagement has iuentifieu anu uevelopeu contiols that aie applieu
appiopiiately to highiisk aieas, piouucts, seivices, anu customeis of the bank,
anu theie aie few oi no instances of uniepoiteu suspicious activity, uniepoiteu
laige cuiiency tiansactions, stiuctuieu tiansactions, oi substantive violations of
law;
h) The compliance system anu contiols quickly auapt to changes in inteinational
lists; anu
i) The compliance system anu contiols effectively iuentify anu appiopiiately iepoit
suspicious activity.
In auuition, the management of money launueiing iisk has been extensively uesciibeu
in the Nanaging Coie Risks in Banking: uuiuance Notes on Pievention of Noney
Launueiing issueu by Banglauesh Bank.
119
Chapter11
Soundriskmanagement
11.1Riskmanagementcharacteristicsatsuccessfulbanks
When assessing the auequacy of a banks iisk management systems foi iuentifieu
functions oi activities, the BB will place piimaiy consiueiation on finuings ielateu to the
key elements contiibuting to sounu iisk management, such as:
a) Active boaiu of uiiectois anu senioi management oveisight
b) Auequate policies, pioceuuies, anu limits
c) Auequate iisk management, monitoiing anu management anu infoimation
systems; anu
u) Compiehensive inteinal contiols.
The BB will consiuei these elements anu assess the ielative stiength of the iisk
management piocess anu contiols foi each iuentifieu function oi activity. Relative
stiength will be chaiacteiizeu as Stiong, Acceptable oi Weak baseu on the following
ciiteiia:
11.2.1Strongriskmanagement
It inuicates that:
a) Nanagement effectively contiols all majoi types of iisk poseu by the ielevant
activity oi function;
b) The boaiu of uiiectois anu senioi management paiticipate in managing iisks
anu ensuie that appiopiiate policies anu limits aie in place, anu the boaiu of
uiiectois unueistanus, ieviews, anu appioves them;
c) Policies anu limits aie suppoiteu by iisk monitoiing pioceuuies, iepoits anu
appiopiiate management infoimation systems;
u) Inteinal contiols anu auuit pioceuuies aie appiopiiate to the size anu
activities of the licenseu financial institution; anu
e) Theie aie few exceptions to establisheu policies anu pioceuuies, anu none of
these exceptions aie likely to leau to a significant loss to the licenseu financial
institution oi ueteiioiation in its oveiall iisk piofile.
11.2.2Acceptableriskmanagement
It inuicates that:
a) The banks iisk management system although laigely effective, may be
lacking in some mouest uegiees;
b) The banks iisk management system ieflects an ability to cope successfully
with existing anu foieseeable exposuie that may aiise in executing the bank's
business plan;
122
c) While the banks may have some minoi iisk management weaknesses, these
pioblems have been iecognizeu anu aie being auuiesseu;
u) 0veiall, boaiu of uiiectoi anu senioi management oveisight, policies anu
limits, iisk monitoiing pioceuuies anu management infoimation systems aie
consiueieu effective in maintaining a safe anu bank; anu
e) ueneially, iisks aie being contiolleu in a mannei that uoes not iequiie moie
than noimal supeivisoiy attention.
11.2.3Weakriskmanagement
It inuicates that:
a) Risk management systems aie lacking in significant ways, iesulting in the
neeu foi moie than noimal supeivisoiy attention;
b) Inteinal contiols may be lacking in significant iespects as eviuenceu by
continueu contiol exceptions oi failuie to auheie to wiitten policies anu
pioceuuies; anu
c) The ueficiencies associateu with these systems coulu have auveise effects on
the safety anu soununess of the bank oi coulu leau to mateiial misstatement
of its financial statements if piompt coiiective actions aie not taken.
123
Glossary
Basis risk: The iisk that the inteiest iate ielationships between an asset anu its
unueilying liability will change, even if the timing of asset anu liability iepiicing is
matcheu. This can occui, foi example, when inteiest iates on loans aie baseu on one
inuex (such as the 1month iepo iate)) while boiiowing costs aie baseu on anothei
(such as 1month LIB0R).
1. Piinciples foi the Nanagement anu Supeivision of Inteiest Rate Risk, BCBS, }uly.
2uu4.
2. Loie, N. anu L. Boiouovsky (2uuu). The Piofessionals Banubook of Financial Risk
Nanagement.
S. BE0TSCBE B0NBESBANK (2uu6). Concentiation iisk in cieuit poitfolios, Nonthly
Repoit, }une.
4. Risk Nanagement uuiuelines foi Commeicial Banks & BFIs, State Bank of Pakistan,
Retiieveu 2S }anuaiy 2u12 www.sbp.org.pk/riskmgm.pdf
S. KPNu (2uu8). 0nueistanuing anu Aiticulating Risk Appetite.
6. FSA. ChecklistforCapitalManagement. uoveinment of }apan, Retiieveu 24 }anuaiy
2u12 " www.fsa.go.jp/en/refer/manual/yokin_e/y06.pdf"
126
127
AppendixA
BBsInstructions/GuidelinesRegardingCapitalManagement