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Risk Management Systems in Banks Genesis, Significance and Implementation

ANUPAMA K JAYA NAIR ANUPAMA S MANJU JAYSHREE

CONTENTS
What is Risk? Classification of Risk Objectives of Risk Management Tools for Managing Risk Risk Management in PNB

The potential loss an asset or a portfolio is likely to suffer due to a variety of reasons.

Survival of the organization Efficiency in Operations Uninterrupted Operations Identifying and achieving acceptable level of risk Earning Stability Continued and sustained Growth

RISKS
FINANCIAL RISK NON FINANCIAL RISK
OPERATING RISK

CREDIT RISK

MARKET RISK

SYSTEMATIC RISK POLITICAL RISK

TRANSACTION RISK

INTEREST RATE RISK

HUMAN RISK
PORTFOLIO RISK LIQUIDITY RISK

TECHNOLOGY RISK
FOREX RISK

CREDIT RISK
Risk that the counterparty will fail to perform or meet the obligation on the agreed terms .

TYPES OF CREDIT RISKS


Transaction Risk
Risk relating to specific trade transactions, sectors or groups.

Portfolio Risk
Risk arising from lending to sectors non related to the core competencies of the Bank / concentrated credits to a particular sector / lending to a few big borrowers.

MARKET RISK
Market risk is the risk to a banks financial condition that could result from adverse movements in market price.

TYPES OF MARKET RISK Interest Rate Risk


Risk felt, when changes in the interest rate structure put pressure on the net interest margin of the Bank.

Liquidity Risk
Risk arising due to the potential for liabilities to drain from the Bank at a faster rate than assets.

TYPES OF MARKET RISK (continued)


FOREX RISK
This risk can be classified into three types.

Transaction Risk is observed when movements in price of a currency upwards or downwards, result in a loss on a particular transaction. Translation Risk arises due to adverse exchange rate movements and change in the level of investments and borrowings in foreign currency. Country Risk. The buyers are unable to meet the commitment due to restrictions imposed on transfer of funds by the foreign govt. or regulators. When the transactions are with the foreign govt. the risk is called as Sovereign Risk.

NON-FINANCIAL RISKS
Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc. Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to threaten the financial stability of the financial system as a whole. Political Risk arises due to introduction of Service tax or increase in income tax, freezing the assets of the bank by the legal authority etc. Human Risk Labour unrest, lack of motivation, inadequate skills, problems faced by the bank after implementation of VRS lead to Human Risk. Technology Risk Obsolescence, mismatches, breakdowns, adoption of latest technology by competitors, etc, come under technology risk

MANAGEMENT OF CREDIT RISK


Measurement through Credit Rating / scoring Quantification through estimate of expected loan losses Pricing on a scientific basis Controlling through Effective loan review mechanism and portfolio management

TOOLS OF CREDIT RISK MANAGEMENT


EXPOSURE CEILINGS :Setting
of prudential norms related to the Banks exposure to a single borrower / group borrowers / sectorial borrowers

REVIEW / RENEWAL :

This involves multi-tier credit approving authority, constitution wise delegation of powers, higher delegated powers for better rated borrowers, discriminatory time for credit review / renewal, hurdle rates / benchmarks for fresh exposures & periodicity for renewal based on risk rating.

COMPREHENSIVE RISK RATING MODELS


RISK BASED SCIENTIFIC PRICING: Linking loan pricing
to expected loss

PORTFOLIO MANAGEMENT :

Stipulate quantitative ceiling on specific rating categories, distribution of borrowers in various industries / business groups , rapid portfolio reviews, on-going system for identification of credit weaknesses well in advance, initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision making process.

TOOLS OF CREDIT RISK MANAGEMENT


LOAN REVIEW MECHANISM : This should be done independent of credit operations & administration and cover all the loans above certain cut-off limit ensuring that at least 30 40% of the portfolio is subjected to LRM in a year.

RISK MANAGEMENT IN PNB


New Capital Adequacy Framework:
Bank has migrated to New Capital Adequacy Framework, popularly known as BASEL II w.e.f. from March 2008. The approaches prescribed by the 'Regulator', namely Standardised Approach under Credit Risk and Basic Indicator Approach under Operational Risk have been implemented.The Bank had adopted Standard Duration Approach for Market Risk, since March 2006.

RISK MANAGEMENT IN PNB(contd)


Bank has already placed credit risk rating models on central server based system PNB TRAC, which provides a scientific method for assessing credit risk rating of a client. The Bank has developed and placed on central server score based rating model PNB SCORE in respect of retail loans and traders up to total limits of Rs 50 lacs. Accept/Reject decisions are also based on the score obtained. Scoring models for remaining sectors like SME segments have been developed and are under testing stage.

Bank is also developing framework for estimating LGD (Loss Given Default) and EAD ( Exposure at Default) and also framework for identifying concentration risk. A data warehouse is being established for effective data management and use of application tools for quantification of risks. For the Market risk bank has a Mid-Office with separate desks for Treasury & Asset Liability Management (ALM). Asset Liability Management Committee (ALCO) is primarily responsible for establishing the market Risk Management, asset liability management of the bank, implementing the risk management of the bank. The policies for hedging and mitigating risk are discussed in ALCO.

A separate independent Division known as Credit Audit & Review Division has been formed to ensure LRM implementation. LRM examines compliance with extant sanction and postsanction process/procedures laid down by the Bank from time to time. Preventive Monitoring System (PMS): It is a tool used by bank for detection of early warning signals with a view to prevent/minimize the loan losses.

Liquidity Risk of bank is assessed through gap analysis for maturity mismatch based on residual maturity in different time buckets & management of same is done through prudential limits fixed thereon. Bank is also monitoring the liquidity through various stock options. The Bank is proactively using duration gap and interest rate forecasting to minimize impact of interest rate changes. Advance techniques such as Stress testing, simulation, sensitivity analysis etc, are conducted at regular intervals to draw contingency funding plan under different liquidity scenarios.

CONCLUSION
In the Banking industry where risk is the norm , rather than the exception, we have to adopt many measures like reducing exposure in high risk areas, emphasising more on the promising industries, optimising the return by striking a balance between the risk and the return on the assets. Our motto should be effective management of risks towards ensuring quality credit portfolio.

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