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CHAPTER 1
1.1 What is Risk?
Risk can be defined as the chance of loss or an unfavorable outcome
associated with an action. Uncertainty is not knowing what will happen in the
future. The greater the uncertainty, the greater the risk. For an individual
farm manager, risk management involves optimizing expected returns
subject to the risks involved and risk tolerance.
Risk is what makes it possible to make a profit. If there was no risk, there
would be no return to the ability to successfully manage it.
Risk is what makes it possible to make a profit. If there was no risk, there
would be no return to the ability to successfully manage it. For each decision
there is a risk-return trade-off. Anytime there is a possibility of loss (risk),
there should also be an opportunity for profit. Growers must decide between
different alternatives with various levels of risk. Those alternatives with
minimum risk may generate little profit. Those alternatives with high risk may
generate the greatest possible return but may carry more risk than the
producer will wish to bear. The preferred and optimal choice must balance
potential for profit and the risk of loss. It all comes down to management, and
there are no easy answers.
The meaning of Risk as per Websters comprehensive dictionary is a
chance of encountering harm or loss, hazard, danger or to expose to a
chance of injury or loss. Thus, something that has potential to cause harm or
loss to one or more planned objectives is called Risk.
The word risk is derived from an Italian word Risicare which means To
Dare. It is an expression of danger of an adverse deviation in the actual
result from any expected result.
While it is impossible that companies remove all the risks from the
organization, it is important that they properly understand and manage the
risks that they are willing to accept in the context of the overall corporate
strategy. The management of the company is primarily responsible for risk
Source: i.investopedia.com
Source: image.slidesharecdn.com
Source: www.curling.com
Source: www.housingwire.com
It is the process for identifying the risk the business faces, evaluating them
according to the likely hood of their occurring and the damage. They would
ensure deciding whether to wear, avoid, control or ensure against then,
allocating responsibility for dealing with them ensuring that the process
actual works and reporting material problems as early as possible to the right
level.
The operation of bank inevitably means facing risk of many kinds risk. Risk is
inherent in bank but it is far from routine, nor is it one-dimensional. All round
the globe, market risks, technical risk, operational risk, political risk, legal
risks, and change rapidly and continually. A recent survey in USA revealed
Source: http://cdn2.hubspot.net
Source: servicestation.co.uk
degree of assurance to the top management that the ultimate corporate goals
that are vigorously pursued by it would be achieved in the most efficient
manner.
2.
In this way, all the risk that come in the way of institution achieving the
goals it has to set for itself would managed properly by the risk management
system.
3.
In the absence of such a system, no institution can exist in the long run
without being able to fulfill the objective for which it was set up.
Market Risk
Others
Operational Risk &
Control System
Settlement Risk
Asset Liability
Management Risk
Financial Risk:
Financial Risk
1.
Credit Risk
Trading Credit Risk
Commercial Credit Risk
The risk of loss from holding positions that is subject to change in value with
changing market conditions. This risk includes all changing, in market
I.
Credit risk
Source: www.origo.ie
10
Source: www.openlink.com
This is the risk of loss from the failure of a trading counterparty to perform its
trading obligations as agreed. The largest exposures for this risk typically
occur between major global trading counterparties e.g. liquidity providers in
several markets. Unlike traditional lending, these exposures change values
with changing market conditions (prices, volatility). Note, however, the
largest risk of loss is linked but not directly proportional to the largest
exposures. Credit risk combines exposure with default and recoveries. Thus
a lower exposure can have a higher risk if the default probability is much
higher.
11
Source: http://www.clker.com
Market Risk:
Market Risk
12
Source: c1327221.myzen.co.uk
This is the risk of loss from having positions in any of the commodity markets.
There are certainly tremendous variety of them, ranging from agricultural
markets, which include various grains, meats, produce, and wood products
to minerals and metals. More recently, the energy market has undergone an
expansion as electricity has deregulated and become a commodity whose
price fluctuates.
II.
13
Source: http://cdn2.hubspot.net/
This is the risk of loss from having positions in any of the currency markets.
The risk can be from outright positions. It can also reside on the balance
sheet or in the income flows of a company. Many Thai companies were
carrying currency risk on their balance sheets with assets in Thai baht and
liabilities/ loans in U.S. dollars. In the summer of 1997, they were bankrupted
overnight by a 20% reduction in their dollar liabilities. Other firms suffer large
fluctuations in income when earnings denominated in foreign currencies
must be converted and reported in dollars.
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German plant.
They could borrow dollars in the U.S. where they are well known and
This will give them exchange rate risk: financing a euro project with
dollars.
They could borrow euro in the international bond market, but pay a
If they can find a German MNC with a mirror-image financing need they
If the spot exchange rate is S0($/ ) = $1.30/ , the U.S. firm needs to
15
Source: www.imf.org
Source: www.imf.org
16
Source: bconnect24.com
The crucial aspect of the management of interest rate risk is to protect the
value of the investments as much as possible from the adverse impact of the
interest rate movements. The focus of the investment strategy revolves
around the overwhelming need to keep the interest rate risk of the portfolio
reasonably low with a view to minimizing losses arising out of adverse
interest rate movements, if any. This approach is warranted as reserves are
viewed as a market stabilizing force in an uncertain environment.
ii) MIFOR swaps: The MIFOR is another popular benchmark that has
developed into a proxy for the AAA corporate funding cost in India. MIFOR is
derived from USD Libor and the USD/INR Forward Premia and is simply the
Indian equivalent of USD Libor and the USD Interest Rate Swaps market.
MIFOR behaves like an interest rate benchmark and not a forex benchmark.
18
19
Source: www.barchart.com/economy/swaps.php
Source: www.global-rates.com
20
21
22
Note that the interest rate swap has allowed Charlie to guarantee himself a
$15,000 payout; if LIBOR is low, Sandy will owe him under the swap, but if
LIBOR is higher, he will owe Sandy money. Either way, he has locked in a
1.5% monthly return on his investment.
Sandy has exposed herself to variation in her monthly returns. Under
Scenario A, she made 1.25% after paying Charlie $2,500, but under Scenario
B she made 2% after Charlie paid her an additional $5,000. Charlie was able
to transfer the risk of interest rate fluctuations to Sandy, who agreed to
assume that risk for the potential for higher returns.
One more thing to note is that in an interest rate swap, the parties never
exchange the principal amounts. On the payment date, it is only the
difference between the fixed and variable interest amounts that is paid; there
is no exchange of the full interest amounts.
23
Source: http://www.regulatory-risk.com/
This is the risk of loss from being unable to buy or sell positions easily, at a
low transaction cost. The speed and ease with which a buyer or seller can
convert assets into cash and vice versa varies with each class of assets in the
market. Gold, for example, is much more liquid than real estate. In addition,
liquidity fluctuates over time. During August and September 1998, some of
the most liquid markets, such as the U.S. government bond market and the
swap markets became considerably less liquid.
In the early 1990s a steep spike in interest rates caused large losses in many
trenches of mortgaged- backed securities (MBS). The market for these
instruments froze because no one was interested in bidding for them, even at
huge discounts to their remaining fair market value. That liquidity freeze
helped keep MBS prices depressed for a long time.
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This is the risk of loss from holding positions in the equity markets. This is
investor risk and almost everyone is familiar with it. Like the other markets it
contains price, volatility, and liquidity.
3.
Internally, there is a total separation of the front office and back office
functions and the internal control systems ensure several checks at the
stages of deal capture, deal processing and settlement. There is a separate
set up responsible for risk measurement and monitoring, performance
evaluation and concurrent audit. The deal processing and settlement system
is also subject to internal control guidelines based on the principle of one
point data entry and powers are delegated to officers at various levels for
generation of payment instructions. There is a system of concurrent audit for
monitoring compliance in respect of all the internal control guidelines.
Further, reconciliation of accounts is done regularly.
In addition to annual inspection by the internal machinery of the RBI for this
purpose and statutory audit of accounts by external auditors, there is a
system of appointing a special external auditor to audit dealing room
25
These are
Settlement Risk:
Source: www.rbnz.govt.nz
26
Source: http://image.slidesharecdn.com
This is the risk that current obligations cannot be met with current assets.
This is a fundamental risk in all organizations, which must maintain liquidity,
or they become insolvent. In financial institutions, this risk is quite significant
because many liabilities can be accelerated if the market perceives a
weakness. Markets and regulators have demanded that financial institutions
maintain a high level of capital to protect the fund providers and a high level
of reserves to safeguard against runs. Most of the risk arises as a result of
mismatch of assets and liability. If the assets of a bank exactly matched its
liability of identical maturity, interest rate conditions and currency risk could
have been avoided. However in practice its near impossible to have such a
perfectly matched balance sheet. A banker, therefore, has to keep different
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Hedged Risk
Portfolio
Exposure
Loan Riak
Other
Risk
New Product
And Risks
Gurantee Risk
Portfolio
Recovery
Global
Portfolio Risk
5.
Portfolio
Defaults
This is the risk of loss from hedging market exposures with instruments
whose changes in value do not exactly offset value changes in the position
being hedged. The mismatch could be in terms of maturity, the underlying
instrument e.g. short a government bond to hedge a long corporate bond
position, or some other characteristic. These small differences can
sometimes cause the combined position to be much more risky than thought.
On May 1, 1997, L.P.Morgan lost $20 to $40 million due to basis risk on one
trade. The trader sold a yen/dollar option, and bought the same option from
counterparty. Both the bought and sold option carried the same knock-out
feature. The change rate is canceled if the dollar/yen exchange rate is
28
Source: www.unomaha.edu
29
Source: www.communitybankeruniversity.com
Bankers dont make loansthey make portfolio decisions and the quality of
those decisions impact bank performance over time. In a constantly changing
world, credit risk management becomes a more important focus for your
bank. Therefore, it is critical that you manage portfolio risk at both the bank
and banker level. This workshop is designed for community bankers who are
in a position to impact credit outcomes in your bank. You will learn a
framework and process for managing credit risk to give you a better
understanding of the factors impacting portfolio quality at the bank level, and
tools for better risk management at the transaction level.
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8.
Loan Risk:`
Source: www.riskmanagementmonitor.com
This is the risk of loss from loaning money and having the borrower fail to
repay, either due to default or because they are not willing to repay. Most
analysis in commercial lending considers how the borrower will repay.
9.
Guarantee Risk:
This is the risk or loss from providing guarantees or letters of credit. These
are from of contingent credit exposure (e.g. the exposure is contingent on
other events occurring).
Guarantees are designed to help extend the reach of private financing by
mitigating perceived risk and encourage private sector involvement in
developing countries. Guarantees provide support to lenders or project
companies against a governments (or government entitys) failure to meet
specific contractual obligations to a private or public project. World Bank
guarantees require a counter-guarantee from the Government. The
guarantee is Partial: The Bank only assumes a portion of risk. The Bank
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10.
Portfolio Exposure:
Source: valueofcommodity.com
A measure of the possible loss that could occur with each given
counterparty and with groups of counterparties, for ex. Industries, countries,
and economics regions. When traditional credit products, such as, loans,
leases, letters of credits and guarantee are transacted the exposure is known
as static. Capturing credit exposure for the corporate counterparties that
typically use these traditional credit products is fairly straightforward and
consideration quickly shifts to default risk for them.
When the portfolio contains a significant proportion of derivative trades,
exposure might undergo large shifts with changes in market conditions.
Therefore, measuring portfolio exposure to the dealer or banks where
derivative trades predominate, is a much more difficult the sum deal by deal
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Portfolio Defaults:
Portfolio Recovery:
Source: www.radiusworldwide.com
33
This is the risk of loss from all financial risks, including the combination of
credit and market risks. There are fundamental factors, like economic
conditions, which create a link between them. Market and credit risks are not
independent from each other, yet most financial firms measures and manage
them separately.
14.
With the introduction of new products like plastic cards, credit, debit, smart
card, etc. The risk of fraud has increased manifold. According to estimation
in an active issuing bank card, fraud is likely to claim the lions share of fraud
being experienced in general and could well dominate average operating
losses as a whole worldwide frauds occurred due to loss or steal of plastic
cards that cause the greatest losses. The second largest sources and the
fastest growing source of loss is use of counterfeit card. Emerging areas of
E-commerce and Internet banking are also a matter of concern.
Source: 1.bp.blogspot.com
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IDENTIFICATION
2)
3)
4)
5)
CONTROL
6)
LEARN
Source: i-technet.sec.s-msft.com/dynimg/IC119053.gif
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taking units through policies standards and procedures. There should be a let
out system to authorize accretion in controlling the risk.
Risk Identification:
Source: www.riskmanagementmonitor.com
36
Source: corporatecomplianceinsights.com
Risk analysis transforms the estimates or data about specific risks that
developed during risk identification into a consistent form that can be used to
make decisions around prioritization. Risk prioritization enables operations
to commit resources to manage the most important risks.
3.
Risk planning takes the information obtained from risk analysis and uses it to
formulate strategies, plans, change requests, and actions. Risk scheduling
ensures that these plans are approved and then incorporated into the
standard day-to-day processes and infrastructure.
4.
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Risk Controlling:
Source: www.larims.org
Risk control is the process of executing risk action plans and their associated
status reporting. Risk control also includes initiating change control requests
when changes in risk status or risk plans could affect the availability of the
service or service level agreement (SLA).
It deals with setting up of limits to each one of the risks and monitoring to
ensure that the actual exposure to each one of the risks defined is within the
limits prescribed in the risk management policy. Any violation of limits needs
to be thoroughly investigated to ascertain the reason for violation and to
avoid such violation in future.
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Risk Learning:
Source: blogs.qub.ac.uk
Risk learning formalizes the lessons learned and uses tools to capture,
categorize, and index that knowledge in a reusable form that can be shared
with others.
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STEPS IN RISK
MANAGEMENT PROCESS
IDENTIFICATION
ASSESSMENT
Identification
A first step in the process of managing risk is to identify potential risks. The
risks must then be assessed as to their potential severity of loss and to the
probability of occurrence. Risks are about events that, when triggered, will
cause problems. Hence, risk identification can start with the source of
problems, or with the problem itself.
Texomonybased Risk
Identification
Source
Analysis
Scenario-based
Risk
Identification
Problem
Analysis
ObjectiveBased Risk
Identification
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the threat of losing money, the threat of abuse of privacy information or the
threat of accidents and casualties. The threats may exist with various
entities, most important with shareholder, customers and legislative bodies
such as the government.
When either source or problem is known, the events that a source may
trigger or the events that can lead to a problem can be investigated. For
example: stakeholders withdrawing during a project may endanger funding of
the project; privacy information may be stolen by employees even within a
closed network; lightning striking a Boeing 747 during takeoff may make all
people onboard immediate causalities.
The chosen method of identifying risks may depend on culture, industry
practice and compliance. The identification methods are formed by templates
or the development of templates for identifying source, problem or event.
Common risk identification methods are:
have objectives. Any event that may endanger achieving an objective partly
or completely is identified as risk. Objective-based risk identification is at the
basis of COSO's
scenarios are created. The scenarios may be the alternative ways to achieve
an objective, or an analysis of the interaction of forces in, for example, a
market or battle. Any event that triggers an undesired scenario alternative is
identified as risk - see Futures Studies for methodology used by Futurists.
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available. Each risk in the list can be checked for application to a particular
situation. An example of known risks in the software industry is the Common
Vulnerability and Exposures list found at http://cve.mitre.org.
Assessment
Source: www.risk-soft.com
Once risks have been identified, they must then be assessed as to their
Source: independentaudit.com
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Avoidance
Reduction
Retention
Transfer
Ideal use of these strategies may not be possible. Some of them may involve
tradeoffs that are not acceptable to the organization or person making the
risk management decisions.
Risk
Avoidance
Risk
Transfer
Risk
Reduction
Risk
Retention
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Source: http://secure360.org
Risk reduction
Source: www.chp-inc.com
Involves methods that reduce the severity of the loss. Examples include
sprinklers designed to put out a fire to reduce the risk of loss by fire. This
method may cause a greater loss by water damage and therefore may not be
suitable. Halon fire suppression systems may mitigate that risk, but the cost
may be prohibited by the strategy.
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development,
spearheaded
by
the
Extreme
Programming
Risk retention:
Source: csbcorrespondent.com
Involves accepting the loss when it occurs. True self-insurance falls in this
category. Risk retention is a viable strategy for small risks where the cost of
insuring against the risk would be greater over time than the total losses
sustained.
All risks that are not avoided or transferred are retained by default. This
includes risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an example since
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Risk transfer
Source: discoveringif.files.wordpress.com
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that
is
always
met
in
any
insurance
contract.
Source: michellemacconnell.com
Decide on the combination of methods to be used for each risk. Each risk
management decision should be recorded and approved by the appropriate
level of management. For example, a risk concerning the image of the
organization should have top management decision behind it whereas IT
management would have the authority to decide on computer various risk.
The risk management plan should propose applicable and effective security
controls for managing the risks. For example, an observed high risk of
computer viruses could be mitigated by acquiring and implementing antivirus software. A good risk management plan should contain a schedule for
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Implementation
Source: www.innovationgames.com
Follow all of the planned methods for mitigating the effect of the risks.
Purchase insurance policies for the risks that have been decided to be
transferred to an insurer, avoid all risks that can be without sacrificing the
entity's goals, reduce others, and retain the rest.
Review and evaluation of the plan.
Initial risk management plans will never be perfect. Practice, experience, and
actual loss results, will necessitate changes in the plan and contribute
information to allow possible different decisions to be made in dealing with
the risks being faced.
Limitations.
If risks are improperly assessed and prioritized, time can be wasted in
dealing with risk of losses that are not likely to occur. Spending too much
time assessing and managing unlikely risks can divert resources that could
be used more profitably. Unlikely events do occur, but if the risk is unlikely
enough to occur, it may be better to simply retain the risk, and deal with the
result if the loss does in fact occur. Prioritizing too highly the Risk
management processes it could potentially keep an organization from ever
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Source: 2.bp.blogspot.com
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CHAPTER 4
4.1
Source: www.hedgefundexchange.net
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Source: ougaz.files.wordpress.com
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Reputational Risk
Source: www.garp.org
53
Source: www.garp.org
Source: www.garp.org
54
Source: thumbs.dreamstime.com
55
Source: www.esecuritytogo.com
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CHAPTER 5
Minimum
Capital
Requirement
Supervisory
Review Process
57
Market
Discipline
Requirements
The extent of risk taken by a bank and the amount of capital required to be
maintained by the bank for such risk-taken is all about capital adequacy
standards. Prior to the implementation of the Basels first capital accord in
the beginning of the 1990s, there was no relationship between capital and
risk taking. Banking businesses, being one of the highly levered businesses,
is the significantly prone to stocks. Moreover, banking business is the
business of public confidence. If public confidence erodes, it becomes
difficult for a bank to be in business. Basel Committee, with a view to
protecting banks from vulnerabilities and to maintain financial stability,
recommended a minimum capital to risk-weighted assets ratio, thereby
limiting the risk exposure to availability of capital. Initially the capital accord
recognized only credit risk. Subsequently, the market risks also brought
under the capital accord. Recently in the Basel Accord-2, sweeping changes
have been suggested for the computation of capital adequacy as Basel
Accord-1 miserably failed to achieve its objectives of promoting safety and
soundness of the financial system. Apart from credit and market risks, the
operational risk would also require minimum capital to be maintained under
Basel Accord-II.
To achieve these objectives, Basel Committee proposed a three-pillared
framework as under:
Pillar 1: Minimum Capital Requirements: Under this, in the current accord, a
minimum capital has been prescribed to be maintained. To arrive at the
capital for various types of risks, a number of approaches, widely classified
as standardized approach, have been prescribed. The critical issues in the
internal approach in which the banks are free to develop their own approach
to measures risks, validating the internal approach and ensuring consistency
across banks.
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Source: comps.canstockphoto.com
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The essence of Basel II is to manage the risk profitably and align the risks
undertaken/assumed by the bank to the economic capital of the bank.
The new accord is designed to introduce safety and soundness into the
banking system. Banks need to measure risk, diversify exposures and
manage risks in an optimum manner that fetches them adequate
compensation, improves bottom-line in the short-term and helps them to
maximize the stakeholders value in the long-run.
Banks have been compelled to review and overhaul the Risk Managements is
also emerging as an important business differentiator in the face of rapid
economic growth that is being witnessed in the global economy and is
capable of ensuring orderliness in the global financial scenario if
implemented properly. The keystone of Basel initiative is to achieve this
objective and to ensure that banks are not strapped for capital to cover the
risks they assume.
Basel II framework provides a methodology for transforming banks into
vibrant and stable entities in the globally competitive and dynamic financial
markets. It points towards RAPM (Risk Adjusted Performance Management)
methodology and RAROC (Risk Adjusted Return on Capital).
All the three pillars are intended to be equal in importance. The first pillar
echoes Basel I in terms of minimum prescriptive levels of regulatory capital,
across credit and market risks, but also introduces operational risk charges
for the first time. With increasing transactional complexities, multiplicity of
technology platforms and various product innovations, banks face a number
of operational risks which could affect their market reputation. Pillar II is
actually the next sieve for any of the risks not captured under Pillar I with a
Supervisory Review Process (SRP) designed for this. Pillar III brings into play
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Source: s3.amazonaws.com
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Basel-II
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Source: pbs.twimg.com
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basis.
of the financial position and the risk profit of the banks. The areas of greater
disclosure include capital ratios, profitability ratios, non-performing loans,
provision for non-performing loans, etc.
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RBI Initiatives
Program.
RTGS System: Many Indian banks (11to be precise) are going in for
Real Time Gross Settlement (RTGS) system, e.g., ING Vysya Bank. This
system will allow the clients to transfer funds instantaneously across RTGSenabled Banks in India, thus putting their funds to better use because of a
quicker realization as compared to current instrument based fund transfers.
Also the bank can manage intraday liquidity effectives.
Nevertheless, there are many challenges that Indian banks faces by virtue of
its culture diversity and lack of infrastructure.
Source: environmentalrisk.org
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The Basel Committee on Banking Supervision has set out the requirement for
an effective risk management system as under:
Capable management
The job of the board is to establish banks strategic direction and define risk
tolerances for various type of risk. The risk management policies and
standards need to be approved by the board. The senior management of the
board is responsible for implementation, integrity and maintenance of the risk
management system.
Source: s3.amazonaws.com
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Challenges
In terms of operational risk, the banks will have to prioritize risk control
among
different
business
lines.
Given
the
complexities
and
data
The issue of credit rating has to be streamlined. Though there are a few
players in the credit rating arena in India, the credit rating methodology used
by these agencies need to be strengthened and applied universally. Also,
encouraging the ratings of issuers could turn out to be a challenge.
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levels for banks for, amongst other things, interest rate in the banking book
and concentration of risk exposures. RBI has already initiated action to
identify these issues in banks. But given the huge magnitude of this task in
the Indian context, the task is, at a very last, daunting.
Note that this list of challenges is not exhaustive, but in all likelihood
Source: sameerdhanrajani.files.wordpress.com
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Impact
RBI in various documents has pointed out that Basel II will involve a shift from
direct supervisory focus to implementation issues, and that banks and
supervisors will be required to invest large resources in upgrading
technology and human resources to meet the minimum standards. Assuming
that banks and supervisors can switch over to the Basel II norms without a
problem, Indian banks, especially the public sector banks, will become more
efficient and globally competitive.
Implementation of Basel II will, in general, lead to decrease in the required
capital with respect to operational risks. However, in India, several factors
may raise the required capital even for credit risks (one example to this effect
could be the use of real estate as collateral for loans attracting a 150% risk
weight on non-performing loans). On the contrary, a 75% risk weight on retail
lending to SMEs and a 35% risk weight on home loans might lead to some
reduction in the capital requirements.
As per Basel II, the bulk of the borrowers in the Indian market fall in the
speculative grade-this might cause a dramatic rise in the debt costs and
heightened cyclicality of bank credit. Augmenting the capital requirements of
the banks could have adverse impact on the credit portfolios of the banking
sectors.
Another issue could be the introduction of the Economic Capital Based (ECB)
models to help banks in capital budgeting, deal pricing and performance
management in a risk adjusted framework. Though this will be a useful tool,
it would require banks and supervisors to understand the two elements of
economic capital assessment; namely:
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risk-efficient basis.
These are some of the major impacts that are going to be felt by all the banks
including the RBI in implementing Basel II. However, there is no doubt that a
successful implementation of Basel II will ensure that the banks would benefit
from the economic capital framework. IT will further provide the banks with a
platform to develop models for managing their business efficiently and
complete with the more sophisticated players. It will also help banks learn to
use their capital in the most efficient manner, which will definitely be the key
to survival in a global, unconstrained and ruthless environment in the
financial service sector.
Source: trauma.massey.ac.nz
71
Basel II is normally seen largely as a compliance driven issue and only a small
number of banks have fully exploited business efficiency and integrity. In fact,
Base II affords a good opportunity to undertake a thorough review of RM
processes and consolidated them. While implementing to comply, we can
implement to gain. We can implement for reduced overall cost, increased
RAROC and improved decision-making process. It also helps build a
transparent corporate accountability and enables management of risk in
accordance with the risk appetite enabling economic capital saving, a
precursor to development of integrated risk management capability across
the bank. It creates an increased level of transparency around disclosure of
risk. Hence, banks need to use the opportunity to implement effective RM
system to achieve competitive efficiency.
As Basel II helps banks differentiate customers by risk, advantages and
disadvantages are likely to accrue for bank customers.
Those with possible advantage:
Prime customer
Well-rated entities.
Uncollateralized credit.
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Challenges Ahead
Infrastructure
In a recent survey conducted by the Federation of Indian Chambers of
Commerce and Industry (FICCI), 55% of the respondents claims that Indian
banks lack adequate preparedness to be able to confirm to the Basel-II
provision by 2006. Whereas, 50% of public sector banks have expressed their
preparedness in meeting these guidelines, only 25% of the old and new
private sector and foreign banks are likely to be ready to meet them by 2006.
According to the survey, concerns of the Indian banks in implementing these
norms are:
And 58% said due to the lack of sufficient training and education to
Source: bocahbancar.files.wordpress.com
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Capital Allocation:
each SBU commensurate with its contribution to the overall risk of the bank,
a target return on the capital allocated needs to be set. The question of
whether the target returns to be achieved by each SBU dependent upon risk
contribution is the most contentious issue occupying the attention of the risk
management community.
Source: www.gvm.net.au
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Source: www.pwc.com.au
on
responses to
and
reporting
on
78
strategic decision-making.
and aligned to the nature and level of risk that stakeholders in the
organization are willing to take.
Each one of the risk is interrelated to the other. It has been observed that
one type of risk can transfer itself into some other type, if not managed
properly thereby causing losses to the bank. For example, it has been
generally observed that when interest rate go up in the economy, the credit
risk also increases as increase in the interest rates on loan increases the
burden of the borrower to pay. Similarly, the market risk and liquidity risk are
highly interrelated. It has been witnessed that when the markets crash, the
liquidity of the traded securities in the market dries up drastically. The recent
example in the Indian market highlighting the interrelationship between
79
Source: www.amicuscompliance.co.uk
80
centralized
fund
management
systems,
public
debt
office
negotiated dealing system etc. measures which can mitigate credit risk
include analysis of industry data, software-based preventive monitoring
system for borrower accounts, straight through processing, implementation
of know your customer guidelines of RBI etc.
Product/Services risk can be controlled by proper customer relationship
management, implementing data warehousing and data mining, proper
market analysis, emphasis on proper deployment of delivery channels.
Technology has a major role in deployment of product and services.
81
Source: www.apec.org.au
Total equity (including subordinated notes) was 3,382 mill. Total assets of
113,503 mill comprised 96,659 mill of advances, of which around 50,000
mill were securitized (although included on the consolidated balance sheet
due to residual exposure) and the rest either funded directly on balance sheet
or by way of covered bonds. 1 Early in 2007, Northern Rock received
approval from the FSA to use the internal ratings based approach for
calculation of capital adequacy requirements.
In August 2007, interbank loan interest rates and wholesale market rates
increased substantially.
82
It should be recognized that the key dependency for Northern Rock was not
its use of wholesale funding per se. In terms of its net short term wholesale
funding to balance sheet asset ratio it was not a significant outlier in relation
to other UK banks. Rather, its key dependency was its use of securitization;
its securitization product was a simple one, based on high quality assets. The
market disruption did not affect Northern Rock's existing securitizations, but
the market for new securitizations had largely closed. Neither did the market
disruption lead to a cessation of Northern Rock's wholesale funding, but
rather to a shortening of its duration and an increase in its price. The
combination of these factors led the Northern Rock Board to seek assurance
that contingency funding from the Bank of England would be available. The
large retail outflows in mid-September led to a significant and sudden
deterioration in Northern Rock's liquidity and required it to draw on the Bank
of England facility. So it is clear that a combination of circumstances led to
the position which Northern Rock is now in, rather than any single event.
http://www.fsa.gov.uk/pubs/other/tsc.pdf 5 Oct, 2007.
Options identified for dealing with Northern Rocks funding difficulties
included (a) Northern Rocks own dealings in short term money markets (b)
arranging takeover by a larger player (c) accessing liquidity support facilities
from the government.
Source: m.ft-static.com
83
Source: im.ft-static.com
Retail depositors ran on the bank on Sept 14, 2007. The UK authorities had
announced a liquidity support package, but not assured depositors that their
funds were safe, relying on a deposit insurance scheme which fully
guaranteed GBP 2,000 plus 90% of the next 33,000 of deposits. The Tripartite
(Treasury, Bank of England, FSA) statement said The FSA judges that
Northern Rock is solvent, exceeds its regulatory capital requirement and has
a good quality loan book. On September 17, the UK government announced
a complete guarantee of deposits in Northern Rock.
The CEO of the FSA commented in October that In terms of the probability of
this organization getting into difficulty, we had it as a low probability.
84
The extent of the market disruption that occurred in the crisis period
From the start of our review period to June 2006, Northern Rock was
overview of the firms strategy and business, its principal activities, capital
85
team]. Comparison would have shown Northern Rock, relative to its peers, as
having a high public target for asset growth (15-25% year-on-year) and for
profit growth; a low net interest margin; a low cost; income ratio; and
relatively high reliance on wholesale funding and securitization.
risk
appetite;
that
its
access
to
funding,
particularly
through
86
The Panel process resulted in a number of the key risks among them
the viability of the firms strategy, including its need to maintain its access to
funding, particularly through securitization being drawn out for the
supervisory team to pursue;
line with Northern Rocks increasing business risk profile and control
framework;
of escalation of the risks which emerged during the supervisory period meant
that there was no trigger to re-assess the level of supervisory resource nor to
increase FSA management scrutiny;
event of a crisis like that experienced in August 2007, general market liquidity
provided by the Bank of England would be increased and, in extremis,
liquidity would be provided for systemically important institutions.
88
Source: anticap.files.wordpress.com
89
90
Source: media.cagle.com
91
Source: s.wsj.net
In the days following the largest bankruptcy filing in United States history, the
American market experienced a shock unlike any it had felt since the Great
Depression. When the domestic stock market opened on Sept. 15, the Dow
Jones dropped 504 points. The following day, Barclays agreed to buy Lehman
Brothers United States capital markets division for the bargain price of $1.75
billion. Meanwhile, insurance giant AIG was on the verge of total collapse,
forcing the federal government to step in with a financial bailout package that
ultimately cost $182 billion (3). On Sept. 16, the Primary Fund announced that
due to its Lehman Brothers exposure, its price had plummeted to less than $1
per share. The ripple effect of Lehman Brothers failure was widespread,
giving rise to a confidence crisis in global banks and hedge funds. Credit
92
Source: www.telegraph.co.uk
93
2.
The second ethical lapse, which was perhaps the most premeditated
3.
Finally, Ernst & Young, the only third party privy to the happenings at
96
Source: asset.tovima.gr
Source: resources1.news.com.au
97
various
risks.
Risk
Management
Committee,
Credit
Policy
98
BOOKS REFERRED
RISK MANAGEMENT S.B. VERMA
MAGAZINES
INSTITUTE AND FACULTY OF ACTUARIES,UK
NEWSPAPERS
ECONOMICS TIMES
FINANCIAL TIMES
99
http://www.communitybankeruniversity.com/CBU/managing-
commercial-credit-risk
http://web.worldbank.org/external/default/main?theSitePK=3985219&p
iPK=64143448&pagePK=64143534&menuPK=64143504&contentMDK=20191
686
https://technet.microsoft.com/en-us/library/cc535304.aspx
http://www.investopedia.com/terms/t/transferofrisk.asp
http://www.garp.org/media/1106495/reputationalriskmanagement_raul
manjarin_112712.pdf
http://christelfouche.com/ewrm-explained/
http://www.pwc.com.au/consulting/risk-
controls/management/enterprise-wide-risk-mgt.htm
http://lexicon.ft.com/Term?term=risk-management
http://www.investinganswers.com/financial-
dictionary/optionsderivatives/interest-rate-swap-2252
http://stcipd.com/interestrate1.aspx
http://sevenpillarsinstitute.org/case-studies/the-dearth-of-ethics-and-
the-death-of-lehman-brothers
https://www.imf.org/external/np/fin/data/rms_mth.aspx?SelectDate=20
15-09-30&reportType=REP
100