RISK MANAGEMENT

Risk & Exposure

Risk is defined as uncertainty in changes

Exposure is the sensitivity to such changes in prices

Classification of Risk
RISK

MACRO RISK

MICRO RISK

LIQUIDITY RISK

CREDIT RISK

MARKET RISK

REPUTATION RISK

INTEREST RATE RISK

CURRENCY RISK

EQUITY RISK

COMMODITY RISK

DEFAULT RISK

LEGAL RISK

OPERATIONAL RISK

MODEL RISK

POLITICAL RISK

Risk Perceptions
Counterparty risk / Credit risk / Settlement risk / Default risk Market risk
Interest rate risk Liquidity risk

Model risk Legal risk

Commodity risk
Price risk Quantity risk Cost risk (input price)
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Risk Perceptions
Operational risk
Frauds Employment practices and work place safety Clients products and business practices Damages to physical assets due to terrorism, vandalism, natural calamities etc. Business disruption and system failures

Reputation risk
Currency risk Political risk

Equity risk
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Risk Management
Dont risk more than you can afford to lose Consider the odds Dont risk a lot for a little

Risk Identification
Techniques
Checklists of risks and their factors

Brainstorming of risks and their factors

Cross Functional Teams to provide multiple viewpoints so that a comprehensive list of risks and their factors is developed. Documentation Studies of risk identification literature and previous risk management plans Incremental Development of the risks and their factors Interviews with stakeholders and domain experts Iteration of the identified risks and their factors

Joint Application Development (JAD) of the risks and their factors

Parallel Development of the risks with other tasks and other teams Reuse of previously identified risks

Measuring Risk
Traditional Financial Models
Value at Risk
Standard Deviation Sensitivity Analysis

Scenario Analysis
Stress Testing

Risk Management Strategies

Protection cover through insurance

Hedging through forwards

Hedging through derivatives Asset Liability Management Collateral security

Risk Management Framework

BOARD OF DIRECTORS

RISK MANAGEMENT COMMITTEE (BOARD SUBCOMMITTEE INCLUDING CEO AND HEADS OF CREDIT, MARKET AND OPERATIONAL RISK MANAGEMENT COMMITTEES) CORE FUNCTION: POLICY AND STRATEGY FOR INTEGRATED RISK MANAGEMENT

CREDIT RISK MANAGEMENT COMMITTEE (COMMITTEE OF TOP EXECUTIVES INCLUDING CEO, HEADS OF CREDIT & TREASURY, AND CHIEF ECONOMIST)

ALCO/ MARKET RISK MANAGEMENT COMMITTEE

OPERATIONAL RISK MANAGEMENT COMMITTEE

CREDIT RISK MANAGEMENT DEPARTMENT (CRMD)

CREDIT ADMINISTRATION DEPARTMENT (CAD)

Risk Planning

- Definition of procedures - Design of credit processes

Risk Assessment and Monitoring

Risk Analytics

Credit Risk Systems

- Sector review - Credit Rating - Review of Credit Proposals (new) - Asset review (existing)

- Credit Risk and pricing models design & maintenance

- Portfolio analysis and reporting

- Integration of risk Procedures with credit systems - Design and development of support systems for risk assessment & monitoring

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Asset Liability Management

Asset Liability mismatching

Unbundling of balance sheet and arranging in

different time buckets Measuring mismatchings
Duration analysis Gap analysis

Dynamic liquidity

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Asset Liability Management Process

ALM Information System

Management Information System

Information availability, Accuracy, Adequacy and Expediency

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ALM Organization
Asset Liability Management Committee
Composition
CEO/CMD or the ED will be the head of the Committee. The Chiefs of Investment,

Credit,
Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Banking and Economic Research. Head of the Technology Division should also be an invitee

Asset Liability Management Authority Committee of Directors Some banks may have sub-committees and sub-groups

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ALM Functions
Liquidity risk management

Management of market risks

Trading risk management Funding and capital planning Profit planning and growth projection

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Composition of Time Buckets

1 to 7 days 8 t0 14 days 15 to 28 days 29 days and up to 3 months

Over 3 months and up to 6 months

Over 6 months and up to 1 year Over 1 year and up to 3 years

Over 3 years and up to 5 years

Over 5 years
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Asset Liability Management

Preconditions for holding securities in trading books: The composition and volume are clearly defined; Maximum maturity/duration of the portfolio is restricted; The holding period not to exceed 90 days; Cut-loss limit prescribed; Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed; Marking to market on a daily/weekly basis and the revaluation gain/loss charged to the profit and loss account; etc.

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Asset Liability Management

Interest Rate Risk
Immediate impact of changes in interest rate is on banks earnings by changing the Net Interest Margin A long-term impact will be on the Market Value of Equity or the Net Worth The interest rate risk when viewed from these two perspectives is known as earnings perspective and economic value perspective, respectively. RBI introduced guidelines on Modified Duration in 2006 the traditional Gap analysis was considered as a suitable method to measure the Interest Rate Risk in the first

Place the Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date.
Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions).
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Asset Liability Management

Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL)
An asset or liability is considered to be rate sensitive if, Within the time interval under consideration, there is a cash flow; The interest rate resets/reprices contractually during the interval; RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered ; and It is contractually pre-payable or could be withdrawn before the stated maturities

. The Gap Report should be generated by grouping rate

sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier

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Asset Liability Management

Assets are priced prospectively whereas liabilities are priced retrospectively The gaps are identified in the following time buckets:
1-28 days 29 days and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years and up to 7 years Over 7 years and up to 10 years Over 10 years and up to 15 years

Over 15 years
Non-sensitive
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Asset Liability Management

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

Gap measures the interest rate sensitivity

RBI permitted the banks having deficiency in skill and infrastructure to calculate the modified duration in the following manner:
group the assets and liabilities under the broad heads under various time buckets; and compute bucket-wise Modified Duration of these groups of assets/ liabilities using the suggested common maturity, coupon and yield parameters

The banks were advised to build up infrastructure facilities and move to more accurate method of computation of modified gap 20

Computation of Modified Duration

Banks are required to calculate the modified duration in the following areas:
Investments Assets/ Liabilities in Foreign Currencies Derivative Instruments having forward component such as Interest Rate Swaps, Forward Rate Agreements, Interest Rate Futures Other derivatives such as Foreign Currency- Indian Rupee options, cross currency options

Banks are required to fix prudential limits with the approval of their Boards
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Computation of Modified Duration

Step-by step approach for computation
1. Identify variables such as principal amount, maturity date / repricing date, coupon rate, yield, frequency and basis of interest calculation for each item / category of asset / liability. 2. Generate the bucket-wise cash flows for each item / category of asset / liability/ off balance sheet item. 3. Determine the yield curve for arriving at the yields based on current market yields / current replacement cost for each item / category of asset / liability/ off-balance sheet item as proposed in the framework above. 4. The mid-point of each time bucket may be taken as a proxy for the maturity of all assets and liabilities in that time bucket.

Calculation of modified duration of equity

Modified Duration of Equity = DGAP x Leverage Leverage = RSA / Equity (which indicates extent to which equity has been leveraged to create assets)
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Computation of Modified Duration

Step-by step approach for computation
5. Calculate the Modified Duration of each category of asset / liability/ off balance sheet item using the maturity date, yield, coupon rate, frequency, yield, and basis for interest calculation for each category of asset / liability/ off balance sheet item. 6. Determine the weighted average Modified Duration of all the assets (DA) and similarly for all the liabilities (DL), including off balance sheet items.

7. The Modified Duration Gap is derived by the equation:

DGAP = Modified DA W x Modified DL where W = RSL/RSA (Rate Sensitive Liabilities / Rate Sensitive Assets). DA= Weighted average Modified Duration of assets and DL= Weighted average Modified Duration of liabilities.

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Currency Risk Management

RBI has issued detailed guidelines covering the

following areas
Forward contracts Contracts Other than Forward Contracts

Hedging of Commodity Price Risk in International

Commodity Markets Facilities for Foreign Institutional Investors Facilities for hedging Foreign Direct Investments in India

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Currency Risk Management

Facilities for Authorized Dealers
Management of banks assets and liabilities Hedging of gold prices Hedging of Tier I Capital Inter-bank foreign exchange dealings Position and gaps Net spot position Net forward position Options position

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Currency Risk Management

Calculation of Overall Net Open Position Calculate the net open position in each currency Calculate the net open position in gold. Convert the net position in various currencies and gold into rupees in terms of existing RBI / FEDAI Guidelines. Arrive at the sum of all the net short positions.. Arrive at the sum of all the net long positions

Capital requirement as prescribed by RBI from time to time Inter-bank transactions Foreign currency accounts

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Managing Market Risk

Market risk is classified into:
Interest rate risk Foreign exchange risk

Commodity price risk

Equity price risk

Risk management differs according to the type of risk

RBI has published extensive guidelines on managing

market risk and liquidity risk

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Managing Market Risk

Deal room functions
Deal room is the place where the security trading operations in the Treasury Department takes place. Separate dealing room for forex and treasury Integrated treasury operation envisages co-operation between treasury and forex deal rooms for effective use of funds RBI has issued detailed guidelines on deal room operations

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Managing Market Risk

RBI Guidelines on Deal room Operations
Undertaking by dealers that they would abide by the code of conduct issued by FEDAI and FIMDA Dealers should adhere to internal limits for operations Dealers should comply with RBI Guidelines Dealings should be restricted to the panel of brokers approved by the risk management committee Brokers should not be principals in any transaction Broker notes and deal confirmations should be obtained from brokers before the close of the business of each day Dealers should not authorize release of payments to brokers Dealers should not accept gifts, gratifications or other favours from brokers Dealers should not nominate a broker in transactions not done through that broker Complaints against dealers should be promptly investigated and report should be submitted to RBI and FEDAI Dealers should be aware of dealing hours, cut off time for overnight positions and rules governing off-site trading Maintenance of confidentiality of the customers trading activities and secure maintenance of access media, keys, passwords and PINS Rotation of dealing staff periodically and compulsory leave for 14 days per annum

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Managing Market Risk

RBI Guidelines on Back Office
Back office should be separate from the dealing room Dealers should not have access to back office

Receiving the deal confirmations, verification and reconciliation of discrepancies if any

Periodical reconciliation of Nostro/ Vostro Accounts Independent sourcing (outside the deal room) of rates used for marking exposures Independently maintaining the risk against limits established by the risk management committee and reporting of the usage Dual control over the procedures and systems for payments independent of the deal room.
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Managing Market Risk

Control Measures
Periodical deal room audit Foreign Exchange inspection and deal room audit by RBI Fixing position limits:
Day light limit Overnight limit

Stop deal/ cut loss limit RBI has prescribed risk weight of 2.5 per cent on the investments in government and other approved securities and 100 per cent on the forex open position and gold in tune with the Basle Committee prescriptions on capital cushion for price risks
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Managing Liquidity Risk

Measurement of liquidity position and funding requirements under crisis scenarios Liquidity risk has three dimensions
Funding risk
Replacement of funds on account of unanticipated withdrawal of deposits

Timing risk
Non-receipt of expected cash flow or performing assets turning to non-performing assets

Calling risk
Crystallization of contingent liabilities

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Managing Liquidity Risk

Formulate an effective risk management policy The risk management policy should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting/ reviewing etc. The key ratios adopted across the banking system are Loan to Total Assets, Loan to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/

Net Loans.
Banks also maintain prudential limits to avoid liquidity crisis

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Managing Liquidity Risk

Prudential Limits
Cap on inter-bank borrowings, especially call borrowings; Purchased funds vis--vis liquid assets; Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans; Duration of liabilities and investment portfolio;

Maximum Cumulative Outflows across all time bands;

Commitment Ratio track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure;

Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.
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Managing Liquidity Risk

Tracking of volatile deposits- high value deposits say deposits above Rs. 1 crore Estimation of seasonal pattern of deposits and potential liquidity needed to meet funds requirements

Develop contingency funding plan

Estimating currency wise liquidity position

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Operational Risk Management

Arises due to failure of control systems The measures for managing operational risk includes:
Strengthening of control system Streamlining the Operational Risk Management Policies, Processes and Procedures

Documenting and communicating to the appropriate staff

Strengthening the internal audit and vigilance system Early detection of the instances of failure etc.

RBI has advised banks to the banks to develop

operational risk management policy framework covering the following areas
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Operational Risk Management

Operational Risk Management Policy Framework:
The roles and responsibilities of the independent bank-wide Operational Risk Management function and line of business management. A definition for operational risk, including the loss event types that will be monitored. The capture and use of internal and external operational risk loss data including data potential events (including the use of Scenario analysis). The development and incorporation of business environment and internal control factor assessments into the operational risk framework. A description of the internally derived analytical framework that quantifies the operational risk exposure of the institution. A discussion of qualitative factors and risk mitigants and how they are incorporated into the operational risk framework. A discussion of the testing and verification processes and procedures. A discussion of other factors that affect the measurement of operational risk.

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Operational Risk Management

Operational Risk Management Policy Framework:
Provisions for the review and approval of significant policy and procedural exceptions. Regular reporting of critical risk issues facing the banks and its control/mitigations to senior management and Board. Top-level reviews of the bank's progress towards the stated objectives. Checking for compliance with management controls. Provisions for review, treatment and resolution of non-compliance issues. A system of documented approvals and authorizations to ensure accountability at an appropriate level of management. Define the risk tolerance level for the bank, break it down to appropriate sub-limits and prescribe reporting levels and breach of limits. Indicate the process to be adopted for immediate corrective action.
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Operational Risk Management

The strategic approach
An emphasis on minimising and eventually eliminating losses and customer dissatisfaction due to failures in processes. Focus on flaws in products and their design that can expose the institution to losses due to fraud etc. Align business structures and incentive systems to minimize conflicts between employees and the institution. Analyze the impact of failures in technology / systems and develop mitigants to minimize the impact. Develop plans for external shocks that can adversely impact the continuity in the institutions operations.
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Operational Risk Management

Risk management system fails because of:
Lack of control culture Inadequate recognition and assessment of risk of certain banking activities like the risk in respect of new products Absence/failure of key control structures such as segregation of duties, approvals, verifications, reconciliations, reviews of operating performance etc. Inadequate communication, and Inadequate/ineffective auditing/monitoring programmes.

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Operational Risk Management

One of the major functions in operational risk management is the identification of the events leading to operational risk The impact of risk is assessed by measuring the potential loss on account of frequency of occurrence of the events leading to the risk Another important aspect of operational risk management is building up a strong management information and business line identification system.

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Operational Risk Management

Measures for managing the operational risk includes:
Insuring cash and valuables for protection against theft and robbery
Transit insurance for carrying cash Property insurance against damage of properties Marine insurance to cover export and import of goods Group insurance to cover human resources Credit insurance to cover default by borrowers The approaches suggested by Basle Committee are:
Basic Indicator Approach Standardized Approach Advanced Measurement Approach Banks have to hold capital for operational risk equal to a fixed percentage (alpha) of a single indicator which has currently been proposed to be gross income. Minimum prescribed ratio is 9 per cent 42

Capital Allocation

RBI has prescribed the Basic Indicator Approach

Operational Risk Management

Risk Management Tools
Natural hedge
Cross hedging Use of derivatives
Futures Options Swaps

Credit derivatives

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Forward Contrats
Forward contracts are over the counter.

They are different form the forward rate agreements.

Full hedge is possible in the case of forward contracts.

No upfront fee or premium.

Cancellation of contract can be costly.

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Use Of Interest Rate Derivatives

Interest Rate Derivatives help to mitigate the interest

rate related risk.

These can be interest rate futures, interest rate options, interest rate swaps, forward rate agreements, caps, floor and collars.

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Interest Rate Futures

Interest rate futures can be bond futures, treasury bills futures etc. Interest futures are treaded in the Wholesale Debt Market segment of NSE and BSE. Banks and Primary Dealers can trade in interest rate derivatives. Interest rate futures and options are not widely used in India. Banks use interest rate swaps to hedge their risk.

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Hedging With Derivatives

Derivatives are protected either by way of initial margin
or by way of upfront premium so as to minimise the potential loss.

Derivatives are highly disastrous if not handled properly.

Some of the derivatives like option gives option to the buyer whether to exercise the contract on maturity or not Perfect hedge is not possible

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Credit Derivatives
Credit Derivatives are derivatives contracts

structured based on an underlying credit obligation,

which will become operative upon the occurrence of a credit event.

Credit Derivatives increase the breadth of the credit market because they simultaneously deepen the

market for hedging and investment.

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Credit Derivative Instruments

Credit Default Swaps Total Return Swap Credit Options Credit Linked Notes
Structured Notes and Credit linked Notes
Credit Default Notes Synthetic bonds Leveraged Credit derivatives

Collaterized Debt Obligations

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Credit Derivatives
RBI has permitted banks to use plain vanilla credit default swaps and issued the following guidelines
the reference entity shall be a single legal entity, which is a resident; the reference entity shall be the obligor for underlying asset/ obligation, the reference asset/ obligation and the deliverable asset/ obligation. the protection buyer and the protection seller shall be resident entities; the underlying asset/ obligation, the reference asset/ obligation, the deliverable asset/ obligation shall be to a resident and denominated in Indian Rupees; the credit derivative contract shall be denominated and settled in Indian Rupees; the underlying asset/ obligation, the reference asset/ obligation, and the deliverable asset/ obligation shall be a tradable financial security or a fund-based credit exposure or a credit risk exposure to a reference entity assumed by a protection seller in a CDS contract. Primary Dealers may transact in CDS where the underlying/reference/deliverable asset/ obligation is a corporate debt security; the reference asset/ obligation shall be identical to the underlying asset / obligation with reference to (a) nature of obligation; (b) seniority (equal or junior); and (c) maturity; The protection seller shall not transact in credit derivatives with underlying assets/ obligations or deliverable assets/ obligations which they are not permitted to undertake; 50

Participants in Futures/Forward Market

Hedgers Speculators

Arbitrageurs

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Risk Management in NBFCs

NBFCs are exposed to credit risk, interest rate risk, , equity / commodity price risk , liquidity risk and operational risk. Failure in liquidity management can adversely affect the reputation of NBFCs NBFCs are required to upgrade their risk management by adopting a more comprehensive Asset Liability Management System

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Risk Management in NBFCs

Asset Liability Management
Three Pillars
ALM Information Systems Management Information Systems Information availability, accuracy, adequacy and expediency ALM Organisation Structure and responsibilities Level of top management involvement ALM Process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.
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Risk Management in NBFCs

Asset Liability Management
ALM Information Systems
Management Information Systems Information availability, accuracy, adequacy and expediency Difficulty in collecting information due to:

Large net work of branches

Lack of computerization

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Risk Management in NBFCs

Asset Liability Management
ALM Organization
Asset Liability Management Committee

CEO/CMD/President/ Director will be the head

Chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury, International Business and Economic Research are the members of the Committee Chief of the Technology Division will be special invitee

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Risk Management in NBFCs

Asset Liability Management

ALM Process
Liquidity Management Distribution of Assets and Liabilities in Time Buckets: 1 day to 30/31 days (One month) Over one month and upto 2 months Over two months and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years

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Risk Management in NBFCs

Asset Liability Management

ALM Process
Liquidity Management Distribution of Assets and Liabilities in Time Buckets: Classification of Investments into mandatory and non-mandatory securities Mandatory securities could be held under any time bucket

Non-mandatory securities are to be held under one month, two months or three months buckets depending upon the defeasance period
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Risk Management in NBFCs

Asset Liability Management

ALM Process
Liquidity Management Alternatively Trading Book concept can be followed: The composition and volume are clearly defined; Maximum maturity/duration of the portfolio is restricted; The holding period not to exceed 90 days; Cut-loss limit prescribed; Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed
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Risk Management in NBFCs

Asset Liability Management

ALM Process
Currency Risk due to cross border capital flow Interest Rate Risk due to changes in interest rates Assets and Liabilities are to be classified as Rate Sensitive (RSA and RSL) if

within the time interval under consideration, there is a cash flow;

the interest rate resets/reprices contractually during the interval; dependent on RBI changes in the interest rates/Bank Rate; it is contractually pre-payable or withdrawal before the stated maturities.

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Risk Management in NBFCs

Asset Liability Management

ALM Process
Interest Rate Risk
The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into the following time buckets according to residual maturity or next repricing period, whichever is earlier 1-30/31 days (One month) Over one month to 2 months Over two months to 3 months Over 3 months to 6 months

Over 6 months to 1 year

Over 1 year to 3 years Over 3 years to 5 years Over 5 years

Non-sensitive
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Risk Management in Insurance Companies

Exposed to the risk of payment of claims in excess of the premiums received General insurance companies are exposed to higher risk when substantial damages happen to a particular locality and all the people incur losses (Example: Tsunami)

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Risk Management in Insurance Companies

Risk Management Tools
Investment in securities
Use of financial derivatives Re-insurance

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Summary
Risk is uncertainty of changes in the price of assets Financial Institutions are exposed to various types of risk The risk can be broadly classified as Macro risk and Micro risk Macro risks are credit risk, operational risk, legal risk, model risk etc. Micro risks are interest rate risk, liquidity risk, currency risk, market risk etc. Banks and non-banking financial institutions use Asset Liability Management as a tool for managing risks Financial institutions use insurance also to manage the risk Insurance companies use reinsurance for risk management

Derivatives are used as effective tools for managing risk

Managing risk effectively enhances the profitability of the financial institution.
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